January 4, 2010

TO: Distribution

FROM: Burt, Staples and Maner, LLP

RE: New Years Update on IRS Withholding Tax Audits

The IRS has warned taxpayers for several years that it intends to conduct comprehensive checks of the compliance level of U.S. withholding agents. Accordingly, in 2009, the IRS elevated withholding taxes to a “Tier 1” audit issue, which means that the IRS will devote the resources necessary to conduct such examinations. Until recently, however, the IRS audited only a small number of companies, and the audits were directed primarily at specialized areas such as derivatives and securities lending transactions. We understand that the situation has now changed, and a more sweeping audit effort is underway that may affect both financial institutions and non-financial companies, whether U.S. or foreign, making U.S. source payments to non-U.S. persons.

The Typical Audit Scenario: The more recent audits have all been associated with regular audit cycles. That is, in conjunction with the IRS’ examination of a corporate income tax return (Form 1120), the IRS notified the taxpayer that the accuracy of its withholding tax return (Form 1042) would also be examined. So far, we are not aware of a similar withholding tax check linked with the examination of a partnership’s return (Form 1065), although there is no reason to believe that the IRS does not intend to perform such audits in due course. The audits were all launched by local IRS audit teams, and not by the IRS withholding tax specialty team in New York City, although in one audit the New York team did get involved to provide direction to the local examination team. To date, IRS National Office withholding tax specialists do not appear either to be directing or intervening in these audits.

Information Document Requests (“IDRs”): In each of the audits, the IRS issued the withholding agent a preliminary set of IDRs. The IDRs requested such basic information as the Forms 1042 and 1042-S filed, procedures associated with withholding matters, and, for financial institutions, certain account documentation. The IDRs have so far not asked about more esoteric withholding tax matters about which the IRS has long expressed concerns (e.g., syndicated loans, REITs, corporate actions, securities lending, repos, derivatives, FX, etc.). On the other hand, the IRS has continued to focus on documentation and procedures associated with vendor payments; accounts payable are a particular focus of the IRS and one emphasized in the IRS audit guidance. We are monitoring these audits to see if the IDRs become more comprehensive as time goes by.

New IRS Audit Approach – “Pens Down”: The IRS informally has told us that the increase in audit activity that we observed at the end of 2009 is no accident and that withholding agents should expect to see many more audits launched in 2010. The IRS officials also stated that they intend to take a more hard-line approach (which we stress that we have not seen to date). In particular, auditors will order a withholding agent to put its “pens down” on efforts to cure missing or invalid tax documentation from payees. The IRS will calculate tax liability on the basis of documentation and account status in existence on the date of the audit’s initiation. Where a review of 100% of the documentation is not feasible, the IRS will base a withholding agent’s tax exposure on the accuracy of sampled documentation and extrapolate the results of that sample to the total population without regard to any cured documentation in that sample.

Our Advice – Keep Your Pens in Your Hands: What should you do if the IRS does initiate an audit, particularly if more specialized IRS auditors or IRS National Office get involved? Quite simple – we respectfully suggest that you do not put your pens down! The regulations allow withholding agents to use documentation collected after the payment was made to prove that the correct amount of tax was withheld at the time of payment (see Treas. Reg. §1441-1(b)(7)). Regardless of what your IRS examination team might say, you should make all necessary efforts to collect curative documentation, particularly for high dollar payments that may give rise to substantial tax exposure if left uncured.

It is important to remember that the IRS audit team is only one part of the audit controversy process. If the team refuses to accept “late-collected” documentation, you stand a good chance in either IRS Appeals or in court to have any significant tax exposures eliminated if you can prove that the withholding was done correctly. You should not simply give up, even if you cannot collect a Form W-8 and an affidavit of unchanged status from the payee, perhaps because the payee’s account is closed or the payee has some reason not to cooperate with your efforts.

We have worked with many withholding agents in such circumstances to collect alternative proof that withholding was done correctly. Even if the IRS audit team were not to accept such proof, IRS Appeals or a court may well reach a different conclusion. While withholding agents had little alternative but to accept IRS examination team determinations during the Voluntary Compliance Program, the nature of the game has now changed, and withholding agents should protect their interests – vigorously, if necessary.

Preparation as the Best Defense: As we have said in many prior audit letters, the best audit defense is to be prepared. We advise our clients to conduct a “health check” of their withholding tax compliance, fix any errors found, and be ready to withstand audit scrutiny of any payments giving rise to a withholding obligation. As always, we are happy to help with such a check or to provide suggestions on any work performed by your internal staff.






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