Originally published in The Tax Institute of Australia on the 1st March 2017
Globalization, multinational corporations and an increasingly mobile workforce has exposed a need for global tax transparency. With the rise of international information exchange, and the introduction of OECD’s Common Reporting Standards (CRS) and the Foreign Account Tax Compliance Act (FATCA), international tax compliance for globally mobile private clients and global business is becoming a more strenuous and expensive endeavor than ever before. As those who have had to deal with the United States (U.S.) tax system may be aware, this sentiment perhaps holds strongest with the U.S. With the number of U.S. taxpayers living in Australia and Australians relocating to the U.S. or establishing a U.S. presence, the need to remain internationally tax compliant is becoming more critical.
The U.S. foreign tax reporting laws carry severe civil and criminal penalties for non-compliance, imposing hefty fines and penalties even where a taxpayer has acted unwittingly. To increase compliance and encourage disclosure of previously unreported foreign accounts, the Internal Revenue Service (IRS) has implemented a number of tax amnesty programs allowing taxpayers to file delinquent tax and information returns, or amend prior year tax returns and information returns, in exchange for lower penalties.
This article will explore the U.S. foreign reporting framework and what options are available where a taxpayer is in non-compliance.
For a long time, U.S. taxpayers have been required to disclose a financial interest in or signatory authority over, foreign bank accounts by way of the Report of Foreign Bank and Financial Accounts (FBAR). For almost three decades, this requirement was largely ignored because the penalties for failure to comply with the FBAR were relatively benign (when compared with current penalties) and international bank secrecy laws made it difficult to obtain the necessary information to prosecute a non-complying taxpayer.
The use of foreign accounts to evade taxes was particularly rampant in Switzerland, which at the time was regarded by many commentators as the largest offshore wealth hub in the world. Switzerland was reluctant to change its privacy laws which made it possible for Swiss banks to refuse to hand over their customers’ data to foreign tax authorities. However, after the IRS and the Department of Justice (DOJ) launched an aggressive crackdown on offshore financial accounts held by U.S. taxpayers, things started to change.
A former private banker at UBS AG, Bradley Birkenfeld, perhaps the most important tax whistleblower in modern times, sparked the demise of traditional Swiss banking after approaching the DOJ and IRS. Birkenfeld provided crucial information on approximately 19,000 clients uncovering tax evasion on an unprecedented scale.
This led UBS to enter into a deferred prosecution agreement with the U.S. and pay $780 million in fines, penalties, interest and restitution. More importantly, in an effort to encourage individuals to report their offshore accounts, the IRS released the Offshore Voluntary Disclosure Program (OVDP) to allow individuals to become compliant regarding any offshore accounts with the promise of criminal amnesty.
Initially, this program resulted in an unprecedented number of U.S. taxpayers who intentionally evaded taxes voluntarily disclosing their offshore accounts and agreeing to pay back tax, interest and penalties to the IRS. However, in the years following the original program it subsequently became apparent that the OVDP was not a suitable framework for all non-compliant taxpayers. Accordingly, in order to address these shortcomings the ‘Streamlined Procedures’ were introduced in 2012 as alternative measures to the OVDP.
After such an extensive period of taxpayer collaboration it would seem that these programs will be with us forever. However, they are by design structured so that the IRS can end the programs at any point and many commentators believe that in light of the high operating costs of FATCA, the likelihood of that happening increases every day.2
The FBAR was born as part of an anti-money laundering initiative and was codified under the Bank Secrecy Act 1970 (BSA). Under the administration of the U.S. Treasury, the penalties for any breach or non-compliance of the FBAR provisions were relatively minor. In 2003, the Secretary of the Treasury delegated civil enforcement authority of the FBAR as part of a crack down on tax evasion and abusive offshore transactions.
The FBAR is required to be filed by all U.S. taxpayers (citizens, green card holders and non-immigrant aliens classified as residents under the substantial presence test)3 with foreign accounts or signatory authority over foreign accounts, that have an annual aggregate balance of over USD$10,000 at any time during the calendar year. The key here is that it does not apply on a per account basis, rather it is a combined total value across all foreign bank accounts, financial accounts and certain insurance policies.4 Where non-disclosure is willful, the penalty may be up to USD$100,000 or 50% of the value of the non-disclosed account at the time of the violation.
Even though U.S. taxpayers have had an obligation to file FBARs for 30 years, a significant portion of the taxpaying population who were obligated to file such forms did not because there was no way for the U.S. government to audit non-compliance. Enter FATCA. FATCA requires foreign financial institutions (FFIs) to report information to the IRS about financial accounts held by U.S. taxpayers and by foreign entities owned by the U.S. taxpayers. According to the U.S. Department of the Treasury, currently there are 113 jurisdictions treated as having FATCA Intergovernmental Agreements (IGA) in effect, with Australia being one of them. In addition to FFI reporting requirements, FATCA introduced an additional layer of compliance for U.S. taxpayers. FATCA expanded foreign financial account reporting by introducing a requirement to report information about certain foreign financial accounts and offshore assets on Form 8938 which is filed with a resident taxpayer’s income tax return.
These initiatives coupled with those that already existed under the BSA have almost made it impossible for a U.S. taxpayer to hide financial assets within a FFI outside of the U.S.
All of the major Australian banks have implemented initiatives to determine whether a taxpayer is a U.S. taxpayer. The outcome of this is that non-compliant taxpayers will not be able to find banks to custody their assets. This is quite a monumental shift from a decade ago – to think that U.S. taxpayers living in Australia who are non-compliant with their U.S. tax obligations may find themselves in a position where an Australian bank may not bank them because of U.S. non-compliance.
The FACTA, Form 8938 filing requirements do not replace or otherwise affect a U.S. taxpayer’s obligation to file an FBAR. In many cases the same accounts are reported on both Form 8938 and the FBAR with the Internal Revenue Code (Code) imposing a $10,000 penalty for failure to disclose the required information on Form 89385 . If a taxpayer does not correct non-compliance within 90 days of receiving an IRS mail notice, the penalty increases by $10,000 for each 30-day period of non-compliance, with the penalty being capped at $50,000.
IRS Form 8938 is required by U.S. taxpayers with a total value of specified foreign assets exceeding the thresholds outlined below. Where a U.S. taxpayer lives outside of the U.S., the financial threshold is higher than that of a U.S. taxpayer residing within the U.S.
|U.S taxpayer in U.S.||Living Abroad|
|Year end||During the year||Year end||During the year|
|Married filing joint||USD 100,000||150,000||USD 400,000||600,000|
|Single||USD 50,000||75,000||USD 200,000||300,000|
Sometimes the biggest challenge can be understanding that you are in non-compliance. For U.S. taxpayers living in Australia or an Australian taxpayer living in the U.S. the key can be understanding how your Australian entities are classified and subsequently taxed under U.S. law.
Classification of foreign entities
In my experience the area that carries the most risk is the failure of a taxpayer to properly classify an Australian entity under U.S. law.
By way of example:
(a) a discretionary trust that is controlled by a U.S. taxpayer will in many cases be classified as a grantor trust, and income derive by it will be attributed to the U.S. taxpayer;
(b) A unit trust in which a U.S. taxpayer is an owner may be classified as a corporation, and therefore possibly a controlled foreign corporation or a passive foreign investment company. It follows that there may circumstances in which, income derived by a unit trust could be attributed to a U.S. taxpayer; and
(c) a self-managed superannuation fund can be classified as a grantor trust or a non-exempt employee trust, again the outcome being that income derived by the fund would be currently attributed to a U.S. taxpayer.
The impact of this is that investment structures that are tax effective under Australian law are tax neutral or defective under U.S. law. Income that can be distributed to a broad range of beneficiaries under Australian law may be attributable to a U.S. taxpayer (with or without a credit for the tax paid in Australia) under U.S. law.
Furthermore, if you are a grantor or owner of any of the abovementioned entities, you will be required to complete information returns6 on which you report the income and activities of such entities. These forms are in addition to the FBAR and the IRS Form 8938 and failure to properly complete them can result in substantial financial penalties.
Are a taxpayer’s actions willful?
The starting point in evaluating the best course of action is to determine whether a taxpayer’s actions were willful. Whether a taxpayer’s actions are willful or non-willful will dictate what programs are available and most suitable. The IRS considers someone to have acted willfully, ‘if they intentionally evaded the payment of taxes or intentionally failed to disclose foreign accounts’.7 The distinction of whether a taxpayer has acted willfully or not will make a major difference in the penalties they will face and their exposure to criminal prosecution.
The remediation programs discussed below are the OVDP and the two programs offered under the Streamlined Procedures. Understanding which program to utilize in a particular circumstance is crucial as the repercussions and consequences under each can be significant.
Offshore Voluntary Disclosure Program
The OVDP, while having been called slightly different names over the years, is essentially the same program as its first iteration, which was introduced in 2003. The most significant change was the increase in the penalty from 27.5% to 50% of the taxpayer’s highest account balance when taxpayer banked with “bad” financial institutions.8 The IRS keeps a list of foreign banks that are being investigated on its website which is constantly being updated.9 Currently there are no Australian banks on this list.10
The OVDP is only available for taxpayers to address their own liability and is not available for individuals or firms who helped facilitate the non-compliance of others.11 Generally, taxpayers will be ineligible for the program if they are already under examination or investigation by the IRS or a law enforcement agency, or if the IRS or a law enforcement agency has notified the taxpayer of their intent to examine or investigate.
Broadly, for eligible taxpayers the OVDP requires the filing of eight years of amended tax returns and FBARs. Participating taxpayers must pay a “miscellaneous offshore penalty” of 27.5% on all foreign assets associated with the non-compliance. Further, where the taxpayer has an account with a “bad” financial institution identified on the IRS list, the penalty is increased to 50%.12
The OVDP is attractive for taxpayers who have willfully not disclosed offshore accounts to avoid tax. The program provides finality in resolving cases by way of the execution of a ‘closing agreement’ on Form 906. This is a legally binding agreement with the IRS and as part of the agreement the IRS will recommend to the DOJ that criminal charges should not be pursued, so long as the taxpayer is truthful in their OVDP disclosures. As IRS procedures are not binding on the DOJ, the DOJ is still able to pursue criminal charges against a taxpayer that has taken part in the OVDP. However, no known case exists where the DOJ has pursued a taxpayer where they have been accepted into the OVDP.13
As the OVDP provides finality, the IRS goes through a great level of scrutiny of the accounts of each disclosing taxpayer. As such, it is important that all disclosures are accurate and no information is omitted. It is advisable that taxpayers seeking to participate in the OVDP engage a specialist team of advisors to assist with this process.
Streamlined Filing Procedures
A major structural flaw of the OVDP is that both willful and non-willful taxpayers face the same penalties and burdensome filing procedures. In order to address this issue (and after strong pressure from the tax practitioner community), the IRS released the Streamlined Filing Procedures in 2012.
The Streamlined Procedures offer a much less cumbersome and relatively inexpensive alternative to the OVDP. It is available only to taxpayers whose non-compliance is non-willful. The IRS defines non-willful conduct as “conduct that is due to negligence, inadvertence, or mistake, or conduct that is the result of a good-faith misunderstanding of the requirements of the law.”14 The Streamlined Procedures require the taxpayer to sign a statement under the penalty of perjury that their failure to report income and comply with the offshore reporting requirements was non-willful. As this comes with potential criminal prosecution, it is important to consider each circumstance on a case-by-case basis to ensure the correct program is utilized.
The Streamlined Procedures offer two programs: a) the Streamlined Domestic Offshore Procedures (Domestic Procedures) for taxpayers living in the U.S.; and b) the Streamlined Foreign Offshore Procedures (Foreign Procedures) for taxpayers that were living abroad during the period for which returns are filed under the Streamlined Procedure.
The Foreign Procedures permit taxpayers who qualify as non-residents15 that have failed to comply with their income tax and information reporting obligations, to avoid all penalties in connection with such failure. A taxpayer will be an eligible non-resident qualifying for the Foreign Procedures if such taxpayer is a non-resident as defined by Code section 911.
Taxpayers that are U.S. citizens and permanent residents will qualify for the Foreign Procedures as eligible non-residents16 if in one or more of the most recent three years for which the U.S. tax return due date has passed, they did not have an abode in the U.S. and were physically outside of the US for at least 330 days in one of those three years. The Streamlined procedures define abode as one’s home, habitation, residence, domicile, or place of dwelling. It does not necessarily mean your principal place of business. ‘Abode’ has a domestic rather than a vocational meaning and will often depend on where you maintain your economic, family, and personal ties.17
Taxpayers that are non-U.S. citizens or lawful permanent residents will be eligible non-residents under the Foreign Procedures if in any one or more of the last three years for which a U.S. tax return due date has passed, they did not meet the substantial presence test.18 In applying the tests for U.S. citizens and non-U.S citizens, you can see that there are certain situations in which a U.S. resident for income tax purposes may be an eligible non-resident for the purposes of the Streamlined procedures. The examples below highlight how taxpayers determine whether they qualify for the Domestic Procedures or the Foreign Procedures.
Example 1: Susan is a U.S. citizen, she was born in the U.S. and moved to Australia with her parents when she was two years old. She has never lived in the U.S. (except for couple years when she came back to study in U.S.) and she does not have a U.S. abode. Susan meets the non-residency requirement applicable to individuals who are U.S. citizens or lawful permanent residents.
Example 2: Same facts as above except that Susan graduated from a university in the U.S. in 2011 and moved back to Australia. In early 2014 she accepted a position with a U.S. engineering firm and acquired a U.S. abode in 2014. She did not file calendar year 2014 and 2015 U.S. income tax returns. The most recent three years for which Susan’s U.S. tax return due date (or properly applied for extended due date) has passed are 2015, 2014, and 2013. Susan meets the non-residency requirement applicable to individuals who are U.S. citizens or lawful permanent residents since she was physically outside the United States for the full year during 2013.
Example 3: Ashleigh is not a U.S. citizen or lawful permanent resident. She was born in Australia, and resided in Australia until February 5, 2014. Ashleigh was physically present in the U.S. for more than 183 days in both 2014 and 2015. She did not file 2014 nor 2015 tax returns in the U.S. The most recent three years for which the U.S. income tax return due date or properly applied for extended due date has passed are, 2015, 2014, and 2013. Since Ashleigh was out of the U.S. during 2013 she meets the non-residency requirement of Code section 911.
Applicants under the Foreign Procedures are required to file three years of delinquent or amended returns and six years of corrected FBARs, pay taxes and interest. The Foreign Procedures also require that the applicant provides a statement of facts which explains the taxpayer’s non-willfulness under penalty of perjury. It is imperative that all relevant facts are disclosed and support the non-willfulness statement. If the taxpayer can establish that he or she has been non-willful, no penalties are assessed for prior non-compliance.
The Domestic Procedures mimic that of the Foreign Procedures in that the applicant is required to file three years of amended income tax returns and six years of corrected FBARs. The key difference is that a 5% penalty applies, as opposed to no penalty under the Foreign Procedures. This is still substantially less than the penalties offered by the OVDP (27.5% or 50%).
The way in which the 5% penalty is calculated is different than under the OVDP. The penalty under the Domestic Procedure is based on the year end value of the financial assets that were unreported. Under this procedure, the penalty will also apply where assets have been reported but the taxpayer failed to report the income from the asset. In this situation the penalty will apply to the asset’s year end value even though the asset was disclosed. An important difference here is that as the penalty only applies to the taxpayer’s financial assets (assets reportable on either FBAR and Form 8938), no penalty will apply to any unreported foreign real estate held by the taxpayer.
However, it is important that a taxpayer understands that entering the Streamlined program is not without risk. If the IRS determines that the taxpayer’s actions were willful, the IRS can deny the taxpayer’s application, levy penalties at rates as high as 50% in accordance with the law and refer the matter to the DOJ for criminal prosecution. Furthermore, even if the taxpayer’s application is accepted the taxpayer’s application can be audited in the future and if upon audit it was determined that the taxpayer’s actions were willful, the matter can again be referred to the DOJ for criminal prosecution. Comparatively once the final determination is made by the IRS as part of the OVDP, the IRS cannot refer the matter to the DOJ for criminal prosecution and it is unable to conduct an audit.
For taxpayer’s that have failed to comply with the U.S. international income tax and information disclosure laws the OVDP and the Streamlined Procedures offer various benefits which should be considered. Although the Streamlined Procedures provide enormous cost savings and bring the taxpayer into compliance with the IRS, failure to be accepted into the program can have dire consequences.
The IRS has the power to end the OVDP and Streamlined Programs at any time and it has indeed been the topic of much commentary amongst U.S. tax professionals.19 Both the OVDP and the Streamlined Procedures provide a valuable opportunity for taxpayers to come into compliance that may not be with us forever.
1 Authors: Peter M. A. Harper U.S. Head of CST Tax Advisors, Jurate Gulbinas Managing Director CST Tax Advisors Los Angeles, and Aman Mullee, Tax Advisor, CST Tax Advisors Atlanta.
2 Andrew Velarde, Will the Other Shoe Ever Drop on the OVDP (2016).
3 s 7701(b)(1)(A)(ii) Internal Revenue Code 1986.
4 Includes indirect ownership or signature authority.
5 § 6038D Internal Revenue Code 1986.
6 For example, IRS Forms 5371 and 5472 (foreign companies), 3520 and 3520A (foreign trusts and foreign funds) and 8865 (foreign partnerships).
7 Internal Revenue Manual 188.8.131.52.5.B.
8 Internal Revenue Service, Foreign Financial Institutions or Facilitators, https://www.irs.gov/businesses/international-businesses/foreign-financial-institutions-or-facilitators.
9 Internal Revenue Service, Foreign Financial Institutions or Facilitators. https://www.irs.gov/businesses/international-businesses/foreign-financial-institutions-or-facilitators.
10 As of August 31 2016.
11 Internal Revenue Manual 184.108.40.206.
12 U.S.C. s 5321(a)(5)(C).
13 Andrew Velarde, Will the Other Shoe Ever Drop on the OVDP (2016).
15 § 911 Internal Revenue Code of 1986.
16 § 911 Internal Revenue Code of 1986.
17 Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad, https://www.irs.gov/pub/irs-pdf/p54.pdf.
18 § 7701(b)(3) Internal Revenue Code of 1986.
19 Janathan L. Allen, Coming Out of the Shadows: IR’s OVDP and Streamlined Disclosure Programs.
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