The IRS Foreign Payments Practice (FPP) has begun increasing the number and scope of its audits of multinationals' reporting on Forms 1042 (Annual Withholding Tax Return for U.S. Source Income of Foreign Persons) and 1042-S (Foreign Person's U.S. Source Income Subject to Withholding) and certain related issues.

Background

The IRS established the FPP unit several years ago. Within this unit, the IRS created enforcement groups geographically throughout the United States (US) to address reporting and withholding requirements for payments made to foreign persons — primarily reported on Forms 1042 and 1042-S. The establishment of the program was concurrent with the IRS's efforts to implement FATCA. The FPP expands the enforcement and policy groups established between 2000 and 2006 that dealt primarily with the information reporting and withholding requirements imposed on the financial services industry.

Increased enforcement activity

We are now hearing of increased enforcement activity by the FPP. This enforcement activity is being conducted primarily in four different ways: (1) standalone examinations of Forms 1042; (2) inclusion of a Form 1042 examination as part of an overall IRS audit of the taxpayer's corporate income tax or partnership filings (i.e., Forms 1120, 1120-F and 1065); (3) coordinated examinations of specific issues; and (4) service center review and inquiries with respect to certain Form 1042 and 1042-S filings.

In addition to an increase in the number of audits, the scope of the Form 1042 examinations appears to be expanding. Recent Information Document Requests (IDRs) have questioned how the withholding agent accounted for and reported time that employees of foreign affiliates spent in the US. These questions affect not only withholding tax and information reporting but also employment tax, transfer pricing and permanent establishment issues.

Additionally, it appears that challenges to information reporting and withholding compliance are not limited to amounts reportable on Forms 1042 and 1042-S. In our experience, IRS Service Center questioning of amounts reported and withheld on effectively connected income of foreign partners under Internal Revenue Code Section 1446 (i.e., Form 8804 and 8804-C) is on the rise.

The FPP is also responsible for enforcing the requirements of the Foreign Account Tax Compliance Act. These are new requirements that significantly affect Form 1042, 1042-S, 1099 and 8966 filings. FATCA requirements are intertwined with the withholding-at-source requirements as they will affect the same payments and the same information returns (e.g., Form 1042-S).

Implications

The IRS FPP is growing and becoming more active. The number of Form 1042 audits is increasing and the scope of those examinations is expanding. We anticipate this trend will continue as FATCA is phased in. IDRs requesting organization charts with foreign entities and their activities seem likely. Further, the IRS's exchange of Form 1042-S information with other countries will shine a brighter light on proper reporting.

Finally, as other countries adopt the Common Reporting Standard (CRS), multinational companies will have to coordinate CRS requirements with FATCA requirements, increasing the complexity of the policies, procedures and systems needed to comply.

A lot has been written about the IRS adoption of an issue-focused approach to examinations and of building campaigns around these issues. In light of the increased FPP activity, including the release of a number of International Practice Units that provide guidance to IRS personnel addressing Form 1042 related issues, it is quite possible that the Service will make withholding a "campaign."

Given this environment, multinationals should consider the following in assessing their potential exposure to IRS audits:

— FATCA and CRS entity classification

— Ownership of financial accounts/relationships and receipt of US-source income, including the related documentation requirements

— Compliance with making payments of US-source income from Accounts Payable, Treasury and any other paying areas

— Inbound foreign workers performing services within the US (both traditional expatriates and business travelers)

— Intercompany payments, whether deemed or actual (e.g., tracking global mobility of employees to determine source of income paid for personal services of a related company; intercompany interest, dividends, and royalties; insurance premiums-allocation between US and non-US risk)

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