    [Senate Hearing 112-781]
    [From the U.S. Government Publishing Office]

                                                            S. Hrg. 112-781

                        OFFSHORE PROFIT SHIFTING AND THE
                             U.S. TAX CODE--PART 1
                        (MICROSOFT AND HEWLETT-PACKARD)

    =======================================================================

                                    HEARING

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                                  COMMITTEE ON
                   HOMELAND SECURITY AND GOVERNMENTAL AFFAIRS
                              UNITED STATES SENATE

                          ONE HUNDRED TWELFTH CONGRESS

                                 SECOND SESSION

                                   ----------

                               SEPTEMBER 20, 2012

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                OFFSHORE PROFIT SHIFTING AND THE U.S. TAX CODE--

                     PART 1 (MICROSOFT AND HEWLETT-PACKARD)

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            COMMITTEE ON HOMELAND SECURITY AND GOVERNMENTAL AFFAIRS

                   JOSEPH I. LIEBERMAN, Connecticut, Chairman
    CARL LEVIN, Michigan                 SUSAN M. COLLINS, Maine
    DANIEL K. AKAKA, Hawaii              TOM COBURN, Oklahoma
    THOMAS R. CARPER, Delaware           SCOTT P. BROWN, Massachusetts
    MARK L. PRYOR, Arkansas              JOHN McCAIN, Arizona
    MARY L. LANDRIEU, Louisiana          RON JOHNSON, Wisconsin
    CLAIRE McCASKILL, Missouri           ROB PORTMAN, Ohio
    JON TESTER, Montana                  RAND PAUL, Kentucky
    MARK BEGICH, Alaska                  JERRY MORAN, Kansas

                      Michael L. Alexander, Staff Director
                   Nicholas A. Rossi, Minority Staff Director
                      Trina Driessnack Tyrer, Chief Clerk
                     Patricia R. Hogan, Publications Clerk
                                     ------

                    PERMANENT SUBCOMMITTEE ON INVESTIGATIONS

                         CARL LEVIN, Michigan, Chairman
    THOMAS R. CARPER, Delaware           TOM COBURN, Oklahoma
    MARY L. LANDRIEU, Louisiana          SUSAN M. COLLINS, Maine
    CLAIRE McCASKILL, Missouri           SCOTT P. BROWN, Massachusetts
    JON TESTER, Montana                  JOHN McCAIN, Arizona
    MARK BEGICH, Alaska                  RAND PAUL, Kentucky
                Elise J. Bean, Staff Director and Chief Counsel
                Robert L. Roach, Counsel and Chief Investigator
                         David H. Katz, Senior Counsel
                           Daniel J. Goshorn, Counsel
              Christopher Barkley, Staff Director to the Minority
              Keith B. Ashdown, Chief Investigator to the Minority
                         Mary D. Robertson, Chief Clerk

                                C O N T E N T S

                                     ------
    Opening statements:
                                                                       Page
        Senator Levin................................................     1
        Senator Coburn...............................................     8
    Prepared statements:
        Senator Levin................................................    77

                                   WITNESSES
                          Thursday, September 20, 2012

    Stephen E. Shay, Professor of Practice, Harvard Law School,
      Cambridge, Massachusetts.......................................    10
    Reuven S. Avi-Yonah, Irwin I. Cohn Professor of Law, University
      of Michigan School of Law, Ann Arbor, Michigan.................    12
    Jack T. Ciesielski, President, R.G. Associates, Inc., Baltimore,
      Maryland.......................................................    14
    William J. Sample, Corporate Vice President, Worldwide Tax,
      Microsoft Corporation, Redmond, Washington.....................    29
    Lester D. Ezrati, Senior Vice President, Tax, Hewlett-Packard
      Company, Palo Alto, California, accompanied by John N.
      McMullen, Senior Vice President and Treasurer, Hewlett-Packard
      Company, Palo Alto, California.................................    39
    Beth Carr, Partner, International Tax Services, Ernst & Young
      LLP, New York, New York........................................    41
    Hon. William J. Wilkins, Chief Counsel, Internal Revenue Service,
      accompanied by Michael Danilack, Deputy Commissioner
      (International), Large Business and International Division,
      Internal Revenue Service.......................................    59
    Susan M. Cosper, Technical Director, Financial Accounting
      Standards Board, Norwalk, Connecticut..........................    62

                         Alphabetical List of Witnesses

    Avi-Yonah, Reuven S.:
        Testimony....................................................    12
        Prepared statement...........................................    97
    Carr, Beth:
        Testimony....................................................    41
        Prepared statement...........................................   119
    Cosper, Susan M.:
        Testimony....................................................    62
        Prepared statement...........................................   150
    Ciesielski, Jack T.:
        Testimony....................................................    14
        Prepared statement...........................................   103
    Ezrati, Lester D.:
        Testimony....................................................    39
        Prepared statement...........................................   135
    McMullen, John N.:
        Prepared statement...........................................   135
    Sample, William J.:
        Testimony....................................................    29
        Prepared statement...........................................   112
    Shay, Stephen E.:
        Testimony....................................................    10
        Prepared statement...........................................    87
    Wilkins, Hon. William J.:
        Testimony....................................................    59
        Prepared statement...........................................   147

                                  EXHIBIT LIST

     1. a. GMemorandum from Permanent Subcommittee on Investigations.   160
        b. GCorporate Income Tax as a Percent of Total Revenue, chart
      prepared by the Permanent Subcommittee on Investigations.......   187
        c. GUndistributed Foreign Earnings, 2001-2010, S&P 500, chart
      prepared by the Permanent Subcommittee on Investigations,
      Source: Credit Suisse..........................................   188
        d. G2011 Microsoft Intellectual Property Payments (Puerto
      Rico), chart
      prepared by the Permanent Subcommittee on Investigations.......   189
        e. G2011 Microsoft Intellectual Property Payments (Two
      Examples), chart prepared by the Permanent Subcommittee on
      Investigations.................................................   190
        f. GHewlett-Packard Offshore Alternating Loan Program, chart
      prepared by the Permanent Subcommittee on Investigations.......   191
        g. GImpact of Check the Box, chart prepared by the Permanent
      Subcommittee on Investigations.................................   192
        h. GSummary of CFC Cash Pool Loans to HP Co. US--Fiscal Year
      2009, prepared by the Permanent Subcommittee on Investigations.   193
     2. GCharts prepared by Jack Ciesielski, R.G. Associates, Inc.
        a. GS&P 500: Cumulative Indefinitely Reinvested Earnings,
      2004-2008......................................................   196
        b. GS&P 500: Cumulative Indefinitely Reinvested Earnings,
      2001 Vs. 2006..................................................   197
     3. GDocuments related to Hewlett-Packard
        a. GHewlett-Packard E&P and Tax for Materials Entities (FY10)   198
        b. GHewlett-Packard Short Term Liquidity Update, including
      slides
      entitled, Offshore cash pools and Access to offshore cash,
      dated
      October 7, 2008................................................   199
        c. GHewlett-Packard Co. Repatriation History, including
      slides entitled,
      Repatriation History and Alternating Loans, undated............   203
        d. GHewlett-Packard Company Cash Profile, dated May 23, 2011.   206
        e. GHewlett-Packard spreadsheet of inter-comany loans for FY
      2009-2011......................................................   209
        f. GHewlett-Packard Company Historical APB 23 Summary........   212
        g. GHewlett-Packard Average Alternating Loan Summary for FY
      2010-2012......................................................   213
        h. GExcerpt from Hewlett-Packard 2011 Walkthrough Template--
      SOX
      Process Review.................................................   214
        i. GHewlett-Packard/KPMG email, dated March 2010, re: apb 23
      question.......................................................   218
        j. GHewlett-Packard US Cash Forecast, FY 11..................   219
        k. GHewlett-Packard/Sandford C. Bernstein & Co. email, dated
      June 2006, re: Questions on Cash...............................   221
     4. GDocuments related to Ernst & Young
        a. GErnst & Young internal email, dated September 2007, re:
      956 issues.....................................................   223
        b. GErnst & Young/HP email, dated April 2010, re: Your 956
      Question ......................................................   226
        c. GErnst & Young internal email, dated September 2011, re:
      APB 23 and Congress............................................   230
     5. GDocuments related to Microsoft
        a. GSelected Microsoft Financial Data........................   231
        b. GSelected Microsoft Tax Information.......................   236
        c. GMicrosoft Distribution Agreement.........................   238
     6. GLetter clarifying testimony of Beth Carr, Ernst & Young LLP.   240
     7. GResponses to supplemental questions for the record from
      Stephen E. Shay, Harvard Law School............................   242
     8. GResponses to supplemental questions for the record from
      Reuven S.
      Avi-Yonah, Irwin I. Cohn Professor of Law, The University of
      Michigan School of Law.........................................   250
     9. GResponses to supplemental questions for the record from Bill
      Sample, Corporate Vice President for Worldwide Tax, Microsoft
      Corporation....................................................   252
    10. a. GResponses to supplemental questions for the record from
      Beth Carr, Partner, International Tax Services, Ernst & Young
      LLP............................................................   255
        b. GSEALED EXHIBIT: Responses to supplemental questions 8 and
      9 for the record from Ernst & Young LLP........................   260
    11. a. GResponses to October 17, 2013 supplemental questions for
      the record from Lester Ezrati, Senior Vice President and Tax
      Director; and John N. McMullen, Senior Vice President and
      Treasurer, Hewlett-Packard Company.............................   261
        b. GPermanent Subcommittee on Investigations' February 6,
      2013
      followup questions and Hewlett-Packard's March 1, 2013
      responses, with attachments....................................   358
        c. GPermanent Subcommittee on Investigations' March 22, 2013
      followup questions and Hewlett-Packard's April 12, 2013
      responses, with
      attachments....................................................   612
    12. GResponses to supplemental questions for the record from the
      Honorable William J. Wilkins, Chief Counsel, Internal Revenue
      Service, and Michael Danilack, Deputy Commissioner
      (International) of the Large Business and International
      Division, Internal Revenue Service.............................   622

                        OFFSHORE PROFIT SHIFTING AND THE

                             U.S. TAX CODE--PART 1

                        (MICROSOFT AND HEWLETT-PACKARD)

                                  ----------

                          THURSDAY, SEPTEMBER 20, 2012

                                     U.S. Senate,
                  Permanent Subcommittee on Investigations,
                        of the Committee on Homeland Security
                                      and Governmental Affairs,
                                                        Washington, DC.
        The Subcommittee met, pursuant to notice, at 2:09 p.m., in
    room G-50, Dirksen Senate Office Building, Hon. Carl Levin,
    Chairman of the Subcommittee, presiding.
        Present: Senators Levin and Coburn.
        Staff Present: Elise J. Bean, Staff Director and Chief
    Counsel; Mary D. Robertson, Chief Clerk; Robert L. Roach,
    Counsel and Chief Investigator; David H. Katz, Senior Counsel;
    Daniel J. Goshorn, Counsel; Brian Egger, Detailee; Allison F.
    Murphy, Counsel; Eric Walker, Detailee; Noah Czarny, Law Clerk;
    Brittany Hilbert, Law Clerk; Christopher Barkley, Staff
    Director to the Minority; and Keith B. Ashdown, Chief
    Investigator to the Minority.

                   OPENING STATEMENT OF SENATOR LEVIN

        Senator Levin. Good afternoon, everybody. The Subcommittee
    will come to order. Senator Coburn will be joining us a little
    bit later. We have a vote on now in the Senate also.
        America stands on the edge of a fiscal cliff, and this
    challenge lends new urgency to a topic that this Subcommittee
    has long investigated: How U.S. citizens and corporations have
    used loopholes and gimmicks to avoid paying taxes. This
    Subcommittee has demonstrated in hearings and comprehensive
    reports how various schemes have helped to shift income to
    offshore tax havens and avoid U.S. taxes. The resulting loss of
    revenue is one significant cause of the budget deficit and adds
    to the tax burden that ordinary Americans bear.
        U.S. multinational corporations benefit from the security
    and stability of the U.S. economy, from the productivity and
    expertise of U.S. workers, and the strength of U.S.
    infrastructure to develop enormously profitable products here
    in the United States. But, too often, too many of these
    corporations use complex structures, dubious transactions, and
    legal fictions to shift the profits from those products
    overseas, avoiding the taxes that help support our security,
    stability, and productivity.
        The share of Federal tax revenue contributed by
    corporations has plummeted in recent decades. That places an
    additional burden on other taxpayers. The massive offshore
    profit shifting that is taking place today is doubly
    problematic in an era of dire fiscal crisis. Budget experts
    across the ideological spectrum are unified in their belief
    that any serious attempt to address the deficit must include
    additional Federal revenue. Federal revenue as a share of our
    economy has plummeted to historic lows--about 15 percent of
    gross domestic product (GDP) compared to a historic average of
    roughly 19 percent. The Simpson-Bowles report sets a goal for
    Federal revenue at 21 percent of gross domestic product. The
    fact that we are today so far short of that goal is, in part,
    due to multinational corporations avoiding U.S. taxes by
    shifting their profits offshore.
        More than 50 years ago, President Kennedy warned that
    ``more and more enterprises organized abroad by American firms
    have arranged their corporate structures aided by artificial
    arrangements . . . which maximize the accumulation of profits
    in the tax haven . . . in order to reduce sharply or eliminate
    completely their tax liabilities.'' So this problem is not new.
        But it has gotten worse, far worse. And what is the result?
    Today U.S. multinational corporations have stockpiled $1.7
    trillion in earnings offshore.
        That is not a pretty picture, and it is not an unacceptable
    one. Today we are going to try to shine some light on some of
    the transactions and gimmicks that multinationals use to shift
    income overseas, exploiting tax loopholes and an ineffective
    regulatory framework.
        We are going to examine the actions of two U.S. companies--
    Microsoft and Hewlett-Packard (HP)--as case studies of how U.S.
    multinational corporations, first, exploit the weaknesses in
    tax and accounting rules and lax enforcement; second,
    effectively bring those profits to the United States while
    avoiding taxes; and, third, artificially improve the appearance
    of their balance sheets.
        The first step in shifting profits offshore takes place
    when a U.S. company games the transfer pricing process to sell
    or license valuable assets that it developed in the United
    States to its subsidiary in a low-tax jurisdiction for a price
    that is lower than fair market value. Under U.S. tax rules, a
    subsidiary must pay arm's-length prices for these assets, but
    valuing assets such as intellectual property is complex, so it
    is hard to know what an unrelated third party would pay.
        These transactions transfer valuable intellectual property
    to wholly owned subsidiaries. Multinational companies and the
    legions of economists and tax lawyers advising them take full
    advantage of this situation to set an artificially low sale
    price to minimize the U.S. parent company's taxable income. The
    result is that the profits from assets developed in the United
    States are shifted to subsidiaries in tax havens and other low-
    tax jurisdictions.
        It is generally accepted that the transfer pricing process
    is widely abused and has resulted in significant revenue loss
    to the U.S. Government. In a 2010 report, the Congressional
    Joint Committee on Taxation wrote that a ``principal tax policy
    concern is that profits may be artificially inflated in low-tax
    countries and depressed in high-tax countries through
    aggressive transfer pricing that does not reflect an arms-
    length result from a related-party transaction.''
        We have a chart here which depicts Microsoft's transfer
    pricing agreements with two of its main offshore groups.\1\ As
    we can see from the chart, in 2011 these two offshore groups
    paid Microsoft $4 billion for certain intellectual property
    rights; Microsoft Singapore paid $1.2 billion, and Microsoft
    Ireland paid $2.8 billion. But look at what those offshore
    subsidiaries received in revenue for those same rights:
    Microsoft Singapore received $3 billion; and Microsoft Ireland,
    $9 billion. So Microsoft USA sold those rights for $4 billion,
    and those offshore subsidiaries collected $12 billion. That
    means that Microsoft shifted $8 billion in income offshore. Yet
    over 85 percent of Microsoft's research and development is
    conducted in the United States.
    ---------------------------------------------------------------------------
        \1\ The chart referenced appears as Exhibit No. 1e and can be found
    in the Appendix on page 190.
    ---------------------------------------------------------------------------
        Another maneuver by Microsoft deserves attention: Its
    transfer pricing agreement with a subsidiary in Puerto Rico.
    Generally, transfer pricing agreements involve the rights of
    offshore subsidiaries to sell the assets in foreign countries.
    The U.S. parent generally continues to own the economic rights
    for the United States, sell the related products here, collect
    the income here, and pay taxes here. However, in the case of
    Microsoft, it has devised a way to avoid U.S. taxes even on a
    large portion of the profit that it makes from sales here in
    the United States.
        Microsoft sells the rights to market its intellectual
    property in the Americas--which includes the United States--to
    Microsoft Puerto Rico. Microsoft in the United States then buys
    back from Microsoft Puerto Rico the distribution rights for the
    United States. The U.S. parent buys back a portion of the
    rights that it just sold, and it does so at the same time.
        Now, why did Microsoft do that? Because under the
    distribution agreement, Microsoft U.S. agrees to pay Microsoft
    Puerto Rico a certain percentage of the sales revenues that it
    receives from distributing Microsoft products in the United
    States. Last year, 47 percent of Microsoft's sales proceeds in
    the United States were shifted to Puerto Rico under this
    arrangement. And the result? Microsoft U.S. avoids U.S. taxes
    on 47 cents of each dollar of sales revenue that it receives
    from selling its own products right here in this country. The
    product is developed here. It is sold here, to customers here.
    And yet Microsoft pays no taxes here on nearly half the income.
    By routing its activity through Puerto Rico in this way,
    Microsoft saved over $4.5 billion in taxes on goods sold in the
    United States during the 3 years surveyed by the Subcommittee.
    That is $4 million a day in taxes that Microsoft is not paying.
        It is also important to note that Microsoft's U.S. parent
    paid significantly more for just the U.S. rights to this
    property than it received from the Microsoft Puerto Rico for a
    much broader package of rights. Now, that is the first step:
    Shifting assets and profits out of the United States to a low-
    tax jurisdiction.
        Next, we move to a second realm of tax alchemy, featuring
    structures and transactions that require a suspension of belief
    to be accepted.
        Once again, the basic rule is pretty straightforward. If a
    company earns income from an active business activity offshore,
    it owes no U.S. tax until the income is returned to the United
    States. This is known as ``deferral.'' However, as established
    under Subpart F of the Tax Code, deferral is not permitted for
    passive, inherently mobile income such as royalty, interest, or
    dividend income. Subpart F should result in a significant tax
    bill for a U.S. parent company's offshore income. Once the
    offshore subsidiaries acquire the rights to the assets, they
    sublicense those rights and collect license fees or royalties
    from their lower-tier related entities--exactly the kind of
    passive income that is subject to U.S. tax under the anti-
    deferral provision of Subpart F. But this straightforward
    principle has been defeated by regulations, exclusions,
    temporary statutory changes, and gimmicks by multinational
    corporations and by weak enforcement by the IRS.
        On January 1, 1997, the Treasury Department implemented the
    so-called check-the-box regulations, which allow a business
    enterprise to declare what type of legal entity it wanted to be
    considered for Federal tax purposes and to do so by simply
    checking a box. This opened the floodgates for the U.S.
    multinational corporations trying to get around the taxation of
    passive income under Subpart F. They could set up their
    offshore operations so that an offshore subsidiary which holds
    the company's valuable assets could receive passive income such
    as royalty payments and dividends from other subsidiaries and
    still defer the U.S. taxes owed on them.
        The loss to the U.S. Treasury is enormous. During its
    current investigation, the Subcommittee has learned that for
    fiscal years 2009, 2010 and 2011, Apple, for instance, has been
    able to defer taxes on over $35.4 billion in offshore passive
    income covered by Subpart F; Google has deferred over $24.2
    billion in the same period; and for Microsoft, the number is
    $21 billion.
        In March 1998, a little over a year after it issued the
    check-the-box regulations, the Treasury Department issued a
    proposed regulation to end the check-the-box option. The
    proposal was met with such opposition from Congress and
    industry groups that it was never adopted. In 2006, in response
    to corporate pressure to protect this lucrative tax gimmick,
    Congress enacted the ``Look-through Rule for Related CFCs,''
    and that excludes certain passive income, including interest,
    rents, and royalties, from Subpart F. This provision is up
    actually right as we speak for extension.
        Now we come to a third level of tax gimmickry. After
    multinational corporations transfer their assets and profits
    offshore and place them in a complex network of offshore
    structures to shelter them from U.S. taxes, some companies
    still want to bring those earnings back to the United States
    without paying taxes.
        A U.S. parent is supposed to be taxed on any profits that
    its offshore subsidiaries send to it. If a foreign subsidiary
    loans money to a related U.S. entity, that money also is
    subject to U.S. taxes.
        But once again, that simple concept is subverted in
    practice. The Tax Code includes a number of exclusions and
    limitations in the rule governing loans. Short-term loans are
    excluded if they are repaid within 30 days, as are all loans
    made over the course of a year if they are outstanding for less
    than 60 days in total. This exclusion allows offshore profits
    to be used for short-term lending--no matter how large the
    amount--without being subject to U.S. taxes.
        What is more, if a controlled foreign corporation (CFC)--
    makes a loan to a related U.S. entity that is initiated and
    concluded before the end of the CFC's quarter, the loan is not
    subject to the 30-day limit and does not count against the
    aggregate 60-day limit for the fiscal year.
        In addition, the IRS declared that the limitations on the
    length of loans apply separately to each CFC of a company. So
    when aggregated, all loans for all CFCs could be outstanding
    for more than 60 days in total.
        Companies have used these loopholes to orchestrate a
    constant stream of loans from their own CFCs without ever
    exceeding the 30- and 60-day limits or extending over the end
    of a CFC's quarter. Instead of being a mechanism to ensure
    taxes are paid for offshore profits returned to the United
    States, the rule has become a blueprint on how to get billions
    of dollars back into the U.S. tax free.
        Take a look at Hewlett-Packard. It has used a loan program
    to return offshore profits back to the United States since as
    early as 2003 and 2004. In 2008, Hewlett-Packard started a new
    loan program called the ``staggered'' or ``alternating'' loan
    program. Funding for the loans came mainly from two Hewlett-
    Packard sources or pools: First, the Belgian Coordination
    Center (BCC); and the second, the Compaq Cayman Holding Corp
    (CCHC). The loans from these two offshore entities helped fund
    HP's general operations in the United States, including payroll
    and repurchases of HP stock.
        HP documents indicate that the lending by these two
    entities was essential for funding U.S. operations because
    Hewlett-Packard did not have adequate cash in the United States
    to run its operations. In 2009, HP held $12.5 billion in
    foreign cash and only $0.8 billion in U.S. cash and projected
    that in the following year it would hold $17.4 billion in
    foreign cash and only $400 million in U.S. cash.
        The loan program, the so-called staggered or alternating
    loan program, was designed to enable Hewlett-Packard to
    orchestrate a series of back-to-back-to-back-to-back loans to
    the United States and to provide a continuous stream of
    offshore profits to the United States without paying U.S.
    taxes. In fact, Hewlett-Packard even changed the fiscal year
    and quarter endings of one of the lending entities. That way,
    there could be a continuous flow of loans through the whole
    year without extending over the quarter ending of either of the
    lending entities.
        Now, we will take a look now at the loan schedule that was
    outlined in a Hewlett-Packard document, and there is a copy of
    this in front of us. Every single day is covered by a loan from
    a CFC, from a Hewlett-Packard CFC. In fiscal year 2010, for
    example, Hewlett-Packard's U.S. operations borrowed between $6
    and $9 billion, primarily from BCC and CCHC, without
    interruption throughout the first three quarters. There does
    not appear to be a gap of even a single day during that period
    where the loaned funds of either BCC or CCHC were not present
    in the United States. A similar pattern of continuous lending
    appears for most of the period between 2008 through 2011.
        Now, what were the loans used for? One Hewlett-Packard
    PowerPoint characterized the loan program as ``the most
    important source of liquidity for repurchases and
    acquisitions.'' That does not sound like a short-term loan
    program. It was closely coordinated by the Hewlett-Packard
    treasury and tax departments to systematically and continually
    fund Hewlett-Packard's U.S. operations with billions of dollars
    each year since 2008, and likely before that. This loan program
    is the ultimate example of form over substance. This is so
    blatant that internal Hewlett-Packard documents openly referred
    to this program as part of its ``repatriation history,'' part
    of its ``repatriation strategy''--and, of course, repatriation
    is totally contrary to the notion that this was a short-term
    loan program and, indeed, leads to paying U.S. taxes.
        Now, this scheme mocks the notion that profits of U.S.
    multinationals are ``locked up'' or ``trapped'' offshore.
    Rather, some of them have effectively and systematically been
    bringing those offshore profits back by the billions for years
    through loan schemes like the one described here, and are doing
    so without paying taxes.
        The IRS has stated that the substance, not the form, of
    offshore loans should be reviewed. So it will be interesting to
    hear today from the IRS about this loan scheme, from HP's
    auditors at Ernst & Young who approved it.
        The Subcommittee has examined a fourth level of offshore
    shenanigans. It involves an accounting standard known as APB
    23, which, among other things, addresses how U.S.
    multinationals should account for taxes that they will have to
    pay when they repatriate the profits currently held by their
    offshore subsidiaries.
        Under APB 23, when corporations hold profits offshore, they
    are required to account on their financial statements for the
    future tax bill they would face if they repatriate those funds.
    Doing so would result in a big hit to earnings. But companies
    can avoid that requirement and claim an exemption if they
    assert that the offshore earnings are permanently or
    indefinitely reinvested offshore. Multinationals routinely make
    such an assertion to investors and the Securities and Exchange
    Commission on their financial reports.
        And yet many multinationals have at the same time launched
    a lobbying effort, promising to bring these billions of
    offshore dollars back to the United States if they are granted
    a ``repatriation holiday,'' which is a tax break for bringing
    offshore funds to the United States. So, on the one hand, those
    companies assert they intend to indefinitely or permanently
    invest this money offshore. Yet they promise, on the other
    hand, to bring it home as soon as it is granted a tax holiday.
    That is not my definition of ``permanent.''
        While this may seem like an obscure matter, it is a major
    issue for U.S. multinational corporations. A 2010 survey of
    nearly 600 tax executives reported that ``60 percent of the
    respondents indicate that they would consider bringing more
    cash back to the United States even if it meant incurring the
    U.S. cash taxes upon repatriation, if their company had to
    record financial accounting tax expense on those earnings
    regardless of whether they repatriate.''
        In 2011, more than 1,000 U.S. multinationals claimed this
    exemption in their Securities and Exchange Commission (SEC)
    filings, reporting more than $1.5 trillion in money that they
    say is intended to be reinvested offshore.
        Now, this build-up has started to create some problems for
    many companies. With such a large percentage of their earnings
    offshore--and a lot of those designated as indefinitely
    reinvested--they need to figure out ways to finance operations
    here in the United States without drawing on those earnings.
    But as the amount of earnings stashed overseas has reached $1.5
    trillion, and the need for financing grows back home, there is
    a real question whether companies can continue to defend their
    assertions that they have legitimate plans and the intent to
    continue to indefinitely reinvest those funds, and billions and
    billions more to come, overseas.
        This situation is also creating a dilemma for their
    auditors, who sign off on those assertions and plans. In one
    document, an auditor at Ernst & Young wrote to a colleague the
    following: ``Under the APB 23 exception, clients are presumed
    to repatriate foreign earnings but do not need to provide
    deferred taxes on those foreign earnings that are `indefinitely
    or permanently reinvested.' '' And he continued: ``If Congress
    enacts a similar law and companies repatriate earnings that it
    previously had needed to be permanently reinvested in foreign
    operations, what effect does that second repatriation have on a
    future assertion that any remaining earnings are indefinitely
    or permanently reinvested?'' And he continued: ``An assertion
    of indefinite or permanent investment until Congress changes
    the law allowing cheaper repatriation again does not sound
    permanent.''
        The issue that is raised by that account is not
    theoretical. Another chart provided by one of the expert
    witnesses that we will hear from today shows what happened to
    the indefinitely reinvested earnings of the Standard & Poor's
    500 companies after the repatriation holiday was passed in
    2004. It shows that the total amount of permanently reinvested
    earnings declined by $84 billion after the repatriation bill
    passed. And then, as soon as the repatriation period ended, the
    total amount of offshore earnings these companies claimed as
    permanently or indefinitely reinvested skyrocketed again--
    increasing by 20 percent or more in almost every year since
    2005.
        Well, what does that say about the true intent of those
    companies? To me, it says that this money is not held offshore
    for permanent reinvestment. It is there to avoid taxes. Yet the
    auditors who must pass off on the validity of a company's
    assertion and the Financial Accounting Standards Board (FASB),
    have appeared to go along, and that is an issue that we will
    discuss today with those witnesses.
        The bottom line of our investigation is that some
    multinationals use our current tax system to engage in gimmicks
    to avoid paying the taxes that they owe. It is a system that
    multinationals have used to shift billions of dollars of profit
    offshore and avoid billions of dollars in U.S. taxes, to their
    enormous benefit. Who are the losers in this shell game? There
    are many. It is our government, which provides the services and
    security that help many of those multinational corporations
    grow and prosper and then watches them shift their profits
    offshore to avoid paying taxes. It is other citizens and
    businesses who must shoulder a greater tax burden. And it is
    our domestic industries that do not exploit the Tax Code to
    shift profits offshore and avoid U.S. taxes. And, finally, it
    is the integrity and the viability of our tax system. So today
    we will be taking a look at how this system works, the legal
    contortions on which it is based, its gimmicks and charades,
    and hopefully, we can generate some enthusiasm to fix it.
        Now let me call on Dr. Coburn, with thanks again for his,
    as always is the case, strong support, himself personally and
    his staff, so that these reports of ours and in this case the
    memorandum of ours can, in fact, emanate on a bipartisan basis.
    Dr. Coburn.

                  OPENING STATEMENT OF SENATOR COBURN

        Senator Coburn. Mr. Chairman, thank you. I do have some
    concerns with the haste at which we accomplished this
    memorandum. I would also say that, by training, I was trained
    and graduated with a degree in accounting, and tax avoidance is
    not illegal. The Congress has created this situation. Our
    problem is we have the highest corporate tax rate in the world.
    It is, on average, double 90 other countries' in the world. And
    we have a Tax Code that is miles long, that is complicated, and
    we are talking about symptoms of that code today, not solutions
    of the real disease, which is reforming the code and lowering
    the rates.
        We are one of the few countries that has a worldwide tax
    system which double taxes corporate profits, and we have smart
    businessmen who know what the rules are, what the IRS has said.
    They hire smart people to make and maximize their profits,
    their liquidity, and their assets. There is nothing wrong with
    that. There is nothing immoral with that. It is the system that
    Congress has set up.
        As a member of the Finance Committee, one of the things we
    have to do if we are going to fix our country is we have to
    change that code. We have to change those rates. We have to
    make it simpler. We have to make it more straightforward. And
    all in the process of this, we have transferred growth out of
    this country. We have incentivized investment overseas. We have
    incentivized capital formation overseas instead of capital
    formation at home. And then we are critical when people take
    advantage of the very statutes, rules, and regulations that we
    ourselves have created.
        What it does is it calls blatantly and honestly for tax
    reform in this country. It is the key to getting out of the
    economic doldrums that we are in. It is the key to quit
    misdirecting investment capital. It is the key to increasing
    jobs in our country.
        So, Mr. Chairman, our report is about the symptoms of the
    disease, not the real disease. And I agree on face that many of
    these do not look great, but they are legal. They are properly
    legal tax avoidance. I do not like them. I understand how they
    work. The short-term loans, I understand that. But under the
    technicalities of the law, they are accurate.
        So they spend a lot of money with accountants and auditing
    firms to take advantage of every loophole that we have created
    in the tax system, to take advantage of a corporate tax rate
    that is twice the world's average, to lessen that impact as
    good fiduciaries. There is nothing heinous in that. There is
    nothing illegal in that. And, in fact, if we want to change it,
    what I would invite my Chairman is come join us on the Finance
    Committee and help me change it.
        The other thing that I would note, Mr. Chairman, is that I
    will be in and out of this hearing with other obligations and
    will try to be here as much as I can. I thank you again for
    holding the hearing. I think it is a good precursor to getting
    real tax reform for our country.
        Senator Levin. Thank you so much, Dr. Coburn.
        We will be exploring today a number of the gimmicks and the
    practices that have been used by these two companies, and it
    will then be determined by others as to whether or not they are
    in compliance with our Tax Code. You mentioned, for instance,
    this loan program. I think it is highly dubious, frankly, that
    the loan program complies with our current tax law. But that is
    not for me or us to say. That is going to be hopefully for the
    IRS to review. But there is an awful lot of evidence which we
    are going to be presenting here today relative to that loan
    program, for instance, that Hewlett-Packard has put into place
    as to whether that is in compliance with the existing law and
    regulation. And we will be presenting evidence which will
    raise, I think, significant questions as to whether or not, in
    fact, it does comply.
        As to the transfer pricing issue, whether or not these are,
    in fact, fair prices that are paid for these assets will be
    determined by others. We have witnesses today that I think are
    going to testify that, in fact, they are not fair, arm's-length
    prices that are being paid. But, again, that will be either
    demonstrated or not by the testimony and the exhibits that we
    are going to be bringing forward today.
        But I agree with Dr. Coburn, our code is far too complex,
    and I also agree that the fact that you try to lower your taxes
    is not illegal in and of itself. However, there are ways that
    you can try to reduce your taxes that do not comply with our
    tax law, and that is up to the IRS and the courts to determine,
    and I think we will be presenting evidence today which raises
    some very serious questions as to whether or not some current
    practices, in fact, do comply with our existing tax law, as
    complicated as they are.
        So I heartily agree on the complexity point, but, again, I
    think that our report lays out some very significant evidence
    that it is highly dubious that some of these practices comply
    with existing IRS regulations or existing law.
        Finally, as I mentioned I think before you came, Dr.
    Coburn, the Congress is to blame for some of this. There is no
    doubt about that. I believe failure to enforce compliance by
    the IRS is to blame for part of this. But I also believe that
    some of the loopholes that have been used, in fact, are not
    true loopholes, that they are not true allowances; quite to the
    contrary, that the practices are using form over substance, and
    under court decisions the IRS is able to pierce through forms
    which are phony and get to the substance. They do that in many
    cases which have been decided, and it is very important that
    the IRS continue on that course.
        Having said all that, I will now call on our first panel of
    witnesses: Professor Stephen Shay, Harvard Law School in
    Cambridge; Professor Reuven Avi-Yonah, the Irwin Cohn Professor
    of Law at the University of Michigan Law School; and Jack
    Ciesielski, who is a Certified Public Accountant and President
    of R.G. Associates, Inc., of Baltimore, Maryland. I appreciate
    all of you coming here today. We look forward to your
    testimony. We very much appreciate your legal and accounting
    expertise being shared with us.
        Pursuant to Rule VI, all witnesses who testify before the
    Subcommittee are required to be sworn, and so at this time I
    would ask all of you to please stand and raise your right hand.
        Do you swear that the testimony you are about to give will
    be the truth, the whole truth, and nothing but the truth, so
    help you, God?
        Mr. Shay. I do.
        Mr. Avi-Yonah. I do.
        Mr. Ciesielski. I do.
        Senator Levin. We will use our traditional timing system
    today. One minute before a red light comes on, you will see the
    lights change from green to yellow, giving you an opportunity
    to conclude your remarks. While your written testimony will be
    printed in the record in its entirety, we ask that you limit
    your oral testimony to no more than 7 minutes.
        We will start with Professor Shay, followed by Professor
    Avi-Yonah, and then Mr. Ciesielski. Then we will turn to
    questions. So, Professor Shay, please proceed.

    TESTIMONY OF STEPHEN E. SHAY,\1\ PROFESSOR OF PRACTICE, HARVARD
                  LAW SCHOOL, CAMBRIDGE, MASSACHUSETTS

        Mr. Shay. Thank you, Chairman Levin, Ranking Member Coburn,
    and Members of the Subcommittee, for the opportunity to
    testify. I am a professor of practice at Harvard Law School,
    but the views I am expressing are my personal views. Thank you
    for putting the testimony in the record. I will just summarize
    some of the key points in my testimony, taking account of your
    summary of the law in your opening statement.
    ---------------------------------------------------------------------------
        \1\ The prepared statement of Mr. Shay appears in the Appendix on
    page 87.
    ---------------------------------------------------------------------------
        The combination of deferral of U.S. taxes on earnings
    earned and reinvested at low foreign tax rates and current
    deductions for expenses contributing to earning this deferred
    income is a powerful incentive to shift income offshore.
    Financial accounting rules contribute to that, but that is
    going to be the subject of another witness.
        Statistics of Income data for 2006 show that approximately
    80 percent of controlled foreign corporate earnings are
    retained and deferred from U.S. taxation, roughly 8 percent are
    distributed as dividends and 12 percent are currently taxed
    under Subpart F. But one should recognize that in that 12
    percent is Subpart F income that is generated deliberately
    either to avoid foreign withholding tax or to bring back other
    foreign tax credits to use to offset U.S. taxes on other
    income.
        Once the income is deferred, there are a set of rules, the
    investment in U.S. property rules, that restrict a controlled
    foreign corporation from making its offshore earnings available
    to its affiliated U.S. group other than through a taxable
    distribution or income inclusion.
        The objective of these rules is to protect the U.S. income
    tax base by preventing a U.S. multinational from using earnings
    not taxed by the United States in its business in the United
    States. They also restrict the advantage that a multinational
    would have competing against a domestic U.S. business that will
    not have available to it the opportunity to earn low-tax
    foreign earnings.
        I note in my testimony that today's discussion is largely
    about U.S. multinationals. I think it is equally important that
    we worry about the treatment of non-U.S. multinationals
    investing in the United States, but that is a subject for a
    different day.
        The transfer pricing rules of Section 482 attempt to ensure
    that taxpayers clearly reflect income attributable to
    controlled transactions and to prevent the avoidance of taxes
    with respect to such transactions. They are intended to place a
    controlled taxpayer transaction on tax parity with an
    uncontrolled taxpayer transaction.
        In 2010, at the same hearing as the Joint Committee study
    that was referenced by the Chairman, the Treasury Department
    described increased tax-induced shifting of offshore U.S.
    corporate income documented in studies that were reviewed in
    its testimony.
        The Subcommittee staff 's investigation of Microsoft
    provides support for the Treasury's conclusions which were
    based on aggregate data by looking at a single company. In both
    cases, the issue is tax-induced income shifting to zero or low-
    tax jurisdictions, including countries that purport to tax but
    allow income allocations to low-tax areas, provide exemptions,
    or other special deductions to achieve a low effective tax
    rate.
        I am not going to repeat the Microsoft structure in
    business, and Professor Avi-Yonah will talk a little bit more
    about the specific techniques. But I wanted to summarize
    salient information from partial consolidating financial
    information that was provided to the Subcommittee staff in
    relation to the companies in Ireland, Singapore, and Puerto
    Rico. I also am not going to talk about specific companies. I
    have simply aggregated the results from the companies in those
    jurisdictions as shown in the information provided to the
    Subcommittee staff.
        So, first to set the stage, in fiscal year 2011, which is
    the year from which we have comparative information, Microsoft
    had global revenues of $69.9 billion and earnings before tax of
    $28 billion. This is all financial data. The global book tax
    rate was approximately 17.5 percent. Microsoft had
    approximately 90,000 employees. Based on its consolidating
    financials, in fiscal year 2011 the Irish, Singapore, and
    Puerto Rican companies combined earned approximately $15.4
    billion in earnings before tax, or approximately 55 percent of
    global EBT. The average effective foreign tax rate for these
    companies combined on a book basis--because that is all we
    have--was approximately $15 billion, effective rate of 4
    percent.
        In order to give one measure of this scale that is
    involved, the companies in these low-tax jurisdictions employed
    approximately 1,900 of Microsoft's 90,000 employees, yet these
    1,914 employees earned $15.4 billion in EBT or over $8 million
    per employee, compared with the average for the global
    Microsoft employees, if you just take the average over the
    whole thing, of $312,000.
        I have not shown or seen sufficiently granular information
    to form a view as to whether these could be argued to be
    consistent with the current transfer pricing regulations. But
    whether they are or not, they are not consistent with a common-
    sense understanding of where the locus of Microsoft's economic
    activity, carried out by its 90,000 employees, is occurring.
    The tax motivation of the income location is evident.
        The incentive for multinational businesses to shift income
    abroad is increased when multinationals are able to use
    deferred earnings for investment in the United States. The
    investment in U.S. property rules are a firewall. They are
    intended to allow the continued benefit of deferral when the
    deferred earnings are reinvested in a multinational's non-U.S.
    business or in portfolio investments awaiting redeployment
    abroad. But they are intended to protect against a
    multinational's benefiting from deferral in its foreign
    businesses and then using the pre-U.S. tax earnings in its
    domestic business. Whether or not the particular HP
    transactions pass muster under current law, the structural
    objective of the investment in U.S. property rules is
    circumvented.
        And may I just add to that comment. The guidance that is
    referred to that was put out in 2009 that refers to loans from
    separate subsidiaries uses the word ``independent'' throughout,
    not ``concerted'' and ``prearranged.'' So I think that we need
    to be cautious about saying that you can do things from
    separate subsidiaries without adding that it cannot be
    prearranged, concerted, without running afoul or risking
    running afoul of the anti-abuse rules.
        Mr. Chairman, I think I have exhausted my time. I will be
    happy to take questions.
        Senator Levin. Thank you so much, Professor Shay. Professor
    Avi-Yonah.

    TESTIMONY OF REUVEN S. AVI-YONAH,\1\ IRWIN I. COHN PROFESSOR OF
     LAW, UNIVERSITY OF MICHIGAN SCHOOL OF LAW, ANN ARBOR, MICHIGAN

        Mr. Avi-Yonah. Thank you, Chairman Levin, for inviting me,
    and thanks, Ranking Member Coburn, as well. It is a pleasure to
    be here and to talk a little bit about, supplementing what
    Professor Shay just said, the ways in which U.S. multinationals
    achieve these pretty astonishing results.
    ---------------------------------------------------------------------------
        \1\ The prepared statement of Mr. Avi-Yonah appears in the Appendix
    on page 97.
    ---------------------------------------------------------------------------
        Going back to a period before 1986, it was standard
    practice for U.S. multinationals to conduct research and
    development in the United States, deduct the costs, and then
    transfer the resulting intangibles overseas to places such as
    Puerto Rico where all the profit was accumulated. Congress
    explicitly tried in 1986 to close this loophole by adopting a
    rule that said that when an intangible is transferred, a
    royalty has to be paid that is ``commensurate with the income''
    attributable to that intangible which was designed to transfer
    all the income back onshore.
        The results of this Subcommittee's investigation show that
    we are back to where we were before 1986, and I think something
    needs to be done about it like it was back then.
        So how is this possible today? Well, there are two major
    issues that have been mentioned by the Chairman's remarks in
    the beginning, and I will just focus on those.
        The first one is the cost-sharing rules which were
    developed by the Treasury and the IRS primarily in the period
    after the 1986 rule change. And what those do is essentially
    allow a multinational to shift the economics of its intangibles
    offshore if various CFCs contribute to the development of those
    intangibles.
        Now, it is important to emphasize that nothing actually
    happens offshore. The money just goes into the CFCs and then
    back again, and you are allowed to then pay tax on those
    profits as if they were actually earned overseas in the same
    proportion as the CFC had contributed to the development of the
    intangible.
        Now, why is this problematic? It is problematic for a
    couple of reasons. The theory behind it is that you would be
    risking losing the deduction for the R&D to the extent that you
    put too much of the deduction in the CFCs and, therefore, you
    will not do too much of that. But there are two issues
    involved.
        The first one is the disproportion between the cost of
    development and the profits, and that you can see from the
    Microsoft case. The payments that were made under cost sharing
    to Microsoft U.S. are a very low percentage compared to the
    very significant profits that resulted from these same
    intangibles. And, again, remember there is nothing actually
    happening offshore, so there is no reason for these profits to
    be offshore at all.
        The assumption is that the multinationals will not know
    whether the R&D will be successful or not when it entered into
    the cost-sharing agreement and, therefore, would actually run a
    risk of losing the deduction if the development is
    unsuccessful. But the reality of the matter is that
    multinationals do know that the development will be successful.
    They enter into these agreements at the point where the
    intangible is, in fact, on the verge of being profitable, and
    they are the only ones that have this information. It is very
    hard for outsiders to get that information, and that has
    resulted in significant litigation, some of which the IRS has
    lost, over the valuation of so-called buy-in payments, which is
    what the CFCs have to pay for the parent earlier development
    before they enter into cost sharing.
        Second, as was mentioned in the beginning, there is this
    whole elaborate scheme of check the box and Subpart F and the
    CFC look-through rule. Essentially, the standard practice now
    is that the U.S. multinational will have single top CFC which
    is treated as a corporation under check the box, and that CFC
    will participate in the cost sharing and will be in a low-tax
    jurisdiction so it will hold the intangibles such as Ireland,
    Singapore, Puerto Rico, and the like. And then every other CFC
    that the multinational has below that top CFC will be check the
    box, be disregarded, and that as a result payments of, for
    example, royalties that go up to the top-level CFC from all the
    other very elaborate structure below that will be disregarded
    for Subpart F purposes and simply not exist. And it is that
    structure that is the standard tax planning device that all the
    multinationals use.
        Now, it has been said, since Treasury tried to check the
    box back in 1998, as was mentioned, that this is only about
    reducing foreign taxes because essentially the payments are
    shifted from high-tax foreign jurisdictions to low-tax foreign
    jurisdictions. But it is not only about reducing foreign taxes.
    What the Subcommittee data show is that essentially it is this
    device that enables the profits to accumulate in the low-tax
    jurisdiction offshore, and that is in turn what is making it
    possible and enticing for the multinationals to engage in the
    initial shifting of the profit. So that even in a situation
    where the sales, let us say, of the intangibles are in other
    countries rather than in the United States--and we have seen it
    in the case of Microsoft that some of them are, in fact, in the
    United States--the shifting is not costless to the U.S.
    Treasury. So those are the two main loopholes that we will
    discuss today.
        The third one, as was mentioned, was the fact that the
    earnings are not actually kept offshore. They are, in fact,
    brought back onshore by a variety of schemes, and the short-
    term loan is only one of them. There were lots of other ones
    which the IRS has been trying to fight.
        So what can be done about it? Well, I think overall we do
    need overall tax reform, as Senator Coburn has mentioned, and
    Senator Levin as well. We do need some kind of broader reform
    of the system, which at the same time as enabling us maybe to
    cut the corporate tax rate will also prevent particularly
    further profit shifting by adopting some rule that will not
    enable multinationals to locate their profits in places where
    they do not have any real activity. But at the very least, I
    would say that these two particular schemes, which I think are
    based on current Treasury and IRS regulations, need to be
    addressed. That is, I would recommend that Congress take steps
    to both eliminate check the box and the CFC look-through rule
    and at the same time restrict the ability to use cost sharing
    in order to shift profits offshore.
        Thank you very much.
        Senator Levin. Thank you very much, Professor Avi-Yonah.
    Mr. Ciesielski.

    TESTIMONY OF JACK T. CIESIELSKI,\1\ PRESIDENT, R.G. ASSOCIATES,
                       INC., BALTIMORE, MARYLAND

        Mr. Ciesielski. Thank you, Chairman Levin and Dr. Coburn. I
    appreciate you inviting me to take part in this important
    hearing today. I will now present my views as summarized from
    my testimony, and I look forward to taking your questions
    afterwards.
    ---------------------------------------------------------------------------
        \1\ The prepared statement of Mr. Ciesielski appears in the
    Appendix on page 103.
    ---------------------------------------------------------------------------
        Senator Levin. And all the testimony will be made part of
    the record.
        Mr. Ciesielski. Right. Thank you.
        The APB 23 indefinite reinvestment exception has been part
    of generally accepted accounting principles in the United
    States for many years. It is an exception to the principle of
    providing income taxes on earnings of all of a company's
    subsidiaries based on the intentions of a firm's managers and
    the geographic location of the subsidiaries involved.
        Because the earnings of certain subsidiaries may be
    included in earnings reported to investors without income taxes
    accrued upon them, a dollar earned in foreign countries may be
    worth more than an after-tax dollar earned in the United States
    as long as the firm's managers have an intention to
    indefinitely reinvest the earnings.
        It should be noted that this exception affects only
    investor financial reporting. It does not affect tax law. Yet
    its availability to managers can exert influence and decisions
    as to where capital investments should be made. If a dollar
    earned overseas will still be worth a dollar after taxes
    compared to a dollar earned in the United States which will be
    worth 65 cents after taxes, where is a firm likely to invest?
    Net income and growth in net income is the scorecard by which
    firms and their managers are judged in the capital markets. So
    there will be a managerial bias to invest overseas and use this
    exception.
        While those indefinitely reinvested earnings may plump the
    firm's bottom line, there is a catch. To stay within the
    confines of the exception, indefinitely reinvested earnings are
    not available to investors, and investors have no way of
    knowing the degree to which net income is off limits to them.
        There is no segregation of such indefinitely reinvested
    earnings from all other earnings. Net income is one figure.
    Investors may flock to a firm with earnings that are
    essentially trapped by managerial intentions. Managers may use
    back-door approaches to moving cash between subsidiaries by
    intercompany loans, but this would appear to be an in substance
    violation of the intention to reinvest earnings indefinitely.
        The exception is not based on robust reasoning. What
    manager would not intend to minimize their firm's tax burden?
    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 exception provides a powerful, flexible tool for
    managers to shape their earnings forecasts without real changes
    in underlying economics, mainly through changes of their
    intentions. Most managers have equity-based compensation
    awards, and they may also be incentivized by bonus programs for
    achieving particular earnings targets. Giving such a powerful
    tool to managers for shaping net income can lead to incentive
    problems.
        The indefinite reinvestment 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 been in a hurry to revisit the
    issue. In their convergence efforts, the FASB and the
    International Accounting Standards Board (IASB) had a chance to
    eliminate the indefinite reinvestment exception in 2004. They
    decided not to act. 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 to the problem, but greater disclosure would
    at least bring more attention to the problem.
        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 flow.
        The exception benefits a relatively few firms, the ones
    with the most portable assets and the greatest global
    footprint. At the end of 2011, there was $1.5 trillion of
    accumulated indefinitely reinvested earnings in the S&P 500
    firms. Of that total, 72 percent of the amount belonged to only
    50 companies, 16 percent of the 318 companies showing such
    balances. There were 182 firms in the S&P 500 that showed no
    accumulated indefinitely reinvested earnings, and I would
    mention that some of them were more or less geographically
    landlocked, financial institutions that operate domestically,
    which calls into question if this is actually something that
    benefits a small group of select companies.
        To the extent that the indefinite reinvestment 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.
        Accounting rules shape management behavior. This exception
    to the rule encouraged firms to make investments that produce
    one kind of special income that really is not 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 management from
    critical market scrutiny.
        That concludes my opening statement. I look forward to your
    questions.
        Senator Levin. Thank you very much, Mr. Ciesielski.
        Let us try a 10-minute round of questions, if that is all
    right.
        Professor Shay, in your written testimony, you stated that
    the IRS in the past has applied the arm's-length standard that
    is involved in transfer pricing mechanically, which has given
    rise to results that do not pass a common-sense reality test.
    Can you be more specific? I think you started to give us an
    example, but can you be more explicit?
        Mr. Shay. Yes, and I think in the testimony it was not
    limiting it to the IRS. In fact, taxpayers have been most
    aggressive at asserting that if something is done between
    unrelated parties, then they can just import it into a related-
    party case even if the results of importing it to the
    circumstances of the related-party case are nonsensical in
    ultimate outcome. In other words, the arm's-length standard
    sets an objective. The objective is to create neutrality in the
    outcome that would occur, in a related-party transaction, had
    unrelated parties being in the same circumstances. So there are
    a number of instances where taxpayers--I can think of one court
    case where there is too literal an application--if an unrelated
    party does it, then it must work here. So the outcome is you
    will justify allocations in a related-party case that had the
    two parties actually been unrelated they just would not have
    agreed to.
        One example is executive compensation. In cost-sharing
    agreements, it has now been changed by regulations, but there
    was a strong argument by companies, well, in a cost-sharing
    agreement between unrelated parties, they would not take into
    account the stock option compensation. And they might not. But
    the fact is that when--if the cost-sharing agreement is between
    a parent and a subsidiary, everybody is subject to the same
    equity stream, and then they may well and probably should take
    into account, the idea being that is it really the case that a
    company would allow a cost-sharing agreement--if unrelated
    companies used a cost-sharing agreement, one used heavy stock
    options and the other one used none, would they really ignore
    that? Absolutely they would not. They would make it work out in
    some other respect, maybe not through just looking at the stock
    option compensation.
        So when you are in a related-party case, you should be
    thinking the same way. It is a subtle and sophisticated
    approach. But the arm's-length standard does not work unless it
    is applied with that sensitivity.
        Senator Levin. Well, how can an arm's-length standard be
    applied when you have a wholly owned subsidiary, a controlled
    foreign corporation, where you are setting some kind of a price
    for an asset that is being transferred, the value of an asset
    that is being transferred, and where there is a huge tax
    benefit if you can sell something and get very few dollars back
    for it where your offshore wholly owned subsidiary or
    controlled financial company or corporation is going to get a
    huge amount, for instance, in royalties for that same asset?
    How can there be an arm's-length transaction? It is being
    negotiated inside the same company, isn't it?
        Mr. Shay. There is not in many cases going to be an arm's-
    length comparable in the circumstances you describe. So the
    objective is to take as much of the interaction between the two
    companies that you can find a market comparable for, work on
    that basis to that extent. Then there is this residual, and the
    residual is the challenge for particularly governments but also
    taxpayers to allocate as though they were operating on an
    arm's-length basis.
        The difficulty with the current rules is procedurally you
    can sometimes only look at one side of the transaction. We
    should be always testing those with profit splits. That is not
    always required today under the current rules, or it is not
    done that way in every case.
        We give too much weight to just the contractual
    relationships in circumstances where, as I think you are
    suggesting, there is no adversity, there is no cost purportedly
    allocating risk contractually. We have to look at other indicia
    of whether risk is really allocated.
        Senator Levin. We see in the Microsoft case a very
    significant transfer of revenue and profit overseas to a wholly
    owned subsidiary in some cases that has no employees whatever.
    And then there is a large amount of profit which is shifted.
        Let me ask Professor Avi-Yonah, does that not create in and
    of itself, that kind of a gap between the revenue received for
    the same royalties by that offshore CFC and what the U.S.
    company, ``received from its own subsidiary, where that gap is
    as huge as we have seen in our exhibits.'' Does that not create
    a common-sense question that this is not an arm's-length
    transaction, this is a transaction that is done very clearly to
    shift profits overseas and avoid paying taxes?
        Mr. Avi-Yonah. I think it clearly does. You have to ask
    yourself what is it that is actually happening in these low-tax
    jurisdictions. It is not the R&D. It is not the development of
    the intangibles. It is not the sales. It is not even any
    significant manufacturing. If you compare, let us say, the
    salary paid to the average Microsoft employee in Puerto Rico of
    $44,000 with the $22 million that they are alleged to have
    earned there, it is pretty clear that there is nothing
    substantive that is happening in the location, and it is the
    rules that we have been discussing that allow the shifting of
    this profit from the location where it is actually earned,
    where actually economic activity is taking place to the low-tax
    jurisdiction. And the only reason to put it there is basically
    because it is low tax.
        Senator Levin. Now, I think that Professor Shay used the
    figures in the case of Microsoft that they had 90,000
    employees, I believe you said. That was your statistic, or was
    that yours, Professor Avi-Yonah? Nineteen hundred of the 90,000
    were in those three jurisdictions. So 2 percent of Microsoft's
    employees are in those jurisdictions, and I believe you said
    they have 55 percent of the income attributed to them.
        Mr. Avi-Yonah. Right.
        Senator Levin. Now, does that not create a presumption that
    this is obviously not a fair price that is being paid? Should
    not the IRS be going after that kind of a gap pretty
    aggressively to try to find out what the justification is for
    that other than to try to shift income overseas?
        Mr. Avi-Yonah. I think they should. I mean, the problem is
    that I think that these possibilities are made possible under
    the rules adopted by the IRS itself, which is why I think the
    rules need to be changed. The attribution of the same
    percentage of profit to the location as the cost of development
    that they contributed is something that is embodied in the IRS
    rules. And, yes, they can argue with the taxpayer about
    valuation of, let us say, buying payments and other payments
    that are being made, but by itself I do not think they would
    recognize that the discrepancy between the profits and the
    percentages that are contributed is giving rise to a problem.
    And so that is why I think that you need to do something beyond
    just asking for more IRS enforcement.
        Senator Levin. Are they rules of the IRS or is it our rules
    that need to be changed?
        Mr. Avi-Yonah. I think it is your rules in this case----
        Senator Levin. What rule would you change?
        Mr. Avi-Yonah. I would override two things. I would
    override cost sharing, that is, I would say notwithstanding any
    cost-sharing agreement, Section 482 applies as written, which
    means that you need to pay a royalty commensurate. Some of the
    suggestions that have been made is specifically intangibles,
    that is, for example, if there is too much of a disproportion
    between the cost of the development of an intangible and the
    profits, then that becomes a part of the income. That was the
    Obama Administration's suggestion.
        Senator Levin. Would that address this gap, this
    discrepancy?
        Mr. Avi-Yonah. That would address this particular gap, yes.
    And the other one would be to do away with the CFC-to-CFC look-
    through rule and check the box, because if you cannot
    concentrate everything in the low-tax jurisdiction, there is
    less of an incentive to profit shift to it.
        Senator Levin. Is there any limit under the current
    regulations to what percentage could be attributed to an
    offshore wholly owned corporation? I mean, let us assume
    instead of 40 percent they said 80 percent. Does that in and of
    itself create a problem?
        Mr. Avi-Yonah. No.
        Senator Levin. Under the current regulations?
        Mr. Avi-Yonah. No. They can set a percentage any----
        Senator Levin. Any way they want, they can shift all that
    income overseas?
        Mr. Avi-Yonah. Yes.
        Senator Levin. Do you agree with that, Professor Shay?
        Mr. Shay. The rules require a taxpayer to justify it, and
    part of their justification would be if they had substantial
    operations there, functions and real activity.
        Senator Levin. Well, there is none in one of these. There
    are no employees whatsoever in Singapore, let us say.
        Mr. Shay. And their justification in that circumstance is
    that they claim they have paid for the rights to use a valuable
    intangible and they paid fair value. That is the claim. The
    difficulty is when you look at the bottom-line outcome, it is
    not credible. It just does not line up with what is actually
    going on there.
        Senator Levin. And if they paid for it with the same
    corporation's money, does that have any difference? Does that
    make a difference?
        Mr. Shay. No. They can get the money----
        Senator Levin. In other words, they can take money from the
    parent----
        Mr. Shay. Yes.
        Senator Levin [continuing]. And then pay the parent back
    for it. That does not make a difference.
        Mr. Shay. That does not make a difference.
        Senator Coburn. Thank you, Prosecutor.
        Dr. Shay, in your testimony, you noted that deferral of
    U.S. taxes and low foreign tax rates are incentives to move
    income offshore. Would you also say that an additional
    incentive to move income offshore is the fact that we have the
    highest tax rate in the world?
        Mr. Shay. I would say that it is that differential between
    whatever the U.S. rate is--and I think the relevant rate is the
    rate that would be taxed--would be paid by the U.S. taxpayer on
    the earnings when repatriated. So I think of the difference
    between the two effective rates. I do not think it is a nominal
    rate in either case.
        Senator Coburn. So the average rate in the 90 leading
    countries in the world is 18.5 or 19 percent.
        Mr. Shay. That may be an average of nominal rates, sir.
        Senator Coburn. It is. And our nominal rate is 35 percent.
        Mr. Shay. But our average effective rate on corporate
    income I think is closer to 27 percent.
        Senator Coburn. OK. So, anyhow, we have a difference of 9
    percent, so that 9 percent you would agree is an incentive for
    people to move earnings offshore.
        Mr. Shay. What I am describing in the testimony is the
    difference between whatever the U.S. effective rate would be,
    which I did not specify, and the rate that can be achieved in a
    foreign jurisdiction. What the Microsoft facts appear to show
    is, on average--I am trying to put all the companies together,
    not to cherrypick--their effective rate in these three
    jurisdictions was somewhere in the range of 4 percent. But let
    us say it is 5 percent. That differential is enormous and
    creates an incentive for shifting the income.
        Senator Coburn. If Congress followed your recommendations
    and eliminated two of these three and did not adjust rates
    commensurately, what do you think the result of that would be,
    Dr. Avi-Yonah?
        Mr. Avi-Yonah. I am in favor of reducing the rate----
        Senator Coburn. I know, but what is your opinion with the
    result?
        Mr. Avi-Yonah. I think that it is problematic to just
    address the loophole without doing something about
    comprehensive tax reform precisely because you would then have
    more pressure to find other loopholes, which is not a reason
    not to close the ones that we have.
        Senator Coburn. Right. Or to move some of the 90,000
    employees actually out of the country to the low-tax
    jurisdiction. You know, it is a zero sum game. We are in a race
    to the bottom in the world on corporate tax rates because of
    the economic situation we find ourselves in. And we are losing
    the race both through our complexity but also our rates. And I
    am with the Chairman in wanting to clean this up, but I do not
    want to clean it up if the end result is going to be the
    reaction is to the domestic corporation of this country because
    we have cleaned up these loopholes that their decision now is
    they are going to put all their investment capital overseas,
    and they are going to grow their businesses overseas, and they
    are going to move their jobs overseas. So it has to be a
    combination of smart tax reform plus elimination of the
    loopholes and the incentives to find loopholes to be able to
    solve this problem.
        Mr. Avi-Yonah. At least in these cases that we are talking
    about when there is almost nothing there, I do not think that
    closing the loopholes would incentivize anybody to move actual
    operations to some of these locations, because it is very hard
    to actually have real operations in places that are real tax
    havens. You do not have the services, you do not have the
    education, and you do not have the infrastructure. There are
    reasons that these things are happening in the United States,
    and I think that closing the loopholes would not by itself
    incentivize taxpayers to move these operations offshore. But I
    do agree that it should be done in the context of broader tax
    reform.
        Senator Coburn. All right. Your statement in your verbal
    testimony was that these companies almost always know when
    their R&D is profitable. My experience in business would lead
    me to say they do not almost always know. Now, maybe in these
    two businesses you were referring to, but generally corporate
    culture--take the pharmaceutical industry, for example. They do
    not almost always know, and yet we see some of this cost
    shifting. We have created a special thing for them called the
    ``Puerto Rico tax set-up.'' So we eliminated for a whole
    industry this problem by a specific law for them.
        I guess I am questioning your statement as to the fact that
    they almost always know. I am having trouble understanding
    that.
        Mr. Avi-Yonah. No, it is a question of timing. I certainly
    agree with you that companies do not know necessarily when
    their R&D will be successful when they engage in it. The point
    is that at the point where they decide to enter into the
    profit-shifting arrangements, they are in the best position to
    know whether it is likely to succeed. And as a result, there is
    no downside, because the reason that--as I mentioned to Senator
    Levin earlier--you can put any percentage on there that you
    want. The theory is that you are going to lose the deduction if
    it is not successful. But if you have the internal knowledge
    that something is likely to be successful, even if it is not
    documented, even if it is not something that the IRS can find,
    at that point you can enter into the cost-sharing agreement,
    and you are not really risking losing the deduction. That was
    my point. It is not necessarily from the beginning.
        Senator Coburn. Thank you very much.
        Mr. Ciesielski, you mentioned incentive problems, and I
    actually understand--a couple of incentive problems you
    mentioned, especially that with foreign earnings that actually
    generate a dollar based on a dollar, versus a dollar versus 65
    cents. But don't we have incentive problems in terms of moving
    money offshore right now? Take the medical device industry for
    an example. Both incentive from a regulatory standpoint of
    approval, but also from a tax standpoint, we are seeing the
    medical device industry leave this country and go to both
    Europe and China. So we are already seeing incentives to move
    business out of here, both by our Tax Code and our regulatory
    code. And this hearing is not about regulatory, and I did not
    mean to actually get into it. But don't we already have
    incentives to move money offshore just given the low tax rates
    of other areas, the comparable differential?
        Mr. Ciesielski. Certainly there are incentives. I think we
    are talking about all different kinds of incentives in this
    situation.
        First of all, I cannot speak to the tax side. I can tell
    you that a 15-percent rate would be much more attractive than a
    35-percent rate. But as for moving all operations offshore, as
    Mr. Avi-Yonah has said, there are other issues that have to do
    with infrastructure, and I am not sure that is possible for all
    industries. And also I think that if you did move all things
    manufacturing to some other countries where they have
    attractive rates, there may be a VAT involved that taxes things
    at the manufacturing level as you move things through a
    process.
        So, there are varying levels of incentives, and I really
    would probably not be the best person to talk about with the
    differing approaches of different countries and what the
    incentives to moving things offshore would be. Yes, there are
    incentives, but the incentives that I was speaking of are more
    of financial reporting incentives. For example, when you think
    about back to the early to mid-1990s, companies did not account
    for stock options. They had incentives to give them to
    managers, and they had incentives to gin up earnings as much as
    they could so the managers would profit at the expense of
    shareholders without ever recording a cost. That is a
    misincentive. That is not a fair reporting to the people that
    actually own the company, who are the shareholders.
        Senator Coburn. Yes, it is a lack of transparency.
        Mr. Ciesielski. It is a lack of transparency. And, we know
    that there are bonus programs designed to reward managers for
    producing operating income and after-tax income. And when you
    have something that is as flabby and soft as the intention of
    moving earnings offshore or not offshore just by massaging a
    profit forecast or a working capital forecast, I think that the
    temptation to managers to meet targets that might benefit them
    at the same time that they are defending it by benefiting their
    shareholders through raising income, I am not sure that is the
    most fair system of capital markets that we can come up with.
        Senator Coburn. All right. Thank you.
        Senator Levin. Professor Avi-Yonah, I think you answered
    this question, but let me ask you again if you have. I think
    everybody would love to reform the Tax Code and reduce tax
    rates if we can in the process. In the meantime, some of these
    tax loopholes which we have identified here it seems to me are
    pretty egregious. Would you agree?
        Mr. Avi-Yonah. Yes.
        Senator Levin. Should they be reformed in the meantime,
    closed?
        Mr. Avi-Yonah. Yes. I mean, you can always say about every
    loophole, well, if you close this, there will be another
    loophole, let us wait until we have an overall reform of the
    system. That is no reason not to close loopholes. I think these
    loopholes need to be closed.
        Senator Levin. And in terms of the tax rates question,
    there is also another factor, that we are not going to be able
    to compete with a zero or a 2-percent or a 4-percent tax rate,
    are we?
        Mr. Avi-Yonah. Right. And that is not what anybody is
    talking about, and those countries where they have the zero or
    the 2- or 4-percent tax rates are not countries in which any
    American company would ever put real operations in. These are
    shells. They are not real operations.
        Senator Levin. So if some of these transfer pricing
    agreements are arranged for a wholly owned subsidiary to be
    located in one of these tax havens and then there is a shifting
    of income or profit to that wholly owned subsidiary and then
    that money is transferred offshore, is that something which we
    ought to address and end?
        Mr. Avi-Yonah. Yes.
        Senator Levin. Now, we have a couple of examples which we
    have used here relative to Microsoft, and I want to just go
    through a couple of these. I think in your testimony, Professor
    Avi-Yonah, you said that the idea of research and development
    cost shares is flawed for two reasons, and you also went into
    those here in your oral testimony.
        Now, in 2005, Microsoft's Puerto Rican affiliate entered
    into a cost-share agreement with Microsoft U.S. to make a cost-
    sharing payment of around $1.9 billion. Microsoft Puerto Rico
    then records profits of around $4 billion. Does that agreement
    strike you as being appropriately priced?
        Mr. Avi-Yonah. That is the thing that I meant was
    problematic. There is no reason for not shifting the entire
    thing back to the United States if there is nothing real
    happening in Puerto Rico, or at least the vast majority of it.
    What is the justification for this disparity? Just the fact
    that they make a large cost-sharing payment does not mean that
    you can then accumulate about two-thirds of the entire profit
    in a place where there is nothing really happening, when
    everything is happening somewhere else.
        Senator Levin. And the justification for that under current
    law should be required, should it not?
        Mr. Avi-Yonah. Yes.
        Senator Levin. And the IRS should aggressively require
    that.
        Mr. Avi-Yonah. Yes. I agree.
        Senator Levin. And is the same thing true with the other
    two examples that we have used here, the Singapore example and
    the Ireland cost-share example? I think you looked at both of
    them.
        Mr. Avi-Yonah. Yes.
        Senator Levin. Is the same thing true there? Take Ireland.
    There is a cost-share agreement with Microsoft U.S. and
    Ireland. Ireland makes an annual cost-share contribution of
    $2.8 billion. Then they re-license these rights for $9 billion.
    That is a huge shift.
        Mr. Avi-Yonah. There is nothing to justify this disparity
    that is actually happening there.
        Senator Levin. Under current law.
        Mr. Avi-Yonah. Under current law, yes.
        Senator Levin. And so if they are required or should be
    required to justify it and you cannot see anything that would
    justify it, shouldn't the IRS then aggressively require a
    justification for that kind of a gap?
        Mr. Avi-Yonah. Yes.
        Senator Levin. Now, Professor Shay, would you agree with
    that?
        Mr. Shay. The observation I would make is that cost sharing
    is supposed to be paying the current costs of R&D. That is
    supposed to be paying for the right to use the future
    developments. The problem that arises is when you enter into
    it, you need to pay at that time the value of all the prior
    developments, and I think conventionally it is believed that is
    by far the most difficult pricing element, and if you do not
    pay that full amount, then you are getting the kind of outcomes
    that you are describing. But I think analytically it is not
    quite correct to compare the current payment of the cost which
    is supposed to relate to the future with the current earnings.
    The current earnings you are getting are the benefit of the
    prior R&D that you should have paid for at the buy-in, and
    just, I think, the evidence is historically we have not done
    well at all--the government has not--at collecting the full
    amount. And now there are new regulations, and the new
    regulations are more robust in seeking to do that. And my
    understanding is although we do not have good information at
    this point, it is having a substantial impact on companies'
    decisions to move into cost sharing. But then you are just
    going to shift the royalties.
        So make no mistake, there is no panacea in transfer
    pricing, which is why, Mr. Chairman, we need aggressive
    enforcement. We need to keep making the rules better than they
    are today with respect to transfer pricing. But we also need to
    restrict and make changes that limit the incentives for
    aggressive transfer pricing because we are never going to
    completely address transfer pricing under any mechanism,
    whether it is an arm's-length standard or any other standard.
    So we need to take on the issue of incentive, and one thing I
    note in my testimony is the Administration has proposals,
    Representative Dave Camp has proposals, Senator Michael Enzi
    has proposals, all of that would indirectly entail a minimum
    tax, a nature of a minimum tax in order not to be taxed
    currently on your income.
        My personal view is there are loopholes in the Enzi
    proposal. There are fewer loopholes in the Camp proposal. But
    something can be designed out of that that could be much more
    effective than what we have today. We should not just try and
    go back and rebuild Subpart F from 1962. We should take an
    approach that works today. And my personal view is it is too
    urgent a problem to wait for tax reform--I respectfully differ
    with Senator Coburn--because tax reform is an enormous and
    complicated task. It is going to take years. If we take the
    numbers we are looking at in front of us for one company, let
    us say it takes us 3 years, that is a lot of potential revenue
    lost. We need it. And we also need to be a leader to the other
    countries in the world. This is not something that we should do
    solo. We should do it because we need to do it, but
    historically when we do things like this, other countries
    follow. Their deficit needs in many cases are worse than ours.
    It is only rational to think if they see us doing something
    that works, we should be able to persuade them to do it as
    well.
        I did happen to look before I came here at the list of per
    capita income of countries of the world. The United States is
    11th. Let me read you the top 10, and this is from the CIA
    facts site. It has some different years, there is a little
    noise in this data, but let me just entertain you for a moment.
        Liechtenstein is No. 1. Qatar is No. 2. Luxembourg is No.
    3. Bermuda is No. 4 in per capita income. Singapore is No. 5.
    Jersey is No. 6. Falkland Islands is No. 8. Norway is No. 8
    because of their oil wealth. Brunei is No. 9. Hong Kong is No.
    10. The United States is number 11.
        There is a race to the bottom, but we do not have to let
    this occur, and I think we should exercise leadership to
    prevent it.
        Senator Levin. And you are talking about what kind of
    leadership in terms of having a tax--connect that to the
    subject of today's hearing.
        Mr. Shay. I think having leadership involves resisting the
    arguments that because other countries do it and do not collect
    the tax they should from their corporations, we should not
    collect the tax we should from our corporations. I have some
    considerable question whether we overestimate the extent to
    which activity will move if we are getting companies to pay
    more of their fair share of their income. I do not think as
    much activity will move as is threatened, certainly. And I
    think in addition to that, given the fiscal situations of other
    countries, it is rational for them to follow a sensible
    approach that cuts off income shifting to low-tax countries. It
    hurts them as well as us.
        Senator Levin. Thank you. Dr. Coburn.
        Senator Coburn. Thank you.
        A couple of questions. Just specifically, Dr. Shay, in
    terms of the example you are talking about on transfer pricing,
    let us say Company X expensed all their R&D for Product Y. So
    they show no value in it. They have already expensed that, both
    on their financial books and their tax books. What is the value
    of that when they go to do transfer pricing to a CFC? If they
    show no value on their books, they have already expensed all
    their R&D associated with this product, what is the value of
    that when you go to transfer pricing? Why isn't it zero since
    they show zero on the books?
        Mr. Shay. Well, because books are not purporting to show
    fair market value. They show the investment. And when you
    expense it, that does not mean that you do not know--you can
    add up all of the money that you expended. The difficulty with
    R&D is you expend much more, some of it results in products
    that do not go forward. So some R&D is failed R&D. Some R&D is
    successful R&D. What is transferred is the rights to the
    successful R&D. So you have multiple layers of valuation
    issues. One is you do not have the starting point of a book
    value, and even if you did, you would change it to fair market
    value. Two is if you try and construct the book value, you have
    to go back to the expenditures and you have to either say you
    are going to look at a broad base of expenditures, including
    those that failed in the same product area, which I think you
    end up having to do, but you have that as an issue. And then
    you have to determine what would be fair value for something
    for which there is, because of its uniqueness, not an easy
    market comparable.
        All of these are the difficulties, but it is not
    impossible, and it is what is required to be done on the buy-in
    at the beginning of the cost-sharing payment.
        We have the same issue, though, with licensing. Let us be
    sure we understand. This issue does not go away with licensing.
    Licensing, you need to make sure you are paying the amount that
    will capture the value that was expended earlier. So it is also
    hard.
        Senator Coburn. So I am a little bit confused because one
    of the principles of accounting is matching revenues with
    expenses, right? That is what our goal is when we account for
    things. We want to timely match revenues with expenses. But if
    we have totally depleted or amortized all our costs in Product
    Y, we have totally matched them against revenues, and now we
    are going to sell it in a new market, where do you get a basis
    from an accounting standpoint that says it has value? It may
    have value once it is sold, but the R&D has already been
    expensed. So now you are talking about good will. You are
    talking about a total intangible cost, and I think the
    testimony of almost all three of you is that is a very
    difficult--there is trouble in valuing intangibles. It is hard.
        Mr. Shay. It is difficult, but I do not think that the fact
    is expensing. The fact you have expensed it does not mean it
    has been matched with the income earned from that expense. That
    is an accounting convention that started because of the
    difficulty of associating it with a particular amount of income
    and because of the conservatism of accounting. It is the
    opposite incentive we should have in tax. But tax follows
    accounting for this purpose. That does not reduce the
    importance if we are going to have a coherent tax system, if
    you are going to shift the right to earn that from a full tax
    environment to a deferred tax environment or, even worse, an
    exempt tax environment, then at that point the system is forced
    to make that valuation analysis.
        Senator Coburn. So why wouldn't the accounting rule be the
    following: That if you are going to do the transfer pricing,
    what happens is, because you have already allocated the expense
    for that asset, that R&D, that potential, why shouldn't that be
    taken back off your books in this country as a penalty for
    transferring that asset somewhere else? In other words,
    thinking about it in reverse, we have given the tax benefit
    through the amortization already, and now what we are saying is
    we really want to match some revenues, so, therefore, you took
    a deduction for amortizing an R&D that, in fact, is not
    matching the revenues that are going to come. Why wouldn't we
    do that as a rule to disincentivize this?
        Mr. Shay. That is an alternative, so let us just compare.
    What the law currently today would say is you need to pay an
    amount for fair value, and if you could determine that, I think
    we would all agree that would be optimal. But what I think you
    are suggesting is in the face of a very difficult valuation
    analysis, could you not at least try and identify the
    expenditures that relate to the asset that you are shifting,
    recapture it, to use a phrase, in other words, reverse those so
    you have to pay income on that amount. That is another
    alternative, and I think it would be interesting to see where
    the numbers would come out from that.
        One comment, though. We have this core problem of
    cherrypicking and that problem, I think, does not go away. So I
    think we have a lot to think about with the issue you are
    raising.
        Senator Coburn. OK. Mr. Ciesielski, you described the APB
    23 accounting rule as a loophole and also say that this APB 23
    exception is a way to manipulate the rules to achieve an
    outcome the rules were intended to discourage. Explain that.
        Mr. Ciesielski. Certainly. The general principle is that
    you accrue income taxes on the earnings of all of your
    subsidiaries. This one says in a special case where you intend
    to indefinitely reinvest, you do not accrue because you are not
    intending to pay taxes. That to me is what I think most people
    would call a loophole. More technically, it is an exception.
    The general rule is you earn, you accrue taxes, whether you are
    going to pay them this year or not. They may be deferred income
    taxes, but that is really what is at issue here in the
    financial reporting arena--accrual of deferred income taxes.
        Once that accrual has been levied on the earnings,
    obviously they are going to be 35 percent less, but management
    would be less inclined to be worried about moving cash in and
    out of a particular country because they have already taken a
    tax charge on them that is on the books. It is the way they
    would handle earnings from Kansas and Maine. They would be
    taxed at the same rate. Move your subsidiary from Kansas to
    Maine and it would not make any difference.
        That exception, like I said, the farthest back I could find
    it in accounting literature was 1959, a much different world,
    and I am not sure where it originated. I could not find
    anything further back than that.
        Senator Coburn. Thank you very much. Thank you, Mr.
    Chairman.
        Senator Levin. I just have one additional question, and
    that is having to do with Hewlett-Packard's staggered loan
    program. Now, we found that HP used two controlled foreign
    corporations over a 30-month period to continuously loan
    without interruption on an alternating basis to HP U.S. for
    general operations, including making payroll and buying back
    shares. So there are two cash pools, controlled corporations
    that HP has out there offshore, billions of dollars day after
    day. The loan schedules were set up in advance by Hewlett-
    Packard's tax department. The timing of the loans was
    orchestrated to be made and then to be retired at specific
    times. And let me ask you, Professor Avi-Yonah, first perhaps:
    Is this the type of transaction that should be excluded from
    Section 956 as a temporary loan?
        Mr. Avi-Yonah. I do not think it can be. I think that in a
    situation where the money is always available to the parent
    every single day of the year, that is certainly not what
    Section 956 or the exception was intended to provide. Section
    956 says that if you reinvest the deferred earnings back into
    the United States, even in the form of a loan to the parent,
    that triggers an inclusion. And I think that when the money is
    always available, regardless of which CFC it comes from, it
    should be included.
        Senator Levin. And you made reference to the fact it is
    supposed to be independent. Is that correct? In other words,
    you have here a parent corporation who structures a program,
    instead of putting it all into one CFC overseas, offshore, you
    have a cash pool that is divided into two, but they are linked,
    they are structured together, the timing of the loans going in
    and coming back, being paid back is together so there is no
    gaps whatsoever. Does that not just clearly violate what the
    whole exception is supposed to be for short terms?
        Mr. Avi-Yonah. I think that given those facts and the fact
    that it is not independent, it violates even current IRS
    guidance. But I think even if they were independent, the fact
    that both CFCs are the same company and the money is always
    available, that for me should be enough. And the guidance in a
    way, if it says that if they are both independent from each
    other, that is OK. When the same parent company controls both
    of them, I do not think that guidance should be out there in
    those terms.
        Senator Levin. Do you have any comment on that, Professor
    Shay?
        Mr. Shay. Yes, I agree that the materials that I have seen
    so far suggest a prearranged, concerted action. Courts are not
    going to be fooled that is independent if that is the case.
        Senator Levin. Even though there are two technically
    separate corporations that are working together----
        Mr. Shay. Even though there are two technically separate
    corporations, they are under common control. The IRS has broad
    authority in other respects under Section 482 with respect to
    companies under common control. This is an area that so far has
    had fairly mechanical rules with some anti-abuse rules. Those
    anti-abuse rules need to be--they have been drafted too
    narrowly, and people are taking a view that maybe they do not
    apply.
        But I would identify one other issue. Even if, as I think
    would be the case in a pre-concerted arrangement, this is
    considered a single loan, you still have the question of maybe
    the earnings and profits are hidden in other companies--or not
    hidden, but this has all been manipulated so that the companies
    making a loan do not have earnings and profits. There is an
    anti-abuse regulation intended to go after that, but it is
    drafted fairly narrowly. So you also need to make sure that the
    overall intent of these rules, which is it cannot be avoided by
    just using separate boxes and separating things out and
    avoiding the mechanics of the Section 956 rules, the fact is
    that the amounts that are being loaned back are ultimately the
    product of the offshore business that has earned low-tax
    foreign earnings. We should find a way not to allow it to be
    circumvented when they are brought back for use in a U.S.
    business, when that neighboring domestic business or small
    business would not be able to do that.
        Senator Levin. Thank you.
        I guess I have one other question of you, Mr. Ciesielski,
    and that is about the APB 23. One of the problems with the
    accounting standard is that FASB, which is the organization
    that sets accounting standards, has not provided much guidance.
    In terms of plans for reinvestment, they have not described the
    type of assets that qualify for this exception. They have not
    put out guidance about the expected duration of the
    investments. Would you agree with that?
        Mr. Ciesielski. I would agree, yes.
        Senator Levin. And would it be helpful if they did do those
    things?
        Mr. Ciesielski. I think it would be helpful if they
    eliminated the exception.
        Senator Levin. But assuming they do not eliminate--I do not
    disagree at all, but assuming that exception is going to
    remain, would it not be essential that FASB put out some
    guidance?
        Mr. Ciesielski. There could be a lot more disclosures that
    would be informative to investors, yes.
        Senator Levin. Thank you. We thank you all very much, and
    now we will move to our second panel: Bill Sample, the
    corporate vice president for worldwide tax at Microsoft. We
    very much appreciate your being with us today.
        Senator Coburn. I am going to have to be absent for about
    an hour or two for an intel briefing. I will submit questions
    for Microsoft to the record. If perhaps you are still here when
    I come back, I will ask them. Hopefully you will not be.
        Senator Levin. Thank you very much, Dr. Coburn.
        Let me first welcome you, Mr. Sample, but I also want to
    thank Microsoft--and this is also true for Hewlett-Packard--for
    the cooperation with our inquiry and our investigation. Both
    companies have cooperated with our Subcommittee. You have
    provided documents that we have asked for. You have appeared
    here willingly, and we very much appreciate that cooperation.
    So while we have obviously some basic questions and basic
    differences with our two companies in that regard, we are very
    much open about our appreciation to you.
        Under Rule VI, our witnesses who testify before the
    Subcommittee are required to be sworn, so I would ask that you
    please stand and raise your right hand?
        Do you swear that the testimony that you are about to give
    will be the truth, the whole truth, and nothing but the truth,
    so help you, God?
        Mr. Sample. I do.
        Senator Levin. OK. We would ask you then to proceed. Were
    you here when I described the timing system?
        Mr. Sample. Yes, Senator.
        Senator Levin. OK. Thank you. Then please proceed.

     TESTIMONY OF WILLIAM J. SAMPLE,\1\ CORPORATE VICE PRESIDENT,
       WORLDWIDE TAX, MICROSOFT CORPORATION, REDMOND, WASHINGTON

        Mr. Sample. Chairman Levin, Ranking Member Coburn, and
    Members of the Subcommittee, good afternoon. My name is Bill
    Sample, and I am the Corporate Vice President for Worldwide Tax
    at Microsoft Corporation. I am here voluntarily today at the
    request of Chairman Levin and Ranking Member Coburn.
    ---------------------------------------------------------------------------
        \1\ The prepared statement of Mr. Sample appears in the Appendix on
    page 112.
    ---------------------------------------------------------------------------
        I would like to provide some information on Microsoft and
    its global footprint. Microsoft is incorporated and
    headquartered in Washington State. We develop and market
    software services and hardware that deliver new opportunities,
    greater convenience, and enhanced value to people's lives. We
    do business worldwide and have offices in more than 100
    countries.
        Our footprint is biggest in the United States and growing.
    From 2007 to 2009, Microsoft increased its employment by 13.2
    percent, to almost 54,000 employees in the United States.
    According to a recent 2009 study, Microsoft's operations
    supported roughly 462,000 U.S. jobs.
        Since 1990, Microsoft has been the single largest
    contributor to economic growth in Washington State. Its impact
    on the State accounted for 32.4 percent of the total gain in
    State employment.
        Despite our size and growth in the United States, one of
    the business imperatives we face as a company in the global
    economy is that we must operate in foreign markets in order to
    compete and succeed. Almost half of our fiscal year 2012
    revenue is foreign revenue, and foreign revenue continues to
    grow faster than U.S. revenue, but we do not view U.S. and
    foreign growth as mutually exclusive. Our foreign revenue
    growth is one of the main reasons why we can continue to grow
    our U.S. operations and create additional U.S. jobs.
        Our worldwide operations are divided into regions, with
    significant investment and employees in each region. Our
    regional operating centers support operations in their
    respective geographic regions, including software production
    and distribution, customer contract and order processing,
    credit and collections, information processing, and vendor
    management and logistics.
        Our worldwide Original Equipment Manufacturer (OEM)
    business, consisting primarily of the licensing of the Windows
    operating system to computer manufacturers for pre-installation
    on PCs, is primarily supplied from our regional operating
    center in Reno, Nevada. The resulting income is fully taxable
    in the United States.
        Our non-OEM retail business is generally supplied by our
    regional operating centers located in three different regions
    around the world.
        Our tax reporting follows the global nature of our
    operations. Microsoft complies with the tax rules in each
    jurisdiction in which it operates and pays billions of dollars
    in U.S. Federal, State, local, and foreign taxes each year.
        For example, our worldwide effective tax rate for fiscal
    year 2012 was 24 percent. In dollar terms, we paid $3.5 billion
    in taxes worldwide in fiscal year 2012.
        Our foreign regional operating centers pay tax locally in
    the jurisdiction in which they operate. Microsoft pays U.S. tax
    on their earnings when repatriated back to the United States as
    provided by U.S. law.
        Microsoft also pays significant U.S. tax on buy-in
    royalties and cost-sharing payments it receives from the
    foreign regional operating centers.
        Microsoft develops most of its software products and
    services internally. This allows us to maintain competitive
    advantages that come from closer technical control over our
    products and services.
        The legal ownership of intellectual property developed as a
    result of our R&D activities generally resides in the United
    States. In accordance with Internal Revenue Code Section 482
    and applicable Treasury regulations, our three foreign regional
    operating center groups--Ireland, Singapore, and Puerto Rico--
    license the rights to use the relevant intellectual property to
    produce and sell Microsoft software products in their
    respective regions.
        The foreign regional operating center groups make multi-
    billion-dollar initial and annual compensation payments back to
    the United States for these license rights. One component of
    these payments requires the three foreign regional operating
    center groups to fund the majority of Microsoft's annual
    worldwide R&D expenditures. These payments increase our U.S.
    taxable income.
        In conclusion, Microsoft's tax results follow from its
    global business. In conducting our business at home and abroad,
    we comply with U.S. and foreign tax laws. That is not to say
    that the rules cannot be improved. To the contrary, we believe
    they can and should be.
        We support U.S. international tax reform efforts that would
    help American businesses compete in global markets and invest
    in the United States. Thank you.
        Senator Levin. Thank you very much, Mr. Sample.
        Let me start with Microsoft in Puerto Rico. Microsoft
    products are primarily developed in the United States. They
    benefit from U.S. research and development tax credits. They
    are sold throughout the United States, as you mentioned, from
    an office in Nevada. Every time, though, a Microsoft product is
    sold, 47 percent of the sales price is sent to Puerto Rico
    where Microsoft pays no tax. Now, that is because Microsoft USA
    has entered into an arrangement with one of its own companies
    called Microsoft Operations Puerto Rico. It has a small
    facility with 177 employees. Microsoft USA sold Microsoft PR--
    Puerto Rico--the right to sell Microsoft products in the
    Americas. Microsoft Puerto Rico paid money for those rights--
    Microsoft money but, nonetheless, Microsoft Puerto Rico paid
    money for the rights, but it does not actually sell Microsoft
    products to any customers. It sells instead the products right
    back to Microsoft USA, which then arranges for them to be sold
    to customers.
        So Microsoft USA sells its intellectual property rights to
    Puerto Rico, turns around and buys some of those rights back at
    a substantial markup, and agrees to transfer 47 percent of net
    revenues from U.S. sales to Puerto Rico.
        Now, if you will look at Exhibit 1d \1\--and I hope the
    exhibits are there in front of you--this is a chart showing how
    Microsoft transferred its intellectual property rights to
    Puerto Rico. One of the first steps was that Microsoft USA
    entered into a cost-share agreement with Microsoft Puerto Rico.
    The idea behind cost-share agreements is that if two companies
    share the development and market risk of a new product, they
    are then allowed to share the profits.
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 1d, which appears in the Appendix on page 189.
    ---------------------------------------------------------------------------
        In 2005, when Microsoft U.S. and Microsoft Puerto Rico
    entered into the cost-share agreement, Microsoft's products
    were some of the most successful in the world, so it was not a
    very risky proposition; 85 percent of the development of
    Microsoft products is done in the United States, so all Puerto
    Rico had to do to share in the development cost is write a
    check. And, by the way, that is Microsoft money. It did not
    have to contribute any know-how. Where did Microsoft Puerto
    Rico get the money to contribute to the cost-share agreement?
    Where did it get that money from, do you know?
        Mr. Sample. Well, Senator, the original funding for the
    current Microsoft Puerto Rico facility was a result of an
    equity contribution from the Irish regional operating center
    group in the amount of about $1.6 billion. That equity
    contribution enabled the construction of a very expensive
    production and distribution facility in Puerto Rico, including
    Microsoft's most advanced product release lab anywhere in the
    world.
        And so Microsoft Puerto Rico is fully equipped and staffed
    to perform all the production and distribution of Microsoft's
    retail software products in the Americas.
        Senator Levin. All right. Now, back to the United States.
    So Microsoft Puerto Rico got $1.6 billion from Microsoft's
    Irish subsidiary called Round Island One. Is that correct?
        Mr. Sample. That is correct, Senator.
        Senator Levin. All right. So now Microsoft money goes to
    Microsoft Puerto Rico, and here is what it unleashes. If you
    will take a look at that Exhibit 1d, $1.9 billion comes each
    year for intellectual property payments to the United States,
    to the Microsoft intellectual property pool. But for those same
    intellectual property assets, Microsoft Puerto Rico gets
    revenues of $6.3 billion, not taxed in the United States.
        So of the $6.3 billion in revenues that come in from sales
    in the United States, $1.9 billion goes to the United States
    and the rest stays in Puerto Rico. Is that correct?
        Mr. Sample. Senator, you are also missing a $400 to $500
    million buy-in payment made by Microsoft Puerto Rico to the
    United States that year.
        Senator Levin. All right. That still exists, so we will add
    that.
        Mr. Sample. That still exists.
        Senator Levin. All right.
        Mr. Sample. And what is also missing from your financial
    analysis. As described by Professor Shay on the last panel is
    Microsoft Puerto Rico was also required to make a buy-in
    payment for pre-existing Microsoft technology in existence at
    the time it entered into the cost-sharing agreement.
        Senator Levin. All right.
        Mr. Sample. As reported in the memo that your staff
    released today, the cumulative amount of that buy-in payment
    from the inception of the cost-sharing agreement to date is $17
    billion.
        Senator Levin. OK.
        Mr. Sample. Which, when added to the cumulative amount of
    cost-sharing payments, inception to date, amount to
    approximately $30 billion.
        Senator Levin. And how much money do they get each year for
    these in revenues from the United States?
        Mr. Sample. I think on average Microsoft Puerto Rico has
    received less than 50 percent of the revenue from retail
    product sales in the Americas market.
        Senator Levin. And that totals how much a year, about?
        Mr. Sample. It is probably in the neighborhood--started out
    initially at probably $6 or $7 billion a year, and increasing
    up to the current amount.
        Senator Levin. About how much?
        Mr. Sample. I would say about $8 to $9 billion.
        Senator Levin. Per year?
        Mr. Sample. Per year.
        Senator Levin. OK. And when you total all the things you
    want to total for Puerto Rico, then that is a total, that $30
    billion that you got to, right?
        Mr. Sample. Correct, and that is an ongoing requirement.
        Senator Levin. Yes, but the total amount of money that has
    gone to Puerto Rico, the way you calculate, is $30 billion, and
    they are now getting half of the sales from the United States.
    What is the justification for that except to save tax money?
    And that is perfectly legitimate, right? Nothing wrong with
    reducing your taxes. But is there any justification for
    transferring half of that retail sale money to Puerto Rico
    other than to reduce taxes and to shift that income offshore?
        Mr. Sample. Yes, there is. Under the U.S. transfer pricing
    rules, specifically the cost-sharing agreements, Microsoft
    Puerto Rico has agreed to share approximately 25 percent of
    Microsoft's worldwide R&D expenses every year. And again, as
    pointed out in the last panel, when you share those expenses,
    you do not know if you are going to realize any benefits from
    the expenses. And under the rules, because you are taking that
    risk, you are entitled to an expected return on that risk. And
    under the transfer pricing rules, we believe that the expected
    return in exchange for taking that risk is approximately
    currently 47 percent of the Americas retail sales revenue.
        Senator Levin. And so the risk that you say was taken was
    with Microsoft Ireland money. Is that correct?
        Mr. Sample. Well, the original $1.6 billion equity
    investment----
        Senator Levin. Was with Microsoft money?
        Mr. Sample. It came from Microsoft Ireland.
        Senator Levin. Yes. That is Microsoft money, is it not?
        Mr. Sample. Well, that money was actually earned from
    operating Microsoft's business in EMEA.
        Senator Levin. Well, wherever it was earned, it was
    Microsoft money, right?
        Mr. Sample. On a consolidated basis, it was part of
    Microsoft's total worldwide revenue.
        Senator Levin. So Microsoft takes some of the money that it
    has and sends it over to Puerto Rico. They build a $1.6 billion
    plant, and then they start collecting--half of the retail sales
    from the United States goes--funneled into Puerto Rico under a
    transfer agreement. So using its own money, so if there is any
    risk here, it is risking its own money in any event. It is all
    Microsoft money. Every bit of it is Microsoft money. And so now
    you have this huge shift of $8 to $10 billion a year to Puerto
    Rico from U.S. retail. It was shifted back and forth at one
    time, was it not? The same time this transfer pricing agreement
    was entered into with Puerto Rico, is it not true that when the
    $1.6 billion was agreed to that the 50 percent retail--the 46
    percent retail transfer was also agreed to at the same time?
        Mr. Sample. I cannot be sure. They were roughly within the
    same year.
        Senator Levin. OK. Now, let me ask you about a couple other
    entities. Let us talk about Microsoft in Singapore. The key
    entity in Microsoft Asia Island Limited--where is Microsoft
    Singapore located?
        Mr. Sample. Well, the Microsoft Singapore Roc Group
    consists of three entities: The parent company in Singapore,
    and two subsidiaries--the operating company, which is also in
    Singapore, and the IP holding company, which is in Bermuda.
        Senator Levin. OK. So Microsoft Asia Island Limited (MAIL),
    is located in Bermuda. Is that correct?
        Mr. Sample. That is correct.
        Senator Levin. And Microsoft Asia Island Limited located in
    Bermuda owns the rights to sell Microsoft products in Asia. Is
    that correct?
        Mr. Sample. Senator, it licenses the rights from Microsoft
    U.S. in exchange for an annual cost-sharing payment plus the
    initial buy-in.
        Senator Levin. And is the reason it is located in Bermuda
    to reduce taxes?
        Mr. Sample. That is correct.
        Senator Levin. Does it have any employees in Bermuda?
        Mr. Sample. No.
        Senator Levin. The sole function of this entity in Bermuda
    then is to enter into a cost-share agreement, re-license the
    rights to a subsidiary in Asia. Is that correct?
        Mr. Sample. Correct.
        Senator Levin. Now, how is it that Microsoft Asia can pay
    the United States $1.2 billion for intellectual property and
    then immediately re-license it and get $3 billion for those
    same rights?
        Mr. Sample. Microsoft Asia Island Limited is realizing the
    premium return because of the risk it takes in agreeing to fund
    roughly 10 percent of Microsoft's worldwide R&D.
        Senator Levin. And the risk that it took was with Microsoft
    money.
        Mr. Sample. With money earned by the Asia group from sales
    to customers.
        Senator Levin. So Microsoft, which globally put a
    consolidated bank account there and balance sheet, is, you say,
    risking some of its own money--fair enough--assigning some of
    that risk to a Bermuda entity to reduce taxes, and every year
    is shifting about $1.8 billion--is that not correct?--from the
    United States into a tax-free area. Does that sound about
    right?
        Mr. Sample. Senator, I respectfully disagree with your
    characterization. The revenue and profits that fund MAIL's
    cost-sharing payments come from producing, distributing,
    marketing, and selling products in Asia Pacific. Those
    functions are performed by our Asia Pacific subsidiaries, and
    the operating expenses of that business are funded primarily by
    the Singapore group.
        Senator Levin. But Microsoft Asia Island Limited, located
    in Bermuda, has no employees. Is that correct? Let us go
    through that again.
        Mr. Sample. That is correct.
        Senator Levin. It has no employees, and, nonetheless, it
    receives $3 billion for intellectual property rights and pays
    Microsoft U.S., where all of this intellectual property was
    created, about 85 percent of the R&D, pays $1.2 billion to
    Microsoft U.S., which means that it is getting $3 billion for
    that asset, but $1.8 billion stays offshore in a tax-free
    entity instead of coming back to Microsoft U.S. where 85
    percent of the R&D was carried out. Are my numbers correct?
        Mr. Sample. Your numbers are correct.
        Senator Levin. And you agreed, I believe, that this was
    located where it is for tax purposes.
        Mr. Sample. That is correct.
        Senator Levin. All right. Now, is it then clearly in
    Microsoft's interest in terms of reducing U.S. taxes to have
    its offshore subsidiaries pay as little as possible to the
    United States and then sub-license the intellectual property to
    others for as much as possible? Is that in Microsoft's tax
    interest?
        Mr. Sample. Senator, again, I would respectfully disagree
    with your characterization----
        Senator Levin. But that is a question, though. Is the
    answer--you can say, no, it is not in Microsoft's interest, if
    you want, to reduce its taxes.
        Mr. Sample. Well, it is in Microsoft's interest to reduce
    its worldwide tax burden.
        Senator Levin. And then in terms of reducing its U.S.
    taxes, I am talking about, is it not in its interest to have
    its offshore subsidiaries pay as little as possible to the
    United States when it sub-licenses intellectual property to
    others?
        Mr. Sample. It is in our interest to comply with the
    transfer pricing laws of the United States.
        Senator Levin. No, I know that. But I am saying does that
    not contribute to tax reduction and paying less tax in the
    United States with those numbers? Three billion is received by
    Microsoft, that wholly owned subsidiary with no employees, and
    $1.2 billion is paid to the United States Microsoft, which
    means you have shifted and left in a non-taxpaying
    jurisdiction, Bermuda, $1.8 billion. Does that not reduce
    Microsoft's tax bill to the United States?
        Mr. Sample. Senator, again, I would respectfully----
        Senator Levin. OK. The answer is no. If you want to say it
    does not reduce its burden, that is OK. You are under oath. If
    you want to say that Microsoft's tax burden in the United
    States is not reduced when Microsoft overseas with no employees
    in that particular entity gets $3 billion a year for its
    intellectual property, and then sends $1.2 billion of that to
    the United States and that is the deal that has been entered
    into. You have agreed that is aimed at reducing taxes, and my
    question to you is: Is it not then in Microsoft's tax interest
    in terms of reducing its taxes to enter into an agreement which
    has little coming back to the United States and has much
    staying in Bermuda?
        Mr. Sample. Senator, it is in Microsoft's interest to
    minimize its foreign tax burden on the profits earned by its
    business operations in foreign markets.
        Senator Levin. And is it also in Microsoft's interest to
    reduce its tax burden in the United States?
        Mr. Sample. Yes.
        Senator Levin. Now, when a company infringes on Microsoft's
    patents, what court does Microsoft go to for relief?
        Mr. Sample. I am not familiar with our patent licensing
    group, Senator, so I do not know the answer to that question.
        Senator Levin. OK. You do not know that it goes to U.S.
    courts?
        Mr. Sample. Well, our patent rights are generally owned by
    the U.S. company. I do not think that necessarily means that
    all patent infringement claims would be litigated in the U.S.
    courts.
        Senator Levin. Are they litigated in Bermuda?
        Mr. Sample. I do not know, Senator.
        Senator Levin. OK. By the way, going back to this previous
    question, if Microsoft did not sell the economic rights
    offshore, you could still do the same business around the
    world, could you not?
        Mr. Sample. Senator, the licenses are generally--and they
    are required to be under the cost-sharing rules--exclusive to a
    geographic region.
        Senator Levin. Could you sell from the United States
    without those kind of cost-sharing agreements with yourself?
        Mr. Sample. Our business people believe that in order to
    succeed and compete in foreign markets, we need to have
    significant local operations and people in order to sell
    Microsoft products in foreign markets.
        Senator Levin. You do not have any people in Bermuda, do
    you?
        Mr. Sample. We do not have any Microsoft employees in
    Bermuda.
        Senator Levin. All right.
        Mr. Sample. But those sales that generate the $3 billion
    you are talking about, Senator, were made to Asia Pacific
    customers and the sales and marketing was done by Microsoft
    Asia Pacific subsidiaries with Asia Pacific employees.
        Senator Levin. I understand. Does Microsoft Asia Island
    Limited have any source of income other than its royalty
    payments?
        Mr. Sample. MAIL's only source of income that I am aware of
    is the royalty payment from its operating subsidiary twin in
    Singapore.
        Senator Levin. Do you know if Microsoft Asia Island Limited
    is a disregarded entity?
        Mr. Sample. Microsoft Asia Island Limited and its twin
    operating subsidiary in Singapore are both disregarded
    entities, Senator.
        Senator Levin. And if they were not disregarded, would the
    $3 billion royalty payment it received from Microsoft Singapore
    operations be considered passive income and be immediately
    taxable in the United States, do you know?
        Mr. Sample. I believe it would, Senator.
        Senator Levin. All right. So that by simply checking the
    box there and disregarding Microsoft Asia Island Limited its
    royalty payment of $3 billion from Microsoft Singapore
    operations is also disregarded, so that the tax on that $3
    billion royalty, which is $610 million in 2011, does not have
    to be paid to the United States. Is that correct?
        Mr. Sample. Yes. Senator, with respect to the check-the-box
    groups we have, we are essentially creating the foreign
    equivalent of a U.S. consolidated group. And if you look at the
    U.S. consolidated group rules, they permit members of the U.S.
    consolidated group to move profits from one entity to another
    with no adverse tax consequences. All the profits that are
    moved in the Singapore group are earned by active operations by
    our Asia Pacific subsidiaries and employees selling to
    customers in Asia. All those profits remain within the Asia
    Pacific ROC group. So it is really just the equivalent of a
    consolidated group for the Asian ROC.
        Senator Levin. Does the U.S. group that you just referred
    to pay U.S. taxes?
        Mr. Sample. Our U.S. consolidated group pays U.S. taxes.
        Senator Levin. And does the Singapore group pay U.S. taxes?
        Mr. Sample. The Singapore group pays U.S. taxes to the
    extent it has passive Subpart F income within the group.
        Senator Levin. And you have taken care of that by
    disregarding it?
        Mr. Sample. Again, I do not have the details in front of
    me----
        Senator Levin. Well, that is what you just said. It was
    disregarded within the group. You analogized it to a U.S.
    group. And now the analogy fails because the U.S. group pays
    U.S. taxes and the Singapore group does not pay U.S. taxes, and
    so your analogy does not relate to the U.S. tax reality. It
    relates to a theoretical reality. It is a pretty big
    difference, isn't it, between those two groups?
        Mr. Sample. Senator, I respectfully disagree with your
    characterization.
        Senator Levin. But didn't you analogize it to the U.S.
    group a minute ago, twice?
        Mr. Sample. No. I analogized it to the U.S. consolidated
    return rules.
        Senator Levin. Right.
        Mr. Sample. This is essentially a Singapore consolidated
    return group, and the earnings of the Singapore consolidated
    return group under the U.S. rules are not required to be taxed
    in the United States until they are repatriated back to the
    United States.
        Senator Levin. And that is because you have checked the box
    and because it is disregarded.
        Mr. Sample. That is correct. But the profits were earned
    from operating an active trade or business outside the United
    States.
        Senator Levin. Is it just basically a fair statement to say
    that tax considerations are a significant factor influencing
    Microsoft's decision regarding its cost-sharing agreements and
    where it locates offshore entities that are the parties to
    those agreements? Is that a fair statement?
        Mr. Sample. Senator, cost and tax consequences are a
    consideration with respect to all our subsidiaries and all our
    operations worldwide. They are certainly a consideration where
    we have decided to locate our regional operating centers.
        Senator Levin. And is it also a significant factor in your
    decisions regarding cost-sharing agreements?
        Mr. Sample. The primary----
        Senator Levin. No. Is it a significant factor that
    influences Microsoft's decisions regarding cost-sharing
    agreements?
        Mr. Sample. Senator, I am not sure I understand the
    question. Are you asking relative to other forms of transfer
    pricing methods or is it a different question?
        Senator Levin. I think it is a clear question.
        Mr. Sample. Well, when we operate----
        Senator Levin. Does it influence your decisions regarding
    cost-sharing agreements? Are tax considerations a significant
    factor influencing your decisions regarding cost-sharing
    agreements? It is a very straightforward question. You are a
    tax expert. I cannot state it more clearly. And I think you
    know it.
        I am just asking you is it a significant factor.
        Mr. Sample. Our transfer pricing policies always involve
    significant consideration of the tax consequences.
        Senator Levin. I think that means the answer is yes.
        Mr. Sample. It is a significant factor in all our transfer
    pricing policies, cost sharing or not.
        Senator Levin. I think that was my question, wasn't it?
        Mr. Sample. I have tried to answer to the best of my
    ability, Senator.
        Senator Levin. Is the straightforward answer to that then
    just simply yes?
        Mr. Sample. Well, Senator, again, respectfully----
        Senator Levin. That is OK. If you cannot give me a yes or
    no, but just repeat the question and say that is what it is,
    that to me is a yes. But if you do not want to utter the word
    ``yes,'' that is your decision.
        Again, we thank you for your cooperation with this inquiry
    of ours. We thank you for your appearance. We are great fans of
    Microsoft and other companies in this country which are as
    creative and entrepreneurial as you are. We are not fans of
    your pricing agreements and what you do with our tax laws. But
    a whole lot of other companies do the same thing, if that gives
    you any solace. It should not give the American public any
    solace, but you are to be congratulated, it seems to me, for
    what you have been able to produce. But this tax system of ours
    which results in the kind of transfer and the drive to transfer
    U.S. funds and profits and income to low-tax jurisdictions is
    not in anybody's interest. It may be in your temporary interest
    as a corporation. It increases your profits and reduces your
    taxes. But there is a heavy cost to the United States.
        But, again, we thank you for your appearance here today.
    Thank so much.
        Mr. Sample. Thank you, Senator.
        Senator Levin. Let us now call our third panel of
    witnesses: Lester Ezrati, Senior Vice President and Tax
    Director, and John McMullen, Senior Vice President and
    Treasurer, at Hewlett-Packard Company; and also Beth Carr, a
    partner at Ernst & Young in International Tax Services.
        Let me thank our witnesses and the companies they
    represent, both Hewlett-Packard and Ernst & Young. The last
    time I was thanking our companies for their cooperation, I
    failed to mention Ernst & Young, but you are included in that
    group that cooperated with us. We appreciate that.
        Under our Rule VI, as you know, all of our witnesses need
    to be sworn, so we would ask that you please stand and raise
    your right hand.
        Do you swear that the testimony you are about to give will
    be the truth, the whole truth, and nothing but the truth, so
    help you, God?
        Mr. McMullen. I do.
        Mr. Ezrati. I do.
        Ms. Carr. I do.
        Senator Levin. OK. Do you want to begin with your opening
    statements? I think you were here before when you heard what
    our ground rules are in terms of time. Were you here, all of
    you? Should I repeat the rule?
        Mr. McMullen. No.
        Mr. Ezrati. I was here, Senator.
        Senator Levin. OK. Ms. Carr, were you here? Did you hear
    the rule about timing of your statement?
        Ms. Carr. I did. Thank you.
        Senator Levin. Thank you. Do you have any preference as to
    who begins? I guess Mr. Ezrati is going to be presenting the
    Hewlett-Packard testimony, so why don't we have you go first,
    and then Ms. Carr.

     TESTIMONY OF LESTER D. EZRATI,\1\ SENIOR VICE PRESIDENT, TAX,
    HEWLETT-PACKARD COMPANY, PALO ALTO, CALIFORNIA, ACCOMPANIED BY
    JOHN N. MCMULLEN, SENIOR VICE PRESIDENT AND TREASURER, HEWLETT-
                 PACKARD COMPANY, PALO ALTO, CALIFORNIA

        Mr. Ezrati. Certainly, Senator. Chairman Levin, my name is
    Lester Ezrati, and I am the Senior Vice President of Tax at
    Hewlett-Packard Company. I have spent nearly my entire three-
    decade professional career at HP.
    ---------------------------------------------------------------------------
        \1\ The prepared statement of Mr. Ezrati and Mr. McMullen appears
    in the Appendix on page 135.
    ---------------------------------------------------------------------------
        I am an attorney, and my duties include providing tax
    advice to HP. My group provides advice regarding HP's tax
    obligations in over 100 countries, including the United States,
    and prepared the relevant documents.
        I am accompanied by my colleague John McMullen, Senior Vice
    President and Treasurer of HP. Mr. McMullen has held this
    position since 2007. One of Mr. McMullen's responsibilities is
    to provide HP with the cash it needs in the United States and
    abroad.
        HP produced over 330,000 pages of documents, voluntarily
    permitted interviews of executives, and cooperated fully for
    the past 3 years with the Subcommittee's inquiry.
        Over 1 billion people rely on HP technology. We operate in
    approximately 170 countries with a workforce of over 320,000,
    including approximately 80,000 U.S. employees. Many of these
    U.S. jobs are highly skilled, high-value, and high-wage jobs.
        In 2011, HP paid approximately $10.3 billion in salaries
    and wages to U.S. employees. HP spent $3.3 billion on R&D
    during its 2011 fiscal year, and about two-thirds of this R&D
    was conducted in the United States.
        In recent years, HP made several strategic acquisitions of
    companies with substantial foreign assets, including Autonomy,
    3Com, Mercury Interactive, and Indigo. For example, funds from
    HP's foreign operations supplied approximately $4 billion for
    the purchase price of U.K.-based Autonomy.
        HP's fiscal year 2011 Generally Accepted Accounting
    Principles (GAAP) effective tax rate (ETR), was 21.2 percent.
    ETR is the blended worldwide effective tax rate which
    incorporates tax rates on U.S. and foreign operations. Most of
    our foreign competitors have much lower effective tax rates,
    such as Lenovo, 13.8 percent; Samsung, 16.5 percent; and Wipro,
    13.9 percent.
        The Subcommittee requested that HP address APB 23 dealing
    with indefinitely reinvested earnings. Examples of indefinitely
    reinvested earnings include the value of overseas facilities,
    inventory, and many other types of assets.
        In 2011, HP earned approximately 65 percent of its revenue
    from non-U.S. sources. Based on this large and increasing
    global footprint, it is both logical and necessary that HP's
    indefinitely reinvested APB 23 amount has increased.
        HP's representation of what is indefinitely reinvested is
    ultimately made by me and reflected in a representation letter
    provided to Ernst & Young, who audits HP on an annual basis.
        In determining the amount of indefinitely reinvested
    earnings, I consult with Treasury, chief financial officer
    (CFO), and others within HP, and I consider many factors,
    including: Prior years' history, working capital forecasts,
    long-term liquidity plans, capital improvement programs, merger
    and acquisition, and other investment plans, U.S. cash needs,
    the expected business cycle, restrictions on distributions in
    certain countries, and country risk.
        Ernst & Young reviews internal HP data that supports this
    representation and can ask for additional information to test
    my decision. Year over year changes in HP's APB 23 reporting
    are in HP's financials and are visible to the public and
    regulators.
        The Subcommittee also asked about HP's loans from foreign
    subsidiaries and the potential application of Internal Revenue
    Code Section 956 to these loans. Under applicable rules, a loan
    from a controlled foreign corporation (CFC) to its U.S. parent
    will only be treated as an investment in U.S. property if it is
    outstanding at the close of the CFC's fiscal quarter. A series
    of loans that collectively span over the CFC's quarter may be
    treated as a single loan by the IRS or the courts under general
    tax principles. Based on IRS guidance, if the period of time
    between separate loans is not brief compared to the overall
    period the debt obligations are outstanding, such loans will
    not be aggregated in this manner.
        HP's non-U.S. structure includes our Belgian Coordination
    Center (BCC). In effect, the BCC serves as HP's internal bank
    and receives cash from most of HP's non-U.S. subsidiaries by
    way of capital contributions and loans. BCC's funds may be used
    in part to buy a foreign company, for example. BCC's funds can
    be used to fund distributions to HP U.S. entities, which are
    fully taxed in the U.S. BCC can lend money within the HP
    corporate family, and is paid market interest rates on those
    loans.
        Pre-merger Compaq also had a foreign subsidiary in the
    Cayman Islands, CCHC, which served a similar function as BCC,
    and HP continues to use that entity for the same purposes as
    the BCC. All loans from these subsidiaries, including the
    alternating loans identified by the Subcommittee, are in
    compliance with Internal Revenue Code Section 956, IRS
    guidance, and case law. In its most recently completed audit of
    HP's tax returns, the IRS reviewed detailed information
    regarding these loans and did not find that the tax treatment
    of them was contrary to the Internal Revenue Code, relevant IRS
    guidance, or case law.
        To be clear, however, alternating loans are only one of
    several sources of liquidity to HP's U.S. entities. Indeed,
    there have been times when no alternating loans were made,
    including a 90-day period that began at the end of fiscal year
    2010. In addition, there were 72 days in the last two fiscal
    years where there was no alternating loan balance.\1\
    ---------------------------------------------------------------------------
        \1\ Subsequent to the hearing, Hewlett-Packard informed the
    Subcommittee that it researched this matter and now corrects this to 86
    days.
    ---------------------------------------------------------------------------
        HP's commercial paper (CP), program has always been
    available to augment short-term liquidity in the United States.
    For example, in 2010, over a 3-day period, HP raised over $3
    billion in commercial paper, part of which funded the Palm
    acquisition. For the last 2 fiscal years, the average balance
    for our commercial paper program was approximately $1.9
    billion. By way of comparison, during the same time period our
    outstanding alternating loan balance averaged approximately
    $1.6 billion.
        HP also uses capital market debt for longer-term needs. HP
    has issued a cumulative amount of long-term U.S. debt totaling
    approximately $16.6 billion for the last 2 fiscal years. In
    addition to CP and long-term debt, HP has $7.5 billion in
    revolving credit facilities with our bank group.
        The average value of alternating loans in use over the past
    2 fiscal years represents only 9 percent of the liquidity
    provided by CP and new U.S. long-term debt combined for the
    period. Additionally, the average value of alternating loans in
    use over the past 2 fiscal years represents only 5 percent of
    the total HP debt outstanding at the end of our most recent
    fiscal third quarter. Clearly, over this period the alternating
    loans were a modest contribution to HP's liquidity.
        I can assure the Subcommittee that HP takes seriously its
    obligations to accurately follow accounting principles and to
    pay the taxes that it owes.
        Mr. McMullen and I are available for your questions. Thank
    you very much.
        Senator Levin. Thank you very much. Ms. Carr.

    TESTIMONY OF BETH CARR,\1\ PARTNER, INTERNATIONAL TAX SERVICES,
                ERNST & YOUNG LLP, PALO ALTO, CALIFORNIA

        Ms. Carr. Good afternoon, Chairman Levin. My name is Beth
    Carr. I am a certified public accountant and an international
    tax partner with Ernst & Young LLP. I am appearing today
    representing the firm.
    ---------------------------------------------------------------------------
        \1\ The prepared statement of Ms. Carr appears in the Appendix on
    page 119.
    ---------------------------------------------------------------------------
        I have been with Ernst & Young for more than 11 years and
    am responsible for leading the Ernst & Young team that performs
    tax-related work for Hewlett-Packard, for which we serve as the
    independent auditor.
        I have been working as a tax professional in the area of
    public accounting since 1994 when I graduated from the
    University of Pennsylvania with a bachelor of science degree
    with a concentration in accounting. Since 1996, my focus has
    been international taxation. I joined Ernst & Young in March
    2001 and have been an international tax partner since 2004. I
    have been the lead tax partner on the Hewlett-Packard account
    since 2006.
        I could not be prouder of the fact that I am a mother of
    two young boys, a wife of a wonderful and supportive husband,
    and a partner at Ernst & Young where I have the opportunity to
    work with a team of extremely knowledgeable, ethical, and
    intelligent individuals in the complex areas of tax and
    accounting. I truly enjoy working with my colleagues and
    clients, and I am honored to represent Ernst & Young before the
    Subcommittee today.
        My firm and I have sought to be helpful in our responses
    and input to the Subcommittee. The policy issues being explored
    are important. I have participated in many hours of questioning
    by the Subcommittee staff relating to my and my firm's work for
    Hewlett-Packard. Ernst & Young in turn has provided to the
    Subcommittee approximately 150,000 pages of documents in a
    highly compressed time frame.
        Today's hearing addresses complex technical issues relating
    to companies' tax and accounting treatment of their foreign
    earnings. As it is difficult to address with brevity the
    substance of the issues the Subcommittee is reviewing, I refer
    the Subcommittee to my written statement which sets forth the
    underlying framework that is central to my and Ernst & Young's
    perspective on these topics.
        The Subcommittee has asked about Hewlett-Packard's
    application of an accounting standard formerly referred to as
    ``APB 23,'' which is now codified in ASC 740. In general terms,
    APB 23 is the accounting standard for temporary differences
    between the book and tax basis in a company's investment in a
    foreign subsidiary, often referred to as ``the outside basis
    difference.'' The most significant outside basis difference
    typically relates to book earnings.
        The accounting rules generally require that a company
    account for the future taxation of this outside basis
    difference even if no tax is currently due. APB 23, however,
    provides an exception to recording this future tax liability if
    the company asserts and demonstrates that it has the ability
    and intent to indefinitely reinvest such earnings outside the
    United States and, therefore, does not expect that any tax will
    be due for the foreseeable future.
        The Subcommittee has also asked about Hewlett-Packard's
    short-term intercompany loans, their consistency with its
    indefinite reinvestment assertion, and whether these short-term
    loans are compliant with the applicable Internal Revenue Code
    provisions. Our written statement outlines the complex legal
    and regulatory framework for evaluating these issues.
        As Hewlett-Packard's independent auditor, we spend tens of
    thousands of hours forming a conclusion on whether Hewlett-
    Packard's financial reports are fairly presented under U.S.
    GAAP. As a part of that effort, my team and I spend more than
    7,000 hours each year reviewing the various aspects of Hewlett-
    Packard's accounting for income taxes. We test with
    independence, skepticism, and objectivity the various
    assertions of Hewlett-Packard.
        Ernst & Young has concluded each year that Hewlett-
    Packard's financial statements fairly presented its financial
    position and results of operations under U.S. GAAP, and Ernst &
    Young stands firmly behind the audit opinions that it has
    issued for Hewlett-Packard.
        As part of our independent audit, we expend considerable
    effort in evaluating HP's loans from its foreign subs, or CFCs.
    In general, during the period under review by the Subcommittee,
    the test for whether CFC loans are deemed a taxable dividend
    has entailed a comprehensive facts-based analysis of whether
    there has been a repatriation to the United States of an
    individual CFC's earnings. IRS guidance also acknowledges the
    important role that CFC loans may serve as a short-term
    alternative source to provide liquidity to a U.S.
    multinational.
        Indeed, during the recent credit crisis, when corporate
    liquidity was suffering greatly, the IRS temporarily relaxed
    the short-term loan requirements in an attempt to encourage
    expansion of the scope of companies' intercompany lending to
    help facilitate liquidity while not triggering repatriation of
    earnings and associated U.S. income tax liabilities.
        In addition to the guidance that the IRS has issued
    regarding the application of Section 956, the IRS regulations
    require that intercompany loan balances between a CFC and its
    U.S. parent or a domestic corporation controlled by the parent
    be included on the taxpayer's Form 5471 or Form 8858. Many
    large companies, including Hewlett-Packard, are subject to
    continuous IRS audit during which some intercompany loans may
    be examined.
        My colleagues and I at Ernst & Young work hard to comply
    with all existing rules and regulations and aspire to the
    highest professional standards in doing so. While the policies
    embodied in the tax law and accounting principles, including
    Section 956 and APB 23, may be questioned or challenged, our
    role as independent auditor is to evaluate whether HP properly
    applies the rules that exist at the time of its financial
    reports.
        On behalf of Ernst & Young, I appreciate the opportunity to
    provide input in connection with the Subcommittee's review, and
    I welcome your questions.
        Senator Levin. Thank you very much, Ms. Carr.
        Let me start with you, Mr. Ezrati. You have maintained most
    of your cash as a company offshore. Is that true?
        Mr. Ezrati. So, Senator, 65 percent of our revenue is
    offshore, and a good chunk of the cash is kept offshore.
        Senator Levin. About what percentage of the cash?
        Mr. Ezrati. It varies at different times. There are certain
    reasons why U.S. cash is depleted more quickly than foreign
    cash, and I can enumerate them for you.
        Senator Levin. At the end of 2009, is it true you had $12.5
    billion of your $13.3 billion offshore?
        Mr. Ezrati. I will have to defer to Mr. McMullen on that.
        Senator Levin. Is that about right?
        Mr. McMullen. Yes, Senator.
        Senator Levin. That would be about, what, 90 percent, 85
    percent?
        Mr. McMullen. I do not have the specific for that period,
    but in the ballpark of 90 percent makes sense.
        Senator Levin. OK. And so you say about 65 percent of your
    earnings offshore, you have about 90 percent of your cash
    offshore. Is that about right?
        Mr. McMullen. Yes.
        Mr. Ezrati. And, Senator, there is a reason why U.S. cash
    gets depleted. There are certain expenses and certain funds you
    can only use U.S. funds to pay those expenses and funding. For
    example, dividends to U.S. shareholders can only be paid from
    U.S. funds. The U.S. pension plan can only be funded by U.S.
    funds. You can only retire debt in the United States using U.S.
    funds. U.S.-based companies can only be acquired with U.S.
    funds. And so there are reasons why U.S. funds get depleted
    more quickly than foreign funds.
        At the same time, foreign funds are reserved for foreign
    acquisitions or for expansion, and we have expanded greatly
    outside the United States. So there is a reason why you are
    reserving foreign funds for that expansion.
        Senator Levin. Does tax strategy influence the location of
    cash balances?
        Mr. Ezrati. What influences the location----
        Senator Levin. I just asked you, does tax strategy
    influence the location of cash balances?
        Mr. Ezrati. HP has an overall strategy to minimize
    expenses, and that is what generates where the cash is located.
    One of those expenses is taxes, just like every other expense.
        Senator Levin. Does tax strategy influence the location of
    cash balances?
        Mr. Ezrati. In part, yes.
        Senator Levin. Well, take a look at Exhibit 3d,\1\ would
    you? Do you see on page 2 there where it says ``Cash Profile''?
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 3d, which appears in the Appendix on page 206.
    ---------------------------------------------------------------------------
        Mr. Ezrati. Yes, Senator.
        Senator Levin. Am I reading that correctly? ``HP's tax
    strategy influences the location of cash balances.'' Is that
    your document?
        Mr. Ezrati. Senator, I did not prepare this document, but I
    just acknowledged that HP's tax strategy in part influences the
    location of cash balances.
        Senator Levin. All right. I asked you whether HP's tax
    strategy influences location of cash balances. I am reading
    your document, and you will not give me a ``yes'' to that?
        Mr. Ezrati. I gave you a ``yes'' to that.
        Senator Levin. You qualified it. You said ``in part.''
        Mr. Ezrati. It is true. It is only in part. I do not want
    to answer the question without telling you exactly what the
    answer is.
        Senator Levin. So there are other influences. Is that
    correct?
        Mr. Ezrati. Oh, absolutely.
        Senator Levin. Yes, but tax strategy influences the
    location.
        Mr. Ezrati. I said yes.
        Senator Levin. The record will show you did not say yes.
    But that is OK.
        Mr. Ezrati, in 2008, HP began what it called a staggered
    loan program. Now, this loan program was designed to allow HP
    through the use of two non-U.S. cash pools called CCHC and BCC,
    one being Belgian and one having the word ``Cayman'' in it, to
    use those two cash pools and to fund U.S. operations with
    billions of dollars yearly since at least 2008. I believe you
    said that alternating loans made a modest contribution to HP's
    U.S. operations. Were those loans as large as $5.9 billion in
    2010?
        Mr. Ezrati. That is correct, Senator.
        Senator Levin. OK. Now, do you agree that the loan program
    that we are talking about contained a prescribed schedule from
    HP's treasury and tax departments for when loans could be made
    and when they needed to be repaid in order to comply with
    Section 956?
        Mr. Ezrati. That is correct. The tax department did tell
    the Treasury Department how to comply with the Internal Revenue
    Code.
        Senator Levin. And so you agree that there was a prescribed
    schedule--take a look, if you would, at 3h.\2\
    ---------------------------------------------------------------------------
        \2\ See Exhibit No. 3h, which appears in the Appendix on page 214.
    ---------------------------------------------------------------------------
        Mr. Ezrati. I am sorry, Senator. I did not understand which
    exhibit you wanted me to look at.
        Senator Levin. On page 2, where it says from CCHC, January
    2 to February 17, from BCC, February 17 to April 2, from CCHC,
    April 2 to May 17,'' and then to the other cash pool, May 17 to
    July 2, back to the first cash pool, July 2 to August 17. Do
    you see all those dates there?
        Mr. Ezrati. I do see those dates.
        Senator Levin. Does that cover every date in the year?
        Mr. Ezrati. It does cover every date of the year. I was
    trying to answer your original question about the prescribed
    schedule. So the word ``schedule'' there does not say this is a
    schedule of loans. It is a following schedule, meaning the
    chart that appears underneath that word.
        Senator Levin. OK. Does it define the windows for loans?
        Mr. Ezrati. They are the windows when loans can be made. It
    is not a prescription as to when loans have to be made or
    should be made.
        Senator Levin. Must they be made within those windows?
        Mr. Ezrati. Not ``must''; can only be made within that
    window.
        Senator Levin. All right. And were there loans continually
    made within those windows?
        Mr. Ezrati. During which fiscal year? Every year?
        Senator Levin. In 2009, 2010, and 2011.
        Mr. Ezrati. No.
        Senator Levin. In 2008, 2009, 2010, 30 straight months
    during those 3 years?
        Mr. Ezrati. I am not familiar with the 30-month period you
    are talking about. I know that in fiscal year 2010, as you said
    in your opening statement, that there was a period when the
    loans were made during the first three quarters of fiscal year
    2010. I will take you with that.
        Senator Levin. OK. And how about 30 months during those
    years, straight months?
        Mr. Ezrati. In 2008, 2009, and 2010? I am not familiar with
    that.
        Senator Levin. All right. So every single period during
    that three quarters there was an outstanding loan from one of
    those two companies, and this schedule had been designed, was
    it not, by the parent company? In other words, they did not
    design their own schedules, did they? They took schedules from
    the tax department and treasury department of HP. Is that
    right?
        Mr. Ezrati. That schedule was designed by the U.S. tax
    department to conform to the U.S. Internal Revenue Code.
        Senator Levin. I understand. But it was designed by your
    tax department. One tax department said we have two pools, we
    have to break them up into two different pools. Would you agree
    that if this were one pool it would not comply with Section
    956? Would you agree with that?
        Mr. Ezrati. I would agree with you that it would be a
    different understanding of the law if it was one pool. I want
    to talk about your characterization of ``breaking it up.'' We
    did not break this----
        Senator Levin. All right. It came at different times.
    Forget the breaking----
        Mr. Ezrati. No, you have to understand me. These two pools
    existed independently of each other. It was not one pool that
    we broke into two.
        Senator Levin. Fine.
        Mr. Ezrati. There always were two pools.
        Senator Levin. OK. Two pools then were given a common
    schedule. Is that correct?
        Mr. Ezrati. The treasury department was given the schedule,
    yes.
        Senator Levin. Two pools, both HP pools, were given a
    common schedule. That pool was told if you are going to make
    loans--which they did every day for three quarters, and we will
    get to the 30 quarters later on. But they were told by the tax
    department if you are going to make loans, they have to be in
    this particular time period; then they alternate to the other
    pool. OK? If you are going to make loans, you cannot make them
    between the same period pool one is doing it; you got to do it
    during the next sequential period.
        Now, the first pool is told, OK, the third sequential
    period, now if you are going to make loans, that is when you
    have to make them and you have to collect them that time, too.
    Then the second pool is told, you are next in sequence, back
    and forth, back and forth, back and forth, back and forth, for
    a whole year, each year. They are given a sequence by the tax
    department. Now, you can call that independent if you want, but
    it is dictated by the tax department; HP dictates the sequence
    for two pools that are HP pools as to when they are going to
    make loans. Would you agree with that?
        Mr. Ezrati. I would agree with you that the tax department
    told the treasury department when they could make loans from
    each of the pools.
        Senator Levin. And they determined the sequence when those
    loans could be made.
        Mr. Ezrati. Exactly what I said. The tax department
    determined----
        Senator Levin. How about what I said?
        Mr. Ezrati [continuing]. When the loans could be made from
    each of those pools and when they could not be made.
        If that is the way you define a sequence, when a loan can
    be made and when a loan cannot be made, if that is what you
    mean by sequence, I am agreeing with you.
        Senator Levin. Is that what you mean by sequence?
        Mr. Ezrati. I do not know what the word ``sequence'' means
    in this case.
        Senator Levin. OK. Now, did those two entities have
    different quarter endings so that they would be able to provide
    a continuous series of loans without crossing over the end
    quarter of either of them?
        Mr. Ezrati. Those two entities, they each have a different
    fiscal quarter end. That is correct.
        Senator Levin. And were they given a different quarter
    ending so that they would be able to provide a continuous
    series of loans without crossing over the end quarter?
        Mr. Ezrati. They were given a different fiscal quarter so
    that they would have a different fiscal quarter for U.S. tax
    purposes and the application of Section 956.
        Senator Levin. How about my question? It is a
    straightforward question. Were they given different quarter
    endings so they would be able to provide a continuous series of
    loans without crossing over the end quarter of either one? That
    is a very direct question.
        Mr. Ezrati. The answer to that is no, it was not so that
    they could have a continuous series of loans.
        Senator Levin. No. Without crossing over the end quarter.
        Mr. Ezrati. Right. They were given different quarter ends
    so that they could be lending at different times and so that
    their loans would not cross over their end quarter. I was just
    quarreling with your use of the word ``continuous.''
        Senator Levin. All right. So, anyway, there is no
    possibility with these sequences of there being a gap between
    available pools. Is that correct?
        Mr. Ezrati. I am not sure I understand what you mean--there
    is always a gap between the available pools. There is always a
    large gap between when the BCC can be lending and when it
    cannot, and there is a gap between when CCHC can be lending and
    when it cannot.
        Senator Levin. I said a gap between the pools. I did not
    say within the pool.
        Mr. Ezrati. I think, if I understand you correctly, you
    mean----
        Senator Levin. Between the pools, there cannot be a gap. In
    other words, money could always be loaned by one or the other,
    and if there were loans made, there could not be a gap if they
    were made according to the prescribed sequence. Is that right?
        Mr. Ezrati. If loans were made in accordance with the
    prescribed sequence, there would not be a gap, right.
        Senator Levin. OK. So by using two pools, was it your aim
    to effectively have an uninterrupted, ongoing loan program to
    assist operations in the United States?
        Mr. Ezrati. As I testified, there were gaps in those,
    depending on what cash was needed. The schedule you are looking
    at is not an actual schedule of loans, Senator. There were gaps
    in the loans.
        Senator Levin. I did not say it was a schedule of loans.
        Mr. Ezrati. There was a period of time in fiscal year 2010
    when there were no loans from----
        Senator Levin. I said it was a schedule when loans could be
    made and, if they were made, must be made, and must be repaid.
        Mr. Ezrati. They could be made and they must be repaid,
    that is correct.
        Senator Levin. OK.
        Mr. Ezrati. And, in fact, when they were made, they were
    repaid within that schedule.
        Senator Levin. And now, I do not know if you answered this
    before, would you agree that if they were in one pool that they
    would be taxed as a long-term loan?
        Mr. Ezrati. So, Senator, if there were only one pool and it
    had made a loan for the entire year----
        Senator Levin. No, made all the loans that were made from
    these two pools.
        Mr. Ezrati. Yes, I guess one way to look at it is there had
    only been one entity and it made all the loans there, it would
    have a different treatment probably subject to tax in the
    United States.
        Senator Levin. OK. Was there an ability to move funds from
    one pool to the other?
        Mr. Ezrati. There is no commingling of funds from one
    pool--no commingling of the funds in those pools.
        [Pause.]
        Senator Levin. Take a look at Exhibit 3c,\1\ would you? And
    it is under ``Alternating Loans.''
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 3c, which appears in the Appendix on page 203.
    ---------------------------------------------------------------------------
        Mr. Ezrati. You mean the last page of Exhibit 3c?
        Senator Levin. Yes, the heading ``Alternating Loans,''
    starting with the words, ``The majority of our offshore cash .
    . .'' Are we on the same page?
        Mr. Ezrati. I am, Senator.
        Senator Levin. OK. Take a look at the third dot: ``We have
    the ability to move cash from BCC to CCHC in fiscal year 10.''
    Was that true?
        Mr. Ezrati. We were definitely exploring possibilities of
    moving cash from the BCC to CCHC in fiscal year 2010.
        Senator Levin. How about my question?
        Mr. Ezrati. Is what true?
        Senator Levin. What I read to you. Was it true that you had
    the ability to move cash from BCC to CCHC in fiscal year 2010?
        Mr. Ezrati. What I do know is that in fiscal year 2010 we
    did not move cash from the BCC to CCHC.
        Senator Levin. My question?
        Mr. Ezrati. We may have had the ability to. We did not.
        Senator Levin. OK. So you may have had the ability to move
    cash from BCC to CCHC in fiscal year 2010.
        Mr. Ezrati. I can easily think of ways you could have moved
    cash from the BCC to the CCHC. A simple way would have been to
    have one lend money to another. We did not do that.
        Senator Levin. All right. But you had the ability to do it.
    That is not what I called--I did not say ``commingle.'' When I
    asked you that first question, I said to transfer cash----
        Mr. Ezrati. I understand. Yes, Senator, we definitely had
    the ability to move cash from one pool to the other. We did
    not.
        Senator Levin. OK. Now, in 2009, your records show that HP
    U.S. borrowed on average from the two alternating pools about
    $5 billion, and there was no gap of a single day for the year
    that we can see. In 2010, your records show that HP U.S.
    borrowed an average from the two alternating pools nearly $6
    billion without a gap of a single day for more than 9 months in
    2010.
        Ms. Carr, were you aware of the extent and breadth and
    regularity of the staggered loan program?
        Ms. Carr. We certainly were aware of the inter-company
    loans that were made by the BCC and CCHC to HP CO.
        Senator Levin. Were you aware of the extent and the breadth
    and the regularity of the staggered loan program?
        Ms. Carr. Again, we were aware of the loans that were made
    by BCC and CCHC.
        Senator Levin. Let me just ask, Ms. Carr, though, is that
    different from a ``yes'' answer?
        Ms. Carr. I do not believe so. We were aware of the loans
    that were made.
        Senator Levin. And the extent and the regularity of those
    loans?
        Ms. Carr. We were aware of the dates and length of the
    notes.
        Senator Levin. OK.
        Mr. Ezrati. Senator, I think you have misstated the extent
    of the loans. Because of the way the Subcommittee staff asked
    for the data, they have miscalculated the average amount
    outstanding at any particular time. I would respectfully
    disagree with the amount you have recharacterized as
    ``outstanding'' on average?
        Senator Levin. Did I say ``outstanding''? I do not think I
    used the word ``outstanding,'' did I?
        Mr. Ezrati. I am sorry then. I will withdraw my objection.
        Senator Levin. I believe that you said, Mr. Ezrati, that
    you did not depend heavily upon these funds for your liquidity.
    Is that true?
        Mr. Ezrati. I said that during the last 2 fiscal years they
    represented a modest amount of our liquidity.
        Senator Levin. Now, take a look at the last 2 fiscal years.
    You mean these last two. How about in October 2008?
        Mr. Ezrati. I think Mr. McMullen can help me with that one
    as to why the loans may have been greater in 2008.
        Mr. McMullen. Sure. Yes, Senator, just for context, in
    2008, in the October time frame, that was shortly after we had
    done the acquisition of EDS, and it was also the point in time,
    if you recall, in mid-September of that same year that the
    capital markets essentially froze. Tier 2 CP market essentially
    froze, and there was some question as to how reliable CP was
    going to be even as a Tier 1 provider, as we were. So the
    alternating loan was absolutely an important aspect of
    liquidity in the United States.
        Senator Levin. Was it the most important source?
        Mr. McMullen. It was the most predictable and at that point
    extremely important, because we were not----
        Senator Levin. Was it just flat out the most important
    source of U.S. liquidity?
        Mr. McMullen. At that point in time, very important.
    ``Most'' is not the word I would use, Senator.
        Senator Levin. You are resisting that word, but now let me
    take a look at your own documents. Take a look at Exhibit
    3b.\1\ I understand your resistance to the word ``most,'' but
    let me refer you to an HP document, October 7, 2008, ``Access
    to Offshore''--no, I am wrong. ``Offshore Cash Pools,'' do you
    see that heading? Do you see the second sentence: ``The pools
    alternately loan to HP UP for 45-day periods. This is the most
    important source of US liquidity.'' Do you see that?
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 3b, which appears in the Appendix on page 199.
    ---------------------------------------------------------------------------
        Mr. McMullen. I do.
        Senator Levin. It does not say ``an important,'' ``one of
    the most.'' It says ``the most.'' Was that accurate when it was
    written?
        Mr. McMullen. I understand, Senator. I did not create that
    slide.
        Senator Levin. You just do not agree with it.
        Mr. McMullen. I agree that at that point it was incredibly
    important.
        Senator Levin. ``Incredibly important.''
        Mr. McMullen. Now, the most important----
        Senator Levin. That is all right. I think that is as much
    as we are going to get on that one.
        Now, were the decisions that were made about when and how
    much of the offshore cash pools in this staggered loan program,
    was that closely coordinated by both treasury and the tax
    offices?
        Mr. Ezrati. I think your question, Senator, is the decision
    on how much----
        Senator Levin. When and how much of the offshore cash pools
    would be utilized closely coordinated by both of those offices?
        Mr. McMullen. The guidelines come from the tax department,
    but the decision relative to the amounts and the execution of
    those amounts within the guidelines are done by the treasury
    department.
        Senator Levin. By the treasury. So the treasury decided
    within each fund how much and when?
        Mr. McMullen. Yes, sir.
        Senator Levin. That was, therefore, coordinated in one
    person, was it not? Was there one person head of the treasury
    office?
        Mr. McMullen. In terms of determining the value, there
    would be input from many people, sir.
        Senator Levin. But was there one office that made that
    decision?
        Mr. McMullen. Yes, the one team that makes that decision is
    the U.S. Treasury Operations Group.
        Senator Levin. OK, so that one group made decisions for
    both funds.
        Mr. McMullen. Yes. They make the decision from period to
    period.
        Senator Levin. For both funds?
        Mr. McMullen. Yes, sir.
        Senator Levin. Now, was this alternating loan program part
    of HP's repatriation strategy?
        Mr. McMullen. No, sir. The alternating loan is a loan, so
    repatriation is not a loan.
        Senator Levin. OK. Take a look at Exhibit 3c,\1\ would you?
    Under ``Repatriation History,'' do you see that? On page 2, it
    says, ``In addition to the permanently repatriated cash, HP has
    increased it's [sic] alternating loans from offshore cash pools
    by approximately $6 [billion] over the last 3 years.'' Do you
    see that?
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 3c, which appears in the Appendix on page 203.
    ---------------------------------------------------------------------------
        Mr. McMullen. I do.
        Senator Levin. OK. So under the heading ``Repatriation
    History,'' you say in addition to permanently repatriated cash,
    you have increased your alternating loans. And then if you look
    at the next page, under ``Alternating Loans,'' where it says,
    ``We have the ability to move cash from BCC to CCHC in fiscal
    year 10, which would result in increased access over quarter
    end--the amount we move, if any, will depend on the outlook of
    other tax repatriation strategies . . .'' And then it says, ``.
    . . all the repatriation strategies are ultimately funded by
    BCC.''
        But putting that one aside--this was looked at as a tax
    repatriation strategy, at least in the language of that
    document, was it not?
        Mr. McMullen. Senator, I can understand the confusion in
    the language. If I were to create those slides, I would have
    flipped the two bullets on both slides.
        Senator Levin. All right.
        Mr. McMullen. It is very clear in the treasury department
    that the loan is a short-term and alternating loan and that
    repatriation represents something completely different. It is
    also true that----
        Senator Levin. It is kind of lumped together, though, in
    that slide.
        Mr. McMullen. In this slide. That is not the way I would
    have done it, sir.
        Senator Levin. All right. Now, Ms. Carr, if a controlled
    foreign corporation lends its earnings to its parent U.S.
    company that owns it, and it is only interrupted by brief
    periods of repayment, you said there exists in substance, did
    you not, a repatriation of the earnings? Or were you not told
    in an email that if a controlled foreign corporation lends
    earnings to its parent U.S. shareholder interrupted only by
    brief periods of repayment, which include the last day of the
    controlled corporation's taxable year, that there exists in
    substance a repatriation of the earnings, right? Is that
    something that you were informed of? Look at Exhibit 4b.\1\
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 4b, which appears in the Appendix on page 226.
    ---------------------------------------------------------------------------
        Ms. Carr. Thank you.
        [Pause.]
        Ms. Carr. I am sorry, Senator. Can you point to exactly
    what page you are on?
        Senator Levin. Yes. It is Exhibit 4b, and it is page 3 or
    4. These pages are not numbered. The page, the heading of it
    is, ``A few thoughts on why I would argue we are OK.'' Do you
    see that line?
        Ms. Carr. I do. Thank you, Mr. Chairman.
        Senator Levin. And then about three paragraphs down, it
    says, ``The facts and circumstances of each case must be
    reviewed to determine if, in substance''--in substance--``there
    has been a repatriation of the earnings of the controlled
    foreign corporation. If a controlled foreign corporation lends
    earnings to its U.S. shareholder interrupted only by brief
    periods of repayment, which include the last day of the
    controlled foreign corporation's taxable year, there exists, in
    substance, a repatriation of the earnings to the U.S.
    shareholder within the objectives of Section 956.'' Do you see
    that?
        Ms. Carr. I do. Thank you.
        Senator Levin. That was your memo?
        Ms. Carr. That is actually--well, yes, it was my email, Mr.
    Chairman.
        Senator Levin. It is from you.
        Ms. Carr. Yes.
        Senator Levin. Now, if you will take a look at Exhibit
    4a,\2\ this is where you were seeking advice from your national
    office concerning HP's loan program in 2007. You received some
    written guidance concerning the Section 956 issues in an email,
    that is Exhibit 4a, and I want to just read to you from the
    concluding paragraph at the end of the email. So that is going
    to be on page 2. Are you with me?
    ---------------------------------------------------------------------------
        \2\ See Exhibit No. 4a, which appears in the Appendix on page 223.
    ---------------------------------------------------------------------------
        Ms. Carr. I am with you. Thank you.
        Senator Levin. ``Thus, it appears that both courts and the
    IRS may seek to apply substance over form to transactions that
    it views as abusive. However, we do believe that we can get
    comfortable with a `should' level of opinion, assuming''--this
    is the assumption--``that HP avoids behavior that could be
    interpreted as abusive. Documents and/or work papers that
    indicate an intention to circumvent or otherwise abuse the
    spirit of Section 956 could prove particularly troublesome and
    thus should be avoided.''
        Would you agree there are all kinds of documents here which
    say that there is an intent here to circumvent Section 956?
        Ms. Carr. Mr. Chairman, I do not know that I would agree
    with that characterization with respect to the documents.
        Senator Levin. OK.
        Ms. Carr. I certainly can explain this, the correspondence,
    if you would like.
        Senator Levin. All right. Then let me keep going.
    ``Furthermore, there would be no loans between the two CFCs
    themselves.'' Do you see that?
        Ms. Carr. I do.
        Senator Levin. Did you hear Mr. Ezrati say that he had the
    ability to lend to each other? You were sitting right there,
    weren't you?
        Ms. Carr. I was. I heard him say that.
        Senator Levin. Shouldn't that be avoided?
        Ms. Carr. Yes. He did not say it occurred.
        Senator Levin. I know, but he said----
        Ms. Carr. He said it was possible.
        Senator Levin. Right.
        Ms. Carr. He did not say that there could or could not have
    been a U.S. tax consequence if there was a loan made, which I
    think is why he used the term ``commingling.''
        Senator Levin. I see. So, in other words, what you are
    saying is that it is OK to say in these documents that we can
    lend to each other without violating Section 956?
        Ms. Carr. No----
        Senator Levin. That is what the point is here, trying to
    avoid Section 956. So you should not put in your documents that
    you might lend to each other.
        Ms. Carr. Again, I think what this is saying is that there
    should be no loans between the two funds, and, again, forgive
    us for using tax terms, tax people will typically use the word
    ``commingling.'' There should be no commingling by the CFCs of
    their funds. If there is, there is an anti-abuse rule which
    exists within Section 956 which would cause you to trigger a
    U.S. tax.
        Senator Levin. Now, how about cash pooling?
        Ms. Carr. Mr. Chairman, do you mean in the next sentence?
        Senator Levin. Yes. It says, ``There should be no loans
    between the two as that might give the IRS the argument that
    the CFC was merely a conduit for repatriating funds from other
    foreign sources.'' It sure sounds like that to me.
        In the next sentence, ``We should probably give this more
    thought as there has been some cash pooling.'' What was that
    all about?
        Ms. Carr. Again, I think this was a reference to, Mr.
    Chairman, specifically loans or a loan from one individual CFC
    to another CFC. Both of those sentences in my mind, in my
    understanding, and in discussions with the person from national
    tax who wrote this, that is what that was referring to.
        Senator Levin. So there had been some cash pooling.
        Ms. Carr. No. There was no loans from one of the CFCs to
    another CFC.
        Senator Levin. What was there? Cash pooling, what is that?
        Ms. Carr. Again, the use of the term ``cash pooling'' here
    was meant to--I will use a slightly different tax term, a
    commingling of the funds, in other words, a loan from one CFC
    to the other.
        Senator Levin. You just said there could be a loan from
    one----
        Ms. Carr. Legally, you certainly could make a loan----
        Senator Levin. Without violating Section 956?
        Ms. Carr. No, I did not say that.
        Senator Levin. That is what this says.
        Ms. Carr. Again, I do not----
        Senator Levin. You said that they had the ability to do it.
    I assume he means without paying taxes on it, or otherwise it
    would be kind of silly in this context to be saying that. That
    is what we are talking about, is avoiding Section 956. So we
    just heard Mr. Ezrati say we can lend from one to another----
        Mr. Ezrati. I did not say that, Mr. Chairman. I said we
    could lend from one to--I did not say ``and avoid Section
    956.''
        Ms. Carr. Right.
        Senator Levin. Well, what are we talking about here except
    avoiding Section 956? That is what this is all about.
        Mr. Ezrati. And that is why there was no lending----
        Senator Levin. Of course you could lend----
        Mr. Ezrati. There was no loan from one to the other.
        Senator Levin. Of course you could lend from one to
    another. But that would violate Section 956.
        Mr. Ezrati. And that is what I said.
        Senator Levin. No.
        Mr. Ezrati. That is why there was no lending from one to
    the other.
        Senator Levin. OK. We are going to let the record speak for
    itself as to exactly what the context of your comment was.
        Mr. Ezrati. I am just trying to clarify so that you do not
    get the record misstated.
        Senator Levin. The record is going to speak for itself on
    that statement of yours.
        Now, ``We should probably give this more thought as there
    has been some cash pooling.'' And you are saying--``there has
    been some cash pooling.'' And you are saying what, again? Was
    there cash pooling?
        Ms. Carr. No, Mr. Chairman. Again, I think what----
        Senator Levin. Excuse me. Had there been cash pooling?
        Ms. Carr. As I understand the word, there was no----
        Senator Levin. Was there cash pooling?
        Ms. Carr. There was no loan from one CFC to the other, Mr.
    Chairman.
        Senator Levin. And my only question is: As you understand
    the word ``cash pooling''----
        Ms. Carr. Yes.
        Senator Levin [continuing]. Had there been some cash
    pooling?
        Ms. Carr. Again, using--I will substitute it, if you do not
    mind, Mr. Chairman, with the word ``commingling,'' and, again,
    there was no commingling or loans made from one CFC to the
    other.
        Senator Levin. I am just asking you, as you understand the
    term ``cash pooling,'' had there been cash pooling? Is your
    answer no?
        Ms. Carr. My answer is no, I am not aware of loans from one
    of the CFCs to the other.
        Senator Levin. All right. Now, ``There should also not have
    been a loan schedule.'' Had there been a loan schedule
    contemplating a series of loans to be made and retired at
    specific times?
        Ms. Carr. Mr. Chairman, what I believe this is referencing
    is to, there should not be a single master loan agreement where
    the loans are dependent upon one another. And, again, you will
    note the date of this particular email, as you had referenced
    earlier, was 2007. As we have talked about, Section 956 is a
    very mechanical test, and while it is a mechanical test and
    certainly there are specific anti-abuse rules within Section
    956, there is no general anti-abuse rule. But as you will note,
    we always need to consider the policy, and this was actually
    before there was a GLAM that was issued in 2009, and, again, in
    fact, that GLAM referred to the dependency of loans and talked
    about there being potentially a single loan agreement, a
    dependency, and referred to the need for independence, as I
    think you did in the written report that was issued.
        Senator Levin. Now, would you consider Exhibit 3h,\1\ which
    said pool one, January 2 to February 17, that loans would need
    to be made, if made, in that period; second pool, from February
    17 to April 2; first pool, April 2 to May 17; pool two, May 17
    to July 2; pool one, July 2 to August 17; pool two--and so
    forth. Do you consider that a schedule?
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 3h, which appears in the Appendix on page 214.
    ---------------------------------------------------------------------------
        Ms. Carr. I apologize, Mr. Chairman. Did you say Exhibit
    3a? I know it was the exhibit----
        Senator Levin. No. Exhibit 3h. Well, you have seen this
    before today, haven't you?
        Ms. Carr. I did, and you referenced it, and I want to be
    clear----
        Senator Levin. That is OK.
        Ms. Carr. Mr. Chairman, I just want to clarify one point.
    When you said that I have seen this before----
        Senator Levin. No. Today.
        Ms. Carr. I actually had not seen this document before your
    staff had shown it to me.
        Senator Levin. OK. You saw it before today----
        Ms. Carr. When your staff had shown it to me during one of
    the interviews 2 weeks ago, that was the first time I had seen
    the document.
        Senator Levin. OK. Does that look like a schedule to you?
        Ms. Carr. No, again, I think I would characterize this very
    similarly to how Mr. Ezrati characterized it. This is a listing
    of guidelines for when the treasury department can choose to
    borrow on a short-term basis from individual CFCs. I would not
    consider that a master loan agreement, as was referenced in the
    email.
        Senator Levin. I am asking you whether or not you consider
    that a schedule.
        Ms. Carr. I would consider those guidelines, Mr. Chairman.
        Senator Levin. The word says ``schedule.'' Read that to me.
    ``The following schedule.'' Why don't you read it?
        Ms. Carr. I understand what you are saying----
        Senator Levin. No. Did I read it correctly?
        Ms. Carr. You certainly read the words correctly.
        Senator Levin. What did I not read correctly?
        Ms. Carr. Well, I think Mr. Ezrati explained that the
    following where it says the words, ``I think that what this is
    referring to is guidelines,'' and I think Mr. Ezrati clarified
    this. These were guidelines that were provided by the tax
    department to treasury of periods of time when the treasury
    department could choose to loan from individual CFCs.
        Senator Levin. I understand. In order to avoid the
    application of Section 956, these were guidelines. Was it also
    a schedule? That is all I am asking you. Does the word
    ``schedule'' appear right above those dates? Do you see that
    word?
        Ms. Carr. Yes, Mr. Chairman.
        Senator Levin. Did I read it correctly?
        Ms. Carr. I do see the word ``schedule.''
        Senator Levin. Could you read it for us?
        Ms. Carr. I certainly could, but I do see the word
    ``schedule.''
        Senator Levin. Would you read it for us?
        Ms. Carr. It says, ``The following schedule defines the
    `windows' for loans to HP Company.''
        Senator Levin. Thank you. I was not sure we could actually
    get you to read the word that was right there, which is
    ``schedule.''
        OK. Was this schedule ever not followed?
        Ms. Carr. I am sorry, Mr. Chairman?
        Senator Levin. Was it ever violated? Was that schedule, the
    word ``schedule''----
        Ms. Carr. Mr. Chairman----
        Senator Levin. Were those eight dates, dividing a year into
    eight different periods, was that ever violated?
        Ms. Carr. Mr. Chairman, can you clarify the period of time
    which you are talking about?
        Senator Levin. Any time you know of was it violated?
        Ms. Carr. Certainly I think Mr. Ezrati pointed to there
    were different periods of time in which there were no loans
    that were made from any individual----
        Senator Levin. I am asking you, was it ever violated? That
    is my question. Was that schedule ever violated? If there were
    no loans made, it was not violated. I am saying, was there ever
    a loan made during any time you know of that violated that
    schedule?
        Ms. Carr. Well, I apologize. Was there ever a loan made----
        Senator Levin. That you know of.
        Ms. Carr [continuing]. That I know of. I do not recall a
    loan being made that was not in accordance with the guidelines
    that the tax department gave to treasury. I do not recall any.
        Senator Levin. During the last 2 years, 2010 and 2011, did
    I hear you correctly, Mr. Ezrati, there were how many days
    where there was no loan outstanding, did you say?
        Mr. Ezrati. I will have to look at my statement again.
        Mr. McMullen. May I help, Senator?
        Senator Levin. Sure.
        Mr. McMullen. The 90-day period was between the end of
    2010----
        Senator Levin. No, my question is how many days were there
    not loans outstanding during those 2 years.
        Mr. McMullen. During those 2 years?
        Senator Levin. Yes.
        Mr. Ezrati. My statement says 72 days.\1\
    ---------------------------------------------------------------------------
        \1\ Subsequent to the hearing, Hewlett-Packard informed the
    Subcommittee that it researched this matter and now corrects this to
    153 days.
    ---------------------------------------------------------------------------
        Senator Levin. Seventy-two days out of 700 days. Is that
    correct?
        Mr. Ezrati. I think we are including fiscal year 2012,
    which has not ended yet.
        Senator Levin. OK. I thought it was just 2010 and 2011.
        Mr. Ezrati. No. It is 2011 and 2012 year to date.
        Senator Levin. OK. So there would be about, what, 500 days,
    something like that?
        Mr. Ezrati. Something like that.
        Senator Levin. And there was no loan outstanding for about
    70 of those days. Is that right?
        Mr. Ezrati. For 365 days and however many days we have had
    this year.
        Senator Levin. I rounded it off. So in about a year and a
    half or a little more, there were 70 days, approximately, when
    there was no outstanding loan from one of those two funds. Is
    that correct? One of those two pools?
        Mr. Ezrati. Am I getting that right? Seventy-two days is
    what we wrote.
        Mr. McMullen. I just want to be clear on dates, Senator, if
    you do not mind. If you go from the period near the end of
    calendar 2010, and you go all the way to the beginning of
    calendar year 2012, there was a total of 162 days where there
    were not any loan balance outstanding. And it included two
    periods----
        Senator Levin. How many days were there loans outstanding?
        Mr. McMullen. Well, I will do a little math here. That
    would be about 365 days and 2 months, 435 days.
        Senator Levin. OK. So about----
        Mr. McMullen. About 435 days total, right?
        Senator Levin. Yes, so you have about 350 days, roughly,
    there were loans outstanding? Is that what you said?
        Mr. McMullen. Yes, of that----
        Mr. Ezrati. I think we are making a mistake here. You have
    to add the 90 days and the 72 days----
        Senator Levin. Add whatever you want. Give me a period of
    time and tell me how many loans were----
        Mr. Ezrati. [Addressing Mr. McMullen] So the 162 days out
    of how many days, is what Senator Levin wants to know?
        Mr. McMullen. Yes, so 365 days, 10/1/10 to 11/1/11, right?
    And then roughly 2 more months. That would be approximately 435
    days.
        Mr. Ezrati. Approximately 162 days out of 435.\1\
    ---------------------------------------------------------------------------
        \1\ Subsequent to the hearing, Hewlett-Packard informed the
    Subcommittee that it researched this matter and now corrects this to
    169 days.
    ---------------------------------------------------------------------------
        Mr. McMullen. Yes, approximately 162 days out of 435.
        Senator Levin. OK. So it is about--that says it.
        Mr. Ezrati. A little more than a third.
        Senator Levin. And then is it also true, as our staff has
    determined, that from February 19, 2008, to July 2, 2010, which
    is a 30-month period, there was a loan outstanding every day.
    Is that correct?
        Mr. Ezrati. I would have to go back and look at the
    schedules we gave you. I do not quarrel with your staff. They
    are very capable.
        Senator Levin. OK.
        Mr. Ezrati. I will check the material we provided and
    clarify if I need to.
        Senator Levin. Why don't you do that. Anyway, unless you
    correct that, I am going to assume that is a correct statement.
    Is that fair enough?
        Mr. Ezrati. Certainly.\2\
    ---------------------------------------------------------------------------
        \2\ Subsequent to the hearing, Hewlett-Packard informed the
    Subcommittee that it determined that there were 31 days where there was
    no loan balance during the relevant time period. As a result, Hewlett-
    Packard wrote that it does not agree that there was a period of 30
    months with an alternating loan outstanding every day.
    ---------------------------------------------------------------------------
        Senator Levin. Finally, to Ms. Carr, did you and another
    colleague provide consulting and auditing services to HP
    contemporaneously, at the same time? Were you both an auditor
    and a consultant?
        Ms. Carr. We certainly provided tax services to Hewlett-
    Packard. In addition, the firm was the auditor, and I worked on
    the audit of the income tax provision.
        Senator Levin. Did you audit your own work and your own
    recommendations?
        Ms. Carr. No, Mr. Chairman, we did not. And in our role as
    tax advisers, the company would come and ask Ernst & Young for
    advice, as well as other advisers. They would then make
    accounting judgments with respect to how to account on their
    financial statements with any transactions or operations that
    they might enter into. In addition, we would then audit the
    accounting for any operations or transactions that the company
    might have chosen to enter into.
        In addition, as you may be aware, there are certain
    standards and guidelines that the PCAOB has issued with respect
    to whether or not you are considered to audit your own work.
        All of the services that we have provided have been
    approved by Hewlett-Packard's audit committee. In addition to
    that, we did not provide any proscribed services.
        Senator Levin. All right. So you never audited your own tax
    advice and the implementation of that advice in HP's
    operations?
        Ms. Carr. We never audited our own work within the
    guidelines of the PCAOB. That is correct.
        Senator Levin. When did the PCAOB come into existence?
        Ms. Carr. I know it is Rule 3522.\1\ I do not know when
    that came in.
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 6, October 18, 2012 correspondence clarifying
    Ms. Carr's testimony appears in the Appendix on page 240.
    ---------------------------------------------------------------------------
        Senator Levin. Was that rule in existence during the entire
    time you were acting as auditor?
        Ms. Carr. I do not believe that the PCAOB guidelines
    existed for the entire time in which Ernst & Young audited
    Hewlett-Packard.
        Senator Levin. How about you personally?
        Ms. Carr. I had been involved in the account before that
    standard, but we would always follow similar guidelines.
        Senator Levin. So the answer to the question is, even
    before the PCAOB guideline, you never audited work where you
    had made recommendations or consulted with HP. Is that fair?
        Ms. Carr. Yes. If you will forgive me, Mr. Chairman, I
    might say it slightly differently. We were always in compliance
    with the PCAOB guidelines under Rule 3522 with respect to the
    services that we always provided to the company since I have
    been involved with the account.
        Senator Levin. Even before the guidelines were in
    existence.
        Ms. Carr. Correct.
        Senator Levin. OK. Thank you. Dr. Coburn.
        Senator Coburn. I will submit my questions for the record.
        Senator Levin. Thank you. We appreciate your appearance
    here today and the cooperation of both your firms with this
    investigation.
        Ms. Carr. Thank you, Mr. Chairman.
        Mr. Ezrati. Thank you, Mr. Chairman.
        Senator Levin. The final panel is William J. Wilkins, Chief
    Counsel of the Internal Revenue Service. He is accompanied by
    Michael Danilack, Deputy Commissioner (International) of the
    Large Business and International Division of the IRS; and Susan
    Cosper, Technical Director for the Financial Accounting
    Standards Board.
        We thank you for your appearance and for your patience, and
    we would ask you to stand and raise your right hands, if you
    would.
        Do you swear that you will tell the truth, the whole truth,
    and nothing but the truth, so help you, God?
        Mr. Wilkins. I do.
        Mr. Danilack. I do.
        Ms. Cosper. I do.
        Senator Levin. Were you here when I described the timing
    system.
        Ms. Cosper. Yes.
        Senator Levin. So you know there is a 7-minute time limit,
    and we ask you to keep within that limit. Even though I
    violated it all afternoon, that is no excuse for you to violate
    it.
        And that was said in a light-hearted manner, by the way,
    for the record, since it does not always get my jokes.
        Then a minute before the red light will go on, you will be
    given a yellow light.
        Mr. Wilkins, why don't we have you go first and then Mr.
    Danilack and then Ms. Cosper.

        TESTIMONY OF HON. WILLIAM J. WILKINS,\1\ CHIEF COUNSEL,
      INTERNAL REVENUE SERVICE, ACCOMPANIED BY MICHAEL DANILACK,
        DEPUTY COMMISSIONER (INTERNATIONAL), LARGE BUSINESS AND
            INTERNATIONAL DIVISION, INTERNAL REVENUE SERVICE

        Mr. Wilkins. Chairman Levin and Ranking Member Coburn,
    thank you for this opportunity to testify on the issue of
    offshore profit shifting. Accompanying me today, as you
    mentioned, is Michael Danilack, who serves as Deputy
    Commissioner (International) of IRS's Large Business and
    International Division. In this capacity, he leads our
    international tax enforcement efforts with respect to large
    business taxpayers who operate in a global environment.
    ---------------------------------------------------------------------------
        \1\ The prepared statement of Mr. Wilkins appears in the Appendix
    on page 147.
    ---------------------------------------------------------------------------
        Today I would like to present the Subcommittee with a broad
    overview of our changing approach to international tax issues,
    especially in the area of transfer pricing. Mr. Danilack will
    then provide a description of the specific challenges the IRS
    faces in dealing with profit-shifting cases.
        Because transfer pricing among related entities is
    important for tax purposes on virtually every cross-border
    transaction within a controlled group, the IRS had to devote
    substantial enforcement resources in this area. Moreover,
    because transfer pricing is not an exact science, companies
    themselves are often left with uncertainty about whether or not
    their transfer pricing positions will survive IRS scrutiny.
        In fact, transfer pricing issues are among the most
    frequently disclosed issues for companies filing the IRS
    Schedule UTP on which large companies report issues giving rise
    to financial reserves. Where aggressive income shifting through
    transfer pricing is involved, the IRS has taken a focused
    enforcement approach.
        As cross-border business restructurings involving shifts of
    intangible property rights became more commonplace in the early
    2000s, the IRS responded by forming teams of experts known as
    issue management teams (IMTs). These teams were comprised of
    IRS transfer pricing specialists and chief counsel attorneys.
    They were led by IRS executives, and they centrally managed the
    inventory of examinations involving transactions in their
    respective areas. The teams ensured that IRS resources were
    appropriately dedicated to these examinations, that best
    practices and processes were shared, and that the IRS position
    on the underlying issues was applied uniformly to cases under
    similar facts and circumstances.
        In addition, in recent years the Treasury Department has
    worked with the IRS to adopt revised regulations in this area.
    In 2008, a new set of Section 482 regulations pertaining to
    cost-sharing transactions were issued. These temporary
    regulations were effective on January 5, 2009, and were
    finalized in 2011. They clarify a number of issues that had
    been contentious under the previous set of cost-sharing
    regulations and better define the scope of intangible property
    contributions that are subject to taxation in connection with
    cross-border business restructurings. While to date the IRS has
    had limited experience in auditing transactions covered by the
    new regulations, early anecdotal information indicates that the
    regulations have had a positive impact on taxpayers' reporting
    positions in that area.
        As an important complement to the cost-sharing regulations,
    in 2009 the Treasury Department and the Office of Chief Counsel
    also finalized regulations covering service transactions,
    including services performed using high-value intangibles.
        Beyond these regulatory efforts, the IRS has continued to
    marshal, coordinate, and augment its resources dedicated to
    transfer pricing enforcement. In 2011, a IRS new executive
    position was created to oversee all transfer pricing functions,
    to set overall strategy in the area, and to coordinate work on
    our most important cases. In building a new function devoted
    exclusively to tackling our transfer pricing challenges, within
    the past year we have been able to recruit dozens of transfer
    pricing experts and economists with substantial private sector
    experience who are now working hard to help us stay on the
    cutting edge of enforcement and issue resolution. This new
    transfer pricing operation will operate as a single, integrated
    team with a global focus, a unified strategy, and a robust
    knowledge base. With this new function focusing on all
    strategic transfer pricing matters, we were able to disband the
    more discrete, ad hoc issue management teams that I mentioned
    earlier.
        So we now have a single, fully integrated transfer pricing
    program overseen by Mr. Danilack and his direct reports. So let
    me now turn to Mr. Danilack to address the specific
    administrative challenges associated with the income-shifting
    phenomenon.
        Mr. Danilack. Chairman Levin, Ranking Member Coburn, and
    Members of this Subcommittee, I add my thanks to that of Mr.
    Wilkins' for the opportunity to testify on tax compliance
    issues related to shifting of profits offshore by U.S.
    multinational corporations. As has already been mentioned, my
    name is Michael Danilack, and I am the Deputy Commissioner at
    IRS in the Large Business and International Division. There I
    serve as the U.S. competent authority under our bilateral tax
    conventions, and I have responsibility for international tax
    enforcement with respect to large business taxpayers.
        The subject of today's hearing, the shifting of profits
    offshore by U.S. companies, is multifaceted, somewhat complex,
    and as we have heard already today, can raise tax
    administration, tax accounting, and tax policy considerations.
    Given my role at the IRS, however, I will limit my comments to
    the tax administration challenges raised in the area.
        The IRS enforcement power in this area arises from Section
    482 of the Internal Revenue Code under which the IRS is charged
    with ensuring that taxpayers report results of transactions
    between related parties as if those transactions had occurred
    at arm's length. So, for example, when a U.S. corporation
    licenses the use of an asset to an offshore affiliate, the
    corporation is required to report a royalty for tax purposes
    based on a royalty rate that would be expected if the
    transaction had occurred between the corporation and an
    unrelated party.
        Under the Section 482 regulations, as well as under
    multinational transfer pricing guidelines, the determination of
    whether the pricing of a transaction reflects an arm's-length
    result is generally evaluated under the so-called comparability
    standard, and under this standard, the results of the
    transaction as reported by the taxpayer are compared to results
    that would be obtained by unrelated taxpayers in comparable
    transactions under comparable circumstances.
        Now, establishing an appropriate arm's-length price by
    reference to comparable transactions is relatively
    straightforward for the vast majority of cross-border
    transactions that involve transfers of common goods or services
    where there are third-party transactions to compare to. But
    enforcing the arm's-length standard becomes much more difficult
    in situations in which the U.S. company shifts to an offshore
    affiliate the rights to intangible property that are at the
    very heart of its business, what we might refer to as the
    company's ``core intangibles.'' In fact, over the past decade,
    applying Section 482 in these types of cases has been the IRS's
    most significant international enforcement challenge.
        When the rights of a business' core intangibles are shifted
    offshore, enforcement of the arm's-length standard is
    challenging for two basic reasons. First, transfers of a
    company's core intangibles outside of a corporate group rarely
    occur in the market. So comparable transactions are difficult,
    if not impossible to find. So the IRS has had to resort to
    other valuation methods which are often referred to as
    ``income-based methods,'' and these are fairly common valuation
    methods.
        Under these types of methods, the IRS typically has to
    conduct an ex ante discounted cash flow analysis. Now, this
    means that we are required to evaluate the projections of the
    anticipated cash flows the taxpayer used in setting its
    intercompany price. Then we must further evaluate how the
    taxpayer discounted those projected cash flows, depending upon
    the risk that is associated with earning those cash flows.
        This is where our economists and other valuation experts
    will come in to assist us, and as you might imagine, evaluating
    the underlying assumptions made by the taxpayer with respect to
    its future cash flows without the benefit of any hindsight
    under the ex ante approach is not an exact science, and it can
    be a difficult exercise.
        The second but related reason that this area is
    particularly challenging for us is because when you are talking
    about the business' core intangible property rights, by their
    very nature these assets are so-called risky assets, if you
    will. So projecting cash flows from these types of 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. And these obviously can be very
    difficult assessments to make, at least in some cases.
        So this is my brief summary of our challenges in evaluating
    the so-called profit shift. Now let me turn briefly to other
    parts of the overall equation because, as most international
    tax specialists know, outbound international tax planning
    involves not only locating profits in low-tax jurisdictions but
    also managing exposures to the anti-deferral provisions,
    managing foreign tax credits and earnings and profit pools, and
    in what might be thought of as the final step in the overall
    equation, determining whether the offshore cash can be invested
    in the United States with minimal U.S. tax consequences. This
    last step, of course, we have been referring to as
    ``repatriation.''
        Each of these other three areas beyond the income shift
    comes replete with its own complexities and its own challenges
    from an international enforcement perspective. That said, I can
    assure you that the IRS is well aware of the underlying stakes
    in each of these areas and has been vigilant and forceful in
    addressing compliance issues we have seen.
        Now, focusing on the repatriation, because this has been
    raised at today's hearing, within the past 6 years I will note
    that Treasury and the IRS have issued several anti-abuse
    notices, one as recently as July of this year, making clear
    that a variety of transaction types give rise to inappropriate
    repatriation results. In several of these cases, Treasury and
    the IRS have already followed up with regulatory changes
    necessary to make clear what the appropriate results should be.
        In general, these transactions were designed to take
    advantage of mechanical rules pertaining to determinations of
    either tax basis or earnings and profits, mechanical rules that
    can be found scattered throughout the code and regulations. In
    other words, the rules that are used to accomplish low- or no-
    tax repatriation results often are not written as anti-
    repatriation rules; rather, the transactions in which the rules
    have been used may not look at all like repatriation
    transactions at first blush, so they can be difficult to find.
    But we are finding them, and when we have, we have acted pretty
    quickly.
        Further, we well know the importance of augmenting this
    focus, and, in fact, just about 3 months ago, we assembled a
    network of experts that will be devoted entirely to developing
    repatriation training for all of our international examiners
    and otherwise spreading the word that these types of
    transactions must be carefully evaluated.
        Mr. Chairman, thank you again for this opportunity to
    testify regarding the IRS's efforts to enforce our laws as they
    relate to the subject of today's hearing. While we know that
    enforcing our international tax law certainly will present for
    us significant challenges in the future, we believe the agency
    has made great strides in recent years and will continue to do
    so.
        Mr. Wilkins and I, of course, would be happy to answer any
    questions you may have at this time.
        Senator Levin. Thank you very much. Ms. Cosper.

    TESTIMONY OF SUSAN M. COSPER,\1\ TECHNICAL DIRECTOR, FINANCIAL
            ACCOUNTING STANDARDS BOARD, NORWALK, CONNECTICUT

        Ms. Cosper. Chairman Levin and Ranking Minority Member
    Coburn, my name is Susan Cosper, and I am the Technical
    Director of the Financial Accounting Standards Board (FASB). I
    oversee the staff work associated with the projects on the
    board's technical agenda. I would like to thank you for this
    opportunity to participate in today's important hearing.
    ---------------------------------------------------------------------------
        \1\ The prepared statement of Ms. Cosper appears in the Appendix on
    page 150.
    ---------------------------------------------------------------------------
        I have been invited to appear before this Subcommittee to
    explain U.S. Generally Accepted Accounting Principles for
    deferred U.S. income taxes attributable to the unremitted
    earnings of a foreign subsidiary. I will do my best to do so,
    but first I would like to give you a brief overview of the FASB
    and the manner in which accounting standards are developed.
        The FASB is an independent, private sector organization
    which operates under the oversight of the Financial Accounting
    Foundation and the Securities and Exchange Commission. Since
    1973, the FASB has established standards of financial
    accounting and reporting for public and private entities and
    for not-for-profit organizations. Those standards are
    recognized as authoritative Generally Accepted Accounting
    Principles (GAAP) by the SEC for public companies and by the
    American Institute of Certified Public Accountants for other
    nongovernmental entities.
        An independent standard-setting process is the best means
    of ensuring high-quality accounting standards since it relies
    on the collective judgment and input of all interested parties
    through a thorough, open, and deliberative process. The FASB
    sets accounting standards through processes that are open,
    afford due process to all interested parties, and allow for
    extensive input from all stakeholders.
        Before I explain the standard, I would like to make two
    basic points. First, it is important to note that while FASB
    sets the accounting standards, it is a company's responsibility
    to apply U.S. GAAP to its financial statements; it is the
    auditor's responsibility to audit those financial statements;
    and it is the Public Company Accounting Oversight Board's
    responsibility to ensure that auditors of public companies have
    performed an audit in accordance with auditing standards. The
    SEC has the ultimate authority to analyze whether public
    companies have complied with accounting standards.
        Second, accounting standards are not intended to drive
    behavior in a particular way; rather, they seek to present
    financial information so that financial statement users can
    make informed decisions about how best to deploy their capital.
    The role of accounting standards is to reflect in the financial
    statement when taxes will be paid. It is not to determine when
    those taxes should be paid. That is set by tax law.
        Now I would like to turn to an explanation of the
    accounting standard. As I just said, one of the primary
    objectives of accounting for income taxes under U.S. GAAP is to
    reflect the amount of income taxes associated with income
    generated in that reporting period. In the case of the earnings
    of a foreign subsidiary of a U.S. company, under existing tax
    law the U.S. company will not pay tax until those earnings are
    repatriated. However, under the accounting standard, when the
    financial statements for that U.S. company recognize in the
    current year a liability for a tax payment that will be made in
    a future year, this is referred to in the financial statements
    as a deferred tax liability.
        Under the accounting standards, it is presumed that foreign
    earnings will be repatriated and that taxes will be accounted
    for and reflected in the financial statements in the same
    period in which they are generated. The presumption may be
    overcome if the U.S. company has sufficient evidence that the
    earnings from the foreign subsidiary are or will be
    indefinitely invested in the foreign jurisdiction or the
    earnings will be remitted in a tax-free liquidation.
        Of course, even though a U.S. company may be required to
    recognize in its financial statements deferred U.S. income
    taxes in a particular period for the unremitted earnings of a
    foreign subsidiary, such taxes are not payable to the United
    States under existing tax law unless the company actually
    repatriates the earnings to the United States. In other words,
    the recognition of deferred U.S. income taxes in financial
    statements does not mean U.S. tax law requires the company to
    actually pay the income taxes in that period.
        Finally, I want to note that in those cases where a company
    has evidence of a plan to indefinitely reinvest the earnings in
    that foreign jurisdiction, U.S. GAAP still requires disclosures
    in the financial statements. These disclosures include the
    amount of U.S. tax that would have been paid related to the
    unremitted earnings of that subsidiary.
        We have found from our extensive stakeholder outreach that
    users of financial statements believe that the existing
    recognition guidance along with the disclosures and the notes
    to the financial statements provide them with transparent,
    decision-useful information. Thank you.
        Senator Levin. Thank you very much, Ms. Cosper.
        First, let us talk about transfer pricing. We have had a
    good bit of testimony on that today. Mr. Shay, in our first
    panel, pointed out that about 1,900 of Microsoft's 90,000
    employees work in Microsoft's subsidiaries in the low-tax
    jurisdictions of Ireland, Singapore, and Puerto Rico. That is
    about 2 percent of their employees. About 55 percent of
    Microsoft's total earnings are attributed to those entities. He
    said that ``these results are not consistent with a common-
    sense understanding of where the locus of Microsoft's economic
    activity, carried out by its 90,000 employees, is occurring.
    The tax motivation of the income location is evident.''
        Now, when you look at transfer pricing, where does common
    sense come in? Where does that kind of a factual situation come
    into play when you look at these situations?
        Are those facts relevant to you when you look at Microsoft,
    for instance, without singling them out? In that kind of a
    situation, are those relevant facts to you?
        Mr. Danilack. Mr. Chairman, I should preface by making
    clear that I think neither Mr. Wilkins nor myself will be able
    to answer questions that pertain to Microsoft or pose with
    reference to Microsoft or with respect to any other taxpayers,
    for that matter.
        Senator Levin. Let me rephrase the question. Let us assume
    you have a company where you have 100,000 employees that are
    working here in the United States, and you have 2 percent of
    their employees in three particular tax havens which have 50
    percent of the total earnings of the company. I have changed
    the facts a little bit so it is not directly asking about
    Microsoft.
        Are those kind of facts relevant to you?
        Mr. Danilack. Frankly, when you pose the question as
    relevant to me, I assume you mean as relevant to an
    international examiner who may be looking at a particular case
    because this is what I could speak to here today.
        Senator Levin. Right.
        Mr. Danilack. If you are posing it as a policy-like
    question, whether I am----
        Senator Levin. Try it both ways.
        Mr. Danilack. Whether I am personally offended or whether
    it is a significant policy----
        Senator Levin. No. I am not interested in whether you are
    personally offended.
        Mr. Danilack. OK.
        Senator Levin. I am interested in whether I am personally
    offended, which I am, but I am not asking you that.
        Mr. Danilack. OK.
        Senator Levin. I am asking you, is it relevant to the
    examiner? And split it up. Is it relevant as a policy question,
    those kind of facts?
        Mr. Danilack. OK. I can answer the first one but not the
    second because, as a tax administrator, which is my role, I do
    not opine on policy. Mr. Wilkins and myself would need to have
    with us someone from the Treasury Department to opine on tax
    policy matters.
        But with respect to what an examiner might look at,
    examiners are trained to look at the law.
        Senator Levin. Are those kind of facts relevant to an
    examiner? That is a pretty straightforward question.
        Mr. Danilack. Yes, and I would say no.
        Senator Levin. OK. Why?
        Mr. Danilack. Because there is nothing in the law that
    requires that one look at the number of employees and the total
    profit as compared to the distribution of the employees.
        Senator Levin. And that does not get to the question as to
    whether or not the agreement on transfer was an arm's-length
    agreement?
        Mr. Danilack. The exercise on determining whether the
    agreement is at arm's length depends on the value of the
    property being exchanged, whether the price that was set in an
    arm's-length price. And it is very much focused on the assets
    in question, what those assets are, and what their value is.
    And as I indicated in my oral statement, these are very
    difficult questions.
        The broader context, how one feels about the company's
    position overall, does not come into play.
        Senator Levin. Let me ask you a slightly different
    question. Take a look at Exhibit 1e.\1\ Never mind. I do not
    even want you to look at exhibits because they are too specific
    to Microsoft.
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 1e, which appears in the Appendix on page 190.
    ---------------------------------------------------------------------------
        Mr. Danilack. Yes, I think that is right.
        Senator Levin. So let us forget that. Now you have a
    company that has no employees in a wholly owned subsidiary of
    that company. It transfers intellectual property rights,
    including the right to receive royalties, to that wholly owned
    subsidiary. And let us assume that it is paid--of course, it is
    all its own funds, but put that aside. It is paid, let us
    assume, $2 billion for those rights. That is the amount of
    money which is coming back to the United States. And the
    offshore company is receiving $10 billion in royalties.
        Are those facts relevant to whether or not there was an
    arm's-length agreement which led to a transfer agreement which
    resulted in the $2 billion payment?
        Mr. Danilack. All right. The facts that would be relevant
    are the numerical facts that you laid out. I cannot recite them
    for you, but the flows of profit and whether the flows are
    commensurate with respect to the entity receiving that profit,
    whether it can support that profitability based on what
    functions it may perform, what assets it may own from a tax
    perspective, and what risks it is bearing in taking on the
    ownership of that asset.
        Senator Levin. How many of these transfer pricing matters
    has the IRS litigated over the last 10 years?
        Mr. Danilack. I could not provide you with that number
    today, but we would be happy to provide it to you afterwards.
        Senator Levin. Would Mr. Wilkins have an idea?
        Mr. Wilkins. You mentioned two cases that were recently
    litigated, so there are at least those two in terms of cases
    that have gone all the way through trial.
        Senator Levin. I mentioned two?
        Mr. Wilkins. Yes, the Veritas and Zylings cases are the
    ones I am thinking of.
        Senator Levin. Are there more than a handful in the last
    few years that have gone to trial on transfer pricing issues?
        Mr. Wilkins. Not to trial.
        Senator Levin. A lot of them have been settled?
        Mr. Wilkins. Yes.
        Senator Levin. Hundreds?
        Mr. Wilkins. I do not have that information.
        Senator Levin. Did you hear the discussion here about the
    short-term loans that HP got involved in?
        Mr. Wilkins. Yes, sir.
        Senator Levin. Let me read to you your criteria. Relative
    to offshore CFC loans that are supposed to ensure that they do
    not circumvent the law, these are some of the standards. If
    loans are provided by different CFCs, were they independent of
    each other?
        Now, would you consider putting aside the precise facts,
    would you consider two CFCs which are part of the same company,
    wholly owned, directed by the same desk, as to when loans would
    be made or could not be made, and were to be directed as to
    when those loans would have to be repaid, would you consider
    those two entities to be independent of each other?
        Mr. Danilack. Senator, when we would address a question
    like that, we would look at it very closely and take into
    account all of the facts and circumstances that surround the
    overall arrangement. I cannot answer a broad question.
        Senator Levin. Would the facts I gave you be relevant, that
    you have one desk that controls the loans of both those
    entities, that the schedule is created by a single desk in the
    parent corporation that owns the two CFCs; they schedule when
    those loans can be made and cannot be made; that they are
    scheduled in a way so that there is always the possibility of a
    loan coming back to the American parent? Are those relevant
    facts so far?
        Mr. Danilack. Yes, sir.
        Senator Levin. OK. My time is up. Thank you. Dr. Coburn.
        Senator Coburn. Mr. Wilkins, you mentioned a moment ago
    that you had noted anecdotal evidence since the changes of
    2009. Could you give us some examples of that in terms of
    improvement?
        Mr. Wilkins. I do not have specific examples, but, I think,
    there were the cost-sharing regulations update was based on
    some experience in the field where some things had been
    unclear, for example, on the employee compensation set of
    issues. And I think the revised regulations removed some
    abilities of taxpayers to make arguments that we did not agree
    with under the prior set of regulations. So that is an example.
        Senator Coburn. So anecdotally you are seeing some change
    in compliance back to the directions that you put out in terms
    of your directives.
        Mr. Wilkins. That is correct.
        Senator Coburn. Mr. Danilack, I want to go back where the
    Chairman went. Just walk me through simply what are the factors
    that you direct those under you to consider in making an
    assessment of an arm's-length transaction? I am not talking
    about any case. I am just saying what is it that is taught for
    those that are actually doing this work, what are the factors
    they are supposed to consider in terms of what is an arm's-
    length transaction?
        Mr. Danilack. Yes. I will try to take that at a relatively
    high level because the potential factors that could come into
    play in making this determination are a very large population
    of factors that I could start to reel off.
        Senator Coburn. Well, go by category, then.
        Mr. Danilack. We would start with what is called for in
    transfer pricing generally, which is the basic paradigm that
    profits are driven off of functions performed by the entity
    earning the profit, driven off of possibly the assets that
    entity is able to employ in its business, and the risks that
    the entity may be able to or has borne in the overall business
    enterprise.
        So it becomes rather quickly an economic type of an
    analysis, and it is really hard to even go one level deeper
    than what I have just said without knowing, well, what industry
    are you talking about. Is this a high-tech industry where
    copyright rights might be a real important part of the drivers
    in terms of profitability? Or is it a very labor-intensive type
    of an industry where you will look at where key employees are
    working from a functional perspective.
        I think coming back to the subject of the hearing today,
    the profit shift I think has been acknowledged by virtually
    everyone who has spoken. The profit shift that we are
    struggling with administratively is usually associated with
    intellectual property rights--or intangible property rights,
    better stated. And when you are dealing with these types of
    very high value, center to the business type intangible
    properties, you are attempting to value this asset, but in the
    equation is the riskiness of supporting that asset going
    forward. Which entity is really bearing the risk associated
    with the asset? And we have heard different statements from
    different folks about the risk factor. The risk factor is
    something that really is very difficult to deal with because
    one might conceive of just simply assuming a risk through a
    contractual arrangement. One might then bring in, well, where
    does the money come from that allows you to bear the risk. And
    then the other factor that we take into account in risk bearing
    is where are the decisionmakers. Who is making the decisions to
    further develop that particular intangible property and deploy
    it? So these are all factors that come into play.
        Mr. Wilkins. It may be helpful, as a legal background--
    valuation in the tax world is--for example, for a sale of
    property, it is the price at which a willing buyer would pay a
    willing seller, neither one being constrained. You know, that
    familiar mantra. And in this area, it is just playing out that
    concept in a very sophisticated setting. If it is a property
    sale, what would a willing buyer pay a willing seller? If it is
    a contract, what would two independent parties----
        Senator Coburn. So that brings up the question, if there is
    no market for this particular intangible, how do you have a
    market price?
        Mr. Danilack. Yes, and this is where we bring in other
    valuation methods, which we loosely describe as income-based
    analysis, where you look at projected cash flows on that asset.
    And then, of course, you need to discount the cash flow that
    you expect to present value, but the discount factors are
    dependent on the riskiness of the asset.
        Senator Coburn. I know you cannot comment on tax policy,
    but maybe you can comment on this. Senator Levin has a pure
    goal here, and the goal is to have a tax policy that is
    transparent, that is reproducible, that is fair, that does not
    allow people to avoid taxes that should not be avoiding taxes,
    and at the same time wants us to be competitive
    internationally. So what is it that we might be able to do that
    would give you greater tools to accomplish Senator Levin's
    goal?
        Mr. Wilkins. Senator, if I might try and respond, from the
    point of view of the tax administrator and without getting too
    much into tax policy, I could say that a couple of things would
    be helpful. One is stable and predictable funding for the
    organization. I know you are working on appropriations for the
    coming fiscal year. Having a full year appropriation ahead of
    the start of the fiscal year is tremendously helpful. Having
    steady levels of funding would be very helpful. And having
    stability in the tax law from our point of view as a tax
    administrator, not having to respond to sort of herky-jerky
    changes in the statutory basis for what we do would be helpful.
        Senator Coburn. What other tools? Nothing? There is nothing
    that Senator Levin and I could reach across the aisle together
    and change that would, in fact, make it easier for you to
    either make an evaluation on one of these or determine whether
    or not transfer pricing was--whether or not there is an arm's
    length--there is not anything that we can do that you can
    comment on?
        Mr. Danilack. There may well be something you can do, and I
    was encouraged to hear some of the discussion that took place
    earlier today about working together to look for ways in which
    this particular area can be more easily addressed, because as I
    have described several times now, it is a difficult area, and
    it makes for controversy and it makes for disagreement. And it
    is hard to say to predict that there may be a bright-line-type
    rule that could resolve issues like this, but if folks sat down
    and worked on it, I would have some confidence that some
    solutions might be found, and we would be happy to work with
    it. But it is not anything that I could--I mean, if there were
    a handy ``if only you would do that,'' we certainly would have
    identified it already.
        Senator Coburn. Yes, you would have. I understand. Well,
    what I would request is if you have those ideas, that you
    forward them to the Chairman and myself, because we are going
    to go into tax reform, and these are legitimate areas of
    concern. There may not be any evasion here. There may be just
    smart avoidance based on the loophole. But I think Senator
    Levin is on to some areas that we need to clean up.
        Ms. Cosper, I wanted to ask you, APB 23 was written 50
    years ago, modified slightly in 1972, and I think in your
    testimony you kind of said that the people that use your
    standards, when they look at financial statements, think that
    they are clear enough. Is that your testimony?
        Ms. Cosper. That is right.
        Senator Coburn. So when we have $1.7 trillion parked
    overseas, is it your organization's intent that these are clear
    enough in terms of the accounting standards, FASB standards,
    that no changes, no new look needs to be done in terms of APB
    23?
        Ms. Cosper. The FASB always strives to improve their
    accounting standards----
        Senator Coburn. No, but that is not what I asked you. What
    I am asking you is: Is it your testimony that, in fact, nothing
    needs to be changed with this APB 23?
        Ms. Cosper. When we had the short-term convergence project
    in 2004 with the International Accounting Standards Board, we
    looked at this area quite extensively. We evaluated the costs.
    We had extensive outreach with users. Users actually told us to
    record a deferred tax liability when a company has absolutely
    no intention to actually pay the tax was more misleading; and
    to provide adequate disclosures that gave them the information
    that they needed.
        Senator Coburn. OK. If FASB knows that some auditing firm
    is abusing these standards or stretching it through their
    recommendations on tax policies, what is your action?
        Ms. Cosper. We do not really have visibility to how the
    PCAOB regulates the audit firms or whether the PCAOB has
    identified a problem with a particular auditing firm on how
    they have, justified a way a company has applied the accounting
    guidance.
        Senator Coburn. One last question on APB 23. When you
    issued the guidance in 1972--and I am going to assume you were
    not there--according to the history that we have looked at, it
    was quite controversial. Why was that?
        Ms. Cosper. I think it was controversial--the original
    guidance was in ARB 51, and that guidance was pretty vague. And
    so in 1972, that is when the actual accounting standard came
    into play. It was revisited again when we readdressed income
    taxes as a whole within FAS 96. In the exposure draft for that
    particular standard, we actually thought about changing it. But
    we had to do, again, extensive research at that time.
        The complexities of trying to estimate what that deferred
    tax liability is, if you think about all of the complexities
    that have been discussed today about all the different
    transactions and how to apply the Tax Code and then to think
    about how far out in the future you have to actually estimate
    when that would be, what the foreign tax credits are, and then
    to apply it back, lends itself to be pretty complex.
        Senator Coburn. So what would happen----
        Ms. Cosper. So the number could actually be quite small
    after it has been discounted back, if somebody might be so far
    out.
        Senator Coburn. So what would happen if this country went
    to a true territorial tax system and reformed the corporate
    code and broadened the base and lowered the rate and had a true
    territorial tax system? What would happen to APB 23? It would
    not be applied, would it?
        Ms. Cosper. Well, I think the accounting for income taxes--
    and APB 23 is codified in ASC 740.
        Senator Coburn. Yes.
        Ms. Cosper. But the accounting for income taxes is a
    principles-based standard. So, for example, if the Tax Code
    says that you have to pay tax, you have to recognize it in the
    financial statements.
        Senator Coburn. Right.
        Ms. Cosper. So you would not be necessarily----
        Senator Coburn. So, if we had a territorial system and X
    company has a company located, whether it is in Bermuda or
    wherever it is, and they put all their assets over there, and
    we allow them to do that, if we did that, and they pay whatever
    tax was in that area, they could move that capital wherever
    they wanted, correct?
        Ms. Cosper. So let me make sure----
        Senator Coburn. In other words, you would not put a
    statement in the financial statement that there was a tax due
    because the tax would have been paid, and since we have a
    territorial tax system, there would not be any deferred tax
    liability on money coming back to the country.
        Ms. Cosper. So what you are saying is that it would not
    have to be distributed back.
        Senator Coburn. They could move it wherever they want.
        Ms. Cosper. That would be right.
        Senator Coburn. And so there would be no disclosure because
    there would be no deferred tax liability.
        Ms. Cosper. For that particular item, yes.
        Senator Coburn. That is right. Thank you, Mr. Chairman.
        Senator Levin. Thank you.
        One of our expert panelists today said that many of the
    rules regarding the transfer pricing and deferral can be
    corrected and improved by regulation. One of the questions is
    whether or not the check-the-box approach has effectively
    gutted Subpart F. You are not in a position to tell us what the
    policy is of the Treasury Department, I gather, Mr. Wilkins. Is
    that correct?
        Mr. Wilkins. That is right.
        Senator Levin. But from an enforcement standard, I guess I
    will ask you then, Mr. Danilack, would that make your life
    easier from an enforcement point of view if we eliminated check
    the box?
        Mr. Danilack. I think the best way I could answer the
    question is that if check the box were eliminated, there would
    be more taxation under Subpart F. I think that is
    straightforward. I do not know that it would make our lives
    more simple. By asking it that way, it presumes that we measure
    the simplicity of our lives by how much tax is collected, which
    is not the case. We measure it based on how challenging the job
    is. I am not sure that eliminating check the box would make our
    lives simpler. I think it would result in additional Subpart F
    taxation, which I think is why you are asking the question.
        Senator Levin. There would not be less complexity in tax
    enforcement if there were no----
        Mr. Danilack. Well, it is pretty straightforward when you
    have a check-the-box entity paying a royalty that is
    disregarded. There is nothing to look at.
        Senator Levin. All right. Section 956, as you heard--and I
    have already asked you about the staggered loan issue. And I
    have to tell you, this form over substance issue which is so
    important in implementing tax law really goes to the heart of
    that matter. If any company can get away with having an
    effective repatriation of money overseas--without paying taxes,
    in other words--it is effective repatriation. In effect, they
    get the use of the money through a loan program where the loan
    program is designed, implemented, it is controlled, it is
    coordinated by the parent company.
        But because there are two pools instead of one, even though
    those pools are coordinated in terms of when the loans have to
    be made, if they are made, when they have to be repaid, if that
    form--because there are two pools, one direction, one
    coordination, one supervision, one decision, one schedule, but
    because it is two pools instead of one, and if that is able
    then to allow an exclusion under Section 956, the IRS is
    honoring form over substance to a degree that is beyond
    anything I think that I have ever seen. I thought this was an
    incredibly clear case, by the way. Even in their own documents
    I thought it was a clear case. I am not asking you to judge the
    case.
        But I am asking you to go back and look at your own
    guidelines, rules, whatever they are, in this area where you
    got money that is supposed to be overseas that is being lent
    here and that if it were lent by one company would clearly be a
    dividend and would be taxable. But because it is two companies,
    although they are coordinated, directed, guided, instructed and
    so forth by one office in the parent company, is able to say
    that they complied with your exclusion from Section 956, I hope
    you will take a look at that. It just violates, it seems to me,
    everything which you folks should be about, which is trying to
    get to substance and trying to get through form, which is what
    a whole bunch of courts have told you you should do in a whole
    bunch of ways.
        So will you take a look at that issue? I am not telling you
    to look at the one case. I am asking you to look at the one
    issue, that exclusion issue from Section 956 on short-term
    loans and as to whether or not under the kinds of circumstances
    which I have just outlined you ought to pierce the form and get
    to the substance. Will you take a look at that?
        Mr. Wilkins. Yes, sir.
        Senator Levin. Let me ask you just a couple questions, Ms.
    Cosper. Under APB 23, under that exception, you have to assert
    that the company has invested or will invest the undistributed
    earnings indefinitely. Is there any time period associated with
    the term ``indefinitely invested'?
        Ms. Cosper. ``Indefinitely'' is not defined within the
    standard.
        Senator Levin. How does that help? In other words, if it is
    invested for a minute, a day, a week, a year----
        Ms. Cosper. I think ``indefinitely'' is intended to mean a
    sufficient period, a sufficiently long period of time. But the
    standard itself requires that there be evidence that there is a
    plan to indefinitely reinvest it.
        Senator Levin. But ``indefinitely'' could mean no
    definition. ``Indefinite,'' the way you define it, means for a
    time that does not have a limit on it.
        Ms. Cosper. If you looked at it the alternative way, you
    could say you have no plan to remit it.
        Senator Levin. No. I am talking about the investment. The
    word ``indefinite,'' as you interpret it, and your guidelines
    intend, the word is for a period which does not have a time
    limit on it.
        Ms. Cosper. That is correct.
        Senator Levin. It cannot be a short period.
        Ms. Cosper. It is not intended to be a short period.
        Senator Levin. It is intended to be a long period.
        Ms. Cosper. But it is not prescribed.
        Senator Levin. It does not prescribe how long, but it is
    intended to be a long period. Is that fair?
        Ms. Cosper. An indefinite period.
        Senator Levin. But you interpret that to mean a long
    period, relatively long period?
        Ms. Cosper. An indefinite period would be you----
        Senator Levin. Is a month a long period? If you intend to
    invest it for a month, is that an indefinite investment?
        Ms. Cosper. One would not expect that to be indefinite.
        Senator Levin. Can't you give some guidance, though, to
    people? I mean, this is being used all the time, and there is a
    problem either way, as you have defined it. You can mislead
    folks either way. But can't you give more guidance than just
    ``indefinitely invested'' as to what you would have in mind as
    to what would constitute indefinite, or a range, it has got to
    be at least 2 years or----
        Ms. Cosper. I think the challenge here is that because of
    the way the Tax Code works, the financial statements are
    intended to reflect the economics that are actually occurring.
    And so what users have told us is that if there is a plan for a
    company to indefinitely reinvest, then they are not interested
    in having that information reflected in the financial
    statements. But they are happy with the disclosures that are
    there.
        Senator Levin. Well, for obvious reasons, I am sure they
    are. I think it works to their advantage to do that, to have
    something that vague that they are able to sign up to.
        Do you require evidence to support whatever the plan is?
        Ms. Cosper. That is correct.
        Senator Levin. And you list the types of investments that
    qualify?
        Ms. Cosper. We do not.
        Senator Levin. So you do not have a time period on what
    ``indefinite'' is. You do require evidence to support a plan
    for indefinite reinvestment or investment, and you do not list
    the types of investments. I think that is just too ambiguous,
    and I know there has been a long debate on this, but I have to
    tell you, I think it is just way too ambiguous.
        Ms. Cosper. The standard does indicate--there are two
    examples in the standard of evidence. The standard says that
    experience of the entities and indefinite future programs of
    operations and remittances are examples of the types of
    evidence required to substantiate the parent entities'
    representation of indefinite postponement of remittances from a
    subsidiary.
        Now, we develop accounting standards, and dependent upon
    the Tax Code, there are many different circumstances, and so it
    would be very difficult for us to put all examples of evidence
    in here, and the auditors have the responsibility to audit
    whether companies have applied the standard appropriately and
    that they do have sufficient evidence and that there is a plan.
        Senator Levin. If you believed, if FASB believed that APB
    23 was being used by multinational corporations as a way of
    managing their earnings, would you view that as a problem?
        Ms. Cosper. Back in 2004, when we actually had the short-
    term convergence project, one of the topics that the board at
    the time discussed was whether APB 23 was used to manage
    earnings. There were extensive discussions. There was outreach
    to stakeholders and users. And what the board at the time said
    was that it would actually be a very mediocre way of trying to
    manage earnings simply because if a company changed their plans
    such that they chose to remit earnings, it would be very
    transparent within the financial statements because of the
    disclosures around deferred tax liabilities, around the
    effective rate reconciliation, and for disclosures as it
    relates to those earnings that have been unremitted, the tax
    associated with it.
        Senator Levin. Is it appropriate to use it as a tool to
    manage earnings?
        Ms. Cosper. I do not think it would be----
        Senator Levin. I know it is not effective, but is it
    appropriate to use it as a tool?
        Ms. Cosper. Well, the board at the time, when it discussed
    managing earnings, in their view managing earnings was really
    an audit issue, not an accounting standard setter issue.
        Senator Levin. So, in other words, you do not have a
    position as to whether it is appropriate or not appropriate.
        Ms. Cosper. That is correct. The Tax Code dictates whether
    companies are allowed to repatriate--whether companies
    repatriate and are taxed on that repatriation.
        Senator Levin. One of the partners of a large accounting
    firm said the following--well, actually it is Exhibit 3i.\1\
    This is an HP employee writing to a KPMG partner. He is asking
    whether tax considerations can be referenced when making the
    assertion under APB 23, and the partner says, ``Sitting on cash
    to avoid tax costs on repatriation doesn't equate to
    reinvestment plans, in our view. . . . It can be a lightning
    rod for a reviewer . . . to second guess the deferral.''
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 3i, which appears in the Appendix on page 218.
    ---------------------------------------------------------------------------
        Do you agree with that?
        Ms. Cosper. As I read this particular email--and I am not
    familiar with it, the context of it--it reads to me as though
    there is no plan for indefinite reinvestment.
        Senator Levin. That would not be a plan?
        Ms. Cosper. It does not appear to me to be a plan.
        Senator Levin. You said that you are neutral on using FASB
    standards to manage earnings. Isn't the whole point of an
    accounting standard to reflect accurate financial results and
    to prevent management of earnings?
        Ms. Cosper. I think accounting standards reflect the
    economic realities of what is occurring, and if a company is
    applying the Tax Code appropriately, then the accounting should
    reflect that.
        Senator Levin. But in terms of FASB standards, you
    indicated you were neutral.
        Ms. Cosper. We set standards in order to reflect economics,
    and so we do not see managing earnings as an accounting issue.
    That is an auditing issue. If a company inappropriately applies
    the guidance in order to manage earnings, it is an auditing
    issue.
        Senator Levin. But the absence of an accounting standard to
    guide people, is not troubling to you when your job is to put
    out standards?
        Ms. Cosper. I am not sure I am following.
        Senator Levin. OK. Well, I may not be stating it very
    clearly.
        Ms. Cosper. I mean, we always strive to improve our
    accounting standards, but in this particular area, in
    preparation for this hearing, we went and looked to see what
    kinds of questions we had gotten on this particular provision,
    and, quite frankly, we have not gotten any. And usually an
    indication that there is a lack of clarity around a particular
    accounting rule or how it is being applied or whether there is
    diversity, we would address if there seemed to be a problem
    associated with it.
        Senator Levin. If there were a problem here in the misuse
    of this assertion, in fact, it is being used routinely to avoid
    the disclosure in that report in APB 23. It has been used to
    avoid having to disclose how much money is being held abroad
    and what is being held until there is the desire to bring it
    back. But in order to avoid any kind of tax liability,
    potential liability, indicate on your books, there is no
    question. Who is going to ask you the question? Who would be
    troubled by this?
        Ms. Cosper. So that is a compliance issue.
        Senator Levin. Except the IRS.
        Ms. Cosper. So that would be a compliance issue. So the
    question is: Is the company appropriately applying the
    accounting standard? The standard requires disclosure. If you
    do not--if you have a plan to indefinitely reinvest, you are
    required to disclose the amount of the tax that you would have
    paid on that unremitted earnings in the financial statements.
        Senator Levin. Who is it that would complain? The companies
    love the status quo. They are not going to complain.
        Ms. Cosper. We regularly meet with folks from the PCAOB,
    the SEC, and the regulators. We have advisory groups and user
    groups that we meet with that would provide--would tell us that
    they do not think that they are getting the appropriate amount
    of information.
        Senator Levin. From the companies.
        Ms. Cosper. Right.
        Senator Levin. But you do not expect that companies who
    would have a better bottom line because they do not have to set
    aside funds, you do not expect to get complaints from them, I
    hope.
        Ms. Cosper. Well, the users would indicate whether----
        Senator Levin. The users being the----
        Ms. Cosper. The investors, the folks----
        Senator Levin. I am talking about the companies, though.
    You would not expect to get complaints----
        Ms. Cosper. Companies may, from time to time, provide us
    questions about how to apply certain provisions of our
    accounting guidance. So, for example, maybe they would ask
    about what ``indefinite'' means, or perhaps they would ask
    about other elements of the standard, what is evidence, or what
    have you. We just simply do not get those questions.
        Senator Levin. But you got one from me today. I want you to
    tell me for the record what ``indefinite'' means. What is the
    minimum length of time that ``indefinite'' means?
        Ms. Cosper. It is not defined.
        Senator Levin. No. I am asking you, though, for guidance.
        Ms. Cosper. I do not have an answer. It would depend on the
    facts and circumstances of the individual situation.
        Senator Levin. Could it be as little as 2 months?
        Ms. Cosper. It is not defined in the accounting standard.
        Senator Levin. But if you have a word that is that vague,
    how good is the standard?
        Ms. Cosper. ``Indefinite'' would be construed to be a
    significantly long period of time.
        Senator Levin. OK. That is helpful.
        Well, we have covered a lot of ground, and the issues are
    complex. We know that. The bottom line, though, is not complex.
    We have a fiscal crisis in this country. Loss of tax revenue is
    a key cause of the problem. Shifting of profits offshore by
    multinational corporations is a major contributor to that
    problem, and we have to do something about it. So we have a
    major multinational transfer of intellectual property abroad
    going on, using gimmicks to direct most of these profits, as it
    turns out, to tax havens. We have another major multinational
    that keeps 90 percent of its cash offshore on paper, then
    brings it back to the United States through coordinated, serial
    loans that it pretends are short term but acts as one of the
    primary sources of cash to run its operations. We have other
    multinationals that keep billions of dollars offshore on paper,
    but then use that offshore cash to buy U.S. Treasury notes,
    stocks, and bonds. That was an earlier hearing of this
    Subcommittee.
        We have auditors and tax regulators and accounting standard
    setters that have not done an adequate job of clamping down on
    transfer pricing abuses and hidden repatriation strategies. We
    do not see an aggressive action in that area at all.
        We have a Tax Code that is full of loopholes and makes
    enforcing general principles of taxing foreign income almost
    unenforceable. That is the Congress' problem. We are major
    contributors to the problems that I have outlined, so we have
    to do better, particularly facing a fiscal disaster, but even
    if we were not, it is just simply not fair to your average
    taxpayer that pays his taxes to see these kind of loopholes
    that are both used and created where they do not exist, and
    then companies getting away with it.
        So we want our corporations, our multinationals to pay
    their fair share if this country is going to support their
    businesses in a way that they deserve to be supported, and
    paying 4 percent or 2 percent or nothing at all is just simply
    not good enough.
        Obviously, our tax system is in need of reform, and one
    area that we clearly need to focus reform efforts is on these
    multinationals that shift profits offshore. I hope our hearing
    today has identified some of the problems that need to be fixed
    to mitigate the loss of tax revenue, the shifting of profits
    offshore that cause that loss.
        We hope that the information, the facts that we brought out
    today in the memorandum which we have issued, both Senator
    Coburn and I, that have sent this memorandum to our
    colleagues,\1\ which will be made part of the record, that this
    will motivate Congress and other parties and the executive
    agencies to move much more aggressively in this area, craft
    some solutions to this problem and these problems.
    ---------------------------------------------------------------------------
        \1\ The memorandum appears in the Appendix on page 160.
    ---------------------------------------------------------------------------
        The Subcommittee has been on this area of the use of
    offshore tax havens to avoid paying taxes for about 10 years
    now. We are going to continue to make an effort in that
    direction because it is unconscionable that money which is
    really owed to the U.S. Treasury is not going to the U.S.
    Treasury because of the gimmicks and because of these tax
    structures, which are extreme, soaking up funds and moving them
    in places where they are not subject to our tax system.
        So we thank our witnesses. We thank Dr. Coburn and his
    staff for their great support on this effort. We worked
    together as a team. We have different views on lots of issues,
    but on a lot of other issues, we very much agree. And I hope
    that comes through and will come through for those who read
    that memorandum, which was sent to our colleagues and which is
    available to the public. It will be on our Web site.
        With that, we will thank again our witnesses and stand
    adjourned.
        [Whereupon, at 6:43 p.m., the Subcommittee was adjourned.]

                                A P P E N D I X

                                  ----------

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