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 IRSï¿½s 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 ownersï¿½ identities, U.S. withholding agents 
can accept ownersï¿½ 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] 

GAOï¿½s 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 QIsï¿½ 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 agentsï¿½ 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 GAOï¿½s 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 [email protected] 

[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 [email protected]. 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 [email protected]: 

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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