On February 8, 2011, the Internal Revenue Service (the “IRS”) published guidance in the form of answers to 53 “frequently asked questions” in announcing its long-awaited follow-up to the Offshore Voluntary Disclosure Program that closed on October 15, 2009 (the “2009 OVDP”). The stated goal of both the 2009 OVDP and this new initiative, the 2011 Offshore Voluntary Disclosure Initiative (the “2011 OVDI”), is the same— to encourage U.S. taxpayers with previously undisclosed foreign assets and income to disclose their existence to the IRS and thereafter be in compliance with U.S. tax laws. As discussed below, taxpayers who successfully participate in the 2011 OVDI will have a significantly reduced risk of criminal prosecution with respect to their prior non-disclosure of offshore assets and income and can avoid substantial civil penalties that would likely exceed the amounts a taxpayer will be required to pay under the 2011 OVDI framework.
The 2011 OVDI is available to (1) any taxpayer with previously undisclosed offshore assets or income who applied to the IRS Criminal Investigation Unit’s traditional voluntary disclosure practice since the close of the 2009 OVDP, and (2) to any similarly situated taxpayer who comes forward, if the taxpayer in either case completes all requirements of the 2011 OVDI on or before August 31, 2011. The offshore assets that taxpayers are required to report include personal and business bank accounts; interests in, or certain assets held by, entities; and certain other assets owned directly.
In recent years, U.S. authorities have increased their focus on international tax compliance relating to offshore and unreported assets and income. This increased scrutiny has resulted in new legislation, highly publicized prosecutions of non-compliant taxpayers, and an increased and continuing effort on obtaining multi-lateral tax transparency. Accordingly, taxpayers with unreported offshore assets or income and who are eligible to participate in the 2011 OVDI should consult with counsel to discuss whether participation in this new voluntary disclosure program is in their best interest given their particular circumstances.
2011 OVDI Highlights
- To obtain the benefits of the 2011 OVDI, the taxpayer must file a voluntary disclosure, as well as all required tax information returns, including Form TD F 90-22.1 (Report of Foreign Bank and Financial Accounts), commonly known as the “FBAR,” and must pay all taxes, penalties, and interest by August 31, 2011.
- The period covered by the 2011 OVDI is 2003 through 2010 (the “2011 OVDI Period”), which means that 2011 OVDI covers eight tax years instead of the historical six-year period.
- The additional one-time penalty on the highest aggregate offshore asset value during the 2011 OVDI Period has been increased to 25 percent from 20 percent under the 2009 OVDP. This 25 percent penalty is relatively good news because many tax practitioners were expecting penalties in the range of -2- 30 to 40 percent. The IRS has also retained the special five percent penalty rate if certain conditions, discussed below, are met. In addition, a new 12.5 percent penalty rate applies if the highest aggregate asset value in each 2011 OVDI Period tax year was less than $75,000.
- There is a slightly revised procedure for making a voluntary disclosure, discussed below, that is intended to streamline and centralize the process.
2011 OVDI Benefits, Costs, and Eligibility
A taxpayer can successfully participate in the 2011 OVDI if (1) the taxpayer provides a truthful and complete disclosure, (2) the disclosure is timely (meaning submitted prior to the IRS obtaining the taxpayer’s information from other sources), and (3) all of the taxpayer’s unreported income comes from legitimate sources. A taxpayer who successfully participates in the 2011 OVDI generally avoids criminal prosecution by the Department of Justice and any potential criminal fines. In addition, a participating taxpayer avoids the application of (1) all penalties from the failure to file any of the information returns required to report ownership of foreign accounts, such as the FBAR, or foreign entities; and (2) the 75 percent civil fraud penalty. Instead, the taxpayer is subject to the payment of tax deficiencies and interest thereon, normal accuracy and failure to file penalties, and in the place of all other tax or information return penalties that may be applicable, a 25 percent penalty on the highest aggregate offshore asset value in any 2011 OVDI Period tax year.
The IRS has also increased the flexibility of the 2011 OVDI by providing that a taxpayer can qualify for
- a five percent penalty rate if the taxpayer (a) did not open or cause the account to be opened (unless the bank required a new account to be opened on the death of the previous owner); (b) has exercised minimal, infrequent contact with the account; (c) has not withdrawn more than $1,000 from the account in any 2011 OVDI Period tax year, unless the taxpayer closed the account and transferred the funds to a U.S. account; and (d) can establish that all applicable U.S. taxes have been paid on funds deposited in the account after January 1, 1991 (i.e., only account earnings have escaped U.S. taxation); or
- a 12.5 percent penalty rate if the taxpayer’s highest aggregate offshore asset value in each 2011 OVDI Period tax year is less than $75,000.
The 2011 OVDI, like its predecessor, is open to corporations, partnerships, trusts, and other entities, in addition to individual taxpayers. However, any taxpayer who is currently under examination, regardless of whether it relates to undisclosed offshore assets or income, is not eligible to participate.
Since the IRS first offered the 2009 OVDP, it has warned taxpayers not to attempt a so-called “quiet” disclosure (i.e., the filing of amended tax returns and the payment of additional tax, interest, and penalties without otherwise formally notifying the IRS that the amended returns and additional tax payments result from undisclosed offshore assets or income). The IRS’s position has been that a “quiet” disclosure is not a proper disclosure under the normal voluntary disclosure practice or the 2009 OVDP. Not surprisingly, the IRS maintains this position in the 2011 OVDI. In fact, the IRS warns that any taxpayer who has attempted a “quiet” disclosure may be subject to examination at any time. If the IRS should examine such a taxpayer, the taxpayer will not be immune from potential criminal prosecution, fines, or the full force of all civil penalties. As a result, eligible taxpayers are “strongly” encouraged to participate in the 2011 OVDI prior to the IRS’s decision to examine any amended tax return.
If a taxpayer has paid all taxes on the income earned from offshore assets, but has simply not filed all necessary information returns to report the ownership of such assets, the taxpayer need not and should not participate in the 2011 OVDI. Instead, that taxpayer should file the delinquent information returns with the appropriate IRS office as provided in the 2011 OVDI guidance and attach a statement explaining the reason for the delinquent returns. These taxpayers will not be subject to the penalties that would otherwise apply if the information returns are filed by August 31, 2011.
2011 OVDI Process
To assist taxpayers, the IRS has provided instructions and a timeline for the steps involved in the 2011 OVDI as follows:
- A taxpayer may engage a representative to contact the IRS without revealing the taxpayer’s identity to discuss hypothetical situations. It should be noted that posing a hypothetical situation does not provide a taxpayer with any benefit of the 2011 OVDI.
- A taxpayer may obtain clearance to participate in the 2011 OVDI by providing the Criminal Investigation Lead Development Center (“LDC”) with certain identifying information (name, date of birth, social security number/taxpayer identification number, and address). LDC will then notify the taxpayer, or its representative, within 30 days whether he/she is cleared to participate in the 2011 OVDI (a “preclearance”). A taxpayer has 30 days from receipt of the pre-clearance to comply with step 3.
- A taxpayer must submit an “Offshore Voluntary Disclosure Letter,” which is generally a letter containing a description of the unreported offshore assets, accounts, entities, and income, as well as certain other information, to LDC. LDC will notify the taxpayer, or its representative, within 30 days whether he/she has been preliminarily accepted into the 2011 OVDI.
- For final acceptance into the 2011 OVDI, a taxpayer must submit a full and complete “Voluntary Disclosure Package,” discussed below, to the IRS office in Austin, Texas, by August 31, 2011.
- The IRS will then assign a civil examiner who will review the Voluntary Disclosure Package to certify its accuracy and completeness, but typically will not conduct a full examination. The timing of the certification process will depend on when the Voluntary Disclosure Package is submitted and the complexity involved with the taxpayer’s file. A taxpayer who submits the Voluntary Disclosure Package in advance of the deadline is more likely to have his/her case resolved quickly.
- The taxpayer and the IRS will enter into a closing agreement on Form 906.
If the taxpayer and the IRS cannot agree to the terms of the closing agreement, the taxpayer’s case will be examined and all applicable penalties will be imposed. A taxpayer may appeal any tax or penalty imposed on the full examination but not the terms offered by the IRS in the closing agreement.
2011 OVDI Voluntary Disclosure Package
As mentioned above, submission of the Voluntary Disclosure Package is the last step a taxpayer must complete by August 31, 2011. The following items comprise the Voluntary Disclosure Package:
- copies of previously filed original (and, if applicable, previously filed amended) federal income tax returns for the 2011 OVDI Period tax years;
- complete and accurate amended federal income tax returns for the 2011 OVDI Period tax years, with applicable schedules detailing the amount and type of previously unreported income from the account or entity;
- a completed Foreign Account or Asset Statement (a form provided by the IRS) for each previously undisclosed foreign account or asset owned during the 2011 OVDI Period tax years;
- properly completed and signed Taxpayer Account Summary with Penalty Calculation (a form provided by IRS);
- for those taxpayers disclosing offshore financial accounts with an aggregate highest account balance in any year of $1 million or more, a completed Foreign Financial Institution Statement (a form provided by the IRS) for each foreign financial institution with which the taxpayer had undisclosed accounts or transactions during the 2011 OVDI Period tax years;
- for those taxpayers disclosing offshore financial accounts with an aggregate highest account balance in any year of $500,000 or more, copies of offshore financial account statements reflecting all account activity for each 2011 OVDI Period tax year in which the taxpayer had an offshore account;
- for those taxpayers disclosing offshore financial accounts with an aggregate highest account balance of less than $500,000 in every year, copies of offshore financial account statements reflecting all account activity for each 2011 OVDI Period tax year in which the taxpayer had an offshore account must be readily available upon request;
- properly completed and signed agreements to extend the period of time to assess tax (including tax penalties) and to assess FBAR penalties; and
- a check payable to the Department of Treasury in the total amount of tax, interest, and penalties for the 2011 OVDI tax years. If a taxpayer cannot pay the total amount of tax, interest, and penalties, the taxpayer must submit its proposed payment arrangement and a completed Collection Information Statement.
After submission of the Voluntary Disclosure Package, the examiner may still request additional relevant documents or contact third parties to certify the accuracy of the amended returns.
2011 OVDI Significant Changes from 2009 OVDP
The first major change, which may have the biggest impact, relates to the penalty structure of the 2011 OVDI. The 25 percent penalty on the highest aggregate value of all offshore assets owned in the OVDI Tax Period now covers eight years. Under the 2009 OVDP, the penalty was 20 percent on the same assets owned during a six-year period. The 2011 OVDI guidance regarding the offshore assets included in the penalty calculation includes one important clarification, which some may consider a difference. Under the 2011 OVDI, the 25 percent penalty applies to all offshore assets that are related in any way to “tax noncompliance” (i.e., a failure to report all gross income). Thus, offshore assets are included in the calculation if the taxpayer failed to report income earned by the assets, or if the taxpayer failed to pay U.S. tax that was due with respect to funds used to acquire the assets, during the 2011 OVDI Period. Additionally, 2011 OVDI guidance confirms that the examiner will calculate the tax, interest, and penalties that the taxpayer would owe outside the 2011 OVDI, under certain assumptions, and the taxpayer is liable only for the lesser of this amount or the 2011 OVDI penalties. Finally, providing the five percent and 12.5 percent alternative penalty rates provides increased flexibility for those taxpayers who qualify for these reduced rates.
As discussed above, a taxpayer must submit the Voluntary Disclosure Package by August 31, 2011. In contrast, a taxpayer who participated in the 2009 OVDP merely had to apply for the program by October 15, 2009 (comparable to submitting the Offshore Voluntary Disclosure Letter), after which there was no set timeline for additional documentation to be filed. This deadline feature places the burden on the taxpayer on the front-end of the disclosure process.
A third significant difference in the 2011 OVDI stems from the fact that it contains clear, upfront guidance on how to proceed if the taxpayer owns an interest in a passive foreign investment company (a “PFIC”). Based on the 2011 OVDI guidance, a taxpayer can use the “Mark to Market” methodology in the Internal Revenue Code rather than complying with the normal PFIC regime. This option is beneficial because many taxpayers do not have the necessary historical information on the cost basis and holding period of their investments.
2011 OVDI and Offshore Enforcement in General
Congress, the Department of Justice, and the IRS have each increased the pressure on international tax compliance relating to offshore and unreported assets and income, which can be seen in recent legislation such as FATCA, the highly publicized prosecutions of non-compliant taxpayers, and an increased effort on multi-lateral tax transparency. This increased pressure is one reason a taxpayer who has unreported offshore assets or income and is eligible for the 2011 OVDI should consider contacting counsel to discuss compliance.
While there is no guarantee that a taxpayer will avoid criminal prosecution and penalties for participating in the 2011 OVDI, the IRS generally will recommend against criminal prosecution and fines if the taxpayer complies with the 2011 OVDI conditions. Further, the significant civil penalties that could be assessed outside the 2011 OVDI can potentially exceed the value of the offshore assets, which would require the taxpayer to use other funds to pay all taxes, interest, and penalties. Thus, avoiding these civil penalties is another significant reason for a taxpayer to consider discussing participation in the program.
A taxpayer who waits until after the 2011 OVDI closes to submit a voluntary disclosure will be faced with uncertainty regarding the “deal,” if any, the IRS will offer. The one certain thing is that any such taxpayer will face increased penalties and may not be able to avoid criminal prosecution and fines. Of course, a taxpayer who chooses not to participate in any kind of voluntary disclosure at all risks up to 15 years in prison and up to $750,000 for each tax year he/she is non-compliant (which tax year is not necessarily limited to the previous eight years) in addition to the significant civil penalties mentioned above.