Delinquent U.S. Foreign Information Returns: Is Filing Under the 2011 OVDI Appropriate?
The following was originally published August 01, 2011 in the AICPA Tax Adviser
Foreign income & taxpayers
In early February, IRS Commissioner Douglas Shulman announced an opportunity for taxpayers to avoid a substantial portion of the penalties that would otherwise be due on previously unreported offshore accounts, entities, and income. Taxpayers who successfully participate in the 2011 Offshore Voluntary Disclosure Initiative (OVDI) will benefit from significantly reduced penalties and avoidance of criminal prosecution. The OVDI generally runs until August 31, 2011; however, the IRS has provided that taxpayers who make a good-faith attempt to fully comply by August 31 but are unable to submit a complete package can request a 90-day deadline extension (FAQ No. 25.1).
Immediately after announcing the OVDI, the IRS released guidance on specific details in the form of frequently asked questions (FAQs). Within those questions and answers, the IRS has presented a significant opportunity for taxpayers who properly reported all their income to obtain automatic relief, outside the OVDI, for failure to file certain U.S. foreign information returns. To qualify, taxpayers must generally file these outstanding returns by August 31, 2011.
FAQs Nos. 17 and 18 specifically state that U.S. persons who reported all their taxable income but only recently learned of their filing failures with respect to Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts (FBAR), or other U.S. foreign information returns (e.g., Forms 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations, and 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts) can obtain penalty relief by filing these delinquent returns under the parameters of the FAQs, but outside the OVDI.
FAQ No. 17
FAQ No. 17 establishes an automatic waiver of the reporting penalties for failure to file an FBAR when the taxpayer has properly reported all taxable income but only recently learned that it was subject to the FBAR requirement. FAQ No. 17 makes it clear that to qualify for this penalty relief a taxpayer should not file under the 2011 OVDI but instead should file any delinquent FBARs in the normal manner by August 31, 2011. The taxpayer should file these delinquent reports with Treasury’s Detroit processing center, along with an explanation of why the reports are late.
FAQ No. 18
FAQ No. 18 establishes an automatic waiver of penalties for failure to file certain U.S. foreign information returns where the taxpayer has properly reported all taxable income and paid the applicable tax but only recently learned that it was subject to these reporting requirements. While this question specifically refers to two U.S. foreign information returns, Forms 5471 and 3520, it does not limit penalty relief to those forms alone. This automatic waiver should also apply to the following additional U.S. foreign information returns:
- Form 926, Return by U.S. Transferor of Property to a Foreign Corporation;
- Form 3520-A, Annual Information Return of a Foreign Trust with a U.S. Owner;
- Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business;
- Form 8858, Information Return of U.S. Persons with Respect to Foreign Disregarded Entities; and
- Form 8865, Return of U.S. Persons with Respect to Certain Foreign Partnerships.
Again, this FAQ makes it clear that a taxpayer qualifying for relief under the terms of the FAQ should not file under the 2011 OVDI but instead should file any delinquent U.S. foreign information returns in the normal manner according to the applicable form filing instructions, along with an explanation of why the reports are late.
To avoid automatic assessment of penalties, it is recommended that submissions to the IRS under these two FAQs should cite the particular FAQ (No. 17 or No. 18, as the case may be) in the explanation statement attached to each information return and include explicit reference to the penalty waiver language set forth in the FAQ.
Key requirement: reported and paid tax
Taxpayers that have unreported income from foreign sources will not qualify for penalty relief under these two FAQs. A key requirement for both Nos. 17 and 18 is that taxpayers must have “reported and paid tax” on all their income. FAQ No. 17 is “[f]or taxpayers who reported and paid tax on all their taxable income for prior years but did not file FBARs.” FAQ No. 18 is for “[a] taxpayer who has failed to file tax information returns, such as Form 5471 for controlled foreign corporations (CFCs) or Form 3520 for foreign trusts but who has reported and paid tax on all . . . taxable income with respect to all transactions related to the CFCs or foreign trusts.”
Thus, if a dual citizen U.S. person has never filed in the United States but has been paying foreign income taxes on all income in his or her present resident foreign country, and such foreign taxes would offset the person’s U.S. income tax liability through the use of foreign tax credits, that person would not qualify for penalty relief under these two FAQs. In other words, since the person never reported that income to the United States, even though no U.S. income tax would be payable, full penalty relief would not be available.
The same rationale would apply in the context of a U.S. corporation that never filed a Form 5471 for a CFC. If a U.S. corporation that owned a CFC was required to report subpart F income and that U.S. corporation did not have to pay any additional income taxes due to the deemed foreign tax credits that resulted from the deemed dividend recognized under subpart F, that corporation would not qualify for penalty relief under FAQ No. 18.
However, on June 2, 2011, the IRS did have a change of heart for these dual citizens. It is now allowing such persons to obtain a reduced penalty of 5% instead of the standard 25% penalty assessment. Through a revision of FAQ No. 52, U.S. citizens who reside in foreign countries, have been fully compliant with the tax laws in those countries, and have U.S. source income of $10,000 or less per year can qualify for the reduced penalty. A taxpayer will still be required to file all the necessary information and statements required under the regular OVDI program by the August 31, 2011, due date.
Practitioners should be aware that the OVDI is not a “one size fits all” process to clean up past nonfilings of U.S. foreign information returns. If a taxpayer has delinquent U.S. foreign information returns, there is a chance to make good on such past noncompliance outside the recently announced OVDI, but only if the income and related taxes have been reported and paid and the late U.S. foreign information returns are filed by August 31, 2011. Otherwise, the taxpayer and his or her tax advisers will have to make a complex and probably expensive decision about whether and how to pursue the optimal method of compliance in light of past nonfilings of U.S. foreign information returns.
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