Tax Compliance: Offshore Financial Activity Creates Enforcement Issues for IRS
Published: 2009-03-17T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Much offshore financial activity by individual U.S. taxpayers is not illegal, but numerous schemes have been devised to hide the true ownership of funds held offshore and income moving between the United States and offshore jurisdictions. In recent years, GAO has reported on several aspects of offshore financial activity and the tax compliance and tax administration challenges such activity raises for the Internal Revenue Service (IRS). To assist the Congress in understanding these issues and to support Congress's consideration of possible legislative changes, GAO was asked to summarize its recent work describing individual offshore tax noncompliance, factors that enable offshore noncompliance, and the challenges that U.S. taxpayers' financial activity in offshore jurisdictions pose for IRS. This statement was primarily drawn from previously issued GAO products.
section_title: What GAO Found
paragraphs: Individual U.S. taxpayers engage in financial activity involving offshore jurisdictions for a variety of reasons. When they do, they are obligated to report any income earned in the course of those activities. They are also required to report when they control more than $10,000 in assets outside of the country. However, much of this required reporting depends on taxpayers knowing their reporting obligations and voluntarily complying. Some taxpayers do not comply with their income and asset reporting obligations. Limited transparency, the relative ease and low cost of establishing offshore entities, and an array of financial advisors can facilitate tax evasion. IRS's Qualified Intermediary program has helped IRS obtain information about U.S. taxpayers' offshore financial activity, but as the recent case against the large Swiss bank UBS AG underscores, the program alone is insufficient to address all offshore tax evasion. Earlier, GAO had recommended changes to improve QI reporting, make better use of reports, and enhance assurance that any fraudulent QI activity is detected. IRS examinations that include offshore tax issues can take much longer than other examinations. GAO's past work has shown that from 2002 through 2005, IRS examinations involving offshore tax evasion took a median of 500 more calendar days to develop and examine than other examinations. The amount of time required to complete offshore examinations is lengthy for several reasons, such as technical complexity and the difficulty of obtaining information from foreign sources. However, the same statute of limitations preventing IRS from assessing taxes or penalties more than 3 years after a return is filed applies to both domestic and offshore financial activity. The additional time needed to complete an offshore examination means that IRS sometimes has to prematurely end offshore examinations and sometimes chooses not to open them at all, despite evidence of likely noncompliance. In testimony before Congress, the Commissioner of Internal Revenue has said that in cases involving offshore bank and investment accounts in bank secrecy jurisdictions, it would be helpful for Congress to extend the time to assess a tax liability with respect to offshore issues from 3 to 6 years.

section_title: Letter
paragraphs: I appreciate this opportunity to discuss offshore financial activity and the  problem of offshore tax evasion by individual taxpayers. International  financial activity is common in our increasingly global economy, it is  encouraged or facilitated by various federal policies, and the number of  U.S. taxpayers with foreign financial accounts is growing. Financial  activity across foreign jurisdictions poses challenges for both tax policy  and administration. Like all forms of noncompliance, offshore schemes  add to the tax gap—the difference between taxes owed and taxes  voluntarily paid on time—and shifts more of the tax burden onto  compliant taxpayers. Honest taxpayers may then find reason to reexamine  their own willingness to stay compliant. Offshore tax evasion can be  especially difficult to identify because of the layers of obfuscation that can  come with doing business in overseas locations outside the jurisdiction of  the United States. Doing business outside of the country is, of course,  perfectly legal, but hiding income or assets in offshore locations in order  to evade taxes is not. As is the case with all tax evasion, the Internal  Revenue Service’s (IRS) success in helping taxpayers who want to comply  with the tax laws as they pertain to offshore financial activity is of critical  importance. Likewise, IRS’s ability to identify and pursue those who  choose not to comply is essential to combating abusive offshore  transactions.
My statement today will largely draw from our prior work, often done for  this committee, to describe individuals and the characteristics of their  offshore tax noncompliance, factors that enable offshore noncompliance,  and the challenges that U.S. taxpayers’ financial activities in offshore  jurisdictions pose for IRS.
Our reports on the Qualified Intermediary (QI) program, the Offshore  Voluntary Compliance Initiative (OVCI), offshore examinations, and the  Cayman Islands upon which this statement is based were prepared in  accordance with generally accepted government auditing standards. Those  standards require that we plan and perform the audit to obtain sufficient,  appropriate evidence to provide a reasonable basis for our findings and  conclusions based on our audit objectives. We believe that the evidence  obtained provides a reasonable basis for our findings and conclusions  based on the audit objectives for those reports.
subsections: section_title: Characteristics of Noncompliant Individual Taxpayers and the Size and Nature of Their Offshore Noncompliance Vary Widely
paragraphs: It is perfectly legal for U.S. persons to hold money offshore. Taxpayers  may hold foreign accounts and credit cards for a number of legitimate  reasons. For example, taxpayers may have worked or traveled overseas  extensively or inherited money from a foreign relative. As shown in figure  1, although holding money offshore is legal, taxpayers must generally  report their control over accounts valued at more than $10,000. Taxpayers  must also report income, whether earned in the United States, or offshore.
The type and extent of individual taxpayers’ illegal offshore activity varies.  In 2004, we reviewed OVCI to provide information to Congress on the  characteristics of taxpayers who came forward regarding their  noncompliant offshore activities, and to understand how those taxpayers  became noncompliant. According to IRS data, OVCI applicants were a  diverse group, for instance with wide variations in income and occupation.  In each of the 3 years of OVCI we reviewed, at least 10 percent of the OVCI  applicants had original adjusted gross incomes (AGI) of more than half a  million dollars, while the median original AGI of applicants ranged from  $39,000 in tax year 2001 to $52,000 in tax year 2000. Applicants listed over  200 occupations on their federal tax returns, including accountants,  members of the clergy, builders, physicians, and teachers.
Some OVCI applicants’ noncompliance appeared to be intentional, while  others’ appeared to be inadvertent. Those applicants who had hidden  money offshore through fairly elaborate schemes involving, for instance,  multiple offshore bank accounts, appeared to be deliberately  noncompliant. Other applicants appeared to have fallen into  noncompliance inadvertently, for example, by inheriting money held in a  foreign bank account and not realizing that income earned on the account  had to be reported to IRS on their tax returns.
OVCI applicants’ median adjustment to taxes due was relatively modest.  For tax year 2001, the median additional taxes owed were $4,401, median  penalties assessed were $657, and median interest owed was $301.
However, other examples of offshore evasion have involved very  substantial sums, complex structures and clear nefarious intent. For  example, in 2006, Congress found several cases involving taxpayers with  relatively large sums involved in abusive offshore transactions, including a  U.S. businessman who, with the guidance of a prominent offshore  promoter, moved from $400,000 to $500,000 in untaxed business income  offshore. In another case, in 2006 a wealthy American pled guilty to tax  evasion accomplished by creating offshore corporations and trusts, and  then using a series of assignments, sales and transfers to place about $450  million in cash and stock offshore. According to the indictment, the  businessman used these methods to evade more than $200 million in  federal and District of Columbia income taxes.
section_title: Several Factors May Facilitate the Use of Offshore Jurisdictions to Avoid Paying Taxes
paragraphs: Limited transparency regarding U.S. persons’ financial activities in foreign  jurisdictions contributes to the risk that some persons may use offshore  entities to hide illegal activity from U.S. regulators and enforcement  officials. For instance, individuals can sometimes use corporate entities to  disguise ownership or income. Abusive offshore schemes are often  accomplished through the use of limited liability corporations (LLC),  limited liability partnerships and international business corporations, as  well as trusts, foreign financial accounts, debit or credit cards, and other  similar instruments. According to IRS, offshore schemes can be complex,  often involving multiple layers and multiple transactions used to hide the  true nature and ownership of the assets or income that the taxpayer is  attempting to hide from IRS.
In addition, creation of offshore entities and structures can be relatively  easy and inexpensive. For example, establishing a Cayman Islands  exempted company can be accomplished for less than $600 (not taking  into account service providers’ fees), and the company is not required to  maintain its register of shareholders in the Cayman Islands or hold an  annual shareholders meeting. Other offshore jurisdictions provide similar  services to those wishing to set up offshore entities.
Another factor that makes it easier for individuals to avoid paying taxes  through the use of offshore jurisdictions is that taxpayers’ compliance is  largely based on voluntary self-reporting. When reporting is entirely  voluntary, compliance can suffer. IRS has found that when there is little or  no reporting of taxpayers’ income by third parties to taxpayers and IRS,  taxpayers include less than half of the income on their tax returns.
One way that taxpayers are required to self-report foreign holdings is  through the Report of Foreign Bank and Financial Accounts (FBAR) form.  Citizens, residents, or persons doing business in the United States with  authority over a financial account or accounts in another country  exceeding $10,000 in value at any time during the year are to report the  account to the Department of the Treasury (Treasury). U.S. persons  transferring assets to or receiving distributions from a foreign trust are  required to report the activity to IRS on Form 3520, Annual Return to  Report Transactions With Foreign Trusts and Receipt of Certain Foreign  Gifts. From 2000 through 2007, the number of FBARs received by Treasury  has increased by nearly 85 percent, according to IRS. In 2008, IRS also said  that, despite the significant increase in filings, concern remains about the  degree of reporting compliance for those who are required to file FBARs.  Also in 2008, the U.S. Senate Joint Committee on Taxation (JCT) reported  that three categories of U.S. persons are potentially not filing FBARs and  Form 3520s as required by law: taxpayers who are unaware or confused  about filing requirements, taxpayers who are concealing criminal activity  and taxpayers who are structuring transactions to avoid triggering the  filing requirements.
Our 2004 review of applicants who came forward to declare offshore  income under OVCI also suggested a high level of FBAR nonreporting,  even by those individuals who reported all of their income to IRS. For  instance, for each year covered by OVCI, more than half of the applicants  had generally reported all of their income and paid taxes due—even on  their offshore income—but had failed to disclose the existence of their  foreign bank accounts as required by Treasury.
Finally, financial advisors often facilitate abusive transactions by enabling  taxpayers’ offshore schemes. We have reported that most possible  offshore tax evasion cases are discovered through IRS’s investigations of  promoters of offshore schemes. During our 2004 review of OVCI, we  examined Web sites promoting offshore investments and found that most  provided off-the-shelf offshore companies or package deals, including the  ability to incorporate offshore within the next day by buying an off-the- shelf company at a cost of $1,500. These promoters provided taxpayers a  way to quickly and easily move money offshore and repatriate it without  reporting that money to IRS.
Congress also has found promoters behind several offshore evasion  schemes such as the Equity Development Group (EDG), an offshore  promoter based in Dallas, that recruited clients through the Internet and  helped them create offshore structures. With few resources and no  employees, EDG enabled clients to move assets offshore, maintain control  of them, obscure their ownership, and conceal their existence from family,  courts, creditors and IRS and other government agencies. In another case,  a Seattle-based securities firm, Quellos Group, LLC, designed, promoted,  and implemented securities transactions to shelter over $2 billion in  capital gains from U.S. taxes, relying in part on offshore secrecy to shield  its workings from U.S. law enforcement. This scheme was estimated to  cost the U.S. Treasury about $300 million in lost revenue.
Large financial firms also have been found to have advised U.S. clients on  the use of offshore structures to hide assets and evade U.S. taxes.  For  example, in 2008 the IRS announced that Liechtenstein Global Trust Group  (LGT), a leading Liechtenstein financial institution, had assisted U.S.  citizens in evading taxes.  In another case, in June 2008, Bradley  Birkenfeld, a former employee of Swiss bank UBS AG, pleaded guilty in  federal district court to conspiring with an American billionaire real estate  developer, Swiss bankers and his co-defendant, Mario Staggl, to help the  developer evade paying $7.2 million in taxes by assisting in concealing  $200 million of assets in Switzerland and Liechtenstein. Birkenfeld  admitted that from 2001 through 2006 he routinely traveled to and had  contacts within the United States to help wealthy Americans conceal their  ownership of assets held offshore and evade paying taxes on the income  generated from those assets.  In February 2009 the Department of Justice  announced that UBS entered into a deferred prosecution agreement for  conspiring to defraud the U.S. government by helping U.S. citizens to  conceal assets through UBS accounts held in the names of nominees  and/or sham entities.  In announcing the deferred prosecution agreement,  the Department of Justice alleged that Swiss bankers routinely traveled to  the United States to market Swiss bank secrecy to U.S. clients interested  in attempting to evade U.S. income taxes. Court documents assert that, in  2004 alone, Swiss bankers allegedly traveled to the United States  approximately 3,800 times to discuss their clients’ Swiss bank accounts.   UBS agreed to pay $780 million in fines, penalties, interest and restitution  for its actions.
section_title: IRS Faces Significant Challenges in Identifying the Nature and Extent of Offshore Noncompliance
paragraphs: IRS has several initiatives that target offshore tax evasion, but tax evasion  and crimes involving offshore entities are difficult to detect and to  prosecute. We have reported that offshore activity presents challenges  related to oversight and enforcement, such as issues involved in self- reporting, the complexity of offshore financial transactions and  relationships among entities, the lengthy processes involved with  completing offshore examinations, the lack of jurisdictional authority to  pursue information, the specificity required by information-sharing  agreements, and issues with third-party financial institution reporting.
As noted earlier, individual U.S. taxpayers and corporations generally are  required to self-report their foreign taxable income to IRS. Self-reporting is  inherently unreliable, for several reasons. Because financial activity  carried out in foreign jurisdictions often is not subject to third-party  reporting requirements, in many cases persons who intend to evade U.S.  taxes are better able to avoid detection. For example, foreign corporations  with no trade or business in the United States are not generally required to  report to IRS any dividend payments they make to shareholders, even if  those payments go to U.S. taxpayers. Therefore, a U.S. shareholder could  fail to report the dividend payment with little chance of IRS detection. In  addition, when self-reporting does occur, the completeness and accuracy  of reported information is not easily verified.
In addition, the complexity of offshore financial transactions can  complicate IRS investigation and examination efforts. Specifically,  offshore schemes can involve multiple entities and accounts established in  different jurisdictions in an attempt to conceal income and the identity of  the beneficial owners. For instance, we have previously reported on  offshore schemes involving “tiered” structures of foreign corporations and  domestic and foreign trusts in jurisdictions that allowed individuals to  hide taxable income or make false deductions, such as in the case of  United States v. Taylor. The defendants in United States v. Taylor and  United States v. Petersen pleaded guilty in U.S. District Court to crimes  related to an illegal tax evasion scheme involving offshore entities. As  part of the scheme, the defendants participated in establishing a “web” of  domestic and offshore entities that was used to conceal the beneficial  owners of assets, and to conduct fictitious business activity that created  false business losses, and thus false tax deductions, for clients.
Given the characteristics of offshore evasion, IRS examinations that  include offshore tax issues for an individual can take much longer than  other examinations. Specifically, our past work has shown that from 2002  through 2005, IRS examinations involving offshore tax evasion took a  median of 500 more calendar days to develop and examine than other  examinations. The amount of time required to complete offshore  examinations is lengthy for several reasons, such as technical complexity  and the difficulty of obtaining information from foreign sources. For  instance, many abusive offshore transactions are identified through IRS  examination of promoters, and IRS officials have said that it can take  years to get a client list from a promoter and, even with a client list, there  is still much work that IRS needs to do before the participants of the  offshore schemes can be audited. Because of the 3-year statute of  limitations on assessments, the additional time needed to complete an  offshore examination means that IRS sometimes has to prematurely end  offshore examinations and sometimes chooses not to open them at all,  despite evidence of likely noncompliance.
We said that to provide IRS with additional flexibility in combating  offshore tax evasion schemes, Congress should make an exception to the  3-year civil statute of limitations assessment period for taxpayers involved  in offshore financial activity. IRS agreed that this would be useful. In  testimony before Congress, the Commissioner of Internal Revenue has  said that in cases involving offshore bank and investment accounts in bank  secrecy jurisdictions, it would be helpful for Congress to extend the time  for assessing a tax liability with respect to offshore issues from 3 to 6  years. Legislation was introduced in 2007, but not enacted, to increase the  statute of limitations from 3 to 6 years for examinations of returns that  involve offshore activity in financial secrecy jurisdictions.
At a more fundamental level, jurisdictional limitations also make it  difficult for IRS to identify potential noncompliance associated with  offshore activity. Money is mobile and once it has moved offshore, the U.S.  government generally does not have the authority to require foreign  governments or foreign financial institutions to help IRS collect tax on  income generated from that money. In prior work we have reported that a  Deputy Commissioner of IRS’s Large and Midsized Business Division said  that a primary challenge related to U.S. persons’ uses of offshore  jurisdictions is simply that when a foreign corporation is encountered or  involved, IRS has difficulty pursuing beneficial ownership any further  because of a lack of jurisdiction. IRS officials told us that IRS does not  have jurisdiction over foreign entities whose incomes are not effectively  connected with a trade or business in the United States. Thus, if a  noncompliant U.S. person established a foreign entity to carry out non- U.S. business, it would be difficult for IRS to identify that person as the  beneficial owner.
In addition, while the U.S. government has useful information-sharing  agreements in place to facilitate the exchange of information on possible  noncompliance by U.S. persons with offshore jurisdictions, agreements  involving the exchange of information on request generally require IRS to  know a substantial amount about the noncompliance before other nations  will provide information. For example, the U.S. government uses Tax  Information Exchange Agreements (TIEA) as the dedicated channel for  exchange of tax information, while Mutual Legal Assistance Treaties  (MLAT) remain the channel for exchanging information for offenses  involving nontax criminal violations. Nevertheless, the Commissioner of  Internal Revenue recently said that in some instances the process to  obtain names of account holders is inefficient, and IRS must rely on other  legal and investigative techniques. As we have reported previously with  regard to the use of these channels with the Cayman Islands government,  neither TIEAs nor MLATs allow for “fishing expeditions,” or general  inquiries about a large group of accounts or entities. Rather, as is standard  with arrangements providing for exchange of information on request, each  request must involve a particular target. For example, IRS cannot send a  request for information on all corporations established in the Cayman  Islands over the past year. The request must be specific enough to identify  the taxpayer and the tax purpose for which the information is sought, as  well as state the reasonable grounds for believing that the information is in  the territory of the other party.
One program IRS established to help ensure compliance when offshore  transactions occur is the QI program. Under the QI program, foreign  financial institutions voluntarily report to IRS income earned and taxes  withheld on U.S. source income, providing some assurance that taxes on  U.S. source income sent offshore are properly withheld and income is  properly reported. However, significant gaps exist in the information  available to IRS about the owners of offshore accounts. Perhaps most  important, a low percentage of U.S. source income sent offshore flows  through QIs. For tax year 2003, about 12.5 percent of $293 billion in U.S.  income flowed through QIs. The rest, or about $256 billion, flowed through  U.S. withholding agents. While QIs are required to verify account owners’  identities, U.S. withholding agents can accept owners’ self-certification of  their identities at face value.
Reliance on self-certification leads to a greater potential for improper  withholding because of misinformation or fraud. IRS does not measure the  extent to which U.S. withholding agents rely on self-certifications. In our  2007 report we recommended that IRS perform this measurement and use  these data in its compliance efforts. For instance, IRS could increase  oversight for U.S. withholding agents who primarily rely on self- certifications in determining whether withholding should occur. IRS has  taken some steps to measure such reliance, but IRS’s approach thus far  has not been systemic and also does not address improving the efficiency  of its compliance efforts.
The previously discussed case of Swiss bank UBS provides a stark  example of the QI program’s vulnerabilities. In February 2009, UBS  entered into a deferred prosecution agreement with Justice and agreed to  pay $780 million in fines, penalties, interest and restitution for defrauding  the U.S. government by helping United States taxpayers hide assets  through UBS accounts held in the names of nominees and/or sham  entities. UBS entered into a QI program agreement with IRS in 2001, and  was required to report U.S. citizens’ income to the IRS during the time that  it conspired to defraud the U.S. government.
We also recommended that IRS require the QI program’s external auditors  report on any indications of fraud or illegal acts that could significantly  affect the results of their reviews of the QIs’ compliance with their  agreements. However, it should be noted that we can not say that having  this reporting requirement in place would have forestalled UBS’s efforts to  defraud the United States or detected them earlier. IRS has proposed some  amendments to the QI program that would somewhat enhance QI auditors’  responsibilities in this area.
In our 2007 report on the QI program, we also recommended that IRS  determine why U.S. withholding agents and QIs report billions of dollars in  funds flowing to unknown jurisdictions and unidentified recipients, and  recover any withholding taxes that should have been paid. IRS has taken  steps toward implementing this recommendation. We also recommended  that IRS modify QI contracts to require electronic filing of forms and  invest the funds necessary to perfect the data. IRS is including an  application for filing information returns electronically in all QI  applications and renewals but has not measured whether including the  forms in the applications has had an impact on the number electronic  filers.
section_title: Multiple Coordinated Strategies Are Necessary to Address the Challenges Posed by Offshore Tax Evasion
paragraphs: In our 2004 review of OVCI, we noted that the diverse types of individuals  involved in offshore noncompliance may require multiple compliance  strategies on the part of IRS. The limited transparency involved in U.S.  persons’ activities in offshore jurisdictions also presents several  challenges to IRS and Treasury. As Commissioner of Internal Revenue  Shulman recently commented, “There is general agreement in the tax  administration community that there is no ‘silver bullet’ or one strategy  that will alone solve the problems of offshore tax avoidance.”
Mr. Chairman, this concludes my statement. I would be happy to answer  any questions you or other members of the committee may have at this  time.
section_title: Contacts and Acknowledgments
paragraphs: For further information regarding this testimony, please contact Michael  Brostek, Director, Strategic Issues, on (202) 512-9110 or  brostekm@gao.gov. Contact points for our Offices of Congressional  Relations and Public Affairs may be found on the last page of this  statement. Individuals making key contributions to this testimony include  David Lewis, Assistant Director; S. Mike Davis; Jonda VanPelt; Elwood  White; and A.J. Stephens.
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