Bankers Institute Urges Changes to QI Audit Guidelines

Uhlick states that the institute's fundamental recommendation is that QI's should be treated the same as other taxpayer groups, and the IRS should not be allowed to perform full-blown audits on 100 percent of QIs. He says that every QI should be required to undergo an audit to verify that it has adequate policies, procedures, and systems for complying with the QI agreement, and that the extensive audits proposed by the IRS should be reserved for a limited number of cases.

[2] Unfortunately, the proposed guidelines recently issued by the Internal Revenue Service (in Notice 2001-66) regarding external audits of QIs are unnecessarily burdensome and costly, as detailed in the attached comment letter. Compliance with these guidelines will likely cost as much as several million dollars per audit year for larger institutions in fees to external auditors, while even smaller QIs will incur external audit costs of several hundred thousand dollars a year, in addition to significant internal costs.

[3] The burdens and costs imposed by these guidelines are completely disproportionate to the benefits to be obtained, either by the IRS or the QIs. Moreover, the imposition of such prohibitive costs on QIs is counterproductive since these institutions are merely performing custodial services, typically operate with very thin profit margins, and are voluntarily accepting QI status. Indeed, the IRS does not, and cannot, perform such an extensive audit on any other group of taxpayers -- and certainly does not audit 100% of any taxpayer population, nor does it require any other group of taxpayers to perform such an extensive audit at their own expense.

[4] Unless the external audit guidelines are re-focused to comport with the concept that was discussed with the financial industry when the new rules were originally conceived, the success of the QI system -- and the willingness of international custodians to invest customer funds in the U.S. capital markets -- will be jeopardized. We respectfully request that the Treasury Department urge the IRS to adopt the recommendations set forth in the attached comment letter.

[5] Our fundamental recommendation is that QIs be treated consistently with other groups of taxpayers and not be required to pay external auditors that in effect are "deputized" by the IRS to perform full blown audits on 100% of the QI population. Instead, every QI should be required to undergo an audit that verifies the adequacy of its policies, procedures and systems for complying with the QI agreement. The extensive step-by-step audit proposed in the IRS' guidelines should be reserved for limited cases (up to, say, 2% of QIs) selected by the IRS using an appropriate audit selection process.

[6] The Institute remains committed to assisting the Treasury Department and the IRS in developing a workable QI regime. Please feel free to contact the undersigned if we can be of further assistance in this regard.

Very truly yours,

[8] The Institute, which represents the interests of intentionally headquartered financial institutions that conduct banking, securities and insurance operations in the United States, has been an active and supportive participant during the past five years in devising the new QI regime and, more generally, the new withholding and reporting regulations. We are appreciative of the opportunities that we and other representatives of the financial industry have been afforded during the past several years to have a dialogue with the IRS regarding the QI regime and the withholding regulations, and we believe that this dialogue has been instrumental in the development of these important new rules.

[9] Most recently, the Institute's letter dated March 19, 2001 to Mr. Larry Langdon, Commissioner, Large & Mid-Size Business Division, contained our recommendations for designing the Guidelines in a manner that strikes a reasonable balance between the legitimate objective of the IRS of ensuring a high level of compliance with U.S. withholding and reporting rules and the risk that international financial institutions might find the burdens and costs of the QI regime to be too great and therefore might encourage their customers to invest their funds outside the United States.

[10] Unfortunately, while the Guidelines make some effort to be responsive to the suggestions made by the Institute, the five major accounting firms and other commentators, the overall effect of the Guidelines is an extremely burdensome and costly set of rules. Compliance with the Guidelines will likely cost as much as several million dollars per audit year for larger institutions in fees to external auditors, while even smaller QIs will incur external audit costs of several hundred thousand dollars a year, in addition to significant internal costs.

[11] The burdens and costs imposed by the Guidelines are completely disproportionate to the benefits to be obtained, either by the IRS or the QIs. As we have previously contended, the imposition of such prohibitive costs on QIs is counterproductive since these institutions are merely performing custodial services, typically at very thin profit margins, and are voluntarily accepting QI status. Indeed, the IRS does not, and cannot, perform such an extensive audit on any other group of taxpayers -- and certainly does not audit 100% of any taxpayer population, nor does it require any other group of taxpayers to perform such an extensive audit at their own expense.

[12] Our fundamental recommendation, discussed below, is that QIs be treated consistently with other groups of taxpayers and not be required to pay external auditors that in effect are "deputized" by the IRS to perform full blown audits on 100% of the QI population. Instead, every QI should be required to undergo an audit that verifies the adequacy of its policies, procedures and systems for complying with the QI agreement. The extensive step-by-step audit proposed in the IRS' guidelines should be reserved for limited cases (up to, say, 2% of QIs) selected by the IRS using an appropriate audit selection process.

[13] In recent weeks, we have discussed our concerns regarding the Guidelines with various groups within the IRS. During our recent discussions, several IRS representatives have questioned the gravity of our concerns and have sought to defend the Guidelines as merely conforming to the terms of Section 10 of the QI Agreements. Our concerns are not new, however. We as well as other interested parties have been expressing our views regarding the audit compliance aspects of the QI regime for several years (and indeed we submitted a comprehensive proposal to the IRS regarding external audits in November 1996, as part of a draft model QI agreement), but we have been told repeatedly by the IRS that consideration of those issues must await the resolution of other aspects of the new withholding rules and the implementation of the QI program. Because a properly conceived compliance audit is integral to the success of the QI program, we fervently hope that the IRS will now carefully consider our concerns regarding the Guidelines.

[14] The following aspects of the Guidelines, in our view, should be reconsidered and revised in the manner suggested below:

1. The Guidelines Require Unreasonably Comprehensive Audits. The Guidelines call for an extensive, step-by-step audit of virtually every aspect of a QI's performance of its responsibilities under a QI agreement. Thus, while the Guidelines follow the recommendation of the Institute and the five major accounting firms that there be precise "agreed-upon procedures" for the external auditors to follow and address in their report, the Guidelines depart from our fundamental recommendation that the procedures be tailored to encourage and confirm a high level of voluntary compliance by QIs, at a reasonable cost. Instead, by insisting on a full step-by-step audit of QIs, the IRS continues to view the external audit function to a great extent as a tax collection mechanism.

[15] The IRS does not itself perform such audits of 100% of any taxpayer population because the cost would be prohibitive, and therefore it relies primarily on a voluntary self-assessment system. As noted above, it would be counterproductive to attempt to inflict such prohibitive audit costs on QIs, which are merely custodial intermediaries, often operating at very thin profit margins and voluntarily accepting QI status.

[16] We recommend that the Guidelines replace the audit of each and every aspect of the QI agreement with a significantly more limited, targeted approach that focuses on the essential components of the QI process with a view to verifying the adequacy of, and identifying any "internal control" weaknesses in, a QI's policies, procedures and systems, eliciting clear information regarding the overall compliance level and good faith of the QIs, and making recommendations for improvement. For a more complete description of our proposal for a "procedures and systems" compliance audit, we refer you to our March 19th letter to Mr. Langdon as well as to our November 1996 submission.

[17] If the IRS deems it appropriate to supplement a periodic "procedures and systems" audit with a full-blown, comprehensive, tax assessment audit of the sort mandated by the Guidelines, then the IRS should reserve the right on a limited basis to require external auditors to perform such audits on QIs identified by the IRS using an appropriate audit selection process, with the maximum number of audits in any of the designated second or fifth year audit cycles limited to, say, up to 2 percent of the QI population. Even such a procedure would result in a QI comprehensive audit rate that is many times more than the audit rate of taxpayers generally. Additionally, even the selective comprehensive audits should be flexibly structured to take account of a QI's information system instead of requiring manual checking of individual accounts.

2. Large Statistical Samples Required. The Guidelines generally require that three statistical samples be created for each QI, drawn from three distinct account populations and representing the lesser of 50% of the relevant population or the sample size determined under a formula (up to a maximum sample size of 456). As a result of the formula, a sample size of 456 will likely be required in many cases. Each account in the statistical sample must be examined separately to test compliance with numerous specific requirements under the regulations. Evidently, in the case of financial institution groups with multiple QIs under a "master" QI agreement, separate statistical samples must be created for each QI.

[18] Such an extensive statistical sampling and examination of accounts far exceeds the norm for bank regulatory audits, where a sampling of perhaps 30 out of 10,000 items is typical. The combined requirements of intricate, comprehensive, full-scope audits involving numerous verification steps to be performed on large statistical samples will result in significant costs being imposed on QIs, comprising both external auditors' fees and internal administrative and systems costs. On a conservative basis, external auditors may need to spend as much as an hour or more on each account in each sample population, in addition to many other hours in gathering materials, interviewing personnel and performing the other functions mandated by the Guidelines. As indicated above, compliance with the Guidelines will likely cost as much as several million dollars per audit year for larger institutions in fees to external auditors, while even smaller QIs will incur external audit costs of at least several hundred thousand dollars a year, in addition to significant internal costs.

[19] With respect to the statistical sample requirements, we recommend that the Guidelines reduce the maximum sample size significantly, to numbers commensurate with those experienced in bank regulatory audits (e.g., 25 - 50 accounts). Such an approach would be consistent with ensuring, through spot checking of accounts, that the procedures and systems are in fact operating properly, rather than seeking to provide a basis for assessing tax through extrapolation from a statistically valid sample. In this regard, the Guidelines should permit the aggregation of multiple QIs within a single financial institutions group and should also permit samples to be drawn from populations of account data of related QIs that are aggregated by product lines.

3. Burdens are Compounded by the Treatment of Pass-through Entities and Pre-KYC Accounts. The burdensome costs of complying with the Guidelines are severely exacerbated by the failure of the IRS to provide workable guidance for the treatment of accounts held by non-qualified intermediaries, partnerships, trusts and other collective investment vehicles that are treated as pass-through entities for U.S. tax purposes. Under existing rules, a QI must obtain complete beneficial owner documentation with respect to each beneficial owner through such an entity, and the Guidelines require the external auditors to check a QI's compliance with respect to such indirect owners. Similarly, the QI agreements require QIs to obtain beneficial owner documentation with respect to each account opened prior to the effective date of the applicable "know your customer" (KYC) rules, generally in 1993 or so, and the Guidelines require the external auditors to check a QI's compliance with this requirement.

[20] It is widely recognized that the previous withholding rates were unworkable because they required financial intermediaries to gather physical documentation and pass that documentation down the chain of intermediaries to the U.S. withholding agent. Apart from the sheer volume of paperwork that could not possibly be accommodated by the financial system, the rules required financial institutions to disclose the identity of their customers to their competitors, which they were not willing to do. The QI regime was designed to eliminate these burdensome and anti-competitive requirements, by allowing QIs to rely on documentation already in their possession under the KYC rules and to provide aggregate, pooled information to financial intermediaries down the chain. However, with respect to accounts held by non-QIs and pass-through entities, as well as with respect to pre- KYC accounts (of which there are many millions), the new QI rules effectively incorporate the unworkable elements of the prior regulations. These vestiges of the prior regulations will continue to be problematic, and the audit of a QI's compliance with these aspects of the rules that is mandated by the Guidelines will add significant costs and burdens.

4. Underwithholding Amounts Should not be Extrapolated from Sampled Accounts. In response to prior comments, the Guidelines indicate that if the external auditor determines that there has been underwithholding, the IRS will direct further procedures to determine whether and how to make a projection of the underwithholding amount and will permit the QI to propose more appropriate, alternative bases for determining the amount of underwithholding. These modest improvements do not adequately protect QIs. from the specter of IRS agents imposing prohibitive underwithholding adjustments, which will inevitably borne by the QIs because they would not be traceable and thus would not be able to be passed on to any customers.

[21] The QI audit function must be re-focused to ensure adequate compliance and to remedy shortcomings in the process rather than to raise tax revenues from financial intermediaries that are acting in good faith with a set of very complicated, detailed rules and are merely custodians operating with very thin profit margins. An approach that is more consistent with this objective and with the tax law generally would be to have QIs be subject to penalties (up to a maximum amount of, say, $250,000) for material failures to comply with a QI agreement without reasonable cause. Projections of underwithholding if used at all, should explicitly be reserved for those very rare situations in which a QI is intentionally acting in bad faith and with gross disregard of the rules.

5. The Guidelines' Proposals Regarding Internal Auditors are Unworkable. The Guidelines allow the external auditor to use a QI's internal audit staff and internal audit reports to the extent it chooses, but provide that the external auditor remains personally responsible for the audit and must certify that the use of the internal audit personnel and reports has not affected the accuracy of the external auditor's report. These conditions render it impossible for internal auditors to meaningfully participate in the audit process, since we understand that external auditors cannot satisfy these conditions under their professional standards. Instead, we have previously recommended that QIs with well-developed, independent, internal audit functions should be permitted to have the compliance examination function divided between its external and internal auditors, each of which would issue an "agreed-upon procedures" report covering the items for which it is responsible.

6. The Guidelines' Proposals for Discretionary Waivers of External Audit are Too Limited and Impractical, and they Need to be Expanded. The proposed Guidelines permit the IRS to waive the performance of external audits in three cases. While we greatly appreciate the IRS' sensitivity, in devising the proposed waivers, towards minimizing the burdens being thrust upon smaller QIs, the conditions for qualifying for a waiver are too limited and impractical, unless the IRS revises the Guidelines to adopt our recommendations regarding a "procedure and systems" compliance audit.

[22] For example, while the IRS may waive one external audit (other than the first one) in each six-year cycle for a QI that has made reportable payments to no more than 2000 direct and indirect account holders, and instead allow the QI to perform the audit with its own personnel, the QI may not use statistical sampling in that case. We recommend that statistical sampling be permitted, and that the threshold be increased to 3,500 direct and indirect account holders.

[23] Another exception would allow the internal auditors to perform one of the audits in each cycle where the QI has a substantial and independent internal audit department that has audited the QI's compliance under the QI agreement for each of the three years prior to the year to be audited. The three-year internal audit condition is far too onerous, and should be relaxed, both in terms of the number of years the internal auditor needs to perform an audit and in terms of the extent of the audit required in those years. Certainly, the internal auditor should not be required to perform the complete audit prescribed by the Guidelines in three years in order to be eligible for the opportunity to perform such an extensive audit for a fourth year.

[24] Waivers should also be available in other cases. For example, QIs that achieve high levels of compliance in an external audit should be permitted to obtain a waiver enabling them to undergo more abbreviated external audits in subsequent audit years.

[25] We appreciate this opportunity to comment on the proposed Guidelines. We believe that the weaknesses and flaws in the proposed Guidelines, if left unattended, will have grave consequences for our QI constituency, and we therefore hope that you will give serious consideration to our recommendations. Please feel free to contact the undersigned or the Institute's tax counsel, Yaron Reich at Cleary, Gottlieb (212-225-2540), if we can be of further assistance regarding this matter.

Very truly yours,