Under the QI program, foreign  financial institutions sign a contract with IRS to withhold and report U.S.  source income sent offshore. 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. 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. 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. 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. 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. 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. 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. 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. Data on both paper and electronically filed returns must also be  reviewed for errors. 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. 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. IRS AUP guidance requires third-party reviewers to sample QI accounts.
Why GAO Did This Study

U.S. source income flows to recipients offshore through foreign financial institutions and U.S. withholding agents. The Internal Revenue Service (IRS) established the Qualified Intermediary (QI) program to improve tax withholding and reporting on such income. QIs are foreign financial institutions that contract with IRS to withhold and report U.S. tax. GAO was asked to (1) describe program features, (2) assess whether weaknesses exist in the U.S. withholding system for U.S. source income, and (3) identify any weaknesses in QI external reviews and IRS's use of program data. GAO interviewed agency officials and private practitioners and reviewed the latest IRS data on U.S. source income flowing offshore.

What GAO Found

The QI program provides IRS some assurance that tax on U.S. source income sent offshore is properly withheld and reported. For example, QIs, located overseas, are more likely to have a direct working relationship with customers who claim tax benefits, such as reduced withholding, and agree to have independent parties review a sample of accounts and report to IRS. However, a low percentage of U.S. source income sent offshore flows through QIs. For tax year 2003, about 12.5 percent of the $293 billion in U.S. income flowed through QIs. The rest or about 87.5 percent flowed through U.S. withholding agents. While QIs are required to verify account owners' identities, U.S. withholding agents can accept owners' self-certification of their identity at face value. IRS does not measure the extent to which withholding agents rely on self-certification and use this data in its compliance efforts. In addition, U.S. persons may evade taxes by masquerading as foreign corporations. In 2003, 68.4 percent of U.S. income flowed through foreign corporations whose ownership is not reported to IRS. GAO's analyses showed that U.S. withholding agents and QIs reported billions of dollars in funds flowing to undisclosed jurisdictions and unknown recipients in 2003. Lacking proper identification, U.S. withholding agents and QIs should withhold taxes at the 30 percent rate. GAO found that withholding on these accounts was much lower than 30 percent. The contractually required independent reviews of QIs' accounts help provide assurance that taxes are properly withheld. However, the external auditors are not required to follow up on indications of fraud or illegal acts, as would reviews under U.S. Government Auditing Standards. As a result, IRS has less information on whether QIs are adequately preventing fraud or illegal acts. Further, while IRS obtains considerable data from information returns, it does not effectively use it to ensure proper withholding and reporting. IRS has not consistently entered data from paper information returns into a database and matched the data to tax returns to identify inappropriate disbursal of tax benefits. IRS could require electronic filing by QIs whenever possible.