The Internal Revenue Service should take immediate action to strengthen its controls over the processing of refunds issued to nonresident aliens to prevent such individuals from receiving erroneous refunds, according to a new government report.

The report, by the Treasury Inspector General for Tax Administration, noted that failure to address the problem could result in significant losses to the federal government as the questionable refunds issued to nonresident aliens are high and the probability of recovering fraudulent refunds from nonresidents living outside the U.S. very low.

“If the IRS does not take immediate steps to improve its ability to verify refunds to nonresident aliens before the refunds are sent out of the United States, the problem could increase significantly,” warned TIGTA Inspector General J. Russell George in a statement. “TIGTA discussed the control weaknesses we identified with the IRS and it is working on actions to address them.”

Nonresident aliens who receive U.S. sources of income must report and pay taxes on that income and file the U.S. Nonresident Alien Income Tax Return (Form 1040NR) with the IRS. This income is also subject to income tax withholding. In 2009, the IRS processed approximately 598,000 Forms 1040NR for tax year 2008. The total taxes withheld on these returns amounted to more than $2.4 billion and refunds amounted to more than $712 million.

TIGTA performed an audit to determine whether IRS controls ensured that only eligible nonresident aliens receive refunds. TIGTA found that inaccurate and fraudulent Forms 1040NR were not detected during processing. As a result, TIGTA identified a significant number of control weaknesses in the processing of refunds claimed on Forms 1040NR. In some 40 cases of questionable refunds issued to nonresident aliens, the refunds were very high, totaling more than $2.3 million.

TIGTA made six recommendations to the IRS in its report, and the IRS agreed with all of those recommendations.

The public version of the report redacted some of those recommendations, but they included a recommendation that the commissioner of the IRS’s Large and Midsize Business Division should use the foreign country codes on Forms 1040NR to systemically verify that the correct rate of tax is applied according to the applicable tax treaty and should work with the IRS’s Forms and Publications function to clarify the instructions on what constitutes U.S source income in regard to income from multi-level marketing companies.