U.S. Tax Enforcement Measures - An Update on Current and Proposed Efforts

By Edward Tanenbaum, Esq. Alston & Bird LLP, New York, NY

It's escaped no one's attention, I am sure, that our country is in the midst of a major tax enforcement effort, attributable in large part to the LGT and UBS scandals involving alleged under-reporting of income by U.S. persons maintaining offshore accounts and/or entities.

As a result, there's been a lot of Congressional pressure put on the Internal Revenue Service (IRS) in recent months to “fix,” amongst other things, the Qualified Intermediary (QI) Agreement in order to prevent it from (unwittingly) facilitating alleged tax abuses. In fact, after the initial Congressional hearings conducted by the Permanent Subcommittee on Investigations on both the LGT and UBS cases, the IRS issued Announcement 2008-98 detailing proposed amendments to the QI Agreement that the IRS intends to make. There are to be three major amendments:

1. A requirement that the QI notify the IRS when it discovers a material failure of controls relating to its performance as a QI under the QI Agreement or if employees allege such failures or if there is any investigation of such failures by regulatory authorities.

2. The addition of a new external audit procedure to test certain accounts that appear to have U.S. persons in authority over them and the addition of new procedures to require the external auditor to identify the persons (and their functions) charged with oversight of QI performance.

3. A requirement that the external auditor associate a U.S. auditor with the audit and a requirement that the U.S. auditor accept joint and several liability for performance of the external audit procedures.

In addition, the IRS has indicated that it will soon propose a number of amendments relating to increased documentation requirements, increased “know your customer” (“KYC”) procedures for the QIs (at least in respect of determining the existence of U.S. customers), increased reporting requirements for the banks with respect to both U.S. and foreign securities transactions of U.S. customers, as well as sanctions in the event of non-compliance.

Many of these proposals are significant for the foreign financial institutions that have taken on the role of QIs, and such proposals will undoubtedly increase the cost and administrative burdens of the banks. Many comment letters from the foreign banks have already been submitted to the IRS in response to these proposals.

On a second front, although not directly affecting QIs, the Treasury issued, in October 2008, a revised Form TD F 90-22.1, affectionately known as the FBAR filing. Issued under the authority of 31 USC 5314, every U.S. person (which now includes a person “in and doing business in” the United States) must file by June 30 of the succeeding year the FBAR form to report a financial interest in, or signature or other authority over, a foreign financial account if the amount exceeds $10,000 at any time during the relevant calendar year. Significant penalties apply for failure to properly report on and file Form TD F 90-22.1. On June 5, 2009, the IRS issued Announcement 2009-51 stating that it would temporarily suspend the reporting requirement with respect to those persons who are not U.S. citizens, residents or domestic entities. With respect to FBARs due this year, all persons may rely on the definition of “U.S. person” found in the instructions for the prior version of the FBAR, which defined a “United States person” as a: (1) citizen or resident of the United States, (2) domestic partnership, (3) domestic corporation, or (4) domestic estate or trust. All other requirements of the current version of the FBAR, however, are still in effect for FBARs due on June 30, 2009. Additional guidance will be issued with respect to FBARs due in subsequent years.

At the same time, what became quite apparent in the course of the UBS proceedings was that there may be a lot of undisclosed offshore entities and unreported offshore financial accounts that the U.S. Treasury was not previously aware of. In an effort to bring U.S. persons with such offshore entities and accounts into the system, the IRS announced on March 23, 2009, a formal six-month voluntary disclosure (“VD”) program designed to encourage U.S. persons to “get right with their government” and to disclose their offshore activities, all in exchange for a reduced package of penalties (provided that all the conditions for a proper VD are met). A number of Frequently Asked Questions (“FAQs”) have been posted to the IRS website providing for some guidance with respect to both the FBAR filing and the current formal VD program.

In addition to the above efforts to shore up reporting and enforcement, the Congressional and Executive branches have been busy at work crafting additional measures. For example, on March 2, 2009, Senator Carl Levin (D-MI) introduced the Stop Tax Haven Abuse Act, S. 506 (the “Bill”). A companion bill was introduced in the House as H.R. 1265. The Bill is based on a previous bill (co-sponsored by then-Senator Barack Obama), S. 681, which failed to garner sufficient support to become law. The stated goal of the Bill is to combat tax evasion through tax havens, money laundering, and the use of tax shelters.

In addition to dealing with a number of significant substantive areas, e.g., proposals to treat certain foreign corporations managed and controlled in the United States as U.S. corporations, to impose withholding taxes on dividend substitute payments, to codify the economic substance doctrine, etc., the Bill provides a blacklist of 34 offshore secrecy jurisdictions, imposes certain rebuttable presumptions regarding control of foreign entities and extends certain Patriot Act measures to entities that impede U.S. enforcement.

On March 12, 2009, Sen. Max Baucus (D-MT), Chairman of the Senate Finance Committee, announced a more modest version of the Bill that focuses on additional tax reporting requirements in order to identify U.S. persons who may be using tax haven jurisdictions to avoid U.S. taxation. Baucus is concerned about offshore tax compliance and the tax gap; however, Baucus apparently favors a more targeted approach than Levin that would give the IRS added power to detect individual U.S. tax evaders, rather than condemning all offshore financial centers. And, unlike the Bill, there is no blacklist.

More recently, President Obama introduced a number of interesting budget proposals (to take effect after 2010). Among the proposals are efforts to strengthen the QI program and to crack down on the abuse of tax havens by individuals and financial institutions.

For example, the administration believes the QI program has become subject to abuse. Under one proposal, no foreign financial institution would qualify as a QI unless it identified all of its account holders that are U.S. persons. A QI would be required to report all reportable payments received on behalf of all U.S. account holders, as well as file Form 1099s with respect to such payments. Withholding agents would be required to withhold 30% of U.S. fixed or determinable annual or periodical (FDAP) payments to individuals who use non-QIs, and to withhold 20% of gross proceeds from the sale of any security that would be reported to a U.S. non-exempt payee when paid to a non-QI located in a jurisdiction without a satisfactory exchange of information program with the United States. Payees would be required to disclose their identities to the IRS and demonstrate compliance to obtain a refund, and a legal presumption against users of non-QIs would be created.

In addition, the Treasury Department would be given the authority to provide: (1) for certain exceptions to the 20-30% withholding requirement on payments made to certain foreign investors as well as certain low-risk payments; (2) that a financial institution can be a QI only if the financial institutions it commonly controls are also QIs; and (3) that for any financial institution to be a QI, it must collect information indicating the beneficial owners of a foreign entity account holder, especially if a U.S. person is a beneficial owner. The proposal also would require a list of QIs to be made publicly available. Lastly, any U.S. person or any QI that formed or acquired a foreign entity on behalf of a U.S. individual or his/her controlled entity would be required to file an information return with the IRS regarding such foreign entity.

The administration has also proposed a comprehensive package of disclosure and enforcement measures to make it more difficult for financial institutions and wealthy individuals to evade taxes. The proposal would increase penalties, as well as extend the statute of limitations for enforcement. U.S. individuals would be required to report on their income tax return any transfers or receipts of money or property, with a value of more than $10,000, from any foreign financial account owned by them or by their controlled entities. U.S. financial intermediaries or QIs that make such transfers would have to comply with certain reporting requirements as well. Taxpayers required to file an FBAR would have to disclose certain information on their tax return in addition to filing the FBAR.

There is sure to be a degree of pushback on many of the foregoing proposals that have been put forth by the IRS, Congress, and the Obama administration from any number of groups lobbying on behalf of offshore jurisdictions, foreign and U.S. financial entities, etc. Nonetheless, at least in the area of tax enforcement, this is a train that seemingly has left the station and the only question is how severe a package of amendments ultimately will be enacted.

This commentary also will appear in the July 2009 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Tello, 915 T.M., U.S. Withholding and Reporting Requirements for Payments of U.S. Source Income to Foreign Persons, and in Tax Practice Series, see ¶7150, Withholding and Compliance.