The U.S. Internal Revenue Service (IRS) recently announced a special voluntary disclosure initiative that should be of particular interest to U.S. citizens resident in Canada. According to the IRS press release dated February 8, 2011, the 2011 Offshore Voluntary Disclosure Program (OVDP) is "designed to bring offshore money back into the U.S. tax system and help people with undisclosed income from hidden offshore accounts get current with their taxes." If you are a U.S. citizen resident in Canada, and you have simple banking relationships in Canada such as chequing accounts, savings accounts and RRSPs, you might not think that this program has any relevance to you. After all, you probably don't consider Canada to be an "offshore" tax haven and you probably have never attempted to "hide" any income from the IRS. However, a closer look at the U.S. income tax filing requirements and foreign bank account disclosure requirements for U.S. citizens living in Canada might reveal that you have unfulfilled obligations with the IRS. If so, it is likely in your best interests to come forward voluntarily, using the 2011 OVDP or one of the IRS's other voluntary disclosure mechanisms.
This is not the first time the IRS has offered a "special" voluntary disclosure program for offshore accounts. The previous program ended on October 15, 2009, and was a resounding success as more than 15,000 voluntary disclosures were made. The IRS had expected only about 1,000. The IRS has also been clear about its focus on the tax compliance of U.S. taxpayers with international tax matters, as evidenced by IRS Commissioner Doug Shulman's comments in the OVDP press release:
As we continue to amass more information and pursue more people internationally, the risk to individuals hiding assets offshore is increasing. This new effort gives those hiding money in foreign accounts a tough, fair way to resolve their tax problems once and for all. And it gives people a chance to come in before we find them.
Clearly, the IRS is focused on U.S. taxpayers with international tax matters. However, you might still be asking yourself how this impacts you.
What U.S. tax filing obligations are included in the OVDP?
U.S. citizens living outside the U.S. are still required to file U.S. tax returns annually with the IRS. This requirement is due to the fact that, in addition to taxing its residents, the U.S. also continues to tax its citizens regardless of where they live in the world. In most cases, the average U.S. citizen living in Canada has no U.S. source income and ultimately there is no U.S. income tax on the U.S. tax return. In such cases, the annual U.S. tax filing obligation is really just an administrative requirement that goes along with being a U.S. citizen. That said, the assumption that there will be no tax on the U.S. tax return has caused many people to become complacent in respect of these filings, and some individuals have ceased filing their U.S. returns altogether. While it is beyond the scope of this article to provide a complete listing of all of the U.S. filing requirements for U.S. citizens in Canada, a few of the more common items, beyond the personal tax return, are listed below.
1. TDF 90-22.1 - Report of Foreign Bank and Financial Accounts (FBAR): U.S. citizens, residents and certain other U.S. persons must report annually their direct or indirect financial interest in, or signature authority over, a financial account that is maintained with a financial institution located in a foreign country if, for any calendar year, the aggregate value of all foreign accounts exceeded $10,000 at any time during the year.
2. 3520 - Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts: Taxpayers must report various transactions involving foreign trusts, including creation of a foreign trust by a U.S. person, transfers of property from a U.S. person to a foreign trust, and receipt of distributions from foreign trusts.
3. 3520A - Information Return of Foreign Trust with a U.S. Owner: Taxpayers must also report ownership interests in foreign trusts by U.S. persons with various interests in, and power over, those trusts.
4. 5471 - Information Return of U.S. Persons with Respect to Certain Foreign Corporations: Certain U.S. persons who are officers, directors or shareholders in certain foreign corporations are required to report specific information related to the corporation.
Again, this is not an exhaustive list. However, if any one of these items applies to you and you have not already addressed the related U.S. tax reporting obligations, you should seek a complete understanding of your obligations. It may be advisable to take advantage of one of the IRS's voluntary disclosure programs.
What are the potential penalties outside the OVDP?
The IRS has the ability to impose substantial penalties for non-compliance. For example, the civil penalty for willfully failing to file an FBAR can be as high as the greater of $100,000 or 50% of the total balance of the foreign account. Even "non-willful" FBAR violations that the IRS determines were not due to reasonable cause are still subject to a $10,000 penalty per violation. In addition to "failure to file" penalties like the one above, the IRS may also impose a penalty for "failure to pay the amount of tax," and an "accuracy-related" penalty. In some cases, violations can even lead to criminal prosecution. Compounding the severity of these penalties is the fact that they generally apply to each tax year in question, so multiple years of non-compliance could lead to a significant accumulation of penalties, sometimes in excess of the underlying assets to which the reporting relates. These are just some of the potential penalties, but they demonstrate the significance and severity of the consequences an individual could face if caught by the IRS with unfulfilled U.S. tax filing obligations.
What relief is provided by the OVDP?
The OVDP does not provide complete relief from any and all penalties. Instead, the OVDP provides a framework to reduce significantly the magnitude of the penalties, as well as the number of penalties that would otherwise apply. The OVDP takes into account eight taxation years from 2003 to 2010 (the "look-back" period). For a Canadian resident U.S. citizen who has failed to report foreign bank accounts on an FBAR and has failed to disclose the income from these accounts on a U.S. tax return, the OVDP process limits the penalties to a one-time 25% penalty on the highest aggregate annual balance in the unreported accounts during the entire look-back period, and a 20% accuracy-related penalty or delinquency penalties on U.S. income tax that should have been paid on any unreported income. If the "offshore" accounts did not exceed $75,000 in any relevant calendar year, the 25% penalty could be reduced to 12.5%. In certain limited circumstances, such as foreign residents who were unaware of their U.S. citizenship, the penalty could be reduced further to 5%. Furthermore, if the unreported income was subject to income tax in the foreign jurisdiction, a foreign tax credit may be available to reduce or eliminate the U.S. tax, thereby limiting or altogether eliminating the penalties associated with unpaid U.S. tax. While the OVDP does not provide relief from all penalties, clearly it provides a more reasonable alternative for many taxpayers with delinquent U.S. tax filings.
What if I only failed to file FBARs?
The OVDP may not be the right program for all situations in which taxpayers have failed to meet their tax filing obligations with the IRS. There are even some scenarios in which the IRS has gone so far as to recommend other approaches where the taxpayer's fact pattern does not fit into the profile of those targeted by the OVDP. By way of example, consider a Canadian resident U.S. citizen who has always filed U.S. tax returns on a timely basis (including properly reporting the income from foreign bank accounts) but was unaware of the annual requirement to file the FBAR. In this case, the IRS states specifically that the voluntary disclosure process is meant to "provide a way for taxpayers who did not report taxable income in the past to come forward voluntarily and resolve their tax matters. Thus, if you reported and paid tax on all taxable income but did not file FBARs, do not use the voluntary disclosure process." Instead, the IRS recommends preparing and filing all delinquent FBARs and attaching a statement explaining why the reports were filed late. It is the IRS's practice in this situation not to impose a penalty for the failure to file FBARs if there are no underreported tax liabilities and the FBARs are filed by August 31, 2011.
What is the process required by the OVDP?
The current OVDP is available to taxpayers who come forward by August 31, 2011. The IRS has established a robust process that must be followed by the taxpayer. The process includes submitting all original and amended tax returns and information returns (i.e. FBARs) for the eight-year look-back period, paying all taxes and related late-payment interest, paying the one -time penalty on the highest aggregate annual balance in the unreported foreign accounts, and paying the accuracy-related penalty or delinquency penalties as applicable on the unpaid taxes for each year. The OVDP process requires substantial preparation and diligence to properly assess which tax filing obligations were missed, which penalties should apply, and how to comply with the disclosure program itself. This fact, coupled with the complexity of the income tax filings and the significance of the potential penalties, makes it important for taxpayers to seek professional tax advice before approaching the IRS.
In these challenging financial times, governments are seeking to capture as much revenue as possible, and the U.S. clearly is no exception. The IRS has been explicit in its public communications that it has devoted, and will continue to devote, significant resources towards identifying taxpayers abroad that have failed to meet their U.S. tax filing obligations. If you are a U.S. citizen living outside the U.S., and you believe that you may have outstanding U.S. tax filing obligations, you should seek assistance to understand your filing obligations sooner rather than later. The 2011 OVDP process may provide you with the most reasonable approach to getting back onside.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.