Life in the era of the automatic exchange of information

Originally, the title of this article was going to be „Life after the automatic exchange of information”. However, it only took me about 3 minutes to realise that this title couldn’t be further from the truth, as we are not looking at the situation after a process, but rather in a process, and right at its beginning. As the world is not going to return to the way it was before, so from now on we have to live with the process, understanding and accepting all of its elements and consequences. The changes in the rules, though, by no means the end of financial freedom: the playing field still offers benefits well worth taking into consideration.

Where does the process stand at the end of 2016? In short: the most important elements of the system have been outlined, but at the same time there is still a lot of uncertainty when it comes to implementation. If we ask 3 bankers about it, we still get 4 different interpretations. This shouldn’t surprise us at all, as the whole thing is completely new for all the players. While all that the bankers can do is repeat what they have been told by their bosses. The real masters continue to be the banks’ compliance or legal departments; in some cases the top management of the banks have given unlimited power to the legal teams, without thinking through the business consequences of the legal steps and internal regulators. This has created a paradox which sooner or later will be rectified by the market, since the aim of the banks is to make profit, and should not be the fattening of bureaucracy.

One thing is certain, and that is that December 31st, 2016 will be one of the defining days for the system. The reports which the countries reporting in the first round of exchanges prepare will refer to this date. They will take into consideration the situation and balance on this day. The banks are expected to send the details to their domestic tax authority during the first half of 2017, while the national tax authorities then forward the relevant details to the countries who signed up to the first round of the exchange of information by October 1st, 2017.

The dates are significant to the story for a number of reasons. December 31st, 2016 as a value date will naturally be modified in cases where an account was closed in the course of 2016. In this case, the balance at the time of closing the account will be reported, as the first period for the exchange of information was the 2016 calendar year. In this way, it seems logical that the closing balance is determined and that this will be reported. Naturally, there is nothing to stop someone transferring the funds to another account, meaning that the balance remaining may even be 0. And if we think about it, the balance when closing an account always has to be 0. Can a bank close an account which still has funds in it? In practice, there is usually a final transfer or cash withdrawal, with just enough remaining in the account to cover the banking costs of closing the account. It is worth keeping a close eye on this, as current banking practices see some banks charging up to 1000 euros to close an account.
While we’re on the subject of the amount, some banks have drawn a line showing which amounts have to be reported, while others have not. There are banks which will not report accounts with less than one million US dollars in the case of individual accounts and 250 000 dollars for company accounts. These banks, however, are in the minority. The majority will send reports irrespective of the amount for 2 reasons.

  • A significant number of the commercial banks simply do not want to bother with differentiation and setting limits, so will report regardless. The logic of the private banks, on the other hand, is that there has to be at least a million dollars in the account anyway – otherwise they wouldn’t have even opened the account in the first place, so there is no point in dealing with the limits.
  • Another important factor, perhaps the most crucial from the point of view of the system, is which accounts will be considered as „active” accounts. Naturally, this refers primarily to corporate accounts, so typically can be categorised as accounts of companies, though in my opinion if somebody is self-employed, then this can cast a bit of a shadow over the accounts of individuals as well. In the case of active accounts, no report is made, so the question is which type of accounts and activities qualify as active. Is it enough for the client to put a X in the active box on the CRS form, or will the bank actually check the source of more than 50% of the company’s income? There are banks, in Switzerland for example, who subject clients to prosecution-type inspections, asking for the certified accounts signed by the auditor, and even the client’s own most recent personal income tax returns. In my opinion, this is complete nonsense, as the role of the banks is to execute financial transactions, whereas this type of inspection and sanctioning is the role of the tax authority. It would be a shame to argue about that now though, as the whole process is built on faulty foundations, and we are not going to be able to change anything here.

Other European banks, such as those in Liechtenstein, ask clients to categorise their own enterprises in a self-assessment declaration. This is a much more liberal approach, though nobody knows how things will change in the future as the whole system is still extremely malleable. But to take matters to the extreme, how could a Free Zone Company in the United Arab Emirates be considered passive given the local regulations? The licence, which has to be extended each year by the Free Zone, is issued for certain activities, meaning that there are „trading licences”, „general trading licences”, „consultancy licences” etc. From this point of view, the point of view of the country of registration, a company can not be passive as everybody carries out active activities.

At this point, of course, we could also raise the question of holding companies, which acquire the majority of their income from asset management. Fortunately, some of the banks understand and appreciate what this means, and allow holding companies to be categorised as active provided that more than 50% of the combined income of the holding company and its subsidiary comes from active activities. Of course, here again the basis on which judgement is made is all very relative. Based on accounting logic, in the case of a group of companies the consolidated balances and relevant auxiliary appendices, together with the auditor’s report should be the deciding factors. It is difficult to argue with this logic, as in the case of a company a dividend arising from a profit is approved by the owners on the basis of the financial report. I am convinced, therefore, that in the future financial reports will also play a significant role in the case of 0-tax companies.

This brings us to individuals, or more precisely which individuals will be reported on, and who are considered to be controlling persons. Well, in my opinion, this is the most foggy part of the whole system. The account beneficiaries were identified by the banks before now. In the case of accounts for individuals this is a relatively straightforward question, with the majority of accounts having 1 or 2 beneficiaries. In the case of companies, it is not so clear. One account may have 10 beneficiaries, each holding 10% of the ownership rights. In this case, will the banks only report when the proportion reaches 25%, or will they ignore the figures? At this point I would recommend that everybody question their bank very thoroughly regarding reportable persons. Especially as in the case of trusts and foundations the banks have different opinions on the reporting of beneficiaries. There are banks who will only send reports on the beneficiaries if a distribution is made from the assets or income of the trust or foundation. But even here opinions differ, and there are banks who differentiate between loans and paid out income when it comes to payments made to beneficiaries. While a payment from the income of a trust or foundation is considered reportable, a loan is not.

A familiar question reappears in the era of information exchange: is it illegal for a foreigner to appear as the owner, beneficiary or senior officer in a company, trust or foundation? The answer remains the same: no, absolutely not. However, increased attention should be paid to the legal consequences, and it is also worth optimising in advance the connection between our sources of income.

The first really big question is where is the individual who is the subject of the report resident for tax purposes? Naturally, if somebody lives in Dubai with their family, then there won’t be too many consequences at all, as there is neither a tax authority nor tax in the whole territory of the United Arab Emirates. In Cyprus and Malta the situation is more hazy, as a number of income types can be free from tax for tax-payers with „resident but not domiciled” status. The majority of countries in continental Europe tax the worldwide income of their tax residents. From this point of view, tax can be applied to the direct and indirect profits from foreign companies, trusts and foundations.

What do I mean by indirect profit? Numerous countries have developed so-called controlled foreign company regulations – based on the OECD principles – which can have a significant effect on the annual income of an individual. This is because in many case these rules class the so-called undistributed profits of low-tax foreign companies as the income of the beneficiary. It is necessary, therefore, to find out whether such legislation exists in a tax-payer’s country, and if it does, what exactly it prescribes. If there are no such regulations, then the situation is probably more liberal, but if there are, then it is necessary to define very clearly what is classed as income, and how much that income will be for 2016.

At this point, we have to „rewind” a little, to what was written earlier:

  • Foreigners are still not prohibited from appearing as the owners or beneficiaries of offshore companies.
  • Incomes from abroad are subject to taxation, even if they arise from non-distributed profits.
  • In the tax laws of many countries, the onus is on the taxpayer to prove whether or not they have to pay.

How can the taxpayer prove this? We mentioned financial statements earlier. Following accounting principles, a well-structured financial report may prove the deciding factor here. It is not by chance that I have used the phrase well-structured, as even offshore companies can prepare accounts and balances. Today, for example, numerous companies registered in the Seychelles prepare annual accounts, showing the turnover of all of the bank accounts. (A company may have several bank accounts in several different countries). It is a very important point that the combined balance of a company’s bank accounts does not equal the amount of the company’s annual profit. An offshore company may have income, but at the same time there may be expenses as part of the company’s activity. If these are calculated accurately, then the company’s profit may be considerably less than the bank balance. We should not, for example, forget deferred payment invoices. A further advantage of the offshore jurisdictions, where there is no audit requirement, is that the term expenses can be interpreted relatively freely.

The information exchange process has not yet begun, though the trends are already visible. One thing is certain: we can not return to the past. The financial freedom enjoyed 25 years ago, when LAVECO was established, is definitely a thing of the past. We have to learn to live with the current regulations; to get to know them and to make the best of them for our businesses. Just as there were winners and losers in the business world in the past, so those same two groups will be present in the future as well. Is there any question as to which group you would like to belong to?

With warm regards,

László Váradi