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Tax Notes International

[CFP's Dump the IRS' NRA Regs Page]

March 19, 2001

Proposed Interest Reporting Regulations
Could Cause Massive Outflow of Funds

by Marshall J. Langer

     Tax attorney Marshall J. Langer argues that new U.S. income tax regulations requiring U.S. banks to report interest payments to nonresident aliens could cause a significant outflow of funds from U.S. financial markets.

     Just four days before the end of the Clinton administration, the U.S. Internal Revenue Service issued proposed regulations (with the apparent approval of the outgoing Treasury Department) that would, if made final, collect zero taxes for the U.S. government, but could have a destructive effect on the U.S. banking system. 1 The promulgation of laws or regulations that collect taxes only for other countries is a matter that should be determined by Congress, not by the IRS.

     Since 1921, interest on bank deposits paid to nonresident alien individuals (and foreign corporations) has been tax-free unless the interest was effectively connected with the conduct of a U.S. trade or business. 2 The proposed regulations would not change the tax- free status of such interest, but they would require every bank operating in the United States to report to the IRS all interest paid to nonresident alien individuals so that the IRS could pass such information on to its tax treaty partners. 3 The United States has no obvious tax interest in collecting the information because it will not result in the collection of any U.S. tax.

     Congress debated the wisdom of retaining the tax exemption on bank deposit interest on several occasions during the 1960s and 1970s, with varied results. President Kennedy's "Alliance for Progress" was supposed to encourage Latin Americans to repatriate their flight capital and reinvest it in their own countries. Latin American governments complained to the United States that U.S. tax law encouraged Latin American taxpayers to invest in the United States. In 1966, Congress decided to impose tax on bank deposit interest paid to foreign persons, but, for balance of payments reasons, Congress postponed the effective date of such tax until the end of 1972. The effective date was postponed on two other occasions, the last of which was due to expire at the end of 1976. Then, after further debate, the Tax Reform Act of 1976 made the exemption permanent once again.

     During 1975 and 1976, Congress debated whether to extend the deposit exemption for three more years or make it permanent. The House of Representatives voted to make the deposit interest exemption permanent. 4 The bill was debated on the floor of the Senate in July 1976. 5 Senators Bob Packwood of Oregon and Edward Kennedy of Massachusetts sought to extend the exemption for only three more years so that Congress would be forced to review the subject again. During the debate, Senator Dick Stone of Florida stated that in gateway cities like Miami, deposits from Latin Americans amount to as much as one-third of all bank deposits. Senator Brock of Tennessee stated that no U.S. financial institution could survive the loss of one-third of its deposits in a short period of months. The Senate voted to extend the exemption for three years, but the conference report followed the House bill, and the 1976 Tax Reform Act made the exemption permanent. 6 No one in Congress seems to have even looked at the provision since 1976.

     The 1976 Senate hearings clearly indicated that many senators felt that the imposition of tax on such bank deposit interest could result in a substantial outflow of funds away from U.S. banks to foreign competitors. Most other countries, including major U.S. trading partners, similarly exempt bank deposit interest paid to foreign persons. Collecting information concerning such deposit interest and passing it on to other countries will almost certainly have the same effect as imposing tax on the interest. If these regulations are adopted in final form, there will be a massive outflow of funds from U.S. banks. Most of these funds will go to banks in major countries that do not collect taxes on such interest and have no rules to collect information with respect to such accounts.

     Some European Union member states have tried very hard in recent years to enact a directive that would compel all 15 EU countries to exchange tax information concerning savings by EU residents in other EU countries. Although they reached a compromise agreement on this issue last year, that agreement has more holes than a piece of Swiss cheese. It is highly doubtful that any EU directive requiring the compulsory exchange of information concerning bank deposit savings interest will ever enter into force. For example, Austria and Luxembourg have said that the directive will be nullified unless the information exchange system is also agreed to by certain third-party countries outside the European Union, including Andorra, the Channel Islands, the Isle of Man, Liechtenstein, Monaco, Switzerland, and the United States.

     Switzerland has since stated that it will not lift its bank secrecy under any circumstances, but that it might consider taxing savings income of foreigners with Swiss bank accounts. Switzerland has also demanded that any agreement also be accepted by all of the major Asian financial centers. In the absence of a deal with Switzerland and other third-party countries, the directive will never take effect, and some major European financial centers will continue to welcome bank deposits from foreign persons and pay them unreported tax-free bank deposit interest.

     When, and if, all of the world's major financial centers can reach agreement and simultaneously begin to exchange information on savings deposits or simultaneously begin to withhold an agreed rate of tax on such bank deposits, it might make good sense for the United States to participate in that agreement. In the absence of such an agreement, it would be financial suicide for the United States to take measures unilaterally either to exchange information concerning such deposits or impose its statutory 30 percent withholding tax on bank deposit interest paid to foreign persons.

I have spoken to a number of bank officers during the few weeks since the proposed regulations were issued. Many of these bankers fear that there will be a massive outflow of funds from U.S. banks if the regulations are not withdrawn. The U.S. Congress should request that the U.S. Government Accounting Office (GAO) study the impact the proposed regulations would have on banks, especially those located in major financial centers like Boston, Chicago, Dallas, Houston, Los Angeles, Miami, New York, and San Francisco.

     At the very least, the IRS should be requested to postpone any hearing on the proposed regulations until after the GAO can complete such a report. If the report confirms that the regulations would result in a serious outflow of funds from U.S. banks, then the IRS should withdraw the proposed regulations. If the IRS fails to do so, then Congress should require it to do so.

Marshall J. Langer is counsel to Shutts & Bowen in London and Miami.


1 REG-126100-00 (Guidance on Reporting of Deposit Interest Paid to Nonresident Aliens), issued 16 Jan. 2001.

2 IRC section 861(a)(1)(A) and (c). See Langer, Marshall J., "Harmful Tax Competition: Who Are the Real Tax Havens?," Tax Notes Int'l, 18 Dec. 2000, p. 2831, or 2000 WTD 243-17 , or Doc 2000-33531 (9 original pages).

3 Until now, the IRS has collected such information only as to U.S. persons and residents of Canada.

4 See H.R. 10612, Section 1041, 94th Cong., 1st Sess. (1975).

5 See 122 Congressional Record, S 12502-S 12508 (26 July 1976).

6 Public Law 94-455 (1976).


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