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DTCC Connection

by Mark Davies, Head of Avox, a DTCC Company | July 16, 2014

Mark Davies, Head of Avox, a DTCC Company
Mark Davies, Head of Avox, a DTCC Company

Since its inception in 2010, the Foreign Account Tax Compliance Act (FATCA) has been one of the most hotly debated and nervously awaited pieces of policy making – which is no mean feat given the amount of regulatory reform that is currently underway.

The aim of the regulation is, very simply, to stymie tax avoidance by U.S. persons with overseas investments by preventing them from hiding income and assets overseas. It will impact financial institutions and investment firms globally, including those engaged in cross-border derivatives transactions.

The measures contained in the regulation are, however, considered so complex and overwhelming by many institutions, that policy makers have agreed to requests to extend the compliance deadline.

The deadline is now fixed at July 1, 2014, by which time participating foreign financial institutions (FFIs) must identify and report certain information to the Internal Revenue Service (IRS) regarding U.S. accounts. However, in May 2014, the U.S. Treasury provided the market with further reprieve by temporarily relaxing enforcement of FATCA1 (note the word enforcement): the regulation will be in effect from July 1, but the IRS will go easy on enforcing it. This means the penalties for failing to accurately identify and classify US persons – namely a 30 percent withholding tax on income from U.S. persons – are unlikely to be in full force until next year. That said, the IRS expects firms to make every effort to comply with the requirements and iron out any issues. This has been stated in no uncertain terms.

The temporary relief should not be considered justification for a slowdown in preparing for FATCA. The regulation is complex and putting measures in place to meet its requirements necessitates due care and attention. Successful implementation will be determined by an institution’s ability to quickly and accurately identify and classify their clients according to the regulation’s criteria. From a customer perspective, FATCA has the potential to either negatively or positively impact on the customer experience. If reporting is not properly managed, and if accurate information pertaining to a particular client cannot be obtained in a timely manner and without duplicate requests, it risks disruption to client relationships. If well-managed, negative impacts can be mitigated and the client experience could even be improved, since the relationship will be based on an efficient collection process and true, meaningful, and useful information.

There are three things in particular that firms should know about FATCA, and making sure there is an appreciation of these factors should help facilitate efficient compliance:

1. FATCA extends the scope of Know-Your-Customer (KYC) requirements significantly

FATCA requires institutions to know who their customers are; maintain accurate, up-to-date information about them; and report this information to home governments or directly to the IRS.

This process sounds simple enough but in practice the regulation will extend the requirements for customer due diligence and reporting practices well beyond the client onboarding function and KYC processes. For example, it requires all accounts to be reviewed for U.S. status, rather than selecting accounts based on a customer risk ratings approach, as required for KYC. And, whereas KYC requires periodic reviews (again, based on customer risk ratings), FATCA requires that institutions should identify any ongoing changes in the clients’ status – for example, a new address or company name – to make sure that information updates have not changed the U.S. or non-U.S. status of that customer.

2. Auditing the management of client data should help to facilitate efficient compliance

Very often, institutions store customer data and documentation in technology silos and across disparate operational processes. For example, KYC data used in the on-boarding function is rarely shared among other levels of the institution, who instead rely on their own data sources. Having multiple views of a single customer can result in unnecessary complexity and costs, and increase the likelihood of clients being contacted with duplicate requests for documentation. This approach is inefficient and increases the risk of error, and it needs to be addressed ahead of the implementation of FATCA.

Moreover, it is important that different functions within an institution share their understanding of how FATCA will impact their use of client data. Compliance functions often wait until they have a clear understanding of all aspects of a final regulation before communicating the details to other departments. This means that the wider business, including operations departments, do not fully appreciate the size and scope of the changes needed to respond to a regulation until very late in the day. An institution-wide approach is needed to develop or execute an action plan for FATCA that takes into account each function’s client data requirements.

Finally, FATCA should be viewed within the context of the wider regulatory reform program, including EMIR, the Dodd-Frank Act, MiFIR and AIFMD. While these regulations are different in purpose, scope and technical requirements, they all necessitate efficient, and up-to-date, client data processes.

3. Having accurate client data is a practical requisite for FATCA compliance

Data quality or ‘cleanliness’ has attracted increased industry attention as a result of the cumulative effect of forthcoming relations, including FATCA.

Indeed, one component in the far-reaching efforts to redress the failings of the financial system post-crisis is the focus on improving data quality. In 2008, in response to global financial crisis, the Financial Stability Board’s Senior Supervisors Group (SSG) sponsored a new counterparty exposure data collection programme to measure improvements in market participants’ ability to produce accurate and timely counterparty information. Worryingly, the group’s recent report finds that progress to date fails to meet supervisory expectations and in particular highlights data quality as an area of concern. The SSG states that recurring data errors indicate that many firms are below benchmark standards for data quality and cannot measure and monitor the accuracy of the data they submit or rectify quality issues in a timely manner.

The lack of progress towards a wholesale improvement in data quality is worrying given its criticality to FATCA. Any flaws in the information that feeds into these processes will result in unexpected outcomes or affect the accuracy of reporting.

The problem of inaccurate data has grown over time. Records have become dormant and, at the same time, clients have undergone multiple changes to their legal structures and company details that, subsequently, may not have been updated in the information held by institutions. In order to ensure compliance with FATCA and other regulatory requirements, data must be validated on an ongoing basis. However, an institution’s ability to manage this process is being held back by their desire to focus resources on core business operations, tested by budgetary constraints and undermined by the sheer volume of data that institutions interact with. Moreover, data management, despite perceptions, cannot survive on automated processing alone. Instead, it requires dedicated teams and expertise, knowledge of where data can be sourced and checked, the ability to adapt to hundreds of languages and, ultimately, human oversight to find the definitive answer. For these reasons firms are turning to external providers to help with the process.

FATCA compliance need not be as challenging as some firms are anticipating. The key – as with all areas of regulation – is to make sure there is a full understanding of the requirements and that from the bottom up, there is a focus on timeliness, accuracy and momentum when it comes to reporting client data. Firms must act now, in earnest, to assess FATCA requirements against their internal data infrastructure in order to understand their readiness to comply.

Reuters, Foreign banks get transition period on U.S. tax evasion law,

Originally published on Thomson Reuters GRC. ©Thomson Reuters