FATCA: Why Obama’s Lose-Lose Game Will Hurt the US

Last Thursday President Obama signed the so-called FATCA into law. FATCA stands for Foreign Account Tax Compliance Act. In a nutshell, FATCA requires not only foreign banks but also other financial institutions (mutual funds, hedge funds, insurance companies, trusts and many others) to disclose all US account holders to the IRS (US tax authority).

US account holders are not only US citizens with a foreign bank account but all those designated as US persons, for instance temporary US residents who were holders of a green card at some point. If the financial institutions fail to disclose US persons they face a punitive 30% withholding tax on all financial proceeds from the US such as interest and dividends, but also including, for example, the repayment of the principal of a bond or other securities.
  The consequences of FATCA for individuals, financial institutions and the global financial industry are profound and negative:

• FATCA will compromise the privacy of hundreds of thousands of individuals, US citizens or not. Without the slightest evidence of tax evasion, these individuals will end up on an IRS list of suspicious subjects just because they committed the crime of opening a foreign account while living in a foreign country.

• Some financial institutions will stop dealing in US securities. They will advise their clients to sell all US securities and will in this way shield themselves from a potential negative impact of the withholding tax. This is a measure that would have been unthinkable just 10 years ago given the financial hegemony that US securities markets had then. But in our more globalized financial age with emerging markets becoming ever more important, many clients will without doubt happily substitute Asian or European bonds or stocks for their American holdings. One medium-sized private bank in Switzerland has already done so.
  

• Large, global financial institutions will comply but will have to shoulder exorbitant costs. Many large banks, particularly those with subsidiaries in the US, will be forced to comply. The effort of complying with FATCA will probably be significant, as banks have to identify not only actual US citizens but also potential US persons who are minority shareholders of trusts and similar vehicles (the act applies to stakes of 10% or more). 

• Derivative products that mirror US securities but are based in other jurisdictions will become very popular. Today, it is easy to create a structured product that tracks an underlying US index, stock or bond. These structured products cannot be subjected to the US withholding tax as they do not fall under US jurisdiction and FATCA. However, as structured products can have disadvantages compared with direct investment in the underlying - default risks, for example - investors have to consider the possible down-side of these types of work-around.

• The US financial industry, especially stock exchanges and hedge funds but also all global banks based in the US, will suffer from a heavy competitive disadvantage. As we have seen in the past with the Sarbanes-Oxley-Act, US legislators often hurt their own financial industry for the sake of more regulation. After the enactment of Sarbanes-Oxley international listings on US stock exchanges all but disappeared because non-US-corporations became afraid of the cost and bureaucratic effort entailed in a US stock market listing. Some international corporations, such as Germany’s Daimler AG, have even delisted in New York. The cost of Sarbanes-Oxley to corporations is immense yet, as the Lehman case and others show, the act obviously has not prevented corporations from committing accounting fraud.

Overall , it seems to us that FATCA’s main effect will be to hurt badly both large financial institutions and the United States’ standing as a financial center. The positive impact on tax revenues will be small (especially compared to the size of the overwhelming public debt the US government has created). It may even be negative if global investors avoid the US. Unfortunately it often takes decades to repeal ill-conceived legislation even when the negative consequences become clearly visible early on. We hope that the US authorities come to their senses and soften the execution of the law. This may be the last opportunity to avoid another negative backlash for the US as a financial center.