SECTION 4. MODIFICATIONS TO

THE PROPOSED AUDIT GUIDANCE

As mentioned in Section 1, above, the concerns arising from the proposed Audit Guidance published in Notice 2001–66 generally related to the following five areas— waivers, scope of audit coverage, sampling, projection, and use of internal audit staff and

reports. This section discusses, in greater detail, the modifications the IRS made to the Audit Guidance in response to those comments.

.01 Discretionary Waivers of External Audit . The Audit Guidance allows QIs to request that the IRS waive the performance of an audit by an external auditor in three cases. As a result of the dialogue with the financial community, and continued analysis of the information available to the IRS, the waiver provisions have been revised to increase the availability of waivers while allowing the IRS to continue to manage effectively its compliance objectives. In general, the waiver provisions have been liberalized and simplified. For instance, the waiver based on a threshold number of accounts has been replaced with a waiver based on a dollar threshold, the waiver based on a dollar threshold has been modified to raise the dollar threshold, the dollar thresholds are based upon reportable amounts rather than reportable payments, and with respect to the reconciliation information that must be included in the waiver request, variances are permitted within reasonable limits based on the facts and circumstances. Whether the IRS will waive the external audit in any case is discretionary. The IRS will not agree to waive the performance of an audit for a Private Arrangement Intermediary (“PAI”) or for a group of QIs for which the IRS permits a consolidated audit. The revised waiver provisions are outlined below.

(i) Waiver One - $1,000,000 Thresh- old . A QI may request a waiver of the external audit if it has received not more than $1,000,000 in reportable amounts during the audit year. A QI requesting Waiver One 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.

(ii) Waiver Two - $1,000,000 to $4,000,000 Threshold . A QI may request a waiver of the external audit if it has received reportable amounts exceeding $1,000,000 but not exceeding $4,000,000 during the audit year, and the QI has been audited by an external auditor under the QI Agreement for the immediately preceding required audit. Thus, the IRS will not agree to waive the external audit, under Waiver Two, for the first audit year of the first term or any renewal term of the QI

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separate audits of those QIs. Specifically, the Audit Guidance provides that the IRS, in its discretion, may permit a consolidated audit of two or more QIs when (1) the QIs are members of a group under common ownership, (2) they operate with uniform practices and procedures and shared systems for performing the functions audited, (3) those practices and procedures and shared systems are subject to uniform monitoring and control, and (4) under the terms of the QI Agreement for each QI, the year to be audited for each QI is the same calendar year. The external auditor must submit an audit plan requesting IRS approval of any proposed consolidated audit.

.03 Sampling . The Audit Guidance permits an external auditor to use a statistical sample of the QI’s accounts in performing the Phase 1 account based tasks. If the external auditor constructs the sample in accordance with the Audit Guidance, it need not submit an audit plan to obtain IRS approval for use of the sample. A sample constructed under the proposed Audit Guidance would have consisted of a maximum of 456 accounts for each of three populations (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), or a total of 1368 accounts.

Commentators stated that the cost burdens could be significantly reduced by limiting the overall number of accounts to be selected for statistical sampling. The final Audit Guidance reduces the overall number of accounts to be selected for statistical sampling by allowing a single sample that represents the three groups of account holders. Also, the revised procedures permit the use of a one-sided confidence level in the sample formula. The single sample constructed under the revised procedures of this Audit Guidance will consist of a maximum of 321 accounts.

.04 Projection of Underwithholding . The QI Agreement provides that if statistical sampling has been used and the auditor determines that underwithholding has occurred with respect to the sampled accounts, the IRS will determine the total amount of underwithheld tax by projecting the underwithholding over the entire population of similar accounts.

The proposed audit procedures would have provided that if the auditor used a sample and found that underwithholding had

examination to those accounts that have received reportable amounts . Under the proposed Audit Guidance, the accounts initially selected for examination would have included accounts that had received reportable payments . Under the QI Agreement, “reportable amounts,” generally consist of U.S. source fixed or determinable, annual or periodical income. “Reportable payments” generally consist of reportable amounts plus certain broker proceeds and certain foreign source income. The financial community expressed concern about the difficulty of making an initial selection of accounts based on reportable payments. The IRS agrees that efficiency may be served by the initial selection of accounts based on receipt of reportable amounts, provided that reportable payments received in those accounts may be examined when required under the Audit Guidance. Accordingly, the revised procedures under this Audit Guidance require the external auditor initially to select for examination only those accounts that have received reportable amounts, and then to examine reportable payments made to accounts within that group when required in Phase 1 of the audit.

(ii) Deferral of Certain Tasks to Phase 2 of the Audit Process . During the audit, the external auditor must perform tasks designed to gather certain basic facts about the QI’s compliance with the QI Agreement. The revised procedures included in the attached Audit Guidance defer certain of these tasks to Phase 2 of the audit process. The revised procedures reflect the view that the most accurate facts relating to a QI’s compliance may be obtained by examining how a QI has (a) documented, (b) pooled, (c) withheld on and (d) reported on particular accounts. Accordingly, tasks that require the examination of particular accounts have been retained in Phase 1 of the audit and tasks that do not relate to examination of particular accounts, generally, have been deferred to Phase 2. For example, tasks requiring interviews of QI employees have been deferred to Phase 2.

(iii) Spot Check Review under AG10.03(B), (C), and (D) . The IRS recognizes that the withholding system is based on information drawn from account holder documentation and that account holders open and close accounts periodically. It also recognizes that pooling, withholding and reporting depend in large part on the procedures and systems the QI uses to process

the information obtained from account holder documentation. The revised procedures reflect the view that a thorough examination of how a QI has documented all, or a representative sample of, its account holders may provide a reliable indication of the QI’s overall compliance, and that its reliability may then be tested by exploratory examination of how the QI has pooled, withheld, and reported based on information drawn from the documentation of a smaller number of account holders.

Accordingly, the revised procedures in this Audit Guidance generally require that in Phase 1 of the audit, the external auditor must use all accounts covered by the QI Agreement, or a statistical sample representing all such accounts, in performing the account based tasks that relate to how the QI has documented its account holders. In performing the account based tasks that relate to how the QI has pooled, withheld, and reported, the revised procedures provide the external auditor with the option of using a smaller number of accounts. The number of accounts to be reviewed for a spot check must include all accounts required to be reported as undocumented or as not satisfying documentation criteria under AG10.03(A), and must in any case include at least 20 accounts from each of the following categories of account holders (assuming there are 20 or more accounts in each such category): QI’s direct account holders that are not U.S. non-exempt recipients; QI’s direct account holders that are U.S. non-exempt recipients; and QI’s indirect account holders.

(iv) Explanatory footnotes or addenda . This Audit Guidance has been modified to include a provision permitting the external auditor to perform or to propose additional procedures or other fact finding and report the results by way of footnotes or addenda to its report for Phase 1 of the audit. This provision offers the opportunity to clarify problematic results reported for Phase 1 of the audit, which may obviate the necessity for follow up in Phase 2.

(v) Consolidated Audits for Certain Re- lated QIs . The financial community has also suggested that cost and efficiency concerns could be mitigated by consolidating the audits of related QIs. In response, the IRS has modified the Audit Guidance to permit a consolidated audit of two or more QIs in circumstances when the consolidated audit may achieve the objectives of

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auditors. To accommodate this concern, this final Audit Guidance has dropped the certification requirement. Based on the external auditor’s disclosure in its report for Phase I of the audit, the IRS will review how the use of a QI’s internal audit personnel and reports may have affected the accuracy of the external auditor’s report, and will take that review into account in determining whether any follow up in Phase 2 of the audit is appropriate. SECTION 5. COMMENTS

The IRS and Treasury recognize that the QI system requires an innovative approach to the audit process and that the process will evolve as experience is gained. The IRS and Treasury will consider further modification of the Audit Guidance in light of experience and encourage further dialogue with the financial community.