In light of the Internal Revenue Service’s (“IRS’s”) new streamlined procedure for bringing the delinquent tax returns of US persons current, many taxpayers who are currently in the 2009 Offshore Voluntary Disclosure Program (“OVDP”) or 2011 Offshore Voluntary Disclosure Initiative (“OVDI”) are considering opting out of these amnesty programs in the hope of filing under the new procedure. Recently we published an extensive analysis of the new streamlined procedure, which you may find by clicking here.
While opting out of these amnesty programs may result in a reduction of penalties that may otherwise be assessed, the taxpayer needs to carefully weigh the numerous consequences before doing so, not least of which is the fact that opting out is irrevocable and cannot be undone. Responsible tax professionals will discuss the consequences of opting out with the client before making such a recommendation. Professionals who do not fully analyze all of the client’s facts and current IRS positions risk turning the client’s already expensive problem into a bigger, more complex, and more expensive one.
Is it possible to opt out of the OVDI or OVDP and into the new streamlined procedure?
At this point it is uncertain whether the new streamlined procedure will be available to current participants in the OVDI and OVDP. The rules for the new streamlined procedure do not authorize the taxpayer to opt out or move from one amnesty program to another. Further, in order to qualify for the new streamlined procedure the taxpayer must not have filed US tax returns for the 2009, 2010 and 2011 tax years. By design, taxpayers who participated in the OVDI or OVDP will have filed returns for the 2003 to 2010 tax years. Thus, based on a plain reading of the eligibility rules, participants in OVDI and OVDP would be ineligible for the new streamlined procedure.
There is some hope, however, that the IRS may amend the rules of the new streamlined procedure to expressly extend eligibility to those taxpayers who are currently in the OVDP or OVDI. At the American Bar Association Tax Section meeting in September 2012, David Breen (a senior lawyer with the IRS) made a statement that indicates such amendment may be forthcoming. Mr. Breen stated:
“Any time the Service has issued a new initiative, we have made it available to taxpayers who came in earlier under a different initiative.”
This is an encouraging statement and practitioners are hopeful that the IRS will clarify the terms of the streamlined procedure to make it available to taxpayers in the OVDI and OVDP. However until such time that the IRS releases specific guidance on this issue, it would be reckless for a taxpayer to opt out of the OVDI or OVDP; no experienced tax professional would recommend opting out until that time.
If you are in the OVDI or OVDP, when should you consider opting out?
Opting out of the OVDI or OVDP is irrevocable. Therefore, the taxpayer must only do so when it is clear that this course of action will produce a better result, considering all facts and circumstances. Pursuant to FAQ 51 of the OVDI and OVDP, the taxpayer can opt out of the program at any time before signing the final closing agreement with the IRS. In other words, the taxpayer is permitted to “test the waters” with the IRS agent to gauge whether there will be additional tax owed or penalties applied if he were to opt out.
For those taxpayers making submissions outside of the OVDI or OVDP, it is important to remember that the onerous penalties for failing to file US tax returns can be completely waived if the taxpayer has “reasonable cause” for not filing. This reasonable cause defense cannot be used by taxpayers while in the OVDI or OVDP.
In the process of deliberating with the IRS agent assigned to a submission made under the OVDI or OVDP, the IRS will be in a position to gauge the strength of the taxpayer’s reasonable cause argument, which will in turn influence the taxpayer’s decision to opt out of or stay in the OVDI or OVDP. Accordingly, prudence would dictate waiting to opt out until the taxpayer has had a chance to confer with the IRS agent assigned to his case.
Factors to consider before deciding to opt out of the OVDI or OVDP
While the OVDI and OVDP programs are long, involved, and expensive processes, they may produce a better, and more certain, result for the taxpayer. Factors that the taxpayer must consider before deciding to opt out include the following:
- The extra cost of professional fees required to opt out and whether such fees outweigh the benefits of doing so. It makes little sense to start a fight over $100 if the fight will cost $500;
- Protection from the risk of criminal prosecution if they remain in the OVDI and OVDP;
- The OVDI and OVDP require the taxpayer to prepare eight years of returns, however, if the taxpayer opts out and is audited he may be required to prepare several additional years of returns;
- The OVDI and OVDP provide the taxpayer with certainty with respect to the quantum of the penalties to be assessed and assurance that such penalties will not be greater than could otherwise be applied (including penalties related to significant US tax and reporting deficiencies for tax years prior to 2009).1 Thus, opting out could expose the taxpayer to additional penalties;
- The OVDI and OVDP do not permit the taxpayer to use the “reasonable cause” defense to the application of penalties. However, by remaining in the programs (at least for the time being) the taxpayer will have the ability to “test the waters” with the IRS during the OVDI and OVDP examination process for the purpose of gauging the quality of his “reasonable cause” arguments for the full abatement of all penalties;
- When the taxpayer’s submission under the OVDI or OVDP has been examined he will receive a closing letter from the IRS which will close the statute of limitations on all returns and forms filed under the OVDI or OVDP. Absent the closing letter, the statute of limitations will typically expire after three years in many cases and six years in other cases; and
- Participating in the OVDI or OVDP allows the taxpayer to make a late election to defer tax in a Canadian Registered Retirement Savings Plan (“RRSP”) and certain other Canadian retirement plans. There is a procedure for filing these late elections outside of OVDI and OVDP, but it is a time consuming, expensive process (we wrote about this topic in a previous article, which you can find by clicking here). It is important to note that the new streamlined procedure affords a relatively easy alternative to make these late elections. However, as discussed above, it is unclear whether a taxpayer will be able to opt out of the OVDI or OVDP and be eligible to participate in the new streamlined procedure.
The new streamlined procedure is deceptively complex and may not apply to many taxpayers
The new streamlined procedure went into effect on September 1, 2012 and is designed for expatriates with simple returns with little or no tax due. However, whether by design or defect, it threatens to entrap most of its likely applicants. We believe that most expats will not likely qualify for the new streamlined procedure for the following reasons:
- Eligibility for the new streamlined procedure is extremely narrow;
- The risk factors used by the IRS in making the determination as to whether a particular taxpayer has “low compliance risk” are neither defined nor weighted; and
- The determination of “low compliance risk” by the IRS is subjective, resulting in significant uncertainty and risk to the taxpayer.
Eligibility for the new streamlined procedure
According to the rules announced in August 2012 a taxpayer will not qualify for the new streamlined procedure if any of the following criteria apply:
- The taxpayer has resided in the US since January 1, 2009. The term “resided” for purposes of eligibility for the new streamlined procedure has not been defined. For example, is a taxpayer who spends winters in the US each year treated as having “resided” in the US since January 1, 2009, and therefore ineligible for the new streamlined procedure?
- The taxpayer has filed a US tax return for any tax year subsequent to 2008. As discussed above, a taxpayer who has filed US tax returns for the 2003 to 2010 tax years under the OVDI or OVDP will be ineligible for the new streamlined procedure. Also, taxpayers who filed US tax returns for the 2011 tax year will be ineligible for the new streamlined procedure.
- The taxpayer does not owe more than $1,499 in any of the tax years beginning in 2009 and ending in 2011. There are a number of situations in which preferential tax treatment in Canada may result in US tax owing on a US tax return, including flow through shares, the capital gains exemption, more generous provisions related to the exemption for principal residence, stock options, and RRSP contributions.2
- The taxpayer is not submitting an amended return for any of the 2009 to 2011 tax years, except to file a late Form 8891 to defer tax in a Canadian RRSP or Canadian Registered Retirement Income Fund (“RRIF”).
A taxpayer who otherwise filed a tax return in any of the 2009 to 2011 tax years but failed to file a required form that is not Form 8891 is ineligible for the new streamlined procedure. For example, where a taxpayer failed to file Form 3520 or Form 3520-A in respect of a Canadian Tax Free Savings Account (“TFSA”)3 or Registered Educational Savings Plan (“RESP”),4 such taxpayer will be ineligible from filing such delinquent forms under the new streamlined procedure.
In another example, where a taxpayer is a member of Canadian pension plan that is not a Canadian RRSP or Canadian RRIF, and has failed to elect deferral from current taxation under the Treaty,5 Form 8891 is not available. Rather, the Treaty position for elective tax deferral must be made on Form 8833. Such taxpayers are ineligible for late filing Form 8833 under the new streamlined procedure.
“Risk factors” under the new streamlined procedure
Notwithstanding that a taxpayer may at first appear to be eligible for the new streamlined procedure, the subjective assessment of “risk factors” by the IRS’s review of the requisite questionnaire completed by the taxpayer may result in the taxpayer’s disqualification from the new streamlined procedure. Such questionnaire contains a number of questions which contain several traps for the unwary.
Given the inherent uncertainty in the subjective assessment of low compliance risk by the IRS, the unwary or uninformed taxpayer is at risk of triggering adverse tax consequences by simply applying under the new streamlined procedure.
Prior to making an application under the new streamlined procedure, taxpayers must understand that such application will result in the following consequences:
- Disclosure of sensitive and detailed information to the IRS through the completion and submission of the requisite questionnaire;
- No protection from the risk of criminal prosecution; and
- Where the IRS determines that the taxpayer’s submission is ineligible for the new streamlined procedure, such disqualified taxpayer will not be eligible to participate in the OVDP.
Opting out of the OVDI or OVDP may produce beneficial results to the taxpayer already in these programs, however, that will not be the case for all taxpayers. Individuals need to carefully consider all of the consequences before choosing to opt out. Once a decision has been made to opt out it is critical to opt out at the appropriate time.
At this time it is unclear whether a taxpayer who is currently participating in the OVDI or OVDP will be able to opt out of those programs and into the IRS’s new streamlined procedure. Until such time that the IRS clarifies the uncertainties discussed above, it would be imprudent for any taxpayer to pursue this course.
1. The new streamlined procedure only applies to the 2009 to 2011 tax years.
2. RRSP contributions made to an individual plan in respect of which the individual’s employer had no involvement are deductible for Canadian income tax purposes, but would not be deductible for US tax purposes. Such RRSP contributions made to an “individual plan” do not constitute a contribution made to a “qualifying retirement plan” for purposes of the Canada – US Tax Convention (the “Treaty”), as required for deductibility in the US.
3. A Canadian TFSA or Tax Free Savings Account is a tax deferred savings vehicle similar to a Roth IRA in the US.
4. A Canadian RESP is a tax deferred educations savings vehicle similar to a US 509 Plan.
5. Article XVIII paragraph 7 of the Treaty.