How FATCA Weakens The International Legal System

Tax evasion is a large and growing problem among developed states that rely heavily on income tax, both as a source of revenue and as an instrument of wealth re-distribution. Loosening restrictions on capital flows, combined with territorial limitations on a state’s ability to enforce tax compliance, contrive to facilitate the flow of assets to low-tax jurisdictions with strong privacy laws preventing the disclosure of information regarding account holders and their assets to authorities in jurisdictions where tax may be due. Faced with sustained revenue shortfalls, developed states are increasingly pursuing automatic information exchange agreements between tax authorities, pressuring tax havens to loosen banking privacy laws, and threatening litigation against banks who may have advised their clients to evade tax. The United States has embarked on a unilateral attempt at extending the reach of its tax collection agency, the Internal Revenue Service (IRS), through the Foreign Account Tax Compliance Act (FATCA, passed18March2010), which offers foreign financial institutions a choice between delivering specific information on United States accounts to the IRS, or being subjected to a30%penalty on all United States-source income; and another choice between whether to enforce this penalty against non-complying institutions, or to forsake any rights secured by tax treaty between the United States and the state to whose jurisdiction they are subject. Although the projected economic costs of FATCA have been explored at length, its legal implications have not been analyzed in sufficient depth.United States courts have neither the means nor the legal authority to enforce either the provision that foreign financial institutions report to the Internal Revenue Service, or the provision that they withhold30%of United States-source pass-thru payments to non-complying institutions. FATCA, however, contains an extrajudicial enforcement mechanism in the form of a statutory obligation for foreign financial institutions to assess a30%penalty on United States-source pass-thru payments. Crucially, this penalty exceeds the statutory minimum10%that may be withheld on US-source income, in violation of the1987China-US tax treaty. Even though the enforcer of this withholding mechanism is not the United States but rather a foreign financial institution, the withholding institution, to the extent that it acts under the direction of the United States, ought to be considered an agent of the United States under international law. Thus, were the enforcement mechanism to be enacted, the United States would have committed an internationally wrongful act; therefore it is the case that the threat of an unlawful act is intended to underpin a foreign financial institution’s formal acceptance of a designated legal obligation.In light of the implementation guidelines released by the Internal Revenue Service and the Intergovernmental Agreements concluded between it and a number of foreign tax authorities, which recognize the impossibility of full compliance, FATCA is increasingly understood as a tool of persuasion utilized to press for international tax information sharing agreements primarily favorable to the United States. In light of the fact that the enforcement mechanism prescribed by FATCA, if exercised, would amount to an internationally wrongful act, the application of FATCA as a coercive measure challenges the universal legal principle that legitimate legal rights may not arise under the threat of illegal action. Furthermore, the passage of FATCA is an affront to both domestic and international rule of law, which relies first on a separation of legislative and judicial powers, and second that the judiciary be bound to apply law impartially. First, by embedding an extrajudicial enforcement mechanism into a statute, FATCA attempts to bypass the courts. Second, by making law that domestic courts lack the jurisdiction to apply (and which foreign courts have no reason to apply), FATCA widens the space between legislation and enforcement, giving way to precisely the environment of noise, confusion, and uncertainty that legal systems are established to prevent. FATCA utilizes domestic legislation containing the threat of extrajudicial measures as a means of coercing the formal acceptance of legal obligations by foreign governments-a move which serves to undermine the role of law in global society.