US and China could play ‘fiscal chicken’ under Fatca, expert warns

China's absence from a list of 50 countries negotiating intergovernmental agreements (IGAs) with the US Internal Revenue Service (IRS) under the Foreign Account Tax Compliance Act (Fatca) could lead to a standoff between the two states once withholding starts, a legal expert has warned.

This month the IRS released a list of 50 countries that are on the road to signing an IGA – either finalising models for IGAs, engaged in dialogue for pursuing an IGA or conducting initial negotiations. China was not on the list as being at any level of negotiation with the IRS. This is significant, according to Dan Neidle, a London-based tax partner at law firm Clifford Chance.

"The interesting question about the list is who's not on it at all. And China is the obvious one," he says. "There are lots of rumours. Early on it was reported that China might just ban its financial institutions from taking part and dare the US to impose withholding taxes."

He points out that it may not be possible for financial institutions in China to comply with Fatca because of legal issues with passing customer details abroad. This could lead to payments flowing out of the US into China being withheld against from 2014 onwards. And Neidle points out that US Treasuries might be included in this.

"This seems an extraordinary result," he says. "Would the US dare to withhold tax on US Treasuries from 2014 held by Chinese institutions? That would seem such an extraordinary thing to do. It will almost be like a game of fiscal chicken – who's going to blink first?"

But Angela Foyle, a tax and financial services specialist at consultancy BDO in London, is less concerned about this. She explains that with respect to existing US Treasuries there is a grandfathering provision that applies to debt obligations issued prior to January 1, 2013. This means that withholding should not apply to these Treasuries, she explains.

"Of course there would in principle be 30% withholding on any interest payments or proceeds from the disposal of Treasuries acquired after January 1 2013 once the relevant withholding provisions come into force," she says. "However, it's worth bearing in mind that certain entities – including foreign governments, political subdivisions, international organisations and so on – are treated as 'exempt beneficial owners' and should not suffer Fatca withholding."

She says this means income and proceeds from US Treasury bonds acquired by the Chinese government should not suffer Fatca withholding. "To the extent that private Chinese banks are looking to purchase Treasuries, it may be that they would seek to route their transactions through government-owned state banks and similarly be exempted from withholding," she adds.

Neidle does not disagree directly, but he isn't convinced that the China-US Treasuries question is that simple under Fatca. "It seems quite far-fetched to me that Chinese banks would be exempted from Fatca on the basis of their links to the Chinese government. The terms of Fatca don't seem to allow this and if they did then a large number of other institutions would slip through. What about Royal Bank of Scotland or Lloyds in the UK, given that they are majority-owned by the government?"