A Primer on the Costs of Noncompliance for U.S. Taxpayers with Foreign Operations

Since the decline in the economy stemming from the Great Recession, there has been continuous Congressional opposition to raising taxes. As a result, the Internal Revenue Service is left in the position of trying to increase revenue for a government in need of funding without a corresponding increase in tax rates.

What does this mean for multinational and other U.S. taxpayers with foreign bank accounts? The IRS has focused on increasing revenue through the aggressive imposition of penalties for U.S. tax payers who have failed to properly report foreign financial accounts. Obtaining abatement of any penalties, even for “reasonable cause” and/or “no willful neglect,” can be an extremely time-consuming, costly and frustrating process. Taxpayers can avoid the imposition of penalties by being diligent, prepared and filing timely. While this summary will focus primarily on monetary penalties, penalties imposed by the IRS can also include the forfeiture of property and even imprisonment.

One of the most significant opportunities for increasing the government coffers is through the strict application of U.S. tax law to the international activities of U.S. taxpayers. For example, the IRS continues to keep open the modified (to include Streamlined option) 2012 Offshore Voluntary Disclosure Initiative, to allow U.S. taxpayers to become compliant with reporting their foreign financial accounts. This program was tabbed as the “last best chance” for U.S. taxpayers to avoid excessive penalties and jail time for nondisclosure of foreign bank accounts.

The penalties related to noncompliance with foreign disclosure requirements generally begin at US$10,000 per form not filed. These forms do not necessarily result in additional U.S. taxable income or income tax, but are required to report foreign transactions and activities such as ownership of a foreign subsidiary, a foreign partnership, a foreign disregarded entity, or a foreign financial asset. Penalties are also imposed for failure to report transactions with related entities if the U.S. entity’s ownership is more than 25% foreign. In addition to the US $10,000 per form penalty, failure to file disclosure forms may also result in the loss of foreign tax credits, which, if lost, could adversely impact a U.S. taxpayer’s federal tax due.

Unreported transfers to foreign corporations can result in penalties of 10% of the value of the transfers up to US $100,000 per transfer, and failure to furnish information related to foreign trusts or gifts can result in penalties of up to 35% of the fair market value of trust assets or the foreign gifts. Penalties also apply for non-reporting of treaty-based positions, as well as transacting business with designated “boycott” countries. Finally, the Treasury regulations require that transactions with related parties should be undertaken on an “arm’s length basis.” Should the IRS determine that an appropriate transfer price was not utilized, or that proper documentation of that transfer price was not maintained, the penalty is 20% to 40% of the understatement of tax, based upon using the incorrect transfer price.

In some cases, willful neglect resulting in a failure to file a return can also carry the threat of criminal prosecution, in addition to monetary penalties. Willful neglect generally involves a conscious, intentional failure or reckless indifference. That said, there is much uncertainty around the application of what constitutes willful neglect.

The best defense against penalties is not only a good offense, but common sense, along with a clear understanding of the rules and regulations, appropriate disclosure of transactions, and timely filing of all returns. Not doing so can result in unnecessary and costly penalties and, in many cases, the statute of limitations on the entire U.S. tax return remaining open until such required information returns have been filed.

The table on the following page summarizes some of the key U.S. information returns required for foreign activities, along with the related applicable penalties.