- New tax laws went into affect on July 1st, FATCA (Foreign Account Tax Compliance Act), with significant investment implications.
- There are many unintended circumstances of its enactment.
- Disinvestment of US Securities could cause higher rates and less demand for Investment in the United States.
With the best of intentions, Congress drafted FATCA legislation and quietly slipped it into the Hiring Incentives to Restore Employment Bill, signed into law by President Obama back in March 2010. And with very little fanfare, the Foreign Account Tax Compliance Act (FATCA) quietly became law on July 1st. In fact, it has been said that if you were to mention FATCA in the halls of Congress, many - both elected legislators and their staffers - would not know what you meant.
FATCA was initially introduced to target those Americans who evade paying taxes by hiding assets in foreign bank accounts. It requires all foreign financial institutions to disclose to the United States Internal Revenue Service (IRS) the names of all US citizens and green-card holders who have accounts abroad. Failure to do so would subject these institutions to a 30% withholding on all their transactions here in the United States. The Act also penalizes individuals for not disclosing their assets in these foreign institutions.
The House Ways and Means Committee estimates the Act will raise $792 million in new revenues. According to Newsweek, however, FATCA was not subjected to a rigorous cost/benefit analysis before Congressional passage of the legislation. The compliance cost to overseas financial institutions alone has been roughly estimated at $8 billion a year, approximately 10 times the amount of tax revenue "guess-timated" by Congress.
As the title of this article may suggest, there are certainly some unintended consequences of its enactment. Those being affected by the Act are the US financial markets, American financial institutions, and US businesses operating in global markets, as well as American citizens residing overseas.
Unfortunately, the average US citizen living and working overseas is already being discriminated against by many foreign financial institutions. For some foreign banks, insurance companies, security firms, and mortgage companies, the cost to comply with FATCA is so great that it is easier and less costly to not accept US citizens as clients. Americans are having their accounts closed and their access limited - and in some cases denied altogether. For example, a recent Wall Street Journal article states that "Fidelity Bans US Investors Overseas from Buying Mutual Funds." The article goes on to say that Putnam, Vanguard, and Charles Schwab are all curtailing or eliminating the purchase of mutual funds through foreign financial institutions.
It is only fair to mention that an attempt is reportedly being made to rectify this situation through Intergovernmental Agreements (IGAs), but success in this effort is at present far from certain.
Another result of FATCA's implementation will likely be foreign divestment of US financial assets. According to ACA (American Citizens Abroad), the Japanese Bankers Association puts it succinctly: In the event the implementation of FATCA is not practically feasible for the Japanese financial services industry, it will result in substantial confusion in the industry and could ultimately lead Japanese financial institutions to withdraw or reduce their investment in American financial markets. ACA goes on to say that the European Banking Federation and the Institute of International Bankers, which represent most of the non-US banks and security firms that are affected by FATCA, take the position that many foreign financial institutions, particularly smaller ones or those with minimal US investments or US customers, will opt out of US securities rather than enter into direct contractual agreements with a foreign tax authority, i.e., the American IRS.
Collectively this could be a very big deal. Total foreign investment in the United States exceeds $21 trillion. Foreign investment in US securities alone exceeds $10 trillion. The capitalization of the two US stock exchanges exceeds $18.6 trillion, according to the US Bureau of Economic Analysis. When you consider that two thirds of the power is controlled by non-US financial institutions, America's legislators are exposing her to the risk of an exodus, whether small or large, out of US investments.
And how will other economic powerhouses, such as China, react to FATCA's requirements? Face it, we have backed ourselves into a corner: our national debt exceeds $17 trillion, and we depend on foreign countries and their financial institutions to purchase our debt and thus keep our interest rates down. If FATCA prompts China and other buyers of American debt to get out of the US financial markets, the impact on interest rates - as well as on the value of the US dollar - could be significant and painful. Keep in mind that, as of May 2014, only 33 countries had signed up to comply with FATCA, and another 34 had reportedly reached an "agreement in substance." In other words, most countries had not yet agreed to comply. At present, we cannot be sure how the world will react to these new global regulations.
It is widely recognized that China has been searching for an opportunity to replace the US dollar as a reserve currency for international transactions. China currently holds over $1.3 trillion of US Treasuries, and Japan has another $1.2 trillion in Treasuries. We are becoming more and more dependent upon foreign investment to purchase our debt. Those two countries alone account for over 10% of America's outstanding debt. We are dependent on them and other buyer nations, in other words. In this environment, could FATCA provide the perfect justification for China, or for Asian nations as a group, to replace the US dollar with another currency of choice? Due to China's current economic woes, this is probably not a near-term possibility. Down the road, however, such a turn of events seems quite possible.
Also worth noting is that in 2013, over 3000 US citizens renounced their American citizenship. That may not sound like many, but considering that in 2012 the number was only 1000, it is certainly a significant increase over years past. It appears that the number will increase again in 2014. Some think this is a direct result of FATCA regulations. In addition to this we have seen US corporations moving their companies abroad in attempt to lower their corporate tax burden.
But let's return to the subject of the US dollar. Can we foresee what impact FATCA will likely have on the US dollar? For the time being little impact will be felt, if only because the US economy is in better shape than the rest of the world, a fact that supports the value of our currency. Over time, however, we can see FATCA potentially driving divestment in US securities and debt instruments, a development which would almost certainly have a significant negative impact on our financial markets as well as on the dollar.
In short, Congressional intentions were no doubt good in enacting FATCA, but our legislators seem to have passed the law without sufficient study of its likely consequences.
Does this road lead us to investment hell? Not yet, but the temperature is clearly rising. For us as investors, it would be prudent to monitor the long-term effects of FATCA's implementation. Foreign divestment in US assets could have long-term negative implications for our financial and economic health.