Germany: 266. U.S. Withholding Tax - IRS Issues Final QI Audit Guidelines

Last Updated: 28 January 2003

by Hans-Dieter Wolf, KPMG Düsseldorf, and Chip K. Collins, KPMG National Office Washington, D.C.

An abridged version of this article appeared in International Tax Review, November 2002 at page 23

1. Q1 Audit Guidelines - Rev. Proc. 2002-55

2. Central features of the QI withholding tax regime
2.1 U.S. withholding on investment income
2.2 Old withholding regime in general
2.3 New withholding regime
2.4 Trade-offs of QI status
2.5 Success of QI system
2.6 Beneficial owner
2.7 Presumption rules
2.8 External audit of QI compliance

3. QI audit guidelines
3.1 External audit of QI compliance
3.2 Highlights of final audit guidelines
3.3 Audit waivers
3.3.1 Waivers in general
3.3.2 Waiver 1: $100,000 threshold (any audit year)
3.3.3 Waiver 2: $100,000 to $400,000 threshold (second audit year only)
3.3.4 Waiver 3: Annual internal review program (second audit year only)
3.3.5 No audit waivers for private arrangement intermediaries (PAIs)
3.3.6 Waiver application deadline June 30th
3.4 Scope of the external audit
3.4.1 Audit scope in general
3.4.2 Only accounts receiving "reportable amounts
3.4.3 "Reportable payments" if account receives "reportable amounts"
3.5 Statistical sampling
3.5.1 Maximum sample size reduced to 321
3.5.2 Sampling methodologies permitted without advance IRS approval - random and dollar-based stratification
3.5.3 Statistical sample of accounts to test documentation vs. "spot" sample to test certain withholding and reporting compliance
3.6 Phase 1 of the external audit - basic fact finding
3.6.1 Phase 1 in general
3.6.2 No need to interview employees or review procedures
3.6.3 Limiting account holder information to be reviewed
3.6.4 Documenting account holder status as a bank, broker, etc.
3.6.5 Testing withholding rate pool classifications by reference to last payment only
3.6.6 Testing compliance for reporting non-U.S. source income paid inside the U.S., and gross sales proceeds from sales effected inside the U.S.
3.7 The external audit reoprt; explaining questionable results
3.8 Audit report deadlines and extensions
3.9 "Consolidated" audits of multiple Qis - the external audit plan
3.10 Use of internal auditors
3.11 Phases 2 and 3 of the audit - extrapolation etc.

4. Concluding Remarks

For editorial cut-off date, disclaimer, and notice of copyright see end of this article.

1. QI Audit Guidelines – Rev. Proc. 2002-55

On 16 August 2002, the U.S. Internal Revenue Service (IRS) released final guidelines for the audit of so-called Qualified Intermediaries (QI). Such audits are carried out by independent external auditors chosen by the QI from a list agreed in advance with the IRS. The final audit guidelines contained in Revenue Procedure (Rev. Proc.) 2002-551 reflect the IRS response to criticism voiced by the financial community with regard to the proposed guidelines published in October 2001.2 Together with the January 2000 model QI Agreement,3 the QI Audit Guidelines define key aspects of the QI withholding tax regime that went into effect on 1 January 2001. A general obligation to submit to an external audit exists under section 10 of the model QI Agreement.

2. Central features of the QI withholding tax regime

2.1 U.S. withholding on investment income

U.S. tax law imposes a 30% withholding tax on payments of fixed or determinable annual or periodic income from U.S. sources to a non-resident alien (NRA withholding tax).4 In addition, a so-called backup withholding tax of 30%5 is levied on a wider range of sums paid to insufficiently identified persons that are, or are presumed to be, subject to U.S. tax on their worldwide income (U.S. persons, essentially, U.S. citizens and U.S. residents). The backup withholding tax extends to capital gains from the sale of securities, whereas the NRA withholding tax does not, because non-resident aliens have no U.S. tax liability on such sales.6 In the case of capital gains, the backup withholding tax is levied on gross sales proceeds and hence generally exceeds the taxpayer's actual tax liability on the net capital gain (proceeds less basis and selling costs). Responsibility for collecting both the NRA withholding tax and the backup withholding tax is imposed on the so-called "withholding agent," generally the last U.S. custodian in the chain of disbursement.

In addition to being exempt from U.S. withholding on capital gains, non-resident aliens are in many cases entitled to reduced withholding rates under tax treaties. Germany's tax treaty with the U.S. for instance gives Germany the exclusive right to tax interest derived by its residents from U.S. sources and reduces withholding on dividends to 5% or 15%, depending on the circumstances.7

2.2 Old withholding regime in general

Under the regulations in force through 2000, the so-called "address rule" permitted U.S. withholding agents to apply a reduced treaty withholding rate to dividends based on the address of the payee. Since this rule applied even where the payee was a financial intermediary, dividends disbursed to e.g. German banks routinely benefited from the dividend withholding rates specified by the U.S.-German tax treaty.8 However, non-resident alien beneficial owners in theory had to file Form W-89 with the U.S. withholding agent to establish foreign status in order to obtain withholding reductions at the source on interest income that qualified for the "portfolio interest" exemption from withholding. Alternatively, they could file refund requests with the IRS.

As a practical matter, many foreigners purchased their U.S. securities through foreign banks that were not anxious to collect and relay account holder information to their U.S. withholding agents. Besides the administrative burden, foreign banks feared attempts to "steal" their customers by the U.S. withholding agents, which were generally also banks. Foreign banks routinely filed a single Form W-8 on their own behalf instead of obtaining a separate Form W-8 from every account holder, and some U.S. custodians paid U.S. source interest to foreign banks at reduced withholding rates on the strength of the banks' Forms W-8.

The address rule for dividends and the unworkable requirement of beneficial owner documentation for portfolio interest resulted in a significant effort by the IRS to overhaul the U.S. withholding tax regulations and create a new regime.

2.3 New withholding regime

A new withholding tax regime was created by changes to the Treasury Regulations under Chapter 3 of the Internal Revenue Code that took effect on 1 January 2001 (New Regulations). The IRS believed the address rule for dividend income was being abused to allow treaty shopping by foreigners and wanted to improve compliance regarding interest flowing to foreigners as well. Another major concern was evasion of U.S. tax obligations by U.S. persons who routed payments through accounts with foreign financial institutions or foreign branches of U.S. financial institutions. The New Regulations therefore abolished the address rule and tightened the requirements for escaping backup withholding. At the same time, they opened up a new opportunity by which banks acting for the account of non-resident alien account holders can obtain reduced rates of withholding on dividend and interest income10 for these account holders without revealing their identities to either the IRS or a U.S. withholding agent.

This new opportunity to obtain reduced withholding rates while shielding the identities of foreign account owners from disclosure is available only to foreign financial intermediaries that have Qualified Intermediary (QI) status. QI status is in general available to foreign financial intermediaries based in countries where banks are subject to "know-your-customer" rules that meet certain standards. QI status is acquired by entering into a contract – a Qualified Intermediary Agreement – with the IRS. By accepting QI status, a foreign financial intermediary agrees to assemble certain documentation and perform certain functions with respect to its forwarding of payments received via accounts it maintains with U.S. withholding agents and designates as accounts for which it chooses to act as a QI.

Foreign financial intermediaries that decline QI status and its concomitant obligations in general receive payments from their U.S. withholding agents net of NRA withholding or backup withholding. Non-QI intermediaries can obtain reductions in NRA withholding only by disclosing the identity of the foreign beneficial owners of the payments in question. The loopholes contained in the Old Regulations (address rule etc.) are closed.

2.4 Trade-offs of QI status

Foreign financial intermediaries that accept QI status are able to file aggregated anonymous information with their withholding agents and obtain reduced withholding rates for non-resident direct account owners without disclosing the owners' identity to either the withholding agent or the IRS. On the other hand, by accepting QI status, a financial intermediary agrees in general either to disclose the identity and U.S. income of account holders that are U.S. persons (U.S. non-exempt recipients) or to exclude all assets from these persons' accounts that could generate income subject to U.S. withholding tax.11

A transition arrangement applies for accounts established prior to 1 January 2001 under which the QI must seek authorisation to disclose the identity of its U.S. account holders or dispose of the assets that could generate reportable payments.12 In the interim, the QI is required to backup withhold on all reportable payments paid to the account holder and report those payments anonymously on Form 1099.

QI status thus benefits the foreign customers of foreign banks, but at the expense of these banks' U.S. customers. Since non-U.S. customers are the largest client segment for foreign banks, those without QI status are at a competitive disadvantage. As non-QI foreign banks become scarcer, U.S. persons will find it harder to hide their U.S. source investment income from the IRS. The tax revenue generated by more complete taxation of U.S. persons will, so the IRS hopes, more than make up for any tax revenue lost by permitting foreigners to claim treaty benefits without disclosing their identities.13

2.5 Success of QI system

Virtually all German financial institutions have either entered into QI agreements with the IRS or become so-called Private Arrangement Intermediaries (PAIs) by signing an agreement with a QI.14 The QI system has thus been successful at least in as much as banks have rushed to secure QI status. The IRS expectation that competitive pressure would make it impossible for major banks to remain aloof from the QI system has thus proven accurate. Whether the QI system will increase U.S. tax revenues from withholding on investment income remains to be seen, however.

2.6 Beneficial owner

The QI system is based on a division of the QI's account holders into two principal groups: foreign persons and U.S. persons. The QI must collect various documentation on both groups in accordance with the QI Agreement and the know-your-customer rules in force in its home jurisdiction, the purpose of the documentation being to classify account holders in one group or the other and, within the group of foreign account holders, to verify the account holder's right to reduced rates of withholding under a tax treaty. Within the group of foreign account holders, various sub-groups or pools are formed depending on the type of income and the applicable withholding rate. The QI may elect either to provide this aggregated information to its U.S. withholding agent so that it can withhold accordingly, or the QI may itself assume the withholding function and file the aggregated information directly with the IRS.

However, the classifications made by the QI must be based on the beneficial owner of income in question. The beneficial owner of income is the person to whom the income is attributable for tax purposes. The QI's direct account holder is not the beneficial owner of the income where:

  • the account holder is another financial intermediary
  • the account holder is an individual (natural person) acting as trustee or other fiduciary
  • the account holder is a flow-through entity, the income of which is attributable to its members or interest holders (e.g. a foreign partnership or a foreign grantor or simple trust) and in other situations.

In such cases, the QI is general required to look beyond its direct account holder through the chain of indirect account holders until it finds the beneficial owner, i.e. the person to whom the income is attributable for tax purposes.

The person to whom a payment is attributable for tax purposes is determined for certain purposes under U.S. law and for other purposes under foreign law (law of the person's country of residence).15 Treatment as a beneficial owner or as a flow-through entity and eligibility to elect corporate or flow-through status under check-the-box rules is governed by U.S. tax law with regard to tax benefits such as portfolio interest that have their basis in U.S domestic tax law. However, classification under U.S. rules is irrelevant with respect to claims for treaty benefits. For treaty claims, beneficial ownership or transparency is determined under the tax law of the taxable person’s country of residence – e.g. Germany.

U.S. and German law agree in treating corporations as non-transparent entities. Hence, a corporation can derive income as a beneficial owner.16 It is not necessary to look through the corporation to its shareholders. However, in the case of a widely held partnership, a look-through approach would be required under German law, even though such partnerships can have thousands of partners. Under U.S. law, the partnership could opt to be treated as a corporation. Such elective corporate status would not be relevant for purposes of claiming treaty benefits, but would be effective with regard to portfolio interest.

The disadvantages of flow-through entities can be circumvented by channelling U.S. passive investment through an offshore entity that is treated as a corporation (or other non-transparent entity) for U.S. and foreign tax purposes. Careful thought must be given to the use of hybrid entities in light of the interplay between U.S. and foreign tax rules when determining the beneficial owner.

Another anomaly in the QI Agreement is the requirement that a QI must file a Form 1042-S disclosing the identity of all beneficial owners of income that are not its direct account holders.17 An exception exists only where the QI's direct account holder is another QI. Hence, only foreign persons that are both beneficial owners and the direct account holders of a QI are permitted to enjoy the reduced withholding rates under tax treaties while being shielded from disclosure to the IRS. Foreign persons who are not individuals (natural persons) must file a statement of entitlement to treaty benefits with the QI, however.18

2.7 Presumption rules

Where insufficient information is available to identify the beneficial owner of a payment, the QI Agreement requires the QI to apply presumption rules to determine whether NRA withholding or backup withholding and reporting apply to the payment.

2.8 External audit of QI compliance

The QI Agreement specifies in detail the documentation, reporting, and withholding requirements to which a QI is subject. A need exists to verify QI compliance, however. Since the major incentive to enter into a QI agreement – reduced tax treaty withholding rates for foreign residents without disclosure of identity – would be jeopardised by a direct IRS audit of QI compliance, the QI Agreement makes audit by an independent external auditor the standard means of verifying compliance. The external audit solution also avoids administrative expense for the IRS, which would need new regiments of revenue agents to audit the entire foreign financial community. Furthermore, many countries would not permit IRS agents to exercise official functions on their soil.

3. QI audit guidelines

3.1 External audit of QI compliance

The model QI Agreement requires external audit of the second full calendar year and the fifth full calendar year that the Agreement is in effect, meaning that the first year to be audited will be 2002 in most cases. The IRS must receive the 2002 audit report by 30 June 2003.19 QI Agreements are initially valid for a term of six years. Any agreement to extend a QI Agreement currently in force will provide for further audits.

In October 2001,20 the IRS issued proposed audit guidelines on the external audit procedures set forth in section 10 of the QI Agreement. The relatively late issuance of the final guidelines in August 200221 reflects the controversy generated by the proposed guidelines and the attempts by the IRS to come to terms with the criticisms of the financial community. The final guidelines differ from the proposed guidelines in numerous respects.

3.2 Highlights of final audit guidelines

The highlights of the final guidelines include the following:

  • The scope of audit waivers is expanded substantially.
  • The scope of accounts subject to external audit is narrowed.
  • The number of accounts required for a valid sample is reduced.
  • The external auditor's responsibilities are reduced, with only a "spot" sample required for testing certain withholding and reporting requirements.
  • The potential use of internal auditors and audit plans is clarified.
  • The threat of projection (extrapolation) of underwithholding liabilities to other accounts is deferred to Phase II of the audit, although no clear "safe harbour" from extrapolation appears in the final guidelines.

3.3 Audit waivers

3.3.1 Waivers in general

The proposed audit guidelines defined three situations in which the IRS was prepared to waive the external audit requirement, resulting in significant cost savings for many QIs. The final audit guidelines expand the potential waiver situations. While the IRS reserves the right to deny all waiver requests, the IRS is expected to routinely grant at least those requests that meet the Waiver 1 requirements. A few requests will probably be denied on a random basis as a check against the waiver policy.

3.3.2 Waiver 1: $1,000,000 threshold (any audit year)

The final audit guidelines allow a QI to request a waiver from external audit if the QI receives $1 million or less of reportable amounts (generally, U.S. source interest and dividends) for the audit year. This waiver represents a substantial increase from the proposed waiver threshold of $250,000 of reportable payments since "reportable payments" include certain foreign source income and gross sales proceeds in addition to "reportable amounts".

A QI requesting this waiver must provide the IRS with: (1) a reconciliation of the Forms 1042-S and 1099 received by the QI and filed by the QI; and (2) information about the number of its account holders in various classes. The required reconciliation need not be perfect, however, as the IRS will allow variances within reasonable limits based on facts and circumstances.

3.3.3 Waiver 2: $1,000,000 to $4,000,000 threshold (second audit year only)

The proposed guidelines contained a waiver for QIs with 2,000 or fewer account holders. This has been replaced by a new waiver for QIs that receive more than $ 1 million but no more than $ 4 million of reportable amounts for the audit year, provided an external audit was performed for the last year subject to audit. For instance, this waiver will be available for the audit of Year 5 provided an external audit was conducted for Year 2.

3.3.4 Waiver 3: Annual internal review program (second audit year only)

QIs with sizeable independent internal audit departments can be exempted from the second required external audit if the internal audit department has conducted a compliance review for each of the three preceding years. The final guidelines make clear that the internal audit department need not carry out a full-blown external audit for Years 2, 3, and 4, as suggested in the proposed guidelines. Instead, the internal auditors may determine which procedures and tests are appropriate, although advance clearance may be requested from the IRS. If this waiver is granted, internal audit personnel will perform the second QI audit (Year 5) instead of an external auditor.

3.3.5 No audit waivers for private arrangement intermediaries (PAIs)

Like the proposed guidelines, the final guidelines deny all waivers to PAIs. A PAI is a foreign financial intermediary to whom a QI has delegated obligations under its QI Agreement pursuant to a contractual arrangement between the QI and the PAI.22

3.3.6 Waiver application deadline June 30th

A QI eligible for an audit waiver must make a formal waiver request to the IRS by June 30th of the year following the audit year. Information required for the waiver request is outlined in the final guidelines.

3.4 Scope of the external audit

3.4.1 Audit scope in general

The QI agreement covers only accounts maintained by a QI with its upstream custodians (U.S. withholding agents) that the QI chooses to subject to the QI Agreement (QI-designated accounts). Only QI customer accounts with assets in a QI-designated account are potentially subject to external audit. By limiting the number of QI-designated accounts, a QI can therefore restrict the scope of the external audit.

The final guidelines further restrict the scope of the external audit as follows.

3.4.2 Only accounts receiving "reportable amounts"

In a significant departure from the proposed audit guidelines, only those customer accounts that receive "reportable amounts" (generally U.S. source interest, dividends, and similar income) will be subject to external audit. Consequently, accounts receiving only non-U.S. source income – which is not a reportable amount – will be outside the scope of the external audit, even if the account holder is a U.S. individual.

This change should significantly benefit QIs that are unable to segregate their non-U.S. securities from U.S. securities and therefore must hold all securities in a QI-designated account. Customer accounts that do not hold U.S. securities – but that exist within a QI-designated account – would fall outside the scope of the external audit. Absent the change in the final guidelines, the external audit costs for QIs that are unable to segregate their securities may have been much higher.

3.4.3 "Reportable payments" if account receives "reportable amounts"

If a customer's account receives a reportable amount, then the external audit will cover both reportable amounts and reportable payments for that account.

3.5 Statistical sampling

3.5.1 Maximum sample size reduced to 321

The maximum sample size is reduced to 321 customer accounts from a potential maximum of 1,368 under the proposed guidelines (456 accounts for 3 categories). The 321 account sample is stratified as follows:

1. Direct account holders that are not U.S. non-exempt recipients. This strata would include, therefore, direct account holders that are non-U.S. individuals and corporations.

2. Direct account holders that are U.S. non-exempt recipients. This strata would include, therefore, direct account holders that are U.S. individual citizens or residents.

3. Indirect account holders. This strata would include, for example, beneficial owners disclosed by nonqualified intermediaries (NQIs) or flow-through entities.

The final guidelines provide rules for allocating the total sample (321 account maximum) among the three strata. The minimum allocation per strata is the lesser of 50 accounts or the total number of accounts in the stratum.

3.5.2 Sampling methodologies permitted without advance IRS approval – random and dollar-based stratification

The IRS will allow statistical sampling to be performed on a random basis. Sampling based on a substratification by the amount of reportable amounts is also permitted as an alternative. Other statistical sampling methodologies (e.g. multistage or cluster sampling) require advance approval by the IRS.

3.5.3 Statistical sample of accounts to test documentation vs. "spot" sample to test certain withholding and reporting compliance

In Phase 1 of the audit, the external auditor reviews account documentation (e.g., Forms W-8, KYC documentation, etc.) for all accounts selected for the statistical sample (or for all accounts if no sample is used). By contrast, compliance with other requirements, such as certain withholding and reporting requirements, may be audited using a smaller "spot" sample, essentially a subgroup of the full statistical sample of accounts. The number of accounts to be selected for the "spot" sample must be the greater of: (1) 20 accounts from each of the three account strata described sec.3.5.1 above; or (2) all accounts within each stratum that are undocumented, or treated as undocumented after applying the "due diligence" requirements.

3.6 Phase 1 of the external audit – basic fact finding

3.6.1 Phase 1 in general

Phase 1 of the external audit consists of basic fact finding. This is the crucial audit phase. If the Phase 1 audit findings – as recorded in the external audit report – show the QI to be in compliance with its QI Agreement, the audit will terminate after Phase 1 and the QI should escape the external audit process without IRS assessments for underwithholding. If the QI does not "pass" the Phase 1 audit, the IRS will instruct the auditor to proceed to Phase 2, which will at a minimum entail additional cost.

As described in the final guidelines, the Phase 1 audit requirements include the following:

3.6.2 No need to interview employees or review procedures

In general, external audit tasks requiring examination of a specific account have been retained in Phase 1 of the audit, while other general requirements have been deferred to Phase 2. Consequently, the external auditor will not be required to interview the QI's employees or review the QI's procedures (including procedures to inform certain account holders of Limitation on Benefits provisions) during Phase 1. Such tasks may be performed by the external auditor under Phase 2 if the QI does not "pass" the Phase 1 audit.

3.6.3 Limiting account holder information to be reviewed

The proposed audit guidelines included a long non-exhaustive list of documentation to be reviewed by the external auditor – including client correspondence, memoranda, and other similar documents. The final guidelines state that the external auditor must examine "the most recently updated information for the audit year" drawn from various account documents, etc. This change should limit the scope of required documentation review to that documentation with the most current information.

3.6.4 Documenting account holder status as a bank, broker, etc.

Although the proposed audit guidelines were silent on this issue, the final guidelines (consistent with the QI Agreement) require the external auditor to determine whether the documentation indicates the account holder to be a bank, broker, custodian, intermediary, or other agent, and if so, whether the account holder provided a statement that it is acting on its own behalf. Otherwise, such an account holder should be treated as an intermediary.

3.6.5 Testing withholding rate pool classifications by reference to last payment only

To determine whether the QI has assigned an account to the proper withholding rate pool, the external auditor is required to check only the last payment of each income type that was made to the account for the audit year. This approach applies to external audits of accounts for which: (1) the QI has not assumed primary NRA withholding responsibility; and (2) the QI has not assumed primary Form 1099 reporting and backup withholding responsibility. QIs that assume such responsibilities apparently do not benefit from a similar limitation.

3.6.6 Testing compliance for reporting non-U.S. source income paid inside the U.S., and gross sales proceeds from sales effected inside the U.S.

For QIs that do not assume primary Form 1099 reporting and backup withholding responsibility, the final guidelines provide rules for determining whether (1) non-U.S. source income should be treated as paid inside the U.S. and (2) gross sales proceeds should be treated as being effected inside the U.S. (thus resulting in reportable payments potentially subject to Form 1099 reporting and backup withholding).

  • With respect to non-U.S. source income, the external auditor is required to identify only payments for which the "account statements and records" include a written instruction from the account holder concerning such income that, on its face, indicates that the written statement was sent from within the U.S.
  • With respect to sales proceeds, the external auditor is required to identify only sales for which the "account statements and records" include: (i) a written instruction from the account holder to sell the asset that on its face indicates that the written statement was sent from within the U.S.; or (ii) indications that payment or confirmation of payment was transmitted to the account holder in the U.S.

The scope of the "account statements and records" that must be reviewed for purposes of the above test is not entirely clear. Furthermore, no similar limiting instruction is evident for QIs that assume primary Form 1099 reporting and backup withholding responsibility.

  • Testing compliance of reporting requirements. The final guidelines resemble the proposed guidelines in that they require the external auditor to perform a general reconciliation between the Forms 1042-S and 1099 received by the QI and those forms filed by the QI. The final guidelines in addition state that unreconciled variances are permitted within reasonable limits based on the facts and circumstances.

3.7 The external audit report; explaining questionable results

Based on the results of the external audit report, the IRS will determine if the audit is satisfactory or if it should proceed to Phases 2 and 3, resulting in a potential assessment (including possible extrapolation of errors to all similar accounts). Consequently, the information provided to the IRS in the audit report will be a critical step in determining the QI’s potential liabilities.

  • Additional procedures, explanatory footnotes, or addenda. The final guidelines provide that the external auditor may conduct any additional procedures or other fact finding that it deems appropriate. Furthermore, explanatory footnotes or addenda may be used to explain certain results in the report.

  • No extrapolation during Phase 1. During Phase 1, the IRS may hold a QI liable for underwithholding liabilities relating to accounts examined by the external auditor. However, the IRS will not extrapolate (project) such withholding errors to other accounts during Phase 1. Extrapolation may occur only during Phase 2 (described below).

3.8 Audit report deadlines and extensions

Although the QI Agreement generally requires external audit reports to be submitted by June 30th of the year following the audit year, the IRS will grant automatic extensions until December 31st if the external auditor submits a request in writing. The IRS also may grant additional extensions, but a reason must be provided with the request.

The IRS still intends to develop a standard report form, which will be available on the IRS website.

3.9 "Consolidated" audits of multiple QIs – the external audit plan

The IRS may allow a consolidated audit of several QIs under certain circumstances. Financial institutions with multiple QIs could significantly reduce their external audit costs through a consolidated audit.

The final guidelines list the following prerequisites for obtaining a consolidated audit:

1. All QIs must be members of a group under common ownership;

2. The QIs must use uniform practices and procedures and shared systems to perform the audited functions;

3. Those practices and procedures and shared systems must be subject to uniform monitoring and control; and

4. The audit must pertain to the same calendar year for all QIs.

To request a consolidated audit, the external auditor must submit an audit plan to the IRS. It is unclear whether the IRS will approve consolidated audits unless all four requirements are met.

3.10 Use of internal auditors

The final audit guidelines allow the use of internal auditors without certification by the external auditor that the accuracy of the audit report was not affected by the use of internal auditors. Nevertheless, the external auditor "remains responsible" for the conduct of the audit, and the use of internal auditors must be disclosed in the audit report. Furthermore, the IRS will review the use of internal audit personnel when determining if follow-up in Phase 2 is appropriate.

3.11 Phases 2 and 3 of the audit - extrapolation, etc.

If the IRS determines that "further action is necessary with respect to underwithholding" based on the Phase 1 audit results, the IRS may direct the external auditor to perform a complete review of the sampled accounts during Phase 2 (IRS-directed procedures). If the complete review shows that underwithholding has occurred, the IRS may calculate the total underwithholding liability by extrapolating withholding errors to all similar accounts.

In deciding whether to extrapolate, the IRS will consider whether: (1) the underwithholding is the consequence of an "identified" error; and (2) the error was repeated throughout the population over which the error would be projected.

The QI may make a case that projection is inappropriate by showing that: (1) the underwithholding was the consequence of an identified error; (2) the QI has "corrected" the error in the stratum in which it was discovered (presumably through, e.g., obtaining the necessary documentation); (3) the error was corrected throughout the population; (4) the QI has established safeguards to prevent repetition of the error in the future; and (5) due to the correction, no underwithholding resulted during the audit year. Accordingly, the ability to "cure" an error by obtaining the proper documentation can be crucial to avoiding extrapolation.

In theory, external audits that cannot be resolved during Phase 2 will proceed to Phase 3 (Audit Meeting). However, the IRS or the QI may request an audit meeting at any time after the external audit report has been submitted in order to accelerate fact finding and to clarify and resolve concerns.

4. Concluding remarks

Release of the final audit guidelines provides QIs and their external auditors with the last document needed to budget and plan the external audit of QI operations in the audit year 2002, which is subject to audit for all QIs whose QI Agreements went into effect on 1 January 2001. This is the case for most German financial institutions. The first QI audit will be a milestone for the financial institutions and auditors as well as for the IRS, and will illuminate all concerned regarding the practicality and efficiency of the QI withholding system.


1 KPMG Germany has prepared a bilingual (English/German) edition of Rev. Proc. 2002-55. Orders should be addressed to Cornelia Püllen, KPMG Düsseldorf, Tel. +49-(0)211-475-7302, Fax +49-(0)211-475-6302, email

2 Notice 2001-66 of 15 October 2001; see bilingual (English/German) edition published by KPMG Germany in January 2002: Neues US-Quellensteuerverfahren: Proposed QI Audit Guidelines gem. IRS Notice 2001-66 (Verlag für Wirtschaftskommunikation, Berlin).

3 Rev. Proc. 2000-12 of 24 January 2000; see bilingual (English/German) edition published by KPMG Germany in March 2000: Neues US-Quellensteuerverfahren: Final QI Agreement gem. Rev. Proc. 2000-12 (Verlag für Wirtschaftskommunikation, Berlin). The IRS subsequently amended the model agreement in certain respects in the process of entering into QI Agreements with specific financial institutions.

4 Chapter 3 of the Internal Revenue Code (IRC), especially sections 871(a), 881(a), and 1441 IRC and the regulations issued thereunder. Payments of so-called portfolio interest to non-resident aliens are exempt from withholding. Portfolio interest includes interest on deposits maintained with U.S banks, certain original interest discount amounts, and interest from registered bonds. Sums effectively connected to the conduct of a U.S. trade or business are also exempt from withholding.

5 The backup withholding rate was 31% for many years. Reductions in U.S. personal income tax rates for the years 2001 – 2010 have led to enactment of corresponding adjustments in the backup withholding rate, which is to be lowered in phases to 28% in 2006. Under current law, the backup withholding rate reverts to 31 % in 2011, as the personal income tax rate reductions are scheduled to expire in 2010.

6 Capital gains by non-resident aliens on sales of shares in corporations owning U.S. real property are subject to U.S. tax under section 897 IRC, but only where real property accounts for 50 % or more of the corporation's assets. An exception also exists for small holdings in listed companies.

7 Articles 10 and 11 of the U.S.-German tax treaty. The 5 % withholding rate for dividends applies where the shareholder is a German resident company holding a minimum 10 % share of the voting stock of the distributing U.S. corporation.

8 See Endnote 7 above.

9 Old Form W-8, Certificate of Foreign Status.

10 I.e. the portfolio interest exemption under U.S. domestic tax law and treaty rates of withholding on dividends and on interest not falling under the portfolio interest exemption.

11 Section 6.04(C) of the model QI Agreement.

12 Section 6.04(A) of the model QI Agreement.

13 See sec. 2.2 above.

14 Section 4 of the model QI Agreement. A QI is permitted to delegate certain functions to a PAI, but assumes full responsibility for the PAI's proper discharge of these functions. A PAI is subject to external audit just like a QI under section 4.01 (A) of the model QI Agreement.

15 See Protocol No. 10 to Articles 10-12 of the German-American tax treaty . See also Reg. §1.4441.1(c)(6) IRC; IRS Notice 99-8D; Reg.1.894-1 T(d) IRC old version; Reg. 1.4441-6(b)(4) IRC; Reg.1.894-3(d)(ii) IRC new version, and Hamacher IStR 2002, 227, 259.

16 Corporations will have to file a so-called treaty statement affirming their entitlement to treaty benefits.

17 Michaels et. al., International Tax Review November 2000, p. 38, 40/2; Pinkernell, IStR 2001. p.242, 246/1.

18 Sec. 5.03(B) Model QI Agreement; cf. Michaels et. al. See Endonte 17 above p.40/3. The treaty statement is an affirmation that the filer meets all requirements necessary to claim a reduced rate of withholding under the applicable treaty, including any limitation on benefits provisions included in the treaty. For instance, the U.S.-German tax treaty contains a detailed limitation on benefits clause (Article 28). The clause provides inter alia that German corporations are entitled to treaty benefits if (i) the principal class of their stock is publicly traded on a recognised stock exchange or (ii) they meet certain requirements as to shareholder composition and use of income (essentially, more than 50% German or U.S. citizen shareholders, and less than 50% of income used to service debt to persons who are not German residents or U.S. citizens). A transition rule applies under section 5.03 (C) of the Model QI Agreement for payments received on or before 31 December 2002 for accounts established prior to 1 January 2001 (pre-2001 accounts).

19 See, however, sec. 3.8 below regarding extensions.

20 Notice 2001-66 of 15 October 2001.

21 Rev. Proc. 2002-55 of 16 August 2002.

22 Sec. 4 Model QI Agreement.

Editorial cut-off date: 09 October 2002

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