Scarlett Letters: Investing for US Clients in a Post-HIRE Act World

US passport and green cards are quickly becoming the financial equivalent of scarlet letters with financial institutions, family offices, custodians and trustees re-evaluating how best to deal with US clients. These concerns come on the heels of significant enforcement and regulatory action by the US government aimed at tracking down noncompliant US taxpayers, both in and outside of the US, and effectively using non-US financial service providers to help bring their non-compliant clients back into the US tax net. Some non-US service providers are reacting by cutting ties with those clients and others are segregating them into specialized divisions.

Given the broad reach of the new US laws and the wide definition of ‘US clients’ can either of these approaches work in practice?   Who will end up servicing US expatriates and international families with US members who may be finding it difficult to maintain their existing investment or trust arrangements?

The rapidly expanding focus on US clients primarily derives from the combined effect of two events: US enforcement actions against non-compliant taxpayers primarily via the Department of Justice case against UBS and the ‘Hiring Incentives to Restore Employment Act of 2010’ (the ‘HIRE Act’). Both represent watershed moments in terms of international private client information exchange and sharing.

In June the Swiss parliament approved the deal reached with the US last August to turn over to the IRS names and account details of 4,450 US clients of UBS.   What was initially resisted as a ‘fishing expedition’ in connection with as many as 50,000 accounts ultimately resulted in the largest haul ever under any tax treaty or information exchange agreement.

Notwithstanding the US record catch, given the difficulties encountered and time taken to obtain US taxpayer details under the treaty information exchange process, in March the US enacted sweeping legislation intended to provide the IRS with ‘new tools to find and prosecute US individuals that hide assets overseas.’ The HIRE Act may be the most remarkable piece of tax legislation ever enacted. Its consequences are severe, wide-ranging and by no means limited to the US. The legislation dramatically affects most non-US banks, financial institutions, funds, collective investment structures and insurance providers by requiring them to identify all of their ‘US account holders’ and turn over details of those persons and accounts to the IRS or suffer 30 per cent gross withholding on all of the proceeds of all of the investments into the US by such provider. Given that much private client investment derives not only from individuals but also trusts, foundations, companies and family offices, all of these investing entities also are affected.

The HIRE Act

While the HIRE Act contains certain limited provisions previously put forward under the Stop Tax Haven Abuse Act Proposal, it abandons that earlier effort to implement a jurisdictional ‘black list’ of tax havens. Rather the HIRE Act effectively creates a blacklist of non-US institutions comprised of those that sign up to the new client identification and disclosure requirements and those that do not. For those institutions signing up to the HIRE Act, they will effectively be undertaking the burden of identifying US citizens, residents and green card holders and reporting those individuals to the IRS as part of the effort to help the US fight tax fraud and maintain its revenue base.

The HIRE Act is an absolute game-changer and will have a dramatic effect on all ‘financial institutions’ with US clients or interests. Its primary targets are extremely broadly defined ‘foreign financial institutions’ (FFIs), which includes not only banks and financial institutions themselves but also hedge funds, private equity funds, mutual funds – in fact pretty much any non-US collective investment structure of any kind, unless regulations are issued to narrow the definition. Also squarely included within the definition of FFIs are custodians. Thus virtually any and every individual or entity investing through an FFI will be affected by the new US legislation. This necessarily includes entities such as trusts and family offices, which would not themselves fall under the definition of financial institutions, but which will nevertheless be required to determine whether US persons are deemed to be ‘account holders’ for the purposes of the legislation.

Under the new rules, unless an FFI enters into an agreement with the IRS to report information about its US account holders each year, a 30 per cent withholding tax will be applied to all US investments. That withholding would apply to any investment by the FFI on account of its US account holders, its non-US account holders and even any investment by the FFI for its own account.

FFIs wishing to avoid this new 30 per cent withholding will therefore have to review their client base annually to identify to the IRS any US persons amongst its clients and report the names and addresses of each US account holder, as well as the account number, the account balance and any gross payments or withdrawals through the account. The FFI will also be required to comply with any due diligence or verification procedures imposed by the US Treasury Department and comply with any requests for additional information from the Treasury.

Assuming that FFIs wish to continue to invest into the US either for any of their clients or on their own behalf without suffering withholding, they will need to understand the composition of not only their direct customers but also the beneficial ownership of those accounts held via trusts, companies and other entities. Related compliance and reporting costs will therefore increase dramatically prompting suggestions that many would opt to refuse services to US clients rather than handle the added compliance burden.

Identifying those US clients will, however, likely prove challenging. With respect to individual account holders, anyone who is US tax resident will have to be identified. With respect to any individual living outside of the US, every individual account holder who is either a US citizen and/or a green card holder will also have to be identified. While most US citizens living outside of the US do hold US passports, thereby easing identification to some degree, anyone born in the US is by definition a US citizen regardless of whether or not they hold a US passport.   Further, a number of US citizens hold dual citizenship such that it’s unlikely that institutions will be allowed to rely on the fact that they may have another country’s passport on record for an account holder; in other words, it’s likely that all account holders will need to be asked if they might have dual citizenship!

With respect to accounts held by trusts and other entities, the compliance requirements will become even more challenging. All such trusts and entities with accounts at FFIs complying with the HIRE Act will need to determine the deemed individual ‘beneficial owners’ of such accounts under look through rules expected to be issued in the autumn. Thus, in the case of trusts, every trustee will need to understand how each of their trusts are classified for US tax purposes and will then need to look to either the identity of the settler or the trust beneficiaries in determining which of them, if any, may be US clients for these purposes and then reporting those individuals to the FFI obligated to turn that information over to the IRS.

Legal proceedings against non-US banks

Part and parcel of the US effort on foreign tax noncompliance is the decision by the US Department of Justice to bring lawsuits against non-US banks and their US clients. In 2008, the US launched legal proceedings against Swiss banking giant UBS in the form of a ‘John Doe’ summons requesting information on 52,000 accounts allegedly unreported by US owners. After months of legal wrangling, UBS ultimately agreed to pay US$780 million and fines and acknowledged that certain bankers assisted US taxpayers in concealing ownership or beneficial interest in accounts. The bank also agreed to hand over information on nearly 5,000 accounts.

The landmark agreement with Switzerland was an undisputed success for the US as noncompliant account holders rushed to voluntarily come clean to the IRS before the Swiss government passed on their information.

The battle has not stopped at the doorstep of UBS. Although the US ambassador to Switzerland said in July that the US is not planning new tax investigations against other Swiss banks, the IRS has been hinting for months that it has plans to initiate legal proceedings against other financial intuitions.

In the past few weeks, it has become clear that the Department of Justice has begun criminal investigations into account holders at HSBC in connection with purported undisclosed accounts in Singapore, India and possibly other countries in Asia. Whether the Department of Justice will pursue HSBC as aggressively as it did UBS, there is no doubt that the US plans to make good on its promise to take action against financial institutions.

Expatriation as an option

As investment options dwindle and compliance costs increase, more and more US citizen and green card holders are considering leaving the US tax and information reporting net altogether by taking the dramatic step of relinquishing US status.

According to information published in the US Federal Register, the number of citizens who expatriated from the United States in 2009 increased dramatically over the previous year. Although the increase in the number of expatriates is likely the result of several factors, including a new expatriation tax regime introduced in 2008, there is no doubt that new restrictions such as those included in the HIRE Act are playing a part in the increase.

Conclusion

The HIRE Act and the legal proceedings against clients of certain financial institutions are proof that the US fully intends to track down US taxpayers abroad. The IRS is being given more tools to identify US taxpayer and it is exploiting the tools it already has at its disposal. As the financial world grows more transparent, taxpayers and institutions will face increased barriers to compliance.

Non-US banks and financial institutions will need to accept the high costs of compliance with the HIRE Act or consider limiting involvement with US customers and US markets. Eliminating their US client base may, however, prove more challenging and less practical than first anticipated given the reach of the rules not only to all US residents but also all US citizens and green card holders wherever they live and regardless of what other passports they may hold and whatever trusts and entities through which they might invest.

As the compliance measures required for maintaining US client accounts become more complex, US citizens and green card holders will find it increasingly difficult to find institutions willing to take them on, which will likely result in an ever increasing number of individuals expatriating from the US. What began as an effort to blacklist certain financial centres may have the unintended effect of putting US clients on a blacklist all their own.