Tax Law Insights

The IRS has long been aware of U.S. taxpayers living overseas who have not filed federal income tax returns or Reports of Foreign Bank and Financial Accounts ("FBARs"). Earlier this year, the IRS announced the reopening of its successful Offshore Voluntary Disclosure Program ("OVDP") allowing individuals with unreported foreign bank account income to come forward and report this income, and to pay the related tax, interest and certain reduced civil penalties, but without criminal prosecution. The IRS has now announced a new alternative compliance procedure designed to provide certain non-resident U.S. taxpayers with a streamlined procedure to file their delinquent federal income tax returns and/or FBARs, without having to go through the OVDP process. This new procedure is effective September 1, 2012.

Generally, an individual is taxed on income earned if the taxpayer is deemed to be a U.S. citizen, resident alien or non-resident alien. U.S. citizens and resident aliens are taxed on their worldwide income whether they reside in the U.S. or abroad using the rates specified in the Internal Revenue Code. U.S. citizens and resident aliens working abroad must compute their tax liability similarly as those taxpayers working solely in the United States. Non-resident alien individuals who are engaged in a trade or business in the U.S. are taxed in the same fashion as U.S. citizens and resident aliens on income which is effectively connected with the conduct of a trade or business within the United States. Thus, all individuals are required to annually file a federal income tax return on income earned whether inside or otherwise the U.S.

Moreover, a U.S. person who has a financial interest in or signature authority over a foreign financial account must file an FBAR if the aggregate value of the foreign financial accounts exceeds $10,000 at any time during the calendar year. A U.S. person is defined as a U.S. citizen, resident alien, or any entity, including a corporation, partnership, trust or limited liability company, organized or formed under U.S. laws or the law of any State, the District of Columbia, or U.S. territories. A "foreign financial account" is any financial account located outside the U.S. A U.S. person has a financial interest in a foreign financial account for which: (1) the U.S. person is the owner of record or holder of legal title, regardless of whether the account is maintained for the benefit of the U.S. person or for the benefit of another person; or (2) the owner of record or holder of legal title is one of certain listed entities, which include (a) an agent, a nominee, attorney, or a person acting in some other capacity on behalf of the U.S. person with respect to the account, or (b) certain entities controlled by the U.S. person.

The new streamlined procedures announced by the IRS are available to non-resident U.S. taxpayers who (1) have resided outside of the U.S. since January 1, 2009, (2) have not filed a U.S. tax return during the same period, and (3) who do not owe more than $1,500 in taxes on submitted returns under the program. These non-resident taxpayers must be deemed a "low level of compliance risk" by the IRS to successfully file under the new program. The IRS has developed a non-resident, non-filer taxpayer questionnaire which it will use to accurately assess a taxpayer's level of risk of compliance risk. A taxpayer will be treated as low risk and processed in a streamlined manner if no high risk factors are present and the tax liability owed is less than $1,500. A taxpayer who submits income tax returns with a higher compliance risk will be subject to a more thorough review and potentially subject to an IRS audit, which may include more than three tax years.

A taxpayer's risk level may rise if factors announced by the IRS are present. These factors include:

1. If any of the returns submitted through this program claim a refund;
2. If there is material economic activity in the United States;
3. If the taxpayer has not declared all of his/her income in his/her country of residence;
4. If the taxpayer is under audit or investigation by the IRS;
5. If FBAR penalties have been previously assessed against the taxpayer or if the taxpayer has previously received an FBAR warning letter;
6. If the taxpayer has a financial interest or authority over a financial account(s) located outside his/her country of residence;
7. If the taxpayer has a financial interest in an entity or entities located outside his/her country of residence;
8. If there is U.S. source income; or
9. If there are indications of sophisticated tax planning or avoidance.

A taxpayer electing to use the new streamlined procedures must:

1. Submit complete and accurate delinquent income tax returns and any appropriate information returns, such as FBARs for the last three (3) years for which a U.S. income tax return is due;
2. Indicate at the top of each tax return "Streamlined" to elect these new procedures;
3. Submit payment of all taxes due including the amount of statutory interest due and owing (for those tax returns considered high risk by the IRS, the failure to file and failure to pay penalties may be imposed);
4. Submit complete and accurate delinquent FBARs for the last six (6) years for which an FBAR is due;
5. Submit a signed Non-Resident, Non-Filer Taxpayer Questionnaire;
6. Submit an ITIN application if the taxpayer does not have a valid social security card to file the required income tax or information returns.

All documents listed above will be sent to the Internal Revenue Service, 3651 South I-H 35, Stop 6063 AUSC, Attn: Streamlined, Austin, TX 78741. The IRS has also issued rules for relief from the failure to timely elect deferral of income from certain retirement or savings plans where deferral is permitted by a treaty which is not discussed herein. The IRS will not accept amended returns from taxpayers into this new streamlined filing compliance program. The IRS will only accept amended returns through this program filed for the sole purpose of submitting late-filed Forms 8891 to seek relief for failure to timely elect deferral of income from certain retirement or savings plans where deferral is permitted by relevant treaty. Amended individual income tax returns submitted through this program will be treated as high risk returns and subject to examination.

Taxpayer Impact

This new streamlined compliance procedure is another initiative offered by the IRS to help U.S. citizens abroad become current with their federal income tax filing and payment obligations and who may not otherwise elect to file a submission under the rigorous OVDP. This new program is intended for taxpayers who have simple federal income tax returns and owe less than $1,500 in taxes for the past three years.

Under the provisions of the present OVDP, taxpayers must file original or amended returns for the current and eight (8) preceding tax years reporting all previously unreported foreign bank account income and paying all associated taxes and interest with these returns which includes a 20% accuracy-related penalty. Also, taxpayers under the OVDP are required to pay an additional "Offshore Penalty" of 27.5% on the highest aggregate balance in foreign bank accounts/entities or value of foreign assets during the eight full tax years prior to the disclosure.

If a taxpayer does not make a submission under the OVDP, the IRS may assess additional and substantial civil penalties and fines, greatly exceeding that offered under the OVDP, including the civil fraud penalty which is 75% of the annual tax liability. Taxpayers who fail to file the annual foreign account disclosure reports ("FBARs") are subject to a minimum annual penalty of $10,000, which can rise to $100,000 per year. Criminal prosecution by the IRS may also be a very real concern for taxpayers.

Unlike the OVDP, the new announced compliance procedure provides taxpayers with the ability to file delinquent income tax returns for just the past three years plus FBARs for the past six years and not have to go through the more laborious task of filing eight amended returns and eight (8) FBARs under the OVDP. Further, taxpayers must pay the tax and interest, if applicable, at the time of filing the delinquent income tax returns, but not other penalties, including the substantial 27.5% Offshore Penalty.

However, the IRS warns that taxpayers concerned about the risk of criminal prosecution should not utilize this new procedure as it will not provide protection from criminal prosecution, as the OVDP does, if the IRS and Department of Justice determine that the taxpayer's particular circumstances warrant such prosecution. If an individual is concerned about possible criminal prosecution, the individual may wish to consider a submission under the OVDP. Once an individual files under the new streamlined filing compliance procedure, OVDP is no longer available, and if a taxpayer is ineligible to use OVDP in the first instance, the taxpayer is not eligible to participate in this new procedure as well. Individuals must therefore carefully consider their options before filing under the new program.