Tax Compliance: Qualified Intermediary Program Provides Some Assurance That Taxes on Foreign Investors Are Withheld and Reported, but Can Be Improved
Published: 2007-12-19T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: 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.
section_title: What GAO Found
paragraphs: 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.

section_title: Letter
paragraphs: In tax year 2003, the most recent data available at the time of our analysis,  individuals and businesses residing abroad, known as nonresident aliens  (NRA), received $293.3 billion in income from U.S. sources. Certain types  of income sent to NRAs, such as certain interest from U.S. and corporate  debt, are exempt from taxation by U.S. statute. Other types of income,  such as the gross proceeds on the sale of equities, are neither reported nor  withheld. Yet some income, such as dividends, is subject to a statutory tax  rate of 30 percent, which may be reduced if the recipient resides in a  country that has negotiated a lower rate through a tax treaty (known as  treaty benefits). About $5 billion of this income was withheld for tax in  2003. If the full 30 percent rate had been applied to the entire $293.3  billion, about $88 billion would have been withheld implying about $83  billion worth of treaty benefits and exemptions. The income and benefits  may have been sent directly to beneficial owners located offshore or may  have flowed through one or more foreign financial intermediaries, such as  banks or brokerage firms.
The Internal Revenue Service (IRS) initiated the Qualified Intermediary  (QI) program in 2000 to improve on the prior system of withholding and  reporting of U.S. source income sent offshore. The QI program, and the  larger withholding regime, are rooted in congressional concerns about tax  evasion by U.S. persons using foreign accounts, treaty benefits claimed by  those who are ineligible, and the effect of tax havens and secrecy  jurisdictions on the U.S. tax system. With these considerations in mind,  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. We were requested by  the Committee on Finance to (1) describe features of the QI program  intended to improve withholding and reporting, (2) assess whether  weaknesses exist in the U.S. withholding system that complicate  identifying owners of U.S. source income, and (3) determine whether  weaknesses exist in QI external reviews and IRS’s use of program data.  This report builds on our testimony given May 3, 2007.
To meet our objectives, we obtained information from several sources. We  reviewed various IRS documents, such as regulations and industry  directives, and interviewed IRS officials, 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. We analyzed IRS  data on U.S. source income that flowed overseas for tax years 2002 and  2003, the most recent data available at the time of our analysis. The QI  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 Standards and the international standard  on agreed-upon procedures (AUP), and visited IRS’s Philadelphia Campus,  which was responsible for processing the information returns submitted  by QIs during our review. We conducted our review from January 2006  through October 2007 in accordance with generally accepted government  auditing standards.
subsections: section_title: Background
paragraphs: least 70 countries. In addition, IRS pointed to certain current QI  requirements that provide IRS with some information on fraud and illegal  acts. However, as discussed in our draft report, we believe IRS could draw  on existing auditing standards to establish a consistent definition of fraud  and illegal acts for the purposes of the QI program. In addition, the  provisions to which IRS refers rely in part on self-reporting by the QI and  in part focus on “know your customer” rule violations alone. However,  self-reporting by the QI is not equivalent to judgments by the auditors  about whether there are indications that fraud or illegal acts have  occurred. And the universe of potential fraud or illegal acts extends  beyond potential violations of know your customer rules. Therefore we  reaffirm our recommendation. Finally, IRS agreed that while there are  benefits to electronic filing of tax Forms 1042 and 1042-S, IRS said such a  requirement would be a burden for QIs that file only a few (3 or fewer)  forms. IRS said it has implemented a procedure to include an application  to electronically file for all QIs applying for or renewing participation in  the program. If IRS were to require all QIs to electronically file, we believe  any burdens filers of few forms would face could be addressed by offering  them a waiver opportunity similar to waivers that are available to all  institutions that are currently required to file electronically (those that file  more than 250 returns). Requiring electronic filing whenever possible  would reduce IRS’s costs and improve the timeliness and accuracy of data  for program oversight.
subsections: section_title: History, Purpose, and Determinants of Withholding
paragraphs: 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  in the U.S. from that money. In 1913, the United States enacted its first  legislation establishing that U.S. persons and NRAs were subject to  withholding at source before the investment income leaves U.S.  jurisdiction. Subsequent legislation made withholding applicable to  dividends and certain kinds of bond income earned by NRAs, foreign  corporations, foreign partnerships, and foreign trusts and estates. IRS  issued a comprehensive set of withholding regulations for NRAs 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 NRA 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.
Among the types of U.S. source investment income sent to NRAs, some are  exempt from U.S. tax and some are taxable. Payors must report this  income to IRS, withhold where appropriate, and deposit such tax with  Treasury. Any entity required to perform these withholding and reporting  duties is known as a “withholding agent.” For example, some types of  income sent to NRAs, such as bank deposits and portfolio interest, 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 sent and to whom. Other types of  investment income sent to NRAs, such as the gross proceeds on the sale of  personal property (e.g., 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. 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 sent  and to whom. About $5 billion of this capital income was withheld for tax  year 2003. Had the full 30 percent rate been applied to the entire $293.3  billion, about $88 billion would have been withheld, implying that about  $83 billion of this income was exempt from tax or was taxed at lower tax  treaty rates.
Chains of payments are routine in modern global finance, and the QI  system of reporting is designed to reflect this normal course of business.  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  which it, in turn, invests in a regional bank. The regional bank may handle  a number of omnibus accounts which 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.
section_title: Multiple Objectives of the Withholding and Reporting System
paragraphs: 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 sent offshore. The new regulations, which the QI program  was intended to help administer, were designed 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.
Under the QI program, foreign financial institutions voluntarily sign an  agreement to withhold and report the appropriate amount of tax on the  U.S. source income they send to their offshore customers. This entails  determining the kind and amount of their clients’ U.S. source income,  determining whether clients are eligible for benefits (which is determined  by the client’s national residency), and then calculating, withholding, and  reporting appropriate amounts to IRS. When customers wish to claim  treaty benefits or exemptions, they must also submit to a QI or other  withholding agent 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 or exemptions and that  any limitations on benefits provisions in the treaty are met. To determine  whether a client is eligible for treaty benefits and exemptions, the QIs  accept documentation declaring clients’ residency, most often a self- certified Form W-8BEN, and verify that with other documents accepted as  part of their account-opening procedures, such as passports or national  health cards, in accordance with the “know your customer” rules already  established by the jurisdiction in which they are located.
If there is insufficient documentation to adequately determine the treaty  status of an account owner, the QI, a nonqualified intermediary, or a U.S.  financial institution must use the presumption rules and apply backup  withholding. Backup withholding is regulated separately, reported  separately, and processed separately from routine NRA income and  withholding. Furthermore, U.S. persons generally are taxed on their  worldwide income. Their income and assets are withheld and reported  separately and individually.
One of the principal incentives for foreign financial institutions to become  QIs is their ability to retain the anonymity of their client list. QIs may  report customer income and withholding information for a group of  similar recipients receiving similar benefits, known as “pooled reporting.”  NQIs, on the other hand, must reveal the identity of their clients to  upstream withholding agents through acceptable documentation in order  for their customers to receive treaty benefits as well as interest and capital  gains exemptions. Income owned by U.S. taxpayers held offshore may not  be pooled and must be reported to IRS individually, either by the QI, NQI,  or the last U.S. payor in a chain of payments. Payors of U.S. source income  to U.S. taxpayers are not required to withhold from this income, but they  must report the income on IRS Form 1099. U.S. taxpayers must report all  of their current income on their income tax returns, including U.S. source  and foreign source income, as well as ownership of foreign bank accounts  and significant ownership in foreign corporations. 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 the  chain of payments. Eventually, the responsibilities and liabilities  associated with these accounts may fall to the last payor within the United  States (and therefore within the jurisdiction of IRS).
Most of the U.S. source income flowing offshore likely is sent to NRAs but  some may be sent to U.S. persons. The income may be sent directly to  NRAs 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. Since U.S.  persons generally are taxed on their worldwide income, while NRAs are  taxed only on certain U.S. source income, the difference in taxation,  withholding, and reporting for NRAs and U.S. persons may motivate some  U.S. individuals or businesses to seek to appear to be NRAs.
section_title: QI Program Provides Some Assurance That Tax Is Properly Withheld and Reported
paragraphs: 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. Because QIs are in overseas locations, they are  more likely to have personal contact with NRAs 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 account ownership information and be able to accurately judge  whether its customers are who they claim to be.
Under the contract signed with IRS, QIs accept enhanced responsibilities  for providing assurance that customers are in fact eligible for treaty  benefits and exemptions. All 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 NRA 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 taxation (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, such as a valid driving license, regarding the  customer’s identity. When determining whether a customer qualifies for  treaty benefits, the kinds of documents QIs may use are based upon the  local jurisdiction’s “know your customer” rules. Because QIs agree to  follow specified account-opening procedures, 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. Further, when QIs do not actually perform withholding, the QIs  adherence to the account-opening procedures gives greater assurance of  proper customer identification than NQIs, who follow account-opening  procedures of unknown rigor.
Furthermore, and importantly, QIs agree to contract with independent  external auditors 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 report. 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 Program were effectively subject to  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 NRAs 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 because  of their pooled reporting. NQIs also can pool results when reporting to  upstream withholding agents but, as discussed earlier, must identify all of  the individual customers for which they have provided treaty benefits.  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.
section_title: Weaknesses in the Withholding System Complicate the Identification of the Owner
paragraphs: The overwhelming portion of U.S. source income flows through U.S.  withholding agents who may accept self-certifications of identity from  indirect account owners that are forwarded by either QIs or NQIs. A high  percentage of U.S. source income flows through U.S. withholding agents,  but IRS has not determined how much of the income, or the associated  withholding, to U.S. withholding agents flows through QIs versus NQIs.  While QIs verify the self-certifications with other original account-opening  documentation, and those accounts are reviewed externally, NQIs provide  somewhat less assurance of proper withholding and reporting than exists  under the QI program. On the other hand, most U.S. source income flows  to treaty countries that have some working relationship with IRS.
However, establishing a foreign corporation provides a legal mechanism  for shielding the identity of the owner of income.
subsections: section_title: The Majority of U.S. Source Income Flows through U.S. Withholding Agents
paragraphs: Although the QI program provides IRS some assurance that tax benefits  are being properly applied, a low percentage of U.S. source income flows  through QIs. As shown in table 1, for tax year 2003, about 88 percent of  U.S. source income reported to IRS was reported by U.S. withholding  agents, not QIs. 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 sent 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 report,  smaller QIs can obtain a waiver from external reviews). Overall, QIs  withheld taxes from U.S. source gross income at more than twice the rate  of U.S. withholding agents, 3.7 percent versus 1.5 percent.
Even though a high percentage of U.S. source income flows through U.S.  withholding agents, IRS has not determined how much of the income, or  the associated withholding, to U.S. withholding agents flows through to  QIs versus NQIs. Indirectly owned account identity information received  from NQIs is a particular weakness because, unlike QIs who contractually  agree to verify W-8BEN information with know your customer  information, NQIs may accept W-8BENs at face value and forward them to  U.S. withholding agents. Therefore, indirect accounts expose the  withholding agent and reporting activity to a greater potential for incorrect  granting of tax exemptions or treaty benefits due to misinformation or  fraud. In 2003, two Large and Mid-sized Business (LMSB) Industry  Directives giving guidelines for withholding agent audits were published,  which did not address the differences in reporting for direct and indirect  account owners. IRS could, but has not yet, analyzed the amount of funds  flowing through U.S. withholding agents that flow to QIs versus NQIs  using information already reported on the Form 1042-S. The 1042-S  includes two federal tax identification numbers—one for the payee and  one for the payor—and IRS knows which identification numbers are  assigned to QIs. Because the Form 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. Doing so  may help IRS in assessing the Treasury’s exposure to unaudited  documentation and exposure to tax benefits flowing to unaudited  accounts. Additionally, this information might help policymakers decide  whether documentation requirements should be modified for unaudited  accounts or whether other changes should be made to improve the  likelihood that tax benefits are properly determined.
section_title: Most U.S. Source Income Flows to Treaty Countries or Jurisdictions That Have Some Working Relationship with IRS
paragraphs: The jurisdiction of recipients is a major determinant of the applicable  withholding rate. The U.S. maintains a network of bilateral tax treaties  designed to set out clear tax rules applying to trade and investment  between the two nations in order to promote the greatest economic  benefit to the United States and its taxpayers. Treaties are intended to  eliminate double taxation of taxpayers conducting economic activity in the  two jurisdictions by allocating taxing rights between the two countries,  establish a mechanism for dealing with disputes between the two taxing  authorities, provide for exchange of tax information between the two tax  authorities, and reduce withholding tax. Reductions in withholding tax 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, as foreign investors may be for investing in the United  States. As of January 2007, there were 54 tax treaties in force, including all  members of the Organization of Economic Cooperation and Development  (OECD).
In addition to treaty countries, the U.S. has other kinds of relationships  with nontreaty countries. For example, the U.S. has signed numerous Tax  Information Exchange Agreements (TIEA) with countries with which the  U.S. does not have full reciprocal tax rate reduction treaties. TIEAs have  less scale and scope than a tax treaty. Furthermore, a number of other  countries have made formal commitments to the OECD to work toward  the goals of tax administrative transparency and effective exchange of tax  information with other countries’ tax authorities in order to countervail  harmful tax practices. Having agreed to these principles, these countries  are no longer considered to be “tax havens.” However, because of their  continued unwillingness to agree to even these two principles, three  countries remain on the OECD’s list of “uncooperative tax havens.”
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. 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.
As shown in table 2, withholding agents in other and undisclosed countries  not falling into any of these categories received about $29 billion in U.S.  source income for tax year 2003. These withholding agents dispensed  about $8 billion in withholding tax reductions that year.
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 undisclosed  jurisdictions or with unknown recipients within various countries. These  transactions may reflect billions of dollars of reduced tax withholding  without proper documentation or reporting to IRS, since eligibility for a  reduced rate of withholding must be determined by the claimants’  documented nationality, residency, and type of investment.
Regarding transactions with undisclosed jurisdictions, for tax year 2003  $19 billion of 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 U.S. withholding agents and $400 million through  QIs) from undisclosed countries. The $500 million withheld represents a  2.7 percent withholding rate on this income. Since withholding at the 30  percent rate would have yielded about $5.7 billion in withheld taxes on the  $19 billion in total income, the withholding agents may have erroneously  underwithheld as much as $5.2 billion.
IRS officials did not have information to explain why withholding was only  $500 million on these transactions. Officials said that some of the money  flowing to unknown or unidentified jurisdictions could be a by-product of  QIs’ ability to pool accounts when reporting. For example, if recipients  from two nations with the same treaty rates for the same type of income  were in a QI reporting pool, the QI would not identify the differing  jurisdictions. However, IRS officials did not have information to show to  what extent this may have accounted for the QIs’ reporting of income  flowing to unknown or unidentified jurisdictions. Nor did they have  information that would explain why U.S. withholding agents reported  money flowing to unknown or unidentified jurisdictions at a reduced  withholding rate.
Regarding U.S. withholding agents and QIs’ reported transactions with  “unknown recipients” within various countries for tax year 2003, U.S.  withholding agents and QIs reported a combined $7 billion of U.S. source  income sent to offshore unknown recipients, from which about $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 nationality,  residency, and type of investment. If the 30 percent withholding rate  should have been applied to all of the funds flowing to unknown  recipients, about $2.1 billion should have been withheld, or about $1.9  billion more than what was withheld.
IRS officials were also unable to explain why our data showed money  flowing to unknown recipients and at low withholding rates. They  suggested that the unknown recipients might result, in part, from  discovery during external audits that the identities of some QI customers  were not adequately documented. The QIs would pay the appropriate  withholding at the 30 percent rate and issue a 1042-S for “unknown  recipient” to prevent the customer from claiming a refund for monies that  had not been withheld. Such corrected information on the amount  withheld may not have been incorporated into the Statistics of Income  (SOI) data base. In addition, IRS officials noted that the Form 1042-S is not  clear about how to report tax payments for customers who are not  adequately documented. IRS did not have any data or firm information to  explain why U.S. withholding agents and QIs reported that $7 billion of  U.S. source income was sent to unknown recipients in tax year 2003.
Two approaches could help IRS determine whether and to what extent  this reduced withholding on funds flowing to undisclosed jurisdictions and  unknown recipients was proper. First, IRS could analyze data it collects to  identify withholding agents who report withholding rates below 30 percent  on funds flowing to these types of recipients. IRS officials said they have  not done so in the past because the data are not routinely processed and  any errors corrected. However, processing and error correction has  occurred in several years, including most recently for tax year 2005.  Second, using this information IRS could request enhanced external  reviews of those QIs that report such withholding and could use the  information both as a factor for selecting which U.S. withholding agents it  will audit and to focus audit efforts on such reduced withholding. To the  extent the enhanced external review of QIs or IRS audits of U.S.  withholding agents reveal improper withholding, IRS then could take the  appropriate steps to recover 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.
section_title: Establishing a Foreign Corporation Provides a Mechanism for Shielding the Identity of the Owner
paragraphs: 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 current  U.S. tax law, corporations, including foreign corporations, are treated as  the taxpayers and the owners of their assets and 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.
Bilateral treaties may reduce or eliminate U.S. taxes on income that would  otherwise be taxable to NRA 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, persons who own 10 percent or more of the debtor corporation  or partnership, or persons failing to meet certain other restrictions.
Withholding agents, regardless of the type of institution, generally may  accept a withholding certificate at face value, and so may grant treaty  benefits or a portfolio interest exemption to 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. 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 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 no third party reporting to IRS.
Although no one knows the extent to which U.S. persons hide behind  domestic and foreign corporations to escape tax on U.S. source income, a  recent case shows that this can happen and substantial sums can be  invested. This example occurred before the advent of the QI program, but  illustrates how corporations can be misused. In summary:  In April 2007, a federal grand jury indicted an adult entertainment  mogul for income tax evasion. The government’s complaint alleges  that this U.S. person, a resident of Nevada, produced, marketed,  sold and distributed videotapes and DVDs through a business  incorporated in Oklahoma and operating in California. He also  formed a Nevada company to perform marketing, purchasing, and  promotional activities on behalf of the Oklahoma/California  company. Using nominee shareholders to conceal his ownership,  the U.S. person also established an international business  corporation in the Cayman Islands which was the named owner of  a bank account in Bermuda and a brokerage account in California.  The indictment alleges that the U.S. person had about $15 million  transferred from the Bermuda bank account to the California  brokerage account, which earned interest income that the U.S.  person neither reported, nor for which he paid income taxes. In  total, the U.S. government alleges that this U.S. person used a web  of U.S. and offshore companies, bank accounts, and brokerage  accounts to obscure his ownership, overstate business and  personal expenses, and underreport more than $18 million of his  true taxable income for the years 2002-2003.
Foreign corporations received at least $200 billion, or 68.4 percent, of the  $293.3 billion in total U.S. source income for tax year 2003 (see table 3).  From this income, almost $3 billion was withheld (a 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.
section_title: QI External Reviews and IRS Use of Program Data
paragraphs: 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 or NQIs. However, within their limited  scope, auditors of QIs are not responsible for following up on possible  indications of fraud or illegal acts that could have a material impact on the  matters being tested or reporting actual fraud and illegal acts detected, as  they would under U.S. Government Auditing Standards. In addition, IRS  obtains considerable data from withholding agents but does not make  effective use of these data to ensure that withholding agents perform their  duties properly.
subsections: section_title: External Reviews
paragraphs: In designing the QI program, IRS, Treasury, and intermediaries and their  representatives had the objective of achieving an appropriate balance to  obtain reasonable assurance that QIs meet their obligations without  imposing such a burden that intermediaries would not participate in the  program. 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 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.
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, on  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.
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 raised 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 underwithholding 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.
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 involved 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 raise 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.
Under current AUPs, the external auditors are 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. However, 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, which does not require auditor follow-up on indications of fraud or  illegal acts.
U.S. Government Auditing Standards are more stringent on this topic  than the ISRS standards. These 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.
As discussed previously, IRS defines the work to be done in a phase 2  review based on the specific concerns surfaced by the phase 1 report,  which is done under the international standards. However, IRS may not  have complete information for its decisions about phase 2 procedures, to  the extent that AUP reports do not include information about situations or  transactions that could indicate fraud, illegal acts, or violations of  provisions of contracts that auditors encountered during the engagement.
During the course of our work, IRS officials told us there were several  reasons for not requiring external auditors to pursue evidence of fraud or  illegal acts in the same manner as required by the U.S. Government  Auditing Standards. First, QIs are located in about 70 countries and each  country has its own definition and interpretation of fraud. Second, the  negotiations involved in establishing the QI program resulted in focused  procedures for discrete tasks and specifically excluded procedures  involving the exercise of professional judgment. Third, in some countries  identifying possible fraud can lead to significant adverse consequences for  the audited entity, such as closing the business until the possible fraud is  investigated.
Due to the above reasons, the requirements of the U.S. Government  Auditing Standards may be challenging to implement across international  jurisdictions. However, the objectives can be met through a modified  approach. IRS could draw on existing auditing standards to establish a  consistent definition of fraud and illegal acts for the purposes of the QI  program. For example, U.S. auditing standards define fraud as an  intentional act involving the use of deception to obtain an unjust or illegal  advantage. The external auditors could be required to report any  indications of fraud or illegal acts that could significantly affect the results  of the review and that could be readily identified by a qualified auditor in  the course of performing normal AUP procedures. IRS then could review  the indications of fraud or illegal acts and specify what procedures the  auditors should follow in phase 2 to investigate the possible fraud or  illegal acts. Finally, if there are situations in which the consequences of  adding a requirement on indications of fraud or illegal acts to the QI  contract could result in outcomes IRS officials judge to be inappropriate,  the provision could be excluded from that contract.
section_title: IRS Does Not Make Full Use of Available Data to Ensure Compliance with Withholding and Reporting Requirements
paragraphs: 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.
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 Forms 1042-S 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 October 2007, this had  not yet occurred. Figure 3 shows the dual processing procedures IRS uses  for receiving, checking, and validating the Form 1042-S data it receives.
IRS officials told us that LMSB would begin routinely funding transcription  and error resolution in the future.
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 underwithheld the amount of  tax their customers’ owed, or might claim a refund if they overwithheld.  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 overwithheld taxes due.
Because the Form 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 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  possibly desirable legislative changes.
IRS’s QI program could have the data it needs to review AUP information  if it were to require QIs to file electronically. Because withholding agents  filing fewer than 250 returns are by law exempted from filing  electronically, with the pooling of accounts offered under the QI regime  most QIs end up filing paper returns as they have fewer than 250 returns.  IRS officials said the statute would need to be changed to require QIs with  fewer than 250 returns to file electronically. However, the QI contract  states that the agreement may be amended by IRS if it determines that the  amendment is needed for the sound administration of the internal revenue  laws or regulations. Therefore, IRS could require QIs to file electronically  as part of the QI contractual process and avoid the problems plaguing the  processing of paper returns.
Other obstacles identified during our work also appear to be  surmountable. For example, QIs would incur additional costs to purchase  the software to prepare the forms or engage electronic transmittal  services, but the basic software can be obtained for less than $200.  Although electronic transmittals sent from certain countries’ internet  service providers may be blocked by IRS’s computer system firewall  protections, an IRS official suggested that QIs facing this challenge could  utilize the services of their third-party auditors to transmit the data  electronically. The third-party auditors often are part of large,  multinational auditing firms. Another concern is that in the short term IRS  may experience an increased electronic filing error rate as QIs file  electronically for the first time and go through a learning curve regarding  IRS’s data formatting conventions. However, similar problems occurred  when the QI program began and were addressed through taxpayer  education. For those QIs for whom filing electronically would be an undue  hardship, IRS could establish a process for granting waivers similar to the  current procedures available for QIs already required to file electronically  because they file more than 250 returns annually.  Additionally, NQIs  falling under the 250-or-more requirement and QIs not choosing not to  assume primary withholding responsibilities could still file paper returns,  but the smaller number of paper filers might then enable IRS to completely  process the paper Forms 1042-S at a reduced cost. Regardless, to the  extent QIs contractually agree to electronically file, IRS would have more  information to use to manage the program and deter noncompliance and  would incur less cost to enter any remaining paper returns into electronic  databases.
section_title: Conclusions
paragraphs: Whether tax is owed on U.S. source income flowing to foreign recipients  depends on accurately identifying those recipients. The QI program’s  features provide some assurance that financial intermediaries in other  nations accurately identify recipients of U.S. source income and thereby  correctly determine and withhold the proper amount of U.S. tax.  However, because the vast majority of U.S. source income flowing to  foreign recipients flows through U.S. withholding agents rather than QIs,  their ability to accurately identify foreign recipients also is critical to the  correct determination of U.S. tax liability. When dealing with indirect  account holders, U.S. withholding agents may rely on the self-certified  identity information (W-8 BENs) forwarded by QIs and NQIs for their  customers, and NQIs may not have rigorous processes for identifying their  account holders. Accordingly, the correct determination of U.S. tax  liability may be at risk. IRS receives information on Forms 1042-S that  could be used to determine what portion of U.S. withholding agents’  accounts are with, and U.S. source income goes to, NQIs and QIs, but it  has not done the analysis. Doing so may help IRS in assessing the  Treasury’s exposure to unaudited documentation and exposure to tax  benefits flowing to unaudited accounts. This information might help  policymakers decide whether documentation requirements should be  modified for unaudited accounts or whether other changes should be  made to improve the likelihood that tax benefits are properly determined.  In addition, if certain NQIs account for a large portion of U.S. withholding  agents’ accounts, IRS might be able to take steps to encourage them to join  the QI program, and if certain countries are the source of a large portion of  the accounts Treasury might focus efforts on improving applicable tax  treaties or information exchange agreements.
IRS Form 1042-S data on the flow of U.S. source income to foreign  recipients in unidentified jurisdictions or to unknown recipients suggest  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 as well as with unknown recipients  across all jurisdictions. In general, lacking proper identification of a  customer, including the customer’s residence, U.S. withholding agents and  QIs should withhold at the 30 percent rate. Yet withholding on the money  flowing to undisclosed jurisdictions and to unidentified recipients was 2.7  and 3.4 percent, respectively. If the 30 percent withholding rate should  have been applied to all or a significant portion of the funds flowing to  unknown jurisdictions or to unknown recipients, several billion dollars  more in taxes should have been withheld. Although IRS officials suggested  some scenarios exist where a specific jurisdiction might not be identified  in reporting to IRS or where a QI might purposely use the term unknown  recipient when reporting to IRS, they had no data to show that the funds  flowing to undisclosed jurisdictions or unknown recipients were properly  taxed.
Although account-opening and withholding procedures for QIs may give  IRS greater assurance that treaty benefits are properly provided, the  effectiveness of those procedures is not assessed until the external  auditors review a sample of accounts as required by the AUPs. However,  the QI contract does not require the auditors to report indications of fraud  or illegal acts that could materially affect the results of the AUP review.  Under U.S. Government Auditing Standards, additional follow-up work is  required in such cases. In the QI environment, this objective could be met  through a requirement for auditors to report to the QI program office that  they found indications of fraud or illegal acts, which the program office  would consider in determining whether and to what extent phase 2  procedures should be conducted.
Furthermore, to better administer all withholding and reporting activities  (by QIs and U.S. withholding agents) IRS needs reliable 1042-S data.  However, Form 1042-S data have not been completely processed every  year. IRS officials point to a lack of available funding. In those years, the  identity, jurisdiction, and income and withholding data generated by  withholding and reporting agents are inadequate for use by IRS, Treasury,  or Congress. These data would be available if IRS required QIs to file  electronically as part of their contractual agreement and completed its  processing. Although QIs might incur some additional expense, IRS would  have readier access to more complete data as well as saving the resources  currently devoted to perfecting and entering data reported on paper forms.  Because such a requirement could be part of contracts with QIs, if in  certain cases electronic filing is not feasible, the contract could exclude  this provision.
section_title: Recommendations
paragraphs: We recommend that the Commissioner of Internal Revenue Service do the  following:    Measure U.S. withholding agents’ reliance on self-certified  documentation and use that data in IRS compliance efforts.
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.
Work to enhance AUPs 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.
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.
section_title: Agency Comments and Our Evaluation
paragraphs: The Acting Commissioner of Internal Revenue provided comments on a  draft of this report in a December 7, 2007, letter, which is reprinted in  appendix II. The Acting Commissioner generally agreed with our  recommendations to improve the QI program, but in several cases her  detailed comments are not fully consistent with our recommendations.
IRS agreed it would be beneficial to investigate both the use of U.S.  withholding agents’ reliance on self-certified identity documents and why  withholding agents reported billions of dollars in tax benefits flowing to  unknown jurisdictions and unidentified recipients. However, for the first  recommendation, IRS’s detailed comments focused on examining the  accuracy of the self-certified documents, rather than systematically  measuring U.S. withholding agents’ exposure to unverified documentation  to determine how large or small a challenge this documentation is to the  integrity of the U.S. withholding system. Although better understanding  the accuracy of self-certified documents is laudable, we believe a  systematic measurement of agents’ reliance on such documents, which  can be made with information IRS already receives, would both assist IRS  in targeting enforcement efforts and inform policymakers’ judgments  about the current reporting regime.  For the second recommendation, the  Acting Commissioner agreed to determine why withholding agents  reported billions of dollars of tax benefits to unknown jurisdictions and  unidentified recipients, and proposed to develop a methodology to  determine the extent of this underwithholding.
Regarding the third recommendation covering indications of fraud or  illegal acts, although IRS agrees that QIs should provide information  indicating fraud or illegal acts, it also states concern about defining fraud  and illegal acts and requiring auditors to report such information when  dealing with at least 70 countries, 60 of which are non-English-speaking. In  addition, IRS pointed to certain current QI requirements that provide IRS  with some information on fraud and illegal acts. However, as discussed in  our draft report, we believe IRS could draw on existing auditing standards  to establish a consistent definition of fraud and illegal acts for the  purposes of the QI program. In addition, the provisions to which IRS refers  rely in part on self-reporting by the QI and in part focus on “know your  customer” rule violations alone. However, self-reporting by the QI is not  equivalent to judgments by the auditors about whether fraud or illegal acts  have occurred. And the universe of potential fraud or illegal acts extends  beyond potential violations of “know your customer” rules. Therefore we  reaffirm our recommendation.
Finally, IRS agreed that there are benefits to electronic filing of tax Forms  1042 and 1042-S, but said such a requirement would be a burden for QIs  that file only a few (3 or fewer) forms. IRS said it has implemented a  procedure to include an application to electronically file for all QIs  applying for or renewing participation in the program. If IRS were to  require all QIs to electronically file, we believe any burdens filers of few  forms would face could be addressed by offering them a waiver  opportunity similar to waivers that are available to all institutions that are  currently required to file electronically (those that file more than 250  returns). Requiring electronic filing whenever possible would reduce IRS’s  costs and improve the timeliness and accuracy of data for program  oversight. We have added language regarding the opportunity for seeking a  waiver to the report based on IRS’s comment.
As agreed with your offices, unless you publicly announce its contents  earlier, we plan no further distribution of this report until 30 days from the  issue date. At that time, we will send copies of this report to appropriate  congressional committees and the Acting Commissioner of Internal  Revenue. We also will make copies available to others upon request. In  addition, the report will be available at no charge on the GAO Web site at  http://www.gao.gov.
If you or your staff have any questions concerning this report, please  contact me at (202) 512-9110 or brostekm@gao.gov. Contact points for our  Offices of Congressional Relations and Public Affairs may be found on the  last page of this report. GAO staff who made major contributions to this  report are listed in appendix III.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: The objectives of this report are to (1) describe features of the Qualified  Intermediary (QI) program intended to improve withholding and reporting,  (2) assess whether weaknesses exist in the U.S. withholding system that  complicate identifying beneficial owners of U.S. source income, and   (3) determine whether weaknesses exist in QI external reviews and the  Internal Revenue Service’s (IRS) use of program data.
To address our objectives, we reviewed various IRS documents and  interviewed IRS officials in the QI program office and U.S. withholding  program audit staff, Large and Mid-sized Business (LMSB) International,  and IRS Counsel, as well as Department of the Treasury (Treasury)  officials in the Office of Tax Policy and FinCEN. Furthermore, we spoke  with private practitioners involved in the development and  implementation of the QI program. We reviewed various studies and  reports on foreign investment and banking practices. We reviewed the  auditing requirements contained in the QI agreement and other standards,  such as the U.S. Government Auditing Standards and the international  standards on agreed-upon procedures (AUP) and visited IRS’s  Philadelphia Campus, which was responsible during our review for  processing information returns submitted by some QIs.
Withholding data used in this report were reported by withholding agents  and edited by IRS. During the 2002-2003 period, paper withholding  information returns were processed at IRS’s Philadelphia Campus and  electronic returns and information returns were processed in Martinsburg,  West Virginia. IRS’s Statistics of Income (SOI) staff collected this  information, made several adjustments and additions to the data described  below, and performed several quality control checks to the data. As a  result, these were the most recent data available.
Because payments may have flowed through tiers of intermediaries before  reaching the owner of the income, SOI stratified payment information by  the type of withholding agent. It then became possible to subtract  payments made from one intermediary to another, eliminating possible  double or multiple counting of one payment. Furthermore, withholding  instructions issued under the new 2001 regulations required withholding  agents to report U.S. source income and withholding information to IRS in  whole dollar figures. However, not all agents followed these instructions,  instead reporting income and tax figures in dollars and cents. This resulted  in an error factor of 100 for some reported payments. In order to correct  these errors, SOI compared income and tax totals for certain withholding  agents with information from prior years for reasonableness, identifying 25  agents whose information required adjustment by a factor of 100. The IRS  database was modified accordingly.
We determined that these data were sufficiently reliable for the purposes  of describing the QI 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 analyzed IRS data on U.S. source income that flowed overseas for tax  years 2002 and 2003. The data do not include an unknown amount of  activity that was unreported. In order to calculate tax benefits by type of  recipient, by destination of account, and by income type, we multiplied the  gross U.S. source income sent offshore by 30 percent, required by IRC  Section 1441, and then subtracted the income actually withheld, and  presumed to be sent to the Treasury. To measure the withholding rates by  type of recipient, by destination of account, and by income type, we  divided the actual monies withheld, and presumed to be paid to the  Treasury, by the gross U.S. source income sent offshore.
IRS AUP guidance requires third-party reviewers to sample QI accounts.  IRS provides guidance on the sample size using a standard statistical  formula and a decision rule. We reviewed the sampling methodology used  in the AUPs and found that it was adequate to identify problems with the  accounts.
section_title: Appendix II: Comments from the Internal Revenue Service
section_title: Appendix III: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Acknowledgments
paragraphs: In addition to the contact person named above, Jonda Van Pelt, Assistant  Director; Susan Baker; Amy Friedheim; Evan Gilman; Shirley Jones;  Donna Miller; John Saylor; Joan Vogel; and Elwood White made key  contributions to this report.