The U.S. government has recently embarked on an aggressive campaign to reduce international tax evasion by U.S. citizens or permanent residents with undisclosed income and assets located in foreign countries. As part of this campaign, the U.S. government is putting pressure on foreign governments and financial institutions to disclose the identities of U.S. citizens and permanent residents and the assets they hold in the respective foreign jurisdictions. In tandem with these enforcement efforts, the Internal Revenue Services (“IRS”) has offered some relief to taxpayers. On January 9, 2012, the IRS reinstituted the Offshore Voluntary Disclosure Initiative (“OVDI”). This program offers an opportunity to American (“U.S.”) citizens or permanent residents with undisclosed foreign assets and income to voluntarily disclose such amounts in exchange for reduced penalties. In addition, in December 2011, the IRS stated that penalties related to the failure to disclose foreign assets may not be imposed in certain situations. This article will provide an overview of the newly reopened OVDI and the U.S. tax law requirements most relevant to U.S. citizens or permanent residents living abroad.
Income Tax Returns and Disclosure of Foreign Assets
Unlike Canada, a U.S. citizen or permanent resident is taxed on his/her worldwide income on the basis of citizenship and immigrant status rather than residence. Therefore, even if a U.S. citizen has never lived or worked in the U.S., he/she is still obligated to file a tax return, pay taxes and make certain financial disclosures to the IRS. Moreover, a U.S. permanent resident who no longer resides in the U.S. may still be subject to U.S. tax laws even if, under immigration laws, the individual has lost his/her right to permanently reside in the U.S. Failure to comply with U.S. tax laws can result in both hefty fines and criminal prosecution. Ignorance about one’s citizenship or immigrant status or obligations under U.S. tax laws is not a valid defense, and will not absolve an individual’s failure to comply with the law. The remainder of this article will refer to U.S. citizens or permanent residents as U.S. taxpayers.
Generally, with certain specific exceptions, a U.S. taxpayer who lives and works in Canada will be required to report and pay taxes to the IRS on their Canadian income, even if the Canadian income has already been taxed in Canada. To avoid double taxation, the U.S. taxpayer will be given a tax credit for any Canadian tax paid to offset his/her U.S. tax liability. Since Canada generally has higher personal tax rates than the U.S., many U.S. taxpayers living in Canada with Canadian income will likely not have to pay additional taxes in the U.S. Furthermore, the penalties for the failure to file tax returns are based on unpaid taxes. Therefore, if there are no unpaid taxes, there will be no penalties.
In addition to filing income tax returns, U.S. taxpayers are obligated to make annual disclosures of their foreign assets to the IRS. The penalties for failing to comply with this requirement can be severe. Unlike the penalties for the failure to file tax returns, penalties for failing to make the required disclosures are not tied to the tax owing. Therefore, a U.S. taxpayer may be subject to penalties on the failure to disclose foreign assets, even if the taxpayer does not owe any money to the IRS.
The Foreign Account Tax Compliance Act (“FATCA”) was enacted in 2010, and is a key tool in addressing international tax evasion. FATCA requires U.S. taxpayers to report their foreign financial assets with an aggregate value exceeding certain thresholds on a new form, Form 8938, with their annual tax return. Most U.S. taxpayers will have to make this disclosure with their 2011 tax return in 2012. Failure to comply will result in a penalty of US$10,000, that will be increased to US$50,000 for continued failure to comply after notification by the IRS. In addition, any unpaid tax that can be attributed to undisclosed foreign financial assets will be subject to an additional penalty of 40%.
FATCA also requires Canadian financial institutions to register with the IRS by June 30th 2013, and disclose information about U.S. taxpayers who hold financial accounts at these institutions. FATCA applies to all types of accounts such as insurance accounts, bank accounts and investment accounts. Canadian financial institutions that fail to comply will face a 30% withholding tax on their income on U.S. assets from 2014, as well as to the proceeds from the sales of these assets from 2015. Therefore, given the harsh terms of FATCA, it is likely that many U.S. taxpayers will be identified to the IRS by Canadian financial institutions.
Even before FATCA, U.S. taxpayers were obligated to file a Foreign Bank Account Report (“FBAR”) on an annual basis using Form TD F 90-22.1, where applicable. The reporting requirement under FATCA is broader than the requirement under FBAR. U.S. taxpayers are required to comply with both the disclosure requirements under FATCA, and to file an annual FBAR if necessary. Generally, a U.S. citizen or resident with a financial interest or signing or other authority over any foreign financial account, including Canadian Registered Retirement Savings Plans (“RRSP”), Registered Education Savings Plans (“RESP”), and Tax-Free Savings Accounts (“TFSA”), must file an FBAR if the aggregate value of these accounts exceeds US$10,000 at any time during the calendar year. The failure to file an FBAR when required may potentially result in civil or criminal penalties. The civil penalty for each violation is a fine up to US$10,000, while the penalty for willful failure to make the required disclosure is the greater of US$100,000, or 50% of the balance in the foreign accounts.
Relief for U.S. Taxpayers
Given the complexity of U.S. tax laws, it is easy for U.S. taxpayers living abroad to run afoul of their obligations under these laws. The IRS launched a series of amnesty programs to offer relief to U.S. taxpayers who have not complied with their various obligations under U.S. tax laws. These programs allow U.S. taxpayers to come forward and voluntarily report hitherto undisclosed income and assets to the IRS without criminal penalties, and with reduced monetary penalties. The first amnesty program took place in 2009, and the second in 2011. The OVDI in 2012 is the third amnesty program offered by the IRS.
According to the IRS, the 2009 and 2011 amnesty programs were successful in eliciting over 33,000 voluntary disclosures, and generating at least $4.4 billion in revenue for the U.S. government. Hence, it is not surprising that the IRS chose to reopen the OVDI. With some exceptions, the terms and penalty structure of the OVDI in 2012 are largely similar to those of the 2011 amnesty program.
In general, participants of the OVDI must file all original and amended tax returns, together with payment for any unpaid taxes and interest for up to 8 years. They must also pay accuracy related and delinquency penalties of 20% of the tax and interest owing on any unreported foreign income. Additionally, with respect to the failure to file annual FBARs, a one-time 27.5% penalty (the “offshore penalty”), an increase of 2.5% from the prior amnesty program in 2011, will be imposed on the highest aggregate annual balance in the unreported foreign accounts during the past 8 years before the disclosure. A U.S. taxpayer whose aggregate foreign accounts or assets did not exceed US$75,000 in any relevant calendar year qualifies for a reduced 12.5% penalty rate on that balance. The OVDI forgoes other potential penalties, such as those for civil fraud, for failure to file various information returns, and for wilful failure to file the FBAR.
The OVDI makes few concessions to “Accidental Americans”. These are individuals who never knew that they were U.S. citizens, and have never lived in the U.S., obtained a U.S. passport, or enjoyed any benefits of being a U.S. citizen. Accidental Americans are still legally required to comply with U.S. tax laws, and are also subject to the full penalties for non-compliance. Under the OVDI, they are granted a reduced 5% offshore penalty rate on the highest aggregate annual balance in the unreported foreign accounts. To qualify for the reduced rate, the U.S. taxpayer must reside in a foreign country, the U.S. taxpayer must make a good faith showing that he/she has timely complied with the tax laws of the foreign country, and the U.S. taxpayer has US$10,000 or less of U.S. source income each year.
However, this reduced rate is not available to those individuals who were aware that they are U.S. citizens, and failed to inquire about their U.S. tax obligations. It is uncertain how the IRS will determine that an individual previously knew about his or her U.S. citizenship. Moreover, individual IRS examiners have no discretion in reducing the offshore penalty to below 5%.
Inability to pay the penalties does not disqualify a U.S. taxpayer from taking advantage of the OVDI. The taxpayer can request that the IRS consider other payment arrangements. The burden is on the taxpayer to prove the inability to pay the penalties.
Unlike the amnesty program in 2011, the current OVDI program does not have a stated end date, and will be available until further notice. However, the IRS reserves the right to terminate the program or alter its conditions at any time. Moreover, since it appears that the terms of each subsequent amnesty program are progressively less generous than its predecessor, it may be prudent to take advantage of this amnesty program as soon as possible.
U.S. taxpayers may also make voluntary disclosures outside of the OVDI program. However, these taxpayers will not be eligible for the special civil terms of the OVDI, and will be liable for all applicable civil penalties, including the willful failure to disclose FBAR penalty. It should be noted that any U.S. taxpayer who is being examined or audited by the IRS cannot qualify for the OVDI.
In December 2011, the IRS released a fact sheet, FS-2011-13, which offers some additional relief. In this document, the IRS stated that the penalty for failing to file an FBAR will not be imposed if the U.S. taxpayer had reasonable cause. According to the IRS, “[f]actors that might weigh in favor of a determination that an FBAR violation was due to reasonable cause include reliance upon the advice of a professional tax advisor who was informed of the existence of the foreign financial account, that the unreported account was established for a legitimate purpose and there were no indications of efforts taken to intentionally conceal the reporting of income or assets, and that there was no tax deficiency…..related to the unreported foreign account. No single factor is determinative.”
Conversely, the IRS may determine that there is an absence of reasonable cause when a U.S. taxpayer’s background and education indicates that he/she should have known of the obligation to file an FBAR, when there is “a tax deficiency related to the unreported foreign account”, and when “the taxpayer failed to disclose the existence of the account to the person preparing his tax return.” Again, this is not an exhaustive or determinative list of factors.
U.S. taxpayers who reside in Canada are placed in the unenviable position of having to navigate two different sets of complicated tax laws in Canada and the U.S. Unfortunately, recent actions by the U.S. government have increased the burden on these taxpayers. Beginning in 2012, FATCA imposes new disclosure requirements for U.S. taxpayers, as well as the penalties for non-compliance. Furthermore, even though U.S. taxpayers have always been required to file an FBAR where applicable, there is now more rigorous and aggressive enforcement of this disclosure requirement by the IRS. In consultation with their tax advisors, U.S. taxpayers living in Canada, or any other foreign countries, should carefully consider their situation, and take steps to file any delinquent FBARs given the renewed fervor of the U.S. government in tracking down foreign assets held by U.S. taxpayers.