Increased scrutiny of NRA withholding for sec. 1441 compliance.

Banks and educational institutions that report nonresident alien (NRA) withholding on Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons, should review their systems and procedures in light of an IRS Large and Mid-Size Business Division industry directive (directive) that outlines issues the IRS will examine to determine compliance with Sec. 1441 withholding regulations.

The directive, issued Oct. 31, 2003, applies to U.S. withholding agents--i.e., to any person with control, receipt, custody, disposal or who makes a payment of any income item to a foreign person subject to withholding. Generally, a U.S. withholding agent is required to file Form 1042 to report U.S. tax withheld (NRA withholding) on certain income of NRAs and foreign partnerships, corporations, estates and trusts. The IRS recently has begun auditing universities and colleges that hire NRA independent contractors to determine their compliance with the NRA reporting and withholding rules.

Audit Process

The directive advises an examiner to use a 10-step process to audit a U.S. withholding agent's compliance with the NRA withholding rules. The examiner will first review the withholding tax system and related interned controls. The directive emphasizes the account opening process, including the identification of a payee as either a U.S. or foreign person; the system's application of presumption rules to undocumented payees; and the system's ability to identify the payee's status (e.g., beneficial owner, intermediary or agent). To expedite the audit, the examiner may rely on the withholding agent to provide summaries, flowcharts and explanations of the withholding system and processes. Thus, persons who fall within the directive's scope should prepare written manuals or procedures that discuss their NRA withholding and reporting process. At a minimum, such documentation should describe the account opening process.

As part of the 10 steps, an examiner will sample the withholding and information reporting of various types of transactions. For each type, the directive suggests that the examiner review at least 100 accounts. The examiner may request that the U.S. withholding agent provide a recommended list of transactions and sample sizes, with appropriate justification for each.

During the sampling process, the examiner will verify that (1) each payee is appropriately identified and classified in accordance with documentation in the withholding agent's records; (2) the withholding agent withheld the correct income tax for the type of income and payee; and (3) the transaction was properly reported on Form 1042-S, Foreign Person's U.S. Source Income Subject to Withholding. Finally, based on the samples, the examiner will calculate penalties for any compliance failures.

The directive's guidelines for U.S. withholding agents mirror those developed for qualified intermediary (QI) audits. QIs are foreign institutions approved by the IRS to make payments of U.S.-source income to foreign persons. As part of their agreement with the IRS, QIs report and withhold U.S. tax from such payments.

FROM ANTHONY MARTIRANO, J.D., LL.M., PARSIPPANY, NJ, MARVIN MICHELMAN, CPA, NEW YORK, NY, AND DIANE RENFROE, J.D.,WASHINGTON, DC