With the closing of the voluntary disclosure program on October 15, 2009, Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts (commonly known as the FBAR), has graduated from a little-known, often forgotten filing requirement to a priority issue that should be at the top of every tax return preparer’s checklist. If the IRS was trying to raise the profile of the FBAR, it has succeeded. But in raising the profile for tax compliance purposes, it also raises questions about the guidance provided with the amended FBAR in October 2008 (the 2008 instructions), the reasoning for certain disclosures, and the appropriateness of the associated penalty regime.
The FBAR is an annual report that U.S. persons file to disclose interests in foreign bank and financial accounts (foreign accounts). Those with a financial interest, or a signatory or similar interest, in a foreign account are required to file. It is an information report only. The report is not filed with the tax return, discloses no information about the income derived in a foreign account, and is not used to calculate any tax obligations.
The requirement to file an FBAR comes from the Bank Secrecy Act and related Treasury regulations, not the Internal Revenue Code. However, the regulations specifically delegate the FBAR’s administration to the IRS commissioner.
IRS Focus on the FBAR
While there has been an obligation to file FBARs for many years, some taxpayers were not aware of their filing obligations or overlooked them. Prior to 2009, the IRS had not aggressively enforced this filing requirement, which likely contributed to taxpayer complacency about FBAR obligations.
In recent years there has been growing awareness of offshore bank accounts worldwide. Various international groups, including the Organisation for Economic Co-operation and Development, the European Union, and the G-20, have announced programs to reduce offshore tax planning that relies on bank secrecy laws. Particular emphasis has been placed on information exchange programs with countries that have traditionally facilitated offshore finance businesses. The United States has been very active in seeking tax information exchange agreements.
At the same time, UBS, a global financial services company, has been accused of encouraging U.S. customers to take advantage of Swiss bank secrecy rules by opening Swiss bank accounts. There may be as many as 52,000 such accounts with UBS alone, potentially hiding billions of dollars from the IRS. This has highlighted the widespread use of foreign accounts to evade U.S. taxes at a time of record budget deficits, attracting the ire of Congress and outrage on Main Street.
In 2009 alone, the IRS and the administration collectively have announced that more than 1,500 workers will be recruited to enforce international tax rules, with a focus on the deferral of income by corporations and hidden foreign accounts of individuals.
With strong political support, international consensus, new tools such as information exchange agreements, and more agents available to pursue these accounts, the IRS is ideally positioned to find these accounts and hunt down tax evaders.
Who Must File an FBAR?
A “person” is defined in 31 C.F.R. Section 103.11(z) as an “individual, a corporation, a partnership, a trust or estate, a joint stock company, an association, a syndicate, joint venture, or other unincorporated organization or group, an Indian Tribe (as that term is defined in the Indian Gaming Regulatory Act), and all entities cognizable as legal personalities.” Entities that may be disregarded for U.S. income tax purposes may still be required to file an FBAR—for example, a single-member limited liability company.
Where they have a relevant interest in a foreign account, 31 C.F.R. Section 103.24 requires “[e]ach person subject to the jurisdiction of the United States” to file an FBAR. This definition is extraordinarily broad and arguably could apply to any person who, for example, transits through LAX or even enters a U.S. embassy abroad.
The 2008 instructions only require “United States persons” to file FBARs; however, because this differs from the definition used in the Code, it is neither clear nor settled. The 2008 instructions define a U.S. person to be “a citizen or resident of the United States” and “a person in and doing business in the United States.” This second clause was sufficiently vague that on June 5, 2009, just 25 days before the 2008 FBARs were due to be filed, the IRS issued Announcement 2009-51, which deferred the introduction of this second clause by one year and retained the previous definition for the 2008 FBARs—i.e., domestic corporations, domestic partnerships, or domestic trusts or estates. Subject to further modification, FBARs due for filing in 2010 will use the uncertain definition found in the 2008 instructions.
In relation to the first clause, the 2008 instructions do not explicitly state that they are importing the definition of “resident” from the Code. However, verbal guidance from the IRS indicates that it is relying on the residency tests in the Code for FBAR purposes. This creates some interesting situations. For example, a citizen who has not been physically present in the United States at any time during the year and has no commercial or business ties to the United States would be required to file an FBAR. Meanwhile, a teacher or student who is present in the United States for the whole year under an F visa may have no FBAR filing obligation.
It would also mean that two resident aliens, one from a treaty country and one from a nontreaty country, with the same type of visa and the same number of days spent in the United States, could be treated differently. The former could be treated as a nonresident under a tie-breaker provision in the treaty and therefore excluded from an FBAR filing requirement, while the latter would be a resident and required to file. Interestingly, if the nonresident is not an employee but instead is carrying on a business in the United States, he or she may be required to file the FBAR (under the 2008 instructions).
If the criterion for distinguishing a U.S. person from a non-U.S. person for FBAR purposes is exposure to U.S. income tax, it would seem that the FBAR is really a tax filing and may do little to pursue the other goals of the Bank Secrecy Act.
Clearly, foreign bank accounts and foreign brokerage accounts need to be disclosed in the FBAR. Foreign accounts include accounts with an offshore branch of U.S. banks but exclude accounts with U.S. branches of foreign banks. While these are relatively clear, there are many matters that require further guidance.
For example, the 2008 instructions require the disclosure of “accounts in which the assets are held in a commingled fund, and the account owner holds an equity interest in the fund (including mutual funds).” As such, investments in offshore mutual funds, hedge funds, and private equity funds that involve the commingling of assets may need to be disclosed on the FBAR. But this raises a question about where to draw the line, especially when there is not always agreement about the meaning of “private equity fund” or “hedge fund”— could a public company be viewed as a commingled fund? Because of this confusion, the IRS has extended the time for filing an FBAR for persons with a financial interest in or signature authority over a foreign commingled fund (Notice 2009-62). Such persons now have until June 30, 2010, to file an FBAR for calendar 2008 or earlier years.
In addition, this needs to be reconciled with the exclusion of individual bonds, notes, and stock from FBAR reporting. If a company issues equity, the acquirer should not be required to report it, but if a private equity fund issues equity, there may be a reporting requirement. This is difficult logic to follow.
Bonds, notes, and stock should not be a foreign account requiring an FBAR filing (unless they are held by a foreign broker, in which case the brokerage account should be a foreign account). Presumably U.S. investors who are concerned about reporting any foreign bank accounts may switch their investments to stock certificates and bearer bonds and keep them in a safe deposit box to avoid the FBAR penalty regime. Is this an acceptable outcome, or should the IRS be modifying the FBAR rules to address this?
The 2008 instructions require that any account with financial institutions or persons engaged in the business of a financial institution be disclosed. Unfortunately, there is no guidance about what constitutes the business of a financial institution. Would a corporate treasury company be viewed as a financial institution? Is a store-specific credit card account with an offshore retailer an account with a financial institution?
An unsecured loan to a nonfinancial institution would not need to be disclosed on the FBAR. However, there is no guidance distinguishing an at-call loan from a deposit, and the meaning of “financial institution” is critical to this example.
While vanilla bank and brokerage accounts will clearly be subject to FBAR requirements, there are many transactions (only some of which are described above) in which additional guidance is needed.
Financial Interest and Signatory or Other Authority
U.S. persons are required to file an FBAR for all foreign accounts in which they have a financial interest or over which they have signatory or other authority. The 2008 instructions dealing with a financial interest require the owner of record, the legal owner, or the beneficial owner of some or all of the accounts to file as having a financial interest. A U.S. person will also have a financial interest in a foreign account of a corporation when he or she owns more than 50% of the corporation’s stock (by vote or value).
The 2008 instructions seem to require a U.S. person to look through another U.S. person for the purpose of this test. This creates a significant burden on the U.S. person while merely providing the same information to the IRS twice. For example, if a U.S. citizen owns a greater than 50% interest in a domestic corporation that has a foreign bank account, the U.S. citizen would be required to file an FBAR reporting that account (but not any related income), even though the domestic corporation would report that same account in an FBAR and would be liable for tax on the income. This is another example where the FBAR rules should be considered more practically and clearer guidance could be provided.
On March 23, 2009, the IRS announced a six-month voluntary disclosure program for 2003–2008 FBARs, giving U.S. persons an opportunity to bring their FBAR filings up to date. As part of this program, the IRS announced a supposedly concessionary penalty regime in which the filer must pay 20% of the highest account balance during the affected years. The announcement did not give agents any authority to reduce the penalties below 20% of the highest account balance.
While not apparent from the initial announcement, the IRS subsequently clarified that where all the income had been reported on the timely filed tax return (not necessarily amended returns) and the taxes paid, the U.S. person could file delinquent FBARs without penalty outside the voluntary disclosure program. In this case, there would be no penalties for late FBARs. While there is no waiver of criminal rights to pursue U.S. persons for late-filed FBARs, the IRS has clarified that entering this program will allow the U.S. person to “avoid substantial civil penalties and generally eliminate the risk of criminal prosecution” (IRS, “Voluntary Disclosure: Questions and Answers,” September 21, 2009, update). However, when comparing the treatment of those who have declared the income but not filed an FBAR with those who did not pay their taxes, the scale of the penalty is severe. Again, this indicates that the FBAR is predominantly being used as a tax compliance tool, not for other law enforcement purposes.
As previously noted, FBAR filing is required under the Bank Secrecy Act. The related regulations, 31 C.F.R. Section 103, deal mainly with suspicious activity reports from financial institutions, which are generally used to combat financial crimes, including money laundering, where the balance in the account often represents the reward for criminal efforts. Therefore, it is not surprising that the penalties are calculated by reference to the balance in the account and can be as much as 50% of the highest balance of the account each year. In addition to these penalties, there are also criminal penalties of up to $500,000 and 10 years in jail.
However, the Code has its own penalties, which tend to be calculated by reference to the taxes avoided, not the balance of the account. This leads to a more equitable result—i.e., where significant taxes are avoided, the penalties are significant, and if small amounts of tax are avoided, the penalties tend to be modest. While the IRS has authority to use the Bank Secrecy Act penalty regime, it is troubling that it has decided to use this penalty regime for tax purposes.
There are numerous examples of how this approach can lead to inequity. For instance, assume that a U.S. person wants to buy an Italian villa for $1 million. The U.S. person establishes an Italian bank account and, one week prior to the closing, funds that account with $1 million. The interest income over the one week, net of bank fees, is $100. The account is then closed immediately after the purchase. Under the voluntary disclosure program, the penalty for failing to file the FBAR would be $200,000, which is completely out of proportion with the amount of tax at issue ($35). If the account were discovered outside the voluntary disclosure program, the penalty could be $500,000.
Another situation might be one in which a U.S. person has a foreign securities account with $1 million of capital generating 15% annually. If that person files an FBAR but discloses only $50,000 of the income in his or her U.S. tax return, the penalty should be $26,250 per year (75% of the tax payable). If the same person failed to file the FBAR, the penalty increases to as much as $526,250 per year. If the account derived 1%—i.e., $10,000— the voluntary disclosure penalty would be $200,000 plus the tax, interest, and accuracy penalty. If the account derived no income, there would be no penalty.
Similarly, where a U.S. person with signatory authority but no economic interest in the account fails to file, the initial guidance from the IRS indicates that the U.S. person could be subject to penalties calculated as a percentage of the balance in the account in which he or she has no economic interest (although the IRS seems to have now modified this position). To give itself time to address this situation, the IRS has extended the time for filing an FBAR for calendar 2008 or earlier years for persons with signature authority over, but no financial interest in, a foreign account to June 30, 2010 (Notice 2009-22).
The IRS invited comments in relation to the 2008 instructions, and at the time of this writing those comments had not been made public. One thing is clear: The 2008 instructions need to be clearer about who should be filing an FBAR and which accounts should be disclosed. Fundamental to this point is that Treasury needs to determine whether the FBAR is predominantly a tax filing. If it is, the definitions used in the 2008 instructions should be reconciled (or replaced) with known tax terms that are defined and understood.
There should also be a careful evaluation of the penalty regime. When a penalty regime is arbitrary and inequitable, it discourages compliance. If the IRS believes the penalties in the Code are inadequate to discourage people from hiding foreign accounts, it should ask Congress for greater penalty powers to be used within limits Congress may define. In any event, the IRS should give its agents the authority to remit FBAR-related penalties when they are excessive and disproportionate to the income not disclosed.
The views expressed in this item are the views of the author and not necessarily the views of Friedman LLP.
Michael Koppel is with Gray, Gray & Gray, LLP, in Westwood, MA.
Unless otherwise noted, contributors are members of or associated with CPAmerica International.
For additional information about these items, contact Mr. Koppel at (781) 407-0300, or email@example.com.