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September 10, 2013
News Analysis: FATCA Arbitrage Through London
by Lee A. Sheppard

Full Text Published by Tax Analysts®

This article originally appeared in the August 26, 2013 edition of Tax Notes, and was updated to include a comment from HMRC that was received after publication.

By Lee A. Sheppard --

Britain and the United States have a special relationship. Actually, the term special relationship is relatively recent. The special relationship has often taken the form of the Americans asking the British to do something big, messy, or ugly with only speculative returns. Many Brits are still wondering what the United Kingdom got in return for assisting in the invasion of Iraq.

Many presidents, including the current one, were not Anglophiles. But the United States depends on its co-lingual former colonial master to communicate with continental Europe -- which, after all, is full of incomprehensible people who know which glass is which and what those really small forks are for. That is why President Obama recently told Prime Minister David Cameron that the United Kingdom must stay in the European Union.

The United Kingdom was the first country to sign a Foreign Account Tax Compliance Act intergovernmental agreement. Cameron made a lot of noise about clamping down on tax evasion -- by which he meant tax evasion by British citizens and those of a few other moneyed European countries. As British FATCA implementation is developing, it is becoming clear that the privileges of the self-governing City of London as a tax and banking haven will be left intact.

FATCA depends crucially on the definition of a foreign account, which is the thing to be reported. Code section 1471(d)(2)(C) defines a financial account to include "any equity or debt interest in such financial institution (other than interests which are regularly traded on an established securities market)." The IGA has a parallel definition of financial account (article 1, paragraph 1(s)(2)).

The point is that tax evaders should not be able to hold special securities issued by financial institutions as substitutes for accounts. Public trading is exempted because it is thought to preclude the potential for that kind of substitution.

FATCA will be primarily implemented through IGAs, which have defined terms that parallel the statutory terms but are synchronized with local law. Remember that IGAs require amendments to local law for banks to be required to comply. But often terms that are not defined in the agreement are defined by reference to the final FATCA regulations (T.D. 9610).

So the U.K.-U.S. IGA preserved the exception for publicly traded securities. Paragraph 1(s) of article 1 states that an equity or debt interest in a financial institution is a financial account unless it is publicly traded. Then the United Kingdom had to make local rules to implement the IGA.

That implementation took the form of guidance for the U.K.-U.S. IGA, the latest version of which HM Revenue & Customs issued on August 14. Section 3.10 of the implementing guidance states:

    3.10 Debt or Equity Interests regularly traded on an established securities market.

    For the purposes of the Agreement any Equity or Debt Interest will be considered "regularly traded" if it is listed on a recognized stock exchange. As such HMRC will treat the term regularly traded on an established securities market, as having the meaning as per Section 1005(3) ITA 2007. There is no need to check annually if any transactions have been undertaken. This provides consistency with existing HMRC treatment and "recognized stock exchange" includes the London Stock Exchange, AIM and PLUS.

    The main markets of the London Stock Exchange and the PLUS Listed market meet the US Established Securities Market definition in their own right as they are EU Regulated Markets under Title III MiFID and are included in the FSA list of Regulated Markets.

    The AIM, PLUS Quoted and PLUS Traded Markets are not Regulated Markets under Title III MiFID. However HMRC view these as also meeting the requirement as they are all markets of exchanges that have been designated as recognized investment exchanges by the FSA, and are recognized stock exchanges for the purposes of the US/UK Double Tax Convention (Article 23 uses the term listed or admitting to dealings on a recognized stock exchange) and are within Section 1005 ITA.

This newest version is consistent with the May 2013 and December 2012 drafts. All versions refer to the definition of a recognized stock exchange in British law (section 1005 of the Income Tax Act of 2007).

In the last paragraph, HMRC included as recognized exchanges some other London exchanges that do not strictly comply with the pertinent European Union directive covering regulated securities markets. But section 3.10 does not limit the exchanges on which securities may be issued to those mentioned in its text. The governing law is section 1005 and the HMRC guidance interpreting it.

Section 1005(1) defines a recognized exchange as:

    any market of a recognized investment exchange which is for the time being designated as a recognized stock exchange for the purposes of this section by an order made by the commissioners for Her Majesty's Revenue and Customs, and any market outside the United Kingdom which is for the time being so designated.

Section 1005(3) defines a security listed on a recognized exchange as including securities that are admitted to trading on that exchange, and which are included on the official U.K. list or are listed in a qualifying country outside the United Kingdom. Under section 1005(4), a qualifying country can be any country with a recognized exchange.

The first paragraph of section 3.10 states that HMRC will treat a security as regularly traded on an approved exchange if it is merely listed, regardless of whether it trades. HMRC previously assured private practitioners that mere listing was good enough. And in the latest version it added a sentence to make that clear: "There is no need to check annually if any transactions have been undertaken."

The punch line is that HMRC has approved exchanges in some known tax havens. HMRC's list of recognized exchanges includes those in the Cayman Islands, the Bahamas, Bermuda, Cyprus, Malta, Mauritius, and Switzerland. It also includes big European exchanges like LIFFE, which reinforces the point that the IGA drafters did not mean to limit the accepted exchanges to those listed in section 3.10 (

Adding all this up, it means that a corporate issuer that is a financial institution by virtue of being an investment fund can list an equity or a debt security on a tax haven exchange where it does not trade at all, and the security would not be a financial account subject to FATCA reporting under the U.K.-U.S. IGA. In other words, London may have become a FATCA haven for foreigners willing to set up their private investment funds there.

Technically, HMRC has two sets of approved exchanges -- U.K. exchanges and the recognized list. So HMRC could cut back the recognized list for IGA purposes, but could not exclude the big European exchanges. Some practitioners interpret the guidance as limiting the acceptable exchanges to the named London exchanges.

This arbitrage might not survive when the United Kingdom gets going with automatic information sharing, a draft agreement for which was issued on June 26. The draft does not discuss an exception for public trading.

In section 10.4 the guidance has an antiavoidance rule. And in section 10.2 HMRC promises to discuss noncompliance with the IRS.

HMRC responded to questions about the potential for arbitrage: "Whilst it would be possible for the scenario outlined to occur, the UK regulations include a targeted anti-avoidance clause which would operate to tackle any arrangements that are designed to avoid any obligations imposed by the regulations."


The reference to section 1005 in the IGA invokes a special rule removing withholding on interest for securities issued by British issuers in foreign currencies, known colloquially as quoted Eurobonds (section 882 of the Income Tax Act of 2007). Most Eurobonds are issued by large British corporations to foreign third-party investors on non-British securities markets. Eurobonds are a legitimate capital market that the IGA negotiators wanted to preserve.

But Eurobond benefits are not limited to this case. What's it take to be a Eurobond under the withholding exemption? Not a helluva lot. The definition of a quoted Eurobond is a security (including a share) that is issued by a company (corporation), is listed on a recognized stock exchange, and carries a right to receive interest (section 987 of the Income Tax Act of 2007).

HMRC guidance states that all that is required is "an interest-bearing security that is issued by a company and is listed on a recognized stock exchange" (CTM 35218). Oh, and Eurobonds are typically issued in bearer form.

The quoted Eurobond exemption does not require that the issuer be a publicly traded company, or that the debt be publicly traded -- just listed. There is no requirement that the issuing corporation be publicly traded or of a certain size. The issuer could be a private corporation that essentially holds investments for its owners.

Is the Eurobond withholding exemption being abused? Yes. Does HMRC know that? Yes. Do they care? Yes. Will they do something about it? No. Ireland has a similar exemption.

Last year, HMRC held a consultation on whether the Eurobond exclusion should be narrowed because groups were listing intragroup debt on the Channel Islands or Cayman exchanges, using it to avoid withholding on intragroup interest payments. Sometimes they would even paint the tape to establish trading.

HMRC proposed to repeal the exemption when the Eurobond was issued to a group member and there was no substantial or regular trading. The estimated revenue pickup from narrowing the exemption was £200 million annually. This was greeted by a predictable amount of whinging and resistance.

Recently, HMRC excused issuance of a Eurobond that doesn't trade and is not widely held from the new general antiabuse rule on the view that it was long-established, standard practice. But hey, HMRC reserves the right to change its mind.

What was the point of the Eurobond exemption from withholding? The same as all withholding exemptions -- to facilitate commerce and financing. The exemption was originally enacted in 1984, around the time of the U.S. portfolio interest exemption, to allow big corporate issuers to tap foreign investors who wanted debt securities denominated in currencies other than the issuer's currency.

British defensiveness about this kind of thing was evident with the 2009 whitewash of the British overseas empire of tax and banking havens. The 2009 Foot Review of British Offshore Financial Centres recommended that the United Kingdom eschew withholding in the name of facilitating financing. The review implied that it would be better if quoted Eurobonds were listed in the Channel Islands than, say, Luxembourg. The review stated:

    As a general point, withholding taxes are becoming harder to sustain in the current market. More widely, given the fact that most funding into the UK will generate a UK tax deduction for the borrower but that some lender jurisdictions may not tax its interest income thereby creating a tax advantage, most financing transactions will place more weight on achieving a tax-free status for the lender than withholding tax mitigation in the UK.

So while problems of withholding tax avoidance are still being debated in Blighty, a new front has opened for FATCA avoidance by non-British investors by virtue of the IGA drafters' attempt to accommodate existing capital markets practices.

U.S. Rules

The concern here is that non-British family offices and private investment funds could organize as U.K. corporations and issue Eurobonds on tax haven exchanges to avoid FATCA reporting. One wonders whether the U.S. negotiators of the IGA were aware of the problem. Private practitioners made HMRC aware of the problem.

Suppose a U.K.-organized company is a financial institution by virtue of being an investment entity. It's fairly easy to fall into investment entity status -- all it takes is professional management (Tax Notes, Mar. 11, 2013, p. 1164). The company's shares or debt would be financial accounts. To avoid this, it lists them on a little exchange where they don't really trade -- that is, they are quoted Eurobonds. The holders are a narrow class of owners.

All that would seem to be required is incorporation in the United Kingdom. The Eurobonds need only be listed on an HMRC-designated exchange, such as Bermuda or the Caymans, and pay interest. They need not trade.

The FATCA regulations for nonfinancial foreign entities have a strict idea of what it means to be publicly traded on an established securities market. The HMRC guidance on the IGA would seem to seriously undercut that. According to its terms, the IGA trumps the FATCA regulations when both apply (article 4, para. 1 of the U.K.-U.S. IGA).

The United States' interpretation of section 1471(d)(2)(C) requires that the security in question be traded, not just listed. The final FATCA rules require that publicly traded securities actually trade regularly on an established securities market. Reg. section 1.1472-1(c)(1)(i)(C)(1)(i) defines established securities market as:

    A foreign securities exchange that is officially recognized, sanctioned, or supervised by a governmental authority of the foreign country in which the market is located, and has an annual value of shares traded on the exchange (or a predecessor exchange) exceeding $1 billion during each of the three calendar years immediately preceding the calendar year in which the determination is being made.

The annual value of shares exchanged has to be calculated by the World Federation of Exchanges in Paris and converted to dollars. The Cayman and Channel Islands exchanges host at least £15 billion of intragroup Eurobonds issued by British corporations, so the total Eurobond issuance, which would include the public issues, would be higher.

The FATCA regulations have a very specific definition of regularly traded in reg. section 1.1472-1(c)(1)(i)(A):

    (A) Regularly traded. For purposes of this section, stock of a corporation is regularly traded on one or more established securities markets for a calendar year if --

      (1) One or more classes of stock of the corporation that, in the aggregate, represent more than 50 percent of the total combined voting power of all classes of stock of such corporation entitled to vote and of the total value of the stock of such corporation are listed on such market or markets during the prior calendar year; and

      (2) With respect to each class relied on to meet the more-than-50-percent listing requirement of paragraph (c)(1)(i)(A)(1) of this section --

        (i) Trades in each such class are effected, other than in de minimis quantities, on such market or markets on at least 60 days during the prior calendar year; and

        (ii) The aggregate number of shares in each such class that are traded on such market or markets during the prior year are at least 10 percent of the average number of shares outstanding in that class during the prior calendar year.

This is a pretty tough rule. It requires a 10 percent float, which is more than the float of some Big Board-listed issues. So the drafters of these regulations were not kidding about regular trading. But as the IGA practice has established, these regulations will only apply to issuers in non-IGA countries. The British negotiators inadvertently opened up a possible arbitrage in FATCA's regular trading rubric.

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