#2 – Privacy in times of transparency
While cutting my hedge at the weekend I was thinking about the importance of privacy. These days people seem to appreciate and need privacy in varying levels, but it’s important to me. I sometimes have discussions with the gentlemen who farms the allotment next door. He would love it if my hedges were as low as possible and ideally didn’t exist. That bothers me. Schoolchildren and others walk along the path which cuts through the allotment. When I’m at home relaxing with my family I don’t want people to be able to spy on us or stare at us. I don’t like the feeling of being watched, and perhaps judged, by other people.
We don’t do anything illegal, and theoretically have nothing to hide, but at home we still feel that what we do and how crazy we behave at home is no business of anyone but us. Unless we’re disturbing someone. Then you have to find a balance. Which is why I was cutting the hedge to a reasonable level. Out of a sense of fairness to the neighbour.
Transparency – it started with the Americans…
In the last 10 years or so, there is a massive move towards transparency in people’s financial affairs. Since some senators in the US decided too many US taxpayers were suffering a bout of amnesia and “accidentally” forgetting about their foreign accounts every year about the same time as they were filing their tax returns 10 or more years ago, there has been a raft of international pressure and legislation designed to go straight to the source and get the banks to report financial information.
There's some detail involved
It’s important to me to raise general awareness of just what information is exchanged under these various rules, so I’ve tried to include just enough detail on the background so that you understand the point I wanted to make, without getting so bogged down in the detail but I’ll write a separate note with a bit more detail another time.
However, if you want to skip the technical stuff and the background (either you’re already familiar with the topic or you’re just not interested), you could probably skip straight to the section below called It’s gone too far. Honestly, I understand. If I didn’t have to learn this stuff I’d probably skip it too…(Mum, if you’re reading this, you’ll understand why I don’t really talk about work when we talk)
The appetiser – US FATCA
At a time when the US was enjoying some successes in extracting funds from (primarily) Swiss banks, starting with a 2009 deferred prosecution agreement with UBS and a
fine of $780 million, which kicked off a programme which is still in operation 10 years later, it didn’t take long for US politicians to looking for ways to get more information than they were getting under previous regimes (something called the Qualified Intermediary regime) about US taxpayers (or suspected US persons).
The rules introduced by the US to tackle this problem (commonly known as “FATCA”) used the threat of huge withholding tax any gross sale proceeds on US investments to implement these rules.
Effectively, for US taxpayers (or suspected US persons) non-US institutions have to share, for each account holder:
- Balance as at 31 December each year, and
- Income, “gross sale proceeds” or payments to the US person in the year, depending on what kind of account it is
This kind of makes sense. Politicians and civil servants created some estimates about the amount of untaxed ($8.7bn according to this congressional report), offshore money out there avoiding the US tax net, IRS was frustrated that it wasn’t getting the tax it expected to recover (see “Tax Gap Estimates for Tax Years 2008–2010”, although only published in 2016), although at the same time, US persons who had previously been less-than-honest about declaring their offshore accounts in the past were coming forward voluntarily to mitigate the risk of huge fines of getting caught out.
The scope of these new rules kind of makes sense in the context and isn’t objectively offensive. Under these rules, banks are reporting things that the IRS or US Treasury should otherwise be getting from the taxpayer anyway:
- Capital value of the account (not taxable, but where over USD 10,000, reportable in an FBAR, also known as FinCEN Form 114). The penalty for not filing an FBAR is up to 25% of the value of the account, for each year there was no filing. It can get expensive to get this wrong.
- Income (taxable and included on the tax return, gains too)
What about trusts?
These rules also apply to trusts, however, and this is where it starts to get interesting and a little complex, because adapting the rules to trusts needed a little contortion to make the concept match.
Trusts which have a corporate trustee and mainly financial assets are reporting different amounts depending on the role:
- Settlor/Income beneficiary:
- Value of the trust at 31 December; and
- Payments to the settlor/beneficiary in the year
- Discretionary Beneficiary:
- Total payments to the beneficiary during the year, if any were made
- Protector or other deemed controller of the trust:
- Needs a specific analysis based on the powers and facts
Other trusts have slightly different rules and reporting is carried out by the bank holding the trust fund, for the account they manage.
If you are a US taxpayer settlor you probably have one or more tax and/or reporting obligations covering the value of the foreign trust, so there’s alignment with tax principles there.
Even if you are the US beneficiary of a foreign trust, and you received a distribution in a year, you would have, at least had to file a 3520 information return, and possibly pay some tax. If the trust were not a “grantor trust” (under US rules, the income wasn’t attributed to the settlor) there is an income tax charge that needs to be included in the beneficiary’s tax return, and if the planning isn’t done right, the tax can get a little scary.
Under US tax and reporting rules there was generally some reason that one of the above probably had to say something to the IRS about the trust they were connected to.
Either way, whether we agree with the approach, or feel it was a little heavy handed, there is a reasonable argument for US purposes that there might have been justifiably motivated to apply pressure to solve a problem they perceived needed to be solved, namely to require other countries to assist in its fight against tax evasion. A noble cause. It’s only fair. We all pay our taxes and a system doesn’t work properly if not everyone is paying their way.
… then came the rest of the world, led by the Europeans
So, FATCA genuinely was the first course. I really want to talk about what happened when the OECD saw the success the Americans had implementing FATCA. Politicians clearly saw the attraction. Other estimates of unpaid tax have been made (this one by the EU), although I struggle with estimates of something you can’t measure. How much money is held outside the country? Is it all untaxed? Which taxes are missing and when would the be triggered?? And will anyone check after the implementation of new rules if the estimates were grossly exaggerated?
Either way, the decision in principal to introduce a worldwide regime was made in July 2014. After some initial delays with implementation, but it came into force in the first few countries in 2016.
The name of this unusual-looking child? “Common Reporting Standard” (I’m going to call it CRS throughout this article. It’s how I know it, and it saves a lot of space in this article to use meaningful abbreviations).
OECD Common Reporting Standard (CRS) – the main course
CRS is the OECD’s supercharged version of FATCA. As I’ve mentioned before the OECD is an international organisation bringing together a number of governments which collaborate on a number of economic and tax alignment projects.
CRS works much like FATCA, as set out above, but it’s a multilateral arrangement. That means lots of countries are exchanging information between themselves instead of everyone sending information to the US. As someone new joins the club, everyone else sizes them up and decides whether and when to start trading information with them.
I thought this was a bit like high school dances, except there wasn’t so much dancing going on there as awkwardness, and here the tax administrations really are motivated to “dance” with each other. Some are more shy than others. And some more awkward.
The OECD maintains a list of who is exchanging with whom at any given time. You might be surprised to see who is partnering with whom. To put this in context, this is the list of who shares information about your bank account or trust with your home country.
The King or Queen of the ball is of course the US: Having set the whole ball rolling, it’s taken the view that it’s done its part and doesn’t need to play with everyone else. Having assured that everyone else has been playing its tune since 2014, it’s happy to sit this one out and smile.
All the time the US has been complaining about the unfairness of naughty foreign banks helping its citizens to avoid tax, its wealth management business has been able to live the simple life. It will take a while before US gets drawn into CRS and share its information on the same level as everyone else is doing. This is the advantage of inventing the game, I suppose. And the US political system makes it challenging for anyone to try to introduce legislation suggesting the US should join the OECD’s efforts. The IRS has what it wants already. Pushing to participate with the OECD’s exchange is a tough sell domestically in the US.
Enough has been written about this inequality and I actually don’t want to make anything more than this observation – I actually wanted to make a different point.
As long as everyone was appeasing the US it was fairly simple to get a homogenous set of rules up and running. Once the OECD started moving towards a “Common Reporting Standard” I guess it should have been obvious that the same rules wouldn’t apply everywhere, although I hold out hope that this will one day be the case.
Ok, so which rules should I look at?
One of the biggest challenges of the CRS is getting lots of countries’ governments to stick with the plan, and introduce local legislation that reflects the agreements that were made internationally. I’ll go into the detail another time, because here I want to focus on how complex it is, and how the local application can create some confusion, inconsistencies and mismatches.
Suffice it to say that the rules are a mix of principles laid down by the OECD, and the interpretations and local implementation rules set up by individual countries, sometimes subject to further guidance issued by the OECD. The various layers of rules don’t always align well, leaving some conflicting provisions and some ambiguity on the detail.
This leaves financial institutions in a bit of a pickle. They need to understand the principles, obey the local law, and if that’s too vaguely drafted, figure out which guidance to follow. For a bank account the concept isn’t that complicated. It’s annoying, sure, but it’s fairly straightforward to figure out who the account holder is, where he/she lives for tax purposes, and what the bank balance is. But for anything a little more complicated, the rules are not always consistent with each other, or within themselves. And the OECD guidance sometimes contradicts the core principles of its initial rules.
Naturally it also leaves clients in a bit of an uncomfortable position. Wherever you live, whether you’ve included everything in your tax return that you had to, it’s not a nice feeling to know your tax authorities are finding out key details about your financials at about the same time you’re filing your tax return. Certainly disturbing, and an incentive to include everything in your tax return and make sure nothing is overlooked.
Some 100+ countries are participating in the information exchange. Do all of them really have a clean record when it comes to applying the rule of law fairly? Do some perhaps have a complicated political history, and a reason not to be trusted by their residents? Theoretically, the OECD has an answer to this question, in that there are some criteria for participating, including giving residents an opportunity to correct their tax affairs, and assurances about data security, but the bar seems to be quite low. So the question, does all this information really need to be shared with all these countries? And will they all use the information for legitimate tax compliance purposes and no other? And will the receiving countries understand the information correctly or just to a number of incorrect assumptions? Would it pay to be more selective?
I’ll take a slightly extreme example: If I live in a country that allows me to pay tax only on income generated in my country, or where I only have to pay tax on my foreign income when I send it to my home country, I might wonder why they should be entitled to receive information from the bank where I hold other assets not subject to my local tax regime.
If they don’t need it for tax collection, why should they have it? My foreign assets aren’t directly relevant for that purpose. Likewise if I am connected to a trust it’s unwise to require trustees to transfer big numbers to my taxing authority when my taxable interest in the trust (if anything) is a much smaller number.
Or, an easier example: If I only have to pay income tax where I live, and income information is exchanged, why does the capital balance need to be reported? What is it being used for? Certainly not a plausibility check of the income tax, that’s why the income information is provided.
I’m sure there are arguments both ways and I do recognise that there are probably many simple examples where ensuring that taxpayers’ investments and deposits held abroad should be made available where there is a legitimate interest in checking whether tax returns are more or less correct, where there is no legitimate fear of abuse of this information, and people simply haven’t been honest. I recognise that governments need to balance the books, and the threat of verifying tax information against an independent source presumably acts as a suitable incentive. And bank deposit accounts and custody accounts belonging to an individual are fairly clear-cut as to ownership and taxation. However, does all this information really need to be reported, or would less be just as useful, and less of an infringement of privacy?
Trust, it’s a complicated thing…
For people connected to a trust, it’s another level of complicated.
As originally drafted, the CRS rules went really far in identifying people who should be considered as an “account holder” in a trust, including beneficiaries who are unlikely to benefit at any time in the foreseeable future. However, in many cases this rule was rationalised.
CRS works in a similar way to FATCA when it comes to trusts but there are some important differences, and weird quirks, made more complicated by the mix of international and domestic legislation.
This means that the tax treatment of a trust and the CRS reporting could yield quite different results, depending on the combination of the rules where the individual lives for tax purposes, and the way the rules work where the trustee is. Not only this, the information exchanged doesn’t give an indication of the interest the person has in the trust, giving rise to potential for lots of misunderstandings.
Rather than set out all the detail, I think it’s easier to illustrate some of the tricky issues arising by providing some examples below of where there is some misalignment.
Hasn't it all gone a bit too far?
So, having set out some background of what the rules on transparency involve (and thanks for sticking with me) I’d like to set out my argument about the problems these rules create, especially in the context of trusts.
Firstly, it’s got horribly complex and confused.
The way in which the international guidance from the OECD and rules issued by national governments interact means it’s sometimes not even clear who should be reported with which values in a complicated setup. Sometimes a short sentence in a document from the OECD can cause hours of headscratching as well-meaning trustees try to understand what they have to do, in order to meet their legal obligations in their home country and avoid a fine for non-compliance, whilst at the same time not overreporting and causing conflicts around the legitimate privacy fears of the people connected to the trust.
This can’t be the intended outcome. It’s messy. It’s unpredictable. It’s not aligned to taxation principles. It’s difficult to argue that the patchwork of outcomes really helps tax administrators collect tax, or focus their attention on cases where compliance with tax rules might be in question, and it often involves governments receiving much more information than they would need to receive, to assess the tax honesty of their residents.
Examples of the mismatch gone too far:
- Reporting a settlor who has no financial interest in the trust fund. Imagine a UK resident settlor who set up a trust for others, ensuring he has no financial or taxable interest in the trust. Unless the trust is in Singapore or the Bahamas, where the rule involves reporting but with a nil balance (I’ll provide the references to the relevant guidance/FAQ in a separate article), his tax authority will receive the full value of the trust against his name. The report doesn’t provide room for subtleties. This will cause unnecessary complications with no gain for anyone.
- A trust makes a payment to another trust – no tax, no money gets paid out to any beneficiary, but OECD rules suggest this should still be reported in respect of the individuals behind each trust (paragraph 256 on page 109 of the OECD’s second edition of the Implementation Handbook, for those that like to see the detail), even though no individual receives any funds and generally this is a tax neutral transfer. Is this what they meant when they added a sentence here or did they have something else in mind?
- Reporting of protectors (people with supervision powers over a trust) as if they were account holders – many individuals either act as a protector (a trusted person keeping the trustee in check) either for free as a family friend, or for a small annual fee. The OECD guidance in the Handbook mentioned above (table 7, page 111, note also the fun typo in the table) suggests the correct reporting is the entire value of the trust fund. Try and explain that one. Some countries will have addressed this in local guidance, but most probably haven’t. Trustees may be able to take a view on this principle if they “otherwise calculate the account value”.
- Reporting of beneficiaries – in certain situations a bank has to report the entire value of a trust-owned bank account in respect of (amongst others) all discretionary beneficiaries if the trustee is not an institution, although most countries seem to have adapted this rule in following years. This is a really odd outcome. Most people set up trusts to protect their kids or grandchildren from large volumes of family wealth, especially before they are financially mature. The idea is that if they know the full extent of what’s in the trust fund, they might not bother working for a living. However, this doesn’t stop the beneficiary’s government knowing the value of the bank account and asking the beneficiary about it. Awkward. And more to the point, damaging.
- Reporting individual employees or agents in respect of a client family’s corporate entity. Imagine you are an administrator for a family and you’ve agreed to be a director of their holding company. Imagine it’s a big family and no-one in the family has a single holding of more than 20% in the fund. Due to default provisions in the reporting rules deeming you as the person reportable, you will most likely get a polite letter from your tax administration asking why you’ve not included these assets in your tax return (spoiler: it’s not your money, that’s why). It’s happened. It’s not pleasant. These people are professionals but not paid enough to have their personal tax affairs questioned because their job connects them to other people’s money. Even more if you have a few mandates and don’t know to which client the enquiry relates, and are legally obliged to maintain client confidentiality.
This leads me to my next main point: The various weird reporting results I’ve outlined above are disproportionate to, or have no direct correlation to the tax avoidance these rules were designed to correct.
I wonder: does the trade-off between complexity, privacy and tax collection really make sense in the context of trusts? We have some really wide-ranging rules, resulting on a huge overshare of information under rules that are so complicated they will probably give rise to litigation, giving data to governments that maybe don’t need it and might not be able to keep it safe. I appreciate the reasons these rules first came about but I think we’ve got a little lost along the way. And privacy? What’s that?
I think a lot of people would be shocked to find out how far this information-sharing really goes, and how much potential there is for governments, hungry for data about understated taxes, to draw the wrong conclusions about the information they receive.
There are legitimate reasons for privacy
It seems to be an unpopular view these days, but I believe there are a number of legitimate reasons why people’s desire to keep their personal affairs and their finances private. I would prefer to relax in my garden without feeling like I’m being overlooked, and families who can afford to set up trusts to keep money aside for the family should be able to do so without financial information being fired around indiscriminately because the rules were poorly drafted.
There are genuine security concerns here. Not all governments are successful at keeping data secure, and sometimes it’s better for them just to have the minimum amount of information they need to do a plausibility check on tax returns, rather than giving them information that might be misleading or exceed what is needed. It will save government going on wild goose chases, looking for money that doesn’t exist.
There’s also a whole lot of collateral damage generated by the clumsy way these rules have been introduced that suggests that the people who introduced these rules didn’t really know what they were doing, and the focus was on financial accounts anyway. Trusts seem to have been the thing they tried a bit to cover but didn’t really do any useful fine tuning on, despite the complex issues arising, the consequences of poorly aligned rules and a large amount of campaigning by professional organisations such as STEP, the Society of Trusts and Estates Practitioners (of which I am a member).
Family members should still be able to establish trusts for their grandchildren and continue to be discreet about the amount of the family wealth in respect to family members who are beneficiaries, if they choose to, for the reasons I mentioned in the example above. Not all young adults from wealthy families manage their money successfully, sometimes marriages can be short-lived with messy divorce proceedings to follow, and being overly transparent about the assets in a trust with younger adult beneficiaries is sometimes going to be counterproductive and defeat the object of giving them a safety net whilst still encouraging them to make their own way in the world. Keeping funds back and adopting a flexible approach to when funds go to beneficiaries remains a solid estate planning tool.
As long as people are acquiring money legitimately (there are more than enough source of wealth compliance rules covering this), paying the correct amount of taxes due on the wealth structures they’ve established for themselves and their families, privacy shouldn’t be treated as a reason to be suspicious.
Is there room for improvement?
I think that if governments are resolute about including information about trusts in CRS exchanges (which I still think is maybe not appropriate) they should seriously consider:
- Being clearer about what they want and focusing more attention on what is a very technical area, perhaps also engaging with industry professionals to make sure the rules work in practice.
- Applying the same rules everywhere for a consistent starting point* (but see 4).
- Adapting the information requirements to more closely align with taxing interests, and removing rules that are just overkill with no practical application. Can’t we tone everything down a little?
- Without wishing to offend, should we really be sharing everything with everyone, or could we afford to be a little more selective?
- Finally, could we live with a de minimis rule to rationalise the flow of information? (i.e. don’t report modest amounts).
I’d like to end with some fitting advice I once heard and now can’t find an attribution for: If someone asks you a question you don’t really want to answer, just smile and ask why they would like to know. It helps. Sometimes people are just curious, or jealous, but that doesn’t mean they’re entitled to an answer. But if it’s a tax related question from a taxing authority, you might have to answer.
Thanks for reading!
PhilG, 7 July 2020
Excellent article. In particular, the point about personal security is well made. Sadly, many law abiding (and fully tax declared) families have an increased risk of kidnap etc due to the sharing of their data.