April 1, 2022

How U.S. Sanctions Work and Their Tax Implications

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Since the onset of the war in Ukraine, many people have wondered precisely how international sanctions work. Some have also wondered whether there are tax implications for individuals or businesses in regard to sanctions. Here’s some background on both questions.

Sanctions in General

The U.S. Department of the Treasury’s Office of Foreign Assets Control (OFAC) administers and enforces U.S. economic and trade sanctions against targeted:

  • Foreign governments,
  • Terrorists,
  • Drug traffickers,
  • Parties engaged in proliferating weapons of mass destruction, and
  • Threats to national security, foreign policy or the economy.

Under the U.S. Code, OFAC can impose civil penalties against parties that violate sanctions. In lieu of penalties, OFAC sometimes agrees to settlements with offending parties. For more details of OFAC civil penalties, see their Civil Penalties and Enforcement Information webpage.

The Financial Crimes Enforcement Network (FinCEN) plays a role as well. In fact, in March, the agency alerted financial institutions to be vigilant against efforts to evade the expansive sanctions and other U.S.-imposed restrictions implemented in connection with the war in Ukraine.

The alert identifies red flags to assist in identifying potential sanction-evasion activity and reminds financial institutions of their reporting obligations under the Bank Secrecy Act (BSA), including with respect to convertible virtual currency (CVC).

FinCEN stressed that it’s critical for financial institutions, especially those with visibility into CVC flows — such as CVC exchangers and administrators generally considered financial services businesses under the BSA — to quickly report suspicious activity associated with potential evasion of sanctions. They should also conduct appropriate risk-based customer due diligence or, where required, enhanced due diligence.

The red flags mentioned in the March FinCEN alert relate specifically to sanction-evasion activity using the U.S. financial system, evasion of sanctions using CVC, and possible ransomware attacks and other cybercrime.

Tax Implications

When it comes to taxes, a common question is: If a U.S. taxpayer is hit with a civil penalty or settlement for violating an OFAC sanction in the course of the taxpayer’s trade or business, is that penalty or settlement deductible?

Although Internal Revenue Code Section 162(a) provides for a deduction for ordinary and necessary business expenses, Sec. 162(f)(1) provides that no deduction is allowed for any amount paid or incurred (whether by suit, agreement or otherwise) to, or at the direction of, the government in relation to the violation of any law.

In addition, Sec. 162(f)(2) provides an exception to the general disallowance rule in Sec. 162(f)(1) for certain amounts paid or incurred for restitution, remediation or to come into compliance with a law. There doesn’t appear to be any case law or IRS rulings as to whether a penalty for an OFAC sanction violation is nondeductible under Sec. 162(f)(1).

New Government Reporting

If a taxpayer has been subject to an OFAC penalty, under a new law that just went into effect at the beginning of this year, the IRS is required to send the taxpayer Form 1098-F, “Fines, Penalties, and Other Amounts.” The form itemizes the total amount of the penalty (shown in Box 1) to show:

  • The amount to be paid for a violation (Box 2; presumably nondeductible),
  • The amount paid for restitution and/or remediation (Box 3; presumably deductible), and
  • The amount paid for compliance (Box 4; presumably deductible).

Form 1098-F is required to be filed with the IRS on or before February 28 (March 31 if filed electronically) of the year following the calendar year in which the orders and/or agreements become binding under applicable law. This date determination is made regardless of whether all appeals have been exhausted or the time for filing an appeal has expired.

Layer of Complexity

Sanctions add another layer of complexity to international taxation and business dealings. For more information on how current or impending sanctions could affect your personal or business finances, contact our International Team.

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