FATCA – Enforcement Win or Expatriate Generator?

The Foreign Account Tax Compliance Act (FATCA) was enacted in 2010 in the wake of the revelations of the use of Swiss bank accounts for US tax evasion and out of a congressional desire to pursue what were supposed to be those most cunning US tax evaders. While FATCA is certainly chasing some taxpayers back into compliance, it has not generated the number of disclosures Congress likely hoped for or suspected would come. FATCA has, however, caused an explosion in expatriations for some of the country’s wealthiest taxpayers, one of several unanticipated consequences of this complex statute.

In the last quarter of 2014, despite a more than 400 per cent hike in the fee the US collects for renunciations, nearly 1,100 expatriated. That quarter’s near record number contributed to a new record for the US, 3,415 expatriations in 2014.  More telling is the fact that only 231 US persons voluntarily expatriated in 2008, the year before the first round of offshore enforcement programs.  Why has the US, which historically boasts the longest lines for entry and citizenship, recorded such a spike in the number of people voluntarily expatriating? For many, the answer is simple: FATCA.

According to the US Department of State, more than seven million US persons (including citizens and greencard holders) reside outside its borders. The US requires its citizens (and greencard holders) to report their worldwide incomes and disclose a wide array of financial information to the US (such as the existence of foreign bank accounts if their aggregate balance exceeds US$10,000 during the calendar year) regardless of where those persons reside. However, reports show only 807,040 Reports of Foreign Bank and Financial Accounts (FBARs now FinCEN 114) were filed in 2012. It appears that the number will exceed one million for 2014, but that includes tens of thousands of prior year FBARs being filed currently with offshore disclosures. Even if you pretend the vast majority of FBARs were filed by US persons residing outside the US (and it is almost certain that the opposite is true), the number is shockingly low and indicates massive non-compliance with (and lack of knowledge of) the FBAR filing requirement.

FATCA was enacted without a single congressional hearing and apparently with no known cost-benefit analysis. The statute shifted from the reliance on individual self-reporting the US has historically embraced and placed the onus squarely on the shoulders of foreign financial institutions (termed FFIs by FATCA). FFIs must now examine their individual records and determine whether accountholders are US persons. If they are, FFIs must report the accountholders’ identities to the U.S. Government. The first delivery of information to the US (for accounts open during 2013 and 2014) occurs this year.

At the same time FATCA loomed large in the eyes of many Americans worldwide, the US Department of Justice (DOJ) continued its pursuit of money ‘hidden’ in the depths of Swiss banks. The DOJ struck a deal with the Swiss Government: eligible Swiss financial institutions could escape US criminal prosecution by providing detailed disclosures of US accountholders and, in some cases, depositing a hefty fine into the US coffers. The convergence of the U.S. focus on international tax enforcement with this unprecedented cooperation from jurisdictions throughout the world produced the perfect storm. There are certainly ‘bad actors’ (US persons, usually residing in the US, who intentionally placed assets in non-US accounts to avoid remitting US income tax) that must be brought to justice. However, the vast majority of persons caught in the current enforcement net do not fall into that category. Instead, they are ordinary US residents who opened foreign accounts for convenience with after-tax funds and simply were unaware that the US Government demanded declaration of such action. Or, they are international residents who, for all intents and purposes, severed ties with the US years ago and fully embraced new home countries. This article focuses on the plight of non-resident Americans and their options as FATCA becomes the law of the land.

In 2015, non-resident Americans with previously unreported foreign accounts are left with three choices. They can: (1) do nothing and hopefully avoid detection as the world moves steadily toward global tax information sharing; (2) return to US tax and reporting compliance; or, (3) expatriate. The first choice is self-explanatory, though it is ill-advised in the current climate of global cooperation. The two remaining options include several variations and associated costs and some remaining potential risk.    

With respect to the second option, returning to compliance, the law only requires prospective adherence. Remedial action is not mandated by law (but failure to remediate may leave potential criminal and civil exposure intact). The US Internal Revenue Service (IRS) introduced a disclosure program in 2009, however, to entice Americans to report previously undisclosed foreign accounts to the US Government. The Offshore Voluntary Disclosure Program (OVDP), in which the IRS agrees not to refer participants for criminal prosecution, carries a heavy cost. In the first version, taxpayers filed six years of returns and paid the additional tax, accompanying regular penalties, and interest on both. They then paid a one-time miscellaneous penalty, termed the ‘FBAR penalty.’ It initially equaled a one time penalty of 20 per cent of the highest value in any single year during the six-year disclosure period of the now disclosed foreign accounts. Five years later, the IRS has revised and reintroduced the OVDP four times. The latest iteration more than doubles the FBAR penalty in certain cases. Entrants into the current OVDP must file eight years of US tax returns (assuming the nonreporting extends that far back in time) and pay tax, regular penalties, and interest on both. The regular penalties are quite daunting for historic non-filers: nearly 50 per cent of the tax owed (when you combine accuracy and late filing penalties). The amount of FBAR penalty owed then depends on whether the individual held an account in one of the banks that, essentially, was publicly identified as under investigation by the US (currently the IRS has identified 12 such banks). In that case, a penalty of 50 per cent is levied on all previously undisclosed foreign assets, even those not held in a listed institution.  A lower FBAR penalty of 27.5 per cent applies to all foreign assets out of tax and reporting compliance if none are held in the listed banks.

In early 2015 the IRS estimated that the various OVDPs had, to date, resulted in more than 50,000 disclosures, and netted over US$7 billion. Yet millions of Americans, both at home and abroad, have still not returned to compliance. Most would agree the terms of the OVDP are really only favourable to the most egregious of participants: those who have hidden assets abroad and evaded tax on its gross for years on end. It is clear that the relative cost of the OVDP grossly outweighs the ‘benefit’ to an American residing in a foreign jurisdiction, especially if the accounts are within his resident country and he has been in tax compliance there.

It seems the IRS has, at least in part, recognised that the masses cannot swallow the terms of the OVDP. In June of last year, the IRS introduced an alternate path. The new program does not offer any protection against criminal prosecution, but it also imposes a far smaller financial burden. Entrants into that ‘foreign’ Streamlined Program file only three years of tax returns and regular information returns and six years of FBARs. More importantly, no FBAR penalty applies assuming they meet the lack of willfulness standards. However, US persons who have spent more than 35 days in the US. during each of the three years immediately preceding the disclosure year cannot qualify for the ‘foreign’ Streamlined Program. The IRS offers the ‘domestic’ Streamlined Program to these persons. Its terms mirror those of the foreign version, except a five per cent FBAR penalty applies to the six-year highest value of the foreign assets.

At first blush, the Streamlined Program offers the panacea to all that ails. However, participants in either Streamlined Program must submit a written statement explaining the prior non-compliance. This statement, which is signed under penalties of perjury, must certify that the past non-disclosure was a ‘non-willful’ omission. Though examples of what constitutes non-willful are scant, the IRS has defined the term for this program to mean “negligence, inadvertence, or mistake or conduct that is the result of a good faith misunderstanding of the requirements of the law.”

One can understand why a US person may ultimately choose to sever ties with the US after wading through the murky waters of the disclosure programs. And often this is the right answer. Unfortunately, it is not without cost, as Congress introduced the ‘exit tax’ in 2008. Citizens and long-term greencard holders (persons who, generally, have held a greencard for 8 out of 15 years) renouncing their US status must examine their net worth, average US income tax liability in past years, and five year US tax compliance history to determine whether the exit tax applies. A person with a net worth of US$2million or an average tax liability in the past five years over US$150,000 (indexed for inflation) will be subject to the exit tax unless certain narrow exceptions apply (as it does for dual-citizens from birth who satisfy specific requirements). Lastly, a person becomes a ‘covered expatriate’ subject to the exit tax regardless of her net worth if she cannot certify five years of US tax compliance. There are no exceptions to that rule.

Once classified as a covered expatriate, a snapshot of the expatriate’s worldwide assets as of the day before expatriation is taken. A fictional sale of these assets occurs, and any gain in excess of US$600,000 (indexed for inflation) is subject to tax. Paying capital gains tax on a deemed sale is painful; however, the treatment of other types of holdings is even more agonizing. A covered expatriate’s interest in an “ineligible” deferred compensation arrangement (ie, one with a non-US payor)or personal tax-deferred account is presently valued as of the day before expatriation and includible in income at marginal tax rates regardless of whether forfeiture risks are present. Some items, such as eligible deferred compensation plans and interests in certain trusts, are exempt from the exit tax provided the taxpayer agrees to a 30 per cent withholding tax on all future distributions. Even absent the inclusion of these items, though, the tax due at expatriation often proves substantial.

Once a covered expatriate satisfies the tax due and finalizes the expatriation, no restrictions on travel into the US exist. However, one nebulous tie remains, sometimes forever. A yet to be implemented US tax law imposes gift and estate tax on US recipients of property from a covered expatriate. Simply severing your personal ties may no longer be enough. A covered expatriate must examine the nationality of his potential heirs and legatees to wholly avoid future US tax.

The verdict judging the success of FATCA has not yet been handed down. Early enforcement impact seems negligible: it has produced at best only a few hundred thousand FBARs per year notwithstanding the fact that the millions of US citizens abroad (not to mention even more US residents) have received communications from banks informing them of imminent third party disclosure pursuant to FATCA. Congress surely supposed that the amount of FBAR filings would skyrocket in 2010 and succeeding years. That has not yet been the case; it remains to be seen whether this changes for 2015. However, one verdict is in – for many US taxpayers, expatriation is a way out.