Source of funds, or how is it anybody’s business how I have earned my money?

In a few words, source of funds refers to the origin or the way in which money or assets have been acquired. It is the origin of the financial resources that are used to make an investment or purchase. In other words, it is the place where the money comes from, such as earnings from employment, business revenue, inheritance, loans, or investments if we refer to funds of an individual, or business profits, dividends, loans, if we refer to a legal entity.

Knowing the source of funds is important for financial institutions, government agencies, attorneys, and other individuals and organizations which have the legal obligation to collect this information upon the commencement of a business relationship/transaction, in order to ensure that the funds being used are legitimate and not linked to illegal activities such as money laundering or terrorism financing.

Generally, financial institutions such as banks, investment firms, and money transfer services, law firms have the right to ask for the source of funds from their customers. This is because they are subject to legal and regulatory requirements to prevent money laundering and terrorist financing.

In addition, businesses may also ask for the source of funds from customers for certain transactions, such as high-value purchases (art, vehicles, yachts) or real estate transactions, to ensure that the funds being used are legitimate and not obtained through illegal means.

Corporate services providers also have the legal obligation to establish the source of funds of their clients. Such service providers should establish if their clients have the proof of sufficient legitimate funds to cover the expense of their business operations, acquisitions, loans.

Government agencies such as tax authorities, law enforcement agencies, and regulatory bodies also have the right to request information about the source of funds for investigative purposes.

The answer to this question is very simple: please show the origin of the funds that you wish to use for the project in question. You need to be able to demonstrate where the money came from that you wish to use for the planned the purchase, financing your business or deposit in a bank account. You must be able to present documentary evidence that shows sufficient income to cover the above.

The question of source of funds arises to prevent the use of funds that are the result of money laundering. Contrary to the popular belief, money laundering is not limited to the disguise of “serious crimes” such as drug trafficking or the proceeds of crimes of organised criminal groups.

Money laundering is a process of concealing the origins of any illegally obtained funds, making them appear legitimate.

The process of money laundering typically involves three stages:

The emphasis, for our purposes, of the above definition is on the part that reads: “any illegally obtained funds”. This captures tax evasion as well.

Tax evasion is an illegal activity in which a person or entity deliberately avoids paying a true tax liability. Tax evasion is not to be mixed up with tax avoidance.

The term tax avoidance refers to the use of legal methods to minimize the amount of income tax owed by an individual or a business. This is generally accomplished by claiming as many deductions and credits as are allowable by law. Tax avoidance, therefore, is not the same as tax evasion, which relies on illegal methods such as concealing, underreporting income and falsifying deductions.

So, while individual taxpayers and corporations can use forms of tax avoidance to lower their tax bills, they should not engage in tax evasion.

The proceeds of tax evasion are considered illicit funds and their use, money laundering. Therefore, when providing a proof of source of funds, such proof should demonstrate funds that are the result of legal activities and have been duly taxed in the country of tax residence of the given individual or legal entity.

Below we look into the typical categories of legitimate sources of income, and the documentation that is acceptable to provide as proof of the same. The lists of these documents aim to be somewhat comprehensive but in no means are exhaustive. Circumstances differ, what may be suitable in a particular case may be discussed and worked out with our assistance.

Nature of income: Most common source of funds for individuals. It refers to the salary, wages, bonuses, compensation for personal services, that an individual earns from their job or as an individual entrepreneurial.

Acceptable supporting documentation: employment agreement, service agreement, confirmation of services rendered, payment confirmations, annual tax returns showing that the income has been declared and taxes due have been paid.

Nature of income: This refers to the returns generated from investments in stocks, bonds, mutual funds, or real estate.

Acceptable supporting documentation: depending on the type of the underlying investment annual account statements of a brokerage account, purchase and sale orders, real estate sale purchase and rental agreements, private bank statements showing incoming and outgoing funds from these sources, annual tax returns that cover the income.

Nature of income: This refers to income received in the form of dividends from an underlying company. Also, business revenue is the money generated from normal business operations of a legal entity.

Acceptable supporting documentation: for an individual, corporate decisions of the paying company about the declaration of dividend, payment confirmations, bank statements showing the incoming dividend, annual tax return showing the payment of taxes on the received dividend. For a legal entity, annual financial statements, bank statements.

Nature of income: Inheritance speaks for itself, money, shares, art, car, yacht, property, or any other asset inherited from a deceased person.

Acceptable supporting documentation: documentation on the probate that passed the title of the inherited asset to the heir. Such documentation may differ depending on the jurisdiction where probate took place, whether probate is concluded before a notary or court.

Nature of income: Gifts are funds or assets given to an individual or organization without the expectation of anything in return. The gift may be of any asset.

Acceptable supporting documentation: deed of gift, agreement on the provision of gift, documentation that shows the transfer of deed, transfer of funds, shares – in other words the transfer of the subject of the gift. Gift is an option that is often used as explanation as source of funds. It is thought to be an “easy category” by many, but this is not the case. An agreement on the provision of the gift would most likely be expected to be signed before a notary or an attorney-at-law. The source of the gift may to be demonstrated, in other words the donor would need to present proof of where he or she originated the assets that is gifted, which of the other, listed categories it falls under. A simple agreement between father and son and the corresponding transfer of money is not an acceptable proof of source of funds, as a gift.

Nature of income: Loans can be taken from financial institutions such as banks, credit unions, or private lenders. Loans can be secured or unsecured, and the funds can be used for various purposes.

Acceptable supporting documentation: another category that is perceived widely and easily usable. Similarly to gift, a notarised or legally countersigned loan agreements are preferred. The terms of the loan may also be examined to see if the loan is genuine: long term, interest free loans with no clear repayment schedule may be seen as a scam. The lender may also be expected to show the legitimate source of income and demonstrate where the lent funds came from.

Nature of income: interest is a charge for borrowed money, generally a percentage of the amount borrowed.

Acceptable supporting documentation: as the other side of the coin for a loan, as a form of source of funds, acceptable documentation is the same: duly executed loan agreement, record of interest payments, tax return that shows taxes paid on the interest received. Genuine source of the loan amount may also be required.

Nature of income: Passive income is a source of income that requires minimal effort to achieve. It is money that you earn without active involvement, typically received in the form of royalties, rent, other investment income (the latter has been covered earlier).

Acceptable supporting documentation: the required source of funds documentation is two-folds: proof of the receipt of the actual income (royalty payments, rent), and proof of funds that allowed the recipient to purchase, develop the asset that generates the passive income, e.g. property sale purchase and rental agreements, documentation of R&D activity that resulted in an IP that generates royalties. When it comes to royalties, franchise fees, licensee fees, the genuine nature of these payments are always under heightened scrutiny, as inflated payment of such fees may help to shift funds, profits, from one individual or organisation to another, hence artificially decreasing their tax base in one location and increase elsewhere, in a lower tax jurisdiction (profit shifting). Documentation on the licensed product, IP should be credible and readily available. As always, tax returns that show the income has been duly taxed at the recipient is paramount.

Nature of income: retirement income received from state of private pension funds.

Acceptable supporting documentation: state pension slips, statements, private pension fund statements, bank statements showing the payments received.

Providing acceptable and credible proof of the source of funds intended to be used for purchases, investment, setting up a business is not something that can be avoided.

The above list is aiming to demonstrate that such documentation cannot be fabricated out of the blue, at a moment’s notice. Some of these documents may date years or even decades back. It takes diligent business and administration practice to have records in order. In our practice we very often see deals fall through or be painfully delayed, because of the effort it takes to reconstruct past financial events.

We strongly recommend to continuously follow a good practice of documenting income streams. In addition, please consider the time and expense it takes to prepare such documentation to be presented to a financial institution or a legal practitioner, such as having them translated, apostilled, sent to the needed location. These steps may take weeks if not months.

Should you contemplate any transaction that may require the presentation of source of funds, please make sure to start preparing at an early stage.