2016 Foreign Tax Issues - Part I
The following is a two-part series by regular Taxing Subjects contributor Ben Tallman, who provides insight into foreign tax issues. Part I describes Foreign Bank Account Reporting (FBAR) and FATCA in detail, while Part II discusses the foreign earned income exclusion and provides three examples of how to determine the residence requirement.
Foreign Bank Account Reporting (FBAR)
It was only a few years ago that we began hearing this new acronym, FBAR. It quickly spread through the tax community as a new compliance item that must be added to our checklist. It also carried an expensive penalty for willful non-filers and had a strange form number that was difficult to remember. The single question we must now remember to ask our clients is whether they had a foreign bank account or could sign on a foreign account. The potential cost of foregoing this issue could have dire consequences on our clients and have future repercussions for us, our integrity, and reputation.
So what is all this fuss about? Our government discovered that a growing number of Americans were moving investment portfolios off shore to prevent paying tax on the earnings. Training seminars were offered annually in Cancun and Vancouver to entice attorneys and accountants to learn about proven methods for avoiding US taxes. This “off shore movement” had become too large to ignore and Congress needed a way to stop the billions of dollars from moving into foreign sanctuaries and safe havens. Their answer was FBAR.
Congress decided to make FBAR part of Money and Finance. These laws govern banks and financial institutions, so you will not find this in the Tax Regulations under Title 26 of the US Code. Instead it is located in Title 31 under the control of the US Treasury (not the IRS). Questions about FBAR can be routed to Department of the Treasury in Detroit, MI at 866-270-0733 (toll free in US) or 313-234-6146 (outside the US). For other questions regarding the FBAR, contact the Detroit Computing Center Hotline at (800) 800-2877, option 2. FBAR questions can also be e-mailed to FBARquestions@irs.gov. They offer help with the completion of the e-filed FBAR Return (FinCEN[i] Form 114 a/k/a TD F 90-22.1). If unable to e-file there is a FinCEN Hotline 1-800-949-2732 or 703-905-3975 (outside the US). The annual deadline changes to April 15th for the 2017 tax season. The good news is FBAR is now eligible for an extension (good for 6 months).
What are Foreign Financial Accounts?
A foreign financial account includes, but is not limited to, securities, brokerage, savings, demand, checking, deposit, time deposit, or other accounts maintained with a financial institution or a person performing the services of a financial institution. A financial account also includes commodity futures or options account, an insurance policy with a cash value (such as a whole life policy), an annuity policy with a cash value, and shares in a mutual fund or similar pooled funds.
An account is not considered foreign under the FBAR rules if it is maintained with a financial institution located in the United States. For example, individuals may purchase foreign securities through a securities broker located in the United States as part of their investment portfolio. The mere fact that an account may contain holdings or assets from a foreign country does not make the account foreign for purposes of the FBAR rules.
A foreign financial account is a financial account opened and located outside of the United States. An account maintained with a branch of a US bank that is physically located outside of the United States is a foreign financial account. This is based on the reasoning that banks that are physically located within the United States already have US government reporting requirements.
A US person who has a financial interest in or signature authority over one or more bank or securities accounts in a foreign country must file a FBAR Return if the aggregate value of all applicable accounts exceeds $10,000 at any time during the calendar year.
Amnesty Program – OVDP effective July 1, 2014
The amnesty program has recently been modified under the Offshore Voluntary Disclosure Program (or OVDP). It is an updated amnesty program from 2009, 2011 and 2012 and is currently open-ended. Spouses can file jointly or separately for the program; and it is available for past-due filers as long as they are not under criminal investigation or as long as they did not willfully fail to file the FBAR. They must agree to a 27.5% or 50% off-shore penalty based on the highest account value over the prior eight years. In addition, there will be a 20% accuracy-related penalty under §6662 added to the off-shore income tax liability (interest, dividends, gains, etc.). The 50% penalty comes into play when the taxpayer’s foreign financial institution is under investigation by the US Treasury, Department of Justice, or IRS. They must literally be “under the radar screen” of the IRS to still qualify for the 27.5% penalty deal. Two other special penalty rates apply: 12.5% on foreign account balances never exceeding $75,000, and 5% for special circumstance cases (recipients that did not know account existed).
Why is this a good deal? Because willfully failing to file the FBAR can subject your client to criminal, as well as, civil penalties. This can include imprisonment and an annual penalty for each unfiled year of $100,000 or 50% of the account balance, whichever is higher. You are probably thinking that this could be more than they have in the foreign bank account – and you would be right!
So how do we get started? The voluntary disclosure period covers the past 8 years. IRS states that acceptance into a voluntary disclosure arrangement depend on the facts and circumstances surrounding each case. Coming in voluntarily, with a desire to satisfy an existing tax obligation, and promising to stay in compliance going forward should help. Establish eligibility by sending in a domestic voluntary disclosure (quiet disclosure) with the taxpayer’s name, date of birth, social security number, and address to the following address:
IRS Criminal Investigation Lead Development Center
Attn: Voluntary Disclosure Coordinator
Philadelphia Lead Development Center
1-D04-100, 2970 Market Street
Philadelphia, PA 19104
For a faster turnaround, fax it to 1-267-941-1115. This disclosure is required to begin the process. After eligibility is determined by IRS, Forms 14457 and 14454 must be completed to move forward. Expect all late-filed tax years to be audited. OVDP Hotline is 267-941-0020.
You can read more about this program affecting US domestic citizens, as well as, US citizens living abroad by reading IR 2014-73, FS 2014-6 and FS 2014-7.
FBARs must be filed electronically through the FinCEN website. Filers will receive an acknowledgement of each report filed. Only one digital signature can be accepted per form, so if a married couple has a joint financial interest in a foreign account, each spouse must file a separate FBAR. A US person must retain the FBAR information for at least 5 years after the filing deadline.
Failure to File Penalties
Understanding the FBAR filing requirements is crucial because the penalties for noncompliance can be devastating. Both civil and criminal penalties can be imposed; the limit for civil penalties depends on whether the failure to file an FBAR is willful or non-willful.
- The civil failure to file penalty for a non willful failure to file can reach $10,000.
- The civil penalty for a willful failure to file can be the greater of $100,000 or 50% of the balance in the account at the time of the violation.
- The criminal penalty is a fine of up to $250,000, and can include imprisonment for up to 5 years. If the violation is a pattern of criminal activity (such as criminal tax evasion), both the fine and the term of imprisonment may be doubled.
The test for willfulness is whether there was a voluntary, intentional violation of a known legal duty. The IRS bears the burden of proof of whether a failure to file the FBAR was due to willful intent. However, if the government shows that the taxpayer knew about the filing requirement, it has met the burden of proof. Thus, that is a small hurdle to overcome. The penalty is determined per foreign account, not per unfiled FBAR, and it can be imposed on multiple people for the same account with each person liable for the entire amount of the penalty. The penalty applies for each year of violation. Whether an account generates taxable income is not a factor in the reporting requirement. However, assertion of these harsh penalties is not automatic, and there is a reasonable cause exception for non-willful violations [31 USC § 5321(a)(5)(B)(ii)].
Internal Revenue Manual Guidance
I.R.M. § 220.127.116.11 tells IRS personnel that FBAR penalties “should be asserted only to promote compliance with the FBAR reporting and recordkeeping requirements.” It notes that
FBAR civil penalties have varying upper limits, but no floor.
The examiner has discretion in determining the amount of the penalty, if any. Examiner discretion is necessary because the total amount of penalties that can be applied under the statute can greatly exceed an amount that would be appropriate in view of the violation.
The manual also tells IRS Examiners that in exercising their discretion, they “should consider whether the issuance of a warning letter and the securing of delinquent FBARs, rather than the assertion of a penalty, will achieve the desired result of improving compliance in the future”.
Guidance for IRS Examiners
I.R.M. § 18.104.22.168 provides this example: If an individual failed to report the existence of five small foreign accounts with a combined balance of $20,000 for all five accounts, but the income from each account was properly reported and the taxpayer made no effort to conceal the existence of the accounts, it may be more appropriate to issue a Letter 3800 to warn the taxpayer rather than assert penalties under the mitigation guidelines.
The IRS has established civil penalty mitigation guidelines so that the penalties determined through the examiner’s discretion are uniform. The examiner’s work papers must document the circumstances that make mitigation appropriate, and the examiner’s manager must give written approval. To qualify for mitigation, the person subject to the FBAR penalty must meet four criteria:
- The person has no history of criminal tax or Bank Secrecy Act (BSA) convictions for the preceding 10 years and has no history of prior FBAR penalty assessments.
- No money passing through any of the foreign accounts associated with the person was from an illegal source or was used to further a criminal purpose.
- The person cooperated during the examination.
- The IRS did not determine a fraud penalty against the person for an underpayment of income tax for the year in question due to the failure to report income related to any amount in a foreign account.
Foreign Account Tax Compliance Act (FATCA)
The Foreign Account Tax Compliance Act (FATCA), more directly targets income tax noncompliance.
Specified Foreign Assets
Effective for calendar years beginning with the 2011 tax year, FATCA requires taxpayers with specified foreign assets to attach a disclosure statement, Form 8938, Statement of Specified Foreign Financial Assets, to their income tax returns for any year that the aggregate value of all such assets exceeds $50,000 ($100,000 MFJ).
There are five categories of specified foreign financial assets:
- Financial accounts maintained by foreign financial institutions
- Any stock or security issued by a foreign person
- Any financial instrument or contract held for investment that has a foreign issuer or counterparty
- Any interest in a foreign entity (corporation, trust, estate, LTD, LLC, etc.)
- Business operations, holdings, or assets (includes rental equipment or rental real estate)
Failure to File Penalty
The IRS may impose a $10,000 penalty for failure to file Form 8938. If the IRS notifies an individual that a statement should have been filed and the statement is not filed within 90 days after the notification, an additional $10,000 penalty can be imposed for each subsequent 30-day period (or fraction thereof) until the statement is filed. The total penalty is capped at $50,000. The penalty can be waived if the failure to report is due to reasonable cause and not to willful negligence. In addition, a 40% accuracy-related penalty (§6662) applies to any understatement of income tax liability that is attributable to a transaction involving an undisclosed foreign financial asset.
Duplicate Reporting Not Required
Disclosure on Form 8938 is not required if a similar disclosure is required on Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts; Form 3520-A, Annual Information Return of Foreign Trust With a US Owner (Under section 6048(b)); Form 5471, Information Return of US Persons With Respect To Certain Foreign Corporations; Form 8621, Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund; or Form 8865, Return of US Persons With Respect to Certain Foreign Partnerships.
Use of ITINs and ATINs
There are some recent changes in the filing requirements for the Individual Taxpayer Identification Number (ITIN) and the Adoption Taxpayer Identification Number (ATIN).
ITIN numbers start in the 900 series for easy recognition. Foreign Nationals and non-resident aliens including foreign spouses/dependent children are the typical recipients of an ITIN number. This number allows the resident of a foreign country with US income to file Form 1040NR or 1040NR-EZ.
To apply for an ITIN one must complete the latest revision of Form W-7. Acceptable documentation verifying identity must accompany the application. A full list of acceptable documents can be found on IRS.gov, which includes items like passports, national identification cards, visas issued by the US State Department, US or foreign military identification, US or foreign driver’s licenses, civil birth certificates, and medical and school records. They must be original copies certified by a certifying acceptance agent (CAA) or by the IRS at a Taxpayer Assistance Center. An ITIN expires after 5 years, at which time the applicant must reapply. Students and Exchange Visa Holders are not subject to this expiration.
Attorneys, CPAs, EAs, and RTRPs can qualify to become a CAA by completing a Forensic Document Identification Training Course authorized by the IRS. Tax Attaché Offices located in London, Paris, Frankfurt, and Beijing may also be used to certify the authenticity of documents.
We will now look at ATINs which are temporary identification numbers for adopted children. This ID number is used as long as the adoption is pending. Once the adoption becomes final and a social security number is re-activated or newly authorized, the ATIN expires. ATIN numbers usually apply to domestic adoptions, but can be used on foreign adoptions if all of the following qualifications are met:
- The child is legally placed in your home for adoption by an authorized placement agency.
- The child has a permanent resident alien card or certification of citizenship.
- If you are unable to obtain the child's existing SSN after making reasonable attempts with the birth parents, the placement agency, and other persons.
- If you are unable to obtain a SSN for the child from the SSA for any reason.
- If you are eligible to claim the child as a dependent on your tax return.
Foreign adoptions unable to obtain an ATIN can still apply for an ITIN number. Obtaining an ATIN or ITIN does not qualify the holder or a 3rd party for the earned income tax credit (EITC). However, the child tax credit (CTC) may still be available, if residency requirements can been met.
Filing Form 1040NR or Form 1040NR-EZ
Form 1040NR applies to residents of foreign countries that are working in the United States. Most of the time they are here on a visa, work permit, or for other business related purposes and earn money in the US. US Employers are required to withhold 30% on the earnings on all non-resident workers (reported on Form 1042-S or Form 8805). In order to get the excess refunded, non-residents must file Form 1040NR, which can take up to 6 months to process. Most non-residents are not required to file an FBAR or FATCA return unless they are bona fide residents of Puerto Rico, American Samoa, or electing to exercise non-resident alien provisions of a tax treaty with the United States. Publications 597 and 901 expound on US Tax Treaties.
You may only use Form 1040NR-EZ if your US sourced income is from wages, salaries, tips, refunds of state and local income taxes, and scholarship or fellowship grants. Any other income or deductions will require filing Form 1040NR. In most instances, you only include US sourced income. Losses on Schedule C or F do not reduce other income on Form 1040NR. Self-employment tax is due on Schedule C and F net income unless it is exempted by a tax treaty.
So what is the real benefit in filing as a non-resident 1040NR? The answer: the taxpayer is only paying tax on US income, not worldwide income. Why would this be better? It segregates income in the country where it is earned, and it avoids FBAR and FATCA filing requirements. Remember that US resident 1040 filers have an additional obligation to disclose foreign accounts and holdings. Because 1040NR provides beneficial treatment, there is a 6-month timing limitations for remaining a non-resident alien. Refer to 1040NR Instructions for more information.
Filing status allows married taxpayers to file as married or single depending on the tests for each. Only foreign dependents from Canada, Mexico, and South Korea (residency requirement) can be claimed on the 1040NR. Many of the deductions and credits available on the 1040 can be used on the 1040NR as long as they are related to the US sourced income. Schedule NEC lists both US and foreign sourced income. In many cases, the foreign income is exempted unless the taxpayer was in the country 183 days or more during the tax year (substantial presence test). Form 1040NR is worth a second look if you are receiving inquiries from non-resident alien students, teachers, or business professionals. If you accidentally file them on Form 1040, you’re subjecting them to reporting all global income and the FBAR/FATCA filing requirements. You hold their filing situation in your hands, so file the right form!
IRS Publications, Comments on and Excerpts from OVDP, ITIN and ATIN, and Form 1040NR/EZ.
LGUTEF (with permission), Comments on and Excerpts from 2009 National Income Tax Workbook, materials have been updated to conform with 2016 changes.
ABOUT THE AUTHOR
Ben Tallman is an Alumnus of the University of West Georgia, he is an NTPI Fellow, and currently has a tax practice in Atlanta. He has taught as an instructor for many local, state, and national organizations over the past decade. Ben has served on the NAEA National Board as Chairman of the Education Foundation, where he is a prior member of the IRS Regional Liaison Committee, and a prior Education Director for two GA Affiliate Tax Organizations. He has appeared as a panelist on Tax Talk Today, as well as, conducting an NAEA 3-Part Webinar in discussions on the Affordable Care Act. He is a US Tax Court Practitioner and writes extensively for national tax publications and tax journals. Ben has served as a volunteer for an Atlanta night shelter and food bank; he has served as a board member on his local Jaycee Chapter, church school board, and two state tax organizations. He recently celebrated 40 years in tax preparation.
[i] FinCEN is the acronym for Financial Crimes Enforcement Network. The organization’s mission statement is “to safeguard the financial system from illicit use and combat money laundering and promote national security through the collection, analysis, and dissemination of financial intelligence and strategic use of financial authorities” (www.fincen.gov).