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FinCEN Financial Institution Due Diligence: A Role Model?

Posted on Oct. 16, 2014

Earlier this year Treasury Department’s Financial Crimes Enforcement Network (FinCEN) proposed rules to require US financial institutions to conduct due diligence to ensure that US institutions identify the beneficial owners of US accounts. The rules have a significant non tax purpose, and are part of broader efforts to combat international money laundering and combat the flow of funds to terrorist organizations. The proposed rules do, however, have a significant tax purpose. The rulemaking states that one of its purposes is “facilitating reporting and investigations in support of tax compliance, and advancing national commitments made to foreign counterparts in connection with the provisions commonly known as the Foreign Account Tax Compliance Act (FATCA).” FATCA imposes significant burden on banks in other countries. In effect the rules extend due diligence obligations on US institutions in a similar way FACTA imposes obligations on foreign financial institutions. These rules demonstrate that we are willing to impose similar rules on our own banks.

I have not spent considerable time with FATCA reporting obligations, though we do summarize the main parts of the provisions in Saltzman and Book Chapter 17. Two things in particular interest me about the FINCEN proposed rules: 1) its extensive discussion of its proposal and its reaction to earlier comments in the preamble to the proposed rules and 2) its adoption of a simple proposed “Certification of Beneficial Ownership” that all financial institutions could use to ensure that they are collecting required information.

As to the first point, the preamble’s extensive discussion of its rationale and proposal, this takes us back to Pat Smith’s excellent post last week on the nontax Perez case involving the Administrative Procedure Act (APA) before the Supreme Court and the issue as to whether agencies must go through notice and comment when offering a new interpretation of most regulations. There is much discussion in administrative law generally about the pros and cons of pushing agencies into the formality of notice and comment. I will not get much into that discussion here (although I do discuss it extensively in an article I wrote in 2012 for the Florida Tax Review called A New Paradigm for IRS Guidance) but I do offer two brief observations about the benefits of input. One, input from interested parties can lead to better rules. Bureaucrats’ limited experiences often mean that getting comments from regulated parties can help agencies think about issues in different ways than when crafting proposed rules. Second, there is a strong participatory value in allowing parties to exchange ideas with the agency making rules. Even if an agency fails to adopt a commentator’s proposal, a regulated party may respect the rules and the process if the agency engages the regulated party and discusses reasons why, for example, it failed to adopt a suggestion made in a comment.

Treasury and IRS often adopt tax rules without meaningful notice and comment. Sometimes there are strong reasons to do so; other times not as much. In a system predicated on voluntary compliance, the default should be an approach that solicits meaningful and transparent input. The FinCEN proposed rulemaking reflects a greater fidelity to the APA then typically associated with Internal Revenue Code guidance; IRS and Treasury employees engaged in the rulemaking process may be able to learn from the folks over at FinCEN.

As to the second point, as I have previously written (and as championed by one of my favorite authors Atul Gawande in the book The Checklist Manifesto: How to Get Things Right), I believe that the creation of checklists or standard forms is an important way to improve tax compliance.

The FinCEN rules in Appendix A contain a fairly clean and straightforward form that institutions can complete and retain. Here is what the preamble says about the comments it received relating to ensuring a standardized approach to collecting beneficial ownership information:

[FinCEN] proposes that a financial institution must satisfy the requirement to identify beneficial owners by obtaining, at the time a new account is opened, the standard certification form attached hereto as Appendix A. To promote consistent customer expectations and understanding, the form in Appendix A plainly describes the beneficial ownership requirement and the information sought from the individual opening the account on behalf of the legal entity customer. To facilitate reliance by financial institutions, the form also requires the individual opening the account on behalf of the legal entity customer to certify that the information provided on the form is true and accurate to the best of his or her knowledge.

As to reliance on information that the customer tells the bank, the preamble discusses how institutions are to focus on the identity of the individual, rather than the status. In other words, the bank generally does not have to conduct its own investigation as to whether the person identifying himself as the beneficial owner is in fact the beneficial owner. Instead, the rules push on to the banks the requirement to verify the identity of the purported owner. Moreover the rules defer to the banks whether they will “verify the identity of a beneficial owner using documentary or non-documentary methods, as it deems appropriate under its procedures for verifying the identity of customers that are natural persons.”

The rules reflect comments that institutions made about the possible cost associated with pushing on banks the requirement to verify with certainty the status of an individual. In addition, FinCEN’s proposal seems to leverage existing procedures banks use under already in place customer identification rules:

These procedures should enable the financial institution to form a reasonable belief that it knows the true identity of the beneficial owner of each legal entity customer. A financial institution must also include procedures for responding to circumstances in which it cannot form a reasonable belief that it knows the true identity of the beneficial owner, as described under the CIP (Customer Identification Program) rules. Because these practices are already well- established and understood at covered financial institutions, FinCEN expects that these institutions will leverage existing compliance procedures.

Some Observations and Parting Thoughts

I am intrigued by the idea of more specific due diligence obligations closely tethered to areas of systemic tax noncompliance. I think the IRS should use due diligence more and particularly with small businesses. It could look to learn from Treasury’s experience with FATCA as well as its own experience with EITC to craft due diligence rules that would promote greater compliance across the board.

One of the complaints about due diligence is its effect on increasing costs of return preparation. Another is its putting preparers in the uncomfortable position of challenging the veracity of clients. There is very limited information to gauge the impact of the due diligence rules in the tax system. As to EITC, the only specific Code-based due diligence requirement, research shows steady decline in reported preparer usage for EITC over the last few years. That period coincides with a heightened statutory penalty for EITC due diligence failures and Treasury’s adoption of more robust due diligence rules. (I discuss the EITC data in an earlier post, which has shown paid preparer usage among EITC returns decline to 62% in the 2012 filing season from 72% in the 2008 filing season; I have also discussed TIGTA’s study of IRS’s failure to assess hundreds of millions of dollars in preparer due diligence penalties). The paid preparer decline in EITC returns may have other causes, such as greater taxpayer facility with tax prep software or preparers failing to sign the returns to avoid the sting of potential penalties for failing to comply with the due diligence rules.

Perhaps it is time for IRS to take a more concerted effort at soliciting feedback on ways it can use targeted due diligence rules. That discussion in the form of proposed rules with meaningful comment and response could perhaps shift the adversarial posture that has dominated the IRS’s efforts to more directly regulate preparers through testing and education, manifesting itself now in for example the AICPA’s suit to stop the IRS’s voluntary certification plan.

A meaningful discussion with the preparer community can also highlight what information IRS may need to solicit from self-prepared returns so the IRS does not create unintended problems if it enhances the information that preparers have to solicit. The problem IRS has to address is noncompliance generally, and additional obligations that only stick to preparer-generated returns are likely to create an even larger problem of ghost prepared returns leaving preparers off the radar and ultimately placing taxpayers at great risk.

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