Tax policy colloquium, week 13: Itai Grinberg's "Emerging Countries and the Taxation of Offshore Accounts"

On Tuesday, we had our penultimate session of the year, featuring Itai Grinberg's follow-up to his UCLA Law Review piece, The Battle Over Taxing Offshore Accounts.  In "Battle," Grinberg discusses the global response to "offshoring" (a truly U.S. term that reflects our distinctive geography) of financial holdings by wealthy individuals around the world.  Many of these people are likely committing tax fraud.  Others are hedging against domestic political instability and expropriation or exile risks, hiding their wealth from potential kidnappers, etcetera.

The U.S. share of this problem is relatively small, since a far lower percentage of U.S. wealth is held offshore than that from most other countries.  Note that U.S. individuals generally cannot lawfully avoid U.S. tax by holding their portfolio assets offshore.  The income from foreign bank accounts, stock trading accounts, etceteram is currently taxable, and even if you do your portfolio investment through a company that you incorporate abroad it is likely to face current U.S. tax (or worse-than-equivalent treatment to current taxation) under the passive foreign investment company or PFIC rules.

But there are of course some U.S. individuals who commit tax fraud through the use of secret overseas accounts.  Moreover, the problem can extend past investment income to labor or active business income, as in the scenario where a fraudster tells people to pay for his services (say, as a contractor) via deposits in the secret accounts.  This leaves only the problem of getting spending money out of the accounts, such as via overseas trips or the use of credit cards.  And then the IRS, unless it can trace the cash or find the accounts, can only use "lifestyle audits" to prove that the fraud is occurring.

As further background to all this, in 2010 Congress passed FATCA (the Foreign Account Tax Compliance Act), almost overnight and without advance notice but leading to huge controversy ever since even though it is not scheduled to take effect until 2014.  FATCA seeks to require foreign financial institutions around the world to identify their U.S. account holders and report on them to the IRS.  (For convenience, I'll call them "foreign banks" although they can be other types of financial entities as well.)  Foreign banks that don't cooperate may face huge withholding taxes that are meant to be a punitive rather than an indirect collection mechanism.

Foreign banks and their U.S. allies or representatives have been screaming bloody murder ever since FATCA passed, and they make several good points.  One is that it may be very difficult for them to determine who are their U.S. account-holders, since U.S. individuals may invest in them via foreign entities.  (E.g., I incorporate in Bermuda, and my Bermuda company invests through a Luxembourg bank.)  Another problem is that complying with FATCA may require one to break home country laws aimed at protecting confidentiality, and on the same ground may violate contracts with one's clients and customers.

A sophisticated defense of FATCA would hold that it was simply a device to require foreign banks and other countries to start negotiating with the U.S. with regard to the offshore wealth problem - which again, is in comparative terms a far worse problem for many other countries than for us.  And indeed there has been significant movement along those lines since FATCA was enacted, which likely would not have taken place otherwise.

Grinberg's UCLA article takes stock of all this, and makes a couple of main points.  One is that there has been enormous movement towards global acceptance of the proposition, which would have been thought absurd pre-FATCA, that financial institutions acound the world should serve as "tax intermediaries" that act on behalf of the home country taxing authorities, just as U.S. banks do domestically by issuing Form 1099s to account-holders and the IRS.  But he describes the battle between two competing models: that of information reporting to the home country authorities, and that of anonymously collecting a withholding tax (with respect to dividends, interest, etc.) that is paid over to such authorities in lieu of any reporting.

The second of these two options appears to have been the brainchild of some very clever Swiss banks that figured they could push back against the pressures for full reporting by making selective withholding tax deals with a couple of influential countries (the U.K. and Germany).  Grinberg argues in the UCLA piece that the reporting approach is better than the withholding approach - a view that has considerable merit if withholding is sufficiently feasible.  The basic point is that only information reporting can lead to fully effective home country worldwide taxation of individuals' passive income, which clearly is how one would like to go if the home country has an income tax that it wants to apply effectively.  Reporting also can address, as withholding taxes on interest and dividends cannot, the fraud problem of not reporting one's earnings or business receipts to the home country authorities by reason of having them secretly paid abroad.

One objection to universal information reporting, assuming it to be feasible, concerns bad people getting information about resident individuals' foreign holdings, in settings where it is not simply a matter of anodyne tax enforcement.  Consider Putin wanting as much information as possible about people who might oppose him, or corrupt officials who would sell the foreign wealth information they procure to prospective kidnappers who want to know whom they should victimize and how much they should demand.  But certainly the system has great appeal, if feasible, not just for countries like the U.S. and those in the EU, but also for what Grinberg calls "emerging countries" that have decent governance.  Indeed, those countries might actually benefit the most, so FATCA, if it plays out as Grinberg hopes, might actually be seen as a generous act that leverages U.S. financial market power in favor of a global cause that has bigger winners than us.

Before we start getting all choked up about U.S. generosity, however, it is worth noting that FATCA, at least on its face, is mainly unilateralist.  The idea is that other countries should tell us what we want to know, whereas we don't necessarily want to tell them anything.  The U.S. is indeed a kind of tax and reporting haven that wealthy people in other countries use to escape the scrutiny of home country authorities.  I gather that Miami, for example, is an offshore global financial haven (or heaven) for wealthy people in Central America and South America.  Miamians who are getting rich off this business are not exceptionally eager to face FATCA-type obligations towards foreign governments.  So FATCA can play out in the direction of U.S. hypocrisy, rather than of providing the benign global leadership that Grinberg favors.

"Emerging Countries and the Taxation of Offshore Accounts," Grinberg's follow-up paper for the colloquium, tries to take stock of fast-moving current developments, which in the last month have been unremitting (e.g., at G-20 meetings).  It argues that we are in a "punctuated equilibrium" type moment in which a system that might persist for decades is still fluid and being set up.  Moreover, it discerns grounds for optimism that there are enough players with common interests for the information reporting model to really take hold.  The two detours that the paper argues against are withholding in lieu of information reporting, and narrow special deals between just a few countries (with everyone else left out) in lieu of broader and more widely applicable deals.  The main reasons offered for optimism are (a) lots of countries would benefit - this is not a rich country versus poor country issue, although it is a "countries with substantial resources versus tax haven countries" issue, and (b) financial institutions might prefer a single and consistent system of global reporting than having to comply with 50 different rules from countries that are going it alone.

On the first of these two points, one would have to rely on the ability of the non-haven countries to pressure all (or enough) of the haven countries - there can be no Pareto improvement here that would make everyone eager to cooperate.  Providing accommodation services for foreign wealth is a nice business model for a small country that is sufficiently well-governed.  On the second point, it's clear that uniform global financial reporting would not be the banks' first choice, so getting them to play ball (including in the sense of not opposing it politically) depends on their assessment of the likely alternatives.

If Grinberg is right about the timing, we will know within a couple of years how it all came out.