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

Letter

Characteristics of Noncompliant Individual Taxpayers and the Size and Nature of Their Offshore Noncompliance Vary Widely

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.

Several Factors May Facilitate the Use of Offshore Jurisdictions to Avoid Paying Taxes

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.

IRS Faces Significant Challenges in Identifying the Nature and Extent of Offshore Noncompliance

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.

Multiple Coordinated Strategies Are Necessary to Address the Challenges Posed by Offshore Tax Evasion

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.

Contacts and Acknowledgments

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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