New IRS Voluntary Disclosure Program
Since the 1970s the United States Congress and the Internal Revenue Service has been seeking ways to collect tax money which they are convinced is being hidden in offshore tax havens. These early efforts resulted in the requirement for US taxpayers to file a report of Foreign Bank and Financial Accounts called the FBAR. Additionally, a compliance regime was foisted on foreign financial institutions through the qualified intermediary regulations, which the IRS issued on its own authority - essentially foreign financial institutions agree to come under the IRS umbrella for purposes of US tax enforcement of foreign accounts.
This compliance process was not satisfactory to the Congress who felt there was some US$100 billion over a 10-year period lost in taxes. The IRS upped the ante by utilising criminal indictments of foreign banks and foreign bankers. The US government felt justified in proceeding with this direct attack rather than going through its cumbersome tax treaty procedures. It is fair to say that these actions were viewed by the foreign financial institutions as highly divisive, creating tension and ill will between the United States and foreign financial and non-financial institutions.
Amid these efforts by the Congress, through the Internal Revenue Service, to bring virtually the entire financial world under the United States taxing authority, they also used a carrot approach whereby in 2009 and then again in 2011 the IRS offered the Offshore Voluntary Disclosure Program (OVDP). This allowed US taxpayers to voluntarily disclose to the IRS that they hold offshore accounts that have not been reported and provided means to civilly settle the affair and avoid potential criminal charges that stick.
For 2009, 2010 and 2011, the IRS reports that they have collected US$4.4 billion and they have closed, as of now, 95 per cent of the cases from the 2009 program. This encompasses some 33,000 voluntary disclosures as a result of this voluntary disclosure initiative. On January 9, 2012, the IRS reopened the Offshore Voluntary Disclosure Program since the IRS is fervently looking for an easy way to deal with otherwise unreported offshore financial accounts.
Between the 2009 Offshore Voluntary Disclosure Program and 2011, Congress enacted the Foreign Account Compliance Tax Act (FACTA). As reported by the Financial Times in 2010, “Tens of thousands of banks, fund managers, insurers and hedge funds face having to give the names of US clients with at least US$50,000 of assets to the Internal Revenue Service under the Foreign Account Tax Compliance Act, passed in March.”
In a New York Times story just three weeks ago, a former international tax policy advisor for the Treasury Department was quoted as saying: “The FACTA story is really kind of insane.” Also the head of global tax compliance at Deloitte in New York is quoted as saying: “They’re trying to force every financial institution in the world to sign onto this regime.”
A backlash has resulted in a growing number of foreign financial institutions and non-financial institutions refusing to have American customers and some are even reducing owning American securities. As a consequence, the Internal Revenue Service has extended the deadlines for the registration of foreign financial and non-financial institutions with the Internal Revenue Service until June 30, 2013. It has been reported that the IRS is struggling to provide detailed guidance by the end of 2012.
While the difficulties of the US in dealing with foreign financial and non-financial institutions because of FACTA remains, the IRS is proceeding with its already established procedures applicable to US taxpayers. This includes the FBAR reporting requirement (involving Form TD 90-22.1), which is filed with the US Treasury. Separately, there is now FACTA reporting requirements, involving a new Form 8938, which is the Statement of Specified Foreign Financial Assets. This will be part of a taxpayer’s regular tax return filed with the IRS. A significant amount of financial information must be reported whether or not there is taxable income. These two separate reporting rules exist side by side. The FACTA rules are tax rules. The FBAR rules are Treasury Department, Bank Secrecy Act rules.
What is expected to be confusing is that there is a great deal of overlap between the two forms in reporting overlapping information. Many of the definitions used in the forms are different for each form. In this regard, if taxpayers are not using a foreign tax specialist previously, they will need to have one now.
Along with this new heightened and intrusive regime the IRS is stepping up the attention it gives to the tax returns of foreign corporations under Form 1120-F. This follows the restructuring by the Internal Revenue Service of the Large and Midsize Business Division to what is known now as the LB&I. As stated by IRS Commissioner Shulman: “The realigning organization will let us focus on high risk international compliance issues and handle these cases with greater consistency and efficiency as we continue to increase our work in this area.”
This effort will directly impact foreign entities having any financial relationship with the United States, which may involve any form of income shifting and inbound financing by foreign entities. Also being examined are foreign companies doing business in the United States through a branch or a subsidiary which has not been reporting as a business/permanent establishment situation.
The IRS is also taking a more direct approach in dealing with taxpayers. The new efforts are to execute a subpoena on the US taxpayers and require them to provide foreign account information. Concomitant with that effort, the IRS, should it have the correct information, will proceed with a direct levy on an office or branch of a bank engaged in the banking business in the United States with which the taxpayers under the microscope has a foreign account. Apparently, following the reasoning that since dollars are a fungible commodity, it follows that it would be impossible to distinguish a taxpayer’s dollars held in an account in a foreign institution when there are dollars being held in its related US sitused institution.
IRS Taxpayer Advocate Enters the Fray
The Taxpayer Advocate Service (TAS) is an independent organisation within the IRS. It was enacted into law by Congress who understood that taxpayers may be having problems with the Internal Revenue Service system and needed a government funded organisation to advocate on their behalf. The TAS not only handles individual problems and tries to resolve them within normal IRS channels but also deals with large scale or systemic problems that can affect a large number of taxpayers.
On January 6, 2012, the National Taxpayer Advocate, Nina Olson, invoked a rarely used administrative tool to try and force the IRS, and its LB&I and small business/self-employed divisions to change their audit procedures with regard to the offshore involuntary disclosure program. In a very rare taxpayer advocate directive (TAD,) the NTA ordered disclosure and revocation of an IRS memo to its frontline examiners. The point of controversy involved a published set of facts and questions by the IRS in its explanation of the Offshore Voluntary Disclosure Program. The taxpayer advocate is authorised by Congress to issue TADs so that as a watchdog enforcing actions against the IRS the TADs would have some teeth. The consequence is that Congress is trying to give the taxpayer advocate directive powers to force IRS compliance on issues that the advocate deems abusive or inequitable to taxpayers. Presently, neither of the commissioners of LB&I or SB/SE have acquiesced to the taxpayer advocate directives. The matter now is for Commissioner Shulman who will make the decision. The report which can be found in 2012 TNT 4-1 is well worth reading.
Impact on Foreign Investment Funds
Many, if not most foreign investment managers and fund managers feel that they are not involved in selling reportable assets to Americans. However, one of the little known provisions of the complex Internal Revenue Code relates to what is known as passive foreign investment companies (PFIC). Essentially, the Internal Revenue Code says that if an American investor owns even one share of a foreign corporation or a deemed foreign corporation that is the fund investment entity, then the US shareholder is treated as owning a PFIC and must report that as part of his annual tax return.
The Hiring Incentives to Restore Employment Act (HIRE) as passed in 2010 amended the Internal Revenue Code and added a new section dealing with information with respect to foreign financial assets. Under Section 6038(D), any individual who during the taxable year held an interest in any specified foreign financial account, the taxpayer is required to attach to his or her income tax return for the taxable year certain required information. This information is in respect to each foreign financial asset if the aggregate of all the individual specified assets exceed US$50,000. To accompany this, the IRS has released Form 8938 dealing directly with the specified foreign assets and also Form 8621 dealing with PFICs or a qualified electing fund. Needless to say, many professionals kindly refer to the Internal Revenue Codes foreign tax position as complex while others perhaps in humor or perhaps in seriousness refer to those same provisions as insane or bizarre. Nonetheless, the reality is that US taxpayers who do have various forms of these specified foreign assets will be paying a great deal more in fees for the preparation of their annual tax return.
Impact on US Tax Compliant Ex-Pats
At the end of 2011, The Wall Street Journal had an article which observed that US persons that are considered ex-pats will soon discover that it is going to be hard to maintain foreign assets. The impact of FACTA on foreign financial institutions is that they are required to collect a 30 per cent tax on any ‘pass through’ transactions made with foreign institutions that are not in compliance with this new regime. As a spokesman for Deloitte stated: “It’s their responsibility to withhold that money and send it to the US.” The article further states that, “in response, some foreign banks have said they will close all their American clients investment accounts rather than incur the expense of complying. That move could prompt even fully tax compliant Americans who reside abroad to renounce their citizenship rather than face this prospect.”
The article does reveal one unquestionable fact about the US foreign tax administration. That is, even without this extensive and complex burden on the IRS, Congress has continually and vastly underfunded the IRS. For all the complexity of tax codes and requirements placed on the Internal Revenue Service, it doesn’t have enough money, and no manpower. Congress seems to be in the mood to continue to pile on duties on to the IRS, which make a difficult problem worse. Nonetheless, the Internal Revenue Service will do its best to go forward and taxpayers are expected to comply.
Virtually all the developed countries of the world are in the position whereby budgeted national expenses far exceed their ability to collect tax revenues. As a result, there are increased efforts aimed at enforcing tax compliance which the US and other governments claim will actually raise revenue to offset the growing amount of national debt.
Practitioners throughout the world will need to prepare and understand exceedingly complex law. Many foreign financial and non-financial institutions will soon have to make a decision in the relatively near future as to whether they will comply with the United States extending its authority over them or whether they will take some other actions.
US taxpayers, whether in the United States or living outside the United States, are expected to comply fully with the US tax law. The IRS, by establishing a third voluntary disclosure program, is encouraging taxpayers to come forward and bring the assets held in foreign accounts back into compliance. In return, the taxpayer will be relieved of the potential for extraordinary civil penalties and the possibility of criminal prosecution as well.
It is really unknown what the consequences will finally be as a result of the US Government’s efforts to use extreme tax compliance methods for revenue enhancement as well as to deal with other egregious international crimes. That will be an unfolding story which will likely dramatically impact the course of global financial relationships as well as the definition of what is a sovereign nation.
Denis Kleinfeld is highly regarded as a lawyer, teacher and author. His private legal practice, Kleinfeld Legal Advisors, is located in North Miami Beach Florida. He is an Adjunct Professor at the LLM Wealth and Risk Management Program, Texas A & M School of Law. His private practice focuses on strategy planning of domestic and international tax, legal, financial, matters involving the wealth and risk management for private clients and private businesses. He is co-author of the two-volume treatise, “Practical International Tax Planning,” 4th Ed. published by Practicing Law Institute. He is the contributing author on Foreign Trusts published in “Administration of Trusts in Florida” by The Florida Bar and authored chapters for the American Bar Association’s in “Asset Protection Strategies: Wealth Preservation Planning with Domestic and Offshore Entities Vols. I and II.” He is a contributing author to the “LexisNexis Guide to FATCA”.