International Financial Law Prof Blog

Editor: William Byrnes
Texas A&M University
School of Law

Thursday, January 11, 2018

Taxpayer Advocate Report to Congress: IRS’s Approach to Credit and Refund Claims of Nonresident Aliens Wastes Resources and Burdens Compliant Taxpayer

Under Internal Revenue Code (IRC) §§ 1441-1443 and 1461-1465 (Chapter 3), the IRS imposes withholding on payments made to nonresident aliens and foreign corporations and allows credits and refunds of the amounts to which these taxpayers are entitled.

For many years, the operation of this regime closely paralleled the approach taken by the IRS with respect to domestic withholding under IRC § 31 in that there were no restrictions limiting credits or refunds to the amount of withheld tax actually paid over to the IRS.

Based on generalized concerns regarding the potential for fraud and systematic noncompliance, however, in 2015, the IRS altered its administrative policy regarding Chapter 3 refunds.

It no longer allows credits and refunds when taxpayers can prove withholding has occurred, as is the practice in the domestic employment tax context. Instead, the IRS now grants credits and refunds only when the information on Forms 1040NR, U.S. Nonresident Alien Income Tax Return, substantially matches the information on Forms 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding, issued directly to the IRS by withholding agents.

These credits and refunds associated with Forms 1042-S will be referred to, for simplicity, as “1042-S filers.”)

Without an analytic foundation, the IRS took the drastic step of freezing refund claims of 1042-S filers for up to one year or longer while attempting to match the documentation provided by taxpayers with the documentation provided by withholding agents.

The IRS did this even though most 1042-S filers (nearly 80 percent) claim relatively small dollar amounts of withholding (an average of approximately $1,100).

Further, as a group, 1042-S filers appear to be substantially more compliant than a comparable portion of the U.S. taxpayer population. 

The IRS ultimately released these frozen refunds, which impacted over 100,000 taxpayers, after the systemic matching program yielded so many “false positives” that it proved untenable.

The IRS is now redesigning this program.

Nevertheless, only the tools and the processes are being revised, while the program’s philosophy remains unchanged and its underlying assumptions unchallenged. The IRS continues to treat 1042-S filers as “tax cheats” anytime a mismatch arises, even if that mismatch is beyond the taxpayer’s control or is based on some other good-faith error.

As a result, the National Taxpayer Advocate is concerned that:

■ The IRS’s current approach to 1042-S filers does not appear to be based on analysis of quantitative evidence;
■ The IRS is wasting resources and needlessly burdening taxpayers by its undifferentiated approach to 1042-S filers;
■ The IRS has demonstrated a reluctance to enforce compliance among Form 1042-S withholding agents, even though it generally has the ability to do so; and
■ The IRS position of forcing nonresident taxpayers to shoulder the burden of their withholding agents’ reporting and compliance may be subject to litigation hazards under Portillo and other naked assessment cases.

While the need to protect against fraud and systematic noncompliance is understandable, the IRS has so far allocated a disproportionate share of this burden to taxpayers and away from both itself and withholding agents, a step that has only exacerbated the problems caused by the undifferentiated approach adopted by the IRS with respect to 1042-S filers. Current IRS practice is to review certain credit and refund claims of 1042-S filers.

Because the IRS’s legal position is that it has no obligation to honor Form 1042-S credits or refund claims unless the taxpayer has an accurate Form 1042-S from the withholding agent and the withholding agent has remitted the withholding to the IRS, a mismatch of various data fields will cause the issuance of a preliminary disallowance letter.

That letter instructs the taxpayer to contact the withholding agent, figure out the reason for the mismatch, and resolve the issue.

If the taxpayer is unable to carry out this instruction, or the withholding agent is unwilling to cooperate, the taxpayer is left with little practical recourse other than to seek redress in the courts, either against the withholding agent or the IRS itself.

This is a step that many taxpayers lack the resources to undertake, as it involves litigating against withholding agents, many of which are large global companies, or against the IRS. Moreover, as the withholding claimed by nearly 80 percent of 1042-S filers averages only about $1,100 per taxpayer, the cost of litigation for most of these taxpayers would vastly exceed the amounts they are attempting to recover.

The IRS has, in effect, shifted the burden of withholding agent noncompliance to these taxpayers, who are comparatively ill-equipped to pursue any remedies in the event that simple reporting inconsistencies cannot be resolved. By contrast to most taxpayers, the IRS has powerful tools allowing it to directly pursue, and collect from, withholding agents who fail to remit funds.

In addition, the IRS can assess assorted failure to pay and failure to file penalties against these withholding agents.

Nevertheless, the IRS has shown some reluctance to seek recovery from, and impose sanctions against, noncompliant withholding agents. For example, IRS actions to recover unpaid deposits from withholding agents have dropped from 4,302 for TY 2014 to only 1,139 for TY 2015.

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