IRS Withholding Tax Enforcement: Dropping the Other Shoe?

Editor: Mary Van Leuven, J.D., LL.M.

Procedure & Administration

The IRS is hot on the trail of cross-border withholding.

As a general rule, a withholding agent must withhold 30% on U.S.-source outbound payments, unless the payee is entitled to relief under a treaty or statutory provision and the withholding agent receives a proper claim for reduced withholding (e.g., on a Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding) prior to payment. Withholding agents must annually disclose withholding information on Forms 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons, and 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding.

Despite a hefty price for noncompliance—including secondary liability for the withholding tax, interest, and various penalties—U.S. companies have yet to master the science of cross-border withholding. In response to what it perceived to be rampant noncompliance, the IRS published Form 1042 audit guidelines in 2008 and designated withholding as a Tier I audit issue in 2009.

Since designating cross-border withholding as a Tier I issue, the IRS’s actual enforcement activity has seemed spotty. But in May 2011, the IRS signaled a renewed focus on this area. Stuart Mann, manager (foreign payments) in the IRS Large Business and International Division, announced that, after spending 2010 reviewing Form 1042-S filings, the IRS would be sending proposed penalty notices to more than 2,000 U.S. withholding agents for late filings and erroneously filed paper versions of Form 1042-S (see Elliott, “IRS Issuing Penalties for Late, Misfiled Nonresident Alien Withholding Forms,” 2011 TNT 86-5 (May 4, 2011)). Mann warned that, while most withholding agents could obtain penalty relief upon showing reasonable cause, persistent failures to file would be met with Sec. 6721 intentional disregard penalties.

In 2003, the IRS performed a similar Form 1042-S review and found that more than 31% of Forms 1042-S filed had errors. The IRS’s response was to offer withholding agents a voluntary disclosure program (see Rev. Proc. 2004-59). This time around, the IRS seems to be singing a different, more serious, tune—fair warning to withholding agents that have so far put off dealing with past compliance failures. (Notably, the IRS is not the only one scrutinizing the issue. As M&A activity has begun to pick up, withholding-related liability has become an increasingly frequent and contentious consideration in the M&A due-diligence process.)

In the recent past, many companies with compliance problems have successfully remediated past compliance failures. The key is to seek remediation before being approached by the IRS and to demonstrate that past failures were not due to willfulness or intentional disregard of applicable rules. Remediation generally includes one or more of the following steps:

1. Obtaining missing withholding certificates (e.g., Forms W-8BEN);
2. Curing flawed documentation (e.g., forms missing payee employer identification numbers);
3. Creating or updating written withholding tax procedures;
4. Memorializing analysis regarding source of income and other substantive issues that could reduce or relieve withholding; and
5. Preparing back and amended Forms 1042 and 1042-S.

It seems clear that intensive IRS review of U.S. withholding agents will continue for the foreseeable future. U.S. withholding agents who fail to satisfy their obligations risk liability for forgone withholding tax, interest, and penalties—all on someone else’s income. To mitigate potential exposure, companies should start the remediation process well before the start of their next IRS exam.

This item was adapted from KPMG LLP’s Tax Dispute Resolution Quarterly (January 2012).

EditorNotes

Mary Van Leuven is senior manager, Washington National Tax, at KPMG LLP in Washington, D.C.

For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or mvanleuven@kpmg.com.

Unless otherwise noted, contributors are members of or associated with KPMG LLP.