    Tax Compliance: Qualified Intermediary Program Provides Some
    Assurance That Taxes on Foreign Investors Are Withheld and
    Reported, but Can Be Improved (19-DEC-07, GAO-08-99).

    U.S. source income flows to recipients offshore through foreign
    financial institutions and U.S. withholding agents. The Internal
    Revenue Service (IRS) established the Qualified Intermediary (QI)
    program to improve tax withholding and reporting on such income.
    QIs are foreign financial institutions that contract with IRS to
    withhold and report U.S. tax. GAO was asked to (1) describe
    program features, (2) assess whether weaknesses exist in the U.S.
    withholding system for U.S. source income, and (3) identify any
    weaknesses in QI external reviews and IRS's use of program data.
    GAO interviewed agency officials and private practitioners and
    reviewed the latest IRS data on U.S. source income flowing
    offshore.
    -------------------------Indexing Terms-------------------------
    REPORTNUM:   GAO-08-99
        ACCNO:   A79128
      TITLE:     Tax Compliance: Qualified Intermediary Program Provides
    Some Assurance That Taxes on Foreign Investors Are Withheld and
    Reported, but Can Be Improved
         DATE:   12/19/2007
      SUBJECT:   Auditing standards
    	     Data collection
    	     Data integrity
    	     Federal taxes
    	     Financial institutions
    	     Noncompliance
    	     Program evaluation
    	     Reporting requirements
    	     Tax administration
    	     Tax evasion
    	     Tax law
    	     Tax return audits
    	     Tax returns
    	     Tax violations
    	     Taxes
    	     Withholding taxes
    	     Waste, fraud, and abuse
    	     IRS Qualified Intermediary program

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    GAO-08-99

    This is the accessible text file for GAO report number GAO-08-99
    entitled 'Tax Compliance: Qualified Intermediary Program Provides Some
    Assurance That Taxes on Foreign Investors Are Withheld and Reported,
    but Can be Improved' which was released on January 25, 2008.

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    Report to the Committee on Finance, U.S. Senate:

    United States Government Accountability Office:

    GAO:

    December 2007:

    Tax Compliance:

    Qualified Intermediary Program Provides Some Assurance That Taxes on
    Foreign Investors Are Withheld and Reported, but Can Be Improved:

    GAO-08-99:

    GAO Highlights:

    Highlights of GAO-08-99, a report to the Committee on Finance, U.S.
    Senate.

    Why GAO Did This Study:

    U.S. source income flows to recipients offshore through foreign
    financial institutions and U.S. withholding agents. The Internal
    Revenue Service (IRS) established the Qualified Intermediary (QI)
    program to improve tax withholding and reporting on such income. QIs
    are foreign financial institutions that contract with IRS to withhold
    and report U.S. tax.

    GAO was asked to (1) describe program features, (2) assess whether
    weaknesses exist in the U.S. withholding system for U.S. source income,
    and (3) identify any weaknesses in QI external reviews and IRS�s use of
    program data. GAO interviewed agency officials and private
    practitioners and reviewed the latest IRS data on U.S. source income
    flowing offshore.

    What GAO Found:

    The QI program provides IRS some assurance that tax on U.S. source
    income sent offshore is properly withheld and reported. For example,
    QIs, located overseas, are more likely to have a direct working
    relationship with customers who claim tax benefits, such as reduced
    withholding, and agree to have independent parties review a sample of
    accounts and report to IRS.

    However, a low percentage of U.S. source income sent offshore flows
    through QIs. For tax year 2003, about 12.5 percent of the $293 billion
    in U.S. income flowed through QIs, as shown below. The rest or about
    87.5 percent flowed through U.S. withholding agents. While QIs are
    required to verify account owners� identities, U.S. withholding agents
    can accept owners� self-certification of their identity at face value.
    IRS does not measure the extent to which withholding agents rely on
    self-certification and use this data in its compliance efforts. In
    addition, U.S. persons may evade taxes by masquerading as foreign
    corporations. In 2003, 68.4 percent of U.S. income flowed through
    foreign corporations whose ownership is not reported to IRS.

    Figure: U.S. Source Income Flowing Through Intermediaries and to
    Foreign Corporations, 2003:

    This figure is a flowchart showing U.S. source income flowing through
    intermediaries and to foreign corporations.

    [See PDF for image]

    Source: GAO analysis of IRS data.

    [End of figure]

    GAO�s analyses showed that U.S. withholding agents and QIs reported
    billions of dollars in funds flowing to undisclosed jurisdictions and
    unknown recipients in 2003. Lacking proper identification, U.S.
    withholding agents and QIs should withhold taxes at the 30 percent
    rate. GAO found that withholding on these accounts was much lower than
    30 percent.

    The contractually required independent reviews of QIs� accounts help
    provide assurance that taxes are properly withheld. However, the
    external auditors are not required to follow up on indications of fraud
    or illegal acts, as would reviews under U.S. Government Auditing
    Standards. As a result, IRS has less information on whether QIs are
    adequately preventing fraud or illegal acts. Further, while IRS obtains
    considerable data from information returns, it does not effectively use
    it to ensure proper withholding and reporting. IRS has not consistently
    entered data from paper information returns into a database and matched
    the data to tax returns to identify inappropriate disbursal of tax
    benefits. IRS could require electronic filing by QIs whenever possible.

    What GAO Recommends:

    GAO recommends that the Commissioner of Internal Revenue (1) measure
    U.S. withholding agents� reliance on self-certification documentation
    and use that data in its compliance efforts, (2) determine why
    withholding agents report billions flowing to undisclosed jurisdictions
    and unidentified recipients, (3) enhance external reviews to include
    reporting of indications of fraud or illegal acts, and (4) require
    electronic filing in QI contracts whenever possible.

    Although IRS generally agreed with GAO�s recommendations, its planned
    actions are not fully consistent with our recommendations.

    To view the full product, including the scope and methodology, click on
    [hyperlink, http://GAO-08-99]. For more information, contact Michael
    Brostek at (202) 512-9110 or brostekm@gao.gov

    [End of section]

    Contents:

    Letter:

    Results in Brief:

    Background:

    QI Program Provides Some Assurance That Tax Is Properly Withheld and
    Reported:

    Weaknesses in the Withholding System Complicate the Identification of
    the Owner:

    QI External Reviews and IRS Use of Program Data:

    Conclusions:

    Recommendations:

    Agency Comments and Our Evaluation:

    Appendix I: Objectives, Scope, and Methodology38:

    Appendix II: Comments from the Internal Revenue Service40:

    Appendix III: GAO Contact and Staff Acknowledgments45:

    Tables:

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

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

    Table 3: Foreign Corporate U.S. Source Income, Withholding, and
    Benefits, Tax Year 2003:

    Table 4: Comparison of Key Features of Audits and Agreed-Upon
    Procedures:

    Figures:

    Figure 1: Tiered Financial Flows:

    Figure 2: U.S. Source Income Flowing Offshore by Type of Jurisdiction,
    Tax Year 2003:

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

    Abbreviations:

    AUP: Agreed-Upon Procedure:

    CTW: Chapter Three Withholding:

    GAGAS: Generally Accepted Government Auditing Standards:

    IAASB: International Auditing and Assurance Standards Board:

    IRMF: Information Returns Master File:

    IRS: Internal Revenue Service:

    ISRS: International Standards on Related Services:

    LMSB: Large and Mid-sized Business:

    NQI: Non-Qualified Intermediary:

    NRA: Nonresident Alien:

    OECD: Organisation for Economic Co- operation and Development:

    OID: Original Issue Discount:

    QI: Qualified Intermediary:

    SOI: Statistics of Income:

    TIEA: Tax Information Exchange Agreement:

    Treasury: Department of the Treasury:

    VCP: Voluntary Compliance Program:

    United States Government Accountability Office:

    Washington, DC 20548:

    December 19, 2007:

    The Honorable Max Baucus:
    Chairman:
    The Honorable Charles E. Grassley:
    Ranking Member:
    Committee on Finance:
    United States Senate:

    In tax year 2003, the most recent data available at the time of our
    analysis, individuals and businesses residing abroad, known as
    nonresident aliens (NRA), received $293.3 billion in income from U.S.
    sources. Certain types of income sent to NRAs, such as certain interest
    from U.S. and corporate debt, are exempt from taxation by U.S. statute.
    Other types of income, such as the gross proceeds on the sale of
    equities, are neither reported nor withheld. Yet some income, such as
    dividends, is subject to a statutory tax rate of 30 percent, which may
    be reduced if the recipient resides in a country that has negotiated a
    lower rate through a tax treaty (known as treaty benefits). About $5
    billion of this income was withheld for tax in 2003. If the full 30
    percent rate had been applied to the entire $293.3 billion, about $88
    billion would have been withheld implying about $83 billion worth of
    treaty benefits and exemptions. The income and benefits may have been
    sent directly to beneficial owners[Footnote 1] located offshore or may
    have flowed through one or more foreign financial intermediaries, such
    as banks or brokerage firms.

    The Internal Revenue Service (IRS) initiated the Qualified Intermediary
    (QI) program in 2000 to improve on the prior system of withholding and
    reporting of U.S. source income sent offshore. The QI program, and the
    larger withholding regime, are rooted in congressional concerns about
    tax evasion by U.S. persons using foreign accounts, treaty benefits
    claimed by those who are ineligible, and the effect of tax havens and
    secrecy jurisdictions on the U.S. tax system. With these considerations
    in mind, IRS began a long, consultative process of developing new rules
    to balance a number of objectives, including a system to routinely
    report income and withhold the proper amounts, dispense treaty
    benefits, meet the U.S. obligation to exchange information with foreign
    tax authorities, and encourage foreign investment in the United States.
    We were requested by the Committee on Finance to (1) describe features
    of the QI program intended to improve withholding and reporting, (2)
    assess whether weaknesses exist in the U.S. withholding system that
    complicate identifying owners of U.S. source income, and (3) determine
    whether weaknesses exist in QI external reviews and IRS's use of
    program data. This report builds on our testimony given May 3,
    2007.[Footnote 2]

    To meet our objectives, we obtained information from several sources.
    We reviewed various IRS documents, such as regulations and industry
    directives, and interviewed IRS officials, Department of the Treasury
    (Treasury) officials, and private practitioners involved in the
    development and implementation of the QI program. We also reviewed
    various studies and reports on foreign investment and banking
    practices. We analyzed IRS data on U.S. source income that flowed
    overseas for tax years 2002 and 2003, the most recent data available at
    the time of our analysis. The QI data were reported by withholding
    agents and edited by IRS, and do not include an unknown amount of
    activity that was unreported. We determined that these data were
    sufficiently reliable for the purposes of describing the qualified
    intermediary program by (1) performing electronic testing for obvious
    errors in accuracy and completeness and [Footnote 3][Footnote 4]

    Results in Brief:

    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 sent offshore than other withholding agents. First, because QIs
    are in overseas locations, they are more likely to have a direct
    working relationship with NRAs or other persons who may claim
    exemptions or treaty benefits as the owners of the income. Second, QIs
    accept enhanced responsibilities for ensuring customers are in fact
    eligible for treaty benefits and exemptions, for example by obtaining
    acceptable account opening documentation. 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 QI's provide enhanced assurance that tax benefits are properly
    provided, the vast majority of U.S. source funds are not reported or
    withheld by QIs, and some U.S. taxpayers may inappropriately receive
    treaty benefits and exemptions as owners of foreign corporations. In
    tax year 2003, the most recent year that data are available, about 88
    percent of U.S. source income was reported and withheld by U.S.
    withholding agents, who provide somewhat less assurance of proper
    withholding and reporting than do QIs.[Footnote 5] One situation in
    which U.S. withholding agents provide less assurance of proper
    withholding is when they accept self-certified identity documents from
    Non-Qualified Intermediaries (NQI) representing indirect account
    holders--those not directly holding an account with the U.S.
    withholding agent.[Footnote 6] Unlike QIs, who verify the identity of
    all account holders through documentation, NQIs can accept account
    holders' self-certification of their identity. Although IRS has the
    information to do so, IRS has not determined how much of the income and
    associated withholding flowing through U.S. withholding agents comes
    from QIs versus NQIs because that information has not been regularly
    processed or corrected. Using this information may help IRS in its
    compliance efforts such as assessing the Treasury's exposure to
    unaudited documentation and exposure to tax benefits flowing to
    unaudited accounts.

    U.S. withholding agents and QIs reported billions of dollars in funds
    flowing to undisclosed jurisdictions and unknown recipients in 2003. In
    general, lacking proper identification of a customer, including their
    residence, U.S. withholding agents and QIs should withhold taxes at the
    30 percent rate. Withholding on these accounts was less than 4
    percent.[Footnote 7] Finally, under current U.S. tax law and
    regulations, corporations are taxpayers and the owners of their assets
    and income, regardless of the nationality and residency of the
    underlying owners of the corporation. Therefore, regardless of what
    type of institution serves as the withholding agent, by establishing an
    offshore corporation, a U.S. person(s) may escape identification and
    required reporting. In 2003, 68.4 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.

    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. Although external reviews are an important attribute of the QI
    program, these reviews do not require auditors to report indications of
    fraud or illegal acts that could materially affect the results of these
    reviews and IRS does not make effective use of withholding data. Under
    U.S. Government Auditing Standards, auditors performing external
    reviews like those done for the QIs must follow up on indications of
    fraud or illegal acts that could have a material effect on the matters
    they are reviewing and report actual fraud or illegal acts detected.
    IRS officials identified several reasons for not requiring the external
    auditors to pursue evidence of fraud or illegal acts. For example, QIs
    are located in about 70 countries and each country has its own
    definition and interpretation of fraud. Also, in some countries
    identifying possible fraud can lead to significant adverse consequences
    for the audited entity, such as closing the business until the possible
    fraud is investigated. Consequently, in applying the fraud or illegal
    acts provisions to QI contracts IRS would need to take certain
    mitigating steps, such as defining fraud or illegal acts for purposes
    of the contracts or excluding the provision to report potential fraud.
    In addition, IRS does not make effective use of withholding data. IRS
    obtains considerable data from overseas withholding agents, but citing
    limited funding IRS has not consistently entered information from paper
    information returns into an electronic database and matched the data to
    tax returns to identify, for example, possible erroneous refund claims.
    Because QIs sign contracts with IRS, the contract offers a vehicle for
    IRS to require electronic filing even when QIs' filing volumes fall
    below statutory levels triggering electronic filing requirements.

    We recommend that the Commissioner of Internal Revenue (1) measure U.S.
    withholding agents' reliance on self-certified documentation and use
    that data in its compliance efforts, (2) determine why some funds are
    reported to flow to unknown jurisdictions and to unidentified
    recipients and take appropriate steps to recover withholding taxes that
    should have been paid and to better ensure that U.S. taxes are withheld
    when account owners do not properly identify themselves, (3) work to
    enhance external reviews by requiring the external auditor to report
    any indications of fraud or illegal acts encountered while performing
    AUPs that could significantly affect the results of the review, and (4)
    require electronic filing of forms in QI contracts whenever possible,
    thereby reducing the need to manually process data reported from
    abroad.

    In commenting on a draft of this report, the acting Commissioner of
    Internal Revenue generally agreed with our recommendations to further
    improve the QI program but in several cases her detailed comments are
    not fully consistent with our recommendations. Regarding our
    recommendation to measure U.S. withholding agents' reliance on self-
    certified documentation, IRS agreed it would be beneficial to determine
    the compliance effect of U.S. withholding agents' use of self-certified
    documentation. However, IRS's detailed comments focused on examining
    the accuracy of self-certified documents rather than systematically
    measuring U.S. withholding agents' exposure to unverified documentation
    to determine how large or small a challenge this documentation is to
    the integrity of the U.S. withholding system. Although better
    understanding the accuracy of self-certified documents is laudable, we
    believe a systematic measurement of agents' reliance on such documents,
    which can be made with information IRS already receives, would both
    assist IRS in targeting enforcement efforts and inform policymakers'
    judgments about the current reporting regime. The acting Commissioner
    agreed to determine why withholding agents reported billions of dollars
    of tax benefits to unknown jurisdictions and unidentified recipients,
    and proposed to develop a methodology to determine the extent of this
    underwithholding. Regarding AUP's coverage of indications of fraud or
    illegal acts, IRS states overall agreement that QIs should provide any
    information indicating fraud or illegal acts. But IRS said it would be
    extremely complex and complicated to define fraud and illegal acts in
    at least 70 countries. In addition, IRS pointed to certain current QI
    requirements that provide IRS with some information on fraud and
    illegal acts. However, as discussed in our draft report, we believe IRS
    could draw on existing auditing standards to establish a consistent
    definition of fraud and illegal acts for the purposes of the QI
    program. In addition, the provisions to which IRS refers rely in part
    on self-reporting by the QI and in part focus on "know your customer"
    rule violations alone. However, self-reporting by the QI is not
    equivalent to judgments by the auditors about whether there are
    indications that fraud or illegal acts have occurred. And the universe
    of potential fraud or illegal acts extends beyond potential violations
    of know your customer rules. Therefore we reaffirm our recommendation.
    Finally, IRS agreed that while there are benefits to electronic filing
    of tax Forms 1042 and 1042-S, IRS said such a requirement would be a
    burden for QIs that file only a few (3 or fewer) forms. IRS said it has
    implemented a procedure to include an application to electronically
    file for all QIs applying for or renewing participation in the program.
    If IRS were to require all QIs to electronically file, we believe any
    burdens filers of few forms would face could be addressed by offering
    them a waiver opportunity similar to waivers that are available to all
    institutions that are currently required to file electronically (those
    that file more than 250 returns). Requiring electronic filing whenever
    possible would reduce IRS's costs and improve the timeliness and
    accuracy of data for program oversight.

    Background:

    History, Purpose, and Determinants of Withholding:

    Money is mobile and once it has moved offshore, the U.S. government
    generally does not have the authority to require foreign governments or
    foreign financial institutions to help IRS collect tax on income
    generated in the U.S. from that money. In 1913, the United States
    enacted its first legislation establishing that U.S. persons and NRAs
    were subject to withholding at source before the investment income
    leaves U.S. jurisdiction. Subsequent legislation made withholding
    applicable to dividends and certain kinds of bond income earned by
    NRAs, foreign corporations, foreign partnerships, and foreign trusts
    and estates. IRS issued a comprehensive set of withholding regulations
    for NRAs in 1956. These regulations have been changed over the years to
    reflect statutory changes or perceived abuses by taxpayers.

    To attract foreign investment, the tax rules were further adapted to
    exclude several types of NRA capital income from U.S. taxation, such as
    capital gains from the sale of personal property, interest income from
    bank deposits, and "portfolio interest," which includes U.S. and
    corporate debt obligations. The latter exemption helps finance the U.S.
    national debt by offering a U.S. tax free rate of return for foreigners
    willing to invest in U.S. bonds.

    Among the types of U.S. source investment income sent to NRAs, some are
    exempt from U.S. tax and some are taxable. Payors must report this
    income to IRS, withhold where appropriate, and deposit such tax with
    Treasury. Any entity required to perform these withholding and
    reporting duties is known as a "withholding agent." For example, some
    types of income sent to NRAs, such as bank deposits and portfolio
    interest,[Footnote 8] are exempt from taxation by U.S. statute. Payors
    of this income do not have to withhold tax on this income but are
    required to report certain information to IRS about the amounts of
    income sent and to whom. Other types of investment income sent to NRAs,
    such as the gross proceeds on the sale of personal property (e.g., such
    as securities in a U.S. corporation), are also exempt from U.S. tax but
    financial intermediaries are neither required to withhold taxes on the
    income nor report information on the payment of the income to IRS. Some
    U.S. investment income, such as dividends, is subject to a statutory
    tax rate of 30 percent.[Footnote 9] Payors of this income generally are
    to withhold the 30 percent tax if the recipients do not reside in a
    nation that has negotiated a treaty with a lower tax rate or cannot
    show they are in fact residents in the treaty country. The payors also
    have to report to IRS certain information covering the amount of income
    sent and to whom. About $5 billion of this capital income was withheld
    for tax year 2003. Had the full 30 percent rate been applied to the
    entire $293.3 billion, about $88 billion would have been withheld,
    implying that about $83 billion of this income was exempt from tax or
    was taxed at lower tax treaty rates.

    Chains of payments are routine in modern global finance, and the QI
    system of reporting is designed to reflect this normal course of
    business. For example, a small local bank in a foreign country may
    handle the accounts of several owners of U.S. investments. The bank may
    aggregate the funds of each of these individual investors into an
    omnibus account which it, in turn, invests in a regional bank. The
    regional bank may handle a number of omnibus accounts which it, in
    turn, aggregates and invests in some U.S. securities. The return on
    these securities will flow out of the United States and reverse this
    chain of transactions until each of the original investors gets their
    pro rata share of profit. See figure 1 for examples of tiered financial
    flows.

    Figure 1: Tiered Financial Flows:

    This figure is a tiered flowchart showing financial flows of owners:
    individual and corporation, and intermediaries: partnership or trust,
    and custodian (e.g. bank or other financial intermediary).

    [See PDF for image]

    Source: GAO analysis of IRS data.

    [End of figure]

    Multiple Objectives of the Withholding and Reporting System:

    IRS established the QI program in 2000. Under the QI program, foreign
    financial institutions sign a contract with IRS to withhold and report
    U.S. source income sent offshore. The new regulations, which the QI
    program was intended to help administer, were designed to balance a
    number of objectives, including a system to routinely report income and
    withhold the proper amounts, dispense treaty benefits, meet the U.S.
    obligation to exchange information with foreign tax authorities, and
    encourage foreign investment in the United States.

    Under the QI program, foreign financial institutions voluntarily sign
    an agreement to withhold and report the appropriate amount of tax on
    the U.S. source income they send to their offshore customers. This
    entails determining the kind and amount of their clients' U.S. source
    income, determining whether clients are eligible for benefits (which is
    determined by the client's national residency), and then calculating,
    withholding, and reporting appropriate amounts to IRS. When customers
    wish to claim treaty benefits or exemptions, they must also submit to a
    QI or other withholding agent an IRS Form W-8BEN, known as a
    withholding certificate, or other acceptable documentation. On the
    withholding certificate the customer provides various identifying
    information and completes applicable certifications, including that the
    customer is a resident of a country qualifying for treaty benefits or
    exemptions and that any limitations on benefits provisions in the
    treaty are met.[Footnote 10] To determine whether a client is eligible
    for treaty benefits and exemptions, the QIs accept documentation
    declaring clients' residency, most often a self-certified Form W-8BEN,
    and verify that with other documents accepted as part of their account-
    opening procedures, such as passports or national health cards, in
    accordance with the "know your customer" rules already established by
    the jurisdiction in which they are located.

    If there is insufficient documentation to adequately determine the
    treaty status of an account owner, the QI, a nonqualified intermediary,
    or a U.S. financial institution must use the presumption rules[Footnote
    11] and apply backup withholding. Backup withholding is regulated
    separately, reported separately, and processed separately from routine
    NRA income and withholding. Furthermore, U.S. persons generally are
    taxed on their worldwide income. Their income and assets are withheld
    and reported separately and individually.

    One of the principal incentives for foreign financial institutions to
    become QIs is their ability to retain the anonymity of their client
    list. QIs may report customer income and withholding information for a
    group of similar recipients receiving similar benefits, known as
    "pooled reporting." NQIs, on the other hand, must reveal the identity
    of their clients to upstream withholding agents through acceptable
    documentation in order for their customers to receive treaty benefits
    as well as interest and capital gains exemptions. Income owned by U.S.
    taxpayers held offshore may not be pooled and must be reported to IRS
    individually, either by the QI, NQI, or the last U.S. payor in a chain
    of payments. Payors of U.S. source income to U.S. taxpayers are not
    required to withhold from this income, but they must report the income
    on IRS Form 1099. U.S. taxpayers must report all of their current
    income on their income tax returns, including U.S. source and foreign
    source income, as well as ownership of foreign bank accounts and
    significant ownership in foreign corporations.[Footnote 12] QIs may opt
    out of primary withholding and reporting responsibilities for
    designated accounts--including those owned by U.S. persons--ceding
    those responsibilities and liabilities to financial institutions
    upstream in the chain of payments. Eventually, the responsibilities and
    liabilities associated with these accounts may fall to the last payor
    within the United States (and therefore within the jurisdiction of
    IRS).

    Most of the U.S. source income flowing offshore likely is sent to NRAs
    but some may be sent to U.S. persons. The income may be sent directly
    to NRAs located offshore, for example when a company pays dividends to
    a foreign stockholder, or may flow through one or more U.S. or foreign
    financial intermediaries, such as banks or brokerage firms. Since U.S.
    persons generally are taxed on their worldwide income, while NRAs are
    taxed only on certain U.S. source income, the difference in taxation,
    withholding, and reporting for NRAs and U.S. persons may motivate some
    U.S. individuals or businesses to seek to appear to be NRAs.

    QI Program Provides Some 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. Because QIs are in overseas locations, they are
    more likely to have personal contact with NRAs or other persons who may
    claim exemptions or treaty benefits than would U.S. withholding agents.
    This direct relationship may increase the likelihood that the QI will
    collect adequate account ownership information and be able to
    accurately judge whether its customers are who they claim to be.

    Under the contract signed with IRS, QIs accept enhanced
    responsibilities for providing assurance that customers are in fact
    eligible for treaty benefits and exemptions. All withholding agents are
    expected to follow the same basic steps when determining whether to
    withhold taxes on payments of U.S. source income made to NRA customers.
    The withholding agents must determine the residency of the owner of the
    income and the kind and amount of U.S. source income, which governs the
    customers' eligibility for no taxation (if the type of income is exempt
    from U.S. tax) or reduced taxation (if a lower taxation rate has been
    set in a treaty). However, under their contract, QIs must obtain
    acceptable account-opening documentation, such as a valid driving
    license, regarding the customer's identity. When determining whether a
    customer qualifies for treaty benefits, the kinds of documents QIs may
    use are based upon the local jurisdiction's "know your customer" rules.
    Because QIs agree to follow specified account-opening procedures, there
    is enhanced assurance that the residency and nationality of the account
    holder has been accurately determined and thus correct withholding
    decisions will be made. Further, when QIs do not actually perform
    withholding, the QIs adherence to the account-opening procedures gives
    greater assurance of proper customer identification than NQIs, who
    follow account-opening procedures of unknown rigor.

    Furthermore, and importantly, QIs agree to contract with independent
    external auditors to review the information contained in a sample of
    accounts, determine whether the appropriate amount of tax was withheld,
    and submit a report of the information to IRS. These reviews are
    discussed in greater detail later in this report. In contrast, U.S.
    withholding agents generally have not yet been subject to external
    reviews for this purpose. IRS officials believe that those U.S.
    withholding agents that participated in IRS's 2004 Voluntary Compliance
    Program[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 NRAs actually qualified for the
    benefits.

    Although account-opening and withholding procedures for QIs may give
    IRS greater assurance that treaty benefits are properly provided by QIs
    than by U.S. withholding agents, QIs provide IRS less information to
    use in targeting its enforcement efforts than do U.S. withholding
    agents because of their pooled reporting. NQIs also can pool results
    when reporting to upstream withholding agents but, as discussed
    earlier, must identify all of the individual customers for which they
    have provided treaty benefits.[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.

    Weaknesses in the Withholding System Complicate the Identification of
    the Owner:

    The overwhelming portion of U.S. source income flows through U.S.
    withholding agents who may accept self-certifications of identity from
    indirect account owners that are forwarded by either QIs or NQIs. A
    high percentage of U.S. source income flows through U.S. withholding
    agents, but IRS has not determined how much of the income, or the
    associated withholding, to U.S. withholding agents flows through QIs
    versus NQIs. While QIs verify the self-certifications with other
    original account-opening documentation, and those accounts are reviewed
    externally, NQIs provide somewhat less assurance of proper withholding
    and reporting than exists under the QI program. On the other hand, most
    U.S. source income flows to treaty countries that have some working
    relationship with IRS. However, establishing a foreign corporation
    provides a legal mechanism for shielding the identity of the owner of
    income.

    The Majority of U.S. Source Income Flows through U.S. Withholding
    Agents:

    Although the QI program provides IRS some assurance that tax benefits
    are being properly applied, a low percentage of U.S. source income
    flows through QIs. As shown in table 1, for tax year 2003, about 88
    percent of U.S. source income reported to IRS was reported by U.S.
    withholding agents, not QIs.[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 sent
    their customers for tax year 2003, or nearly $34 billion, flowed
    through QIs that each handled $4 million or more of U.S. source income.
    These QIs and the income they handled were subject to external review
    (as discussed later in this report, smaller QIs can obtain a waiver
    from external reviews). Overall, QIs withheld taxes from U.S. source
    gross income at more than twice the rate of U.S. withholding agents,
    3.7 percent versus 1.5 percent.

    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 withholding 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 withholding 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 withholding 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%.

    Totals;
    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 do not add due to rounding.

    [End of table]

    Even though a high percentage of U.S. source income flows through U.S.
    withholding agents, IRS has not determined how much of the income, or
    the associated withholding, to U.S. withholding agents flows through to
    QIs versus NQIs. Indirectly owned account identity information received
    from NQIs is a particular weakness because, unlike QIs who
    contractually agree to verify W-8BEN information with know your
    customer information, NQIs may accept W-8BENs at face value and forward
    them to U.S. withholding agents.[Footnote 16] Therefore, indirect
    accounts expose the withholding agent and reporting activity to a
    greater potential for incorrect granting of tax exemptions or treaty
    benefits due to misinformation or fraud. In 2003, two Large and Mid-
    sized Business (LMSB) Industry Directives giving guidelines for
    withholding agent audits were published, which did not address the
    differences in reporting for direct and indirect account owners. IRS
    could, but has not yet, analyzed the amount of funds flowing through
    U.S. withholding agents that flow to QIs versus NQIs using information
    already reported on the Form 1042-S. The 1042-S includes two federal
    tax identification numbers--one for the payee and one for the payor--
    and IRS knows which identification numbers are assigned to QIs. Because
    the Form 1042-S information returns have not been routinely
    transcribed, IRS has not been able to automatically match the
    information return documents to the annual tax return data. Doing so
    may help IRS in assessing the Treasury's exposure to unaudited
    documentation and exposure to tax benefits flowing to unaudited
    accounts. Additionally, this information might help policymakers decide
    whether documentation requirements should be modified for unaudited
    accounts or whether other changes should be made to improve the
    likelihood that tax benefits are properly determined.

    Most U.S. Source Income Flows to Treaty Countries or Jurisdictions That
    Have Some Working Relationship with IRS:

    The jurisdiction of recipients is a major determinant of the applicable
    withholding rate. The U.S. maintains a network of bilateral tax
    treaties designed to set out clear tax rules applying to trade and
    investment between the two nations in order to promote the greatest
    economic benefit to the United States and its taxpayers. Treaties are
    intended to eliminate double taxation of taxpayers conducting economic
    activity in the two jurisdictions by allocating taxing rights between
    the two countries, establish a mechanism for dealing with disputes
    between the two taxing authorities, provide for exchange of tax
    information between the two tax authorities, and reduce withholding
    tax. Reductions in withholding tax are negotiated with each treaty
    partner individually and the benefits are reciprocal--so U.S. residents
    may benefit from a reduced tax rate for investing abroad, as foreign
    investors may be for investing in the United States. As of January
    2007, there were 54 tax treaties in force, including all members of the
    Organization of Economic Cooperation and Development (OECD).

    In addition to treaty countries, the U.S. has other kinds of
    relationships with nontreaty countries. For example, the U.S. has
    signed numerous Tax Information Exchange Agreements (TIEA) with
    countries with which the U.S. does not have full reciprocal tax rate
    reduction treaties. TIEAs have less scale and scope than a tax treaty.
    Furthermore, a number of other countries have made formal commitments
    to the OECD to work toward the goals of tax administrative transparency
    and effective exchange of tax information with other countries' tax
    authorities in order to countervail harmful tax practices. Having
    agreed to these principles, these countries are no longer considered to
    be "tax havens." However, because of their continued unwillingness to
    agree to even these two principles, three countries remain on the
    OECD's list of "uncooperative tax havens."

    Although the vast majority of U.S. source income flows outside the QI
    system, the preponderance flows through countries with which the United
    States has tax treaties, as shown in figure 2. For tax year 2003, about
    80 percent of U.S. source income flowed through treaty countries, with
    88 percent of that flowing through U.S. withholding agents. The data
    indicate that persons in the treaty countries received the
    preponderance of U.S. source income and the lowest withholding rates,
    because of a combination of reduced withholding rates negotiated by
    treaty and residents receiving certain kinds of income that are exempt
    by statute. About $28 billion flowed through TIEA countries, and
    recipients received significant withholding tax reductions--without
    mutually beneficial treaties.[Footnote 17] 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.

    Figure 2: U.S. Source Income Flowing Offshore by Type of Jurisdiction,
    Tax Year 2003:

    This figure is an illustration of a globe showing U.S. source income
    flowing offshore by type of jurisdiction during tax year 2003.

    [See PDF for image]

    Source: GAO analysis of IRS data, and PhotoDisc (image).

    [End of figure]

    As shown in table 2, withholding agents in other and undisclosed
    countries not falling into any of these categories received about $29
    billion in U.S. source income for tax year 2003. These withholding
    agents dispensed about $8 billion in withholding tax reductions that
    year.

    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.

    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 and 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, and U.S. Virgin Islands.

    OECD committed jurisdictions: American Samoa, Anguilla, Bahrain,
    Belize, Cook Islands, Gibraltar, Malta, Mauritius, Montserrat, Nauru,
    Netherlands Antilles, Niue, Panama, San Marino, Seychelles, St. Kitts
    and Nevis, St. Vincent and Grenadines, Turks and Caicos, and Vanuatu.

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

    Note: Due to rounding, the amount of gross income shown in this table
    differs slightly from the amount of gross income shown in figure 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 undisclosed
    jurisdictions or with unknown recipients within various countries.
    These transactions may reflect billions of dollars of reduced tax
    withholding without proper documentation or reporting to IRS, since
    eligibility for a reduced rate of withholding must be determined by the
    claimants' documented nationality, residency, and type of investment.

    Regarding transactions with undisclosed jurisdictions, for tax year
    2003 $19 billion of income was reported ($7.8 billion through U.S.
    withholding agents and $11.3 billion through QIs), on which $500
    million was withheld ($100 million through U.S. withholding agents and
    $400 million through QIs) from undisclosed countries. The $500 million
    withheld represents a 2.7 percent withholding rate on this income.
    Since withholding at the 30 percent rate would have yielded about $5.7
    billion in withheld taxes on the $19 billion in total income, the
    withholding agents may have erroneously underwithheld as much as $5.2
    billion.

    IRS officials did not have information to explain why withholding was
    only $500 million on these transactions. Officials said that some of
    the money flowing to unknown or unidentified jurisdictions could be a
    by-product of QIs' ability to pool accounts when reporting. For
    example, if recipients from two nations with the same treaty rates for
    the same type of income were in a QI reporting pool, the QI would not
    identify the differing jurisdictions. However, IRS officials did not
    have information to show to what extent this may have accounted for the
    QIs' reporting of income flowing to unknown or unidentified
    jurisdictions. Nor did they have information that would explain why
    U.S. withholding agents reported money flowing to unknown or
    unidentified jurisdictions at a reduced withholding rate.

    Regarding U.S. withholding agents and QIs' reported transactions with
    "unknown recipients" within various countries for tax year 2003, U.S.
    withholding agents and QIs reported a combined $7 billion of U.S.
    source income sent to offshore unknown recipients, from which about
    $233 million was withheld at a rate of 3.4 percent. The transactions
    with unknown or unidentified jurisdictions and with unknown recipients
    indicate a significantly reduced rate of withholding without proper
    documentation or reporting to IRS, since eligibility for a reduced rate
    of withholding must be determined by the claimants' documented
    nationality, residency, and type of investment. If the 30 percent
    withholding rate should have been applied to all of the funds flowing
    to unknown recipients, about $2.1 billion should have been withheld, or
    about $1.9 billion more than what was withheld.[Footnote 18]

    IRS officials were also unable to explain why our data showed money
    flowing to unknown recipients and at low withholding rates. They
    suggested that the unknown recipients might result, in part, from
    discovery during external audits that the identities of some QI
    customers were not adequately documented. The QIs would pay the
    appropriate withholding at the 30 percent rate and issue a 1042-S for
    "unknown recipient" to prevent the customer from claiming a refund for
    monies that had not been withheld. Such corrected information on the
    amount withheld may not have been incorporated into the Statistics of
    Income (SOI) data base. In addition, IRS officials noted that the Form
    1042-S is not clear about how to report tax payments for customers who
    are not adequately documented. IRS did not have any data or firm
    information to explain why U.S. withholding agents and QIs reported
    that $7 billion of U.S. source income was sent to unknown recipients in
    tax year 2003.

    Two approaches could help IRS determine whether and to what extent this
    reduced withholding on funds flowing to undisclosed jurisdictions and
    unknown recipients was proper. First, IRS could analyze data it
    collects to identify withholding agents who report withholding rates
    below 30 percent on funds flowing to these types of recipients. IRS
    officials said they have not done so in the past because the data are
    not routinely processed and any errors corrected. However, processing
    and error correction has occurred in several years, including most
    recently for tax year 2005. Second, using this information IRS could
    request enhanced external reviews of those QIs that report such
    withholding and could use the information both as a factor for
    selecting which U.S. withholding agents it will audit and to focus
    audit efforts on such reduced withholding. To the extent the enhanced
    external review of QIs or IRS audits of U.S. withholding agents reveal
    improper withholding, IRS then could take the appropriate steps to
    recover withholding taxes that should have been paid and to better
    ensure that U.S. taxes are withheld when account owners do not properly
    identify themselves.

    Establishing a Foreign Corporation Provides a Mechanism for Shielding
    the Identity of the Owner:

    U.S. tax law enables the owners of offshore corporations to shield
    their identities from IRS scrutiny, thereby providing U.S. persons a
    mechanism to exploit for sheltering their income from U.S. taxation.
    Under current U.S. tax law, corporations, including foreign
    corporations, are treated as the taxpayers and the owners of their
    assets and income. Because the owners of the corporation are not known
    to IRS, individuals are able to hide behind the corporate structure. In
    contrast to tax law, U.S. securities regulation and some foreign money
    laundering and banking guidelines treat shareholders as the owners.
    Even if withholding agents learn the identities of the owners of
    foreign corporations while carrying out their due diligence
    responsibilities, they do not have a responsibility to report that
    information to IRS. However, if it provides them with actual knowledge
    or reason to know that the claim for reduced withholding in the
    withholding certificate or other documentation is unreliable for
    purposes of establishing residency, new supporting documentation must
    be obtained.

    Bilateral treaties may reduce or eliminate U.S. taxes on income that
    would otherwise be taxable to NRA recipients, including foreign
    corporations, but generally not for U.S. persons. Similarly, the U.S.
    tax exemption for foreign recipients of portfolio interest, created to
    encourage foreign investors to purchase U.S. government and corporate
    debt, eliminates their tax on this type of income. The exemption is not
    available to U.S. persons, persons who own 10 percent or more of the
    debtor corporation or partnership, or persons failing to meet certain
    other restrictions.

    Withholding agents, regardless of the type of institution, generally
    may accept a withholding certificate at face value, and so may grant
    treaty benefits or a portfolio interest exemption to a foreign
    corporation that is owned by a U.S. person or persons. IRS regulations
    permit withholding agents (domestic and QIs) to accept documentation
    declaring corporations' ownership of income at face value, unless they
    have "a reason to know" that the documentation is invalid.[Footnote 19]
    Consequently, it may be possible for U.S. persons to establish a
    corporation offshore, submit a withholding certificate to the
    withholding agent(s) and receive a reduced rate of withholding. In
    situations where the foreign corporation is owned by a U.S. person or
    persons, it is incumbent upon the owners to report their corporate
    ownership and any income appropriately taxable to them on their own
    U.S. tax returns. There is no independent third-party reporting of that
    income to IRS. Generally, compliance in reporting income to IRS is poor
    when there is no third party reporting to IRS.

    Although no one knows the extent to which U.S. persons hide behind
    domestic and foreign corporations to escape tax on U.S. source income,
    a recent case shows that this can happen and substantial sums can be
    invested. This example occurred before the advent of the QI program,
    but illustrates how corporations can be misused. In summary:

    In April 2007, a federal grand jury indicted an adult entertainment
    mogul for income tax evasion. The government's complaint alleges that
    this U.S. person, a resident of Nevada, produced, marketed, sold and
    distributed videotapes and DVDs through a business incorporated in
    Oklahoma and operating in California. He also formed a Nevada company
    to perform marketing, purchasing, and promotional activities on behalf
    of the Oklahoma/California company. Using nominee shareholders to
    conceal his ownership, the U.S. person also established an
    international business corporation in the Cayman Islands which was the
    named owner of a bank account in Bermuda and a brokerage account in
    California. The indictment alleges that the U.S. person had about $15
    million transferred from the Bermuda bank account to the California
    brokerage account, which earned interest income that the U.S. person
    neither reported, nor for which he paid income taxes. In total, the
    U.S. government alleges that this U.S. person used a web of U.S. and
    offshore companies, bank accounts, and brokerage accounts to obscure
    his ownership, overstate business and personal expenses, and
    underreport more than $18 million of his true taxable income for the
    years 2002-2003.

    Foreign corporations received at least $200 billion, or 68.4 percent,
    of the $293.3 billion in total U.S. source income for tax year 2003
    (see table 3). From this income, almost $3 billion was withheld (a
    withholding rate of 1.4 percent), representing more than $57 billion of
    treaty benefits and exemptions. About half of all foreign corporate
    investment in the United States that year was in debt instruments,
    which are paid U.S. tax free to qualified investors. The preponderance
    of tax withheld from corporations was derived from dividends.

    Table 3: Foreign Corporate U.S. Source Income, Withholding, and
    Benefits, Tax Year 2003:

    Dollars in billions.

    Interest[A];
    s income: $96.3;
    Tax withheld: $0.2;
    Withholding rate percentage: 0.22%;
    Benefits: $28.7.

    Dividends[B];
    Gross income: $42.4;
    Tax withheld: $1.9;
    Withholding rate percentage: 4.56%;
    Benefits: $10.8.

    Miscellaneous[C];
    Gross income: $61.8;
    Tax withheld: $0.7;
    Withholding rate percentage: 1.14%;
    Benefits: $17.8.

    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]

    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 or NQIs. However, within their
    limited scope, auditors of QIs are not responsible for following up on
    possible indications of fraud or illegal acts that could have a
    material impact on the matters being tested or reporting actual fraud
    and illegal acts detected, as they would under U.S. Government Auditing
    Standards.[Footnote 20] In addition, IRS obtains considerable data from
    withholding agents but does not make effective use of these data to
    ensure that withholding agents perform their duties properly.

    External Reviews:

    In designing the QI program, IRS, Treasury, and intermediaries and
    their representatives had the objective of achieving an appropriate
    balance to obtain reasonable assurance that QIs meet their obligations
    without imposing such a burden that intermediaries would not
    participate in the program. IRS generally does not have the legal
    authority to audit a foreign financial intermediary, but IRS requires
    specific periodic procedures to be performed by external auditors to
    determine whether QIs are documenting customers' identities and
    accurately withholding and reporting to IRS. The QI agreement requires
    each QI to engage and pay for an external auditor to perform "agreed-
    upon procedures" (AUP) and submit a report of factual findings to IRS's
    QI program office for the second and fifth years of the agreement. The
    QI selects the external auditor, but IRS must approve it after
    considering the external auditor's qualifications and any potential
    independence impairments.

    IRS selected AUPs as the type of engagement to monitor QI compliance
    because of their flexible and scalable attributes. AUPs differ from a
    full audit in both scope of work and the nature of the auditor's
    conclusions. As shown in table 4, in performing a full audit, an
    auditor gathers sufficient, appropriate evidence to provide assurance
    regarding the subject matter in the form of conclusions drawn or
    opinions expressed, for example, on whether the audited entity is in
    material compliance with requirements overall. Under AUPs the external
    auditor performs specific work defined by the party requesting the
    work, in this case, IRS. In general, such work would be specific but
    less extensive, and less expensive, than the amount of work an auditor
    would do to provide assurance on the subject matter in the form of
    conclusions or an opinion. Thus, withholding agents would likely be
    more willing to participate in the QI program with a required AUP
    review than a full audit, which they would have to pay for under the
    program requirements. AUPs can provide an effective mechanism for
    oversight when the oversight needs relate to specific procedures.

    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 raised by the phase 1 report. Phase 3 is necessary only if IRS
    still has significant concerns after reviewing the phase 2 audit
    report. In phase 3, IRS communicates directly with the QI management
    and may request a face-to-face meeting in order to obtain better
    information and resolve concerns about the QI's performance. IRS cited
    high rates of documentation failure, underreporting of U.S. source
    income, and underwithholding as the three most common reasons for phase
    3 AUPs.

    Data from the 2002 audit cycle shows that IRS required phase 2
    procedures for about 18 percent of the AUPs performed. IRS moved to
    phase 3 procedures for 35 QIs, which is around 3 percent of the 2002
    AUPs performed. Of the QIs that had phase 3 reviews, IRS met face-to-
    face with 13 and was ultimately satisfied that all but 2 were in
    compliance with their QI agreements. The remaining 2 were asked to
    leave the QI program.

    Since the QI program's inception in 2000, there have been 1,245
    terminations of QI agreements. Of the 1,245 terminations, 696 were the
    result of mergers or consolidations among QIs and not related to
    noncompliance with the QI agreements. Aside from the 2 terminations
    mentioned above, the remaining 549 terminations involved QIs that
    failed to file either an AUP report of factual findings or requests for
    an AUP waiver by the established deadline.

    IRS grants waivers of the AUP requirement if the QI meets certain
    criteria. A QI may be eligible for a waiver if it can demonstrate that
    it received not more than $1 million in total U.S. source income for
    that year. In order to be granted a waiver, the QI must file a timely
    request that includes extensive data on the types and amounts of U.S.
    source income received by the QI. Among items required with the waiver
    request are a reconciliation of U.S. source income reported to the QI
    and U.S. source income reported by the QI to IRS; the number of QI
    account holders; and certifications that the QI was in compliance with
    the QI agreement. IRS evaluates the data provided with the waiver
    request to determine if AUPs are necessary despite the relatively small
    amount of U.S. source income, and will deny the waiver request if the
    data provided raise significant concerns about the QI's compliance with
    the agreement. About 3,400 QIs (around 65 percent of the QIs at that
    time) were approved for audit waivers in 2005. The largest 5 percent of
    the QIs accounted for about 90 percent of the withholding based on data
    from the 2002 audit cycle.

    Under current AUPs, the external auditors are required to report
    whether, based on information from the QI or its own information, the
    QI is in material violation of, or is under investigation for violation
    of "know your customer" rules applicable to the QI. However, one
    notable difference between the AUPs used for the QI program and AUPs
    that would be done under U.S. Government Auditing Standards is that the
    QI contract is silent on whether external auditors have to perform
    additional procedures if information indicating that fraud or illegal
    acts that could materially affect the results of the AUP review come to
    their attention. Absent specific provisions in the contract, the
    auditors perform the QI AUPs in accordance with the International
    Standard on Related Services (ISRS) 4400,[Footnote 21] which does not
    require auditor follow-up on indications of fraud or illegal acts.

    U.S. Government Auditing Standards[Footnote 22] are more stringent on
    this topic than the ISRS standards. These standards state that auditors
    should be alert to situations or transactions that could indicate
    fraud, illegal acts, or violations of provisions of contracts. If the
    auditor identifies a situation or transaction that could materially
    affect the results of the engagement, the auditor is to extend
    procedures to determine if the fraud, illegal acts, or violations of
    provisions of contracts are likely to have occurred and, if so,
    determine their effect on the results of the engagement. The auditor's
    report would include information on whether indications of fraud or
    illegal acts were encountered and, if so, what the auditors found.

    As discussed previously, IRS defines the work to be done in a phase 2
    review based on the specific concerns surfaced by the phase 1 report,
    which is done under the international standards. However, IRS may not
    have complete information for its decisions about phase 2 procedures,
    to the extent that AUP reports do not include information about
    situations or transactions that could indicate fraud, illegal acts, or
    violations of provisions of contracts that auditors encountered during
    the engagement.

    During the course of our work, IRS officials told us there were several
    reasons for not requiring external auditors to pursue evidence of fraud
    or illegal acts in the same manner as required by the U.S. Government
    Auditing Standards. First, QIs are located in about 70 countries and
    each country has its own definition and interpretation of fraud.
    Second, the negotiations involved in establishing the QI program
    resulted in focused procedures for discrete tasks and specifically
    excluded procedures involving the exercise of professional judgment.
    Third, in some countries identifying possible fraud can lead to
    significant adverse consequences for the audited entity, such as
    closing the business until the possible fraud is investigated.[Footnote
    23]

    Due to the above reasons, the requirements of the U.S. Government
    Auditing Standards may be challenging to implement across international
    jurisdictions. However, the objectives can be met through a modified
    approach. IRS could draw on existing auditing standards to establish a
    consistent definition of fraud and illegal acts for the purposes of the
    QI program. For example, U.S. auditing standards define fraud as an
    intentional act involving the use of deception to obtain an unjust or
    illegal advantage. The external auditors could be required to report
    any indications of fraud or illegal acts that could significantly
    affect the results of the review and that could be readily identified
    by a qualified auditor in the course of performing normal AUP
    procedures. IRS then could review the indications of fraud or illegal
    acts and specify what procedures the auditors should follow in phase 2
    to investigate the possible fraud or illegal acts. Finally, if there
    are situations in which the consequences of adding a requirement on
    indications of fraud or illegal acts to the QI contract could result in
    outcomes IRS officials judge to be inappropriate, the provision could
    be excluded from that contract.

    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.[Footnote 24] When
    returns are paper filed, IRS personnel must transcribe information from
    the paper returns into an electronic database in order to efficiently
    and effectively make use of the data. Data on both paper and
    electronically filed returns must also be reviewed for errors.

    Data from Forms 1042 have been routinely transcribed and checked for
    errors. However, since the inception of the QI program, IRS has not
    consistently entered information from the paper Forms 1042-S into an
    electronic database. In years when data were not transcribed, the
    unprocessed paper Forms 1042-S were stored at the Philadelphia Service
    Center in Philadelphia and then destroyed a year after receipt in
    accordance with record retention procedures. Additionally, for certain
    tax years, the electronically filed Forms 1042-S did not go through
    computerized error resolution routines. For tax year 2005 IRS's Large
    and Midsize Business Division transferred $800,000 in funding to the
    service center to fund transcribing paper Forms 1042-S and performing
    error resolution for all Forms 1042-S.[Footnote 25] IRS officials
    anticipate funding 2006 transcription and error resolution although as
    of October 2007, this had not yet occurred. Figure 3 shows the dual
    processing procedures IRS uses for receiving, checking, and validating
    the Form 1042-S data it receives. IRS officials told us that LMSB would
    begin routinely funding transcription and error resolution in the
    future.

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

    This figure is a flowchart showing 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.

    [End of figure]

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

    As of January 1, 2007, the processing of paper returns was transferred
    to IRS's campus in Ogden, Utah.

    Because the Form 1042-S data have not been routinely transcribed and
    corrected, IRS lacks an automated process to use the Form 1042-S
    information return data to detect underreporting on the Form 1042 or to
    verify refunds claimed. Forms 1042 are due in March and the withholding
    agents might report owing IRS more if they underwithheld the amount of
    tax their customers' owed, or might claim a refund if they
    overwithheld. After performing simple consistency and math checks on
    the Forms 1042, IRS accepts the returns as filed and either bills
    withholding agents that did not include full payment or refunds amounts
    to those whose Forms 1042 indicates they overwithheld taxes due.

    Because the Form 1042-S information returns have not been routinely
    transcribed, IRS has not been able to automatically match the
    information return documents to the annual tax return data, which is
    one of IRS's most efficient and effective tools to ensure compliance.
    IRS had planned to perform such automatic document matching, but
    suspended the plans for matching the Form 1042-S and Form 1042 data
    since funding has not been available to routinely transcribe Form 1042-
    S data. Therefore, when Forms 1042-S had been electronically filed or
    transcribed, IRS has only been able verify the accuracy of Forms 1042
    by individually retrieving the 1042-S data stored in the Chapter Three
    Withholding (CTW) database, a time-consuming and seldom used process.
    When Forms 1042-S were not transcribed, IRS was only able to verify
    Forms 1042 by manually retrieving and reviewing the paper 1042-S.
    Further, for years when transcription did not occur, if a QI filed an
    amended return after the paper Forms 1042-S were destroyed, IRS could
    not even perform a manual verification and had to take the amended
    return claiming a refund at face value provided other processing
    criteria were met. IRS has no information to determine whether or how
    often such erroneous or fraudulent refunds might occur.[Footnote 26]

    Properly transcribed and corrected 1042-S data would have other uses as
    well. For instance, IRS officials said that such data could be used to
    check whether the AUP information submitted by QI withholding agents is
    reliable. For U.S. withholding agents, Form 1042-S information might be
    used to determine whether to perform audits. Several other units within
    IRS, as well as Treasury, the Joint Committee on Taxation, and
    congressional tax-writing committees also could use these data to
    research and evaluate tax policy and administration issues and to
    identify possibly desirable legislative changes.

    IRS's QI program could have the data it needs to review AUP information
    if it were to require QIs to file electronically. Because withholding
    agents filing fewer than 250 returns are by law exempted from filing
    electronically, with the pooling of accounts offered under the QI
    regime most QIs end up filing paper returns as they have fewer than 250
    returns. IRS officials said the statute would need to be changed to
    require QIs with fewer than 250 returns to file electronically.
    However, the QI contract states that the agreement may be amended by
    IRS if it determines that the amendment is needed for the sound
    administration of the internal revenue laws or regulations. Therefore,
    IRS could require QIs to file electronically as part of the QI
    contractual process and avoid the problems plaguing the processing of
    paper returns.

    Other obstacles identified during our work also appear to be
    surmountable. For example, QIs would incur additional costs to purchase
    the software to prepare the forms or engage electronic transmittal
    services, but the basic software can be obtained for less than $200.
    Although electronic transmittals sent from certain countries' internet
    service providers may be blocked by IRS's computer system firewall
    protections, an IRS official suggested that QIs facing this challenge
    could utilize the services of their third-party auditors to transmit
    the data electronically. The third-party auditors often are part of
    large, multinational auditing firms. Another concern is that in the
    short term IRS may experience an increased electronic filing error rate
    as QIs file electronically for the first time and go through a learning
    curve regarding IRS's data formatting conventions. However, similar
    problems occurred when the QI program began and were addressed through
    taxpayer education. For those QIs for whom filing electronically would
    be an undue hardship, IRS could establish a process for granting
    waivers similar to the current procedures available for QIs already
    required to file electronically because they file more than 250 returns
    annually. Additionally, NQIs falling under the 250-or-more requirement
    and QIs not choosing not to assume primary withholding responsibilities
    could still file paper returns, but the smaller number of paper filers
    might then enable IRS to completely process the paper Forms 1042-S at a
    reduced cost. Regardless, to the extent QIs contractually agree to
    electronically file, IRS would have more information to use to manage
    the program and deter noncompliance and would incur less cost to enter
    any remaining paper returns into electronic databases.

    Conclusions:

    Whether tax is owed on U.S. source income flowing to foreign recipients
    depends on accurately identifying those recipients. The QI program's
    features provide some assurance that financial intermediaries in other
    nations accurately identify recipients of U.S. source income and
    thereby correctly determine and withhold the proper amount of U.S. tax.
    However, because the vast majority of U.S. source income flowing to
    foreign recipients flows through U.S. withholding agents rather than
    QIs, their ability to accurately identify foreign recipients also is
    critical to the correct determination of U.S. tax liability. When
    dealing with indirect account holders, U.S. withholding agents may rely
    on the self-certified identity information (W-8 BENs) forwarded by QIs
    and NQIs for their customers, and NQIs may not have rigorous processes
    for identifying their account holders. Accordingly, the correct
    determination of U.S. tax liability may be at risk. IRS receives
    information on Forms 1042-S that could be used to determine what
    portion of U.S. withholding agents' accounts are with, and U.S. source
    income goes to, NQIs and QIs, but it has not done the analysis. Doing
    so may help IRS in assessing the Treasury's exposure to unaudited
    documentation and exposure to tax benefits flowing to unaudited
    accounts. This information might help policymakers decide whether
    documentation requirements should be modified for unaudited accounts or
    whether other changes should be made to improve the likelihood that tax
    benefits are properly determined. In addition, if certain NQIs account
    for a large portion of U.S. withholding agents' accounts, IRS might be
    able to take steps to encourage them to join the QI program, and if
    certain countries are the source of a large portion of the accounts
    Treasury might focus efforts on improving applicable tax treaties or
    information exchange agreements.

    IRS Form 1042-S data on the flow of U.S. source income to foreign
    recipients in unidentified jurisdictions or to unknown recipients
    suggest potential problems with the withholding and reporting
    activities for tax year 2003. Both U.S. withholding agents and QIs
    reported transactions in unknown or unidentified jurisdictions as well
    as with unknown recipients across all jurisdictions. In general,
    lacking proper identification of a customer, including the customer's
    residence, U.S. withholding agents and QIs should withhold at the 30
    percent rate. Yet withholding on the money flowing to undisclosed
    jurisdictions and to unidentified recipients was 2.7 and 3.4 percent,
    respectively. If the 30 percent withholding rate should have been
    applied to all or a significant portion of the funds flowing to unknown
    jurisdictions or to unknown recipients, several billion dollars more in
    taxes should have been withheld. Although IRS officials suggested some
    scenarios exist where a specific jurisdiction might not be identified
    in reporting to IRS or where a QI might purposely use the term unknown
    recipient when reporting to IRS, they had no data to show that the
    funds flowing to undisclosed jurisdictions or unknown recipients were
    properly taxed.

    Although account-opening and withholding procedures for QIs may give
    IRS greater assurance that treaty benefits are properly provided, the
    effectiveness of those procedures is not assessed until the external
    auditors review a sample of accounts as required by the AUPs. However,
    the QI contract does not require the auditors to report indications of
    fraud or illegal acts that could materially affect the results of the
    AUP review. Under U.S. Government Auditing Standards, additional follow-
    up work is required in such cases. In the QI environment, this
    objective could be met through a requirement for auditors to report to
    the QI program office that they found indications of fraud or illegal
    acts, which the program office would consider in determining whether
    and to what extent phase 2 procedures should be conducted.

    Furthermore, to better administer all withholding and reporting
    activities (by QIs and U.S. withholding agents) IRS needs reliable 1042-
    S data. However, Form 1042-S data have not been completely processed
    every year. IRS officials point to a lack of available funding. In
    those years, the identity, jurisdiction, and income and withholding
    data generated by withholding and reporting agents are inadequate for
    use by IRS, Treasury, or Congress. These data would be available if IRS
    required QIs to file electronically as part of their contractual
    agreement and completed its processing. Although QIs might incur some
    additional expense, IRS would have readier access to more complete data
    as well as saving the resources currently devoted to perfecting and
    entering data reported on paper forms. Because such a requirement could
    be part of contracts with QIs, if in certain cases electronic filing is
    not feasible, the contract could exclude this provision.

    Recommendations:

    We recommend that the Commissioner of Internal Revenue Service do the
    following:

    * Measure U.S. withholding agents' reliance on self-certified
    documentation and use that data in IRS compliance efforts.

    * Determine why U.S. withholding agents and QIs report billions of
    dollars in funds flowing to unknown jurisdictions and to unidentified
    recipients. Based on this determination, IRS should take appropriate
    steps to recover any withholding taxes that should have been paid and
    to better ensure that U.S. taxes are withheld when account owners do
    not properly identify themselves.

    * Work to enhance AUPs by requiring the external auditor to report any
    indications of fraud or illegal acts that could significantly affect
    the results of the review. Under current AUPs, the external auditor is
    required to report whether, based on information from the QI or its own
    information, the QI is in material violation of, or is under
    investigation for violation of "know your customer" rules applicable to
    the QI. IRS should direct the head of the QI program office to expand
    this reporting requirement in the QI contractual agreement to require
    the external auditor to report any indications of fraud or illegal acts
    encountered while performing AUPs that could significantly affect the
    results of the review. This would give the QI program office the
    information necessary to pursue any indications of significant fraud or
    illegal acts identified during the AUP review through additional
    targeted procedures in phase 2 of the AUPs.

    * Require electronic filing of forms in QI contracts whenever possible,
    thereby reducing the need to manually process data reported from
    abroad. Further, IRS should invest the funds necessary to perfect these
    data.

    Agency Comments and Our Evaluation:

    The Acting Commissioner of Internal Revenue provided comments on a
    draft of this report in a December 7, 2007, letter, which is reprinted
    in appendix II. The Acting Commissioner generally agreed with our
    recommendations to improve the QI program, but in several cases her
    detailed comments are not fully consistent with our recommendations.

    IRS agreed it would be beneficial to investigate both the use of U.S.
    withholding agents' reliance on self-certified identity documents and
    why withholding agents reported billions of dollars in tax benefits
    flowing to unknown jurisdictions and unidentified recipients. However,
    for the first recommendation, IRS's detailed comments focused on
    examining the accuracy of the self-certified documents, rather than
    systematically measuring U.S. withholding agents' exposure to
    unverified documentation to determine how large or small a challenge
    this documentation is to the integrity of the U.S. withholding system.
    Although better understanding the accuracy of self-certified documents
    is laudable, we believe a systematic measurement of agents' reliance on
    such documents, which can be made with information IRS already
    receives, would both assist IRS in targeting enforcement efforts and
    inform policymakers' judgments about the current reporting regime. For
    the second recommendation, the Acting Commissioner agreed to determine
    why withholding agents reported billions of dollars of tax benefits to
    unknown jurisdictions and unidentified recipients, and proposed to
    develop a methodology to determine the extent of this underwithholding.

    Regarding the third recommendation covering indications of fraud or
    illegal acts, although IRS agrees that QIs should provide information
    indicating fraud or illegal acts, it also states concern about defining
    fraud and illegal acts and requiring auditors to report such
    information when dealing with at least 70 countries, 60 of which are
    non-English-speaking. In addition, IRS pointed to certain current QI
    requirements that provide IRS with some information on fraud and
    illegal acts. However, as discussed in our draft report, we believe IRS
    could draw on existing auditing standards to establish a consistent
    definition of fraud and illegal acts for the purposes of the QI
    program. In addition, the provisions to which IRS refers rely in part
    on self-reporting by the QI and in part focus on "know your customer"
    rule violations alone. However, self-reporting by the QI is not
    equivalent to judgments by the auditors about whether fraud or illegal
    acts have occurred. And the universe of potential fraud or illegal acts
    extends beyond potential violations of "know your customer" rules.
    Therefore we reaffirm our recommendation.

    Finally, IRS agreed that there are benefits to electronic filing of tax
    Forms 1042 and 1042-S, but said such a requirement would be a burden
    for QIs that file only a few (3 or fewer) forms. IRS said it has
    implemented a procedure to include an application to electronically
    file for all QIs applying for or renewing participation in the program.
    If IRS were to require all QIs to electronically file, we believe any
    burdens filers of few forms would face could be addressed by offering
    them a waiver opportunity similar to waivers that are available to all
    institutions that are currently required to file electronically (those
    that file more than 250 returns). Requiring electronic filing whenever
    possible would reduce IRS's costs and improve the timeliness and
    accuracy of data for program oversight. We have added language
    regarding the opportunity for seeking a waiver to the report based on
    IRS's comment.

    As agreed with your offices, unless you publicly announce its contents
    earlier, we plan no further distribution of this report until 30 days
    from the issue date. At that time, we will send copies of this report
    to appropriate congressional committees and the Acting Commissioner of
    Internal Revenue. We also will make copies available to others upon
    request. In addition, the report will be available at no charge on the
    GAO Web site at [hyperlink, http://www.gao.gov.

    If you or your staff have any questions concerning this report, please
    contact me at (202) 512-9110 or brostekm@gao.gov. Contact points for
    our Offices of Congressional Relations and Public Affairs may be found
    on the last page of this report. GAO staff who made major contributions
    to this report are listed in appendix III.

    Signed by:

    Michael Brostek:

    Director, Tax Issues:

    Strategic Issues Team:

    [End of section]

    Appendix I: Objectives, Scope, and Methodology:

    The objectives of this report are to (1) describe features of the
    Qualified Intermediary (QI) program intended to improve withholding and
    reporting, (2) assess whether weaknesses exist in the U.S. withholding
    system that complicate identifying beneficial owners of U.S. source
    income, and (3) determine whether weaknesses exist in QI external
    reviews and the Internal Revenue Service's (IRS) use of program data.

    To address our objectives, we reviewed various IRS documents and
    interviewed IRS officials in the QI program office and U.S. withholding
    program audit staff, Large and Mid-sized Business (LMSB) International,
    and IRS Counsel, as well as Department of the Treasury (Treasury)
    officials in the Office of Tax Policy and FinCEN. Furthermore, we spoke
    with private practitioners involved in the development and
    implementation of the QI program. We reviewed various studies and
    reports on foreign investment and banking practices. We reviewed the
    auditing requirements contained in the QI agreement and other
    standards, such as the U.S. Government Auditing Standards and the
    international standards on agreed-upon procedures (AUP) and visited
    IRS's Philadelphia Campus, which was responsible during our review for
    processing information returns submitted by some QIs.

    Withholding data used in this report were reported by withholding
    agents and edited by IRS. During the 2002-2003 period, paper
    withholding information returns were processed at IRS's Philadelphia
    Campus and electronic returns and information returns were processed in
    Martinsburg, West Virginia. IRS's Statistics of Income (SOI) staff
    collected this information, made several adjustments and additions to
    the data described below, and performed several quality control checks
    to the data. As a result, these were the most recent data available.

    Because payments may have flowed through tiers of intermediaries before
    reaching the owner of the income, SOI stratified payment information by
    the type of withholding agent. It then became possible to subtract
    payments made from one intermediary to another, eliminating possible
    double or multiple counting of one payment. Furthermore, withholding
    instructions issued under the new 2001 regulations required withholding
    agents to report U.S. source income and withholding information to IRS
    in whole dollar figures. However, not all agents followed these
    instructions, instead reporting income and tax figures in dollars and
    cents. This resulted in an error factor of 100 for some reported
    payments. In order to correct these errors, SOI compared income and tax
    totals for certain withholding agents with information from prior years
    for reasonableness, identifying 25 agents whose information required
    adjustment by a factor of 100. The IRS database was modified
    accordingly.

    We determined that these data were sufficiently reliable for the
    purposes of describing the QI program by (1) performing electronic
    testing for obvious errors in accuracy and completeness and (2)
    interviewing agency officials knowledgeable about the data,
    specifically about how the data were edited.

    We analyzed IRS data on U.S. source income that flowed overseas for tax
    years 2002 and 2003. The data do not include an unknown amount of
    activity that was unreported. In order to calculate tax benefits by
    type of recipient, by destination of account, and by income type, we
    multiplied the gross U.S. source income sent offshore by 30 percent,
    required by IRC Section 1441, and then subtracted the income actually
    withheld, and presumed to be sent to the Treasury. To measure the
    withholding rates by type of recipient, by destination of account, and
    by income type, we divided the actual monies withheld, and presumed to
    be paid to the Treasury, by the gross U.S. source income sent offshore.

    IRS AUP guidance requires third-party reviewers to sample QI accounts.
    IRS provides guidance on the sample size using a standard statistical
    formula and a decision rule. We reviewed the sampling methodology used
    in the AUPs and found that it was adequate to identify problems with
    the accounts.

    [End of section]

    Appendix II: Comments from the Internal Revenue Service:

    Department Of The Treasury:
    Internal Revenue Service:
    Washington, D.C. 20224:

    Commissioner:

    December 7, 2007:

    Mr. Michael Brostek:
    Director, Tax Issues:
    U.S. Government Accountability Office:
    441 G Street, N.W.:
    Washington, D.C. 20548:

    Dear Mr. Brostek:

    Thank you for providing your draft report entitled "Tax Compliance"
    Qualified Intermediary Program Provides Some Assurance that Taxes on
    Foreign Investors Are Withheld and Reported but Can Be Improved (GAO-08-
    99) for our review and comments before the final report is issued. I am
    pleased the GAO recognizes that the Qualified Intermediary (QI) Program
    provides the Internal Revenue Service (IRS) some assurance that tax on
    U.S. source income sent offshore is properly withheld and reported. I
    generally agree with your recommendations to further improve the QI
    Program, and I have enclosed a detailed response to address your audit
    recommendations,

    The QI Program started in 2000 when about $1.9 billion was withheld for
    tax on U.S. sourced income moving offshore. About $5 billion was
    withheld in 2003. This amount represents a 250 percent increase since
    the program was implemented. The a Program is a significant reason for
    this improved compliance,

    To increase voluntary compliance by U.S. withholding agents, we
    conducted a Voluntary Compliance (VC) Program from 2004 to 2006. This
    was an initiative on the amount of tax reported, tax withholding, and
    reporting obligations that applied to withholding agents in connection
    with payments to foreign persons. Approximately 500 entities
    participated in the VC Program. This resulted in a significant
    reporting of income and additional withholding tax.

    We also implemented the Broker Initiative Project in which we are
    examining forms 1042, Annual Withholding Tax Return for U.S. Source
    income of Foreign Persons, filed by U.S. clearing brokers. These "dual
    purpose" examinations are assessing the withholding and information
    reporting compliance of the withholding agent as well as the tax
    compliance of U.S., beneficial owners of U.S. brokerage accounts held
    in the name of nominee entities domiciled in secrecy jurisdictions.

    In addition, we implemented the U.S. Withholding Agent (USWA) Program
    this year. The USWA Program Team was convened to follow up with the VC
    Program participants, examine forms 1042, and participate in outreach
    activities at professional conferences such as tax forums.

    We believe that the combined impact of the QI, VC, and USWA programs
    and the Broker Initiative Project will further improve compliance
    efforts to ensure the proper amount of tax is withheld on U.S. source
    income moving offshore,

    I appreciate the time the GAO Team spent reviewing our QI Program and
    its recommendations for improvement. If you have any questions or need
    any additional information to clarify our comments and/or response to
    the audit recommendations, please contact Walter L. Harris, Director,
    Financial Services Industry, at (212) 298-2048.

    Sincerely,

    Signed by:

    Linda E. Stiff:
    Acting Commissioner:

    Enclosure:

    The GAO recommends that the IRS Commissioner:

    Recommendation 1:

    Measure U.S. withholding agents' reliance on self-certified
    documentation and use that data in IRS' compliance efforts.

    Response:

    We agree it would be beneficial to determine the compliance effect of
    U.S. withholding agents' self-certified documentation. We will study
    the feasibility for a process to measure the accuracy of the self-
    certified documentation.

    In early 2007, we formed a separate USWA Program. The manager and some
    team members were formerly with the QI Program. Some of the objectives
    of the USWA Program are to follow up with the participants of the VC
    Program, examine forms 1042, Annual Withholding Tax Return for U.S.
    Source Income of Foreign Persons, and participate in outreach events
    such as tax forums.

    The USWA Program is currently examining forms 1042. During these
    examinations, we have reviewed some forms W-8BEN, Certificate of
    Foreign Status of Beneficial Owner for United States Withholding, and
    have observed some deficiencies. However, we did not view them as
    significant in relation to the whole program. Therefore, we will
    continue to review self-certified documentation from withholding agents
    during examinations of the forms 1042 and 1042-S, Foreign Person's U.S.
    Source Income Subject to Withholding. in addition, we will gather
    information and provide guidance on self-certified documentation
    through our VCP follow up and outreach activities. We post our findings
    on our Website and use the information on subsequent examinations. We
    also communicate our findings at outreach activities to change
    withholding agents' reliance on accepting forms W-8BEN at face value.

    We also implemented the Broker Initiative Project in which we are
    examining forms 1042 filed by U.S. clearing brokers. These "dual
    purpose" examinations are assessing the withholding and information
    reporting compliance of the withholding agent as well as the tax
    compliance of U.S. beneficial owners of U.S. brokerage accounts held in
    the name of nominee entities domiciled in secrecy jurisdictions. This
    project is currently in the pilot phase. As it continues, we expect
    improved compliance by withholding agents and U.S. beneficial owners of
    brokerage accounts.

    Recommendation 2:

    Determine why U.S. withholding agents and QIs report billions of
    dollars in funds flowing to unknown jurisdictions and to unidentified
    recipients. Based on this determination, IRS should take appropriate
    steps to recover any withholding taxes that should have been paid and
    to better ensure that U.S. taxes are withheld when account owners do
    not properly identify themselves.

    Response:

    We agree that further investigation into the extent and reasons why
    withholding agents report undisclosed jurisdictions and unidentified
    recipients may be necessary. We will investigate the extent of the
    underwithholding and take appropriate actions to recover any
    withholding taxes that should have been paid if our investigation
    confirms any underwithholding. We anticipate that our investigation
    into this matter will require development of a methodology or process
    to determine the extent of the underwithholding, cross-functional
    coordination, and agreements on information sharing.

    During Form 1042 examinations and QI audit reviews, the USWA and Ql
    programs routinely review and question withholding agents and Qls about
    forms 1042-S that show undisclosed jurisdiction and unidentified
    recipients. A number of forms 1042-S included a complete address with
    country in the address box (2003 Form 1042-S, box 13), but the country
    code was left blank (2003 Form1042-S, box 16). We have observed some
    forms 1042-S with incorrect country codes. For example, the address box
    may show an address in London, England, but the country code entered
    was ENG or GB. The correct code should only be UK. We inform the
    withholding agents about the errors and request they file amended
    forms1042-S with the correct country codes.

    Statistics of Income (SOI) prepared a special report for GAO on U.S.
    source capital income data, including data from forms 1042 and 1042-S
    for 2002-2003. Since there are some systemic issues associated with
    processing, matching, and reconciling the form contents, we believe
    that the reported unidentified and undisclosed transactions may be
    somewhat less than what is reported in the SCSI report. To illustrate,
    if the country code was blank, no attempts were made to cross-reference
    it to another field such as address. Therefore, it would be categorized
    as unidentified or undisclosed.

    Recommendation 3:

    Work to enhance agreed-upon procedures (AUPs) by requiring the external
    auditor to report any indications of fraud or illegal acts that could
    significantly affect the results of the review. IRS should direct the
    head of the QI Program office to expand this reporting requirement in
    the QI contractual agreement to require the external auditor to report
    any indications of fraud or illegal acts encountered while performing
    AUPs that could significantly affect the results of the review. This
    would give the QI Program office the information necessary to pursue
    any indications of significant fraud or illegal acts identified during
    the AUP review through additional targeted procedures in phase 2 of the
    AUPs.

    Response:

    We agree Qls should provide any information indicating fraud or illegal
    acts. However, an attempt to define fraud and illegal acts in at least
    70 countries (60 non-English speaking) would be extremely complex and
    complicated. Current AUPs include two sections that provide some
    guidance or indications addressing fraud or illegal acts. One section
    requires the external auditor to obtain a letter from the Ql stating it
    is in material violation or under investigation for violation of know-
    your-customer (KYC) rules. This section also requires the external
    auditor to state if they are aware of any violation or investigations
    of KYC rules by the Ql. Another section of the AUP requires the Qls to
    report on U.S. accounts removed to avoid an AUP. In addition,
    indications of fraud or illegal activities are addressed during the
    Phase 2 review, when we contact the external auditor, and during the
    Phase 3 review, when we meet with the 01.

    Therefore, current AUPs and the QI Program include opportunities for
    Qls to report indications of fraud or Illegal acts. We are concerned
    that GAO's suggestion to require the reporting and pursuing of
    indications of fraud or illegal acts may have repercussions on our
    broader relationship (economic, political, and cultural) with various
    countries, and we have to carefully consider those consequences.

    Recommendation 4:

    Require electronic filing of forms in Ql contracts whenever possible,
    thereby reducing the need to manually process data reported from
    abroad. Further, IRS should invest the funds necessary to perfect these
    data.

    Response:

    We agree with the benefits of electronic filing and perfecting the
    data. However, we recognize the burden issues with some Qls who only
    file a few (three or less) forms 1042-S.

    The Ql Program has implemented the procedure to include Form 4419,
    Application for Filing Information Returns Electronically, to all QI
    applications and renewals. The majority of Qls receiving this form file
    electronically. In addition, we have continued to fund the
    transcription of Form 1042-S and error resolution for fiscal year 2008
    and plan to use 1042-S data for compliance purposes (e.g., assembling
    databases for analysis and testing). We expect continued funding in the
    future beyond current levels.

    [End of section]

    Appendix III: GAO Contact and Staff Acknowledgments:

    GAO Contact:

    Michael Brostek, (202) 512-9110 or brostekm@gao.gov:

    Acknowledgments:

    In addition to the contact person named above, Jonda Van Pelt,
    Assistant Director; Susan Baker; Amy Friedheim; Evan Gilman; Shirley
    Jones; Donna Miller; John Saylor; Joan Vogel; and Elwood White made key
    contributions to this report.

    [End of section]

    Footnotes:

    [1] The beneficial owner is the true owner of the income, corporation,
    partnership, trust, or transaction who receives or has the right to
    receive the proceeds or advantages of ownership. For the rest of this
    report, we will use the term "owner."

    [2] GAO, Tax Compliance: Challenges in Ensuring Offshore Tax
    Compliance, GAO-07-823T (Washington, D.C.: May 3, 2007).

    [3] GAO, Government Auditing Standards, July 2007 Revision, GAO-07-731G
    (Washington, D.C.: July 2007).

    [4] Responsibility for processing QI information returns was
    transferred to IRS's Ogden Campus in January 2007.

    [5] A withholding agent is responsible for withholding tax on payments
    of U.S. source income and depositing such tax with Treasury.

    [6] An indirect account holder is any person who receives amounts from
    a U.S. withholding agent but does not have a direct account
    relationship with the U.S. withholding agent. Indirect account holders
    can be NQIs, flow-through entities, or U.S. branches of a foreign bank
    or insurance company subject to U.S. or state regulatory supervision.

    [7] The effective withholding rate of less than 4 percent may be the
    result of income that is eligible for a lower treaty rate or a
    statutory exemption from withholding, or both.

    [8] 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.

    [9] Dividends include those paid by U.S. corporations, dividends
    qualifying for reduced withholding under a tax treaty, and dividends
    paid by foreign corporations.

    [10] The limitations on benefits 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 nontreaty country). Accordingly,
    the limitations on benefits 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.

    [11] The presumption rules require that an account owner without
    acceptable documentation may not be eligible for U.S. tax benefits.
    Therefore, U.S. source income must be withheld at the 30 percent
    statutory rate.

    [12] Under the Bank Secrecy Act, a U.S. person must file a Report of
    Foreign Bank and Financial Accounts if (1) the person has financial
    interest in, signature authority, or other authority over one or more
    accounts in a foreign country and (2) the aggregate value of the
    accounts exceeds $10,000 at any time during the calendar year.

    [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.
    payor in a chain of payments.

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

    [16] An indirect account holder is any person who receives amounts from
    a U.S. withholding agent but does not have a direct account
    relationship with the U.S. withholding agent. Indirect account holders
    can be nonqualified intermediaries, flow-through entities, or U.S.
    branches of a foreign bank or insurance company subject to U.S. or
    state regulatory supervision.

    [17] Recipients resident in TIEA countries may have received
    withholding tax reductions if the type of income earned is exempt from
    withholding by statute.

    [18] Some of the transactions may have been reported both with
    undisclosed jurisdictions and unknown recipients. Therefore, the
    potential amounts underwithheld should not be added together.

    [19] As discussed earlier, however, under their contract with IRS, QIs
    are implicitly expected to use know your customer documentation when
    judging whether a customer's withholding certificate is valid.

    [20] GAO-07-731G.

    [21] 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.

    [22] These standards are commonly known as the Yellow Book.

    [23] IRS officials also said that the AUPs already include some steps
    requiring auditors to alert IRS to possible "know your customer"
    violations and IRS can ask for additional information during phases 2
    and 3 if IRS suspects fraud or illegal acts on the basis of phase 1
    results. However, the universe of possible fraud or illegal acts is
    broader than "know your customer" violations. Further, the on-site
    auditor is likely to have information beyond that which is currently
    required to be reported to IRS.

    [24] The 250-or-more electronic filing requirement applies separately
    to each type of form filed.

    [25] In addition to the $800,000 in transcription and error resolution
    costs, IRS also incurs an opportunity cost because those resources
    could be reallocated to revenue producing activities. It is difficult
    to precisely estimate this opportunity cost without knowing how the
    resources would be reallocated, but IRS generally estimates that it
    returns $4 to the Treasury for every $1 increase in its budget.

    [26] Data in the CTW system are retained for a period of 3 years as
    provided by regulation.

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