As many people know from experience, systems of personal income tax vary enormously around the world – simple, complex, high rates, low rates, even some countries impose no income tax at all. However, almost all nations are unified on one point: residents are fully taxed by the country according to its tax code, but non-residents are taxed on only the income earned within that country. This is the essence of “territorial taxation”.

But the USA imposes personal income taxes based on another system – “citizenship taxation” – under which all citizens of the United States are taxed under the same personal income tax system, wherever they reside. According to a 1995 Congressional report, with the sole exception of Eritrea, the United States is the only country in the world to base world-wide taxation solely on citizenship.

It is important to note that this “unfair” system is tempered by a number of income tax treaties aimed at avoiding double taxation, the possibility of claiming a foreign tax credit for foreign taxes paid even outside a treaty, and that a US person who is a bona fide resident of a foreign country is provided an exclusion for about $90,000 of foreign earned income. Nonetheless, the 2009 National Taxpayer Advocate report to Congress noted that “It appears that not all U.S. taxpayers overseas are aware of the requirement to file a return. As noted above, of the estimated seven million U.S. citizens located abroad, only about 6.6 percent filed U.S. tax returns from a foreign address in Tax Year 2007.” (Note: The Taxpayer Advocate Service (TAS) is an independent organization within the IRS billed as the taxpayer’s “voice at the IRS”).

But 2009 was not just a year where the Taxpayer Advocate noted “only about 6.6 percent” compliance – it was also the year that IRS launched an “Offshore Voluntary Compliance Initiative” aimed at taxpayers with unreported income relating to offshore transactions and who wished to voluntarily disclose the information to the IRS.

For the 93.4% of non-resident American taxpayers who had not properly filed their taxes, the problem is that most have “unreported income relating to offshore transactions” (eg. they earn salaries from foreign companies – their employers, and may even have earned a few Francs of interest in their savings or investment accounts). But in 2009, the IRS road to “tax salvation” needed to go through the OVDI which provided a “uniform penalty structure” so that all taxpayers are “treated consistently and predictably.” What this meant was that a non-resident American would be treated just like a resident American and in addition to any tax due, and interest on that tax, our non-resident American would also face a “miscellaneous offshore penalty” equal to 20% of the highest aggregate balance in foreign bank accounts or entities, or value of foreign assets, during the period covered by the voluntary disclosure (2003-2008).

The 2009 program was essentially replicated in February 2011 with the announcement of the 2011 OVDI. The main difference between the 2 programs was that in 2011 the “miscellaneous offshore penalty” was equal to 25% of the highest aggregate balance in foreign bank accounts/entities or value of foreign assets; the period covered by the voluntary disclosure was also made longer (2003-2010).

But for non-residents, a big development arrived in June when new criteria qualifying a taxpayer for a 5% penalty was made. These criteria were as follows:

Taxpayers who are foreign residents and who meet all three of the following conditions for all of the years of their voluntary disclosure: (a) taxpayer resides in a foreign country; (b) taxpayer has made a good faith showing that he or she has timely complied with all tax reporting and payment requirements in the country of residency; and (c) taxpayer has $10,000 or less of U.S. source income each year. For these taxpayers only, the offshore penalty will not apply to non-financial assets, such as real property, business interests, or artworks, purchased with funds for which the taxpayer can establish that all applicable taxes have been paid, either in the U.S. or in the country of residence.

Obviously, a 5% penalty is a whole lot easier to accept than a 25% penalty – so we made concerted efforts to reach out to the community of non-resident Americans and tell them that finally IRS was acknowledging their special circumstance, and that the program with a 5% penalty was an opportunity worth considering, and probably acting on.

The 2911 OVDI was only available to taxpayers through August 2011, but three things of note have happened since:

1. On January 9, 2012 IRS reopened the Offshore Voluntary Disclosure Program (OVDP) “following continued strong interest from taxpayers and tax practitioners after the closure of the 2011 and 2009 programs.” The program essentially mirrors the previous ones except that the “miscellaneous offshore penalty” is now equal to 27.5% of the highest aggregate balance in foreign bank accounts/entities or value of foreign assets. Also, unlike the other programs, the 2012 one has no announced end date – meaning that it may become a sort of permanent disclosure program.

2. The Taxpayer Advocate Service (TAS) 2011 report to Congress was released including an unprecedented 68 pages addressing “International Issues.” The 2011 TAS report is quite critical of IRS’ “enforcement” focused approach and in one instance states: “Absent clear procedures and transparent guidance about how these taxpayers can return into compliance without being subject to maximum penalties, the IRS is squandering an opportunity to substantially improve voluntary compliance by millions of low-profile U.S. taxpayers abroad.”

3. Perhaps in anticipation of the 2011 TAS report, on December 13, 2011 IRS released a “fact sheet” of information for “U.S. Citizens or Dual Citizens Residing Outside the U.S.” The fact sheet details the tax reporting obligations of non-resident Americans, but it also go to pains to discuss “reasonable cause” and the possible abatement of penalties. Reasonable cause relief is generally granted by the IRS when a taxpayer demonstrates that he or she exercised ordinary business care and prudence in meeting their tax obligations but nevertheless failed to meet them. In determining reasonable cause IRS says it will look at:

• The reasons given for not meeting your tax obligations;
• Your compliance history;
• The length of time between your failure to meet your tax obligations and your subsequent compliance; and
• Circumstances beyond your control.

But new details are provided for establishing reasonable cause on the basis that a taxpayer was not aware of specific obligations to file returns or pay taxes. The facts and circumstances considered include the taxpayer’s:

• Education;
• Having previously been subject to the tax;
• Prior penalties;
• Recent changes in the tax forms or law; and
• The level of complexity of a tax or compliance issue.

The Fact Sheet goes on to state that a taxpayer “may have reasonable cause for noncompliance due to ignorance of the law if a reasonable and good faith effort was made to comply with the law or you were unaware of the requirement and could not reasonably be expected to know of the requirement.”

All of this of course moves away from the old adage the “ignorance of the law is no defense” and the list of criteria to be considered certainly allows the taxpayer and his advisors to paint a good argument for reasonable cause.

Surely “reasonable” is the key word here, and if IRS truly shows that it has started down a path where reasonable cause is given proper consideration when a taxpayer makes a disclosure, then surely reasonable taxpayers will also give proper consideration to a reasonable IRS.

For more information, please go to our dedicated compliance and voluntary disclosure page.