U.S. Tax Officials: Biting Without Teeth...

For many years, we have pleaded in these columns that no government should pass diamond industry specific anti-money laundering and anti-terrorism financing (AML/CFT) legislation without consultation with the industry. We feared more Belgium-type situations where the rules are so out-of-tune with accepted industry practices that full compliance may almost become a “mission impossible”. Not because of any industry ill will, but rather because of simple practical or logistical inabilities. For example, if you are a small polished exporter and sell to a firm in Korea controlled by a handful of other companies, including some in Asian offshore locations, how can you establish the natural beneficial owner of each of the ownership companies, and how can you determine that the sources of the money used to pay for your diamonds are proper sources? Due diligence checks similar to those that international banks can carry out – after investing hundreds of millions of dollars in AML/CFT software supported by mammoth compliance departments – can not so easily be done by the mostly small players in the diamond trade.

            We always praised the United States as a good example where the government conducted lengthy consultations with the diamond and jewelry trade to achieve a workable AML/CFT compliance program. However, it never occurred to us that the U.S. government would suddenly discover that it lacks the skills, the manpower, the expertise, and the tools to examine (audit) the diamond and jewelry industry.

When the Jewelry Rule took effect on January 1, 2006, the industry was told that there would be a six-month “grace” period before the Internal Revenue Service (IRS) began compliance examinations. (In Australia’s comparable AML/CFT law, enacted in December 2006, this grace period is called a 'prosecution free' period, which more aptly describes its really meaning.)

            In the United States, the “grace period” is well behind us – but the IRS, which has been tasked with checking the industry’s compliance, “isn’t prepared to examine the jewelry industry’s anti-money laundering programs,” reports an anti-money laundering specialist’s website. Technically, the IRS is still writing an inspection manual and developing the policies on how to audit a few thousand diamond offices and some 25,000 independent jewelers operating throughout the United States.

            One might jubilantly argue, “We are lucky. The IRS doesn’t understand our business. They cannot get their act together. So we have nothing to worry about.” From bitter experience, it would seem that the opposite is true. The damage that government officials, especially those entrusted with both taxation and law enforcement, who are unfamiliar with industry practices, can inflict is enormous. The governments in Israel, Belgium (and, in the next few months, also in India) have recognized their inability to audit diamond industry’s books effectively – and therefore have adopted industry-wide assessment mechanism of “assumed profits”, with the tax payable based on turnover rather than on the profit and loss accounts per se.    

            A Washington-based AML consultant, Ross Delston, who commented on the challenge faced by IRS officials who must enforce compliance in a range of non-banking sectors (such as money service businesses, insurers, casinos, credit card operators, etc.), noted that these sectors have dissimilar financial statements. “A gaming examiner can’t just start examining money services businesses. He probably needs considerable training first.”

            What is happening in the United States is the opposite of what we see in some other centers: the industry has a compliance regime that is agreed with government (good), but the government hasn’t the foggiest notion how to check the industry. (According to the moneylaundering.com website, the IRS agent talking at a recent Jewelers Vigilance Committee seminar on AML compliance “may have had a strong background in compliance for other industries, but as far as jewelry is concerned, she was lost.”)

AML Compliance in Hands of Internal Revenue Service

            What we are concerned about is unintended consequences – the IRS may solve its problems in ways that may create additional concerns. AML programs in diamond countries – or in general – are mostly being supervised by banking authorities or other bodies. In the United States, the responsibility of the IRS in respect to AML/CFT compliance programs in the non-financial institutions is very complex and significant. Everyone seems to be familiar with the role of FinCEN, but less aware of the role of the IRS. Both FinCEN and IRS have distinct roles in implementing the AML rules, though there are some overlapping responsibilities.

FinCEN’s role is to oversee the administration of the AML programs (through the Banking Secrets Act) by numerous agencies, including the IRS. The IRS is merely one of eight federal financial regulatory agencies that conduct AML compliance examinations – and the IRS is specifically responsible for the diamond and jewelry industry. The IRS also investigates potential criminal AML/CFT violations. Moreover, IRS collects and stores the reports of financial transactions filed by industry players. The role of IRS is dominant and central, at least in the diamond and jewelry spheres.

            The IRS needs to examine AML/CFT compliance of up to 200,000 different non-banking businesses in the United States. In fact, and that is a concern, the IRS doesn’t even know to what businesses it must go.

 According to a recent GAO report, “some IRS officials told us that tax return information might help identify potential businesses that need to comply, but IRS is prohibited by law from disclosing tax information for non-tax purposes, with some exceptions. The disclosure provisions in the Internal Revenue Code do not currently include an exception for AML/CFT compliance examinations.” [Emphasis added.]

The industry should be aware of the various options the IRS has in order to do its examination job properly. Currently, the IRS may not use taxpayers return to conduct a “fishing expedition” and select the diamond and jewelry companies that are likely to need a compliance program – and then go and visit these companies.

But they may have no other way but to go down that road. Says the GAO: The IRS, “has not made a decision about whether it would be worth pursuing a legislative change” [to be allowed to use tax returns to identify companies required to have an AML programs.]

In 2005, IRS completed 3,712 examinations of compliant non-financial institutions — 3.5 percent of the approximately 107,000 potentials it had in its database. Since then the diamond and jewelry, precious metals and other sectors have had to implement programs, and it is estimated (says the GAO) that the IRS may have to examine a group of potentially 200,000 businesses.

There is a related issue of data sharing, data collection and data bank maintenance between IRS and FinCEN. We don’t want to get into that, except to say that in Europe there have always been observers that viewed AML/CFT compliance program basically as a way for the respective tax authorities to get a tighter grip on the tax payers.

It isn’t known at this point how the IRS is going to address its difficulties in examining the diamond and jewelry industry – and how they are going to “discover” and “identify” the companies they need to visit.

We intuitively feel that if they decide to change legislation and to get permission to use individual tax returns to select where to make a visit to examine a company’s AML/CFT compliance, this will raise a whole range of addition issues. It is not that anyone has anything to hide. It has more to do with the specific expertise necessary to audit a diamond company’s books – and the likelihood that a non-understanding of the diamond business may lead to unnecessary adverse consequences.

It is fair to say that few people have a particular fondness for a tax agent, unless he happens to be either your son-in-law or husband. We all have an interest, however, in tax agents that understand the business. Understand the business well enough to conduct the needed examinations – without having to resort to fishing expeditions in the industry’s tax returns.

Have a nice weekend.