On January 9, 2012 the Internal Revenue Service ("IRS") issued a statement that contains two very important announcements for Canadian residents who have US tax and filing obligations: first, it will shortly issue new instructions to bring unfiled returns current for taxpayers who owe no US tax; and second, it indefinitely extends the basic terms of the 2011 Offshore Voluntary Disclosure Initiative ("OVDI" or "IRS amnesty program"), which allowed taxpayers to file delinquent returns and pay a reduced penalty. Thus, it appears Mr. Flaherty's promise of relief for Canadian residents made on December 2 of last year is coming to fruition.
What this means for Canadian residents is that they now have options for bringing unfiled returns current. The first step is to prepare the past eight years of returns and determine whether any US tax is due. If no tax is due, then it may make sense to participate in the newly announced program (though the details of the program are not yet available). If some tax is owed, it may make sense to participate in the new OVDI. Each case is unique and needs to be evaluated on its own merits, so what may make sense for one person may not for another.
Canadian residents with these filing obligations should act now to bring filings current. The onerous failure to file penalties can be reduced to zero under the doctrine of "reasonable cause." Reasonable cause can exist when the individual simply did not know about the filing obligations. As media exposure increases on filing requirements it will become increasingly difficult to rely on ignorance as a defense to the imposition of penalties.
The US tax code as it applies to those residing outside the US is punishingly complex. Publication 4732, Federal Tax Information for US Taxpayers Living Abroad illustrates this complexity. The publication refers to at least eight other IRS publications and 667 pages of forms for a total of 7,322 pages.
The US requires its citizens and residents to file returns and pay tax on their worldwide income. However, according to statistics released last week, only about 11 percent of those residing outside of the US filed returns. Of those returns that were filed, only nine percent of them showed a US tax obligation.
It is Not the Taxes, it is the Penalties
Tax obligations, however, are only a minor part of the problem for non-filers. The US requires the filing of many other forms on which no tax is due. The failure to file these forms can trigger penalties that can be financially ruinous. For example, the failure to file the Foreign Bank Account Report carries a $10,000 penalty if the failure was not willful, and enhanced monetary and criminal penalties if the failure was willful. There are numerous other forms that carry $10,000 penalties if not filed when due.
"Reasonable Cause" Defense to Penalties
Most of these onerous penalties may be reduced to zero provided the taxpayer can prove reasonable cause for not filing. Reasonable cause is a legal doctrine, the application of which is determined by all of the facts and circumstances surrounding the taxpayer's failure to file. Particular facts that support its application are found in case law, administrative interpretations, the statutes, and the treasury regulations.
Depending on the particular facts, one of the theories that may support a finding of reasonable cause is that the taxpayer was unaware of his filing obligations. In guidance published in December, the IRS lists facts that the IRS will, apparently, weigh more heavily than others in determining whether being unaware is sufficient to support the reasonable cause argument, including:
- The taxpayer's education;
- Whether the taxpayer has previously been subject to the tax for which the return has not been filed;
- Whether the taxpayer has been penalized before;
- Whether there were recent changes in the tax forms or law the taxpayer could not reasonably be expected to know; and
- The level of complexity of a tax or compliance issue.
In the same guidance the IRS issued in December, the IRS gave several examples, the facts of which support a finding of reasonable cause, the most telling of which is Example 4. Under Example 4 the IRS concludes that reasonable cause is shown based on the following facts:
- The taxpayer complied with tax filing and payment obligations in his country of residence;
- He was previously unaware of his US filing obligations;
- After discovering his US filing obligations he filed his previously unfiled returns;
- He attached a statement to his returns setting forth his reasonable cause argument;
- He had a legitimate reason for maintaining non-US accounts;
- There was no indication that he had taken efforts to intentionally conceal the reporting of income or assets; and
- There was no additional US tax due.
In making the reasonable cause argument, it is critically important to analyze the facts, support the facts with affidavits or other evidence, and to make sure that the facts are supported by existing law. If the facts are either false or misleading, the IRS could charge the individual with criminal tax evasion.
The good news is that we now have good guidance as to what facts will support reduction of penalties. Further, it appears that the IRS appears to be listening to the impassioned arguments made by Mr. Flaherty and others who have been affected.
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.