Does residency status under a treaty affect whether a taxpayer must file FBAR forms? An often-used “escape hatch” to avoid FBAR filing may be the subject of future litigation after a judge’s order.

A recent decision from the U.S. District Court for the Southern District of California ruled in part for one side and in part for the other in Aroeste v. United States, a case of Report of Foreign Bank and Financial Accounts (FBAR) filing and penalties and where a request for records might just the first stage in litigation that could impact many FBAR non-filers.

Plaintiffs Alberto and Estella Aroeste sued the U.S. to recoup penalty payments and to discharge still- outstanding penalties for the non-filing of an FBAR for 2012 and 2013. The penalties were assessed after a three-year administrative audit of the Aroestes’ filings for tax years 2011 through 2015. The U.S. counterclaimed against the plaintiffs to recover the balance of unpaid penalties.

The district court partially stayed the case while it awaits a U.S. Supreme Court decision in Bittner v. U.S. That case presents a conflict over statutes under the Bank Secrecy Act whether a “violation” is the failure to file an annual FBAR no matter the number of foreign accounts or whether there is a separate violation for each account improperly reported.

The California district court said a decision in Bittner will control any penalties the plaintiffs owe.

Discovery question

Neither side disputed some details of this case. For example, an IRS audit of both plaintiffs’ tax filings for the 2011 through 2015 resulted in an assessment of some $3 million in back taxes and penalties, most of that from penalties assessed for failure to file information returns. The IRS audit led to the FBAR penalties at issue in this lawsuit, which were assessed only for tax years 2012 and 2013 because the plaintiffs did not disclose their holdings in various foreign bank accounts during those tax years.

The Aroestes seek in discovery the entire administrative record of the IRS during the now-completed audit – more than 7,000 pages.

Only a portion of the record concerns FBAR penalties; most of the audit concerned the IRS determination of the plaintiffs’ residency under the United States-Mexico Tax Treaty for the tax years. The U.S. has far produced 800 to 900 pages of documents, at least some of which have been extracted from the administrative record but has limited its production to those portions of the record it contends are related solely to imposing the FBAR penalties at issue.

Five steps to an escape hatch

The Court granted in part and denied in part the plaintiffs’ request to discover the entire administrative record.

Whether Alberto Aroeste’s status under the treaty has any effect on the FBAR filing requirement in 2012 and 2013 depends, the court admits, “on the application of multiple, interconnected statutes and regulations.” A “United States person” must file an annual FBAR report to disclose foreign bank holdings and the IRS assesses penalties against those who fail to file.

The parties dispute whether Aroeste’s status under the treaty has any bearing on him being considered a “United States person” for filing FBARs. The plaintiffs contend that Aroeste being a Mexican resident under the treaty would disqualify him from being counted as a “United States person” under FBAR regulations. The government contends that Aroeste’s status under the treaty is irrelevant because the treaty solely concerns residency for purposes of income tax and excise tax assessments under Title 26 of the United States Code; FBAR penalties are assessed under Title 31.

The court added that the framework in which tax treaties provide a potential escape hatch that excuses certain “United States persons” from filing FBARs can be expressed in five sequential steps:

1. Anyone allowed to permanently reside within the U.S. according to American immigration law is a “lawful permanent resident” for tax purposes unless an applicable tax treaty allows them to be treated as a resident of a foreign country for tax purposes only;

2. Any “lawful permanent resident” is a “resident alien”;

3. Any “resident alien” is a “resident of the United States”;

4. Any “resident of the United States” is a “United States person” required to file an FBAR; and

5. Any person allowed to permanently reside in the United States by virtue of U.S. immigration laws must file an FBAR unless that person is entitled to be treated as a resident of a foreign country under a tax treaty.

Aroeste is and has been for many years a “lawful permanent resident” of the United States as a matter of immigration law. That status makes him a “resident alien,” which means he is a “resident of the United States” and therefore at least presumptively a “United States person” required to file FBARs, the court said.

Does the U.S.-Mexico treaty provide him an escape hatch? That the treaty concerns income and excises taxes and that Aroeste was assessed FBAR penalties under a different body of law does not refute the language of the FBAR regulations – including required consideration of an individual’s status under an applicable tax treaty for the purpose of determining whether an individual is a “United States person” subject to FBAR filing.

Given that and other factors, the court ruled that if the record is relevant to determining Aroeste’s residency status under the treaty and to assessing whether he was a “United States person,” it is discoverable, though only for the years in question.

This entire case could be the beginning of new concerns for some FBAR non-filers: To what degree will tax treaty residency status affect required filing? Much depends next on the Supreme Court’s eventual decision in Bittner.

Your tax specialist needs to stay on top of this and many other issues of wealth, foreign income and tax enforcement.

Have a question? Contact Alicea Castellanos, Global Taxes LLC.