Risk & Compliance

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

Smart use of tax havens. A far-reaching form of creative accounting. It is legal and therefore  it happens. But the fact that tax avoidance is legal does not mean that there are no risks involved for banks. In this article, you will read all about the risks for banks of tax avoidance by their customers. What gatekeeper function does a bank have? What does Dutch regulator De Nederlandse Bank expect from banks? Where does the bank draw the line? And what is the effect on the internal processes at banks?

Date:January 9, 2020

Tax evasion versus tax avoidance

But first a step back. Tax avoidance is different from tax evasion. Tax evasion is not allowed. It is illegal. Tax avoidance, on the other hand, is legal. But is something that is legal always morally right?

Legally paying as little tax as possible has long been high on the social and political agenda. Many people think tax avoidance is wrong. Whether individuals or companies, they see tax avoidance as ethically or socially undesirable. Barack Obama said it back in 2014: ‘I don’t care if it’s legal, it’s wrong’.

Barack Obama zei het al in 2014: ‘I don’t care if it’s legal, it’s wrong’.

Obama made this statement in response to US companies saving billions of dollars in taxes through subsidiaries in Ireland. But this is also an issue in Europe. For instance, the Panama Papers raised a lot of dust. Politicians, professional footballers and other rich and famous people were found to be stashing their money in tax havens. Legally it is allowed, but shouldn’t we do more to avoid it? How far is tax avoidance allowed to go? Soon, the role of banks and other financial companies in tax avoidance also became the subject of discussion.

The time was ripe to scrutinise existing ways of working. In 2017, DNB therefore reminded banks to expect them to better describe where they draw the line. From now on, banks should explicitly describe to what extent they do or do not accept the risks of tax avoidance by customers and under what conditions. After extensive consultation, DNB subsequently drew up a number of so-called Good Practices. These Good Practices for managing tax integrity risks by banks were published in July 2019.

DNB Good Practices

In short, DNB expects three things from a bank:

  • tax avoidance is treated as an integral part of the so-called Systematic Integrity Risk Assessment.
  • the bank has a concrete Tax Integrity Risk appetite in terms of customer acceptance and revision policies.
  • risks are recognised on an ongoing basis so that appropriate follow-up steps can be taken.

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

Tax avoidance as an integral part of the SIRA

DNB expects so-called tax integrity risks, not only tax avoidance but also tax evasion, to be part of the risk analysis. To what extent is there exposure to tax havens? To what extent does the bank help clients optimise wealth or inheritance planning? In short, where and how does the bank face tax integrity risks from their customers’ tax avoidance?

Tax integrity risk appetite 

Second, DNB expects banks to formulate a so-called Tax Integrity Risk appetite in terms of customer acceptance and revision policies. What types of activities, customers, structures or deals are not acceptable to the bank? This varies from bank to bank. Some banks are very reluctant to simply serve target companies without a broader customer relationship. After all, this makes it very difficult to get sufficient insight. Other banks will not accept a customer once there are certain legal entities in the customer structure. By this we mean risky jurisdictions from a tax perspective. Such issues help to define the boundary and make the Tax Integrity Risk Appetite more concrete.

Recognising risks

Third, risks should be recognised on an ongoing basis so that appropriate follow-up steps can be taken. This is by far DNB’s most difficult to implement expectation. This is because DNB wants banks to recognise risks both when entering into a new customer relationship and during the course of providing services. Indeed, they must not only recognise tax integrity risks, but also follow up on them. That is quite something to ask. It means that the processes and systems around Customer Due Diligence, Deal Due Diligence and Transaction Monitoring must be in place so that:

  • risks emerge at the right times,
  • these risks are analysed, and
  • this leads to appropriate follow-up steps.

Such a follow-up step could be anything from escalation to the compliance officer, discussion of the customer in a risk committee, reporting to the FIU, offboarding the customer or increased monitoring.

So how should banks deal with this in practice?

Tax integrity risks must be structurally included in the SIRA, the risk appetite and the underwriting and revision policy. So, left or right, some things will have to be determined and described.

For the design of processes, a risk-based and pragmatic approach usually works well. An example: imagine a domestic retail customer with only a domestic current and savings account and mortgage. Such a customer will in principle have very limited tax risk for the bank. This will remain so unless red flags rise during the course of the relationship. Such a red flag could be, for example, that the customer regularly transfers large sums to an account in a tax haven. But without red flags, a customer like this will remain a low tax risk.

Sensing and recognising risks becomes a lot trickier with complex customer relationships.  For example, a foreign wealthy client with accounts in multiple countries. Or a business relationship that uses offshore entities. A customer who only partially banks with his large company or significant assets. Or banks that themselves have targeted asset planning activities in countries considered tax havens.

These specific client groups and activities require more time and attention. And especially when assessing the extent of tax integrity risk. After all, this requires expertise. And this necessary expertise is often not present in the compliance organisation. Of crucial importance in such a case is cooperation between the business, compliance and tax specialists. Only by working together can the bank properly assess the tax integrity risk.

DNB Good Practice as guidance 

So DNB expects a lot from banks. But is it really the bank’s job to counter legal tax evasion? Of course, that question came up in recent years. During the consultation phase of DNB’s Good practices paper, some banks really did grumble here and there. According to them, the gatekeeper function that banks perform was stretched too far by DNB. Of course, banks have a legal duty to prevent them from facilitating illegal tax evasion. But the role DNB gave them in legal tax evasion they felt went too far. DNB disagreed.

Does this make DNB’s Good Practices the minimum standard in risk management for tax evading clients? Not exactly. It does mean that banks should be smart enough to test their policies and processes against the Good Practices described by DNB. It is then up to the banks themselves to make their own trade-offs.

Want to know more?

Want to understand more about legal and social developments in tax integrity? Then follow our Tax Integrity Awareness e-learning. In this training, we explain the differences between tax evasion, tax avoidance and tax optimisation. Furthermore, you learn what the expectations of regulators are, and what international (law) initiatives there are to prevent tax evasion.