By Thomas E. Zehnle, Steven R. Dixon and Kevin G. Mosley
By now, nearly everyone (or at least everyone with enough money to have a foreign bank account) has heard about the UBS account fracas and the end of Swiss bank-account secrecy. If you didn't know that your clients have to report foreign accounts to the government, you certainly know now. Maybe you're hoping that the government won't notice the account. Or maybe you haven't had the time to deal with disclosing the account. For the procrastinators and risk-takers of the world, the IRS has a "new" deal for you-voluntarily identify your foreign financial accounts and other offshore income-producing assets, get straight with the American taxman, and you don't have to worry about IRS agents knocking on your door-or snooping in your trash.
Now, if this all sounds somewhat familiar, it should. This is the second time since 2009 that the IRS has offered a deal for those willing to come clean. On February 8, the IRS announced its 2011 Offshore Voluntary Disclosure Initiative, which follows the fairly successful 2009 Offshore Voluntary Disclosure Program that officially closed in October 2009 after accepting almost 15,000 voluntary disclosures. Like the earlier program, the current initiative is meant to provide "consistency and predictability to taxpayers"-provided they fulfill the program's requirements on or before August 31. Like its predecessor, the 2011 OVDI couples ordinary voluntary disclosure-which dramatically minimize the chance that a taxpayer will face criminal prosecution for tax violations-with the promise of consistency and leniency on the civil side by "defining the number of tax years covered and setting the civil penalties that will apply."
More specifically, the disclosure period for the 2011 OVDI includes the 2003-2010 tax years. Taxpayers who participate in the 2011 OVDI will:
Avoid criminal prosecution for tax violations related to their failure to report their previously undisclosed foreign accounts and assets;
Limit examination of their foreign bank account activity occurring before the disclosure period;
Avoid paying offshore account-related information penalties, including the penalty for failure to file a Report of Foreign Bank and Financial Accounts (FBAR) that can amount, by itself, to 50% of the total value of the unreported foreign assets for each year the assets go unreported;
In lieu of the FBAR and related penalties, pay a one-time miscellaneous offshore account penalty no greater than 25% of the highest total value of the foreign account or asset occurring during the disclosure period;
Pay a 20% accuracy-related penalty on the full amount of underpayments for the period;
Pay any applicable failure to file or failure to pay penalties;
Submit copies of all previously filed returns and file complete and accurate amended or original returns;
Pay all applicable tax and interest; and
Provide information regarding their foreign accounts, banks and bankers.
"Tell On Myself, Part Two" is, on balance, good news for taxpayers who, for whatever reason, have yet to disclose their offshore accounts and assets. Because they too can opt into the 2011 OVDI, this announcement is good news for the 3,000 taxpayers who made voluntary disclosures after the close of the 2009 OVDP and were therefore ineligible for the more lenient tax and penalty regime it offered. The 2011 OVDI is-for most taxpayers-a better deal than they would get if they disclosed their offshore accounts outside of the OVDI regime.
With the 2011 OVDI, the IRS attempts to build upon its experience administering the 2009 OVDP by streamlining or eliminating several of the 2009 OVDP's more irksome elements. For example, the 2011 OVDI guidance now specifies the information that the IRS expects to see on the power-of-attorney form that practitioners file on behalf of individuals making voluntary disclosures. The IRS's demand for magic language on those forms in the 2009 OVDP was a seemingly innocuous issue, but it unnecessarily increased costs for clients and it gave clients the impression that their representatives could not properly fill out basic forms. In addition, the IRS appears to have systematized elements of the civil audit process associated with the voluntary disclosure by insisting that taxpayers' disclosures be documented in a "package" that includes the following new forms:
Foreign Account or Asset Statement;
Foreign Financial Institution Statement; and
Taxpayer Account Summary (with Penalty Calculation).
In the 2009 OVDP, the information for these forms was provided to the IRS in work papers created by taxpayer representatives and provided to individual civil agents in a somewhat hit-or-miss fashion, an incremental process that developed mostly through trial and error. Ideally, these forms will save OVDI participants the cost of submitting and resubmitting calculations.
One notable aspect of the 2011 OVDI is its detailed guidance about how taxpayers are to account for and report investments in foreign mutual funds that the IRS treats as "passive foreign investment companies," or "PFICs." That guidance presents taxpayers with an alternative method for determining PFIC tax that is effectively the same as-although slightly more detailed than-the alternative method of determining the tax on PFICs that eventually emerged, at the urging of private practitioners, under the 2009 OVDP.
These changes are welcome and should make the 2011 OVDI more efficient. But taxpayers should be aware that there are hidden costs associated with the implementation of the civil program that make it difficult for practitioners to give clients a definitive idea of the timing fees associated with the completion of the OVDI process.
Compliance On A Short Deadline
The 2011 OVDI requires taxpayers to submit completed disclosures on or before August 31, which does not give taxpayers a lot of time. It means the time-consuming process of collecting all relevant bank records and completing highly detailed returns has to be finished in a relatively short amount of time. The IRS indicates its "experience with offshore cases in recent years" has shown that "taxpayers are ultimately successful in retrieving copies of statements and other records from foreign banks." In our experience, there is a vast difference between "ultimately" obtaining account information and obtaining that information on an expedited basis. In some cases, it has taken more than ten months for taxpayers to receive relevant records, particularly if their accounts were held by foreign foundations or other entities.
Even if taxpayers obtain records on a timely basis, they may face obstacles in submitting a complete disclosure by the deadline. The speed at which a tax preparer will be able to complete the amended or original returns depends on the preparer's ability to decipher dense and often confusing bank records that were not constructed with U.S. tax compliance in mind. In many cases, these problems are compounded because the bank statements are in a foreign language. Translating and then slogging through the morass of foreign bank records made for slow going in return preparation in the 2009 OVDP. And since most preparers had other clients to deal with at the same time, expedited return preparation was difficult if not impossible. Taxpayers should be aware that these issues may persist in the 2011 OVDI. If meeting the August deadline becomes a widespread problem, the IRS may extend the deadline as it did in the 2009 OVDP, but taxpayers cannot count on such an extension. In short, taxpayers should be aware that record retrieval and return completion is often not a simple process and it may be more costly than the IRS guidance indicates, particularly if the IRS rejects taxpayers' return calculations.
Problems With Do-It-Yourself Penalty Calculations
After taxpayers receive their bank records, their representatives will be tasked with determining the taxes and penalties associated with each disclosure. In the 2009 OVDP, it was common for practitioners to calculate taxes and penalties and complete amended returns based on guidance from agents only to be later informed that the IRS required more or different information, or that the IRS determined their methodology was flawed. These issues usually arose because the IRS's demands changed while the amended returns were being completed or because zealous agents decided to look into areas of individual returns that were tangentially related or unrelated to the reporting and taxation of income related to the offshore accounts. Practitioners complained that by treating the 2009 OVDP disclosures like full-scale audits, agents were defeating the purpose of creating a special disclosure program.
Unlike audits, however, agents in the 2009 OVDP usually required taxpayers to submit their own penalty calculations. One penalty-calculation issue that taxpayers should understand about the 2011 OVDI is that the IRS may include reported accounts in computing the 25% penalty assessed against the highest account balance over the period covered by the voluntary disclosure. Under the 2009 OVDP, taxpayers and practitioners were surprised to learn that disclosed accounts were still factored into the 20% penalty that applied in lieu of FBAR and other penalties. That penalty applied to the year in which the taxpayer had the highest aggregate balance for all accounts. In computing the highest aggregate balance for each year, the IRS has, at least in some cases, refused to exclude account balances for accounts that had been disclosed for that year. And the IRS met protestations about the unfairness of including disclosed accounts in the penalty calculation with the response that the 2009 OVDP was elective. Some agents cited the IRS memorandum announcing the 2009 OVDI, which directed agents to "assess a penalty equal to 20% of the amount in foreign bank accounts/entities in the year with the highest aggregate account/asset value," as if that memorandum somehow ruled out the possibility of excluding reported accounts in computing the aggregate account balance for each year for penalty purposes.
The IRS may attempt to include reported accounts in penalty calculations in the 2011 OVDI. The 2011 OVDI guidance states that "[t]he values of accounts and other assets are aggregated for each year and the penalty is calculated at 25% of the highest year's aggregate value during the period covered by the voluntary disclosure." If the IRS were to decide that the "period covered by the voluntary disclosure" immutably includes all years from 2003 through 2010, then the IRS may levy the penalty on disclosed accounts. The IRS elsewhere states that for calendar year taxpayers that period includes "tax years 2003 through 2010 in which they have undisclosed foreign accounts and/or undisclosed foreign entities." This suggests that taxpayers could argue that the period excludes years in which they have disclosed accounts or entities when computing the penalty. It would certainly make sense that a taxpayer who voluntarily disclosed accounts and filed an FBAR for a particular year should be able to exclude that year from the 25% penalty calculation in the 2011 OVDI. But it also would have made sense to exclude 2008 from the 20% penalty calculation in the 2009 OVDP for those taxpayers who had disclosed accounts for that year, and the IRS barred at least some taxpayers from making that exclusion.
Another penalty-calculation surprise that taxpayers encountered in the 2009 OVDP was that the IRS levied the 20% penalty on offshore income-producing assets. This also makes little sense because no reporting obligation attaches to offshore assets that are not in a foreign account. But taxpayers faced penalties on the value of offshore income-generating assets, like rental properties. This was often a significant penalty hit because the values of these assets could be quite high. Moreover, paying the penalty was typically problematic because these offshore assets were not liquid. This penalty on the "value of foreign assets" remains in place for the 2011 OVDI.
While neither the inclusion of reported accounts nor the penalty on offshore assets necessarily makes the 2011 a bad deal, they are factors to bear in mind in computing the cost associated with participating in the 2011 OVDI.
The PFIC Mess
A surprise for many of the participants in the 2009 OVDP was that some (or in many cases, a large portion) of their foreign accounts had been invested in foreign funds that U.S. law treats as PFICs. PFICs are subject to a complex regime of anti-deferral rules under the Internal Revenue Code. Not only is that regime complex, the tax determined under the regime can change based on taxpayer elections. Obviously, taxpayers with unreported accounts had not made any elections under the PFIC regime. In fact, in many cases taxpayers were completely unaware of how the foreign financial institution had invested the taxpayers' money and had no idea that they owned PFIC interests. More importantly, however, most taxpayers did not have the necessary historical basis information that would have been needed to prepare statutory PFIC computations.
The IRS devised an alternative (and, according to the IRS and some commentators, generous) method for determining the tax on PFIC investments within the 2009 OVDP which was based on the elective mark-to-market method under the PFIC regime. The IRS has retained and clarified this alternative method for the 2011 OVDI.
For a PFIC investment that the taxpayer holds during the OVDI period, the taxpayer must mark the investment to market each year and pay a 20% tax on any gains. Taxpayers pay the same rate for any gains from disposition of PFIC investments during the period. Taxpayers can make limited use of PFIC losses. There is an additional 7% tax in the first PFIC year in lieu of the interest charge that would apply under the standard PFIC regime.
Because the rates are low and the method is simpler than the regular statutory PFIC regime, the alternative method will be the best choice for nearly all taxpayers with PFICs in the 2011 OVDI. But the alternative method is still fraught with administrative hassle and expense. Here are some things taxpayers should keep in mind about the alternative PFIC method:
Identifying PFIC investments may be tricky. Determining whether an investment is a PFIC requires some knowledge about the investment, and OVDI taxpayers are unlikely to know anything about their account investments. There is typically no way to definitively determine whether an investment is a PFIC based on account statements. Taxpayers are left with some guesswork in identifying PFICs and can expect pushback from civil agents about which investments the taxpayer chooses to treat as PFICs. Any back and forth with the agent on this issue quickly drives up costs for the taxpayer.
Alternative method computations are still complex. While the alternative method is indisputably simpler than the computations that would be required under the standard PFIC regime, the computations are nevertheless complex and require taxpayers to spend more on accounting services than they would without the PFIC computations. This is compounded where the statements are complex or statements are missing.
Accounting software is not designed to do alternative method computations. One factor that drives up computation costs is the reporting method that the OVDI prescribes. Taxpayers are to compute their PFIC liability outside the context of their amended return and then add the PFIC liability to their total tax-regardless of whether that total is regular tax or AMT. Most accountants use tax preparation software that doesn't do this computation-it typically requires an override to display the PFIC liability on the return.
There are no shortcuts. Consistent with the standard PFIC regime, the alternative method requires taxpayers to compute the PFIC tax on an investment-by-investment basis. The IRS did not allow taxpayers to aggregate PFIC investments under the 2009 OVDP for the sake of administrative simplicity, and it appears that they will not allow aggregation under the 2011 OVDI.
There may be continuing complications. Taxpayers who retain their PFIC investments must remain on the mark-to-market method for post-OVDI years.
Cost of computations may outstrip underlying PFIC tax. Taxpayers with small offshore accounts or who had little invested in PFICs may find that the cost of computing the additional PFIC liability will be higher than the additional PFIC tax owed under the alternative regime.
While none of these considerations-either alone or in combination-are likely to counsel taxpayers to attempt to compute their PFIC liability using the standard regime, taxpayers should nevertheless be aware of these pitfalls and expenses.
Opting Into The 2011 OVDI
Some 3,000 taxpayers opted for voluntary disclosure even after the October 2009 date had passed for the 2009 OVDP. The IRS is allowing voluntarily disclosing taxpayers who missed the 2009 OVDP deadline to elect into the 2011 OVDI. We suspect that in the vast majority of cases, the most economical route for these taxpayers will be to elect into the 2011 OVDI.
There are, however, may be some issues that will crop up for taxpayers who elect into the 2011 OVDI. One issue is that those taxpayers may have already submitted substantial filings and the IRS may require them to resubmit a separate application that complies with the 2011 OVDI package requirements. Practitioners hope that taxpayers will be able to opt in more simply, like with a letter to the IRS.
Another possible issue involves the 25% penalty on the highest aggregate account balance. The penalty-calculation issue described above-that the IRS may include disclosed accounts in penalty calculations-is more likely to arise for taxpayers who have voluntarily disclosed before opting into the 2011 OVDI because it is likely that those taxpayers have already filed FBARs for 2009 or 2010 or both before opting into the 2011 OVDI. Those taxpayers should be aware that despite the patent unfairness of including timely-disclosed accounts in the penalty calculation, the IRS may nevertheless try to include disclosed accounts from 2009 or 2010 in computing the 25% penalty.
How Will The IRS Administer The 2011 OVDI?
A host of case-specific factors will determine whether taxpayers who opt into the 2011 OVDI incur the same level of administrative expense and burden as those who elected the 2009 OVDP: how quickly the taxpayer can obtain bank records, whether the taxpayer has kept records herself, the number of accounts and volume of account activity, whether the taxpayer can complete the package before other taxpayers, whether the taxpayer has the PFIC issue, etc. An important factor that will determine the administrative burden associated with 2011 OVDI participation is the manner in which the IRS administers the program. There have been meaningful delays for 2009 OVDP participants, some of which have yet to have their case assigned to revenue agents. Part of the problem appears to be that the IRS did not anticipate the volume of participation in the 2009 OVDP.
The IRS is more optimistic about its ability to efficiently process cases in the 2011 OVDI. The IRS has represented that for the 2011 OVDI, it is "handling [the] processing of the voluntary disclosures in centralized units" for the sake of efficiency and that it "has taken certain steps to improve our efficiency in processing cases." The IRS has also stated that it has made efforts to centralize the pre-clearance process (the process by which a taxpayer can determine whether she is already under IRS investigation before making a voluntary disclosure). While the IRS has undoubtedly improved its processes after the 2009 OVDI and we are optimistic that things will move more quickly in this go around, taxpayers hoping for a swift and inexpensive resolution on the civil side would be wise to temper their expectations.
Zehnle, Dixon and Mosley are attorneys with the law firm of Miller & Chevalier in Washington D.C.