Significant Efforts Have Been Made to Improve Information
Reporting for Foreign Persons, But Substantial Work Remains
September 2001
Reference Number: 2001-30-181
This
report has cleared the Treasury Inspector General for Tax Administration
disclosure review process and information determined to be restricted from
public release has been redacted from this document.
September
27, 2001
MEMORANDUM FOR
COMMISSIONER, LARGE AND MID-SIZE BUSINESS DIVISION
COMMISSIONER,
SMALL BUSINESS/SELF-EMPLOYED DIVISION
FROM: Pamela J. Gardiner
/s/ Pamela J. Gardiner
Deputy
Inspector General for Audit
SUBJECT: Final Audit Report – Significant Efforts Have Been Made to Improve Information Reporting for Foreign Persons, But Substantial Work Remains
This report
presents the results of our review of efforts taken by the Internal Revenue
Service (IRS) to address the tax compliance of foreign persons. The overall objective of this review was to
follow up on previously identified conditions in a prior IRS Inspection Service
(now the Treasury Inspector General for Tax Administration (TIGTA)) report[1] and
determine whether the actions taken have corrected problems or whether risks
still exist. We also evaluated the
effect of new withholding regulations[2]
(effective January 1, 2001) for United States (U.S.) source income paid to
foreign persons.[3]
In summary,
the IRS has taken substantial actions in several areas to address conditions
identified in the prior report. For
example, the IRS identified the need to develop an improved system to address
data quality problems that were occurring in the processing of the Annual
Withholding Tax Return for U.S. Source Income of Foreign Persons (Form 1042),
and Foreign Person’s U.S. Source Income Subject to Withholding (Form
1042-S). The system will eventually
allow computer matching of payments to foreign persons with related tax
returns. The IRS also developed the
Individual Taxpayer Identification Number (ITIN) Program, which assigns an
identifying number to foreign individuals who are not eligible for Social
Security Numbers (SSN), but do have some U.S. tax-related transactions.
However, the
IRS needs to take additional actions to better ensure the compliance of foreign
persons. Specifically, the IRS did not
completely resolve the data quality problems identified in our prior
report. For example, invalid income codes were still accepted by the processing system
in effect at the time of our audit. As a
result:
·
The IRS cannot determine the correct withholding rate since
different withholding rates apply to different income types (i.e., interest,
dividends, etc.).
·
The IRS provides potentially inaccurate Form 1042-S data to
its treaty partners under the Routine Exchange of Information Program (REIP).[4]
·
Any Form 1042-S data currently used in examinations may not
be reliable because of the existing computer processing control weaknesses.[5]
Compliance
issues with the Form 1042-S information documents affect both the payee and the
payer. To address the first issue, payee
compliance, an information system with a proposed completion date of March 2004
will allow computer matching of withholding reported on Form 1042-S to a
foreign person’s tax return. However, at
this time, there is no system with IRS-wide accessibility for examination,
collection, and research purposes.
Computer analysis of Form 1042-S data has not regularly occurred, and
there are no specific plans for this type of analysis until the new system is
implemented.
The second
compliance issue concerns payers. The
IRS still cannot determine whether withholding agent compliance has
improved. IRS examinations of
withholding agents found that most interest income was paid to foreign
financial institutions serving as intermediaries for the actual account
holders. Foreign financial institutions
filed withholding exemption forms in their own names, and not in the names of
the account holders. In some cases,
interest was not reported on the Forms 1042-S and withholding exemption forms
were not obtained. Consequently, the IRS
cannot determine whether the account holders are foreign persons entitled to
the withholding exemption for certain interest income, or
The IRS is
still at risk because there is no effective system to monitor and encourage
taxpayer compliance. The ITIN provision
does not eliminate the compliance risks.
Under the new withholding regulations, an identification number is not
required when certain interest income is reported, so the IRS is unable to
identify the recipients of the income.
This prevents the IRS from systemically cross-checking Forms 1042-S with
foreign persons’ tax returns before issuing refunds. In addition, the risk of
Management’s
Response: In response to our report, IRS management
agreed to take corrective actions for most of the audit recommendations. However, IRS management did not agree to
pursue revised regulations for identification numbers on all foreign investment
income reporting documents. IRS
management responded that this proposal was previously considered by the IRS
and Treasury but not pursued because of the adverse effect that requiring an
identification number could have on foreign investments in the
Copies of this
report are also being sent to the IRS managers who are affected by the report
recommendations. Please contact me at
(202) 622-6510 if you have questions or Gordon C. Milbourn III, Assistant
Inspector General for Audit (Small Business and Corporate Programs), at (202)
622-3837.
Many Positive Steps Have Been Taken to Improve the Overall Program for Foreign Persons’ Compliance
Foreign Persons’ Data Could Be Better Used in Compliance Efforts
The Program to Monitor the Compliance of Withholding Agents Could be Strengthened
Enforcement Efforts Are Needed to Encourage Taxpayer Compliance
Appendix I – Detailed Objective,
Scope, and Methodology
Appendix II – Major Contributors to
This Report
Appendix III – Report Distribution
List
Appendix IV – Management’s Response to
the Draft Report
One of the major strategies of the Internal Revenue Service’s (IRS) Large and Mid-Size Business (LMSB) Division is to build a tax administration to effectively deal with globalization. This strategy includes addressing specific areas of non-compliance, promoting customer satisfaction by understanding issues from the taxpayer’s viewpoint, and enabling development of appropriate new tax legislation.
Generally, a foreign person is subject to United States
(U.S) tax on
The chart was removed due to its size. To see the chart, please go to the Adobe PDF
version of the report on the TIGTA Public Web Page.
The IRS issued new regulations,[6]
effective January 1, 2001, related to the withholding of tax and reporting of
Generally, withholding agents are legally responsible for
proper withholding and reporting.
However, under the new regulations, foreign financial institutions that
meet the IRS’ requirements can agree to withholding and reporting conditions
normally required of
A 1994 IRS Inspection Service (now the Treasury Inspector
General for Tax Administration) report[8]
identified areas where the IRS could improve payer and payee compliance with
The IRS identified foreign persons’ compliance as a material weakness for financial reporting purposes in 1994 as required under the Federal Managers’ Financial Integrity Act (FMFIA) of 1982.[9] The material weakness was closed in 1998 because the IRS’ Office of the Assistant Commissioner (International)[10] stated that steps to address this weakness were taken and a compliance problem no longer existed.
We performed this audit at the LMSB Division’s Office of
Pre-Filing and Technical Guidance between January and May 2001. The audit was conducted in accordance with Government Auditing Standards. Detailed information on our audit objective,
scope, and methodology is presented in Appendix I.
Many Positive Steps Have Been Taken to Improve the Overall Program for Foreign Persons’ Compliance
The IRS has taken significant actions in several areas to address conditions identified in the prior report. These actions included:
· Forming a task force to address the concerns identified in the 1994 audit report. The task force issued written results in 1995 outlining corrective actions taken and planned.
· Adding computer processing controls, including data validity and consistency checks,[11] for TY 1994 returns processed by the IRS in 1995 to ensure higher quality information entered the system.
· Ensuring that the Form 1042-S database was provided annually to its International function. This function’s Foreign Payments Division provided assistance in obtaining Form 1042-S information in specific examination situations. The Foreign Payments Division also took steps to educate withholding agents, examiners and tax agents in foreign persons’ withholding issues.
·
Developing a
regulation to require a Taxpayer Identification Number (TIN) be reported on all
returns filed with the IRS. This required that the IRS establish the Individual
Taxpayer Identification Number (ITIN) Program to assign an identifying number
to foreign individuals who are not
eligible for Social Security Numbers (SSN), but do have some U.S. tax-related
transactions. Foreign individuals are
required to furnish either an SSN or an ITIN on tax returns filed after
December 31, 1996.
·
Identifying the need for a new processing system
with IRS-wide accessibility. The system
is currently being developed and will be implemented in phases with the first
phase scheduled for completion March 2002. The first phase will address how foreign
persons’ withholding documents are posted to the IRS’ Information Returns
Master File (IRMF). IRMF contains data
from third party sources and is used for compliance purposes. Upon completion in March 2004, the new system
will allow the computer matching of payments to foreign persons with related
tax returns.
·
Revising the foreign withholding tax regulations
extensively.
·
Redesigning withholding forms including the
Certificate of Foreign Status (Form W-8) and revising Publication 515, Withholding of Tax on Nonresident Alien and
Foreign Corporations to satisfy and explain the new documentation
requirements.
·
Developing Revenue Procedure 2001-20[12]
that describes the Voluntary Compliance on Alien Withholding Program (VCAP),
which allows certain colleges and universities to resolve issues arising from
the underreporting of taxes on payments to foreign individuals.
These positive efforts have helped address some of the conditions
identified in the prior report. However,
the IRS needs to take additional actions to better ensure the compliance of
foreign persons.
Effective Processing of Foreign Person’s
United States Source Income Subject to Withholding (Form 1042-S) Is Needed to
Ensure the Accuracy of Data
As previously stated, the IRS added computer processing controls, including data validity and consistency checks, for TY 1994 returns processed in 1995. The IRS also lowered the rate of errors allowed in the computer system when Forms 1042-S were filed magnetically. A lower acceptable error rate increases the quality of information entering the computer system because data with errors above the acceptable rate are not processed until the errors are corrected. When errors are identified, the IRS notifies the filers that the Form 1042-S data submitted need to be corrected and resubmitted.
However, the added computer processing controls did not completely resolve the data quality problems identified in the prior report. The IRS’ Statistics of Income (SOI) function identified problems with the Form 1042-S data after the processing changes took effect, including duplicate records and invalid or incorrect codes. For example, invalid income codes were still accepted by the processing system in effect at the time of our audit. Consequently, the IRS cannot determine the correct withholding rate since different withholding rates apply to different income types (i.e., interest, dividends, etc.).
The General Accounting Office’s (GAO) Standards for Internal Control in the Federal Government require that systems include controls that are designed to help ensure the completeness, accuracy, and validity of all transactions during processing.
There were two primary reasons that additional computer processing controls were not programmed. First, the International function’s requests to modify the existing system or develop a new system were initially denied because of funding shortages and other priority projects. Also, the International function anticipated having to redesign a new processing system because of the changes in the withholding regulations and waited to incorporate additional processing controls in the new system.
As a result, the IRS provides potentially inaccurate Form 1042-S data to its treaty partners under the Routine Exchange of Information Program (REIP).[13] In addition, any Form 1042-S data currently used in examinations may not be reliable because of the existing computer processing control weaknesses. The scope of this audit did not include specific tests to identify inaccurate data provided to the REIP or for examinations. Therefore, the extent of any inaccurate data that may have been provided is not known.
1.
The Submission Processing function of the Small
Business/Self-Employed (SB/SE) Division’s Customer Account Services
organization should ensure the accuracy of the foreign persons’ data from the
new processing system. If inaccuracies
in the data are identified after the new system is implemented, the causes of
the inaccuracies should be identified, and system enhancements should be
requested to resolve any further processing weaknesses.
Management’s Response: The Commissioner,
LMSB Division responded that the IRS formed the Chapter Three Withholding (CTW)
Working Group which has restructured the entire CTW Processing System. The IRS expects to implement Phase I of the
new Chapter Three Withholding programs by April 1, 2002. The Submission Processing function of the
SB/SE Division’s Customer Account Services will perform random data
verification throughout the implementation, which will include those areas
involving data input, program consistency, validity accuracy, and posting
progress. In addition, the Submission
Processing function submitted a placeholder Request for Information Services to
address Phase II processing and to refine those areas identified as not meeting
the specifications requested in Phase I.
IRS has revised the Internal Revenue Manual to include the new program
specifications and processes. The
Submission Processing function staff will monitor the implementation of the new
processing system.
Foreign
Persons’ Data Could Be Better Used in Compliance Efforts
The prior
report recommended that the International function increase efforts to measure,
examine, and enforce compliance with Form 1042-S requirements because of the
significant income involved. For TYs
1995 through 1999, the recommended additional tax and penalties resulting from
examinations of the Annual Withholding Tax Return for U.S. Source Income of
Foreign Persons (Forms 1042) have ranged from $45 million to $189 million per
year.[14]
The prior report also recommended that computer analysis and trending of
Form 1042-S data be used to identify large-dollar transactions and unusual
trends that may require additional actions to verify the payee income
reported. At this time, computer
analysis and trending of Form 1042-S data have not occurred on a regular basis
and there are no specific plans for this type of analysis until the new system
is implemented.
The GAO’s Standards for Internal Control in the Federal Government state that internal control should provide reasonable assurance that the objectives of an agency are being achieved. These encompass the effectiveness and efficiency of operations, including the use of the entity’s resources, and compliance with applicable laws and regulations.
The International
function submitted two requests for the development of a system for compliance
purposes. These requests were denied
because of funding shortages and other priority projects.
A system with IRS-wide accessibility for examination, collection, and research purposes does not exist. The IRS cannot develop and implement strategies to accomplish business needs and objectives without an effective system to analyze and trend Form 1042-S data. This is significant because foreign persons’ income reported on Forms 1042-S has increased from over $79 billion in TY 1990 to over $124 billion in TY 1998. Yet, despite a statutory tax rate of 30 percent on foreign persons’ income, withholding amounts have decreased from approximately 2.75 percent of TY 1990 income to 1.93 percent of TY 1998 income.
2.
The LMSB Division’s Office of the Director, International,
which will be responsible for the Foreign Payments Program as of September
2001, should ensure the data from the new processing system provide useful
information that will meet the IRS’ business needs and objectives. The information should be distributed to all
IRS offices that would require the information to carry out their duties.
Management’s Response: The Commissioner,
LMSB Division responded that the LMSB Division’s Strategy, Research and Program
Planning function will receive information from the Form 1042 and Form 1042-S
databases. That function will be
responsible for developing objectives, examination plans, and criteria for
audit selection of cases. Information
will also be shared with the SB/SE Division’s planning staff and distributed to
the appropriate IRS offices once the new processing system is implemented. The Foreign Payments Team will work with the
Strategy, Research and Program Planning function and the SB/SE Division to
ensure Form 1042 and 1042-S databases are used to develop effective return
classification programs and examination plans.
The
Program to Monitor the Compliance of Withholding Agents Could be Strengthened
The IRS still does not have an effective program to
monitor payer compliance. This condition involving withholding agent
compliance with laws and regulations was identified in the prior review and has
not improved since 1994.
The IRS removed foreign persons’ compliance issues from its list of FMFIA material weaknesses in September 1998 after concluding that a compliance problem no longer existed in this area. Among the steps taken to reach that conclusion, the IRS examined Form 1042 returns filed by 10 of the largest withholding agents. These withholding agents were financial institutions including banks and brokerage houses.
As part of their examinations of the withholding agents, the examiners reviewed the issue of portfolio interest. Portfolio interest is interest earned on qualified investments and is tax exempt if earned by a foreign person. The examiners determined that most portfolio interest had been paid to foreign financial institutions serving as intermediaries for the beneficial account holders. A beneficial account holder is the entity (individual, corporation, etc.) that ultimately receives the interest income.
The examiners noted that foreign financial institutions furnished to the withholding agents Certificates of Foreign Status (Form W-8) in their own names, and not in the names of the beneficial account holders. The Form W-8 is used to identify the beneficial account holder as a non-U.S. person for tax purposes and may qualify the account holder for a withholding exemption for portfolio interest. The examiners also noted that income items such as portfolio interest were not reported on the Forms 1042-S and that the financial institutions did not obtain Forms W-8. The IRS examiners referred to the Office of Chief Counsel the issue of whether the Forms W-8 should be in the names of the foreign financial institutions or in the names of the beneficial account holders. Chief Counsel did not issue formal guidance regarding this issue; however, the withholding regulations were subsequently rewritten.
The Internal Revenue Code[15] requires a statement that the
beneficial account holder is not a
After foreign persons’ compliance was removed as a material weakness, there was a decreased emphasis on the portfolio interest issue as the IRS reevaluated the foreign persons’ compliance program including the potential effect of the new withholding regulations. In addition, requests were made for the development of a computer system that would be useful in a compliance program, but the requests were never funded.
Without proper documentation of foreign status, the IRS
cannot determine whether the beneficial account holders are foreign persons
entitled to the withholding exemption for portfolio interest, or
The potential
adjustment related to interest and penalties could amount to 18 percent of the
portfolio interest paid. Since it is
common for undocumented “portfolio interest” to be in excess of $200,000,000
per year, an interest and penalty adjustment would amount to $36,000,000.
3. The LMSB Division’s Office of the Director, International should increase management attention to the compliance aspects of the Program, particularly improving withholding agent compliance, in addition to the customer service aspects already being provided.
Management’s Response: The Commissioner, LMSB Division disagreed
with our conclusion that the IRS still does not have an effective program to
monitor payer compliance. The
Commissioner, LMSB Division responded that the IRS established the Qualified
Intermediary (QI) Team in the LMSB Division’s Financial Services Industry to
monitor compliance issues of financial institutions with the Foreign
Withholding Tax Regulations. The IRS
will staff the QI Team with subject matter experts who will assist revenue
agents in their examinations of Forms 1042 filed by Financial Service Industry
taxpayers. The QI Team will also review
reports filed by auditors of qualified intermediaries. The Foreign Payments Team will work with the
QI Team to develop a Compliance Program covering
Office of Audit Comment: We concur that the LMSB Division has planned actions to address compliance issues in the future. Our conclusion, however, is based on the results of compliance efforts actually taken in recent years, not on the planned actions for the future.
Enforcement Efforts Are
Needed to Encourage Taxpayer Compliance
The prior
report recommended that the IRS improve enforcement efforts by ensuring that
individuals claiming nonresident status are entitled to exemptions under the
law. Critical to this effort is the use
of a Tax Identification Number (TIN) to identify individual taxpayers and link
all their tax-related transactions. As
previously stated, the IRS
established the ITIN Program to assign an identification number to foreign
individuals who are not eligible for an SSN, but do have some U.S. tax-related
transaction. Foreign individuals are
required to furnish either an SSN or an ITIN on tax returns filed after
December 31, 1996.
However, this provision does not eliminate the compliance risks. The IRS still does not have an effective program to monitor and encourage taxpayer compliance. The intent of the ITIN Program was to provide a unique identification number to foreign persons so Forms 1042-S and related tax returns could be computer matched, taxpayer compliance could be monitored, and enforcement actions could be taken if appropriate.
Under the IRS’ new withholding regulations, an identifying number is not required when portfolio interest income is reported. Also, ITINs will not be provided to the IRS under the new regulations’ QI Program. In this Program, approved foreign financial institutions establish an agreement with the IRS to maintain documentation supporting withholding exemptions, but the identities of the beneficial account holders are generally not disclosed to the withholding agent or the IRS.
The GAO’s Standards
for Internal Control in the Federal Government state that internal control
should provide reasonable assurance that the objectives of an agency are being
achieved. These encompass the
effectiveness of operations, and compliance with
applicable laws and regulations.
Delays in finalizing the new withholding regulations, in
addition to extensive amendments to the regulations, caused delays in building
a new computer processing system with matching capability. Information from the computer processing system
would allow the IRS to systemically monitor taxpayer compliance and take
enforcement actions if necessary.
The IRS is still at risk because the ITIN provision does not
allow the IRS to identify the recipients of the income. This prevents the IRS from systemically
cross-checking Forms 1042-S with the foreign persons’ tax returns before
issuing refunds. In addition, the risk
of
4. The LMSB Division’s Office of the Director, International should consider pursuing revised regulations that require an identification number (ITIN or SSN) on all foreign investment income reporting documents.
Management’s Response: The Commissioner, LMSB Division responded
that the IRS had previously proposed legislation to Treasury requiring backup
withholding if an identification number was not provided to a withholding
agent. Treasury made a policy decision
not to seek legislation because of a concern that requiring a TIN would have an
unnecessary adverse effect on foreign investment in
Office of Audit Comment: We have a continuing concern that the IRS needs a system to identify individual foreign investors.
Appendix I
Detailed Objective, Scope, and Methodology
The overall
objective of the audit was to follow up on the previously identified conditions
in a prior Internal Revenue Service (IRS) Inspection Service (now the Treasury
Inspector General for Tax Administration) report[17] and determine whether the actions taken have
corrected the problems or whether risks still exist. As part of the follow-up, we evaluated the
effect of new withholding regulations[18] (effective January 1, 2001) for
I. Evaluated the status of corrective
actions taken in response to the recommendations made in the prior audit
report.
A.
Interviewed IRS
personnel to determine the status of corrective actions.
B.
Obtained and reviewed
documentation to support the status of the corrective actions for the prior
report.
C.
Reviewed the IRS’
report titled, Final Report of the
Nonresident Alien Withholding Task
Force (dated September 11, 1995).
II.
Reviewed the new
withholding regulations under the Internal
Revenue Code (I.R.C.)[19] and determined whether
the recommendations and corrective actions from the prior audit report were
still applicable.
III.
Reviewed procedures
for processing foreign persons’ information returns and evaluated how changes
in the withholding regulations would affect future processing of foreign
persons’ information.
A.
Interviewed IRS
personnel responsible for developing the new processing system.
B.
Reviewed available
system documentation including action plans, requests for computer support, and
processing flowcharts.
IV.
Evaluated the IRS’
Federal Managers’ Financial Integrity Act of 1982[20] records to determine
management’s justification for removing foreign persons’ information documents
as a material weakness.
Appendix II
Major Contributors to This Report
Gordon C. Milbourn
III, Assistant Inspector General for Audit (Small Business and Corporate
Programs)
Philip Shropshire,
Director
Richard Hayes, Audit
Manager
Lisa Stoy, Senior
Auditor
Carole Connolly,
Auditor
Appendix III
Commissioner N:C
Deputy
Commissioner, Large and Mid-Size Business Division LM
Director, International LM:IN
Director, Pre-filing and Technical Guidance LM:PFT
Director, Customer Account Services, Small Business/Self
Employed Division S:CAS
Deputy Chief Financial Officer,
Department of Treasury
Appendix IV
Management’s Response to the Draft
Report
The response was
removed due to its size. To see the
response, please go to the Adobe PDF version of the report on the TIGTA Public
Web Page.
[1] Review of
Nonresident Alien Information Documents (Reference Number 041403, dated
January 21, 1994).
[2] Treas. Reg. § 1.1441 [Treasury Decision (T.D.)
8734, (October 1997), amended T.D. 8804, (December 1998), amended T.D. 8856,
(December 1999), amended T.D. 8881(May 2000)].
[3] The report addresses the entire group of foreign
person payees that include nonresident alien individuals, foreign corporations,
foreign partnerships, foreign trusts, foreign estates, and any other persons
that are not
[4] The IRS provides Form 1042-S data to foreign tax
authorities.
[5] The scope of this audit did not include specific
tests to identify inaccurate data provided to the REIP or for
examinations. Therefore, the extent of
any inaccurate data that may have been provided is not known.
[6] Treas. Reg. § 1.1441 [Treasury Decision (T.D.)
8734, (October 1997), amended T.D. 8804, (December 1998), amended T.D. 8856,
(December 1999), amended T.D. 8881(May 2000)].
[7] A withholding agent is any
[8]
Review of
Nonresident Alien Information Documents (Reference Number 041403, dated January 21, 1994).
[9] The Federal
Managers’ Financial Integrity Act of 1982, 31 U.S.C. §§ 1105, 1113, and 3512
(1994 & Supp. IV 1998) requires that all federal agencies establish
processes for the evaluation and improvement of financial and internal control
systems to ensure that management control objectives are met. A material weakness is a significant control
deficiency of sufficient importance to be reported annually to the Office of
Management and Budget.
[10] Foreign persons’ withholding issues were the
responsibility of the Office of the Assistant Commissioner (International) but
were transferred to the LMSB Division when it was established in June 2000.
[11] These checks are controls built into a computer
system to identify unacceptable data.
[12] IRS Revenue Procedure 2001- 20, Voluntary Compliance on Alien Withholding
Program issued February 26, 2001, Internal Revenue Bulletin No. 2001-9.
[13] The IRS provides Form 1042-S data to foreign tax
authorities.
[14] We obtained these statistics from the IRS’
Examination Program Monitoring Reports.
[15] Internal Revenue Code § 871(h)(2)(B)(ii)(1999).
[16] Financial
Institutions Withholding on Payments to Nonresident Aliens, dated June 1,
1998, prepared by the International function’s Foreign Payments Division and
Examination function’s Coordinated Examination Program.
[17] Review of
Nonresident Alien Information Documents (Reference Number 041403, dated
January 21, 1994).
[18]Treas. Reg. § 1.1441 [Treasury Decision (T.D.)
8734, (October 1997), amended T.D. 8804, (December 1998), amended T.D. 8856,
(December 1999), amended T.D. 8881(May 2000)].
[19] I.R.C. §§ 1441-1464, 6041-6050N.
[20] 31 U.S.C. §§ 1105, 1113, and 3512 (1994 & Supp. IV 1998)