Canadian RRSPs and the OVDI Penalty Base

Part of the OVDI penalty base?

Those who entered OVDI understood (hopefully) that they were paying a fine based on a percentage of a base of assets. Obviously the lower the base, the lower the amount of the penalties. An interesting thread on this appeared on the Jack Townsend blog.

For Canadians who entered OVDI (for whatever reason) there has much been much concern over whether RRSPs would be part of the base for which the OVDI penalty was calculated. People have been asking: will RRSPs be included or not? Why won’t the IRS take a position? Now, what follows is just my thinking and interpretation. It is not legal advice (or any other kind of advice). But, here is how I think you should view this and the arguments you should make.

The obvious question is: how is the penalty base determined under OVDI?

Let’s begin by looking at the FAQs for the OVDI program. You are dealing with the IRS, so you begin by looking at their FAQs.

FAQ 35 is relevant:

35. What kinds of assets does the 25 percent offshore penalty apply to?

The offshore penalty is intended to apply to all of the taxpayer’s offshore holdings that are related in any way to tax non-compliance, regardless of the form of the taxpayer’s ownership or the character of the asset.  The penalty applies to all assets directly owned by the taxpayer, including financial accounts holding cash, securities or other custodial assets; tangible assets such as real estate or art; and intangible assets such as patents or stock or other interests in a U.S. or foreign business.  If such assets are indirectly held or controlled by the taxpayer through an entity, the penalty may be applied to the taxpayer’s interest in the entity or, if the Service determines that the entity is an alter ego or nominee of the taxpayer, to the taxpayer’s interest in the underlying assets. Tax noncompliance includes failure to report income from the assets, as well as failure to pay U.S. tax that was due with respect to the funds used to acquire the asset.  See FAQ 52, category 3, for a limited exception to this rule.”

Three points:

1. The penalty applies to ALL assets (this is more than what is required to be reported on an FBAR) related to “tax noncompliance”.

2. “Tax noncompliance” is defined as the failure to report income from and/or a failure to report the funds that were used to acquire the asset.

3. “Tax noncompliance” is not defined to include “Reporting (FBAR) noncompliance”.

FAQ 36 provides an example that is  helpful in understanding FAQ  35. As you read FAQ 36 you will see again that the emphasis is on “tax noncompliance”.

36. A taxpayer owns valuable land and artwork located in a foreign jurisdiction. This property produces no income and there were no reporting requirements regarding this property. Must the taxpayer report the land and artwork and pay a 25 percent penalty? What if the property produced income that the taxpayer did not report?

“The answer to the first question depends on whether the non-income producing assets were acquired with funds improperly non-taxed. The offshore penalty is intended to apply to offshore assets that are related to tax non-compliance. Thus, if offshore assets were acquired with funds that were subject to U.S. tax but on which no such tax was paid, the offshore penalty would apply regardless of whether the assets are producing current income. Assuming that the assets were acquired with after tax funds or from funds that were not subject to U.S. taxation, if the assets have not yet produced any income, there has been no U.S. taxable event and no reporting obligation to disclose. The taxpayer will be required to report any current income from the property or gain from its sale or other disposition at such time in the future as the income is realized. Because there has not been tax noncompliance, the 25 percent offshore penalty would not apply to those assets.

In answer to the second question, if the assets produced income subject to U.S. tax during 2003-2010 which was not reported, the assets will be included in the penalty computation regardless of the source of the funds used to acquire the assets. If the foreign assets were held in the name of an entity such as a trust or corporation, there would also have been an information return filing obligation that may need to be disclosed. See FAQ 5.”

Now, let’s apply this reasoning to an RRSP. Obviously an RRSP is bought with funds that are easily traceable from income. But remember that the U.S. is viewing your behavior from the perspective of U.S. laws.

Case 1: A U.S. citizen in Canada has been filing U.S. tax returns but enters OVDI for some other reason. The money used to buy the RRSP has been properly reported on the U.S. return. Furthermore, the appropriate election is made under the Canada U.S. tax treaty, then I see no way on earth that the RRSP can be part of the penalty base.  There is simply no “tax noncompliance”.

In addition, this reasoning should apply to checking accounts that do not pay interest and any other kind of account that did not pay interest.

Case 2: A U.S. citizen has not been filing U.S. tax returns and enters OVDI. The question is now whether there has been “tax noncompliance.” You file your returns as part of the OVDI program and there is no tax owing. Is there “tax noncompliance”? I believe that the IRS would take the position that there was “tax noncompliance”. The income from RRSPs is taxable in the U.S. unless the appropriate elections are made. But, now you rely on the Canada-U.S. tax treaty. You would need to get advice from a “trusted professional” on this point.

1. The issue of whether an RRSP is part of the penalty base depends on whether there was “tax noncompliance” in relation to it. Some people may have a problem here (non filers) and some will probably not. Those who have filed U.S. tax returns but did not know about FBARs (almost everybody who filed U.S. tax  returns) should not have a problem if they have made the appropriate election.

For these reasons I don’t think it is possible (in terms of the FAQs) to say in advance whether an RRSP is part of the OVDI penalty base. It depends …

The IRS has announced the reactivation of OVDI. Those who are considering entering this program should be very careful.

THIS POST IS NEITHER LEGAL ADVICE OR ANY OTHER KIND OF ADVICE. IT IS SIMPLY MY ATTEMPT TO APPLY THE FAQS TO A PARTICULAR SITUATION. COMPETENT LEGAL ADVICE IS ESSENTIAL!!!

I would be grateful for your comments.

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4 thoughts on “Canadian RRSPs and the OVDI Penalty Base

  1. Charles Storrs

    I’m an Enrolled Agent in the U.S. and I must warn you that in the heirarchy of reliable evidence the FAQ has to rank below the form instructions. That is, you can use the advice when preparing the relevant forms but you can’t rely on them for appeals purposes. For that you must rely on the Tax Code, Treasury Regs, and IRS Revenue Procedures, also relevant court cases. The IRS can ignore the FAQ, even if it is the best or only advice they offer.

    Reply
    1. renounceuscitizenship Post author

      Thank you for your comment. I certainly accept that as a general principle that the code, regs, procedures (and at the top of the hierarchy court cases) are more important.

      In this particular case though this is a voluntary program created by the IRS. Hence, (at least in so far as I am aware) none of these things would apply.

      Are you saying that the IRS would not be bound by their answers to these FAQs?

      Looking forward to your insight into this hugely important issue.

      Thanks again!

      Reply
  2. Just Me

    Not being a Canadian, and not having an RRSP, I have no skin in the game, but do think your analysis will be very helpful for the arguments OVDI participants have with their examiner.

    My advice for them, for what it is worth, is to hit the RRSP argument from every angle they can. Do it in writing requesting a written response. This will mildly frustrate the Examiner and his/her technical adviser, but forces them to really think about the issue and consult with higher management.

    If one approach or argument doesn’t work, then try another. Be persistent, but be nice, professional, and keep it from becoming personal. I think this slows down the OVDI process a bit, but that delay could work in your advantage as the process evolves and more and more Examiners put pressure up the IRS ladder to exclude RRSPs from the penalty base. It is the right thing to do, but as we know the IRS sometimes resists the right thing, and therefore the TAS has to issue TADs, but we still don’t know if Shulman will see the light.

    Reply
  3. ij

    two points on RRSP,

    1. if tax deferral election has never been made (but RRSP has also never been cashed out), it is likely that a late tax deferral election would have been approved by IRS (9100 relief). This is so called taxpayers act in good faith, and there is no loss to US gov.

    2. since RRSP source funds were well documented on CRA side, so it should be easy to prove if or not the source fund were US tax compliance (for example, if it was contributed before the taxpayer becoming a US person.

    So, non-compliance can become compliance with late tax defferal election. And RRSP can be excluded from base penalty.

    My recent communication with IRS OVDI examiner gave me the impression that IRS is likely to exclude RRSP from base penalty if a taxpayer file tax deferral election via f8891, and if it can be proved that source fund was US tax compliance.

    Reply

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