IRS Uses U.S. - Canada Treaty as Leverage to Recover FBAR Penalty from U.S. Citizen Living in Canada

(Parker Tax Publishing August 2017)

A district court held that a provision in the U.S. - -Canada tax treaty under which Canadian tax authorities can withhold Canadian tax refunds from a U.S. citizen who owes a debt to the IRS is not unconstitutional. The IRS used the treaty as leverage against a U.S. citizen living in Canada who had refused to pay a penalty he owed to the IRS in the amount of $120,000 for not filing a Report of Foreign Bank and Financial Accounts for 12 years. Dewees v. U.S., 2017 PTC 366 (D. D.C. 2017).

Donald Dewees is a U.S. citizen living in Canada, where he operates a consulting business. U.S. citizens who hold controlling interests in foreign corporations must annually file Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, with the IRS. This form discloses certain ownership and financial information about the foreign corporation. In addition, U.S. citizens living abroad must disclose holdings in foreign bank accounts over certain thresholds by filing a Report of Foreign Bank and Financial Accounts (FBAR). In 2009, Dewees learned that he had failed to comply with these requirements and, on the advice of a tax specialist, applied to participate in the IRS's Offshore Voluntary Disclosure Program (OVDP).

OVDP is intended to encourage taxpayers who have not disclosed their offshore assets, and who are not already under investigation by the IRS, to voluntarily comply with applicable disclosure requirements. In return for their disclosures, the program offers taxpayers compromise terms on penalties for outstanding taxes, assurance that the IRS will not refer the matter to the Department of Justice for criminal prosecution, and finality regarding previous non-disclosures. The IRS assessed a penalty of $185,862 against Dewees for not filing FBARs from 2003 to 2008, but did not at that time calculate a penalty for Dewees' failure to file Form 5471.

Dewees refused to pay the assessed penalty and withdrew from the OVDP. In September 2011, the IRS notified Dewees that it had assessed a different penalty of $120,000 against him for failing to file Form 5471 from 1997 to 2008. Code Sec. 6038(c) authorizes the IRS to impose a $10,000 penalty for each missed filing. The total penalty was based entirely on Dewees' failure to file; he was not liable for any unpaid taxes. Dewees requested an abatement of this penalty for reasonable cause, which was denied, as was his subsequent appeal of that decision.

Well after Dewees' appeal had been rejected, the IRS introduced another program to encourage taxpayers to voluntarily disclose offshore assets - the Streamlined Filing Compliance Procedures (SFCP). The SFCP differs from the OVDP in several respects: The SFCP involves less paperwork and imposes lower penalties than the OVDP, but only covers three years of non-compliance as opposed to the OVDP's eight-year coverage period. And, unlike the OVDP, the SFCP does not offer immunity from criminal prosecution. Transferring between the two programs is generally discouraged, but taxpayers who are otherwise eligible for the SFCP and made their OVDP submissions before July 1, 2014, could remain in the OVDP while requesting the more favorable terms available under the SFCP.

In May 2015, the Canadian Revenue Agency notified Dewees that it was holding his Canadian tax refund in abeyance due to his outstanding $120,000 debt to the IRS. This international collection assistance is allowed under the United States-Canada Income Tax Convention. Dewees promptly sent the Canadian Revenue Agency a check for $134,116, representing the $120,000 penalty plus interest. In September 2015, he filed a claim seeking a refund of that amount, which was rejected in May 2016.

Dewees then filed suit in the D.C. District Court, requesting that the court find the collection assistance provisions of the United States-Canada Tax Convention unconstitutional for violating (1) the Excessive Fines Clause of the Eighth Amendment, (2) the Due Process Clause of the Fifth Amendment, and (3) the Equal Protection Clause of the Fifth Amendment. The government moved to dismiss the case.

The district court held that Dewees failed to state a claim for relief on his Eighth Amendment and due process claims, and lacked standing to bring his equal protection claim. As a result, the court granted the government's motion and dismissed the case.

With respect to Dewees claim under the Excessive Fines Clause, the court noted that it had to first decide whether a penalty is a fine before determining if it is unconstitutionally excessive. A payment to the government, the court noted, is only considered a "fine" under the Eighth Amendment if it is punishment for some offense. In other words, the purpose of the penalty must be primarily retributive or a deterrent rather than remedial. Tax penalties, the court observed, have been held to fulfill a remedial purpose and, thus, are not subject to the Excessive Fines Clause.

With respect to Dewees' claim relating to the Due Process Clause, the court said Dewees likewise failed to establish a due process violation because he had been afforded an adequate opportunity to be heard at a meaningful time and in a meaningful manner. The mere postponement of an opportunity to challenge the imposition of a tax penalty, the court said, is not a denial of due process if the opportunity given for the ultimate judicial determination of the liability is adequate. Delays are an inevitable consequence of disputes between taxpayers and the IRS, the court observed, and are not unconstitutional.

With respect to Dewees' claim relating to the Equal Protection Clause, the court noted that the claim was based on the contention that Dewees was not allowed to participate in the SFCP while other similarly situated taxpayers were, and thus he was denied the opportunity to have a lower penalty imposed. The court rejected this claim, saying the IRS never denied Dewees the opportunity to participate in the SFCP, and thus he could not establish that he suffered an actual injury. As a result, Dewees lacked standing and the court had no jurisdiction to hear his claim on this issue.

For a discussion of the FBAR requirements and penalties, see Parker Tax ¶203,170.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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