Tax Compliance: Challenges in Ensuring Offshore Tax Compliance
(03-MAY-07, GAO-07-823T).
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.
-------------------------Indexing Terms-------------------------
REPORTNUM: GAO-07-823T
ACCNO: A69068
TITLE: Tax Compliance: Challenges in Ensuring Offshore Tax
Compliance
DATE: 05/03/2007
SUBJECT: Auditing standards
Foreign corporations
Income taxes
Investigations by federal agencies
Noncompliance
Program evaluation
Statutory limitation
Tax administration
Tax evasion
Tax returns
Taxpayers
Treaties
Voluntary compliance
Withholding taxes
Policies and procedures
Yellow Book
IRS Qualified Intermediary program
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GAO-07-823T
* [1]Additional Time Needed to Complete Offshore Tax Evasion Exam
* [2]Offshore Tax Evasion Takes Longer to Find but Offshore Exami
* [3]IRS Does Not Pursue Some Apparent Offshore Tax Evasion Becau
* [4]QI Program Provides Some Assurance That Tax Is Properly With
* [5]Background
* [6]The QI Program Provides Some Additional Assurance That Tax I
* [7]QIs Account for a Small Portion of U.S. Source Income and In
* [8]The Majority of U.S. Source Income Flows Outside the QI
Syst
* [9]Foreign Corporations May Provide U.S. Taxpayers a
Mechanism
* [10]QI External Reviews and IRS Use of Program Data
* [11]External Reviews
* [12]IRS Does Not Make Full Use of Available Data to Ensure
Compl
* [13]Contact and Acknowledgments
* [14]GAO's Mission
* [15]Obtaining Copies of GAO Reports and Testimony
* [16]Order by Mail or Phone
* [17]To Report Fraud, Waste, and Abuse in Federal Programs
* [18]Congressional Relations
* [19]Public Affairs
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
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^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.^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.
^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, [20]GAO-07-237 (Washington, D.C.: Mar. 30,
2007).
Let me begin by highlighting two major points about IRS's examination of
returns with offshore activity:
o 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.
o 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:
o 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.
o Although QIs provide enhanced assurance that treaty benefits are
properly provided, the vast majority of U.S. source funds do not
flow through QIs, and some U.S. taxpayers may inappropriately
receive treaty benefits and exemptions as owners of foreign
corporations. For tax year 2003, about 88 percent of U.S. source
income flowed through U.S. withholding agents, which provide
somewhat less assurance of proper withholding and reporting than
do QIs.^3 In addition, under current U.S. tax law and regulations,
corporations are taxpayers and the owners of their assets and
income, regardless of the residency of the underlying corporate
owners. By establishing an offshore corporation, a U.S. person(s)
may escape identification and required reporting. In 2003, at
least 68 percent of U.S. source income was received by foreign
corporations. Since the identity of corporate owners is not
reported to IRS, U.S. persons may be able to evade taxes.
o QI external reviews give IRS greater assurance that QIs perform
their responsibilities properly, but these reviews do not require
auditors to follow up on indications of fraud or illegal acts; and
IRS does not make effective use of withholding data. Under U.S.
Government Auditing Standards,^4 auditors performing external
reviews like those done for the QIs must follow up on indications
of fraud or illegal acts that could affect the matters they are
reviewing. Further, data that IRS needs to effectively administer
the QI program and ensure that withholding agents perform their
duties properly are not readily available and in some instances no
longer exist.
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.
^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,
[21]GAO-07-162G (Washington, D.C.: January 2007).
IRS generally uses the term "offshore" to mean a country or
jurisdiction that offers financial secrecy laws in an effort to
attract investment from outside its borders.^5 IRS examinations,
both offshore and nonoffshore, are generally of one of three
types--correspondence, office, or field. The most complex
examinations are done through revenue agent field visits to
taxpayer locations, that is, field examinations. Most offshore
examinations from 2002 through 2005 were of this type. Generally,
unless a taxpayer's tax return involves fraud or a substantial
understatement of income, or unless the taxpayer agrees to an
extension, the statute of limitations for IRS to assess additional
taxes is 3 years from when IRS receives the taxpayer's tax return.
Taking an examination past the statute of limitations date may
result in disciplinary action against the responsible revenue
agent and his or her manager.
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,^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.
^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.
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.^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.
^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.
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^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.
^8 [22]GAO-07-162G .
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^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.^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.
^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.
Figure 1: Tiered Financial Flows
Although QIs generally agree to be withholding agents for their customers,
QIs may opt out of primary withholding and reporting responsibilities for
designated accounts--including those owned by U.S. persons, ceding those
responsibilities and liabilities to financial institutions upstream in
that chain of payments. Eventually, the responsibilities and liabilities
associated with these accounts may fall to the last payor within the
United States (and therefore within the jurisdiction of IRS). Even though
this income may be paid to account holders in QIs or nonqualified
intermediaries (NQI), the reporting and withholding might be executed by
U.S. institutions.^11
The United States maintains a network of bilateral treaties designed to
set out clear tax rules applying to trade and investment between the
United States and each nation in order to promote the greatest economic
benefit to the United States and its taxpayers. Each treaty is intended to
eliminate double taxation of taxpayers conducting economic activity in the
United States and another nation by allocating taxing rights between the
two countries, establishing a mechanism for dealing with disputes between
the two taxing authorities, providing exchange of information between the
two taxing authorities, and reducing withholding taxes. Reductions of
withholding taxes are negotiated with each treaty partner individually and
the benefits are reciprocal--so U.S. residents may benefit from a reduced
tax rate for investing abroad, just as foreign investors may be for
investing in the United States. As of January 2007, 54 tax treaties were
signed, including for all members of the Organization of Economic
Cooperation and Development (OECD).
The QI Program Provides Some Additional Assurance That Tax Is Properly Withheld
and Reported
Compared to U.S withholding agents, IRS has additional assurance that QIs
are properly withholding the correct amount of tax on U.S. source income
sent offshore. QIs accept several responsibilities that help ensure that
their customers qualify for treaty benefits.
First, because QIs are in overseas locations, they are more likely to have
personal contact with nonresident aliens or other persons who may claim
exemptions or treaty benefits than would U.S. withholding agents. This
direct relationship may increase the likelihood that the QI will collect
adequate ownership information and be able to accurately judge whether its
customers are who they claim to be.
Second, QIs accept enhanced responsibilities for providing assurance that
customers are in fact eligible for treaty benefits and exemptions. All
withholding agents are expected to follow the same basic steps when
determining whether to withhold taxes on payments of U.S. source income
made to nonresident alien customers. The withholding agents must determine
the residency of the owner of the income and the kind and amount of U.S.
source income, which governs the customers' eligibility for no (if the
type of income is exempt from U.S. tax) or reduced taxation (if a lower
taxation rate has been set in a treaty). However, under their contract,
QIs must obtain acceptable account opening documentation regarding the
customer's identity. When determining whether a customer qualifies for
treaty benefits, the kinds of documents QIs may use are approved by IRS
based upon the local jurisdiction "know your customer" (KYC) rules. When
customers wish to claim treaty benefits, they must also submit an IRS Form
W-8BEN, known as a withholding certificate, or other acceptable
documentation. On the withholding certificate the customer provides
various identifying information and completes applicable certifications,
including that the customer is a resident of a country qualifying for
treaty benefits and that any limitations on benefits (LOB) provisions in
the treaty are met.^12 Because QIs agree to follow specified account
opening procedures in all cases, regardless of whether a QI performs
withholding itself or it passes the responsibility to another withholding
agent, there is enhanced assurance that the residency and nationality of
the account holder has been accurately determined and thus correct
withholding decisions will be made.
^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).
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^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.
^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.
Although account opening and withholding procedures for QIs may give IRS
greater assurance that treaty benefits are properly provided by QIs than
by U.S. withholding agents, QIs provide IRS less information to use in
targeting its enforcement efforts than do U.S. withholding agents. One of
the principal incentives for foreign financial institutions to become QIs
is their ability to retain the anonymity of their customer list. QIs
report customer income and withholding information to IRS in the aggregate
for groups of similar recipients receiving similar benefits. This is known
as "pooled reporting." NQIs also can pool results when reporting to
upstream withholding agents, but nevertheless, must identify all of the
individual customers for which they have provided treaty benefits.^14
Although pooling restricts the information available to IRS on individuals
receiving treaty benefits, to the extent that QIs do a better job of
ensuring treaty benefits are properly applied up front, IRS has less need
for after-the-fact enforcement. The accuracy of the pooled reporting by
QIs is also subject to the external reviews of QIs' contractual
performance.
QIs Account for a Small Portion of U.S. Source Income and Individuals May
Inappropriately Receive Treaty Benefits as Owners of Corporations
Although the QI program provides IRS some assurance that treaty benefits
are being properly applied, a low percentage of U.S. source income flows
through QIs and U.S. taxpayers may inappropriately receive treaty benefits
and exemptions as owners of foreign corporations.
^14 Income owned by U.S. taxpayers held offshore may not be pooled and
must be reported to IRS individually, either by the QI or the last U.S.
payer in a chain of payments.
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.^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
Source: GAO analysis of IRS data.
Note: Numbers may not total because of rounding.
The jurisdiction of recipients of U.S. source income is a major
determinant of the applicable withholding rate and the degree of
cooperation IRS may expect from foreign governments in enforcing U.S. tax
administration. Bilateral tax treaties are one means of reducing
withholding taxes that treaty partners may impose on their residents. In
general, a treaty provides enhanced assurance that both nations' tax rules
will be properly applied. When a treaty does not exist, tax administration
can be furthered by agreements to exchange information. As of November
2006, 15 nations had Tax Information Exchange Agreements (TIEA) with the
United States.^16 To countervail harmful tax practices, the OECD
encourages countries to develop and practice administrative transparency
and effective exchange of tax information in their local tax
administrations. A number of countries have made formal commitments to
work toward these principles. However, because of their continued
unwillingness to agree to these two principles, five countries are on the
OECD's list of "uncooperative tax havens."^17 Finally, 165 other
jurisdictions receive U.S. source income but do not fall into any of these
categories.
^15 Tax year 2003 is the most recent year for which reliable data is
available.
Although the vast majority of U.S. source income flows outside the QI
system, the preponderance flows through countries with which the United
States has tax treaties, as shown in figure 2.
^16 Since we performed our analysis, according to the Department of the
Treasury, the number of countries with TIEAs reached a total of 22.
Although, Mexico has a TIEA, it also has a tax treaty with the U.S. and
has been reported as such in the following figure and table.
^17 The Marshall Islands is one of the 15 nations with TIEA agreements in
force. However, it is classified by OECD as an "uncooperative tax haven"
and has been reported as such in the following figure and table.
Figure 2: U.S. Source Income Flowing Offshore by Type of Jurisdiction, Tax
Year 2003
As shown in table 2, for tax year 2003 about 80 percent of U.S. source
income flowed through treaty countries with 88 percent of that flowing
through U.S. withholding agents. The data indicate that persons in the
treaty countries received the preponderance of U.S. source income and the
lowest withholding rates, because of a combination of reduced withholding
rates negotiated by treaty and residents receiving certain kinds of income
that are exempt by statute. About $28 billion flowed through TIEA
countries, and recipients received significant withholding tax
reductions-without mutually beneficial treaties. Persons in jurisdictions
committed to OECD's principles, that is, "committed jurisdictions," and
OECD-identified "uncooperative tax havens" accounted for relatively little
U.S. source income. Withholding agents in other and 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
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.
aRounded down to less than $0.1 billion.
A close look at the data points to some potential problems with the
withholding and reporting activities for tax year 2003. Both U.S.
withholding agents and QIs reported transactions in unknown or
unidentified jurisdictions. For example, for tax year 2003, $19 billion of
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.^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
Source: GAO analysis of IRS data.
aInterest 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.
^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.
bDividends include those paid by U.S. corporations, dividends qualifying
for reduced withholding under a tax treaty, and dividends paid by foreign
corporations.
cMiscellaneous income includes royalties, pensions, compensation for
personal services, REIT distributions, notional principal contracts and
other income.
To test the level of due diligence exercised by withholding agents, a GAO
investigator using an assumed identity created a shell corporation and
then sought to establish an overseas bank account for that corporation.
Our investigator approached a European QI to open an account. The QI
required our investigator to provide documentation sufficient to establish
his identity as an officer of the corporation and documentation showing
the source of the funds to be invested. Further, a representative from the
QI contacted the investigator and questioned him in detail to ensure
compliance with KYC standards and requested to meet with him in person.
The investigator discontinued the effort and did not open an account with
the QI. Our investigator also contacted an NQI in the Caribbean to open an
account. The NQI requested that the investigator provide documentation of
his identity and a letter explaining the purpose of the corporation. In
addition, the NQI contacted a U.S. bank where the investigator had an
account and requested a letter of reference. The NQI opened an account for
our investigator. We did not then make an investment to earn U.S. source
income in part because of the relatively large minimum investments
required by QI and NQI firms we contacted. Thus, we were able to open a
solely owned foreign corporation that was not actually an active business
but do not know whether a QI or NQI intermediary would then have
questioned a withholding certificate had we made an investment and claimed
treaty benefits.
QI External Reviews and IRS Use of Program Data
Because QIs agree to have external auditors perform oversight of their
compliance with required procedures, IRS has greater assurance that taxes
are properly withheld and treaty benefits are properly dispensed by QIs
than by U.S. withholding agents. However, within their limited scope, QIs'
auditors are not responsible for following up on possible indications of
fraud or illegal acts that could have an impact on the matters being
tested as they would under U.S. Government Auditing Standards.^19 In
addition, IRS obtains considerable data from withholding agents but does
not make effective use of the data to ensure that withholding agents
perform their duties properly.
^19 [23]GAO-07-162G .
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
Source: GAO analysis of audit and AUP characteristics as defined by U.S.
Government Auditing Standards and International Auditing and Assurance
Standards Board standards.
aThese are attributes of AUPs performed under international accounting
standards.
IRS developed a three-phase AUP process to focus on key performance
factors to address specific concerns while minimizing compliance costs. In
phase 1 procedures, the external auditor is required to examine all or a
statistically valid sample of accounts with their associated documentation
and compile information on whether the QI followed withholding
requirements and the requirements of the QI agreement. IRS reviews the
data from phase 1 AUPs and determines whether significant concerns exist
about the QI's performance. If concerns exist, IRS may request that
additional procedures be performed. For example, additional procedures may
be requested if the external auditor identified potential problems while
performing phase 1 procedures. IRS defines the work to be done in a phase
2 review based on the specific concerns surfaced by the phase 1 report.
Phase 3 is necessary only if IRS still has significant concerns after
reviewing the phase 2 audit report. In phase 3, IRS communicates directly
with the QI management and may request a face-to-face meeting in order to
obtain better information and resolve concerns about the QI's performance.
IRS cited high rates of documentation failure, underreporting of U.S.
source income and under-withholding as the three most common reasons for
phase 3 AUPs.
Data from the 2002 audit cycle shows that IRS required phase 2 procedures
for about 18 percent of the AUPs performed. IRS moved to phase 3
procedures for 35 QIs, which is around 3 percent of the 2002 AUPs
performed. Of the QIs that had phase 3 reviews, IRS met face-to-face with
13 and was ultimately satisfied that all but 2 were in compliance with
their QI agreements. The remaining 2 were asked to leave the QI program.
Since the QI program's inception in 2000, there have been 1,245
terminations of QI agreements. Of the 1,245 terminations, 696 were the
result of mergers or consolidations among QIs and not related to
noncompliance with the QI agreements. Aside from the 2 terminations
mentioned above, the remaining 549 terminations were of QIs that failed to
file either an AUP report of factual findings or requests for an AUP
waiver by the established deadline.
IRS grants waivers of the AUP requirement if the QI meets certain
criteria. A QI may be eligible for a waiver if it can demonstrate that it
received not more than $1 million in total U.S. source income for that
year. In order to be granted a waiver, the QI must file a timely request
that includes extensive data on the types and amounts of U.S. source
income received by the QI. Among items required with the waiver request
are a reconciliation of U.S. source income reported to the QI and U.S.
source income reported by the QI to IRS; the number of QI account holders;
and certifications that the QI was in compliance with the QI agreement.
IRS evaluates the data provided with the waiver request to determine if
AUPs are necessary despite the relatively small amount of U.S. source
income, and will deny the waiver request if the data provided raises
significant concerns about the QI's compliance with the agreement. About
3,400 QIs (around 65 percent of the QIs at that time) were approved for
audit waivers in 2005. The largest 5 percent of the QIs accounted for
about 90 percent of the withholding based on data from the 2002 audit
cycle.
One notable difference between the AUPs used for the QI program and AUPs
that would be done under U.S. Government Auditing Standards is that the QI
contract is silent on whether external auditors have to perform additional
procedures if information indicating that fraud or illegal acts that could
materially affect the results of the AUP review come to their attention.
Absent specific provisions in the contract, the auditors perform the QI
AUPs in accordance with the International Standard on Related Services
(ISRS) 4400.^20 Our U.S. Government Auditing Standards, known as the
Yellow Book, are more stringent on this topic than the ISRS standards.
^20 The International Auditing and Assurance Standards Board (IAASB) is an
independent body that establishes and provides guidance on auditing,
assurance and other related services, including ISRSs, for its member
organizations. Member organizations agree to comply with IAASB standards.
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
Notes: The forms are Form 1042-S, Foreign Person's U.S. Source Income
Subject to Withholding; Form 1042-T, Annual Summary and Transmittal of
Forms 1042-S; and Form 4804, Transmittal of Information Returns Reported
Magnetically.
CTW is Chapter Three Withholding; IRMF is Information Returns Master File.
Because the Form 1042-S data have not been routinely transcribed and
corrected, IRS lacks an automated process to use the Form 1042-S
information return data to detect underreporting on the Form 1042 or to
verify refunds claimed. Forms 1042 are due in March and the withholding
agents might report owing IRS more if they under-withheld the amount of
tax their customers' owed, or might claim a refund if they over-withheld.
After performing simple consistency and math checks on the Forms 1042, IRS
accepts the returns as filed and either bills withholding agents that did
not include full payment or refunds amounts to those whose Forms 1042
indicates they over-withheld taxes due.
Because the Forms 1042-S information returns have not been routinely
transcribed, IRS has not been able to automatically match the information
return documents to the annual tax return data, which is one of IRS's most
efficient and effective tools to ensure compliance. IRS had planned to
perform such automatic document matching, but IRS suspended the plans for
matching the Form 1042-S and Form 1042 data since funding has not been
available to routinely transcribe Form 1042-S data. Therefore, when Forms
1042-S had been electronically filed or transcribed, IRS has only been
able verify the accuracy of Forms 1042 by individually retrieving the
1042-S data stored in the Chapter Three Withholding (CTW) database, a
time-consuming and seldom used process. When Forms 1042-S were not
transcribed, IRS was only able to verify Forms 1042 by manually retrieving
and reviewing the paper 1042-S. Further, for years when transcription did
not occur, if a QI filed an amended return after the paper Forms 1042-S
were destroyed, IRS could not even perform a manual verification and had
to take the amended return claiming a refund at face value provided other
processing criteria were met. IRS has no information to determine whether
or how often such erroneous or fraudulent refunds might occur.
Properly transcribed and corrected 1042-S data would have other uses as
well. For instance, IRS officials said that such data could be used to
check whether the AUP information submitted by QI withholding agents is
reliable. For U.S. withholding agents, Form 1042-S information might be
used to determine whether to perform audits. Several other units within
IRS, as well as Treasury, the Joint Committee on Taxation and
congressional tax-writing committees also could use these data to research
and evaluate tax policy and administration issues and to identify 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
[email protected] . 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.
(450598)
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Highlights of [32]GAO-07-823T , a testimony before the Committee on
Finance, U.S. Senate
May 3, 2007
TAX COMPLIANCE
Challenges in Ensuring Offshore Tax Compliance
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.
[33]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.
Examinations involving offshore tax evasion take much more time to develop
and complete than other examinations--a median of 500 more days for cases
from fiscal years 2002 to 2005, but their resulting median assessment is
almost three times larger than for all other examinations. Nevertheless,
because they take more staff time, offshore examinations yielded tax
assessments per hour of staff time that were about one-half of that for
all other examinations. Because of the 3-year statute of limitations, the
time needed to complete an offshore examination means that IRS sometimes
prematurely ends offshore examinations or decides not to open an
examination, despite evidence of likely noncompliance. Congress has
granted a statute change or exception when enforcement challenges similar
to those found in offshore cases have arisen in the past.
QIs are foreign financial institutions that contract with IRS to withhold
and report U.S. source income paid offshore to foreign customers. The QI
program provides IRS some assurance that QIs are properly withholding and
reporting tax on U.S. source income paid offshore. QIs (1) are more likely
to have a direct working relationship with customers who claim reduced tax
rates under tax treaties, (2) accept responsibilities for ensuring
customers are in fact eligible for treaty benefits, and (3) agree to have
independent parties review a sample of accounts and report to IRS.
However, a low percentage of U.S. source income flows through QIs. For tax
year 2003, about 12.5 percent of U.S. source income flowed through QIs.
About 87.5 percent flowed through U.S. withholding agents, which provide
somewhat less assurance of proper withholding and reporting than do QIs.
In addition, U.S. persons may be able to evade taxes by masquerading as
foreign corporations.
The contractually required independent reviews of QIs' accounts do not
require auditors to follow up on indications of illegal acts, as would
reviews under U.S. Government Auditing Standards. While IRS obtains
considerable data from withholding agents, it does not make effective use
of the data to ensure proper withholding and reporting has been done.
U.S. Source Income Flowing through QIs and to Foreign Corporations, 2003
Source: GAO analysis of IRS data.
References
Visible links
20. http://www.gao.gov/cgi-bin/getrpt?GAO-07-237
21. http://www.gao.gov/cgi-bin/getrpt?GAO-07-162G
22. http://www.gao.gov/cgi-bin/getrpt?GAO-07-162G
23. http://www.gao.gov/cgi-bin/getrpt?GAO-07-162G
32. http://www.gao.gov/cgi-bin/getrpt?GAO-07-823t
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