INTRODUCTION I. FATCA, CRS, AND THE REPORTING OF BENEFICIAL OWNERS A. FATCA 1. Background 2. How to Report Beneficial Owners of Accounts Held Through Entities a. Reporting Beneficial Owners of Passive NFEs b. Reporting Beneficial Owners of FIs 3. FATCA's Choice of Who to Regulate B. CRS 1. Background 2. CRS's Choice of Who to Regulate C. Analysis of the Choice of Who to Regulate 1. Compliance Costs 2. Effectiveness of Compliance 3. Distortions 4. Noncompliance Opportunities and Loopholes D. Why Did FATCA and CRS Get It Wrong? E. Model Mandatory Disclosure Rules F. Potential Solutions 1. Changing the FI Definition 2. Parallel Reporting 3. Third Party Verification II. CONSIDERATIONS WHEN CHOOSING WHO TO REGULATE III. CONCLUDING REMARKS INTRODUCTION
FATCA (1) and CRS (2) are two of the most costly and onerous pieces of tax regulation in recent history. (3) Some analysts argue that despite the large implementation costs, FATCA has generated only a modest increase in tax revenues, (4) which calls into question the cost-effectiveness of FATCA and possibly CRS. (5) A possible reason for this limited effectiveness is that tax evaders use noncompliance opportunities and loopholes to avoid FATCA and CRS reporting. (6)
Law enforcement agencies and the courts try to counter such noncompliance. On February 6, 2017, the U.S. District Court for the Eastern District of New York imposed prison sentences on the defendants in United States v. Bandfield, (7) which was the first federal prosecution for a conspiracy to avoid FATCA reporting. (8) In that case, Bandfield and his business partner admitted that they had engaged in schemes that provided their clients--U.S. tax evaders--with ways to illegally circumvent FATCA reporting of their offshore financial assets by concealing them through shell companies and nominees. (9)
The OECD attempts to identify and dismantle schemes that are used to circumvent CRS reporting. On March 8, 2018, the OECD approved model mandatory disclosure rules ("Model Mandatory Disclosure Rules") that require promoters and intermediaries (such as lawyers, accountants, financial advisors, banks, and other service providers) to inform tax authorities of the schemes they put in place in order for their clients to circumvent CRS reporting or to prevent the identification of the beneficial owners of entities or trusts. (10) Although countries are not obligated to follow these rules, it is likely that these rules will become the international norm and be adopted by the countries that implement CRS.
If such efforts continue, will FATCA and CRS succeed in their war on offshore tax evasion? This Article shows that the noncompliance and enforcement challenges of FATCA and CRS are substantial and go well beyond schemes such as those offered by Bandfield or those targeted by the OECD under the Model Mandatory Disclosure Rules.
As discussed in Part I of this Article, tax evaders can avoid FATCA and CRS reporting without the assistance of any intermediaries or enablers and without using complicated offshore structures. All they need to do is to hold their offshore financial assets through a private entity controlled by them that certifies that it meets the definition of a "Financial Institution" ("FI"). This can be done rather easily because many private investment entities are classified as FIs under FATCA and CRS. Such entities are required to report their beneficial owners. However, in reality, where a tax evader holds unreported financial assets through a private entity that he or she owns and manages, it is unlikely that this entity will report its owner to the tax authorities. In addition, CRS reporting is not required where the investment entity FI and its owner are resident in the same jurisdiction. At the same time, banks and other FIs that maintain the financial accounts of such entities are not required to report the beneficial owners of these entities. The result is that FATCA and CRS are completely ineffective in catching these tax evaders.
This Article shows that this noncompliance opportunity is a result of a decision by the drafters of FATCA and CRS regarding who should report the beneficial owners of private investment entities that hold offshore financial assets. In general, under FATCA and CRS, FIs must identify and report certain account holders who are tax residents of the U.S. or other reportable jurisdictions. (11) Many people hold financial accounts and assets, not directly under their names, but through closely-held private companies and family trusts (this Article refers to these entities collectively as "private investment entities" (12)). Thus, the drafters of FATCA and CRS needed to choose who should be required to identify and report these beneficial owners. Two groups of agents could have been chosen for that purpose: (1) the financial institutions that maintain the financial assets of these private investment entities, (13) or (2) the private investment entities themselves. The drafters of FATCA and CRS chose to impose the reporting requirements on many of the private investment entities by classifying them as FIs. (14)
This policy is deeply flawed. First, it creates vast opportunities for noncompliance as mentioned above. Where the beneficial owners control and manage these closely-held private investment entities, imposing reporting obligations on these entities is in substance similar to requiring self-reporting of the beneficial owners. (15) If the reporting obligations are imposed on the FIs that maintain such entities' financial accounts, then this is third-party reporting, which significantly increases the likelihood of compliance and detection of noncompliance. (16) Under the current policy, tax evaders can transfer financial assets that are not currently held through private investment entities into such entities. They might remove third parties, such as professional trustees and directors, to ensure that the private investment entities' failure to comply with the reporting obligations goes undetected.
Second, this policy results in higher costs for compliant taxpayers. It would be more cost-effective to impose the reporting obligations on the FIs that maintain the private entities' financial assets because these FIs already implement FATCA and CRS with respect to other accounts they maintain; they are typically larger and more sophisticated, equipped with legal and compliance teams that can handle these obligations at a lower cost because of the economies of scale, and they are already required to identify the beneficial owners under anti-money laundering rules.
Third, imposing reporting obligations on certain private investment entities might distort the behavior of tax-compliant beneficial owners because they could make certain changes in the holding structure, asset management style, and asset location to avoid holding entities that need to comply with costly and complicated regulatory obligations. Imposing the reporting obligations on the FIs that maintain the financial accounts of private investment entities would likely result in fewer distortions and lower deadweight loss.
The result is that tax evaders love this policy because they can exploit it to avoid FATCA and CRS reporting and keep their unreported offshore financial assets at a low detection risk. Compliant beneficial owners hate this policy because it imposes large compliance costs on them and distorts their behavior. This could have been avoided if the reporting obligations had been imposed on the FIs that maintain these private investment entities' financial assets instead of on the private investment entities. As FATCA and CRS are in their early years of implementation, it is important to identify and fix the problems this policy has created. This Article proposes possible solutions that the U.S. Treasury and the OECD should consider.
This Article builds on the analysis of FATCA and CRS to explore an important general question of regulatory design: how to choose which group of agents should be required to satisfy a regulatory obligation where that obligation can be imposed on one of two or more alternative groups of agents. Choices of who to regulate arise in various regulatory regimes, such as financial, tax, environmental, and product safety regulation. As shown in the context of FATCA and CRS, these choices may have significant implications on the costs and the effectiveness of the regulation. In general, as discussed in Part II, choosing who to regulate requires a cost-effectiveness analysis of imposing the regulatory obligations on each of the alternative groups. (17) This analysis should consider the cost-effectiveness of compliance, the distortions created by imposing the regulatory obligations, and the likelihood of noncompliance, as these factors may be different for different groups of agents. After analyzing these factors, we should compare the aggregated societal benefits and costs of imposing regulatory obligations on each of the alternative groups.
The structure of this Article is as follows: Part I discusses the decision made by the drafters of FATCA and CRS regarding who should report the beneficial owners of private investment entities, and the substantial implications of this decision. Part II explores the general question of regulatory design: how to choose who to regulate. Part III concludes.
FATCA, CRS, AND THE REPORTING OF BENEFICIAL OWNERS
FATCA and CRS revolutionized the way countries collaborate on fighting offshore tax evasion. Under these regimes, FIs are required to identify account holders who are foreign tax residents and report their information to the local tax authority. (18) The local tax authority then transfers this information to the tax authority of the account holders' jurisdiction of tax residence.
As many people hold financial accounts not directly under their names but through closely-held private investment entities, the drafters of FATCA and CRS...