SECTION 1. PURPOSE AND SCOPE

This Revenue Procedure contains final Audit Guidance for an external auditor engaged by a qualified intermediary (QI) to verify the QI’s compliance with the withholding agreement entered into with the Internal Revenue Service (IRS) pursuant to Rev. Proc. 2000–12, 2000–1 C.B. 387 and Treasury Regulation § 1.1441–1(e)(5) (QI Agreement). Under its QI Agreement, the QI generally must report annually certain aggregate information concerning the beneficial owners of U.S. source payments and make any necessary tax payments to the IRS. In lieu of an IRS audit, the QI may engage an external auditor to conduct an audit to determine whether it is complying with the withholding and reporting obli

2002–35 I.R.B. 435 September 3, 2002

process do not raise significant concerns for the IRS, the QI will not be required to complete any further phase of the process during that audit cycle.

.01 PHASE 1: Basic Fact Finding . Phase 1 consists of basic fact finding. The external auditor performs those tasks detailed in the attached Audit Guidance for Phase 1 of the Audit. Generally, this consists of

• documentation review for all accounts (or the sample), under AG10.03(A)(4) through (A)(7), and (A)(10);

• a spot check review of withholding rate pools, underwithholding, and reporting, under AG10.03(B)(4) through (B)(6), (C)(1), (C)(3), and (D)(2); and

• the completion of the procedures in AG10.03(A)(8) and (A)(9), (C)(2), (C)(4) through (C)(7), (D)(1) and (E). From these fact finding activities, the auditor will develop a report of numerical results. The attached Audit Guidance contains precise directions on what numerical information must be included in the auditor’s report. The auditor will send a hard copy of this initial report to the IRS. The IRS intends to develop a standard report form.

Based on the IRS analysis of the numerical report for Phase 1 of the QI’s audit, the IRS will notify the QI whether the audit is complete or whether additional fact finding must be undertaken to resolve concerns. If the audit is complete after Phase 1, the QI must pay any underwithholding that is discovered as a result of the spot check for underwithholding (AG10.03(C)). If the numerical reports suggest that the QI has experienced difficulties in meeting its obligations under its QI Agreement, the IRS will notify the QI that it is proceeding to Phase 2 of the audit process.

.02 PHASE 2: Follow Up Fact Find- ing . In Phase 2 of the audit process, the IRS will contact the auditor to ask about facts and circumstances associated with certain numerical results in the auditor’s report. If additional information is needed, the IRS will direct the auditor to perform additional procedures and to report on the results. Phase 2 of the audit process may include some or all of the procedures in AG10.03 that were not performed in Phase 1 of the audit process, including a full sample review for those procedures for which a spot check review was performed in Phase 1. If, after completion of the full sample review, the external auditor deter

quest Waivers One and Two, variances are permitted within reasonable limits based on the facts and circumstances.

• Waiver Three (which is available to QIs with a substantial and independent audit staff) is clarified to reflect that the annual internal reviews required for eligibility are not the comprehensive audit described in this Audit Guidance but, rather, those tests and checks that the internal staff deems appropriate. (ii) Scope of Audit Coverage . Comments from the financial community stated that the scope of audit coverage required by the proposed audit guidance was overly broad and would prove to be prohibitively expensive for QIs. In response, to those comments, the following changes have been made:

• The accounts subject to audit are changed from those that receive reportable payments (generally, reportable amounts plus certain broker proceeds and certain foreign source income) to those that receive reportable amounts (generally U.S. source fixed or determinable annual or periodical income). However, for accounts of U.S. non-exempt recipients that receive reportable amounts, the external auditor must take reportable payments into account when performing certain procedures.

• Certain procedures and reports are deferred to Phase 2 of the audit.

• In Phase 1 of the audit, the review of withholding rate pools, underwithholding, and reporting in Audit Guidance (“AG”)10.03(B), (C), and (D) may be performed on a “spot check” rather than full sample basis.

• Consolidated audits are allowed for certain related groups. (iii) Sampling . Some commentators asserted that the proposed audit guidance required examination of an excessively large number of accounts, which would greatly increase the cost of the audit. In response to these comments, the following changes have been made:

• The maximum number of accounts sampled has been reduced from 1368 accounts to 321 accounts. This reduction results from (1) reducing the number of required samples from three to

one with the one sample including all account holders ( i.e., direct account holders that are not U.S. non-exempt recipients, direct account holders that are U.S. non-exempt recipients, and indirect account holders), and (2) reducing the maximum sample size from 456 to 321.

• With respect to accounts reviewed for purposes of withholding rate pools, withholding, and reporting under Phase 1 of the audit, described above, the number of accounts reviewed will be limited to a “spot check.” (iv) Projection . Some commentators expressed concern that the proposed audit procedures appeared to require “automatic” projection of underwithholding in a sample across the QI’s account population, which they believed could result in very large, and potentially unfair, tax assessments being imposed on the QI. In response to these comments, the following changes were made:

  • The issue of projection is deferred to Phase 2 of the audit, but in Phase 1 the QI must pay any underwithholding that is discovered in the spot check for underwithholding (AG10.03(C)). (v) Use of Internal Audit . Some commentators asserted that requiring the external auditor to certify that the use of internal audit staff did not affect the accuracy of its report would severely limit the use of internal audit staff, thereby increasing the cost of the audit for the QI. In response to these comments, the following change was made:

  • A QI’s external auditor that uses the QI’s internal audit staff and internal audit reports will not be required to certify that such use has not affected the accuracy of its report, but the external auditor will remain responsible for the conduct of the entire audit.