Table Of Content

\V S. Hrg. 103-102 THE BREAKDOWN OF IRS TAX ENFORCEMENT REGARDING MULTIN—ATIONAL CORPORATIONS: — REVENUE LOSSES, EXCESSIV—E LI—TIGATION, ^AND UNFAIR BURDENS FOR U.S. PRODUCERS Y 4. G 74/9; S. HRG. 103-102 Tlie Breikdoua of IRS Ijx EnforceneB. iRING BEFORE THE COMMITTEE ON GOVERNMENTAL AFFAIES UNITED STATES SENATE ONE HUNDRED THIRD CONGRESS FIRST SESSION MARCH 25, 1993 Printed for the use of the Committee on Governmental Affairs ^'"iUJs'CiVid. Al'G 2 5 t'" U.S. GOVERNMENT PRINTING OFFICE 66-349±i WASHINGTON : 1993 ForsalebytheU.S.GovernmentPrintingOffice SuperintendentofDocuments,CongressionalSalesOffice,Washington,DC 20402 ISBN 0-16-0A1126-2 V \ S. Hrg. 103-102 THE BREAKDOWN OF IRS TAX ENFORCEMENT — REGARDING MULTINATIONAL CORPORATIONS: REVENUE LOSSES, EX^CESS~IVE ~UTIG—ATION, AND UNFAIR BURDENS FOR U.S. PRODUCERS V 4. G 74/9; S, HRG. 103-102 He Breakdout of IRS Tjx Eaforcenee. .. iRING BEFORE THE COMMITTEE ON GOVERNMENTAL AFFAIRS UNITED STATES SENATE ONE HUNDRED THIRD CONGRESS FIRST SESSION MARCH 25, 1993 Printed for the use of the Committee on Governmental Affairs s^Uircv ''*^• "7 '»--.' Al'G 2 5 1J:3 U.S. GOVERNMENT PRINTING OFFICE 66-349ti WASHINGTON : 1993 ForsalebytheU.S.GovernmentPrintingOffice SuperintendentofDocuments,CongressionalSalesOffice,Washington,DC 20402 ISBN 0-16-041126-2 COMMITTEE ON GOVERNMENTAL AFFAIRS JOHN GLENN, Ohio, Chairman SCAARMLNLUENVNI,N,GeMoircghiiagan TWEIDLLSITAEMVEVN.SR,OTAlHa,skJar., Delaware JDIAMVISDASPSREYRO,RT,enAnreksasneseas TWIHLALDIACMOCSH.RCAONH,EN, Maine JDOASNEIPEHL KI..LAIKEABKEAR,MAHNa,waCioinnecticut JOHN McCain, AriMziosnsiassippi BYRON L. DORGAN, North Dakota Leonard Weiss, StaffDirector Allen Huffman, Professional StaffMember Franklin G. Polk, Minority StaffDirectorand ChiefCounsel Michal Sue Prosser, ChiefClerk (n) CONTENTS Openingstatements: Page SenatorDorgan 1 Senator Levin 13 WITNESSES Thursday, March 25, 1993 Natwar M. Gandhi, Associate Director, Tax Policy and Administration Issues, U.S. General Accounting Office; accompanied by Jose Oyola, Assistant Di- rector, International Taxation, Larry Korb and Kevin Daly, Transfer Pric- ing 7 Dan R. Bucks, Executive Director, The Multistate Tax Commission, Washing- ton, DC 17 PhilipM. Aldape, Division Manager, IdahoStateTaxCommission, Boise, ID... 20 Benjamin F. Miller, Associate ChiefCounsel, California Franchise Tax Board, Sacramento, CA 21 Louis M. Kauder, InternationalTax Attorney, Washington, DC 26 RobertS. McIntjTe, Director, Citizens forTaxJustice, Washington, DC 30 Prof Dale W. Wickham, The American University, International and Tax Policy, Wickham & Associates, Washington, DC 31 Kevin L. Kearns, President, U.S. Business and Industrial Council, Washing- ton, DC 35 Alphabetical List of Witnesses Aldap)e, PhilipM.: Testimony 20 Preparedstatement 86 Bucks, Dan R.: Testimony 17 Preparedstatement 73 Gandhi, NatwarM.: Testimony 7 Prepared statement 45 Kauder, Louis M.: Testimony 26 Prepared statement 102 Kearns, Kevin L.: Testimony ., 35 Preparedstatement(with attachments) 232 Mclntyre, RobertS.: Testimony 30 Preparedstatement 123 Miller, Benjamin F.: Testimony 21 Prepared statement 92 Wickham, Prof. DaleW.: Testimony 31 Preparedstatement(with attachments) 130 (III) IV Page APPENDIX Prepared statementsofwitnesses in orderofappearance 45 Questionsand answersofSenator Dorgan 5 "Technotax: How Japan's Tax System Spurs Technology Development," byJohnStearn 262 A Law Review article entitled "RICO Meets Keiretsu: A Response to PredatoryTransfer Pricing," byJim Harmon 284 Ms. Frances Zuniga, prepared statement 317 GAO Factsheet entitled "International Taxation, Taxes of Foreign- and U.S.-ControUed Corporations 326 THE BREAKDOWN OF IRS TAX ENFORCEMENT REGARDING MULTINATIONAL CORPORATIONS: REVENUE LOSSES, EXCESSIVE LITIGATION, AND UNFAIR BURDENS FOR PRODUCERS U.S. THURSDAY, MARCH 25, 1993 U.S. Senate, Committee on Governmental Affairs, Washington, DC. The Committee met, pursuant to notice, at 1:36 p.m., in room SD-342, Dirksen Senate Office Building, Hon. Byron Dorgan, pre- siding. Present: Senators Dorgan and Levin. OPENING STATEMENT OF SENATOR DORGAN Senator Dorgan. The hearing will come to order. This is the Senate Committee on Governmental Affairs and we are pleased that all ofyou are here at this hearing today. We apologize very much for the disruption this morning. As you know, the Senate held a long series of votes with no debate, 15 minutes for each vote, and it was simply impossible to hold a hearing at that time. All the hearings, I believe, that were scheduled this morning had to be rescheduled. We appreciate your patience. We will perhaps try to contract this hearing just a bit, because there are some people on the witness list who have airplanes to catch this afternoon. Having said all that, I would like to make a brief opening statement, and then I would like to call on the witnesses we have with us today. To see why we were here today, a good place to start would be at the U.S. Tax Court down the street. There in room G-24, you could see the debris from the nation's current multinational tax enforcement system. One recent case is a good example. It occupies 19 file boxes full of legal and economic arcana that took 10 years and a small fortune to produce. The judge in the case called this sophistry mainly "useless." He needed 4 y—ears to slog through the mess, and his de- cision came to 240 pages and that was just one C£ise and one corporation. What was the point of this monumental paper chase? To argue over the "correct" prices for some spare airplane parts that a U.S. corporation produced in the tax haven of Singapore and shipped back to its U.S. operations. The case resolved only 2 years of taxes, (1) 1978 and 1979, and the government and the taxpayers have to repeat this same exercise in years that are disputed since then. So welcome to the world ofmultinational tax enforcement, which the U.S. Treasury has turned into a massive public works program for beltway tax lawyers, accountants and economic consultants, and a major drain on the public purse. Easily, in my judgment, at least $10 billion a year disapp—ears into the dark recesses of this complicated enforcement mess not even counting the costs of the bureaucracy and litigation. The U.S. Treasury has taken a modest first step towards a solution, which is in the President's economic plan. But the new IRS regulations will raise well under a billion dollars, and the litigation may well get even worse. Corporations will now have to justify all their internal pricing decisions up front. This will be a potlatche for economic consultants. But it will be a huge burden for honest business taxpayers, and it won't bring us much closer to a solution. We have to find a better way, and that is the purpose of this hearing. The Federal Government simply cannot afford all this bureaucracy and litigation, and neither can the corporate taxpayers. Fundamental questions of tax justice are at stake as well. The individuals and small businesses ofthis country have demonstrated they are willing to do their share. They have responded to Presi- dent Clinton's proposal with a public spirit that has defied many of the pundits. Now we have to ask multinational corporations that do so well in our market to pay their fair share oftaxes, too. If America raises corporate tax rates, without a radical reform of our multinational enforcement, then America's smaller businesses and home-grown producers will end up paying the bill, while the multinational giants continue to contribute little or nothing. This is not mere polemics. The tax avoidance by multinational firms, and especially foreign-based firms, is epidemic. As the GAO will testify today, some 72 percent of foreign based corporations that do business here pay no Federal income taxes. These are not just obscure import-export firms, either. We are talking about some of the largest corporations in the world, including foreign auto and electronics makers that are household names, they do business in our country, earn money in our country, but pay no Federal income taxes in our country. Under Representative Jake Pickle, the House Ways and Means Subcommittee on Oversight identified one foreign auto maker, for example, that sold $3.4 billio—n worth of cars here in 2 years and paid no Federal income taxes not a penny. Now, how do we justify that to individual taxpayers and Main Street businesses that are digging into their bank accounts in order to satisfy their April 15th obligation? The answer is we cannot justify it, because it simply is not fair. The IRS is actually helping these foreign firms to compete against U.S. firms, by giving them tax breaks through a hapless enforcement system. Is it any wonder that Treasury has consistently played down the lost revenue and has tried to keep the whole issue under wraps? The problem has festered at the IRS for decades, and only the explosion in world trade has forced it into the open. How do you distinguish between a corporation's U.S. income from the income that should be reported elsewhere? That sounds simple, but it is not. The fact is the States had to grapple with that problem early on and have come up with a solution that I think makes a lot of sense. I was involved in tax administration in one State, and was Chair- man of an organization called the Multistate Tax Commission that brought together many States, in a cooperative enforcement effort. We developed a formula which resulted in a fair apportionment of a corporations income among the various States in which it did business. That is precisely the approach the Federal Government ought to take. There's a new and worka—ble way for corporations to report their income for tax purposes one that is simpler for them and that eliminates bureaucracy, and that most importantly, results in a fair tax burden for those who are doing business in this country. I am going to insert the rest ofmy statement in the record today. Opening Statementof Senator Dorgan To see why we are here this morning, a good place to start is at the U.S. Tax Court down the street. There, in room G-24, you can see the debris from the nation'scurrent multinational tax enforcementsystem. One recent CEise is a good example. It occupies 19 file boxes full oflegal and economic arcana that took ten years and a small fortune to produce. Thejudge in the case called this sophistry mainly "useless." He needed four years to slog through the mess; hisdecision cameto 240 pages. What was the point ofthis monumental paper chase? To argue over the "correct" prices for some spare airplane parts, that a U.S. corporation produced in the tax haven of Singapore, and shipped back its U.S. operations. The case resolved only two tax years, 1978-79, moreover. The government and the taxpayer have to repeat thisinsaneexercise forthedisputedyears sincethen. Welcome to the world ofmultinational tax enforcement, which the U.S. Treasury has turned into a massive public works program for Beltway tax lawyers, accountants and economic consultants, and a major drain on the public purse. Easily, —at least $10 billion a year disappears into the dark recesses ofthe compliance mess not even countingthe costsofbureaucracyand litigation. The Treasury has taken a modest first step towards a solution, in the President's economic plan. But the new IRS regulations will raise well under a billion dollars, and the litigation may well get worse. Corporationswill now have tojustify all their internal pricing decisions up front. This will be a potlache for economic consultants. But it will be a hugeburden forhonest taxpayers, and itwon'tbringus much closer toa solution. We have to find a better way. The Federal Government can't afford all this bureaucracy and litigation, and corporatetaxpayers can'teither. Fundamental questions ofjustice are atstake. The individuals and small businesses of this country have shown that they are willing to do their share. They have responded to PresidentClinton's call with a public spirit that has defied the pundits and flumoxed those who think the sole purpose ofgovernment is to cater to greed. Nowwe have to ask the multinational corporations thatdo so well in our market, to pay theirsharetoo. IfAmerica raises corporate tax rates, without a radical reform ofourmultination- al enforcement, then America's smaller businesses and home-grown producers will end up paying the bill, while the multinational giants continue to contribute little or nothing. — This is not mere—polemics. Tax avoidance by multinational firms and especially foreigii based firms is epidemic. As the General Accounting Office will testify this morning, some 72 percent of the foreign-based corporations that do business here, pay no Federal income taxes. These aren'tjust obscure import-export firms, either. We are talking about some of the largest corporations in the world, including the foreign autoand electronicsmakers thatare household names. Under Rep. Jake Pickle, the —House Ways and Means Ove—rsight Subcommittee identified one foreign automaker fairly typical, it turned out that sold $3.4 billion worth of cars here over two years, and paid no Federal income tax. Not a penny. How do wejustify that to our individual taxpayers and Main Street businesses that are now digging into their bank accounts to pay the taxes that are due on April 15th? We can'tjustify it, because it simply is not fair. The IRS actually is helping these foreign firms to compete against U.S. firms, by giving them under-the-table tax breaks through haplessenforcement policies. Is itany wonder thattheTreasury has consistently played down the lost revenue, and has tried to keep the whole issue underwraps? The problem has festered at the IRS for decades, and only the explosion in world trade has forced it into the open. How to distinguish a corporation's U.S. income, from the income that should be reported elsewhere? It sounds simple, but it isn't. A global enterprise such as Sony, say, operates through a multitude of subsidiaries throughout the world. All kinds ofproducts and services flow back and forth within the corporation's worldwide web: patents, parts, shared overhead, finished products, and azillion otherthings. By putting "prices" on these transfers, the company can easily shift its income off its U.S. books and into the black holes in its international balance sheets. And that'swhathappens. Theway the IRS tries to uncovertheseshellgames isstraightoutofthe Keystone Kops. It is the most lawyer-intensive system one can imagine. The agency di—s- patches audi—tors to comb through a corporation's millions ofinternal transactions one by one and try to adjust the prices to a hypothetical market level. Usually such a market price does not exist, because the transactions are unique to the par- ticularcorporation. Sotheauditorhasto make one up. This is the bureaucratic equivalent oftr3dng to empty the ocean with a teaspoon. TquhaegmIiRrSeisinovwehriwchheltmheedc,orapnodratbiigoncourspuoarlaltyioennsdsknuopwonit.toTph.eTrheesuGltAOis awilllegtaelsitsitfiyc today that in a recent year, only 5% ofour auditor's assessments on foreign-based firmswere ultimatelysustained. Meanwhile, medieval disputes over "correct" prices arecloggingthetaxcourtatan increasing rate. Frances Zuniga, a former IRS examiner, says in written testimony that "no one can reallydetermine an arms length price." Even the Wall StreetJournal suggested (while misstating the underlying issue) that the Treasury's enforcement approach is "impossible." What makes this situation truly strange, is that a remedy is at hand. Long ago, the states had to come to grips with corporations operating freely across their bor- ders. They knew they couldn'tpossibly disentangle the spaghetti pileofa largercor- poration's internal accounting. So they devised a simple formula to do the job instead. This formula approach works. The U.S. Supreme Court has upheld it contin- ually as reasonable and fair. Today, we C£m apply that basic approach to corpora- tionsoperatingacross national bordersaswell, assomestatesdo already. The formula approach would ease compliance burdens on honest taxpayers. It would flush out the billions ofdollars thatcurrently disappear into the enforcement morass. Better still, the formula approach would render the medieval accounting games irrelevant; corporations could focus on business instead of fancy tax strate- gieNs,oawnodndtheergtohveecrrniemsenoftpcrooutledstsaovneKmoSnteryee.t. Transfer pricingschemes havebecome a major industry in this town. Thisone tax avoidance niche is now so lucrative, that the Bureau of National Affairs publishes a special "Transfer Pricing" newsletter that goes for $895/yr. Lawrence Summers, the administration's nominee to be Treasury undersecretary for international affairs, recently called the current system a "full emplojonent actfor tax attorneys." This is agrowth industry that America can do without. The IRS can change without any new laws, moreover. It has all the authority it needs under laws already on the books. Critics say that the formula method would result in "double taxation," by grab- bing income thatought tobe reported elsewhere. Butthere's a longwaytogobefore we get even to single taxation. Besides, regulations could easily guard against any double taxation that mightoccur. Critics also say that our tax treaties prohibit the use ofthe formula method. But this morning we will hear a contrary view. The purpose ofthose tax treaties, after all, isto promote tax enforcement, not frustrate it. There's a game goingon here. Lobbjdsts for multinational firms have helped keep the IRS mired in a rut. Then they go abroad and say, "See, the U.S. is using the 'arms-length' method, so you should use it too." Then they come back to the U.S. and say, in effect, "Now you can't change because your trading partners are using thisantiquated system too."