The Assault on Financial Privacy Goes Parabolic

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The conflict of ideals that ultimately determine the circumstances that define the human condition at any given point – freedom, privacy, human rights, morality, charity, entitlement, obligation, promising – are the ingredients of the world’s oldest and perpetual ideological battles. It is said that if you isolate any two people in a room long enough they will find something about which to disagree. True enough.

It is not so much that the dominant beliefs and accepted norms that throughout history have evolved through a cycle of embracing and rejection that disconcerts people. Homo sapiens seem genetically hardwired to ideological rivalries. It is the process of failing ideological paradigms and progression into the terminal phase that unfolds just before failure that can be alarming.

Today’s situation in Greece is a prime example. At its genesis, the ideal of a socialist society takes hold among the people. Promises are made and the manifesto of entitlement, social fairness, obligation, and social equality infects the populace. The socialist ideal eventually goes viral, and the majority learns to game the system. Everyone is trying to live at the expense of everyone else. In the terminal phase, the failure of the system is disguised under a mountain of lies, hollow promises, and debts. When the stream of other people’s money runs out, the system collapses.

If this were plotted on a graph, however, the line depicting this progression would display a predictable trajectory: linear at first, then parabolic. In just two years, Greece decayed from a perceived state of manageable instability to the verge of collapse. In chart-speak, it is called a “hockey stick” pattern. Greece meandered along the blade of the hockey stick for years, decades even – the linear phase of the pattern. But once troubles surfaced in Greece, the transition from blade to handle – the parabolic phase – happened quickly, leaving little time for adjustment.

A similar pattern is emerging within the U.S. revenue collection apparatus comprised of the Treasury Dept., the Justice Dept., and the IRS. Recalling the chartist lingo from above, let’s pick up the story just as it was about to enter the transition from blade to shaft.

The UBS Scandal Sets The Stage

By now, most readers are familiar with the UBS tax evasion scandal. The allegations of tax fraud against UBS surfaced in 2008 and dominated the headlines during the spring and summer of 2009. The U.S. Justice Department and UBS reached an agreement where the bank paid US$780 million to settle criminal charges that it aided U.S. taxpayers in avoiding their tax obligations to the IRS. The day after the settlement was announced, a civil suit was filed seeking to force UBS to divulge account information on 52,000 of UBS’ American clients. The number later grew to 85,000.

The case was quietly closed in October 2010, when criminal charges against UBS were dropped. Account information on approximately 4,450 U.S. clients has been turned over to U.S. authorities, with about another 100 cases pending review in the Swiss courts. Not quite the 85,000 that the IRS and Justice Dept. had demanded, but enough to embolden the agencies to pursue greater compliance enforcement tactics.

The push to return all American’s into reporting compliance led the IRS to unveil its 2009 Offshore Voluntary Disclose Initiative (OVDI). The program allowed U.S. persons to possibly avoid civil prosecution for criminal tax fraud in exchange for full disclosure via the Treasury FBAR form (see below) and cooperation with an IRS examiner and pay interest and penalties.

The IRS claimed that over 15,000 U.S. taxpayers - half of them UBS clients – entered the program. Another 3,000 U.S. taxpayers came forward after the 2009 OVDI closed. A second OVDI program concluded on August 31, 2011, and U.S. taxpayers that entered this second program faced fines and penalties that exceeded those in the 2009 version.

The message to non-compliant U.S. taxpayers seemed clear: you better enter this program because the next one - if there is a next one - will have a penalty structure even more onerous. To that point, the IRS recently announced that 33,000 taxpayers entered the latest OVDI. With a nearly 100% increase in the participation rate in the second program over the first, it is not difficult to imagine the IRS contemplating a third round of voluntary disclosure.

Three of the most common reasons that a taxpayer decides to enter the OVDI are:

  1. Failure to file yearly tax returns, whether a tax liability exists or not.
  2. Claiming exemption from taxes on interest income earned at foreign banks under the double taxation treaties in force between the U.S. and many foreign governments, and then also failure to report the income to the IRS on Schedule B, Form 1040.
  3. Failure to file Treasury Form TD F 90.22-1, Report of Foreign Bank and Financial Accounts, commonly referred to as the FBAR.

The first two generally require a taxpayer to file late or amended federal returns for the applicable years and pay interest and penalties. Not a painless resolution but overall an easy fix with the IRS.

Not so for number three.

Expansion of FBAR Reporting Requirements

Many readers are intimately familiar with the FBAR. A US person is required to submit this form “… to report a financial interest in, signature authority, or other authority over one or more financial accounts in foreign countries” if the aggregate value of the account(s) exceeds US$10,000 at any time during the year.

The form is due at the Treasury by June 30th following the year for which reporting is triggered. If Tim Geithner had US$20,000 in a Swiss bank in 2009, he needed to file an FBAR by June 30, 2010.

If a taxpayer is discovered to have a foreign bank(s) or financial account(s) (i.e., a brokerage account) that was not reported to the Treasury Dept. on the FBAR, the taxpayer could face civil prosecution. Further, the penalty framework in most cases for failure to file can reach levels that will inflict financial ruin on the taxpayer.

(This is a gross simplification of the OVDI [Offshore Voluntary Disclose Initiative] program and the penalty framework for FBAR negligence. Details are available here.)

Prior to 2011, this one-page form filed yearly with the Treasury Dept. seemed more of an innocuous inconvenience than an insidious invasion of financial privacy.

That is no longer the case. The compliance reporting net continues to broaden and snare a growing number of taxpayers.

The language used on the old form and its instructions left open to debate what constituted a “financial account.” One area in question of particular importance to those of us in the hard money camp and seeking to internationalize our assets concerned storing gold and silver bullion offshore. Did this meet the definition of a financial account? And there are many options for storing bullion offshore – bank safe box, private fault, pooled, allocated, segregated - do all these meet the definition?

In an attempt to resolve this question and others, on February 24, 2011, the Treasury Dept. released its Final Ruling on amendments to FBAR reporting and it was published in the Federal Register. The new regulations became effective March 28, 2011, and applied to FBARs that were required to be filed for calendar year 2010.

That’s right. The new regulations were retroactively effective, leaving investors no time to make adjustments with their offshore holdings as regards reporting requirements. That is not a good sign, and I hope it does not presage more of the same. One is left wondering: What’s next, retroactive tax increases?

The final ruling contains mostly areas of lengthy clarification of the definition of terms. Regarding bullion, it now appears that US persons holding physical gold offshore are required to report such holdings on the FBAR (with possible exceptions noted below). We think the language in the Final Ruling make this new reporting quite clear, as you can read here.

The Final Ruling, however, still contains language that is open to interpretation: is only gold reportable? What about silver, platinum, palladium? Are allocated or segregated bullion accounts reportable?

But for many investors with offshore assets, these questions might have been rendered moot with the new IRS reporting regulation.

If we thought compliance with FBAR reporting was intrusive, the compliance net has just become very wide and the mesh very fine.

New IRS Reporting Takes Compliance Parabolic

Earlier this year, the IRS quietly released a draft version of new Form 8938, Statement of Specified Foreign Financial Assets, found here. Until recently, no instructions for the form were available, leaving international investors in limbo wondering what, exactly, constitutes a specified foreign asset.

After reviewing the draft instructions, and as the title of the form suggests, US persons will be required to report all worldwide assets subject to exceptions and applicable threshold amounts. And it appears that the new form and reporting requirements apply to tax year 2011.

There is some good news. The reporting threshold amounts for foreign held assets are moderately high, as follows:

  • Unmarried taxpayers living in the US: more than US$50,000 on the last day of the tax year, or US$100,000 at any time during the tax year.
  • Married taxpayers filing a joint income tax return and living in the US: more than US$100,000 on the last day of the tax year, or US$200,000 at any time during the tax year.
  • Married taxpayers filing separate income tax returns and living in the US: same as for an unmarried taxpayer living in the US.

There are a few exceptions to the threshold, and here are two worth noting:

  • Taxpayers living abroad. Must be a bona fide resident of a foreign country. The rules that determine residence for Form 8938 are patterned after those for claiming the Foreign Earned Income exemption on IRS Form 2555. If a US person is physically present in the foreign country for at least 330 full days during any period of 12 consecutive months ending in the tax year, they satisfy the reporting threshold. If a taxpayer is filing, or expects to file, Form 2555 the following thresholds will apply to them:

- If not a joint return: more than US$200,000 on the last day of the tax year, or US$400,000 at any time during the tax year.
- For married filing jointly: more than US$400,000 on the last day of the tax year, or US$600,000 at any time during the tax year.

Questions about what constitutes a foreign financial account continue to plague FBAR reporting. However, Form 8938 makes it fairly clear what is considered a specified foreign financial asset in two paragraphs:

You have an interest in a specified foreign financial asset if any income, gains, losses, deductions, credits, gross proceeds, or distributions from holding or disposing of the asset are or would be required to be reported, included, or otherwise reflected on your income tax return.

You have an interest in a specified foreign financial asset even if there are no income, gains, losses, deductions, credits, gross proceeds, or distributions from holding or disposing of the asset included or reflected on your income tax return for this tax year.

The 11-pages of instructions cover much more, including many more taxpayer asset structures and scenarios. And there are numerous nuances to the new language contained in the Final Ruling on FBAR reporting. This is not intended, nor should it be considered, as comprehensive tax or reporting advice. As always, do your own due diligence and consult a professional for guidance.

Advance interpretation prior to the release of Form 8938 instructions was that the form’s wording suggested that gold held within or outside the banking system, whether pooled, allocated, or segregated, would be reportable, as well as foreign owned real estate. It now looks as though that interpretation will hold. Keep in mind that the just released instructions for Form 8938 are a draft version and subject to change.

Where to From Here?

The FBAR was introduced in the 70’s and was an obscure piece of legislation unknown to most Americans and tax preparers alike. For nearly 30 years it languished on the books with little enforcement… until 2003. That year its administration was shifted from the Treasury Dept. to the IRS along with increased penalties for non-compliance.

That was the period along the blade of the hockey stick. Since 2003, FBAR reporting enforcement continues to ratchet higher, the assets it covers broadened, and the penalties for non-compliance pushed to absurd heights.

Over the past eight years, reporting requirements of foreign assets held by US persons have exploded from essentially bank and brokerage accounts to nearly all assets worldwide. We are now making our way down the shaft of the stick.

Which begs the question: where to from here?

One prescient clue can be gleaned from the 2003 administrative shift mentioned above. Under Title 26 of the US Code the IRS is only authorized to administer taxation; the FBAR falls under USC Title 31 law that is the responsibility of the Treasury Dept. Indeed, the scope and mandate of the IRS is pretty narrow and straightforward: to ensure that taxes are paid according to Internal Revenue laws.

Both the FBAR and new Form 8938 carry no tax liability, per se, for the filer. So why is the IRS, whose authority it is to collect taxes, administering the FBAR and introducing a sweeping new reporting requirement?

It seems quite logical to deduce that the Treasury Dept. and the IRS are preparing for the eventual implementation of a wealth tax. Why else would they need to know the kind and whereabouts of a taxpayer’s worldwide assets? Many countries already impose this tax on their citizens. And it would be an easy sell to the envy-driven, “punish the rich” mindset that is taking hold in the US.

Whatever the IRS has in store for US taxpayers, the only way to fight back is to keep what you have. And to do that means complying with reporting requirements no matter how offensive, intrusive, maddening, or unjust they are. Penalties are now defined by the IRS as a revenue raising measure. The new mindset is clear: If we can’t tax them, we will penalize them.

Unfortunately, a new era for individual privacy is upon us. We must sacrifice our financial privacy for our financial security. We will accomplish this by staying compliant with reporting requirements and safeguarding our wealth from confiscation via seizure and penalties.

We will prevail by keeping our wealth outside the US and invested in assets that will protect and grow our wealth. That is the mission of today’s international investor.

Source: International Man

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