Several weeks ago, we reported that changes to the IRS’s Offshore Voluntary Disclosure Program (“OVDP”) were imminent and would focus on distinguishing between taxpayers who willfully violated their reporting requirements, and those whose past reporting failures were non-willful.
On Wednesday, the IRS officially announced the anticipated changes to the OVDP. The IRS’s announcement of the modifications and additional guidance regarding the modifications can be found here. As predicted, the changes create a clear distinction in treatment between OVDP filers who can successfully certify their reporting failures were non-willful and those who cannot.
Fundamentally, OVDP filers whose past reporting failures were non-willful are, from July 1, 2014 forward, eligible for admission into the OVDP under “streamlined” procedures that previously only applied to a narrow category of filers (generally non-US residents with less than $1,500 of unpaid tax in tax years covered by the OVDP). Moreover, taxpayers whose past non-compliance was non-willful will be subject to dramatically lowered penalties (5 percent of the penalty base as opposed to 27.5 percent for US residents or no penalties for non-US residents). A more detailed description of the new, streamlined procedure is set forth below. However, before an OVDP filer can take advantage of the streamlined procedure and reduced or eliminated penalties, he must establish that his violations were non-willful.
Non-willfulness: A Crucial, Yet Uncertain, Determination
The streamlined procedures and reduced or eliminated penalties only apply under the modified OVDP if the filer can successfully certify that his or her past non-compliance was non-willful. For this purpose, the IRS has defined 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.” By adopting this definition, the IRS has more closely aligned the concept of willfulness within the OVDP with the standard definition of willfulness applied by the federal courts in civil cases, i.e. an intentional violation of a known legal duty.
It is essential to recognize that filing a streamlined disclosure and certifying that past reporting failures were non-willful does not immunize the OVDP filer from examination and does not guarantee that the non-willfulness certification will be accepted. The information and supporting documents submitted by the filer may still be examined and the IRS is permitted to overrule the filer’s non-willfulness certification. Thus, the IRS’s ability to reject a non-willfulness certification upon its independent examination may justifiably create a great deal of uncertainty for an OVDP filer whose non-willfulness is difficult to prove.
Although the IRS has articulated a standard of non-willfulness that appears to be in line with the standard generally applied by courts across the country, the true test lies in whether the IRS will be faithful to that standard. Willfulness is a potentially malleable concept, and though court decisions regarding willfulness under civil and criminal tax statutes abound, because the OVDP is subject to the IRS’s plenary authority, it is doubtful whether judicial precedent regarding willfulness can be meaningfully relied upon. Also, there are no appeal rights in the OVDP; once the IRS makes a determination regarding the willfulness or non-willfulness of an OVDP filer’s past non-compliance, that determination is fixed.
Moreover, due to privacy laws applicable to the IRS and the generally secretive nature with which the IRS treats its resolution of cases under the OVDP, it will be extremely difficult for potential OVDP filers to discern any sort of uniform applicability of the non-willfulness requirement with the IRS. The standard applied could vary from case to case and examining agent to examining agent without OVDP filers ever being aware of the disparate standards being applied.
The uncertainty surrounding the standard by which the IRS will analyze non-willfulness in the context of the streamlined OVDP was exemplified by reports of comments made by IRS officials at a recent conference held by New York University Law School. Specifically, division counsel for the Small Business and Self-Employed Division, John McDougal, was reported as saying that an OVDP filer is non-willful if he “isn’t really worried about being prosecuted.” Additionally, McDougal was quoted as saying “the concept of willfulness is well-documented in the case law,” and “we’re depending on practitioners to help clients work their way through what the risk is of criminal prosecution and significant penalties.” In other words, it appears not even IRS officials are exactly sure what “non-willfulness” means for the streamlined OVDP, which begs the question: if the IRS can only vaguely define what non-willfulness means, what hope does an uncertain OVDP filer have?
The Effect of Rejection
The fact that the IRS’s initial determination regarding whether an OVDP filer’s past reporting failures were willful or non-willful are binding and final leads to perhaps the most pressing underlying issue created by the OVDP modifications. If a taxpayer certifies that his past non-compliance was not willful and thereby attempts to take advantage of the streamlined disclosure program, and the IRS examines the disclosure and rejects the non-willfulness assertion, that taxpayer is precluded from entering the traditional OVDP, as confirmed by this statement in the IRS announcement of the streamlined program: “Once a taxpayer makes a submission under either the Streamlined Foreign Offshore Procedures or the Streamlined Domestic Offshore Procedures, the taxpayer may not participate in OVDP.”
As a result, if an OVDP filer attempts to certify non-willfulness and the certification is overruled, the filer will have disclosed his offshore assets and past non-compliance, and exposed himself to the maximum potential penalties, without any benefit. In essence, taxpayers that are not completely confident about their ability to prove that their past non-compliance was not willful–as that term is defined by the IRS–are taking a significant risk in attempting to avail themselves of the streamlined procedure.
Unfortunately for potential OVDP filers, how strict the IRS will be in evaluating a filer’s past non-compliance can only remain to be seen. Further, unless the IRS alters its generally secretive approach to the OVDP, OVDP filers will be forced to rely on anecdotal evidence gleaned from others who have attempted to participate in the streamlined disclosure. Sadly, while the OVDP program is meant to provide certainty for taxpayers seeking to resolve past non-compliance, the IRS, in attempting to draw the line between willful and non-willful filers, appears to have created a brand-new source of uncertainty.
The Specifics of Disparate Treatment for Willful and Non-Willful Past Noncompliance
Under the modified OVDP, taxpayers successfully certifying that their non-compliance was non-willful are treated much more leniently than they previously were, when almost all OVDP filers were subject to a 27.5 percent penalty regardless of the circumstances surrounding their past non-compliance. Moreover, the disclosure obligations of non-willful OVDP filers are less onerous than those of willful filers.
Under the modified program, non-willful filers (again, those who successfully establish that their reporting failures were due to negligence, inadvertence, or a good faith misunderstanding of the law) are broken into two groups: those who are U.S. residents and those that are not. For each group, the procedure for taking advantage of the new, streamlined OVDP is largely the same, with a key difference noted below. OVDP filers in either non-willful group are required to:
File three years of amended or delinquent returns. Note that US residents cannot file delinquent returns, so for US residents to be eligible for the streamlined procedures, they must have filed a return for the previous three tax years. If a US resident has not filed returns for the previous three tax years, that person should not attempt to enter the OVDP under the streamlined procedures, as it is likely their submission will be rejected and they may end up being precluded from using the traditional OVDP;
Pay all previously unpaid tax and interest reflected on the newly filed returns;
File any FBARs that were required to be filed, but were not, for any of the six most recent tax years for which the filing due date has passed;
Sign and file a certification regarding the taxpayer’s residency status (either a U.S. resident or non-resident), and further certifying that all required FBARs have been filed and that all past reporting failures were due to non-willful conduct.
The primary difference in the IRS’s treatment of U.S. residents and non-residents is that non-residents are not subject to any penalties (and therefore are required only to pay back taxes and interest to resolve their past non-compliance), whereas U.S. residents will be required to pay a miscellaneous 5 percent penalty. The determination of whether a taxpayer is a US resident depends on that taxpayer’s legal status. If the taxpayer is a US citizen or green card holder, he will be considered a non-resident if, in any one or more of the three most recent years for which the tax return due date has passed, the individual did not have a US abode (which generally means the location of the taxpayer’s primary residence) and was physically outside the US for at least 330 full days.
For taxpayers who are not US citizens or green card holders, they will be considered non-residents for OVDP purposes if they do not meet the substantial presence test of IRC § 7701(b)(3), which generally requires a taxpayer to be present in the US for at least 31 days in the current year and at least 183 days over the previous three years (with days in the years 2 being counted as 1/3 of a day and days in year 3 being counted as 1/6 of a day).
Additional Modifications to the OVDP
While generally beneficial to OVDP filers whose past non-compliance was not willful, the IRS’s modifications increase the burden on filers who cannot certify that their non-compliance was not willful. Before the IRS’s modifications, a 27.5 percent penalty was applied to OVDP filers almost uniformly. Now, beginning August 4, 2014, if an OVDP filer fails to disclose an offshore account and it has become public that the host financial institution is under investigation by or is cooperating with the IRS or Department of Justice or the host financial institution has been identified by in a “John Doe summons,” then a 50 percent penalty will apply to all of the taxpayer’s undisclosed assets (not just those hosted by the subject financial institution). The IRS has published a list of those financial institutions that currently meet these criteria:
1. UBS AG
2. Credit Suisse AG, Credit Suisse Fides, and Clariden Leu Ltd.
3. Wegelin & Co.
4. Liechtensteinische Landesbank AG
5. Zurcher Kantonalbank
6. swisspartners Investment Network AG, swisspartners Wealth Management AG, swisspartners Insurance Company SPC Ltd., and swisspartners Versicherung AG
7. CIBC FirstCaribbean International Bank Limited, its predecessors, subsidiaries, and affiliates
8. Stanford International Bank, Ltd., Stanford Group Company, and Stanford Trust Company, Ltd.
9. The Hong Kong and Shanghai Banking Corporation Limited in India (HSBC India)
10. The Bank of N.T. Butterfield & Son Limited (also known as Butterfield Bank and Bank of Butterfield), its predecessors, subsidiaries, and affiliates
Taxpayers who have or had accounts in those institutions and failed to report the accounts or pay tax on the interest or dividends generated by the account should act promptly if they plan to enter the OVDP. Additionally, this list will likely expand in the future.
Furthermore, under the modified program all OVDP filers must provide the account statements generated during the OVDP period (previously that requirement applied only to account holders that had a balance in excess of $500,000 at any point during the OVDP period), and, more importantly, the OVDP filer must pay the OVDP penalty at the time the voluntary disclosure is made. Under the old rules, the taxpayer waited until negotiations with the examining agent assigned to the disclosure were complete before paying the OVDP penalty.
Has the IRS Truly Eased the Burden on OVDP Filers?
In his statement previewing the OVDP modifications earlier this month, IRS Commissioner John Koskinen repeatedly emphasized the need to treat OVDP filers who did not willfully violate their reporting obligations consistently with the non-willful manner of their violations. In some ways, the IRS’s modifications to the OVDP have met that goal. The modifications more appropriately take into account the willfulness of the OVDP filer’s non-compliance in setting the applicable punishment and are especially helpful in the case of obvious non-willfulness, such as US citizens who have lived abroad for nearly their entire lives and were never aware they had any US tax obligations.
Yet at the same time, IRS’s modifications create a significant conundrum for potential filers whose non-willfulness is not clear cut. In many factual circumstances, the IRS can plausibly assert that a taxpayer’s reporting failures were the result of willful blindness. This is especially so given the questions regarding foreign accounts taxpayers are required to answer on Schedule B of the 1040.
Specifically, in order to determine whether the taxpayer has an FBAR filing obligation, schedule B asks taxpayers whether they have a financial interest in or signatory authority over a financial account located in a different country, and then directs the taxpayer to read the applicable instructions. Any taxpayer who files schedule B with their tax return has arguably been placed on notice that they have an FBAR or other reporting obligation regarding their foreign account, which the IRS can use to overrule an OVDP filer’s non-willfulness certification.
One can imagine a multitude of other scenarios in which an OVDP filer’s honest misunderstanding of the facts or law can be painted as willful blindness. Until the IRS more clearly articulates how it will judge non-willfulness in the context of the OVDP, based on real, practical circumstances rather than an abstract legal standard, the looming threat of the IRS making a willful blindness determination and rejecting a filer’s entry into the streamlined procedure will undoubtedly affect the decisions of many OVDP filers.
Additionally, while it is clear the IRS has reduced the burden on filers who successfully establish non-willfulness, a strong argument can be made that taxpayers whose non-willfulness was readily apparent should have never faced the possibility of significant penalties or criminal prosecution for their non-compliance in the first place, and that by including those taxpayers at all within the scope of the previous iterations of the OVDP the IRS was overreaching.
Now, by either eliminating or lowering the applicable penalty for non-willful filers, the IRS can be seen as justified in nearly doubling the penalty applicable to certain willful filers (i.e. taxpayers with undisclosed accounts in banks that are cooperating with the US government, such as those listed above). Overall, while the fallout remains to be seen, the IRS’s OVDP modifications should not be viewed as being as forgiving to taxpayers disclosing their offshore assets and past non-compliance as the IRS might argue or publicize.