In a recent intriguing decision, the U.S. District Court for the Southern District of California tackled the issue of whether a taxpayer is required to file an FBAR if he has the status of a non-US tax resident by virtue of the tie-breaker provisions of a tax treaty.
While the Court’s conclusion seems very taxpayer favorable, it remains to be seen whether the decision will be upheld if and when it’s appealed.
Background on the FBAR Filing Requirement
The FBAR must be filed by U.S. persons if the maximum values of their foreign financial accounts exceed $10,000 in the aggregate at any time during the calendar year.
The FBAR regulations (31 CFR § 1010.350) state that the term “United States person” means either:
(1) a citizen of the United States;
(2) a resident of the United States, i.e., an individual who is a resident alien under IRC Section 7701(b) and the regulations thereunder; or
(3) an entity, including but not limited to, a corporation, partnership, trust, or limited liability company created, organized, or formed under the laws of the United States.
The IRS FBAR guide (Publication 5569) gives the following example for the second category – residents of the United States:
Example: Kyle is a permanent legal resident of the U.S. Kyle is a citizen of the United Kingdom. Under a tax treaty, Kyle is a tax resident of the United Kingdom and elects to be taxed as a resident of the United Kingdom. Kyle is a U.S. person for FBAR purposes. Tax treaties with the U.S. do not affect FBAR filing obligations.
In giving this example, the IRS is clearly taking the position that as long as an individual is considered a resident under U.S. domestic law, the FBAR requirement is triggered, even if the individual elects to be treated as a nonresident under a tax treaty.
Background on the Aroeste Case
As a matter of background, the taxpayer, Mr. Aroeste, is a Mexican citizen who lived in Mexico but obtained a U.S. green card in 1984. Mr. Aroeste had always filed his Mexican tax returns as a resident of Mexico.
During the tax years in issue (2012 and 2013), Mr. Aroeste held five accounts in Mexico with an aggregate balance in excess of $10,000, which would trigger an FBAR reporting requirement if he were considered a U.S. person for purposes of the FBAR requirement.
For the years at issue, Mr. Aroeste initially filed income tax returns as a U.S. resident, but did not file FBARs. Later, in 2016, he filed amended returns, using a filing status of married filing separately and claiming to be a nonresident of the United States pursuant to the tie-breaker provisions of the U.S.-Mexico income tax treaty.
Under Article 4 of the treaty, where an individual is a tax resident of both countries, residency is determined as follows:
- a) he shall be deemed to be a resident of the State in which he has a permanent home available to him; if he has a permanent home available to him in both Contracting States, he shall be deemed to be a resident of the State with which his personal and economic relations are closer (center of vital interests);
- b) if the State in which he has his center of vital interests cannot be determined, or if he does not have a permanent home available to him in either State, he shall be deemed to be a resident of the State in which he has an habitual abode;
- c) if he has an habitual abode in both States or in neither of them, he shall be deemed to be a resident of the State of which he is a national;
- d) in any other case, the competent authorities of the Contracting States shall settle the question by mutual agreement.
In May 2020, the U.S. government assessed $50,000 in FBAR penalties for each of 2012 and 2013, totaling $100,000. He paid $3,004 towards these penalties, and the government, after applying certain mitigation, asserted that he continued to owe $21,852. Mr. Aroeste sued for a refund of the $3,004 penalty payment and to discharge the outstanding liability. The government counter-claimed to recover the balance of unpaid penalties.
The Aroeste Decision
In analyzing the issue at hand, the Court cited the definition of a “United States person” in the FBAR regulations, which includes a “resident of the United States,” which in turn is defined to include any individual who is a resident alien under Section 7701(b) the Code. Thus, the FBAR regulations incorporate by reference the definition of a resident individual used for income tax purposes. Under this definition, any individual who is a lawful permanent resident (i.e., a green card holder) is a resident of the United States.
The Court then noted that Section 7701(b)(6) of the Code states that an individual ceases to be treated as a lawful permanent resident if he or she commences to be treated as a resident of a foreign country under the provisions of an income tax treaty between the United States and a foreign country, does not waive the benefits of such treaty, and notifies the IRS of the commencement of such treatment.
As such, given that utilizing the treaty caused Mr. Aroeste to cease to be treated as a lawful permanent resident under the Code, he should not have had an FBAR filing requirement.
The government argued that Mr. Aroeste should nonetheless still be required to file the FBAR notwithstanding that he was a Mexican resident under the treaty. In support of this argument, the government pointed to the preamble to the FBAR regulations, which states that a “legal permanent resident who elects under a tax treaty to be treated as a non-resident for tax purposes must still file the FBAR.” The Court, however, rejected this argument, pointing out that it is contradicted by the plain language of the FBAR regulations themselves.
Analyzing the Impact of the Aroeste Decision
While the Aroeste decision at first glance seems to be a major taxpayer win, it remains to be seen exactly what impact the decision will have moving forward for a couple of reasons.
First, there is some ambiguity surrounding Section 7701(b)(6) of the Code and to what extent a green card holder’s tax residence truly “ceases” upon a taxpayer claiming to be a treaty nonresident. Arguably, only a so-called long-term resident’s tax residence in fact ceases when taking a treaty position as this triggers an expatriation that ends the individual’s U.S. tax residence (in brief, a “long-term resident” is a green card holder who has had permanent resident status for at least 8 of the previous 15 years). In contrast, other green card holders continue to technically have a filing obligation (even if a treaty position is taken) until they have abandoned their green cards, so the FBAR analysis should arguably be different. The Court did not analyze this aspect in its decision.
Second, it remains to be seen whether the U.S. government will appeal the Court’s decision. A higher court may or may not affirm the Court’s conclusion, or may limit the decision’s scope. For now, given that the IRS has clearly made its position known, and given that the case may be appealed, some practitioners are advising treaty nonresidents to err on the side of caution and continue filing FBARs in order avoid exposing themselves to potential FBAR penalties.
