201410.290

An Overview of the 2014 IRS Offshore Voluntary Disclosure Program (OVDP) and Enhanced Streamlined Filing Compliance Procedures (SFCP)

By Alexey Manasuev, U.S. Tax IQ**

*The article was published by Tax Notes International on August 25, 2014. The full text of the article can be provided upon request. (Contact Us)

**Alexey Manasuev is a Principal with U.S. Tax IQ, a boutique tax consulting and compliance firm with offices in Oakville and Toronto, Canada. In addition, Alexey is a U.S. tax lawyer and is a Foreign Legal Consultant licensed to provide U.S. tax and legal advice in Ontario. Alexey can be reached at [email protected]. The views and opinions are those of the author and do not necessarily represent the views and opinions of U.S. Tax IQ. The information contained herein is general in nature and based on authorities that are subject to change. Applicability to specific situations is to be determined through consultation with your tax adviser.

On June 18, 2014, the IRS released significant changes to its Offshore Voluntary Disclosure Program (“OVDP”) and enhancements to the Streamlined Filing Compliance Procedures (“SFCP”).[1] Along with the new rules, the IRS offered transitional treatment to those taxpayers who are currently participating in the OVDP and meet certain requirements.[2] Unfortunately, the IRS only allowed limited time for such taxpayers to qualify for the transitional treatment. Specifically, the transitional treatment is only extended to those taxpayers who were “participating” in the OVDP (managed to file their OVDP submission and did not enter into a closing agreement with the IRS) on or before June 30, 2014. The benefit of the transitional treatment is in applying the reduced and more favorable penalty structure of the enhanced SFCP for those taxpayers who, even though participating in the OVDP, are qualifying under the terms of the enhanced SFCP. Another benefit of qualifying for the transitional treatment is in the taxpayers’ ability to elect the processing of their OVDP cases under the old rules, in existence before the new rules became effective on July 1, 2014 (see the discussion of significant OVDP changes below).

Taxpayers who may face increased penalties under the new OVDP rules may still benefit from the old 2012 OVDP penalty structure if they file their pre-clearance OVDP submissions with the IRS Offshore Voluntary Disclosure Coordinator on or before August 4, 2014.

For the first time since the IRS released in 2009 its OVDP initiative, the IRS clarified options available to U.S. taxpayers with undisclosed foreign financial assets and accounts to come into compliance with their U.S. tax obligations and FBAR filing obligations. These options are as follows: (i) OVDP; (ii) SFCP (for U.S. taxpayers residing outside the United States and U.S. taxpayers residing in the United States; (iii) delinquent FBAR filing procedures; and (iv) delinquent international information return filing procedures.

This article summarizes significant changes made by the IRS to the two programs, comments on a few areas that remained unaddressed, and shares the author’s views and recommendations on certain aspects of the new rules that may present increased challenges and complexities for taxpayers.

Practical Tools

Attached to this article are two practical tools. One is decision-making trees on options available to taxpayers to become tax-compliant under the new rules announced by the IRS on June 18, 2014.[3] The purpose of the tool is to assist taxpayers in evaluating the options available to them under the new rules and to allow taxpayers, based on their facts and circumstances, to navigate the new rules in an easier manner.

Another tool is the table containing a side-by-side comparison of Frequently Asked Questions (FAQ) under the 2012 IRS Offshore Voluntary Disclosure Program (“OVDP”)[4] and the recently announced (on June 18, 2014) 2014 FAQ[5] under the IRS OVDP. The purpose of the table is to serve as a practical tool for tax practitioners who evaluate the changes to the OVDP announced by the IRS in evaluating procedural alternatives available to taxpayers in resolving their U.S. tax compliance issues. The table will be of particular interest to those taxpayers and tax advisors who currently participate in the 2012 OVDP or whose facts and circumstances may warrant a more favorable penalty structure under the SFCP. Although the value of the side-by-side comparison is now limited because of the passed June 30, 2014 deadline for applying for the transitional treatment, the side-by-side comparison may still be of use to some practitioners and U.S. taxpayers who want to have a quick and easy reference material identifying the changes to the programs.

The Treasury and the IRS should be commended for their efforts to simplify and enhance options available to U.S. taxpayers with undisclosed foreign financial assets, both residing outside the United States and in the United States, to become U.S. tax compliant. Unfortunately, some of the new rules may, whether by design or inadvertently, prevent many U.S. taxpayers residing overseas from qualifying for the enhanced SFCP, even though they would have qualified under the 2012 SFCP terms.

 

The Good and Bad

The good news is that the new rules:

  1. Provide more clarity on options available to U.S. taxpayers to become tax-compliant.
  2. Reduce penalties in situations where taxpayers do not willfully fail to report their foreign financial assets, to pay tax, or to file their delinquent U.S. tax returns and required information returns.
  3. Expand the SFCP to eliminate the low compliance risk threshold and to open the program to U.S. taxpayers residing in the United States.
  4. Invite U.S. taxpayers who previously made “quiet disclosures” to come forward under the SFCP, with certain limitations. However, in several areas the new rules are more restrictive than the old rules (some of the below discussed changes are understandable, while overly restrictive nonetheless), as follows:
    • The non-residency test, as drafted, whether by design or inadvertently, would prevent many U.S. taxpayers residing overseas from qualifying for the enhanced SFCP, even though they would have qualified under the 2012 SFCP (please see the discussion on the new non-residency test later in the article for a detailed analysis of this requirement).
    • The increased information and documentation requirements at the time of applying for the OVDP would add additional burden for taxpayers.
    • The requirement to pay the full amount of any tax owed, penalties, and interest at the time of applying for the OVDP or SFCP, as applicable, would also add additional burden for taxpayers.
    • The requirement to certify that the failure to pay tax or file requisite U.S. tax returns or forms was due to a non-willful conduct would add additional burden for taxpayers because they will have to make the respective determination prior to making the applicable submission.
    • Very limited time was provided to taxpayers to qualify for the transitional treatment.

In many instances in the newly issued guidance, the IRS emphasized possible examination of the taxpayer’s returns. Although this is not a new requirement per se, the IRS did not include it in its prior guidance. Accordingly, applying for the enhanced SFCP (as opposed to, for example, resolving outstanding U.S. tax issues with the IRS directly under the existing IRS assessment, examination, and collection process) will not provide taxpayers with any guarantee that their returns would not be subject to a possible examination.[6]


What Got In?

Summarized below are some of the notable changes to the OVDP and the SFCP.

Overview of OVDP Changes

  • Introduction of an increased 50 percent (compared to the previous 27.5 percent) miscellaneous offshore penalty on all undisclosed foreign financial assets in cases where, at the time of submitting the pre-clearance letter to the IRS CI:

  • Foreign financial institution in which the taxpayer has or had an account or another facilitator who assisted the taxpayer in establishing or maintaining the taxpayer’s offshore arrangement has been publicly identified as being under investigation the U.S. government investigation (by IRS or Department of Justice) in connection with accounts that are beneficially owned by a U.S. person;[7]

  • Foreign financial institution or other facilitator is cooperating with the IRS or the Department of Justice in connection with accounts that are beneficially owned by a U.S. person; or

  • Foreign financial institution (or other facilitator) has been identified in a court-approved issuance of a summons seeking information about U.S. taxpayers who may hold financial accounts (a “John Doe summons” – a summons issued to compel the financial institution to identify its U.S. account holders) at the foreign financial institution or have accounts established or maintained by the facilitator.[8]

Penalty applies beginning on August 4, 2014 if, at the time of submitting the pre-clearance OVDP letter to the IRS Criminal Investigation (“CI”), a “public disclosure” event discussed above has already occurred.

  • The undisclosed assets must have come from legal sources.[9]

  • Reduced 5 percent and 12.5 percent penalties are no longer available under the OVDP.[10]

  • Taxpayers who opt out of the OVDP after July 1, 2014, will be subject to the IRS examination process.[11]

  • Additional criminal conspiracy charges added to the OVDP FAQs as criminal charges that a taxpayer may be subject to if she/he does not participate in the OVDP and the IRS examines the taxpayer.[12]

  • Conspiracy to defraud the government with respect to claims (18 U.S.C. §286). If convicted, a prison term of up to not more than 10 years or a fine of up to US $250,000.

  • Conspiracy to commit offense or to defraud the United States (18 U.S.C. §371). If convicted, a prison term of not more than 5 years and a fine of up to US $250,000.

  • Significantly more information is required, including during the pre-clearance process.

  • All account statements must be submitted at the time of the OVDP submission filing.[13]

  • Electronic submission encouraged (such as on a CD or USB flash drive).[14]

  • Requirement to pay the tax, interest, offshore penalty, accuracy-related penalty, and failure-to-file and failure-to-pay penalties at the time of the OVDP submission filing.[15]

  • Taxpayers who are unable to pay the full amount must include with their OVDP submission a proposal on payment arrangements and complete the collection information statements (on Form 433-A, Collection Information Statement for Wage Earners and Self-Employed Individuals or Form 433-B, Collection Information Statement for Businesses, as applicable).[16]

Overview of SFCP Changes

  • Significant penalty relief provided to U.S. taxpayers qualifying for the SFCP. Specifically, the following penalties will not apply to U.S. taxpayers residing outside the United States (the IRS clarified that even if taxpayer’s returns are “subsequently selected for audit, no penalties would apply, unless the examination results in a determination that the original tax noncompliance was fraudulent and/or that the FBAR violation was willful”):[17]

  • FBAR penalties;
  • Failure-to-file tax return penalties;
  • Failure-to-pay tax penalties;
  • Accuracy-related penalties; and
  • Information return filing penalties.

  • S. taxpayers residing in the United States, however, will be subject to a 5 percent penalty based on the individual’s highest aggregate balance / value of the foreign financial asset.[18]

  • 5 percent miscellaneous offshore penalty applies for failure to report the asset on an FBAR;

  • 5 percent miscellaneous offshore penalty applies for failure to report the asset on IRS Form 8938, Statement of Foreign Financial Assets;

  • 5 percent miscellaneous offshore penalty applies if the asset was properly reported on a tax return, but gross income in respect of that asset was not reported.

  • SFCP is now open to certain delinquent U.S. taxpayers residing in the United States.[19]

  • Taxpayers must provide a certification under penalties of perjury that their failure to report foreign financial assets and pay all tax due in respect of those assets was not due to willful conduct.[20]

  • The low compliance risk threshold of US $1,500 was removed.

  • The requirement to complete a risk questionnaire was removed.

  • The IRS provided coordination rules for taxpayers currently participating in the OVDP (including those who apply to the OVDP prior to July 1, 2014). Such taxpayers may be eligible to transition to the SFCP, provided they qualify under the SFCP requirements and:

  • Contact the assigned OVDP examiner; and

  • Submit a request and any additional documents according to the SFCP requirements (including “non-willful” certification) to the Austin OVDP Unit.[21]

 

What Did Not Make It?

Although the IRS made significant progress on clarifying and enhancing the two programs, there are several areas that have not been addressed and, as such, are left for taxpayers to figure out. Unfortunately, the figuring out part is likely to continue being a challenge for many taxpayers.

Passive Foreign Investment Companies (“PFICs”)

A comprehensive discussion of PFIC issues is outside the scope of this article, but a few points are worth mentioning.

PFIC is a foreign corporation if: (i) 75 percent or more of its gross income for the tax year is passive income; or (ii) at least 50 percent of its assets produce passive income.[22] Passive income for PFIC purposes generally means “foreign personal holding company income” under Subpart F (part of the U.S. anti-deferral regime) rules and generally includes dividends, interest, royalties, rents, annuities, certain gains, and other similar income.[23] As part of the U.S. anti-deferral regime, PFIC rules were designed to discourage U.S. persons from deferring their U.S. tax by subjecting to tax income derived from investments in foreign corporations on a current basis and effectively penalizing those U.S. taxpayers who chose to defer such income by imposing the highest ordinary income tax rate and an interest charge.[24] The rules do not require a U.S. tax avoidance motive before they apply and catch any U.S. person who makes an investment in a foreign corporation, no matter how minimal it may be and irrespective of such person’s common investment strategy, driven in many cases by investment advisors and financial planners who often recommend investing in foreign mutual funds[25] (especially, when they are not aware of punitive PFIC regime).

The PFIC rules contain a general “excess distribution” penalty regime[26] (triggered by a distribution or a disposition of stock) and elective regimes (qualified electing fund (QEF)[27] and mark-to-market rules).[28] The elections, if done properly, may allow U.S. shareholders of a PFIC to “purge” the PFIC taint and thus avoid the punitive excess distribution regime.[29] If elected to be treated as a QEF, the U.S. taxpayer is required to include currently in each year’s taxable income a pro rata share of the PFIC’s ordinary earnings and net capital gains. Although the taxpayer is subject to current U.S. taxation as a result of the QEF election, she/he would not be subject to the general excess distribution penalty regime.[30] The common challenge under this election is obtaining the necessary information from PFIC. The mark-to-market election is another way for the U.S. taxpayer to elect current U.S. taxation by marking the foreign stock to market each tax year and to avoid being subject to the general excess distribution penalty regime. However, under the statute, that method is limited to those assets that are regularly traded on a qualified exchange or other market (not all PFIC investments may meet that requirement).[31]

As a general matter, obtaining the information from PFICs to determine U.S. taxpayer’s tax liability may be very challenging. It also depends on how substantial a particular PFIC investment is (some PFICs would go out of their way to simplify lives of their significant U.S. shareholders). In addition, there is no de minimis safe harbor that would exempt insignificant investments from the application of the PFIC regime.[32] Although these issues are unlikely to be resolved without Congressional action, there must be a way to provide relief to those U.S. taxpayers who reside overseas, come forward voluntarily, and whose non-compliance was not due to a willful conduct. Accordingly, providing some PFIC relief as part of a practical approach under the OVDP or the SFCP would be a very welcome development.

Indeed, the Treasury and the IRS have previously recognized the U.S. taxpayers’ challenges in identifying PFIC investments and making complex calculations of U.S. tax liability arising from their holdings in PFICs. As an alternative method, the IRS in its 2012 OVDP guidance provided the modified mark-to-market method.[33] Although the calculations required under the mark-to-market method and the information required to make such calculations are somewhat manageable, the mark-to-market method raised several issues in practice. For example, one issue is how to apply it to PFICs which shares are not meeting the “marketable” standard. Another issue relates to the availability of the mark-to-market method outside of the OVDP or SFCP (once the taxpayer has resolved his past non-compliance issues under one of the programs and is current in her/his U.S. tax obligations).

It is not a secret that U.S. taxpayers residing overseas for legitimate reasons, in many cases dual citizens (U.S. and foreign country where they reside), are frequently advised by financial planners and investment advisors to make investments in foreign mutual funds that are generally treated as PFICs for U.S. federal income tax purposes. Such investments are made in most cases for wealth preservation and net wealth accumulation purposes, and U.S. taxpayers who receive investment recommendations do not necessarily attempt to avoid current U.S. taxation of their PFIC investments. In fact, many U.S. taxpayers were and still may be unaware of the PFIC status of mutual funds in which they invest. In some cases, the amount of time and resources used to collect the information from PFICs necessary to calculate potential U.S. tax liability and the amount of professional fees of tax advisors by far outweigh the amount of any U.S. tax liability arising from PFIC investments.

The author believes that at least in cases where the U.S. taxpayer’s failure to comply with the U.S. tax law was due to a non-willful conduct and when such taxpayer participates in the OVDP or the SFCP, the Treasury and the IRS should provide relief or additional alternatives for dealing with PFIC issues. As part of potential relief, the IRS may consider weighing the administrative burden imposed on taxpayers and the best way to protect fisc before requiring the taxpayer to file delinquent PFIC filings or engage in complex calculations.


Willful Conduct Guidance

To qualify for the SFCP or to file delinquent FBARs under the Delinquent FBAR Filing Procedures, U.S. taxpayers are now required to complete a certification that the failure to file the requisite returns was not due to willful conduct. The IRS clarified that non-willful conduct is “due to negligence, inadvertence, or mistake or conduct that is the result of a good faith misunderstanding of the requirements of the law.”[34] A willful conduct determination is also important later in the process if the taxpayer’s case has been selected for IRS examination.

There is limited guidance on what constitutes willful conduct or willful violation for FBAR penalty purposes and a determination is highly factual.[35] Two recently decided cases that addressed the issue of willful violations for FBAR purposes are United States v. Williams[36] and United States v. McBride.[37] Previously, the IRS also issued a Chief Counsel Advice.[38]

The IRS does not plan on providing any additional guidance for taxpayers and suggested they make a determination of willfulness under the existing tax authorities and talk to their tax advisors to determine if they meet the non-willful conduct requirement.[39]

The standard of willfulness under the existing law appears to be stricter than the standard the IRS seems to be using for purposes of the SFCP.[40] The requirement to make a non-willful conduct certification at the time of the SFCP submission (the IRS intends on reviewing all such certifications) and the need to make the respective willfulness determination prior to filing their submission with the IRS, will no doubt lead to increased due diligence by the taxpayers and their tax advisors. Taxpayers who are able to establish non-willful conduct may still need to carefully review their situation and determine if they can claim a reasonable cause defense for purposes of both filing delinquent FBARs and international information forms. It appears that the IRS left the door open to potential non-willful FBAR violation penalties (US $10,000 per violation) as opposed to providing full relief from penalties under the SFCP.[41]

U.S. taxpayers making the non-willful conduct certifications should carefully review their facts and circumstances and consult with their U.S. tax advisors to make the respective determination before they file their submission with the IRS.


Timing and Certainty of Resolution

In this area, predicting how long the process would take is close to impossible. It is reasonable, therefore, for the IRS not to provide any specific deadlines or timeline considerations as part of the process. By the same token, taxpayers would benefit from understanding, at least very generally, the commitment of time that they should expect from going through the process that would be applicable to the respective option pursued to become U.S. tax compliant. In this respect, some timeframe notice would be very helpful. For example, the IRS could publish general statistics on case processing times under the OVDP based on its previous and current practice.

Another area that remains to be clarified is the resolution of the taxpayer’s case under the applicable procedural alternatives to become U.S. tax compliant. The OVDP provides such resolution by requiring the IRS and the taxpayer to conclude a closing agreement. The SFCP, however, is silent in this respect. Granted, under the enhanced SFCP, the IRS indicated that the taxpayer’s delinquent returns filed under the SFCP would be processed in the ordinary course of business (under regular tax return processing procedures) and may be subject to an IRS examination. It would be helpful if the IRS provided more certainty as to the resolution of taxpayers’ issues under all options available to U.S. taxpayers under the June 18, 2014 guidance, not limiting it only to OVDP cases.

Options Available to Taxpayers To Become Tax-Compliant

Along with the changes and enhancements to the two programs, the IRS also explained four options available to taxpayers who want to become U.S. tax compliant.[42] Although, for ease of reference, we discuss those options at a high-level below, please refer to decision-making trees in Appendix A to this article for a more detailed overview.

OVDP

Taxpayers who may be concerned about potential criminal prosecution or who failed to disclose their foreign bank accounts or assets due to willful conduct should seriously consider OVDP as a forum for resolving their non-compliance related tax issues. Due to the increased penalty regime, taxpayers who are otherwise eligible for the OVDP should file their pre-clearance requests prior to August 4, 2014, to the extent possible, to still be eligible for the lower 27.5 percent penalty threshold.[43] Taxpayers who file their OVDP pre-clearance requests post August 4, 2014 should expect to pay a 50 percent miscellaneous offshore penalty.

To qualify for the OVDP, U.S. taxpayers should have funds invested in undisclosed foreign assets and bank accounts from legal sources and should meet other requirements of the OVDP.[44] See Appendix A to this article for decision-making trees designed to assist taxpayers navigate through the eligibility requirements for the OVDP.

As part of the eligibility criteria for the OVDP, U.S. taxpayers must agree to provide information about financial institutions and other facilitators, who helped the taxpayer establish or maintain an offshore arrangement. Notably, facilitators, or individuals who assisted taxpayers in their tax non-compliance are ineligible to participate in the OVDP. In addition, U.S. taxpayers who apply for SFCP are ineligible to participate in OVDP.

The OVDP option is open to both individual taxpayers and businesses.


SFCP

The SFCP is not available to businesses. Only individuals or estates of individual U.S. taxpayers may participate in the program. Further, to be eligible for this option, taxpayers must certify that the failure to comply was due to non-willful conduct and must outline in accordance with the certification the reasons for not filing, and if not, add a statement to provide the necessary explanation

Importantly, for a taxpayer to be eligible for the SFCP, the IRS must not have started a civil examination of a taxpayer’s returns for any tax years.

The IRS extended this procedural alternative to those U.S. taxpayers who made a “quiet disclosure” – filed delinquent returns in the ordinary course of business, without drawing IRS’ attention to their file. The IRS stated that such taxpayers can still use this option, but will continue to be liable for any penalties already due.

Significantly, the IRS clarified that the delinquent tax returns submitted under SFCP can be selected for an audit if the IRS decides that civil and / or criminal liability is appropriate.

As noted above, the IRS clarified that the delinquent returns submitted under this option will be processed like any other return submitted to the IRS.

As a welcome enhancement of the program, the IRS opened the SFCP to certain U.S. taxpayers residing in the United States (although not without a cost – see the discussion of penalties in the overview of significant SFCP changes discussed earlier in the article). Accordingly, the SFCP now is offered to U.S. taxpayers residing outside the United States and U.S. taxpayers residing in the United States.


U.S. Taxpayers residing outside the United States

To be eligible for this option, in addition to the above requirements, U.S. taxpayers residing oversees must meet the non-residency test and meet other requirements, including those that have not changed since the 2012 SFCP was introduced.[45] See Appendix B to this article for decision-making trees designed to assist taxpayers navigate through the eligibility requirements for the SFCP for U.S. taxpayers residing outside the United States.

The discussion below focuses on the non-residency test that, if applied as currently in effect, would effectively create a “no-man land” – a category of U.S. non-compliant taxpayers residing overseas who want to come into U.S. tax compliance and whose non-compliance was due to a non-willful conduct, but who would be ineligible for the SFCP because they cannot meet the non-residency test.


The Ugly – Non-Residency Test

As one of the new requirements for the SFCP, U.S. taxpayers residing outside the United States must meet a non-residency test. The IRS stated in its guidance that the IRC section 911 (foreign income exclusion) and its regulations apply in making the respective determination.

As a background, IRC section 911 generally provides a mechanism for U.S. persons to avoid double taxation by allowing them to exclude from their U.S. taxable income the income earned in a foreign country (up to an applicable threshold), provided that various requirements are met. IRC section 911 contains two residency requirements: (i) bona fide residence test;[46] and (ii) physical presence test.[47] In addition to meeting either of the two residence requirements, an individual must have a tax home in a foreign country.[48] Under the bona fide residence test, a U.S. citizen[49] must establish to the satisfaction of the Secretary that she/he has been a bona fide resident of a foreign country (or countries) for an uninterrupted period which includes an entire year.[50] Under the physical presence test, a U.S. citizen or U.S. resident must have been present in a foreign country during any period of 12 consecutive months during at least 330 full days in such period.[51]

Under the non-residency test of the SFCP, the U.S. taxpayers residing overseas are eligible to participate in the SFCP if:

  • S. citizens or lawful permanent residents (i.e., “green card holders”) – in any one or more of the most recent three (3) years for which the U.S. tax return due date (or properly applied for extended due date) has passed, the individual did not have a U.S. abode and the individual was physically outside the United States for at least 330 full days.

  • Non-U.S. citizens or lawful permanent residents – in any one or more of the last three (3) years for which the U.S. tax return due date (or properly applied for extended due date) has passed, the individual did not meet the substantial presence test under IRC section 7701(b)(3).

The IRS gives two examples under the first requirement discussed above that focus on whether the U.S. taxpayer had home of abode in the United States for purposes of the non-residency test. Interestingly, in either example, the IRS failed to consider the second prong of the test – the 330 full day presence requirement.

Although the IRS explicitly stated that IRC section 911 and its regulations apply for purposes of the SFCP procedures, the bona fide residence test is not part of the current non-residency test of the SFCP. As the discussion below will demonstrate, this may be a significant oversight of the enhanced SFCP.

For purposes of IRC section 911, when determining whether a U.S. citizen established bona fide residence in a foreign country, the courts used the following factors:

  • Intention of the taxpayer;
  • Establishment of his home temporarily in the foreign country for an indefinite period;
  • Participation in the activities of his chosen community on social and cultural levels, identification with the daily lives of the people and, in general, assimilation into the foreign environment;
  • Physical presence in the foreign country consistent with his employment;
  • Nature, extent and reasons for temporary absences from his temporary foreign home;
  • Assumption of economic burdens and payment of taxes to the foreign country;
  • Status of resident contrasted to that of transient or sojourner;
  • Treatment accorded his income tax status by his employer;
  • Marital status and residence of his family;
  • Nature and duration of his employment; whether his assignment abroad could be promptly accomplished within a definite or specified time;
  • Good faith in making his trip abroad; whether for purpose of tax evasion.[52]

The fact that the taxpayer temporarily leaves his home country for work, family visits, or vacation, in the absence of tax evasion motives and in view of all other applicable facts and circumstances, does not in itself preclude the taxpayer from meeting the bona fide residence test.[53]

The regulations under IRC section 911 also provide that whether an individual is a bona fide resident of a foreign country shall be determined by applying, to the extent practical, the principles of IRC section 871 and its regulations.[54] The regulations specifically provide that “[b]ona fide residence in a foreign country or countries for an uninterrupted period may be established, even if temporary visits are made during the period to the United States or elsewhere on vacation or business.”[55]

As a general matter, there is nothing wrong with applying the IRC section 911 standard for determining if a U.S. taxpayer residing outside the United States should qualify for the SFCP. However, the IRS only borrowed one of the tests under IRC section 911 – physical presence test – the 330 full day physical absence rule and home of abode requirement.

To demonstrate the intended or unintended result under the non-residency test as currently drafted, let us consider a few examples. For all example purposes we assume that no tax evasion motive existed.

Example 1: Danny is a dual Canadian and U.S. citizen who has been living and working in Canada for the last ten years. In at least one of the most recent three (3) years, Danny did not have a U.S. abode and was physically outside the United States for at least 330 full days. Danny earned US $80,000 in 2013. He paid taxes in Canada and timely filed Canadian income tax return. Canadian individual income tax rates are generally higher than or, at least as high as, in the United States. Danny did not file U.S. income tax returns and would like to become U.S. tax compliant and take advantage of the SFCP. Danny’s non-compliance is not due to willful conduct. If Danny were to file his delinquent U.S. tax returns under the SFCP, he would not owe any U.S. tax because the IRC section 911 foreign income exclusion (US $99,200 for the 2014 tax year)[56] would exclude the whole amount of Danny’s income earned in Canada from U.S. tax.

Example 2: The same facts as above apply, except that Danny does not meet the 330 full day requirement. For instance, he may have spent vacation in the United States, is a Snowbird, visited his family, or traveled for work to the United States and as such was physically present outside the United States 310 full days in each of the most recent three (3) years. If Danny were to file a U.S. tax return and claim the foreign income exclusion under IRC section 911, he would not be eligible for the IRC section 911 relief under the physical presence test because he would not meet the physical absence requirement. However, Danny would still meet the bona fide residence test and as such qualify for the IRC section 911 foreign income exclusion. Even if the IRC section 911 relief was unavailable, Danny could claim a foreign tax credit (FTC) with respect to Canadian taxes paid to avoid double taxation. Danny, again, is unlikely to owe any U.S. tax (in excess of Canadian taxes paid).

Example 3: Assume the same facts as in Example 2, but now Danny earns US $150,000 and frequently travels to the United States, mainly for work. As a result, in the most recent three (3) years, Danny was physically present in Canada for only 320, 310, and 290 full days. Assume that while on business in the United States, Danny’s employment income includes U.S. source income (as Danny is performing personal services on behalf of his Canadian employer while physically present in the United States). Again, Danny pays all Canadian taxes and is tax compliant in Canada. Danny does not meet the physical presence test under IRC section 911, but he still meets the bona fide residence test. In addition, Danny’s income exceeds the foreign income exclusion amount. While Danny can claim the foreign income exclusion up to US $99,200, the Canadian tax paid on the remaining balance of US $50,800 should be eligible for FTC. Danny is eligible to claim FTC for taxes paid in Canada, even though a portion of his employment income technically has U.S. source.[57] Even if Danny was only able to claim a partial FTC for the employment taxes paid in Canada, his U.S. tax liability would be quite limited. More importantly, Danny should be able to claim a refund for the portion of the tax paid in Canada as attributable to the U.S. source income and claim a credit in Canada for the U.S. tax paid in the United States as a result of the FTC re-calculation. In any event, any U.S. tax liability of Danny under these facts is likely to be very low, if at all.

Under the current expanded SFCP rules, Danny would only meet the non-residency test in Example 1. Danny will fail the non-residency test in Examples 2 and 3 and as such would not be eligible for the SFCP. Importantly, Danny would not qualify for the SFCP for U.S. taxpayers residing in the United States (at a minimum, Danny did not file his U.S. tax returns and as such would not meet the tax return filing requirement under the program).

Although the reasoning of the IRS may make sense overall and using only the physical presence test may allow the IRS to achieve administrative simplicity by avoiding making complex and time-consuming factual determinations, it does not appear to make sense from a perspective of sound tax administration. A large group of non-compliant U.S. citizens or Green card holders residing overseas who would be eligible for the SFCP, other than for the non-residency test (and who would have been eligible under the 2012 SFCP terms), will now be excluded from qualifying for the SFCP (this is especially true with respect to U.S. taxpayers who are Canadian citizens or residents; because of close economic and family ties as well as border proximity between the United States and Canada, Canadians cross the U.S. border on a regular basis and spend lots of time in the United States, thus in some cases easily triggering the 330 full day threshold).

There is a hope that the IRS made a mistake or it was a drafting oversight when the non-residency test for purposes of the SFCP was being designed. An argument speaking for an inadvertent mistake by the IRS is supported by the following:

  1. The two examples that the IRS provided to illustrate the application of the non-residency test under the SFCP do not discuss the 330 full day requirement. They only focus on the home of abode.

  1. In view of intended enhancement of the SFCP, narrowing the program down is inconsistent with the vision that the IRS had when announcing the changes. Specifically, IRS Commissioner John Koskinen stated when announcing the enhanced SFCP on June 18, 2014 that “we [are] expanding the streamlined procedures to cover a much broader group of U.S. taxpayers we believe are out there who have failed to disclose their foreign accounts but who aren’t willfully evading their tax obligations. To encourage these taxpayers to come forward, we’re expanding the eligibility criteria, eliminating a cap on the amount of tax owed to qualify for the program, and doing away with a questionnaire that applicants were required to complete.”[58]

  1. The IRS specifically refers to IRC section 911 and its regulations as applying for purposes of the SFCP procedures. IRC section 911 uses an alternative bona fide residence test in determining whether a U.S. taxpayer should be treated as “qualified individual” for foreign income exclusion purposes.

  1. There does not seem to be a good policy reason for limiting the non-residency test solely to the physical presence test. Even if it was intended, the IRS should distinguish situations where individual income tax rates in the applicable foreign country are higher or equal to the U.S. individual income tax rates and/or where an applicable U.S. income tax treaty provides relief from sourcing partial employment income to U.S. source when a person has not met certain physical presence threshold (as discussed above, in case of Canada, for example, it is 182 days). If at all, the IRS should distinguish the qualification for the SFCP versus the issue of determining any outstanding U.S. tax liability. Even if, as a result of disallowing the foreign income exclusion or limiting FTC, the U.S. taxpayer ends up with a U.S. tax bill, he still should be eligible to participate in the SFCP as long as he meets all other program requirements.

Recommendation

The author recommends that the IRS take a closer look at the non-residency test and either add the bona fide residence requirement (also extending it to U.S. residents who have U.S. income tax treaty protection) under IRC section 911(d)(1)(A) or, in the alternative, provide a clarification that the non-residency test should be based on all facts and circumstances and, depending on applicable facts, even if the U.S. taxpayer did not meet the 330 full day test, she/he may still qualify for the SFCP. The former solution seems to be most effective and would provide for an easy fix. The second solution would be less efficient, but at least would allow some flexibility in applying the new rules. Again, we are talking about U.S. taxpayers whose non-compliance was not due to a willful conduct and who have been and are legitimate residents of foreign countries where they have been living and working for a long time.

 

U.S. Taxpayers residing in the United States

Certain U.S. taxpayers residing outside the United States who failed to meet the requirements applicable under the above option may still qualify for the SFCP if they meet the requirements applicable to U.S. taxpayers residing in the United States. In such case the taxpayers would be subject to a 5 percent miscellaneous offshore penalty, if applicable. However, under the new rules, the U.S. taxpayers would not be subject to accuracy-related penalties, information return penalties, or FBAR penalties. Even if the return is selected for audit later, the U.S. taxpayer will not be subject to those penalties, unless the examination results in a determination that return was fraudulent or FBAR violation was willful. Retroactive relief is available for deferral of certain retirement and savings plans.[59]

See Appendix A to this article for decision-making trees designed to assist taxpayers navigate through the eligibility requirements for the SFCP applicable to U.S. taxpayers residing in the United States.


Delinquent FBAR Submission Procedures

This option is available to U.S. taxpayers who do not need to use OVDP or SFCP, but have delinquent FBARs. To qualify for this procedural alternative, the U.S. taxpayer may not have been contacted by the IRS with respect to an income tax examination or delinquent FBARs for the applicable tax years. See Appendix A to this article for decision-making trees designed to assist taxpayers navigate through the eligibility requirements for the Delinquent FBAR Submission Procedures.

Importantly, the IRS will not impose penalties for the failure to file delinquent FBARs on those U.S. taxpayers who properly reported on their U.S. tax returns and paid their tax liability arising from the income from undisclosed foreign financial accounts.

FBARs may be selected for audit under regular audit selection procedures.


Delinquent International Information Return Submission Procedures

This option was available to U.S. taxpayers before the June 18 changes. However, the IRS, for the first time, posted the relevant information on its OVDP website that clarified this procedural alternative and removed some mystery from the process. See Appendix A to this article for decision-making trees designed to assist taxpayers navigate through the eligibility requirements for the Delinquent International Information Return Submission Procedures.

Taxpayers are still expected to show reasonable cause to qualify for no penalty treatment. Furthermore, U.S. taxpayers applying for this procedural alternative to become U.S. tax compliant must also certify that any entity for which the information returns are being filed was not engaged in tax evasion. No guidance is provided as to the reasonable cause standard that the IRS would be using in this respect, but it should not differ from a general reasonable cause standard under the existing tax law.

Delinquent Forms 3520 and 3520-A should be filed according to the forms’ instructions. Taxpayers must attach a reasonable cause statement to each delinquent information return filed for which the reasonable cause defense is raised.

Taxpayers should consult their U.S. tax advisor on whether they may meet the reasonable cause exception and to develop arguments applicable under their facts and circumstances.


Conclusion

The changes brought to the two programs are important and are generally favorable to U.S. taxpayers residing overseas and in the United States. However, the new IRS guidance fails to address certain areas. Taxpayers would greatly benefit from additional IRS guidance and, possibly, additional relief in such areas as PFIC reporting and non-willful conduct determination.

The non-residency test for U.S. taxpayers residing outside the United States under the SFCP should be fixed. Either the complete IRC section 911 standard should be applied, with potential application of the bona fide residence requirement to treaty protected U.S. residents, or the determination on whether a U.S. taxpayer qualifies for the non-residency test should be based on all facts and circumstances.

Although the modified programs are overall favorable to U.S. taxpayers, they are going to add to taxpayer’s administrative burden and compliance costs. Taxpayers will need to make a determination of whether their conduct was “non-willful” and to determine, as applicable, if they can show reasonable cause for failure to comply with their U.S. tax obligations.

U.S. taxpayers would be well advised to closely review the new rules and the program eligibility requirements, consult with their U.S. tax advisors, and seriously consider coming forward voluntarily now, when they still can.

[1]     OVDP and SFCP are each referred to as “Program” and collectively as “Programs”. IR-2014-73, IRS Makes Changes to Offshore Programs, Revisions Ease Burden and Help More Taxpayers Come Into Compliance (June 18, 2014). Available at: https://www.irs.gov/pub/irs-news/IR-14-073.pdf (last visited July 3, 2014). See also Statement of IRS Commissioner John Koskinen at: http://www.irs.gov/uac/Newsroom/Statement-of-IRS-Commissioner-John-Koskinen (last visited July 3, 2014).

[2]     See Transition Rules: Frequently Asked Questions (FAQs) at: http://www.irs.gov/Individuals/International-Taxpayers/Transition-Rules-Frequently-Asked-Questions-FAQs (last visited July 3, 2014).

[3]     See Options Available For U.S. Taxpayers With Undisclosed Foreign Financial Assets at: http://www.irs.gov/Individuals/International-Taxpayers/Options-Available-For-U-S–Taxpayers-with-Undisclosed-Foreign-Financial-Assets (last visited July 3, 2014).

[4]     The 2012 OVDP FAQ are available at: http://www.irs.gov/Individuals/International-Taxpayers/Offshore-Voluntary-Disclosure-Program-Frequently-Asked-Questions-and-Answers (last visited July 3, 2014).

[5]     The 2014 OVDP FAQ are available at: http://www.irs.gov/Individuals/International-Taxpayers/Offshore-Voluntary-Disclosure-Program-Frequently-Asked-Questions-and-Answers-2012-Revised (last visited July 3, 2014).

[6]     Although being subject to IRS examination, as a general matter, is not desirable for any taxpayer (for example, due to a lengthy process), any taxpayer applying for the procedural alternative available to them under the new rules should keep all relevant records and documentation, as well as be prepared to have relevant support for the position(s) taken as part of the submission.

[7]     IRS published a list of such foreign financial institutions or facilitators (currently, the list has 10 entries, but the IRS will update it on an ongoing basis) at: http://www.irs.gov/Businesses/International-Businesses/Foreign-Financial-Institutions-or-Facilitators (last visited July 3, 2014).

[8]     2014 OVDP FAQ 7.2.

[9]     2014 OVDP FAQ 12.

[10]    2014 OVDP FAQ 1.1 (see 2012 OVDP FAQs 52 and 53).

[11]    2014 OVDP FAQs 49 and 51.

[12]    2014 OVDP FAQ 6.

[13]    2014 OVDP FAQ 25.

[14]    2014 OVDP FAQ 25.2.

[15]    2014 OVDP FAQ 25.

[16]    Id.

[17]    See IRS guidance for U.S. Taxpayers Residing Outside the United States at: http://www.irs.gov/Individuals/International-Taxpayers/U-S-Taxpayers-Residing-Outside-the-United-States (last visited July 3, 2014).

[18]    See the IRS guidance for U.S. Taxpayers Residing in the United States at: http://www.irs.gov/Individuals/International-Taxpayers/U-S-Taxpayers-Residing-in-the-United-States (last visited July 3, 2014).

[19]    Id.

[20]    Id. See also the IRS guidance for U.S. Taxpayers Residing Outside the United States at: http://www.irs.gov/Individuals/International-Taxpayers/U-S-Taxpayers-Residing-Outside-the-United-States (last visited July 3, 2014).

[21]    See Transition Rules: Frequently Asked Questions (FAQs), FAQ 6 at: http://www.irs.gov/Individuals/International-Taxpayers/Transition-Rules-Frequently-Asked-Questions-FAQs (last visited July 3, 2014).

[22]    IRC section 1279(a).

[23]    IRC sections 1297(b)(1) and 954(c).

[24]    IRC section 1291(c)(1).

[25]    Mutual and hedge funds are typically PFICs.

[26]    IRC section 1291(a)(1).

[27]    IRC section 1295.

[28]    IRC section 1296.

[29]    See Treas. Reg. §1.1297-3; Treas. Reg. §1.1291-1T.

[30]    The election is made on Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund.

[31]    IRC section 1296; see also Treas. Reg. §1.1296-2(a).

[32]    The Treasury and the IRS issued final and temporary regulations that provided certain exceptions from PFIC reporting. See T.D. 9650 (Dec. 31, 2013); Treas. Reg. §1.1298-1T(c).

[33]    2012 OVDP FAQ 10. See also 2014 OVDP FAQ 10.

[34]    See U.S. Taxpayers Residing Outside the United States at: http://www.irs.gov/Individuals/International-Taxpayers/U-S-Taxpayers-Residing-Outside-the-United-States (last visited July 3, 2014).

[35]    For a discussion of “willful” standard in the FBAR context, see Rufus Rhoades, Rufus Rhoades on An Analysis of the Meaning of “Willful” in the FBAR Context, 2013 Emerging Issues 7044 (LexisNexis Emerging Issues Analysis, September 2013).

[36]    110 AFTR 2d 2012-5298 (4th Cir. 2012).

[37]    110 AFTR 2d 2012-6600 (DC Utah 2012).

[38]    CCA 200603026, January 20, 2006.

[39]    See, e.g., Alison Bennett, IRS Expands Relief for Some Foreign Account Disclosures, Tightens Rules for Willful Neglect, 33 TMWR 815 (June 23, 2014) (comments by Michael Danilack, IRS Large Business & International Division Deputy Commissioner (International)).

[40]    The IRS defined “non-willful conduct” in its June 18, 2014 guidance 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.” See IRS guidance for U.S. Taxpayers Residing Outside the United States at: http://www.irs.gov/Individuals/International-Taxpayers/U-S-Taxpayers-Residing-Outside-the-United-States (last visited July 3, 2014) and IRS guidance for U.S. Taxpayers Residing in the United States at: http://www.irs.gov/Individuals/International-Taxpayers/U-S-Taxpayers-Residing-in-the-United-States (last visited July 3, 2014).

[41]    For a willful violation penalty structure, see Rufus Rhoades, Rufus Rhoades on An Analysis of the Meaning of “Willful” in the FBAR Context, 2013 Emerging Issues 7044 (LexisNexis Emerging Issues Analysis, September 2013).

[42]    There may be other procedural alternatives for becoming U.S. tax compliant that may be available to taxpayers depending on their facts and circumstances. However, a discussion of such other options is outside the scope of this article. Taxpayers should consult their tax advisors to determine what procedural alternative best suits the taxpayers’ facts.

[43]    Ideally, such taxpayers would have filed their OVDP requests on or before June 30, 2014 to qualify for the transitional treatment that under certain facts provides a more favorable penalty structure. Unless the IRS extended the deadline for transitional treatment relief, the July 1, 2014 deadline is no longer relevant for the purposes of this article as the article would be published well beyond that deadline.

[44]    A detailed list of requirements for OVDP is outside the scope of this article, but all requirements are listed in Appendix B that contains a table with a side-by-side comparison of 2012 and 2014 OVDP FAQ.

[45]    A detailed discussion of all requirements of SFCP is outside the scope of this article. However, we discuss some challenges presented by the non-residency test in some situations below.

[46]    IRC section 911(d)(1)(A).

[47]    IRC section 911(d)(1)(B).

[48]    IRC section 911(d)(1).

[49]    Although the statute seems to limit the bona fide residence test to U.S. citizens, U.S. residents who are citizens of foreign countries that have in effect an applicable U.S. income tax treaty may also qualify under the bona fide residence test even though they are not U.S. citizens pursuant to the non-discrimination article. For example, with respect to Canadian citizens, the applicable treaty provision would be Article XXV of the Convention Between Canada and the United States of America With Respect to Taxes on Income and on Capital, signed on September 26, 1980 (as amended by protocols). See also Rev. Rul. 91-58, 1991-2 C.B. 340.

[50]    IRC section 911(d)(1)(A).

[51]    IRC section 911(d)(1)(B).

[52]    Sochurek v. Commissioner, 9 AFTR 2d 883, 886 (7th Cir. 1962), revg.  36 T.C. 131 (1961).

[53]    Id. at 887. See also Rose v. Commissioner, 16 T.C. 232 (1951); Schoneberger v. Commissioner, 74 T.C. 1016, 1026 (1980).

[54]    See Treas. Reg. §1.871-2(b) (“an alien actually present in the United States who is not a mere transient or sojourner is a resident of the United States for purposes of income tax. Whether he is a transient is determined by his intentions with regard to the length and nature of his stay.”)

[55]    Treas. Reg. §1.911-2(c).

[56]    Rev. Proc. 2013-35, 2013-47 I.R.B. 537.

[57]    In Danny’s case, pursuant to the Canada-U.S. income tax treaty, Danny’s employment income would be sourced to Canada (assume Danny’s portion of employment income potentially attributable to the United States would exceed US $10,000) since his presence in the United States did not exceed in the aggregate 183 days in any twelve-month period (we assume that the Canadian employer of Danny did not have a permanent establishment in the United States and that Danny’s remuneration was not borne by that permanent establishment. See Article XV.2(b) of the Convention Between Canada and the United States of America With Respect to Taxes on Income and on Capital, signed on September 26, 1980 (as amended by protocols). In addition, Danny, as a Canadian citizen may benefit from Article XXV of the Canada-U.S. income tax treaty (non-discrimination).

[58]    Statement of IRS Commissioner John Koskinen at: http://www.irs.gov/uac/Newsroom/Statement-of-IRS-Commissioner-John-Koskinen (last visited July 3, 2014).

[59]    A detailed discussion of all requirements of SFCP is outside the scope of this article. However, we discuss some challenges presented by the non-residency test in some situations below.

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