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Canada offsetting Canadian tax refund by amount of U.S. tax deficiency not unconstitutional

A district court has held that a provision of the U.S.-Canada treaty, under which Canada offsets Canadian tax refunds against the unpaid U.S. tax liability of taxpayers, is not unconstitutional under the Eighth Amendment or the Due Process clause of the Fifth Amendment. The court also held that the taxpayer lacked standing to bring an equal protection claim.

Background—information reporting with respect to foreign financial accounts. The Bank Secrecy Act (BSA) gave the Treasury Department authority to collect information from U.S. persons who have financial interests in or signature authority over financial accounts maintained with financial institutions located outside of the U.S. A provision of the BSA requires that a Form 114, Report of Foreign Bank and Financial Accounts (FBAR) be filed if the aggregate maximum values of the foreign financial accounts exceed $10,000 at any time during the calendar year. Enforcement authority regarding the FBAR has been delegated to IRS.

Background—information reporting with respect to foreign corporations. Code Sec. 6038(a)(1) requires U.S. persons to furnish information with respect to any foreign business entity that that person controls. The relevant IRS form is Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations.

A $10,000 penalty is imposed on a U.S. person who fails to timely furnish information required under Code Sec. 6038(a)(1) for any foreign corporation or partnership it controls for each annual accounting period for which the failure exists. (Code Sec. 6038(b)(1))

Background—IRS’s foreign account voluntary compliance programs. Since 2009, IRS has had programs in place to encourage compliance by persons that are not in compliance with reporting requirements with respect to foreign assets, accounts and income. Two of those programs are the Offshore Voluntary Disclosure Programs (“OVDPs”) and Streamlined Filing Compliance Procedures (“SFCP”).

The 2009 version of OVDP provided that, in return for their disclosures, taxpayers received compromise terms on penalties for outstanding taxes, assurance that IRS would not refer the matter to the Department of Justice for criminal prosecution, and finality regarding previous non-disclosures.

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 8-year coverage period.

Under the “Transition Rules,” a taxpayer that had already entered an OVDP before July 1, 2014 may be able to receive the favorable penalty terms of the SFCP, but must remain in the OVDP in order to do so.

Background—the Eighth Amendment and the Due Process clause of the Fifth Amendment. The Eighth Amendment to the United States Constitution provides: “Excessive bail shall not be required, nor excessive fines imposed, nor cruel and unusual punishments inflicted.” The Excessive Fines Clause limits IRS’s power to extract payments, whether in cash or in kind, as punishment for some offense. (Austin v. United States, (S Ct 1993) 509 U.S. 602 )

The Due Process clause of the Fifth Amendment says that no one shall be “deprived of life, liberty or property without due process of law.”

Background—jurisdiction/standing. The first question in every case brought in federal court is whether the court has jurisdiction, which includes the issue of standing. To obtain standing, a plaintiff must show that it suffered an injury in fact that is fairly traceable to the defendant’s conduct and that is capable of being redressed by a favorable decision from the court. (Lujan v. Defs. of Wildlife, (S Ct 1992) 504 U.S. 555 )

Facts. The taxpayer, Mr. Dewees, was a U.S. citizen living in Canada, where he operated a consulting business.

In 2009, Dewees learned that he had failed to comply with the FBAR requirements, and, thereafter, successfully applied to participate in the OVDP. IRS assessed a penalty of over $185,000 for not filing the FBARs. Dewees refused to pay the assessed penalty and withdrew from the OVDP.

Because the business was incorporated abroad, Dewees was required to furnish certain annual information pursuant to Code Sec. 6038(b). Dewees neglected to do so for over a decade.

In September 2011, IRS notified Dewees that it had assessed a different penalty of $120,000 against him for failing to file Form 5471 from ’97 to 2008. Dewees requested an abatement of this penalty for reasonable cause, which was denied.

Pursuant to the U.S.-Canada tax treaty (the Treaty), the Canadian tax authority held Dewees’ Canadian tax refund in abeyance until the IRS penalty was paid in full.

After paying the penalty, Dewees brought this suit challenging the relevant treaty provisions as unconstitutional under the Eighth Amendment and both the Due Process and Equal Protection Clauses of the Fifth Amendment.

Court dismisses taxpayer’s claims. Finding 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, the Court dismissed the case.

…Eighth Amendment claim. The court held that the Treaty did not violate the Eighth Amendment.

The court said that it must first decide whether a penalty is a fine before determining if it is unconstitutionally excessive. A payment to IRS is only considered a “fine” under the Eighth Amendment if it is “punishment for some offense.” (United States v. Bajakajian, (S Ct 1998) 524 U.S. 321) In other words, the purpose of the penalty must be primarily retributive or deterrent rather than remedial.

The court said that tax penalties, by contrast, having been held to fulfill a remedial purpose, are therefore not subject to the Excessive Fines Clause. The court noted that a Bankruptcy Court recently applied this precedent in holding that Form 5471 non-compliance penalties are not fines. (In re Wyly, (Bktcy Ct TX 2016) 117 AFTR 2d 2016-1508)

Dewees argued that a smaller penalty would have achieved the same objective of making IRS whole. But, the court said, that is beside the point. Congress authorized a $10,000 penalty for every instance of non-compliance because it recognized the expenses and loss that could result if U.S. taxpayers no longer felt obligated to disclose their foreign assets. IRS strictly applied that statutorily authorized amount across Dewees’ twelve years of non-compliance, resulting in a total penalty of $120,000—an amount designed to mitigate the harm suffered by IRS. The court said that, because Congress authorized this penalty for a legitimate remedial purpose, Dewees’ Eighth Amendment claim failed.

… Due Process claim. Dewees claimed that he was denied adequate due process because he had no opportunity to appeal his penalty “through administrative means or the U.S. Tax Court” before it was collected. But, the court said, the absence of Dewees’ requested avenue of relief does not mean his due process rights had been violated. 28 USC 1346(a)(1) gives district courts original jurisdiction over “any civil action against the United States for the recovery of … any penalty claimed to have been collected without authority…” The ability to challenge tax penalties in district courts under 28 USC 1346(a)(1) fulfills the Fifth Amendment’s due process requirements.

Accordingly, the court said, Dewees failed to state a claim for relief under the Due Process Clause of the Fifth Amendment.

…Equal Protection claim. The court held that Dewees did not have standing for his equal protection claim.

The court said that, under the standing rules, there must be a sufficient injury in fact, i.e., one that isis concrete and particularized, and actual or imminent, as opposed to merely hypothetical.

Dewees based his equal protection claim on the contention that he 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 said that this argument suffers from a fatal flaw because Dewees did not plea that he sought entrance into the SFCP or that his application was denied. Because Dewees did not show (or attempt to show) that IRS ever denied him the opportunity to participate in the SFCP, he could not establish that he suffered an actual injury. By failing to show that he was injured, Dewees lacked standing.

References: For Code Sec. 6038(b)(1) penalty for failure to file, see FTC 2d/FIN ¶  V-1961; United States Tax Reporter ¶  60,384. For foreign account voluntary disclosure programs, see FTC 2d/FIN ¶  V-3851; United States Tax Reporter ¶  72,014.15.

Dewees, (DC Dist Col 8/8/2017) 119 AFTR 2d ¶ 2017-5127