EFTA01114626.pdf

IRS Response To The PFIC Problem In The UBS Voluntary Disclosure Initiative Tanya M. Marcum Tanya M. Marcum and Sandra J. Perry is an assistant professor of law in the Department of Business Administration, Foster College of Business Administration, at With a high volume of cases, a lack of informa- Bradley University in tion, and harsh penalties, voluntary disclosure Peoria, Illinois. She has of PFIC income presents the perfect storm for taught law for over 12 years and has published taxpayers. 16 scholarly articles on various legal topics. She holds a BS. degree from Central Michigan University, 1983, and a J.D. from Thomas M. Cooley Law School, 1987. She is licensed to practice law in the State of Michigan. THE RECENT SURGE in enforcement of US. tax law She served as General Counsel for the IRS in the Detroit and Grand Rapids offices for 10 years. She by the IRS for non-reporting of foreign income coupled can be reached at tmarcumPbradleyedu. with the complicated tax treatment of passive foreign in- vestment companies (PFICs) threatened to create a per- Sandra J. Perry fect storm for the taxpayers, their representatives, and the is a professor of law in the Department of IRS. Thousands of U.S. taxpayers have come forward to Business Administration, participate in the IRS's voluntary disclosure initiative fol- Foster College of lowing the UBS agreement in order to disclose to the US. Business Administration, at Bradley University in their identities and account information. Much of this Peoria, Illinois. She has previously unreported income is subject to harsh tax treat- taught law for over 29 ment requiring detailed financial information about these years and has published 29 scholarly articles on foreign investments, which is largely unavailable to the various legal topics. She taxpayers and the IRS. The volume of cases and lack of holds a B.S. degree from information threatened to bottleneck enforcement of the Bradley University, 1976, and a J.D. from Southern Illinois University School law This article reviews the background of the high-pro- of Law, 1979. She is licensed to practice law in the file UBS caw, the IRS's voluntary disclosure program for State of Illinois. She can be reached at sioftbradlev. these cases, and the tax problems associated with passive edu. foreign investment companies. The current IRS alterna- tive resolution method of dealing with the passive foreign investment company income of the many taxpayers who The Practical Tax Lawyer 131 EFTA01114626 32 I The Practical Tax Lawyer Summer 2011 have come forward is explained, and some future SWISS TAX HAVEN INVESTIGATION • issues regarding PFIC income are highlighted. Until recentl), Switzerland and its banking system were considered a tax haven for U.S. account hold- FOREIGN TAX HAVEN CRACKDOWN • The ers wishing to keep their income private from the 1990s saw a marked increase in schemes to evade the IRS (Todero 2010). Union Bank of Switzerland AG payment of US. taxes through the use of accounts (UBS) provided financial secrecy for its US. custom- and credit cards in foreign countries. In 1996, the ers by not disclosing account ownership informa- FBI uncovered money laundering in a cable piracy tion to the IRS and/or creating fictitious foreign en- investigation and turned the defendant into an IRS tities as the owners of the accounts (Lovejoy 2010). informant on tax evasion in the Cayman Islands Although UBS provided secrecy, U.S. citizens could banking system. In 1999,John Mathewson pleaded voluntarily disclose their UBS accounts to the IRS guilty to money laundering and provided what the by filing the appropriate forms and reporting the prosecutor called at the time "the most important income on their tax returns. However, many chose cooperation for the Government in the history of not to voluntarily disclose income earned on funds tax haven prosecution" (Smothers 1999) (note that in the UBS accounts. all parenthetical references appear in full at the end UBS signed an agreement to be part of the US. Qualified Intermediary Program in 2001 of this article). (Tax Haven Banks and US Tax Compliance 2008). The On the heels of that investigation, the IRS an- Qualified Intermediary Program allows a finan- nounced its Offshore Credit Card Program to com- cial institution to enter into an agreement with the bat tax avoidance schemes involving credit cards IRS to "assume certain documentation and with- issued by offshore banks to U.S. citizens (IRS.gov holding responsibilities in exchange for simplified 2003). As part of that program during 2000-2002, information reporting for its foreign account hold- the IRS sought and obtained "John Doe" sum- ers and the ability not to disclose proprietary ac- monses against American Express, VISA, and Mas- count holder information to a withholding agent terCard, as well as more than 100 businesses in an that may be a competitor" (Qualified Intermediary effort to identify US. taxpayers evading payment Frequently Asked Questions Q&A- .). The IRS of taxes. A "John Doe" summons is any summons soon realized that UBS was not reporting account where the name of the taxpayer under investigation information (Lovejoy, supra). The IRS and the De- is unknown and therefore not specifically identified partment of Justice (DOJ) began a criminal inves- according to I.R.M. §25.5.7.2. In January of 2003, tigation of UBS in 2004 (See US. Senate, Perm. the IRS announced its Offshore Voluntary Compli- Subcomm. on Investig, US Tax Shelter Industg: The ance Initiative aimed at bringing wayward taxpay- Role of Accountants Lattyers and Financial Professionals ers back into compliance with US. tax law using off- (2003, available at http://levin.senate.gov/imo/ shore credit cards or other offshore arrangements. media/doc/supporting/2003/111803TaxShelter Those who came forward under this initiative still Report.pdf). had to pay back taxes, interest, and penalties, but In the spring of 2007, the IRS and the US. gov- they did not face civil fraud and information return ernment received a big break in its investigation. penalties, and more importantly, criminal penalties. Swiss banker Bradley Birkenfeld informed the US. In July 2003, the IRS reported that this initiative government, through his attorneys, of a conspiracy had netted more than $75 million in taxes (Offshore between UBS and its US. customers to keep finan- Compliance Program Shows Strong Results 2003). cial account information secret from the IRS (Hil- EFTA01114627  IRS Response to PFIC 133 zenrath 2010). He hoped to become a whistleblow- (DOJ News Release #831: Former UBS Banker Sen- er and provide information to the US. which might tenced to 40 Monthsfir Aiding Billionaire American Evade entitle him to a share of the billions of unreported Taxes 2009). At Mr. Birkenfeld's sentencing, the US. offshore income hidden by UBS. However, Birken- prosecutor admitted that "without Mr. Birkenfeld feld had engaged in criminal conduct himself and walking into die door of the DOJ in the summer tried to obtain immunity from prosecution from the of 2007, I doubt...that this massive fraud scheme DOJ as part of the deal. As part of the standard would have been discovered by die United States agreement with the government called a proffer; government" (Hilzenrath 2010). Birkenfeld provided information such as cell phone numbers, email addresses, and the names of Ameri- can hotels used by UBS salesmen, even though lie IRS VOLUNTARY DISCLOSURE INITIA- knew he could still be prosecuted by the U.S. After TIVE: POST -UBS AGREEMENT • On March many back-and-forth discussions with the DOJ, im- 23, 2009, the IRS issued three memoranda regard- munity was declined. Birkenfeld then tried to work ing the voluntary disclosure of offshore accounts with the Securities Exchange Commission and con- with the following points: tinued to offer to help the U.S. in exchange for im- • The IRS's was committed to the challenges of munity. Birkenfeld was arrested in 2008 when he re- international tax administration in high-risk ar- turned to the US. to attend a high school reunion. eas by prioritizing the investigation of abusive UBS was then die primary target of die DOJ. offshore transactions designed to evade the pay- On July 1, 2008, a federal judge in Miami autho- ment of US. taxes (SBSE Examination Area rized the IRS to serve a "John Doe" summons on Directors LMSB Industry Directors 2009); UBS to obtain the names of US. taxpayers with • The Criminal Investigation Division of the IRS hidden accounts at the Swiss bank. Birkenfeld's was made responsible for initially screening any statements that UBS had about $20 billion in assets of US. taxpayers in undeclared accounts and that taxpayer amended return to determine the ac- UBS had assisted them in concealing their identi- tual eligibility of die taxpayer to make a volun- ties by creating sham entities and filing false IRS tary disclosure of this income to the IRS; forms provided the basis for issuance of die sum- • The amended returns with offshore account mons (Press Release #584: FederalJudge Approves IRS disclosures were to be processed for civil penal- Summonsfir UBS Swiss Bank Account Records 2008). ties through die Philadelphia Offshore Identifi- UBS entered into a deferred prosecution agree- cation Unit; ment with the DOJ in early 2009 (Levine and • The Philadelphia office would attempt to ex- Vasiliadis 2010). In the agreement, UBS admitted ecute agreements with taxpayers to resolve the that it participated in a scheme to assist US. citi- offshore issues, including: the assessment of all zens in hiding accounts from die IRS and agreed taxes and interest for six years; an accuracy or to disclose the identities and account information delinquency penalty for all years; and penalties for some of its US. customers. Birkenfeld pleaded guilty on August 21, 2009 to a single count of as- "equal to 20 percent of die amount in foreign sisting an American billionaire real estate developer bank accounts/entities in the year with the evade paying $7.2 million in taxes (IRS News Re- highest aggregate account/asset value"; lease: Offshore Tax-Avoidance and IRS Compliance Ef- • Taxpayers had until October 15, 2009 to make forts n.d.) and was sentenced to 40 months in prison their voluntary disclosures. EFTA01114628 34 I The Practical Tax Lawyer Summer 2011 THE PFIC PROBLEM • Congress enacted the This means that the company must be able to cal- passive foreign investment company tax rules in culate its ordinary earnings and net capital gains for 1986. These rules limit tax incentives to invest out- each year and provide to each investor his or her side the United States (Staff of Joint Committee pro rata share of the same. In addition, a QEF elec- on Taxation. 991h Cowers General Explanation of the tion is only available if the PFIC complies with the Tax Reform Act of 1986) and arguably treat passive IRS information disclosure requirements that en- foreign investments more harshly than passive in- able the IRS to determine the PFICs ordinary earn- vestments in domestic companies (Crenshaw 2006). ings and capital gains. Many foreign companies do Many of the UBS accounts held by US. taxpayers not provide the necessary financial information to involved passive foreign investment companies that its US. customers rendering this election unavail- would have been subject to this special tax treat- able to most taxpayers. Taxation as QEF treats as ment, had the foreign investment been declared by ordinary income the shareholder's pro rata share of die taxpayer. ordinary earnings for die year and treats as long- A PFIC is any foreign corporation where 75 term capital gain the shareholder's pro rata share percent or more of its gross income in a taxable of the net capital gains for the year, whether or not year is passive income, or where the average per- distributions of income are made to the investors in centage of assets held by the corporation during accordance with 26 U.S.C.S. §1293(a). Stock basis is a taxable year which produces passive income or increased for income recognized and decreased for which is held for the production of passive income amounts distributed. is at least 50 percent according to Internal Revenue Code (I.R.C.) §1297(a). For purposes of PFIC, pas- Mark-To-Market Election sive income includes any income such as dividends, The second alternative election available to the interest, royalties, rents, annuities, certain property taxpayer who reports the PFIC income is die mark- or commodities transactions, gains from foreign to-market election as described in I.R.C. §1296. This currency, income equivalent to interest, or personal election option was added in the Taxpayer Relief service contracts as described by I.R.C. §§1297(b) Act of 1997 (Pub. L. No. 105-34) because foreign and 954(c). A return involving a PFIC must also in- banks often did not provide enough information clude a Report of Foreign Bank and Financial Ac- for taxpayers or the IRS to make die QEF election counts (FBAR) Form TD F 90-22.1 (revised March (IRS Plain Language Regulations, Reg-112306-00 2011). There are three taxation alternatives for 2002, July 31, 2002). The mark-to-market election PFIC. Two of the alternatives require an election is available for marketable stock and includes as or- by the reporting taxpayer. The third is the default dinary income to the taxpayer the excess of the fair method which is more punitive. market value of stock over the taxpayer's adjusted basis of die stock. A loss deduction is allowed to the Election To Treat Income As A lesser of the excess value or unreversed inclusions. Qualified Electing Fund Mark-to-market compares die value of the stock at In the first alternative, the taxpayer may elect the beginning of die year to its value at the end of to treat the income as a Qualified Electing Fund the year. If the value of the stock went up, the gain (QEF) if the company complies with such require- was ordinary income. If the value went down, there ments as the secretary may prescribe for purposes was an ordinary loss. This election is considered less of determining the ordinary earnings and net capi- favorable than die QEF election for most US. tax- tal gain of the company according to I.R.C. §1295. payers because the tax is based on the individual EFTA01114629