Qualified Intermediary Rules - Proposed Regulations

MEMORANDUM RE:

QUALIFIED INTERMEDIARY RULES - IRS ANNOUNCEMENT 2008-98 (PROPOSED REGULATIONS)

I.

Background

Edward Kleinbard, Chief of Staff Joint Committee on Taxation, on 3/31/09 stated (with respect to international tax enforcement): “The global recession and the UBS Scandal have created a Katrinatype movement. There is a push to improve tax enforcement and deter tax havens.” According to the IRS: 1. Since 1990, cross-border capital flows increased to $8.2 trillion. 2. An estimated $50 billion per year is lost in tax revenue through off-shore tax haves (President Obama identified $212 billion in tax revenue over the next decade from IRS international enforcement). 3. After UBS bought Paine Webber they entered into a Qualified Intermediary (“QI”) Agreement with the U.S. which required U.S. tax reporting of tax information for U.S. source income (i.e., U.S. securities held in foreign bank accounts) paid to either: a. A “non-exempt” U.S. Person. b. A foreign person (subject to U.S. tax withholding at a 30% tax rate for U.S. “FDAP” income). According to the IRS, UBS failed to report the U.S. Taxpayer information as required. The U.S. government is currently suing UBS to reveal the identity of approximately 52,000 U.S. persons with UBS foreign bank accounts, who have not reported the income to the IRS.

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At a 3/4/09 hearing, Senator Carl Levin, Chairman of the Senate Homeland Security and Governmental Affairs Permanent Subcommittee on Investigations examined: 1. The recent deferred prosecution agreement between the Department of Justice (DOJ) and UBS AG Bank of Switzerland (which paid a $780 million fine). 2. The DOJ’s ongoing attempts to force the bank to identify its U.S. customers with secret Swiss bank accounts. Senator Levin advocated putting pressure on U.S. Taxpayers who avoid paying U.S. tax by using the Swiss (UBS) bank’s secrecy. Previously, the U.S. congress action to combat off-shore tax havens included: 1. Senate Bill 506: Stop Tax Haven Abuse Act The bill would “black list” 34 countries and impose new reporting obligations on banks when a U.S. customer establishes a foreign bank account. 2. The Senate Finance Committee has proposed a draft tax compliance bill, which includes new diligence requirements for tax preparers and include the Report of Foreign Bank and Financial Accounts (FBAR) rules in the tax code. Senator Levin has updated his “improved version” of the Stop Tax Haven Abuse Bill to “fight back and end the abuses inflicted upon us by these tax havens”. At a 3/4/09 hearing, Senator Levin recommended: 1. Establishment of a special enforcement unit to handle the prosecutions from the UBS Case. 2. Finalize a regulation to allow the U.S. to engage in automatic information exchanges of information with countries (such as Switzerland), specifically for taxenforcement purposes. 3. In addition: a.Establish certain legal presumptions that can be used to combat off-shore secrecy.

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b.Authorize special measures against financial institutions (or countries) that impede U.S. tax enforcement. c.Require 3rd transactions.

party

disclosures

of

off-shore

d.Extend the statute of limitations for assessing taxes (against off-shores cases) from 3 years to 6 years. e.Improve U.S. tax treaties and tax information exchange agreements. The IRS Commissioner Douglas Shulman, at the 3/4/09 hearing, stated: 1. The IRS would expand QI’s information reporting requirements to include disclosure of U.S. citizen’s income beyond only foreign accounts with U.S. securities (i.e., U.S. source income). 2. Improve its audits of trusts used to enable offshore tax evasion. On 3/31/09, Commissioner Shulman testified before the Subcommittee on Select Revenue Measures of the House Ways and Means Committee and stated, the IRS: 1. Increased the number of audits in the offshore banking arena (since 11/08). 2. Prioritized “stepped-up” hiring of international tax experts and investigators. 3. Offered a 6-month amnesty program (thru 10/09) for offshore account holders who reveal their unreported assets, including: payment of back taxes, interest (for up to 6 years), pay either an accuracy-related or delinquency penalty (for up to 6 years), pay a penalty of 20% of the amount in the foreign bank account in the year with the highest aggregate account or asset value. II.

IRS QI’s and Announcement 2008-98

In his 3/31/09 testimony, the Commissioner stated that a “main tool” to combat international tax evasion will be the revamping of the 3

IRS QI program, which provides the IRS with information on the activities of foreign banks and financial institutions, will include: 1. Expansion of the reporting requirements to include more sources of income for U.S. account holders. 2. Strengthening the documentation rules. 3. Require tax withholding for accounts with insufficient documentation. As of 2001, the QI program was established to make sure U.S. Taxpayers (U.S. citizens, U.S. tax residents, and non-U.S. tax residents who receive U.S. source income) report their U.S. source income (from U.S. securities) and pay tax on their income. Under the QI agreement (with the IRS, under IRC §1441) for a 5 year term (subject to renewal) the QI agrees to assume U.S. tax withholding and tax reporting for payments of U.S. source income to a foreign person (subject to 30% tax withholding under the FDAP rules unless withheld at a lower tax rate, e.g., treaty), or payments to a U.S. Person (and issue Form 1099’s for the payment, and if required withhold 31% tax under IRC §3406 for back-up withholding). The QI responsibilities include: 1. Obtain documentation to establish the identity and tax status of the beneficial owner of U.S. source income. 2. Proper tax reporting for U.S. source income (on U.S. securities held in foreign bank accounts). 3. Withhold and remit taxes of U.S. non-resident aliens (and “back-up” tax withholding for U.S. residents). IRS Announcement 2008-98, (2008-44 I.R.B. (10/15/08) proposed amendments to the Qualified Intermediary (QI) Agreement (Rev Proc 2000-12, 2000-1, CB 387) and the Guidance for External Auditors of QI’s (Rev Proc 2005-55, 2002-2 CB 435)). IRS Announcement 2008-98 contained 3 principal amendments to the QI rules regarding: 1. Material failure of internal “QI” controls. 2. External Auditor Fact Findings to determine if foreign accounts are subject to control by U.S. Persons.

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3. Audit oversight/review by U.S. auditors (who accept joint and several liability for the conduct of the QI audit and co-sign the audit report). Material Failure of Internal “QI Controls” A QI must notify the IRS of any material failure of internal controls relating to performance under a QI agreement, including: 1. Employee allegations of failure. 2. Investigation by regulatory authorities regarding such failure. The purpose is for the IRS to be notified so they may work with the QI and remedy failures, not terminate the QI agreement. External Auditor Fact Findings Foreign accounts may be subject to control by U.S. Persons. The external auditor must: 1. Assess material failure of internal controls. 2. Test accounts for foreign account control by U.S. Persons. 3. Report any facts to the IRS regarding risk of material failure of internal controls. To determine if the accounts are subject to a U.S. Person’s control, the Auditor is required to: 1. Review and examine updated information for the audit year, drawn from the opening account statement. 2. Review account documents, correspondence and reports. 3. Review other information for purposes of anti-money laundering, know your customer, tax or other loans. 4. Review account holder’s files that show a U.S. Person has: a.Signature authority. b.Other authority (e.g., withdraw funds, trade, give instructions, receive account statements). c.U.S. Person has given or received a power granting such authority to or from a foreign person.

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U.S. Auditor Oversight The goal in associating a U.S. auditor is to assure appropriate application of U.S. tax withholding rules and to enhance accuracy and accountability in the audit process. For a U.S. auditor, who co-signs the audit report and accepts joint and several liability for the conduct of the audit, they assume both risk and potential exposure as follows: 1. Liability for External Auditor Omissions, fraud, negligence, or crimes. 2. Act as a “3rd party guarantor” with unlimited liability for external auditor conduct. 3. Dual liability for both the conduct and services performed by the U.S. auditor, and the services performed by the external auditor. Conclusion The IRS intends to force foreign banks and governments to identify U.S. Taxpayers who are evading taxes. The UBS case proves the difficulty, in this case, the Swiss government interpreted the U.S. – Switzerland treaty to prevent U.S. authorities from successfully identifying and prosecuting UBS customers. The Swiss government will not disclose information on these U.S. Taxpayers unless the U.S. government specifically asks for their financial information by name, shows that the citizen is engaged in an affirmative act of deception, such as falsifying a document. IRS Commissioner Shulman stated that tax-enforcement provisions of U.S. treaties often interfere: “Tax information requests need to have a specific Taxpayer that we identify. In a lot of cases, sovereign law (i.e., Switzerland) actively trumps the treaty . . . in cases where sovereign law trumps it . . . we use John Doe summons and other tools.”

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Gary S. Wolfe A PROFESSIONAL LAW CORPORATION 9100 Wilshire Blvd., Suite 530 East Beverly Hills, CA, 90212 Tel: 310-274-8847 Fax: 310-274-3118 http://www.gswlaw.com email: [email protected]

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