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

[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

before the

PERMANENT SUBCOMMITTEE ON INVESTIGATIONS

of the

COMMITTEE ON
HOMELAND SECURITY AND GOVERNMENTAL AFFAIRS
UNITED STATES SENATE

ONE HUNDRED TWELFTH CONGRESS

SECOND SESSION

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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

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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.
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\1\ The chart referenced appears as Exhibit No. 1e and can be found
in the Appendix on page 190.
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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.
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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.
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\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''?
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\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\
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\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.''
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\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.
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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.
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\1\ See Exhibit No. 1e, which appears in the Appendix on page 190.
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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.''
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\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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