Staff Guidance, Accredited Investors, and "Reasonable Steps": The Use of Foreign Tax Returns
The income safe harbor in Rule 506(c) permits income verification through the use of tax returns. Tax returns were permitted because they were deemed reliable since they were subject to "numerous penalties for falsely reporting information" in Internal Revenue Service forms. See Securities Act Release No. 33-9415 (July 10, 2013).
The staff responded to a question about foreign tax returns.
- Question: A purchaser is not a U.S. taxpayer and therefore cannot provide an Internal Revenue Service form that reports income. Can an issuer review comparable tax forms from a foreign jurisdiction in order to rely on the verification method provided in Rule 506(c)(2)(ii)(A)?
The returns did not squarely fit within the safe harbor. Nonetheless, they were deemed acceptable so long as they were subject to "comparable penalties" for false filings as those imposed in the US.
- Answer: No, the verification safe harbor provided in Rule 506(c)(2)(ii)(A) would not be available under these circumstances. In adopting this safe harbor, the Commission noted that there are "numerous penalties for falsely reporting information" in Internal Revenue Service forms. See Securities Act Release No. 33-9415 (July 10, 2013). Although the safe harbor is not available for tax forms from foreign jurisdictions, we believe that an issuer could reasonably conclude that a purchaser is an accredited investor and satisfy the verification requirement of Rule 506(c) under the principles-based verification method by reviewing filed tax forms that report income where the foreign jurisdiction imposes comparable penalties for falsely reported information.
The staff also remineded issuers that additional verification was necessary where the company had "reason to question the reliability of the information about the purchaser's income after reviewing these documents".
It is highly probable that all countries have on the books penalties for false tax returns. As a result, the import of the staff guidance is that a foreign return is always acceptable. The problem with the approach is that comparable penalties are only as good as the system of enforcement. In plenty of countries, corruption is rampant and there is no guarantee that documents filed with the government will be accurate. See Brazil's secret fiscal weapon: the tax 'lion', Reuters, May 8, 2012 ("Several Latin American countries such as Mexico and Paraguay are believed to lose as much as half of potential tax revenues to evasion and lax enforcement. ").
Where there is lax enforcement, the imposition of "comparable penalties" does not act to ensure accuracy. Nonetheless, establishing accredited investor status is mosly a matter of making sure that investors meet the income and asset requirements. In most cases, individuals will not be likley to overstate their income (understatement is a more likely problem). The issue with making foreign returns easy to use is an increased risk of fraudulent returns. Particularly with respect to affinity fraud aimed at particular ethnic groups, much of the relevant documentation may arrive in the form of "returns" written in a foreign language. These will most likely be difficult to verify.
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