IRS’s Recent Action Against HSBC Highlights Need for U.S. Taxpayers with Undisclosed Offshore Accounts to Consider Voluntary Disclosure under the IRS’s Latest Voluntary Disclosure Initiative
Kelley Drye Client Advisory
April 18, 2011

On April 7, 2011, the U.S. Department of Justice filed a petition with the U.S. District Court for the Northern District of California seeking, in effect, to require HSBC India to turn over information regarding U.S. holders of accounts there.  According to the Department of Justice, as of September 2010, approximately 9,000 U.S. residents held accounts at HSBC India, but only 1,391 required forms identifying such accounts had been filed for 2009.  Meanwhile, the Department of Justice announced on April 13, 2011, that a U.S. taxpayer had pled guilty to filing a federal income tax return that failed to disclose accounts at HSBC India valued at approximately $8.3 million.

The foregoing action highlights the need for U.S. taxpayers who hold or have held overseas financial accounts that have not been disclosed to the IRS to consider participating in the IRS's newest voluntary disclosure program - the 2011 Offshore Voluntary Disclosure Initiative (the "2011 Disclosure Program").  The 2011 Disclosure Program offers taxpayers an opportunity to disclose hidden foreign financial accounts to the IRS in exchange for a reduced risk of criminal prosecution and reduced civil penalties.  The 2011 Disclosure Program is only available until August 31, 2011.

The 2011 Disclosure Program stems from the success of the voluntary disclosure program that the IRS conducted from March 23, 2009 through October 15, 2009 (the "2009 Disclosure Program" or the "Initial Disclosure Program").  Pursuant to the 2009 Disclosure Program, the IRS received approximately 15,000 voluntary disclosures.  After the October 15, 2009 deadline under the Initial Disclosure Program, approximately 3,000 additional taxpayers came forward with undisclosed foreign financial accounts.  The 2011 Disclosure Program offers these taxpayers and other eligible taxpayers the benefit of reduced risk of criminal prosecution and reduced civil penalties (but slightly higher civil penalties than under the 2009 Disclosure Program).

Taxpayers who are eligible to participate in the 2011 Disclosure Program and who fail to come forward will face an increased risk that their undisclosed overseas financial accounts will be detected by the IRS.  At the time the 2009 Disclosure Program was introduced, the IRS was focused primarily on holders of undisclosed accounts at UBS in Switzerland.  Since then, the IRS has greatly expanded the scope of its probe and is now seeking information regarding U.S. holders of accounts at other foreign financial institutions, including, most recently, at HSBC India.

Foreign Financial Account Reporting Requirements

A U.S. citizen or resident with a financial interest in, or signature authority over, a foreign financial account is generally required to file a Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts (commonly known as an "FBAR") by June 30th each year if the aggregate value of all such financial accounts exceeded $10,000 at any time during the previous calendar year. A U.S. citizen or resident is also generally required to report any interest or other income generated by such an account on his or her federal income tax return.

A U.S. citizen or resident who fails to file a required FBAR or who fails to report income generated by a foreign financial account may face significant civil and criminal penalties. The current civil penalty for the willful failure to file a required FBAR can be as high as the greater of $100,000 or 50% of the total balance in the foreign financial account (for each such failure). The IRS has taken the position that a separate penalty may be imposed for each year for which a required FBAR was not filed. Thus, for example, a taxpayer who held $1,000,000 in an undisclosed foreign bank account from 2006 through 2009 may theoretically face potential civil FBAR penalties of $2,000,000 (i.e., $500,000 per year for four years). A taxpayer who fails to report income from a foreign financial account may, in addition to other civil penalties, be subject to a penalty equal to 75% of the tax on the unreported income if the IRS is able to prove that the underreporting was due to fraud.

Potential Benefits of Participating in the 2011 Disclosure Program

The IRS will generally not recommend the criminal prosecution of eligible taxpayers who participate in the 2011 Disclosure Program. Eligible taxpayers should generally also be subject to reduced civil penalties. Potential penalties under the 2011 Disclosure Program include an accuracy-related penalty equal to 20% of the tax on any unreported income and a miscellaneous offshore penalty capped at 25% of the highest value of undisclosed financial accounts and other "tainted" foreign assets (including assets that generated unreported income or were acquired with unreported income), plus interest, for 2003 through 2010. In certain, limited circumstances the 25% miscellaneous penalty is reduced to 12.5% or 5%.

Account holders who participated in the 2009 Disclosure Program and who paid a penalty in excess of the penalty applicable under the 2011 Disclosure Program might be eligible for a reduction in their previously paid penalty.

Requirements of the 2011 Disclosure Program

Taxpayers who wish to participate in the 2011 Disclosure Program must generally satisfy the following requirements:

  • Provide copies of previously filed original (and, if applicable, previously filed amended) federal income tax returns for tax years covered by the voluntary disclosure;

  • Provide complete and accurate amended federal income tax returns (for individuals, Form 1040X, or original Form 1040 if not yet filed) for all tax years covered by the voluntary disclosure;

  • File complete and accurate original or amended offshore-related information returns and FBARs for calendar years 2003 through 2010;

  • Cooperate in the voluntary disclosure process, including providing information on offshore financial accounts, institutions and facilitators, and signing agreements to extend the period of time for assessing tax and penalties;

  • Pay the 20% accuracy-related penalty for each year covered by the disclosure and the 25% (or 12.5% or 5%) miscellaneous offshore penalty, as described above;

  • Submit full payment of all tax, interest, accuracy-related penalties, and, if applicable, the failure to file and failure to pay penalties with the required submissions or make good faith arrangements with the IRS to pay in full, the tax, interest, and penalties; and

  • Execute a Closing Agreement on Final Determination Covering Specific Matters, Form 906.
Differences Between the 2011 Disclosure Program and the 2009 Disclosure Program

There are a number of differences between the 2009 Disclosure Program and the 2011 Disclosure Program. In general, the terms of the 2011 Disclosure Program are slightly less favorable than the terms of the 2009 Disclosure Program. The IRS has stated publicly that it did not wish to reward taxpayers for deferring their disclosures. The differences include the following:

Penalties:

Under the 2009 Disclosure Program, participating taxpayers were generally required to pay a penalty equal to 20% of the highest aggregate value of undisclosed foreign bank accounts and other income producing assets for which no income was reported, for the period from 2003 through 2008. Taxpayers were also generally required to pay taxes on unreported income, a 20% accuracy related penalty, and interest, for the period from 2003 through 2008.

As indicated above, under the 2011 Disclosure Program, participating taxpayers will generally be required to pay a miscellaneous offshore penalty equal to 25% (or, in certain, limited cases, 12.5% or 5%) of the highest aggregate value of undisclosed or tainted foreign assets (including bank accounts and other assets that generated unreported income or were acquired with unreported income) for the period from 2003 through 2010. Taxpayers will also be required to pay taxes on unreported income, a 20% accuracy-related penalty, and interest, for the period from 2003 through 2010.

While the penalties under the 2011 Disclosure Program are higher than they were under the 2009 Disclosure Program, the penalties generally remain far lower than the penalties that might be asserted against taxpayers who do not come forward under the 2011 Disclosure Program.

Fixed Deadline for Submission of Documentation:

Under the 2009 Disclosure Program, taxpayers were generally required to come forward prior to a fixed deadline and then await notification that they had been accepted into the program. Taxpayers accepted into the program would then generally wait, in some cases for several months, to be contacted by an IRS agent. The IRS agent would then typically request amended returns, FBARs, and other documentation.

Under the 2011 Disclosure Program, participating taxpayers must complete their submission, including amended returns, FBARs, and other documentation, by the August 31, 2011 deadline. Because participating taxpayers are generally required to complete their submissions by August 31, 2011, taxpayers who wish to participate in the 2011 Disclosure Program should consult with an attorney well in advance of August 31, 2011. It should be noted that obtaining the necessary foreign account statements to support the amended tax returns and FBARs is often a lengthy process.

The IRS's Pre-Existing Voluntary Disclosure Program

The IRS's Criminal Investigation Division has historically offered a voluntary disclosure program, pursuant to which participants may reduce their risk of criminal prosecution. The 2009 Disclosure Program enhanced the pre-existing program, by providing taxpayers with the opportunity to cap their potential civil penalties. The 2011 Disclosure Program likewise enhances the pre-existing program, except that the cap on civil penalties is generally higher than it was under the 2009 Dislcosure Program. Account holders who do not take advantage of the 2011 Disclosure Program before the August 31, 2011 deadline, might still be eligible to make a voluntary disclosure under the pre-existing program, but without the cap on civil penalties available under the 2011 Disclosure Program.

For account holders who do not take advantage of the 2011 Disclosure Program or who are ineligible for it, different strategies may be available to minimize potential penalties. The success of such strategies will depend, to a large extent, on the facts and circumstances relating to the particular account holder and his or her failure to report the existence of the account and the associated income.

Importance of Consulting with an Attorney

There are other eligibilty requirements for the 2011 Disclosure Program. Account holders should consult with an attorney to determine whether they are potentially eligible for relief under the program.

Account holders should exercise caution in consulting with an accountant regarding a potential disclosure. The limited accountant-client privilege is narrower in scope than the traditional attorney-client privilege, and provides no protection in the case of criminal investigations (unless the accountant has been engaged directly by the account holder's attorney and certain other requirements are met). Accordingly, account holders who are considering making a voluntary disclosure should consult with an attorney. The attorney, if necessary, can separately engage an accountant to assist the attorney. Through this arrangement, the attorney-client privilege can be extended to cover communications with an accountant, provided certain other conditions are met.

Swift Action May be Required

Account holders who wish to take advantage of the 2011 Disclosure Program with respect to undisclosed offshore accounts should act quickly, as participating account holders must complete their submissions by August 31, 2011. In addition, if the IRS initiates a civil examination or criminal investigation of an account holder, he or she will not be eligible for the 2011 Disclosure Program, unless he or she previously made a disclosure to the IRS that meets all of the requirements of the program. Moreover, the IRS has indicated that once it obtains information regarding a specific taxpayer's noncompliance under a "John Doe" summons served on a foreign bank, that taxpayer may become ineligible for participation in the 2011 Disclosure Program.

Kelley Drye & Warren LLP

The Tax Practice Group represents numerous clients in tax controversies at both the field office and appeals levels and in judicial proceedings, including in connection with voluntary disclosures. The Group also advises international and domestic corporations, partnerships, limited liability companies, individuals and tax-exempt entities on a full range of strategic tax planning issues. Attorneys in the Group represent clients in a diverse variety of transactions, including mergers and acquisitions, equity and debt financings, leasing transactions, financial products, venture capital and restructurings. In addition, we advise foreign clients on formation and operation of their U.S. businesses and U.S. clients on the complex tax aspects of their foreign operations. Additionally, the attorneys in the Tax Practice Group have expertise in joint venture planning, including partnership and limited liability company issues.

For more information about this Client Advisory, please contact:

Gregory M. McKenzie
(212) 808-7689
gmmckenzie@kelleydrye.com

Andrew H. Lee
(212) 808-7859
alee@kelleydrye.com

This client advisory is provided by Kelley Drye & Warren LLP for educational and informational purposes only and is not intended and should not be construed as legal advice.  This document is not intended and cannot be used for the purpose of avoiding tax-related penalties.  Account holders seeking advice regarding potential tax penalties should consult directly with an attorney.