[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

                               ----------                              

                           SEPTEMBER 20, 2012

                               ----------                              

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

                 PART 1 (MICROSOFT AND HEWLETT-PACKARD)


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        COMMITTEE ON HOMELAND SECURITY AND GOVERNMENTAL AFFAIRS

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

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

                PERMANENT SUBCOMMITTEE ON INVESTIGATIONS

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


                            C O N T E N T S

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

                               WITNESSES
                      Thursday, September 20, 2012

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

                     Alphabetical List of Witnesses

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

                              EXHIBIT LIST

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


                    OFFSHORE PROFIT SHIFTING AND THE


                         U.S. TAX CODE--PART 1


                    (MICROSOFT AND HEWLETT-PACKARD)

                              ----------                              


                      THURSDAY, SEPTEMBER 20, 2012

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

               OPENING STATEMENT OF SENATOR LEVIN

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

              OPENING STATEMENT OF SENATOR COBURN

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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