William Byrnes' Tax, Wealth, and Risk Intelligence

On June 3, 2014 the IRS Commissioner John A. Koskinen stated before The U.S. Council For International Business-OECD International Tax Conference:

“Now while the 2012 OVDP and its predecessors have operated successfully, we are currently considering making further program modifications to accomplish even more. We are considering whether our voluntary programs have been too focused on those willfully evading their tax obligations and are not accommodating enough to others who don’t necessarily need protection from criminal prosecution because their compliance failures have been of the non-willful variety. For example, we are well aware that there are many U.S. citizens who have resided abroad for many years, perhaps even the vast majority of their lives. We have been considering whether these individuals should have an opportunity to come into compliance that doesn’t involve the type of penalties that are appropriate for U.S.-resident taxpayers who were willfully hiding their investments overseas. We are also aware that there may be U.S.-resident taxpayers with unreported offshore accounts whose prior non-compliance clearly did not constitute willful tax evasion but who, to date, have not had a clear way of coming into compliance that doesn’t involve the threat of substantial penalties.

 We are close to completing our deliberations on these respects and expect that we will soon put forward modifications to the programs currently in place. … We believe that re-striking this balance between enforcement and voluntary compliance is particularly important at this point in time, given that we are nearing July 1, the effective date of FATCA. …”

Amount Recovered Thus Far from Non-Compliant Taxpayers 

According to the GAO Reports and the Senate Subcommittee report, the 2008, 2011, and the ongoing 2012 offshore voluntary disclosure initiative (OVDI) have led to 43,000 taxpayers paying back taxes, interest and penalties totaling $6 billion to date, with more expected.

However, the vast majority of this recovered $6 billion is not tax revenue but instead results from the FBAR penalties (anti money laundering financial reporting form sent by June 30 to FINCEN, separate from the 1040 tax filing to the IRS sent by April 15) assessed for not reporting a foreign account.  The Taxpayer Advocatefound that for noncompliant taxpayers with small accounts, the FBAR and tax penalties reached nearly 600% of the actual tax due!  The median offshore penalty was about 381% of the additional tax assessed for taxpayers with median-sized account balances.

From the IRS OVDP FAQ:

“For example, assume the taxpayer has the following amounts in a foreign account over the period covered by his voluntary disclosure. It is assumed for purposes of the example that the $1,000,000 was in the account before 2003 and was not unreported income in 2003.

(NOTE: This example does not provide for compounded interest, and assumes the taxpayer is in the 35-percent tax bracket, does not have an investment in a Passive Foreign Investment Company (PFIC), files a return but does not include the foreign account or the interest income on the return, and the maximum applicable penalties are imposed.)

If the taxpayers in the above example come forward and their voluntary disclosure is accepted by the IRS, they face this potential scenario:

They would pay $518,000 plus interest. This includes:

• Tax of $140,000 (8 years at $17,500) plus interest,
• An accuracy-related penalty of $28,000 (i.e., $140,000 x 20%), and
• An additional penalty, in lieu of the FBAR and other potential penalties that may apply, of $385,000 (i.e., $1,400,000 x 27.5%).

If the taxpayers didn’t come forward, when the IRS discovered their offshore activities, they would face up to $4,543,000 in tax, accuracy-related penalty, and FBAR penalty.”

The IRS example to enter the OVDP has 75% of the OVDP collection amount from the FBAR penalty.  The FBAR penalty is 2.75 larger than the tax due.  But not entering leads to owing an amount four times the account value.

Thus, judged by the amount of tax funds recovered, the OVDP has substantially underperformed to date.  But by leveraging a taxpayer’s lack of compliance with the non-tax FBAR, the OVDP and IRS civil prosecutions appear to meet performance goals of raising revenue and obtaining overall tax compliance for US persons with foreign accounts and/or residing abroad.  Or do they?

Have These Initiatives Increased Taxpayer Compliance?

The Taxpayer Advocate, replying on State Department statistics, cited that 7.6 million U.S. citizens reside abroad and many more U.S. residents have FBAR filing requirements, yet the IRS received only 807,040 FBAR submissions as recently as 2012.  The Taxpayer Advocate noted that in Mexico alone, more than one million U.S. citizens reside, and many Mexican citizens reside in the U.S. (and thus are required to file a FBAR for any Mexican accounts of $10,000 or greater).  Moreover, Non-Resident Aliens (NRAs) must file a FBAR as well.  Thus, all the initiatives to date have produced a compliance rate below 10% compliance.  Sounds more like the War on Drugs rather than a drive to increase tax compliance.

This is not to say that obtaining a highly level of compliance with the tax law, like compliance with the drug laws and DUI laws, is not a public good in itself – such tax compliance is a public good that the public has chosen, via Congress (and its investigatory hearings), for resource allocation. But like the War on Drugs, there are many potential strategies to bring about compliance.  The ones used to date just haven’t worked very well, and caused more problems (the War on Drugs has led to one of the highest rates of imprisonment of the world, that some have called a scorched earth policy against young male minorities in particular).

Have These Initiatives Met the Tax Collection Goals?

The Subcommittee Report states: “Offshore tax evasion has been an issue of concern … because lost tax revenues contribute to the U.S. annual deficit, which today exceeds $500 billion. Collecting unpaid taxes is one way to reduce the deficit without raising taxes.”

The Senate Subcommittee reported that: “According to the IRS, the current estimated annual U.S. tax gap is $450 billion, which represents the total amount of U.S. taxes owed but not paid on time, despite an overall tax compliance rate among American taxpayers of 83 percent. Contributing to that annual tax gap are offshore tax schemes responsible for lost tax revenues totaling an estimated $150 billion each year.”

To justify the reporting of the number of $150 billion a year of lost tax revenue due to “offshore tax schemes”, the Senate Report primarily cites its own investigatory reports and third party articles that refer to transfer pricing issues.  While transfer pricing regulations have been under scrutiny, at least by the Democrats, in the Senate, it is certainly not commonly held by those same Democrats that transfer pricing is illegal or constitutes an “offshore scheme”.

It is proven beyond a doubt by the UBS, Credit Suisse, and other similar investigations, validated by the OVDI disclosures, that some Americans are noncompliant, and that some of those noncompliant Americans would owe tax if disclosing foreign income on their tax returns.  There is also no doubt that the total number of noncompliant Americans between 2008 and 2013 was more than the 43,000 who were brought in from the wilderness.

There is also no doubt that the tax that would have been collected from these noncompliant taxpayers had they been compliant during their time in the wilderness is in fact, relative to the reported figure of $150 billion lost annually, miniscule (somewhere probably between $300 million and $500 million a year for lost tax (recalling the majority of the $6 billion collected representing FBAR penalties, tax penalties, and interest).  To date, of the $150 billion referred to as lost a year to offshore schemes, only approximately .003% (a third of one percent) has been collected – and that assuming the higher number of $500 million a year.  Not a good result by any measure.  And not going to dent the annual $450B – $500B deficit (not including unfunded liabilities).

Are More Than 90% of Taxpayers with Foreign Accounts Tax Evaders?

The Taxpayer Advocate, relying on State Department statistics, cited that 7.6 million U.S. citizens reside abroad.  Most are required to file a FBAR.  The Taxpayer Advocate noted that in Mexico alone, more than one million U.S. citizens reside, and many Mexican citizens reside in the U.S. (and thus are required to file a FBAR for any Mexican accounts of $10,000 or greater).

Many more U.S. residents have FBAR filing requirements because of having signatory, control, or ownership of an overseas account.  The Department of Homeland Security reported in Population Estimates (July 2013) that an estimated 13.3 million LPRs lived in the United States as of January 1, 2012, some of who will have FBAR filing requirements.

For 2011, approximately four million individual returns included foreign source income and 450,000 included the Foreign Earned Income Exclusion.  Yet the IRS received only 807,040 FBAR submissions as recently as 2012.

Based on these numbers, more than 90% of taxpayers with foreign accounts are NOT compliant with the FBAR filing requirement.  Add it up: 7.6 million Americans abroad, 13.3 LPRs in the USA, at least 1 million NRAs in the US, and some number of American citizens in the US with foreign accounts.  Must equal at least 10 million taxpayers that should be filing the FBAR.   The IRS has stated that a substantial number of US taxpayers living abroad do not file tax returns at all.

The IRS reports that 87% of American residing taxpayers are tax compliant.  So the remaining 13% … statistically speaking, being an American residing in America and having a foreign account is indicative of tax evasion, especially if FBAR is considered a “tax” compliance obligation (which it is not).

Based on these numbers, being an American living in a foreign country is a leading cause of criminality.  What the statistics do not tell is which comes first: criminality or foreign activity?  A person tends toward criminality and thus opens a foreign account or moves to a foreign country?  Or the act of moving abroad to a foreign country leads to criminality?  Absurd questions?      

Is the FBAR form necessary?  Why has it not been combined with the 1040?  Why not with the new 8938?  Questions to ponder in another article.