May 24, 2010 - Phil Hodgen

New US tax laws will close cross-border investment possibilities

Here’s a little game for you.  The next time that the Federal government announces economic statistics, look for the word “unexpected.”  Joblessness is always “unexpected”.  Interest rate increases are always “unexpected”.

Here’s another item that will be “unexpected” — the United States will become financially isolated from the rest of the world due to the HIRE Act — the March, 2010 Federal law designed to encourage businesses to hire people.  All of that Federal largesse is to be paid for via a number of provisions designed to reduce tax evasion by U.S. citizens.

The Financial Times has it partly right.  In an article today Trouble ahead in US hire law (dear FT editors, how about properly capitalizing the acronym “HIRE”?) there is a brief discussion of the knock-on effects of the HIRE Act.  But there’s more to the picture than the FT article says.

What the HIRE Act does

Think of the prototypical (to IRS Commissioner Douglas Schulman) tax evader:  a U.S. person who plays wink-wink-nudge-nudge with a non-U.S. bank and stashes millions of dollars in a secret place that the IRS cannot see.

The HIRE Act shifts economic incentives in this situation by way of a withholding tax.  It places an economic burden on the evil foreign bank.  The burden can be eliminated if the bank gives the IRS a bunch of information.

The economic burden on the bank is a withholding tax — if the evil foreign bank invests in U.S. assets, there is a 30% withholding tax imposed on payments from the United States to Evil Foreign Bank.

Let’s be clear about what is new:

There is a new and expensive paperwork compliance problem imposed on Evil Foreign Bank; and

There is a substantial economic risk to Evil Foreign Bank for screwing up the paperwork.

How the foreign bank eliminates its risk

The foreign bank can eliminate its risk in the following ways:

  • Do not take on U.S. customers.  This is one desired outcome for the Internal Revenue Service.  If this is foreign bank’s strategy, the foreign bank must still deal with paperwork to satisfy the IRS that it has no U.S. customers.  Otherwise the 30% withholding tax will still apply.
  • Add overhead and play the game the IRS wants it played.  Hire a lot of people and implement systems to deal with the additional complexity and economic risk to the bank.  This is bad for the bank’s profit margin.  So the foreign bank will increase its charges to its customers.  This makes look less attractive to potential customers, so let’s say the foreign bank only increases the charges to U.S. customers.  This drives away U.S. business, and is also a desirable outcome as far as the IRS is concerned.  Given a choice, a rational U.S. investor will choose an asset manager who charges lower fees, all else equal.  This is not so desirable from the foreign bank’s point of view.
  • Don’t invest in the United States.  The economic risk and requirement of massive overhead and paperwork is entirely eliminated (with or without U.S. customers) if the bank simply does not invest in the United States.  The IRS can only impose a 30% withholding tax on money that is flowing from U.S. sources.  If, hypothetically, the foreign bank invests its assets (and the assets of its customers) in London, Frankfurt, Paris, Shanghai, Hong Kong, Sydney, Tokyo, (should I go on?) there is no need to add overhead or turn away customers.

What I expect to see

Let’s loop back to the the future.  When the economic statistics are published, and the word “unexpected” unexpectedly 🙂 appears, what are we looking for?

I expect to see some early effort by most non-U.S. banks and asset managers to play by the rules of the game, as written by the United States.  Over time, however,  I would expect the true cost of compliance with U.S. tax rules to become clear to these institutions — by cost I mean the additional overhead plus penalty risks for inevitable screw-ups.  When this occurs, the slow decay will begin:

  • U.S. customers will no longer be welcome, as they carry with them an outsized overhead cost; and
  • U.S. investments (NYSE, NASDAQ, U.S. corporate bonds, etc.) will no longer be appealing because of the new regulatory risk baked into such an investment.

What to do?

Take Nassim Taleb’s Tweet to heart.  How can the government’s stupidity be exploited for fun and profit?

Americans Living Abroad Nonresidents with US Activities