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REPORTNUM: GAO-06-851T
TITLE: Tax Compliance: Challenges to Corporate Tax Enforcement
and Options to Improve Securities Basis Reporting
DATE: 06/13/2006
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GAO-06-851T
* changed d06851T.pdf
* Background
* Corporate Income Taxes Are a Significant Source of Federal R
* Opportunities Exist to Improve Corporate Tax Compliance
* Corporate Tax Avoidance Is Bred in Part by Complexity
* IRS's Incomplete and Dated Estimates of Corporate Tax Noncom
* IRS Has Strengthened Corporate Tax Compliance Efforts, but C
* Continuing to Leverage Technology
* Improving the Collection of Delinquent Taxes Would Send a Co
* Capital Gains Basis Reporting
* Contacts and Acknowledgments
* Order by Mail or Phone
* d06851T.pdf
* Background
* Corporate Income Taxes Are a Significant Source of Federal R
* Opportunities Exist to Improve Corporate Tax Compliance
* Corporate Tax Avoidance Is Bred in Part by Complexity
* IRS's Incomplete and Dated Estimates of Corporate Tax Noncom
* IRS Has Strengthened Corporate Tax Compliance Efforts, but C
* Continuing to Leverage Technology
* Improving the Collection of Delinquent Taxes Would Send a Co
* Capital Gains Basis Reporting
* Contacts and Acknowledgments
* Order by Mail or Phone
Mr. Chairman and Members of the Committee:
I appreciate the opportunity to discuss the corporate income tax with you
as well as our work on options for improving taxpayers' voluntary
compliance in reporting their capital gains or losses from the sales of
securities. As the Committee is well aware, the U.S. position in the
worldwide economy has fundamentally changed and the structure and
composition of our economy has shifted. U.S. workers and firms must now
succeed in a world of fast-paced technological change and constantly
evolving global competition. This raises two sets of questions about the
corporate income tax. The first is about reforming the overall U.S. tax
system and perhaps changing the role of corporate taxes. The second set of
questions is about how to administer and enforce the existing corporate
income tax in a changing world. As per your request, my statement focuses
principally on this question.
The complexity of the corporate income tax generates opportunities for tax
avoidance that can be categorized as clearly legal, clearly noncompliant
(illegal), or of uncertain legality. Corporate tax base is reduced by
statutory corporate tax expenditures, legal and illegal tax avoidance, and
deliberate underreporting of income. The overall amount of tax base
reduction is unknown but the Internal Revenue Service (IRS) has estimated
the amount of clear noncompliance to total $32 billion for tax year 2001.
Corporate tax avoidance in its various forms reduces overall federal
revenue or, for the government to take in the same revenue, means that
other taxpayers pay more.
My statement today makes the following points:
o Although less of a revenue source than it once was, the
corporate income tax is one of the pillars of the federal tax
system.1 The $277 billion in corporate tax revenues that the
Office of Management and Budget (OMB) estimates will be paid in
fiscal year 2006 must be part of overall considerations for
dealing with the nation's long-term fiscal imbalance. More
specifically, corporate tax policy, corporate tax expenditures and
corporate tax enforcement all must be part of a multi-pronged
approach that reexamines both federal spending and revenues.
o Determining corporate income tax liabilities and the extent of
corporate tax avoidance is a challenge because of the complex tax
code, complex business transactions and often multinational
corporate structures. Opportunities exist to improve corporate tax
compliance, such as simplifying the tax code, obtaining better
data to the extent feasible on noncompliance, continuing to
oversee the effectiveness of IRS's efforts, continuing to leverage
technology, and sending sound compliance signals through such
things as increased effectiveness in collecting taxes owed.
1 For purposes of this statement, when we refer to the corporate income
tax or corporations, we are excluding S-corporations, which are
pass-through entities whose income or losses are generally not taxed at
the corporate level, but are passed through to their owners.
Also, at your request, I have included a section in this statement that
discusses our findings in the area of capital gains basis reporting. In
summary, we found that many taxpayers misreport capital gains or losses,
sometimes inappropriately underpaying their taxes and sometimes overpaying
them. IRS has efforts in place to help ensure proper reporting of capital
gains and losses, but these efforts face several obstacles. Finally, we
found that expanding third-party information reporting on the cost basis
of capital assets could help mitigate this problem if related problems are
addressed.
My statement today is largely drawn from previous GAO reports and
testimonies, which were done in accordance with generally accepted
government auditing standards. We also relied on other published
information for the sections of this statement dealing with corporate
taxation. The latter part of this statement discusses capital gains basis
reporting and is drawn from the report on that subject we are releasing
today.
Background
The base of the federal corporate income tax includes net income from
business operations (receipts, minus the costs of purchased goods, labor,
interest, and other expenses). It also includes net income that
corporations earn in the form of interest, dividends, rent, royalties, and
realized capital gains. The statutory rate of tax on net corporate income
ranges from 15 to 35 percent, depending on the amount of income earned.2
The United States taxes the worldwide income of domestic corporations,
regardless of where the income is earned, with a foreign tax credit for
certain taxes paid to other countries. However, the timing of the tax
liability depends on several factors, including whether the income is from
a U.S. or foreign source and, if it is from a foreign source, whether it
is earned through direct operations or through a subsidiary.3
2 In addition, present law imposes an alternative minimum tax (AMT) on
corporations to the extent that their minimum tax liability exceeds their
regular tax liability. In general, the AMT applies a lower tax rate to a
broader tax base. Specifically, the regular tax base is increased for AMT
purposes by adding back certain items treated as tax preferences and
disallowing certain deductions and credits. Also, marginal rates are
higher over limited income ranges to recapture the benefits of the rates
below 35 percent.
Statutory and effective tax rates are not necessarily the same. An
effective tax rate, which is often lower-even substantially lower-than the
statutory rate, measures the amount of tax that a corporation actually
pays on a dollar of its economic income, when all aspects of the tax
(deductions, credits, deferrals, etc.) are taken into account. Statutory
and effective rates may differ, for example, because depreciation
allowances for specific types of capital investments exceed (or fall short
of) the true (economic) depreciation. Other differences arise because
income from foreign subsidiaries is generally not taxed until it is
repatriated to the United States. Special incentives, such as the research
tax credit, that are designed to encourage certain behavior, also cause
the effective rate of the tax to differ from its statutory rate. A recent
Congressional Budget Office (CBO) study found that the United States'
statutory corporate tax rates are high relative to Organization for
Economic Cooperation and Development (OECD) countries but comparable with
the rates for what were then the G-7 countries.4 Comparisons of effective
rates depend on the type of investment and the type of financing.
According to CBO, U.S. effective corporate tax rates in 2003 were the G-7
median for equity-financed investments in machinery, second lowest for
debt-financed investment in machinery, and second highest for
equity-financed investment in industrial structures.5
3 Very generally, corporations first calculate their taxable income.
Taxable income is total income, including taxable income from foreign
sources, minus deductions such as for salaries and wages, depreciation,
and net operating loss carryovers. The next step is to calculate the
tentative tax owed (taxable income times the applicable rate). The last
step is to subtract any tax credits, including the foreign tax credit, to
get the taxes owed.
4 OECD consists of 30 market democracies and its purpose is to provides
member countries a setting where governments can compare policy
experiences, seek answers to common problems, and coordinate domestic and
international policies. At the time of the CBO study, the G-7 consisted of
Canada, France, Germany, Italy, Japan, the United Kingdom, and the United
States. The G-7's purpose is to provide a forum for the leaders of the
largest industrialized democracies to discuss major economic and political
issues. When the Russian Federation participates at the meetings, the
group is known as the G-8.
Differences in effective tax rates across types and sources of income are
pervasive, reflecting the complexity of the tax code. The corporate income
tax (1) reduces the after tax return on capital income and, therefore,
affects the incentive individuals have to save and invest; (2) taxes
corporations differently than partnerships and sole proprietorships; (3)
taxes U.S. corporations operating in foreign countries differently than
those operating domestically and differently than foreign governments tax
corporations; (4) taxes different types of corporate investments, such as
machinery or structures, unevenly; and (5) taxes debt-financed investment
at lower rates than equity-financed investment. These differences in
effective tax rates alter both investment decisions and the reporting of
corporate income as firms try to minimize their taxes. Such tax avoidance,
much of it legal but some illegal, reduces tax revenue. Guiding
investments to lightly taxed activities rather than those with high before
tax productivity may reduce economic growth, further reducing tax revenue
from what it otherwise would have been.
Corporate Income Taxes Are a Significant Source of Federal Revenue and Must Be
Part of the Overall Considerations for Fiscal Reform
At about $277 billion, corporate income taxes are far smaller than the
$841 billion in social insurance taxes and $998 billion in individual
income taxes that OMB estimates will be paid in fiscal year 2006 to fund
the federal government.6 Figure 1 shows the relative importance of federal
taxes.
5 Congressional Budget Office, Corporate Income Tax Rates: International
Comparisons, (Washington, D.C.: November 2005). The study focuses on how
corporate income taxes affect incentives for investment by calculating
marginal effective tax rates in different countries. The calculations
include differences across countries in statutory tax rates and
depreciation rules.
6 Office of Management and Budget. Historical Tables, Budget of the United
States Government, Fiscal Year 2007. (Washington, D.C.: Feb. 2006).
Figure 1: Trend in Federal Taxes, 1962-2005
Figures 1 and 2 show the trend in corporate tax revenues since 1962. Tax
experts have written that corporate tax revenues fell from the 1960s to
the early 1980s for several reasons. For example, corporate income became
a smaller share of national income during these years, partly due to the
fact that corporate debt, and therefore deductible interest payments,
increased relative to corporate equity, reducing the tax base. In
addition, tax expenditures, such as more generous depreciation rules and
corporate tax rate reductions lowered corporate taxes.7 Since the early
1980s corporate tax revenues have fluctuated in a narrower range,
reflecting changes in corporate profits, tax laws, and other factors.
7 Steuerle, C. Eugene, Contemporary U.S. Tax Policy. Washington, D.C.: The
Urban Institute Press, 2004.
Gravelle, Jane G., "The Corporate Tax: Where Has It Been and Where Is It
Going?" National Tax Journal, vol. 57, no. 4 (2004): 903-23.
Since the early 1980s the corporate tax has accounted for from about 6 to
13 percent of federal revenue, as shown in figure 2. Consequently,
although not the largest, it remains an important source of federal
revenue. Relative to the gross domestic product (GDP), the corporate tax
has ranged from a little over 1 percent to just under 2.5 percent during
those same years. CBO has recently projected that despite the recent
uptick, corporate tax revenue for the next 10 years as a percentage of GDP
is expected to stay within this same range.
Figure 2: Corporate Income Tax Revenues as a Share of Federal Taxes and as
a Share of GDP, 1962-2005
Corporate tax revenues of the magnitude shown in figure 2 make them
relevant to considerations about how to address the nation's long-term
fiscal imbalance. Over the long term, the United States faces a large and
growing structural budget deficit primarily caused by demographic trends
and rising health care costs as shown in figure 3, and exacerbated over
time by growing interest on the ever larger federal debt. Continuing on
this imprudent and unsustainable fiscal path will gradually erode, if not
suddenly damage, our economy, our standard of living, and ultimately our
national security.
Figure 3: Composition of Federal Spending as a Share of GDP, Assuming
Discretionary Spending Grows with GDP after 2006 and That Expiring Tax
Provisions Are Extended
Note: This includes certain tax provisions that expired at the end of
2005, such as the increased alternative minimum tax exemption amount.
We cannot grow our way out of this long-term fiscal challenge because the
imbalance between spending and revenue is so large. We will need to make
tough choices using a multipronged approach: (1) revise budget processes
and financial reporting requirements; (2) restructure entitlement
programs; (3) reexamine the base of discretionary spending and other
spending; and (4) review and revise tax policy, including tax
expenditures, and tax enforcement programs. Corporate tax policy,
corporate tax expenditures, and corporate tax enforcement need to be part
of the overall tax review because of the amount of revenue at stake.
Corporate tax expenditures reduce the revenue that would otherwise be
raised from the corporate income tax. As already noted, to reduce their
tax liabilities, corporations can take advantage of preferential
provisions in the tax code, such as exclusions, exemptions, deductions,
credits, preferential rates, and deferral of tax liability. Tax
preferences-which are legally known as tax expenditures-are often aimed at
policy goals similar to those of federal spending programs. For example,
there are different tax expenditures intended to encourage economic
development in disadvantaged areas and stimulate research and development,
while there are also federal spending programs that have similar purposes.
Also, by narrowing the tax base, corporate tax expenditures have the
effect of raising either corporate tax rates or the rates on other
taxpayers in order to generate a given amount of revenue.
The sum of estimated forgone revenue for the federal government because of
corporate tax expenditures was $80 billion for fiscal year 2005.8 In its
most recent report, the Department of the Treasury (Treasury) listed 27
tax expenditures for corporate taxpayers only and another 52 provisions
available to both corporations and other businesses. As of fiscal year
2005, the two largest tax expenditures used by corporations were the
accelerated depreciation of machinery and equipment ($15.9 billion) and
the deferral of income of controlled foreign corporations ($10.5 billion);
these two accounted for a third of the sum of corporate revenue losses
estimated by Treasury.
We reported in September 20059 that the effectiveness of many tax
expenditures is not subject to a level of review similar to that of
programs that spend money directly. Although some corporate income tax
expenditures are reviewed by government agencies, academics, and others,
all should be reviewed periodically to ensure they have not outlived their
usefulness, are not redundant, or are not inefficient in accomplishing
their intended purpose. In that report, we recommended that the OMB and
Treasury take steps to ensure regular reexamination of tax expenditures,
including the corporate provisions. OMB disagreed with the
recommendations, citing methodological and conceptual issues. Our report
discusses in detail the issues that OMB raised and why we continue to
believe that our recommendations are valid. Also, as far back as 1994, we
have suggested that Congress should review these tax expenditures,
considering such things as how well the corporate tax expenditures are
achieving their purposes and whether they should remain, given the
potential benefits of a simpler corporate tax code, possibly with reduced
tax rates.10
8Summing the individual tax expenditure estimates is useful for gauging
the general magnitude of the federal revenue involved, but it does not
take into account possible interactions between individual provisions. See
GAO, Government Performance and Accountability: Tax Expenditures Represent
a Substantial Federal Commitment and Need to Be Reexamined, GAO-05-690
(Washington, D.C.: Sept. 23, 2005).
9 GAO, Government Performance and Accountability: Tax Expenditures
Represent a Substantial Federal Commitment and Need to Be Reexamined,
GAO-05-690 (Washington, D.C.: Sept. 23, 2005).
Opportunities Exist to Improve Corporate Tax Compliance
Ensuring corporate income tax compliance is challenging because much
corporate tax avoidance is legal and the true tax liability for large
corporations is difficult to determine. A wide variety of strategies will
undoubtedly be needed to address corporate tax compliance. Opportunities
to pursue include simplifying the tax code, obtaining better data to the
extent feasible on noncompliance, continuing to oversee the effectiveness
of IRS's efforts, continuing to leverage technology, and sending sound
compliance signals through such things as increased effectiveness in
collecting taxes owed.
Corporate Tax Avoidance Is Bred in Part by Complexity
The amount of corporate tax avoidance is unknown. A complex tax code,
complicated business transactions, and often multinational corporate
structures make determining corporate tax liabilities and the extent of
corporate tax avoidance a challenge. Tax avoidance has become such a
concern that some tax experts say corporate tax departments have become
"profit centers" as corporations seek to take advantage of the tax laws in
order to maximize shareholder value. Some corporate tax avoidance is
clearly legal, some falls in gray areas of the tax code, and some is
clearly noncompliance or illegal. Tax code simplification has the
potential to reduce at least some of this avoidance.
10 GAO, Tax Policy: Tax Expenditures Deserve More Scrutiny,
GAO-GGD/AIMD-94-122 (Washington, D.C.: June 3, 1994).
Often corporate tax avoidance is legal. For example, multinational
corporations can locate active trade or business operations in
jurisdictions that have lower effective tax rates than does the United
States and, unless and until they repatriate the income, defer taxation in
the United States on that income, thus reducing their effective tax rate.
Similarly, making investments that qualify for accelerated depreciation
can lower a corporation's current effective tax rate, although in the
future its rate would be higher.11
Corporate tax planners may find legal ways to exploit tax code complexity
to play one provision of the code off another in ways that Congress never
intended. In response, Congress has sometimes acted to address what it
considered to be abusive tax shelters. For example, the American Jobs
Creation Act of 200412 limited the tax benefits of leasing transactions
involving tax-exempt entities, such as transit authorities. One type of
transaction the act limited was the sale-in/lease-out (SILO) arrangement,
which involved a taxable entity buying assets, such as railcars, from a
tax-exempt entity, for example, a metropolitan transit system, and leasing
them back to the tax-exempt entity. The estimated revenue gain from the
2004 act's provision covering leasing transactions with tax-indifferent
parties was about $26.6 billion for 2005 through 2014.
Complicating corporate tax compliance is the fact that in many cases the
law is unclear or subject to differing interpretations. In fact, some have
postulated that major corporations' tax returns are actually just the
opening bid in an extended negotiation with IRS to determine a
corporation's tax liability. An illustration is transfer pricing. Transfer
pricing involves setting the appropriate price for such things as goods,
services, or intangible property (such as patents, trademarks, copyrights,
technology, or "know-how") that is transferred between the U.S.-based
operations of a multinational company and a foreign affiliate. If the
price paid by the affiliate to the U.S. operation is understated, the
profits of the U.S. operation are reduced and U.S. taxable income is
inappropriately reduced or eliminated. The standard for judging the
correct price is the price that would have been paid between independent
enterprises acting at "arm's length." However, it can be extremely
difficult to establish what an arm's length price would be. Given the
global economy and the number of multinational firms with some U.S.-based
operations, opportunities for transfer pricing disputes are likely to
grow.
11 Accelerated depreciation lowers a corporation's marginal effective tax
rate on investments by increasing the present value of these deductions.
12 Pub. L. No. 108-357 (2004).
Tax shelters are one example of how tax avoidance, including corporate tax
avoidance, can shade into the illegal. Some tax shelters are legal though
perhaps aggressive interpretations of the law, but others cross the line.
In a 2003 testimony, we reported that IRS had identified 27 kinds of
abusive shelter transactions-called listed transactions-promoted to
corporations and others. As of June 2006, IRS's web site lists 31 such
listed transactions. IRS also had a number of other transactions that had
to be reported to IRS and may have had some characteristics of abusive
shelters but were not, and possibly never would be, listed.
Abusive shelters often are complex transactions that manipulate many parts
of the tax code or regulations and are typically buried among legitimate
transactions reported on tax returns. Because these transactions are often
composed of many pieces located in several parts of a complex tax return,
they are essentially hidden from plain sight, which contributes to the
difficulty of determining the scope of the abusive shelter problem. Often
lacking economic substance or a business purpose other than generating tax
benefits, abusive shelters have been promoted by some tax professionals,
often in confidence, for significant fees, sometimes with the
participation of tax-indifferent parties, such as foreign or tax-exempt
entities. These shelters may involve unnecessary steps and flow-through
entities, such as partnerships, which make detection of these transactions
more difficult.
For example, a company had a sizable gain from the sale of a subsidiary
and wanted to avoid or minimize paying tax on the gain. An investment bank
proposed forming an offshore partnership with a foreign corporation (a
tax-indifferent party) for the express purpose of sheltering the capital
gains of its corporate client. The partnership purchased and quickly
resold notes in a contingent installment sale transaction. The partnership
earned a large capital gain, most of which it allocated to the foreign
corporate partner. Later, related losses were allocated to the U.S.
corporation, generating approximately $100 million in capital loss for the
investment bank's client. The corporation used this capital loss to
shelter its U.S.-based capital gains. Both the Tax Court and the Third
Circuit Court of Appeals ruled that the transaction lacked economic
substance. The Third Circuit, in addition to requiring economic substance,
held that a transaction must have a subjective nontax business motive to
be respected for tax purposes.13 For this transaction, the investment bank
was to earn a fee of $2 million.
In part because tax shelters are intentionally hidden, IRS has not been
able to produce a reliable estimate of the revenues lost because of
shelters. As we reported in October 2003, one estimate, which had a number
of methodological limitations, suggested an average annual tax gap because
of tax shelters (both corporate and individual) that could have been from
about $11.6 billion to about $15.1 billion for the years 1993 through
1999.14 Because the methodological limitations were serious, the true
amount of the revenue loss could be lower or higher than this range.
Furthermore, this estimate does not cover non-abusive tax shelters.
Establishing a presence in a low-tax country is another technique for
avoiding corporate income tax. Some low-tax countries are called tax
havens. The company's presence in a tax haven in some cases may be
nominal, nothing more than a file in an office. Use of a tax haven can be
questionable when combined with abusive transfer pricing or techniques,
such as interest stripping, to artificially shift income to the tax haven.
In several reports since 2002, we reported on federal contractors' use of
tax havens. We reported that 4 of the top 100 federal contractors that
were publicly traded corporations in 2001 were located in tax havens and
that 3 of these were originally U.S.-headquartered corporations. Later, we
reported that large tax haven contractors in both 2000 and 2001 had a tax
cost advantage compared to large domestic contractors.15
13 ACM Partnership v. Commissioner, 157 F. 3d 231 (3d Cir. 1998), aff'g,
73 T.C.M. 2189 (1997), cert. denied, 526 U.S. 1017 (1999).
14 GAO, Internal Revenue Service: Challenges Remain in Combating Abusive
Tax Shelters, GAO-04-104T , (Washington, D.C.: Oct. 21, 2003).
15 GAO, Information on Federal Contractors That Are Incorporated Offshore,
GAO-03-194R (Washington, D.C.: Oct. 1, 2002) and International Taxation:
Tax Haven Companies Were More Likely to Have a Tax Cost Advantage in
Federal Contracting, GAO-04-856 (Washington, D.C.: June 30, 2004).
IRS's Incomplete and Dated Estimates of Corporate Tax Noncompliance Can Be
Improved
In large part because of the complexity and uncertainty in the application
of tax laws, the actual level of corporate income tax noncompliance
(illegal tax avoidance) is poorly understood. IRS estimates a corporate
tax gap in the tens of billions of dollars, but also acknowledges that
this estimate is not based on robust, recent, and reliable research. 16
As noted above, IRS's published estimate of the corporate tax gap-the
difference between what corporations pay voluntarily and on time in taxes
and what they are required to pay under the law-is $32 billion for tax
year 2001. This is out of an overall gross tax gap of $345 billion for
that year. Underreporting of income was the largest component of the
corporate tax gap, contributing an estimated $30 billion. The IRS estimate
included both small corporations (those reporting assets of $10 million or
less) and large corporations (those reporting assets of over $10 million).
Underpayment of taxes due accounted for $2 billion of the corporate tax
gap for tax year 2001. IRS has no estimate for nonfiling of corporate
income tax returns for tax year 2001.
However, the available tax gap estimates are highly uncertain and
incomplete. IRS has not systematically measured the level of compliance
for large corporations, and the last measure of noncompliance for small
corporations was from the 1980s. IRS's level of certainty with regard to
the accuracy of the corporate tax gap estimate is low for reasons such as
use of incomplete and old data, interpretation of complex laws, and
resource constraints. The 2001 estimate used data from the 1970s and 1980s
to estimate underreporting of corporate income taxes. For large corporate
income tax underreporting, IRS based its estimate on the amount of tax
recommended from operational examinations. As we reported in July 2005,17
according to IRS officials, IRS relies on the amount of tax recommended
because it is difficult to determine the true tax liability of large
corporations because of complex and ambiguous tax laws that create
opportunities for differing interpretations and that complicate the
determination. Because these examinations do not cover all firms and do
not test all items on a tax return, the estimate produced from the
examinations is incomplete. IRS officials also explained that because of
these complexities and the costs and burdens of collecting complete and
accurate data, IRS has not systematically measured large corporation tax
compliance through statistically valid studies.
16 The tax gap estimate is an aggregate of estimates for three primary
types of noncompliance: underreporting of tax liabilities on tax returns;
underpaying of taxes due from filed returns; and nonfiling, which refers
to the failure to file a required tax return altogether or on time.
17 GAO, Tax Compliance: Better Compliance Data and Long-term Goals Would
Support a More Strategic IRS Approach to Reducing the Tax Gap, GAO-05-753
(Washington, D.C. July 18, 2005).
As of June of this year, IRS did not have approved plans to update the
corporate tax gap estimate. Although measuring corporate tax compliance
can be challenging and costly, such compliance data aid in identifying new
or growing types of noncompliance, identifying changes in tax laws and
regulations that may improve compliance, more effectively targeting
examinations of tax returns, understanding the effectiveness of its
programs to promote and enforce compliance, and properly determining its
resource needs and allocations. In order to improve efforts to reduce the
tax gap, we have recommended that IRS develop plans to periodically
measure tax compliance for areas that have been measured, and study ways
to cost effectively measure compliance for other components of the tax gap
that have not been measured, such as excise taxes and corporate taxes. IRS
agreed with our recommendations.18
IRS Has Strengthened Corporate Tax Compliance Efforts, but Continued Oversight
Will Be Warranted
IRS has recently increased the number of corporate audits and recommended
tax assessments. These trends are promising. However, given the lack of a
reliable measure of the extent of corporate noncompliance and other
factors, continued oversight of these efforts will be warranted to make
informed judgments about their overall effectiveness.
As shown in figure 4, the number of corporate income tax returns that IRS
examined rose from its recent low of 0.71 percent in fiscal year 2004 to
1.25 percent in fiscal year 2005. This number includes examinations of 20
percent of large corporations in fiscal year 2005 as well as audits of all
1,100 of the nation's largest corporations with assets of more than $250
million.
18 GAO, Tax Administration: Better Compliance Data and Long-term Goals
Would Support a More Strategic IRS Approach to Reducing the Tax Gap,
GAO-05-753 (Washington, D.C.: July 18, 2005).
Figure 4: Percentage of Corporate Tax Returns IRS Examined, Fiscal Years
2001-2005
Figure 5 shows that the amount of taxes that IRS recommended as a result
of examinations performed grew from its recent low of $13.5 billion in
fiscal year 2003 to $32 billion in fiscal year 2005.
Figure 5: Amount of Taxes Recommended from Examinations of Corporations in
Billions of Dollars, Fiscal Years 2001-2005
According to IRS, about a third of the increase in recommended assessments
comes from tax shelter examinations, and nearly all of the increase comes
from examinations of the largest corporations. IRS notes, not
surprisingly, that a large portion of the recommended taxes were not
agreed to by the corporations. In the past, we found that under IRS's
examination program of the nation's largest corporations, the amount of
taxes IRS actually assessed has been about 20 percent of the amount
initially recommended during examinations.19 Further, the amounts assessed
often are not ultimately collected after cases are reviewed in IRS's
Appeals function or in the courts. Because the various review and appeal
options can be time consuming, it may be a number of years before actual
collection occurs on some cases.
19 GAO, Tax Administration: IRS Measures Could Provide a More Balanced
Picture of Audit Results and Costs, GAO/GGD-98-128 (Washington D.C.: June
23, 1998).
The shelter-related results come from IRS's multiyear effort to attack tax
shelters. In 2003 we reported that IRS had shifted resources to create a
broad-based strategy to combat what it considered to be a high priority
challenge-abusive tax shelters. IRS had adopted a broad-based strategy for
addressing abusive shelters, including
o targeting promoters to head off the proliferation of shelters;
o making efforts to deter, detect, and resolve abuse;
o offering inducements to businesses to disclose their use of
questionable tax practices; and
o using performance indicators to measure outputs and some
outcomes and intending to go down the path it had started and
develop long-term performance goals and measures linked to those
goals. We said that without these latter elements, Congress would
find gauging IRS's progress difficult.
In addition to examinations, IRS has undertaken a number of initiatives to
address corporate tax compliance. Some of these initiatives are intended
to resolve tax issues beyond the examination process. The Advance Pricing
Agreement (APA) program, the Fast Track Settlement program, the Pre-Filing
Agreement program, and the Industry Issue Resolution program all work to
some degree to resolve contentious tax issues outside of the examination
process. For example, the APA program is intended to address transfer
pricing issues up front so that they do not arise during subsequent
examinations.
IRS has also been revising the corporate tax examination process. For
instance, IRS reports that it has shortened the cycle time of
examinations. According to IRS, reducing cycle time allows IRS to examine
additional taxpayers and reduces administrative burdens on taxpayers.
Similarly, IRS's Limited Issue Focused Examination process seeks to have
IRS and corporations reach a formal agreement to govern key aspects of the
examination.
Future success in following through on these initiatives will require
replenishment of IRS's staff, which could be challenging given the
increasing numbers of key employees who are eligible for retirement or who
are otherwise leaving key occupations. The Large and Mid-Size Business
Division (LMSB), which is responsible for the compliance of the largest
corporations, reported in its fiscal year 2006 strategic assessment that
it will continue to lose substantial experience as revenue agents leave.
The Small Business and Self Employed Division, which covers the rest of
corporations, also has growing numbers of employees eligible for
retirement or leaving their enforcement positions. Although hiring to fill
positions is occurring, past experience suggests that training these new
employees and giving them on-the-job experience will take time and likely
adversely affect the divisions' overall productivity to some extent. The
Treasury Inspector General for Tax Administration has designated managing
human capital a management and performance challenge for IRS.
In part because IRS does not have a reliable measure of corporate tax
compliance, it will be challenged to demonstrate the effectiveness of the
increased audits and the various initiatives it has undertaken. The
effectiveness of IRS's efforts will depend on the extent to which the
taxes recommended are actually collected given past data showing that a
relatively small portion of recommended assessments is ultimately
collected. For these reasons, as well as human capital management
challenges, IRS's increased compliance efforts will warrant continued
oversight.
Continuing to Leverage Technology
Judicious use of technology has already helped IRS improve its
productivity, and continued, well-managed technology initiatives have the
potential to further improve the use of its resources. According to IRS,
electronic filing of individuals' tax returns has enabled it to reduce the
amount of staffing devoted to processing paper tax returns and to transfer
staffing allocations to other endeavors, including compliance work.
Further, because of the software used in electronically preparing and
filing returns, these returns have fewer errors, thus saving IRS and
taxpayers needless time and effort to correct avoidable errors.
Starting in 2006, many larger corporations are now required to file their
tax returns electronically. This is no small undertaking, and some
transition issues are likely to occur. However, electronic returns offer
the potential to speed examinations-if for no other reason than often very
voluminous corporate tax returns can be moved to appropriate locations for
review immediately. IRS believes electronically filed returns will also
speed analysis of corporate tax returns and the identification of issues
and taxpayers most in need of examination or other resolution of potential
compliance issues. IRS plans to gradually expand the number of firms
required to electronically file. This and other opportunities to leverage
modern technology can serve to help IRS deal with the complex tax issues
in corporate tax returns.
Improving the Collection of Delinquent Taxes Would Send a Compliance Signal
When any taxpayer has been found to owe taxes and those amounts are no
longer in dispute, failure to collect the taxes sends an adverse
compliance signal. While not collecting these debts may send a message to
corporations that IRS is not serious about enforcing the tax law,
developing and exploiting opportunities to improve collections sends the
opposite signal and can contribute to reducing corporate noncompliance. In
February 2004, we reported that some Department of Defense (DOD)
contractors abuse the federal tax system with little consequence.20 We
reported that based on our analysis of a limited number of DOD
disbursement systems, more than 27,000 DOD contractors owed nearly $3
billion in unpaid federal taxes. In June 2005, we reported that many
contractors of civilian agencies throughout the federal government also
abuse the federal tax system.21 Our analysis showed that about 33,000
contractors that received substantial federal payments from civilian
agencies during fiscal year 2004 owed a total of more than $3 billion in
unpaid taxes. The unpaid taxes owed by DOD and civilian agency contractors
included corporate income, excise, unemployment, individual income, and
payroll taxes.22 We also found evidence of abusive and potentially
criminal activities on the part of both DOD and civilian agency
contractors.23
In our reports on this issue, we made numerous recommendations intended to
improve the Federal Payment Levy Program by expanding the amount and type
of tax debt eligible for inclusion in the program, expanding the volume of
federal payments subject to levy, and correcting process and control
deficiencies that hindered the program's ability to maximize the amount
levied from payments to contractors with unpaid federal taxes. In our 2004
report, we also recommended that OMB develop options for prohibiting
federal contract awards to businesses and individuals that abuse the
federal tax system, including designating such tax abuse as a cause for
government wide debarment or suspension. The agencies involved did not
agree with all of our recommendations. We discuss their views and our
responses in detail in our reports, as well as our continued belief that
our recommendations are valid. Consistent with our recommendation to OMB,
I believe Congress should consider suspending government business with
contractors who are delinquent on their taxes as of a specific and
prospective effective date, with a provision for limited waivers if
necessary in unique circumstances.
20 GAO, Financial Management: Some DOD Contractors Abuse the Federal Tax
System with Little Consequence, GAO-04-95 (Washington, D.C.: Feb. 12,
2004). Although some of the contractors were corporations, we did not
estimate how many were corporations.
21 GAO, Financial Management: Thousands of Civilian Agency Contractors
Abuse the Federal Tax System with Little Consequence, GAO-05-637
(Washington, D.C.: June 16, 2005).
22 Payroll taxes are amounts that businesses withheld from employees'
wages for federal income taxes, Social Security, and Medicare but failed
to remit to IRS, as well as the related employer matching contributions
for Social Security and Medicare taxes.
23 We considered activity to be abusive when a contractor's actions or
inactions, though not illegal, took advantage of the existing tax
enforcement and administration system to avoid fulfilling federal tax
obligations and were deficient or improper when compared with behavior
that a prudent person would consider reasonable. We characterized as
potentially criminal any activity related to federal tax liability that
may be a crime under a specific provision of the Internal Revenue Code.
Capital Gains Basis Reporting
Finally, you also asked us to testify on a report-done at your
request-that we are issuing today on individual taxpayers' compliance in
reporting capital gains' income from the sale of securities.24
Misreporting such income25 contributes to the annual tax gap, which is the
gap between tax amounts that taxpayers should pay under the law and do pay
voluntarily and on time. For tax year 2001, the IRS estimated a gross tax
gap of $345 billion, of which at least $11 billion is attributed to
individual taxpayers who misreported their income from capital gains or
losses.26 Taxpayers are to determine their capital gains or losses by
subtracting the "basis" amount, which is generally the cost for an asset,
from the gross proceeds amount when selling the asset.
24 GAO, Capital Gains Tax Gap: Requiring Brokers to Report Securities Cost
Basis Would Improve Compliance if Related Challenges Are Addressed,
GAO-06-603 (Washington, D.C.: June 13, 2006).
25 Taxpayers are to report gains or losses from selling securities on
Schedule D of the federal income tax returns as well as the purchase and
sale dates, adjusted cost basis, and gross proceeds from the sale.
26 The overall capital gains tax gap could be larger than $11 billion if
IRS had estimated the portion of the $48 billion tax gap for unfiled tax
returns or unpaid taxes that is related to capital gains. According to an
IRS research official, in mid-2006, IRS plans to publish its final report
on the 2001 tax gap that will include an updated tax gap estimate based on
a refined methodology. It is possible that the updated tax gap figures
could differ from the current estimates.
In summary:
o For tax year 2001, an estimated27 36 percent (over 7 million)
of individual taxpayers who sold securities misreported capital
gains or losses. Using the wrong cost basis for the securities was
a primary type of noncompliance leading to this misreported
income. About two-thirds of the misreporting taxpayers understated
gains or overstated losses, while about one-third overstated gains
or understated losses. Additionally, a few taxpayers with
securities sales misreported whether their gains or losses were
short-term or long-term.28
o IRS attempts to address misreported securities sales' income
through enforcement and taxpayer service programs, which are to
find noncompliance or help taxpayers comply voluntarily. Various
challenges limit the impact of these programs, such as that IRS
enforcement programs contact relatively few taxpayers and the lack
of cost basis information impedes efficient use of IRS's
enforcement resources. IRS also faces difficulties in ensuring
that taxpayers understand their obligations for determining and
reporting their capital gains and losses.
o Expanding information reporting29 to taxpayers and IRS on
securities sales to include cost basis has potential to improve
taxpayer voluntary compliance and help IRS verify securities gains
or losses. Basis reporting would raise challenges, many of which
can be mitigated to some extent. For example, broker costs would
increase but could be constrained by limiting the scope of any
reporting requirement and by building on the basis reporting to
taxpayers that many brokers already do. For example, reporting
basis for only future purchases would mitigate challenges when
brokers do not know the basis for securities purchased in the
past. To the extent that actions to mitigate the challenges to
basis reporting delay its implementation or limit coverage to only
certain types of securities, the resulting improvements to
taxpayers' voluntary reporting compliance would be somewhat
constrained. IRS's broad authority to require information
reporting for securities sales may not be enough to require all
the actions necessary to implement cost basis reporting and
mitigate the challenges.
27 Our estimates are based on a review of a probability sample of IRS
examinations selected from the nearly 46,000 randomly selected individual
tax returns for tax year 2001 in its National Research Program, IRS's most
recent study of individual tax compliance. We express our confidence in
our estimates as a 95 percent confidence interval, plus or minus the
margin of error. Our estimate for the percentage of misreporting taxpayers
has a sampling error of (+/-) 7 percent or less, and we are 95 percent
confident that from 6.2 million to 8.3 million taxpayers misreported
securities sales.
28 Securities assets sold after being held for 1 year or less are
considered short-term while others sold are considered to be long-term and
are generally taxed at lower tax rates.
29 Information reporting involves third parties filing returns with IRS
and taxpayers to report certain income. Brokers are required to file Form
1099-B with IRS and the taxpayer to report such information for securities
sales as the dates, number of shares, and gross proceeds of the sale, but
not the cost basis.
Based on these results, our report includes matters that Congress may want
to consider, including requiring brokers to report to both taxpayers and
IRS the adjusted basis of sold securities and ensuring that IRS has
sufficient authority to implement the requirement. Congress could also
require brokers to report whether the securities sold were short- or
long-term and IRS to work with brokers to develop rules that mitigate the
challenges. Further, we recommend that IRS modify the instructions for the
individual tax return to (1) clarify the appropriate use of capital losses
to offset capital gains or other income and (2) provide guidance on
resources available to taxpayers to determine basis. IRS agreed with our
recommendations.
Mr. Chairman, this concludes my prepared statement. I would be happy to
respond to any questions you or other Members of the Committee may have at
this time.
Contacts and Acknowledgments
For further information on this testimony, please contact Michael Brostek
at (202) 512-9110 or [email protected] . David Lewis, Assistant Director;
Jeffrey Arkin; Kevin Daly; Amy Friedheim; Thomas Gilbert; Lawrence Korb;
Signora May; Edward Nannenhorn; Cheryl Peterson; Michael Rose; Marylynn
Sergent; Thomas Short; Michael Volpe; James White, Jennifer Wong; and
James Wozny made key contributions to this testimony.
(450506)
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Highlights of GAO-06-851T , a Testimony to Committee on Finance, U.S.
Senate
June 13, 2006
TAX COMPLIANCE
Challenges to Corporate Tax Enforcement and Options to Improve Securities
Basis Reporting
Corporate income taxes are expected to bring in about
$277 billion in 2006 to help fund the activities of the federal
government. Besides raising revenue, the tax alters investment decisions
and raises concerns about competitiveness in an environment of increasing
global interdependency. The complexity of the tax breeds tax avoidance,
including an estimated $32 billion of noncompliance detected by the
Internal Revenue Service (IRS).
This testimony provides information on trends in corporate taxes and
opportunities to improve corporate tax compliance.
The committee also asked that GAO discuss recent work on the misreporting
of capital gains income from securities sales and options to improve
compliance.
This statement is based largely on previously published GAO work.
The corporate income tax is an important source of federal revenue and
must be considered in dealing with the nation's long-term fiscal
imbalance. Reexamining both federal spending and revenues, including
corporate tax policy, corporate tax expenditures and corporate tax
enforcement must be part of a multi-pronged approach to address the
imbalance.
Corporate Income Tax Revenues as a Share of Federal Taxes, 1962-2005
Source: GAO Analysis of OMB Data.
The total amount of corporate tax avoidance, which includes the $32
billion in noncompliance estimated by IRS, is unknown. A complex tax code,
complex business transactions, and often multinational corporate
structures make determining corporate tax liabilities and the extent of
corporate tax avoidance a challenge. Opportunities exist to improve
corporate tax compliance and include simplifying the tax code, obtaining
better data on noncompliance, continuing to oversee the effectiveness of
IRS enforcement, leveraging technology, and sending sound compliance
signals through increased collections of taxes owed.
In a companion report issued today, GAO found that many taxpayers
misreport capital gains or losses, sometimes inappropriately underpaying
their taxes and sometimes overpaying them. IRS has efforts in place to
help ensure proper reporting of capital gains and losses, but these
efforts face several obstacles. GAO found that expanding third-party
information reporting on the cost basis of capital assets could help
mitigate this problem if related problems are addressed. GAO suggested
that Congress consider requiring brokers to report adjusted basis to
taxpayers and IRS and requiring IRS to work with the securities industry
to develop cost-effective ways to mitigate reporting challenges. GAO also
recommended that IRS clarify its guidance on reporting capital gains and
losses.
*** End of document. ***