IRS Response To The PFIC Problem In The UBS Voluntary Disclosure Initiative Tanya M. Marcum is an assistant professor of law in the Department of Business Administration, Foster College of Business Administration, at Bradley University in Peoria, Illinois. She has taught law for over 12 years and has published 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. She served as General Counsel for the IRS in the Detroit and Grand Rapids offices for 10 years. She can be reached at tmarcumPbradleyedu. Sandra J. Perry is a professor of law in the Department of Business Administration, Foster College of Business Administration, at Bradley University in Peoria, Illinois. She has taught law for over 29 years and has published 29 scholarly articles on various legal topics. She holds a B.S. degree from Bradley University, 1976, and a J.D. from Southern Illinois University School of Law, 1979. She is licensed to practice law in the State of Illinois. She can be reached at sioftbradlev. edu. Tanya M. Marcum and Sandra J. Perry With a high volume of cases, a lack of information, and harsh penalties, voluntary disclosure of PFIC income presents the perfect storm for taxpayers. THE RECENT SURGE in enforcement of US. tax law by the IRS for non-reporting of foreign income coupled with the complicated tax treatment of passive foreign investment companies (PFICs) threatened to create a perfect storm for the taxpayers, their representatives, and the IRS. Thousands of U.S. taxpayers have come forward to participate in the IRS's voluntary disclosure initiative following the UBS agreement in order to disclose to the US. their identities and account information. Much of this previously unreported income is subject to harsh tax treatment requiring detailed financial information about these foreign investments, which is largely unavailable to the taxpayers and the IRS. The volume of cases and lack of information threatened to bottleneck enforcement of the law This article reviews the background of the high-profile UBS caw, the IRS's voluntary disclosure program for these cases, and the tax problems associated with passive foreign investment companies. The current IRS alternative 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 have come forward is explained, and some future issues regarding PFIC income are highlighted. FOREIGN TAX HAVEN CRACKDOWN • The 1990s saw a marked increase in schemes to evade the payment of US. taxes through the use of accounts and credit cards in foreign countries. In 1996, the FBI uncovered money laundering in a cable piracy investigation and turned the defendant into an IRS informant on tax evasion in the Cayman Islands banking system. In 1999,John Mathewson pleaded guilty to money laundering and provided what the prosecutor called at the time "the most important cooperation for the Government in the history of tax haven prosecution" (Smothers 1999) (note that all parenthetical references appear in full at the end of this article). On the heels of that investigation, the IRS announced its Offshore Credit Card Program to combat tax avoidance schemes involving credit cards issued by offshore banks to U.S. citizens (IRS.gov 2003). As part of that program during 2000-2002, the IRS sought and obtained "John Doe" summonses against American Express, VISA, and MasterCard, as well as more than 100 businesses in an effort to identify US. taxpayers evading payment of taxes. A "John Doe" summons is any summons where the name of the taxpayer under investigation is unknown and therefore not specifically identified according to I.R.M. §25.5.7.2. In January of 2003, the IRS announced its Offshore Voluntary Compliance Initiative aimed at bringing wayward taxpayers back into compliance with US. tax law using offshore credit cards or other offshore arrangements. Those who came forward under this initiative still had to pay back taxes, interest, and penalties, but they did not face civil fraud and information return penalties, and more importantly, criminal penalties. In July 2003, the IRS reported that this initiative had netted more than $75 million in taxes (Offshore Compliance Program Shows Strong Results 2003). Summer 2011 SWISS TAX HAVEN INVESTIGATION • Until recentl), Switzerland and its banking system were considered a tax haven for U.S. account holders wishing to keep their income private from the IRS (Todero 2010). Union Bank of Switzerland AG (UBS) provided financial secrecy for its US. customers by not disclosing account ownership information to the IRS and/or creating fictitious foreign entities as the owners of the accounts (Lovejoy 2010). Although UBS provided secrecy, U.S. citizens could voluntarily disclose their UBS accounts to the IRS by filing the appropriate forms and reporting the income on their tax returns. However, many chose not to voluntarily disclose income earned on funds in the UBS accounts. UBS signed an agreement to be part of the US. Qualified Intermediary Program in 2001 (Tax Haven Banks and US Tax Compliance 2008). The Qualified Intermediary Program allows a financial institution to enter into an agreement with the IRS to "assume certain documentation and withholding responsibilities in exchange for simplified information reporting for its foreign account holders and the ability not to disclose proprietary account holder information to a withholding agent that may be a competitor" (Qualified Intermediary Frequently Asked Questions Q&A- .). The IRS soon realized that UBS was not reporting account information (Lovejoy, supra). The IRS and the Department of Justice (DOJ) began a criminal investigation of UBS in 2004 (See US. Senate, Perm. Subcomm. on Investig, US Tax Shelter Industg: The Role of Accountants Lattyers and Financial Professionals (2003, available at http://levin.senate.gov/imo/ media/doc/supporting/2003/111803TaxShelter Report.pdf). In the spring of 2007, the IRS and the US. government received a big break in its investigation. Swiss banker Bradley Birkenfeld informed the US. government, through his attorneys, of a conspiracy between UBS and its US. customers to keep financial account information secret from the IRS (HilEFTA01114627 IRS Response to PFIC 133 zenrath 2010). He hoped to become a whistleblower and provide information to the US. which might entitle him to a share of the billions of unreported offshore income hidden by UBS. However, Birkenfeld had engaged in criminal conduct himself and tried to obtain immunity from prosecution from the DOJ as part of the deal. As part of the standard agreement with the government called a proffer; Birkenfeld provided information such as cell phone numbers, email addresses, and the names of American hotels used by UBS salesmen, even though lie knew he could still be prosecuted by the U.S. After many back-and-forth discussions with the DOJ, immunity was declined. Birkenfeld then tried to work with the Securities Exchange Commission and continued to offer to help the U.S. in exchange for immunity. Birkenfeld was arrested in 2008 when he returned to the US. to attend a high school reunion. UBS was then die primary target of die DOJ. On July 1, 2008, a federal judge in Miami authorized the IRS to serve a "John Doe" summons on UBS to obtain the names of US. taxpayers with hidden accounts at the Swiss bank. Birkenfeld's statements that UBS had about $20 billion in assets of US. taxpayers in undeclared accounts and that UBS had assisted them in concealing their identities by creating sham entities and filing false IRS forms provided the basis for issuance of die summons (Press Release #584: Federal Judge Approves IRS Summons fir UBS Swiss Bank Account Records 2008). UBS entered into a deferred prosecution agreement with the DOJ in early 2009 (Levine and Vasiliadis 2010). In the agreement, UBS admitted that it participated in a scheme to assist US. citizens in hiding accounts from die IRS and agreed to disclose the identities and account information for some of its US. customers. Birkenfeld pleaded guilty on August 21, 2009 to a single count of assisting an American billionaire real estate developer evade paying $7.2 million in taxes (IRS News Release: Offshore Tax-Avoidance and IRS Compliance Efforts n.d.) and was sentenced to 40 months in prison (DOJ News Release #831: Former UBS Banker Sentenced to 40 Months fir Aiding Billionaire American Evade Taxes 2009). At Mr. Birkenfeld's sentencing, the US. prosecutor admitted that "without Mr. Birkenfeld walking into die door of the DOJ in the summer of 2007, I doubt...that this massive fraud scheme would have been discovered by die United States government" (Hilzenrath 2010). IRS VOLUNTARY DISCLOSURE INITIATIVE: POST -UBS AGREEMENT • On March 23, 2009, the IRS issued three memoranda regarding the voluntary disclosure of offshore accounts with the following points: • The IRS's was committed to the challenges of international tax administration in high-risk areas by prioritizing the investigation of abusive offshore transactions designed to evade the payment of US. taxes (SBSE Examination Area Directors LMSB Industry Directors 2009); • The Criminal Investigation Division of the IRS was made responsible for initially screening any taxpayer amended return to determine the actual eligibility of die taxpayer to make a voluntary disclosure of this income to the IRS; • The amended returns with offshore account disclosures were to be processed for civil penalties through die Philadelphia Offshore Identification Unit; • The Philadelphia office would attempt to execute agreements with taxpayers to resolve the offshore issues, including: the assessment of all taxes and interest for six years; an accuracy or delinquency penalty for all years; and penalties "equal to 20 percent of die amount in foreign bank accounts/entities in the year with the highest aggregate account/asset value"; • Taxpayers had until October 15, 2009 to make their voluntary disclosures. EFTA01114628 34 I The Practical Tax Lawyer THE PFIC PROBLEM • Congress enacted the passive foreign investment company tax rules in 1986. These rules limit tax incentives to invest outside the United States (Staff of Joint Committee on Taxation. 991h Cowers General Explanation of the Tax Reform Act of 1986) and arguably treat passive foreign investments more harshly than passive investments in domestic companies (Crenshaw 2006). Many of the UBS accounts held by US. taxpayers involved passive foreign investment companies that would have been subject to this special tax treatment, had the foreign investment been declared by die taxpayer. A PFIC is any foreign corporation where 75 percent or more of its gross income in a taxable year is passive income, or where the average percentage of assets held by the corporation during a taxable year which produces passive income or which is held for the production of passive income is at least 50 percent according to Internal Revenue Code (I.R.C.) §1297(a). For purposes of PFIC, passive income includes any income such as dividends, interest, royalties, rents, annuities, certain property or commodities transactions, gains from foreign currency, income equivalent to interest, or personal service contracts as described by I.R.C. §§1297(b) and 954(c). A return involving a PFIC must also include a Report of Foreign Bank and Financial Accounts (FBAR) Form TD F 90-22.1 (revised March 2011). There are three taxation alternatives for PFIC. Two of the alternatives require an election by the reporting taxpayer. The third is the default method which is more punitive. Election To Treat Income As A Qualified Electing Fund In the first alternative, the taxpayer may elect to treat the income as a Qualified Electing Fund (QEF) if the company complies with such requirements as the secretary may prescribe for purposes of determining the ordinary earnings and net capital gain of the company according to I.R.C. §1295. Summer 2011 This means that the company must be able to calculate its ordinary earnings and net capital gains for each year and provide to each investor his or her pro rata share of the same. In addition, a QEF election is only available if the PFIC complies with the IRS information disclosure requirements that enable the IRS to determine the PFICs ordinary earnings and capital gains. Many foreign companies do not provide the necessary financial information to its US. customers rendering this election unavailable to most taxpayers. Taxation as QEF treats as ordinary income the shareholder's pro rata share of ordinary earnings for die year and treats as longterm capital gain the shareholder's pro rata share of the net capital gains for the year, whether or not distributions of income are made to the investors in accordance with 26 U.S.C.S. §1293(a). Stock basis is increased for income recognized and decreased for amounts distributed. Mark-To-Market Election The second alternative election available to the taxpayer who reports the PFIC income is die markto-market election as described in I.R.C. §1296. This election option was added in the Taxpayer Relief Act of 1997 (Pub. L. No. 105-34) because foreign banks often did not provide enough information for taxpayers or the IRS to make die QEF election (IRS Plain Language Regulations, Reg-112306-00 2002, July 31, 2002). The mark-to-market election is available for marketable stock and includes as ordinary income to the taxpayer the excess of the fair market value of stock over the taxpayer's adjusted basis of die stock. A loss deduction is allowed to the lesser of the excess value or unreversed inclusions. Mark-to-market compares die value of the stock at the beginning of die year to its value at the end of the year. If the value of the stock went up, the gain was ordinary income. If the value went down, there was an ordinary loss. This election is considered less favorable than die QEF election for most US. taxpayers because the tax is based on the individual EFTA01114629