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, We thought your readers would be interested in the following article from leading US/UK tax expert Paul Hocking, Chairman of Frank Hirth, based in London. Frank Hirth also have offices in New York. We do hope you will find the space to include this interesting article, but do not hesitate to contact us if you would like any amendments or additions. We very much look forward to hearing from you. RECENT IRS VOLUNTARY DISCLOSURE GUIDANCE COMPLICATES THE POSITION FOR DELINQUENT US TAXPAYERS OVERSEAS A recent announcement by the IRS regarding modifications to its voluntary disclosure programme may have significant fallout for any taxpayer who has failed to comply with his US tax filing obligations where there is an “international dimension”. “Voluntary disclosure” is a term of art which applies to individuals who may have committed tax crimes by wilfully failing to report income and/or make required disclosures to the IRS. An individual who is in this position faces not only exposure to tax, interest and penalties in relation to any unreported income and civil penalties for any failure to disclose but also criminal sanctions including imprisonment and/or heightened fines. The IRS has always encouraged such individuals to make a voluntary disclosure of their position to the IRS criminal investigation division prior to the time that the IRS commences an investigation into the individual’s tax affairs or otherwise receives information which could result in it independently discovering the individual’s non-compliance. The disclosure is made in the first instance to the appropriate IRS criminal investigation unit, which then decides whether to prosecute, it being understood that the voluntary disclosure will be viewed as a favourable factor in that decision. If the decision not to prosecute is reached, the matter is referred to IRS tax investigators to agree liability and penalties. Until now, the voluntary disclosure procedure has not been relevant to taxpayers who, although they have failed to fully comply with their tax filing obligations, have not done so with criminal intent but rather through inadvertence. Such individuals clearly are obliged to correct their non-compliance and in doing so to pay any liability and applicable penalties, with the possibility that penalties may be abated where a failure is due to reasonable cause. A subset of this group with which we have had considerable experience are those overseas Americans who have never complied with their US tax filing obligations, often without any tax avoidance because, as fully taxable residents of the UK or another country, their US liability will have been eliminated through credits. Over the years an informal practice has developed under which such individuals may effectively be considered to have brought themselves into compliance by filing back returns for a period of years (at most six). Any back liability for tax, interest and late payment/understatement penalties must be paid, but penalties for failure to report information may be abated due to reasonable cause. Until recently it had been possible for penalties to be addressed directly with an IRS representative in an overseas embassy, but at least in relation to the US embassy in London this practice ended several months ago, making it necessary to deal with penalty issues as assessments are issued by IRS offices processing the late information returns. Our experience in abating penalties in such cases has been almost uniformly positive. The importance of being able to abate civil penalties for failure to meet international reporting obligations has grown exponentially in recent years as efforts have been made increasingly to impose “criminal size” penalties for mere civil failures owing to the IRS’s inability to obtain this information any other way. These penalties, generally addressed at US residents, nonetheless apply alike to US citizens residing overseas. Among the most important of these are the penalties for failure to report Foreign Bank and Financial Accounts which can run to $100,000 per account per annum, failure to report the settlement of or receipt of distributions from a foreign trust, which is up to 35% of the amount transferred to or received from the trust and failure to report significant interests in foreign corporations, again up to $10,000 per interest per annum. In all cases penalties can be abated for reasonable cause (with the addition, in the case of the FBAR requirement, that any income from the account has been fully reported). Failure to meet the obligation to report annually foreign accounts over which an American citizen or resident has ownership or signature authority normally carries heavy penalties, even if any income earned in the accounts has been properly reported on their US tax return. But the IRS have just announced that individuals who are delinquent in their FBAR filings, but who have properly reported and paid tax on the income earned in the relevant accounts, will avoid penalties if the filings are made not later than 23 September 2009 *. Penalties for the criminal violation of these provisions can in some cases be much worse and these, when coupled with underpayment penalties, can result in an individual owing more than 100% of the relevant income/assets. The new changes in the voluntary disclosure procedure have been an indirect result of the IRS’s recent widely reported success in prosecuting UBS for aiding and abetting US persons to evade tax by holding assets in undisclosed Swiss accounts. The case was settled with a substantial payment from UBS and UBS’ agreement to release client information for certain US clients suspected of tax fraud. We understand some 200 criminal investigations of US taxpayers with undisclosed accounts at UBS have already been launched. The IRS has announced it will be seeking to investigate other offshore financial institutions suspected of similar practices. This has led to a wave of frightened UBS customers and others similarly situated frantically seeking to regularise their position. The IRS is quite happy to welcome these individuals back into the system and to facilitate this announced on 23 March 2009 a penalty framework for individuals making voluntary disclosure involving overseas issues, provided any undisclosed income is not from illegal sources. Where the IRS decides not to prosecute such cases, the tax liability will be considered settled if the individual pays: • all taxes and interest, and all underpayment penalties, going back six years (i.e. from 2003 to 2008) or, if later, where the “account/entity” was acquired; and • In lieu of all other penalties, including FBAR and information return penalties, a penalty equal to 20% of the maximum value of the account/entity during the six-year period. Except in extremely narrow circumstances, this penalty is not subject to abatement for reasonable cause. Although nowhere stated in the notice setting out the penalty framework, it seems clear that the “account/entity” referred to is one which has not been disclosed, or the income from which has not been reported. In the past week there has been further information released about the new initiative, including clarification of the 20% penalty in relation to entities. Where the penalty is imposed on an undisclosed entity, e.g. an interest in a foreign corporation, the penalty is imposed on a pro-rata share of the entity’s assets. The clarification states that “the twenty percent penalty applies to all assets ... held by foreign entities ... as well as all foreign assets (e.g. financial accounts, tangible assets such as real estate or art, and intangible assets such as patents or stock or other interests in a US business) held or controlled by the taxpayer.” The bold language if intended literally converts the 20% penalty from a charge on undisclosed accounts/entities into a charge on foreign assets generally, most of which are not subject to any disclosure requirement. Undoubtedly the clarification will itself require further clarification. This framework is to be available initially for six months, i.e. until 23 September 2009. While not precluding the possibility it will be extended, the IRS has noted that this is not guaranteed and that if there is an extension it may not be on as favourable terms. In the words of IRS commissioner Shulman, “for taxpayers who continue to hide their head in the sand, the situation will only become more dire.” The penalty framework may be a welcome development for Americans who have been guilty of tax evasion involving undisclosed foreign accounts, etc., but may be less welcome for Americans, particularly those residing overseas, who while not in compliance with their tax obligations have not done so wilfully. While the voluntary disclosure procedure is clearly directed at the former group, the language of the recent IRS announcements suggests that the voluntary disclosure procedure is to be applicable to all cases in which an individual has understated his liability and there are “offshore issues”, in other words the distinction between individuals who have engaged in tax fraud in relation to offshore interests and those who have not has been eliminated. While it remains available for any individual to proceed outside the voluntary disclosure procedure by simply filing amended and late forms as necessary (referred to as a quiet disclosure), the IRS warns that its agents are instructed to fully develop cases involving undisclosed overseas income, “pursuing both civil and criminal avenues, and consider all penalties...” Again, no distinction is made between cases involving wilful and non-wilful non-disclosure. We understand that all such cases will be funnelled to the same IRS units handling voluntary disclosures. We nonetheless remain of the view that where no criminal behaviour is involved it should be possible to proceed outside the voluntary disclosure regime and making clear on submission that there is no attempt to avoid scrutiny, but rather that the voluntary disclosure process is not appropriate as there is no wilful or criminal behaviour involved. A careful analysis of defences to applicable penalties must be undertaken in each such case before deciding which route to take. Following discovery of any failure to fully comply with US tax and reporting rules in an international context, prompt action is now even more important than ever. * The delinquent reports, together with copies of tax returns for relevant years and an explanation for late filing, should be sent to: Philadelphia Offshore Identification Unit, 11501 Roosevelt Blvd. South Bldg., Room 2002, Philadelphia, PA 19154, USA. Contacts: Paul Hocking, Frank Hirth: 020 7883 3500 paulh@frankhirth.com www.frankhirth.com Lauren Alexander, Maltin PR: 020 7887 1357 lauren@maltinpr.com www.maltinpr.com Photograph: www.maltinpr.com/paul-hocking