Treaty Tie-Breaker is an FBAR Escape Hatch, Says the Court!

It has been the position of the Internal Revenue Service (IRS) that a “Report of Foreign Bank and Financial Accounts” (Form 114), commonly called the “FBAR”, must still be filed to report any foreign accounts, despite a green card holder’s treaty tie-breaker claim. It came as a big surprise to me that the United States District Court, Southern District Court of California disagreed with the IRS on this issue just last month. The taxpayer-friendly case, Aroeste v. United States, Case No. 22-cv-682-AJB-KSC (S.D. Cal. February 13, 2023), is sure to be appealed by the undoubtedly furious IRS.  In a nutshell, the Aroeste court determined that FBAR filing is not required if the individual is entitled to be treated as a resident of a foreign country under a tax treaty.  Before delving into the case, let’s review a few points about treaty tie-breakers and FBARs.

What is a Treaty Tie-Break Clause?

My recent blog post dealt with the green card holder, who while taxed as a US “resident”, may also be resident of a foreign jurisdiction with which the United States has an income tax treaty.  Such a “dual resident” might qualify as a resident of the other country under a tie-breaker rule contained in the treaty. After applying the treaty rules, if the individual qualifies as a “resident” of the foreign country, the individual may compute his US tax liability for all or part of a tax year as if he was a nonresident alien of the US using Form 1040-NR.

If the green card holder chooses to be treated as a resident of a foreign country under an income tax treaty, he or she will still be treated as a US resident for tax purposes other than figuring the individual’s US income tax liability (see Treasury Regulations section 301.7701(b)-7(a)(3)), quoted below.

(3) Other Code purposes. Generally, for purposes of the Internal Revenue Code other than the computation of the individual’s United States income tax liability, the individual shall be treated as a United States resident. Therefore, for example, the individual shall be treated as a United States resident for purposes of determining whether a foreign corporation is a controlled foreign corporation …..

What does it mean to still be a US resident for other tax purposes?   As stated in the Regulation, the individual’s US status will still count for many purposes of the US tax laws. Ownership of shares in a foreign corporation will still be counted for purposes of classifying the entity as a controlled foreign corporation (CFC). In a similar vein, might the shareholder’s US status still count when determining the validity of the S corporation status?  This issue is “reserved” in the Regulations.

What about FBARs?

It is worthwhile to make an initial, but very important, point.  FBAR issues are governed by the Bank Secrecy Act (“BSA”) found in Title 31 of the United States Code.  This is not part of the Internal Revenue Code (“IRC”), which is contained in Title 26 of the United States Code. The BSA is not a tax statute. Its purpose, while in part seeking to prevent tax evasion, is aimed at money laundering and terrorist activities.

Under the BSA, every “United States person” (which includes a green card holder) has a duty to file an FBAR on Form 114 with respect to foreign financial accounts (see 31 CFR Section 1010.350 – this is a regulation issued under the BSA, not the IRC).  Is a green card holder still treated as a “United States person” for FBAR reporting purposes if he has made a treaty tie-breaker election?

As defined by the Treasury Regulations issued for FBAR, a United States person (as relevant here for a green card holder) means:

(2) A resident of the United States. A resident of the United States is an individual who is a resident alien under 26 U.S.C. 7701(b) and the regulations thereunder ….

Thus, the FBAR regulations specifically refer to the IRC and relevant Treasury Regulations under Section 7701 for the definition of a resident alien. These Regulations recognize that a green card holder may also be treated as a resident of a foreign country under that foreign country’s domestic law with which the United States has an income tax treaty in force. Such an individual is a “dual resident taxpayer.” See Treas. Reg. § 301.7701(b)-7.  Such a dual resident green card holder may compute his US income tax liability as if he were a nonresident alien by filing Form 1040NR along with a Form 8833 claiming the treaty tie-breaker.  Details are set out in Treas. Reg. § 301.7701(b)-7(b) and (c).

Aroeste v. United States and the “Escape Hatch” 5-Step Process

The taxpayer, Alberto Aroeste was a green card holder.  He lived in Mexico and claimed to be a resident of Mexico under the United States – Mexico income tax treaty (“Treaty”).  Mr. Aroeste argued that because of his residence in Mexico he was not a ‘United States person’ required to file an FBAR for the 2 tax years in issue.  IRS disagreed, claiming that FBAR filings are still required even if the treaty tie-break clause is invoked. Various assessments were levied against the taxpayer by IRS for 2012 and/or 2013 amounting to approximately US $2 million (the bulk of which appeared to be information reporting penalties).

The IRS contended that Mr. Aroeste’s status under the Treaty was irrelevant. IRS’ view was that the Treaty solely concerned residency for the purposes of income tax and excise tax assessments under Title 26 of the United States Code.  The IRS believed that the Treaty is not relevant for FBAR issues because FBAR matters are governed by Title 31, not Title 26.

The court acknowledged that the analysis is quite complex and “depends on the application of multiple, interconnected statutes and regulations”. (As an aside, how the average taxpayer or his advisor is to grapple with such complicated and confusing issues is beyond me, but I digress….).  The court analysis is below, verbatim. Pay attention to the citations noted by the court indicating the distinctions, yet inter-relationship, between Title 26 and Title 31:

“The upshot of this statutory and regulatory framework applicable to this action, in which tax treaties provide a potential escape hatch that excuses certain ‘United States persons’ from filing FBARs, can be expressed as a 5-step process:

(1) Under 26 U.S.C. § 7701(b)(6), anyone allowed to permanently reside within the United States by virtue of US immigration laws is a ‘lawful permanent resident’ for tax purposes unless an applicable tax treaty allows that person to be treated as a resident of a foreign country for tax purposes only;

(2) Under 26 U.S.C. § 7701(b)(1)(A)(i), any ‘lawful permanent resident’ is a ‘resident alien’;

(3) Under 31 C.F.R. § 1010.350(b)(2), any ‘resident alien’ is a ‘resident’ of the United States”;

(4) Under 31 C.F.R. § 1010.350(b), Any ‘resident of the United States’ is a ‘United States person’ required to file an FBAR;

(5) Therefore, any person allowed to permanently reside in the United States by virtue of US immigration laws must file an FBAR unless that person is entitled to be treated as a resident of a foreign country under a tax treaty.”

IRS Appeal?

I am sure the IRS will appeal this decision. Let’s see what that Ninth Circuit has to say. It will be recalled that the Ninth Circuit has been taxpayer friendly when it comes to FBAR penalties.  See discussion of US v. Boyd).

Listen to my podcast with attorney John Richardson on the Aroeste case – it’s surely shaking up the FBAR world.

 

Posted March 2, 2023

 

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