Final Guidelines for QI External Audits

The IRS has finalized external audit guidelines for qualified intermediaries (QIs) in Rev. Proc. 2002-55. A QI is a financial institution located outside the U.S. that has entered into an agreement with the IRS involving tax reporting and withholding. QIs are required to comply with these reporting and withholding agreements. The final regulations are more beneficial to QIs than the October 2001 proposed rules, subjecting fewer QIs to external audits. The guidelines have several key aspects.

Discretionary Waiver of External Audit

The IRS has discretion to waive an external audit requirement in three circumstances. Applications for a waiver are due before June 30 of the year after the audit year. The “audit year” is defined as the second and fifth calendar years the agreement is in effect, which are 2002 and 2005—the first audit year is 2002, the second, 2005.

The three waivers are:

1. QI has not received more than $1 million in reportable payments: This will apply to the first and second audit years if the QI has not received more than $1 million in reportable amounts (i.e., U.S.-source dividends and interest, but not gross proceeds) during the year. (In the proposed regulations, the threshold was $250,000.)

2. QI has received $1 million–$4 million in reportable payments: This exemption will apply to the second audit year (i.e., 2005), but not to the first. (In the proposed guidelines, a waiver was allowed for QIs with no more than 2,000 direct and indirect accountholders.)

3. Internal auditors have reviewed the QI's compliance annually: Under certain circumstances, the IRS may permit internal (rather than external) audits. A QI cannot use an internal auditor for a 2002 audit. However, to meet the 2005 audit requirement, it may be able to substitute annual internal audit reviews for external audits.

A QI could request the IRS to waive an audit by an external auditor if (1) the QI maintains a substantial and independent internal audit staff and (2) its internal auditors have determined that the QI is in compliance with its agreement for each of three preceding years. If the IRS grants a waiver, the QI's internal auditors must perform the audit and send a report to the IRS. The internal auditors do not have to conduct the three preceding annual reviews in accordance with the IRS's external audit guidelines; rather, they can perform tests, checks or other procedures that they deem appropriate. The internal auditors may request IRS clearance of any such proposed program by submitting a written description of the program before June 30 of the year following the audit year.

Three-Part QI Audit Process

The final audit procedures are much the same as those in the proposed regulations:

• Step 1: basic fact-finding. The QI performs the tasks detailed in Notice 2001-66 and prepares a report of the findings. The IRS is very precise about the information to be included in the report. If the audit's numerical results demonstrate that the QI has a high level of compliance with its agreement, the IRS will probably deem the audit as complete, not requiring additional steps. However, if the results are not satisfactory, the QI will have to proceed to Step 2.
• Step 2: follow-up fact-finding. The IRS will note the problems with the audit report and, perhaps, the source of the problems, possibly offering solutions. If it is satisfied with the QI's correction of the situation and if the QI has a high level of compliance with other parts of its agreement, the Service will not proceed to Step 3.
• Step 3: audit meeting with QI. If a QI does not resolve the problem(s) discovered in Steps 1 and 2, the IRS will meet with the QI in person.

Statistical Sampling and Underwithholding Projection

The final rules modify the proposed rules on sampling and projecting tax underwithholding. They reduce the number of sample populations that a QI has to examine to one account group and the maximum number of accounts from 1,368 to 321.

If the Service finds an underwithholding in Step 1, it will project it to the entire account only if an audit progresses to Step 2.

From Thomas J. Mooney, CPA, MST, Commerzbank Capital Markets Corporation, New York, NY (Not affiliated with AFAi)