The (U.S.) Taxman Cometh

In the investment world, most of these questions are intended to equip the firm with a clear understanding of the client’s circumstances and objectives that will inform the account/portfolio management process.

However, there’s no denying that many questions arise more from the firm’s legal or regulatory obligations than because the answers will truly help the firm “know the client” and serve them better. Moreover, it seems the number of such questions is increasing. For better or worse, financial services businesses have surveillance and quasi-policing roles in such diverse realms as tax collection, anti-money laundering, and securities law compliance. In principle, the privilege of being a part of the financial system comes with a responsibility to protect that system from those who abuse it.

One realm where the number of these “legal questions” has grown steadily may surprise you: foreign tax compliance. It started with the United States’ Foreign Account Tax Compliance Act (“FATCA”) 10 years ago as the U.S. broadened its tax enforcement efforts in two directions: to ensure U.S. taxpayers report earnings on all their financial assets, including foreign ones; and to ensure U.S. persons living abroad file U.S. tax returns and pay any taxes owing. (Unlike Canada and most other nations, the United States taxes based on citizenship, not just residency.) Subsequently, other nations around the world have joined the parade under the moniker of the “Common Reporting Standard” – what some refer to as “FATCA for the rest of the world”.

For FATCA to work, the Internal Revenue Service in the U.S. needs information from foreign financial institutions about the accounts they maintain for U.S. nationals. Tax treaties between the U.S. and various other countries are the mechanism for gathering that information. In Canada’s case, domestic tax laws were revised to oblige Canadian financial institutions to provide the requisite information to the Canada Revenue Agency, and CRA gives it to the IRS.

FATCA has been like a steamroller: moving slowly, but inexorably. It started by requiring firms like Nexus and custodians like RBC Investor Services Trust to determine if holders of new accounts are or might reasonably be U.S. persons, so that information about their (non-registered) accounts could be reported to the IRS via CRA. The requirements subsequently broadened to include holders of so-called “large” accounts existing when the new rules came into force, and then broadened again to include holders of all existing accounts.

As you might imagine, the accompanying reporting and record-keeping obligations are not trivial, and, they, too have expanded over time. A U.S. taxpayer is obliged to provide Nexus with their social security number, if they have one, and obtain one if they don’t. Initially, Nexus’s only obligation was to ask for it, and to follow up periodically to obtain it. There were no dire consequences to firms like Nexus or custodians like RBC for not getting an accountholder’s social security number.

However, that has now changed. Thanks to recent little-noticed amendments to FATCA and the bilateral treaty that governs Canada’s tax reporting obligations, starting this year, Canadian financial firms can be fined for continuing to operate an account without a social security number for a U.S. person. There are only two “escape routes” to avoid financial penalties: obtain the social security number or close the account.

This is not an enviable position for either Nexus or the client. Both face a dilemma. Consider the following. By maintaining an account for a client who committed no offence greater than simply being born in the U.S., Nexus has become a vehicle for transmitting U.S. tax law – part of the IRS police force, if you will. The client is unlikely to view Nexus in a favourable light in the circumstances, even though the requirements to have a social security number and file a U.S. tax return are not new – wishful thinking to the contrary notwithstanding.

To comply, the client faces a stark choice. Close the account entirely. (It may not be possible to transfer it to another financial institution without a social security number as all firms are subject to the same obligations and potential penalties as Nexus.) Or obtain a social security number and undertake the arduous and potentially expensive process of filing back tax returns with the U.S., perhaps to incur penalties, despite possibly not owing any actual income tax to the U.S. Add into this unpleasant mix the fact of exploding U.S. fiscal deficits, and it’s easy to imagine the IRS ramping up its enforcement efforts and having little appetite for leniency.

The (U.S.) taxman cometh.