Daily Tax Update - September 20, 2012: Senate Investigations Subcommittee Hearing on Offshore Profit Shifting and US Tax Code

SENATE INVESTIGATIONS SUBCOMMITTEE HEARING ON "OFFSHORE PROFIT SHIFTING AND US TAX CODE":  Today, the Senate Permanent Subcommittee on Investigations held a hearing to "examine the shifting of profits offshore by U.S. multinational corporations and how such activities are affected by the Internal Revenue Code and related regulations."

The witnesses were:

Panel One:

STEPHEN E. SHAY, Harvard Law School, Cambridge, MA

REUVEN S. AVI-YONAH, Irwin I. Cohn Professor of Law, The University of Michigan School of Law, Ann Arbor, MI

JACK T. CIESIELSKI, President, R.G. Associates, Inc., Baltimore, MD

Panel Two:

BILL SAMPLE, Corporate Vice President for Worldwide Tax, Microsoft Corporation,
Redmond, WA

Panel Three:

BETH CARR, Partner, International Tax Services, Ernst & Young LLP, New York, NY

LESTER EZRATI, Senior Vice President and Tax Director, Hewlett-Packard Company,
Palo Alto, CA

Accompanied by:   JOHN N. McMULLEN, Senior Vice President and Treasurer, Hewlett-Packard Company, Palo Alto, CA

Panel Four:

THE HON. WILLIAM J. WILKINS, Chief Counsel, Internal Revenue Service, Washington, DC

Accompanied by:   MICHAEL DANILACK, Deputy Commissioner (International) of the Large Business and International Division, Internal Revenue Service, Washington, DC

SUSAN M. COSPER,  Technical Director, Financial Accounting Standards Board, Norwalk, CT

  • Mr. Shay testified, "The issues highlighted by the Subcommittee staff investigation, relating to transfer pricing and porous rules relating to use of deferred profits in ways not consistent with our deferral regime, are susceptible to immediate action by the executive branch without new legislation and that should be done.  But the Subcommittee staff’s work product also highlights the potential for the two parties to work together to strengthen and adopt broadly similar antibase erosion proposals put forward by the Administration, Chairman Camp and Senator Enzi as deficit reduction measures without waiting for a tax reform process that will take years."  Shay continued, "The incentive for multinational businesses to shift income abroad is increased and therefore income shifting is further encouraged when they are able to use deferred earnings for investment in the United States."  Shay added, "The Subcommittee is to be applauded for exposing practices that do not show up on public financial statements because of the elimination of intercompany transactions in consolidated financial statements.  The Microsoft case study adds strong support to the findings reported by Treasury in 2010 testimony and in the report on transfer pricing by the staff of the Joint Committee on Taxation.  The study further buttresses the conclusion that there is substantial shifting of profits offshore by U.S. multinationals.  Because the study involves a single company, it would be very valuable to expend the study to include other companies.  This should not hold up continued work by the IRS to improve its enforcement efforts, to develop procedural approaches that would reduce incentives for aggressive transfer pricing on tax returns and to re-examine the application of the arm's length principle to instances of tax motivated location of profits that is de-coupled from the reality of where business is carried on.  The transfer pricing issues I have discussed become increasingly important under an exemption system.  Until there is evidence that the gusher of profit shifting through transfer pricing has been capped in some way, it is risky, even foolhardy to consider shifting to an exemption system and inviting additional businesses to the income shifting trough.  Instead, it would make sense to first adopt one or more of the anti-base erosion proposals that have been proposed in different contexts by both parties and evidence that the U.S. tax base is adequately protected.  Similarly, with respect to investment in U.S. property rules, additional investigation is warranted to determine the scope of use of the techniques described in the HP case study.  The IRS should, as it has repeatedly in this area, adopt guidance that would permit grouping of related controlled foreign corporations for purposes of testing whether earnings are invested directly or indirectly in the United States as part of a broader anti-abuse rule.”
  • Mr. Avi-Yonah said, "The situation described in the Subcommittee report represents a complete reversal of what Congress intended when it adopted the super-royalty rule in 1986.  Once again, U.S. multinationals are able to shift most of their profits from intangibles developed in the U.S. to a select group of low-tax offshore locations.  A complete solution to the profit- shifting opportunities in the current regime is not possible without thorough reform of the international tax system.  In the short run, however, it is advisable to address the specific loopholes that underlie the current situation.  I would therefore recommend restoring the efficacy of the super-royalty rule by (a) adding a proviso to IRC section 482 that the rule will apply notwithstanding any cost-sharing agreement entered into after the date of enactment; (b) repealing IRC 954(c)(6) and requiring Treasury to adopt the regulations it proposed under IRC 954 to limit the application of check the box in ways that undermine Subpart F."
  • Mr. Ciesielski said, "The area I will address is the APB 23 exception to accruing income taxes on foreign earnings, as long as they are intended to be indefinitely reinvested in those jurisdictions."  Mr. Ciesielski continued, "The most important points to understand regarding the APB 23 exception:  It erodes and undermines the meaning of net income as understood by investors.  It provides a powerful, flexible tool for managers to shape their earnings forecasts without real changes in underlying economics, solely through changes of intention.  That may lead to incentive problems.  To the extent that the indefinite reversal exception distorts earnings reporting, it introduces inefficiencies into the capital allocation process of markets. If these earnings influence investors to favor securities of such companies, they may not be getting what they expect - and they may have forgone other opportunities.  The idea of intending to indefinitely reinvest earnings to avoid accruing income tax is absurd. Heavy industries continually reinvest in capital projects to obtain accelerated depreciation benefits and reduce their current income tax burden.  They accrue deferred income taxes even though they intend to indefinitely reinvest their earnings this way.  Would anyone suggest that they should not accrue deferred income taxes?  The extent to which the indefinite reinvestment exception affects any given company’s earnings is not disclosed.  Investors do not have a clear idea of how much this kind of encumbered income comprises net income and have little idea of how it will affect future earnings and cash flows.  The exception benefits a relatively few firms: the ones with the most portable assets and the greatest global footprint.  Of the $1.542 trillion of accumulated indefinitely reinvested earnings in the S&P 500, 72% of the amount belonged to only 50 companies - only 16% of the 318 firms with such balances.  Note that there were 182 firms in the S&P 500 that showed no accumulated indefinitely reinvested earnings.  The exception dates back to at least 1959.  What may have been a minor distortion in financial reporting at that time has grown tremendously in an era of global markets, instant communications, and the ability to move cash around the world in seconds.  Standard setters have not served investors well in that they had a chance to remedy it in 2004 but did nothing.  Likewise, the SEC has done some letter-writing to individual companies, but has done nothing in terms of setting standards of disclosure on the matter.  Disclosure is not the solution, but greater disclosure would at least bring attention to the problem.  Accounting rules shape management behavior.  This rule, or rather, this exception to the rule, encourages firms to make investments that produce one kind of “special” income that really isn’t, in substance, very special at all.  It may encourage firms to take on more complex management tasks than they really need to take, in order to show a kind of earnings pattern that may be more of an optical illusion than anything - while serving to buffer them from critical market scrutiny."
  • Mr. Sample testified, "Microsoft’s tax results follow from its business, which is fundamentally a global business that requires us to operate in foreign markets in order to compete and grow.  In conducting our business at home and abroad, we abide by US and foreign tax laws as written.  That is not to say that the rules cannot be improved--to the contrary, we believe they can and should be.  In our view, the U.S. international tax rules are outdated and are not competitive with the tax systems of our major trading partners.  These rules all too often provide a disincentive for US investment.  The US now has the highest corporate tax rate among OECD countries and, unlike our major trading partners, taxes the worldwide income of its domestic corporations.  The US also requires worldwide American businesses to pay residual US tax when foreign subsidiary earnings are repatriated back to the US, which creates a significant tax burden for US companies, a disincentive for US investment, and compares unfavorably with 26 of the 34 OECD member countries (including recent converts Japan and the U.K.) that offer a permanent tax exemption for the repatriation of foreign subsidiary profits.  We believe the U.S. should reform its tax rules to support the ability of worldwide American businesses to compete in global markets and invest in the US."
  • Ms. Carr stated, "In summary, a CFC’s short-term loan to its US parent does not constitute a taxable dividend if either: (1) the loan is not outstanding at the CFC’s quarter-end and, in the case of a recurring loan that is 'off' at quarter-ends, such loan was 'off' for a period of time that was approximately equivalent to or greater than the time such loan was 'on' or outstanding during the year; or (2) the loan is paid off within 30 days from the time it is incurred and the CFC's total loans that would otherwise be considered U.S. Investments are not outstanding for 60 days or more during the calendar year." Ms. Carr continued, "HP has an intercompany loan program that utilizes more than one CFC to engage in alternating ‘off/on’ loans to the U.S. parent company.  In the context of our audit work relating to HP’s income tax expense and income tax provision, Ernst & Young regularly reviews HP's loan programs to be satisfied both that the company is appropriately applying section 956 and its related guidance and (to the extent applicable) that the loans are consistent with HP’s indefinite reinvestment assertion.  As with the other aspects of Ernst & Young's work, we bring skepticism, objectivity, and independence to our audit procedures and require that HP provide us with substantial support evidencing its compliance with these requirements each year.  Only after a review of all of the available information relevant to these issues are we in a position to complete our audit and issue our audit report.  As the independent auditor of HP, Ernst & Young's responsibility is to perform an audit in conformity with applicable professional standards.  As a part of our audit, we evaluate HP's compliance with relevant accounting principles, income tax laws, and other laws and regulations to the extent they could affect HP's financial statements.  At the end of our audit, we form a conclusion with respect to HP’s financial statements and issue an audit report setting forth our opinion as to whether HP's financial statements are fairly stated under US GAAP.  We stand by the audit reports our firm has issued."
  • Mr. Ezrati said, "The Committee has asked how HP complies with accounting principles, such as APB 23, and tax obligations such as those provided in the US Internal Revenue Code ('IRC').  It asked HP to address its current repatriation strategy.  Before I address these issues in more detail, I want to emphasize for the Committee that HP has always had an extremely productive and professional relationship with the Internal Revenue Service ('IRS').  As is customary for a company of our size, HP has been under continual audit by the IRS. . . . HP's transfer pricing was subject to an APA from 1993 to 2010 and we are currently working on a renewal of that agreement for years after 2010."  Mr. Ezrati added, "Now, let me address more specifically HP’s compliance with the accounting principles and tax law implicated by the Committee's inquiry.  In summary, HP prepares documents for both accounting purposes, which are included in HP’s financial reports that are made public, and its private, confidential and proprietary information that is included in its tax returns in other countries and in the US  HP does not operate in a vacuum.  Ernst & Young (E&Y), one of the Big Four accounting firms, is HP's independent auditor and conducts extensive reviews of HP's compliance with accounting principles such as APB 23.  E&Y also provides advice on how HP complies with its tax obligations.  The IRS continuously and extensively audits HP's U.S. tax returns. In addition, the SEC reviews all of HP’s public financial reporting, including its compliance with APB 23.  The financial community that analyzes companies such as HP expertly review and report to the public on issues such as HP's  compliance with APB 23, the amount of tax HP pays, and compares HP with its peer companies."  Mr. Ezrati continued, "HP makes strategic decisions to bring back to the US earnings from its foreign operations when they are needed in the US, and when such earnings are not needed abroad.  It would not make business sense to repatriate such funds, have them taxed at a 35 percent US tax rate, and then send them back to HP’s foreign subsidiaries for immediate needs, such as the acquisition of a foreign business like Autonomy in 2011.  HP does repatriate funds to help pay unique US expenses.  Such expenses include stock buy backs, pension plan contributions, US payroll expense, research and development expenses, making IP royalty payments (including royalty payments to Microsoft who is at this hearing), among many other needs."  Mr.  Ezrati added, "HP takes seriously its obligations to accurately follow principles and to pay the taxes that it owes.  To successfully operate a U.S.-headquartered worldwide company in a highly competitive global market requires that HP account for and pay what it owes US and foreign governments.  HP plays an important role in the US economy and employs many US citizens at the cutting edge of technology."
  • IRS Chief Counsel Wilkins testified, "The subject of today’s hearing – the shifting of profits offshore by US multinational corporations – is a multifaceted and somewhat complex subject that can raise tax administration, tax accounting, and tax policy considerations – and perhaps other legal and policy considerations as well.  This testimony, however, will be limited to the tax administration considerations raised in the area."  Wilkins added, “For tax purposes and under basic economic principles, business profits are generally associated with the performance of functions, the assuming of risk, or the employment of assets.  With this in mind, it should be noted that this testimony is focused on the shifting by a multinational company of future profits to offshore affiliates through the actual shifting of the underlying functions, risks, or assets that will give rise to those future profits.  In other words, this testimony will not address attempts to shift profits realized by a multinational offshore while the income-producing functions, risks, and/or assets are clearly within the US taxing jurisdiction.  Such shifts could be attempted through blatant disregard of governing tax and economic principles or through an artifice that might be described as an assignment of income.  While, of course, the IRS would and does take enforcement measures regarding the latter class of transactions, this testimony will focus on the more common transactions where future profits are shifted to a related offshore affiliate of a U.S. corporation due to a shift of functions, risks, and/or assets to that affiliate."  Wilkins continued, "When the rights to a business’s core intangible property are shifted offshore, enforcement of the arm’s length standard is challenging for two reasons.  First, transfers of such critical business assets outside of a corporate group rarely occur, so comparable uncontrolled transactions are difficult, if not impossible, to find.  Thus, the IRS has been forced to resort to other methods that do not require direct evidence of comparable uncontrolled transactions, such as income-based methods that depend on an ex ante discounted cash flow analysis, which in turn depends on evaluating financial projections developed by the taxpayer.  Second, because a business’s core intangible property rights are by nature 'risky' assets, projecting cash flows from such assets, and the appropriate discount rate, requires an inherently challenging assessment of the underlying risk and how, and by which party, that risk is borne."
  • Ms. Cosper stated, "It is important for the Members of the Subcommittee to keep in mind that my comments relate to the accounting for income taxes in financial statements under US GAAP, not the accounting in tax returns under US law."  Ms. Cosper continued, "The FASB continues to monitor tax law changes and update its accounting standards accordingly...  In addition, the FASB has several mechanisms to receive input about US GAAP from our stakeholders (including regulators, users, preparers, auditors, academics, foreign standards setters and regulators) and our advisory groups.  The FASB continues to regularly monitor the accounting for income taxes as well as other areas of accounting."
  • Testimony can be accessed here.
  • The exhibits can be accessed here.
  • For additional information, contact Philip R. West - pwest@steptoe.com or  Amanda Varma - avarma@steptoe.com.

JOINT HEARING ON TAX REFORM AND THE TAX TREATMENT OF CAPITAL GAINS:  Today, the House Ways and Means and Senate Finance Committees held a joint hearing entitled "Tax Reform and the Tax Treatment of Capital Gains" to review the tax treatment of capital gains in the context of comprehensive tax reform.

  • In his opening remarks, House Ways and Means Committee Chairman Dave Camp said, "Today’s hearing focuses on capital gains in the context of comprehensive tax reform.  For nearly its entire history, our income tax system has taxed capital gains differently than other income...  Today, the maximum capital gains tax rate is 15 percent, as compared to the maximum individual ordinary income tax rate of 35 percent.  While the focus of this hearing is a longer term view on capital gains as part of comprehensive tax reform, we cannot forget that, absent Congressional action to stop the impending tax hikes we face at the year’s end, the maximum capital gains rate will increase to 25 percent and the maximum individual ordinary income tax rate will increase to 40.8 percent when certain hidden marginal tax rate increases are factored in."  Camp added, "Along these same lines, I believe it is also important to mention that, regardless of what rate we apply to capital gains, we should strive to retain parity between the rates for capital gains and dividends.  Just as we need to eliminate the 'lock-out' effect that our worldwide tax system imposes on foreign earnings, we also should not restore the ‘lock-in’ effect on domestic corporate earnings that makes it more tax-efficient to retain earnings inside a corporation when it might be more productive to push the cash out to shareholders so they can reinvest it elsewhere in the economy.  There are compelling arguments for providing a preferential tax treatment for capital gains, but we all know that there are important trade-offs to be considered with each piece in the complex process of comprehensive tax reform.  One of the main objectives for this hearing is to examine the trade-offs inherent in different proposals for capital gains taxation."
  • In his opening statement, Senate Finance Chairman Max Baucus said, "As we work on comprehensive tax reform, the treatment of capital gains is one of the most difficult issues we face.  Some are pessimistic and don’t believe we can agree.  I am optimistic.  We need to come together and find a workable solution."

The witnesses were:

Mr. David H. Brockway, Partner, Bingham McCutchen LLP

Dr. Lawrence B. Lindsey, President & CEO, The Lindsey Group

Dr. Leonard E. Burman, Daniel Patrick Moynihan Professor of Public Affairs at the Maxwell School, Syracuse University

Mr. David L. Verrill, Founder and Managing Director, Hub Angels Investment Group LLC

Mr. William D. Stanfill, General Partner, Montegra Capital Income Fund, Founding Partner, TrailHead Ventures, L.P.

  • Mr. Brockway testified, "If you do decide to retain a preferential rate for capital gains, there are other important issues regarding the taxation of capital gains that you should consider in this process.  The definition of what qualifies for the preferential rate should be reexamined in light of the policy reasons that persuade you to retain it.  There is no particular reason to believe that the current definitions are in all respects consistent with the particular investment activities that you conclude should be afforded a preferential rate.  Moreover, as long as there is any difference between the tax rates imposed on ordinary income and capital gains, there will be arbitrage activity designed to convert ordinary income (and short-term capital gains not qualifying for the preferential rate) into long-term capital gains and to  convert capital losses into ordinary losses. The larger the spread in rates and the fewer and less effective the speed bumps you put in the Code to discourage this activity, the more arbitrage activity there will be. The reality is that arbitrage is an inevitable aspect of any tax system because the law generally, and the tax law in particular, is based on relatively crude attempts to compartmentalize a very complex society and dynamic economic behavior.  It is not possible to create a system that does not have lines providing different treatment for activities defined by the law to be different but which, as cases get close to the line, do not in substance differ all that much."  Brockway continued, "I do not, however, want to oversell the simplification that would come from merging the capital gains and ordinary income tax rates.  While the reduction or elimination of the rate differential would, without a doubt, substantially reduce tax arbitrage activity, it is important to understand that even taxing both at the same rates would not eliminate the need for distinguishing between capital gains, or at least certain categories of capital gains, and ordinary income.  The current distinction between capital gains and losses on the one hand, and ordinary income and losses on the other, serves two purposes:  (i) it provides tax relief for long-term capital gain income for various policy reasons, and (ii) it limits the cherry-picking that is available to taxpayers having both appreciated and depreciated assets.  A necessary component of our tax system is that, to some significant degree, income and loss from the appreciation and depreciation in value of assets will be taxed on a realization basis rather than an economic accrual basis."
  • Dr. Lindsey stated, "First, rates need to be moderate.  The current effective tax rate on capital income and entrepreneurship is in the 38 to 44 percent range. That is internationally uncompetitive and raising rates from that level can only be viewed as counterproductive.  Second, capital taxation should be as neutral as possible with regard to financial decisions.  The current heavy taxation of equity capital and generous taxation of debt helped create an overleveraged economy for which we are now paying a heavy price.  It also has tended to distort and overly complicate the tax treatment of capital gains since the gains implicit in debt financed capital get doubly preferred treatment.  Limiting the favorable tax treatment of debt relative to equity will produce a better tax system while also providing revenue gains that can be used to pay for lower and better designed taxation of equity.  Third, the differences between the ordinary and capital gains tax rates should probably be reduced.  As noted above, the incentives provided for both capital formation and entrepreneurship depend crucially on the ordinary rate as well as the capital gains rate.  Although there are many competing cross-currents in these issues, on balance, it seems that low-to moderate rates of taxation of both types of income would be the best approach."
  • Dr. Burman stated, "To summarize, while targeted relief from capital gains tax may be warranted for some corporate stock, the current blanket income tax preference for capital gains is very poorly targeted and, on balance, may do more harm than good to the economy.  The capital gains tax preference also creates gross inequities, significantly undermining the progressivity of the income tax."
  • Mr. Verrill testified, "The question about how much to change the capital gains rate is not an easy one, and as a member of the angel community I understand that.  However higher taxes will always cause behavioral change.  My argument is that we have found a rate that works.  At a time when small businesses and startups are still having trouble accessing capital, this is not the time to increase the capital gains rate for individual investors who take great risks in supporting job creating businesses.  Our overall recommendation is that the best way to ensure a strong flow of angel capital into innovative small businesses throughout this country is to provide tax incentives and education to allow and encourage private citizens to risk their own capital to support start‐ups and early‐stage businesses."
  • Mr. Stanfill stated, "So here I am, urging you to lead and find a win-win solution and forge comprehensive tax reform.  What better way to begin than to tax all income – wages, dividends, capital gains, royalties – alike.  End preferences, close loopholes, eliminate most, if not all, deductions and add a dash of progressivity.  Let the market, instead of the tax code, determine the allocation of investment capital.  Let the various legal, accounting and lobbying industries re-invent themselves and do productive work for a change.  We have a choice.  We can change the tax code in favor of equity and fairness.  Or we can continue to cut back vital services and pile up debt while we give tax breaks to the wealthy."
  • Testimony can be accessed here.
  • For additional information, contact Philip R. West - pwest@steptoe.com or Amanda Varma - avarma@steptoe.com.

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