Loophole preventing the FATCA reporting of a U.S. person


In brief

The report published by the U.S. Senate last August highlighted the existence of schemes to prevent FATCA reporting, also known as the "shell bank loophole". This report comes in the wake of the Robert Brockman affair, which revealed that the late American billionaire was at the head of a scheme involving interposed offshore entities qualifying as financial institutions. This scheme allowed him to not be reported by its Swiss banks under FATCA and thus hide approximately $2.7 billion from the U.S. tax authorities.

In detail

The so-called “shell bank loophole” is a quite simple mechanism. First of all, an entity is created in an offshore jurisdiction. It is then artificially classified as a foreign financial institution under FATCA, and thus registered on the Internal Revenue Service (IRS) portal. Next, a bank account is opened in the name of this new entity, meaning that the bank is not required under FATCA to identify and report the underlying U.S. ultimate beneficial owner (also known as Controlling Persons under FATCA/CRS). 

This loophole stems from the fact that the bank is not obliged under FATCA to verify that the offshore financial institution has filed its own FATCA report disclosing its U.S. owners (even though this could be envisaged in some circumstances from an AML tax-fraud perspective). This mechanism relies on the absence of checks conducted by the IRS when the offshore entity is registered as a foreign financial institution and by the tax authorities in the country of residence of said offshore entity. The lack of resources and the large number of financial institutions prevent the IRS from effectively monitoring Global Intermediary Identification Number (GIIN) applications. This means that tax evaders can set up multiple offshore entities without being subject to any scrutiny. For example, in the following seven jurisdictions, over 120,000 entities are registered on the IRS portal, including over 80,000 in the Cayman Islands alone.

Popular Tax havens

Brockman favored IRS-registered entities in places like the Cayman Islands to avoid scrutiny. Below is a tally of all such entities in those jurisdictions:

Source : Senate Finance Committee

Cayman Islands 84,713
British Virgin Islands 15,218
Guernsey 9,394
Switzerland 6,847
Singapore 6,147
Bermuda 4,177
Malta 1,716

While the U.S. Senate report only deals with FATCA, this avoidance mechanism is also directly applicable for CRS purposes.

In addition to investigating a potential breach of the FATCA and CRS due-diligence obligations by the banks in question, i.e. testing the reasonability of the corporate account holder’s FATCA and CRS status and not merely checking the presence of a GIIN, this type of structure will need to be analysed according to the tax-fraud indicators of CSSF Circular 17/650 as well as DAC 6, specifically Hallmark D on CRS avoidance arrangements. This is particularly relevant for closely held private investment vehicles that are located in offshore jurisdictions and whose fulfilment of the criteria to be treated as financial institutions is dubious.

With this in mind, it is important that Luxembourg banks identify this type of structure among their clients. They must therefore define the governance and checks to be implemented, based on the tax-fraud risk level of those clients qualifying as financial institutions. For medium-risk or high-risk clients (and depending on the defined tax-risk appetite), best practices could involve obtaining a memo from a reputable adviser which confirms the relevance of the chosen FATCA/CRS status or a confirmation (or proof in case of doubt) that the foreign financial institution in question duly filed a FATCA and/or a CRS report disclosing their (U.S.) Controlling Persons.

What’s next?

Financial institutions should review their existing internal checks from both a tax and an AML perspective, especially with regard to the client onboarding phase. We may indeed expect additional checks from the tax authorities and regulators (accelerating the current trend) and possibly a change in the regulatory framework (a DAC 9 proposal?).

Our experts are available to further discuss the above and help you implement sound governance if needed. Our team can assist you with:

  • drafting or review of procedures and the control matrix;
  • reporting through our online collaborative platform;
  • reviewing self-certifications obtained from clients or investors;
  • performing due diligence on service providers (e.g. on transfer agents for the fund industry); and
  • organising training sessions.