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Streamlined Foreign Offshore Procedure

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One of the most dramatic changes to the voluntary disclosure process made by the IRS on June 18, 2014, was the complete revamping of the Streamlined Foreign Offshore Procedure. As long as the taxpayer can honestly certify that his prior violations of U.S. tax laws were non-willful, the Streamlined Foreign Offshore Procedure offers a unique opportunity for such a taxpayer to bring his tax affairs with respect to foreign accounts and other offshore assets into complete compliance with the U.S. tax rules with potentially no penalties. In this article, I am going to outline the Streamlined Foreign Offshore Procedure and discuss why it is important to take advantage of it as soon as possible.

Old Streamlined Foreign Offshore Procedure

The Streamlined Foreign Offshore Procedure already existed prior to June 18 changes. However, while it offered a no penalty solution to U.S. taxpayers residing overseas, it also imposed severe limitations preventing the great majority of these taxpayers from qualifying to participate in the Streamlined Foreign Offshore Procedure.

The most difficult conditions were the $1,500 additional tax liability threshold and the risk assessment process (to comply with the “simple return” rule). Further complications would arise from the failure to timely file original tax returns.

2014 Changes to Streamlined Foreign Offshore Procedure

It is precisely these difficult requirements that were removed by the IRS in June of 2014, thereby opening up a tremendous opportunity to U.S. taxpayers residing overseas: the $1,500 tax limit was gone, the risk assessment process was gone, and the importance of timely filed U.S. tax returns was also downgraded. Instead, the IRS created a new advantageous (to U.S. taxpayers) Streamlined Foreign Offshore Procedure with simplified eligibility requirements.

If these requirements are met, a U.S. taxpayer residing overseas can now avoid the imposition of all FBAR penalties if he follows the Streamlined Foreign Offshore Procedure for filing amended tax returns and delinquent FBARs.  Moreover, as an additional bonus, the IRS is stating that it will waive all failure-to-file and failure-to-pay penalties, accuracy-related penalties, and information return penalties.

There are some limitations on this generous gift. Any previously assessed penalties with respect to those years, however, will not be abated. Furthermore, as with any U.S. tax return filed in the normal course, if the IRS determines an additional tax deficiency for a return submitted under these procedures, the IRS may assert applicable additions to tax and penalties relating to that additional deficiency.

Since Streamlined Foreign Offshore Procedure offers such tremendous benefits to U.S. taxpayers who reside outside of the United States, it is important to make sure that all of the eligibility and filing requirements are met.

Streamlined Foreign Offshore Procedure: Eligibility requirements

There are three main eligibility requirements for participation in the Streamlined Foreign Offshore Procedure. First, the taxpayer must meet the applicable non-residency requirement. Here is the first caveat, for joint return filers, both spouses must meet the applicable non-residency requirement. Different rules apply to taxpayers who are U.S. citizens and U.S. permanent residents than to those taxpayers who do not fall into these categories.

The second requirement of the Streamlined Foreign Offshore Procedure is that the taxpayer violated the applicable U.S. tax requirements non-willfully – i.e. the taxpayer failed to report the income from a foreign financial asset and pay tax as required by U.S. law, and may have failed to file an FBAR (FinCEN Form 114, previously Form TD F 90-22.1) with respect to a foreign financial account, and such failures resulted from non-willful conduct.

The third requirement of the Streamlined Foreign Offshore Procedure is that the participating taxpayer is not subject to an IRS civil examination or an IRS criminal investigation.  Two important points here – it does not matter whether the examination relates to undisclosed foreign financial assets and it does not matter whether the examination involves any of the years subject to the voluntary disclosure.  In either case,  the taxpayer will not be eligible to use the Streamlined Foreign Offshore Procedure.

In reality, there is a more obscure fourth requirement that there is a valid Taxpayer Identification Number (TIN), but this issue can be solved by enclosing a completed ITIN application with the disclosure package under the Streamlined Foreign Offshore Procedure.

Filing Requirements Under the Streamlined Foreign Offshore Procedure

There are five main filing requirements that must be met in order to comply with the Streamlined Foreign Offshore Procedure.

The first filing requirement under the Streamlined Foreign Offshore Procedure is that, for each of the most recent 3 years for which the U.S. tax return due date (or properly applied for extended due date) has passed, the taxpayer must file delinquent or amended tax returns, together with all required information returns (e.g., Forms 3520, 5471, and 8938). Specific procedures must be followed in the preparation of these returns.

The second filing requirement under the Streamlined Foreign Offshore Procedure is that, for each of the most recent 6 years for which the FBAR due date has passed, the taxpayer must file delinquent FBARs according to the FBAR instructions and include a statement explaining that the FBARs are being filed as part of the Streamlined Filing Compliance Procedures. The taxpayer is required to file these delinquent FBARs electronically at FinCen. Detailed instructions must be followed to file these FBARs properly.

The third filing requirement under the Streamlined Foreign Offshore Procedure is the submission of the payment of all tax due as reflected on the tax returns and all applicable statutory interest with respect to each of the late payment amounts. The taxpayer’s TIN must be included on the check.

The fourth filing requirement under the Streamlined Foreign Offshore Procedure is the submission of any requests for relief for failure to timely elect deferral of income from certain retirement or savings plans where deferral is permitted by an applicable treaty.  Specific additional requirements apply to this request (especially, in the Canadian RRSP context).

Finally, the fifth filing requirement under the Streamlined Foreign Offshore Procedure is the most important part of this application – completed and signed “Certification by U.S. Person Residing Outside of the U.S.” (as of July 4, 2014, this is still in draft format but the final version should appear soon).

This is the most important legal document in the Streamlined Foreign Offshore Procedure. This is the statement that certifies that the taxpayer: (1) is eligible for the Streamlined Foreign Offshore Procedures; (2) that all required FBARs have now been properly filed; and (3) that the failure to file tax returns, report all income, pay all tax, and submit all required information returns, including FBARs, resulted from non-willful conduct. I cannot emphasize enough the importance of contacting your international tax attorney prior to submitting this document to the IRS.

The taxpayer must submit the original signed statement as well as attach copies of the statement to each tax return and information return being submitted through these procedures.

Streamlined Foreign Offshore Procedure: Some Considerations

While participation in the Streamlined Foreign Offshore Procedure may offer tremendous benefits to U.S. taxpayers who reside outside of the United States, it is important to understand that this may not be a simple process and all considerations should be taken into account. From the legal determination of whether the residency requirements are met to the very complicated legal decision on whether the “non-willful” determination applies, Streamlined Foreign Offshore Procedure involves significant legal analysis.

Based on my extensive experience, I believe that the great majority of the U.S. taxpayers who are currently not in compliance with the FBAR requirements are non-willful at heart. However, it is important to make sure that the legal case supports this finding – i.e. the facts of the case should support the determination of legal non-wilfulness.

I strongly advise against making such determination without the help of an international tax lawyer. You need an attorney who can look at your case objectively and with a “cool head”, and make such determination based on his experience and knowledge of law.

Finally, it is essential to understand that there is no guarantee that Streamlined Foreign Offshore Procedure will be available even in half a year in the same format.  The IRS reserved the power to change the rules regarding  Streamlined Foreign Offshore Procedure at any point.  This is why it is so important to act fast to make sure that you are able to take advantage of this unique opportunity.

Contact Sherayzen Law Office for Professional Help with Your Participation in the Streamlined Foreign Offshore Procedure

If you have undisclosed foreign accounts, contact Sherayzen Law Office for a professional analysis of your voluntary disclosure options. Our international tax law firm has helped hundreds of U.S. taxpayers worldwide and we can help you.

Contact Us to Schedule Your Confidential Consultation!

Significance of Income Source Rules in International Tax Law

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When dealing with the international transactions, the United States tax law usually divides income into two broad categories: foreign source income and the U.S. source income. The determination of whether the income is foreign or U.S. in origin depends on a set of rules – the source-of-income rules – created by Congress, elaborated by the U.S. Treasury regulations, refined in courts, and further modified by the international treaties. While jurisdictional in nature, the income source rules are fundamentally and critically important to the understanding and operation of international transactions, primarily because these rules generate real operational consequences that affect a variety of substantive U.S. tax provisions. For the purposes of this essay, these consequences may be classified according to the grouping of the affected taxpayers.

The first set of such taxpayers are U.S. citizens, residents and domestic corporations subject to foreign tax on their income. The income source rules are crucial for these taxpayers because the U.S. foreign tax credit is available only if the foreign taxes are paid on the foreign source income. Hence, foreign taxes paid on the U.S. source income are not available to offset U.S. income tax liability. For example, suppose that a U.S. corporation earns income in the United Kingdom, which under the U.S. tax rules and relevant treaties is considered to be U.S. source income. If the U.K. authorities tax this income, the U.S. corporation will not be able to credit these taxes against the U.S. tax liability. Thus, the unfortunate result in this situation is double-taxation of the same income (note, however, that a deduction may be available to the U.S. corporation).

The other set of affected taxpayers is comprised of the nonresident aliens and foreign corporations. For this group, the impact of income source rules is two-fold. First, with respect to the business income, only U.S. source income may be regarded as effectively connected income and subject to the U.S. taxation. Hence, if the income is not a U.S. source income, then it cannot be considered as effectively connected income, thereby avoiding taxation by the U.S. government, unless the exception under I.R.C. §871(c)(4) applies. Under this exception, where certain types of income (such as dividends, interest, rents, royalties, sale of personal property, et cetera) are attributed to the nonresident alien’s (or foreign corporation’s) U.S. office or other fixed place of business, the income is regarded as effectively connected income and may be subject to the U.S. taxation.

Second, in case of non-business (usually, investment) income, the 30 percent withholding tax may be imposed only on U.S. source income. If, however, the income is considered by the U.S. tax authorities to be foreign source income, then no such tax may be imposed. For example, if a French investor receives interest that is deemed not to be U.S. source income, then the withholding tax will not be imposed.

Thus, based on the analysis above, the enormous importance of the income source rules in structuring international transactions becomes apparent. Obviously, for the purposes of illustrating their significance, I simplified this discussion into a simple domestic versus foreign dichotomy. The reality may quickly become much more complex when one takes into account various variations with respect to U.S. territories, certain types of income and/or transactions, politically-motivated exceptions regarding some foreign countries, and modification of the rules by bilateral tax treaties.

It should be remembered, however, that while they contain many traps and dangers for the unwary, the income source rules may provide excellent opportunities for beneficial and responsible tax planning.

Definition of Foreign Earned Income for the purposes of Foreign Income Exclusion under I.R.C. §911

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Under I.R.C. §911, if certain conditions are met, a qualified individual can exclude as much $91,400 (for tax year 2009) of foreign earned income from taxable gross income. Two questions arise: what is earned income, and when is such income considered to be foreign earned income?

Earned Income

Earned income usually means wages, salaries, or professional fees, and other amounts received as compensation for personal services actually rendered, but does not include that part of the compensation derived by the taxpayer for personal services rendered by him to a corporation which represents a distribution of earnings or profits rather than a reasonable allowance as compensation for the personal services actually rendered.

The issue of earned income becomes complicated in a situation where a taxpayer engaged in a trade or business in which both personal services and capital are material income producing factors. Capital is a material income-producing factor if the operation of the business requires substantial inventories or substantial investments in plant, machinery, or other equipment. In this case, a reasonable allowance as compensation for the personal services rendered by the taxpayer, not in excess of 30 percent of his share of the net profits of such trade or business, shall be considered as earned income (I.R.C. §911(d)(2)(B)). This rule, however, would not apply where the capital is merely incidental to the production of income (see Rousku v. Commissioner (Tax. Ct.1971)).

In a situation where the services rendered abroad culminate in a product that is either sold or licensed, it is difficult to determine whether the proceeds are earned income. Usually, such issues are resolved on a case-by-case basis.

Foreign Earned Income

Earned income is usually considered as “foreign earned income” if it is attributable to services actually rendered by the taxpayer while oversees. The place at which the taxpayer receives the income is not relevant. For example, an employee working abroad for a U.S. employer does not lose the exclusions by having her compensation paid into a bank account in the United States. Note, however, that services rendered in anticipation of, or after the conclusion of an oversees assignment are not covered by the exclusion. I.R.C. §911(b)(1)(A) and §911(d)(2)

Understanding Foreign Income Exclusion under I.R.C. §911: General Information

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Under I.R.C. §911, a U.S. citizen or resident can elect to exclude as much as $91,400 (for tax year 2009) of foreign earned income and some or all foreign housing costs from taxable gross income if two conditions are met. First, the individual must satisfy either a foreign presence or bona fide residence test. Second, the individual’s tax home must be in a foreign country. The first requirement (foreign presence/bona fide residence test) is satisfied when: (i) the individual is a U.S. citizen or resident who is physically present in a foreign country for at least 330 full days during any 12 consecutive months, or (ii) the individual is a U.S. citizen who is a bona fide resident of a foreign country for an uninterrupted period that includes an entire tax year. The second requirement is satisfied if the individual’s tax home – i.e. main place of business, employment, or post of duty – is in a foreign country. Tax home generally means the place where the individual is permanently or indefinitely engaged to work as an employee or self-employed individual.