Foreign Bank Accounts, Bank Secrecy, and Voluntary Disclosure

Foreign Bank Accounts, Bank Secrecy, and Voluntary Disclosure

Switzerland, Liechtenstein and the Cayman Islands all bring to mind discrete bankers, numbered accounts and strong bank-secrecy laws. Many people use bank accounts identified only by number, foreign trusts or nominee corporations organized in these countries to protect their assets from the prying eyes of creditors. At the same time, United States taxpayers with financial arrangements in these bank secrecy jurisdictions sometimes fail to report income earned in their foreign accounts or fail to file the required reports with the Internal Revenue Service (“IRS”). 
 
While there is nothing inherently illegal about having a foreign bank account in a bank secrecy jurisdiction, the government recently has taken steps to acquire information about U.S. taxpayers who may be using such accounts to avoid paying U.S. taxes. Just a few weeks ago, the Senate Permanent Subcommittee on Investigations conducted hearings on the use of foreign bank accounts to skirt U.S. tax laws and reported that “each year the United States loses an estimated $100 billion in tax revenue due to offshore tax abuses.” [i] Shortly before the hearings started, the IRS served a summons on Union Bank of Switzerland(“UBS”) demanding the names of certain U.S. taxpayers who had signature or other authority with respect to any financial accounts, maintained at or managed through, any office in Switzerland of UBS or its subsidiaries at any time from 2002 to 2007. And, last year, Senators Levin, Coleman and Obama introduced the “Stop Tax Haven Tax Abuse Act” which, among other things, (i) creates a presumption in civil tax proceedings that transfers to offshore entities are unreported income; (ii) extends the statute of limitations for tax assessments and collection proceedings involving transfers to or from offshore accounts; (iii) adds new reporting requirements for financial institutions concerning the beneficial owners of offshore accounts; and (iv) increases penalties for failing to disclose offshore holdings.[ii]  
 
FOREIGN BANK ACCOUNTS ARE NOT ILLEGAL
 
There is nothing illegal about owning a foreign bank account or conducting transactions overseas. Indeed, such multi-national transactions are a part of everyday life in the global economy. However, the government does require U.S. taxpayers to file reports disclosing their off-shore financial arrangements, including foreign bank accounts, controlled foreign corporations and foreign trusts. And the penalties for failing to file the necessary reports can be steep.   
 
For example, Schedule B of Form 1040 Individual Income Tax Return requires taxpayers to check “yes” in a box on the form if they have an interest in, or signature or other authority over, one or more foreign financial accounts if the combined value of such accounts exceeds $10,000.[iii] Individual taxpayers are also required to check “yes” if they own more than 50% of the stock in any corporation that owns one or more foreign bank accounts with more than $10,000.[iv] Taxpayers must disclose on Schedule B the foreign country where the foreign account is located. In addition, Schedule B requires taxpayers to confirm whether they received a distribution from a foreign trust or whether they were the grantor of, or transferor to, a foreign trust. Failure to check the box can be the basis for a prosecution for filing a false income tax return.[v] 
 
Schedule B also notifies taxpayers of additional filing requirements. Taxpayers who have an interest in a foreign account may have to file Form TD F 90-22.1, Foreign Bank Account Report. Taxpayers who are involved with a foreign trust may have to file a Form 3520-Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts. Similarly, taxpayers who own a controlling interest in a foreign corporation are required to file a Form 5471-Information Return of U.S. Persons With Respect To Certain Foreign Corporations.
 
Foreign Bank Account Reports (“FBARs”) must be filed by any U.S. taxpayer who has signatory or other authority over a foreign account or accounts that have a combined value of more than $10,000 at any time during the calendar year. The FBAR is separate from a taxpayer’s regular income tax return and must be filed with the Treasury Department on or before June 30th of the calendar year following the year in which the taxpayer had the account at issue.[vi]  The FBAR requires taxpayers to report their name, address and taxpayer identification number and disclose the type, location and account number of the foreign bank accounts and the amount held in the accounts. The penalty for failing to file a FBAR is a $10,000 for each year of non-filing and, in the case of a willful failure to file, the penalty is increased to the greater of $100,000 or 50% of the value of the account for each non-filed year.[vii] A willful failure to file a FBAR can also be prosecuted as a criminal felony.[viii]
 
Taxpayers must file a Form 5471 if, among other things, they own 10% or more of a foreign corporation or control a foreign corporation. Form 5471 must be filed with the taxpayer’s income tax return and requires the taxpayer to identify the foreign corporation, describe its stock and disclose any dividends received. Taxpayers who fail to timely file Form 5471 may be penalized by a reduction of their foreign taxes credit and can be fined $10,000 to $60,000 for each year in which they fail to file the form. A willful failure to file a Form 5471 mayalso be prosecuted as a criminal felony.        
 
Taxpayers who owned all or part of a foreign trust, or were involved with certain transfers to or from a foreign trust, during the taxable year must file a Form 3520 with their income tax return.[ix] Form 3520 requires the disclosure of trust beneficiaries, other trust owners, related trusts and information concerning the fair market value of distributions received from a foreign trust. Additionally, taxpayers who own a foreign trust are responsible for filing an annual return on Form 3520-A reporting the trust’s operations for the year. Failure to file these reports can result in stiff civil penalties of up to 35% of the amount of any transfers to or from the foreign trust and 5% of the gross value of the foreign trust. Again, there are criminal penalties as well for a willful failure to file the required reports.   
 
THE IRS CHALLENGES SWISS BANK SECRECY
 
Despite all of these requirements, many U.S. taxpayers continue to hold foreign accounts without reporting the existence of the accounts or the income earned in the accounts to the IRS. And what better place to hold such foreign accounts than a country with strict bank secrecy laws? Switzerland is famous for its bank secrecy laws. Article 47 of the Federal Law on Banks and Savings Banks provides that a bank professional who “divulges a secret entrusted to him in his [professional] capacity” or “tries to induce others to violate professional secrecy,” shall be punished by imprisonment for up to six months or by a fine of up to 50,000 Swiss Francs (about $50,000). A bank professional must abide by this law even after he leaves the banking profession.
 
Against this back-drop of strict bank secrecy laws, it is very difficult for foreign governments like the United States to obtain information about Swiss bank accounts and their owners. Any attempt by an agency such as the IRS to obtain information about an account in Switzerland is likely to be met with a firm explanation that it would be illegal, and could be criminal, for the Swiss bank to provide the requested information.   Switzerland does have a law entitled “International Mutual Assistance in Criminal Matters” that allows the Swiss government to share information with other governments of other countries, but that law only applies to the extent that it is not inconsistent with other agreements between Switzerland and the country requesting the information.  
 
Switzerland has entered into two treaties with the United States that provide for the sharing of information: a Mutual Legal Assistance Treaty (“MLAT”); and the Convention Between the United States of America and the Swiss Confederation for the Avoidance of Double Taxation with Respect to Taxes on Income (the “Convention”).[x] However, neither of these agreements allows the IRS to obtain the names of U.S. taxpayers or related account information in most circumstances. The MLAT does not apply because it expressly excludesinformation relating to tax violationsfrom the scope of the treaty. The Convention does not help either because it allows the sharing of information only in the case of tax fraud which is specifically defined in the Convention as conduct that involves or is intended to involve forged or false documents.[xi] Accordingly, a U.S. taxpayer who has not falsified any documents and who has simply failed to file a return or failed to report taxes has not engaged in tax fraud as defined in the Convention and, therefore, the information sharing provision in the Convention would not apply to such a taxpayer.                     
 
For years, the IRS has been frustrated by the shroud of secrecy surrounding Swiss bank accounts. However, on July 1, 2008, the IRS threw down the gauntlet and proceeded unilaterally, without the cooperation of the Swiss government, to obtain information about U.S. taxpayers with Swiss bank accounts. It did so by issuing a “John Doe” summons to UBS demanding the identities of all U.S. taxpayers who had authority over accounts managed through any ofUBS’ Switzerlandoffices or its affiliates from 2002-2007 and for whom UBS did notfile a required Form 1099 with the IRS.[xii] The summons to UBS was triggered when the IRS learned that UBS allegedly assisted taxpayers in concealing their offshore accounts from the U.S. government. 
 
The IRS obtained this information about UBS from Bradley Birkenfeld, a UBS private banker. Birkenfeld pled guilty in June 2008 of conspiring to help Igor Olenicoff, a U.S. taxpayer and billionaire real estate developer,[xiii] evade $7.2 million in federal income taxes. Birkenfeld claimed that he helped Olenicoff to conceal his ownership of the UBS account by working with others to create shell corporations in the Caribbean. Birkenfeld and Olenicoff then claimed that the Caribbean entity was the UBS account holder of Olenicoff’s assets so that UBS would not file Form 1099 reporting Olenicoff’s earnings to the IRS. According to Birkenfeld, other UBS bankers used similar shell corporations to prevent the bank from filing Forms 1099 with respect to their U.S. account holders.      
 
UBS and the Swiss government are currently negotiating compliance of the summons with the Department of Justice.[xiv] The number of taxpayers potentially covered by the summons is huge. UBS has stated that it has about 20,000 accounts in Switzerland for U.S. clients -- 19,000 of which are undeclared. The declared and undeclared accounts combined hold approximately $17.9 billion in assets, most of which are held in the undeclared accounts.[xv] 
 
On July 17, 2008, Mark Branson, UBS’ Chief Financial Officer of Global Wealth Management and Business Banking, appeared before the Senate Subcommittee on Permanent Investigations and stated that UBS would work with the government to identify the names of U.S. taxpayers who have engaged in tax fraud. In addition, Mr. Branson stated that UBS would no longer provide offshore banking or securities services to U.S. residents through UBS bank branches and that in the future, such services will only be provided to U.S. residents through licensed U.S. companies.[xvi] Of course, the summons served on UBS by the IRS includes all taxpayers with financial arrangements at or managed through UBS’s offices in Switzerland during the relevant period and Mr. Branson did not address what UBS intends to do with the names of U.S. taxpayers who have not engaged in tax fraud as defined in the Convention. The extent to which the IRS will demand full compliance with the summons remains to be seen. However, IRS Commissioner Doug Shulman has stated that the agency intends to take enforcement action beyond its investigation concerning UBS, “People should take notice that the secrecy surrounding these accounts is rapidly fading. The IRS will pursue people and advisers identified through the summons process who use offshore bank and financial accounts to circumvent their tax responsibilities.”[xvii]
 
In addition to serving a summons on UBS, the IRS is also initiating enforcement action against more than 100 U.S. taxpayers involved with LGT Bank.[xviii] The bank, which is owned and operated by the Liechtenstein royal family, touts its secrecy and asset protection abilities and manages approximately 63 billion Euros for its clients.[xix] The IRS learned the identities of the U.S. taxpayers involved with LGT Bank when a former employee of the bank, Heinrich Kieber, provided tax authorities from several countries with information disclosing the identities of approximately 1,400 persons who held accounts at the bank. Kieber believed that LGT Bank was facilitating tax evasion and when his employer would not listen to his concerns, Kieber contacted tax authorities.[xx] In connection with the IRS’ enforcement efforts concerning the Liechtenstein accounts, then Acting Commissioner Linda Stiff warned “…[i]t should be clear from recent events that there is no safe hiding place for the proceeds of tax avoidance and tax evasion. Anyone with hidden income and gains would be well-advised to make a prompt and complete disclosure to the Internal Revenue Service.” (Emphasis added.)[xxi]           
 
TAXPAYERS WITH FOREIGN ACCOUNTS CAN MAKE AMENDS WITH THE IRS 
 
As suggested by then Acting Commissioner Stiff, those who do not wish to take the risk that their foreign bank accounts eventually will be discovered can make a “voluntary disclosure” to the IRS. The IRS’ position on voluntary disclosures has changed over the years, and while it does not provide absolute immunity from prosecution, it does provide a strong measure of comfort, particularly in matters where the IRS invites disclosures, as it most recently has with offshore accounts.   
 
Prior to 1952, the IRS had an official voluntary disclosure “policy,” which promised that a taxpayer who discloses undeclared income would not be criminally prosecuted as to any past tax violations communicated to the IRS.[xxii] The policy was abandoned in 1952, after congressional hearings concluded that there was corruption and laxity in administering criminal sanctions concerning the Internal Revenue laws.[xxiii] 
 
In 1961, the IRS announced a voluntary disclosure “practice,” whereby if a taxpayer made a disclosure before any investigation was initiated, the disclosure would be considered with all the other facts in determining whether prosecution would be recommended, but the disclosure itself would not guarantee prosecution immunity.[xxiv] Section 707 of the IRS’ Regional Counsel Enforcement Division Manual instructed that the “initial inquiry” was whether the disclosure was timely and stated that “[w]e view a disclosure as timely if it is communicated to...the Service at a time when the Service is not actively considering information which is virtually certain to lead to evidence that the taxpayer committed a tax crime involving the matters disclosed.”[xxv]                   
 
In 1974, the IRS withdrew Section 707 and the objective definition of the term “voluntary” was replaced by a subjective standard which examined the taxpayer’s timeliness and motivation, whereby a disclosure would not be deemed voluntary if it was “triggered” by an outside event.[xxvi] The IRS later refined that definition by explaining that a disclosure was not timely if “[s]ome event known by the taxpayer occurred, which event is likely to cause an audit into the taxpayer’s liabilities.”[xxvii] These definitions proved to be a source of uncertainty because it was unclear if threats by a third party to report the taxpayer to the IRS would be considered a “triggering event” thereby disqualifying the taxpayer from receiving the benefit of a voluntary disclosure.[xxviii]                                  
 
On December 11, 2002, the IRS admitted that its definition of “timely” in connection with a voluntary disclosure was confusing and set forth a new standard which remains in effect today. A voluntary disclosure will be considered timely if it is received (i) before the IRS has initiated an investigation or examination of the taxpayer or related to the specific liability of the taxpayer; and (ii) before the IRS has received information concerning the specific taxpayer’s noncompliance from a third party or from another criminal enforcement action.[xxix] Additionally, as with the previous voluntary disclosure practice, a taxpayer’s disclosure must also be truthful and complete and the proceeds of the undeclared income must not have been obtained from an illegal source (such as the sale of narcotics). The taxpayer must agree to pay the tax, interest and civil penalties on the income in exchange for the IRS’ consideration of the voluntary disclosure “along with all other factors” to determine whether criminal prosecution will be recommended.[xxx]   
 
A taxpayer who wishes to participate in a voluntary disclosure should engage a representative to contact the IRS on his or her behalf so that the taxpayer does not have to engage in direct communications with the agents. Depending on the facts of the case, the representative may present the taxpayer’s case to the IRS agent without disclosing the taxpayer’s name and inquire whether such an individual would be a candidate for a voluntary disclosure.[xxxi] If the agent believes that the taxpayer would qualify for a voluntary disclosure, then the taxpayer’s identity may be disclosed so that the agent can check the taxpayer’s name against IRS databases to determine whether an investigation of the taxpayer already has commenced. If no such investigation or audit has begun, then the taxpayer’s representative will provide the IRS with accurate amended returns. Throughout the process, there are opportunities to discuss whether and what types of civil penalties will be imposed. The Internal Revenue Code provides, inter alia, for a 20 percent negligence penalty, a 75 percent fraud penalty, as well as penalties for failure to file FBARs and Forms 3520 and 5471.[xxxii] 
 
Various types of voluntary disclosures concerning offshore assets have been encouraged by the IRS in the past. In 2003, the IRS promoted its Offshore Voluntary Compliance Initiative (“OVCI”). For a limited period of time, this program permitted taxpayers who used offshore bank accounts and trusts to disclose those accounts (and the promoters of those accounts) and file corrected returns. In exchange for this disclosure, the IRS waived criminal prosecution, the 75% civil fraud penalty on the additional income, and often other civil penalties.[xxxiii]   By July 2003, the IRS had collected more than $75 million in taxes and had identified over 400 offshore promoters.[xxxiv]  
 
After the OVCI program ended, the IRS instituted the “Last Chance Compliance Initiative” pursuant to which IRS agents contact taxpayers who are known to possess offshore financial arrangements and encourage them to amend their tax returns and submit FBARs in exchange for no criminal prosecution and limited penalties. The Last Chance Compliance Initiative continues to this day. It is uncertain whether yet another program will be instituted in light of recent enforcement efforts concerning offshore bank accounts.
 
CONCLUSION
 
Many taxpayers worry about whether the voluntary disclosure practice really works and whether they can trust the IRS if they come forward. The tax controversy defense bar agrees that if the IRS is properly approached by an experienced representative, a voluntary disclosure is effectively a grant of immunity for the taxpayer, although the IRS will not make such an express acknowledgement. If the IRS were to deviate now from their long standing voluntary disclosure practice by imposing criminal or severe civil penalties on taxpayers who voluntarily come forward, it will undermine the very purpose of the policy. Such actions will discourage taxpayers from making disclosures, paying back taxes and repatriating their assets. There is no incentive for the IRS to alter its current voluntary disclosure practice. Rather, as recent statements from the IRS demonstrate, the IRS is motivated to encourage disclosures, particularly if the disclosures concern income from offshore accounts. Thus, making a voluntary disclosure is a prudent consideration for taxpayers who wish to eliminate the risk of criminal prosecution and limit the civil penalties concerning undeclared income. For those who control, or are the beneficiaries of foreign financial arrangements, a voluntary disclosure is a sensible option -- sooner rather than later.  
 
Reprinted with permission from the 09/03/2008 edition of the New York Law Journal © 2008 ALM Properties, Inc, an Incisive Media Company. All rights reserved.


[i] United States Senate Permanent Subcommittee on Investigations, Committee on Homeland Security and Governmental Affairs, “Tax Haven Banks and U.S. Tax Compliance” at 1(July 17, 2008) (hereinafter, “Tax Haven Banks”). 
[ii] Stop Tax Haven Abuse Act, S. 681, 110th Cong. §§ 101; 103; 104; 201 (2007).
[iii] See Instructions for Schedule B, Interest and Ordinary Dividends, Part III. Foreign Accounts and Trusts.
[iv] Id.
[v] United States v. Mueller, 74 F.3d 1152, 1156 (11th Cir. 1996)(defendant convicted for filing a false tax return because he falsely checked “no” on his tax return when asked if he had authority over a foreign bank account).
[vi] See 31 CFR §§ 103.24; 103.27(c); 31 U.S.C. § 5314.
[vii] See 31 U.S.C. § 5321(a)(5). 
[viii] See 31 U.S.C. § 5322
[ix] Treas. Reg. § 404.6048-1(c); Notice 97-34, 1997-25 I.R.B. 22.
[x] Mutual Assistance in Criminal Matters, U.S.-Switz., May 25, 1973, 27 U.S.T. 2019; Convention Between the United States of America and the Swiss Confederation for the Avoidance of Double Taxation with Respect to Taxes on Income, U.S.-Switz., Oct. 2, 1996. 
[xi]Convention, Protocol 10.  
[xii] In the Matter of the Tax Liabilities of John Does, Case No. 08-21864-MC-Lenard/Garber (S.D.Fl. 2008), Ex Parte Petition. IRC § 7609(f) permits the IRS to serve a “John Doe” summons after demonstrating to a court that (1) the summons relates to an investigation concerning a certain class of persons; (2) there is reasonable basis for believing that the class may or has failed to comply with the Internal Revenue law; and (3) the information requested by the summons is not readily available from other sources. Here, pursuant to a Qualified Intermediary Agreement between UBS and the IRS, UBS was required to file a 1099 Form with the IRS for its U.S. account holders who buy or sell U.S. securities through their account.      
[xiii] On December 10, 2007, Mr. Olenicoff pled guilty to filing a false tax return by failing to disclose bank accounts that he controlled. See United States v. Olenicoff, Case No. SA CR No. 07-227-CJC (C.D.Cal. 2007), plea agreement. 
[xiv] Tax Haven Banks, at 3. 
[xv] Tax Haven Banks, at 8-9; 84.
[xvi] See Opening Statement of Mark Branson, Chief Financial Officer of UBS’Global Wealth Management and Swiss Businesses, Before the Permanent Subcommittee on Investigation, United States Senate (July 17, 2008).  
[xvii] Statement of IRS Commissioner Doug Shulman on the John Doe Summons Approval (July 1, 2008).
[xviii] IRS News Release, IRS and Tax Treaty Partners Target Liechtenstein Accounts, IR-2008-26 (Feb. 26, 2008) at 1.
[xix] Tax Haven Banks, at 33-34. 
[xx]Statement of Former LGT Truehand Employee, Formerly Known as Henrich Kieber, Tax Haven Banks, Exh. 5a.   
[xxi] IRS News Release, IRS and Tax Treaty Partners Target Liechtenstein Accounts, IR-2008-26 (Feb. 26, 2008) at 1.  
[xxii] United States v. Tenzer, 127 F.3d 222, 226 (2d Cir. 1997)(quoting Shotwell Mfg. Co. v. United States, 371 U.S. 341, 349 (1963)).
[xxiii] 1 Robert S. Fink, Tax Controversies – Audits, Investigations, Trials at 14-2 (Feb. 2006). 
[xxiv] IRS News Release IR-432 (Dec. 13, 1961); United States v. Tenzer, 127 F.3d at 226.
[xxv] Regional Counsel Enforcement Division Manual § 707 (1974). 
[xxvi] Tax Controversies – Audits, Investigations, Trials at 14-4 (citing IRM (31) 330(2)(b)(ii)(since repealed)).
[xxvii] Id. (citing IRM 31.3.3.1(2)(B)(ii)(1-17-96)(since repealed)). 
[xxviii] Id
[xxix] IRM 9.5.11.9 (9-9-04).
[xxx] Internal Revenue Manual 9.5.3.3.1.2.1(1).
[xxxi] Tax Controversies – Audits, Investigations, Trials at 14-8. 
[xxxii] Internal Revenue Code § 6662 (negligence penalty); § 6663 (fraud penalty). 
[xxxiii] 2003-4 IRB (Jan. 27, 2003). 
[xxxiv] IR-2003-95 (July 30, 2003).