Tax Compliance
Challenges in Ensuring Offshore Tax Compliance
Gao ID: GAO-07-823T May 3, 2007
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.
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.
GAO-07-823T, Tax Compliance: Challenges in Ensuring Offshore Tax Compliance
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Testimony:
Before the Committee on Finance, U.S. Senate:
United States Government Accountability Office:
GAO:
For Release on Delivery Expected at 10:00 a.m. EDT:
Thursday, May 3, 2007:
Tax Compliance:
Challenges in Ensuring Offshore Tax Compliance:
Statement of Michael Brostek:
Director:
Strategic Issues:
GAO-07-823T:
GAO Highlights:
Highlights of GAO-07-823T, a testimony before the Committee on Finance,
U.S. Senate
Why GAO Did This Study:
Offshore tax evasion is difficult for the Internal Revenue Service
(IRS) to address. IRS examines tax returns to deal with offshore
evasion that has occurred. IRS‘s Qualified Intermediary (QI) program
seeks to foster improved tax withholding and reporting.
GAO was asked to testify on two topics. First, GAO was asked to provide
information on (1) the length of, and assessments from, IRS‘s
examination of tax returns with offshore activity and (2) the impact of
the 3-year statute of limitations on offshore cases. Second, for the QI
program, GAO was asked to address (1) program features intended to
improve withholding and reporting, and (2) whether weaknesses exist in
the U.S. withholding system for U.S. source income and QI external
reviews and IRS‘s use of program data. GAO relied on prior work for the
first topic. For the QI program, GAO used the latest data that were
available and corroborated by IRS.
What GAO Found:
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.
What GAO Recommends:
A report GAO released today suggests that Congress make an exception to
the 3-year civil statute of limitations period for taxpayers involved
in offshore financial activity. GAO will consider recommendations for
the QI program in a forthcoming report.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-07-823T].
To view the full product, including the scope and methodology, click on
the link above. For more information, contact Michael Brostek on (202)
512-9110 or brostekm@gao.gov.
[End of section]
Mr. Chairman and Members of the Committee:
I am pleased to be here today to discuss two topics related to offshore
tax evasion: the impact of the 3-year civil statute of limitations on
Internal Revenue Service (IRS) offshore enforcement efforts, and the
Qualified Intermediary (QI) program. IRS's success in identifying and
pursuing all tax evasion is of critical importance. When some taxpayers
do not pay their fair share of taxes, honest taxpayers are left with
higher tax bills and may find reason to doubt their own willingness to
stay compliant. Offshore tax evasion is especially difficult to
identify because of the layers of obfuscation that can come with doing
business in overseas locations beyond the effective reach of the U.S.
government. Doing business outside of the country is, of course,
perfectly legal, but hiding income or assets in offshore locations in
order to evade taxes is not. Generally, to address offshore tax
evasion, IRS examines tax returns with offshore activity to deal with
noncompliance once it has occurred. IRS has also initiated the QI
program to improve upon the prior system of withholding and reporting
of U.S. source income that flows offshore. QIs are foreign financial
institutions, such as banks, trusts, and partnerships, that contract
with IRS to withhold and report U.S. source income paid offshore to
individuals who are not U.S. persons and do not live in the United
States (nonresident aliens).
My remarks regarding IRS's offshore compliance activity will focus on
(1) IRS's examination of tax returns with offshore activity and how
those examinations differ from nonoffshore examinations in their length
and in the assessments they ultimately yield and (2) the implications
of the 3-year statute of limitations on offshore examinations.
Regarding the QI program, I will address (1) features of the QI program
intended to improve withholding and reporting, (2) whether weaknesses
exist in the U.S. withholding system that complicate identifying
beneficial owners[Footnote 1] 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.[Footnote 2] 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.[Footnote 3] In addition, under
current U.S. tax law and regulations, corporations are taxpayers and
the owners of their assets and income, regardless of the residency of
the underlying corporate owners. By establishing an offshore
corporation, a U.S. person(s) may escape identification and required
reporting. In 2003, at least 68 percent of U.S. source income was
received by foreign corporations. Since the identity of corporate
owners is not reported to IRS, U.S. persons may be able to evade taxes.
* QI external reviews give IRS greater assurance that QIs perform their
responsibilities properly, but these reviews do not require auditors to
follow up on indications of fraud or illegal acts; and IRS does not
make effective use of withholding data. Under U.S. Government Auditing
Standards,[Footnote 4] auditors performing external reviews like those
done for the QIs must follow up on indications of fraud or illegal acts
that could affect the matters they are reviewing. Further, data that
IRS needs to effectively administer the QI program and ensure that
withholding agents perform their duties properly are not readily
available and in some instances no longer exist.
Additional Time Needed to Complete Offshore Tax Evasion Examinations:
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.[Footnote 5] IRS examinations, both
offshore and nonoffshore, are generally of one of three types--
correspondence, office, or field. The most complex examinations are
done through revenue agent field visits to taxpayer locations, that is,
field examinations. Most offshore examinations from 2002 through 2005
were of this type. Generally, unless a taxpayer's tax return involves
fraud or a substantial understatement of income, or unless the taxpayer
agrees to an extension, the statute of limitations for IRS to assess
additional taxes is 3 years from when IRS receives the taxpayer's tax
return. Taking an examination past the statute of limitations date may
result in disciplinary action against the responsible revenue agent and
his or her manager.
Offshore Tax Evasion Takes Longer to Find but Offshore Examinations
Yield Larger Assessments Than Other Types of Cases:
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,[Footnote 6] with an average of 46 hours spent
directly on offshore examinations and 12 hours on nonoffshore
examinations. IRS officials told us that the longer time needed to
complete offshore examinations is because of the inherent difficulty in
identifying and obtaining information from foreign sources, 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.
IRS Does Not Pursue Some Apparent Offshore Tax Evasion Because of the 3-
Year Statute of Limitations:
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.[Footnote 7] Since many offshore schemes exhibited
enforcement problems similar to those of unreported listed
transactions, it follows that a similar statute extension could be
granted for certain offshore transactions.
IRS officials and individuals from the tax practitioner and policy
communities told us of both advantages and disadvantages of an
exception to the statute for taxpayers involved in offshore financial
activity. For example, an advantage was increased flexibility for IRS
to direct enforcement resources to egregious cases. A disadvantage was
lack of closure for taxpayers. In our report discussed earlier, we
suggest that Congress make an exception to the 3-year civil statute of
limitations assessment period for cases involving offshore activity. In
e-mail comments on a draft of our report, IRS expressed agreement that
a longer statute makes sense and should enhance compliance.
QI Program Provides Some Assurance That Tax Is Properly Withheld and
Reported but Limitations Exist:
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[Footnote 8] 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.
Background:
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[Footnote 9] 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.[Footnote 10] Payors
of this income generally are to withhold the 30 percent tax if the
recipients do not reside in a nation that has negotiated a treaty with
a lower tax rate or cannot show they are in fact residents in the
treaty country. The payors also have to report to IRS certain
information covering the amount of income paid and to whom. About $5
billion of this capital income was withheld for tax year 2003, implying
that about $83 billion of this income was exempt from tax or was taxed
at lower tax treaty rates (known as treaty benefits).
IRS established the QI program in 2000. Under the QI program, foreign
financial institutions sign a contract with IRS to withhold and report
U.S. source income paid offshore. The QI program, and the larger
withholding regime, is rooted in the 1980s when Congress expressed
concerns about tax evasion by U.S. persons using foreign accounts,
treaty benefits claimed by those who were ineligible, and the effect of
tax havens and secrecy jurisdictions on the U.S. tax system. With these
considerations in mind, and a general view that the old regulations
were simply not being followed, IRS began a long, consultative process
of developing new rules to balance a number of objectives, including a
system to routinely report income and withhold the proper amounts,
dispense treaty benefits, meet the U.S. obligation to exchange
information with foreign tax authorities and encourage foreign
investment in the United States.
Chains of payments are routine in modern global finance, and the QI
system of reporting is designed to reflect this normal course of
business. 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.
Figure 1: Tiered Financial Flows:
[See PDF for image]
Source: GAO analysis of IRS data.
[End of figure]
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.[Footnote 11]
The United States maintains a network of bilateral treaties designed to
set out clear tax rules applying to trade and investment between the
United States and each nation in order to promote the greatest economic
benefit to the United States and its taxpayers. Each treaty is intended
to eliminate double taxation of taxpayers conducting economic activity
in the United States and another nation by allocating taxing rights
between the two countries, establishing a mechanism for dealing with
disputes between the two taxing authorities, providing exchange of
information between the two taxing authorities, and reducing
withholding taxes. Reductions of withholding taxes are negotiated with
each treaty partner individually and the benefits are reciprocal--so
U.S. residents may benefit from a reduced tax rate for investing
abroad, just as foreign investors may be for investing in the United
States. As of January 2007, 54 tax treaties were signed, including for
all members of the Organization of Economic Cooperation and Development
(OECD).
The QI Program Provides Some Additional Assurance That Tax Is Properly
Withheld and Reported:
Compared to U.S withholding agents, IRS has additional assurance that
QIs are properly withholding the correct amount of tax on U.S. source
income sent offshore. QIs accept several responsibilities that help
ensure that their customers qualify for treaty benefits.
First, because QIs are in overseas locations, they are more likely to
have personal contact with nonresident aliens or other persons who may
claim exemptions or treaty benefits than would U.S. withholding agents.
This direct relationship may increase the likelihood that the QI will
collect adequate ownership information and be able to accurately judge
whether its customers are who they claim to be.
Second, QIs accept enhanced responsibilities for providing assurance
that customers are in fact eligible for treaty benefits and exemptions.
All 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.[Footnote 12] Because QIs agree to follow specified account opening
procedures in all cases, regardless of whether a QI performs
withholding itself or it passes the responsibility to another
withholding agent, there is enhanced assurance that the residency and
nationality of the account holder has been accurately determined and
thus correct withholding decisions will be made.
Third, and importantly, QIs agree to contract with independent third
parties to review the information contained in a sample of accounts,
determine whether the appropriate amount of tax was withheld, and
submit a report of the information to IRS. These reviews are discussed
in greater detail later in this statement. In contrast, U.S.
withholding agents generally have not yet been subject to external
reviews for this purpose. IRS officials believe that those U.S.
withholding agents that participated in IRS's 2004 Voluntary Compliance
Program[Footnote 13] 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.[Footnote 14] Although pooling
restricts the information available to IRS on individuals receiving
treaty benefits, to the extent that QIs do a better job of ensuring
treaty benefits are properly applied up front, IRS has less need for
after-the-fact enforcement. The accuracy of the pooled reporting by QIs
is also subject to the external reviews of QIs' contractual
performance.
QIs Account for a Small Portion of U.S. Source Income and Individuals
May Inappropriately Receive Treaty Benefits as Owners of Corporations:
Although the QI program provides IRS some assurance that treaty
benefits are being properly applied, a low percentage of U.S. source
income flows through QIs and U.S. taxpayers may inappropriately receive
treaty benefits and exemptions as owners of foreign corporations.
The Majority of U.S. Source Income Flows Outside the QI System:
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.[Footnote 15] Thus, the overwhelming portion of this income flowed
through channels that provide somewhat less assurance of proper
withholding and reporting than exists under the QI program. More than
90 percent of the U.S. source income QIs paid their customers for tax
year 2003, or nearly $34 billion, flowed through QIs that each handled
$4 million or more of U.S. source income. These QIs and the income they
handled were subject to external review (as discussed later in this
statement, smaller QIs can obtain a waiver from external reviews).
Overall, QIs withheld taxes from U.S. source income at more than twice
the rate of U.S. withholding agents, 3.7 percent versus 1.5 percent.
Table 1: Income and Withholding Flows by Type of Intermediary for Tax
Year 2003:
Dollars in billions.
Amount of U.S. source income reported by witholding agent: $4 million
or more;
U.S. withholding agents: Number of returns: 5,503;
U.S. withholding agents: Total gross income: $223.3;
U.S. withholding agents: Total tax withheld: $2.4;
U.S. withholding agents: Withholding rate (percentage): 1.1;
U.S. withholding agents: Percentage total income: 76.1;
QIs: Number of returns: 716;
QIs: Total gross income: $33.8;
QIs: Total tax withheld: $1.1;
QIs: Withholding rate (percentage): 3.2;
QIs: Percentage total income: 11.5.
Amount of U.S. source income reported by witholding agent: Less than $4
million and equal or greater than $1 million;
U.S. withholding agents: Number of returns: 8,553;
U.S. withholding agents: Total gross income: 16.9;
U.S. withholding agents: Total tax withheld: 0.5;
U.S. withholding agents: Withholding rate (percentage): 3.2;
U.S. withholding agents: Percentage total income: 5.8;
QIs: Number of returns: 805;
QIs: Total gross income: 1.7;
QIs: Total tax withheld: 0.1;
QIs: Withholding rate (percentage): 8.6;
QIs: Percentage total income: 0.6.
Amount of U.S. source income reported by witholding agent: Less than $1
million;
U.S. withholding agents: Number of returns: 1,977,001;
U.S. withholding agents: Total gross income: 16.5;
U.S. withholding agents: Total tax withheld: 1.0;
U.S. withholding agents: Withholding rate (percentage): 5.9;
U.S. withholding agents: Percentage total income: 5.6;
QIs: Number of returns: 40,648;
QIs: Total gross income: 1.2;
QIs: Total tax withheld: 0.1;
QIs: Withholding rate (percentage): 10.6;
QIs: Percentage total income: 0.4.
Amount of U.S. source income reported by witholding agent: Subtotals;
U.S. withholding agents: Number of returns: 1,991,057;
U.S. withholding agents: Total gross income: $256.7;
U.S. withholding agents: Total tax withheld: $3.9;
U.S. withholding agents: Withholding rate (percentage): 1.5;
U.S. withholding agents: Percentage total income: 87.5;
QIs: Number of returns: 42,169;
QIs: Total gross income: $36.6;
QIs: Total tax withheld: $1.4;
QIs: Withholding rate (percentage): 3.7;
QIs: Percentage total income: 12.5.
Source: GAO analysis of IRS data.
Note: Numbers may not total because of rounding.
[End of table]
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.[Footnote 16] To countervail harmful tax
practices, the OECD encourages countries to develop and practice
administrative transparency and effective exchange of tax information
in their local tax administrations. A number of countries have made
formal commitments to work toward these principles. However, because of
their continued unwillingness to agree to these two principles, five
countries are on the OECD's list of "uncooperative tax
havens."[Footnote 17] Finally, 165 other jurisdictions receive U.S.
source income but do not fall into any of these categories.
Although the vast majority of U.S. source income flows outside the QI
system, the preponderance flows through countries with which the United
States has tax treaties, as shown in figure 2.
Figure 2: U.S. Source Income Flowing Offshore by Type of Jurisdiction,
Tax Year 2003:
[See PDF for image]
Sources: GAO analysis of IRS data, and PhotoDisc (image0.
[End of figure]
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.
Table 2: U.S. Withholding Agents' and QIs' Withholding Rates by
Jurisdiction, Tax Year 2003:
Dollars in billions.
Treaty countries;
U.S. withholding agents: Gross income: $212.7;
U.S. withholding agents: Withholding: $2.9;
U.S. withholding agents: Withholding rate (percentage): 1.3;
QIs: Gross income: $22.0;
QIs: Withholding: $0.9;
QIs: Withholding rate (percentage): 4.0.
TIEA countries;
U.S. withholding agents: Gross income: 24.9;
U.S. withholding agents: Withholding: 0.7;
U.S. withholding agents: Withholding rate (percentage): 2.7;
QIs: Gross income: 3.0;
QIs: Withholding: 0.1;
QIs: Withholding rate (percentage): 2.3.
OECD committed jurisdictions;
U.S. withholding agents: Gross income: 1.2;
U.S. withholding agents: Withholding: 0.1;
U.S. withholding agents: Withholding rate (percentage): 5.4;
QIs: Gross income: [A];
QIs: Withholding: [A];
QIs: Withholding rate (percentage): 2.6.
OECD uncooperative tax havens;
U.S. withholding agents: Gross income: 0.2;
U.S. withholding agents: Withholding: [A];
U.S. withholding agents: Withholding rate (percentage): 9.3;
QIs: Gross income: [A];
QIs: Withholding: [A];
QIs: Withholding rate (percentage): 6.9.
Other countries;
U.S. withholding agents: Gross income: 9.9;
U.S. withholding agents: Withholding: 0.2;
U.S. withholding agents: Withholding rate (percentage): 1.6;
QIs: Gross income: 0.3;
QIs: Withholding: [A];
QIs: Withholding rate (percentage): 1.2.
Undisclosed;
U.S. withholding agents: Gross income: 7.8;
U.S. withholding agents: Withholding: 0.1;
U.S. withholding agents: Withholding rate (percentage): 1.4;
QIs: Gross income: 11.3;
QIs: Withholding: 0.4;
QIs: Withholding rate (percentage): 3.5.
Not Listed;
U.S. withholding agents: Gross income: [A];
U.S. withholding agents: Withholding: [A];
U.S. withholding agents: Withholding rate (percentage): 24.2;
QIs: Gross income: 0.1;
QIs: Withholding: [A];
QIs: Withholding rate (percentage): 2.1.
Unidentified;
U.S. withholding agents: Gross income: 7.5;
U.S. withholding agents: Withholding: [A];
U.S. withholding agents: Withholding rate (percentage): 1.1;
QIs: Gross income: 11.1;
QIs: Withholding: 0.4;
QIs: Withholding rate (percentage): 3.5.
Unknown;
U.S. withholding agents: Gross income: 0.3;
U.S. withholding agents: Withholding: [A];
U.S. withholding agents: Withholding rate (percentage): 8.6;
QIs: Gross income: 0.1;
QIs: Withholding: [A];
QIs: Withholding rate (percentage): 12.1.
All countries;
U.S. withholding agents: Gross income: $256.7;
U.S. withholding agents: Withholding: $3.9;
U.S. withholding agents: Withholding rate (percentage): 1.5;
QIs: Gross income: $36.6;
QIs: Withholding: $1.4;
QIs: Withholding rate (percentage): 3.7.
Source: GAO analysis of IRS data.
Notes:
Treaty countries: Australia, Austria, Bangladesh, Barbados, Belgium,
Canada, China, Cyprus, Czech Republic, Denmark, Egypt, Estonia,
Finland, France, Germany, Greece, Hungary, Iceland, India, Indonesia,
Ireland, Israel, Italy, Jamaica, Japan, Kazakhstan, Korea, Latvia,
Lithuania, Luxembourg, Mexico, Morocco, Netherlands, New Zealand,
Norway, Pakistan, Philippines, Poland, Portugal, Romania, Russia,
Slovakia, Slovenia, South Africa, Spain, Sweden, Switzerland, Thailand,
Trinidad & Tobago, Tunisia, Turkey, Ukraine, United Kingdom, and
Venezuela.
TIEA countries: Antigua and Barbuda, Aruba, Bahamas, Bermuda, British
Virgin Islands, Cayman Islands, Dominica, Grenada, Guernsey, Isle of
Man, Jersey, St. Lucia, U.S. Virgin Islands.
OECD committed jurisdictions: Anguilla, Bahrain, Belize, Cook Islands,
Gibraltar, Malta, Mauritius, Montserrat, Nauru, Netherlands Antilles,
Niue, Panama, American Samoa, San Marino, Seychelles, St. Kitts &
Nevis, St. Vincent & Grenadines, Turks and Caicos, and Vanuatu.
OECD uncooperative tax havens: Andorra, Liberia, Liechtenstein,
Marshall Islands, and Monaco.
Due to rounding, the amount of gross income shown in this table differs
slightly from the amount of gross income shown in fig. 2.
[A] Rounded down to less than $0.1 billion.
[End of table]
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.
Foreign Corporations May Provide U.S. Taxpayers a Mechanism for Evading
Taxation:
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.[Footnote 18] Consequently, it may be possible for U.S.
persons to establish a corporation offshore, submit a withholding
certificate to the withholding agent(s) and receive a reduced rate of
withholding. In these situations where the foreign corporation is owned
by a U.S. person or persons, it is incumbent upon the owners to report
their corporate ownership and any income appropriately taxable to them
on their own U.S. tax returns. There is no independent third-party
reporting of that income to IRS. Generally, compliance in reporting
income to IRS is poor when there is not third party reporting to IRS.
Foreign corporations received at least $200 billion, or 68 percent, of
the $293 billion in total U.S. source income for tax year 2003 (see
table 3). From this income, almost $3 billion was withheld (an
effective withholding rate of 1.4 percent) representing more than $57
billion of treaty benefits and exemptions. About half of all foreign
corporate investment in the United States that year was in debt
instruments which are paid U.S. tax free to qualified investors. The
preponderance of tax withheld from corporations was derived from
dividends.
Table 3: Foreign Corporate U.S. Source Income, Withholding, and
Benefits, Tax Year 2003:
Dollars in billions.
Type of income: Interest[A];
Gross income: $96.3;
Tax withheld: $0.2;
Withholding rate (percentage): 0.22;
Benefits: $28.7.
Type of income: Dividends[B];
Gross income: 42.4;
Tax withheld: 1.9;
Withholding rate (percentage): 4.56;
Benefits: 10.8.
Type of income: Miscellaneous[C];
Gross income: 61.8;
Tax withheld: 0.7;
Withholding rate (percentage): 1.14;
Benefits: 17.8.
Type of income: Total income;
Gross income: $200.5;
Tax withheld: $2.8;
Withholding rate (percentage): 1.42;
Benefits: $57.3.
Source: GAO analysis of IRS data.
[A] Interest includes interest paid by U.S. obligors general, interest
paid on real property mortgages, interest paid to controlling foreign
corporations, interest paid by foreign corporations, interest on tax-
free covenant bonds, deposit interest, and Original Issue Discount.
[B] Dividends include those paid by U.S. corporations, dividends
qualifying for reduced withholding under a tax treaty, and dividends
paid by foreign corporations.
[C] Miscellaneous income includes royalties, pensions, compensation for
personal services, REIT distributions, notional principal contracts and
other income.
[End of table]
To test the level of due diligence exercised by withholding agents, a
GAO investigator using an assumed identity created a shell corporation
and then sought to establish an overseas bank account for that
corporation. Our investigator approached a European QI to open an
account. The QI required our investigator to provide documentation
sufficient to establish his identity as an officer of the corporation
and documentation showing the source of the funds to be invested.
Further, a representative from the QI contacted the investigator and
questioned him in detail to ensure compliance with KYC standards and
requested to meet with him in person. The investigator discontinued the
effort and did not open an account with the QI. Our investigator also
contacted an NQI in the Caribbean to open an account. The NQI requested
that the investigator provide documentation of his identity and a
letter explaining the purpose of the corporation. In addition, the NQI
contacted a U.S. bank where the investigator had an account and
requested a letter of reference. The NQI opened an account for our
investigator. We did not then make an investment to earn U.S. source
income in part because of the relatively large minimum investments
required by QI and NQI firms we contacted. Thus, we were able to open a
solely owned foreign corporation that was not actually an active
business but do not know whether a QI or NQI intermediary would then
have questioned a withholding certificate had we made an investment and
claimed treaty benefits.
QI External Reviews and IRS Use of Program Data:
Because QIs agree to have external auditors perform oversight of their
compliance with required procedures, IRS has greater assurance that
taxes are properly withheld and treaty benefits are properly dispensed
by QIs than by U.S. withholding agents. However, within their limited
scope, QIs' auditors are not responsible for following up on possible
indications of fraud or illegal acts that could have an impact on the
matters being tested as they would under U.S. Government Auditing
Standards.[Footnote 19] 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.
External Reviews:
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.
Table 4: Comparison of Key Features of Audits and Agreed-Upon
Procedures:
Audit: Auditor gathers sufficient, appropriate evidence to provide
assurance, draw conclusions or express an opinion on the subject
matter;
AUPs[A]: Auditor performs specific procedures and provides the
requestor with a report of factual findings based on the procedures
performed.
Audit: Auditor determines nature and extent of procedures necessary to
provide assurance;
AUPs[A]: Party or parties requesting the report determine and agree to
the procedures performed by the auditor.
Audit: Report distribution usually not limited;
AUPs[A]: Report distribution limited to party or parties requesting the
report.
Source: GAO analysis of audit and AUP characteristics as defined by
U.S. Government Auditing Standards and International Auditing and
Assurance Standards Board standards.
[A] These are attributes of AUPs performed under international
accounting standards.
[End of table]
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.[Footnote 20] 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.
IRS Does Not Make Full Use of Available Data to Ensure Compliance with
Withholding and Reporting Requirements:
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.
Figure 3: IRS Processing of Paper and Electronic 1042-S Forms:
[See PDF for image]
Source: GAO analysis of IRS information.
Notes: The forms are Form 1042-S, Foreign Person's U.S. Source Income
Subject to Withholding; Form 1042-T, Annual Summary and Transmittal of
Forms 1042-S; and Form 4804, Transmittal of Information Returns
Reported Magnetically.
CTW is Chapter Three Withholding; IRMF is Information Returns Master
File.
[End of figure]
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.
Contact and Acknowledgments:
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.
FOOTNOTES
[1] The beneficial owner is the true owner of the income, corporation,
partnership, trust or asset, who receives or has the right to receive
the proceeds or advantages of ownership. For the rest of this
statement, we will use the term "owner."
[2] GAO, Tax Administration: Additional Time Needed to Complete
Offshore Tax Evasion Examinations, GAO-07-237 (Washington, D.C.: Mar.
30, 2007).
[3] A withholding agent is responsible for withholding tax on payments
of U.S. source income and depositing such tax into the U.S. Treasury.
[4] GAO, Government Auditing Standards, January 2007 Revision, GAO-07-
162G (Washington, D.C.: January 2007).
[5] IRS officials noted that although many enforcement problems occur
in certain foreign jurisdictions that are characterized by strict
financial privacy regimes, the term "offshore" broadly includes the
activities of U.S. taxpayers in all foreign transactions.
[6] Direct examination time does not include time spent waiting for a
taxpayer's response to a request for information or other such time
spent between specific tasks related to the examination.
[7] Listed transactions are the same as, or substantially similar to, a
transaction specifically identified by IRS as a tax avoidance
transaction. For a transaction to be a listed transaction, IRS must
issue a notice, regulation, or other form of published guidance
informing taxpayers of the details of the transaction. IRS listed 31
such transactions as of January 2007.
[8] GAO-07-162G.
[9] Interest includes interest paid by U.S. obligors general, interest
paid on real property mortgages, interest paid to controlling foreign
corporations, interest paid by foreign corporations, interest on tax-
free covenant bonds, deposit interest, and Original Issue Discount
(OID) which is the profit earned by purchasing a bond at a price less
than its face value.
[10] Dividends include those paid by U.S. corporations, dividends
qualifying for reduced withholding under a tax treaty, and dividends
paid by foreign corporations.
[11] An NQI is any intermediary that is not a U.S. person and not a
qualified intermediary who is a party to a withholding agreement with
the IRS. It can also refer to a qualified intermediary that is not
acting in its capacity as a qualified intermediary with respect to a
payment. See Treasury Regulations 1.1441-1(c)(14).
[12] The LOB provisions seek to prevent nonresidents of the two treaty
countries from taking advantage of the preferential tax treatment in
the favorable tax treaty by forming a conduit entity in the treaty
country but then funneling the profits back (to the United States or
another non-treaty country). Accordingly, the LOB provisions contained
in many tax treaties between the United States and other countries
disallow the availability of treaty benefits to recipients that do not
maintain significant contacts with the treaty jurisdiction in question.
[13] The Voluntary Compliance Program, announced in Rev. Proc. 2004-59,
was a program in which IRS invited U.S. withholding agents to disclose
and resolve issues arising from the implementation of the final
withholding regulations.
[14] Income owned by U.S. taxpayers held offshore may not be pooled and
must be reported to IRS individually, either by the QI or the last U.S.
payer in a chain of payments.
[15] Tax year 2003 is the most recent year for which reliable data is
available.
[16] Since we performed our analysis, according to the Department of
the Treasury, the number of countries with TIEAs reached a total of 22.
Although, Mexico has a TIEA, it also has a tax treaty with the U.S. and
has been reported as such in the following figure and table.
[17] The Marshall Islands is one of the 15 nations with TIEA agreements
in force. However, it is classified by OECD as an "uncooperative tax
haven" and has been reported as such in the following figure and table.
[18] As discussed earlier, however, under their contract with IRS, QIs
are implicitly expected to use KYC documentation when judging whether a
customer's withholding certificate is valid.
[19] GAO-07-162G.
[20] The International Auditing and Assurance Standards Board (IAASB)
is an independent body that establishes and provides guidance on
auditing, assurance and other related services, including ISRSs, for
its member organizations. Member organizations agree to comply with
IAASB standards.
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