FATCA and CRS: the changing landscape of fiscal disclosure

With the increase in cross-border business and access to global financial services, it is common for wealth to be held by individuals in offshore accounts. Offshore tax evasion has therefore become a growing concern for jurisdictions around the world and has attracted the attention of governments who are now looking at collecting tax relating to such undisclosed accounts by obtaining data from the offshore financial institutions that hold them. As a result, there is a coordinated effort by governments to obtain a more accurate picture of income and assets held by citizens worldwide. Global initiatives commencing with the US Foreign Account Tax Compliance Act (FATCA) and more recently, the Common Reporting Standard (CRS) provide a foundation for exchange of information to combat tax evasion by individuals and entities.

The US federal income tax system relies on voluntary compliance by taxpayers in computing, reporting and remitting their tax liability each year. The US Congress, driven by concerns that taxpayers have achieved sophisticated means of investing offshore to potentially avoid US taxation, enacted FATCA. US persons are taxed on their worldwide income regardless of where they live. FATCA is meant to encourage the proper reporting of all investment income and all dispositions of securities of a US person, including those held offshore.

FATCA, effective from July 1 2014, is a reporting regime aimed at the disclosure of US persons with offshore accounts and investments. Generally, FATCA requires the identification and reporting of US taxpayers by Foreign Financial Institutions (FFIs), that is, institutions located outside of the US, to the US Internal Revenue Service (IRS). FATCA imposes a penal withholding tax of 30% on US sourced withholdable payments made to FFIs and other foreign entities that fail to comply with the disclosure requirements.

The FATCA regulations also introduced the concept of government-to-government reporting under intergovernmental agreements (IGAs). There are two types of IGA:

• A Model 1 IGA generally requires financial institutions to report account information of US taxpayers to their own government, who commits to exchanging such information on an automatic basis at a governmental level with the IRS.

• A Model 2 IGA generally requires financial institutions to report account information of US taxpayers directly to the IRS.

The IGAs also help overcome jurisdiction-specific legal barriers (for example, data privacy regulations), simplify practical implementation and facilitate compliance with FATCA by financial institutions in the countries concerned.

Hong Kong and the US signed a Model 2 IGA on November 13 2014. Under the Hong Kong-US IGA, FFIs in Hong Kong may rely on a set of streamlined due diligence procedures to screen and identify US indicia to locate US accounts and clients for reporting purposes, for example, in determining whether a new individual account is a US account, based on a customised self-certification received from the applicant, rather than more esoteric procedures under FATCA regulations, such as the use of US-centric withholding certificates. Foreign financial institutions are required, however, to confirm the reasonableness of such certification which can be accomplished by reference to other documents obtained during the account opening process.

As noted above, as Hong Kong is a Model 2 jurisdiction, FFIs there are required to report the relevant account information of US taxpayers directly to the IRS, as opposed to reporting to local authorities under the Model 1 IGA. This is supplemented by group requests made by the IRS to the Hong Kong Inland Revenue Department (IRD) for the exchange of information about relevant US taxpayers at a government level on a need basis. Foreign financial institutions in Hong Kong should have completed the 2014 FATCA reporting before June 30 2015 pursuant to the timeframe applicable to Model 2 IGAs.

China, as one of the US's largest trading partners, reached an "agreement in substance" for a Model 1 IGA with the US on June 26 2014. As of September 30 2015, China is yet to finalise an IGA to address the US reporting requirements. No local guidance notes have been publicly issued by the Chinese government either regarding FATCA compliance to-date.

Under China's "agreement in substance" status, Chinese financial institutions may register at the IRS FATCA Registration Portal as Registered Deemed-Compliant FFIs within a Model 1 IGA jurisdiction. However, as of September 24 2015, only 1,066 entities in China have registered as FFIs on the IRS portal versus the 3,170 that have registered for Hong Kong. The relatively low FFI registration rate suggests a substantial number of China-headquartered financial institutions are taking a wait-and-see approach on FATCA registration and compliance pending the issuance of guidance from the Chinese government.

China has state secret laws governing the disclosure of sensitive commercial information, particularly cross-border. Similar to other Model 1 IGA jurisdictions, after the signing of an IGA between China and the US, financial institutions in China should be able to report information pertaining to US account holders directly to the Chinese authorities. The Chinese government will then exchange such information with the IRS on an automatic basis, thus alleviating the need for Chinese institutions to report such information abroad. The delay in China finalising an IGA with the US and issuing FATCA guidance notes creates some uncertainty for Chinese branches of overseas financial groups about complying with their requirements under FATCA (including new customer onboarding and existing customer due diligence procedures). To ensure certainty and compliance, it is hoped that further guidance will be provided shortly by the Chinese government on how financial institutions can fully comply with their FATCA obligations and details of any local exemptions. This would also encourage China-headquartered financial institutions to comply with the FATCA registration and reporting requirements.

The OECD CRS is another significant step towards a globally coordinated approach to the exchange of information on income earned by individuals and organisations. As a measure to counter tax evasion, it builds upon other information-sharing legislation, such as FATCA and the EU Savings Directive. Cayman Islands, the British Virgin Islands and most European countries will be early CRS adopters, that is, implementing the CRS requirements from January 1 2016 and undertaking the first exchange of information in respect of the financial information of foreign tax resident account holders in 2017.

Hong Kong, China and the majority of Asian countries, while generally committing to adopt CRS, will not adopt CRS before January 1 2017 and will therefore only undertake the first exchange of information in 2018 at the earliest. As a result, while there is a general awareness of automatic exchange of information (AEOI), a number of financial institutions in Asia have not started considering the impact of CRS on their business operations. This lack of awareness has been further exacerbated by a number of Asian jurisdictions not having finalised their IGAs, including Indonesia, Malaysia, Taiwan and Thailand as of September 30 2015. Therefore, the local focus is still on FATCA and not CRS.

The CRS provides a common global approach for jurisdictions to obtain financial information from their financial institutions and to automatically exchange that information with multiple jurisdictions on an annual basis. It has a similar reporting basis to FATCA Model 1 IGA's, except that the CRS is a single framework to be adopted and implemented by various participating jurisdictions.

There are a number of inherent similarities between CRS and FATCA. Both regimes mainly impact financial institutions and require annual reporting on similar information on the account holders and assets held, for example, the identity and residence of financial account holders (including certain entities and their controlling persons), account details, reporting entity, account balance/value and income/sale or redemption proceeds.

However, there are a few key differences between the two regimes. In particular, CRS is based upon tax residence rather than US citizenship under FATCA. Under CRS, financial institutions are required to report to their local tax authorities on information about financial accounts held by overseas tax residents. The laws regarding tax residency are complicated, and differ by country/jurisdiction, so the validation procedures may not be straightforward. It is hoped that individual governments will make tax residence definitions and examples available on their websites, which could assist account holders in making the determination.

Another difference is the increased scope and volume of reporting. The CRS does not provide the option of electing a de minimis threshold for individual account holders as in FATCA, therefore increasing the number of customers in scope for further due diligence and reporting. Also, CRS does not provide for exemptions available to low-risk financial institutions available under FATCA, bringing more financial institutions in scope for CRS. For example the following entities perceived to have a low risk for tax evasion under FATCA would not be excluded from reporting under CRS: financial institutions with a local client base, local banks, certain retirement funds, financial institutions with only low-value accounts, sponsored investment vehicles, certain investment advisors and investment managers, and certain investment trusts. This would mean that far more entities and accounts would be subject to CRS reporting, therefore increasing the amount of due diligence work significantly.

Unlike FATCA, there is no withholding obligation under CRS, so no new withholding systems will be necessary. Penalties for non-compliance will, however, be introduced by each government under local law. Also, CRS introduces a simplified indicia search which allows financial institutions to rely on the current residence address of account holders in determining the tax residency of an individual for pre-existing accounts with balances of less than $1 million. If no such address is held by the financial institution, a search of electronic records for any of six defined indicia for overseas residency must be performed.

Hong Kong does not allow for the automatic exchange of information. An exchange of information can only be made under a comprehensive avoidance of double taxation agreement (CDTA) or tax information exchange agreement (TIEA) and on a request basis. The Hong Kong government indicated its support for implementing CRS in September 2014, though new legislation will be required to allow the government to exchange information automatically. It issued a consultation paper on April 24 2015 to gather feedback on the proposed CRS model to be adopted in terms of the legislative regime and operational framework. In particular, views were sought on the following key aspects:

• the proposed scope of financial institutions, non-reporting financial institutions and excluded accounts;

• the types of information financial institutions have to secure from account holders;

• the due diligence procedures and reporting requirements that financial institutions have to follow;

• the powers of the Hong Kong IRD to collect relevant information from financial institutions and forward such information to designated bilateral AEOI partners;

• the proposed sanctions for failure to comply with the AEOI requirements;

• the mechanism for financial institutions to meet the confidentiality safeguards; and

• the related information technology infrastructure to support the implementation.

The Hong Kong government has indicated that AEOI will be conducted on a bilateral basis with jurisdictions with which Hong Kong has signed a CDTA or TIEA, rather than under a multilateral instrument (that is, the Multilateral Convention on Mutual Administrative Assistance in Tax Matters) for flexibility in choosing AEOI partners. In identifying AEOI partners from among Hong Kong's CDTA or TIEA partners, the Hong Kong government will take into account their capability to meet the CRS requirements and to protect data privacy and the confidentiality of the information exchanged.

Forty-three submissions were made in response to the Hong Kong consultation paper. As mentioned above, Hong Kong does not plan to sign a multilateral instrument for CRS implementation which allows the exchange of information between the Hong Kong government and other participating jurisdictions directly. This gave rise to one commonly expressed view which was the ability for financial institutions in Hong Kong to collect and keep information of all non-Hong Kong tax resident account holders (the wider approach). Most financial institutions in Hong Kong prefer to adopt the wider approach because the narrow approach, that is, limiting financial institutions to collect information relating to account holders in countries only where agreements have been reached to share such information would lead to financial institutions being required to perform due diligence procedures each time Hong Kong signs a new bilateral competent authority agreement for CRS purposes, resulting in very high compliance costs and inefficiencies. However, under the existing Hong Kong Personal Data (Privacy) Ordinance (PDPO), financial institutions in Hong Kong would only be able to implement the wider approach if they are "required or authorised" to collect the personal data in question. For such financial institutions to lawfully adopt the wider approach, amendments to the Hong Kong Inland Revenue Ordinance (RO) or the PDPO would be required. In the consolidated response to the consultation paper published by the Hong Kong government on October 12 2015, the Hong Kong government has decided to maintain its initial proposal to impose a narrow approach for CRS due diligence, but will permit financial institutions to adopt the wider approach as an option.

Another view expressed in the submissions is that the proposed offences and sanctions under CRS should be limited to the financial institutions themselves and not extended to employees. To the extent that employees of a financial institution are subject to penalties, the employees must have taken deliberate steps rather than merely permitting the offence to occur, given the nature of these reporting duties. After the Hong Kong consultation process, the Hong Kong government has maintained its stance that appropriate deterrent penalty provisions are necessary to ensure the effective implementation of CRS. The proposed sanctions, will however, be refined by confining them to those employees who have willfully caused or permitted the financial institutions to provide incorrect returns.

The Hong Kong government is working towards a very strict timeframe to meet its commitment to CRS. The first automatic information exchange is expected to commence by the end of 2018. Financial institutions in Hong Kong will therefore be required to commence due diligence procedures in 2017. The government is proposing that a Bill be introduced into the Legislative Council in early 2016 and the necessary legislation be passed by the summer of 2016.

Similar to other jurisdictions in Asia which have not finalised their IGAs for US FATCA to date, CRS is not the focus of the Chinese government yet. As a late adopter jurisdiction to CRS, it is expected that China will aim for a first exchange of information in 2018. In this regard, it may need to expedite its process (including the signing of the Multilateral Competent Authority Agreement) to meet the global timeline.

The OECD CRS initiative involves governments obtaining information from their financial institutions and exchanging data automatically with other jurisdictions. Financial institutions will have significant additional reporting responsibilities to disclose details of their account holders after the implementation of CRS, with potential penalties for those unable or unwilling to comply fully. The new global standard poses significant challenges for financial institutions in China and Hong Kong in terms of customer due diligence, including reviewing self-certifications for reasonableness provided by customers and other documentation remediation. This is in line with the tightened rules on anti-money laundering (AML) and Know Your Customer (KYC) requirements globally in recent years.

Most financial institutions, after the implementation of FATCA, accept that the increased cost of compliance is now part of their normal business expenditure. However, CRS does not include the minimum $50,000 threshold, and thus all of a financial institution's accounts are subject to review and potential reporting under CRS. This, combined with the fact that the review must be done with respect to multiple reportable jurisdictions (rather than only US accounts under FATCA), means that financial institutions will have to collect and remit information for significantly more accounts under CRS when compared to FATCA. Given this higher volume, some financial institutions that have implemented manual review processes for FATCA will not be able to use the same procedures for CRS.

For those financial institutions in China and Hong Kong with a significant customer or investor base outside their home jurisdiction, CRS means a big increase in the volume of data to be reported to the local tax authority. In integrated regions such as Asia, the sheer scale of reporting will make manual or semi-manual solutions impractical. Similarly, it would impact due diligence and customer data monitoring, as financial institutions may have to store more than one classification for a customer or investor with multiple tax residences, and track all changes to customer status or residence, to keep up-to-date.

Financial institutions which took a tactical approach to their FATCA solution, either by creating temporary manual processes or by excluding US persons from maintaining accounts with them, cannot now simply upgrade their existing framework to cater for CRS. Some financial institutions chose to limit their burden under FATCA, including closing accounts of US individuals to reduce reporting, or centralising all US investments in one entity. These strategies will not work for CRS given the expected increase in the number of clients impacted. Furthermore, CRS allows for additional requirements to be introduced bilaterally between reportable jurisdictions. Financial institutions must therefore keep a close eye on regulatory developments, and face the possibility of additional operational issues and associated cost increases for reporting, including repeated remediation of customer or investor information, as each new group of jurisdictions enters into competent authority agreements. Financial institutions in China and Hong Kong should look to invest in a sustainable and flexible IT architecture that can adapt to evolving regulations and to new jurisdictions coming on board for CRS purposes.

As a response to the coordinated effort by governments to obtain a more accurate picture of income and assets of their taxpayers worldwide and get a fairer share of tax revenue, financial institutions in China and Hong Kong need to keep abreast of new regulations locally, manage relationships with tax authorities, and educate staff and clients on reporting requirements and account opening procedures. Above all, they should be sensitive to how their customers react to additional information requests. All these changes will have a significant impact on their systems and processes, and will require an understanding of regulatory developments and enhanced controls accordingly.

The authors would like to thank Eva Chow for her contribution to this chapter.

Charles Kinsley Principal, Tax KPMG China 8th Floor, Prince's Building 10 Chater Road Central, Hong Kong Tel: +86 852 2826 8070 charles.kinsley@kpmg.com Charles is a tax partner of the KPMG tax practice in Hong Kong. He has more than 20 years tax experience, the last 19 years of which have been spent in Hong Kong. Charles is a leader in the financial services industry, with extensive knowledge and experience in retail and investment banking, securities dealing, funds (including those in the private equity, real estate, alternative investments and infrastructure business) and fund management. He specialises in all tax issues relating to financial institutions and related companies including: financial products, M&A (including divestments), tax structured products, setting up, disposal and structuring of funds and similar investment vehicles in Asia. His role includes advising on operational taxes, the US Qualified Intermediary regime and FATCA and CRS. Following on from his FATCA engagements, which involve working closely with AML controls and procedures, Charles has been working with KPMG's AML practice on engagements to assist with reviewing and developing controls and procedures around tax evasion.

Khoonming Ho Partner, Tax KPMG China 8th Floor, Tower E2, Oriental Plaza 1 East Chang An Avenue Beijing 100738, China Tel: +86 10 8508 7082 khoonming.ho@kpmg.com Khoonming Ho is the tax partner in charge of China and Hong Kong SAR. Since 1993, Khoonming has been actively involved in advising foreign investors about their investments and operations in China. He has experience in advising issues on investment and funding structures, repatriation and exit strategies, M&A and restructuring. Khoonming has worked throughout China, including in Beijing, Shanghai and southern China, and has built strong relationships with tax officials at both local and state levels. He has also advised the Budgetary Affairs Committee under the National People's Congress of China on post- WTO tax reform. Khoonming is also actively participating in various government consultation projects about the ongoing VAT reforms. He is a frequent speaker at tax seminars and workshops for clients and the public, and an active contributor to thought leadership on tax issues. Khoonming is a fellow of the Institute of Chartered Accountants in England and Wales (ICAEW), a member of the Chartered Institute of Taxation in the UK (CIOT), and a fellow of the Hong Kong Institute of Certified Public Accountants (HKICPA).

Lewis Lu Partner, Tax KPMG China 50th Floor, Plaza 66 1266 Nanjing West Road Shanghai 200040, China Tel: +86 21 2212 3421 lewis.lu@kpmg.com Lewis Lu is the partner in charge for tax in Central China. He is based in Shanghai and specialises in the financial services and real estate industries. He specialises in formulating entry and exit strategies for these clients for the PRC market and has assisted many foreign and domestic funds in structuring their investments in China. Lewis regularly undertakes tax due diligence and advisory engagements on M&A transactions. He also frequently assists foreign multinationals in discussing tax policy matters with the PRC tax authorities. Lewis is a frequent speaker at various international tax fora. He teaches international taxation for the master of taxation students at Fudan University. He is a member of Canadian and Ontario institutes of chartered accountants and is a fellow of the Hong Kong Institute of Certified Public Accountants.