Changes to US Legislation to Curtail Tax Evasion – Impact on Financial Intermediaries

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22 Apr 2009 Changes to US Legislation to Curtail Tax Evasion – Impact on Financial Intermediaries

There is nothing new about politicians spewing hot air about cracking down on tax havens. In fact Senators Carl Levin, Norman Coleman and the then Senator Barack Obama attempted to do more than that when they introduced the ‘Stop Tax Haven Tax Abuse Act’ in 2007, but it was not passed by the United States Congress under the Bush administration. However, that was then and this is now.
 
In the midst of the current financial crisis, the United States and European nations have grown less tolerant of tax havens. The recent offshore tax evasion scandals, most prominently the UBS case, have focused minds and raised public outcry. Gordon Brown’s speech to the United States Congress earlier this year where the prime minister asked: “How much safer would everybody’s savings be if the whole world finally came together to outlaw shadow banking systems and offshore tax havens?” exemplified the new hard-line approach to tax evasion.[1] Given the unprecedented magnitude of the bailout plans and the worsening economic downturn, national treasuries need to shore up their shrinking tax bases more than ever before.[2] An estimated $13 trillion is said to be held in offshore bank accounts.[3] Taxing wealth held in offshore bank accounts could potentially add $255 billion to treasury coffers. Id.
 
These recent developments have amassed the political will to bring about some revisions which Washington plans to implement to the tax code in order to address offshore tax evasion, namely the Stop the Tax Haven Abuse Act and changes to the Qualified Intermediary program.
 

Stop Tax Haven Abuse Act

 
The Stop Tax Haven Abuse Act bill (the ‘Bill’) was recently resurrected and re-introduced to the Senate by Senator Carl Levin on 2 March 2009. The House of Representatives’ version was introduced by Representative Lloyd Doggett on the following day. Given today’s hostile political climate towards tax evasion, it is likely the bill will pass this time. The Bill proposes amendments to the Internal Revenue Code specifically directed at offshore accounts.
 
Some of the proposed amendments most relevant to the business operations of private banks with US clients and hedge funds are: (1) the establishment of legal presumptions against the validity of transactions involving offshore secrecy jurisdictions; (2) the treatment of foreign corporations managed and controlled in the United States as domestic corporations for  income  tax purposes;  (3)  the requirement  that  withholding  agents  and financial institutions to disclose offshore accounts and certain transactions with US clients; and (4) increased penalties and deterrents.
 
Rebuttable Presumptions
 
Among the rebuttable presumptions are:

  • A US taxpayer is presumed to have ‘control’ of an offshore entity if he/she formed, transferred asset to, was a beneficiary of, or received money or property from
  • Funds transferred to or from a US taxpayer to or from an offshore account is presumed
  • Any foreign account controlled by a US taxpayer in an offshore secrecy jurisdiction is presumed to contain at least $10,000, thereby triggering FBAR (Foreign Bank Account Report) filing requirements to the
  • Federal authorities may presume that securities nominally owned by an offshore entity are beneficially owned by any US Person who controls the offshore entity directly or

 
Treat Foreign Corporations Managed in the US as Domestic Corporations
 
The Bill proposes to treat foreign corporations that are either publicly traded or have gross assets of USD 50 million or more and are primarily managed in the United States as domestic for US federal tax purposes. These entities would, consequently, be subjected to entity-level US net income taxation.
 
If most of the executive officers and senior management of a  foreign corporation who exercise day to day responsibility for making strategic decisions of the corporation  are primarily located in the United States, the corporation will be considered “managed and controlled” in the United States. This amendment to the tax code would seriously affect the tax liabilities of investment funds domiciled in offshore jurisdictions, if their fund managers are based in the United States.
 
Additional Reporting and Disclosure Requirements for W ithholding Agents and Financial Institutions
 
The Bill would require any financial institution opening a financial account or creating an entity in an offshore secrecy jurisdiction for a US client to report the transaction to the IRS. Additionally, banks and securities firms that have a US person as the beneficial owner of one of its foreign-owned financial accounts must report the account income of the US person to the IRS. Additional reporting translates to increased cost of doing business for banks and hedge funds.
 
Increased Penalties and Deterrents
 
It is clear the Bill will not be just a paper tiger, as significantly increased penalties for violations are planned. The Bill seeks to expand the use of ‘John Doe’ summonses that are used to obtain information from offshore jurisdictions in tax investigations. The US Department of Treasury could also prohibit US banks from opening accounts for non- compliant foreign financial institutions and prohibit US financial institutions from accepting credit card transactions involving noncompliant foreign banks.
 
An anti-money laundering rule would be imposed for hedge funds, requiring unregistered investment companies to establish anti-money laundering programs and submit suspicious activity reports.  The same will be required of company formation agents.
 
To further deter non-compliance, the Bill seeks to impose a penalty of up to USD 1 million per violation of US securities law on public companies or their officers, directors or major shareholders who knowingly fail to disclose offshore holdings that should have been reported to the Securities and Exchange Commission.
 
Baucus Draft Bill
 
Senate Finance Chairman Max Baucus has also circulated a draft bill to target tax evasion, which has not been publicly released. The bill, although said to be less punitive than the Stop Tax Haven Abuse Act, seeks also to deter tax evasion by doubling fines and penalties for underpayments. Financial institutions transferring more than USD 10,000 to an account outside the United States on behalf of an individual or business other than a publicly traded company, would be required to report such transfer to the IRS. The bill would also allow the IRS to require US taxpayers to submit reports on their foreign financial accounts with their tax returns.
 

Qualified Intermediary Rule Changes

 
The Qualified Intermediary Program was established in 2001 to improve the withholding and reporting of US-source income sent to foreign financial institutions receiving it on behalf of their account holders. Under the program non-US persons could hold US-source investments through a QI without disclosing their identity to US withholding agents. The QI only reports pooled information, or rather a summary, about all their non-US account holders and their eligibility for a reduced withholding tax rate on interest, dividends and royalties on US investments. At the same time the QI reports payments on US investments for each US person.  The QI generally does not withhold any tax from payments to US persons, however if the US person is undocumented (did not submit a Form W-9) they will be presumed to be a tax evader. In such instances the QI must report the payments and perform backup withholding on US investments as well as foreign-source investments held by the US person.
 
Recent events, most notably the UBS tax evasion scandal, have exposed weaknesses in the Qualified Intermediary system. American clients of UBS’ North American Private Banking business unit masqueraded as foreign persons behind sham entities domiciled in offshore jurisdictions in order to avoid paying US taxes on assets held in their offshore accounts. Under the current regulations and Qualified Intermediary Agreement the Qualified Intermediary (‘QI’) is not obligated to look behind corporations to see whether the beneficial owner is American.
 
The Internal Revenue Service (IRS) has proposed amendments to the Qualified Intermediary Program that are primarily directed at unmasking Americans using foreign accounts to hide income from the IRS. The proposed amendments, which were released for comments on 15 October 2008, would: (1) require the QI to notify the IRS whenever it becomes aware of a material failure of internal controls; (2) expand phase 1 of the external audit of the QI to detect US Persons behind foreign-owned accounts; and (3) require the external auditor to associate a US auditor with the audit and require the US auditor to accept joint and several liability for the conduct of the QI audit. Proposed Amendments to Qualified Intermediary Withholding Agreement and to Audit Guidance for External Auditors of Qualified Intermediaries, IRS Announcement 2008-98. The changes will be effective for calendar years after 2009.

 

Notification of Material Failures of Internal Controls
 
The QI has 60 days to notify the IRS of material failures of internal controls. Any employee allegations of a material failure, or investigations by any regulatory authority or material failures must also be reported to the IRS. Reports of material failures will not result in an automatic termination of the QI Agreement, but is rather intended to facilitate cooperation between the IRS and the QI to remedy such failures. The IRS, may still decide to terminate the QI Agreement if they represent a “significant change in circumstances.”
 
Expansion of Phase 1 of the Audit Report
 
There are three phases to the QI external audit. Phase 1 comprises a fact finding stage which is intended to provide the IRS examiner with information on evaluate risk that certain foreign accounts may be controlled by US Persons and material failure of internal controls. Thus, the proposed amendments will add an audit procedure to test certain accounts for characteristics suggesting that a US Person has authority over the account. Such information must be turned over the IRS upon discovery.
 
Additional procedures will also be added for fact finding by the external auditor relating to the risk of material internal controls to ensure that the QI is adequately monitoring the process for material failures. The external auditor will be required to identify QI personnel charged with the oversight of performance under the QI Agreement, identify such persons’ posts of duty, the persons to whom they report and the positions of those persons and the extent of their authority over operational personnel.
 
Audit Oversight by US Auditor
 
Foreign external auditors will be required to associate a US auditor with the audit and the US auditor will be required to accept joint and several liability for the conduct of the audit and must co-sign the report. These changes are intended to ensure that the audit process is reviewed by persons who are accountable and knowledgeable about US withholding rules.
 
At present these proposed changes have not become final. The IRS are taking public comments into consideration before adopting final changes to the QI program. Some tax practitioners have warned that the proposed amendments could limit participation in the
 
Qualified Intermediary program due to the increased reporting requirements, uncertainty and potential liability of program participants.[4]

 

1 Prime Minster Gordon Brown, Address to the United States Congress, at the [     ] Joint Session of Congress (March 4, 2009).

2 At the G20 summit earlier this month world leaders pledged $1.1 trillion to revive the global economy.

World Leaders Pledge $1.1 Trillion to Tackle Crisis, Mark Lander and David E. Sanger, New York Times (April 2, 2009).

3  Nick Mathiason, Obama Bid to Stamp Out Tax Havens, March 4, 2009, Guardian (London), at

Business Sec;

4 Practitioners Urge Caution on Qualified Intermediary Program Changes, Tax Notes Today (April 8,

2009).

 

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