Canada: IRS Offers Partial Tax Amnesty For Canadians With "Low Compliance Risk," Though Questions Remain

On June 26, 2012 the IRS announced new procedures that will enable non-resident US taxpayers who demonstrate "low compliance risk" to bring unfiled tax returns and related tax reporting obligations current and avoid potentially ruinous penalties. The new procedures will become effective September 1, 2012 and further details will be announced in advance of that date. While this is welcome news, it is unclear who will be eligible to participate and what constitutes "low compliance risk."

The IRS also announced that the new procedures will allow taxpayers who hold Registered Retirement Savings Plans ("RRSPs"), or certain other foreign retirement plans, to seek relief for failure to make timely elections under a tax treaty to defer the income earned in such retirement plans. Such details will be discussed in a separate article.

Mechanics of the New Procedures

For those taxpayers who are "low compliance risk," the new procedures appear to be relatively straightforward and require the submittal of the following:

  1. Three years of tax returns and related information returns;
  2. Six years of IRS form TD F 90-22.1, Report of Foreign Bank and Financial Accounts ("FBAR");
  3. A statement dated and signed under penalties of perjury that sets forth the taxpayer's reasonable cause argument for previous failures to file;
  4. Payment of any federal tax and interest due thereon; and
  5. Additional information and disclosures, the details of which will be announced before the effective date of September 1, 2012.

For those who qualify, the new procedures promise expedited review, no penalties and no follow-up action by the IRS. The new procedures represent a substantial improvement for qualifying taxpayers who, until now, had few viable options to bring their US tax return and related filing obligations current.

Only those Taxpayers who are "Low Compliance Risk" are Eligible

The IRS's announcement makes clear that the new procedures will apply only to those taxpayers who are "low compliance risk." The announcement states:

"Submissions that present higher compliance risk are not eligible for the procedure and will be subject to a more thorough review and possibly a full examination, which in some cases may include more than three years..."

Therefore, before taxpayers decide to avail themselves of the new procedures, they must carefully examine their affairs for purposes of determining whether they have low compliance risk and are therefore eligible to participate.

If a taxpayer mistakenly concludes he is a "low compliance risk" and the IRS determines otherwise, the result could be a full examination or audit of greater than the three tax years submitted under the new procedures.

Further, the IRS reserves the right to impose tax, penalties and interest if it determines that the taxpayer does not constitute a "low compliance risk." Thus, it should be clear that the new procedures are not a true "amnesty" and the penalty abatement is available only if the taxpayer is a "low compliance risk," or if the taxpayer qualifies for a statutory defense to the penalties. Further, the new procedures do not provide protection from criminal prosecution.

The announcement states in part:

"Tax, interest, and penalties, if appropriate will be imposed in accordance with U.S. federal tax laws based on a review of the submission."

"Taxpayers who are in a situation where they are concerned about the risk of criminal prosecution should be advised that this new procedure does not provide protection from criminal prosecution . . ."

Definition of "Low Compliance Risk"

"Low compliance risk" will be predicated on "simple returns with little or no US tax due" and there are no indicia of "high risk factors."

"Simple returns with little or no US tax due"

The announcement does not define the criteria the IRS will use to determine whether a return is "simple." Any taxpayer living abroad who has prepared tax returns (or paid to have them prepared) will attest that these returns are far from simple. Further, in the National Taxpayer Advocate 2011 Annual Report to Congress, the IRS acknowledged that the returns required by US taxpayers residing abroad are "overwhelmingly complex."1

The announcement does, however, define "little or no US tax due" as being less than $1,500 in each of the three years submitted under the new procedures. The $1,500 is a deceptively low threshold. Notwithstanding that tax rates are typically higher in Canada than they are in the US, there are a number of tax deductions and tax credits available in Canada that are not available in the US. As a result, taxes exigible in Canada in any given year may be lower than that in the US. (Please click here for our prior article on this topic.)

"High risk factors"

Even if each return submitted is "simple" and has less than $1,500 in US tax due, the taxpayer will not be "low compliance risk" if he possesses "high risk factors." Such factors will be set out in further detail when the final details of the procedure are released. Notwithstanding the foregoing, the announcement lists the following factors which the IRS considers "high risk."

  1. High income levels;
  2. High net worth;
  3. Sophisticated tax planning or avoidance;
  4. Material economic activity in the US;
  5. History of non-compliance with US tax law; or
  6. The amount and type of US source income.

Concerns About the New Procedure

Since the IRS will be issuing additional procedural and substantive guidance in advance of the September 1, 2012 effective date, it is premature to get overly concerned about ambiguities evident in the announcement until that guidance is released. However, there are a few items that US citizens residing in Canada should note.

First, sophisticated tax planning is a high-risk factor. This could be problematic for Canadian residents who have undertaken estate planning, or a number of very common tax planning strategies frequently utilized2 that the IRS may deem sophisticated and therefore high-risk.

For example, Registered Educational Savings Plans ("RESPs") and Tax Free Savings Accounts ("TFSAs") are very popular and effective tax deferral vehicles that could easily be considered a high-risk factor because they are deemed to be foreign trusts under US law.3 If that is the case, any Canadian resident who owns one of these tax deferred savings plans may be precluded from participating in the new procedures.

Second, high net worth individuals may be precluded from participating in the program under the new procedures. This is problematic as assets are typically not disclosed on the income tax return. Thus, it appears probable that taxpayers may be required to submit a personal financial statement to the IRS in order to participate under the new procedures.

For purposes of determining whether a taxpayer's net worth is too high to participate under the new procedures, valuation may be an issue. Many assets are notoriously difficult to value, including interests in the following:

  • private corporations;
  • defined benefit retirement plans;
  • stock options; and
  • mineral rights.

Third, on January 9, 2012 the basic terms of the 2011 Offshore Voluntary Disclosure Initiative ("OVDI") were extended indefinitely. (Click here to see our prior article on the 2012 announcement.) The OVDI allowed taxpayers to bring unfiled returns current, pay a reduced penalty, but avoid the risk of criminal prosecution. In the recent announcement, the IRS states that if a taxpayer chooses to participate in the new program, he will be unable to enter into the 2012 OVDI. As a result, the taxpayer must be very careful when electing to participate in the new program.

Conclusion

For many Canadian residents who need to get caught up on US tax and filing obligations, the new procedures should come as a relief. However the terms of the new procedures, and the determination of who may qualify make it unclear as to the actual number of Canadians who may be able to qualify. We are hopeful that the impending details are sensitive to typical Canadian tax and estate planning and indicia of such does not disqualify these individuals from the relief afforded under the procedures.

Footnotes

1 National Taxpayer Advocate 2011 Annual Report to Congress at 130.
2 For example, income splitting or tax deferral strategies using trusts, corporations or partnerships.
3 Treasury Regulation 301.7701-4.

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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