In an earlier post, I explained why the Canada Revenue Agency assisted the IRS in collecting a penalty on a Canadian resident. The bottom line was that he was presumably NOT a Canadian citizen and therefore did NOT have the benefits of the tax treaty. This post is to explain where the penalty came from in the first place.

It has been widely reported that a U.S. citizen residing in Toronto, Canada since 1971, paid a $133,000 U.S. dollar penalty for failing to file IRS forms disclosing that he was running a business through a Canadian corporation. How did this fly get caught in the spider’s web?

The Spider and the Fly is a poem by Mary Howitt (1799–1888), published in 1829. The first line of the poem is “‘Will you walk into my parlour?’ said the Spider to the Fly.” The story tells of a cunning spider who ensnares a naive fly through the use of seduction and flattery. The poem is a cautionary tale against those who use flattery and charm to disguise their true evil intentions.

Once upon a time, in 2009 the “spider” invited people into (what was described by the media) as an “amnesty” program. The “spider” enlisted the help of the “media” who were quick to proclaim this wonderful offer of “amnesty”. (Oxford defintion of “amnesty” is: “An undertaking by the authorities to take no action against specified offences during a fixed period.”) The “amnesty” was the 2009 “Offshore Voluntary Disclosure Program” better known as OVDP.

Sept. 23, 2009, was to mark the end of an amnesty period for U.S. taxpayers to come forward and file past tax returns and certain forms without the usual potential for criminal charges. The good news is that the IRS has now extended the amnesty period to Oct. 15, 2009. The IRS has not promised to waive criminal charges, but the likely result is that you’ll pay the taxes, interest and penalties only.

The lawyers did their part in advertising the “amnesty”. At least this lawyer noted that the “amnesty” was really just a promise (if the “spider” could be trusted) to not pursue criminal charges. Since, the offer was to NOT pursue “criminal charges” one would think that the program would be ONLY for those who were criminals. Americans abroad are not criminals.

Q. How did the “spider” describe the 2009 OVDP program? A. Participants were agreeing they had used offshore accounts to avoid or evade taxes and they were asking to pay penalties. What follows are sections from the IRS FAQs:

Q2. What is the objective of these steps?

A2. The objective is to bring taxpayers that have used undisclosed foreign accounts and undisclosed foreign entities to avoid or evade tax into compliance with United States tax laws.  Additionally, the information gathered from taxpayers making voluntary disclosures under this practice will be used to further the IRS’s understanding of how foreign accounts and foreign entities are promoted to United States taxpayers as ways to avoid or evade tax.  Data gathered will be used in developing additional strategies to inhibit promoters and facilitators from soliciting new clients.

Q3. Why should I make a voluntary disclosure?

A3. Taxpayers with undisclosed foreign accounts or entities should make a voluntary disclosure because it enables them to become compliant, avoid substantial civil penalties and generally eliminate the risk of criminal prosecution.  Making a voluntary disclosure also provides the opportunity to calculate, with a reasonable degree of certainty, the total cost of resolving all offshore tax issues.  Taxpayers who do not submit a voluntary disclosure run the risk of detection by the IRS and the imposition of substantial penalties, including the fraud penalty and foreign information return penalties, and an increased risk of criminal prosecution.

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The obvious question: Why would an advisor recommend that a “middle class” Canadian enter this program under any circumstances? Do you believe that “middle class” Canadians are using Canadian bank accounts and corporations to avoivd or evade taxes? In addition, look at the magnitude of these penalties!!!!!!!!!!!!!!!

A possible (but still unlikely) answer: The IRS appeared to be saying that the penalties would not “under any circumstances” exceed the the penalties owing if one had NOT entered OVDP.

Q35. Will examiners have any discretion to settle cases?  For example, if a penalty for failing to file a Form 5471 for 6 years is $10,000 per year, will that be compared to 20 percent of the corporation’s asset value?  Would the lesser amount apply?

A35. Voluntary disclosure examiners do not have discretion to settle cases for amounts less than what is properly due and owing.  These examiners will compare the 20 percent offshore penalty to the total penalties that would otherwise apply to a particular taxpayer.  Under no circumstances will a taxpayer be required to pay a penalty greater than what he would otherwise be liable for under existing statutes.  If the taxpayer disagrees with the IRS’s determination, as set forth in the closing agreement, the taxpayer may request that the case be referred for a standard examination of all relevant years and issues.  At the conclusion of this examination, all applicable penalties, including information return penalties and FBAR penalties, will be imposed.  If, after the standard examination is concluded the case is closed unagreed, the taxpayer will have recourse to Appeals.  See Q&A 34.  

But, notice this says that under standard audit, “all applicable” penalties will be imposed. But, penalties are subject to “reasonable cause”. At what point is “reasonable cause” considered? Before the 20% penalty is imposed or AFTER rejection of the 20% penalty. This is the key issue.

Who could have known? The “spider” decided that “reasonable cause” would be considered ONLY after the “fly” rejected the 20% penalty. This was the context that Donald Dewees found himself in AFTER he had entered OVDP 2009. This is what led directly to his unfair penalties.

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Introducing Mr. Donald Dewees: These facts are inferred from the description on Jack Townsend’s blog and from the actual complaint in his lawsuit against the IRS. Mr. Dewees was born in 1941 in the United States. He moved to Canada in 1971 where he has lived ever since. In 1979 (on the advice of his Canadian accountant) he incorporated a Canadian Controlled Private Corporation. It appears that he had not been filing U.S. tax returns (few Americans in Canada knew that they were supposed to). In late September of 2009 he consulted a U.S. tax specialist. He entered the 2009 OVDP program by the October 15 cut off date. He was initiatlly assessed a $252,000 miscelaneous penalty which was reduced (as a result of IRS error) to $185,000. (Perhaps his lawyer believed that “reasonable cause” would be considered BEFORE the imposition of the penalty (see above). In any event, Mr. Dewees did NOT accept the $185,000 penalty and removed himself from the OVDP program. He then was subjected to the “standard audit” procedures. Under the “standard audit” procedures (after consideration of “reasonable cause”) he was assessed a $120,000 penalty (12 years of failure to file Form 5471). The Canada Revenue Agency assisted the IRS with collection (presumably Mr. Dewees was NOT a Canadian citizen). He then sued the IRS to recover his penalties, with the following result.

How could such a horrible thing happen? Why did Mr. Dewees enter the 2009 OVDP program at all? By its own terms (see above) OVDP was for Criminals and not for Canadians! OVDP by its express terms was voluntary. But, some more general observations and questions:

• The earlier that Americans abroad have attempted to come into U.S. tax compliance the worse they have been treated. If Mr. Dewees had come into compliance today he (because of the Streamlined Compliance Program) would have paid no penalties.
• Why did the IRS not simply reconsider his case under the current Streamlined Procedures? The result in this case simply shocks the conscience.
• Speaking of shocking the conscience, I am reminded of another Canadian whose life was destroyed by attempting to “do the right thing” by entering the 2009 OVDP program.
• There is NO indication that Mr. Dewees owed any U.S. taxes. His penalties are based on “Form Crime” – nothing more and nothing less.
• For those who don’t understand why: “All Roads Lead To Renunciation”, this is your answer.

Oh well, another day. Another life destroyed. Your comments are welecomed!