Tax Compliance: Challenges in Ensuring Offshore Tax Compliance
Published: 2007-05-03T00:00:00

Fast Facts:

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

section_title: Letter
paragraphs: 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 owners 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. The  portion of this statement addressing the QI program is based on the  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  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. 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, 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.
subsections: section_title: Additional Time Needed to Complete Offshore Tax Evasion Examinations
paragraphs: 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.
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. 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.
subsections: section_title: Offshore Tax Evasion Takes Longer to Find but Offshore Examinations Yield Larger Assessments Than Other Types of Cases
paragraphs: 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,  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,  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.
section_title: IRS Does Not Pursue Some Apparent Offshore Tax Evasion Because of the 3- Year Statute of Limitations
paragraphs: 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. 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.
section_title: QI Program Provides Some Assurance That Tax Is Properly Withheld and Reported but Limitations Exist
paragraphs: 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  Standards 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.
subsections: section_title: Background
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  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  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  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 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. 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.
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.
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  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.
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).
section_title: The QI Program Provides Some Additional 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. 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  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. 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 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 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. 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: QIs Account for a Small Portion of U.S. Source Income and Individuals May Inappropriately Receive Treaty Benefits as Owners of Corporations
paragraphs: 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.
subsections: section_title: The Majority of U.S. Source Income Flows Outside the QI System
paragraphs: 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. 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 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  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. 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.” 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.
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  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.
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  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.
section_title: Foreign Corporations May Provide U.S. Taxpayers a Mechanism for Evading Taxation
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 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.
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  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 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.
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.
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. 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. In addition,  IRS obtains considerable data from withholding agents but does not make  effective use of the 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 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.
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.
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.
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. Our U.S. Government Auditing Standards, known  as the Yellow Book, are more stringent on this topic than the ISRS  standards.
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.
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 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  yet occurred. Figure 3 shows the dual processing procedures IRS uses for  receiving, checking and validating the Form 1042-S data it receives.
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  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.
section_title: Contact and Acknowledgments
paragraphs: 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.
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