US crackdown on tax evasion: What FATCA means for mid-tier banks

September 10, 2014

While FATCA is a US law it has a global reach, and it requires financial institutions worldwide to disclose information to the Internal Revenue Service (IRS) if they do business with US clients. The intent behind FATCA is to prohibit US taxpayers from hiding their income and assets overseas.

Unless financial institutions enter into agreements with the IRS and report their US customers, FATCA will impose a 30 percent withholding tax on any payment (including interest, dividends or sales proceeds) on US securities made to a foreign financial institution. Under these agreements, financial institutions are required to:

  • identify US accounts
  • comply with verification and due diligence procedures
  • perform annual reporting
  • deduct and withhold 30 percent from any passthru payment made to a ‘recalcitrant’ account holder or another institution without an agreement; and
  • comply with requests for additional information.

To date, approximately 50 countries have entered into intergovernmental agreements (IGAs) with the IRS. There are two models of IGA. The first, a Model 1 IGA, requires financial institutions to report account information of US taxpayers to their own government, which will in turn exchange information at a government level with the IRS. Model 1 IGAs have been adopted by countries including the UK, France, Italy and Germany. The second model, a Model 2 IGA, requires financial institutions to report relevant account information directly to the IRS. This is supplemented by group requests made by the IRS on an ‘as-needed’ basis for exchange of information on relevant US taxpayers at a government level. Model 2 IGAs have been adopted by countries including Switzerland and Japan.

How will this impact mid-tier financial institutions?

FATCA will have a significant impact on financial institutions – particularly mid-tier financial institutions, for which the costs will be significant. Financial institutions will have to weigh up the costs of implementing new systems and processes to comply with the reporting and identification requirements of FATCA or face the risk of a 30 percent withholding tax being imposed for non-compliance. The FATCA requirements go beyond what information is already gathered by institutions for anti-money laundering and know-your-customer (KYC) requirements, and complying with FACTA will mean an enormous administrative burden for financial institutions.

To decide whether they will remain invested in the US market (for customers’ and for their own accounts), a mid-tier financial institution would first need to conduct a cost-benefit analysis. If they do decide to remain in the US market, due diligence searches will need to be conducted for US indicia over the entire customer base before a decision is made on whether to maintain or withdraw contact with US clients. If proceeding with US clients, affected clients will need to sign a waiver allowing the financial institution to report their sensitive client information to the IRS.

While the IRS has announced that the 2014 and 2015 calendar years will be ‘transition periods’ for the enforcement of FATCA, financial institutions will still have to demonstrate ‘good faith’ efforts to comply with their obligations. Entities that have not made good faith efforts to comply will be subject to full enforcement during the transition period. This provides some comfort to financial institutions in that minor ‘foot-faults’ in meeting obligations will not necessarily be penalised. However, it is important to note that this does not delay FATCA implementation, and financial institutions and other affected participants should proceed with planned FATCA compliance efforts and not rely on the fact that the IRS will not enforce penalties or sanctions for non-compliance.

For smaller institutions, the costs of enhancing their KYC programmes and investing in customer data collection and processing will be onerous. Technology will form part of the solution but will only be effective as long as it is implemented strategically, endorsed from the top and supported by trained personnel once implemented. For a capital expense of this magnitude, shareholders of these institutions will want to see more than just regulatory compliance. The challenge is for mid-tier financial institutions to rely on their customer due diligence to do more than minimise risk, and instead begin to create a competitive advantage.

The information gained from this enhanced customer knowledge can be turned into good business practice by allowing institutions to understand their customers better. Many organisations are beginning to reap the rewards of collecting and analysing customer information through big-data mining by producing tailored customer solutions. A strategic approach to KYC will be challenging for smaller institutions and will require significant investments of time, effort and money. A further challenge will be having the ability to leverage the data collected for FATCA to ensure full compliance across the various other regulatory requirements. However, with improved KYC procedures, increased data collection and advanced analysis of this data, firms can turn these obligations into a competitive advantage.

Mirror FATCAs to come?

Several nations, including China, are expected to create their own versions of FATCA to clamp down on foreign tax evasion. In March, China’s deputy tax commissioner Zhang Zhiyong said that China needed to step up its international tax-collection efforts and take part in the international exchange of information to curb cross-border tax evasion. If, and when, other nations do follow suit and implement a similar law for their citizens, financial institutions will need to be prepared. In a similar vein, the Organisation for Economic Co-operation and Development (OECD) proposed an automatic sharing of tax data between governments earlier this year that looks set to extend the data exchanges included in FATCA to all participating governments.

With the possibility of a wave of copycat legislations, financial institutions need to move away from the traditional ‘project-by-project’ approach to new regulations and towards developing integrated risk and regulatory frameworks to manage compliance obligations in a coordinated and cost-effective way. Comprehensive due diligence conducted on new clients and a robust compliance programme that allows financial institutions to accurately identify client information and keep effective records will ensure compliance with any extra-territorial laws. Carrying out these measures should place financial institutions in good stead to retain clients and not be negatively impacted by the changes.

Financial organisations should set themselves a timeframe for compliance with these new objectives, set targets and align compliance goals with the broader business goals in order to get buy-in and have an effective programme. As with any compliance programme, regular revision of objectives and monitoring achievements are essential components for success.

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In today’s complex regulatory environment, mid-tier financial institutions will need time and ‘buy-in’ from executive employees and the board in order to achieve success from their investment in advanced KYC processes. Appropriate resourcing is unlikely to be allocated unless such institutions have the necessary ‘tone at the top’ on integrity and compliance.

 

 

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