SECTION 3. OVERVIEW OF AUDIT

GUIDANCE — THREE PHASE AUDIT PROCESS

The Audit Guidance included in this Revenue Procedure reflects a three phase audit process. As described further below, whether a particular QI’s audit will progress through all three phases generally will depend upon the IRS analysis of the facts reported in each phase. For example, the IRS expects that, if the facts reported in each preceding phase of the audit

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Agreement. Waiver Two will be available only for the second audit year of any term of the QI Agreement. As under Waiver One, a QI requesting Waiver Two must submit a reconciliation (for the audit year) of the Forms 1042–S and 1099 issued to the QI and issued by the QI and information about the number of its account holders in various classes.

(iii) Waiver Three - Annual Internal Review Program . A QI may request a waiver of the audit by an external auditor if it has a substantial and independent internal audit department that has reviewed the QI’s compliance under the QI Agreement for each of the three years preceding the year to be audited. The internal audit department is not required to perform the annual reviews according to the procedures in this Audit Guidance. Instead, it may perform any tests, checks or other procedures that it determines to be appropriate. The internal audit department may request IRS clearance of any proposed program of tests, checks or other procedures by submitting a written description of the proposed program. If this waiver is granted, instead of the required audit by an external auditor, the QI’s internal audit department may perform the audit and report to the IRS in accordance with the attached Audit Guidance. The IRS will not agree to grant this waiver for the first audit year of the first term of the QI Agreement. Waiver Three will be available for any subsequent audit year of any term of the QI Agreement.

2. Scope of Audit . In response to comments from the financial community, the IRS has revised the scope of the audit and, in particular, the procedures required for Phase 1 of the audit process. The revised procedures accommodate mutual concerns relating to cost, efficiency and compliance by (i) limiting the accounts initially selected for examination to accounts that have received reportable amounts, (ii) deferring certain tasks to Phase 2 of the audit process, (iii) adopting exploratory “spot check” techniques for certain tasks; (iv) allowing explanatory footnotes or addenda; and (v) allowing consolidated audits for certain groups of related QIs. Set forth below is a discussion of the changes to each of these five areas of the audit.

(i) Reportable Amounts . The revised procedures included in the attached Audit Guidance limit the accounts initially selected for

mines that underwithholding under AG10.03(C)(1), (2), (3), (4) or (5) occurred with respect to the sample, the IRS will determine the total amount of underwithheld tax by projecting the underwithholding as provided in AG10.04.12.

The goal of this step of the audit process is to identify the cause for the numerical results and to determine whether corrective action readily can be devised. For example, the audit report may show that the auditor was unable to associate beneficial owner information with a specified percentage of the QI’s accounts. Through discussion of facts with the auditor, the IRS then determines that the problem was attributable to deficient account opening procedures in one of the QI’s branches. If the IRS were satisfied that the QI had taken steps to ensure that the branch had appropriately corrected procedures for opening new accounts, and if the QI had otherwise shown a high level of compliance with the QI Agreement, the IRS generally would not proceed to Phase 3 of the audit process.

.03 PHASE 3: Audit Meeting with QI . If the concerns arising from the numerical results reported in Phase 1 of the audit process cannot be resolved by directed fact finding in Phase 2, the IRS will propose to meet with the QI to attempt to clarify and resolve those concerns. This phase is designed specifically to provide a forum where a productive dialogue between the IRS and the QI can occur. Treasury and the IRS continue to believe that the QI system, which is intended to allow the IRS’s compliance goals to be met while minimizing the administrative burdens on financial institutions, is a critical component of the withholding regulations. Accordingly, the IRS will seek to develop mutually acceptable solutions to the issues that arise in the course of administering the QI Agreements so that it will not become necessary to terminate a QI Agreement.