IRS withholding tax enforcement: dropping the other shoe?

• Author: Van Leuven, Mary

The IRS is hot on the trail of cross-border withholding.

As a general rule, a withholding agent must withhold 30% on U.S.-source outbound payments, unless the payee is entitled to relief under a treaty or statutory provision and the withholding agent receives a proper claim for reduced withholding (e.g., on a Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding) prior to payment. Withholding agents must annually disclose withholding information on Forms 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons, and 1042-5, Foreign Person's U.S. Source Income Subject to Withholding.

Despite a hefty price for noncompliance--including secondary liability for the withholding tax, interest, and various penalties--U.S. companies have yet to master the science of cross-border withholding. In response to what it perceived to be rampant noncompliance, the IRS published Form 1042 audit guidelines in 2008 and designated withholding as a Tier I audit issue in 2009.

Since designating cross-border withholding as a Tier I issue, the IRS's actual enforcement activity has seemed spotty. But in May 2011, the IRS signaled a renewed focus on this area. Stuart Mann, manager (foreign payments) in the IRS Large Business and International Division, announced that, after spending 2010 reviewing Form 1042-S filings, the IRS would be sending proposed penalty notices to more than 2,000 U.S. withholding agents for late filings and erroneously filed paper versions of Form 1042-S (see Elliott, "IRS Issuing Penalties for Late, Misfiled Nonresident Alien Withholding Forms," 2011 TNT 86-5 (May 4, 2011)). Mann warned that, while most withholding agents could obtain penalty relief upon showing reasonable cause, persistent failures to file would be met with Sec. 6721 intentional disregard penalties.

In 2003, the IRS performed a similar Form 1042-S review and found that more than 31 % of Forms 1042-S filed had errors. The IRS's response was to offer withholding agents a voluntary disclosure program (see Rev. Proc. 2004-59). This time around, the IRS seems to be singing a different, more serious, tune--fair warning to withholding agents that have...