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The Panama Papers: A Postmortem – Financial Advisor Magazine (registration)

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Nearly a year after the Panama Papers set off a virtual bomb in the offshore private banking industry, advisors and their clients are still grappling with the aftershocks.

In particular, the massive disclosure of private banking accounts re-emphasized the need for advisors to recognize the fine line between legal and illegal methods for hiding assets.

The Panama Papers are a collection of 11.5 million documents from the Panama-based law firm Mossack Fonseca that an anonymous tipster leaked to the German newspaper Süddeutsche Zeitung. These documents were released after being analyzed collaboratively by more than 370 journalists from over 40 countries.

The Panama Papers disclose the identity of the “true” owners of approximately 214,000 shell companies and billions of dollars of assets. Yet these disclosures barely scratch the surface of international shell banking operations. Mossack Fonseca has spent the past 40 years creating shell companies and opening offshore accounts in the names of these shell companies in various tax havens throughout the world. There are hundreds of similar firms in dozens of countries around the world that have been doing the exact same thing, and they will continue to do so for as long as there is a demand for “anonymous” global banking relationships.

In order to understand the significance of the Panama Papers, it is first necessary to understand the legal context that gave rise to the demand for Mossack Fonseca’s services. Beginning in 1970 with the enactment of the Bank Secrecy Act (BSA), Congress began enacting a series of laws designed to crack down on money laundering and tax evasion. Congress’s latest major legislation, the Foreign Account Tax Compliance Act (FATCA), was passed in 2010. FATCA requires non-U.S. foreign financial institutions (FFIs) to report information about their U.S. account holders to the U.S. Treasury. These two major pieces of legislation—in addition to all of the statutes, rules and regulations that complement FATCA and BSA—make Mossack Fonseca’s services particularly valuable to clients who seek total anonymity from public disclosure. Because law firms are not FFIs, they are not subject to FATCA’s reporting and record-keeping requirements.

How would a wealthy U.S. citizen use the services of a firm like Mossack Fonseca to avoid U.S. income and transfer taxes? Consider the following example: Tom, a U.S. real estate mogul, hires Mossack Fonseca to create a Panamanian private foundation (PPF). Under this arrangement, Tom “contributes” funds to the foundation, and these contributions are shielded from U.S. legal claims under Panamanian law. Mossack Fonseca appoints its employees as officers of the foundation. Tom is the foundation’s real beneficiary, but his identity is not revealed in any public documents. Mossack Fonseca churns Tom’s foundation contributions through accounts in various offshore tax havens such as the British Virgin Islands, Switzerland, Andorra and Panama. The foundation is named as a shareholder of various shell corporations—which are listed as the owners of the offshore accounts—to further obscure the beneficial ownership of the assets. Tom’s cash moves both to and from the foundation and the accounts owned by the shell companies. Tom sets up accounts for his children under the same shell structure and orders payments to himself or his children at any time. When Tom dies, the money held in the foundation is distributed to his children, who are its contingent beneficiaries.

This is not an example of money laundering because Tom’s initial contribution to the foundation has a legal source and is compliant with taxes, and is not designed as funds for any legal purpose. But once Tom’s money enters “the system,” the global transfer of the money is extremely difficult to trace—the only parties that have the information required to prepare true, correct and complete U.S. income, gift and estate tax forms are Mossack Fonseca and Tom. And because Mossack Fonseca requires clients to sign disclaimers stating that the final decision to take the money out of the United States is the client’s alone and that the client obtained a professional opinion from a U.S. tax advisor, it is the client rather than the firm who will be expected to answer for the consequences of non-compliance with U.S. tax laws.

If Tom fails to report any income he might have earned on the assets after he hired Mossack Fonseca to establish the Panamanian private foundation, he may be subject to a variety of civil and criminal penalties. To establish a case of felony tax evasion, the government would have to prove that Tom willfully failed to report all of his income and performed “an affirmative act constituting an evasion or attempted evasion of the tax”—also referred to as a “badge of fraud.” In this case, the badge of fraud is a false tax return that omits income, but it could also be any affirmative step by the taxpayer to conceal his or her ability to pay taxes or to remove assets from the reach of the IRS. Tom could also be prosecuted for misdemeanor tax evasion, in which case the government would need only prove that Tom willfully failed to supply accurate information about his income.

In addition to criminal penalties for tax evasion, U.S. clients of Mossack Fonseca and similar firms also risk criminal and civil penalties for failure to file an FBAR (the Report of Foreign Bank and Financial Accounts). The FBAR is not a tax return but an information return filed with the U.S. Treasury. The taxpayer must file an FBAR if his or her aggregate interest—which includes ownership interests and signature authority—in all foreign financial accounts exceeds $10,000 at any time during the taxable year.

The FBAR does not simply ask about direct account ownership; it asks whether the filer has any indirect ownership interest in any foreign account, regardless of the shell companies or other alter egos of the beneficial owner. The criminal penalties for failing to file an FBAR are severe: up to five years in prison, a fine of $250,000, or both, or up to 10 years in prison, a fine of $500,000 or both if the failure to file an FBAR is part of a pattern of illegal activity.

For most U.S. clients of firms such as Mossack Fonseca, the real exposure is to civil rather than criminal penalties for FBAR violations. The maximum penalty for non-willful failure to file FBAR violations (which can be abated or reduced in cases of reasonable cause) is $10,000 per occurrence. The maximum penalty for willful failure to file FBAR violations (which can be reduced if there are mitigating circumstances) is the greater of $100,000 or 50% of the balance of the account at the time of the violation.

To support a civil penalty for a willful FBAR violation, the IRS need only show that there was a voluntary, intentional violation of a known legal duty. Willfulness is established in one of two ways: if there is evidence the person had actual knowledge of the FBAR requirements and made a conscious choice not to comply, or if there is evidence of the person’s “willful blindness,” in which case the person made a conscious effort to avoid learning about the FBAR requirements.

Many taxpayers are surprised to learn that the page of the Form 1040 that reports the detail of interest and dividends (Schedule B) also directly asks taxpayers whether they have an interest in any foreign accounts. But the mere fact that a person checked the wrong box, or no box, on a Schedule B is not sufficient in itself to establish that the FBAR violation was attributable to willful blindness. The IRS needs to show more, such as a copy of a tax organizer in which the taxpayer failed to disclose the existence of a foreign account to his or her accountant.

Despite the stigma attached to the Panama Papers, there is nothing inherently illegal, immoral or unethical about using a firm like Mossack Fonseca to establish a Panamanian private foundation or shell corporation. There are perfectly legitimate reasons that Mossack Fonseca’s clients—especially celebrities, CEOs and other high-net-worth individuals—would want to protect their anonymity by owning assets through one or more foreign shell corporations. And everyone has the right to privacy, regardless of economic or social status, especially when communicating with attorneys. But it is important to remember that the Panama Papers opened a window into a global industry designed solely to distance the shell corporation accountholders from the true beneficial owners. It will take years to distinguish those shell corporations that have been established for legitimate purposes (such as protecting the anonymity of high-profile celebrities and CEOs) from those that have been established for illegitimate purposes (such as money laundering, tax evasion and political corruption).

But unfortunately, as we found out when the Panama Papers became publicly available, many people around the world have used firms like Mossack Fonseca for illegitimate purposes such as money laundering, tax evasion and political corruption.

Clients of Mossack Fonseca and similar firms should be aware that the biggest threat to anonymity may not be from FATCA or any other government-instituted transparency regime, but from hackers such as John Doe or insiders of the firm who seek to expose income inequality rather than to advance a specific political agenda.

The Panama Papers serve as a constant reminder that no information can be considered truly safe or sacred in a digital world.

Matthew A. Morris is a partner at the law firm of Bowditch & Dewey LLP who focuses on corporate and individual tax controversies; federal, state and international tax planning; estate planning; and probate administration.

Jon Barooshian is also a Bowditch & Dewey partner who focuses on tax evasion, tax controversy, securities fraud, internal and governmental investigations and related criminal and civil litigation.

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