The “qualified intermediary” (“QI”) system was established by the IRS in 2001 to improve the withholding, and ultimately the reporting, of U.S.-source income sent offshore to foreign financial institutions receiving it on behalf of their account holders. Under the QI system, foreign financial institutions agree to determine whether their non-US account holders are eligible for reduced withholding taxes, and withhold the appropriate tax, and to report and backup withhold on payments beneficially owned by U.S. tax residents. There are currently over 5,600 foreign financial institutions in the QI program.

Recent events have exposed apparent weaknesses in the QI rules, and the IRS is clearly in a mood to try to correct them. The Senate Permanent Subcommittee on Investigations held hearings in July that targeted Americans using foreign accounts to hide income from the IRS, and suggested a number of steps the IRS should consider to improve compliance, including making changes in the QI rules. The IRS is investigating a number of foreign financial institutions for failure to implement the QI rules properly. Both the Senate committee and the IRS are focusing on allegations that Americans are using foreign financial institutions to illegally evade paying their U.S. taxes, and that the QI system is not effective in preventing this tax evasion.

The first steps in this direction came in proposed changes to the QI agreement itself as well as to the QI Audit Guidelines that were issued October 14, 2008. The changes are to be effective for calendar years after 2009. Although that is still over a year away, QIs need to consider the steps they will need to take internally to comply with the new requirements.

Presumably, these changes in the QI agreement and Audit Guidelines are only the first of a series of changes that may be expected from the IRS over the near future. Because of the prominence of the QI system, wealth professionals everywhere need to understand the QI system and how it will be altered.

Announcement 2008-98, 2008-44 IRB 1, proposes changes designed to ensure that QIs are “taking the steps necessary to comply fully with their obligations under the QI agreement.” The proposed changes are discussed below.

Detecting U.S. Persons Behind QI Accounts
An important proposed amendment to the audit guidelines is designed to unearth evidence of U.S. persons behind QI Accounts during the earliest phase of the external audit.

There are three “phases” to an external audit of the QI. The IRS proposes to expand the Phase 1 portion of the audit to try to detect whether there are U.S. persons behind apparently foreign-owned accounts. New procedures are added testing certain accounts for characteristics that suggest a U.S.person has authority over the account. In particular, the external auditor is to examine the most recently updated information on the QI account from all available documents, including correspondence, reports, etc., in the QI’s hands. If any of this information suggests that a U.S. person has signature or other authority over the funds in the account, this information must be turned over to the IRS as part of the Phase 1 audit report. Relevant information is identified as including not only signature authority, but also “other authority” such as the right to withdraw funds, trade, give instructions, or receive account statements, confirmations or other information, notices, advice or solicitations with respect to the account. Transferring to or receiving authority from a foreign person is also reportable. According to the IRS, this will permit it to pursue this information further in later phases of the audit.

Internal Controls
Reasoning that compliance was dependent upon the effectiveness of the QI’s internal controls, the IRS will now require the external auditor to report on the QI’s internal controls, including:

• QI personnel charged with oversight of performance under QI agreement;

• Identify their posts of duty, the persons to whom they report, and the positions of those persons in the QI;

• The extent of their authority over operational personnel;

• List significant actions taken by QI personnel to prevent, deter, detect and correct errors, including exams, audits, testing procedures, and training since the last QI audit year; and

• Determine if QI has procedures for receiving and investigation allegations of material failures.

Implication: QIs should make sure that QI personnel are clearly identified, have appropriate authority, and exercise that authority to ensure compliance.

Notice of Material Failure of Internal Controls
The QI will be required to notify the IRS whenever it becomes aware of a “material failure of internal controls.” The QI has 60 days to notify the IRS once discovered, or the QI agreement may be terminated. Moreover, not only must an actual failure be reported, but any employee allegations of a material failure, or any investigations by any regulatory authority of a material failure must also be reported.

A “material failure” can occur where internal controls are lacking or are not functional; but it also can refer to errors, either intentional or unintentional, that appear to have originated with client-relations personnel.

Although the IRS states that this kind of failure would allow the termination of the QI agreement, it says that an automatic termination on a report of a “material failure” will not occur. Rather, the IRS expects prompt notification will allow it to work with the QI to remedy the problem.

These changes are clearly aimed at making the QI do more, affirmatively, to ensure compliance, particularly among customer relations personnel.

Detecting “Material Failure” in Internal Controls
To check on whether the QI is, indeed, monitoring for “material failures,” the audit guidance would be amended by adding procedures for fact gathering by the external auditor that would assist the IRS in evaluating the risk of a material failure of internal controls. The procedures include, for example, identifying the persons charged with oversight of QI performance and their authority to prevent, detect, and correct failures on the part of operational personnel, as well as those to whom they report, etc. The auditor will be required to report any facts or circumstances that reasonably relate to the evaluation of the risk of material failures occurring.

Audit Oversight and Review by U.S. Auditor
The IRS contends that a “key feature” of the external audit is oversight and review by persons that are “objective, accountable and knowledgeable about U.S. withholding rules.”

Accordingly, a foreign external auditor will be required to bring in a U.S. accounting firm or a U.S. branch or U.S. associated accounting firm for the audit, and the U.S. auditor must accept joint and several liability for the conduct of the QI audit and must cosign the report.

The IRS’s aim, it says, “is to assure appropriate application of U.S. withholding rules and to enhance accuracy and accountability in the audit process.”

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We expect that there will be future proposals and changes to the QI regime to reflect recent events, and QIs will need to stay abreast of these.

This news item is derived from a recent alert from the Baker & McKenzie global private banking team. Details are available on the Private Banking Helpdesk, an online information and training service offered by LawInContext, the interactive knowledge and training venture of Baker & McKenzie.