The Internal Revenue Service has been hammering U.S. taxpayers with foreign activities lately. Over the past several months, the Obama administration has introduced a strongly anti-business proposal to remake the system of U.S. taxation of international activities. In early June, news reports surfaced that the United States Attorney for the Southern District of Manhattan obtained subpoenas to seize in excess of $34 million in funds won by U.S. online poker players. Most recently, the IRS, in the auspicious venue of a continuing education telephone conference, sent shockwaves through the investment community by concluding that an equity interest in offshore hedge or private equity funds was an interest in a “foreign financial account” that must be disclosed by filing a Report of Foreign Bank and Financial Account, Form TD F 90-22.1 (popularly known as an FBAR).
These recent developments in the international arena of U.S. taxation have significant importance for gaming businesses. The gaming industry is directly impacted because it is a global industry. Thus, consideration should be given to whether investments made by U.S. gaming businesses—specifically those involving offshore activities—must be reported on an FBAR. Second, at an indirect level, these developments offer insight to the mindset of the Obama administration concerning financial transactions that may be used to launder money or otherwise circumvent U.S. income taxation. Gaming businesses are often unknowing participants in financial transactions that result in the filing of Suspicious Activity Reports and Currency Transaction Reports and, therefore, must remain keenly aware of the latest developments relating to IRS enforcement activities. Ultimately, the purpose behind the IRS’ recent focus on the foreign activities of U.S. taxpayers may be to combat both money laundering and efforts to evade U.S. income taxation.
The Obligation to File
Each person with a financial interest in or signature authority or other authority over any “foreign financial account” may be required to file an FBAR. An FBAR must be filed when the aggregate value of the foreign financial account(s) exceeds U.S. $10,000 at any time during a calendar year. The FBAR must be filed by June 30 following the calendar year in which a person had an interest in a foreign financial account. In other words, a United States taxpayer with an interest in a foreign financial account that exceeded $10,000 during 2008 is required to file an FBAR on or before June 30, 2009.
What is a “Foreign Financial Account”?
On the face of the instructions and underlying statutory language, one could readily conclude that a “foreign financial account” is simply a bank or other financial account holding securities. In the arcane world of tax law, however, the meaning that courts and the IRS give to the term “foreign financial account” can defy logic. The IRS issued revised instructions to the FBAR in October 2008, which in turn has generated a great deal of uncertainty over what constitutes a “financial account.” The revised definition of “financial account” provides that a financial account “includes any bank, securities, securities derivatives or other financial instruments accounts.” The FBAR instructions further explains that “[s]uch accounts generally also encompass any account in which the assets are held in a commingled fund, and the account owner holds an equity interest in the fund (including mutual funds).”
The uncertainty culminated during a June 12, 2009, telephone conference when three IRS personnel articulated their position that an interest in an offshore private equity or hedge fund was a “financial account” and, accordingly, U.S. investors should file an FBAR, regardless of whether the fund held any offshore bank or securities accounts. The apparent basis of the IRS’ conclusion is that such offshore funds are similar to a mutual fund. As noted above, the FBAR instructions include mutual funds within the definition of a “financial account.”
Many offshore funds are organized as a business entity, often classified as “partnerships” for federal income tax purposes. Investors in offshore funds typically acquire equity interests in the form of a partnership interest. The IRS appears to have adopted the position that a partnership interest can be a “financial account” for purposes of filing an FBAR. The IRS’ recent pronouncement was specifically directed at the investment community, particularly hedge and private equity funds. However, the IRS interpretation potentially casts a much wider net and could even impact U.S. gaming businesses with foreign activities. For instance, a U.S. gaming business could be subject to the FBAR filing obligations if the gaming business conducts foreign activities by using an offshore joint venture entity that serves as a holding company for a business entity that directly conducts an active business offshore.
The Impact on Gaming Businesses
The IRS has broadly interpreted the meaning of “financial account” and, thus, several forms of investments conceivably may be pulled within the IRS’ interpretation. For gaming businesses, there are two general categories of persons who may be required to file an FBAR: (1) U.S. gaming businesses holding an equity interest in an offshore hedge or private equity fund, or (2) U.S. business entities that invest in offshore funds. Additionally, members of the investment community may be required to file an FBAR. Therefore, prudence suggests that the following persons should consider filing an FBAR:
• Any U.S. investor, including a gaming business, that has invested in an offshore fund, including investors in standalone offshore funds, an offshore feeder fund in a master/feeder fund structure, or master funds;
• U.S. feeder funds that invest in offshore master funds;
• Any U.S. taxpayer who holds more than a 50 percent profit or capital interest in a U.S. feeder fund that invests in an offshore master fund; and
• Investment managers that may have a financial interest in an offshore fund, such as a carried interest.
As discussed above, the fact that an investor may hold a partnership or other equity interest in an offshore entity does not appear to negate the obligation to file an FBAR under the IRS’ interpretation of the term “financial account.” Thus, conceivably, under the view expressed by the IRS, a U.S. gaming business that invests in an offshore business entity that essentially serves as a holding company for an active business could be viewed as analogous to a private equity fund and, accordingly, necessitate the filing of an FBAR.
Failure to File
One reason U.S. investors in offshore funds are adopting a cautious approach and filing FBARs is because significant civil monetary and criminal penalties may be imposed for failing to timely file an FBAR. Civil penalties range from $10,000 to the greater of $100,000 or 50 percent of the balance of the account if there is a willful failure to file an FBAR. Criminal penalties include a fine of up to $500,000 and imprisonment of up to 10 years for failing to file an FBAR. Gaming businesses with foreign activities may similarly consider adopting a cautious approach, depending on the structure of their foreign activities.
Voluntary Disclosure and Extensions
The IRS recently launched a voluntary disclosure program for taxpayers with undisclosed foreign financial accounts for 2008 and prior years. Taxpayers with previously undisclosed foreign financial accounts may disclose the accounts between March 23 and Sept. 23, 2009. The disclosure is made to the IRS Criminal Investigation unit pursuant to the voluntary disclosure procedures of the Internal Revenue Manual. The benefit gained from making a voluntary disclosure is that, if accepted by the IRS, a person will generally eliminate the risk of criminal prosecution and avoid substantial civil penalties.
A person who has previously reported and paid taxes associated with foreign financial accounts is not eligible to participate in the voluntary disclosure program. Rather, the IRS has instructed persons who have only failed to file an FBAR for 2008 and prior years to file the delinquent FBARs and attach a statement explaining why the reports were filed late. In these circumstances, the IRS has stated that it will not impose a penalty for failure to file FBARs.
As discussed above, an FBAR must ordinarily be filed by June 30. Typically, as stated in the FBAR instructions, “[t]here is no extension of time available for filing [the FBAR].” On June 24, 2009, the IRS issued revised Frequently Asked Questions (FAQs) addressing numerous issues surrounding the obligation of U.S. taxpayer to file an FBAR. The revised FAQs effectively provide an extension to Sept. 23, 2009, to file an FBAR for U.S. taxpayers meeting certain requirements.
Under the IRS’ most recently stated position, a U.S. investor in an offshore hedge or private equity fund, or analogous investment structure, would either have had to file an FBAR by June 30, 2009, or face the prospect that draconian civil—and potentially criminal—tax penalties could be imposed. For U.S. taxpayers, including gaming businesses, with investments that use structures analogous to a hedge or private equity fund structure, the IRS initially offered virtually no time to consult with tax law advisors to assess whether it is appropriate to file an FBAR. The revised FAQs offer an opportunity for gaming businesses to further assess whether they are obligated to file an FBAR.
The revised FAQs guidance permits a U.S. person to file an FBAR on or before Sept. 23, 2009, without the imposition of penalties. The revised FAQs contemplate two scenarios under which a U.S. taxpayer may be eligible to file an FBAR late without imposition of penalties:
(1) a U.S. taxpayer who has reported and paid applicable taxes on all their 2008 taxable income; or
(2) a U.S. taxpayer who timely reports all 2008 taxable income attributable to the foreign financial account (i.e., for returns due after Sept. 23), if the U.S. taxpayer (a) recently became aware of the obligation to file an FBAR, and (b) has had insufficient time to gather information to complete the FBAR.
A person submitting a late FBAR must also include a statement explaining the reason for the late filing. The FBAR is to be filed both with the U.S. Department of Treasury’s Detroit office and with the IRS Offshore Identification Unit. Except for 2008 tax returns due after Sept. 23, 2009, U.S. taxpayers must also include a copy of their 2008 tax return with the FBAR submitted to the IRS Offshore Identification Unit.
Greater Scrutiny
Coupled with the IRS’ expansive view with respect to when an FBAR must be filed, federal prosecutors and the IRS have taken aim at specific gaming-related activities. As has been widely reported in mainstream media, in early June federal prosecutors sought and obtained subpoenas to seize nearly $34 million in funds won by online poker players residing in the U.S. There have been various theories attempting to explain the rationale of the enforcement activity, ranging from conspiracy to a belief that the U.S. Department of Justice is signaling opposition to Congressman Barney Frank’s (D-Mass.) legislation to authorize Internet gaming in the U.S. These theories may offer fascinating subplots, however, a missing piece that has not been widely discussed involves the enforcement activity of the IRS relating to Suspicious Activity Reports filed by casinos. Therefore, viewed collectively, all three developments seem to point to increased efforts by the federal government to combat money laundering and efforts to evade U.S. income tax.
Final Thoughts
The recent attention the IRS has placed on the foreign activities of U.S. taxpayers echoes the rapidly changing regulatory environment that has developed over the past year. The pattern that can be discerned from the enforcement activities is that the IRS and the federal government are interested in transactions that could be used to launder money or avoid U.S. income taxation. Gaming businesses are in a unique position to feel the brunt of the IRS’ newfound interest: Gaming is a global industry, where U.S. gaming businesses often have foreign operations and casinos are often the unknowing participants in efforts by third parties to launder money.