M E M O R A N D U M
August 15, 2008
TO: Distribution
FROM: John Staples and Dan Burt
RE:New Withholding Tax Audit Guidelines
NEW WITHHOLDING TAX AUDIT GUIDELINES: The IRS published guidelines on August 7, 2008, for their examiners to follow when conducting withholding tax audits of U.S. withholding agents other than Qualified Intermediaries ("Guidelines"). See Chapter 4.10.21 of the Internal Revenue Manual on the IRS’ website at http://www.irs.gov/irm/part4/ch09s24.html; http://www.irs.gov/irm/part4/ch09s25.html . We cannot stress enough that every U.S. withholding agent, not just financial institutions, should review these Guidelines to prepare for a potential IRS audit. The IRS has publicly stated that it intends to achieve 100% audit coverage for Form 1042 filers and they are making good on that promise. Now is the time to determine whether you have any information reporting and withholding obligations that may not have been met in the past and to ensure that any such reporting and withholding that you have performed will pass muster. The tax liability for shoddy compliance can be significant.
USE GUIDELINES AS A DEFENSE ROADMAP: Use the Guidelines to prepare your first line of audit defense by having the materials ready for the IRS when they come knocking. The easier it is for the IRS to check items off its audit list, the better off you potentially will be. The Guidelines are divided in two parts – one for financial institutions and one for all other potential U.S. withholding agents. However, both parts are relevant to your compliance. Every withholding agent should ensure that it has the items that the IRS will ask for, unless it is clear that your withholding obligations are so minimal that the items would be overkill: (1) Description of your information reporting and withholding systems; (2) System flow charts; (3) Written procedures and training manuals; (4) Any internal control reports; (5) Document validation procedures (that is, check now to see if Forms W-8 and W-9 have been collected and are valid); (6) Reconciliation of Form 1042 and Forms 1042-S; (7) Tax deposit information; (8) Account opening procedures (for financial institutions). NOTE ON DRAFT IDRs: The Guidelines contain draft Information Document Requests ("IDRs") – make sure that you have the information available to answer these IDRs.
CHECK WHAT THE IRS WILL CHECK: The IRS intends to look at your Forms 5471 or 5472 to determine if you reported, and if appropriate, withheld on, all relevant intercompany payments. You should check these Forms now to see if they show payments that may be subject to reporting and withholding (e.g., royalties, related party dividends and interest, rents, pensions). Likewise, do an inventory of all payments that your company makes, particularly to foreign vendors and make sure that all U.S. source income has been identified, and, if not withheld on, that they are properly documented with Forms W-8 and Forms 8233 if necessary. The IRS has a three step process for their examiners to (1) identify foreign vendors; (2) determine all payments made to them; and (3) establish if any payments were U.S. source and subject to withholding. The IRS knows that the accounts payable departments of many companies have little or no withholding tax compliance. Don’t find out too late that you are in this class, and don’t forget that the presumption, in the regulation, is that, if you can’t show that services were performed outside the U.S., they will be presumed to have been performed inside the U.S. and therefore subject to reporting and withholding.
TARGETED INDUSTRIES AND BUSINESSES: Obviously the IRS is highly focused on the financial services industry. Financial institutions should be aware that the IRS has identified the following activities and transactions for particular scrutiny: (1) REITs; (2) OID; (3) Securities Lending; (4) Notional Principal Contracts; (5) Syndicated Loans; and (6) Portfolio Interest. In addition, the Guidelines direct examiners to focus on the following industries which are likely to be making payments to non-U.S. vendors: (1) Professional Services Providers; (2) High Tech (e.g., software, hardware, medical equipment); (3) Intellectual Property Providers (e.g., entertainers, publishers); (4) Pharmaceuticals; and (5) Real Estate.
VCP – NO DEFENSE: Many taxpayers who participated in the VCP might think that they are immune to IRS audit. The Guidelines clarify that the IRS will ask VCP participants (as well as anyone receiving a closing agreement or a Memorandum of Understanding) if they have adhered to the agreed upon terms. Check these documents closely and make sure that you have done what you promised to do.
DOMESTIC BACKUP WITHHOLDING AUDIT ANGLE: The Guidelines ostensibly are limited to payments to foreign persons, but they also state that problems with foreign information reporting and withholding may be indicative of problems with domestic information reporting and backup withholding compliance that may bear examining. In our experience, domestic backup withholding failures can quickly dwarf foreign withholding failures. We believe that U.S. withholding agents have some breathing room since the Guidelines remain primarily focused on foreign withholding. However, Congress is exerting great political pressure on the IRS to improve its collection of information for overall U.S. tax compliance. We recommend that you spend some time cleaning up this area if needed. Remember – the only way to "cure" a backup withholding failure is to collect a Form 4669 from the payee proving that the payee paid tax on the payment. Not easy.
MIXED BLESSING: The Guidelines are surprisingly high level and do not provide a great deal of detail to examiners on a number of issues, such as document validation. This may be a two edged sword. We believe that the Guidelines potentially provide withholding agents with room to negotiate and maneuver with respect to a number of audit issues. On the other hand, withholding agents can expect to see continued uneven application of the rules, and worse, continued "oral history" on what the IRS considers to be appropriate or inappropriate. The IRS may be intending to address these vexing issues through new regulations, Forms and Instructions or Frequently Asked Questions. However, until such guidance appears, we anticipate wide disparity in application of the Guidelines in audits.