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August 24, 2009
News Analysis: How the U.S. Is a Tax Haven for Mexico's Wealthy
by Robert Goulder

Full Text Published by Tax Analysts®

As if Treasury Secretary Timothy Geithner didn't have enough on his plate, there's one underappreciated problem his department now must address. This latest headache can be summarized in three words: U.S. bank secrecy.

The issue landed on Geithner's desk shortly after he accepted his current job, in the form of a February 9 letter from Mexican Secretary of Finance Agustin Carstens. At first glance, its polite language seemed innocuous. Geithner most likely read the letter, mumbled "ho-hum," and added it to the stack of low-priority items on the back burner.

But six months later, Carstens's letter — and how Treasury will respond to it — has the potential to become a lightning rod for controversy. That's because the IRS and the Justice Department, after decades of passive acquiescence, decided to pick a fight with Swiss banking giant UBS, the world's largest manager of private wealth.

At the heart of the UBS litigation is the U.S. government's newfound resolve to challenge Switzerland's bank secrecy regime and end the cross-border tax evasion it facilitates. Carstens's letter raises an embarrassing issue for Treasury given the timing of last week's UBS settlement, which made newspaper headlines here and abroad.

What does the letter contain that's so shocking?

It asks the U.S. government to offer Mexico the same exchange of information terms the United States has with Canada. That's significant because Canada is a special case when it comes to cross-border tax enforcement. Despite possessing one of the world's most comprehensive tax treaty networks, the United States has meaningful information exchange with only one country: Canada.

Mexico has now put the U.S. government on notice: It wants in on what's previously been Canada's exclusive arrangement. Should that inclination spread to other governments across the hemisphere, it could have extraordinary consequences for the U.S. financial sector. Think of it as the fiscal equivalent of the H1N1 flu virus. (For Carstens's letter, see Doc 2009-5928or 2009 TNT 50-12.)

Carstens's letter is a direct admission that Mexican tax authorities, like other tax agencies around the world, are frustrated in their attempts to tax their own residents. They've run into a brick wall when trying to collect taxes due and owing from income earned in U.S. bank deposits. Their frustration bears a striking resemblance to the IRS's in trying to tax U.S. residents with offshore accounts in Swiss banks. (For related coverage, see p. 744.)

Replace the nationalities mentioned in the letter, and you've replicated the UBS affair point for point. We see the same fact pattern and the same grievance about beggar-thy-neighbor tax practices. One country is trying to tax its own residents on their investment income but is getting nowhere because of another country's banking and tax rules. Just as the United States spent the last year demanding that Switzerland give ground on its bank secrecy regime, Mexico now wants the U.S. Treasury Department to yield on its own bank secrecy.

Fair is fair, the argument goes, lest Washington be accused of extraordinary hypocrisy.

By now you're probably thinking that something is wrong here; U.S. banks must be very different from Swiss banks. Guess again — they're not.

It's true that technically speaking, the United States doesn't have a formal bank secrecy regime. But as a practical matter, U.S. law offers de facto bank secrecy to every nonresident alien who places money in U.S. banks, a point I'll return to. Only Canadians are excluded from this treatment.

Why does Congress tolerate de facto bank secrecy? The answer is simple: Our banks need the money. If you think that excuse sounds familiar, you're correct. It's the same response Swiss bank authorities threw back at U.S. officials during the recent UBS negotiations.

The shoe is now on the other foot.

Beginnings in the Mérida Initiative

The story starts in Mexico City. Shortly after prevailing in Mexico's closely fought election in 2006, President Felipe Calderón decided to get tough on his country's illegal drug trade. Prior administrations had engaged in similar efforts, but this time was different. Calderón was prepared to go nuclear with coordinated assaults on every aspect of the deadly drug trade.

The crackdown produced prolonged violent clashes with Mexico's powerful drug cartels that continue to this day. Much blood has been spilled, and many lives have been lost. The cartels have been revealed to be highly organized, well funded, and ruthless. They are as slick as any multinational corporation engaged in global trade. Their bosses, like other CEOs, wear elegant suits and complain about spending too many hours on the phone with lawyers and accountants.

Calderón has been exceptionally bold in his actions, often calling in the military when the cartels were too cozy with the local police. He's also looked for strategic partnerships with allies abroad, most notably the United States — the ultimate destination for most of the drugs produced in or channeled through Mexico.

In October 2007 Calderón struck a political agreement with President George W. Bush to provide Mexico with much needed support for fighting the new drug war. Thus was born the Mérida Initiative. The pact included financial support as well as vital operational assistance in the form of training, equipment, and intelligence. In June 2008 Congress agreed to provide Mexico with up to $400 million in direct payments for the Mérida Initiative. To date, about $300 million has been disbursed.

Despite the continuing violence, the crackdown is generally viewed as a success. Calderón has emerged as a hero to the global counternarcotics movement — so much so that law enforcement authorities across the Caribbean region have begun complaining that Mexico's drug cartels are shifting their business east to avoid the Mexican military. During the Summit of the Americas in April 2009, several Caribbean officials asked U.S. officials if they could join the Mérida Initiative and benefit from similar financial and operational support.

Little has changed under the Obama administration, which favors a continuation of the Mérida Initiative. On August 9 President Obama met with Calderón and Canadian Prime Minister Stephen Harper in Guadalajara, Mexico, to discuss a variety of economic and security issues. There's no indication that Carstens's February 9 letter to Geithner was discussed at that minisummit.

Mexican officials want not only to run the drug cartels out of town, but also to tax them.

Drug traffickers are also money launderers and tax evaders. It's in their job description. You can't really declare a few million pesos of unexplained income on your tax return and list "drug lord" as your occupation. Besides, the moral threshold that's crossed by falsifying tax returns is nothing for people who regularly bribe police, kidnap judges, and slit the throats of informants.

We're talking lots of money here. The illegal drug trade between Mexico and the United States is a multibillion-dollar business. If Mexico could tax a fraction of those earnings, it would represent a huge revenue haul. Therein lies the connection to the letter on Geithner's desk. Carstens has a pretty good idea where the cartels are keeping their fortune, and it ain't Tijuana.

Mexican drug bosses aren't fools. They won't walk down the street of some border town carrying a sack of cash and try to open an account at the local bank. They will search for a welcoming host country where they can safely park their ill-gotten gains without attracting much attention. The ideal host jurisdiction is a place where their money: (1) won't be taxed, (2) won't be reported to the host country tax authorities, and (3) won't be reported to Mexican tax authorities.

Such a place exists. It's called San Diego, which the Geneva daily newspaper Le Temps recently characterized as one of the world's most successful tax havens given its proximity to the Mexican border and popularity with Mexican NRAs. (Le Temps, "Les Etats-Unis Servent de Paradis Fiscal aux Capitaux Mexicain," July 23, 2009, p. 15.) San Diego, of course, is only a symbol of the problem. The same de facto bank secrecy exists in Miami, Charlotte, New York, or any U.S. town where there's a bank open for business.

These are not rogue banks operating on the fringes of society. No, these are the mainstream banks you pass every day on your morning commute. This is your bank and my bank. All U.S. banks engage in de facto bank secrecy when they accept deposits from NRAs; we just don't talk about it.

The appeal of U.S. bank secrecy is not limited to Mexico's criminal element. The same temptation exists for the many thousands of affluent or middle-class Mexicans who earn legitimate incomes. Why would they put their money in a Mexican bank? U.S. banks are widely regarded as more secure, better regulated, and better managed. All things being equal, there's no reason why the entire merchant class of Mexico wouldn't want to place its savings north of the border.

But then how can Mexico collect tax revenue from its own residents? How does the Mexican government find out about these offshore accounts? It can't. That's what prompted Carstens's letter.

Our Ring-Fence Regime

Mexican residents who hold an account with a U.S. bank — just like U.S. account holders at Swiss banks — are essentially on the honor system when it comes to declaring bank deposit income for tax purposes in their home countries. As students of the subject have learned, tax law enforcement using the honor system translates to rampant tax evasion.

Under conventional U.S. tax policy, domestic-source income must be subject to U.S. taxation regardless of the taxpayer's residence. In most cases, satisfactory compliance rates are ensured by various forms of mandatory reporting or withholding.

A prominent exception applies to individual NRAs with U.S. bank deposits. The interest income they earn on U.S. bank deposits is not subject to tax in the United States, although it almost certainly will be subject to tax in the NRA's country of residence. Even countries with territorial corporate regimes routinely tax individuals on a worldwide basis.

The policy is not new. U.S. law has exempted income from bank deposits held by foreign persons since 1921. (See reg. section 1.6049-5(b).)

For many decades that exemption resulted from a bizarre source rule providing that interest from such U.S. bank accounts was foreign-source income. That nonsensical source rule was replaced in 1986, but the tax exemption remained unchanged. The interest is U.S.-source income and is exempt from U.S. taxation if it's not effectively connected to a U.S. trade or business. Because most individual bank deposits represent passive investments, the effectively connected standard is easily avoided.

Because the interest income on NRA bank deposits is exempt from U.S. income tax, it is also exempt from U.S. estate taxes when the foreign account holder dies. (See section 2105(b)(1).) The capital remains in the U.S. financial system, and the cycle repeats for another generation. All the while, these funds are eligible for FDIC insurance like any other U.S. bank account.

Think about that: Your interest income from a U.S. bank is fully taxable, but the same type of income is not taxable to an NRA. Uncle Sam is purposefully favoring a foreigner over you and me. This is a classic example of a ring-fence regime — that is, a favorable rule (here a full tax exemption) whose benefits are made available only to outsiders. It's as if the tax law constructs a figurative ring around the U.S. population to prevent them from sharing in the benefits.

Unfair as they seem, ring-fence regimes are common throughout the world, especially in tax havens and offshore financial centers. Ring fencing was one of the four attributes associated with tax haven status in the OECD's landmark 1998 report on harmful tax competition. The other three tax haven attributes were low tax rates, lack of fiscal transparency, and lack of information exchange.

In May 2001 then-Treasury Secretary Paul O'Neill criticized the initial OECD tax haven report for its targeting of ring fencing. (For prior coverage, see Tax Notes, May 14, 2001, p. 1061.) As a result of opposition from the Bush administration and members of Congress, subsequent OECD reports removed ring fencing from the list of tax haven criteria. (For prior coverage, see Tax Notes, July 2, 2001, p. 24, Doc 2001-17977, or 2001 TNT 126-3 .)

The critical element of U.S. bank secrecy, however, is not the generous exemption from U.S. taxation. It's the related exemption from reporting requirements.

U.S. law requires banks to report interest income to the IRS. If you are reading this article, you know the concept very well. At the end of each calendar year, your bank sends a Form 1099 to the IRS informing it of how much interest income you are earning on your accounts. A copy of the Form 1099 is mailed to the resident account holder's home address on file with the bank. U.S. residents have a clear incentive to declare that income on their Form 1040. Failure to do so would produce a glaring mismatch with the income reported by the bank. Underreport your interest income, and you're busted.

Not so for NRAs. Not only is their interest income from bank deposits not subject to taxation in the United States, it's never even reported to the IRS. The data are readily available, but they're cleverly bottled up at the level of the bank. This is another classic ring-fenced regime in that U.S. residents are denied the same treatment. There is no equivalent to the Form 1099 for individual NRAs.

What about tax treaties? Don't tax treaties and tax information exchange agreements envision information exchange between national revenue bodies?

Yes, but that doesn't help much. Like its counterparts in other countries, Treasury negotiates every tax treaty so that it contains an article on information exchange (article 26 under both the U.S. and OECD model treaties). Those treaty articles call for information exchange "on demand." That means the tax collectors must already know who they're looking for.

Should the tax authorities in one contracting state want to obtain information about one of their own residents from the other contracting state, they must know exactly what they're looking for. Required information typically includes the account holder's name and — depending on the countries involved — additional information such as the taxpayer identification number, the name and address of the foreign bank, and possibly even the foreign bank account number.

Rarely are those facts available to tax administrators. On a practical level, information exchange on demand means the IRS would have to already know a U.S. resident was stashing money in another country. If the identity of the scofflaw isn't already known to tax authorities, these treaty articles are of limited use.

No U.S. tax treaty or TIEA calls for automatic information exchange, in which tax officials actively assist each other in spotting offshore accounts held by residents of the other contracting state. On the international level, that omission has been described as the great shortcoming in cross-border tax enforcement. (Privacy advocates, however, view automatic information exchange as an inappropriate fishing expedition and a perceived violation of personal liberty.)

As mentioned, Canada is the only country with which the United States has robust information exchange. That's less a matter of treaty interpretation and more a matter of regulatory law. (See reg. section 1.6049-8(a).) The carveout for Canadian NRAs has been in place since 1997. (For T.D. 8664, see Doc 96-11207 or 96 TNT 75-10.)

Carstens's letter acknowledges this inadequacy of available treaty procedures. He writes:

      As you are aware, Mexico and the United States regularly exchange information on a case-by-case basis, in accordance with our bilateral tax treaty. We also exchange bulk information on interest payments (between corporations), dividends, and royalties. However, we do not exchange information on interest paid by banks from one country to residents of the other country. Canada and the U.S. implemented such [a] mechanism years ago.

The letter continues:

      The exchange of information on interest paid by banks will certainly provide us with a powerful tool to detect, prevent and combat tax evasion, money laundering, terrorist financing, drug trafficking, and organized crime.

Carstens doesn't say it in his letter, but that information exchange would also allow Mexican tax authorities to identify doctors, dentists, and business executives who knowingly shelter money tax free in U.S. banks.

Profiles in Irony

In view of the parallels to the Swiss UBS affair, how can Treasury possibly oppose Mexico's request that it be placed on the same terms as Canada? Our nations are friends and neighbors and, through the North American Free Trade Agreement, make up the world's largest trading bloc. Moreover, Washington has just spent significant political capital to publicly challenge offshore tax evasion. Will the policy shift when the tax evaders are Mexican and the offshore accounts are on Main Street USA?

For better or worse, there's good reason to think Treasury will want to preserve the status quo. For starters, the United States has little to gain from its own revenue perspective. It's not as though U.S. taxpayers are hoarding cash in Mexican banks. Maybe the Cayman Islands, but certainly not Mexico. The reciprocity that Mexico will offer Treasury has little appeal. This particular subset of the offshore sector is a decidedly one-way street.

More important, powerful U.S. domestic interests stand to be adversely affected by sharing tax information with the Mexican government. The evidence for that is overwhelming — consider the firestorm of criticism that was triggered the last time Washington tried to alter the exemption for reporting NRA bank deposit income. That episode is worth reviewing.

In January 2001, only three days before the end of the Clinton administration, Treasury issued a proposed regulation requiring U.S. banks to report interest income paid to NRAs (REG-126100-00). The regulation would not have altered the tax exemption for that interest, only the reporting exemption. (For REG-126100-00, see Doc 2001-1779or 2001 TNT 14-130.)

Just as a Form 1099 is required for each U.S. resident account holder, alternate paperwork, Form 1042-S, "Foreign Person's U.S. Source Income Subject to Withholding," would have been required for each NRA account holder. One copy would be sent to the IRS; a second copy would be mailed to the NRA's last known address or delivered in person; and a third copy would be retained by the bank. The reporting obligation would apply for any NRA accounts with interest income over $10. The banks' determination of NRA status would require scrutiny of paperwork presented by the account holder at the time the account was established.

The title of Form 1042-S is a bit misleading in this instance. The stated purpose of the regulation was not to withhold tax on the bank deposit income, which is exempt from U.S. taxation, but to allow the IRS to collect data for the purpose of exchanging them with foreign governments, including tax authorities of the NRA's country of residence that want to tax that income. Knowing that the information would be made available to tax officials in their home countries, the NRA account holders would have an incentive to self-report income from their offshore accounts in the United States. That's the same incentive U.S. taxpayers face as a result of reporting under Form 1099.

The proposed reg drew fierce opposition from the U.S. banking sector, especially regional banks that cater to clients in Mexico and Latin America. In October 2001 the Florida Bankers Association (FBA) and the Florida International Bankers Association (FIBA) wrote O'Neill and met with Treasury Assistant Secretary for Tax Policy Mark Weinberger to express concern that the reg would cause foreign investors to withdraw their deposits from U.S. banks.

FBA and FIBA officials presented Weinberger with a research paper prepared by the Washington Economics Group and written by Antonio Villamil, a former undersecretary of commerce under President George H.W. Bush. Villamil's report estimated that banks in South Florida could lose $34 billion in NRA deposits.

Such an exodus of capital would spell disaster for affected banks. The FBA/FIBA letter to O'Neill warned that "in Florida alone [banks] would experience a loss in operating revenue ranging from $4.4 billion to $8.36 billion each year." It continued: "The economic losses to Florida are likely to be mirrored in similar U.S. states with significant amounts of NRA deposits such as New York, California, and Texas." Ripple effects would damage the U.S. economy, the letter warned. As financial capital dries up, banks would be forced to lend less money to American businesses. Real estate would suffer, as would the construction industry. In addition to bank profits, jobs would be lost. (For the FBA/FIBA letter, see Doc 2001-25966or 2001 TNT 198-36.)

Then-Florida Gov. Jeb Bush, brother of President George W. Bush, was among the prominent opponents of the proposed reg and sent a similar letter to Treasury, as did the California Bankers Association (CBA). The CBA letter spoke openly about the feared exodus of foreign capital: "It is likely that customers will remove their deposits away from U.S. banks and into jurisdictions that have no such reporting requirements. This would place U.S. banks at a competitive disadvantage." (For the CBA letter, see Doc 2001-29041or 2001 TNT 226-18. For Gov. Bush's letter, see Doc 2001-17100or 2001 TNT 120-22.)

A powerful figure in both California and national politics at the time was then-House Ways and Means Committee Chair William M. Thomas. Thomas joined the chorus of voices opposing the proposed regulation on the grounds that it would hurt local banks along the Mexico-U.S. border. In July 2001 Thomas threatened to hold hearings and consider remedial legislation if Treasury attempted to implement the proposed reg.

The relentless pressure — and notably, the influence of the president's brother and Congress's top taxwriter — paid off the following year. In July 2002 Treasury issued a revised proposal (REG-133254-02) that would have limited the scope of the original proposal to only 15 countries. The list of countries whose residents would be subject to the revised proposal did not include any South American, Central American, or Caribbean countries. It also left out Mexico. (The countries that were subject to the revised proposal were Australia, Denmark, Finland, France, Germany, Greece, Ireland, Italy, the Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, and the United Kingdom.) (For REG-133254-02, see Doc 2002-18379or 2002 TNT 162-6.)

Like its predecessor, the revised regulation drew vocal opposition from the banking industry and its Capitol Hill allies. In May 2003 more than 20 U.S. lawmakers wrote then-Treasury Secretary John Snow, O'Neill's successor, in opposition. Their letter said: "Simply stated, international investors surely will move their funds — potentially more than $100 billion — to banks in London, Zurich, Hong Kong, and elsewhere if the regulation is finalized." (For the lawmakers' letter, see Doc 2003-12838or 2003 TNT 100-32.)

There is every reason to think these views will be rehashed if Treasury attempts to put Mexico on the same terms as Canada.

Geithner's Next Step?

The above criticisms, standing on their own, make perfect sense. Financial capital is highly mobile, and NRAs with U.S. bank accounts benefit from their anonymity. NRAs do not want to be taxed in their country of residence any more than UBS account holders want to be taxed by the IRS. The case for protecting the U.S. banking sector is obvious.

The problem is that those arguments amount to a hearty endorsement of bank secrecy. Not only does U.S. bank secrecy exist, it's thriving. The evidence above reveals U.S. bank secrecy to be a smashing success. Eliminate it, and America will suffer. Our banks will lose profits; our workers will lose jobs.

In terms of basic economics, those claims are difficult to rebut. A troubling dissonance arises only because rational minds are unable to square this reality with the policies Washington embraced in the recent UBS agreement.

Bear in mind that U.S. and Swiss banks are rivals that compete to attract foreign capital from global markets. That capital is highly mobile and can be transferred across continents and time zones with just a few clicks of a mouse. The competition is a zero-sum game; the more capital that can be driven out of Zurich, the more there is for U.S. banks to sponge up.

To the neutral observer it might seem that America's opposition to bank secrecy is highly selective. Perhaps we object only when it's our tax base that's being eroded.

Geithner now must decide whether Treasury spoke with a forked tongue in the United States' showdown with the Swiss. Mexico City is awaiting a response.

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