Offshore investment entities in the Cayman Islands and many other international financial centers should now start turning their attention to compliance with the Common Reporting Standard ("CRS") promulgated by GATCA – Global FATCA. They must document all account holders existing on December 31, 2015, with the exception of entities with an account balance or value not exceeding USD250,000. There is no de minimis exception for individual account holders.
By late 2017, tax authorities in over 50 jurisdictions – in addition to the US and UK – will be entitled to information on accounts and certain indirect interests held by any residents in those off shore investment entities. That number nearly doubles one year later. The CRS sets the scene for unprecedented international collaboration on compliance and enforcement of domestic income tax law. Off - shore investment entities should consider making new GATCA disclosures and other arrangements with that end in mind.
This article discusses the preparatory and precautionary steps that reporting financial institutions should take not only to comply with GATCA, but also to safeguard against potential regulatory investigation or enforcement action arising from the tax status of their account holders.
The US Foreign Account Tax Compliance Act ("FATCA") is now gaining considerable momentum since FATCA came fully into effect on January 1, 2015. US withholding agents and non-US investment entities, depositories, custodial institutions and other Participating Foreign Financial Institutions ("PFFIs") and Reporting Financial Institutions ("RFIs") are scrambling to prepare for the first automatic exchange of information ("AEOI"). This will intensify next year when the scope of reportable accounts and information becomes much broader. AEOI will become an avalanche in 2017 when reporting and exchange of information under the OECD's GATCA takes effect. This will represent an unprecedented change in tax authorities' ability to tackle off shore tax evasion. The change in volume of cross border tax information requests will then probably curve up like a hockey stick.
What will the financial services industry look like then? It is inevitable that some account holders, financial institutions and jurisdictions will feel frost bitten and others could find themselves buried deep in an icy drift with little breathing room. How many and where will they be? Are there practical legal precautions that FFIs and their account holders should take now to avoid being "snowed in"?
FATCA's "Carrot And Stick"
FATCA is designed to stop American tax evasion on their foreign accounts by requiring Foreign Financial Institutions ("FFIs") to report on those accounts either directly to the IRS or indirectly via their domestic tax authority. FATCA was introduced in the United States as Chapter 4 of the Internal Revenue Code and US Treasury Regulations. The US Treasury's "carrot-and-stick" approach has proven quite effective in gaining other countries' and FFIs' cooperation on FATCA.
The "carrot" is the US promise of reciprocal exchange of information with those countries with which it enters into a Reciprocal Model 1 Intergovernmental Agreement ("IGA") with the US. There are now 118 jurisdictions in various stages of negotiation or agreement on their IGAs with the US. Most are likely to require reciprocal exchange of information under GATCA if they take a consistent approach with the type of IGAs they have signed with the US regarding FATCA.
The "stick" is 30 percent FATCA withholding tax on any withholdable payments of US source income made to Non-Participating Financial Institutions ("NPFIs") and to "recalcitrant" account holders that do not cooperate with the due diligence requirements. As of March 1, 2015, the IRS had issued 156,276 Global Intermediary Identification Numbers ("GIINs") to FFIs registered on the FATCA FFI Registration System. Registration is required to establish an FFI's commitment to comply with its obligations under the FFI Agreement and FATCA or its jurisdiction's Model 1 IGA and domestic IGA-enabling regulations. The GIIN protects FFIs from being treated as an NPFI and being subject to FATCA withholding tax, reporting, and/or account closure.
GATCA: Same Carrot, Different Stick
GATCA and FATCA offer the same "carrot," reciprocal exchange of information. This is appealing because most countries impose individual income tax and corporate tax on the worldwide income of their residents and companies. The global averages are 31.4 percent and 23.6 percent, respectively. These numbers are quite consistent across Africa, the Americas, Asia, Europe, and Oceania.1 Before addressing GATCA's stick, it is worth considering how GATCA is constituted.
GATCA's foundational document is the Convention on Mutual Administrative Assistance in Tax Matters developed in 1988 by the Organisation for Economic Co-operation and Development and the Council of Europe.2 It is multilateral (a single legal basis for multi-country cooperation), wide in its scope (extensive forms of cooperation on all taxes), flexible (reservation is possible on certain issues), and uniform (the Secretariat, as the coordinating body, ensures consistent application). The Convention is the most comprehensive multilateral instrument available for all forms of tax cooperation on tax evasion and avoidance. It provides for exchange of information on request, automatic exchange of information, spontaneous exchange of information, and simultaneous tax examinations. All G20 countries, nearly all OECD countries, major financial centers, and a growing number of developing countries have signed the Convention and/or its amending Protocol of 2010.
Multilateral Competent Authority Agreement ("MCAA")
Fifty-two countries have entered into the OECD MCAA pursuant to Article 6 of the Convention.3 Forty-eight "early adopters" intend to commence exchanging information by September 2017 and the remaining four by September 2018. The 2017 group include almost all members of the European Union and several other European countries, the United Kingdom Crown Dependencies and main Overseas Territories, and several other jurisdictions such as Argentina, Colombia, Mexico, South Korea, and South Africa. Another 48 signatories to the Convention have not yet signed the MCAA, but 12 of them have also committed to AEOI by September 2017, with the rest by September 2018. These include the United States and six other jurisdictions from the Americas, Russia, Ukraine and six others from Europe, China, Australia and seven others from the Asia Pacific, Nigeria and five others from Africa, and Saudi Arabia from the Middle East.
Common Reporting Standard ("CRS")
The MCAA is a multilateral framework agreement. Automatic exchange of tax information between two parties to the MCAA may occur once they have both filed the notifications with the OECD Coordinating Body Secretariat with information prescribed in Annexes to the MCAA. This requires confirmation that the jurisdiction has the necessary laws in place to implement the OECD's CRS, whether reciprocal exchange is required, the methods for data transmission including encryption, any specified safeguards for the protection of personal data, and confirmation that it has in place adequate measures to ensure the required confidentiality and data. The jurisdiction must list the jurisdictions of any other Competent Authorities with which it intends the MCAA to take effect upon establishment of any national legislative procedures. Competent Authorities must notify the Secretariat promptly of any subsequent change to be made to the Annexes. The MCAA prescribes what information will be exchanged and when, as set out in the CRS. It outlines how jurisdictions will cooperate to ensure compliance and establish a consultation process to ensure efficiency and flexibility.
Information On Request
Unlike FATCA, GATCA does not impose punitive withholding tax on non-cooperating financial institutions and account holders. Instead of relying on that new stick, GATCA will make much better use of the Convention's old "stick," tax information exchange agreements ("TIEAs"). The Convention has long been used as a basis for bilateral TIEAs between the tax authorities of Convention parties for the exchange of "information on request." Since the first TIEA was signed between the United States and the Cayman Islands in 2001, a total of 101 jurisdictions4 have entered into 5185 TIEAs with each other. These bilateral TIEAs are based on a model6 providing for one Competent Authority to provide information on a foreign taxpayer's financial accounts in its jurisdiction in response to a request by the foreign Competent Authority. The information must be foreseeably relevant to the requesting party's administration and enforcement of domestic tax laws regardless of whether the conduct being investigated constitutes a crime under the requested party's tax laws.
The volume of information requests between tax authorities under the TIEAs is likely to increase very substantially over the next three years as a result of automatic exchange of information under FATCA and GATCA. The TIEAs do not permit so-called "fishing expeditions," and a requested party may decline to assist the requesting party if the prescribed information is not provided in conformity with the TIEA. FATCA and GATCA ensure that tax authorities will soon have a great deal more information on which they can base their requests under the TIEAs.
Like FATCA's FFI Agreement and IGAs, GATCA's MCAA and CRS will ensure that Reporting Financial Institutions collect and record tax status, identification and account information on account holders, and report the same to their own tax authorities for exchange with the tax authorities of their account holders and certain controlling persons and beneficial owners. This information includes the account holder's name, address, tax information number, and date and place of birth (in the case of an individual) required to identify individuals resident or entities established in another party jurisdiction to the MCAA. RFIs that are investment entities must report, in respect of the relevant calendar year or other period, the ending account balance or value and the total gross amount paid or credited to the account holder with respect to the account to which the RFI is the obligor or debtor, including the aggregate amount of any redemption payments.
RFIs established in any of the "early adopter" party jurisdictions to the MCAA now have a limited window of time to consider and implement common sense precautions regarding GATCA. These include new offering document disclosures, new subscription agreement clauses, and a risk-based assessment of any accounts which should be closed prior to December 31, 2015. These precautions are intended to mitigate the risk or at least the cost of the RFI being subjected to any regulatory investigation or enforcement action arising from the tax status of its account holders.
First, the RFI should update its offering document to reflect the additional AEOI obligations and risks created by GATCA. Generally, these disclosures should enable existing and prospective investors to make an informed decision whether or not to retain/open their accounts with the RFI. This is a legal requirement for any RFI that is regulated as a mutual fund in the Cayman Islands. Starting on January 1, 2016, the RFI will be required to collect self-certifications as to tax residence from every account holder and also from every controlling person of an account holder that is a "Passive Non- Financial Entity." The following year the RFI will be required to report on any such person who is resident in another party jurisdiction to the MCAA.
Second, the RFI should update its subscription agreement to require any subscriber (a) to represent and covenant that he/it will file all applicable personal income tax/corporate tax returns in respect of his/its subscription for and ownership of securities in the RFI, and (b) to indemnify and hold harmless the RFI (and other relevant persons and service providers) from and against all loss, damage, liability or expense such indemnified person may incur by reason of that representation being false when made, or any failure by the RFI to fulfill that covenant.
Third, the RFIs should consider taking a risk-based approach on whether to close any existing accounts by December 30, 2015 to avoid them being treated as "pre-existing accounts" on December 31, 2015. There is no de minimis threshold for individuals whereas, like FATCA/IGAs, entity accounts not exceeding USD250,000 will be out of scope for subsequent due diligence and reporting obligations. If the RFI is not confident that the account holder/ controlling person is filing applicable tax returns for his/its holdings in the RFI, the RFI may prefer to close the account rather than become embroiled in a subsequent tax investigation by that person's tax authority as a result of the RFI's GATCA reporting. Tax investigations may have adverse consequences depending on how long it takes to resolve them and what publicity they receive. These include a distraction from management's other duties, legal fees, reputational damage resulting in loss of capital and/or difficulties with other financial institutions and withholding agents, and prosecution. The RFI and its directors or equivalent may face prosecution if they are alleged to have committed an offense under GATCA-enabling domestic regulations, such as failure to make a report, filing an inaccurate report, and failure to maintain proper records or to provide those records to or otherwise cooperate with its competent authority in a timely manner.
FATCA is forcing RFIs to focus more closely than ever before on their account holders' tax status. That is, RFIs should now only open new accounts for account holders that have provided the prescribed tax certifications and government identification documents. This documentation must also be in place by June 30, 2015 for all pre-existing ( i.e. , June 30, 2014) high value accounts of individuals and a year later for all pre-existing lower value accounts of individuals and all pre-existing accounts of entities. RFIs should take the opportunity now to reflect on what, if any, precautionary measures should be taken to avoid being snowed in by GATCA.
1. Individual Income Tax Rates Table: http://www.kpmg.com/global/en/services/tax/tax-tools-and-resources/pages/individual-income-tax-rates-table.aspx.