The Internal Revenue Service (IRS) issued a new Internal Revenue Manual (“Manual”) Section on the examination and audit of U.S. withholding agents, with an effective date of July 29, 2008. U.S. withholding agents are responsible for certain U.S. tax withholding and reporting requirements on payments of specific types of U.S. source income to foreign persons.Background –
Requirement to Withhold and Report
Under Sections 871(a) and 881(a) of the Internal Revenue Code (“Code”), U.S. source fixed or determinable, annual or periodical (FDAP) income that is not effectively connected with the conduct of a U.S. trade or business is subject to U.S. tax in the hands of foreign payees. The tax is generally 30 percent, which can be reduced or eliminated under an applicable treaty. In addition, certain types of FDAP income are exempt from U.S. tax under the Code. The 30 percent tax is collected through withholding. More specifically, under Section 1441, persons having the control, custody, receipt, disposal or payment of U.S. source non-effectively connected FDAP income of a foreign person must withhold U.S. tax from such income. U.S. withholding agents and, in some cases, foreign withholding agents, are liable for the U.S. tax that is required to be withheld and must deposit the amount withheld and file U.S. tax returns with respect to the amounts withheld, as provided in the Section 1461 regulations. Withholding agents may also be subject to interest and penalties for failure to report or withhold U.S. tax.
Manual Section 4.10.21 – U.S. Withholding Agent Examinations
Section 4.10.21 of the Manual (U.S. Withholding Agent Examinations – Form 1042) covers two types of U.S. withholding agent audits in detail. The first part provides guidance for the audit and examination of U.S. financial institutions that may have to satisfy withholding and reporting requirements in connection with their brokerage or custodial activities for their foreign clients. The second part provides guidelines for the audit and examination of U.S. non-financial entities that may have withholding and reporting responsibilities in connection with their payments to foreign persons for services rendered or property acquired.
When auditing a U.S. financial institution, the examiner’s focus will be on determining whether amounts paid to foreign account holders have been properly subjected to U.S. withholding, whether such amounts were properly reported and whether any such payments should have been subjected to backup withholding instead. The examiner will be charged with reviewing the U.S. withholding agent’s operational procedures related to nonresident alien and foreign person withholding and reporting and with reviewing the written procedure and training manuals that address (i) the withholding system, (ii) internal control and audit, (iii) payment system designs, (iv) account opening procedures, (v) validation procedures for Form W-8 and (vi) similar items. In addition, for each account selected for review (using statistical sampling), the examiner will be required to review Forms 1042 and 1042-S and to review the financial institution’s reconciliation workpapers to ensure that the gross income and net tax liability on Form 1042 equals the sum of gross income and net tax liability on Forms 1042-S. Finally, the examiner will review the new account opening and account updating documents, which includes a review of any information the U.S. withholding agent used to determine if the account is held by a U.S. person or a foreign person, such as residence and mailing addresses on the account forms, passport copies, driver’s license copies or articles of incorporation and similar corporate documents, as well as Forms W-8. If the examiner finds that the amount of U.S. tax withheld is incorrect, he/she will determine the correct amount by conducting a line-by-line review of Form W-8, comparing the information on Form W-8 to the information in the account file and checking the expiration date of Form W-8 to ensure validity. If a foreign person provides a Form W-8 to the U.S. withholding agent after payment has been made, the U.S. withholding agent may be subject to interest and penalties even if the foreign account holder already paid the tax that should have been withheld by the U.S. withholding agent.
The audit of nonfinancial institutions will generally involve the audit of companies or other business entities that make payments to foreign persons in connection with obtaining services, property or financing from such foreign persons. Manual Section 4.10.21 highlights the following industries as falling into this category and requiring withholding and reporting by the withholding agent: professional service providers, high tech industries, intellectual products providers, pharmaceutical industry and real estate industry. When auditing a nonfinancial institution, the examiner will review the account payable file and the vendor records to determine whether U.S. withholding and reporting is required, then determine all foreign vendors and payments of U.S. source FDAP income to such foreign vendors by analyzing the withholding agent’s accounts payable file. The examiner’s document request will include Forms 1042, 1042-S, 5471 and 5472, documents regarding existing systems and policies used to identify payments subject to withholding and reporting, and documents regarding existing policies and procedures to ensure the acquisition of withholding certificates.
Although the examination and audit of withholding agents is nothing unusual, Section 4.10.21 is new to the Manual. At this time, it is unclear whether it will result in increased audits and examinations of U.S. withholding agents, but any audit is likely to be more rigorous. However, what is clear is that both the IRS and Congress are paying close attention to withholding tax leakage in the face of the investigations of UBS AG and Liechtenstein’s LGT Group and U.S. taxpayer abuse. Accordingly, U.S. withholding agents should verify that they are in compliance with all various requirements related to their U.S. tax withholding and reporting obligations so as to avoid potential penalties and interest as a result of an audit.