This transcript has been edited for clarity. 

David D. Stewart: Welcome to the podcast. I'm David Stewart, editor in chief of Tax Notes Today International. This week: It's fine.

Over the years we've often talked about efforts to identify and regularize hidden assets around the world. In the U.S., one of the main tools is the foreign bank account report, but recent court decisions have come to different conclusions on the FBAR regime's penalty provisions. So what is happening, and where can we expect these cases to go?

Here to talk more about this is Tax Notes contributing editor Robert Goulder. Bob, welcome back to the podcast.

Robert Goulder: Thanks for having me, Dave.

David D. Stewart: So why don't you start off with a refresher on what is the FBAR?

Robert Goulder: Yeah, absolutely. And that's necessary because so many people don't know about FBARs. What is an FBAR? It is not a tax provision. It is not part of the Internal Revenue Code. You'll find it in the federal statutes under the Bank Secrecy Act of 1970. So it doesn't seek to impose a tax on anyone. It is about information gathering, and again, it goes all the way back to 1970, roughly 40 years before we have something like the Foreign Account Tax Compliance Act regime.

But way back then, Congress knew there was a problem, a sort of Achilles' heel in the U.S. tax system, where if you contrast a domestic bank with a foreign bank, right? Say you walk down the street and put money in a domestic bank. There's going to be a 1099 for your interest income. You have no incentive to underreport that income on your tax return. The IRS is going to know about every penny of it. Not so with foreign banks because the U.S. government doesn't have the ability to impose these dual safeguards of reporting or withholding on these foreign banks, or at least they didn't before FATCA.

But we have to go back to 1970 to make sense of this. What do you do? They came up with a requirement that says every U.S. citizen or resident with a foreign financial account is obliged to file an annual statement with a group called FinCEN, not the IRS, FinCEN. That's the Financial Crimes Enforcement Network, which is another subunit of the Treasury Department, distinct from the IRS.

So now there's a de minimis threshold here. If the amount of money in the account is just trivially small, you don't have to file an FBAR. But if you're over the designated threshold amount, then yeah, you have to file this report, which is called FinCEN Report 114. We just call them FBARs. The vast majority of the American public has no idea that they have to do this if they have a foreign bank account, and they probably have never heard of FinCEN.

So it's a reporting regime that people don't know about, and a federal agency that people don't know about. And just a few other key points, you do not satisfy your FBAR requirement by timely filing a Form 1040. So you can be compliant with the Internal Revenue Code but still get a penalty for not filing your FBAR. Also, when there is a violation, FinCEN does not enforce it itself. It doesn't really have the talent or the skill set to do that. It gets helped out by the IRS. So the IRS, even though it doesn't receive the FBAR report, it enforces the penalty regime.

And there's two types of penalties. One for an innocent, nonwillful violation — that's the $10,000 per account. There's a lot of litigation about what that means, $10,000 per account, but we won't get into that for now. There's a much bigger, steeper penalty for a willful FBAR violation that could range up to half of the account balance. Technically, these are civil penalties, not criminal penalties. So the concept is not to throw anyone in jail, but to slap them with a very large, or a potentially very large, penalty.

David D. Stewart: OK, so 1970. We get this new FBAR regime. How did it work? Did it meet its purpose?

Robert Goulder: Well, I suppose so, but how does the IRS know if an undisclosed account is being found out? It's really hard for the IRS to even compile accurate statistics about whether the FBAR regime is working. What we do know is that the propriety, the legality of these FBAR penalties, it's very keenly litigated now. In the post-FATCA era, there wasn't a lot of litigation over these things before the last five or 10 years.

So the swell of litigation concerning FBAR penalties is very much on the rise. If you look across the country from coast to coast on the federal court dockets, there is a boatload of FBAR litigations, and a lot of it centers on this idea of the Bill of Rights, believe it or not. If you read the Eighth Amendment, it says there won't be excessive bail, there won't be cruel and unjust punishment, which is a criminal concept, but it does talk about the excessive fines clause. "There shall not be excessive fines."

What if you have a willful FBAR penalty, which again could be up to half of the amount of the bank account in question. And that's just the penalty, that's not including interest on the penalty or late charges. How does that square with the Eighth Amendment? Couldn't you make a case that as written and currently under the Bank Secrecy Act, these penalties for a willful FBAR violation are violating the Constitution?

That has been coming up, and there's two cases I'd like to tell you about. Now, one of them is a little bit old, just as in like two years ago. It's Toth v. the United States, and this was up in the Boston area. This was the First Circuit, and the decision came down from that First Circuit that an FBAR penalty doesn't count as a fine because it's not meant to punish anyone; it's meant to be remedial. In other words, what the IRS is trying to do is collect all this income that's stashed out there offshore that it can't get at. And that's why we have this regime, and we need these penalties if the regime is going to have any teeth.

So because it's remedial, not punitive, it's not a fine. And because it's not a fine, it's not subject to the Eighth Amendment. Well, that got appealed to the U.S. Supreme Court, and they did not grant certiorari. However, Justice Neil Gorsuch issued a dissent. So it's one of these weird situations where you have a dissent in isolation. There is no majority opinion against which it can be compared or contrasted with. It's just a three-page dissent from Justice Gorsuch basically saying that the first court got it wrong. They got it completely wrong, and he concludes his dissent by saying, "I hope other federal courts across the country do not repeat the mistakes of Toth."

David D. Stewart: Well, how do you make that distinction between a fine versus a penalty? What sort of reasoning did the court come to about that?

Robert Goulder: The court seemed to be hung up on the fact that it was the IRS assessing the penalty, and they said, "Well, what is the function of the IRS? It's got to go chase all this revenue that it should be hidden. The public fisc needs it. We need to pay for things. We've got spending obligations. We've got a military, we've got a Pentagon. We have hurricanes and FEMA and things. We have to collect revenue to pay for the federal government." And because the IRS is the one enforcing this, the penalties have to be about ultimately chasing that revenue that's out there.

Now, that assumes anything the IRS touches is about collecting revenue. Query whether that's really true. There's something called a 1095-B form that has to do with basically the Affordable Care Act. That's not really about collecting revenue. So we can say objectively that the IRS is involved in providing healthcare. That has nothing to do with revenue.

So the court is very much hung up that the party assessing the penalty is the IRS. It really seems like it is splitting hairs to say that it's not a penalty. Now, the individual here, Ms. Toth, she's in her eighties — it's a bit of an unusual story. Her father fled Germany in the 1930s, but he ends up in Buenos Aires, becomes a very successful businessman. Years go by, and it turns out he had one meaningful relationship with continental Europe, even though he moved his family's life from Germany to Argentina. He kept a Swiss bank account. He didn't mention it to anybody. And as he was passing away, he tells his daughter the litigant, Ms. Toth, "Hey, I've got this account. It's got $4 million or $5 million in it." I think the balance was closer to $4 million. "I'm passing away. This is going to be yours now."

So she inherits an account and never told anyone about it, never declared any of the income. There was no FBARs. She became owner of the account in 1999. She never filed any FBARs until you get to 2010. The following year, 2011, she gets audited, and the IRS starts asking about that Swiss bank account that was declared for the first time on her FBAR for 2010. Well, they start to go back looking at the statute of limitations. So you can only go back so far, but they're looking at the tax years from 2005 to 2009. Why were there no FBARs for those years? And she's found to be, pending this audit, the audit concludes that she violated her FBAR requirements for those years. For one of those years, 2007, her penalty was over $2 million, and there's another $1 million of interest and penalties. So the combined assessment just for 2007 is $3 million.

The account only had $4 million in it, and we still have those other years to worry about — 2005, 2006, 2009, and so forth. Really, what's going on here is that she's going to have to take that UBS account, and just basically give it to the IRS, say, "Here you go" — all because she declared it in her 2010 FBAR. Her reward for being compliant in 2010 was being audited in 2011.

So anyway, when you just think about it, if you've got a foreign bank account, let's say $4 million, and the penalty for not disclosing it is $3 million, is that excessive? Now, I'm not getting into the substance of that issue. Reasonable minds can differ. Is that an excessive penalty? Is it not an excessive penalty? The issue that the Supreme Court did not hear is whether it should be subject to the Eighth Amendment. They said it's not even a fine because it's remedial, not punitive.

David D. Stewart: You mentioned that there is a smaller fine regime for nonwillful.

Robert Goulder: Yes.

David D. Stewart: So how does one establish willful versus nonwillful?

Robert Goulder: Well, I hate to use Latin. It's mens rea. So what the IRS must have found in that audit was some sort of documentation suggesting very strongly that she knew about her FBAR requirements during the years before she made that first filing. Now, that could have taken the form of a letter. Say the bank account manager in Zurich, or wherever, sends her a written correspondence saying, "Oh, hey, by the way, did you know? We're just reminding you, there's this FBAR regime, and our records show that you're a U.S. resident. You're subject to this." And so say that's in her file somewhere. That comes up during pretrial discovery. That could cross the line from a nonwillful FBAR violation to a willful one, which can be the difference between a fine of $10,000 and something over $3 million, and just that differential. There's a big difference between, "Oh, I forgot," an innocent nonwillful violation, and just saying, "Yeah, I'm going to blow off my obligations here."

There is a difference between that, but the dollar amount, $10,000 versus over $3 million. So I don't want to get too deep, but there's this other case that comes out of the Eleventh Circuit. So we're talking about down in Florida, the [United States v.] Schwarzbaum case. There's a different fact pattern, but you get to the same issue. There's a willful violation. There's a penalty for a willful FBAR violation. It's a whole lot of money. The attorneys argue the penalty is blocked by application of the Eighth Amendment. It violates the excessive fines clause.

The Eleventh Circuit said, "Oh yeah, we agree with you. Absolutely." This is not really remedial. It's far more punitive than it is remedial. Who's to say it can't be both? It's at least partially punitive. So it's clearly a fine, and because it's a fine, it's subject to the Eighth Amendment. So, Dave, the situation we have right now today as we're sitting in the Tax Notes studio, is that the Eighth Amendment of the Constitution means one thing in Boston and a completely different thing in Miami, and that's an untenable situation.

David D. Stewart: So I take it that this case is likely to get appealed all the way up?

Robert Goulder: Well, we hope so. Procedurally speaking, the next step, I believe, would be for the U.S. solicitor general, which lost in Schwarzbaum in the Eleventh Circuit, for them to appeal that to the Supreme Court. So they would be seeking certiorari. Before with Toth, it was the individual, the taxpayer, Ms. Toth. Here it would be the U.S. government. We're still waiting to hear whether that's going to happen. The last time I checked, no notice of appeal was noted. So I think they should.

Personally, my own view is once you have a split among the circuits, what are you waiting for? Why wait? What benefit is there from waiting more years, waiting another decade or more, for other circuits to weigh in? That just to me seems like dithering. We've got the circuit split. How they decide, I don't know. Would they even accept it? I don't know. We know Justice Gorsuch would take it in a heartbeat because he wanted to take Toth. What would happen is, he'd need to sort of convince his colleagues on the bench that they need to resolve this, but maybe they don't want tax cases. Of course, this isn't really a tax case because it's not a tax provision, it's an information gathering provision.

David D. Stewart: So assuming that the Supreme Court sees the circuit split, says, "Well, we have to come in and fix this issue," how do you think that's going to go?

Robert Goulder: Well, my knee-jerk reaction would be to say that dissent by Gorsuch is really persuasive, and he raises some issues there about the punitive nature of these penalties. And if you really look at them and you really just absorb what's going on here, how can you say with a straight face that these penalties are not punitive?

Some people would say a nonpunitive penalty is a, what is an oxymoron, it's a contradiction in terms. It's like jumbo shrimp. That's what we're talking about. The First Circuit basically said the FBAR penalty is a nonpunitive penalty because it's remedial. I don't think that stands up. So again, I don't want to prejudge the outcome, or pretend that I have a crystal ball with perfect insights into how the justices see these matters, but there's a very persuasive case that all of the penalties under the FBAR regime, at least the willful penalties, are going to need to be reconsidered, which would need to take an act of Congress to rewrite the statute, because as the statute is written, the penalties are up to 50 percent of the account balance.

David D. Stewart: So would this potentially just take the teeth entirely out of the FBAR regime if this willful penalty goes away?

Robert Goulder: People have been asking me that. That's the right question, I think. And it's important to remember that the FBAR regime has evolved over time. If you go back to the early decades of it — this is going to be the '70s and '80s — the penalty for an FBAR violation was $1,000, and it was not assessed against the individual account holder. It was assessed against the financial institution.

So the financial institution said, "Hey, it's only a thousand dollars. We'll pay it, and we will debit the person's account." So when they're sitting at the kitchen table going over their bank statement — again, this was the days before the internet and no one could do online banking — you'd get a monthly statement from the bank and you'd say, "Hey, they assessed me a fee. What's this $1,000?" Oh, you didn't file their FBAR. That was it, $1,000.

Now they amended it in the mid-'80s because they thought the compliance rates are too low. People are just ignoring these FBAR things. We need beefier penalties, right? They increased it to $100,000. So the maximum penalty was $100,000. That was between 1986 and 2004. So it wasn't until the early 2000s that they adjusted the maximum penalty, deciding that even $1,000 was not enough. It had to be more punitive. And that's where they came up with the idea of half the account balance.

There's no cap. You have $50 million in the account, the FBAR penalty could be $25 million. The sky's the limit. So what would happen? I think it would just go back to what the rules were before 2004. If you look at those 1986 reforms, that's something that Congress could go back to. They might say that's not high enough though, because compliance was a problem.

David D. Stewart: Well, Bob, thank you so much for being here. It's always great to talk to you, and this is a fascinating subject that we're going to have to keep an eye on.

Robert Goulder: Absolutely, Dave. Time will tell.

David D. Stewart: And now, coming attractions. Each week we highlight new and interesting commentary in our magazines. Joining me now is Senior Executive Editor for Commentary Jasper Smith. Jasper, what will you have for us?

Jasper Smith: Thanks, Dave. In Tax Notes Federal, three tax professors explain how the subpart F regime and the GILTI regime contribute to a decline in domestic manufacturing employment. Craig White explores how environmental, social, and governance efforts affect tax accounting principles.

In Tax Notes State, three DLA Piper practitioners examine the recent Loper Bright decision and its impact on state and local tax. Michael Lurie analyzes SCOTUS's call for the view of the solicitor general in Zilka.

In Tax Notes International, Arne Møllin Ottosen and Lenni Hangaard Jensen considered the Danish perspective on the importance of cross-border project development for companies expanding globally. Lucas De Lima Carvalho analyzes the tax treatment of payments for video game downloadable content.

And finally, in featured analysis, Nana Ama Sarfo outlines discussions surrounding the tax treatment of fast fashion companies in the U.S., EU, and South Africa.

David D. Stewart: That's it for this week. You can follow me online @TaxStew, that's S-T-E-W, and be sure to follow @TaxNotes for all things tax. If you have any comments, questions, or suggestions for a future episode, you can email us at podcast@taxanalysts.org. And as always, if you like what we're doing here, please leave a rating or review wherever you download this podcast. We'll be back next week with another episode of Tax Notes Talk.

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