With the intent of encouraging United States citizens abroad to file their tax returns and foreign bank account statements, the US Internal Revenue Service has issued a fact sheet emphasising US citizens who owe no US tax will not be subject to penalties for failure to file returns in the past.
International tax reporting specialist Patrick Hackenberg, who is a CPA with Capital Accountants, said the IRS notice does not constitute a change in the law, but is meant to persuade US and dual citizens to get back into the US tax system on their own initiative.
“The law has always been out there, but generally it’s only been known to tax professionals because it’s buried in the tax law,” Mr. Hackenberg said. “Now, the IRS is taking an active effort to market that to dual citizens around the world.”
The IRS’ approach dovetails with the strategy employed in the Offshore Voluntary Disclosure Initiative it held this summer. Mr. Hackenberg said IRS officials realised during the voluntary disclosure programmes that a lot of people who participated actually owed no taxes or penalties at all.
“This is just another extension of those offshore programmes,” he said. “A lot of people in countries like the Cayman Islands can get back in the system with no problems at all.”
The IRS fact sheet also notes US citizens will not be penalised for failing to file Reports of Foreign Bank and Financial Accounts if they can demonstrate reasonable cause for not filing.
According to the IRS fact sheet, “[T]axpayers who owe no US tax (e.g., due to the application of the foreign earned income exclusion or foreign tax credits) will owe no failure to file or failure to pay penalties. In addition, no FBAR penalty applies in the case of a violation that the IRS determines was due to reasonable cause.”
Generally, US taxpayers are only required to file income tax returns and FBARs going back six years.
The foreign earned income exclusion is adjusted for inflation on an annual basis. In 2011, it was US$92,900 per person, and in 2012 it is US$95,100, for example. While they must report worldwide income, US taxpayers will not be taxed on their foreign earnings up to that amount. There are also deductions and exclusions for foreign housing amounts.
As the IRS fact sheet clarifies, that means a person living in Cayman who has US citizenship, and who earned less than the foreign earned income exclusion amount each year, can submit US income tax returns that they failed to file over the past six years, with no fear of incurring penalties.
Indeed, as the IRS stresses, the penalties for failure to file and failure to pay income tax are calculated according to the amount of tax due, and start out from 5 per cent of tax due to a maximum of 25 per cent, for each of the two violations. “Note that there is no penalty if no tax is due,” according to the IRS fact sheet.
US persons with assets of more than US$10,000 in foreign financial accounts are required to file an FBAR on 30 June of each year. Failing to file an FBAR can result in a “wilful or non-willful civil penalty,” according to the IRS. The maximum wilful penalty is the greater of US$100,000 or 50 per cent of the total foreign account balance, while the non-wilful penalty is up to US$10,000 per violation.
For both tax return and FBAR violations, no penalty will be assessed if the taxpayer can demonstrate “reasonable cause” for the violation. According to the IRS, “Reasonable cause relief is generally granted by the IRS when you demonstrate that you exercised ordinary business care and prudence in meeting your tax obligations, but nevertheless failed to meet them.”
The IRS takes several factors into account when judging if reasonable cause exists, including reasons given for the violation, the taxpayer’s compliance history and external circumstances.
“Sometimes it’s difficult to prove reasonable basis because you have to have a valid excuse. You can’t just say you were ignorant of the law,” Mr. Hackenberg said.
Cayman not unreachable
It would be wise for US citizens in Cayman to consider the possible repercussions of not voluntarily reconciling with US tax authorities, Mr. Hackenberg said.
“It does become clear that you should file on your own because if the IRS eventually determines that you should have filed but didn’t, you could lose that foreign earned income exclusion and be subject to tax and penalties, if the IRS were to find and audit you,” he said.
Mr. Hackenberg pointed to existing initiatives, such as the IRS Whistleblower Office Informant Award, which pays informants 15 to 30 per cent of the tax and penalties collected as a result of specific information about noncompliant taxpayers who owe more than US$2 million or earn more than US$200,000 per year. (There is a different programme for noncompliant taxpayers owing and earning less than that, with awards up to 15 per cent of taxes and penalties collected.)
He also said the US and Cayman Islands governments have a Tax Information Exchange Agreement from 2001, under which, with substantial information, the Cayman Islands government can force Cayman banks to disclose their information about US persons to the IRS. He also highlighted the upcoming implementation of the Foreign Account Tax Compliance Act, which compels foreign financial institutions to report information on US account holders to the IRS.
“Some people say, ‘I’m offshore. How will the IRS ever find me?’ With the new FATCA stuff coming in 2013, the IRS will eventually have the means to know that you have foreign bank accounts,” he said.