Offshore hedge fund investors latest IRS target

After a tax evasion clampdown on holders of offshore bank accounts, US investors into offshore hedge funds could become the next target of increased IRS investigations.

In August the IRS reached an agreement with Swiss bank UBS over the disclosure of nearly 5,000 names of US citizens, suspected of using offshore bank accounts to evade US income tax. The IRS is now widening the scope of its investigation. Using Foreign Bank Account reporting as its main tool of leverage, the IRS made a surprise announcement in June that FBAR filing requirements also apply to investors in offshore hedge funds and mutual funds.

This caused consternation and confusion among tax attorneys, who until then had not interpreted the reporting rules as applicable to offshore hedge funds investors.

The FBAR is not a tax return, it is a report filed with the Treasury. As such it has long been familiar to US holders of offshore bank accounts who have to declare these accounts, if they contain aggregated funds exceeding US$10,000 at any time during a year. In 2003 the Treasury delegated the enforcement authority over FBAR reporting to the IRS.

The penalties for FBAR offences are among the highest in the US tax code. Failure to report offshore income may be subject to a US$10,000 penalty and wilful tax evasion may carry a penalty of up to US$100,000 or half the value of the offshore account. Criminal violations are punished by up to five years imprisonment and a pattern of criminal violations by up to ten years imprisonment.

In response to the IRS announcement in June the New York State Bar Association sent a letter to the Treasury and the IRS demanding clarification of the definition of ‘financial accounts’ in the context of the FBAR.

FBAR instructions considered financial accounts as ‘any bank, securities derivatives or other financial instruments account.’ This includes ‘any accounts in which the assets are held in a commingled fund, and the account owner holds an equity interest in the fund (including mutual funds).’

The parentheses ‘including mutual funds’ was only added to the instructions during revisions made to the FBAR in October 2008. The insertion triggered queries over what equity interests and what types of funds were concerned, but no official guidance was given. Bruce Friedland, a spokesman for the IRS, simply confirmed in an interview with Tax Analysts on June 29 that ‘the IRS’s position is that investments in foreign hedge funds and private equity funds are reportable for FBAR purposes.’

Due to the lack of specific guidance and the widespread confusion, the New York State Bar Association recommended a one-year moratorium on FBAR filings that did not cover traditional bank accounts.

The Managed Funds Association also contacted the IRS in a letter arguing that private investment funds do not function like other foreign accounts and only permit subscriptions or redemptions on a monthly or quarterly basis. The MFA also emphasised that the typical investors in private investment funds that are organised as foreign corporations are either non-US persons or US entities, such charities or pension funds, which are exempt from US tax.

The hedge funds interest organisation said in addition that the ‘absence of guidance on such a fundamental question creates a continuing level of uncertainty that seems inappropriately and unacceptably high given the penalties for non-compliance with FBAR requirements.’

The IRS agreed to delay the deadline for filing the 2008 form until September 23 instead of the original due date of June 30.

To provide administrative relief, the deadline has been extended until mid-2010 for ‘taxpayers with signature authority over, but no financial interest in, a foreign financial account, and taxpayers with a financial interest in, or signature authority over, a foreign commingled fund,’ an IRS Notice explained.

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