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: