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Recent legislative proposals emanating from members of Congress and the Administration seek to strengthen and extend the IRS's “qualified intermediary” (QI) program¹ in an attempt to address, among other things, tax evasion by U.S. individuals hiding behind foreign corporate shells. This author is extremely sympathetic to the desire expressed by many in government to strengthen and extend the Code's reporting and withholding rules in a manner that would discourage tax cheating by hiding assets offshore. Unfortunately, in their current form the QI rules are the wrong tool for the job - trying to use the current QI regime to police offshore tax evasion is like using a wrench to repair a ripped gown.

Some inside and outside government have made statements implying that the QI regime is broken and needs fixing. Actually, the QI regime has been a great success and has largely accomplished the rather limited goals that were set for it. The QI regime was never the problem. Due in large part to its success, however, it may become part of the solution. That is why the QI rules are proposed to be changed.

The QI regime assumes that there are two kinds of persons that invest money in offshore accounts: U.S. persons and non-U.S. persons. It does not concern itself with who owns or controls a corporation; it does not incorporate Limitation-on-Benefits (LOB)-type rules. If the corporation is foreign, it is subject to a 30% U.S. withholding tax on certain types of U.S.-source income, unless entitled to a lower rate of tax by virtue of U.S. domestic law or a tax treaty. If the corporation is domestic, no withholding applies (domestic corporations, unlike U.S. individuals, are generally exempt from back-up withholding).

The QI regime is based in part on the reasonable assumption that U.S. individuals would not invest offshore through foreign corporations without very good reason. If a U.S. individual were foolish enough to set up a shell foreign corporation to hold his investments, he would be looking at the following dire consequences:

• The foreign corporation would be a passive foreign investment company (PFIC), a controlled foreign corporation (CFC), and/or a personal holding company (PHC). At best, its income would be taxed currently to its owner. At worst, its income would be taxed at ordinary income rates with a penalty under the PFIC regime, assuming no qualified electing fund (QEF) election is made.

• The individual owner would forfeit his ability to pay tax at lower capital gains rates on any capital gains and qualifying dividends earned by the corporation.

• The foreign corporation would be subject to U.S. tax at the rate of 30% (or lower treaty rate) on the gross amount of any U.S.-source dividends, and the individual owner would normally not be entitled to claim any foreign tax credit for such tax, effectively resulting in double taxation of this type of income.

• The U.S. individual would be required to file tax returns and reports in connection with the creation and funding of the corporation, as well as annual statements with the IRS.

The problem, of course, is that all of these punitive rules, designed to discourage hiding income and assets behind foreign corporate veils, are powerless to prevent cheating by people determined to cheat. The enactment of the portfolio interest exemption in 1984 was red meat for potential tax cheats. Because a foreign person pays no U.S. tax on portfolio interest, whereas a U.S. person would, some have probably found it far too tempting to pretend to be “foreign.” Although the QI rules make it nearly impossible to pretend to be a foreign individual, it is relatively easy to disguise oneself as a foreign corporation.

Before Congress embarks upon an initiative to “re-purpose” the QI rules as a tool to combat this type of cheating, it should understand why the current QI regime does not work to address offshore tax evasion by U.S. individuals. There are three basic problems:

1. Nothing in the rules prevents a U.S. person from creating a foreign corporation to open an offshore account with a QI. A QI must ascertain the identity of its account holders and withhold a back-up withholding tax on non-exempt U.S. individual account holders (generally U.S. persons that fail to file a Form W-9). However, a QI is not required to report such person's identity to the IRS. Moreover, the QI is not required to treat a foreign corporation owned by a U.S. person as anything other than a foreign beneficial owner. There is no “look-through” rule.

Even if the QI is aware that the foreign corporation is owned or controlled by a U.S. person, the §1441 regulations do not require the QI to report that fact to the IRS. The current regime was developed to police §1441 withholding on payments of fixed or determinable annual or periodical U.S.-source income (“FDAP”) to foreign persons, and because the foreign corporation is clearly a foreign person subject to withholding, there is nothing here that implicates a violation of §1441.

2. The 30% withholding tax imposed by §1441 is not a deterrent to U.S. persons that decide to invest through a foreign corporation. Because the tax is not imposed on capital gains or on most interest income, it “bites” only with respect to U.S.-source dividends. Most U.S. investors are not investing offshore to earn dividends, so they don't care about the 30% withholding tax.

3. The QI regime applies only to U.S.-source income. Because the United States has withholding tax jurisdiction only over U.S.-source income (which jurisdiction it guards by imposing its rules on withholding agents), these rules do nothing to stop a U.S. person from investing in assets that produce only foreign-source income and simply not reporting that fact. The United States actually has a better chance of getting at this tactic where the U.S. person invests with a QI, because at least the QI provides a nexus to the U.S. withholding and reporting system.

In order to use the QI rules to address offshore tax evasion, each of these systemic flaws would need to be fixed so that the QI rules could function to go after the problem. It's a tall order, and possibly quixotic. But the recent proposals do try. Section 105 of the bill that would, if enacted, become the “Stop Tax Haven Abuse Act” (S. 506) would amend the Code to require withholding agents to report any account that they find is controlled by a U.S. person. The presumption is that a QI that follows required know-your-customer (KYC) procedures would normally know this. In such event, the QI would be required to report the name and address (and TIN if known) of such a U.S. beneficial owner. A bill introduced by Senator Max Baucus would do something similar.² The Administration's bill would require a QI to file an information return with respect to a foreign entity that it forms or acquires on behalf of a U.S. person or on behalf of an entity controlled by a U.S. person, and authorizes regulations that could require reporting of U.S.-controlled entities.³

The Administration's proposal would also require the QI to report payments of both U.S.- and foreign-source income to U.S. persons, much in the way U.S. withholding agents currently report such payments on Form 1099. The proposals would also grant the IRS authority to require QIs to report the existence of accounts of foreign corporations controlled by U.S. persons.

Given that QIs are, by definition, subject to local KYC rules, it should not be too much to ask that they ascertain and report certain levels of U.S. ownership and/or control. However, this rule should not go overboard, because if it becomes too difficult for QIs to comply with the rule, it will act as a disincentive for financial intermediaries to become QIs in the first place.

The good news for QIs is that if QIs are required to and do undertake to report U.S. beneficial ownership and control of foreign corporations, the resulting paperwork burden will largely disappear, because dishonest U.S. taxpayers will simply cease to invest through QIs. The bad news for the U.S. tax system is that those dishonest U.S. taxpayers will look elsewhere for accommodation. This is why current proposals attempt to sweep in not only QIs, but other intermediaries that are not regulated, not subject to KYC rules, or otherwise not QIs. And this is where the real problems begin. These issues will be the subject of Part Two.

This commentary also will appear in the November 2009 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Tello, 915 T.M., U.S. Withholding and Reporting Requirements for Payments of U.S. Source Income to Foreign Persons, and in Tax Practice Series, see ¶7150, Withholding and Compliance.