United States Government Accountability Office

GAO Testimony 

Before the Committee on Finance, 

U.S. Senate

TAX COMPLIANCE 

Challenges in Ensuring 

Offshore Tax Compliance 

Statement of Michael Brostek 

Director 

Strategic Issues 

For Release on Delivery

Expected at 10:00 a.m. EDT 

Thursday, May 3, 2007

 

GAO-07-823T 
What GAO Found

United States Government Accountability Office

Why GAO Did This Study

Highlights

Accountability Integrity Reliability

www.gao.gov/cgi-bin/getrpt?GAO-07-823T.

To view the full product, including the scope 

and methodology, click on the link above. 

For more information, contact Michael 

Brostek on (202) 512-9110 or 

brostekm@gao.gov. 

Highlights of GAO-07-823T, a testimony 

before the Committee on Finance, U.S. 

Senate 

May 3, 2007

TAX COMPLIANCE

Challenges in Ensuring Offshore Tax 

Compliance 

Examinations involving offshore tax evasion take much more time to 

develop and complete than other examinations—a median of 500 more days 

for cases from fiscal years 2002 to 2005, but their resulting median 

assessment is almost three times larger than for all other examinations. 

Nevertheless, because they take more staff time, offshore examinations 

yielded tax assessments per hour of staff time that were about one-half of 

that for all other examinations. Because of the 3-year statute of limitations, 

the time needed to complete an offshore examination means that IRS 

sometimes prematurely ends offshore examinations or decides not to open 

an examination, despite evidence of likely noncompliance. Congress has 

granted a statute change or exception when enforcement challenges similar 

to those found in offshore cases have arisen in the past. 

QIs are foreign financial institutions that contract with IRS to withhold and 

report U.S. source income paid offshore to foreign customers. The QI 

program provides IRS some assurance that QIs are properly withholding and 

reporting tax on U.S. source income paid offshore. QIs (1) are more likely to 

have a direct working relationship with customers who claim reduced tax 

rates under tax treaties, (2) accept responsibilities for ensuring customers 

are in fact eligible for treaty benefits, and (3) agree to have independent 

parties review a sample of accounts and report to IRS. 

However, a low percentage of U.S. source income flows through QIs. For tax 

year 2003, about 12.5 percent of U.S. source income flowed through QIs. 

About 87.5 percent flowed through U.S. withholding agents, which provide 

somewhat less assurance of proper withholding and reporting than do QIs. 

In addition, U.S. persons may be able to evade taxes by masquerading as 

foreign corporations. 

The contractually required independent reviews of QIs’ accounts do not 

require auditors to follow up on indications of illegal acts, as would reviews 

under U.S. Government Auditing Standards. While IRS obtains 

considerable data from withholding agents, it does not make effective use of 

the data to ensure proper withholding and reporting has been done. 

U.S. Source Income Flowing through QIs and to Foreign Corporations, 2003 

Dollars in billions 

Amount and percentage 

flowing through QIs 

Amount and percentage 

Total U.S. source flowing to foreign corporations

income Amount Percentage Amount Percentage

$293.3 $36.6 12.5 $200.5 68.4

Source: GAO analysis of IRS data. 

Offshore tax evasion is difficult for 

the Internal Revenue Service (IRS) 

to address. IRS examines tax 

returns to deal with offshore 

evasion that has occurred. IRS’s 

Qualified Intermediary (QI) 

program seeks to foster improved 

tax withholding and reporting. 

GAO was asked to testify on two 

topics. First, GAO was asked to 

provide information on (1) the 

length of, and assessments from, 

IRS’s examination of tax returns 

with offshore activity and (2) the 

impact of the 3-year statute of 

limitations on offshore cases. 

Second, for the QI program, GAO 

was asked to address (1) program 

features intended to improve 

withholding and reporting, and 

(2) whether weaknesses exist in 

the U.S. withholding system for 

U.S. source income and QI external 

reviews and IRS’s use of program 

data. GAO relied on prior work for 

the first topic. For the QI program, 

GAO used the latest data that were 

available and corroborated by IRS. 

What GAO Recommends

A report GAO released today 

suggests that Congress make an 

exception to the 3-year civil statute 

of limitations period for taxpayers 

involved in offshore financial 

activity. GAO will consider 

recommendations for the QI 

program in a forthcoming report. 
Mr. Chairman and Members of the Committee: 

I am pleased to be here today to discuss two topics related to offshore tax 

evasion: the impact of the 3-year civil statute of limitations on Internal 

Revenue Service (IRS) offshore enforcement efforts, and the Qualified 

Intermediary (QI) program. IRS’s success in identifying and pursuing all 

tax evasion is of critical importance. When some taxpayers do not pay 

their fair share of taxes, honest taxpayers are left with higher tax bills and 

may find reason to doubt their own willingness to stay compliant. Offshore 

tax evasion is especially difficult to identify because of the layers of 

obfuscation that can come with doing business in overseas locations 

beyond the effective reach of the U.S. government. Doing business outside 

of the country is, of course, perfectly legal, but hiding income or assets in 

offshore locations in order to evade taxes is not. Generally, to address 

offshore tax evasion, IRS examines tax returns with offshore activity to 

deal with noncompliance once it has occurred. IRS has also initiated the 

QI program to improve upon the prior system of withholding and reporting

of U.S. source income that flows offshore. QIs are foreign financial 

institutions, such as banks, trusts, and partnerships, that contract with IRS 

to withhold and report U.S. source income paid offshore to individuals 

who are not U.S. persons and do not live in the United States (nonresident 

aliens). 

My remarks regarding IRS’s offshore compliance activity will focus on 

(1) IRS’s examination of tax returns with offshore activity and how those 

examinations differ from nonoffshore examinations in their length and in

the assessments they ultimately yield and (2) the implications of the 3-year 

statute of limitations on offshore examinations. Regarding the QI program, 

I will address (1) features of the QI program intended to improve 

withholding and reporting, (2) whether weaknesses exist in the U.S. 

withholding system that complicate identifying beneficial owners1

 of U.S. 

source income, and (3) whether weaknesses exist in QI external reviews 

and IRS’s use of program data. My statement today is drawn, in part, from 

our report on offshore tax evasion being publicly released today.2

 The 

portion of this statement addressing the QI program is based on the 

 1

 The beneficial owner is the true owner of the income, corporation, partnership, trust or 

asset, who receives or has the right to receive the proceeds or advantages of ownership. 

For the rest of this statement, we will use the term “owner.” 

2

 GAO, Tax Administration: Additional Time Needed to Complete Offshore Tax Evasion

Examinations, GAO-07-237 (Washington, D.C.: Mar. 30, 2007). 

Page 1 GAO-07-823T 
preliminary results of new work. We describe the methodology for our QI 

program review later in this statement. The offshore report and our QI 

program review were prepared in accordance with generally accepted 

government auditing standards. 

Let me begin by highlighting two major points about IRS’s examination of 

returns with offshore activity: 

• IRS examinations involving offshore tax evasion take longer than other 

examinations but also yield higher assessments. In conducting offshore 

examinations, IRS faces inherent difficulty in identifying and obtaining 

information from foreign sources, often dilatory and uncooperative tactics 

on the part of taxpayers and their representatives, and technical 

complexity. Our analysis of IRS examination data from fiscal years 2002 

through 2005 showed that offshore cases—measured from when the 

return was filed to when the examination closed—took a median of about 

500 more calendar days overall to close than nonoffshore cases and 

required nearly four times as many staff hours to examine, on average. 

These examinations had a median assessment that was nearly three times 

larger than all nonoffshore examinations but given the greater staff time 

taken per case, yielded about one half as much in tax assessments per 

hour of examination time. 

• Offshore examinations are subject to the same 3-year statute of limitations 

on assessments as other types of cases. IRS officials told us that the need

to complete an examination and make an assessment no later than 3 years 

after the return was filed sometimes means that IRS closes an examination 

before some work is complete and sometimes chooses not to open an 

examination at all, despite evidence of likely noncompliance. Changes to 

the statute in the past provide precedent for a longer statute for offshore 

cases, but any change would likely have both advantages and 

disadvantages. In a separate report being released today, we suggest that 

Congress lengthen the statute of limitations for cases involving offshore 

activity. 

I would also like to make three major points about the QI program: 

• The QI program contains features that give IRS some assurance that QIs 

are more likely to properly withhold and report tax on U.S. source income 

paid offshore than other withholding agents. First, because QIs are in 

overseas locations, they are more likely to have a direct working 

relationship with nonresident aliens or other persons who may claim 

exemptions or treaty benefits. Second, QIs accept enhanced

responsibilities for ensuring customers are in fact eligible for treaty 

benefits and exemptions. Third, and importantly, QIs agree to contract 

Page 2 GAO-07-823T 
with independent third parties to review the information contained in a 

sample of accounts, determine whether the appropriate amount of tax was 

withheld, and submit a report of the information to IRS. 

• Although QIs provide enhanced assurance that treaty benefits are properly 

provided, the vast majority of U.S. source funds do not flow through QIs, 

and some U.S. taxpayers may inappropriately receive treaty benefits and 

exemptions as owners of foreign corporations. For tax year 2003, about 88 

percent of U.S. source income flowed through U.S. withholding agents, 

which provide somewhat less assurance of proper withholding and 

reporting than do QIs.3

 In addition, under current U.S. tax law and 

regulations, corporations are taxpayers and the owners of their assets and 

income, regardless of the residency of the underlying corporate owners. 

By establishing an offshore corporation, a U.S. person(s) may escape 

identification and required reporting. In 2003, at least 68 percent of U.S. 

source income was received by foreign corporations. Since the identity of

corporate owners is not reported to IRS, U.S. persons may be able to 

evade taxes.

• QI external reviews give IRS greater assurance that QIs perform their 

responsibilities properly, but these reviews do not require auditors to 

follow up on indications of fraud or illegal acts; and IRS does not make 

effective use of withholding data. Under U.S. Government Auditing 

Standards,

4

 auditors performing external reviews like those done for the 

QIs must follow up on indications of fraud or illegal acts that could affect 

the matters they are reviewing. Further, data that IRS needs to effectively 

administer the QI program and ensure that withholding agents perform 

their duties properly are not readily available and in some instances no 

longer exist.

Examinations involving offshore tax evasion take much more time to 

develop and complete than examinations of other types of returns, but 

when offshore examinations are completed, the resulting median 

assessment is almost three times larger than for all other types of 

examinations. However, because of the 3-year statute, the additional time 

needed to complete an offshore examination means that IRS sometimes 

has to prematurely end offshore examinations and sometimes chooses not 

to open an examination at all, despite evidence of likely noncompliance. 

Additional Time 

Needed to Complete 

Offshore Tax Evasion 

Examinations 

 3

 A withholding agent is responsible for withholding tax on payments of U.S. source income

and depositing such tax into the U.S. Treasury. 

4

 GAO, Government Auditing Standards, January 2007 Revision, GAO-07-162G 

(Washington, D.C.: January 2007). 

Page 3 GAO-07-823T 
Some offshore examinations exhibit enforcement problems, such as 

technical complexity, which are similar to those where Congress has 

granted a statute change or exception in the past. In a separate report 

being publicly released today, we suggest that Congress lengthen the 

statute of limitations for cases involving offshore activity. 

IRS generally uses the term “offshore” to mean a country or jurisdiction 

that offers financial secrecy laws in an effort to attract investment from 

outside its borders.5

 IRS examinations, both offshore and nonoffshore, are 

generally of one of three types—correspondence, office, or field. The most 

complex examinations are done through revenue agent field visits to 

taxpayer locations, that is, field examinations. Most offshore examinations 

from 2002 through 2005 were of this type. Generally, unless a taxpayer’s 

tax return involves fraud or a substantial understatement of income, or 

unless the taxpayer agrees to an extension, the statute of limitations for 

IRS to assess additional taxes is 3 years from when IRS receives the 

taxpayer’s tax return. Taking an examination past the statute of limitations 

date may result in disciplinary action against the responsible revenue 

agent and his or her manager. 

Comparing offshore and nonoffshore examinations, IRS examination data 

from fiscal years 2002 through 2005 showed that it takes IRS longer both 

to develop a potential offshore examination case after a return is filed and 

to conduct the examination itself. The median of offshore case total cycle 

time—the time that elapses between a return being filed and IRS’s closing 

of the examination of that return—was almost 500 calendar days longer 

than for nonoffshore cases, a 126 percent difference. Offshore 

examinations also required significantly more direct examination time,6

with an average of 46 hours spent directly on offshore examinations and 

12 hours on nonoffshore examinations. IRS officials told us that the longer 

time needed to complete offshore examinations is because of the inherent

difficulty in identifying and obtaining information from foreign sources, 

Offshore Tax Evasion 

Takes Longer to Find but 

Offshore Examinations 

Yield Larger Assessments 

Than Other Types of Cases 

 5

 IRS officials noted that although many enforcement problems occur in certain foreign

jurisdictions that are characterized by strict financial privacy regimes, the term “offshore”

broadly includes the activities of U.S. taxpayers in all foreign transactions. 

6

 Direct examination time does not include time spent waiting for a taxpayer’s response to

a request for information or other such time spent between specific tasks related to the 

examination. 

Page 4 GAO-07-823T 
often dilatory and uncooperative tactics on the part of taxpayers and their 

representatives, and technical complexity. 

About half of all offshore examinations resulted in a recommended 

assessment of additional taxes due compared to approximately 70 percent 

of nonoffshore examinations. While fewer offshore examinations resulted 

in assessments, the median assessment of all types of offshore 

examinations was nearly three times larger than for nonoffshore 

examinations. Although assessments were larger, the greater number of 

hours of direct examination time meant that assessment dollars per hour 

of offshore direct examination time were about half that of nonoffshore 

examinations—$1,084 per hour from offshore examinations and $2,156 

from nonoffshore examinations. 

IRS created guidance for continuing offshore examinations past the 3-year

point. Subject to management approval, agents can carry on the 

examination past the 3-year point based on their judgment that, given 

additional time, they will ultimately prove that the examination met one of 

the criteria necessary for IRS to make an assessment after the 3-year 

statute date has passed. 

All of the examinations allowed to extend past the statute date under this

guidance represent a gamble on the part of IRS that the examination will 

ultimately meet one of the exceptions to the statute and an assessment 

will be allowed under the law. IRS records show that 1,942 offshore 

examinations were taken past the 3-year statute period from fiscal years 

2002 through 2005. IRS ultimately made assessments on 63 percent of 

these examinations and these assessments were significantly higher than 

assessments from all other types of examinations, with a median 

assessment of about $17,500 versus about $5,800 from offshore 

examinations that were closed within the 3-year statute of limitations. The 

median assessment for all nonoffshore examinations that went past the 

statute date was about $4,900 versus about $2,900 from all nonoffshore 

examinations closed within 3 years. IRS databases do not allow systematic 

analysis of the approximately 700 offshore examinations that did not result 

in an assessment, so we do not know if these were accurate returns or if 

the agent discovered tax evasion but it did not rise to the level of fraud or 

substantial understatement of income. 

Page 5 GAO-07-823T 
Revenue agents and managers told us that because IRS has only 3 years 

from the time the taxpayer files a tax return, and offshore cases take 

longer than nonoffshore cases to identify and develop, some case files are 

not opened for examination because insufficient time remains under the 

statute to make the examination worthwhile. They added that, in order to

avoid violating the statute, they will often choose case files to examine 

with more time remaining under the 3-year statute of limitations over case 

files that have less time remaining and with more likely or more 

substantial possible assessments. Similarly, IRS revenue agents and 

managers sometimes close cases without examining all issues rather than 

risk taking the examination past the statute period, losing revenue, and 

facing disciplinary action.

Congress has lengthened or made exceptions to the statute in the past. For 

example, Congress changed the statute in 2004 to provide IRS with an 

additional year to make assessments in the case of unreported listed 

transactions.7

 Since many offshore schemes exhibited enforcement 

problems similar to those of unreported listed transactions, it follows that 

a similar statute extension could be granted for certain offshore 

transactions. 

IRS officials and individuals from the tax practitioner and policy 

communities told us of both advantages and disadvantages of an 

exception to the statute for taxpayers involved in offshore financial 

activity. For example, an advantage was increased flexibility for IRS to 

direct enforcement resources to egregious cases. A disadvantage was lack

of closure for taxpayers. In our report discussed earlier, we suggest that 

Congress make an exception to the 3-year civil statute of limitations 

assessment period for cases involving offshore activity. In e-mail 

comments on a draft of our report, IRS expressed agreement that a longer 

statute makes sense and should enhance compliance. 

IRS Does Not Pursue Some 

Apparent Offshore Tax 

Evasion Because of the 3-

Year Statute of Limitations

 7

 Listed transactions are the same as, or substantially similar to, a transaction specifically 

identified by IRS as a tax avoidance transaction. For a transaction to be a listed 

transaction, IRS must issue a notice, regulation, or other form of published guidance 

informing taxpayers of the details of the transaction. IRS listed 31 such transactions as of 

January 2007. 

Page 6 GAO-07-823T 
For tax year 2003, withholding agents reported that individuals and 

businesses residing abroad received about $293 billion in income from 

U.S. sources. The QI program provides IRS some assurance that tax is 

properly withheld and reported to IRS. However, a low percentage of U.S 

source income flows through QIs. In addition, although QIs are subject to

external reviews, the auditors conducting these reviews are not required 

to follow up on indications of fraud or illegal acts. Further, IRS does not 

make effective use of the data it receives from withholding agents to 

ensure that withholding agents perform their duties properly.

To address our objectives for the QI program, we reviewed various IRS 

documents and interviewed IRS and Department of the Treasury 

(Treasury) officials and private practitioners involved in the development 

and implementation of the QI program. We also reviewed various studies 

and reports on foreign investment and banking practices. A GAO 

investigator created a shell corporation and opened a bank account for 

that corporation to test the due diligence exercised by withholding agents. 

We also analyzed IRS data on U.S. source income that flowed overseas for 

tax years 2002 and 2003. The qualified intermediary data were reported by

withholding agents and edited by IRS, and do not include an unknown 

amount of activity that was unreported. We determined that these data 

were sufficiently reliable for the purposes of describing the qualified 

intermediary program by (1) performing electronic testing for obvious 

errors in accuracy and completeness and (2) interviewing agency officials 

knowledgeable about the data, specifically about how the data were 

edited. We reviewed the auditing requirements contained in the QI 

agreement and other standards, such as the U.S. Government Auditing 

Standards8

 and the international standard on agreed-upon procedures 

(AUP) and visited IRS’s Philadelphia Campus, which is responsible for 

processing the information returns submitted by QIs. 

Money is mobile and once it has moved offshore, the U.S. government 

generally does not have the authority to require foreign governments or 

foreign financial institutions to help IRS collect tax on income generated 

from that money. In 1913, the United States enacted its first legislation 

establishing that U.S. persons and nonresident aliens were subject to 

withholding at source before the investment income leaves U.S. 

jurisdiction. Subsequent legislation made withholding applicable to 

QI Program Provides 

Some Assurance That 

Tax Is Properly

Withheld and 

Reported but 

Limitations Exist 

Background 

 8 GAO-07-162G. 

Page 7 GAO-07-823T 
dividends and certain kinds of bond income earned by nonresident aliens, 

foreign corporations, foreign partnerships and foreign trusts and estates. 

The Internal Revenue Service issued a comprehensive set of withholding 

regulations for nonresident aliens in 1956. These regulations have been 

changed over the years to reflect statutory changes or perceived abuses by 

taxpayers. 

To attract foreign investment, the tax rules were further adapted to 

exclude several types of nonresident alien capital income from U.S. 

taxation, such as capital gains from the sale of personal property, interest 

income from bank deposits and “portfolio interest,” which includes U.S. 

and corporate debt obligations. The latter exemption helps finance the 

U.S. national debt by offering a U.S. tax free rate of return for foreigners 

willing to invest in U.S. bonds. 

Most of the U.S. source income flowing offshore likely is paid to 

nonresident aliens but some may be paid to U.S. persons. The income may 

be paid directly to nonresident aliens located offshore, for example when 

a company pays dividends to a foreign stockholder, or may flow through 

one or more U.S. or foreign financial intermediaries, such as banks or 

brokerage firms. Whether this income paid to nonresident aliens is subject 

to U.S. tax and, if so, how much depends on a number of factors, including 

the type of income and whether the recipient is a resident of a country 

with which the United States has negotiated a lower tax rate. If U.S. source 

income is subject to U.S. tax, the payor of that income has to report 

information about the recipient and the type and amount of income to IRS, 

and in some cases would be required under U.S. law to withhold the taxes 

due from the recipient. Any entity required to perform these withholding 

and reporting duties is known as a “withholding agent.” The difference in

taxation, withholding, and reporting for nonresident aliens and U.S. 

persons can motivate some U.S. individuals or businesses to seek to 

appear to be nonresident aliens. 

Among the types of U.S. source investment income paid to nonresident 

aliens, some is exempt from U.S. tax and some is taxable. Payors must 

report this income to IRS and withhold where appropriate. For example, 

some types of income paid to nonresident aliens, such as bank deposits 

Page 8 GAO-07-823T 
and portfolio interest9

 are exempt from taxation by U.S. statute. Payors of 

this income do not have to withhold tax on this income but are required to

report certain information to IRS about the amounts of income paid and to

whom. Other types of investment income paid to nonresident aliens, such 

as the gross proceeds on the sale of personal property, such as securities 

in a U.S. corporation, are also exempt from U.S. tax but financial 

intermediaries are neither required to withhold taxes on the income nor 

report information on the payment of the income to IRS. Some U.S. 

investment income, such as dividends, is subject to a statutory tax rate of 

30 percent.10 Payors of this income generally are to withhold the 30 percent 

tax if the recipients do not reside in a nation that has negotiated a treaty 

with a lower tax rate or cannot show they are in fact residents in the treaty 

country. The payors also have to report to IRS certain information 

covering the amount of income paid and to whom. About $5 billion of this

capital income was withheld for tax year 2003, implying that about 

$83 billion of this income was exempt from tax or was taxed at lower tax 

treaty rates (known as treaty benefits). 

IRS established the QI program in 2000. Under the QI program, foreign 

financial institutions sign a contract with IRS to withhold and report U.S. 

source income paid offshore. The QI program, and the larger withholding 

regime, is rooted in the 1980s when Congress expressed concerns about 

tax evasion by U.S. persons using foreign accounts, treaty benefits claimed 

by those who were ineligible, and the effect of tax havens and secrecy 

jurisdictions on the U.S. tax system. With these considerations in mind, 

and a general view that the old regulations were simply not being 

followed, IRS began a long, consultative process of developing new rules 

to balance a number of objectives, including a system to routinely report 

income and withhold the proper amounts, dispense treaty benefits, meet 

the U.S. obligation to exchange information with foreign tax authorities 

and encourage foreign investment in the United States. 

Chains of payments are routine in modern global finance, and the QI 

system of reporting is designed to reflect this normal course of business. 

 9

 Interest includes interest paid by U.S. obligors general, interest paid on real property

mortgages, interest paid to controlling foreign corporations, interest paid by foreign 

corporations, interest on tax-free covenant bonds, deposit interest, and Original Issue 

Discount (OID) which is the profit earned by purchasing a bond at a price less than its face 

value. 

10 Dividends include those paid by U.S. corporations, dividends qualifying for reduced

withholding under a tax treaty, and dividends paid by foreign corporations.

Page 9 GAO-07-823T 
For example, a small local bank in a foreign country may handle the 

accounts of several owners of U.S. investments. The bank may aggregate 

the funds of each of these individual investors into an omnibus account 

that it, in turn, invests in a regional bank. The regional bank may handle a 

number of omnibus accounts that it, in turn, aggregates and invests in 

some U.S. securities. The return on these securities will flow out of the 

United States and reverse this chain of transactions until each of the 

original investors gets their pro rata share of profit. See figure 1 for 

examples of tiered financial flows. 

Page 10 GAO-07-823T 
Figure 1: Tiered Financial Flows

Although QIs generally agree to be withholding agents for their customers, 

QIs may opt out of primary withholding and reporting responsibilities for 

designated accounts—including those owned by U.S. persons, ceding 

those responsibilities and liabilities to financial institutions upstream in 

that chain of payments. Eventually, the responsibilities and liabilities 

Page 11 GAO-07-823T 
associated with these accounts may fall to the last payor within the United 

States (and therefore within the jurisdiction of IRS). Even though this 

income may be paid to account holders in QIs or nonqualified 

intermediaries (NQI), the reporting and withholding might be executed by 

U.S. institutions.11

The United States maintains a network of bilateral treaties designed to set 

out clear tax rules applying to trade and investment between the United 

States and each nation in order to promote the greatest economic benefit 

to the United States and its taxpayers. Each treaty is intended to eliminate

double taxation of taxpayers conducting economic activity in the United 

States and another nation by allocating taxing rights between the two 

countries, establishing a mechanism for dealing with disputes between the 

two taxing authorities, providing exchange of information between the 

two taxing authorities, and reducing withholding taxes. Reductions of 

withholding taxes are negotiated with each treaty partner individually and 

the benefits are reciprocal—so U.S. residents may benefit from a reduced

tax rate for investing abroad, just as foreign investors may be for investing

in the United States. As of January 2007, 54 tax treaties were signed, 

including for all members of the Organization of Economic Cooperation 

and Development (OECD). 

The QI Program Provides 

Some Additional 

Assurance That Tax Is 

Properly Withheld and 

Reported 

Compared to U.S withholding agents, IRS has additional assurance that 

QIs are properly withholding the correct amount of tax on U.S. source 

income sent offshore. QIs accept several responsibilities that help ensure 

that their customers qualify for treaty benefits. 

First, because QIs are in overseas locations, they are more likely to have 

personal contact with nonresident aliens or other persons who may claim 

exemptions or treaty benefits than would U.S. withholding agents. This 

direct relationship may increase the likelihood that the QI will collect 

adequate ownership information and be able to accurately judge whether 

its customers are who they claim to be. 

Second, QIs accept enhanced responsibilities for providing assurance that

customers are in fact eligible for treaty benefits and exemptions. All 

 11 An NQI is any intermediary that is not a U.S. person and not a qualified intermediary who 

is a party to a withholding agreement with the IRS. It can also refer to a qualified 

intermediary that is not acting in its capacity as a qualified intermediary with respect to a

payment. See Treasury Regulations 1.1441-1(c)(14). 

Page 12 GAO-07-823T 
withholding agents are expected to follow the same basic steps when 

determining whether to withhold taxes on payments of U.S. source income 

made to nonresident alien customers. The withholding agents must 

determine the residency of the owner of the income and the kind and 

amount of U.S. source income, which governs the customers’ eligibility for 

no (if the type of income is exempt from U.S. tax) or reduced taxation (if a 

lower taxation rate has been set in a treaty). However, under their 

contract, QIs must obtain acceptable account opening documentation 

regarding the customer’s identity. When determining whether a customer 

qualifies for treaty benefits, the kinds of documents QIs may use are 

approved by IRS based upon the local jurisdiction “know your customer” 

(KYC) rules. When customers wish to claim treaty benefits, they must also 

submit an IRS Form W-8BEN, known as a withholding certificate, or other

acceptable documentation. On the withholding certificate the customer 

provides various identifying information and completes applicable 

certifications, including that the customer is a resident of a country 

qualifying for treaty benefits and that any limitations on benefits (LOB) 

provisions in the treaty are met.12 Because QIs agree to follow specified 

account opening procedures in all cases, regardless of whether a QI 

performs withholding itself or it passes the responsibility to another 

withholding agent, there is enhanced assurance that the residency and

nationality of the account holder has been accurately determined and thus

correct withholding decisions will be made. 

Third, and importantly, QIs agree to contract with independent third 

parties to review the information contained in a sample of accounts, 

determine whether the appropriate amount of tax was withheld, and 

submit a report of the information to IRS. These reviews are discussed in 

greater detail later in this statement. In contrast, U.S. withholding agents 

generally have not yet been subject to external reviews for this purpose. 

IRS officials believe that those U.S. withholding agents that participated in

IRS’s 2004 Voluntary Compliance Program13 were effectively subject to 

 12 The LOB provisions seek to prevent nonresidents of the two treaty countries from taking 

advantage of the preferential tax treatment in the favorable tax treaty by forming a conduit 

entity in the treaty country but then funneling the profits back (to the United States or 

another non-treaty country). Accordingly, the LOB provisions contained in many tax

treaties between the United States and other countries disallow the availability of treaty 

benefits to recipients that do not maintain significant contacts with the treaty jurisdiction 

in question. 

13 The Voluntary Compliance Program, announced in Rev. Proc. 2004-59, was a program in

which IRS invited U.S. withholding agents to disclose and resolve issues arising from the 

implementation of the final withholding regulations. 

Page 13 GAO-07-823T 
external review because under the program they had to provide IRS 

essentially the same information that IRS would have reviewed in an audit. 

IRS is preparing to audit all of the U.S. withholding agents that did not 

participate in the Voluntary Compliance Program. However, because U.S. 

withholding agents generally rely on identity documentation from 

downstream intermediaries, even when U.S. withholding agents have been 

audited by IRS, there is less assurance that nonresident aliens actually 

qualified for the benefits. 

Although account opening and withholding procedures for QIs may give 

IRS greater assurance that treaty benefits are properly provided by QIs 

than by U.S. withholding agents, QIs provide IRS less information to use in

targeting its enforcement efforts than do U.S. withholding agents. One of 

the principal incentives for foreign financial institutions to become QIs is 

their ability to retain the anonymity of their customer list. QIs report 

customer income and withholding information to IRS in the aggregate for 

groups of similar recipients receiving similar benefits. This is known as 

“pooled reporting.” NQIs also can pool results when reporting to upstream 

withholding agents, but nevertheless, must identify all of the individual 

customers for which they have provided treaty benefits.14 Although pooling 

restricts the information available to IRS on individuals receiving treaty 

benefits, to the extent that QIs do a better job of ensuring treaty benefits 

are properly applied up front, IRS has less need for after-the-fact 

enforcement. The accuracy of the pooled reporting by QIs is also subject 

to the external reviews of QIs’ contractual performance. 

QIs Account for a Small 

Portion of U.S. Source 

Income and Individuals 

May Inappropriately

Receive Treaty Benefits as 

Owners of Corporations 

Although the QI program provides IRS some assurance that treaty benefits

are being properly applied, a low percentage of U.S. source income flows 

through QIs and U.S. taxpayers may inappropriately receive treaty benefits

and exemptions as owners of foreign corporations. 

 14 Income owned by U.S. taxpayers held offshore may not be pooled and must be reported

to IRS individually, either by the QI or the last U.S. payer in a chain of payments. 

Page 14 GAO-07-823T 
As shown in table 1, for tax year 2003, 87.5 percent of U.S. source income 

reported to IRS was reported by U.S. withholding agents, not QIs.15 Thus, 

the overwhelming portion of this income flowed through channels that 

provide somewhat less assurance of proper withholding and reporting 

than exists under the QI program. More than 90 percent of the U.S. source 

income QIs paid their customers for tax year 2003, or nearly $34 billion, 

flowed through QIs that each handled $4 million or more of U.S. source 

income. These QIs and the income they handled were subject to external

review (as discussed later in this statement, smaller QIs can obtain a 

waiver from external reviews). Overall, QIs withheld taxes from U.S. 

source income at more than twice the rate of U.S. withholding agents, 3.7 

percent versus 1.5 percent. 

The Majority of U.S. Source 

Income Flows Outside the QI 

System 

Table 1: Income and Withholding Flows by Type of Intermediary for Tax Year 2003

Dollars in billions 

U.S. withholding agents QIs

Amount of

U.S. source 

income 

reported by

withholding

agent 

Number 

of 

returns

Total

gross

income 

Total

tax 

withheld

Withholding 

rate 

(percentage)

Percentage

total 

income

Number 

of 

returns

Total

gross

income

Total

tax 

withheld

Withholding 

rate 

(percentage)

Percentage

total 

income

$4 million or 

more 

5,503 $223.3 $2.4 1.1 76.1 716 $33.8 $1.1 3.2 11.5

Less than $4

million and 

equal or 

greater than

$1 million 

8,553 16.9 0.5 3.2 5.8 805 1.7 0.1 8.6 0.6

Less than 

$1 million 

1,977,001 16.5 1.0 5.9 5.6 40,648 1.2 0.1 10.6 0.4

Subtotals 1,991,057 $256.7 $3.9 1.5 87.5 42,169 $36.6 $1.4 3.7 12.5

Source: GAO analysis of IRS data. 

Note: Numbers may not total because of rounding. 

The jurisdiction of recipients of U.S. source income is a major determinant 

of the applicable withholding rate and the degree of cooperation IRS may 

expect from foreign governments in enforcing U.S. tax administration. 

Bilateral tax treaties are one means of reducing withholding taxes that 

 15 Tax year 2003 is the most recent year for which reliable data is available. 

Page 15 GAO-07-823T 
treaty partners may impose on their residents. In general, a treaty provides

enhanced assurance that both nations’ tax rules will be properly applied. 

When a treaty does not exist, tax administration can be furthered by 

agreements to exchange information. As of November 2006, 15 nations had 

Tax Information Exchange Agreements (TIEA) with the United States.16 To 

countervail harmful tax practices, the OECD encourages countries to 

develop and practice administrative transparency and effective exchange

of tax information in their local tax administrations. A number of 

countries have made formal commitments to work toward these 

principles. However, because of their continued unwillingness to agree to 

these two principles, five countries are on the OECD’s list of 

“uncooperative tax havens.”17 Finally, 165 other jurisdictions receive U.S. 

source income but do not fall into any of these categories. 

Although the vast majority of U.S. source income flows outside the QI 

system, the preponderance flows through countries with which the United 

States has tax treaties, as shown in figure 2. 

 16 Since we performed our analysis, according to the Department of the Treasury, the

number of countries with TIEAs reached a total of 22. Although, Mexico has a TIEA, it also

has a tax treaty with the U.S. and has been reported as such in the following figure and

table. 

17 The Marshall Islands is one of the 15 nations with TIEA agreements in force. However, it 

is classified by OECD as an “uncooperative tax haven” and has been reported as such in the

following figure and table. 

Page 16 GAO-07-823T 
Figure 2: U.S. Source Income Flowing Offshore by Type of Jurisdiction, Tax Year 2003 

As shown in table 2, for tax year 2003 about 80 percent of U.S. source 

income flowed through treaty countries with 88 percent of that flowing 

through U.S. withholding agents. The data indicate that persons in the 

treaty countries received the preponderance of U.S. source income and 

the lowest withholding rates, because of a combination of reduced 

withholding rates negotiated by treaty and residents receiving certain 

kinds of income that are exempt by statute. About $28 billion flowed 

through TIEA countries, and recipients received significant withholding 

tax reductions–without mutually beneficial treaties. Persons in 

jurisdictions committed to OECD’s principles, that is, “committed 

jurisdictions,” and OECD-identified “uncooperative tax havens” accounted 

for relatively little U.S. source income. Withholding agents in other and 

Page 17 GAO-07-823T 
undisclosed countries not falling into any of these categories received 

about $29 billion in U.S. source income for tax year 2003, and dispensed 

about $8 billion in withholding tax reductions that year. 

Table 2: U.S. Withholding Agents’ and QIs’ Withholding Rates by Jurisdiction, Tax Year 2003 

Dollars in billions 

U.S. withholding agents QIs

Gross

income Withholding

Withholding rate 

(percentage)

Gross

income Withholding

Withholding rate 

(percentage)

Treaty countries $212.7 $2.9 1.3 $22.0 $0.9 4.0

TIEA countries 24.9 0.7 2.7 3.0 0.1 2.3

OECD committed jurisdictions 1.2 0.1 5.4 a a 2.6

OECD uncooperative tax havens 0.2 a9.3 a a6.9

Other countries 9.9 0.2 1.6 0.3 a1.2

Undisclosed 7.8 0.1 1.4 11.3 0.4 3.5

 Not Listed a a24.2 0.1 a2.1

 Unidentified 7.5 a1.1 11.1 0.4 3.5

 Unknown 0.3 a8.6 0.1 a12.1

All countries $256.7 $3.9 1.5 $36.6 $1.4 3.7

Source: GAO analysis of IRS data. 

Notes: 

Treaty countries: Australia, Austria, Bangladesh, Barbados, Belgium, Canada, China, Cyprus, Czech

Republic, Denmark, Egypt, Estonia, Finland, France, Germany, Greece, Hungary, Iceland, India, 

Indonesia, Ireland, Israel, Italy, Jamaica, Japan, Kazakhstan, Korea, Latvia, Lithuania, Luxembourg, 

Mexico, Morocco, Netherlands, New Zealand, Norway, Pakistan, Philippines, Poland, Portugal, 

Romania, Russia, Slovakia, Slovenia, South Africa, Spain, Sweden, Switzerland, Thailand, Trinidad & 

Tobago, Tunisia, Turkey, Ukraine, United Kingdom, and Venezuela.

TIEA countries: Antigua and Barbuda, Aruba, Bahamas, Bermuda, British Virgin Islands, Cayman

Islands, Dominica, Grenada, Guernsey, Isle of Man, Jersey, St. Lucia, U.S. Virgin Islands. 

OECD committed jurisdictions: Anguilla, Bahrain, Belize, Cook Islands, Gibraltar, Malta, Mauritius,

Montserrat, Nauru, Netherlands Antilles, Niue, Panama, American Samoa, San Marino, Seychelles,

St. Kitts & Nevis, St. Vincent & Grenadines, Turks and Caicos, and Vanuatu. 

OECD uncooperative tax havens: Andorra, Liberia, Liechtenstein, Marshall Islands, and Monaco. 

Due to rounding, the amount of gross income shown in this table differs slightly from the amount of 

gross income shown in fig. 2. 

a

Rounded down to less than $0.1 billion. 

A close look at the data points to some potential problems with the 

withholding and reporting activities for tax year 2003. Both U.S. 

withholding agents and QIs reported transactions in unknown or 

unidentified jurisdictions. For example, for tax year 2003, $19 billion of 

Page 18 GAO-07-823T 
income was reported ($7.8 billion through U.S. withholding agents and 

$11.3 billion through QIs), on which $500 million was withheld ($100 

million through withholding agents and $400 million through QIs) from

undisclosed countries. In a separate analysis, we calculated that $5 billion 

of treaty benefits and exemptions were given that were not associated 

with any particular country. And other data analysis indicates that both 

U.S. withholding agents and QIs reported transactions with “unknown 

recipients” across all jurisdictions. For tax year 2003, U.S. withholding 

agents and QIs reported a combined $7 billion of U.S. source income paid

to offshore unknown recipients, from which $233 million was withheld at 

a rate of 3.4 percent. The transactions with unknown or unidentified 

jurisdictions and with unknown recipients indicate a significantly reduced

rate of withholding without proper documentation or reporting to IRS, 

since eligibility for a reduced rate of withholding must be determined by 

the claimants’ documented residency and type of investment. 

U.S. tax law enables the owners of offshore corporations to shield their 

identities from IRS scrutiny, thereby providing U.S. persons a mechanism 

to exploit for sheltering their income from U.S. taxation. Under U.S. tax 

law, corporations, including foreign corporations, are treated as the 

taxpayers and the owner of their income. Because the owners of the 

corporation are not known to IRS, individuals are able to hide behind the 

corporate structure. In contrast to tax law, U.S. securities regulation, and

some foreign money laundering and banking guidelines treat shareholders 

as the owners. Even if withholding agents learn the identities of the 

owners of foreign corporations while carrying out their due diligence 

responsibilities, they do not have a responsibility to report that 

information to IRS. However, if it provides them with actual knowledge or 

reason to know that the claim for reduced withholding in the withholding 

certificate or other documentation is unreliable for purposes of 

establishing residency, new supporting documentation must be obtained.

Foreign Corporations May 

Provide U.S. Taxpayers a 

Mechanism for Evading 

Taxation 

Bilateral treaties may reduce or eliminate U.S. taxes on income that would 

otherwise be taxable to nonresident alien recipients, including foreign 

corporations, but generally not for U.S. persons. Similarly, the U.S. tax 

exemption for foreign recipients of portfolio interest, created to encourage

foreign investors to purchase U.S. government and corporate debt, 

eliminates their tax on this type of income. The exemption is not available 

to U.S. persons, or to persons who own 10 percent or more of the debtor 

corporation or partnership as well as certain other restrictions. 

Withholding agents generally may accept a withholding certificate at face 

value, and so may grant treaty benefits or a portfolio interest exemption to 

Page 19 GAO-07-823T 
a foreign corporation that is owned by a U.S. person or persons. IRS 

regulations permit withholding agents (domestic and QIs) to accept 

documentation declaring corporations’ ownership of income at face value, 

unless they have “a reason to know” that the documentation is invalid.18

Consequently, it may be possible for U.S. persons to establish a 

corporation offshore, submit a withholding certificate to the withholding 

agent(s) and receive a reduced rate of withholding. In these situations 

where the foreign corporation is owned by a U.S. person or persons, it is 

incumbent upon the owners to report their corporate ownership and any 

income appropriately taxable to them on their own U.S. tax returns. There 

is no independent third-party reporting of that income to IRS. Generally, 

compliance in reporting income to IRS is poor when there is not third 

party reporting to IRS. 

Foreign corporations received at least $200 billion, or 68 percent, of the 

$293 billion in total U.S. source income for tax year 2003 (see table 3). 

From this income, almost $3 billion was withheld (an effective withholding 

rate of 1.4 percent) representing more than $57 billion of treaty benefits 

and exemptions. About half of all foreign corporate investment in the 

United States that year was in debt instruments which are paid U.S. tax 

free to qualified investors. The preponderance of tax withheld from 

corporations was derived from dividends. 

Table 3: Foreign Corporate U.S. Source Income, Withholding, and Benefits, Tax 

Year 2003 

Dollars in billions 

Type of income Gross income Tax withheld

Withholding rate 

(percentage) Benefits

Interesta$96.3 $0.2 0.22 $28.7

Dividendsb 42.4 1.9 4.56 10.8

Miscellaneousc 61.8 0.7 1.14 17.8

Total income $200.5 $2.8 1.42 $57.3

Source: GAO analysis of IRS data. 

a

Interest includes interest paid by U.S. obligors general, interest paid on real property mortgages, 

interest paid to controlling foreign corporations, interest paid by foreign corporations, interest on taxfree covenant bonds, deposit interest, and Original Issue Discount. 

 18 As discussed earlier, however, under their contract with IRS, QIs are implicitly expected 

to use KYC documentation when judging whether a customer’s withholding certificate is 

valid. 

Page 20 GAO-07-823T 
b

Dividends include those paid by U.S. corporations, dividends qualifying for reduced withholding 

under a tax treaty, and dividends paid by foreign corporations. 

c

Miscellaneous income includes royalties, pensions, compensation for personal services, REIT

distributions, notional principal contracts and other income. 

To test the level of due diligence exercised by withholding agents, a GAO 

investigator using an assumed identity created a shell corporation and 

then sought to establish an overseas bank account for that corporation. 

Our investigator approached a European QI to open an account. The QI 

required our investigator to provide documentation sufficient to establish 

his identity as an officer of the corporation and documentation showing 

the source of the funds to be invested. Further, a representative from the 

QI contacted the investigator and questioned him in detail to ensure 

compliance with KYC standards and requested to meet with him in person. 

The investigator discontinued the effort and did not open an account with

the QI. Our investigator also contacted an NQI in the Caribbean to open an

account. The NQI requested that the investigator provide documentation 

of his identity and a letter explaining the purpose of the corporation. In 

addition, the NQI contacted a U.S. bank where the investigator had an 

account and requested a letter of reference. The NQI opened an account 

for our investigator. We did not then make an investment to earn U.S. 

source income in part because of the relatively large minimum 

investments required by QI and NQI firms we contacted. Thus, we were 

able to open a solely owned foreign corporation that was not actually an 

active business but do not know whether a QI or NQI intermediary would 

then have questioned a withholding certificate had we made an investment 

and claimed treaty benefits. 

QI External Reviews and 

IRS Use of Program Data 

Because QIs agree to have external auditors perform oversight of their 

compliance with required procedures, IRS has greater assurance that taxes 

are properly withheld and treaty benefits are properly dispensed by QIs 

than by U.S. withholding agents. However, within their limited scope, QIs’ 

auditors are not responsible for following up on possible indications of 

fraud or illegal acts that could have an impact on the matters being tested 

as they would under U.S. Government Auditing Standards.

19 In addition, 

IRS obtains considerable data from withholding agents but does not make 

 19 GAO-07-162G. 

Page 21 GAO-07-823T 
effective use of the data to ensure that withholding agents perform their 

duties properly. 

In designing the QI program, IRS, Treasury, and intermediaries and their 

representatives had the objective of achieving an appropriate balance to 

obtain appropriate assurance that QIs meet their obligations without 

imposing such a burden that intermediaries would not participate in the 

program. As discussed earlier, IRS generally does not have the legal 

authority to audit a foreign financial intermediary, but IRS requires 

specific periodic procedures to be performed by external auditors to 

determine whether QIs are documenting customers’ identities and 

accurately withholding and reporting to IRS. The QI agreement requires 

each QI to engage and pay for an external auditor to perform “agreed upon 

procedures” (AUP) and submit a report of factual findings to the IRS’s QI 

program office for the second and fifth years of the agreement. The QI 

selects the external auditor, but IRS must approve it after considering the 

external auditor’s qualifications and any potential independence 

impairments. 

External Reviews 

IRS selected AUPs as the type of engagement to monitor QI compliance 

because of their flexible and scalable attributes. AUPs differ from a full 

audit in both scope of work and the nature of the auditor’s conclusions. As 

shown in table 4, in performing a full audit, an auditor gathers sufficient, 

appropriate evidence to provide assurance regarding the subject matter in 

the form of conclusions drawn or opinions expressed, for example, 

whether the audited entity is in material compliance with requirements 

overall. Under AUPs the external auditor performs specific work defined 

by the party requesting the work, in this case, IRS. In general, such work 

would be specific but less extensive, and less expensive, than the amount 

of work an auditor would do to provide assurance on the subject matter in

the form of conclusions or an opinion. Thus, withholding agents would 

likely be more willing to participate in the QI program with a required AUP 

review than a full audit, which they would have to pay for under the 

program requirements. AUPs can provide an effective mechanism for 

oversight when the oversight needs relate to specific procedures. 

Page 22 GAO-07-823T 
Table 4: Comparison of Key Features of Audits and Agreed-Upon Procedures 

Audit AUPsa

Auditor gathers sufficient, appropriate 

evidence to provide assurance, draw 

conclusions or express an opinion on the 

subject matter.

Auditor performs specific procedures and 

provides the requestor with a report of factual 

findings based on the procedures performed. 

Auditor determines nature and extent of 

procedures necessary to provide 

assurance. 

Party or parties requesting the report 

determine and agree to the procedures 

performed by the auditor. 

Report distribution usually not limited. Report distribution limited to party or parties 

requesting the report. 

Source: GAO analysis of audit and AUP characteristics as defined by U.S. Government Auditing Standards and International Auditing

and Assurance Standards Board standards. 

a

These are attributes of AUPs performed under international accounting standards. 

IRS developed a three-phase AUP process to focus on key performance 

factors to address specific concerns while minimizing compliance costs. In 

phase 1 procedures, the external auditor is required to examine all or a

statistically valid sample of accounts with their associated documentation

and compile information on whether the QI followed withholding 

requirements and the requirements of the QI agreement. IRS reviews the 

data from phase 1 AUPs and determines whether significant concerns 

exist about the QI’s performance. If concerns exist, IRS may request that 

additional procedures be performed. For example, additional procedures 

may be requested if the external auditor identified potential problems 

while performing phase 1 procedures. IRS defines the work to be done in a 

phase 2 review based on the specific concerns surfaced by the phase 1

report. Phase 3 is necessary only if IRS still has significant concerns after 

reviewing the phase 2 audit report. In phase 3, IRS communicates directly

with the QI management and may request a face-to-face meeting in order 

to obtain better information and resolve concerns about the QI’s 

performance. IRS cited high rates of documentation failure, 

underreporting of U.S. source income and under-withholding as the three 

most common reasons for phase 3 AUPs. 

Data from the 2002 audit cycle shows that IRS required phase 2 

procedures for about 18 percent of the AUPs performed. IRS moved to 

phase 3 procedures for 35 QIs, which is around 3 percent of the 2002 AUPs 

performed. Of the QIs that had phase 3 reviews, IRS met face-to-face with 

13 and was ultimately satisfied that all but 2 were in compliance with their

QI agreements. The remaining 2 were asked to leave the QI program. 

Page 23 GAO-07-823T 
Since the QI program’s inception in 2000, there have been 1,245 

terminations of QI agreements. Of the 1,245 terminations, 696 were the 

result of mergers or consolidations among QIs and not related to 

noncompliance with the QI agreements. Aside from the 2 terminations 

mentioned above, the remaining 549 terminations were of QIs that failed to

file either an AUP report of factual findings or requests for an AUP waiver 

by the established deadline. 

IRS grants waivers of the AUP requirement if the QI meets certain criteria.

A QI may be eligible for a waiver if it can demonstrate that it received not 

more than $1 million in total U.S. source income for that year. In order to 

be granted a waiver, the QI must file a timely request that includes 

extensive data on the types and amounts of U.S. source income received 

by the QI. Among items required with the waiver request are a 

reconciliation of U.S. source income reported to the QI and U.S. source 

income reported by the QI to IRS; the number of QI account holders; and

certifications that the QI was in compliance with the QI agreement. IRS 

evaluates the data provided with the waiver request to determine if AUPs 

are necessary despite the relatively small amount of U.S. source income, 

and will deny the waiver request if the data provided raises significant 

concerns about the QI’s compliance with the agreement. About 3,400 QIs 

(around 65 percent of the QIs at that time) were approved for audit 

waivers in 2005. The largest 5 percent of the QIs accounted for about 90 

percent of the withholding based on data from the 2002 audit cycle. 

One notable difference between the AUPs used for the QI program and 

AUPs that would be done under U.S. Government Auditing Standards is 

that the QI contract is silent on whether external auditors have to perform 

additional procedures if information indicating that fraud or illegal acts 

that could materially affect the results of the AUP review come to their 

attention. Absent specific provisions in the contract, the auditors perform 

the QI AUPs in accordance with the International Standard on Related 

Services (ISRS) 4400.20 Our U.S. Government Auditing Standards, known

as the Yellow Book, are more stringent on this topic than the ISRS 

standards. 

 20 The International Auditing and Assurance Standards Board (IAASB) is an independent

body that establishes and provides guidance on auditing, assurance and other related

services, including ISRSs, for its member organizations. Member organizations agree to

comply with IAASB standards. 

Page 24 GAO-07-823T 
Yellow Book standards state that auditors should be alert to situations or 

transactions that could indicate fraud, illegal acts, or violations of 

provisions of contracts. If the auditor identifies a situation or transaction 

that could materially affect the results of the engagement the auditor is to 

extend procedures to determine if the fraud, illegal acts, or violations of 

provisions of contracts are likely to have occurred and, if so, determine 

their effect on the results of the engagement. The auditor’s report would 

include information on whether indications of fraud or illegal acts were 

encountered and, if so, what the auditors found. Therefore the report 

would provide IRS with the information necessary to pursue the 

indications of fraud or illegal acts through phase 2 procedures. 

Data that IRS needs to effectively administer the QI program are not 

readily available for use and in some instances no longer exist.

Consequently, IRS has difficulty ensuring that refunds claimed by 

withholding agents are accurate and is less able to effectively target its 

enforcement efforts. 

IRS Does Not Make Full Use of 

Available Data to Ensure 

Compliance with Withholding 

and Reporting Requirements 

All withholding agents, whether QIs or not, are to report withholding 

information on their annual withholding tax returns (Forms 1042) and

information returns (Forms 1042-S). Forms 1042 are filed on paper. Forms 

1042-S may be filed electronically or on paper. The law requires 

withholding agents filing more than 250 returns to file electronically; 

consequently, most U.S. financial institutions file the information returns 

electronically, while most QIs file on paper. When returns are paper filed, 

IRS personnel must transcribe information from the paper returns into an 

electronic database in order to efficiently and effectively make use of the 

data. Data on both paper and electronically filed returns must also be 

reviewed for errors. 

Data from Forms 1042 have been routinely transcribed and checked for 

errors. However, since the inception of the QI program, IRS has not 

consistently entered information from the paper Forms 1042-S into an 

electronic database. In years when data were not transcribed, the 

unprocessed paper 1042-S forms were stored at the Philadelphia Service 

Center in Philadelphia and then destroyed a year after receipt in 

accordance with record retention procedures. Additionally, for certain tax 

years, the electronically filed Forms 1042-S did not go through 

computerized error resolution routines. For tax year 2005 IRS’s Large and

Midsize Business Division transferred $800,000 in funding to the service 

center to fund transcribing paper Forms 1042-S and performing error 

resolution for all Forms 1042-S. IRS officials anticipate funding 2006 

transcription and error resolution although as of March 2007, this had not 

Page 25 GAO-07-823T 
yet occurred. Figure 3 shows the dual processing procedures IRS uses for 

receiving, checking and validating the Form 1042-S data it receives. 

Figure 3: IRS Processing of Paper and Electronic 1042-S Forms 

Page 26 GAO-07-823T 
Notes: The forms are Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding; 

Form 1042-T, Annual Summary and Transmittal of Forms 1042-S; and Form 4804, Transmittal of 

Information Returns Reported Magnetically. 

CTW is Chapter Three Withholding; IRMF is Information Returns Master File. 

Because the Form 1042-S data have not been routinely transcribed and 

corrected, IRS lacks an automated process to use the Form 1042-S 

information return data to detect underreporting on the Form 1042 or to 

verify refunds claimed. Forms 1042 are due in March and the withholding 

agents might report owing IRS more if they under-withheld the amount of 

tax their customers’ owed, or might claim a refund if they over-withheld. 

After performing simple consistency and math checks on the Forms 1042, 

IRS accepts the returns as filed and either bills withholding agents that did

not include full payment or refunds amounts to those whose Forms 1042 

indicates they over-withheld taxes due. 

Because the Forms 1042-S information returns have not been routinely 

transcribed, IRS has not been able to automatically match the information 

return documents to the annual tax return data, which is one of IRS’s most 

efficient and effective tools to ensure compliance. IRS had planned to 

perform such automatic document matching, but IRS suspended the plans 

for matching the Form 1042-S and Form 1042 data since funding has not

been available to routinely transcribe Form 1042-S data. Therefore, when 

Forms 1042-S had been electronically filed or transcribed, IRS has only 

been able verify the accuracy of Forms 1042 by individually retrieving the

1042-S data stored in the Chapter Three Withholding (CTW) database, a 

time-consuming and seldom used process. When Forms 1042-S were not 

transcribed, IRS was only able to verify Forms 1042 by manually retrieving

and reviewing the paper 1042-S. Further, for years when transcription did 

not occur, if a QI filed an amended return after the paper Forms 1042-S 

were destroyed, IRS could not even perform a manual verification and had 

to take the amended return claiming a refund at face value provided other 

processing criteria were met. IRS has no information to determine 

whether or how often such erroneous or fraudulent refunds might occur.

Properly transcribed and corrected 1042-S data would have other uses as 

well. For instance, IRS officials said that such data could be used to check

whether the AUP information submitted by QI withholding agents is 

reliable. For U.S. withholding agents, Form 1042-S information might be 

used to determine whether to perform audits. Several other units within 

IRS, as well as Treasury, the Joint Committee on Taxation and 

congressional tax-writing committees also could use these data to 

research and evaluate tax policy and administration issues and to identify 

Page 27 GAO-07-823T 
possibly desirable legislative changes. We are considering 

recommendations in a forthcoming report on the QI program regarding 

IRS’s data management.

Mr. Chairman, this concludes my prepared statement. I would be happy to

answer any questions you or other members of the committee may have at

this time. 

For further information regarding this testimony, please contact Michael 

Brostek, Director, Strategic Issues, at (202) 512-9110 or 

brostekm@gao.gov. Contacts for our Offices of Congressional Relations 

and Public Affairs may be found on the last page of this statement. 

Individuals making key contributions to this testimony include Jonda Van 

Pelt, Assistant Director; Jeffrey Arkin; Susan Baker; Perry Datwyler; Amy 

Friedheim; Evan Gilman; Shirley Jones; David L. Lewis; Donna Miller; John 

Mingus; Danielle Novak; Jasminee Persaud; Ellen Rominger; John Saylor; 

Jeffrey Schmerling; Joan Vogel; and Elwood White. 

Contact and 

Acknowledgments 

Page 28 GAO-07-823T (450598) 
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