Over the last several years, the Internal Revenue Service (IRS) has focused its efforts on enforcement of U.S. laws with respect to offshore assets held by U.S. citizens and residents, including their tax payment and reporting obligations. One initiative has involved prosecution of foreign financial institutions and personnel who have marketed tax avoidance schemes to U.S. taxpayers. The IRS has also been encouraging taxpayers to voluntarily disclose their previously unreported and untaxed foreign accounts by offering a series of amnesty programs and a streamlined filing compliance procedure.
The amnesty programs have been successful. More than 45,000 taxpayers have come into compliance, and they paid about $6.5 billion in taxes, interest and penalties. However, the programs have also been routinely criticized for treating willful tax evaders no differently than individuals who inadvertently or non-willfully failed to disclose and pay all taxes on foreign assets, discouraging many taxpayers with non-willful violations from participating in the amnesty programs. The streamlined filing compliance procedure, designed for U.S. taxpayers living abroad since 2009 and who had not filed a U.S. tax return during the period, was also found to be limited in its effectiveness to encourage participation. On June 18, 2014, the IRS finally announced changes to address these problems.
2012 Offshore Voluntary Disclosure Program (OVDP)
Under the 2012 OVDP, an individual who wished to declare previously undisclosed foreign assets could send a request to the IRS Criminal Investigation Division (CID) and seek pre-clearance for an OVDP submission. If pre-clearance was granted (which would generally occur if the CID was not already actively investigating the individual), the individual could then submit an OVDP application.
As part of the OVDP application, the taxpayer was required to:
file amended returns for each of the eight proceeding tax years;
pay the back taxes along with interest, an accuracy-related penalty, and (where applicable) failure-to-file and failure-to-pay penalties;
file Report of Foreign Bank and Financial Accounts (FBAR) forms for the preceding eight years;
file all other required informational returns (e.g., Forms 520, 3520-A, 5471, 5472, 8938);
submit copies of account statements for the foreign accounts; and
pay a penalty of 27.5% of the highest aggregate balance of all of the accounts and assets in any of the preceding eight years.
Taxpayers who met very limited criteria could qualify for a 5% or 12.5% reduced penalty rates. When faced with a potential criminal indictment and/or willful FBAR penalties (that are equal to 50% of the account value and are cumulative for each year there was a willful failure to file), the amnesty program is an attractive option. However, for those individuals who did not willfully fail to disclose the accounts or pay taxes, a flat 27.5% penalty on the highest aggregate value of the accounts seems excessive.
2012 Streamlined Filing Compliance Procedures
On June 26, 2012, the IRS announced that, starting from September 1, 2012, U.S. taxpayers living abroad since January 1, 2009, who had failed to file their U.S. federal income tax returns or their FBAR forms, and who presented low compliance risks (e.g., with less than $1,500 tax due each year), had a means to come into compliance. As part of this procedure, a taxpayer was required to:
submit delinquent tax returns and information returns for the last three years;
pay all tax and statutory interest due and owing;
file delinquent FBARs and submit copies of filed FBARs for the last six years; and
submit a Questionnaire (used to assess whether the taxpayer presents a high or low compliance risk).
Changes Announced on June 18, 2014
The June 18, 2014 announcement expanded the streamlined filing compliance procedures and modified the 2012 OVDP. The streamlined filing compliance procedures are now made to include taxpayers residing in the U.S., and the risk assessment component has been eliminated. Returns are to be submitted under either the Streamlined Foreign Offshore Procedure or the Streamlined Domestic Offshore Procedure. Taxpayers are required to certify that their prior failures to comply were non-willful. Eligible taxpayers residing outside the U.S. may have all penalties waived, while eligible taxpayers residing in the U.S. may be assessed a miscellaneous offshore penalty of 5% of the highest aggregate balance of the foreign financial assets related to the non-compliance.
With respect to the OVDP, beginning August 4, 2014, taxpayers with accounts held with financial institutions that have been publicly identified as being under investigation (or cooperating with an investigation) are required to pay a 50% offshore penalty on the aggregate balance of the accounts instead of a 27.5% penalty. Additionally, taxpayers are required to pay the offshore penalty with their OVDP submission. Previously, the penalty was not due until just before the closing agreement was signed, usually months after the submission. Taxpayers are now also required to include all account statements at the time of the OVDP application.
The Foreign Account Tax Compliance Act (FATCA) goes into full effect July 1, 2014. Foreign financial institutions are negotiating with the IRS to enter into deferred prosecution agreements, seeking to reduce the civil penalties, and agreeing to provide information regarding the accounts of U.S. persons. As a result of FATCA and these negotiations, many financial institutions are closing the accounts of U.S. citizens and residents or are turning over account information to the IRS. If an individual has undisclosed foreign assets, now is the time to get into compliance, especially (1) with the reduced penalty structure for non-willful taxpayers, and (2) the increased penalty (beginning August 4, 2014) for taxpayers with accounts at financial institutions that have been publicly identified as under investigation. Once an audit has been initiated (or the CID has begun its investigation), a taxpayer is precluded from entering the OVDP or taking advantage of the streamlined procedures.