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Qualified Intermediary: Phase II      
 

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03 March 2002

Qualified Intermediary One Year On
Bankers (and others) Anxiously Await Phase II
By: Edward Flaherty

With the recent passing of the one year anniversary of implementation of the "qualified intermediary" ("QI") agreements around the world between the US Internal Revenue Service and financial service provides, bankers in countries that count the financial services industry as a major part of their national output are now bracing for the real bite of the QI regime to kick in. The intention of this article is to give a brief overview of the QI to date, and to speculate a bit on what non-US banks and financial intermediaries can look forward to, at least over the next two years.

 

The History
For nearly twenty years, the US Treasury Department through its IRS agency has been threatening to reform the way in which it taxed and treated the payment of US source interest, dividends, royalties and certain other types of income to a foreign person under Section 1441 and 1442 of the Internal Revenue Code (IRC). Although the payer of such income to a foreign person generally was obligated to withhold thirty (30%) percent of the payment as back-up withholding against potential US income tax liability, a lower rate of withholding was often claimed pursuant to a particular section of the IRC, IRS Regulations, or an applicable tax treaty. Because the IRS had few easy or cost-effective means to verify the validity of such claimed reductions, or the identity (i.e., tax nationality) of the ultimate beneficiary (leading the IRS to suspect that many such payments were being paid offshore to US taxpayers thereby facilitating the non-reporting of such payments as US taxable income), it had long searched for a methodology which would allow it to do just that-thus was born the QI Agreement.

In what some practitioners have labeled an ingenious Trojan Horse, the IRS came up with the idea of going around foreign governments (neatly avoiding nasty and sticky issues of sovereignty and strict banking secrecy regimes in a number of countries) and approaching foreign banks and intermediaries directly with the QI regime. Those foreign banks and financial intermediaries that acted as a conduit for US source interest, dividends, royalties and other types of income paid to foreign persons were asked to enter a long and detailed agreement with the IRS (the Revenue Procedure which explains and sets out the QI Agreement numbers some 65 pages [Rev. Proc. 2000-12] of which the agreement makes up 55 pages of the total) in which they became withholding agents for the IRS, subjecting themselves not only to the terms and conditions of the QI Agreement, but also the IRC itself.

 

By becoming withholding agents, the foreign banks and intermediaries essentially made it impossible for US taxpayers to hold US securities and instruments anonymously offshore. In addition, those foreign institutions which became QI's were able to pass on an applicable lower rate of withholding to foreign beneficiaries, provided they provided the IRS with sufficient information and/or representations concerning the ultimate beneficiaries of the US source payments. Institutions that chose not to become QI's not only were charged the highest withholding rate provided by the IRC (31%), but were also warned that they might have their access to US markets and exchanges denied on the grounds that their refusal to enter the QI regime might be evidence of complicity with US tax evaders or worse.

With nary a whimper from the governments of countries with heretofore-sacrosanct banking secrecy laws (notably Switzerland and Luxembourg), by December 2000, approximately seven hundred QI applications had been received by the IRS. The IRS had sent out another two hundred QI agreements for signature and had received about fifty signed agreements back. As the QI Agreement imposed significant additional reporting burdens on intermediaries that did not enter an agreement by the date the new regime was to take effect (1 January 2001), it is presumed that many intermediaries entered the agreements without taking account of the long-term costs and effects of such agreements, as well as the ramifications from withdrawing from a QIA (or being deemed in default thereunder by the IRS) later in time.

As of today, some 48 countries1 have submitted to the IRS and have had approved their "know your customer rules", a substantial precondition to the conclusion of a QIA by an intermediary in one of those jurisdictions. (For the full list, see www.irs.gov/businesses/display/0,,i1%3D2%26genericId%3D7115,00.html) Additionally, the following eight jurisdictions have submitted their rules to the IRS and are awaiting approval:

  • Antigua
  • Bahrain
  • Colombia
  • Lebanon
  • United Arab Emirates
  • Saudi Arabia
  • Slovenia

Having spent most of 2001 making sure their files contained (or otherwise obtaining) the required documentation under the QI regime, the foreign qualified intermediaries now face the prospect of reporting the results of the mandatory audits called for in the QIA for the years 2002 and 2005. The prospect of such audits, although to be undertaken by the intermediaries' existing external auditors, and often claimed to be no threat to the requirements of any foreign banking secrecy regime, have begun to send shivers down the spines of QI's everywhere, for a number of reasons.

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The Present and Beyond
In October 2001, the IRS issued Notice 2001-662 entitled "Proposed Audit Guidance for External Auditors of Qualified Intermediaries", numbering some 45 pages.(For full text, see www.irs.gov/pub/irs-drop/n-01-66.pdf) Not only does this notice set out detailed and explicit guidance for audit compliance by a QI, it also requested public comments on the proposed guidelines (although the deadline for receipt was 12 December 2001).

The audit process proposed by the IRS in its notice foresees a three-part process3. The first step is fact finding in which the external auditor of a QI reviews its client's compliance with its obligations under the QIA, and then reports its findings in a statistical format to the IRS. If the results of the audit indicate a generally high level of compliance with the Agreement by the QI, it is anticipated that the IRS would then notify the QI that the audit process is complete and that no additional reporting steps for the subject audit year would be needed. In the event, however, that the audit results indicate that the QI had difficulties meeting its documentation/reporting requirements under the QIA, the audit with then progress to Part 2.

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Part 2 is called "Follow Up Fact Finding", and entails the IRS directly contacting the QI's external auditor to inquire about certain numerical results that the IRS had questioned from the auditor's initial report to the IRS. The auditor may be directed by the IRS to obtain additional information, and to then report the additional results back. The general purpose of this phase of the audit process it to determine the cause for the QI's unsatisfactory reporting results, and to identify any reasonable remedies for such deficiencies.

If the IRS is satisfied at the end of Part 2 that the QI has addressed the causes of the statistical problems from the initial report and has otherwise shown a substantial level of compliance with the QIA, then the audit would likely end at that point; otherwise, it would require implementation of Part 3.

Part 3 of the audit process involves a meeting directly between the IRS and the QI in order to solve the apparent deficiencies in the reporting process under the QIA that could not be solved after resort to Parts 1 and 2 of the audit. The IRS asserts that Part 3 was specifically designed "to provide a forum where a productive dialogue between the IRS and the QI can occur", with the goal of reaching "mutually acceptable solutions to the issues that arise in the course of administering QI agreements so that it will not become necessary to terminate a QI agreement."

Notice 2001-66 provides for the discretionary waiving by the IRS of the external audit requirement in certain limited cases4, but some practitioners have complained that these limits are set too unrealistically low to be of much help.

 

Conclusion
As the hypothetical effects of QI Agreements start to become a reality, many of the QI's are now quite concerned that the audit requirements might not only overwhelm their external auditors (causing unforeseen delays in their obligatory reporting exercises to the IRS), but will also result in exorbitant additional costs which could well reduce or eliminate the already slim profit margins experienced by many financial intermediaries in a number of jurisdictions. Additionally, their initial concerns about the effects of QIAs on banking secrecy requirements have not abated, and may well become more of a worry should their external audits reveal problems with their QI compliance, ultimately resulting in direct IRS "contact". More time will be needed to determine if the QI has achieved its initial goals of reducing US tax evasion and proper withholding tax rate allocation, or whether it has otherwise simply created a cumbersome and bureaucratic behemoth that only serves to inhibit law-abiding institutions that have the misfortune of being based outside the United States.

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Edward Flaherty
International Lawyer

11 Rue Verdaine
Case Postale 3377
1211 Geneva 3, Switzerland
Tel: + 41 22 317 8020  Fax: + 41 22 317 8030
Mail: flaherty@lfsa-law.com   www.lsfa-law.com 

 

 

Footnotes:
1 For the full list, see:
http://www.irs.gov/faqs/display/0,,i1%3D54%26genericId%3D7115,00.html#Approved 
2 For full text, see http://www.irs.gov/pub/irs-drop/n-01-66.pdf  
3 Notice 2001-66 does allow a QI to deviate from the specific audit guidelines set out in the subject notice if the particular circumstances of the QI demand it (such in the case of a QI with an inordinate amount of reportable payments), but it requires the QI to seek and obtain approval of any alternative plan prior to its submission to the IRS.
4 Such as where the QI has not received more than USD 250,000 in reportable payments during the year to be audited, or if the QI has not made reportable payments to more than 2000 direct or indirect account holders during the year to be audited.

 


 
   

 

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Last modified: augustus 03, 2006

© 2000 - 2004 Samuel M. Lohman
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