Although much has been written about the Foreign Account Tax Compliance Act, one topic that has received little discussion is the impact of FATCA on the fiscal sovereignty of other countries.

Traditionally, the United States has obtained overseas tax information through bilateral treaties and other agreements with foreign countries. Those agreements specify guidelines within which each country provides information to the other to assist in enforcing tax laws. Those guidelines generally include limitations on the type of information provided and procedural safeguards over how the information is collected and used by the recipient government. For example, the exchange of information article in the U.S. Model Income Tax Convention ‘‘would not support a request in which a Contracting State simply asked for information regarding all bank accounts maintained by residents of that Contracting State in the other Contracting State, or even all accounts maintained by its residents with respect to a particular bank.’’¹

FATCA is designed to obtain overseas tax information through an entirely different mechanism. Rather than negotiating with the government of the country where information is located, the IRS concludes an agreement directly with the foreign financial institution (FFI) possessing the information.² An FFI that signs an agreement (a participating FFI) generally agrees to identify its U.S. account holders and report information about their accounts to the IRS. To create an incentive for the FFI to sign an agreement, FATCA imposes two types of confiscatory taxes on an FFI that does not participate (a nonparticipating FFI).

The first type of confiscatory tax is imposed on payments that a nonparticipating FFI receives from investments in U.S. financial assets (withholdable payments). The tax rate on all payments of financial-type income and on principal and sales proceeds received on U.S. stocks and debt obligations is 30 percent.

The second type of confiscatory tax is imposed on payments that a participating FFI makes to a nonparticipating FFI, or to an account holder that refuses to cooperate with the reporting regime. A participating FFI agrees with the IRS to collect a 30 percent tax on payments attributable to withholdable payments (passthrough payments). FATCA grants broad authority to the Treasury Department to define passthrough payments, and Treasury has announced its intention to impose the tax whenever a participating FFI holds U.S. financial assets or a financial interest in another participating FFI that holds U.S. financial assets.

The purpose of the tax on passthrough payments is to create an incentive for FFIs holding few or no U.S. financial assets directly to become participating FFIs. To avoid the reach of FATCA, a nonparticipating FFI must avoid holding not only U.S. assets but also financial interests in participating FFIs that hold U.S. financial assets or interests in other participating FFIs with U.S. financial assets.

The tax on passthrough payments greatly expands U.S. taxing jurisdiction because it applies to payments having no U.S. nexus other than a payer holding U.S. financial assets, or investments in another participating FFI that directly or indirectly holds U.S. financial assets. For example, the tax would apply to a portion of the payments of principal or interest on a loan from a Chinese nonparticipating FFI to a German participating FFI that holds no U.S. assets directly but has made a loan to a Canadian participating FFI that holds U.S. assets.

FATCA provides for refunds (without interest) of the taxes on withholdable and passthrough payments to the extent that the nonparticipating FFI receiving those payments as a beneficial owner is entitled to a reduced rate of tax under a U.S. treaty obligation. However, existing treaties were not negotiated with those taxes in mind and therefore do not address many situations in which the taxes on withholdable and passthrough payments may apply.

FATCA intrudes on the sovereignty of other countries in three ways. First, the United States demands that foreign FFIs deliver tax information located there without using the bilateral information exchange mechanisms contained in treaties or other governmental agreements. Because FATCA collects information unilaterally, the foreign government has no control over the type of information collected, the manner of its collection, or how the United States uses it. Further, the foreign government has no equivalent access to tax information held by U.S. financial institutions pertaining to its own taxpayers.³

Second, the tax on passthrough payments applies to payments that a country may consider as falling within its exclusive taxing jurisdiction, such as payments of principal and interest on a loan between two local FFIs, if the borrower is a participating FFI and the lender is a nonparticipating FFI. Any tax collected on passthrough payments burdens the local economy with no corresponding local benefit.

Third, a participating FFI bears the considerable cost of complying with the FATCA information reporting and withholding obligations, which ultimately will be reflected in the economy where the participating FFI is located. In effect, the participating FFI must recover that cost through charging higher prices for its services, reducing its other expenditures, or generating a lower return on capital invested in the participating FFI. The economic burden has no corresponding benefit to the country because the information reporting only assists the United States in collecting U.S. tax.

Faced with this situation, a government may respond in several ways. First, it may initiate bilateral discussions with the United States on the scope of information to be collected from the country’s FFIs and the scope of the tax on passthrough payments made or received by its FFIs. However, in discussions of that type, the United States may have little incentive to make concessions. In particular, it may view a concession made to one country as an invitation to others to seek equivalent or greater concessions.

Second, the government may enact or maintain laws that prohibit FFIs located in the country from complying with one or more elements of FATCA. For example, if local laws prohibit local FFIs from transmitting tax information to the IRS, the United States would be forced to seek tax information through governmental channels. If laws prohibit local FFIs from withholding tax on passthrough payments, nonparticipating FFIs would not incur a financial cost in dealing with the local FFIs and would therefore have less incentive to become participating FFIs. ⁴

If the government prohibits local FFIs from complying with one or more elements of FATCA, they will be nonparticipating FFIs and will incur the taxes on withholdable and passthrough payments. However, that will not be a desirable outcome for the United States for two reasons: The purpose of FATCA is to obtain tax information, not collect taxes on withholdable and passthrough payments; and local FFIs will inevitably arrange their affairs to reduce U.S. taxes by divesting U.S. financial assets and limiting investments in participating FFIs. Prohibitions of that type therefore create an incentive for the United States to negotiate bilateral information exchange arrangements.

Third, the government may institute a regime comparable to FATCA to equivalently intrude on U.S. sovereignty and thereby create an incentive for the United States to negotiate a bilateral information exchange arrangement. The difficulty with imposing that type of regime is its intrusion on the sovereignty of third countries. If it is modified to exclude third-country financial institutions, there will be less impact on the United States because U.S. financial institutions can invest through thirdcountry financial institutions as a shield against the local FATCA-equivalent regime.

Finally, the country can more directly retaliate against the United States — for example, by suspending information exchange under a treaty or other agreement. The purpose of retaliation would be to create an incentive for the United States to negotiate a bilateral information exchange arrangement. The success of that strategy will depend on the retaliation’s potential harm to the United States, and the potential for the United States to respond in kind.

The objective of those measures would be to induce the United States to negotiate a bilateral (or multilateral) information exchange arrangement that provides each country with information on financial accounts its taxpayers may hold in the other country, in lieu of the unilateral information gathering under FATCA. Those arrangements normally would impose similar requirements on the financial institutions of each country. And because each country, through its financial institutions, internalizes the costs of providing information to the other, there is a natural incentive to control those costs.⁵ Also, those arrangements allow each government to negotiate safeguards over how the information is collected and used.

Governments worldwide agree on the importance of deterring tax evasion that is conducted through offshore financial institutions. However, FATCA illustrates the conflict and disruption that can arise if one country seeks to address the issue unilaterally. The unilateral imposition of FATCA by the United States will create a precedent for other countries to use confiscatory taxation of the global financial system as a tool to achieve their own tax or foreign policy goals. Therefore, it is in the interest of the global tax and financial system for countries to create incentives for the United States to reach appropriate bilateral or multilateral arrangements to share tax information.

This article first appeared in Tax Analysts 2011.

¹ Treasury, Technical Explanation to Article 26, para. 1 (2006).

² FATCA defines FFIs broadly to include banks and other deposit-taking institutions, broker dealers, and other financial custodians, funds, securitization vehicles, insurance companies, pension plans, family trusts, and other investment-holding vehicles.

³ As mentioned above, the existing bilateral information exchange arrangements to which the United States is a party generally do not permit wholesale requests for financial account information, and therefore the United States is not required to provide to the other country information equivalent to that gathered under FATCA. Even if the information exchange arrangements permitted requests for that information, the IRS receives incomplete information regarding payments made by U.S. financial institutions to non-U.S. persons. Under current U.S. rules, a U.S. financial institution holding financial assets for a non-U.S. taxpayer that has provided a Form W-8BEN, ‘‘Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding,’’ reports to the IRS only a limited set of U.S.- source payments made to the account holder, including dividends and some items of interest. Payments of non-U.S.-source income and broker proceeds, as well as specific items of U.S.- source interest — such as portfolio interest on bearer obligations, bank deposit interest, and interest on short-term obligations — generally are exempt from reporting. (Proposed regulations would require the reporting of U.S.-source bank deposit interest paid to nonresident aliens, but not to other non-U.S. persons.)

⁴ A prohibition against withholding tax on passthrough payments will be less effective if a participating FFI can terminate its relationships with nonparticipating FFIs and ‘‘recalcitrant’’ account holders.

⁵ It is worth considering what level of costs U.S. financial institutions would be willing to bear to provide tax information to other countries. The current debate over the proposed regulations to require the reporting of U.S.-source bank deposit interest paid to NRAs suggests that U.S. financial institutions would strongly resist the types of costs that FATCA will impose on participating FFIs.