The Model Mandatory Disclosure Rules (‘AEOI PHASE 3’) Briefing Series: PART II

By Rodrigo Zepeda, CEO, Storm-7 Consulting

INTRODUCTION

The ‘Model Mandatory Disclosure Rules for CRS Avoidance Arrangements and Opaque Offshore Structures’ (MMD Rules) were published by the Organisation for Economic Co-operation and Development (OECD) on 9 March 2018. Firms should note that the international legal framework supporting the implementation of the MMD Rules is already in place. So, this is not a case of if a version of the MMD Rules will be implemented in a particular State, but rather when a version will be implemented.

Existing regulatory frameworks under the United States (US) ‘Foreign Account Tax Compliance Act’ (FATCA) (U.S. Department of the Treasury) and the OECD Common Reporting Standard (CRS), already include substantive obligations pertaining to the MMD Rules. For example, the Model 1 FATCA Intergovernmental Agreement (IGA) executed between the US and the United Kingdom (UK) (US-UK Model 1 IGA 2014) took effect on 11 August 2014 (U.S. Department of the Treasury). Article 5(4) (Prevention of Avoidance) of the US-UK Model 1 IGA 2014 states:

“The Parties shall implement as necessary requirements to prevent Financial Institutions from adopting practices intended to circumvent the reporting required under this Agreement.”

Also, section IX (Effective Implementation) of the Second Edition (27 March 2017) of the CRS, A1 states (p. 61):

“A jurisdiction must have rules and administrative procedures in place to ensure effective implementation of, and compliance with, the reporting and due diligence procedures set out above including… rules to prevent any Financial Institutions, persons or intermediaries from adopting practices intended to circumvent the reporting and due diligence procedures”.

Consequently, the MMR Rules are intended to implement pre-existing high-level treaty obligations.

A SUMMARY OF HOW THE MMD RULES OPERATE

The underlying objective of the MMD Rules is to provide Domestic Tax Administrations (DTAs) with information on:

(1) ‘CRS Avoidance Arrangements’ (Arrangements); and

(2) ‘Opaque Offshore Structures’ (Structures) (MMD Rules 2018, p. 9).

This includes information on users and suppliers. In practice, the MMD Rules cover any types of mechanisms, structures, designs, or schemes that have been set up or created in order to directly or indirectly avoid legal CRS obligations. They also cover any types of offshore structures that have been defined to be structured in opaque ways, e.g., chains of trust structures designed to hide the identity of beneficial owners via nominee entities.

In short, the MMD Rules framework essentially operates like this. Within each State, persons covered by the MMD Rules (i.e., governed by their provisions) are legally required to disclose any Arrangements that they know about – the persons covered are referred to as ‘Intermediaries’ which are involved in facilitating or marketing tax avoidance structures and schemes (these may be aggressive but still legal). They tend to be individuals or entities involved in providing offshore legal, financial, and tax advice and services, such as trust and company service providers (TCSPs) (OECD 2021). However, they may also include certain types of banks or financial services firms.

The MMD Rules then provide specific details as to the types of Arrangements that have to be disclosed, when the disclosure obligation arises, what information Intermediaries must report to DTAs, and what penalties, or non-compliance mechanisms are to be imposed. FATCA/CRS frameworks require firms to identify covered individuals and entities, and then report details of the financial accounts of such persons to DTAs. So, for example, a Cayman Islands bank may have to report the financial accounts of all its clients that are covered individuals and entities.

The MMD Rules support these frameworks, by requiring Intermediaries to disclose any potential Arrangements or Structures that may typically have been used by the persons that own financial accounts that are reportable under the CRS. So, a Cayman Islands Intermediary may be required to provide information on the Arrangements or Structures used by 200 of its clients to the DTA, and it just so happens that 100 of these clients are also clients of the Cayman Islands bank.

Using the information reported, the DTA may be able to identify a range of potential tax evasion strategies that may have been used by firms to circumvent CRS obligations, that it subsequently wishes to investigate. These firms may be clients of both the Cayman Islands bank and the Cayman Islands intermediary. Previously, the CRS information reported may have been insufficient to allow the DTA to understand what was really going on. However, the MMD Rules information has now provided the DTA with the missing link to understand what potential tax evasion strategies have been implemented by individuals and firms in the Cayman Islands.

Now imagine this situation except with all CRS jurisdictions automatically exchanging this additional information with hundreds of other DTAs around the world. Now, take this one step further and imagine DTAs applying programmed algorithms that have been specifically designed to identify tax evasion links or patterns in the data reported (Didimo et al. 2018; IBM 2019; Collosa 2021). In addition, DTAs can open up tax evasion investigations and automatically request additional data from other DTAs around the world. It is this regulatory scenario that is to be introduced by AEOI Phase 3.

THE STRUCTURE OF THE MMD RULES

The MMD Rules are set out in three parts: (1) Introduction; (2) Model Rules; and (3) Commentary. The Introduction sets out the Key Elements which are:

(1) ‘Hallmarks’;

(2) Definition of Intermediary and Timing of Disclosure Obligations;

(3) Information required to be disclosed; and

(4) Penalties and other mechanisms for dealing with non-compliance.

The Model Rules are divided into two parts: (1) Definitions (Rules 1.1 to 1.4); and (2) Requirement to disclose CRS avoidance arrangements and opaque offshore structures (Rules 2.1 to 2.7). The Commentary provides brief commentary on the definitions, the disclosure requirements, and the penalties and other mechanisms for dealing with non-compliance. There are five key elements used for the mandatory disclosure regime design:

(1) a description of Arrangements that must be disclosed (Hallmarks of a disclosable scheme);

(2) a description of persons that must disclose such Arrangements (Intermediaries subject to reporting obligations);

(3) a trigger for imposing a disclosure obligation (crystallisation of an obligation to disclose);

(4) a description of what information must be reported; and

(5) appropriate penalties or mechanisms to address non-compliance (MMD Rules 2018, p. 10).

Rule 1.1 extensively defines an Arrangement, Rule 1.2 extensively defines a Structure, and Rule 1.3 defines an Intermediary.

CRS AVOIDANCE ARRANGEMENTS (RULE 1.1)

An Arrangement is defined to refer to:

“…any Arrangement for which it is reasonable to conclude that it is designed to circumvent or is marketed as, or has the effect of, circumventing CRS Legislation or exploiting an absence thereof… where it is reasonable to conclude that such Arrangement is designed to circumvent or is marketed as, or has the meaning of, circumventing CRS Legislation or exploiting an absence thereof.” 

An Arrangement includes any agreements, plans, schemes, or understandings (legally enforceable or not), as well as all steps and transactions that bring it into effect (Rule 1.4(a)). So, the beauty of including this type of definition in the MMD Rules, is that it not only aims to cover arrangements that intentionally seek to avoid CRS obligations (e.g., by exploiting existing weaknesses or loopholes in CRS frameworks), but it also covers new and emerging arrangements that may be legitimate (but which tax authorities may believe are being too widely exploited and should be stopped).

The MMD Rules are therefore highly pro-active in nature, as they are effectively arming DTAs with all the information that they need to monitor evolving trends and patterns. Such information may cover both legitimate and illegitimate tax avoidance and tax evasion schemes and strategies. If an Arrangement undermines or exploits weaknesses in due diligence procedures used by CRS Financial Institutions to correctly identify an Account Holder, or a Controlling Person, then this is prima facie covered (Rule 1.1(e)). If an account, product, or investment that on the face of it states that it is not a CRS defined Financial Account, but in practice, has features that are substantially similar to those of a Financial Account, then this is prima facie covered (Rule 1.1(a)).

For instance, on the face of it, an account that is used by gamers online to purchase credits for use in an online game may expressly state in its rules (and terms and conditions) that it is not a Financial Account. However, if that account has features which are substantially similar to those of a Financial Account (e.g., allows a user to make deposits and withdrawals for large denominations of fiat currencies), then this may be enough to count as an Arrangement which must be reported under the MMD Rules.

Remember, this type of account would definitely NOT be reportable under domestic FATCA or CRS regulatory frameworks, but in theory, it would now have to be reported under the MMD Rules. In addition, a distinct weakness of the CRS rules, is that entities that qualify as an Active Non-Financial Entity (NFE) (e.g., an active retail business) are typically exempt from CRS reporting requirements. Consequently, this is a weakness that can be targeted and exploited by tax evaders by misclassifying an entity, so it is technically labelled as an Active NFE. However, if there is evidence this has occurred or has been allowed, then this is prima facie covered as an Arrangement, which is now reportable (Rule 1.1(f)(i)).

OPAQUE OFFSHORE STRUCTURES (RULE 1.2)

Structures are made up of two components, namely: (1) a ‘Passive Offshore Vehicle’ (POV); that is held through (2) an ‘Opaque Structure’ (Rule 1.2(a)). A POV refers to either a ‘Legal Person’ or ‘Legal Arrangement’ that does not carry out substantive economic activity supported by adequate assets, equipment, staff, and premises in the jurisdiction in which it is either established or tax resident (Rule 1.2(b)). For instance, this may include shell offices used in certain offshore jurisdictions to provide shell companies with mailbox and other operational facilities. Opaque Structures refer to:

“a Structure for which it is reasonable to conclude that it is designed to have, marketed as having, or has the effect of allowing, a natural person to be a Beneficial Owner of a Passive Offshore Vehicle while not allowing the accurate determination of such person’s Beneficial Ownership or creating the appearance that such person is not a Beneficial Owner” (Rule 1.2(d)).

In this sense, a Structure is designed to refer to an Arrangement that concerns ownership or control (direct/indirect) of a person or asset (Rule 1.4(i)). The definitions of POV and Opaque Structures have therefore intentionally been widely defined to cover a very broad range of operational structures that may be used in practice. For instance, through the use of nominee shareholders with undisclosed nominators (Rule 1.2(d)(i)); through the use of means of indirect control beyond formal ownership (Rule 1.2(d)(ii)); or through the use of Arrangements that facilitate access to assets without triggering Beneficial Owner identification rules (Rule 1.2(d)(iii)).

At this stage, it is crucial to note that this analysis of mechanisms and structures not only interacts with existing FATCA/CRS due diligence and identification procedures, but it also interacts with existing anti-money laundering (AML) and beneficial ownership due diligence and identification requirements. Consequently, this is a key area that is likely to be addressed by regulatory technology (RegTech) reporting firms in the future. That is, these types of firms are very well placed to provide holistic reporting solutions for firms, that can incorporate regulatory identification obligations under FATCA/CRS frameworks with both AML frameworks and new MMD Rules frameworks.

INTERMEDIARIES (RULE 1.3)

An Intermediary is defined to mean either a ‘Promoter’ or a ‘Service Provider’. A Promoter refers to any person that is responsible for designing or marketing an Arrangement or Structure (Rule 1.3(a)). A Service Provider refers to any person providing ‘Relevant Services’ for an Arrangement or Structure, in circumstances where that person could reasonably be expected to know (Evidentiary Standard) that the Arrangement or Structure is a CRS Avoidance Arrangement or an Opaque Offshore Structure (Rule 1.3(b)).

Say that HM Revenue & Customs (HMRC) is carrying out an investigation into a potential Intermediary in the UK, the Evidentiary Standard it would apply would be determined by reference to the actual knowledge of the Service Provider based on all information that is readily available, combined with the degree of expertise and understanding required to provide Relevant Services (Rule 1.3(b)).

What this means, is that although a Service Provider might try to plead that it was innocent, and it had no actual knowledge of an Arrangement or Structure, HMRC could impute such knowledge to the Service Provider, based on the depth of expertise and knowledge that such a Service Provider would need, to provide the services that it is providing. This is a potentially troubling provision for Intermediaries that might have previously attempted to rely on practical liability circumvention methods, such as ‘plausible deniability’.

THE POLICY OBJECTIVES OF THE MMD RULES

The whole point of the MMD Rules is that Arrangements and Structures that are reported by Intermediaries to DTAs may or may not be legitimate. It is the reporting of the information that matters, as this can be used for future compliance purposes as well as to inform future tax policy design (MMD Rules 2018, p. 9). The reporting of this information to DTAs is arguably the missing piece of the puzzle in tackling tax evasion on a global basis, as it will allow DTAs to create a much more granular map of potential tax evasion patterns and strategies in use around the world today.

The MMD Rules also carry with them an element of criminal policy, as they are also intended to have a deterrent effect against the design, marketing, and use of covered arrangements (MMD Rules 2018, p. 9). How the MMD Rules are interpreted in domestic legislation, and how they operate in practice, is therefore absolutely crucial to their overall long-term effectiveness. The MMD Rules go way beyond existing reporting and compliance obligations under FATCA/CRS regulatory frameworks.

This means firms covered by the MMD Rules, may not only be required to be FATCA/CRS compliant, but they may also now have to report new information to DTAs on other persons and arrangements that may be technically compliant under FATCA/CRS, but may still be reportable under the MMD Rules. In theory, this not only means that such firms must be extensively trained in identifying and understanding the range of potential FATCA/CRS loopholes that exist, but they must also understand in depth how to interpret and apply the MMD Rules to all group entities, affiliates, and subsidiaries.

TO BE CONTINUED

In the next blog, I will provide commentary on the implementation of the MMD Rules in the UK and how they are legally structured, as well as identifying a number of potential operational challenges for firms under this new global regulatory framework.