QIs—Confidentiality, with Limitations

The new regulations on qualified intermediaries (QIs) that became effective Jan. 1, 2001 create a possible conflict between a QI and the IRS after the signing of a QI agreement.

A QI is a foreign entity or a foreign branch of a U.S. entity that enters into an agreement with the Service on U.S. tax withholding and reporting obligations for its customers. Generally, a QI is a foreign financial institution, a foreign clearing organization or a foreign branch of a U.S. financial institution or U.S. clearing organization. Pursuant to an agreement with the IRS, the QI certifies its customers' eligibility for a reduction in withholding rates without disclosing their identities. A payor can treat a person as foreign if the payor can reliably associate the payment with documentation that establishes that the person is the beneficial owner of the income or a foreign payee.

Primary Advantage

QIs do not have to disclose the identity of their foreign customers. Foreign entities or foreign branches of U.S. entities can benefit from this advantage as of Jan. 1, 2001. Additionally, most of the reportable payments to the Service are made on a pooled basis. The confidentiality aspect is essential for all foreign entities with QI status located in countries that guarantee bank secrecy to their customers under national law. At first glance, it seems that the QI regime solves the conflict facing foreign entities caught between the obligation to disclose their customers' identities for U.S. tax purposes and the obligation of maintaining confidentiality for the customer under foreign national law.

However, in certain circumstances, the new QI regime creates further conflict for foreign QIs, when confidentiality cannot be maintained.

Cases in Which Confidentiality Is Not Maintained

Nonexempt U.S. recipients. Disclosure of a taxpayer's identity is required for all nonexempt U.S. recipients. Thus, confidentiality is not maintained for U.S. citizens and residents. In this context, the following unsolved situations exist:

• The foreign "know-your-customer-rules" (KYC) accepted by the IRS do not require that a bank determine whether a customer might be subject to U.S. taxation because of dual citizenship (one of which is U.S.), U.S. permanent residence status or U.S. resident alien status. The QI rules do not require the foreign QI to go beyond the documentation normally required under the KYC rules to establish identity. This interpretation has been confirmed in conversation with the Service, but not in writing. In light of the penalties that can be levied on a QI, a binding ruling on this issue would be helpful.
• If the QI positively knows that the customer is a U.S. person, it is obliged to disclose the customer's identity by submitting a Form W-9 to the IRS. By complying with its obligations under the QI regime, a QI may, however, breach its obligation toward the customer under national law not to disclose the customer's identity. The customer may be entitled to sue under national law. Thus, the QI may face a liability regardless of how it handles the situation.

Beneficial owner as indirect account holder. A QI must disclose to the Service, on a Form 1042-S, Foreign Person's U.S. Source Income Subject to Withholding, every beneficial owner who is an indirect account holder. This requirement applies to partners of a partnership and to a grantor of a grantor trust. It even applies when the indirect account holder is not a U.S. person or the correct amount of tax has already been withheld from payments made to the account holder or both. Therefore, a QI must disclose every investor (including investors with no connection to the U.S.) in an investment fund organized as a partnership for U.S. tax purposes to the IRS if the fund has any U.S. investments.

Liability Issues

A crucial issue for a foreign QI is the conflict between the disclosure requirements of the QI agreement and the obligation toward its customers to maintain confidentiality under local law. In the final analysis, the QI will be liable. The QI agreement thus becomes a contract burdening third parties. Under some European jurisdictions (e.g., Germany), a QI agreement is invalid to the extent rules are imposed that become a burden for third parties.

Conclusion

In the conflict situations discussed, neither choice is satisfactory for a QI. As a practical solution, a number of German banks simply do not accept U.S. citizens and U.S. residents as customers (undoubtedly not the Service's intention).

From Birgit Findeis, Rechtsanwalt/Wirtschaftspruefer/Steuerberater, and Leonard Levin, J.D., New York, NY