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August 9, 2012
FATCA -- a Report From the Front Lines

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by J. Richard Harvey

J. Richard (Dick) Harvey Jr. is the distinguished professor of practice at the Villanova University School of Law and Graduate Tax Program. He served as senior adviser to IRS Commissioner Douglas Shulman and was involved in the development of the Foreign Account Tax Compliance Act and the IRS's response to offshore accounts. Harvey also served in Treasury's Office of Tax Policy during the drafting and implementation of the Tax Reform Act of 1986. He is a retired managing tax partner at a Big Four accounting firm, where he was the leader of the U.S. banking and capital markets tax practice.

In this article, Harvey reports on two recent FATCA debates in Switzerland, where he explained what led to FATCA and defended its enactment. This article summarizes FATCA issues discussed during the debates, including: (1) whether Swiss sovereignty has been violated; (2) whether FATCA generates enough revenue to justify its existence; (3) whether Swiss financial institutions have considered the impact of a multilateral FATCA regime on their business model; and (4) how to address the extensive termination of U.S. accounts by Swiss financial institutions.

Harvey also briefly discusses the need for a multilateral FATCA regime that involves many major countries, and includes globally acceptable customer due diligence procedures. Harvey suggests that Treasury and the IRS may want to increase coordination with Treasury's anti-money-laundering/terrorist financing arm. Detailed customer due diligence may be easier to justify if it is being done for both tax and anti-terrorist or anti-money-laundering reasons.

Harvey can be reached at rharvey@law.villanova.edu. All views expressed are solely his.


Copyright 2012 J. Richard Harvey Jr.
All right reserved.

J. Richard Harvey, Jr. On June 26 and 27th, two debates on the Foreign Account Tax Compliance Act were held in Zurich and Geneva. The debates were sponsored by the Swiss CFA Society.1 Because I was tasked with explaining the background of FATCA, and implicitly its virtues, a friend suggested that a food tester may be needed. Fortunately, I survived the debates with no known health issues,2 but it is safe to say I was the least popular person in the room during those debates.

As one of the architects of FATCA, it was helpful for me to hear how those on the front lines view FATCA's impact. Participants included financial institutions (FIs), investment and tax advisers, and U.S. citizens living abroad. This article describes several topics discussed during the debates, including:

  • Does FATCA violate the sovereignty of Switzerland?
  • Is FATCA justified from a cost-benefit perspective?
  • Is FATCA reporting unique?
  • Have Swiss FIs considered the impact of a multilateral FATCA regime on their business model?
  • What should be done to address Swiss FIs unilaterally closing the accounts of many U.S. citizens (and in some cases, demanding that mortgage liabilities be immediately repaid)?

The final section of this article discusses actions Treasury and the IRS could consider in their continuing efforts to implement FATCA.

Does FATCA Violate Swiss Sovereignty?

One of the consistent themes during the two debates, as well as during private conversations, was that the United States is way out of line in attempting to implement FATCA and that the new regime violates Swiss sovereignty. In responding to that criticism, my first point was that Switzerland has the sovereign right to adopt favorable tax and bank secrecy rules. If Switzerland wants to base its banking system on attracting tax evaders from around the world, such a decision is well within Switzerland's sovereign rights.

After making that statement, one could sense excitement in the audience. That quickly evaporated when I argued the United States also has the sovereign right to protect its tax base by implementing a FATCA regime, and that if a Swiss FI does not want to be part of the regime, it is free to either avoid the U.S. financial system or incur a 30 percent withholding tax. Said differently, if tax haven and bank secrecy jurisdictions want to build their banking system to cater to tax evaders, the United States and other countries should not be prevented from taking counteractions.

Once there was agreement that Switzerland had the sovereign right to operate as a bank secrecy/tax haven jurisdiction, there did not seem to be much pushback on the view that the United States has the sovereign right to attempt to protect its tax base. The discussion then turned to whether the cost of implementing FATCA is justified from a cost-benefit perspective.

Does FATCA's Benefit Justify Its Cost?

This question was raised during both debates in reference to the Joint Committee of Taxation's projection that FATCA will raise only $8.7 billion over 10 years.3 The inference was that $8.7 billion over 10 years is not that much money and that the cost of implementing FATCA may exceed that amount.

I admitted the cost will be significant, but doubted it would come close to $8.7 billion. In response to the $8.7 billion revenue estimate, several points were made:

  • Revenue estimates are inherently very difficult and require many assumptions.
  • The JCT historically is very cautious about estimating additional revenue to be gained from increased information reporting.
  • FATCA's real benefit is protecting the U.S. tax base over the long term, as opposed to collecting the tax owed on assets already overseas. That is especially the case in a world where offshore financial accounts can be easily established on the Internet. It is not clear how much of this potential future behavioral response the JCT factored into its revenue estimate.

As a result of those points, my view is that the $8.7 billion revenue estimate is substantially understated. During drafting of FATCA, I did a "back of the envelope" calculation indicating that FATCA should raise approximately $30 billion to $50 billion over 10 years. Like any revenue estimate, it was judgmental.

No one will ever know the amount of tax revenue that FATCA will raise, or the cost of implementation. It comes down to a judgment call as to how concerned one is about the possibility of future offshore tax evasion. Given events over the past four years have demonstrated widespread offshore tax evasion, the benefits from FATCA should substantially outweigh its costs.

Is FATCA Reporting Unique?

During several private discussions in Switzerland, there seemed to be general disbelief that the United States was going to require Swiss FIs to report information to the IRS. There seemed to be very little understanding of the current Qualified Intermediary (QI) regime that already requires FIs to report information on U.S. persons holding U.S.-source assets. From a reporting perspective, FATCA is effectively just extending the existing QI reporting rules to foreign-source assets.

After further discussion, it became obvious that most Swiss QIs were not doing any reporting on U.S. persons. It was not clear why there was no reporting, but plausible explanations could be that U.S. customers are only holding non-U.S. assets, U.S. customers established shell entities to hold U.S.-source assets, or U.S. customers were not identifying themselves (that is, they had so-called undeclared accounts). It is also possible some FIs decided to simply ignore the QI reporting obligation.

Regardless, if the conclusions can be considered representative of other Swiss FIs, they do help explain why many Swiss FIs may be terminating customer relationships with U.S. persons. If a Swiss FI has never done any information reporting to the United States, the thought of initiating that reporting may be overwhelming. Alternatively, if an FI had previously reported to the United States as part of the QI regime, FATCA reporting may not be as daunting.

FATCA Impact on Business Models

Given that FATCA is a U.S. law, most of the hostility in the audience seemed aimed at the United States. More importantly, the primary strategy for coping with FATCA seemed to focus on eliminating U.S. accounts. However, it was not clear how many Swiss FIs had really focused on the ultimate endgame: some sort of multilateral FATCA regime.4

If FATCA reporting is ultimately only going to be applicable to U.S. persons, terminating investment accounts with U.S. customers may make some sense. However, if some version of FATCA is ultimately adopted by several major countries, terminating investment accounts with customers in all of those countries could result in a substantially reduced customer base. For private banks and asset managers that cater primarily to those attempting to evade taxes, a multilateral FATCA regime strikes at the heart of their business models. Those FIs will either need to adapt or perish under a multilateral FATCA regime.

During the debates, I urged Swiss FIs to think about the future effect of multilateral discussions taking place among the United States and many other countries. One has to presume the endgame is some sort of multilateral FATCA regime.5 If so, Swiss FIs may want to reevaluate their current strategy.

Accounts of U.S. Citizens Being Closed

During the development of FATCA it was expected that some non-U.S. FIs would close the investment accounts of U.S. citizens. That is one of the reasons that deposit accounts of up to $50,000 are exempt from reporting under FATCA. However, it was anticipated that other FIs would see a business opportunity to provide accounts for U.S. customers; a belief supported by informal discussions with selected FIs.

After attending the debates and speaking with U.S. citizens living in Switzerland, Swiss FIs, and various Swiss investment advisers, reality may be somewhat different than expected. Specifically, it appears that substantially all Swiss FIs are refusing to do business with U.S. customers. In addition to refusing to open new accounts for U.S. citizens, Swiss FIs are terminating existing accounts.6 It should be noted there are a handful of Swiss FIs providing checking and savings accounts, but if a U.S. citizen wants to invest in a securities account, he likely will need at least $1 million to invest -- and in many cases, $5 million.

Although the lack of access to investment accounts is clearly a problem, a big surprise is that many U.S. citizens are reporting that Swiss FIs are demanding they pay the balance of existing mortgage obligations. The purported reason being given is that the Swiss FIs need to terminate the mortgages to avoid reporting under FATCA. To the extent U.S. citizens can find alternative financing, it usually is at a substantially higher rate. Leaving aside whether it is legal under Swiss law for a Swiss bank to unilaterally terminate a mortgage,7 a mortgage account should not be a financial account for purposes of FATCA.8 The existence of a mortgage should not itself create an additional reporting burden under FATCA or cause a Swiss FI to lose deemed-compliant status.

Thus, my question is: Why are some Swiss FIs terminating the mortgages of U.S. citizens?9 There are several possibilities. The most benign is that the Swiss FIs and their advisers do not understand that FATCA reporting applies only to investment accounts; it does not apply to a liability owed by a U.S. person to a Swiss FI. If that is the case, my hope is that Swiss FIs can be educated quickly about any misunderstanding.

A more technical explanation might be that a mortgage escrow account often could be linked to a mortgage account. It is therefore possible that Swiss FIs are worried that those escrow accounts may not qualify for the $50,000 depository account exception in section 1471(d)(1)(B). An escrow account may not qualify because some may not view it as a depository account. Alternatively, it is possible the escrow account could be greater than $50,000.

If those are the real concerns, Treasury and the IRS should consider revising the FATCA regulations to make clear that an escrow account will qualify as a depository account for purposes of the $50,000 exception. Also, if escrow accounts routinely exceed $50,000, Treasury and the IRS should consider using their authority under section 1471(d)(2) to potentially exclude a mortgage escrow account from the definition of a financial account.

A more Machiavellian explanation might be that Swiss FIs are purposely terminating mortgages of U.S. citizens to make their lives difficult as a way of punishing the United States, or more likely, in an effort to get U.S. citizens to advocate the repeal of FATCA. If it is the latter, the strategy might be working: U.S. citizens living in Switzerland are very hostile toward FATCA and are advocating its repeal (several attended the debates).

Assuming the information is correct, one can understand why some U.S. citizens are upset with the practical consequences of FATCA. At best, it is inconvenient to switch deposit and investment accounts from one FI to another. It becomes a much more serious problem when FIs are demanding payment of existing mortgages and there are few, if any, investment alternatives.

From a policy perspective, the question is: What should be done about the problems facing U.S. citizens abroad? Although there may be other alternatives,10 perhaps there should be government-to-government discussions on the topic. Given the United States and Switzerland announced on June 21 that they are discussing ways to implement FATCA,11 an additional item could be added to the agenda. For example, it may be possible for the Swiss government to encourage several Swiss FIs to offer security accounts to U.S. persons on reasonable business terms.

If government-to-government discussions are not the answer, an alternative might be to better educate Swiss and foreign FIs by making it clear that terminating mortgages provides no benefit under FATCA, and that if other countries adopt FATCA, it may no longer make sense to discriminate against U.S. customers.

As mentioned, it is unclear whether Swiss FIs have really considered the possibility that other countries might adopt FATCA-type disclosure regimes (that is, a multilateral FATCA approach). If similar regimes are adopted by other countries, a much higher percentage of Swiss FIs' customer bases may be affected; therefore, terminating customer relationships will not be a viable long-term strategy.

Final Thoughts

After spending several days in discussions with those on FATCA's front lines, I am more aware of how Swiss FIs are implementing FATCA and the resulting practical problems faced by U.S. citizens. Nevertheless, the United States needs to continue aggressively pursuing FATCA, especially in the multilateral context. Obtaining significant progress toward a multilateral FATCA regime could provide many benefits:

  • reducing discrimination against U.S. citizens living abroad;
  • providing relatively standard customer due diligence procedures;
  • reducing the number of investment options available to U.S. persons attempting to hide money overseas; and
  • eliminating the complex passthrough payment rules.

The development of relatively standard customer due diligence procedures is crucial to the success of a multilateral FATCA regime. Although reporting of customer information is not without its complications, performing adequate customer due diligence to determine the true beneficial owner of an account seems to be significantly more challenging, especially for accounts held by legal entities. As a result, Treasury and the IRS should vigorously pursue agreement with other major countries as to the proper customer due diligence procedures. In pursuing that goal, the tax arms of government should consider further joining forces with the anti-terrorist-financing/money laundering arms of government.

The goals of each arm of government are similar,12 and it may be easier politically to justify detailed customer due diligence if it is being done for a joint purpose (that is, both tax reasons and anti-terrorist-financing/money-laundering reasons).

Whatever is ultimately agreed, it is imperative that governments have appropriate audit and enforcement mechanisms in place. Recent scandals in the financial world have highlighted the possibility that some employees or FIs may be willing to ignore the law for financial gain.13

In summary, the U.S. government has made significant progress toward addressing the use of offshore accounts to evade U.S. tax, but the war is not yet won. Much work still needs to be done. In addition to implementing FATCA in the United States, Treasury and the IRS should be pursuing an agreement among major countries as to the proper level of customer due diligence, and, ultimately, a multilateral FATCA regime involving several major countries. A multilateral approach will provide many benefits.


FOOTNOTES

1 An organization with more than 2,000 chartered financial analysts in Switzerland.

2 However, the cost of food in Switzerland is enough to cause serious financial issues.

3 See JCT, "JCT Estimates Budget Effect of HIRE Act," JCX-5-10 (Feb. 23, 2010), Doc 2010-3977, 2010 TNT 36-20.

4 This could be a series of similar bilateral agreements or a true multilateral agreement.

5 A multilateral regime could take many forms and would be flexible enough to incorporate different reporting regimes, and possibly a whithholding regime. However, any withholding regime needs to address new money. See section 3.1.3 of J. Richard Harvey Jr., "FATCA and Schedule UTP: Are These Unilateral US Actions Doomed Unless Adopted by Other Countries?" available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2029963.

6 In various countries, FIs have insisted they did not have the ability to close existing customer accounts. Apparently that is not an issue in Switzerland.

7 One presumes it must be legal or otherwise the Swiss FIs would not be able to do it. Nevertheless, it seems somewhat unusual that an FI could demand immediate payment of a mortgage loan because of a FATCA reporting obligation.

8 Financial accounts are defined in section 1471(d)(2) as investment accounts (i.e., depository and custodial accounts, and equity/debt instruments in the FI).

9 Since I have yet to hear an explanation that makes sense, I am left to speculate.

10 Some, such as the group American Citizens Abroad, argue that FATCA should be repealed. Although I believe American citizens residing abroad have a legitimate concern, it does not justify throwing the baby out with the bath water -- FATCA should not be repealed. At most, it could be delayed while governments work out a multilateral system that would require reporting for customers of many different countries.

11 See http://www.news.admin.ch/message/index.html?lang=en&msg-id=45046.

12 Both want FIs to determine the true owner of an account.

13 For example, HSBC PLC has admitted to avoiding anti-money-laundering procedures, Barclays PLC has admitted to manipulating LIBOR, UBS has admitted to committing tax evasion and violating U.S. securities law, and MF Global and Peregrine Financial Group have not properly segregated customer accounts, and the list goes on.


END OF FOOTNOTES


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