Amid significant criticism, the intergovernmental agreement between Canada and the United States that exponentially expands the sharing of tax-related information between the two countries came into effect on July 1.
“What the [agreement] means is that the Canada Revenue Agency will now exchange financial information about Americans living in Canada with the Internal Revenue Service,” says Veronika Chang, a foreign legal consultant with Toronto-based tax boutique Morris Kepes Winters LLP.
In the process, however, the agreement amends the reporting and withholding obligations of foreign financial institutions and others who make payments to a “U.S. person,” as the U.S. Foreign Account Tax Compliance Act (FATCA) defines the terms. But the designation as a foreign financial institution can be misleading.
“Any entity, both financial and non-financial, must consider whether it is subject to FATCA because FATCA is not limited in scope to the financial services industry,” says Roanne Bratz, a partner at Stikeman Elliott LLP’s Montreal office.
All foreign financial institutions must report the activities of their U.S. clients to the IRS and withhold funds in appropriate circumstances. But the agreement allows Canadian institutions to report to the CRA instead. This aligns the reporting obligations of financial institutions under U.S. and Canadian law.
This aspect of the agreement is, however, a double-edged sword.
“On the one hand, the fact that the legislation requires Canadian institutions to flag their U.S. accounts to the Canada Revenue Agency rather than the Internal Revenue Service removes some pressure from Canadian banks in terms of their privacy obligations under Canadian law,” says Roy Berg, director of U.S. tax law at Calgary-based Moodys Gartner Tax Law LLP.
“On the other hand, it changes the landscape for any entities characterized as foreign financial institutions by imposing an obligation on them to figure out who their U.S. account holders are.”
The upshot is that the agreement has major implications for Americans living in Canada and others defined as “U.S. persons” under the U.S. law. Indeed, the law’s main purpose is to track down Americans who are avoiding their obligations to pay tax on their worldwide income.
“The reason for FATCA’s creation was that many American citizens, including those not residing in the U.S., were not reporting their worldwide income,” says Bratz. “But instead of going directly after the non-reporters, the U.S. approach appears to be to have the world police the situation for them.”
Still, these developments might come as a surprise to a significant number of U.S. citizens living abroad.
“Many Americans living in Canada and elsewhere don’t understand that the U.S. is one of only two countries in the world that require its citizens to file tax returns no matter where they are living,” says Berg.
The gap in understanding could be costly. “Even U.S. citizens who have lived most of their life in Canada can be considered to have tax obligations under U.S. law and could face heavy penalties of up to $10,000 for each year they have failed to file tax returns,” says Chang. “It’s even possible that a person born in Canada who has an American parent could be affected.”
To comply with the law, Canadian foreign financial institutions, including subsidiaries of U.S. parents, must use due diligence in searching for U.S. indicia that will identify U.S. accounts and report specified information about them to the CRA. The Canadian agency will in turn share the information with the IRS on an automated basis.
The task is daunting, all the more so because Canada’s draft implementing legislation provides for significant penalties for non-compliance. “Regardless of the method Canadian banks use to identify U.S. account holders, they will be undertaking a monumental project that is ongoing and not time-limited,” says Chang.
Indeed, Chang suggests FACTA projects amount to a significant internal restructuring for many organizations.
“The restructuring will be aimed at better aligning an institution’s tax function and its operating structure with the aim of improving communication between in-house counsel, the tax department, and the client relationship department and its managers,” she says.
Complicating the issue is the fact the implementing legislation appears to have many problems. Some prominent tax lawyers, for example, believe it eviscerates the agreement.
“The U.S. Treasury Department may ultimately view the legislation as an invalid implementation of the [agreement] and may therefore not afford Canadian financial institutions the benefit of the agreement,” says Berg.
By way of example, the Canadian definition of financial institution is considerably narrower than the one contained in the agreement, U.S. treasury regulations, intergovernmental agreements executed by other jurisdictions, and guidance notes issued by Britain and Ireland.
“The result is that many entities that would be classified as financial institutions, such as private trusts and private holding companies, would not be so classified in Canada,” says Berg.
Should the United States regard the Canadian legislation as an invalid implementation of the agreement, Canadian institutions would face the dilemma of complying with Canadian law and suffering the consequences under FATCA or complying with FATCA and suffering the consequences under Canadian law.
As well, Canadian entities not considered financial institutions under Canadian law but so classified under U.S. law would likely face withholding rules for which they would have to seek refunds directly from the IRS.
Finally, inconsistent definitions among jurisdictions that have executed intergovernmental agreements with the United States will cause increased compliance costs and uncertainty in the marketplace. “The U.K. realized this risk early on and has taken the lead in developing its domestic legislation to avoid this result,” says Berg.
But even if the Canadian legislation ultimately satisfies the United States, a constitutional challenge may be looming. Peter Hogg, scholar-in-residence at Blake Cassels & Graydon LLP’s Toronto office, has warned the legislation may violate the Charter of Rights and Freedoms.
But the IRS keeps on coming. U.S. authorities have recently added another tool that will help them keep track of the comings and goings of U.S. citizens and others crossing the Canada-U.S. border and perhaps assist in identifying U.S. citizens who are residents of Canada or have financial dealings here.
As of June 30, 2014, travellers must swipe their passports both when they enter and depart each country with the two jurisdictions sharing the information the new practice provides. These changes, part of the entry-exit initiative and the perimeter security and competitiveness action plan, fall under a larger co-operative effort announced in February 2011.
Previously, each country counted individuals only when they entered but not when they left. Because they rarely shared even that limited information, typically neither country knew how long someone had been within its borders.
“Now both countries will be able, for the first time and in real time, to independently determine the number of days spent in each country,” says Berg.