Minding the Gaps?: Corporate Transparency Act Rules Highlight Need for Legislative Improvements

The first set of rules implementing the Corporate Transparency Act demonstrate the need for further legislative action on beneficial ownership reporting to effectively carry out the CTA’s purposes of countering financial crimes and preventing tax evasion.

By Sophia Yan

At the end of September, the Financial Crimes Enforcement Network (FinCEN) finalized the initial set of rules implementing the Corporate Transparency Act (CTA), a beneficial ownership reporting regime seeking to counter money laundering, corruption, tax evasion, and other financial crimes. Despite Treasury Secretary Janet Yellen’s suggestion that the rules will “level the playing field for honest businesses that play by the rules but are at a disadvantage when competing against bad actors who use shell companies to evade taxes, hide their illicit wealth, and defraud customers and employees,” it remains unclear how these objectives can be achieved with the CTA and its implementation in their current form.

Secretary Yellen’s comments reflect the original purposes behind the CTA, which sought to combat the growth of illicit finance in the United States. Anonymous shell companies became a particular focus of lawmakers following the Panama Papers leaks, which showed that foreign nationals were increasingly parking their wealth in the US, while using US shell companies without employees, products, or revenues to hold assets anonymously — obfuscating their identities and ownership from regulators. Increased focus on the tax gap (taxes owed but not paid) also revealed that incorrectly reported income of opaque entities like partnerships are among the largest sources of US revenue shortfalls. The CTA’s proposed solution to these issues was to require companies to report the identities of their individual owners (“beneficial owners”) to FinCEN, which collects them in a database for regulatory and law enforcement use.

The CTA’s purposes would seem to align well with the Biden Administration’s priorities in this area, which have included reducing tax evasion and non-compliance among the wealthy and large businesses; countering corruption; and taking a multilateral approach that supports and complies with strong global standards, including by “effectively combat[ing] financial crime alongside our partners and allies.” These priorities have taken on increasing urgency in the wake of the Pandora Papers revelations that wealthy individuals often use fragmented United States reporting regimes to shelter their assets from law enforcement agencies and tax authorities all over the world.

Unfortunately, these priorities cannot be fully and most efficiently achieved with the current weaknesses in the CTA. Between the limitations inherent in the statute and their implementing regulations, some of the most concerning ownership structures remain in the dark and constrain the extent to which the IRS can efficiently use the information that is collected. These weaknesses have only been confirmed by the language of the final rules published in September. Some of the largest gaps in the CTA, many of which we raised in our comment to the proposed rule, are as follows:

• Bad actors can avoid beneficial ownership reporting requirements. The CTA relies in part on state law to determine which entities are considered “reporting companies” and are therefore subject to beneficial ownership reporting requirements. But some states do not require reporting for all entities, which creates incentives for malicious actors to create entities in those states. Additionally, the reliance on state law requirements means that states could alter their entity formation rules to circumvent CTA reporting in an effort to encourage businesses to incorporate there — a race to the bottom that we have already seen elsewhere in tax, in the form of lax trust rules from tax haven states like Wyoming and South Dakota. Reporting companies themselves could also reorganize or convert into nonreporting entities in an attempt to avoid being considered “created” by a state filing and evade compliance requirements — an issue that FinCEN’s rules did not address with specificity and opted to leave for potential future guidance.
• Opaque ownership structures can remain hidden. Due to the CTA’s statutory reliance on state law, the database of beneficial ownership will not cover many trusts, partnerships, or other entities that have no state law filing requirement. This hole is not a marginal issue, and has led to criticism of the CTA by the EU for not meeting international best practices. As seen previously in tax enforcement, the activities that are most corrosive to tax compliance and the rule of law are likely to flow over time towards these entities. The South Dakota trusts that are a focus of the Pandora Papers do not have a filing requirement at creation, and will become more attractive, not less, as a means to shield assets from tax and other regulatory authorities. In the absence of further guidance, trusts formed in other countries and later brought onshore could also avoid reporting requirements.
• Inefficient use of limited investigative resources. Despite the statute’s requirement that the beneficial ownership reports be “highly useful” to law enforcement, the final rules do not require beneficial owners to report their Taxpayer Identification Numbers (TINs), nor do they require beneficial owners to report information about their ownership type or amount. A TIN reporting requirement is important to ensure the IRS can easily and accurately identify and link taxpayer information across entities and tax years. Without TINs or additional information about the type of beneficial ownership involved in the report, investigators may need to spend limited and valuable resources verifying the identity of taxpayers and building links across databases and information from multiple sources.

Many of these gaps in the CTA stem directly from the statutory text. As noted above, because the statute defines reporting companies as those “created” by the filing of a document with a secretary of state, beneficial ownership reporting obligations are ultimately dependent on state law and entity formation rules, making those jurisdictions that trigger the fewest reporting requirements most attractive to malicious actors.

This structural dependence on state law also created problems for FinCEN in drafting targeted rules that were still applicable to potential reporting companies in all jurisdictions. This tension is apparent throughout the preamble to the final rule. For example, FinCEN discussed its difficulties in crafting a generally-applicable rule for reporting companies involved in reorganizations or conversions, opting instead to issue a broad rule and consider “issuing guidance as necessary” in the future to resolve potential questions, given the many “scenarios for conversions or reorganizations under state law and the variety of outcomes.” FinCEN also described a similar process when creating attribution rules for trusts, also resulting in a broad rule relying on the concept of “substantial control.” This pattern of reliance on broad principles is especially problematic in a self-reporting scheme where the malicious actors that the government is seeking to target are also the most likely to avoid reporting.

These flaws underscore structural infirmities at the heart of the CTA that will likely require additional legislation to fix. We see two broad approaches for legislation addressing these issues:

• The first approach is to amend the CTA or otherwise legislate to (i) cover some of the most worrisome entities currently left out (e.g., certain trusts and partnerships), and (ii) ensure the CTA database is structured to link to TINs and modes of access so that it has practical utility for the IRS. Changes like these are consistent with international best practices that generally apply to all legal entities or associations. The US’s current failure to meet these standards has been noted by the EU.
• The second approach is to pursue a parallel track to ensure the IRS has the ability to identify ultimate beneficial ownership of complex webs of entities. This would likely mean some duplication in reporting (as occurs today under the overlapping Foreign Bank and Financial Accounts (FBAR) and Form 8938 reporting requirements). Duplicative reporting is suboptimal — but superior to the IRS not having adequate tools to efficiently identify beneficial ownership and to satisfy its existing information exchange obligations with partner jurisdictions.

Unless such legislative fixes are imminent, the Administration should explain in detail how the IRS will be able to effectively use the beneficial ownership information it does receive as a result of the implementing regulations.

The CTA represents an important step on the path toward improved financial transparency in the United States. Unfortunately, the need for a functional and effective beneficial ownership reporting regime has only increased in recent months, with increased domestic and international attention on financial transparency in the wake of the war in Ukraine, given that many sanctioned Russian elites hold extensive assets in the US through opaque entities and ownership structures. Legislators should act to ensure the CTA lives up to its promise as a useful tool for combating corruption, tax avoidance, and other financial crimes — now more than ever before.

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