Is the Sheriff Finally Coming to FATCA-Town?

For all the sound and fury, Sturm und Drang, massive expenditure and general anxiety about its implementation, one peculiar element of FATCA has been the near total absence of enforcement by the IRS or other authorities. Predictions that FATCA reports would be compared instantly with FBAR submissions, discrepancies identified automatically and inquiry letters dispatched forthwith, have not been fulfilled. Instead, the IRS seemed content to deputize the major custodial banks and other large Financial Institutions (FIs) through the dual threat of withholding and the Responsible Officer (RO) Certification requirement and then to rely upon them to ensure that everyone else obeyed. As of today, I have seen a single story of a FATCA violation resulting in an enforcement action and, in that case, the FATCA violation seemed a pretext for prosecuting a securities fraud unrelated to FATCA entirely.
 
That may be about to change...
 
On 9 July, the Treasury Inspector General for Tax Administration (TIGTA) published an audit report, castigating the IRS for its lenient enforcement of FATCA. This report highlighted the massive outlay by the US fisc for FATCA implementation (Note: This eye-popping sum of USD 380M omits the multiples of it spent by non-US FIs on FATCA activities). Despite this sum TIGTA contended, the IRS had failed to implement its own blueprint for enforcement. While the criticisms and recommendations had several shades, the main thrust was that the IRS does not adequately ensure the collection of bona fide Taxpayer Identification Numbers (TINs). Accordingly, the IRS struggles to conduct reconciliation and crosschecking across Forms submitted by other parties to a transaction, a critical step for the identification of non-compliance by US taxpayers and withholding agents.
 
Generally, the IRS did not contest the report’s main claim that it needed to improve TIN collection and exploit the information to stiffen enforcement mechanisms. Specifically, the TIGTA report issued six recommended modifications, four of which the IRS agreed to adopt. Notably, one it rejected (to the chagrin of TIGTA) was the validation of all TINs collected. Instead, the IRS countered that the TIGTA recommendation to improve certain automated processes, which it had accepted, would also encompass this activity (which seems correct to me only if you squint very hard at it).
 
In any case, the IRS will need to show more FATCA enforcement return on its investment in order to allay internal pressure. That is clear. One way would be to prosecute US Person taxpayers for not filing FBARs or not reporting income earned through financial accounts abroad. But the TIGTA report suggested that the IRS might not have sufficient data for such a crackdown. If so, could IRS attention turn elsewhere? Perhaps and, thus, the real question for us is: What will be the consequences for Swiss and non-Swiss Reporting FIs? With that in mind, I contemplated a few scenarios and then thought through the ramifications, as set forth below.
 
Possible Outcome 1 - The IRS implements the agreed-upon TIGTA recommendations with a keen eye for Reporting FIs that repeatedly submit TINs identified as inaccurate. 
 
How many ROs would state unequivocally that the TINs on their FATCA reports or Forms 1042-S are 100% correct? Few, if any, is my guess. Therefore, if the IRS decides to review the FATCA-related submissions - current, future and perhaps past - many reports and submissions will need to be revised. That means lots of busy work for Reporting FIs that must re-process rejected submissions, re-confirm TINs from account holders and potentially argue with the IRS where the account holder confirms an original TIN different from the IRS one.
 
In the short term, this scenario threatens a broad, but shallow ripple across the marketplace. It means that many Reporting FIs will need to re-document US Person account holders and prepare amended reporting. In the longer term, these Reporting FIs will need to invest more in operational processes in order to upgrade and monitor their TIN collection process. The alternative - an on-going stream of reports submitted with bad TINs - could lead to unwelcome IRS scrutiny. 
 
 
Possible Outcome 2 - An under-resourced IRS cannot implement the audit revisions in a timely fashion, but needs to deflect the pressure to enforce FATCA more strictly.
 
In this scenario, the IRS adopts the old Chinese adage: Kill the chicken to scare the monkey. By ostentatiously cracking down on blatant non-compliance by means of a few, high-profile examples of punishment, the IRS will spook the rest into compliance, thereby relieving the auditor pressure temporarily while it pursues the agreed-upon fixes.
 
One source of ammunition for such an assault could be amnesty programs, plea bargains or the like. As the Justice Department did with Wegelin & Co. - the Swiss bank it torpedoed in order to jump-start the so-called Swiss Bank Program - the IRS might amass evidence of FATCA non-compliance against a bank vulnerable to the imposition of FATCA withholding. If a few client advisors helped a few well-heeled US Person account holders to avoid FATCA reporting and the Reporting FI cannot point to a top-notch compliance program that should have thwarted such misdeeds, the IRS could claim non-compliance sufficient to revoke its FFI Agreement. While its discretion is tempered somewhat for Model 2 IGA FIs and there is a 12-month period afforded Swiss FIs to address such claims, the prospect alone of revocation could be damning. If executed, such a revocation would convert the Reporting FI into a Non-participating FFI and other banks would start withholding on US-source FDAP payments made to it in its role as intermediary, essentially freezing the bank’s account holders out of the US capital markets and thus presumably triggering asset flight and cratering the share price.
 
The potential objects of such a campaign are in the unenviable position that they already committed the infractions for which they could be punished. All is not lost, however, for any Reporting FI concerned that it could be vulnerable to a charge of substantial non-compliance. The review of the Reporting FI’s FATCA compliance program, an element of the pending RO Certification process, is an ideal time to identify and redress concrete errors through amended reporting and systematic defects though compliance program enhancements. Such efforts would help the Reporting FI to depict the FATCA violations as the actions of rogue employees, rather than any institutional negligence. Conversely, any Reporting FI with serious compliance lapses known to the IRS whose RO submits an unqualified certification will be a ripe target for enforcement action.
 
 
Possible Outcome 3 - Some other form of heightened enforcement entirely.
The IRS may well have multiple FATCA enforcement strategies under development and ready to be unleashed. Timing-wise, it makes sense to have waited until non-compliant FIs had the chances to miss multiple action deadlines and thus will struggle to argue in their defense that they are just a bit late in getting everything in order, but are acting in good faith. At this point, non-compliance across multiple reporting cycles and potentially with the RO Certification will carry the whiff of reckless or intentional disregard for compliance duties, rather than innocent oversight. 
 
Examples of abuses endemic to FATCA that the IRS might be primed to confront include:

• Non-compliant registered Reporting FIs - A crosscheck of Reporting FIs registered on the IRS FATCA Portal against those submitting FATCA reports and RO Certifications could lead to a purge of non-compliant registered Reporting FIs from the GIIN list.
• Intermediaries and advisors - Piggy-backing off the OECD’s Mandatory Disclosure Rules, the IRS could propose a similar framework for FATCA, obliging intermediaries and advisors to report on avoidance efforts by principals and clients. This approach would be heavy-handed, extra-territorial and controversial, but that is nothing new for FATCA.
• Model 1 IGA compliance deserts - A somewhat common view is that certain Model 1 IGA tax havens have scant intention of enforcing FATCA and that entities governed by those IGAs enjoy carte blanche to conceal US Person account holders or otherwise flaunt their FATCA duties. By singling out one or more such Model 1 IGA jurisdictions and threatening to annul the IGA, the IRS and the Treasury Department would hope to spur these jurisdictions to discharge their treaty obligations more strictly.

 
Possible Outcome 4 - A combination of some or all of the above?
As the fairly breezy analysis of IRS enforcement options set forth above suggests, the IRS has an array of options, doubtless many of which I overlooked. As with much of FATCA implementation, enforcement too will be new. Accordingly, the IRS may adopt a multi-pronged approach in order to test which specific approach is most effective. Hopefully, in spite of the internal pressure, the IRS will not shoot first and ask questions afterwards.