Tuesday, September 10, 2013

Elimination of Duplications and Short Term Deposits in Miscellaneous Penalty Base - FAQ 37 and Extrapolations (9/10/13)

2012 FAQ 37 provides (as I think it did in earlier FAQs):
Q. If a taxpayer transferred funds from one unreported foreign account to another during the voluntary disclosure period, will he have to pay a 27.5 percent offshore penalty on both accounts?
A. No. If the taxpayer can establish that funds were transferred from one account to another, any duplication will be removed before calculating the 27.5 percent penalty. However, the burden will be on the taxpayer to establish the extent of the duplication.
Example 1:  Taxpayer has 2 foreign accounts that are income tax noncompliant - FAC1 at FB1 and FAC2 at FB1.  In 2009, the Taxpayer deposits $100,000 into FAC1 and, one day later pursuant to instructions at the bank upon the deposit, the bank transfers the $100,000 to FAC2 at the same bank, FB1.  FAC1 earns $-0- interest on the temporary deposit of $100,000 (the banks rules require that a deposit stay for 7 days before interest is earned) and FAC2 earns $5,000 interest on the longer-term deposit of $100,000.  (Note FAC1 is income tax noncompliant because of other deposits.)  According to FAQ 37, in calculating the OVDI/P miscellaneous / in lieu of penalty base (inside penalty without opt out, which I hereafter call the miscellaneous penalty), the "duplication" is eliminated.  The way I have done that in the past is to eliminate the duplication amount in FAC1, the temporary account, and include it in FAC2.  Either way, of course, since both accounts are noncompliant, the elimination of the duplication has the same effect on the aggregate penalty base for the year.  But it is logical to exclude it from FAC1 because there is no income tax noncompliance with respect to the $100,000.

Example 2:  Same Example except that FAC2 is at a different bank, FB2.   The result is the same.  Again, the bottom line effect on the penalty base for the year is the same whether the elimination of the duplication occurs in FAC1 or FAC2.

Example 3:  Same Example except FAC2 (the destination account) is income tax compliant.  In this case, there is no duplication.  Is the temporary deposit in FAC1 included in the miscellaneous penalty base?  Technically, this situation does not fit FAQ 37.

Example 4:  Same as Examples 1 and 2 except that, rather than transferring the temporary deposit in FAC1 to another account, it is transferred out of FAC1 to purchase noncompliant real estate that produces the same amount of income for the year -- i.e., $5,000 rental income (just as in the earlier examples FAC2 had produced $5,000 of interest income).  Reading Example 37 literally, it does not eliminate the duplication because the destination asset is real estate rather than an account.  Note in this regard that, for the miscellaneous penalty calculation, the real estate is included since it is noncompliant (just as noncompliant accounts are included).  The key difference between the two is that a transfer to another foreign account (an FBAR reportable asset) gets a penalty base reduction to eliminate the duplication whereas a transfer into real estate (a non-FBAR reportable asset) gets no penalty base reduction to eliminate the duplication.  (It is reported in a Linked-In practitioner discussion that the IRS is taking the position that double counting is required because the foreign real estate is not an account.)

Example 5:  Taxpayer has 1 foreign account - FAC1 at FB1.  Taxpayer also has noncompliant real estate worth $100,000.  On this fact alone and if nothing else happened during the year, both the real estate and the amount in the account would be included in the penalty base for the year; there is no duplication.  During the year Taxpayer sells the foreign real estate for $100,000 and deposits the money in FAC1 for a day and transfers it to his parents as a gift for them to buy a home.  Does the taxpayer then have to duplicate the same $100,000 "asset" -- the enhanced temporary $100,000 in FAC1 and the noncompliant real estate -- in the miscellaneous penalty base?  [Note I earlier erroneously inserted FAC2 as the account into which the sales proceeds were deposited; thanks to Asher Rubinstein for pointing this out; see his comments below; note that since Example 6 incorporates these facts, this change affects it as well.]

Example 6:  Same as Example 5 except that the real estate is compliant and thus not included in the miscellaneous penalty base?  Keep in mind that not a cent of interest is earned on the one day deposit.  But, since the real estate is compliant, including the temporary deposit in the miscellaneous penalty base will not be a duplication.

Example 7:  Same as Example 6 (real estate is compliant), the real estate having a net value of $100,000 is worth $200,000 with a mortgage of $100,000.  Upon sale of the real estate, the taxpayer takes his $100,000 equity and redeploys it into another compliant real estate investment and deposits the $100,000 for the mortgage payment into FAC1 account with instructions to the bank to pay the mortgage holder immediately, which  the bank does the next day, so the taxpayer has a $100,000  spike in his account.  Is the $100,000 included in the miscellaneous penalty base?  (In fact, I can report that the IRS technical advisers have allowed the elimination of $100,000 in this case.)

Example 8:  Same as Example 7 except the real estate is noncompliant.  Will there be an elimination of the duplication?  (I think the IRS under the concept applied by the technical advisers to eliminate the duplication in Example 7, it would be eliminated in Example 8 as well.)


1.  Do these results seem right and logically consistent?  Notice particularly the apparent result of treating noncompliant FBAR reportable accounts better than compliant FBAR reportable accounts and nonFBAR reportable noncompliant and even compliant foreign assets.  This is just, to me, illogical.

2.  Can Example 7 (and Example 8) be reconciled with the other results?

3.  Would it make any difference if the in-and-out in FAC1 occurred the same day rather than being delayed a day by FB1?

4.  What if the bank statements show only day-closing balance so that a same day in and out would not be reflected on the balance (either for the day or for the month)?  If the taxpayer must report the high balance and knows that there was an in-and-out which is not reported on the day-close balance, can the taxpayer use the day-close balance to report the high balance for the month?  Is the taxpayer whose foreign account statements only show day-close balances (or use such balances for high monthly balance) benefited whereas the taxpayer whose foreign account statements show real high balances during the month screwed?  Why?

While I have no personal information about specific instances, it is reported to me that in anecdotal cases, the IRS has eliminated temporary deposits, whether the source or destination of those temporary deposits were compliant or noncompliant and then require inclusion in the miscellaneous base based upon the compliance of the source or destination accounts or assets.  The IRS technical people deny that such eliminations are authorized (I don't think they can state that they did not occur, just that they were not authorized if they did).  However, the IRS technical person with whom I discussed the problem did admit that they authorized the elimination in Examples 7 and/or 8.

I would appreciate hearing results from readers -- either anonymously or for attribution.  Keep in mind that readers can post anonymous comments.  Also readers can send me an email at jack@tjtaxlaw.com; I would appreciate readers sending emails to state whether I am authorized to disclose their identities and information or just the information without disclosing the identifies.


  1. Jack...

    In the OVDP, I was able to eliminate all long and short term duplicates between accounts.

    It took me a lot of work to create a spreadsheet flow chart to show each and every transfer that occurred between various accounts (mostly term deposits) that I had over 6 years. I then figured the aggregate without any duplicates.

    As I remember, the examiner took my aggregates as accurate, and only on one year, did I have to correct her aggregate amount where she had failed to follow my flow chart correctly.

    I don't recall that there were any issues with the shortness of the time of the transfer and sometimes I went from one account to another to another in the same day because of the way they rolled accounts when they matured... IE from Term Account to a Short Term Savings Acct to a Checking Account.

    So, long and short of it, with a LOT of preparation and would have hated to pay a CPA or associate attorney for the hours it took to do this. I had no issues other than, I still did not like the results, especially with her insistence my house had to be included in the total as shown in Number 4 FAQ example above. There was NO reduction for duplication of funds that went into the purchase of the home, as the home purchase was prior to the period of the OVDP 6 years look back.

    As you know, the TAS interceded on my behalf to negotiate a reduction to something I could live with, rather than be life alternating. I still feel like I shouldn't have had to pay anything other than get a "go and sin no more" letter, but so it goes. At the time I was so stressed by the $172K they wanted, that a $25K settlement came as a BIG relief to a nightmare without end. I took it.

    Now there really is no point on belaboring or second guessing my decision and acceptance back then, as it just P....es me off and would rather not go there. This was at a time that the Opt Out was just becoming available, and there was a LOT of uncertainty of how it would be administered. In the end, they took their pound of flesh, so they could waste it on payments to Raytheon for cruise Missiles that can launched at Syria.

    In response to your question number 4, I don't recall this ever happening, unless I missed it.

  2. This is hearsay reported to me by one of my lawyers who handles OVDI, so I do not have the details. I was told of a case where there was a temporary spike to buy real estate (the money was in the account for 2 or 3 days) and they were successful in having the spike removed ... but it was not easy.

    Separately, I have been told (in my case) that tax-compliant foreign accounts are not included in the penalty base, and specifically this would include non-interest-bearing accounts (since income was zero, the account was tax-compliant.) (Unfortunately my non-interest bearing account was so small as to not make much of a difference.) By extension, I would argue that if the spike occurred in an account used only to hold the money for/from the real estate transaction (in other words, not commingled with other funds) and the account earned no interest (not even a token amount) then one could argue that it should be excluded.

  3. Somewhat off topic but an issue with the penalty balance calculation.
    I have an account. A PFIC sold in 2011. There are no distributions in the 2003-2010 OVDP window. So the tax due on this account in the tax returns for 2003-2010 is correct. It is zero. I would have had to sell in those years or file a mark to market form to change that. Of course I didn't know what a PFIC was.
    Now the agent wants to assert the 27.5% balance penalty on this account because in the amended return it showed income. Her methodology seems to be to look at what accounts have had income added in the amended returns. Of course the income generated is purely a function of the OVDP M2M calculation. My 2011 return effectively assumes I will accept the OVDP offer though. Doh!
    Similarly I had a small account that generated $3 in income and $1 in income in only two years on a few thousand dollars. Calculating the tax minus foreign tax credit drops the tax below 0.5c and so falls away. The FAQ says missing income so maybe this is on weaker ground than the first.
    would you expect to be able to argue these should be removed?

  4. In this context, I would again like to ask on this forum experiences regarding India Demat accounts. The Demat account hold securities in electronic format. It is not a brokerage account. The demat account is linked to a bank account. Dividends earned on securities related to the demat account are deposited into the bank account. Does the Demat account and bank account be included in the penalty base or only the bank account?

    Does anybody have experience dealing with demat account with an IRS agent in the context of OVDI?

  5. Example 1: I agree with the result (the transfer of the $100K will not be counted twice for penalty purposes). However, I disagree with the final statement ("it is logical to exclude it (the $100K) from FAC1 because there is no noncompliance with respect to the $100,000"). In fact, technically, there is noncompliance with respect to the $100K in FAC1 because that $100K deposit caused the highest value of FAC1 to increase by $100K, and said highest value would be reportable on the FBAR. If there was no FBAR reporting for FAC1 showing a highest value inclusive of the $100K, then FAC1 is noncompliant. In terms of penalty, though, the $100K would not be counted twice.

  6. Example 2: I agree.

    Example 3: I agree, no duplication, and not an FAQ 37 issue because no duplication.

    "Is the temporary deposit in FAC1 included in the miscellanous penalty base[?]" Yes, for the reason that I stated in Example 1, above. Even if the $100K was in FAC1 for one day, that $100K spike in highest account value is reportable on the FBAR and, if it was not reported, the IRS would include the $100K in the penalty calculation.

  7. Example 4: I agree fully that there is an unfair paradox at work here. A transfer from an account (FBAR reportable asset) to an account (FBAR reportable asset) would give rise to elimination for duplication. However, a transfer from an account (FBAR reportable asset) to real estate (not an FBAR reportable asset) would be counted twice for penalty purposes. Stated otherwise, two instance of FBAR non-compliance would lead to one penalty on $100K, but one instance of FBAR noncompliance (the account, not the real estate) would lead to a penalty on $200K.

    However, what is really behind the penalty imposition in this example is not so much the FBAR non-compliance, but rather the income tax noncompliance with respect to the failure to report the $5,000 rental income from the real estate. If the $100K had been transfered from FAC1 to the real estate, and said real estate did not give rise to unreported rental income, then the real estate would not be a noncompliant asset, and the real estate would not be counted in the penalty calculation, and the penalty would only apply to the $100K in FAC1.

    I will also point out that I have faced this scenario in my practice. My client in the OVDI transferred monies from a noncompliant foreign bank account to buy foreign real estate. The real estate, which did not throw off rental income, was not noncompliant. The funds transferred from the foreign account to purchase the real estate were not counted for penalty purposes. The value of the real estate was also not counted for penalty purposes. If the real estate had been noncompliant (whether because rental income went unreported, or because the real estate was sold and the profit not declared to the IRS), then the result would likely have been very different. In such a case, a sub-issue would have been: would the amount of the transfer for the purchase of the real estate have been deducted from the value of the real estate for penalty purposes, because the amount transferred had already been included in the penalty calculation of FAC1?

  8. Example 5: Here there are three non-compliant assets to consider: (1) FAC1, the value of which we do not know, and which, according to the example, has no transfer to either of the other two assets. (2) The real estate. (3) FAC2, into which the proceeds of the sale of the real estate were deposited. All three assets would appear on the Penalty Calculation Worksheet in the OVDI/OVDP. (1) and (2), because the facts of the example tell us that they are noncompliant, and (3) because the deposit of $100K from the sale of the real estate into FAC2 presumably was not reported on the FBAR as the highest value of FAC2 for the one day prior to the transfer to the parents.

    "Does the taxpayer then have to duplicate the same $100,000 'asset' - - the enhanced temporary $100,000 in FAC1 and the noncompliant real estate - - in the miscellaneous penalty base?" First, I think there may be an error in this question, inasmuch as FAC1 never saw the $100K proceeds of the real estate (FAC2 did). Would the penalty apply to the $100K value of the real estate and the $100K value of FAC2? The IRS would almost certainly argue yes, for the same reason as the paradox noted above in Example 4. However, I would fight hard on this, as it is unfair, contrary to the intent of FAQ 37, and twice penalizes the same noncompliant amount (first when it was in the form of real estate equity, and second when the same amount was deposited in FAC2).

    As a side note, did the taxpayer file a gift tax return with respect to the $100K gift to the parents?

  9. Example 6:

    "Same as Example 5 except that the real estate is compliant and thus not included in the miscellaneous penalty base."

    Agree, but there is still the issue of the transfer of the real estate proceeds to FAC2, and the inclusion of that amount for penalty purpose for FAC2.

    "Keep in mind that not a cent of interest is earned on the one day deposit."

    Doesn't matter. The account is deemed noncompliant because it was not reported on the FBAR showing the $100K spike in value, assuming that the balance inclusive of the $100K is the highest account balance. If there was interest earned in the account, and the interest was not reported, then there would be two instances of noncompliance, failure to disclose the account on the FBAR and failure to declare income on the 1040 and pay tax on the interest.

    "But, since the real estate is compliant, including the temporary deposit in the miscellaneous penalty base will not be a duplication."

    Yes, no duplication, and the practical result is that the $100K would be counted in the penalty for FAC2 (in addition to the value of FAC1). The taxpayer committed no noncompliance with respect to the real estate, but having sold it, and depositing the proceeds into FAC2 for only one day, now the IRS would include that one-day account in the penalty calculation. Taxpayer should have sold the real estate, gotten a check, joined the OVDI/OVDP and then deposited the check into a US bank account after being accepted into the program.


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