"If you have ten thousand regulations you destroy all respect for the law." ~ Winston Churchill
Until a few weeks ago, I was living under the assumption that by now everyone knew about the Foreign Account Tax Compliance Act (FATCA) and had a broad understanding of its implications. I realized, though, that I was wrong. FATCA is generally understood by non-US financial institutions; they are directly impacted by the rules and are trying to cope with its enormous administrative and legal requirements. But private investors are frequently not even aware of the regulatory monster preparing to invade.
For some investors, FATCA may have little to no implications. Clearly, it is primarily Americans who live or invest abroad, i.e. outside of US borders, who may be impacted. In our opinion, the most severe implications exist not for individual investors, but for non-US banks and financial institutions, or "Foreign Financial Institutions" (FFIs), as defined in the respective FATCA provisions.
However, to simply assume that non-American investors will not be impacted, or that private investors in general do not need to be concerned about FATCA, is false and could turn out to be a costly mistake. Although this topic is important for ANY investor worldwide, the subject matter is not being given the attention it deserves.
My goal in this article is to summarize FATCA in as straightforward and concise language as possible, in order to then highlight (1) some of the risks that FATCA bears for any international investor, and (2) how you might minimize exposure to these risks.
What is FATCA?
The US government intends to combat tax evasion in the United States more intensively. As such, the Foreign Account Tax Compliance Act (FATCA) was enacted into law on March 18th, 2010. It set out to impose a 30% withholding tax on US source income unless the respective foreign financial institution (FFI) entered into an agreement with the IRS and report its US customers.
Highlights of the agreement with the IRS
The rules represent an unprecedented challenge for the global financial services industry, as the additional efforts in compliance and impact on daily operations will be considerable. According to FATCA guidance, existing client relationships must all be identified, documented and classified.
What is striking is the intentional incongruity existing between the payments collected, on the one hand, and the FFI's registration obligations, on the other. In addition to the name of the accountholder and the US Social Security number, the registration requirements include an account summary and gross realized revenues, withdrawals made by the account holder, and a reporting of the highest month-end balance of the previous 12 months.
Under this regime, the FFI must agree to:
The following summary graph, courtesy of KPMG, depicts the principle mechanisms. A few points are worth noting here. Generally, the U.S. withholding agents are large American commercial banks. This is an interesting business for them for manifold reasons. FFIs that have signed an agreement with the IRS (so-called Participating FFIs or PFFIs) will be required to withhold directly when dealing with 'recalcitrant account holders' (of any nationality!!) or FFIs without an agreement (i.e., non-participating FFIs).
Source: KPMG Luxembourg, www.kpmg.lu
In situations where the accountholder is merely a US individual, the FFI's task of identifying and reporting an accountholder is relatively straightforward. However, in many cases, FFIs will be dealing with cases that are quite different and convoluted.
In cases where the institution is dealing with a recalcitrant account holder (US or non-US!), the situation could be more complicated. For instance, in countries with strict client confidentiality rules, the FFI is in a conundrum − do they comply with US rules or with their own, local rules? Banks can generally close accounts unilaterally, but life insurance companies are normally not able to merely send their clients away. Or what happens if a client is simply not responding for other reasons? FFIs would be obliged to withhold on such accounts as well, even if the account holder is a non-US account holder. A number of legal and procedural complications may follow with FFIs making this determination.
And what about foreign entities? FFIs are required to identify the beneficial owners 'behind' foreign entities, corporations, trusts, mutual funds, etc. This would not be a simple task. This would be a process that can generally not be automated. On the contrary, the structural and legal nature of many legal entities will require the investigative brains of highly qualified compliance and legal staff. It is clear already that in many cases errors could and would occur.
General Impact of FATCA
You get the picture… FATCA is an administrative nightmare. The roughly US$ 850 million that this law is being estimated to generate in US tax revenues doesn't compare to the enormous implementation costs, not to mention the resulting operating costs, of those institutions that will be impacted. A provisional and very rough estimate shows average introduction costs of approximately US$ 5-10 million per FFI, which if introduced by all FFIs results in global costs of US$ 1-2 trillion! This represents approximately the yearly gross domestic product of Brazil or India.
One dares to wonder whether increased tax revenues are truly the purpose here. As initially designed, a domestic-focused law intended to improve tax transparency, FATCA has become a monster causing havoc on the world economy, through which all participants will lose … Americans and non-Americans.
Some describe FATCA as the "neutron bomb of the global economic system." The financial institutions may pass along these enormous costs to the clients by way of higher fees, and due to reduced profits of financial businesses, countries will have to take considerable tax revenue losses into account. Additionally, financial and direct investments in the US will decrease, possibly in considerable amounts, to the detriment of employment and tax revenue in the USA.
Impact on American Investors
Some American investors that I have met are greatly concerned about FATCA and I share some of that concern. However, I must also let you know that, in my view, the biggest costs of FATCA will be borne by the financial services industry and the international investment community in aggregate.
American investors should not be impacted substantially at an individual level as long as they comply with the US reporting rules, namely completing the FBAR (TDF 90-22.1) and the "Shadow FBAR" (IRS/TDF 8938).
Of course, FATCA will, and already has started to, negatively affect American citizens living or investing overseas by limiting access to banking facilities abroad. Because the cost of reporting information to the IRS is so high and the process so cumbersome, many foreign institutions are no longer providing banking services to Americans. These institutions are closing current accounts or refusing to open new accounts, including simple accounts used on a day-to-day basis. However, via the right contacts and advisory relationships, there are still a good number of first-class institutions Americans can work with.
(To read more about negative impacts on Americans and other consequences, please see the letter by ACA to the Treasury).
Risks to all international investors, including non-Americans
As noted earlier, I consider FATCA an administrative monster and yet another regulatory redundancy created by over-zealous politicians and dim-witted government bureaucrats. It will result in enormous costs and an economic drag at the aggregate level. As such, it should be fought together with all the other nonsense regulations coming out of the various increasingly socialistic and increasingly bankrupt governments.
For anyone investing directly or indirectly in American assets and securities, at the individual level, I consider the complexity of this law the greatest risk. The FFIs forced into signing up with the IRS will be dealing with a highly convoluted set of rules and guidelines. The system is prone to error. Even those who created FATCA probably haven't read all of the legislation.
Mistakes will happen for sure. Accountholders will be "recalcitrant" without knowing it. All investors − Americans and non-Americans − will be required to complete all kinds of forms and inquiries, and withholding will end up being applied erroneously to accounts. And, the respective FFIs and/or accountholders will have to deal with the arduous task of somehow obtaining redemptions from the IRS. Interest on such erroneous withholding, by the way, will not be paid, and thus the IRS might not be in any hurry.
What you can do
Since it is clear that administrative and procedural errors will be made, you will want to minimize exposure to the respective risks. With that in mind, you might consider the following strategies and steps:
• With any offshore investing, avoid US investments and securities. Under such circumstances, you might be able to work with FFIs that will not fall under the FATCA requirements based on their being 'deemed compliant,' 'exempt' or based on the country-level agreements that are currently still being developed.
• If you want to invest in US securities or other investments that may lead to "US source income," then ensure that (1) the financial institution you work with is a PFFI, (2) the investment advisor/asset manager you work with understands the FATCA rules and thus knows what kinds of investments (e.g., mutual funds) to invest in, and (3) if you don't own the account individually, ensure that whichever structure you are using is set up and administered adequately.
• Consider investments overseas that will not be affected by FATCA. There are a number of investment strategies that work outside of the typical structure. For instance, one should consider non-banking solutions for international gold storage. Also, a number of international life insurance companies offer PPLI policies (a variety of DVAs and VULs) that are not subject to FATCA rules.
In conclusion, a variety of risk management steps can and should be taken. The rules of FATCA will start coming into effect in July of 2013. By then, I strongly recommend you get proper advice on what your options are and what safeguards you might be able to install.
In any case, you should not underestimate or even ignore the potential implications of FATCA. However, you also don't need to sweat over it; there are strategies available for both American as well as non-American investors. For Americans, no matter which strategy you choose, ultimately you are well advised to "check the box" and declare your foreign assets as required.