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Feb 8, 2013 - One Size Does Not Fit All: Unintended Consequences of the Offshore Voluntary. Disclosure Program. By Matth
January–February 2013

One Size Does Not Fit All: Unintended Consequences of the Offshore Voluntary Disclosure Program By Matthew A. Morris

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I. Introduction

Matthew A. Morris, LL.M., Esq., is an Associate at M. Robinson & Company, a boutique tax firm in downtown Boston.

On January 9, 2012, the Internal Revenue Service (IRS) reopened the Offshore Voluntary Disclosure Program (“2012 OVDP”) “on the heels of strong interest in the 2011 and 2009 programs.”2 Although the IRS maintains that it may “end the 2012 program at any time in the future,”3 there is no indication that it will abandon its well-established pattern of announcing new iterations of the OVDP with slight changes to form and slightly more significant changes to substance. The steadily increasing rate of the miscellaneous penalty—currently 27.5 percent of the highest aggregate value of foreign accounts and/or assets that are connected in any way to the taxpayer’s noncompliance, a significant increase from the 20-percent miscellaneous penalty in the 2009 Offshore Voluntary Disclosure Program (“2009 OVDP”)—suggests that the IRS is seeking to deter noncompliant taxpayers from taking a “wait and see” approach.4 As Doug Shulman stated four days before the expiration of his term as IRS Commissioner, the IRS has “fundamentally changed the risk calculus of taxpayers who are thinking about hiding their money overseas . . . .”5 The problem with “fundamentally chang[ing] the risk calculus” is that the OVDP has consistently focused on deterrence for a specific group of individuals—“[w]ealthy people who unlawfully hide their money offshore [and who] aren’t paying the taxes they owe”6—without addressing the potential impact of the program on permanent

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One Size Does Not Fit All residents, “substantial presence” residents and new citizens of the United States whose compliance issues stem from misunderstanding of tax laws rather than intentional concealment of income.7 The archetype of the wealthy United States citizen, born and raised in the United States, who opens a Swiss bank or brokerage account for the purpose of evading United States income tax laws, is too simplistic to capture the full spectrum of OVDP participants. When new permanent residents, substantial presence residents and new citizens suddenly become subject to U.S. income tax on their worldwide income rather than just their U.S.-source income, there will inevitably be a “compliance gap” associated with the transition to a new set of tax rules and regulations. Clustering these new citizens and residents caught in the compliance gap with archetypal tax evaders may actually undermine the central objective of the OVDP by discouraging voluntary compliance. The purpose of this article is to propose a solution to the overly broad “one size fits all” OVDP penalty structure by creating a “compliance gap exception” for permanent residents, substantial presence residents and new citizens of the United States. Part II of this article provides an overview of the background and mechanics of the OVDP and similar offshore disclosure initiatives. Part III identifies some of the major problems of the OVDP for new residents and citizens of the United States. Part IV proposes a solution to the problems associated with a “one size fits all” penalty structure by advocating a compliance gap exception to the OVDP miscellaneous penalty.

II. Background and Mechanics of the 2012 OVDP and Similar Initiatives Since March 2009, the IRS has attempted to bring taxpayers with previously unreported foreign income into compliance by offering a promise to not recommend the taxpayers for criminal prosecution in exchange for the taxpayers’ full cooperation with the rigid terms of the various voluntary disclosure programs. The following is a brief overview of the background and mechanics of these programs.

A. The 2009 OVDP On March 23, 2009, the IRS opened admission to its first Offshore Voluntary Disclosure Program (2009 OVDP). The widely reported response from taxpay-

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ers surprised IRS officials who had expected around 1,000 participants.8 Instead, nearly 15,000 taxpayers came forward by the October 15, 2009, deadline, and about 3,000 came forward to request admission to the 2009 OVDP after that deadline.9 The terms of the 2009 OVDP, at least on the face of the Frequently Asked Questions posted on the IRS website,10 are straightforward and mechanical. The basic requirements of the program are as follows: 1. Meet the deadline. The deadline for the 2009 OVDP was originally September 23, 2009, which is six months after the program was announced. The IRS extended the deadline to October 15, 2009, with no further extensions. However, prospective participants in the 2009 OVDP needed only to make their initial voluntary disclosure (in the form of the “Optional Format” or similar letter) by October 15, 2009, in order to be accepted to the program.11 2. Include the correct scope of tax years in the disclosure. The relevant timeline of the 2009 OVDP is the six full tax years following the disclosure. Thus, a taxpayer who came forward under the 2009 OVDP in August 2009, needed to prepare and file amended returns and Forms TD F 90-22.1 (FBARs) (or original returns and FBARs if not previously filed) for tax years 2003 through 2008.12 3. File the correct forms. In addition to amended income tax returns and FBARs—or original returns and FBARs if not previously filed—a 2009 OVDP participant needed to prepare and file all information returns associated with their foreign income. These forms include, but are not limited to: Form 3520 (relating to gifts from foreign persons and transactions with foreign trusts), Form 5471 (information return for U.S. persons with respect to foreign corporations) and Form 8865 (information return for U.S. persons with respect to foreign partnerships). 4. Explain the nondisclosure. A 2009 OVDP participant needed to provide “[a]n explanation of previously unreported or underreported income or incorrectly claimed deductions or credits related to undisclosed foreign accounts or undisclosed foreign entities, including the reason(s) for the error or omission.”13 A 2009 OVDP participant also needed to explain her disclosure through a preliminary letter (often referred to as the “Optional Format Letter” or “Intake Letter”), a Form 8275: Disclosure Statement if the taxpayer is taking an uncertain tax position, and a final 2009 OVDP submission letter.

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January–February 2013 5. Pay (or make arrangements to pay)14 the additional income tax plus interest. The interest on the additional income tax liability accrues from the due date of the original income tax return.15 6. Pay (or make arrangements to pay) the accuracy-related penalty. Regardless of whether the amount of additional income tax qualifies as a “substantial understatement of income tax” as that term is defined in Code Sec. 6662(d)(1), a 2009 OVDP participant is required to pay an “accuracy-related penalty” equal to 20 percent of the additional income tax due.16 Interest will accrue on the accuracy-related penalty, in addition to the additional income tax, from the due date of the original return.17 7. Pay (or make arrangements to pay) the “offshore penalty.” Under the terms of the 2009 OVDP, the taxpayer must pay an “offshore penalty” equivalent to 20 percent of the highest aggregate account balance of any foreign account that was connected in any way to the taxpayer’s noncompliance.18

B. The 2011 OVDI On February 8, 2011, the IRS announced its second offshore disclosure initiative in less than two years, changing the name of the program to the 2011 Offshore Voluntary Disclosure Initiative (“2011 OVDI”).19 The terms of the 2011 OVDI are substantially identical to the terms of the 2009 OVDP, with the following exceptions: 1. Deadline: Like the 2009 OVDP, participants in the 2011 OVDI needed to submit their names, dates of birth, social security numbers and as much of the other information on the “optional format” letter as possible before the September 9, 2011, deadline.20 2. Amount of the “offshore” or “miscellaneous” penalty: The amount of the “offshore” or “miscellaneous” penalty increased from 20 percent in the 2009 OVDP to 25 percent in the 2011 OVDI.21 The 2011 OVDI FAQs also introduced a 12.5-percent penalty for taxpayers whose highest aggregate account balance is less than $75,000. The 2011 OVDI FAQs also provided a more detailed framework for the imposition of the five-percent penalty in cases (1) in which the taxpayer (a) did not open or cause the account to be opened, (b) exercised minimal, infrequent contact with the account, (c) did not withdraw more than $1,000 from the account in any year (except for a withdrawal closing the account and transferring the funds to an account in the United

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States), and (d) can establish that all applicable U.S. taxes have been paid on funds deposited to the account; (2) in which the taxpayer is a foreign resident who is unaware that he or she is a United States citizen; and (3) in which the taxpayer is a foreign resident who (a) resides in a foreign country, (b) made a good-faith showing that he or she complied with tax filing and payment requirements in the foreign country, and (c) had $10,000 or less of U.S. income each year.22 3. Scope of included tax years: Unlike the 2009 OVDP—which only required returns and FBARs for the six full tax years preceding the disclosure (2003 to 2008)—the 2011 OVDI includes tax years 2003 to 2010.23 The 2011 OVDI FAQs do not address the situation in which a taxpayer’s 2010 return has not yet been filed (either prior to the extended deadline of October 15, 2011, or the standard deadline of April 15, 2011) and the original return filed prior to the standard or extended deadline is true, correct and complete in all respects (reporting the taxpayer’s worldwide income). In this situation, the scope of the disclosure period would remain the same (2003 to 2010) even though the taxpayer’s noncompliance is limited to tax years 2003 to 2009.

C. The 2012 OVDP On January 9, 2012, the IRS announced its third offshore disclosure initiative in less than three years, changing the name of the program to the 2012 Offshore Voluntary Disclosure Program (2012 OVDP).24 The terms of the 2012 OVDP are substantially identical to the terms of the 2011 OVDI, with the following exceptions: 1. Deadline: Unlike the 2011 OVDI, there is no set deadline for taxpayers to apply for participation in the 2012 OVDP.25 2. Amount of the miscellaneous penalty: The amount of the “offshore” or “miscellaneous” penalty increased from 25 percent in the 2011 OVDI to 27.5 percent in the 2012 OVDP.26 The 2012 OVDP FAQs reiterate the same guidance set forth in the 2011 OVDI FAQs regarding the imposition of the 12.5-percent and five-percent penalty rates.27 3. Scope of included tax years: The 2012 OVDP FAQs contain detailed guidance regarding the scope of tax years in the voluntary disclosure period. For calendar-year taxpayers, the scope of the disclosure period is the “most recent eight

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One Size Does Not Fit All tax years for which the due date has already passed.”28 The eight-year period “does not include current years for which there has not yet been non-compliance.”29 Thus, for a calendar-year taxpayer who files a voluntary disclosure on March 1, 2012—prior to the filing of her 2011 personal United States income tax return—will have to file returns and FBARs from 2003 to 2010. Needless to say, this taxpayer has to (a) report her worldwide income on a timely filed original income tax return for tax year 2011 and (b) report her foreign accounts (if any) on a timely filed FBAR for 2011.30

III. Problems with the OVDP for New Residents and New Citizens of the United States Although the 2012 OVDP, 2011 OVDI and 2009 OVDP are slightly different in both form and substance, the basic objective of all three programs is the same: “to bring taxpayers that have used undisclosed foreign accounts and undisclosed foreign entities to avoid or evade tax into compliance with United States tax laws.”31 Predictability is the hallmark of all three programs. A taxpayer with $1 million of unreported income and $10 million in unreported foreign accounts and assets knows, to a reasonable degree of certainty, what her liability will be under the 2012 OVDP: (1) income tax and interest on the $1,000,000 in unreported income,32 (2) an accuracy-related penalty equal to 20 percent of the additional income tax (plus interest), and (3) a miscellaneous penalty equal to $2.75 million. The taxpayer also knows what she will get in return for her unquestioning acceptance of the penalty structure: a promise from the IRS that it will not recommend her to the Department of Justice for criminal prosecution.33 Without the predictable and mechanical application of the 2012 OVDP penalty structure, this taxpayer would likely be paralyzed with fear of criminal prosecution and uncertainty regarding her potential exposure to civil penalties.34 There is another cost associated with the predictability of the OVDP that is harder to quantify than the miscellaneous penalty: the potential impact of the program on permanent residents, substantial presence residents and new citizens of the United States. The following is an overview of some of the

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problems associated with the “one size fits all” OVDP penalty structure for new United States citizens and residents:

A. The transition to the United States income tax regime is sudden. New permanent residents, substantial presence residents and new citizens of the United States typically have no idea that they are subject to U.S. income tax on their worldwide income immediately following a sudden change in immigration or tax status (the “triggering event”). The following fact pattern, loosely based on one of our OVDP cases, illustrates how a “triggering event” can have a dramatic impact on a taxpayer’s U.S. income tax compliance: Example 1: John is a citizen and lifetime resident of the Cayman Islands. Mary, John’s wife, is a U.S. citizen who lived and worked in the Cayman Islands for approximately 25 years (1980-2005). John and Mary met in the Cayman Islands and were married in 1985. Mary moved back to the United States in 2004 and asked John to join her after he obtained his green card. John applied for his green card in October 2004 and received his green card in February 2005. As soon as John received his green card, he joined Mary in the United States. John sold his home in the Cayman Islands in March 2005 and did not report the proceeds from the sale of his home on his U.S. income tax return for that or any other year. There is no income tax in the Cayman Islands. John and Mary both filed their 2005 U.S. income tax returns as “married, filing separately.” John’s capital gain on the sale of the house—after application of the Code Sec. 121 exclusion for sale of a principal residence—is approximately $750,000. If John sold the Cayman Islands property before receiving his green card, he would have owed no income tax to Cayman Islands or the United States. If John had sold his home in the Cayman Islands in January 2005 instead of March 2005, then there would not be any U.S. or Cayman Islands income tax liability associated with the sale. John did not become subject to the U.S. worldwide income tax regime until February 2005, which is when he received his green card. Therefore, the fact that John sold his house one month after receiving his green card subjected him to U.S. capital gains tax on $750,000. Timing is everything,

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January–February 2013 in that account is treated—within the confines of the OVDP penalty structure—exactly the same as a retired middle-class government employee from India with $100 in unreported interest income in his Indian savings accounts. IRS examiners do not have the discretion to mitigate the miscellaneous penalty or the accuracy-related penalty on the basis of reasonable cause: if a taxpayer wants to participate B. New permanent residents and in the OVDP, then she will have to pay the flat-rate substantial presence residents often penalties without mitigation, regardless of the reasons for his or her noncompliance. do not retain qualified tax counsel In an attempt to mitigate the harsh financial imin the United States or abroad pact of the OVDP penalties on taxpayers whose to assist in the transition to U.S. noncompliance is completely unintentional, the income tax laws. IRS offers the possibility of “opting out” of the OVDP penalty structure As Example 1 illustrates, to request mitigation of John needed to consult civil penalties on the bawith competent tax counIRS examiners do not have sis of “reasonable cause” sel prior to transitioning the discretion to mitigate the in a full-scale audit. As to the United States in miscellaneous penalty or the will be discussed in secorder to minimize his U.S. tions D and E of Part III, income tax exposure. A accuracy-related penalty on the below, the “risk calculus” competent tax profesbasis of reasonable cause: if a for permanent residents, sional in the Cayman taxpayer wants to participate in substantial presence resiIslands who is familiar dents, and new citizens of with the U.S. income tax the OVDP, then she will have to the United States—with regime would have told pay the flat-rate penalties without respect to both the initial John to liquidate all of mitigation, regardless of the reasons decision to participate in his foreign assets prior the OVDP and the subto applying for his green for her noncompliance. sequent decision to “opt card. Without adequate out” of the OVDP—is tax counsel, John had no fundamentally different than the “risk calculus” for way of anticipating the disastrous tax consequences lifetime U.S. citizens. resulting from an earlier-than-expected approval of his green card application. As Nina Olsen, National D. Permanent residents, substantial Taxpayer Advocate, states in the Taxpayer Advocate presence residents and new U.S. 2011 Report to Congress, the inability of international taxpayers to access tax advice and other IRS services citizens are more likely to apply for from abroad contributes to “growing confusion and participation in the OVDP because frustration about U.S. tax administration.”36 and a difference of two months in the sale of John’s house could have reduced his U.S. capital gains by $750,000. This example illustrates just how difficult it can be for foreign nationals to minimize their U.S. income tax exposure by liquidating all of their foreign assets prior to the “triggering event” that subjects them to U.S. income tax on their worldwide income.35

C. Noncompliance for permanent residents and new U.S. citizens is usually unintentional. One problem with the predictably rigid OVDP penalty structure is that is does not account for the fundamentally different reasons for taxpayers’ noncompliance. A wealthy U.S. hedge fund manager who opens an account in the Cayman Islands with the intent to evade U.S. income tax on the earnings

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of fear of criminal prosecution and deportation.

Many permanent residents, substantial presence residents and new citizens of the United States are intimidated by the threat of criminal prosecution and deportation back to their country of origin. As Nina Olsen explains in the Taxpayer Advocate Annual Report to Congress, much of the fear surrounding the IRS’s ability and willingness to impose severe penalties on bad actors and benign actors alike is attributable to “tough talk” in the FAQs.37 Some of

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One Size Does Not Fit All this “tough talk” includes a threat that taxpayers who “do not submit a voluntary disclosure run the risk of detection by the IRS and the imposition of substantial penalties, including the fraud penalty and foreign information return penalties, and an increased risk of criminal prosecution.”38 Criminal prosecution for a U.S. permanent resident or “substantial presence resident” on a temporary visa will likely result in deportation back to the taxpayer’s country of origin.39 Thus, in consideration of this threatening posture of the IRS, the “risk calculus” of a new U.S. citizen or resident when deciding whether to apply for participation in the OVDP is fundamentally different from the “risk calculus” of a lifetime citizen of the United States. While a lifetime citizen of the United States with a small amount of unreported income who has not willfully failed to report her income may decide to take her chances by submitting a “quiet disclosure” or by not taking any action at all (“zero disclosure”), a new resident or citizen of the United States may decide that the risk of criminal prosecution, loss of employment in the United States and eventual deportation outweighs the potential cost savings associated with a quiet or zero disclosure. The following fact pattern, loosely based on another OVDP case in our inventory, illustrates the tension associated with this decision-making process: Example 2: Karthik was born and raised in India. He has two sons, both of whom were born and raised in India and are Indian citizens. Both sons moved to the United States when they turned 18 to attend college. After his youngest son moved to the United States in 2005, Karthik also moved to the United States. Karthik retained his Indian citizenship but became a permanent resident of the United States in August 2005. Karthik retained his Indian bank and brokerage accounts and did not report the earnings from these accounts on his U.S. income tax returns for tax years 2005 to 2011. Karthik hopes to become a citizen of the United States as soon as he resolves his income tax compliance problems. Karthik’s children both plan to become U.S. citizens and have no desire to return to India. Even though his failure to report his foreign income was not willful, Karthik is not willing to take his chances with a quiet or zero disclosure because the stakes are simply too high. If he does nothing or

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the IRS decides to examine the “quiet disclosure,” Karthik runs the risk of being criminally prosecuted and possibly deported back to India. A lifetime U.S. citizen who failed to report the same amount of income may feel more comfortable with the risks of a quiet or zero disclosure because she is confident that she could prevail if the IRS chose to prosecute and there are no attendant risks of deportation.40

E. The risks of “opting out” outweigh the benefits of potential penalty abatement. The IRS offers taxpayers the possibility of “opting out” of the OVDP penalty structure and subjecting themselves to full-scale audits after the voluntary disclosure is certified as complete, in which case the IRS promises that it will not recommend taxpayers who have “opted out” for criminal prosecution. After a taxpayer has been admitted to the program, the “risk calculus” involved in an opt-out decision—which appears to be so clearly defined in the 2012 OVDP FAQs41—is fundamentally different for a permanent resident or new U.S. citizen than for a lifetime citizen of the United States. Similar to the “risk calculus” associated with the initial decision to participate in the OVDP, the “risk calculus” associated with a permanent resident or new citizen’s decision to “opt out” is influenced by (1) the fear and uncertainty of civil penalties outside the OVDP42 and (2) the potential impact of a detailed, time-consuming and potentially expensive audit on the taxpayer’s immigration and employment status.

F. The requirements for the fivepercent penalty are too rigid. The eligibility requirements for the five-percent penalty are far too rigid to offer a meaningful mitigation of the OVDP penalty structure for the vast majority of new citizens and new residents of the United States. As addressed in the 2011 OVDI section, Part II.B.2 discussed earlier, the five-percent penalty is limited to cases (1) in which the taxpayer (a) did not open or cause the account to be opened, (b) exercised minimal, infrequent contact with the account, (c) has not withdrawn more than $1,000 from the account in any year (except for a withdrawal closing the account and transferring the funds to an account in the United States), and (d) can establish that all applicable U.S. taxes have been paid on funds deposited to the account; (2) in which the taxpayer is a foreign resident who is unaware that she is a U.S. citizen; and (3)

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January–February 2013 2. Exercised minimal, infrequent contact with the acin which the taxpayer is a foreign resident who (a) count: “[M]inimal, infrequent contact” is loosely resides in a foreign country, (b) made a good-faith defined in the FAQs as communications with the showing that he or she complied with tax filing and foreign financial institution “to request the account payment requirements in the foreign country, and balance, or update accountholder information such (c) has $10,000 or less of U.S. income each year.43 as a change in address, contact person, or email Two of the three categories of taxpayers that qualify address.”45 Again, this requirement is directed at for the five-percent penalty do not even apply to permanent residents, substantial presence residents the archetype of an inherited account. Most comor new citizens of the United States. The last two munications with a foreign financial institution, “foreign resident” categories are directed to U.S. especially in the case of foreign brokerage or other expatriate citizens who are either unaware that they investment accounts, are necessarily more involved are citizens or who have made every effort to comply then providing administrative details such as the with the tax requirements of their resident country.44 accountholder’s contact information. Furthermore, foreign accounts established for the management The first category is the only category under which costs of foreign real estate—even if all applicable permanent residents, substantial presence residents foreign taxes are paid on or new U.S. citizens can the rental income from qualify for the reduced In order to mitigate the draconian that real estate and there five-percent penalty. For is no U.S. income tax lithe reasons set forth later impact of the OVDP penalty ability after application of in this article, however, structure, the IRS should the foreign tax credit—will the first category is directimmediately consider adopting a disqualify all of the pared at inherited accounts ticipant’s accounts from and is too limited to offer “compliance gap” exception for eligibility for the five-permeaningful relief to the low-compliance-risk permanent cent penalty because of vast majority of new citiresidents, substantial presence the extent of activity in the zens and residents. Each account in the form of deof the four eligibility represidents, and less-than-five-year posits (rental income) and quirements under the first United States citizens. withdrawals (for mortgage category creates unique and/or maintenance costs). challenges for new U.S. 3. Did not withdraw more than $1,000 from the citizens and residents whose ownership of foreign account in any year: This requirement is also diaccounts did not originate from inheritance: rected at the archetype of an inherited account. 1. Did not open or cause the account to be opened: For example, foreign accounts established for There are some permanent residents, substantial the management costs of foreign real estate— presence residents, and new U.S. citizens who addressed in discussion of Requirement 2, did not open or cause the account to be opened above—will disqualify all of the participant’s acbecause the foreign account was inherited from counts from eligibility for the five-percent penalty a family member or opened by a family member because withdrawals from the account will likely as a joint or beneficiary account. Most new resiexceed $1,000 in any given year in order to pay dents and U.S. citizens, however, have opened mortgage and/or maintenance costs. accounts for themselves when they were living 4. All applicable U.S. taxes have been paid on in their countries of origin. These accounts may funds deposited to the account (if the deposited be in the form of current checking accounts, funds are subject to U.S. income tax): Answer savings accounts, brokerage accounts or other 52.1, Example 2, of the 2012 OVDP FAQs proinvestment accounts. Regardless of the parvides a fact pattern with an inherited account in ticular type of their accounts, these individuals which $40,000 was deposited into the account will not be eligible for the reduced five-percent in 1995, which precedes the eight-year scope of penalty if they opened or caused the account the OVDP period. In this situation, the taxpayer to be opened, even if they were not subject to “would have to identify the source of the deU.S. income tax laws at the time of the accounts posit and, if the source was taxable in the U.S., were opened.

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One Size Does Not Fit All prove that U.S. income tax was paid on those funds.”46 This requirement—although once again directed at an inherited account—does provide a much-needed exception for accounts seeded with funds not subject to U.S. income tax. If all the requirements for the reduced five-percent penalty were structured with the same sensitivity to the circumstances of the account’s initial opening (regarding the purposes of the account and whether the taxpayer was subject to U.S. income tax when the account was first opened), then new permanent residents, substantial presence residents and new U.S. citizens might have an opportunity for some relief from the severe miscellaneous penalty. Nina Olsen, National Taxpayer Advocate, shares the opinion that the five-percent penalty rate “is too narrow to apply in some sympathetic cases.”47

G. Relief for U.S. citizens living abroad is too narrowly drawn. On June 26, 2012, the IRS announced new streamlined filing procedures for nonresident U.S. taxpayers who present a “low compliance risk.”48 These new filing procedures enable nonfiling taxpayers with less than $1,500 in tax due in each tax year to file delinquent tax returns for the past three years and FBARs for the past six years. The relief for nonresident U.S. taxpayers—which in the vast majority of cases will apply to U.S. expatriates—is a step in the right direction, but does not go far enough. The IRS should immediately considering implementing a streamlined filing procedure for new citizens and residents caught in the “compliance gap” who are deemed to be a “low compliance risk” through a similar set of objective criteria. The details of this proposed “compliance gap” exception are explained in detail immediately below.

IV. A Possible Solution to the “One Size Fits All” Dilemma: The “Compliance Gap” Exception for Permanent Residents, Substantial Presence Residents and New Citizens of the United States The IRS can no longer stand behind the nondiscretionary rigidity of its “one size fits all” OVDP

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penalty structure. From the inception of the OVDP, the FAQs have repeated the mantra that “[v]oluntary disclosure examiners do not have discretion to settle cases for amounts less than what is properly due and owing.”49 In order to mitigate the draconian impact of the OVDP penalty structure on new residents and new citizens of the United States, the IRS should immediately consider adopting a “compliance gap” exception for low-compliance-risk permanent residents, substantial presence residents and lessthan-five-year United States citizens.

A. Eligibility for the “compliance gap” exception The “compliance gap” exception to the OVDP miscellaneous penalty would be limited to taxpayers who meet the following conditions: 1. Meet the immigration status test. Taxpayers must fall into one of the following categories for each of the eight full tax years preceding their voluntary disclosures to be considered for the “compliance gap” exception: a. Permanent residents: These individuals meet the permanent resident or “green card test” as set forth in Code Sec. 7701(b)(1)(A).50 b. “Substantial presence residents”: These individuals are residents of the United States who meet the “substantial presence test” as set forth in Code Sec. 7701(b)(3).51 c. “New” U.S. citizens: A “new” U.S. citizen would be defined as a foreign national who became a United States citizen less than five years prior to the date of her disclosure to the IRS. 2. Meet the “low compliance risk” test. In addition to the threshold eligibility requirements outlined above, a taxpayer must qualify as “low compliance risk.” The term “low compliance risk” for new U.S. citizens and residents would be defined the same as for U.S. expatriates: less than $1,500 in unreported income for each year in the eightyear disclosure period.52 Assuming that the taxpayer meets the immigration status and low-compliance-risk requirements, she will be eligible for participation in a streamlined amended filing program and penalty structure. The details of the new proposed program are as follows: 1. File amended income tax returns, FBARs and other information returns (or original returns, FBARs and information returns if not previously filed) for the eight full tax years preceding the disclosure;

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January–February 2013 2. Pay or make arrangements to pay the full amount of additional income tax (plus interest) for each of the eight years preceding the disclosure; and 3. Pay the “accuracy-related” penalty without mitigation (20 percent of additional tax) for each year in which additional income tax is due. Note that the “miscellaneous penalty” is conspicuously absent from the “compliance gap” streamlined procedures detailed above. This is because the “miscellaneous penalty” should not be imposed on benign actors who have been intimidated into OVDP participation by the IRS’s “tough talk” on consequences for deciding not to apply for a voluntary disclosure or opting out of the OVDP penalty structure after their preliminary acceptance to the program.

B. Public policy objectives of the compliance gap exception It may seem unfair to carve out an exception to the OVDP miscellaneous penalty on the basis of the taxpayer’s immigration status, but that is exactly what the IRS has already done for U.S. expatriates.53 A new set of streamlined criteria for new citizens and residents is necessary to retain the fundamental objective of the OVDP to promote compliance with U.S. income tax laws. The IRS acknowledges in its “Penalty Handbook” portion of the Internal Revenue Manual that “[a] wrong [penalty] decision, even though eventually corrected, has a negative impact on voluntary compliance.”54 Stated in the simplest possible terms, the imposition of the OVDP miscellaneous penalty on compliance gap taxpayers who meet the criteria set forth in Part IV.A above is the wrong penalty decision.

V. Conclusion New residents and new citizens of the United States have no lobbying power. They pay their income taxes just like lifetime citizens of the United States,

but they may not necessarily be aware of the requirement to report their worldwide income immediately after the “triggering event,” such as meeting the substantial presence test or receiving a green card. They may own certain accounts and assets in foreign countries that generate income subject to tax in the United States, but they might assume that this income is not subject to tax because (1) the seed funding for the account was not U.S.-source or (2) all foreign taxes have been paid on this income. These taxpayers are not bad actors intending to evade U.S. income tax; rather, they are benign actors caught in the “compliance gap.” In order to avoid the overly harsh imposition of a miscellaneous penalty inside the OVDP or a failureto-file FBAR penalty up to 50 percent of the account balance outside the OVDP,55 the IRS should offer these benign actors the opportunity to come forward under the “compliance gap exception” to the OVDP miscellaneous penalty. These taxpayers would apply for participation in the OVDP just like every other participant, but would be eligible for a complete elimination of the miscellaneous penalty if they can prove that they are a low compliance risk and meet the immigration status requirement as new citizens, permanent residents or “substantial presence” residents. The overarching objective of the OVDP is to promote voluntary compliance. Unfortunately for many new residents and citizens of the United States, the overarching impact of the OVDP has been to promote an atmosphere of fear and perceived hostility to international taxpayers. In order to mitigate the disproportionately harsh penalties on these benign actors in comparison to the relatively small amount of income tax noncompliance, the IRS should immediately consider adopting a “compliance gap exception” to the OVDP penalty structure. A failure to adopt such an exception will continue to undermine the incentive for new citizens and residents to comply with their U.S. income tax obligations.

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The views expressed in this article are the author’s own. The author would like to thank attorneys Morris Robinson and Amy Brown for their helpful commentary and editorial assistance. 2012 Offshore Voluntary Disclosure Program Landing Page, available at: www.irs.gov/ uac/2012-Offshore-Voluntary-DisclosureProgram (last visited November 14, 2012). Id. See, e.g., 2009 OVDP FAQs at A17, available at: www.irs.gov/uac/Voluntary-

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Disclosure:-Questions-and-Answers (last visited November 14, 2012) (“Taxpayers should not wait until the end of the 6-month period to make their voluntary disclosures as there is no guarantee that the taxpayer will still be eligible or that the current penalty terms will be available after 6 months.”). Prepared Remarks of IRS Commissioner Doug Shulman before the AICPA, Washington, D.C. (November 7, 2012), available at: www.irs.gov/uac/Newsroom/CommissionerDoug-Shulman-Speaks-at-AICPA-Meeting

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(last visited November 14, 2012). Id. (“We view offshore tax evasion as an issue of fundamental fairness. Wealthy people who unlawfully hide their money offshore aren’t paying the taxes they owe, while schoolteachers, firefighters and other ordinary citizens who play by the rules are forced to pick up the slack and foot the bill.”). U.S. citizens and resident aliens are subject to income tax on their worldwide income. The term “resident aliens” is defined as permanent residents (green card holders),

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One Size Does Not Fit All ENDNOTES

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foreign nationals who meet the “substantial presence test” set forth in Code Sec. 7701(b) (3), and foreign nationals who make a firstyear election to be taxed as a resident of the United States. For the purposes of simplicity, this article will only focus on the U.S. income tax requirements for new U.S. citizens, permanent residents and “substantial presence” residents. See Code Sec. 7701(b)(1)(A). See Shulman, supra note 5 (“In a typical year, we used to get 100 or so taxpayers who used our voluntary disclosure program. When we first set up our new program in 2009, we thought that figure would rise to maybe 1,000.”). See IRS News Release, IR-2011-14, Feb. 8, 2011: Second Special Voluntary Disclosure Initiative Opens; Those Hiding Assets Offshore Face August 31 Deadline , available at: www.irs.gov/uac/Second-SpecialVoluntary-Disclosure-Initiative-Opens%3BThose-Hiding-Assets-Offshore-Face-Aug.31-deadline (last visited Jan. 13, 2013). See generally 2009 OVDP FAQs, supra note 4. Id. at A6 (providing a hyperlink to the 2009 OVDP “Optional Format Letter”). The optional format letter requests, among other information, the source of funds in the foreign account(s) and disclosure of whether the taxpayer is currently under investigation by any law enforcement authority. Id. Id. at A13 (“A taxpayer is expected to file correct delinquent or amended tax returns for tax year 2008 back to 2003.”). Id. at A25. It is possible for a taxpayer who is unable to make a full payment of the income tax (plus interest), accuracy-related penalty (plus interest) and the “offshore penalty” to make arrangements to pay such as an installment agreement. See 2009 OVDP FAQs, supra note 4 at A27 (“The burden will be on the taxpayer to establish inability to pay, to the satisfaction of the IRS, based on full disclosure of all assets and income sources, domestic and offshore, under the taxpayer’s control.”). Id. at A12 (including interest on the income tax in the taxpayer’s hypothetical liability). Id. at A12; Code Sec. 6662(d)(1). 2009 OVDP FAQs, supra note 4 at A36. Id. at A12 (listing an “additional penalty, in lieu of the FBAR and other potential penalties that may apply” equal to 20 percent of the highest aggregate account balance). 2011 OVDI FAQs, available at: www.irs.gov/ Businesses/International-Businesses/2011Offshore-Voluntary-Disclosure-InitiativeFrequently-Asked-Questions-and-Answers (providing that FAQs 1 to 53 were posted on February 8, 2011). Id. at A24.1. Id. at A7. Id. at A7 (listing the three different penalty rates); A52 (detailing the requirements for

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26 27

28 29 30

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the five-percent penalty); A53 (detailing the requirements for the 12.5-percent penalty). Id. at A9. See IRS News Release, IR-2012-5, Jan. 9, 2012: IRS Offshore Programs Produce $4.4 Billion to Date for Nation’s Taxpayers; Offshore Voluntary Disclosure Program Reopens, available at: www.irs.gov/uac/ IRS-Offshore-Programs-Produce-$4.4Billion-To-Date-for-Nation%E2%80%99sTaxpayers;-Offshore-Voluntary-DisclosureProgram-Reopens. 2012 OVDP FAQs at A1, available at: www. irs.gov/Individuals/International-Taxpayers/ Offshore-Voluntary-Disclosure-ProgramFrequently-Asked-Questions-and-Answers (last visited November 15, 2012). Id. at A7. See id. at A7 (listing the three different penalty rates); A52 (detailing the requirements for the five-percent penalty); A53 (detailing the requirements for the 12.5-percent penalty). Id. at A9. Id. FBARs for the preceding calendar year are due on June 30 of each current calendar year. See Form TD F 90-22.1, General Instructions, available at: www.irs.gov/pub/ irs-pdf/f90221.pdf. This deadline cannot be extended. Id. 2012 OVDP FAQs, supra note 25 at A2. The actual amount of this taxpayer’s income tax liability depends on a variety of factors, including but not limited to, the amount (if any) of foreign taxes paid on this income, other deductions and credits to which the taxpayer may be entitled and the taxpayer’s tax bracket. See 2012 OVDP FAQs, supra note 25, at A3. Although the IRS promises that it will not recommend OVDP participants for criminal prosecution, the United States Attorney “may initiate . . . direct prosecution of direct referral matters without first obtaining Tax Division approval. U.S. Attorney Manual 6-4.243, available at www. justice.gov/usao/eousa/foia_reading_room/ usam/title6/4mtax.htm#6-4.243 (last visited January 22, 2013) (listing the direct referral matters that the U.S. Attorney can prosecute without Tax Division approval). Furthermore, the Internal Revenue Manual’s position regarding criminal prosecution for voluntary disclosure participants is less reassuring than the IRS’s position as set forth in A3 of the 2012 OVDP FAQs. See I.R.M. 9.5.11.9(1) (“[A] voluntary disclosure will be considered with all other factors in the case in determining whether criminal prosecution will be recommended.”). The Internal Revenue Manual also states that “a voluntary disclosure will not automatically guarantee immunity from prosecution.” Id. at 9.5.11.9(2).

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31 U.S.C. §5321(a)(5)(C); see also U.S. v. Mary Estelle Curran, Plea Agreement at ¶12, No. 12-80206-CR-RYSKAMP (S.D. Fl. Jan. 8, 2013) (taxpayer agreed to accept a civil penalty for failing to file FBARs of approximately $21.6 million, which represents 50 percent of the highest year-end balance of her undisclosed foreign accounts from the period 2001 to 2007); David Voreacos and Susannah Nesmith, UBS Client Pleads Guilty in Largest Tax Case Since 2008, BLOOMBERG, Jan. 9, 2013, available at www.bloomberg.com/ news/2013-01-08/ubs-client-pleads-guiltyin-u-s-tax-case-in-florida.html (last visited January 22, 2013) (discussing Mary Estelle Curran’s guilty plea). Even without a green card, resident aliens in the United States will be subject to income tax on their worldwide income if they meet the “substantial presence test” set forth in Code Sec. 7701(b)(3)(B). See Code Sec. 7701(b)(3)(A) (an individual will meet the “substantial presence test” if she is present in the United States for at least 31 days in the calendar year, and a total of 183 days using the weighted multiplier of 1 for the current year, 1/3 for the first preceding year, and 1/6 for the second preceding year). Nina Olsen, TAXPAYER ADVOCATE SERVICE, 2011 Annual Report to Congress, Vol. 1 at 182, available at: www.taxpayeradvocate.irs. gov/Media-Resources/FY-2011-AnnualReport-To-Congress-Full-Report (last visited November 16, 2012). Id. at 195. 2012 OVDP FAQs, supra note 25, at A4. See, e.g., Julia Preston, Agents’ Union Stalls Training on Deportation Rules, N.Y. TIMES (Jan. 7, 2012), available at: www.nytimes. com/2012/01/08/us/illegal-immigrantswho-commit-crimes-focus-of-deportation. html?pagewanted=all (last visited November 16, 2012). But see United States Department of Justice, Bank Director Charged with Hiding Foreign Assets (May 19, 2011), available at: www. justice.gov/tax/txdv11642.htm (concerning the criminal prosecution of a taxpayer’s failed attempt at a “quiet disclosure”). See, e.g., 2012 OVDP FAQs, supra note 24 at A51.1. See generally, 31 U.S.C. §5321 (detailing FBAR penalties). 2011 OVDI FAQs, supra note 19 at A52. The 2012 OVDP FAQs are substantially identical to the 2011 OVDI FAQs with respect to the eligibility for the reduced five-percent miscellaneous penalty. See 2012 OVDP FAQs, supra note 25, at A52. 2012 OVDP FAQs, supra note 25 at A52.2 & A52.3 (both addressing situations involving U.S. citizens living in other countries). Id. at A52.1. Id. at A52.1, Example 2 (emphasis added). Nina Olsen, NATIONAL TAXPAYER ADVOCATE,

January–February 2013 ENDNOTES 48

supra note 36 at 194 n.17. See IRS, Instructions for New Streamlined Compliance Procedures for Non-Resident, Non-Filer U.S. Taxpayers (Aug. 31, 2012), available at: www.irs.gov/uac/Instructionsfor-New-Streamlined-Filing-ComplianceProcedures-for-Non-Resident-Non-Filer-US-

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Taxpayers (last visited November 16, 2012). Compare 2009 OVDP FAQs, supra note 4 at A35 with 2011 OVDI FAQs, supra note 19 at A50 and 2012 OVDP FAQs, supra note 25 at A50 (identical language). Code Sec. 7701(b)(1)(A). Id. Code Sec. 7701(b)(3); see also supra note

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34. See supra note 48 and accompanying text. See supra note 48 and accompanying text. IRM 20.1.1.1.3 (4)(C) (Dec. 11, 2009) (cited by Nina Olsen, TAXPAYER ADVOCATE SERVICE, supra note 36 at 194n.20). See 31 U.S.C. §5321(a)(5)(C).

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