Originally published on Forbes.com.
Donald Dewees is struggling to recoup a $120,000 penalty that the Canadian Revenue Department grabbed from him on behalf of our Internal Revenue Service. He had a setback last week with an unfavorable decision from Judge Christopher Cooper of the United States District Court for the District of Columbia. His attorney Mark Feigenbaum, who is also a CPA and a Canadian Chartered Accountant, tells me that there will be an appeal, but before we get to the struggle, we should take a look at what got Mr. Dewees into this pickle in the first place. That is the practical takeaway from this post.
The United States is unusual in that citizens of the United States are taxed on their worldwide income. There are a couple of provisions that mitigate this substantially. One is the foreign earned income exclusion. Another is the foreign tax credit. They tend to either mitigate or eliminate double taxation, so there is a good chance that an American living and working in a high tax country will not owe any US income tax. Canada is a good example of a high tax country. So Mr. Dewees who has lived and worked in Canada since 1971 probably does not have to worry about ever owing much in the way of US income taxes. Reporting requirements, on the other hand, at least in the last few years are an entirely different matter. The penalty that Mr. Dewees faced was for failing to file Form 5471.
I Hate Form 5471
Form 5471 is titled Information Return of U.S. Persons With Respect To Certain Foreign Corporations. It makes it sound like Mr. Dewees was into really big stuff, but that was not the case. Mark Feigenbaum, the attorney, gave me a short course in Canadian tax planning. The corporate rate is much lower than the individual and there is relief from double taxation. So you can get a significant deferral by trapping income in a corporation. Because of that lots of very small businesses that would be flow-through entities or disregarded in the US are organized as corporations in Canada. Besides his employment income, Mr. Dewees had some side consulting income. He used a corporation for the consulting income because that is what a lot of people do in Canada.
A foreign corporation that is actually doing business that is considered a corporation under US tax principles does not create US tax liability for a US person unless it actually makes distributions. (I’m glossing over a ton of complications here. There are these things called PFICs. Don’t get me started). There is however a reporting requirement for Americans who are involved in foreign corporations. I use the vague term “involved in” deliberately. The “Who Must File” section of the instructions to Form 5471 runs two pages and includes a chart for which of the schedules have to be filed by each of the five categories of potential filers.
A working CPA who is aware in general of these requirements might reasonably go on the theory that if you think you have to file it, you probably should and that given that you might as well fill out the whole thing. The ownership threshold that requires filing is 10%. So imagine your client comes in and tells you that he just heard from a lawyer that his uncle Luigi who owned a restaurant in Rome died four years ago and that he has just learned that he inherited 15% of the stock. This would encourage you to brush up on Form 5471.
Despair begins when you get to Schedule C – “Report All information in function currency in accordance with US GAAP. Also, report each amount in US dollars translated from functional currency (using GAAP translation rules).” How much does a CPA who is involved in individual tax returns know about “GAAP translation rules”? Well, ]there is a reason why the tax partners in regional and national firms can’t sign audit opinions. I’ll leave it at that. But maybe you have a bright lad or lass who recently passed the CPA exam who can help you. How good is their Italian? Do you think your client’s cousin who has a restaurant in Rome to run cares enough about his cousin’s US tax reporting obligations to get answers to all the questions you might have to do a GAAP income statement? And, here is the real kicker, how much is your client going to be willing to pay for all this?
And If Your Accountant Is Canadian?
A question I had for Attorney Feigenbaum was how Mr. Dewees went all those years without filing Form 5471 without anybody ever cluing him in. What he told me was that awareness of the requirements is only slowly penetrating Canadian accountancy even after quite a bit of publicity in the last few years. He gives continuing professional courses for US CPAs and Canadian Chartered Accountant on Cross border issues. What he told me is that the requirement is only slowly penetrating into the consciousness of Canadian accountants who are quick to recommend the formation of corporations. People who do continuing professional education can sometimes be a little like missionaries obsessed with some particular aspect of the faith, which most people would not ever trouble themselves about without hearing it from the zealous. Clearly though the last several years have taught us that you ignore foreign reporting requirements at your peril.
Coming Out Of The Cold
In 2009 the IRS commenced an Offshore Voluntary Disclosure Program . Besides Form 5471, there is also the matter of reporting ownership of foreign bank accounts and paying income taxes on money earned overseas that never made it to a US bank. Again this brings up images of numbered bank accounts in Switzerland with millions in ill gotten gained stashed away, but much of the noncompliance was pretty mundane and innocent. An expatriate American needs a bank account in the country where he or she is living to, you know, pay bills and the like.
Mr. Dewees entered the program, but withdrew when the IRS came up with him owing $185,862 for not filing bank account disclosures (FBAR) for 2003 through 2008. Then in 2011 IRS notified Mr. Dewees that he was being assessed $120,000 for not filing Form 5471 from 1997 to 2008. Meanwhile the IRS had introduced a Streamlined Filing Compliance Procedure (SFCP) that could be a better deal than the OVDP. In May 2015 the Canadian Revenue Agency notified Mr. Dewees that it was holding up his refund. Under the treaty between the United States and Canada, the CRA and IRS provide one another with international collection assistance. Mr. Dewees paid CRA $134,116.34 and filed a claim for refund which was denied. The denial was his ticket to district court.
Excessive?
One argument raised was an Eighth Amendment claim – “Excessive bail shall not be required, nor excessive fines imposed nor cruel and unusual punishments inflicted.” Personally, I count just reading the instructions to Form 5471 cruel and unusual punishment for going to a high school that gave lousy career guidance , but Mr. Dewees was talking about the fine being excessive. The argument went nowhere. Tax penalties “held to fulfill a remedial purpose” are not subject to the Excessive Fines Clause.
Due Process Claim
Unlike income tax deficiencies there is no procedure for appealing the penalty for not filing Form 5471 which Mr. Dewees viewed as lack of due process. The answer to that was more or less – Well here you are in district court. This is your due process.
Equal Protection Claim
The equal protection claim was based on the new deal, SFCP, being a better deal than OVDP. That claim went nowhere, because there was no evidence offered that Mr. Dewees applied for the SFCP.
Expert Commentary
Jack Townsend on Federal Tax Crimes analyzes the timeline in the court filing to try to determine went awry in Mr. Dewees’s participation in the OVDP program. For what it is worth, the program currently in effect is different so there might not be a lot of practical knowledge to be gained from deep study of this decision. Thomson Reuters also had an analysis of the decision – Canada offsetting Canadian tax refund by amount of US tax deficiency not unconstitutional. Eugenio Montesano had something in International Adviser.
More From The Attorney
Mr. Feigenbaum thinks his client got a raw deal and will likely appeal.
The Court did not understand the due process claim. The taxpayer had no ability for review of the file once the penalty was assessed beyond another individual looking it over at the IRS and then being sent to collections. The Canada-US collections treaty provision specifically says the other country will collect on the debt with no possibility of appeal The court dismissed his only chance for judicial review before even this case was heard.
As well he was told to leave the program or face substantial fbar penalties. The IRS said his returns would be only subject to normal audit (and did not advise they would apply 5471 penalties). Instead they assessed 12 years of 5471 penalties when only 6 years of returns were under review. Additionally they moved other taxpayers to the new streamline program at the time with no penalties for both fbar and 5471, but would not let him do the same.
He also wrote me that
]The Taxpayer at issue isn’t a “bad actor” but rather undertook tax planning as a regular Canadian. He was an employee of a company and had a side corporation that had a few shares of public stocks. He is not wealthy by any measure. The IRS acknowledges that many US people abroad are unintentionally non-compliant, as recognized by their various initiative to bring these taxpayers into good standing (with each program seemingly reducing the penalty for noncompliance).