Under penalties of perjury, each filer of a US individual, corporate, partnership or trust tax return has answered the following question: At any time during the calendar year did you have an interest in, or a signature or other authority over, a financial account in a foreign country, such as a bank account, securities account, or other financial account?1 If the answer was “yes,” the filer was then directed to Form TD F 90-22.1 and the related instructions to understand potential reporting obligations. Before October 2008, the date the form and its instructions were updated, this additional piece of the tax compliance process seemed fairly straightforward. In 2009, however, this all changed.

As the hedge fund industry has become well aware, the above question relates to the Report of Foreign Bank and Financial Accounts, or FBAR for short. Although many potential filers associated with the hedge fund industry may have only recently learned about FBAR filing requirements through recent informal clarifications by the IRS, the question is not new. The IRS website2 makes available Form 1040 Schedule B, the schedule that contains the question on individual returns, dating back to 1980.3 In fact, the 1980 form asks almost the exact same question as the 2008 form.4 Even the instructions in the 2008 booklet that provide additional guidance as to whether a tax preparer should check yes or no to the FBAR question are almost identical to those in the 1980 instruction booklet.5

On the surface, one might wonder why FBAR has generated so much interest this year. The form itself is an information-only report, requires no tax calculation or tax payment, collects a maximum of 46 discrete data points, and includes only three pages of instruction. While at first glance this might appear to be the model of informational reporting simplicity, in actuality the lack of instructions can give rise to many unanswered, fact-specific questions. When practically applied – that is, when tax preparers attempt to fill out the form – it becomes clear that more than three pages of instructions are necessary to ensure reporting consistency.

For those in the hedge fund community, a certain level of ambiguity is tolerated – each day investment decisions are made with imperfect information. Given the severity of the penalty provisions associated with FBAR non-compliance, many fund operators have found the level of risk associated with not complying completely with FBAR requirements to be unacceptable. As detailed on the IRS website, and in FAQs published by the IRS, FBAR violations can result in the levying of both criminal and civil penalties.6 A worst-case civil penalty can equal 50% of the amount in the account at the time of the violation, which can be assessed for each year of the violation, thus resulting in a penalty that is a multiple of the actual account balance.

As is true with any aspect of a hedge fund’s operation where levels of risk become unacceptable, it is only natural that fund operators will look to mitigate, or hedge, these risks. In the case of FBAR compliance, many hedge funds adopted a view that in order to avoid “failure to file” penalties they would simply file the form under every possible applicable scenario unless a specific exclusion existed. Of the three pages of FBAR instructions, two paragraphs are dedicated to filing exceptions, and only in rare instances do aspects of hedge fund operations meet the requirement for FBAR filing exclusion.