NTA Blog: An Analysis of Tax Settlement Programs as Amnesties: A Discussion of Belated Alternatives to the Offshore Voluntary Disclosure Program and Recommendations for Further Improvements (Part 3 of 3)
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In the first blog in this series we discussed how those who participate in amnesties also tend to be people who made inadvertent errors, that is, “benign” actors, rather than bad actors. We discussed how it can make sense to offer some form of amnesty before implementing a sudden increase in penalties or enforcement. Otherwise, the increase is more likely to be viewed as unfair and erode trust for the government. Moreover, a decline in trust can erode voluntary compliance.
In the second blog, we cited data showing that, consistent with the research on amnesties, IRS’s first amnesty alternative – the Offshore Voluntary Compliance Initiative (OVCI) – generally attracted people who failed to report offshore accounts but had paid their taxes or had underreported small amounts. Notwithstanding the IRS’s experience with the OVCI, it designed its Offshore Voluntary Disclosure Program (OVDP) as a punitive one-size-fits-all program for bad actors. It discouraged benign actors from using the longstanding penalty-free options available to them (e.g., filing qualified amended returns) and made statements that discouraged them from opting out. Some felt pressured into agreeing to pay disproportionate penalties to correct honest mistakes. This seemed unfair to them, eroding trust for the agency. We cited studies suggesting that trust for the government is correlated with voluntary compliance. Thus, we were not surprised to find a study that suggested the OVDP reduced voluntary compliance.
In this blog, we describe how the IRS eventually created reasonable alternatives for benign actors. Although the IRS announced on March 13, 2018, that it will discontinue the OVDP, we also discuss how it could improve the program.
The IRS Eventually Created Reasonable Alternatives for Benign Actors
Nearly nine years after it began its offshore settlement initiatives, in 2012, the IRS created its “streamlined” program, which provided an appropriate alternative to the punitive Offshore Voluntary Settlement Program for “low risk” nonresidents who had made relatively small and probably unintentional errors. While streamlined submissions did not result in closing agreements or even prevent the IRS from examining returns, they were the solution for many taxpayers who just wanted to correct past mistakes without being accused of making “quiet corrections,” against which the IRS had warned.
Between September 1, 2012, and April 24, 2014, the streamlined program attracted 8,851 taxpayers, and only eight percent (or 697 taxpayers) were classified as high risk and examined. Even among the “high risk” group, most returns (51 percent) were not changed by the IRS. Among those whose returns were adjusted, the average adjustment was only $810 per return.
On June 18, 2014, the IRS established the 2014 OVDP and created two new “streamlined” programs and eliminated the lower five and 12.5 percent OVDP penalty rates. Taxpayers were required to certify their violations were not willful, report income from the unreported account(s), and pay any resulting taxes. Residents would be subject to a five percent penalty (under the so-called Streamlined Domestic Offshore Procedures (SDOP)). Nonresidents would not be subject to a penalty (under the so-called the Streamlined Foreign Offshore Procedures). The IRS also established programs (here and here) for those with information return filing foot faults and reasonable cause. For the first time, the IRS was offering reasonable alternatives to some benign actors.
In addition, on May 13, 2015, the IRS instructed its examiners “in most cases” to limit penalties for Foreign Bank and Financial Accounts (FBAR) violations to 50 percent of the highest aggregate balance of the unreported account(s) during the year(s) at issue if they are willful and $10,000 per year if they are not. (For several years the IRS allowed the public to believe it might apply this provision in an unreasonably disproportionate way.) This guidance reduced the risk to benign actors of opting out of the OVDP. Perhaps because this guidance and the streamlined programs have provided alternatives for them, the disproportionality of the offshore penalty appeared to decline under the 2012 OVDP, as shown below.
Figure 1, Comparison of Median Offshore Penalties to Unreported Tax by Median Account Size and Representation for the 2012 OVD Program
Under the SDOP (the U.S. resident initiative), the IRS was still proposing to penalize U.S. residents who came forward voluntarily and whose violations were not willful, but the five percent penalty rate was more proportionate. Moreover, the IRS stopped lumping them in with tax evaders. Those who had already applied to the OVDP during a transition period were offered closing agreements with the same terms as the streamlined program.
However, the IRS refused to provide refunds to people who would have been eligible for streamlined treatment if they had already agreed to a higher offshore penalty pursuant to a signed closing agreement. The National Taxpayer Advocate has recommended legislation to authorize and require the IRS to amend them. Taxpayers should not be penalized for correcting errors early.
Where Do We Go From Here: Should We End the OVDP?
Some type of settlement program should probably continue. There is little evidence that compliance with international information reporting requirements has become the norm. For example, the U.S. Department of State estimated there were nine million U.S. citizens residing abroad in 2016, but the government received only about 1.2 million FBARs in that year. The IRS cited that it only received 600 applications to the OVDP in 2017 as a reason to end the program. However, the lack of interest could be because taxpayers and tax practitioners view the IRS’s administration of the program as so unfair that it is better to risk continued noncompliance or quiet corrections than to participate.
Settlement programs and other amnesty alternatives may be particularly effective if the agency can credibly commit to improve compliance norms by explaining and enforcing the rules more effectively in the future or making it easier to comply. In such cases, the program could raise revenue, save resources, and improve compliance norms, without creating the perception that it is unfairly surprising otherwise honest people with sudden and disproportionate penalties. This approach is consistent with the responsive regulation model, as well as the taxpayer rights to be informed, quality service, privacy, and to a fair and just tax system.
Under normal circumstances it may be difficult for tax agencies to change compliance norms. However, the IRS is beginning to receive and use more information as a result of the Foreign Account Tax Compliance Act (FATCA) and information exchange programs. FATCA provides an incentive for foreign financial institutions to report information on their U.S. clients to the IRS and for foreign governments to sign bilateral automatic information exchange agreements. The IRS has received and may continue to receive new information from offshore banks and financial institutions. Many countries have also agreed to the automatic exchange of information under the Common Reporting Standard, and the Organisation for Economic Co-operation and Development has recommended that member countries consider OVDPs before these exchanges begin. Those that have done so often attribute the success of their OVDPs to these automatic exchange agreements.
In such cases, previously-compliant taxpayers may be annoyed by the amnesty or amnesty alternative, but should not feel silly for complying given the increased likelihood that any underreporting will be detected. Participants save the government money that it would otherwise have to spend on enforcement; and subsequent noncompliance by participants is more likely to be detected and punished, freeing up resources for the agency to go after those who do not participate.
For everyone else, the settlement program shows that the agency can be trusted to pursue only reasonable and proportionate penalties against those who have been put on notice, removing at least one excuse for future noncompliance (i.e., the agency’s lack of fairness and proportionality). Therefore, as new automated information exchanges and other types of third-party information reporting become available for use by the IRS, it has a rare opportunity to use settlement programs and other forms of amnesty as a lower-cost way to improve compliance norms while respecting taxpayer rights, provided it can address legitimate concerns about the misuse of confidential tax information.
The IRS will undoubtedly want to continue to settle with many taxpayers, particularly those who come forward to comply voluntarily. Indeed, it will continue to want to encourage this type of cooperation and to ensure these settlements are consistent, fair, and transparent. Therefore, even as it ends the current OVDP, it is likely to decide that some form of disclosure and settlement program would be useful, though it may not be called an OVDP.
If We Keep Some Form of OVDP, How Do We Fix It?
I have discussed problems with the IRS’s OVDP in ten Reports to Congress (not counting my responses to the IRS’s responses) – five annual reports (2017, 2014, 2013, 2012, and 2011) and five objectives reports (2018, 2017, 2014, 2013 and 2012) – and in TAD 2011-1, which I elevated to former IRS Commissioner Shulman. (He did not respond.) To preserve trust for the agency and suspicion that IRS employees are acting arbitrarily, I have repeatedly offered many (but not all) of the following recommendations to the IRS:
- Publish OVDP-related program guidance as a revenue procedure (or similar guidance published in the Internal Revenue Bulletin) after soliciting and incorporating comments from internal and external stakeholders, just like other important procedures. As we discussed, a study found that amnesties had significantly greater positive effects on voluntary compliance when citizens voted on them. While allowing stakeholders to comment is not as participatory as voting, it could increase the perceived legitimacy of the program and address the problems with FAQs.
- Assign interpretation of the OVDP-related program guidance to attorneys or technical advisors whose advice is required to be disclosed to the public just like Chief Counsel Advice under IRC § 6111. Otherwise, taxpayers get the impression the IRS is operating unfairly based on secret rules.
- Provide instructions to OVDP staff only by distributing interim guidance memos that are published on irs.gov and incorporated into the IRM, which is also disclosed to the public. This is already required by IRM 22.214.171.124 and the Freedom of Information Act, 5 USC 552(a)(2), but the IRS sometimes communicates clarifications through private meetings or calls, undisclosed emails, training materials, guides, job aids, and other materials posted to internal SharePoint sites. It should post these materials on irs.gov.
- In OVDP cases, allow taxpayers to have a conference with anyone who makes a determination on their submissions (e.g., a revenue agent, Territory Manager, or Central Review Committee) or advises another employee who makes a determination with respect to a disputed issue (e.g., a technical advisor or IRS attorney). Also, require the advisor to explain his or her reasoning to the taxpayer in writing and reconsider the advice in light of any new facts or analysis provided by the taxpayer. Otherwise, taxpayers have no confidence their facts and arguments have been understood and considered, or that their case has been handled properly.
- Allow taxpayers to elevate or appeal a revenue agent’s OVDP determinations pursuant to procedures that will be published in the IRB. Permitting appeals to an independent function would lend credibility to the determinations.
- Establish procedures that help taxpayers suspend the refund limitations period with respect to payments submitted with OVDP or streamlined applications until at least six months after the IRS finishes processing the case. The IRS takes great care to ensure the assessment period does not lapse while processing cases, and it should make the same effort to ensure that taxpayers do not lose the payments they make to enter these programs simply due to the length of the process.
- When taxpayers opt out or are removed from the OVDP, the IRS should not audit the failure to file returns due more than six years before the disclosure. Policy Statement 5-133 provides that the IRS will normally enforce filing requirements for only the prior six years. Because those who apply to an OVDP are generally the least committed to noncompliance, they should not be penalized more harshly than those who have not submitted a voluntary disclosure.
- Allow taxpayers to amend their closing agreements to benefit from any taxpayer-favorable changes to the OVDP-related program terms, just as the IRS did when it offered the five percent and 12.5 percent rates available under the 2011 program to those who had already signed closing agreements under the 2009 OVDP. If the IRS believes it lacks authority to reopen agreements, it should work with Treasury to lend the administration’s support to my legislative recommendation (p. 341) to authorize such modifications. This is necessary so that taxpayers are not punished for correcting errors early.
Why Are These Changes Needed?
These changes will require additional resources, but they could make a big difference in how the IRS is viewed by OVDP participants and stakeholders. At present, OVDP FAQs are not vetted with TAS or outside stakeholders, and changes are difficult to track. FAQs are interpreted by revenue agents, technical advisors, and IRS attorneys. At the outset of the 2009 program, the IRS issued a secret internal memo to “clarify” key terms of the program (2009 OVDP FAQ #35), but refused to disclose it to the public (as required by FOIA) until my office intervened. Even today, the IRS’s interpretations of the program terms are not always accessible to taxpayers. As a result, TAS receives valid complaints every year from taxpayers that an IRS employee is interpreting the terms of the program in a way that is counterintuitive and seems unnecessarily punitive and unfair.
The IRS nearly always responds to OVD-related Taxpayer Assistance Orders (TAOs) from my office by explaining that whatever it is doing is consistent with the FAQs as interpreted solely by the employees who administer the program. It generally says it has been interpreting these terms consistently all along and that the taxpayer and I are both unreasonable for questioning its interpretation of the program terms. According to the IRS, any deviation would provide the taxpayer with special treatment, which would be unfair.
Revenue agents rely on technical advisors and attorneys who answer questions about how to apply the terms in specific cases. (We note that if the program terms were so crystal clear, these advisors would be unnecessary.) Sometimes these advisors agree to discuss their analysis with the taxpayer and sometimes they refuse.
The IRS generally resolves complaints about determinations by its employees – whether elevated by taxpayers themselves or by a TAO – by authorizing the employee to remove the taxpayer from the program if the taxpayer does not accept his or her seemingly unilateral determination. The IRS rationalizes that taxpayers can receive due process outside the program.
When a taxpayer opts out or is removed from the OVDP, a committee determines the scope of any subsequent exam. It considers the taxpayer’s submission if the taxpayer opted out, but not if the taxpayer was removed. In some cases, cooperative taxpayers are removed simply because the agent is unsatisfied with the information that is available. Taxpayers can only appeal removal decisions to a Territory Manager. Anecdotal evidence suggests Territory Managers generally approve or delay (rather than reverse) removal decisions without holding a conference with the taxpayer or providing an adequate explanation.
The decision about whether to accept a taxpayer’s certification that the noncompliance was nonwillful – a determination required to get a closing agreement that incorporated the streamlined terms signed under the transition rules – was assigned to be reviewed by a secret committee. The taxpayer could not communicate with the committee, and the revenue agent’s communications with the committee were withheld from taxpayers under FOIA as privileged. The taxpayer could not be sure the facts were being presented accurately. The committee would reject streamlined treatment on the basis that the taxpayer had not proven his actions were nonwillful, notwithstanding the fact that it is nearly impossible to prove a negative and that the IRS had provided little guidance about what proof would be required.
The cumulative result of these procedures is to leave taxpayers with the impression that revenue agents and their unidentified advisors have the unchecked authority to extract disproportionately punitive settlements based on the credible threat that they can drag the taxpayer into a full-scale examination without accountability, transparency, or due process. Instead of giving the impression that it is arbitrarily punitive to those who are trying to correct their errors, the IRS should strive to promote voluntary compliance by interpreting ambiguities in their favor.
Not only did the OVDP fail to provide transparency and due process to participants, it also failed to provide transparency and accountability to stakeholders about the overall results of the program. In 2017, when TAS reported to Congress on the overall results of the program – results that Congress and anyone charged with making decisions about the effectiveness of the program would want to see – the Large Business & International Operating Division asked us to redact them. Moreover, it asked TAS not to publish any more data about the program from the IRS’s systems.
If the IRS wants to be viewed as a responsible and trustworthy tax administrator, it needs to address these problems, even if it only views them as “appearance” problems. Therefore, it should establish transparent, fair, and reasonable OVDP procedures that respect taxpayer rights. The recommendations above would be a good first step. These recommendations should not be the last step, however. If the IRS subjects the OVDP to public notice and comment, it will receive many other worthy ideas.
A Final Suggestion
Before closing I will offer one more suggestion that could encourage more taxpayers to comply voluntarily. Some may not participate in the OVDP because of legitimate concerns about the risks resulting from the potential redisclosure of their financial information to foreign governments. IRC § 7602(c) balances privacy concerns against the IRS’s need for information from third parties by requiring the IRS to provide notice to taxpayers before it contacts third parties – contacts that will reveal that the taxpayer is subject to an examination or collection action. Along the same lines, an article by Ali Noroozi, Australia’s Inspector General of Taxation, in a Special Issue of Tax Notes suggests that Australia’s tax agency provide notice to taxpayers when it provides their private information to other governments.
The U.S. OVDP could potentially attract holdouts by reassuring them that the IRS will not redisclose an applicant’s financial information to other governments, or at least provide the applicant with advanced notice before it does. Such notice would give the taxpayer an opportunity to minimize risks to his or her property and physical safety. It would also provide an opportunity for the applicant to address or mitigate any erroneous information, noncompliance, and the potential for misinterpretation or improper redisclosure of the information by the requesting agency.
The views expressed in this blog are solely those of the National Taxpayer Advocate. The National Taxpayer Advocate is appointed by the Secretary of the Treasury and reports to the Commissioner of Internal Revenue. However, the National Taxpayer Advocate presents an independent taxpayer perspective that does not necessarily reflect the position of the IRS, the Treasury Department, or the Office of Management and Budget.