- Description of the program
On February 8, 2011 the Internal Revenue Service (IRS) unveiled its latest initiative to encourage taxpayers to report undisclosed foreign accounts and assets and unreported income from such accounts and assets. The program, titled the 2011 Offshore Voluntary Disclosure Initiative (2011 OVDI), offers eligible taxpayers several incentives for reporting offshore assets maintained during the 2003 through 2010 tax years covered by the program. The program enables delinquent taxpayers to become compliant, avoid compounded civil penalties, minimize the risk of criminal prosecution, and calculate, with a relative degree of certainty, the total cost of resolving offshore tax issues. In exchange, participants in the initiative must, among other things, file all original or amended tax returns, update all offshore information returns, agree to extend the statute of limitations on assessment, remit all back taxes, along with interest and penalties, and execute a Closing Agreement with the IRS.
Eligible taxpayers are those who disclose their identity to the IRS before the IRS or the Department of Justice learns of their identity. Timely disclosure is key to participation in the initiative.
Under the 2011 initiative taxpayers will encounter a revised penalty framework. Taxpayers will be responsible for either a 20% accuracy-related penalty on the total amount of underpayment for the 8 years covered by the program or, if applicable, the failure to file and failure to pay penalties. In addition, taxpayers must pay a penalty of 25% imposed on the highest aggregate balance of all financial accounts and certain foreign assets maintained during the period covered by the disclosure. The 25% penalty may be reduced to 12.5% or even 5% in certain limited circumstances. These penalties are imposed in lieu of all other penalties, including various foreign information reporting related penalties.
- The rationale for the 2011 initiative
The 2011 OVDI is the latest installment in the Internal Revenue Service's offshore voluntary disclosure program. The previous initiative launched in March 23, 2009 and concluded on October 15, 2009. During a span of time in excess of six months, the agency received approximately 15,000 voluntary submissions and since the end of the program an additional 3,000 taxpayers have volunteered information on bank accounts maintained around the world.
The Service views the offshore disclosure program as a complement to its continuous effort in combating international tax evasion. As an incentive to come forward under the 2011 initiative, the Service cited its ability to readily obtain information from tax treaties and whistleblowers, as well as pursuant to the recently enacted Foreign Account Tax Compliance Act and the Foreign Financing Asset Reporting requirements located in Section 6038D of the Internal Revenue Code. If the IRS discovers offshore account information through these avenues, however, taxpayer face substantial penalties and risk criminal prosecution. In some cases, the combined effect of these penalties could easily result in a total penalty that is a multiple of the balance in the foreign accounts.
The offshore voluntary disclosure program enables taxpayers to avoid such severe consequences and allows the IRS to streamline the effort of processing offshore disclosures. Based on the success of the 2009 predecessor program, the IRS decided to offer taxpayers another opportunity to disclose their offshore holdings. The new initiative maintains certain components of the former program and adds several new features.
- DETAILS OF THE 2011 OVDI
- Penalty structure
Under the 2011 OVDI, the civil penalty regime is generally less favorable to taxpayers who failed to disclose foreign accounts previously or during the 2009 initiative. In contrast to the 2009 program, the 2011 OVDI increases the applicable undisclosed asset-based penalty from 20% to 25%. The 25% penalty is imposed on the highest aggregate value of total offshore holdings during the 8 years included in the new program as contrasted to 6 years in the old. The penalty is a proxy for all other potentially applicable penalties such as the "normal FBAR" penalty, fraud penalty, and other penalties imposed under the Internal Revenue Code. Along with the 25% asset-based penalty, as noted above taxpayers will also be responsible for a 20% accuracy-related penalty and, if applicable, failure to file and pay penalties on previously unreported foreign income from such assets.
The 25% penalty may be reduced in several circumstances. The penalty may be decreased to 12.5% for taxpayers whose highest aggregate asset balance for each year covered by the program did not exceed $75,000.
The penalty may be further reduced to 5% if the taxpayer falls into one of the following two categories. A taxpayer in the first category may qualify for the reduced penalty if the taxpayer (a) did not open or cause the foreign account to be opened, (b) exercised minimal and infrequent contact with the account, (c) has not withdrawn more than $1,000 from the account in any year covered by the initiative (with the exception for a withdrawal closing the account and remitting the funds to the United States), and (d) can establish that all applicable taxes have been paid on funds deposited in the account. For funds deposited before January 1, 1991 and absent evidence to the contrary, the IRS will presume that the funds have been appropriately taxed. The second category of taxpayers eligible for a reduction in penalty are those taxpayers who are foreign residents and who were unaware they were U.S. citizens. Taxpayers who participated in the 2009 program and who qualify for the reduced penalties under the 2011 OVDI may contact the IRS for a re-evaluation of the applicable penalties imposed in their case.
The IRS has stressed that under no circumstances will taxpayers be exposed to penalties greater than what they would otherwise be liable for under the maximum existing statutory penalties. Examiners will compare the amount due under the 2011 initiative to the tax, interest, and penalties that a taxpayer would owe for all open years in the absence of the 2011 program and assess the lesser amount only.
- Tracing of assets
The 25% penalty (or the lesser penalties) will be imposed on a taxpayer's entire foreign asset base, which includes all offshore holdings that are in any way related to tax non-compliance. Therefore, the penalty will attach not only to unreported foreign financial accounts but also to assets acquired with funds that were improperly non-taxed. To exclude an asset from the base upon which the penalty will be imposed, taxpayers must establish that the foreign asset was acquired with after-tax funds or with funds not subject to U.S. taxation. This task effectively requires taxpayers to trace the source of the funds used to acquire a foreign asset.
- Sham entities
Under the 2011 OVDI, the Service will waive the requirement for filing delinquent information returns on behalf of an entity that a taxpayer controlled and that existed solely for the purpose of concealing ownership of foreign assets. Generally, a taxpayer who holds assets through a controlled foreign entity is obligated to file information returns for that entity, regardless of whether the taxpayer honored the form of the entity in dealing with the assets. However, if a taxpayer dissolves the entity and submits a statement to the IRS, signed under penalties of perjury, that the sole purpose of the entity was to conceal the taxpayer's ownership of the assets, the IRS will waive the informational filing requirement and related penalties.
- Continuation of the simplified PFIC regime
The IRS is continuing to offer participants in the 2011 OVDI a simplified method for valuating investments in passive investment foreign companies (PFIC). The IRS recognizes that a lack of historical information on cost basis and holding period of many PFIC investments renders it difficult for taxpayers to prepare statutory PFIC computations and for IRS to verify them. Alternatively, taxpayers can use the mark-to-market (MTM) methodology authorized by Revenue Code Section 1296, without reconstructing historical data. Using the MTM method, the IRS will apply a 20% tax rate to MTM gains, net gains, and gains from all PFIC dispositions during the period covered by the 2011 initiative. In addition, a rate of 7% of the tax computed for PFIC investments marked to market in the first year of the 2011 OVDI application will be added to the tax for that year.
- The 2011 OVDI process
Taxpayers who desire to be advised by the Service whether their disclosure would be "timely" are encouraged to request a pre-clearance before submitting their offshore voluntary disclosure. Pre-clearance can be obtained by faxing to the Criminal Investigation Lead Development Center in Philadelphia, Pennsylvania, identifying information (name, date of birth, social security number and address), executed power of attorney (if represented) and a request for pre-clearance before making a disclosure. Criminal Investigation personnel will then notify the taxpayers or their representatives whether or not they are cleared to make an offshore voluntary disclosure. Taxpayers who are cleared should, within 30 days from receipt of notification, make their voluntary disclosure by submitting an offshore voluntary disclosure letter to the Internal Revenue Service centralized voluntary disclosure management office, located in Philadelphia, Pennsylvania. Criminal Investigation personnel, responsible for coordinating this program, will review the disclosure letter and notify taxpayers or their representatives whether their offshore voluntary disclosures have been preliminarily accepted or declined.
- HOW TAXPAYERS SHOULD PROCEDE
The IRS Commissioner has described the 2011 OVDI as the "last, best chance for people to get back into the system" as "tax secrecy continues to erode" and the "risk of being caught" increases. In light of the impending August 31, 2011 deadline for disclosure and the foregoing pre-clearance procedures which must be completed long before this date.