Proposed Elimination of All 'Bearer' Bonds

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By Kenneth J. Krupsky, Esq.
Jones Day, Washington, DC

On October 27, 2009, Ways and Means Committee Chairman Rangel, Finance Committee Chairman Baucus, and others introduced the Foreign Account Tax Compliance Act of 2009 (H.R. 3933, S. 1934) (the "Bill") to "clamp down on tax evasion and improve taxpayer compliance by giving the IRS new administrative tools to detect, deter and discourage offshore tax abuses. … [The Bill] would force foreign financial institutions, foreign trusts, and foreign corporations to provide information about their U.S. accountholders, grantors, and owners, respectively." According to the sponsors, the Bill is based on consultations with Treasury, the IRS, the Joint Committee on Taxation, and "industry stakeholders" and "represents the best ideas from both the House and the Senate on how to strengthen IRS resources to root out tax cheats once and for all." (Emphasis added.) The Joint Committee on Taxation estimated that the Bill would prevent U.S. individuals from evading $8.5 billion in U.S. taxes over the next 10 years. President Obama, Treasury Secretary Geithner, and IRS Commissioner Shulman all issued statements in support of the legislation.

One provision of the Bill will engender significant interest and, I would guess, strong opposition, from a variety of "industry stakeholders" concerned about its potentially negative impact on the global capital markets, particularly U.S. and foreign issuers of, underwriters of, and (honest) investors in "bearer" bonds. Section 102 of the Bill would effectively repeal the existing portfolio interest exemption from U.S. withholding tax for certain foreign-targeted bearer bonds, whether issued by U.S. or foreign borrowers.  (The exemption for registered bonds would remain intact.) It would impose U.S. tax sanctions on issuers and holders of bearer paper.  The proposal would most directly affect U.S. issuers seeking to obtain debt capital from foreign investors in foreign markets. But it could (would) also have a "chilling" effect on foreign issuers seeking to raise bearer bond capital solely from foreign investors solely in foreign markets. Chilling, that is, to the extent foreign market participants perceive the possibility of U.S. enforcement – and perhaps coordinated foreign government enforcement – of the new provision. The Bill provides no clue as to the "administrative tools" the IRS might use to enforce §102.

Under existing law, a bond is in registered form if the issuer or its agent maintains a registration of the identity of the owner and the bond can be transferred only through this registration system. A bearer bond is not so registered. To obtain exemption from U.S. withholding tax on interest on a registered bond, the beneficial owner must provide the withholding agent with a statement (Form W-8BEN) certifying that the owner is not a U.S. person. In the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) and the Deficit Reduction Act of 1984 (DEFRA), Congress sought to curtail the issuance and marketing of bearer bonds in the United States, hoping to reduce tax evasion by U.S. persons who might buy bearer bonds in the United States or abroad and fail to report the interest income on their U.S. tax returns.  At the time, Congress was less (not at all) concerned about foreign tax cheats who cheat their own governments.

Accordingly, under existing law, private U.S. and foreign issuers (and the U.S. government) cannot issue bearer bonds marketed to U.S. investors, but bearer bonds can be sold abroad under arrangements reasonably designed to ensure that the bonds will be sold or resold in connection with their original issuance only to non-U.S. persons, interest is payable only outside the United States, and there is a warning on the face of the bond that any U.S. holder will be subject to limitations under U.S. tax law. Thus, the so-called "foreign-targeted" bearer bond issuance. If an issuer foolishly offers bearer bonds to U.S. investors, the issuer is denied interest deductions on the bond. The issuer is also subject to an excise tax of 1% of the principal amount of the bond times its term. If the issuer is not subject to the excise tax, then the holder is denied capital gain treatment on a sale and no loss is allowed on a sale or worthlessness of the bond. 

Section 102 of the Bill would repeal the existing regime that allows U.S. and foreign issuers to avoid sanctions for bearer bonds "targeted" to foreigners.  Both U.S. and foreign issuers would be denied the ability to market and sell bearer bonds anywhere in the world.

A foreign issuer who violates the prohibition would be denied a U.S. interest deduction on its bonds (a loud "ho hum" to a foreign issuer not engaged in a U.S. trade or business).  That foreign issuer would also be subject to the 1% excise tax (enforceable by the IRS against the foreign issuer overseas, exactly how?). Perhaps foreign governments will stand up, join hands with the IRS, and help the United States eliminate opportunities for U.S. (and foreign?) investors to purchase bearer bonds issued outside (as well as within) the United States.

A few questions leap to mind, and the answers are not apparent to this writer. Does the existing regime for issuing foreign-targeted bearer paper work, or not work, in minimizing (leave aside, eliminating "once and for all") cheating by U.S. persons? If it isn't working, why not? If it's broken, can we "fix" it without outright repeal, and without seeking an extraterritorial reach to punish foreign issuers? Will Section 102, if enacted as written, have an adverse affect on international capital markets? How will foreign exchanges and foreign governments – e.g., in Europe – react? Are there other reasons why non-U.S. jurisdictions allow the issuance of bearer securities – e.g., balancing general privacy concerns with collection of tax revenues? Is it appropriate for the United States to interfere with the decisions of these non-U.S. jurisdictions? Can the issue be addressed in a narrower manner without interfering with the sovereign independence of these non-U.S. jurisdictions? Will U.S. corporations, which would otherwise issue foreign-targeted bearer bonds, find it more difficult and costly to finance their businesses? Will foreign corporations also be hampered in raising capital? How can the IRS enforce §102 overseas? And will U.S. tax evaders – having been denied, at least on paper, an investment in bearer paper – "give in" and honestly report their true names and identities for registration with the issuer or a qualified intermediary, and thereafter truthfully report the interest income on their U.S. returns? In sum, in my view, the proposal needs a good deal of further work and public comment.

This commentary also will appear in the January 2010 issue of the Tax Management International Journal.  For more information, in the Tax Management Portfolios, see Tello, 915 T.M., U.S. Withholding and Reporting for Payments of U.S. Source Income to Foreign Persons,  and in Tax Practice Series, see ¶7120, Foreign Persons' U.S. Activities.