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Firm Comments on Scope of FBAR Reporting Requirement

OCT. 6, 2009

Firm Comments on Scope of FBAR Reporting Requirement

DATED OCT. 6, 2009
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October 6, 2009

 

 

Internal Revenue Service

 

Attn: CC:PA:LPD:PR (Notice 2009-62)

 

Room 5203

 

P.O. Box 7604

 

Ben Franklin Station

 

Washington, D.C. 20044

 

 

Financial Crimes Enforcement Network

 

Department of the Treasury

 

P.O. Box 39

 

Vienna, VA 22183

 

Re: Foreign Bank Account Reporting-Notice 2009-62 Request for Public Comments

 

Ladies and Gentlemen:

The following is in response to Notice 2009-62 request for comments related to the Report of Foreign Bank and Financial Accounts, Form TD F 90-22.1 (the "FBAR").

An FBAR is required to be filed by each U.S. person with a financial interest in, or signature or other authority over, any foreign "financial accounts" exceeding $10,000 in aggregate value at any time during a calendar year. The FBAR instructions define a "financial account" in part as:

 

"any bank, securities, securities derivatives or other financial instruments accounts. Such accounts generally also encompass any accounts in which the assets are held in a commingled fund, and the account owner holds an equity interest in the fund (including mutual funds)."

 

In the weeks leading up to the June 30, 2009 FBAR filing deadline, IRS representatives stated that interests in non-U.S. hedge funds and even non-U.S. private equity funds constitute foreign "commingled funds" and therefore must be reported as financial accounts for purposes of FBAR reporting. Prior to -- and even after -- these statements, taxpayers and practitioners did not believe that hedge funds and private equity funds constituted "financial accounts" for purposes of FBAR reporting.

On August 7, 2009 the IRS issued Notice 2009-62 extending until June 30, 2010 the filing deadline for FBARs relating to interests in foreign "commingled funds." In addition, the Notice stated that the Treasury Department intends to issue regulations addressing FBAR requirements, and requested comments on FBAR issues including when an interest in a foreign entity should be subject to FBAR reporting.

The failure to file an FBAR can result in very substantial penalties. A civil penalty of up to $10,000 can be assessed for each failure to file an FBAR (which can be waived for reasonable cause). It is not clear that simple lack of knowledge of the filing requirement by a U.S. person who is engaged in an entirely innocent, ordinary course investment activity constitutes reasonable cause for this purpose. In considering the scope of the reporting requirement, we hope you will focus your aim on situations where (a) there is a significant potential that the person subject to potential penalties is utilizing a foreign account in connection with unlawful activities and (b) such person has reason to be aware of the FBAR filing obligation with respect to such account.

 

1. Exclude illiquid interests in foreign entities from FBAR reporting.

 

It has long been clear that equity interests in non-U.S. entities are not, as a general matter, foreign "financial accounts" for FBAR reporting purposes. Given the resemblance of many open-end or exchange traded mutual funds to bank accounts, we certainly understand the extension of FBAR reporting to equity interests in such mutual funds. But we think it would be unreasonable to extend FBAR reporting to illiquid equity interests in a foreign entity. FBAR reporting is designed to assist in detection of offshore money laundering activities. The ability to transfer cash to and withdraw cash from an account with relative ease is a significant determinant as to whether such account is susceptible to money laundering activity. Therefore, FBAR filing requirements for entity interests should be limited to an interest affording owners with liquidity either (i) by being listed on an exchange or secondary market equivalent or (ii) through redemption rights.

In particular, an equity interest in a typical private equity fund should not constitute a "financial account" for FBAR purposes because investors are locked-in for the fund's life (generally, ten plus years), do not control when they transfer money into the fund (rather, the general partner may call commitments at any time during the multi-year commitment period), and do not have the right to withdraw cash on demand or otherwise (rather, the general partner of the fund determines when to make distributions).

In addition, a typical hedge fund interest should not be treated as a financial account for FBAR purposes. Although affording greater liquidity rights than a typical private equity fund, a typical hedge fund's liquidity rights are still quite limited, especially as compared to those associated with a traditional financial account. For example, investors in a hedge fund are traditionally subject to a substantial lock-up period (generally 18 to 24 months) and typically can withdraw funds only at designated intervals (e.g., quarterly) with significant advance notice (e.g., 30 to 45 days).

If, contrary to our suggestion, the term "financial account" is defined very broadly to include interests not ordinarily considered financial accounts, the language in Line 7a of Form 1040 Schedule B (and line 6a of Form 1120 Schedule N) and the instructions thereto should be broadened to alert taxpayers of the potential FBAR filing obligations.

 

2. Clarify when equity interest is treated as "foreign" for FBAR reporting.

 

The FBAR instructions state that "[t]he geographical location of the account, not the nationality of the financial entity institution in which the account is found determines whether it is in an account in a foreign country." Therefore, a bank account maintained at a U.S. branch of a foreign bank is not a "foreign" account subject to FBAR reporting. It is not clear, however, how this rule applies to an equity interest in a foreign entity. For example, is a fund considered foreign if formed in the Cayman Islands but managed and maintaining its assets, books and records in the United States?

Because the rule for traditional bank accounts looks to the account location, the test for an equity interest in an entity should look to the location of the entity's management, books, records and assets. Thus, in the case of a fund organized outside the United States which manages and maintains its assets in the United States, equity interests in the fund should not be considered "foreign."

 

3. Eliminate duplicative FBAR filing requirements.

 

Under current FBAR instructions, a U.S. person is treated as having a financial interest in a foreign financial account if such U.S. person owns, directly or indirectly, more than 50% of the vote or value of a corporation (or more than 50% of the capital or profits interests in a partnership or LLC) and the controlled entity holds a foreign financial account.

Limited consolidated reporting is allowed for a corporation that owns directly or indirectly more than 50% of one or more other corporations required to file FBAR. This consolidated reporting does not apply to individuals or non-corporate entities that own a controlling interest in a corporation, and also provides relief only where a responsible corporation actually files the report.

Therefore, if a U.S. partnership or LLC owns, directly or indirectly, more than 50% of a U.S. or foreign corporation's stock, the U.S. partnership or LLC is required to file FBAR with respect to each foreign financial account owned by such corporation.

For example, assume a U.S. individual owns 51% of a U.S. partnership, which in turn owns 100% of the stock of a U.S. corporation, which in turn owns 100% of the stock of a Hong Kong subsidiary. In this case, each of the U.S. individual, the U.S. partnership and the U.S. corporation must file FBAR with respect to all foreign financial accounts owned by the U.S. corporation or its Hong Kong subsidiary.

A U.S. partnership or U.S. individual owning more than 50% of the stock of a U.S. corporation is not, as a general matter, held responsible for activities (even criminal) or unpaid tax liabilities of such U.S. corporation. Therefore, it seems to us entirely inappropriate to subject the U.S. partnership or U.S. individual in the example above to substantial potential penalties that relate to the actions of the U.S. corporation and not to the actions of the corporation's shareholders. If the U.S. corporation fails to make required FBAR filings, it would be subject to the applicable penalties. We see little reason to multiply the penalties up the ownership chain. If the U.S. corporation does make the required FBAR filings, we see no reason to impose penalties on direct and indirect shareholders of the corporation who have done nothing wrong and may have no reason to even suspect that any filing on their part is required.

In order to alleviate duplicative filing requirements and inappropriate penalty exposure, regulations should provide that FBAR filing is not required for a U.S. person where such U.S. person is treated as owning a financial interest in a foreign financial account solely through its ownership of a U.S. lower tier entity which is required to make FBAR filings with respect such foreign financial account.

 

4. Eliminate FBAR obligation where duplicative of other IRS filing obligation.

 

Regulations should eliminate FBAR reporting for any year in which the existence of the relevant foreign financial account is already required to be disclosed to the IRS pursuant to another reporting regime. For example, we believe it unnecessary to require a U.S. partner in a foreign partnership treated as a "commingled fund" to file FBAR with respect to its partnership interest if such foreign partnership is already required to file a Form 1065 with the IRS, including a Schedule K-1 with respect to such partner, as is generally the case if the foreign partnership has any U.S. source income. Similarly, we believe FBAR reporting should not be required with respect to stock in a foreign corporation treated as a commingled fund owned by a U.S. person if such U.S. person is already required to report the ownership of such stock on a Form 5471 (for example, if such U.S. person acquires 10% of the voting power or value of the corporation's stock).

Therefore, regulations should provide that no FBAR reporting by a U.S. person is necessary for any year with respect to a foreign financial account that is (1) an interest in a foreign partnership filing a Form 1065 and Schedule K-1 with respect such U.S. person, or (2) an interest in a foreign partnership where such U.S. person files a Form 8865 with respect to such foreign partnership, or (3) an interest in a foreign corporation where such U.S. person files a Form 5471 with respect to such foreign corporation.

 

5. Clarify reasonable cause exception for penalty relief.

 

Title 31 Section 5321(a)(5)(B) of the U.S. Code provides for a $10,000 penalty for failure to comply with obligations imposed under 31 U.S.C. 5314 (which include the FBAR filing obligation), except that no penalty is imposed if the failure (1) was due to "reasonable cause" and (2) "the amount of the transaction or the balance in the account at the time of the transaction was property reported."

It is unclear how this reasonable cause exception applies where income with respect to a foreign financial account was correctly reported on a U.S. person's income tax return, but such person inadvertently failed to file FBAR with respect to such account. Regulations should state that the civil penalty for failure to file FBAR with respect to a foreign financial account does not apply so long as (1) a U.S. person did not knowingly fail to file the FBAR and (2) such person correctly reported income and paid tax with respect to income earned in such financial account.

 

6. Reduce duplicative filing obligations by employers and employees.

 

Under current FBAR instructions, each U.S. person with "signature or other authority" over a foreign financial account must file FBAR with respect to such account, even if such person has no financial interest in the account. A person has signature or other authority over an account if such person can control the disposition of money or other property in the account by delivery of such person's signature, or can exercise comparable power over the account by any other communication with the bank or other person maintaining the account, including through an agent.

A limited exception (the bank exception) provides that an officer or employee of a bank supervised by a U.S. Federal agency who has signature or other authority over a foreign financial account maintained by the bank is not required to file FBAR with respect to such account so long as such officer or employee does not have a personal financial interest in the account.

Another limited exception (the widely-held exception) provides that an officer or employee of a domestic corporation (and its controlled subsidiaries) whose equity securities are listed on a U.S. national securities exchange or which has assets exceeding $10 million and 500 or more shareholders of record is not required to file FBAR with respect to foreign financial accounts of the corporation so long as such officer or employee does not have any personal financial interest in the account and has been advised in writing by an officer of the corporation that the corporation has filed a current FBAR with respect to such account.

These two limited exceptions should be expanded to provide that no officer or employee with signature or other authority over a foreign financial account owned by such person's employer (or any entity related to such person's employer) is required to file FBAR with respect to such account so long as (1) such person has no financial interest in the account and (2) such person's employer is required to file an FBAR with respect to such account. This broader exception should apply to all U.S. employers (i) regardless of the amount of assets held by such employer, the number of shareholders it has, or whether the company is listed and (ii) regardless of whether the employer is organized as a corporation, partnership, or other entity. Also, regulations should clarify that an individual does not have a "financial interest" in an account for purposes of this exception so long as the individual does not have a financial interest in the account for purposes of general FBAR reporting. For example, a corporation's employee with signature or other authority over an account owned by the corporation should not be treated as having a financial interest in such account merely because the employee owns stock of the corporation (so long as the employee owns 50% or less or the corporation's stock).

 

* * * * * * * *

 

 

Please contact Jack Levin (at 312-862-2004), Thomas Evans (at 312-862-2196), Patrick Gallagher (at 212-446-4998), Donald Rocap (at 312-862-2266),William Welke (at 312-862-2143), or Paul Patrow (at 312-862-2219) if you have questions or would like to discuss these comments.
Very truly yours,

 

 

Jack S. Levin

 

Thomas L. Evans

 

Patrick C. Gallagher

 

Donald E. Rocap

 

William R. Welke

 

Paul D. Patrow
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