Tax Compliance:

Qualified Intermediary Program Provides Some Assurance That Taxes on Foreign Investors Are Withheld and Reported, but Can Be Improved

GAO-08-99: Published: Dec 19, 2007. Publicly Released: Jan 25, 2008.

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U.S. source income flows to recipients offshore through foreign financial institutions and U.S. withholding agents. The Internal Revenue Service (IRS) established the Qualified Intermediary (QI) program to improve tax withholding and reporting on such income. QIs are foreign financial institutions that contract with IRS to withhold and report U.S. tax. GAO was asked to (1) describe program features, (2) assess whether weaknesses exist in the U.S. withholding system for U.S. source income, and (3) identify any weaknesses in QI external reviews and IRS's use of program data. GAO interviewed agency officials and private practitioners and reviewed the latest IRS data on U.S. source income flowing offshore.

The QI program provides IRS some assurance that tax on U.S. source income sent offshore is properly withheld and reported. For example, QIs, located overseas, are more likely to have a direct working relationship with customers who claim tax benefits, such as reduced withholding, and agree to have independent parties review a sample of accounts and report to IRS. However, a low percentage of U.S. source income sent offshore flows through QIs. For tax year 2003, about 12.5 percent of the $293 billion in U.S. income flowed through QIs. The rest or about 87.5 percent flowed through U.S. withholding agents. While QIs are required to verify account owners' identities, U.S. withholding agents can accept owners' self-certification of their identity at face value. IRS does not measure the extent to which withholding agents rely on self-certification and use this data in its compliance efforts. In addition, U.S. persons may evade taxes by masquerading as foreign corporations. In 2003, 68.4 percent of U.S. income flowed through foreign corporations whose ownership is not reported to IRS. GAO's analyses showed that U.S. withholding agents and QIs reported billions of dollars in funds flowing to undisclosed jurisdictions and unknown recipients in 2003. Lacking proper identification, U.S. withholding agents and QIs should withhold taxes at the 30 percent rate. GAO found that withholding on these accounts was much lower than 30 percent. The contractually required independent reviews of QIs' accounts help provide assurance that taxes are properly withheld. However, the external auditors are not required to follow up on indications of fraud or illegal acts, as would reviews under U.S. Government Auditing Standards. As a result, IRS has less information on whether QIs are adequately preventing fraud or illegal acts. Further, while IRS obtains considerable data from information returns, it does not effectively use it to ensure proper withholding and reporting. IRS has not consistently entered data from paper information returns into a database and matched the data to tax returns to identify inappropriate disbursal of tax benefits. IRS could require electronic filing by QIs whenever possible.

Status Legend:

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  • Review Pending-GAO has not yet assessed implementation status.
  • Open-Actions to satisfy the intent of the recommendation have not been taken or are being planned, or actions that partially satisfy the intent of the recommendation have been taken.
  • Closed-implemented-Actions that satisfy the intent of the recommendation have been taken.
  • Closed-not implemented-While the intent of the recommendation has not been satisfied, time or circumstances have rendered the recommendation invalid.
    • Review Pending
    • Open
    • Closed - implemented
    • Closed - not implemented

    Recommendations for Executive Action

    Recommendation: The Commissioner of the Internal Revenue Service should work to enhance agreed-upon procedures (AUP) by requiring the external auditor to report any indications of fraud or illegal acts that could significantly affect the results of the review. Under current AUPs, the external auditor is required to report whether, based on information from the QI or its own information, the QI is in material violation of, or is under investigation for violation of "know your customer" rules applicable to the QI. IRS should direct the head of the QI program office to expand this reporting requirement in the QI contractual agreement to require the external auditor to report any indications of fraud or illegal acts encountered while performing AUPs that could significantly affect the results of the review. This would give the QI program office the information necessary to pursue any indications of significant fraud or illegal acts identified during the AUP review through additional targeted procedures in phase 2 of the AUPs.

    Agency Affected: Department of the Treasury: Internal Revenue Service

    Status: Closed - Not Implemented

    Comments: IRS issued Announcement 2008-98 on November 3, 2008 which required external auditors to report to Qualified Intermediary Program (QIP) staff any material failure of internal controls uncovered during an audit of a QI. Additionally the announcement requires QIs to associate with a U.S. accounting firm. However, in an e-mail on June 27, 2012, Thomas Chillemi of IRS said that Announcement 2008-98 was not implemented. He said that next year will be the sunset of the QI program because of FATCA and there there will be no QI external audits.

    Recommendation: The Commissioner of the Internal Revenue Service should determine why U.S. withholding agents and QIs report billions of dollars in funds flowing to unknown jurisdictions and to unidentified recipients. Based on this determination, IRS should take appropriate steps to recover any withholding taxes that should have been paid and to better ensure that U.S. taxes are withheld when account owners do not properly identify themselves.

    Agency Affected: Department of the Treasury: Internal Revenue Service

    Status: Closed - Not Implemented

    Comments: IRS reviewed a sample of paper Forms 1042-S to understand the problem relating to blank entries in the "Recipient Country of Residence for Tax Purposes" box and "Unknown" in the "Recipient's Name" field. IRS determined that a significant part of the problem with paper documents was that taxpayers were putting the address and country in same box and leaving the country box blank. IRS has met with bankers and withholding agents to discuss its concerns with a high format error rate involving the electronic transmission of data. IRS officials stated that they have not taken any action to recover amounts identified as having not been paid in the sample of returns they reviewed. Instead, they have used the information gathered from their review to identify examples of under withholding to help guide future audit selection.

    Recommendation: The Commissioner of the Internal Revenue Service should measure U.S. withholding agents' reliance on self-certified documentation and use that data in IRS compliance efforts.

    Agency Affected: Department of the Treasury: Internal Revenue Service

    Status: Closed - Not Implemented

    Comments: IRS attempted to measure the accuracy of the self-certified documentation, including sampling Forms W-8BEN during an examination of Forms 1042 and 1042-S. IRS found this approach very difficult as there was very little information to measure against. We had hoped that IRS would compute the percentage of cases in which U.S. financial intermediaries were relying on self certified documentation from foreign investors without direct interaction with the person. IRS then could have and then focused its compliance efforts on those institutions where a high percentage of cases involved such self certified documents or involved significant dollars. Rather IRS chose to look generally at the accuracy of self-certifications. Thus IRS's approach has not been the systemic identification of non-compliance. IRS told us that they have not looked for patterns involving institutions reliance on self certified documentation, but instead they have looked to make sure the institutions had checked the boxes on the forms.

    Recommendation: The Commissioner of the Internal Revenue Service should require electronic filing of forms in QI contracts whenever possible, thereby reducing the need to manually process data reported from abroad. Further, IRS should invest the funds necessary to perfect these data.

    Agency Affected: Department of the Treasury: Internal Revenue Service

    Status: Closed - Not Implemented

    Comments: IRS chose not to make use of the contractual nature of Qualified Intermediary (QI) program. Instead they implemented a procedure to include Form 4419, Application for Filing Information Returns Electronically, in all QI applications and renewals. By not contractually requiring electronic filing and continuing to permit paper filing of the forms, IRS runs the risk that some Form 1042-S data may not be transcribed and included in the CTW database in years were funding is not allocated for transcribing and perfecting these data.

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