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WorldJuly 1 2016

US government acts to combat shell companies across states

With tax evasion, money laundering and finances for terrorism often concealed in offshore shell companies, the US is introducing rules to shine a light on the owners of these anonymous companies. But the government will not have an easy ride in bringing in the changes across all states, writes Jane Monahan. 
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The Obama administration has announced new measures to fight financial crime, tax evasion and money laundering in the US at a time of increased scrutiny of offshore accounts and the anonymous companies that conceal money.

The initiatives, analysts say, are expected to establish a level playing field across US financial institutions and all 50 US states, in anti-money laundering (AML), combating financial terrorism (CFT) and anti-tax evasion programmes. However, several obstacles lie in the way of implementing even minimum standards, according to bankers, activists and congressmen.

A long-standing weakness in the US's AML programme, recognised by US Department of Treasury officials, is that it has never been mandatory either in the financial services industry or at state level to collect and track information on the real owners – the ‘beneficial owners’ – of offshore accounts and anonymous companies and trusts. There is nothing illegal about the use of such entities, but in practice tax offenders and criminals can take advantage of the anonymity that these entities provide.

Two sides of the coin

The flaw has led to contradictory outcomes. On the one hand, with more than 1000 prosecutions brought each year in the US for money laundering, there is more AML enforcement in the country “than probably in the rest of the world combined”, says Shruti Shah, vice-president of the American office of Transparency International. On the other hand, the US, which has vigorously promoted reforms in more than 100 tax havens, has itself become one of the most secretive and the fourth largest ‘offshore’ centre in the world behind Switzerland, Hong Kong and Singapore, with about $800bn of offshore wealth, nearly half of which comes from Latin America, according to Boston Consulting Group.

Meanwhile, according to the Treasury department’s 2015 Money Laundering Risk Assessment report, the estimated amount of money laundered annually in the US is $300bn, if you combine money laundering done by foreigners to hide assets and evade foreign tax obligations and money originating from illegal activities in the US.

But according to Sheldon Whitehouse, a Democrat senator for Rhode Island, “the international environment has shifted”. First, he says, because the Panama Papers (a leak of millions of documents from Panamanian law firm Mossack Fonseca) have “shed a very cold light on the mischief that goes on behind these shell company screens, and that makes it more difficult for opponents to create a credible argument”.

And second because the UK and a handful of other EU countries, in the wake of the Panama Papers scandal, have decided to set up public registries of companies’ beneficial ownership information in their countries, the strongest action taken so far on the issue. For more than a year all 28 EU member countries are obliged to collect this information when companies are formed in their territories.

“That creates a new norm of transparency and I don’t think the US wants for long to be an outlier, along with Panama and the Cayman Islands, on the wrong side of that norm,” says Mr Whitehouse. Earlier this year, he sponsored a bill in the Senate to make the collection of beneficial ownership information at the time companies are formed obligatory in the US.

Dearth of data

James Richards, head of global financial crimes and risk management at Wells Fargo, the fourth largest bank in the US by Tier 1 capital, agrees that the country is under pressure. Its continued lack of more detailed information at the time companies are formed makes it likely the country “may not fare very well” when the Financial Action Task Force (FATF) on money laundering – the leading international anti-AML organisation – publishes its most recent evaluation of US compliance with FATF’s international recommendations and standards in October.

These and other factors (including pledges made to the G20 leading industrial and developing countries by the US on the collection of US companies’ beneficial information and the sharing of tax information) could put legislation on the matter “over the top”, says Mr Richards.

In these circumstances, the government’s first major change addressing gaps in the country’s AML programme was the publication in May, after years of consideration, of a final customer due diligence rule, known as the Final CDD Rule. This makes it compulsory for banks, brokers, mutual funds and other financial institutions to collect and identify the beneficial owners of companies, partnerships and trusts when these entities open new accounts from the date the Final CDD Rule takes effect, in May 2018.

The second prong of the strategy, designed to work with the financial services rule, is government-proposed beneficial ownership legislation that will make it mandatory for all legal entities to disclose adequate and accurate beneficial ownership information to the Department of the Treasury at the time of companies’ creation, and include a requirement to regularly update the information, as well as impose penalties for failure to comply.

The legislation would also create a central companies’ beneficial ownership registry, which would be run and updated by the Department of the Treasury’s Financial Crimes Enforcement Network (FinCEN). Initially, only US law enforcement and some US government officials would have access to this information.

Hopes of success

Bankers and activists believe the government is proposing the new legislation because it has a better chance of being approved as a simple amendment to the 1970 US Bank Secrecy Act than the alternative – the bill sponsored by Democrats in the Lower House and the Senate in February, which requires all 50 US states to collect, update and keep a record of the beneficial ownership information of all companies now registered in their territories and formed in future. Variations of this proposal have been fielded in Congress about half-a-dozen times in the past decade, on one occasion, in 2008, with Barack Obama, then a Democrat senator for Illinois, as a co-sponsor. However, the February 2016 bill, like its predecessors, has so far failed to get beyond the committee stage.

A principal reason for the US’s failure to make information on the real owners and controllers of anonymous companies more transparent – and the biggest conundrum in efforts to obtain this beneficial ownership information – is the recalcitrance, at least up to now, of the National Association of Secretaries of State, a politically powerful group representing every US state.

Wells Fargo’s Mr Richards sums up the challenge. “Incorporation in the US is done at the state level. With the exception of just three or four states, none of them collect beneficial ownership information when companies are set up and no state updates and maintains beneficial ownership information,” he says.

On top of that, critics abroad and in the US have for some time viewed Delaware and other US states, including Nevada and Wyoming, as tax havens (an accusation these states’ leaders vigorously deny). Reasons given are their failure to obtain meaningful information when companies are formed (a person forming a corporation in these three states typically provides less information than is needed to obtain a driver’s licence); their secrecy (Delaware in particular has established a reputation for being a favoured location for the creation of anonymous companies); and the ease of incorporation (automated procedures allow companies to be formed in 24 hours).

In addition, Delaware – which rakes in about $1bn, or one-quarter of the state government’s annual operating budget, in incorporation fees and taxes, will form a company in two hours in exchange for a substantial fee. The secretary of state’s office in Nevada, meanwhile, earned $138m from commercial recordings, which include new business filings, in 2014. In Wyoming, the secretary of state took in $31m in revenue in the 2013-14 fiscal year from its business division that includes corporation filing fees.

United approach

Another obstacle is that Congress has a short calendar before November’s presidential and congressional elections and is dominated by opposition Republicans, who have relentlessly  stalled government reforms. Nonetheless, senators, bankers and activists believe momentum is building to bring about greater transparency, sparked partly by embarrassment stemming from the Panama Papers and the increased international scrutiny of shell companies. (The leaks revealed that more than 1000 Nevada-registered business entities are linked to a Mossack Fonseca affiliate and the firm also has a Wyoming affiliate that has formed a much smaller number of companies.)

The government’s pragmatic approach to the problem, working with Congress and all stakeholders to find a practical solution, according to US Treasury officials, also appears to be paying off. On May 9, Jeffrey Bullock, the secretary of state for Delaware – which previously was vocal in its criticism of any changes to incorporation transparency – took observers by surprise, publicly endorsing the Obama administration’s beneficial ownership legislative proposal in no uncertain terms.

“It will be interesting to see where the secretaries of state come down in the wake of [the Panama Papers],” says Mr Sheldon.

Meanwhile, the Final CDD Rule defines what constitutes beneficial ownership and what financial institutions have to do to obtain it when new accounts are opened. First, they must obtain and verify the identity of a person who holds 25% or more of the equity interest of a company or a partnership or a trust. And second, they must identify a person who exercises management control over the company. In both cases a bank would have to obtain the name, address, date of birth and social security number or a passport number if the person was a foreigner, and the information has to be maintained and updated if there are changes.

Activists, including Ms Shah at Transparency International – one of only two activists invited to the US FATF evaluation meetings early this year – have criticised the approach, saying it is not strong enough and has gaps. Ms Shah says the new rule makes it possible for an individual to name a senior manager or an executive officer of a company on opening a bank account, when that person may simply be a nominee, or a straw manager, and not the person who really controls and benefits from the company (the beneficial owner).

Fears of confusion

Wells Fargo’s Mr Richards says in practice the two tests could be “very confusing for the innocent and provide easy loopholes for those who want to get round them”. He adds: “In managed relationships such as private banking it’s possible to get this information. But it’s more difficult in mass-market banking to verify actual ownership, regardless.”

Robert Rowe, vice-president and chief counsel for regulatory compliance at the American Bankers Association, says: “Our position is we can collect the information; we don’t know if it’s true or not.” Meanwhile, one banker says: “If I was a money launderer I would make sure, on paper legally, no one owns 25% or more of the company but 20% or less.” The 25% equity threshold, however, is the internationally recognised standard, already used in the EU for instance, to determine who are the beneficial owners of anonymous companies.

Mr Richards believes the biggest impact of the rule will be at the front office, when customers first come into a branch. “I don’t think the public understands this yet. Or the impact [the rule] will have on small businesses,” he says. The scale of the problem is certainly daunting. Currently, 2 million companies are formed under US state law each year, of which 99% employ fewer than 500 people, according to the US Census Bureau. And currently there are almost 28 million small businesses in the US altogether.

Added to that, many small businesses are family owned, and complications are inevitable when a person who walks into a branch to open an account and is presented with questions regarding whether there is anyone who owns 25% or more of the company and somebody who has practical control of the company. 

Striking a balance

Notwithstanding this, in comments on the Final CDD Rule, FinCEN officials said an objective was to strike a balance between rooting out corruption and avoiding overly burdensome requirements on financial firms and legitimate clients. For this reason, the requirements do not apply to all existing account holders but only to bank accounts opened after the rule’s enactment.

Moreover, FinCEN officials and bankers emphasise that financial institutions have had to comply with AML and CFT programmes for years, and these include customer identification requirements, understanding the nature and purpose of the customer’s relationship with the bank and record-keeping and filing suspicious activity reports (SARs) in accounts. Between 2010 and 2014, US banks filed an average of about 850,000 of these SARs to FinCEN each year.

For this reason, FinCEN officials have said that financial institutions should use the Final CDD Rule as “a floor and not a ceiling”. Indeed, in 2010 it recommended that banks collect and verify beneficial ownership information in circumstances of heightened risk (for instance, with politically exposed people, known colloquially as PEPs). So there are circumstances where the Final CDD Rule could be applied retroactively to existing account holders.

In the current situation, due to US banks’ risk-based approach and differences in size and lines of business, there are considerable inconsistencies in the way AML and CFT programmes are applied. However, with the new requirements there will be a level playing field. “A customer is not going to get thrown out of one [US] bank and then find financial services in another,” says Mr Richards.

Meanwhile, a regulatory impact assessment by FinCEN of the Final CDD Rule estimates the costs to financial institutions of implementation (including additional time at account opening, training and especially IT adjustments to track beneficial ownership information) could range between $700m and $1.5bn, depending on the bank’s size, over a 10-year period.

BOX

Anti-tax evasion measures

To fight foreigners’ tax evasion, the US government has also announced a regulation that would close a small but significant tax loophole that allows one type of foreign-owned company – called a single-member limited liability company – to operate anonymously in the US.

Additionally, the administration has urged Congress, for the fourth year in a row, to pass legislation allowing US financial institutions to provide US partners in the Foreign Account Tax Compliance Act (Fatca) with the same information about US banks that foreign banks provide the Internal Revenue Service. Not providing full reciprocity under Fatca has left the US in the position of being a comparatively easy place to set up offshore companies, which has provoked considerable criticism from major compliant Fatca members.

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