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Is the Canadian FATCA lawsuit a Pyrrhic War?

In 280 BC the Greek King Pyrrhus won a decisive battle against the Roman army. However in winning the battle, Pyrrhus’s army suffered great losses and when Rome had a chance to reconnoiter, it easily defeated what remained of the Greek’s army. Hence is derived the modern term Pyrrhic victory, or a victory gained at too great a cost… at least that’s what Wikipedia has to say about the term. After all, we’re not historians, we’re tax professionals, and we prefer to leave the interpretation of history to those who do it well. Similarly, it occurs to us that the litigants in a recently filed lawsuit could be headed, at best, to a Pyrrhic end.

Just as we’re in no position to comment with any authority on ancient history, neither are we in a position to comment on the strength of the arguments in the lawsuit. The lawyers representing the plaintiffs are among the best in Canada, so we are confident that they are well prepared for the battle that lies ahead… the question we’ll address is what comes afterward.

By way of background, on August 11, 2014, two Canadians commenced a lawsuit against the Government of Canada that essentially challenges the constitutionality of the implementation of the Intergovernmental Agreement (“IGA”) between Canada−US, and newly enacted Part XVIII of the Income Tax Act (that adopts the IGA provisions). The press has been reporting the filing of the lawsuit in droves. When distilled to terms so simple that even a tax professional can understand, the lawsuit seeks to invalidate the IGA and Part XVIII of the Income Tax Act on constitutional issues. Will the lawsuit succeed? Will the Flames win the Stanley Cup? Will Rob Ford solve Toronto’s raccoon problem? We will assume the answer to all is “yes.”

The constitutionality of FATCA in Canada and other countries is not a new issue. When FATCA was first introduced into US law in 2010, there were many commentators that bluntly stated that FATCA would not be able to be enforced in many countries, such as Canada, because of constitutional issues, privacy laws, etc. What is new is that the lawsuit appears to be the first of its kind, with likely many more coming around the world.

Given the above, our firm has long questioned internally what would happen if a country, such as Canada, would find that its own domestic laws make it illegal to comply with FATCA. It seems to us that if the Canadian courts found the IGA and Part XVIII of the Income Tax Act invalid, that Canadian financial institutions would be on the horns of a dilemma. They would face the choice of: 1) complying with the full force of FATCA, thereby possibly breaching Canadian law; or 2) not complying with FATCA, thereby complying with Canadian law, but now being exposed to a 30% withholding tax on certain income streams and possibly being shut out of the US capital markets. Roy Berg of our firm was recently quoted in an article that described that dilemma.

We acknowledge that framing the result as such is likely a false dichotomy because the problem is more complex than simply IGA or no IGA. Treaties between sovereigns frequently override domestic law (though not always) and the diplomatic corps are full of bright creative people. However, we believe it is important to consider what could happen if the litigation is successful.

To that end, the following are issues that we believe need to be considered:

  1. If successful, are the plaintiffs expecting that Canada will negotiate a “better deal” with the US? If so, what does that “better deal” look like? We have asked that question to some people who are hoping for the lawsuit to be successful and some of the answers received have been along the lines of “….that is for the two governments to figure out…” As some of our mentors have taught us, it is fine and dandy to rail and rant against something, but the better and more constructive avenue is to pose reasonable alternatives.
  2. If successful, will the result be a pre-FATCA world where US citizens residing in Canada can have a good chance of not being identified by the US as non-compliant by simply putting their heads in the sand? In our view, FATCA is not going away and therefore, the answer is a simple no – a pre-FATCA world will not exist as a result of the success of the Canadian lawsuit. Another prominent US tax lawyer seems to agree with our view that FATCA is not going away anytime soon. More on our views on FATCA below.
  3. If successful, will the result be that the US will not seek to tax its citizens who live outside of its borders? Nope. More on our views on US citizenship taxation below.

As an aside, we acknowledge that the two Canadian plaintiffs are exposing themselves to tremendous tax and other legal risks. Sticking to what we know, the plaintiffs seem to have admitted that they willfully did not file FBARs and US tax returns, both of which are criminal acts. In addition, there might be US tax exposure to them personally because a Canadian non-profit organization is raising funds and paying their legal fees to fund the litigation. Even the most casual observer has to applaud the bravery of the plaintiffs and the not-so-subtle parallel to original signatories to the Declaration of Independence.

So how do we feel about FATCA and US citizenship taxation? We recently wrote two blog postings that discusses those points. Roy Berg wrote about whether or not the IGA was a “good deal” for Canada. In that post, he stated the following about FATCA:

Before addressing whether the IGA is a good deal, a very brief background is helpful. FATCA is many things: it is extra-territorial, ham-fisted, unilateral, complex, and most importantly, validly enacted US law. Personally and professionally, I wish FATCA didn’t exist in its current form, however as my dad (with the eloquence of a 35-year Navy veteran) used to say: “wish in one hand and spit on the other and see which one fills up faster.” My old man was right: wishing things were different doesn’t make them so.

So true. Kim Moody wrote about what really the vocal minority seem to be upset with regarding FATCA and the IGA. It seems that the tiny but vocal minority are really upset that the US taxes on a citizenship basis and such tax policy extends to such US citizens who are in Canada. Kim wrote the following:

While unique of developed countries, the US taxes the worldwide income of its citizens and has done so since the adoption of the 16th Amendment to the US Constitution in 1913. That is not new… what is relatively new is the US attempt to ensure that US citizens who are living abroad, or have foreign assets, are compliant with their tax matters. In my opinion, citizenship-based taxation is an archaic remnant of the early 20th Century, however, it is US law and there is nothing wrong with these efforts to enforce its laws (even if ill-suited to the 21st Century). US citizens who desire to keep their citizenship should not feel threatened by their government’s attempt to “find them.”

One group who may feel blindsided by citizenship taxation laws are “accidental Americans” (generally, a group of Canadians who have only recently come to realize that they are US citizens and thus have very complex tax filing obligations). I can certainly appreciate the fact that Canadians who are “accidental Americans” feel that their government – the Canadian government, given the fact that this group of people often do not identify themselves as Americans – may “cooperate” with the US government by exchanging data with the US that will identify them as US citizens. But, there is a solution to their plight: renounce their US citizenship. Admittedly, this is easier said than done, but renunciation with professional help is likely the solution if they are concerned about being disclosed. Yes, I am sympathetic to “accidental Americans” but the simple fact is: “it is what it is.”

We stand by those comments. Given such, it will be interesting to see how the Canadian lawsuit plays out. We don’t believe victory in the lawsuit will necessarily result in a better alternative to what the IGA and Canadian legislation already provides and, as a result, victory would mean uncertainty and appurtenant risk. Accordingly, we are hopeful, however doubtful, that the lawsuit does not result in a victory of the type achieved by King Pyrrhus.