Washington Gets Serious About Tax Havens

The House Ways and Means Committee and Joint Committee on Taxation today introduced the Foreign Account Tax Compliance Act of 2009. The bill intends to close loopholes that allow foreign assets to be hidden from the Internal Revenue Service. The White House also supports the measure. This new legislation is coincidental to the post I wrote earlier about the IRS ramping up its staff to investigate tax evasion by wealthy individuals. It seems this must be 'make sure the rich pay their taxes' week in Washington. If it passes, this bill would make it more difficult to avoid paying taxes by using fancy offshore trust schemes.

First, I think it should be made clear that this bill is not the far more controversial proposal that sought to increase the taxes of multinational corporations through eliminating tax deferrals on foreign income. As I mentioned earlier in the month, that proposal has been set aside for now. Today's legislation mostly goes after individuals who are using foreign tax havens to avoid paying taxes.

So what does this bill seek to do? I'll go through each summarizing bullet point from the House Ways and Means Committee website:

- The bill requires 30% withholding on payments to foreign financial institutions and other entities unless they acknowledge the accounts' existence to the IRS and disclose relevant information including account ownership, balances and amounts moving in and out of the accounts.

30% withholding is pretty darn high. That should kill most of the incentive to deal with financial institutions that ignore the IRS. I highly doubt this will end tax evasion problems with offshore entities, but will make such dealings more secretive, and consequently, more difficult.

- Individuals and entities would be required to report offshore accounts with values of $50,000 or more on their tax returns. The statute of limitations will be extended to six years when offshore accounts are unreported or misreported.

$50,000 is actually a relatively low value for an offshore account. I suspect it would cover most accounts that used to be a part of tax evasion. It would also make hiding a large sum of money by dividing it into many smaller accounts more cumbersome. For example, for every million dollars, you would need at least 20 accounts.

- Advisors who help to set up offshore accounts would be required to disclose their activities or pay a penalty. The proposal would also require electronic filing of information reports about withholding on transfers to foreign accounts to enable the IRS to better match reports to tax returns.

That penalty, per the legislation, is the greater of $10,000 or 50% of the gross income in advisory fees. While significant, that could just result in shady advisors doubling their fees. Still, with the other rules in place, I think it would be pretty hard for advisors to feel comfortable not reporting.

- The bill strengthens rules and penalties with regard to foreign trusts, including rules to determine whether distributions from foreign trusts are going to U.S. beneficiaries and reporting requirements on U.S. transfers to foreign trusts.

This is a good one. If foreign trusts are providing income to U.S .beneficiaries, then they must be taxed. Seems logical enough. It could also increase U.S. investment by removing some potential incentive to utilize foreign trusts.

- The legislation clarifies that U.S. dividend payments received by foreign persons are treated as dividends even when couched as another type of distribution in an effort to avoid U.S. taxes.

This is really the only bullet point that I squinted a little at, because it's vague. My fear here is that they're really creating new taxes on various securities. That would deter foreign investment. If that's the case, then I would be quite worried about the suggestion. If this is just a way to better enforce current law, then it doesn't bother me as much.

From the technical document, it sounds like the former. It appears that the Treasury Secretary will have the power to determine how to define what kinds of returns are dividends. That could potentially open up a slew of new foreign investment profits to the 30% foreign dividends tax rate. You can debate whether or not all foreign investment gains should be subject to the dividends tax, but I'm not convinced right now is the time to reduce foreign investment.

If you really want to dig into the gory details of the new proposal, find the bill here (.pdf) and the technical description here (.pdf).

Pretty much all of these rules have something in common: if you are rich enough, and determined to disregard the law, then you can still probably avoid paying taxes. But that's always true, no matter what rules are in place, since, well, you're intent on breaking the law. But most of these rules would do a pretty good job of closing loopholes and making it harder to act like techniques for evading taxes are simply smart personal financial management. As a result, it will also probably be easier to find and prosecute those who fail to pay the taxes they owe.