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On January 25, 2008, the United States Government Accountability Office issued a report (the “Report”), entitled “Tax Compliance--Qualified Intermediary Program Provides Some Assurance That Taxes on Foreign Investors Are Withheld and Reported, but Can Be Improved.”

The Report was delivered at the request of the U.S. Senate Committee on Finance, presumably in response to its ongoing offshore tax evasion program focused on the under-withholding of U.S. taxes on U.S.-source payments made to foreign persons (whether or not residents of tax treaty jurisdictions).

The Qualified Intermediary (QI) program, or system, is one that forms the centerpiece of the §1441 withholding tax regulations that were substantially revised back in 2001. Although not necessarily so limited, its chief utility is in the area of omnibus custodial accounts, i.e., accounts consisting of deposits taken by foreign financial institutions from persons all over the world and which are then placed with U.S. custodians for portfolio investment.

The upshot of the QI system is to enable foreign financial institutions to obtain documentation/certification from bank customers and to certify to U.S. custodians and withholding agents as to the correct amount of withholding on payments of U.S.-source income (in some cases, taking on the withholding responsibility themselves), all without disclosure, in most cases, of the identity of the beneficial owner of the income. The quid-pro-quo is that the foreign financial institutions must subject themselves to verification via a “systems and procedures” check conducted by independent external auditors, with the results of such a report sent to the IRS.

The massive overhaul of the §1441 regulations was borne of a delicate balancing act between a number of objectives, which included, among other things, simplification and dealing with commercial competitive issues, from the vantage point of the foreign financial institutions; clarity and a leveling of the playing field, from the vantage point of the U.S. withholding agents; and tracking down U.S. citizens behind these omnibus accounts and dealing with abuses by foreign persons of treaty-shopping provisions, from the vantage point of the IRS.

As its title makes clear, the Report concludes that the QI program provides some assurance that taxes on foreign investors are properly withheld and collected but can be improved. The Report acknowledges that, at least with respect to the 2003 tax year examined and reported on, only about 12.5% of U.S.-source income flowed through the QI system while 87.5% flowed through U.S. withholding agents and that in the latter case, the additional QI program safeguards are not capturing the majority of the U.S.-source income outflow.

In the case of QIs, the Report is somewhat laudatory of the successes of the program but points out a number of deficiencies and areas in which the program can be improved upon. For example, the Report cites the fact that a QI's external auditors do not test for fraud or illegal acts as a part of their systems and procedures check. In addition, QIs are alleged to have paid significant funds to undisclosed jurisdictions and unknown recipients for which there was significant under-withholding.

With respect to withholding agents (non-QIs), generally, significant payments have also been made to undisclosed jurisdictions and unknown recipients for which there was under-withholding (although the IRS acknowledged that this could be due to eligibility for a lower treaty rate or statutory exceptions from withholding). Moreover, the Report points to the fact that, unlike QIs, withholding agents have the ability to accept and rely upon self-certification with respect to the identity of beneficial owners whereas QIs are required to inquire further into customer identities.

As a result, the Report recommends that the IRS:

1. measure U.S. withholding agents' reliance on self-certified documentation and use the data in its compliance efforts;

2. determine why funds are being reported to flow to unknown persons and undisclosed jurisdictions and take appropriate steps to rectify the situation;

3. work to enhance external reviews by requiring external auditors to report indications of fraud or illegal acts; and

4. require electronic filing of forms in QI agreements, thereby reducing the need to manually process data reported from abroad.

In a response to the Report prior to its issuance, the IRS generally agreed with points (2) and (4) above (except that electronic filing would be an option and not a requirement) and, as a general matter, it agreed with point (1) above, although in that case, the Report suggests, disapprovingly, that the IRS appeared more interested in verifying the accuracy of the self-certification statements rather than in measuring the U.S. withholding agent's exposure to unverified documentation as it relates to the integrity of the U.S. withholding tax system. With respect to point (3), the IRS argued that this suggestion would be difficult to accommodate since fraud and illegality have different meanings in different countries. In response, the Report suggests that the IRS could consider establishing a consistent definition of fraud and illegality for purposes of the QI program.

Senators Max Baucus and Chuck Grassley were quick to react, stating that the IRS should do a better job of measuring noncompliance and indicating that legislative measures to address offshore tax compliance would be initiated.

While no one can argue that the QI program is foolproof, perfect, and not ever in need of improvement, it is important to recall that the QI system is in a relative stage of infancy and glitches in the system will always need to be ironed out. In fact, the year under review in the Report, 2003, was only the third year into the program. To be sure, IRS audits conducted, and external auditors reports reviewed, with respect to the 2002 year, the second year into the process, did reveal significant noncompliance. We are now five years later, however, and hopefully, a number of issues which gave rise to noncompliance have been resolved and better systems and procedures are now in place to prevent recurrence.

That the QI program has been a success cannot be denied. Thousands upon thousands of financial institutions have signed onto the program. More withholding tax revenue has poured into the U.S. Treasury than ever before. Is that a reason to be lax and content with the status quo? Of course not. Can and should the system be improved upon? Of course. Having said that, we should also remember that the QI program is one borne of compromise, i.e., an attempt to bridge the interests of all groups involved in the negotiation process leading up to the program's implementation while minimizing costs and burdens to the relevant players and encouraging the flow of capital into the United States. Not every objective can be met in pristine form.

However, as we continue to live under the system and learn from experiences, adaptations should and will be made. And, as the IRS continues to receive a multitude of forms and filings, it will, hopefully, wisely use the information gleaned from them in an attempt to monitor and measure improved compliance.

This commentary also will appear in the April 11, 2008, issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Tello, 915 T.M., U.S. Withholding and Reporting Requirements for Payments of U.S. Source Income to Foreign Persons, and in Tax Practice Series, see ¶7150, Withholding and Compliance.