Foreign investments are likely to pay out big returns this year and in years to come - not necessarily for investors, but definitely for the IRS.
The U.S. is taking a hard line against owners of foreign investments, who for years have been avoiding taxes by opening accounts in Switzerland, the Cayman Islands and other countries that promised secrecy for account holders.
Almost all taxpayers with foreign investments will be subject to the new Foreign Account Tax Compliance Act (FATCA), which increases the cost and complexity of reporting foreign assets, increases penalties for noncompliance and doubles the statute of limitations during which the IRS can audit taxpayers.
Accountants, likewise, will be affected, as those who fail to gather the required information will be held responsible and may be assumed to be complicit with tax-evading clients.
Accountants will need to be diligent, because some private investors may own foreign investments and not know it. If, for example, a client has invested in a fund of funds with even a small amount invested offshore or given money to a venture investor with a fund that's investing in a non-U.S holdings, problems could arise.
Some clients may also think they can continue to hide their foreign investments and avoid a hefty tax bill, but a Swiss bank account isn't what it used to be. In fact, neither is an account in Liechtenstein, Panama or the Virgin Islands, as the IRS is going worldwide in search of uncollected tax revenues.
In general FATCA takes effect in 2013 but the additional reporting requirements relating to foreign bank accounts will take effect in 2012. Accountants should be discussing the 2012 changes with their clients this year when preparing the Foreign Bank Account Reports (FBARs) due in June. Preparing for the changes now will ease the stress of implementation next year.
The UBS Case
The U.S. is one of the few countries in the world that requires investors to pay taxes on their foreign investments. Even U.S. citizens living abroad are taxed on foreign investments. Given the potential cost of tax payments, the practice by wealthy taxpayers of using foreign banks to maintain secrecy and avoid taxes has been widespread for many years.
The beginning of the end of hiding money in secret accounts began in 2006, when the IRS offered a reduced sentence to billionaire Igor Olenicoff for information relating to his foreign accounts in his tax evasion case.
Swiss banking giant UBS was implicated by Olenicoff. When faced with the potential to lose its license to operate in the U..S., UBS provided details about thousands of U.S. clients to the IRS in 2009. The IRS has been mining that data ever since.
Empowered by the UBS case, in 2009 the IRS created a voluntary disclosure program that required those who come forward to pay back taxes, interest and delinquency penalties based on the past six years of reporting. To date over 2,000 cases have been resolved resulting in $400 million of additional tax revenue.
With the first voluntary disclosure program having ended successfully, the IRS recently announced a new voluntary disclosure program with harsher penalties. The new program, which runs through Aug. 31, 2011, requires payment of back taxes, interest and delinquency penalties based on the past eight years. Penalties are up to 25 percent of the highest annual amount in the overseas account from 2003 through 2010. In some cases, taxpayers could owe more than the actual value of their foreign account.
However, those who fail to volunteer will face even stiffer penalties and possible jail time. And the probability of not being caught is low and getting lower.
Once a criminal investigation begins, it's too late to use the voluntary disclosure program.
What's Coming Next
Even taxpayers who have consistently paid taxes on foreign investments may feel like they are being penalized when they learn about FATCA reporting requirements.
Investors with international mutual funds and other investments purchased in the U.S. are not affected, but foreign residents who moved to the U.S. and other private investors with funds in offshore accounts will be affected.
FATCA requires all U.S. taxpayers with foreign assets that have an aggregate value exceeding $50,000 to report them on a special return. It is not clear yet whether the threshold applies for asset value at the end of the tax year or anytime during the year.
The FATCA reporting requirements are in addition to, not in place of, filing a foreign bank account report (FBAR). Unlike FBAR, they apply to foreign private equity funds, foreign hedge funds and real estate, foreign partnerships, corporations and trust funds.
Even without FATCA, noncompliance penalties were harsh. The penalty for willful failure to file an FBAR, for example, is the greater of $100,000 or 50% of the total account balance of the foreign account per violation. Willful violations may also be subject to criminal penalties.
While details are still being worked out, regulations will require taxpayers to list all financial institutions and the country where the institution is located, dates the accounts were opened and closed, plus contacts at each institution. An explanation of all communications, including face-to-face meetings, will also be required, as well as the names, locations and dates of any communications.
In addition, taxpayers will be required to provide the name and address of the issuer of any securities, and information about the assets, such as the class or issue of securities, and the maximum value of the asset during the tax year.
FATCA also increases the statute of limitations for auditing returns with foreign assets from three years to six years.
It's clear that the FATCA reporting requirements will be burdensome, but, considering the consequences of noncompliance, taxpayers should be grateful when their tax preparer starts asking lots of questions about their foreign assets.