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An Internal Revenue Services office in New York.Lucas Jackson/Reuters

Canadian banks and securities dealers are bracing for a hefty tax on derivatives sold after next March – the first wave of a U.S. crackdown on offshore bank accounts.

The full force of the controversial U.S. campaign to nab tax evaders and shut down offshore havens won't come into force until 2014, when foreign financial institutions must start identifying their American account holders.

But because derivatives, such as swaps and options, can trigger payouts decades into the future, phase-in rules require that foreign financial institutions ensure all transactions dated after March 18, 2012, comply with the new rules.

The little-noticed provision is causing angst among Canadian financial institutions, who say they'll be put at a major competitive disadvantage to their U.S. competitors in the lucrative derivatives business. Some Canadian securities dealers do tens of thousands of derivative deals every week.

"The derivatives contracts of non-U.S. financial institutions become ticking time bombs" on March 19 next year, warned an official at a major Canadian brokerage firm, who declined to be named.

Foreign financial institutions would have to prove they, and all counterparties to these deals, are fully compliant with the U.S. Foreign Account Tax Compliance Act, or FATCA. If they can't, the U.S. Internal Revenue Service would deem the payments suspect and tax them. Even then, the IRS acknowledges it won't be ready to vet foreign institutions until much later.

The derivatives problem is just the latest hitch in the U.S. effort to stem what it says are $100-billion-a-year in tax losses from money held in offshore accounts.

FATCA has become a lightning rod for million of Americans living outside the U.S., foreign financial institutions and major U.S. trading partners, including Canada.

Speaking to reporters after a speech in New York Wednesday, Canadian Finance Minister Jim Flaherty said he's optimistic there will be a resolution to a tax dispute that affects roughly one million U.S. citizens living in Canada. But he offered no details.

The financial services industry, in Canada and elsewhere, is predicting a compliance nightmare if FATCA goes ahead as planned. In a letter this week to the IRS, the Securities Industry and Financial Markets Association warned of "significant disruptions to the international financial markets."

The looming derivatives deadline puts Canadian brokers in an awkward spot. Most have large and strategic U.S. subsidiaries, and they depend on good relations with the IRS to do business there.

Brokers can either get out of parts of the derivatives business, ceding market share to their U.S. rivals, whose derivatives deals are generally exempt from the 30 per cent FATCA withholding tax. Or, they can continue to deal in derivatives and run the risk of being hit with a tax later on if one of their counterparties winds up afoul of the law, possibly rendering the transactions uneconomic.

"The goal of FATCA is purportedly to catch U.S. citizens and residents seeking to evade U.S. tax," the brokerage official added. "Absent change to the approach proposed . . . the result will be to make U.S. financial institutions the organizations of choice for those looking to evade U.S. tax."

Typically in a derivatives contract, the party making the payment is also responsible for any tax owing on the transaction.

Canadian banks have been pushing Ottawa to take a more forceful stand against FATCA.

Without changes, Americans living in Canada could eventually be denied service by Canadian financial institutions if they balk at providing their U.S. Social Security number or taxpayer ID number, as demanded by the IRS.

Mr. Flaherty and federal Privacy Commissioner Jennifer Stoddart have warned the Obama administration that the new U.S. law may run afoul of Canadian privacy and banking laws.

Under Canadian banking laws, customers are typically only required to prove they are residents of Canada, not their immigration status or citizenship.

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