Client integrity Client integrity Risk management Risk management

Tax avoidance: how does the bank manage the risks of clients avoiding tax?

9 min reading time

Clever use of tax havens. A radical form of creative bookkeeping. It is permitted by the law, and therefore it happens. But the fact that tax avoidance is legal does not mean that this doesn’t involve any risks for the banks. In this Charco & Dique podcast, you will hear all about the risks for banks resulting from tax avoidance by their clients. What is the bank’s gatekeeper’s function? What does the Nederlandsche Bank expect from banks? Where does the bank draw the line? And what is the effect on the internal processes of the banks?

But let’s go back a step first. Tax avoidance is not the same as tax evasion. Tax evasion is not allowed. It’s illegal. But tax avoidance is legal. But when something is legal, does that necessarily mean it’s morally right?

Paying as little tax as is legally possible has been high on the social and political agenda for a long time. Many people feel that tax avoidance is wrong. Whether this concerns individuals or companies: they regard tax avoidance as ethically or socially undesirable.

As Barack Obama said in 2014: “I don’t care if it’s legal, it’s wrong.”

As Barack Obama said in 2014: “I don’t care if it’s legal, it’s wrong.” Obama said this in response to American companies that saved billions of dollars in tax via subsidiaries in Ireland. But this is also a topical issue in Europe. The Panama Papers, for example, caused quite a stir. Politicians, professional football players and other wealthy and famous people turned out to stash their money in tax havens. This is permitted by law, but should it be allowed? To what extent should tax avoidance be allowed? Soon, the role of banks and other financial enterprises in tax avoidance also became a topical issue.

The time had arrived to examine the existing procedure in more detail. In 2017, DNB therefore made banks aware that it expected from them that they would describe more precisely where they drew the line. From then on, banks had to formulate explicitly to what extent they accepted the risks of tax avoidance by customers, and under which conditions. Following an elaborate consultation, DNB drew up a number of Good Practices. These Good Practices for banks for controlling tax integrity risks were published in July 2019.

In brief, DNB expects three things from a bank:

  • Tax avoidance forms an integral part of the so-called Systematic Integrity Risk Analysis.
  • The bank has a concrete Tax Integrity Risk Appetite in terms of client acceptance and review policy.
  • Risks are constantly being recognised, so that the correct follow-up steps can be taken.

Before we talk about how a bank can deal with this in practice, we will explain these three expectations in a bit more detail.

First: Tax avoidance as an integral part of the Systematic Integrity Risk Analysis. DNB expects that so-called tax integrity risks – not only tax avoidance but also tax evasion – form part of the risk analysis. To what extent is there any exposure to tax havens? To what extent does the bank help clients optimise asset or succession planning? In short, where and how does the bank run tax integrity risks as a result of the tax avoidance of their clients?

Second: A concrete Tax Integrity Risk Appetite in terms of client acceptance and review policy. DNB expects banks to formulate a so-called Tax Integrity Risk Appetite. What kinds of activities, clients, structures or deals are not acceptable for the bank? This differs for each bank. Some banks are very reluctant to serve target companies without having a broader client relationship, as this makes it very difficult to develop an adequate picture of the client. Other banks will not accept a client as soon as there are specific legal entities in the client structure. By this we mean high-risk jurisdictions from a tax perspective. Such questions help to define the limit and the Tax Integrity Risk Appetite in concrete terms.

Third: Risks are constantly recognised, so that the correct follow-up steps can be taken. This is DNB’s expectation that is the hardest to implement by far. DNB wants banks to recognise risks both when they enter into a new client relationship and while providing services. Even more so, banks not only ought to recognise the tax integrity risks, but also follow them up. That’s quite a lot to ask. It means that the processes and systems concerning Customer Due Diligence, Deal Due Diligence and Transaction Monitoring must be implemented in such a way that:

  1. risks emerge at the right time;
  2. these risks are analysed,

and C. this leads to the correct follow-up steps.

Such a follow-up step can consist of all kinds of things, like an escalation to the compliance officer, discussing the client in a risk committee, reporting the client to FIU, the client’s exit or increased monitoring.

So how should a bank deal with all this in practice?

Tax integrity risks must be structurally included in the SIRA, the risk appetite and the acceptance and review policy. This means that, one way or another, the details have to be decided and described.

It is usually very well possible to follow a risk-based, pragmatic approach for the development of processes. An example. Imagine the following: a domestic retail client with only a current and savings account and mortgage in this country. In principle, such a client will only involve a very small tax risk for the bank. This will continue to be the case, unless red flags are raised during the relationship. Such a red flag could be, for example, that the client regularly transfers large amounts to an account in a tax haven. But without any red flags, a client like this remains a low tax risk.

Developing a sense for and recognising risks involving complex client relationships is much more difficult.  For example, a wealthy international client with accounts in several countries. Or a business account that uses offshore entities. Or a client with a large company or considerable wealth who only partly does their banking with a bank. Or banks that are actively involved themselves in asset planning in countries considered a tax haven.

These specific client groups and activities require more time and attention, in particular in terms of the assessment of the extent of the tax integrity risk. This requires expertise. And this essential expertise is often not present in the compliance organisation. Cooperation between business, compliance and tax experts is crucial in such a case. Only by cooperating will the bank be able to make a proper estimate of the tax integrity risk.

All very well, those expectations of DNB. But is it actually the bank’s task to combat legal tax avoidance? This question has obviously been raised over the past few years. Some banks were certainly grumbling a bit during the consultation phase of DNB’s Good Practices Paper. They felt that the gatekeeper’s function fulfilled by banks was stretched too far by DNB. Of course, banks have a legal task to prevent a situation where they facilitate illegal tax evasion. But they thought that the role in legal tax avoidance assigned to them by DNB went too far. DNB did not agree with this.

Does this mean that DNB’s Good Practices have become the minimum standard in risk management with regard to tax-avoiding clients? No. But what it does mean is that banks should be smart enough to check their policy and processes against the Good Practices described by DNB. It is then up to the banks to take their own decisions.

Would you like to know more?

Would you like to know more about DNB’s Good Practices? Charco & Dique will be happy to answer your questions.