Tax Law Update
On November 29, 2018, the Internal Revenue Service (the "IRS") published a memorandum (the "Memorandum") dated November 20, 2018, outlining the new process for all voluntary disclosures, both domestic and offshore (the "New VDP"). The Memorandum follows the March 2018 announcement by the IRS that the 2014 Offshore Voluntary Disclosure Program (the "OVDP") would be closed to new taxpayers after September 28, 2018. As expected, taxpayers participating in the New VDP are generally exposed to more penalties and less certainty than under the OVDP.
Over the years, Congress has enacted various reporting regimes intended to reduce tax noncompliance with respect to offshore activities of U.S. taxpayers. Specifically, the Bank Secrecy Act of 1970 requires each U.S. taxpayer with an interest in, signature, or other authority over one or more bank, securities, or other financial accounts in a foreign country to file a Report of Foreign Bank and Financial Accounts (an "FBAR") if the aggregate value of such accounts exceeds $10,000 at any time during a calendar year (on FinCEN Form 114, which replaced Form TD F 90‑22.1). The FBAR requirement applies even if the account produces no taxable income. U.S. taxpayers may also have additional reporting requirements with respect to foreign financial assets including: statements of specified foreign financial assets (Form 8938), information returns with respect to certain foreign corporations (Form 5471), reports of transactions with foreign trusts and receipt of certain foreign gifts (Forms 3520 and 3520-A), and returns with respect to certain foreign partnerships (Form 8865). These reporting requirements are generally accompanied by stiff penalties for failure to timely comply.
Historically, if a taxpayer disclosed tax noncompliance to the IRS before the IRS had either begun an investigation or received information relating to such noncompliance, and the taxpayer cooperated and agreed to pay in full all taxes, interest and penalties due, the IRS generally would not pursue criminal prosecution. To effectuate this policy, the IRS offered voluntary disclosure programs in 2014, 2011 and 2009 as a path for U.S. taxpayers with offshore tax noncompliance to resolve potential criminal liability or substantial civil penalties for willful failure to report foreign financial assets and pay taxes due on those assets. The most recent of those programs, the OVDP, generally required taxpayers to pay a 27.5 percent penalty on the value of all noncompliant offshore assets, as well as taxes, penalties and interest on any unreported income.
According to the IRS, OVDP participation had slowed significantly over time, and in March 2018 the IRS announced that it would not accept OVDP submissions after September 28, 2018. However, the IRS retained voluntary compliance programs – such as the Streamlined Filing Compliance Procedures, the Delinquent FBAR Submission Procedures, and the Delinquent International Information Return Submission Procedures – for taxpayers whose misconduct did not include willful failure to report and pay taxes due. These alternative methods are still available, although the IRS has warned that these programs could be discontinued at any time.
It is noteworthy that there have also been important developments in the case law surrounding the application of FBAR penalties to "willful" noncompliance. A split between the Federal Court of Claims and two federal district courts, and the Western District of Texas in the 5th Circuit and the District of Colorado in the 10th Circuit, has developed over the application of the limitation on penalties for willful FBAR violations. The courts are divided on whether a 2004 amendment to the Bank Secrecy Act of 1970, which states that the limitations on penalties "shall be increased" to the greater of $100,000 or 50 percent of the account in question, overrides regulations promulgated under the statute as it existed before the 2004 amendment. These regulations capped the penalties for willful FBAR penalties to $100,000 per account. The two federal district courts that have decided on this issue have held that the regulations promulgated under the prior statute are still applicable, i.e. the FBAR penalty for willful violations is capped at $100,000 per account. The Federal Court of Claims held that the amendment to the statute overrides the regulations so that the cap is either $100,000 or 50 percent of the account, whichever is greater. This split will likely cause taxpayers who are contemplating appealing a willful FBAR penalty by filing a refund claim to avoid the Federal Court of Claims and, instead appeal to the appropriate federal district court.
The New VDP
Following months of anticipation, the IRS revealed a framework for how voluntary disclosures received after September 28, 2018 will be handled by the IRS. The New VDP process is summarized below.
The New VDP will begin when the taxpayer submits a preclearance request on a (yet-to-be-released) form. This form is screened by the IRS's Criminal Investigation division ("CI") to determine if the taxpayer is eligible to make a voluntary disclosure. Whether the taxpayer is eligible will be determined by CI under the same guidelines that were released for the 2009 voluntary disclosure program (e.g. taxpayers cannot currently be under audit or have reason to believe the IRS has obtained information about their tax liability).
Where preclearance is granted, taxpayers will submit all necessary documents along with a form that will require certain information related to the taxpayer's noncompliance in a narrative form. This narrative will include information about the assets, entities, related parties, and professional advisors involved in the noncompliance. If the taxpayer's voluntary disclosure is preliminarily accepted, CI will notify the taxpayer via letter and forward the documents internally within the IRS for case development.
CI will send all of the information and documents it has gathered to the LB&I Austin unit. The LB&I Austin unit determines the last year of the disclosure period and then forwards the case to the applicable Business Operating Division. From this point, it is expected that the New VDP will follow standard exam procedures, and that participating taxpayers will fully cooperate. Failure to fully cooperate can result in CI revoking their preliminary acceptance of the taxpayer's voluntary disclosure.
The goal under the New VDP is to resolve the voluntary disclosure with an agreement between the taxpayer and the government. The penalties imposed under the agreement will be determined using existing law and procedures. Properly imposed penalties for willful FBAR violations shift the burden of proof to the taxpayer, who must provide convincing evidence to the contrary if they decide to challenge the penalties imposed. We note that the New VDP leaves much discretion to the IRS in resolving cases.
Length of Disclosure Period
The New VDP generally will be limited to a six-year disclosure period, instead of the eight years required by the OVDP. The six-year period can be increased, up to the full duration of the period of noncompliance, if the voluntary disclosure is not resolved by agreement under the New VDP.
Under the OVDP, taxpayers were required to pay the 20 percent accuracy-related penalty; the failure to file penalty, if applicable; the failure to pay penalty, if applicable; and a miscellaneous penalty equal to 27.5 percent of the highest aggregate balance or value in foreign financial accounts, or other assets related to tax noncompliance (increased to 50 percent if the government was already investigating the taxpayer's foreign financial institution or another facilitator). The New VDP similarly imposes two main penalties, a penalty related to underpayment of tax and a penalty for failure to file FBARs, but also gives IRS examiners discretion to impose additional penalties.
Under the New VDP, the penalty for underpayment of tax is the 75 percent civil-fraud penalty. According to the Memorandum, this 75 percent penalty is generally assessed for the tax year with the highest tax liability during the disclosure period. However, if the taxpayer does not resolve the New VDP by agreement, the Memorandum warns that the penalty can be assessed for each year of the disclosure period.
The penalty under the New VDP for FBAR violations is the willful failure penalty of 50 percent of the highest aggregate balance in the noncompliant accounts. However, the Memorandum gives IRS examiners the discretion to recommend a penalty up to 100 percent of the highest aggregate balance in the noncompliant accounts. Note that the FBAR penalty under the New VDP appears to be based solely on the balances of unreported accounts and not on the value of other noncompliant offshore assets.
The Memorandum states that a taxpayer is not precluded from requesting the imposition of the 20 percent accuracy-related penalty instead of the 75 percent civil-fraud penalty or the non-willful FBAR penalty (generally up to $10,000 per year) instead of the $100,000/50 percent willful penalty. However, the Memorandum states that such requests will be granted only in "exceptional" circumstances. The Memorandum also indicates that penalties for the failure to file information returns will not be automatically imposed, but will be subject to examiner discretion.
Comparing the New VDP to the OVDP
The following chart compares the New VDP to the OVDP:
Length of Disclosure Period
Generally a six-year period.
Generally an eight-year period, but can be extended where the voluntary disclosure is not resolved by agreement.
General Tax Penalties
Accuracy-related penalty of 20% on full amount of underpayments for all years.
Failure to file and failure to pay penalties may also apply.
Civil penalty of 75% for the year with the highest tax liability.
Penalty for FBAR Violations
A 27.5% (increased to 50% if the government was already investigating the taxpayer's foreign financial institution or another facilitator) of the highest aggregate balance in foreign bank accounts/entities or value of foreign assets during the disclosure period.
50% of the highest aggregate balance in the noncompliant accounts.
Examiners have limited discretion to impose penalties other than those described above.
Examiners have discretion to impose the 75% civil-fraud penalty to multiple years and an FBAR penalty of up to 100% of the highest aggregate balance in the noncompliant accounts, as well as additional reporting and other penalties.
The Memorandum is a welcome development for taxpayers seeking comfort that the IRS will continue its historical practice of not imposing criminal penalties where taxpayers voluntarily disclose prior noncompliance. But the cost to obtain that comfort has increased. Please reach out to a member of the Orrick tax department for experienced guidance in making these difficult choices.