M E M O R A N D U M
March 18, 2008
TO: Distribution
FROM: John Staples, Roger Cardinal, and Cyrus Daftary
RE: GAO report on Qualified Intermediary ("QI") Program and U.S. Withholding Agent ("USWA") Compliance
Background
Eight years ago, the IRS allowed foreign institutions to hold securities on behalf of their clients and obtain a reduced withholding rate without disclosing their client's identity, provided the institution agreed to become a QI. But, the QI itself must know the identity of its customer, beneficial ownership, and, if applicable, tax treaty eligibility before it provides the appropriate withholding tax rate to the USWA. The QI consents to an Agreed Upon Procedure ("AUP") review, i.e., a form of audit conducted by a third party, which the IRS reviews.
There are now 6,000 participants in the QI program. The Government Accounting Office ("GAO") recently reviewed the QI program at the Senate's behest. It noted that, in 2003, QIs paid their customers $36.6B, but only withheld $1.4B or five (5) percent in tax, raising the concern that the vast majority of U.S. income paid to foreigners is not reported or withheld upon by QIs. The GAO was particularly concerned that USWAs and QIs credit much of the income to investors in "unknown locations" or to "unknown payees" indicating that, in such situations, the government should expect to see a tax withholding rate of thirty (30) percent. The GAO, however, accepted that QIs may report "on a pooled basis," in which case the location of the investors is not required to be reported by the QI.
The GAO criticized the IRS for focusing on the accuracy of the Forms W-8, rather than on the challenge of determining whether the self-certification nature of the Form W-8BEN itself, wherein a recipient could easily provide false information, is a threat to the integrity of the U.S. tax withholding system. They questioned whether it was possible to put additional burdens on the external auditors to unearth and identify indications of fraud or illegal acts. Finally, the GAO said that the IRS has not adequately analyzed and utilized the data it receives on Forms 1042-S, and therefore has not realized that many of the forms were incomplete or inaccurate.
GAO Recommendations
The GAO recommended that the IRS should:
- "Measure U.S. Withholding Agents' reliance on self-certification documentation and use that data in its compliance efforts,"
- "Determine why withholding agents report billions flowing to undisclosed jurisdictions and unidentified recipients,"
- "Enhance external reviews to include reporting on indications of fraud or illegal acts," and
- "Require electronic filing in QI contracts whenever possible."
[Comment: Because most of the reporting processes that are unique to QIs are spelled out in the QI Agreement, it is likely that the IRS will need to make changes to the QI Agreements in order to effectively implement this requirement for QIs, who generally file very few Forms 1042-S.]
Consequences
1. The GAO noted that the IRS intends to audit every USWA that did not enter the IRS' Voluntary Compliance Program. Although it is unlikely that the IRS would be able to audit every USWA, it would not be unreasonable to expect a substantial increase in audits that will closely scrutinize Form 1042-S filings, Forms W-8, and supporting documentation, such as passports and other identifying documents.
2. The GAO concern about reporting "undisclosed jurisdictions" could result in a change to the QI reporting requirements, perhaps a move towards "country-based" reporting. This proposal, previously rejected, could easily resurface with the possible support of the U.S. Senate behind it.
3. The GAO report could lead the IRS to expand the QI Audit Guidelines.
4. The GAO report notes that, although the IRS generally agreed with the recommendations in the report, their proposed response to it is not entirely consistent with the report's recommendations. This could indicate that the IRS believes that they do not have the authority to implement some of the recommendations, and could trigger IRS requests for legislative changes, if they believe that such changes are necessary to address the failings highlighted in the report.
5. Finally, if the GAO recommendation for QIs to file Forms 1042-S electronically is adopted even when electronic filing would not normally be required (i.e., fewer than 250 forms), it would result in increased IRS scrutiny of the Forms 1042-S, and therefore could have serious implications not only for QIs, but also USWAs. In addition, if the IRS lowers the electronic filing threshold for QIs, it may do so for USWAs as well. This would likely be paralleled by closer, automated scrutiny of all aspects of the Form 1042-S by the IRS. It would also facilitate an increased ability by the IRS to reconcile Forms 1042-S with Forms 1042.
Recommendations
USWAs and QIs should review all aspects of their compliance with the U.S. tax withholding and information return reporting rules. These self-reviews should focus on the accuracy of the tax withholding and supporting documentation that customers have provided, and also on reviewing the accuracy of their information return reports to confirm that they contain the correct income codes, exemption codes, country codes, entity types, and so on. These latter items may not have been closely reviewed in the past, since they had no "economic impact." If the IRS identifies reporting errors and believe such errors represent fundamental system failures, this may potentially result in a greatly expanded IRS review of those systems. This increased IRS scrutiny could also result in penalty exposures to USWAs and QIs.