IRS watchdog finds flaws, wasted funds in IRS FATCA systems, as effective date nears

The multi-billion dollar, high stakes information and tax gathering effort that tax authorities worldwide will commence in July 2014 under the US Foreign Account Tax Compliance Act, known as FATCA, now faces another major hindrance.

The US Internal Revenue Service, the principal agency spearheading the massive undertaking to obtain the cooperation of governments and financial institutions has been found to have major flaws in its computer systems that will permit compliance with its regulations and the law by institutions in every country.

FATCA, a 2010 US law prompted by the multi-year operation of the huge Swiss bank, UBS, to secretly harbor tens of millions of dollars belonging to US persons to facilitate tax evasion in the United States, has now produced the first international system to combat offshore tax evasion.

The law requires non-US banks, securities dealers, certain insurance companies and investment firms and others to report substantial information about the accounts of US persons, not just citizens, that they maintain. Beginning July 1, 2013, these businesses that fail to register as “covered entities” under FATCA will face a 30 percent withholding tax on any payments or income that is due to them in the US.

As FATCA effective date nears, IRS system needing repair

Now, just seven months before the landmark law takes effect, the Inspector General of the US Treasury Department, which houses the IRS, has found that the information repository developed by the IRS to implement FATCA lacks critical safeguards.

In a report made public Thursday, the Treasury Inspector General for Tax Administration (TIGTA) details system weaknesses that could severely handicap the ability of the IRS to administer one of the most significant tax enforcement measures in United States history, since income tax laws were enacted in the early 20th century.

The IRS estimates that FATCA will require more than 200,000 non-US financial institutions to register on a special online portal it has created for submission of information by these institutions that have been given the FATCA acronym FFIs. They will be reporting information on the accounts they hold for US persons in their countries.

The ability of US efforts to monitor and process this voluminous information and to pursue instances of tax evasion by the identified US persons — and possibly of conspiracy by the facilitating FFI — will hinge in large part on the functionality and utility of the technology system the IRS has designed to catalogue the data.

TIGTA conducted the inspection and audit to determine if the IRS reporting system development is rigorous enough to meet FATCA’s goals and unprecedented information gathering and processing challenges. It said “the successful development, deployment, and implementation of the Foreign Financial Institution Registration System should significantly improve taxpayer compliance internationally and thus enhance IRS tax administration.”

TIGTA found several IRS systems deficiencies

The TIGTA inquiry and report found these deficiencies in the IRS FATCA “Foreign Financial Institution Registration System” (FRS):

  • The system lacks measures to “ensure consistent adherence to risk mitigation… for program management, security controls…, testing documentation, and requirements management,”
  • The system’s fraud detection elements and framework are not strong enough and need improvement,
  • The IRS has not adequately leveraged management controls to assure successful deployment, and
  • The system is at risk of “not functioning as intended,” thus threatening FATCA’s long-term success.

“[FATCA] can effectively improve U.S. tax administration involving offshore accounts by utilizing… computer applications… developed and implemented in a timely and effective manner,” J. Russell George, the Treasury Inspector General for Tax Administration, said in a statement.

“[However], improved system development, management controls, and testing are needed to ensure the system works as intended to improve tax compliance.”

For the IRS, the unprecedented FATCA technology challenge adds another layer to the many challenges it already faces in managing the massive and extensive tax administration system the United States has constructed and assigned to the beleaguered agency to administer.

The IRS online portal that has been launched will allow FFIs, through a “FATCA Responsible Officer,” to comply with the various requirements of the 550-page FATCA regulations the tax agency issued.

System overhauled due to FATCA dallying, IRS says

The registration system was set to launch in November 2012, but the IRS scrapped it for various reasons, including delays in finalizing FATCA regulations and the signing of various Intergovernmental Agreements (IGA) by the US with other nations.

The IGAs, of which 12 have been signed to date, specify the steps that FFIs in signatory nations must take to comply with FATCA. The IGAs come in two Models that the IRS prescribes for nations, permitting reporting of information directly to the IRS or through the domestic tax agency. They  add a further complication to the information gathering challenges the IRS systems face.

The IRS said it was not aware until September 2012 of the expanding scope of FATCA through the IGAs and their corresponding reporting requirements. TIGTA said the system the IRS had built was not equipped to meet the scale of the increasing information demands under the law, the TIGTA report says.

The IRS disputes this finding, arguing that Congress instructed it to develop and complete the system as the requirements of the law were still in flux and being determined. It says it was hamstrung by budget constraints and could not finance a governing body to be responsible for all FATCA information technology projects.

FFIs must register with new IRS system by April 2014

The IRS spent $8.6 million over 19 months in developing the first version of the registration system. In January 2013, the IRS began developing “Release 1.1,” which adopts many of the features from the predecessor system. The TIGTA report says it apparently is encumbered by some of the same prior problems. The new system will cost about $16.6 million compared to the $ 14.4 that was budgeted for the original version.

The IRS launched the revamped system on July 30, 2013. While TIGTA says the IRS has made strides in improving its controls, it is not known how they will succeed in sustaining the coming deluge of financial information from FFIs.

FFIs must register with the system by April 25, and will be required to report volumes of data that includes customer identity, account numbers, balances, gross receipts and withdrawals of US persons who maintain accounts at their facilities.

TIGTA recommendations

The TIGTA report makes several recommendations to the IRS chief technology office, including:

  • Work with internal IRS units to identify and communicate system changes for future FATCA releases, ensuring the IRS documents and maintains test cases and results.
  • Assure the implementation of and consistent adherence to adequate program management controls to allow the IRS to meet FATCA goals and objectives.
  • Assure that all “system requirements documentation includes the requirements being tested and all security requirements, and that corresponding test cases are identified and sufficiently traced managed and tested.”

IRS disagrees with TIGTA conclusion

While the IRS agreed to the recommendations by TIGTA, it challenged the report’s characterization of a lackluster effort in developing the first FATCA registration system.

“We take exception to the conclusion drawn… that… a major redesign of the system was necessary due to IRS not sufficiently developing requirements,” Terrence Milholland, IRS Chief Technology Officer, said in a September memo to the Deputy Treasury Inspector General of Tax Administration.

“(T)he major redesign was due to late regulatory changes, driven by significant public feedback on the draft regulations that impacted the in-flight system design,” he added.

“Therefore, we disagree with TIGTA’s conclusion that adequate program controls improvements are necessary. FATCA did in fact have strong program management principles in place.”