The Department of Justice and the Internal Revenue Service (IRS) have pursued for several years a well-publicized and successful enforcement campaign directed against U.S. taxpayers holding undisclosed offshore accounts. To take advantage of its deferred prosecution agreement with Swiss banking giant UBS A.G., as well as various related prosecutions of individual account holders, the IRS rolled out a special version of its voluntary disclosure program for holders of offshore accounts from March 2009 through Oct. 15, 2009. To date, the IRS has stated that about 15,000 taxpayers entered this special program, and that about another 3,000 taxpayers submitted voluntary disclosures after the special program ended.

The government repeatedly has stated that it will continue to pursue banks, account holders, and tax advisers involved in undisclosed offshore accounts. Further, IRS Commissioner Douglas Schulman has made several recent announcements that the IRS is likely to launch a new version of the special voluntary disclosure program for offshore accounts, more aggressive and onerous than the special program that closed in October 2009.

The most significant price tag imposed for an otherwise qualifying disclosure under the former program was, subject to very narrow exceptions, a monetary penalty equal to 20 percent of the value of the entire undisclosed account at its highest level during the prior six years. Any new program clearly will carry an even higher price tag. Some commentators and criminal tax practitioners have raised the question: If a U.S. taxpayer with an undisclosed foreign account has not already decided to enter the voluntary disclosure program, and if their foreign bank — unlike UBS — is not being prosecuted or cooperating with the government, why would they decide to pursue a voluntary disclosure going forward, which surely will be even less palatable than before?

One reason for remaining account holders to consider disclosing their accounts is that two major recent legislative and regulatory developments are making it increasingly difficult as a practical matter to continue to conceal an offshore account, or to actually use the money by bringing it into the United States. These two developments reflect an apparently coordinated effort by different branches of the enforcement community to complement their respective assaults on foreign bank secrecy practices. Further, both of these converging enforcement efforts come in the form of system-wide pressures that place the onus on financial institutions to provide vast swaths of data that the government hopes to mine for patterns suggesting criminal activity.

HIRE/FATCA

The first prong of the continued effort to undercut foreign bank secrecy was spearheaded by Congress, which has enhanced significantly the reporting and withholding requirements of foreign financial institutions in regard to their U.S. clients. Specifically, Section 501(a) of the Hiring Incentives to Restore Employment (HIRE) Act of 2010, Pub. L. 111-147, enacted on March 18, 2010, put into place the foreign reporting and withholding provisions of the Foreign Account Tax Compliance Act (FATCA), legislation that had been introduced in 2009 but was never enacted on its own.

Very broadly, these new statutory requirements will oblige banks and other foreign financial institutions (FFIs), as defined, to enter into an agreement with the IRS in which the FFI agrees to identify its U.S. account holders, obtain information from these account holders and report it to the IRS, and perform related due diligence. The information to be reported includes the account holder’s name, address and tax identification number; the account number and its balance; and the amount of gross receipts and withdrawals.

HIRE/FATCA comprehensively seeks to close potential loopholes. If a foreign law would prevent the FFI from complying with HIRE/FATCA, then it must either obtain a waiver from the relevant account holder or close the account. Further, if a U.S. account holder fails to provide the FFI with sufficient information to comply with its reporting requirements, then the FFI must withhold 30 percent from all pass-through payments involving the account at issue. Ultimately, through system-wide reporting obligations placed upon financial institutions, HIRE/FATCA seeks to circumvent the cumbersome and often ineffective process of seeking information regarding individual taxpayers through treaty requests with other governments.

Failure by an FFI to enter into or comply with the required IRS agreement can produce a potentially severe sanction: The FFI will be subject to a 30 percent withholding tax on all payments to the FFI involving certain U.S.-source income and asset sales. This penalty will apply to U.S.-source income — a broad category of income that includes the disposition of stock of a U.S. corporation — flowing into all accounts of the FFI, including accounts held by non-U.S. account holders.

Accordingly, HIRE/FATCA forces an FFI to confront the following scenario: If it shields a U.S. account holder from the IRS by not complying with the new law, then it will risk imperiling the accounts of many of its other clients because the U.S.-source income of those other account holders will be subject to a stiff penalty. Put another way, the foreign bank must choose between harboring all of its U.S. clients, no matter how lowly, or risking the assets of all of its other clients, no matter how important.

Congress is calculating, quite correctly, that the choice will be clear to any FFI. Unless an FFI elects to shed from its portfolio every investment that generates U.S.-source income, which would include shedding the stocks of U.S. corporations, then the FFI either will root out and disclose its U.S. account holders to the IRS or flatly cease doing business with U.S. account holders entirely. Any U.S. client with a still-undisclosed foreign account will find himself in a legal wilderness: Unless he chooses to hunt for a new foreign bank willing to conceal his funds (thereby breaking laws while also creating a potential paper trail), he must try to disclose his account to the IRS before the FFI does and accept the consequences. Attempting to quietly bring the offshore money into the United States will create other problems, such as reporting duties for the individual involving U.S. Customs, or the possible filing of a suspicious activity report by the domestic bank that is receiving the funds.

Although the reporting requirements imposed upon FFIs do not take effect until 2013, FFIs must now start considering what processes will be put into place so as to be ready by that time. FFIs will have to perform a business assessment of the costs of doing business with U.S. customers, and likely will become increasingly wary of them. U.S. account holders still retaining undisclosed accounts also must access their options, which appear to be dwindling.

Moreover, the scope of HIRE/FATCA is not limited to FFIs, but includes the account holders themselves. Very generally, U.S. taxpayers holding more than $50,000 in foreign financial assets during a tax year will have to file a disclosure statement — yet to be set forth by the IRS — with their income tax return regarding the assets. This new reporting obligation will become effective during the 2011 tax year. This duty is under the tax code and therefore is separate from, and in addition to, the existing requirement under the Bank Secrecy Act to report foreign accounts worth more than $10,000 in the aggregate on a Report of Foreign Bank and Financial Accounts, or FBAR. Although this new duty is somewhat redundant given the FBAR reporting requirement, these reports will result in information that will be accessible directly by the IRS.

Proposed Bank Secrecy Act Regulations

The IRS is not the only agency that is attempting to draw the enforcement net even tighter around offshore accounts. The Financial Crimes Enforcement Network (FinCEN), an agency of the Department of Treasury that administers the Bank Secrecy Act (BSA), recently issued proposed regulations that, as with HIRE/FATCA, seek to bolster the government’s ability to monitor the transfer of funds between offshore accounts and the United States. Unlike HIRE/FATCA, however, these regulations apply to domestic, not foreign, financial institutions. These proposed regulations are extremely broad and would require the annual reporting of an estimated 750 million transactions — as well as the creation by each affected institution of the costly systems and processes capable of complying with such massive reporting obligations.

Specifically, in September 2010, FinCEN issued a notice of proposed rule making, set forth at 75 Fed. Reg. 60377, regarding regulations underlying 31 U.S.C. §5318(n) of the BSA. Very generally, these proposed regulations would require certain domestic banks and money transmitters to report cross-border electronic transmittals of funds (CBEFTs) by submitting to the government the money transmittal order, or equivalent information, related to each transmittal. They also would require affected banks to annually file a report with FinCEN that lists the accounts and taxpayer identification numbers of all account holders who sent or received CBEFTs. The proposed CBEFT reporting requirement has no monetary threshold for banks — i.e., it applies to all such transfers, no matter how small — but it does contain a $1,000 threshold for money transmitters. Further, for reportable transactions of $3,000 or more, money transmitters must provide the taxpayer identification number of the recipient or transmitter.

According to FinCEN, the purpose of these proposed regulations is to close perceived loopholes in the BSA and thereby better combat money laundering, terrorist financing, and tax evasion. The scope of the proposed regulations greatly eclipses the current rules regarding wire transfers, which essentially consist of reporting requirements only for particular transactions deemed to be “suspicious,” and record-keeping duties for transactions involving $3,000 or more.

During the notice and comment period for these proposed regulations, which closed in late December 2010, industry groups expressed numerous criticisms. For example, the American Bankers Association raised the common concerns that the proposed regulations would not only consume considerable time and money, but also would imperil the security of private information without accomplishing the regulations’ stated goals.

As industry groups also have noted, FinCEN simply may lack the resources and capacity to use effectively the enormous amount of information that it is seeking. Indeed, FinCEN has acknowledged that it will not set forth the final version of these regulations any earlier than 2012 because FinCEN itself is currently incapable of satisfying its statutory obligation to possess the necessary technology systems to accept, maintain securely, and analyze the reports sought by the regulations. Further, the general estimate of the number of annual reports that would be triggered by the proposed regulations — 750 million — overwhelms the number of reports filed in fiscal year 2010 for every type of current BSA reporting requirement, combined: 16.2 million. Thus, the real-world ability of the government to actually use the information that it is demanding is a very open question.

Regardless of the final contours of these proposed regulations, they, combined with HIRE/FATCA, illustrate a trend toward the convergence of enforcement efforts that aim to undermine further foreign bank secrecy practices. Although both of these new developments broadly seek to impose systemic changes in the conduct of financial institutions, they ultimately will force individuals to examine their own behavior and push them toward tax compliance. •

Peter D. Hardy is a principal in the Philadelphia office of Post & Schell and is part of the firm’s national white-collar defense, internal investigations and corporate compliance practice. Hardy is the author of “Criminal Tax, Money Laundering, and Bank Secrecy Litigation,” a legal treatise published by BNA Books. He can be reached through the firm’s website at www.postschell.com or e-mail at phardy@postschell.com .