Canada: Internal Revenue Service Announces Guidance For U.S./Canadian Dual Citizens With Unreported Offshore Accounts

Summary Overview

Recent expectations about an announcement by the Internal Revenue Service (the "Service") that it would be providing broad relief to certain Canadians who failed to file foreign bank account reports ("FBARs") and U.S. tax returns appear to have been overly optimistic. The Service recently issued this guidance (click here to view the full announcement). Rather than providing any new relief to Canadian residents or citizens who also happen to be U.S. citizens who fail to file FBARs and U.S. tax returns, the guidance largely reiterates the rules already in existence.

The Service's announcement comes on the heels of a widely reported letter sent by Canadian Finance Minister Jim Flaherty to the U.S. government in which he criticized the U.S. requirement that dual citizens file FBARs providing information about their Canadian bank accounts and the onerous penalties for failures to comply with this requirement, which can be as high as 50% of the highest account balance for each of the past six years. One problem was that these penalties can apply even if the person owes no U.S. federal income tax. Flaherty's letter pointed out that most of these Canadians were fully reporting the income on their accounts to Canada and were not aware of any U.S. requirement to file FBARs until recently. Flaherty particularly criticized the treatment many Canadians were experiencing under the Offshore Voluntary Disclosure Program (the "OVDP"), which did not distinguish between tax evaders and innocent taxpayers living abroad who used foreign bank accounts for all of their ordinary banking activities.


By way of background, in 2009, the Service commenced the OVDP, an amnesty program for U.S. persons with undisclosed foreign accounts. The Service adopted a second, similar OVDP that ended on September 9, 2011. Under both of those programs, a U.S. person was required to disclose his or her foreign accounts, file amended returns from 2003 until the time of disclosure reporting the income from those accounts, pay interest on any tax liability owed, and pay a penalty calculated at 20%, under the 2009 OVDP (or 25% under the 2011 OVDP), of the highest account balance for the foreign accounts for the years covered by the disclosure. In exchange, the U.S. person was generally to be protected from criminal prosecution, even if the U.S. person later withdrew from the program.

Taxpayers who voluntarily file late tax returns and FBARs outside of the OVDP continue to face significant uncertainty and the risk that the Service will seek to impose onerous penalties. Recent news articles suggested that dual citizens who had failed to file FBARs would be afforded relief from draconian penalties under the statute and offered a path to correcting past noncompliance that was more reasonable than the one available under the OVDP. Viewed in that light, the announcement is disappointing. Rather than providing any real certainty, it merely reviews the existing legal and administrative standards for penalty imposition on prior failures by a dual citizen to file returns and FBARs and notes that a facts-and-circumstances approach will continue to apply. However, the guidance does include a couple of examples of how the Service might, in its discretion, find that penalties are not appropriate in cases involving taxpayers living abroad who were not aware of their U.S. tax obligations. These examples could apply if a dual citizen files late returns and FBARs and is audited or if such dual citizen makes a voluntary disclosure under the Service's informal voluntary disclosure practice, which is now clearly still available even though the time for the OVDP has expired.

Details of the Announcement

The announcement makes clear that dual citizens are required to file U.S. federal income tax returns and FBARs. The announcement states that if a dual citizen files such returns and owes no U.S. federal income tax because of the foreign income exclusion or the foreign tax credit, the dual citizen will not be subject to failure to file or failure to pay penalties. These penalties are calculated on the amount of tax due, so this just reflects existing law.

The announcement also explains that these dual citizens are required to file FBARs and the penalties for failure to file. The Service points out that the 50% penalty will only apply to a failure to file if the failure was willful. If a failure to file was not willful but lacked reasonable cause, the taxpayer may be subject to a maximum $10,000 penalty per violation. However, the announcement notes that internal Service guidelines direct agents to mitigate or waive the penalty in situations where imposing the penalty is determined not to be necessary to induce future compliance. This penalty framework is not new, but the reference to the internal mitigation guidelines should at least alleviate concerns that the harsh OVDP penalty structure was going to become the internal Service penalty guideline.

The announcement also includes examples indicating when the taxpayer owes no U.S. tax (e.g., because of foreign tax credits for Canadian taxes paid by the taxpayer), the Service is prepared to accept a claim of reasonable cause by a taxpayer resident outside the United States based solely on the taxpayer's claim of ignorance of the FBAR filing requirement. Unfortunately, the examples suggest that this conclusion may not apply in all cases and could depend on the facts and circumstances, such as whether the taxpayer's background and education indicate that the taxpayer should have been aware of the filing requirement. In addition, it is unclear whether the Service would accept ignorance of the law as reasonable cause in situations where the taxpayer has an unsatisfied U.S. tax liability, particularly if the amount owed is not de minimis.

What Avenues Forward?

Many dual citizens with undisclosed foreign accounts did not make a disclosure under either OVDP before their expiration dates. Accordingly, they have operated under the assumption that they are no longer able to do so and are unsure what to do about their undisclosed foreign accounts. These persons should be aware that, although the OVDPs have ended, the Service has a long-standing practice of allowing voluntary disclosures.

The Service practice is to allow a voluntary disclosure and to consider such disclosure along with all other factors in an investigation in determining whether criminal prosecution will be recommended. This practice extends to a disclosure of any tax issue and is not limited to offshore accounts. While protection from criminal prosecution is not guaranteed, the disclosure will generally result in criminal prosecution not being recommended.

A significant difference from the OVDP is that the format of the disclosure under the Service practice is not specified. Instead, the disclosure can take various forms so long as (i) the communication is truthful, timely, and complete; (ii) the disclosing person shows a willingness to cooperate (and does cooperate) with the Service in determining his or her tax liability; and (iii) the disclosing person makes good faith arrangements with the Service to pay in full the tax, interest, and any penalties the Service determines to be applicable. Under the practice, therefore, the penalties asserted are not limited to the 20% or 25% provided under the OVDPs.

Like the OVDPs, under the Service's practice, a disclosure must take place before the Service has initiated a civil or criminal investigation of the taxpayer or has notified the taxpayer that it intends to open an examination or investigation, the Service has received information from a third-party regarding the taxpayer's noncompliance with the tax laws, the Service has initiated a civil or criminal investigation directly related to the specific liability of the taxpayer, or the Service acquired information directly related to the specific liability from a criminal enforcement action.

The Service practice lacks the delineated civil penalty protections of the OVDP and may not be attractive to many U.S. persons with foreign accounts. However, it is an option available to dual citizens that may reduce the risk of criminal prosecution. Whether a dual citizen chooses to make a voluntary disclosure under the Service practice or is subject to penalties on audit, the new announcement by the Service provides some guidance to how that dual citizen can expect to be treated but does not provide the clear path to avoid penalties for which many were hoping.

It remains to be seen whether any further relief will be forthcoming. Some have suggested that the Service should consider altogether exempting Canadians from FBAR filing requirements with respect to their Canadian bank accounts, perhaps on the ground that the requirements are inconsistent with the intent of the non-discrimination provisions of the Canada-U.S. Income Tax Convention.

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.

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