Tax Planning

The Canadians to save us from FATCA? Maybe…

  • author Mark Nestmann
  • calendar September 22, 2015

FATCA, officially known as the Foreign Account Tax Compliance Act, is probably the worst law that most Americans don't know about.

I've written about this monstrous law repeatedly, most recently here. But now, it looks as if the prospects for FATCA's implementation could be throttled by the courts of meek and mild-mannered Canada, of all places.

If you haven’t heard of FATCA, you’re not alone. US citizens living in the US who don’t invest outside the US aren’t affected by the law. But if you’re a US citizen living in another country, or one who invests outside the US, FATCA is very bad news, indeed.

In short, FATCA demands that every foreign financial institution (FFI) in the world sign and strictly comply with an agreement with the IRS to turn over account information with respect to its US clients.  FFIs that fail to do so are subject to a 30% withholding tax on certain “withholdable payments” from U.S. sources. They'll also likely be subject to 30% withholding on payments from participating FFIs as well, anywhere in the world.

FATCA is especially hard on US citizens living outside the US. That’s because US, uniquely among major nations, imposes the same tax and reporting obligations on US citizens living outside the US as those living in its territory. With careful maneuvering, it’s generally possible for such persons to avoid being taxed twice on the same income. But income that’s legally tax deferred in, say, a country like Canada, might not be tax deferred in the US. That leads to unexpected and occasionally tragic results, as I discussed in this essay.

To implement FATCA, a country must first sign an inter-governmental information-exchange agreement (IGA) with the IRS. The agreements vary, but all of them require the signatory country to require its financial institutions to identify their US clients. Then, each financial institution must either turn over information on its US clients directly to its own tax authority for transmission to the IRS (“Type 1” agreement) or directly to the IRS (“Type 2”) agreement.

In many countries, information that the IGA requires either FFIs or foreign tax authorities to turn over to the IRS would otherwise be protected by bank secrecy laws or other rules protecting financial privacy. That’s an especially aggravating fact in a high-tax country like Canada, where more than one million people living there are dual US-Canadian citizens. Due to the operation of the US-Canada IGA, these dual citizens have fewer privacy rights than citizens living there with only Canadian nationality.

Not surprisingly, this discrimination makes dual US-Canadian citizens hopping mad. And in response, two US-Canadian dual citizens at birth filed a lawsuit in 2014 against the Attorney General of Canada and the Ministry of National Revenue. The lawsuit seeks to invalidate the US-Canada IGA. It alleges that due to the insistence of a foreign power (the US), Canada enacted laws that:

  • Discriminated against certain Canadians; namely, those defined by the US as “US persons”; and

  • Required Canadian financial institutions to identify US persons (most of whom are also Canadian citizens) and provide information about these individuals required of persons not defined as US persons.

The question boils down to this: Do all Canadian citizens enjoy equal protection under Canadian law? Or do Canadian citizens who also happen to be US citizens have fewer rights than other Canadians?

While it may be a long shot for this litigation to succeed, it could prove disastrous for the long-term success of FATCA if it does. And it’s not the only challenge that FATCA faces.

In July, presidential contender Senator Rand Paul (R-KY) filed a federal lawsuit with six other plaintiffs against the Treasury Department, IRS and the U.S. Financial Crimes Enforcement Network (FinCEN). The lawsuit claims that:

  • The IRS has no constitutional authority to enter into IGAs without the advice and consent of Congress;

  • The reporting requirements of FATCA and IGAs are unconstitutional under the Fourth Amendment;

  • The heightened reporting requirements for foreign accounts deny US citizens living abroad equal protection under the law;

  • The 30% withholding penalty is unconstitutional under the excessive fines clause of the Eighth Amendment; and

  • The “willfulness” penalty of the Bank Secrecy Act (discussed in this essay) also violates the excessive fines clause.

Naturally, the Obama administration and the IRS vigorously disagree. Once again, the lawsuit is a long shot, but if the courts agree that even one of the arguments is valid, FATCA could be stopped dead in its tracks by an injunction.

In the meantime, efforts to repeal FATCA have thus far failed, but if the 2016 election results in a Republican president and a Republican-dominated Congress, repeal could become a realistic possibility.

But even if challenges to FATCA in the courts and in Congress don’t succeed, the law has an “Achilles heel” that could ultimately lead to its downfall.
 
That’s because the IGAs the IRS has signed with more than 100 countries, are, in effect, a complete fabrication. That’s because even though the agreements call for the reciprocal exchange of information, US law doesn’t permit the IRS to send tax information to any other country. The only exception is if that country makes a specific request about a specific taxpayer, and also has a “double taxation agreement” in effect with the US. In other words, information flow under an IGA is only one-way. The Obama administration has proposed legislation to deal with this omission, but it’s gotten nowhere in Congress. Many in Congress justifiably fear that foreign investors could pull trillions of dollars out of US banks if the proposal becomes law. That could dramatically reduce foreign purchases of US Treasury debt and crush the US dollar.

Yet without actual reciprocity, I think foreign governments could quickly tire of sending information on US taxpayers to the US, and getting nothing in return.

I sincerely hope that if the courts don’t invalidate FATCA and governments that have signed IGAs don’t renege on their agreements, Congress eventually repeals the law. (Congress could also bring US law in line with the laws of every other major nation by imposing tax only on individuals resident in the US, and not on non-resident citizens. But that’s even a longer shot than outright repeal.)

In the meantime, I'm advising our clients to deal only with offshore banks and financial advisors that are making a good-faith effort to comply with FATCA. I'll keep you posted of new developments as they occur.

Mark Nestmann
Nestmann.com

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