Death of a Loophole, and Swiss Banks Will Mourn

 It's about damned time!

By GRETCHEN MORGENSON

WITH all the hoopla over the health care bill, hardly anybody noticed that a job creation bill that President Obama signed on March 18 makes it much harder for United States citizens to avoid taxes by hiding money in overseas bank accounts.

Nobody likes to pay taxes, of course. But for those of us dutifully handing over our share each year, there is nothing more maddening than stories of tax-avoidance schemes created by fee-hungry bankers for well-heeled clients.

We’ve heard a lot of these tales in recent years, alas. Foreign tax havens like Switzerland, Liechtenstein and some Caribbean countries thrive by keeping their clients’ money under wraps and safe from tax authorities’ reach.

Now, Congress is attacking some of these schemes, courtesy of interesting provisions aimed at curbing tax avoidance that legislators wrote into the new jobs bill, known as the Hiring Incentives to Restore Employment Act.

The most substantive section of the bill states that foreign financial institutions will face a 30 percent tax on their United States investments if they refuse to disclose information about accounts they have opened for American citizens in offshore jurisdictions. Another aspect of the bill eliminates a clever derivatives strategy used by investors to make their tax bills on dividends disappear.

Individuals have stashed an estimated $1 trillion in offshore accounts, the government says, allowing them to avoid up to $70 billion in taxes each year. The federal government estimates that abusive offshore schemes by corporations cost our Treasury an estimated $30 billion in tax revenue as well.

Given our large and growing deficits, $100 billion in annual tax revenue would sure come in handy.

“The bill is a huge step in the right direction because you cannot imagine how negligent we were with this stuff for years and years,” said Lee Sheppard, contributing editor of Tax Notes, a tax journal in Washington. “We’re getting serious about tax enforcement on cross-border investment flows in a way that we never have before.”

UNDER the bill, a 30 percent withholding tax would be imposed on foreign financial institutions that refuse to provide details on their United States clients’ accounts, such as who owns them and how much money moves through them. The tax would be assessed on earnings generated by investments these foreign institutions have in United States Treasury securities, stocks, bonds or debt and equity interests in American businesses.

The law was written broadly and covers banks, hedge funds, securities houses, derivatives dealers, commodity traders and private equity firms. Indeed, any financial firm that holds or trades assets for its own account or for clients must comply with the new reporting requirements.

It will be up to the Treasury Department to decide how the law applies to insurance companies. The Treasury will also have to create a system to withhold the tax from institutions that do not comply with the reporting requirements. It has until the end of 2012 to do so.

“Before this bill was passed, the I.R.S. had no reliable way to learn about offshore accounts, and that gave people the opportunity to cheat the system,” said Max Baucus, the Montana Democrat who leads the Senate Finance Committee and pushed for the bill’s reporting rules. “Tax evaders cost our country tens of billions of dollars every year in unpaid taxes, and honest, law-abiding taxpayers pay the price.”

It might seem surprising that the bill sailed through the legislative process, given its implications for financial institutions. But United States banks had no interest in lobbying against it; in fact, they may well benefit from the law as potential customers find it harder to shelter money in foreign institutions.

The law also closes a gaping tax loophole that allows investors who receive dividends on companies’ shares to pay no taxes on them. The Government Accountability Office estimates that billions of dollars in potential tax revenue are lost each year through the use of so-called dividend equivalent strategies.

Under our laws, dividends paid by United States companies to foreign shareholders are supposed to be taxed at 30 percent. But for many years, banks have structured deals using derivatives that allow clients to turn dividends into “dividend equivalents.” Though these payments look like dividends, because they are embedded in a derivative they do not generate a tax.

Here’s how they work: Say a hedge fund holds shares in General Electric. By entering into a swap agreement with a financial institution, the fund can simultaneously sell its G.E. shares a few days before the dividend is issued and receive a derivative tied to the value of the shares and the dividend payment.

After G.E. pays the dividend, the swap is canceled and the investor gets back the shares plus the dividend equivalent payment. The bank that did the trade typically charges a fee linked to the amount of tax savings the hedge fund reaps.

The new law eliminates the tax-free aspect to this transaction, because it treats the swap payments as dividends.

Carl Levin, the Michigan Democrat who leads the Senate’s Permanent Subcommittee on Investigations, has been scrutinizing tax-avoidance schemes for years. His staff’s investigations turned up the dividend equivalent transactions that the law addresses.

“We’ve got a ways to go, but these are significant steps,” Mr. Levin said last week. He added that he still hopes to pass a law “that would allow us to take the same measures against foreign financial institutions that impede our tax-collection efforts that we do against our own.”

While Ms. Sheppard predicted that the new law would have a big effect, she said there were more effective ways to clamp down on schemes. “If you really wanted to stop this, you would define tax evasion as a predicate act to money laundering,” she said. “Currently the money-laundering information the banks give the government is not given to the I.R.S. for civil tax enforcement.”

Such a move would be deemed too radical by many. As a result, we must be content with incremental changes.

ROBERT M. MORGENTHAU, the former Manhattan district attorney who spent many years cracking down on tax-avoidance schemes, commended the new law.

“When citizens don’t pay their taxes, then other citizens have to pick up the burden,” he said. “It’s important that no group of people have immunity from U.S. laws, and this will go a long way to reaching these offshore accounts where U.S. citizens hide their earnings.”
With our nation’s debt levels swelling by the day, we all face the prospect of higher taxes levied to cover those obligations. That makes chasing down tax evaders more important than ever.

Let The Sun Shine In......