Why Swiss Bank Clients Who Can’t Stand the Heat Are Getting Out of the Kitchen

Every July, people from around the world descend upon a small village in Spain called Pamplona for the fiesta of San Fermin.  Encierro, or “The Running of the Bulls,” is the event at the heart of the fiesta.  The fiesta is celebrated in honor of San Fermin, patron saint of Navarra, although the religious aspect would seem to have taken on a secondary role over the last number of years.

The bull-run is a spectacle unlike no other.  It is defined by the level of risk and the physical ability of the runners.  After the launching of two rockets, a herd of six bulls is released from the corral.  These bulls charge behind runners for a distance of 825 meters.  Needless to say, runners must have cool nerves, quick reflexes, and a good level of physical fitness.

A similar Encierro is taking place right here in the United States.  Only in this Encierro, the stampede is not a herd of angry bulls.  Instead, it is a horde of frightened U.S. taxpayers with undisclosed offshore accounts.

There is a new rush by U.S. taxpayers to confess secret offshore accounts to the IRS.  The cause of this rush is not the usual suspect: the IRS.  Instead, it’s pressure from none other than the Swiss banks themselves.  This pressure has been manifested in the form of a stern warning to current and former U.S. customers: “Come forward now before your name and account information are turned over to the IRS.”

But a veiled threat is not the only way in which Swiss banks are getting the attention of their customers.  Some banks have even resorted to freezing accounts unless their customers can prove that they have disclosed the account to the IRS, or that they are at least trying to enter the agency’s Offshore Voluntary Disclosure Program.  OVDI is the IRS’s limited-amnesty program for U.S. taxpayers with undisclosed foreign accounts.

A couple of years ago, this would have been unimaginable.  After all, Switzerland has a reputation for being an unbreachable land of bank secrecy.

What has changed the tide?  Why are these banks now nudging their customers to confess their offshore accounts?  Stated otherwise, why are Swiss banks all of the sudden thumbing their noses at decades-long bank secrecy laws that are so engrained in their economy as to be part of its social fabric?

Before answering this question, some background information is needed.  Foreign banks are personally responsible for compliance.  This means that they can be criminally charged if found to have assisted U.S. taxpayers in hiding money abroad.  Thus, when it comes to criminal prosecution, a bank is treated no different than a person.

The possibility of criminal prosecution is just the tip of the iceberg.  Banks may also be subject to civil penalties.  Because these penalties are based on the amount of assets in the accounts they helped conceal, the amounts could be staggering – up to a billion dollars or more.

As an incentive for banks to nudge noncompliant accountholders to confess their offshore accounts, the U.S. government has cleverly employed the “carrot and stick approach.”  As Swiss banks know all too well, the U.S. government does not look favorably upon foreign banks that assist U.S. taxpayers in hiding money abroad.

Case in point is Swiss-banking giant UBS.  Back in 2009, UBS paid $ 780 million to the U.S. and turned over the names of more than 4,000 U.S. accountholders in order to avoid criminal charges.  According to most experts, this was a watershed moment that marked the end of Swiss bank secrecy as the world then knew it.

Of course, no Swiss bank wants to become the next UBS.  Recognizing this, the U.S. has agreed not to prosecute any Swiss bank that provides account holder information and pays stiff penalties that could be as high as 50% of the account’s highest balance.

But there is yet another way in which Swiss banks can be rewarded for scaring noncompliant taxpayers into the IRS’s program.  Next to criminal prosecution, this might be the most enticing carrot of them all.  Banks might be able to reduce their own penalties.

But there is a string attached.  And that string is a stark reminder to banks that in order to successfully reduce or eliminate their penalties, they must win a race.  By race, the government is not referring to a marathon or to Aesop’s fable, “The Tortoise and the Hare.”

Instead, the government is referring to the race to disclose an accountholder’s information.  Here’s how it works.  In order to get out from under paying what could potentially be an astronomical penalty on the undisclosed assets in a customer’s account, banks must nudge their customers to disclose before they actually do so themselves.  In other words, a customer’s disclosure must come on the heels of a warning issued by the bank.  Typically, that warning takes the form of a letter to the customer stating that information about his or her account will soon be turned over to the IRS.

Conversely, if the client confesses an offshore account voluntarily – without any nudging from the IRS – then the IRS can double-dip.  This means that the IRS can assess penalties against both the customer and the bank.  Therefore, the reason why Swiss banks are thumbing their noses at decades-long bank secrecy laws and cooperating to the fullest extent possible with the U.S. government – even at the risk of alienating some of its best customers – is quite simple: to avoid the risk of criminal prosecution and exorbitant penalties.

If there is any doubt that the “carrot and stick approach” has had the desired effect on foreign financial institutions that the U.S. government was hoping for, one need look no further than recent statistics.  As of mid-December 2013, half of all government-backed Swiss banks disclosed account holder information to the United States.  In fact, an article published in “Tax Controversy Watch” on January 27, 2014 reported that as many as 106 Swiss Banks had already disclosed account holder information to the IRS.

What we know is that this list is ever-expanding and bound to grow exponentially this year, especially in light of the fact that the Foreign Account Tax Compliance Act (“FATCA”) takes full effect in 2014.  FATCA imposes requirements on Foreign Financial Institutions (“FFIs”).  For example, Foreign Financial Institutions must register with the IRS and disclose account holder information.  Any financial institution not independently complying with FATCA’s withholding requirements could be forced to withhold up to 30% of payments made to U.S. accountholders.

What incentive do foreign institutions have to comply with FATCA?  For starters, the IRS imposes a 30% withholding requirement on all U.S.-source income or gross proceeds resulting from the disposition of a U.S. asset.  If that’s not incentive enough, then the fact that the IRS will start penalizing those banks that don’t turn over information about U.S. taxpayers surely is.

As banks strive to comply with FATCA in order to avoid these draconian penalties, it is anticipated they will close the accounts of U.S. customers who do not attest to their own compliance with IRS disclosure rules.  This new regime leaves foreign financial institutions with two choices: (1) either disclose their once-protected client lists, or (2) suffer stiff penalties.  If the action of 106 Swiss banks is any indication, they’ve chosen the former, not the latter.

Why should the aggressive position taken by Swiss banks be a matter of concern for U.S. taxpayers with undeclared offshore accounts?  While it might appear obvious, it is still worth explaining.  First and foremost, willfully failing to disclose an offshore account – by not filing an FBAR – is a crime.  It’s tax evasion in its purest form.  Second, taxpayers who don’t step forward and disclose their offshore accounts to the IRS before the agency obtains information about them will be barred from entering the OVDI.

To use a metaphor, if the bloodhound is hot on the trail of the fox before the fox reaches its hole, then it is too late.  From the hunting field to the field auditor’s office, the same principal applies.  The only difference is that the predator is not a bloodhound.  Instead, it is the IRS.  Nor is the prey a fox.  Instead, it is a U.S. taxpayer with an undisclosed offshore account.  Finally, the shelter is not a foxhole.  Instead, it is the Offshore Voluntary Disclosure Program.

Thus, if the IRS obtains the name and account information of a U.S. taxpayer with an undisclosed offshore account before the taxpayer enters the OVDI, then it will be too late.  As the IRS has stated repeatedly, it won’t negotiate if it finds you first.

To the extent that the IRS learns about the offshore account from someone other than the taxpayer, the source of that information – whether it be from a “John Doe” summons or the bank itself – is meaningless for purposes of determining a taxpayer’s OVDI eligibility.  Very simply, the taxpayer is barred from participating in the program.

With the pressure on taxpayers to disclose offshore accounts at an all-time high, it is no longer a matter of if the IRS will track down those taxpayers that are still sitting on the fence, but what will happen to them when it does.

What, if anything, can be done to avoid the inevitable?  How about OVDI?  What is all the buzz about?  For those who have just recently become acquainted with OVDI, it is good to have some background information about the program.  OVDI is the IRS’s limited-amnesty program for U.S. taxpayers with undeclared offshore accounts.

According to information released by the IRS in 2012, more than 38,000 U.S. taxpayers have entered the OVDI.  They have paid more than $ 5.5 billion to resolve issues.  And with an estimated $ 5 billion yet to come, this program is not going anywhere anytime soon.

The benefits of OVDI cannot be overstated.  OVDI shields taxpayers from possible criminal prosecution while helping them to avoid a full-blown audit that could be more intrusive than a prostate examination.  While criminal prosecution is reserved for only the most egregious cases, recent statistics show that this is not a hollow threat.  Since 2009, more than 120 U.S. taxpayers and advisers have been criminally charged in connection with offshore accounts.

The latest victims of the Department of Justice’s zealous prosecution campaign were a tax lawyer from Zurich, Switzerland named Edgar Paltzer and a former bigwig at UBS named Raoul Weil.  In August 2013, Mr. Paltzer pleaded guilty to helping clients evade U.S. taxes using Swiss bank accounts.  In 2008, Mr. Weil was indicted on numerous counts of encouraging U.S. tax evasion.

Before viewing OVDI as a panacea or solve-all, it is important to recognize that there is a heavy price to pay in order to get the peace of mind that comes from a clear assurance that the government will not come after you with its guns blazin’.  Nonetheless, while it may not be the best option, in this new climate, it might be the only rationale option.

What is required of a taxpayer who participates in OVDI?  For starters, taxpayers must provide all original returns, amended returns reflecting offshore income, and Reports of Foreign Banks and Accounts (“FBARs”).  In addition, taxpayers must consent to extend the statute of limitations for the following: (1) assertion of civil penalties, (2) penalty computation worksheets, and (3) Foreign Asset Statements.

By far, the most burdensome penalty is the offshore penalty.  To say that it is severe would be an understatement.  Indeed, the offshore penalty is the 800-pound gorilla of the OVDI.  It is 27.5% of the highest aggregate balance in the offshore bank account during the eight-year look-back period.  If your heart just skipped a beat and you are wondering if there is any way to avoid paying a penalty this obscene, you will be sorely disappointed.

The offshore penalty is a “one size fits all penalty.”  Only in limited circumstances can it be reduced.  For example, non-resident U.S. taxpayers who have lived outside of the U.S. since January 1, 2009 may be eligible for a lesser penalty.  But because this exception applies to only a relatively small percentage of U.S. taxpayers, the only sure way to avoid the offshore penalty is by not entering OVDI in the first place or by opting out later on.

For those who find the offshore penalty too hard to swallow, I offer the following advice.  If you remember nothing else from this article, remember this: As bad as the offshore penalty might be, it might still be less than the penalties that exist outside of the OVDI framework.  Indeed, a penalty far more severe might await you outside of the OVDI framework.  Hence, the idiom, “The grass is always greener on the other side” takes on greater meaning.

As the following example illustrates, it would be a tragic mistake to arbitrarily reject OVDI without first comparing the penalties that exist outside of the OVDI regime (at their maximum levels) to those within the OVDI.  For example, outside of the OVDI regime, the penalties for willfully failing to file an FBAR are up to the greater of $ 100,000 or 50% of the highest aggregate balance in the offshore bank account during the eight-year look-back period.

Thus, if the highest aggregate balance in the account was $ 1,000,000, the maximum FBAR penalty would be a staggering $ 500,000.  However, the offshore penalty would only be $ 275,000, $ 225,000 less than the maximum FBAR penalty.  Therefore, the above example offers a valuable lesson to any taxpayer who is contemplating whether to opt in, or for that matter, to opt out, of the OVDI: The severity of the penalty is always relative.  Exercise sound judgment before making a knee-jerk response to what at first blush might appear to be a shocking and outrageous penalty.

The takeaway is this.  FATCA puts pressure on foreign institutions and individuals to disclose assets and comply with IRS requirements.  In addition to those banks voluntarily complying with IRS disclosure rules, the IRS also has a treasure trove of information obtained from 40,000 offshore voluntary disclosure submissions to date.

All of this can mean only one thing.  You’ve heard it before and you’ll hear it again: bank secrecy is dead.  Very simply, there are no places in the world truly safe to hide your money from the IRS.  For individuals with undisclosed assets, it now seems inevitable that the IRS will track them down.

Encierro has a particularly emotional prelude.  It is when the runners, just a few meters up the slope from the corral where the bulls are waiting, raise their rolled newspapers and chant to an image of San Fermin.  Against a wall of silence, the following words can be heard: “Viva San Fermin!  Gora San Fermin!”  In English, the phrase means, “Long live Saint Fermin.”  One might envision a similar chant, sung not by runners in the Encierro but by U.S. taxpayers who are accepted into OVDI: “Long live the IRS!”  Alright, maybe not with as much gusto.