International Taxation: Transfer Pricing and Information on Nonpayment of
Tax (Letter Report, 04/13/95, GAO/GGD-95-101).

Pursuant to a congressional request, GAO provided information regarding
transfer pricing issues and foreign-controlled corporations' (FCC) and
U.S.-controlled corporations' (USCC) tax compliance, focusing on: (1)
the Internal Revenue Service's (IRS) handling of transfer pricing issues
through its examinations, appeals, and litigation functions; and (2) IRS
use of available regulatory and procedural tools.

GAO found that: (1) recent IRS experiences with transfer pricing cases
have been mixed; (2) although there were as many regulatory violations
in 1993 and 1994 as in previous years, the value of the 1994 adjustments
increased $1.3 billion over 1993 adjustments; (3) a large number of the
1993 and 1994 cases involved pricing methods other than the three
methods specifically described in earlier IRS regulations; (4) the
outcomes of IRS appeals and legal processes for the 2 years were similar
to those in 1987 and 1988, with a sustention rate of about 30 percent of
the proposed adjustments' value; (5) IRS has used certain procedural
tools, such as simultaneous examinations and arbitration, as effective
deterrents to abusive transfer pricing practices; (6) IRS expects to
increase its use of advanced pricing agreements; (7) the success of the
new transfer pricing regulations remains to be seen; (8) about 75
percent of FCC and 60 percent of USCC paid no U.S. income tax between
1987 and 1991; (9) the corporations that paid U.S. taxes in 1991 held 80
percent of FCC and USCC assets and generated 81 percent of their
receipts; (10) the largest nontaxpaying corporations accounted for most
FCC and USCC assets and receipts; and (11) factors other than transfer
pricing abuse may contribute to the differences in tax amounts paid by
FCC and USCC.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  GGD-95-101
     TITLE:  International Taxation: Transfer Pricing and Information on 
             Nonpayment of Tax
      DATE:  04/13/95
   SUBJECT:  Tax administration
             Foreign investments in US
             Tax nonpayment
             Tax evasion
             Foreign corporations
             Income taxes
             Price adjustments
             Litigation
             Tax law
             Voluntary compliance

             
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Cover
================================================================ COVER


Report to Congressional Requesters

April 1995

INTERNATIONAL TAXATION - TRANSFER
PRICING AND INFORMATION ON
NONPAYMENT OF TAX

GAO/GGD-95-101

Transfer Pricing


Abbreviations
=============================================================== ABBREV

  AC(I) - Assistant Commissioner (International)
  APA - Advance pricing agreement
  FCC - Foreign-controlled corporation
  IRS - Internal Revenue Service
  SOI - Statistics of Income
  USCC - U.S.-controlled corporation

Letter
=============================================================== LETTER


B-260157

April 13, 1995

The Honorable Byron L.  Dorgan
United States Senate

The Honorable Paul E.  Kanjorski
House of Representatives

This report responds to your requests to provide recent data on
transfer pricing issues and on tax compliance of foreign- and
U.S.-controlled corporations.\1 Specifically, we are providing
information and analysis to update our 1993 work on (1) IRS' recent
experience in dealing with transfer pricing issues through its
examinations, appeals, and litigation functions and (2) IRS' use of
available regulatory and procedural tools.  We have also used 1990
and 1991 tax data to update our analyses of how many U.S.-controlled
corporations (USCC) and foreign- controlled corporations (FCC)\2 ,
did not pay U.S.  income taxes.  Our 1993 work in some instances
provided information for tax years dating back to 1987. 


--------------------
\1 We previously testified on these issues in International Taxation: 
Updated Information on Transfer Pricing (GAO/T-GGD-93-16, Mar.  25,
1993) and provided tax information in International Taxation:  Taxes
of Foreign- and U.S.- Controlled Corporations (GAO/GGD-93-112FS, June
11, 1993). 

\2 Foreign-controlled corporations are U.S.  corporations of which at
least a specified percentage of the voting stock is owned by a
foreign individual, partnership, corporation, estate, or trust. 
U.S.-controlled corporations are other corporations, although certain
entities such as subchapter S corporations, which are corporations
that are treated for federal income tax purposes like partnerships,
are not included in either category. 


   BACKGROUND
------------------------------------------------------------ Letter :1

A transfer price is the price charged by one company for a product or
service supplied to a related company, such as the price a parent
corporation charges its wholly-owned subsidiary.  Any company that
has a related company with which it transacts business establishes
transfer prices for those intercompany transactions.  Although often
associated with the pricing of tangible goods, transfer pricing
occurs whenever income and expenses are allocated among interrelated
companies.  For example, the payment of royalties, interest payments
for debts, leasing expenses, and fees for other services between
interrelated companies are transactions requiring transfer prices. 

Pricing of intercompany transactions affects the distribution of
profits and, therefore, taxable income among the related companies
and, sometimes, across tax jurisdictions.  Abusive transfer pricing
occurs when income and expenses are improperly allocated among
interrelated companies for the purpose of reducing taxable income in
a high-tax jurisdiction.  Underpayment of U.S.  income taxes can
result from inappropriate transfer pricing between interrelated
companies with operations in both the United States and in a country
with a lower tax burden.  Even when the U.S.  corporate tax rate is
lower than that of some other country, transfer pricing abuses can
occur by shifting income through another related company that
operates in a tax haven, that is, a country with low or no taxes. 

The following is an example of abusive cross-border transfer pricing. 
A foreign parent corporation with a subsidiary operating in the
United States charges the subsidiary excessive prices for goods and
services rendered (for example, $1,000 instead of the going rate of
$600).  This raises the subsidiary's expenses (by $400), lowers its
profits (by $400), and effectively shifts that income ($400) outside
of the United States.  At a 35-percent U.S.  corporate income tax
rate, the subsidiary will pay $140 less in U.S.  taxes than it would
if the $400 in profits were attributed to it. 

Section 482 of the Internal Revenue Code provides IRS authority to
allocate income among related parties if IRS determines that the
transfer prices used by the taxpayer are inappropriate.  To evaluate
transfer pricing, the IRS examiner considers what the price would
have been if the parties had not been related to each other.  Such a
price between unrelated parties is called the "arm's length" price. 
Finding a section 482 violation, that is, a difference between the
price a related party charged and the arm's length price, the IRS
examiner can propose an adjustment to the taxpayer's income.  If the
taxpayer does not agree with the proposed adjustment, it can appeal
the dispute through IRS' appeals process or take the case to court. 

In July 1994, IRS issued new regulations under section 482 that
differed significantly from previous section 482 regulations.  Under
the new regulations, taxpayers have great latitude in establishing
transfer prices.  However, under 1993 legislation, taxpayers are
subject to new requirements for documenting their transfer prices,
and they face stiff penalties for substantially misstating them. 


   RESULTS IN BRIEF
------------------------------------------------------------ Letter :2

IRS' recent experiences with examinations, appeals, and litigation
relating to section 482 issues have been mixed.  For instance, in
1993 and 1994, IRS examiners found, as they had in previous years,
large section 482 violations.  However, the total dollar value of the
adjustments in the 2 years differed by $1.3 billion.  Examiners also
noted that, in a large proportion of cases, transfer pricing activity
involved pricing methods other than the three--uncontrolled price,
cost plus, and resale price--that were specifically described in
section 482 regulations over the years.  The outcomes of the appeals
and legal processes in 1993 and 1994 were similar to those in 1987
and 1988, with IRS sustaining less than 30 percent of the proposed
section 482 adjustment amounts.  In 1993 and the first part of 1994,
IRS had somewhat better success litigating large transfer pricing
cases than in 1990 through 1992. 

According to IRS officials, certain enforcement tools available to
IRS, such as measures to obtain information and stronger penalties,
have served mostly as deterrents that altered taxpayer behavior. 
Alternatives to traditional examinations, appeals, and litigation,
such as simultaneous examinations, arbitration, and advance pricing
agreements, either have been used infrequently or are expected to
grow in number in the future.  Similar to examiners' experience,
advance pricing agreements have prominently featured pricing methods
other than the three specifically described in earlier regulations. 

How successful the new transfer pricing regulatory regime will be
remains to be seen.  The flexibility that new regulations allow
taxpayers in applying the arm's length standard must be weighed
against the flexibility given IRS and the increased documentation
required of taxpayers under threat of penalty. 

A majority of all FCCs and USCCs paid no U.S.  income tax in each
year from 1987 through 1991, and the percentages of each--nearly
three-quarters of FCCs and about 60 percent of USCCs--remained
largely unchanged over the 5-year period.\3 Although taxpaying
corporations were a minority of all FCCs and USCCs, they owned the
majority of corporate assets and generated most of the receipts. 
Furthermore, the largest nontaxpaying corporations--those with assets
of $100 million or more--were relatively few in number but accounted
for relatively large proportions of all FCCs' and all USCCs' total
assets and receipts.  While the differences in tax payment rates
between FCCs and USCCs are not convincing evidence of transfer
pricing abuse, transfer pricing abuse cannot be ruled out as at least
a possible cause for part of the observed differences.  Other
factors, such as the different types of industries for the
nontaxpaying FCCs and USCCs, may also account for some of the
observed differences. 


--------------------
\3 The confidence intervals are plus or minus 4 percent for the FCC
data and plus or minus 0.9 percent for the USCC data.  (See app.  V.)


   IRS' EXAMINATION, APPEALS, AND
   LITIGATION EXPERIENCES WITH
   SECTION 482 WERE MIXED
------------------------------------------------------------ Letter :3

IRS' international examiners continued to propose substantial
adjustments to the taxable income of FCCs and USCCs in fiscal years
1993 and 1994, although the total dollar value of the adjustments in
1993 was $1.3 billion less than in 1994.  In examinations finished in
fiscal year 1993, international examiners proposed adjustments to
taxable income of $2.2 billion for 369 corporations--$900 million for
247 FCCs and $1.3 billion for 122 USCCs.  For 1994, IRS data showed
$3.5 billion in proposed adjustments. 

Most of the dollar value of these proposed section 482 adjustments
was for large cases, those that had total proposed adjustments of $20
million or more.  For example, in 1993 examiners proposed $1.8
billion in adjustments for 51 of these large cases--$700 million for
18 FCCs and $1.1 billion for 33 USCCs.  Although the 18 large FCCs
subject to proposed income adjustments in 1993 represented an
increase in number over the previous 4 years, when 11 to 13 FCCs were
subject to proposed income adjustments for transfer pricing, they
also represented a decrease in dollars.  The number of USCCs subject
to income adjustments for transfer pricing in 1993, in contrast, was
about the same as in previous years, although this group also
involved fewer dollars.\4 According to IRS, the 1993 adjustments for
transfer pricing might be understated due to data that were lost in
implementing a new management information system. 

Transfer pricing issues for which IRS examiners proposed income
adjustments in 1993 occurred about equally in four categories, while
pricing of tangible goods represented the largest share of the
adjustment dollars proposed.  As shown in figure 1, the categories
with the most frequent section 482 issues were interest, royalties,
pricing of tangible goods, and a nonspecific category of income
allocations and deductions, each accounting for between 11 and 14
percent of occurrences found by IRS examiners.  Yet, adjustments for
pricing of goods accounted for 49 percent of all the section 482
adjustment dollars proposed. 

   Figure 1:  Section 482 Issues
   With Proposed Income
   Adjustments and Their Related
   Dollars, As Percentages of All
   Proposed Section 482 Issues and
   Dollars, Fiscal Year 1993

   (See figure in printed
   edition.)

Note 1:  A particular taxpayer may have multiple occurrences--that
is, multiple challenges by IRS--for the same section 482 issue. 

Note 2:  Income/deductions is a general category whose full title is
allocation of income and adjustments. 

Source:  GAO analysis of IRS data. 

IRS' recent experience with section 482 issues in the appeals
process--the IRS administrative process that attempts to negotiate
disputes--and with the Chief Counsel's office, which is also involved
in dispute resolution, was in some ways similar to, but also
different from, the experience about which we testified in March
1993.\5 The section 482 issues pending resolution in Appeals or in
litigation with Counsel involved about the same dollar value, $14
billion in both June 1994 and September 1992, the dates for which
information was available for our current report and for our March
1993 testimony.  However, fewer taxpayers were involved at the more
recent date--114 as opposed to 180 in the earlier time. 
Foreign-controlled taxpayers accounted for just under 20 percent of
the total both times.  The sustention rate for section 482 issues,
which is the ratio of income adjustments proposed by the examiners to
the final income adjustment after the appeals and legal processes ran
their courses, peaked at 52 percent in 1990, then in succeeding years
fell back to prior levels of less than 30 percent.\6

While the data IRS maintains on examination and appeals staff time do
not have sufficient detail to link them to specific tax issues, we
determined that IRS examiners, economists, and appeals staff spent
about 186 staff years on cases closed in fiscal year 1993 which
contained transfer pricing issues, compared to about 227 staff years
on cases closed in fiscal year 1992.  The 1993 cases, which involved
section 482 issues among other IRS findings, represented 148
international examiner years, 13 economist years, and 25 appeals
years.  According to IRS officials, the number of years associated
with closed cases can fluctuate over time because large cases incur
time charges over a period of years and close at different times
within a year. 

In calendar year 1993 and the first part of calendar year 1994, IRS
was more successful in litigating section 482 issues than it had been
in calendar years 1990 through 1992.  While IRS did not prevail in
any of the four major court cases with section 482 issues that we
analyzed, it lost only one and was a partial winner in the other
three. 


--------------------
\4 A few large adjustments significantly affect comparisons of
adjustments for FCCs and USCCs and across years because they comprise
large percentages of the totals. 

\5 GAO/T-GGD-93-16. 

\6 The great majority of section 482 proposed adjustments that were
closed in recent years were closed by Appeals as opposed to Counsel. 


   IRS MADE CIRCUMSCRIBED USE OF
   AVAILABLE PROCEDURAL TOOLS
------------------------------------------------------------ Letter :4

IRS has a number of procedural tools--that is, discretionary
measures, including designated summonses and formal document
requests, and additional penalties specifically for section 482--that
can be invoked to obtain needed documents, to encourage a
recalcitrant taxpayer's cooperation, or to otherwise facilitate
examinations.  IRS, however, actually used these tools infrequently
because, according to IRS officials, they had their desired effect as
deterrents inducing a positive change in taxpayer behavior, and
recordkeeping requirements were also helping.  Arbitration, a tool
available only if both parties agree, was used only once for section
482 issues--with a favorable outcome for IRS.  Simultaneous
examinations of related parties by IRS and foreign tax enforcement
agencies promote tax compliance and exchange of documents, but, for a
number of reasons, including questions of the timing of examinations,
IRS and the foreign governments have only agreed to examine five to
eight each year.  Advance pricing agreements (APA), which allow the
taxpayer to detail and IRS to approve in advance the methodology to
be used in setting transfer prices, require an upfront investment of
resources to negotiate in order to save IRS examination time in
future years.  APAs increased from the 9 we cited in our 1993
testimony\7 to 26 completed as of January 1995.  IRS expected the
number of APAs to grow significantly in the immediate future, which
will require additional upfront staff time. 


--------------------
\7 GAO/T-GGD-93-16. 


   SUCCESS OF NEW REGULATIONS IS
   UNCLEAR
------------------------------------------------------------ Letter :5

Issued in July 1994, the final transfer pricing regulations are too
recent for their impact to be known.  The new regulations replace the
strict priority of pricing allocation methods contained in the prior
regulations with the best method rule, which recognizes that the most
reliable measure of an arm's length result will vary depending upon
the facts and circumstances of the transaction under review.  As a
result, taxpayers will have flexibility in selecting and justifying
transfer prices, and IRS will also be using considerable judgment in
applying the arm's length standard.  As it was, taxpayers were
already using transfer pricing methods other than the three formerly
most well-defined methods for a large proportion of their transfer
pricing activity reviewed by IRS, including that in APAs.  The new
regulations also recognize a range of acceptable transfer prices,
providing a taxpayer protection for a reasonable and economically
justified pricing methodology. 

The Omnibus Budget Reconciliation Act of 1993 required
contemporaneous documentation of the pricing method used in setting
transfer prices and established more widely applicable penalties for
transfer pricing abuses than existed earlier.  The extent to which
the new documentation requirements and IRS' use of judgment in
applying the arm's length standard will offset the risks of
controversy brought on by taxpayer flexibility remains to be seen. 


   THE MAJORITY OF FCCS AND USCCS
   PAID NO U.S.  INCOME TAX
------------------------------------------------------------ Letter :6

In each of the 5 years studied, FCCs were less likely than USCCs to
pay U.S.  income tax, as shown in figure 2 and appendix V.  In 1991,
73 percent of FCCs paid no U.S.  income tax compared with 62 percent
of USCCs.  The relative flatness of the top two lines in the figure
demonstrates how little has changed overall during this 5-year
period.  Yet, the bottom two lines show that between 1987 and 1991 an
increasing percentage of large FCCs and USCCs (those with assets of
$100 million or more) did not pay U.S.  income tax. 

   Figure 2:  Percentage of
   Corporations That Paid No U.S. 
   Income Taxes, 1987-1991

   (See figure in printed
   edition.)

Note:  Data presented are based on the number of corporate income tax
returns filed with IRS in the indicated year.  Large FCCs or USCCs
are those with assets of $100 million or more in the year the tax
return was filed. 

Source:  GAO analysis of IRS data. 


      NONTAXPAYING FCCS AND USCCS
      HAD SMALLER SHARES OF ASSETS
      AND RECEIPTS THAN THEIR
      TAXPAYING COUNTERPARTS
---------------------------------------------------------- Letter :6.1

The nontaxpaying corporations, both FCCs and USCCs, accounted for the
majority of all returns filed in 1991, but for much smaller
proportions of total corporate assets and receipts.  Although 73
percent of FCCs paid no U.S.  income tax in 1991, they accounted for
only 37 percent of the assets and 31 percent of the gross receipts of
all FCCs that year, as shown in figure 3.  This means the 27 percent
of FCCs that paid U.S.  income tax had 63 percent of FCC assets and
69 percent of receipts.  Similarly, 62 percent of USCCs paid no U.S. 
income tax in 1991, but these nontaxpaying corporations accounted for
only 20 percent of the assets and 19 percent of receipts of all
USCCs.  So, the 38 percent of USCCs that paid U.S.  income tax in
1991 held 80 percent of the assets and generated 81 percent of all
gross receipts. 

   Figure 3:  Nontaxpaying
   Corporations' Proportions of
   Corporate Returns, Assets, and
   Receipts--Fiscal Year 1991

   (See figure in printed
   edition.)

Note:  Percentages are the proportions of nontaxpaying FCCs' or
USCCs' numbers of returns filed, total assets, and gross receipts to
the returns, assets, and receipts of all FCCs or USCCs. 

Source:  GAO analysis of IRS data. 


      A FEW LARGE NONTAXPAYING
      CORPORATIONS ACCOUNTED FOR A
      LARGE SHARE OF GROSS
      RECEIPTS
---------------------------------------------------------- Letter :6.2

The largest nontaxpaying FCCs and USCCs were relatively few in number
but had disproportionately large shares of total assets and gross
receipts relative to all FCCs and all USCCs.  In 1991, 715
nontaxpaying FCCs and 3,713 nontaxpaying USCCs had assets of $100
million or more.  The large nontaxpaying FCCs accounted for only 1.5
percent of all FCCs that filed U.S.  corporate income tax returns in
1991 but 31 percent of all FCCs' assets and 22 percent of their total
receipts.  Similarly, the largest nontaxpaying USCCs represented
one-fifth of 1 percent (0.2 percent) of returns but 16 percent of
assets and less than 7 percent of receipts generated by all
U.S.-controlled corporations in 1991.  Conversely, smaller
nontaxpaying FCCs (those with assets under $100 million) accounted
for 71 percent of the 48,246 FCCs in 1991 but only 6 percent of FCC
assets and 9 percent of FCC receipts.  For USCCs, the smaller
nontaxpaying corporations accounted for 62 percent of all USCC
returns but only 4 percent of assets and 12 percent of the gross
receipts. 


      REASONS WHY FCCS PAID LESS
      OR NO U.S.  INCOME TAX ARE
      UNCLEAR
---------------------------------------------------------- Letter :6.3

As already discussed, large FCCs were more likely than large USCCs to
pay no U.S.  income tax.  Furthermore, large FCCs that did pay income
tax, on average, paid less in taxes relative to receipts than their
taxpaying U.S.  counterparts in 1991.  Abusive transfer pricing--that
is, inflating prices of intercompany transactions to shift income
outside the United States and reduce tax liability--is logically
suspect as a possible cause of these observations, yet this suspicion
is not easily confirmed by analyzing the tax data. 

For example, costs of goods sold and purchases accounted for larger
proportions of receipts for large nontaxpaying FCCs than for USCCs,
as would be expected if FCCs were inflating the price of goods more
than USCCs were.  Yet, it is not true that interest paid as a
percentage of receipts is higher for the FCCs than for the USCCs, as
would be expected if FCCs were shifting income by inflating interest
paid to a related party.  So, while abuse of transfer pricing may be
occurring and may be a reason why FCCs are more likely to pay no or
less tax than USCCs, other factors, such as differences between FCCs'
and USCCs' industries, may be at work.  Analysis of industry
representation found that large nontaxpaying FCCs were more likely to
be in manufacturing and wholesale trade, and less likely to be in
finance, insurance, and real estate, than the large nontaxpaying
USCCs--differences that may explain some of the tax disparities. 


   OBJECTIVES, SCOPE, AND
   METHODOLOGY
------------------------------------------------------------ Letter :7

As mentioned earlier, our objectives for this report were to provide
information and analysis to update our 1993 work on (1) IRS' recent
experience in dealing with transfer pricing issues through its
examinations, appeals, and litigation functions; (2) IRS' use of
available regulatory and procedural tools; and (3) the extent to
which USCCs and FCCs did not pay U.S.  income taxes.  In some cases,
the information we were updating dated back to tax year 1987.  To
meet the objectives relating to IRS' recent experience and use of its
tools, we obtained and analyzed the most recent data available from
IRS.  To update our analyses of nonpayment of U.S.  income taxes by
FCCs and USCCs, we obtained and analyzed data on U.S.  corporate
income tax returns for the 1990 and 1991 tax years, again the most
recent IRS data available at the time we did our work.  See appendix
I for a full discussion of our objectives, scope, and methodology. 


   AGENCY COMMENTS
------------------------------------------------------------ Letter :8

We discussed a draft of this report with responsible Treasury and IRS
officials on January 27 and 31, 1995.  These officials included
members of the Office of the Assistant Secretary of the Treasury for
Tax Policy, the Deputy Assistant Commissioner (International),
Appeals and other representatives of IRS' Office of Chief Counsel,
and an employee of IRS' Statistics of Income Division.  While
generally agreeing with the report's contents, the officials brought
to our attention corrected, updated, and clarifying information.  We
modified the report where appropriate. 

IRS officials also raised other points that merit special mention. 
First, they pointed out various initiatives related to transfer
pricing that were beyond the scope of our work.  These initiatives
included recent technological improvements given to IRS international
examiners. 

Second, an IRS official from the Statistics of Income Division noted
some limitations of our statistical analysis of the corporations that
did and did not pay taxes.  By focusing on corporations that paid no
tax, we gave little attention to those that paid minimal taxes.  By
defining large corporations in terms of asset size rather than
receipts, we included, for example, a larger number of finance
companies such as banks and fewer trade companies than we would have
otherwise.  Finally, by comparing all FCCs to all USCCs, we did not
consider industry differences. 

Although these limitations are inherent to some degree in our
selected methodology, our analyses provide data on corporations that
paid minimal taxes (see table V.4) and on industry differences (see
table V.6).  Further analyses would provide additional insights into
the differences between FCCs and USCCs. 


---------------------------------------------------------- Letter :8.1


As agreed with your office, unless you publicly announce its contents
earlier, we plan no further distribution of this report until 30 days
from the date of this letter.  At that time, we will send copies to
the Commissioner of the Internal Revenue Service, the Secretary of
the Treasury, and other interested parties.  The major contributors
to this report are listed in appendix VI.  If you have any questions,
please call me at (202)-512-9044. 

Natwar M.  Gandhi
Associate Director, Tax Policy and
 Administration Issues


OBJECTIVES, SCOPE, AND METHODOLOGY
=========================================================== Appendix I

Our objectives directly related to section 482 were to update our
1993 work by providing information and analyzing (1) how much money
was involved in transfer pricing cases, and what issues were at hand;
(2) what allocation methods were used or proposed; (3) how many
resources IRS used in transfer pricing cases; and (4) what regulatory
and procedural tools IRS used in transfer pricing cases.  Another
objective was to update our analyses of FCCs and USCCs that paid no
U.S.  income taxes by including 1990 and 1991, the latest years for
which tax data were available during our review.  In some instances,
the information we were updating dated back to tax year 1987. 

To determine how much money and what issues were involved in transfer
pricing cases, we used an examination database maintained by IRS'
Assistant Commissioner (International) (AC(I)).  At the time we used
it, this database contained relevant transfer pricing information
extracted from examination reports completed in fiscal year 1993 and
the first half of fiscal year 1994.  We obtained from IRS' Office of
Appeals information for a similar period generated from its case
database that generally had large issues and issues that met certain
tax deficiency or other criteria.  Finally, we researched 1993 and
early 1994 court cases involving transfer pricing issues. 

To determine the allocation methods used or proposed in transfer
pricing cases, we summarized information from a database that IRS
compiled in early 1993 covering fiscal years 1990 through 1992 to
help it share examination findings across the country.  We also
gathered data on the allocation methods appearing in advance pricing
agreements as of mid-1994. 

To determine how many resources IRS used in transfer pricing cases,
we again used the AC(I) examination database.  From this database, we
determined the amount of time international examiners and economists
spent on cases that involved section 482 issues and cases that did
not.  Similarly, the Office of Appeals provided us with the number of
hours spent by Appeals personnel on cases containing section 482
issues as well as other issues.\1

To report on the tools used by IRS personnel in transfer pricing
cases, we obtained data covering fiscal year 1993 (and 1994 when
available) from AC(I) and interviewed IRS and outside officials. 

We did not audit any of IRS' management information systems from
which we obtained section 482 data.  An IRS internal audit report
pointed out problems with some of the international management
systems, which IRS is improving.  For instance, due to a programming
error, IRS officials told us they could not be sure that the 1993 and
1994 international examination information they were giving us was
comprehensive or completely accurate, but they were continuing to
refine it.  According to IRS officials, problems with the data
included the loss of significant information categorizing audit
adjustments by specific issue, such as section 482.  The management
information we used was the best available at the time we did our
work. 

To determine the percentage of foreign-controlled and U.S.-controlled
corporations that paid no tax, we obtained from IRS' Statistics of
Income (SOI) Division data for 1990 and 1991.  As we did in 1993, we
broke these statistics out by returns, receipts, and assets.  The
statistics were based on tax returns as filed and did not reflect IRS
audits or net operating loss carrybacks that would result from any
losses in future years. 

The SOI statistics in this report, other than those for corporations
with assets of $100 million or more, are based on SOI's probability
sample of taxpayer returns and thus are subject to some imprecision
due to sampling variability.\2 In this report, we measure the
imprecision with the 95-percent confidence intervals that surround
estimates of numbers of taxpayers and the assets and receipts for
those taxpayers.  For example, our finding that 35,138
foreign-controlled corporations did not pay tax in 1991 is surrounded
by a 95-percent confidence interval of plus or minus 3,996.  This
means that the chances are 19 out of 20 that the interval from 31,142
to 39,134 includes the actual number of such corporations.  Table I.1
shows this and other confidence intervals for 1991. 

We worked mainly with IRS' National Office in Washington, D.C.  We
did our review from April through December 1994 in accordance with
generally accepted government auditing standards. 



                          Table I.1
           
            Confidence Intervals for Sampled Data,
                             1991

                    (Dollars in millions)

                   Lower bound       Estimate    Upper bound
---------------  -------------  -------------  -------------
FCCs not paying tax
------------------------------------------------------------
Number                  31,142         35,138         39,134
Assets                $675,460       $679,261       $683,062
Receipts              $352,812       $358,802       $364,792

USCCs not paying tax
------------------------------------------------------------
Number               1,246,529      1,265,272      1,284,016
Assets              $3,249,333     $3,256,986     $3,264,639
Receipts            $1,546,707     $1,569,477     $1,592,247
------------------------------------------------------------
Source:  GAO analysis of IRS data. 


--------------------
\1 Neither AC(I) nor Appeals had a system for capturing staff time
used on individual Internal Revenue Code sections. 

\2 SOI information for the largest corporations is not based on
samples and thus is not subject to sampling error. 


IRS' RECENT EXPERIENCE WITH
TRANSFER PRICING IN EXAMINATIONS,
APPEALS, AND LITIGATION
========================================================== Appendix II

In fiscal years 1993 and 1994, IRS examiners continued to propose
substantial section 482 adjustments to income.  However, IRS appeals
officers, who are charged with resolving tax controversies without
litigation, continued in 1993 and 1994 to substantially reduce
adjustments proposed by examiners in earlier years.  Further, IRS had
mixed success in litigating important section 482 cases in the
courts, although this was an improvement over its record in earlier
years. 


   IRS' EXAMINATION OF SECTION 482
   ISSUES
-------------------------------------------------------- Appendix II:1

As shown in table II.1, in fiscal years 1993 and 1994, for cases with
total proposed adjustments of $20 million or more, IRS proposed
section 482 income adjustments for 51 and 64 taxpayers, respectively,
of $1.8 billion and $3.5 billion.  The number of proposed adjustments
was similar to or larger than the numbers in previous years, although
the associated dollar amount for 1993 was significantly lower than in
several of those years.  The dollar amount can fluctuate, however, on
the basis of a few large adjustments.  Also, proposed adjustments to
income may or may not result in increased tax collections, depending
on such things as whether a company has offsetting adjustments,
offsetting corporate net operating losses carried over from other
years, or success in challenging the proposed adjustment. 



                                              Table II.1
                               
                               Proposed Section 482 Income Adjustments
                                    of Foreign-and U.S.-Controlled
                               Corporations With $20 Million or More of
                                      Total Proposed Adjustments

                                        (Dollars in billions)


                     Number of    Adjustment     Number of    Adjustment     Number of    Adjustment
Fiscal year       corporations        amount  corporations        amount  corporations        amount
----------------  ------------  ------------  ------------  ------------  ------------  ------------
1989                        12          $0.7            31          $4.1            43          $4.8
1990                        11           1.6            26           4.4            37           6.0
1991                        12           1.1            23           1.2            35           2.3
1992                        13           1.0            37           3.1            50           4.1
1993                        18           0.7            33           1.1            51           1.8
1994                        31           2.0            33           1.5            64           3.5
----------------------------------------------------------------------------------------------------
Note 1:  A few large adjustments significantly affect comparisons of
adjustments for foreign- and U.S.-controlled corporations because
they comprise large percentages of the totals. 

Note 2:  We generally used IRS' determinations of whether particular
corporations were foreign controlled, but if we were aware that an
IRS determination was incorrect, we used our own. 

Sources:  Data for 1989 through 1992 and for 1994 were accumulated by
IRS, and data for 1993 were developed by us working with IRS and
using information obtained from IRS' International Case Management
System. 

While the cases with proposed adjustments of $20 million or more
accounted for the bulk of all the dollars in proposed section 482
adjustments, they did not comprise the majority of all proposed
adjustments.  For instance, as shown in table II.2, for fiscal year
1993, IRS proposed $2.2 billion in section 482 adjustments to income
for 247 FCCs and 122 USCCs.\1 Only about 12 percent of the section
482 issues for any of these taxpayers were for tax years after 1990,
the first recent year in which transfer pricing received intensive
congressional scrutiny.  Tax years ranged from 1975 through 1992. 
Because we received the 1994 information at the end of our review, we
could not similarly analyze it.  According to IRS, both 1993 and 1994
adjustments for transfer pricing might be understated due to data
that were lost in implementing a new management information system. 



                                              Table II.2
                               
                                Total Proposed Section 482 Adjustments
                                   for Foreign-and U.S.-Controlled
                                             Corporations

                                        (Dollars in billions)


                     Number of    Adjustment     Number of    Adjustment     Number of    Adjustment
Fiscal year       corporations        amount  corporations        amount  corporations        amount
----------------  ------------  ------------  ------------  ------------  ------------  ------------
1993                       247          $0.9           122          $1.3           369          $2.2
1994                       236           2.0           156           1.5           392           3.5
----------------------------------------------------------------------------------------------------
Note:  Numbers do not always add due to rounding. 

Source:  IRS data on international examinations completed in fiscal
years 1993 and 1994.  GAO compiled the numbers for 1993, and IRS
supplied those for 1994. 

The nature of the section 482 issues IRS disputed varied from company
to company.  As shown in table II.3, several different sorts of
issues accounted for at least 7 percent each of the section 482
issues IRS raised in fiscal year 1993.  These relatively frequently
occurring issues were interest, royalties, intercompany pricing of
tangible goods, general allocation of income and deductions, and
service charges and fees, which accounted for 55 percent of all
section 482 challenges by IRS and 71 percent of section 482 dollars
involved. 



                                    Table II.3
                     
                        Most Frequently Occurring Proposed
                        Section 482 Income Adjustments for
                                 Fiscal Year 1993

                              (Dollars in millions)

                                              Percent of
                                                     all              Percent of
                                                 section                     all
                                                     482     Section     section
                                   Number of    proposed         482         482
                                  occurrence  adjustment     dollars     dollars
Issue description                       s \a           s    involved    involved
--------------------------------  ----------  ----------  ----------  ----------
Interest                                 249         14%        $ 32          1%
Royalties                                216          12          99           5
Pricing of tangible goods                195          11       1,083          49
Allocation of income and                 193          11         242          11
 deductions (general category)
Service charges and fees                 120           7         115           5
================================================================================
Total                                    973         55%      $1,570         71%
--------------------------------------------------------------------------------
\a A particular taxpayer may have multiple occurrences, that is,
multiple challenges by IRS for the same section 482 issue. 

Source:  IRS data. 

As shown in figure II.1, for cases closed in fiscal year 1993 or the
first half of fiscal year 1994, IRS spent about a third of its total
international examiner time, and a much higher percentage of its
economist time, on those cases that had a section 482 issue, among
other issues.\2 We could not break out the amount of time spent only
on section 482 because AC(I) did not have a system for capturing
staff time on individual Internal Revenue Code sections.  However,
using a formula provided by IRS, we estimated that for cases closed
in fiscal year 1993, IRS spent about 148 international examiner staff
years and about 13 economist staff years on examinations that
included a section 482 adjustment.  The corresponding numbers for
fiscal year 1992 were 164 and 19.\3

According to IRS officials, the time spent on cases closed is
expected to fluctuate from year to year because large cases may close
that incurred time charges over several years.  In addition, most of
the time reflected on cases that close early in a fiscal year will
likely have been incurred on the cases in previous years. 

   Figure II.1:  Percentage of
   International Examiner and
   Economist Staff Time Spent on
   Taxpayers With Section 482
   Issues

   (See figure in printed
   edition.)

Source:  GAO analysis of IRS data. 


--------------------
\1 As we reported in Tax Administration:  Information on IRS'
International Tax Compliance Activities (GAO/GGD-94-96FS, June 27,
1994), IRS' closed international examinations of FCC tax returns
increased 353 percent from fiscal year 1990 to 1993, while
examinations of other tax returns declined 31 percent.  In its
examination of corporations, IRS included in its category of FCCs
foreign corporations operating through branches in the United States. 

\2 According to IRS officials in January 1995, the equivalent
percentages for all of fiscal year 1994 were 39 percent of total
international examiner time and 75 percent of economist time. 

\3 In January 1995, IRS indicated that its computations for fiscal
year 1994 showed 190 international examiner staff years and 21
economist staff years spent on cases involving section 482 issues. 


   APPEALS CONTINUED TO
   SUBSTANTIALLY REDUCE EXAMINERS'
   PROPOSED INCOME ADJUSTMENTS
-------------------------------------------------------- Appendix II:2

When adjustments to income are proposed in examinations, the taxpayer
can take the dispute to Appeals, which is the administrative body
within IRS authorized to settle tax controversies.  Also, when
litigation is involved, so is IRS' Chief Counsel. 

In March 1993,\4 we testified that IRS' experience with section 482
issues in Appeals had not improved from the experience we described
in our 1992 report.\5 Since that time, while IRS examiners again
identified billions of dollars in proposed adjustments to income for
section 482 issues, Appeals again substantially reduced previous
years' proposals.\6


--------------------
\4 GAO/T-GGD-93-16. 

\5 International Taxation:  Problems Persist in Determining Tax
Effects of Intercompany Prices (GAO/GGD-92-89, June 15, 1992). 

\6 IRS staff do not track every issue related to section 482 but
believe they capture the large ones by generally focusing on large
issues and issues that meet certain tax deficiency or other criteria. 


      OPEN ISSUES\7
------------------------------------------------------ Appendix II:2.1

As table II.4 shows, as of June 30, 1994, IRS had 114 large taxpayers
with total section 482 proposed adjustments to income of $14.4
billion pending administrative resolution in Appeals or litigation
with Counsel as opposed to the 180 taxpayers with proposed section
482 adjustments of $14.4 billion as of September 30, 1992.\8 Thus,
although the dollar value of open proposed adjustments stayed the
same, the number of taxpayers involved declined.\9 As of June 30,
1994, IRS Appeals officials had spent almost 96,000 hours on the open
work units that contained section 482 issues as well as other issues. 
None of the tax returns involved were for tax periods after 1990.  Of
the $14.4 billion in proposed adjustments as of June 30, 1994, $1.8
billion was for foreign- controlled issues.\10



                                    Table II.4
                     
                             Open Section 482 Issues

                              (Dollars in billions)


Da    Number of       Dollar    Number of       Dollar    Number of       Dollar
te    taxpayers       amount    taxpayers       amount    taxpayers       amount
--  -----------  -----------  -----------  -----------  -----------  -----------
Se           34         $2.4          146        $12.0          180        $14.4
 p
 t
 e
 m
 b
 e
 r
 3
 0
 ,
 1
 9
 9
 2
Ju           19          1.8           95         12.6          114         14.4
 ne
 3
 0
 ,
 1
 9
 9
 4
--------------------------------------------------------------------------------
Source:  GAO analysis of IRS data. 


--------------------
\7 "Open" issues are issues referred beyond examination but not yet
settled. 

\8 We compared information for September 30, 1992, and June 30, 1994,
because those were the two dates for which data were available for
our March 1993 testimony (GAO/T-GGD-93-16) and our current report. 

\9 IRS officials attributed the decline to more examinations being
resolved at the examiner level without being appealed. 

\10 A small part of the information we received was for taxpayers,
such as individuals, that were not corporations.  Therefore, in
discussing this information, we use the terms "foreign-controlled
issues" and "U.S.-controlled issues" rather than FCCs and USCCs. 


      CLOSED ISSUES\11
------------------------------------------------------ Appendix II:2.2

In March 1993, we testified that from 1987 through 1989, 29 percent
of section 482 proposed adjustments to income were sustained by
IRS.\12 As shown in table II.5, this number rose to 52 percent in
1990 but declined in the years afterwards to the 21 to 28 percent
range.  A very large part of the section 482 proposed adjustments
were closed by Appeals as opposed to Counsel.  Sustention rates for
foreign-controlled issues fluctuated more than did those for
U.S.-controlled issues. 



                                              Table II.5
                               
                                Sustention Rates for Large Section 482
                                                Issues

                                        (Dollars in billions)


                      Proposed    Sustention      Proposed    Sustention      Proposed    Sustention
Fiscal year        adjustments          rate   adjustments          rate   adjustments          rate
----------------  ------------  ------------  ------------  ------------  ------------  ------------
1987                      $0.1           12%          $0.5           25%          $0.6           24%
1988                       0.5            34           1.5            25           2.0            27
1989                       0.2             9           1.0            43           1.2            37
1990                        NA            NA            NA            NA           1.8            52
1991                       0.2            24           2.0            28           2.2            28
1992                       0.4             5           1.5            30           1.9            24
1993                       0.4            20           0.5            32           0.9            27
1994\a                      NA            NA            NA            NA           1.0            21
----------------------------------------------------------------------------------------------------
\a We received the 1994 information late in our review and did not
have a chance to ascertain the breakout between foreign- and
U.S.-controlled issues. 

Note:  The 1991 sustention rate for foreign-controlled issues (24
percent) differs from the 23 percent that we reported in our 1993
testimony because we had more precise information available the
second time.  Also, the 1992 percentages are estimates derived from
less precise information than was available for the other years. 

Source:  GAO analysis of IRS data. 

In fiscal year 1993, the sustention rate was 27 percent, or $249
million of the $926 million of proposed adjustments to income.  This
percentage was very close to the 29-percent fiscal year sustention
rate for all international recommended tax, credit, and penalty
adjustments for large dollar issues that we reported in June 1994.\13
During fiscal year 1993, Appeals and Counsel closed 82 transfer
pricing issues (involving 51 taxpayers), and the vast majority of
those applied to tax years before 1988.  During fiscal year 1994,
Appeals and Counsel closed 61 transfer pricing issues and sustained
about $208 million of the slightly less than $1 billion proposed by
IRS for a sustention rate of 21 percent. 

Using a formula provided by IRS, we estimated that Appeals personnel
spent about 25 staff years on work units that included at least one
section 482 issue as well as possibly other issues that were closed
during fiscal year 1993.  Of these years, 7 percent, or about 2
years, were spent on foreign-controlled issues, and 93 percent, or
about 23 years, on U.S.-controlled issues.  For cases closed during
fiscal year 1992, Appeals personnel spent about 44 staff years. 


--------------------
\11 "Closed" issues are issues where settlement has been reached. 

\12 The sustention rate is the ratio of the adjustment amount
determined after an issue has been resolved by Appeals, Chief
Counsel, or a court to the adjustment amount proposed by examiners. 
IRS highly qualifies sustention rates because the data collected
before 1992 were not gathered to measure sustention rates and/or were
not subjected to rigorous accuracy checks.  Also, IRS cautions that
sustention rates for individual issues like section 482 ignore such
distortionary effects as those caused by negative proposed
adjustments.  Finally, according to IRS officials, the fluctuation in
sustention rates from year to year might be due to the resolution of
a few cases with large dollar implications. 

\13 GAO/GGD-94-96FS. 


      REASONS FOR REACHING A
      SETTLEMENT
------------------------------------------------------ Appendix II:2.3

In recent years, IRS began tracking the reasons why it reached a
particular settlement in particular cases.  As table II.6 shows, the
most prevalent reason why IRS reached a settlement of transfer
pricing issues in cases closed during fiscal year 1993 was concern
about whether a court would apply the same judgment to the evidence
as IRS had.  This reason appeared in 29 of the 82 issues closed,
accounting for 63 percent, or $426 million, of the $677 million
reduction in the original proposed adjustments to income. 



                          Table II.6
           
           Reasons for Fiscal Year 1993 Reductions
             to Proposed Section 482 Adjustments

                    (Dollars in millions)

                                                  Percent of
                           Number of      Amount     overall
Reason for reductions         issues     reduced   reduction
------------------------  ----------  ----------  ----------
Hazards of litigation             29        $426         63%
 relating to facts or
 evidence being open to
 judgment
Hazards of litigation             14         143          21
 relating to uncertainty
 about how the court
 will apply the law
New facts or evidence             14          98          14
 was obtained and
 evaluated by Appeals or
 Counsel
All reasons                       82        $677        100%
------------------------------------------------------------
Note:  The reasons here are not mutually exclusive; more than one
reason may be assigned to the same issue.  Also, the closed case
information that IRS gave us did not always have IRS reason codes
attached. 

Source:  IRS data. 

Two other reasons appeared in 14 issues each.  These were (1)
uncertainty about how the court would interpret or apply the law in a
particular case and (2) the need to deal with new facts or evidence
obtained and evaluated by Appeals or Counsel. 


   IRS' EXPERIENCE IN THE COURTS
   WITH TRANSFER PRICING ISSUES
-------------------------------------------------------- Appendix II:3

As shown in table II.7, IRS' recent experience in the courts with
section 482 has been mixed.  However, this is an improvement over
what we reported in our 1993 testimony--that is, that IRS lost a
significant section 482 issue for each of the five cases we examined. 



                          Table II.7
           
              Summary of Major Court Cases With
              Section 482 Issues Decided Between
              January 1, 1993, and May 20, 1994

              Date of   Date    Amount
              returns   of      at
Name          at issue  ruling  issue   Winner and ruling
------------  --------  ------  ------  --------------------
National      1978-     1994    $122    Mixed--The Tax Court
Semiconducto  1982              millio  increased the
r                               n in    taxpayer's income
Corporation                     income  under section 482 by
                                \a      $40.6 million to
                                        bring the pricing
                                        relationships closer
                                        to what would have
                                        occurred at arm's
                                        length. According to
                                        the Court, neither
                                        party presented the
                                        Court with evidence
                                        that would satisfy
                                        any of the
                                        prescribed methods
                                        of transfer pricing
                                        under section 482
                                        regulations. The
                                        Court, however,
                                        adopted the IRS
                                        expert's analysis
                                        with certain
                                        modifications as the
                                        "least unacceptable
                                        methodology"
                                        presented.

Seagate       1983-     1994    $285    Mixed--The Tax Court
Technology,   1987              millio  held that IRS'
Inc.                            n in    reallocation of
                                income  income under section
                                \b      482 was arbitrary
                                        and capricious but
                                        that the
                                        manufacturer failed
                                        to prove that the
                                        transactions were
                                        arm's length. The
                                        Court determined the
                                        appropriate transfer
                                        prices on the basis
                                        of its own "best
                                        estimate."

Perkin-       1975-     1993    $22     Mixed--The Tax Court
Elmer         1981              millio  noted that in this
Corporation                     n in    case, as in other
                                income  significant section
                                \c      482 cases, each
                                        party spent most of
                                        the time attacking
                                        the other party's
                                        allocation formula
                                        rather than
                                        establishing the
                                        soundness of its own
                                        formula. Thus, the
                                        Court was left to
                                        find a formula
                                        without the benefit
                                        of sufficient help
                                        from the parties.
                                        Income allocations
                                        to the taxpayer were
                                        less than called for
                                        by IRS.

Exxon         1979-     1993    Over    Taxpayer--The Tax
Corporation/  1981              $6.5    Court rejected IRS'
Texaco,                         billio  income reallocation,
Inc./Aramco                     n in    stating that
Advantage                       taxes\  restrictions from
                                d       the Saudi Arabian
                                        government made a
                                        higher transfer
                                        price legally
                                        unfeasible.
------------------------------------------------------------
Note:  We selected the four cases by reviewing cases decided between
January 1, 1993, and May 20, 1994, that involved what we considered
to be a major section 482 reallocation issue.  IRS officials agreed
that we had selected the major cases. 

\a After an expert's recommendation was taken into account, the
maximum total proposed adjustment at trial was less than $77 million. 

\b As reflected in expert reports introduced at trial, the total
proposed adjustment became $171 million. 

\c IRS' alternative trial position showed income at issue to be $29
million. 

\d According to commentators, the Aramco Advantage case represents
the biggest dollar deficiency in Tax Court history. 

Sources:  Court cases. 

In this report, we identified four major section 482 cases that had
been decided in court between January 1, 1993, and May 20, 1994. 
These cases took an average of 15 years from the earliest tax year
audited until resolution in the courts.  As we reported in our 1993
testimony,\14 cases like these illustrate how disputes over section
482 issues can become extremely expensive for taxpayers and the
government by requiring the employment of outside experts, resulting
in long, drawn out litigation and keeping corporate tax liabilities
in an uncertain status for years. 

In three of the cases, the Tax Court expressed its displeasure with
IRS and found its reallocation of income to be arbitrary, capricious,
or unreasonable.  However, an IRS official noted that under its
standard of review, the Tax Court must find IRS "arbitrary and
capricious" to differ with adjustments proposed by IRS and then try
to find a middle ground between the company and IRS.  Thus, even
though IRS was found arbitrary, capricious, and unreasonable in the
National Semiconductor case, the Tax Court still increased the
taxpayer's income by $40.6 million.  IRS also noted that in the one
case in which the taxpayer was the complete winner--the Aramco
Advantage case--the Tax Court limited IRS' authority to propose
adjustments under section 482. 


--------------------
\14 GAO/T-GGD-93-16. 


IRS' USE OF CERTAIN PROCEDURAL
TOOLS
========================================================= Appendix III

IRS used certain new and existing procedural tools--designated
summonses, formal document requests, additional penalties,
simultaneous examinations, and arbitration--sparingly.  However,
advance pricing agreements (APA) were increasingly used.  Gauging the
ultimate impact of procedural tools is difficult because, while their
direct use is limited, their real effectiveness may be as deterrents
that alter behavior and as remedies to uncertainty.  Also, while IRS
can use some of the tools unilaterally, it must have a partner for
others. 


   DESIGNATED SUMMONSES AND FORMAL
   DOCUMENT REQUESTS
------------------------------------------------------- Appendix III:1

As shown in table III.1, very few designated summonses for transfer
pricing cases have been used since they were sanctioned by Congress
in 1990.  Designated summonses are summonses issued by IRS that could
result in suspending the running of the statute of limitations
governing the time IRS has for assessing additional taxes against a
taxpayer.  According to IRS officials, increased taxpayer cooperation
has made the use of designated summonses unnecessary, and just the
threat that the designated summonses could be imposed is enough to
stir taxpayers to action. 



                         Table III.1
           
              Number of Designated Summonses and
                   Formal Document Requests

                              Designated     Formal document
Fiscal year                    summonses            requests
--------------------  ------------------  ------------------
1991                                   2                  28
1992                                   1                  13
1993                                   0                   3
1994 (first half)                      0                   1
------------------------------------------------------------
Note:  IRS believed that the information for 1993 and 1994 might not
have been complete, but that complete information would not have been
significantly different.  Also, some of the activity listed here may
not relate to transfer pricing issues. 

Source:  IRS. 

A similar reason was given for the drop in formal document requests
issued by IRS from 28 in 1991 to 1 in the first half of fiscal year
1994, also included in table III.1.  Formal document requests are
issued when relevant taxpayer documents are outside the United
States.  According to one IRS official, the need for formal document
requests has been overtaken by the success of section 6038A of the
Internal Revenue Code, which outlines recordkeeping requirements for
certain foreign-owned corporations.  IRS provided us many examples of
taxpayers who became more compliant in the face of section 6038A. 


   ADVANCE PRICING AGREEMENTS
------------------------------------------------------- Appendix III:2

Since our 1993 testimony,\1 IRS has continued to make progress with
its APAs, which are agreements under a program begun in fiscal year
1991 in which IRS approves ahead of time the methodology a taxpayer
volunteering for the program will use in setting transfer prices. 
According to IRS' APA program director, as of January 1995, 26 APAs
were complete, up from the 9 APAs we cited in our 1993 testimony. 

The director also anticipated substantial additional growth in APAs
and growth in APA staff resources in the immediate future as the APA
office was entertaining about 100 active matters.  He expected the
extra resources to result in reduced audit demands and enhanced
voluntary compliance.  When we asked, IRS did not have information on
the number of staff hours it had devoted to APAs. 


--------------------
\1 GAO/T-GGD-93-16. 


   ADDITIONAL PENALTIES
------------------------------------------------------- Appendix III:3

Section 6662 of the Internal Revenue Code, as modified in 1990 and
1993, imposes substantial penalties on tax underpayments attributable
to certain transfer prices that were substantially misstated. 
According to an IRS official, only one penalty has been proposed
since new provisions took effect in 1990 because substantiating
penalties was originally difficult on account of the broad exceptions
allowed.  The difficulty was eased, according to the official,
starting in April 1993, when tougher documentation standards went
into effect.  To head off concerns that penalties might be applied
inconsistently or unfairly, future penalties must be reviewed by an
IRS Penalty Oversight Committee. 

Since the latest version of the penalties was enacted for tax years
beginning after December 31, 1993, the full force and impact of the
penalty cannot be measured at this time.  However, IRS officials
believe that taxpayers are acting differently than they did before
because of the existence of the penalties. 


   SIMULTANEOUS EXAMINATIONS
------------------------------------------------------- Appendix III:4

In simultaneous examinations, the United States and another country
examine related parties under their jurisdictions at the same time in
an effort to promote international tax compliance and information
exchange. 

As shown in figure III.1, the number of simultaneous examinations
proposed in fiscal years 1993 and 1994--18--was substantially lower
than the 33 proposed in 1991 and 1992, which in turn was a much
higher number than were proposed in previous years.  However, from
1991 through 1994, only a moderate number of the proposed
simultaneous examinations had been accepted for follow through at the
time of our review, although a few were still pending.  According to
an IRS official, the relatively high number of proposals in 1991 and
1992 was due to a misunderstanding between IRS and foreign countries. 

   Figure III.1:  Simultaneous
   Examinations Proposed and
   Accepted During Fiscal Years
   1991 Through 1994

   (See figure in printed
   edition.)

Source:  IRS. 

As we testified in 1993, for years, at least since our 1981 report on
transfer pricing, IRS has emphasized that its simultaneous
examination program is important in protecting U.S.  interests in
international tax enforcement.\2 According to an IRS official,
however, questions of the timing of U.S.  and foreign examinations,
examination proposal format, and resources have presented obstacles
to doing more simultaneous examinations.  However, IRS has developed
model procedures to encourage the carrying out of more of these
examinations. 


--------------------
\2 IRS Could Better Protect U.S.  Tax Interests in Determining the
Income of U.S.  Multinational Corporations (GAO/GGD-81-81, Sept.  30,
1981). 


   ARBITRATION
------------------------------------------------------- Appendix III:5

Only one section 482 case has been resolved through arbitration, even
though both IRS and the taxpayer considered that arbitration a
success.  Under Tax Court Rule 124, any time a factual case is at
issue and before trial, the parties to the case may move to resolve
it through voluntary binding arbitration.  In the one case, the
arbitration panel ruled in favor of IRS after the agency
substantially modified its position after examination.  According to
the taxpayer's attorneys, arbitration reduced the taxpayer's
expenses, improved its settlement opportunities, and produced a
binding decision. 

Although recommendations have been made to improve the arbitration
process, a second case has not been forthcoming.  Before arbitration
can occur in a specific instance, both IRS and the taxpayer have to
voluntarily agree to it, which is unlikely if either party is unsure
of the strength or desirability of its arbitration position. 
However, IRS officials indicated their interest in pursuing
arbitrations and other means of alternate dispute resolution.  IRS
was beginning a program that would allow certain cases to be subject
to mediation. 


CHALLENGES OF SECTION 482 WILL
CONTINUE
========================================================== Appendix IV

Although IRS has issued new regulations on section 482, how
successful they will ultimately be in resolving transfer pricing
issues is unclear.  Subjectivity will still be involved, and thus
controversy may still arise.  The flexibility that the regulations
allow taxpayers for tax planning must be weighed against the
flexibility allowed IRS and the more stringent documentation and
penalty provisions that have recently been enacted. 


   PROBLEMS THAT HAVE EXISTED WITH
   ARM'S LENGTH PRICING
-------------------------------------------------------- Appendix IV:1

As we testified in 1993, the arm's length standard required that the
price charged on a transaction between related corporations be the
price that would have been charged if the corporations had been
unrelated.  To enforce this standard, IRS had to analyze comparable
transactions between unrelated corporations to identify the arm's
length price that the related corporations had to charge.  If IRS
found a difference between an arm's length price and the price that
the related corporations charged, it could propose an adjustment to
the related corporations' income.\1

IRS and taxpayers have used direct and indirect methods for
identifying arm's length prices.  The comparable uncontrolled price
was based on a direct comparison of the prices charged on readily
identifiable, comparable transactions between unrelated parties. 
More indirect methods, such as the resale price, cost plus, and other
appropriate methods, based prices on comparisons with unrelated
corporations performing similar functions.  These methods may require
IRS examiners to use considerable judgment and to develop and analyze
a great deal of data. 

A major obstacle in enforcing the arm's length standard has been the
difficulty that IRS examiners have had in finding readily
identifiable, comparable transactions.  The data requirements and the
subjective nature of the pricing methods imposed a significant
administrative burden on both corporate taxpayers and IRS, and also
led to uncertainties for corporations about their ultimate tax
liabilities. 

As shown in figure IV.1, indirect methods have been used for most
section 482 cases.  For transfer pricing issues completed in fiscal
years 1990 through 1992, IRS international examiners reported that
the three then most well-defined methods--comparable uncontrolled
price, cost plus, and resale price--had been used only about half the
time, with other methodologies being used the other half.  Similarly,
these three methods accounted for only 38 percent of the 75 methods
used in APAs that had been started and/or finished without being
withdrawn as of July 7, 1994, and that had decided-upon
methodologies.  Another 36 percent used different profit measures or
formulary or allocation apportionment,\2 with 27 percent using
miscellaneous other allocation methods.  IRS officials indicated that
formulary apportionment has been used only in difficult cases and
only after obtaining the agreement of affected treaty partners. 
Because the APA information is more recent than the examination
information we have, it is more likely to show recent trends in
methodologies. 

   Figure IV.1:  Allocation
   Methods Reported by IRS
   Examiners and Those Used in
   Advance Pricing Agreements

   (See figure in printed
   edition.)

Note 1:  Percentages do not add to 100 due to rounding. 

Note 2:  Eighteen of the 430 transfer pricing issues reported by IRS
examiners arose in APAs. 

Source:  GAO analysis of IRS data. 

The difficulty of finding comparables is further illustrated by
concerns expressed by the IRS Commissioner's Advisory Group Task
Force on Third Party Transfer Price Information.  These concerns
centered on the confidentiality of price and cost information and the
reliability of aggregated data on comparables.  The problem of access
to information on comparable transactions, and the difficulty of
finding such transactions for many intangible properties, make
transfer pricing difficult for both taxpayers and IRS. 


--------------------
\1 The new July 1, 1994, section 482 regulations that will be
described later modified the interpretation of the arm's length
standard but retained the idea of comparability.  The standard is met
if the results of a transaction are consistent with the results that
would have been realized if uncontrolled taxpayers had engaged in the
same transaction under the same circumstances.  As a practical
matter, whether a transaction produces an arm's length result will be
determined by reference to results of comparable transactions under
comparable circumstances. 

\2 Treasury officials told us that they would be surprised if IRS was
using formulary apportionment in the sense of applying the same
formula to different companies. 


   IMPACT OF NEW SECTION 482
   REGULATIONS IS UNCERTAIN
-------------------------------------------------------- Appendix IV:2

On July 1, 1994, the Department of the Treasury issued new final
regulations on intercompany transfer pricing, replacing temporary and
proposed regulations issued on January 21, 1993.  According to
Treasury, the new regulations emphasize comparability and
flexibility.  The "best method rule" under the regulations provides
that the pricing method the taxpayer chooses must be the one that
gives the most reliable measure of the arm's length result under the
facts and circumstances.  Thus, both taxpayers and IRS will have to
use considerable judgment in applying the arm's length standard.  To
help taxpayers and IRS exercise this judgment, the new regulations
have a greatly expanded discussion of the factors to consider in
applying the best method rule. 

As we said in our 1993 testimony,\3 because the best method approach
is still based on the facts and circumstances of each case, the task
of selecting and justifying transfer prices will remain complex and
open to interpretation.  Some commentators on the new regulations
have echoed this, saying that there is room for aggressive tax
maneuvering by taxpayers and warning that examination and litigation
controversy between taxpayers and IRS will increase and certainty
decrease.  According to Treasury officials, however, the general
opinion is that the regulations are relatively workable. 

Further complicating the task of dealing with the regulations are the
data problems described earlier.  According to the Commissioner's
Advisory Group Task Force, the data needed for section 482
regulations are extensive, but the ability to create a single
database is inhibited.  According to an IRS official, this lack of
good data on comparables led IRS to develop profit-oriented methods
that do not rely so heavily on information on comparable
transactions.  Still, the new regulations prefer the use of direct
evidence of arm's length prices over profit-related methods.  The
lack of good data also explains IRS' practice of asking individual
companies other than the one being audited to voluntarily submit
information on comparables.  Without this information, IRS believes
that it runs the risk of inappropriately raising or abandoning
section 482 issues, settling for far less than the arm's length
amount, or failing to sustain litigation. 

The increased documentation required by new penalty legislation\4

may ease the regulatory risks and IRS' enforcement burden, despite
the continuing difficulty in identifying comparables.  The
requirement for contemporaneous documented support provides IRS with
information about the methods used by taxpayers when setting their
transfer prices.  According to IRS officials, this information
provided by taxpayers should enable examiners to determine whether
transfer prices are appropriate without, in each case, having to
develop alternative methods and data.  These IRS officials believed
that the documentation requirements combined with the substantial
misstatement penalties also provided in the legislation will reduce
transfer pricing abuse. 

The documentation requirements may add to the compliance burden of
taxpayers to the extent that transactions will be documented whether
or not they are at issue with IRS.  However, contemporaneous
documentation will be useful to taxpayers in justifying their prices
and in avoiding the penalties.  Furthermore, taxpayers should benefit
from the new section 482 regulations' additional guidance in
determining comparable transactions and from the recognition that the
arm's length price may belong to a range of prices.  Taxpayers with
prices within the arm's length range will be protected to some degree
from small changes in transfer prices by IRS that result in large
increases in tax liabilities. 


--------------------
\3 GAO/T-GGD-93-16. 

\4 The Omnibus Budget Reconciliation Act of 1993. 


A HIGH PERCENTAGE OF FCCS AND
USCCS DID NOT PAY U.S.  INCOME TAX
FROM 1987 THROUGH 1991
=========================================================== Appendix V

A higher percentage of FCCs than USCCs paid no U.S.  income tax in
each year from 1987 to 1991.  Larger corporations (both foreign- and
U.S.-controlled) were more likely than smaller corporations to pay
U.S.  income tax. 

Overall, nontaxpaying corporations accounted for a smaller proportion
of total assets and receipts in 1991 than taxpaying corporations did,
which means that the relatively smaller proportion of taxpaying
corporations generated the majority of receipts.  But the very small
number of large nontaxpaying corporations accounted for a
disproportionately large share of total corporate assets and
receipts.  Finally, large taxpaying FCCs, on average, paid less U.S. 
income tax relative to receipts than large taxpaying USCCs. 

Analyzing foreign- and U.S.-controlled corporations' costs of goods
sold, purchases, and other tax data as a percentage of their gross
receipts indicated differences but provided no clear evidence of
transfer pricing abuses.  Comparing the types of industries
represented by the largest foreign- and U.S.-controlled corporations
may explain some of the differences between them. 


   A HIGHER PERCENTAGE OF
   FOREIGN-CONTROLLED CORPORATIONS
   THAN U.S.-CONTROLLED
   CORPORATIONS PAID NO U.S. 
   INCOME TAX
--------------------------------------------------------- Appendix V:1

FCCs were less likely than U.S.-controlled corporations to pay U.S. 
income tax.  In 1991, 73 percent of FCCs versus 62 percent of USCCs
paid no U.S.  income tax. 

The trend over 5 years, as shown in table V.1, was relatively
constant for FCCs.  The change in the percentage of FCCs that did not
pay U.S.  income tax--from 71 to 73 percent--is small relative to the
sampling error in the 1991 estimate of about plus or minus 4
percent.\1 Although the USCC data are also based on statistical
samples, the differences for the USCCs that did not pay income
tax--from 57 percent in 1987 to 62 percent in 1991--are statistically
significant.\2



                          Table V.1
           
             Number and Percentage of Foreign-and
            U.S.-Controlled Corporations That Paid
              No Income Taxes, 1987 Through 1991


            Number of                 Number of
Year          returns      Percent      returns      Percent
--------  -----------  -----------  -----------  -----------
1987           29,928           71    1,333,470           57
1988           33,636           73    1,310,698           58
1989           32,135           72    1,265,970           59
1990           32,343           73    1,265,462           61
1991           35,138           73    1,265,272           62
------------------------------------------------------------
Source:  GAO analysis of IRS data. 

The increase from 57 to 62 percent in the USCCs that did not pay
income tax from 1987 through 1991 should be interpreted with care. 
The absolute number of USCCs that did not pay income tax in 1991 was
the lowest of the 5 years--1,265,272--as opposed to 1,333,470 in
1987.  The explanation can be found in the changing number of
USCCs--that is, the number of USCCs overall is decreasing faster than
the decrease in nontaxpaying USCCs. 


--------------------
\1 The estimates based on IRS' statistical samples that in 1989 72
percent and in 1991 73 percent of FCCs did not pay U.S.  income tax
are plus or minus 4 percent at a 95-percent confidence level.  As a
result, the 1- and 2-percent changes during these years were small
relative to the precision of the estimate for any given year. 

\2 The confidence interval for the USCC estimates of 59 percent in
1989, 61 percent in 1990, and 62 percent in 1991 is plus or minus 0.9
percent at a 95-percent confidence level.  Therefore, the differences
of two or more percentage points between years is statistically
significant. 


   LARGE FCCS AND USCCS WERE MORE
   LIKELY TO PAY U.S.  INCOME TAX
--------------------------------------------------------- Appendix V:2

As table V.2 shows, large FCCs and USCCs were more likely than their
smaller corporate counterparts to pay U.S.  income tax.  In each year
from 1987 through 1991, a higher percentage of FCCs and USCCs with
assets of $100 million or more paid income tax than did FCCs and
USCCs with assets of less than $100 million. 



                          Table V.2
           
           Corporations That Paid No Income Taxes,
           by Ownership and Size, 1987 Through 1991



            Number of  Percent not    Number of  Percent not
Year          returns   paying tax      returns   paying tax
--------  -----------  -----------  -----------  -----------
1987           29,632         71.5    1,330,988         56.9
1988           33,286         73.6    1,307,881         58.4
1989           31,690         72.8    1,262,801         59.0
1990           31,800         74.4    1,261,999         60.8
1991           34,423         73.7    1,261,559         62.0

Assets greater than or equal to $100 million
------------------------------------------------------------
1987              297         36.0        2,483         29.9
1988              350         31.8        2,817         30.8
1989              445         34.3        3,169         33.7
1990              543         39.1        3,463         35.8
1991              715         46.3        3,713         37.2
------------------------------------------------------------
Source:  GAO analysis of IRS data. 

While the largest companies were more likely than smaller companies
to pay U.S.  income tax, an increasing number of the largest
companies, both foreign- and U.S.-controlled, paid no tax in these 5
years.  The number of large foreign-controlled corporations that did
not pay U.S.  income tax more than doubled in this period, from 297
in 1987 to 715 in 1991.  During the same period, the number of large
U.S.-controlled corporations that did not pay U.S.  income tax also
increased, although not as dramatically, from 2,483 in 1987 to 3,713
in 1991.  This trend among the largest corporations is not based on
samples and therefore is not subject to sampling error. 


   NONTAXPAYING CORPORATIONS
   ACCOUNTED FOR A SMALLER SHARE
   THAN TAXPAYING CORPORATIONS OF
   TOTAL ASSETS AND RECEIPTS
--------------------------------------------------------- Appendix V:3

Nontaxpaying corporations, both foreign- and U.S.-controlled,
accounted for the majority of all returns filed, but for much smaller
proportions of total assets and receipts.  This indicates that many
of the nontaxpaying corporations, both foreign- and U.S.-controlled,
were smaller in terms of assets and generated fewer receipts than
their taxpaying counterparts. 

While 73 percent of FCCs did not pay U.S.  income tax in 1991, these
35,138 nontaxpaying corporations accounted for only 37 percent of the
assets and 31 percent of the gross receipts of all FCCs that year, as
shown in table V.3.  This means the 13,108 taxpaying FCCs accounted
for only 27 percent of the returns but 69 percent of receipts. 



                                    Table V.3
                     
                         Returns, Assets, and Receipts of
                       Corporations That Did Not Pay Income
                                   Taxes, 1991

                              (Dollars in billions)


Di
d
no
t
pa
y
in
co
me
ta
x        Number      Percent       Amount      Percent       Amount      Percent
--  -----------  -----------  -----------  -----------  -----------  -----------
Al       35,138         72.8      $ 679.3         37.2      $ 358.8         31.4
 l
 F
 C
 C
 s
La          715          1.5        568.8         31.1        255.0         22.3
 r
 g
 e
 F
 C
 C
 s
Al    1,265,272         61.9      3,257.0         20.1      1,569.5         18.7
 l
 U
 S
 C
 C
 s
La        3,713          0.2      2,582.8         16.0        574.1          6.8
 r
 g
 e
 U
 S
 C
 C
 s
--------------------------------------------------------------------------------
Note 1:  "Large" refers to those USCCs and FCCs that had $100 million
or more in assets. 

Note 2:  All percentages are of total FCCs or USCCs, including both
those that paid income tax and those that did not. 

Source:  GAO analysis of IRS data. 

This observation is even more striking for the nontaxpaying USCCs. 
They numbered 1,265,272 or 62 percent of all U.S.-controlled
corporate returns filed, but accounted for only 20 percent of the
assets and 19 percent of receipts.  So, the 38 percent of USCCs that
paid income tax in 1991 had 81 percent of all gross receipts
generated by USCCs. 


   A SMALL NUMBER OF LARGE
   CORPORATIONS PAID NO INCOME TAX
   BUT HAD LARGE RECEIPTS AND
   ASSETS
--------------------------------------------------------- Appendix V:4

The largest nontaxpaying FCCs and USCCs were relatively few in number
but had a disproportionately large share of the total assets and
receipts of all FCCs and all USCCs. 

In 1991, 715 nontaxpaying FCCs had assets of $100 million or more. 
These 715 corporations represented only 1.5 percent of all FCCs that
filed U.S.  corporate tax returns in 1991 but, as shown in table V.3,
31 percent of all FCCs' assets and 22 percent of their total
receipts.  In contrast, the 34,423 nontaxpaying FCCs with assets of
less than $100 million were 71 percent of all FCCs but accounted for
only 9 percent of total FCC receipts and 6 percent of total FCC
assets. 

The observation is also true for USCCs.  The 3,713 nontaxpaying USCCs
with assets of $100 million or more accounted for a tiny 0.2 percent
(one-fifth of one percent) of returns, but 16 percent of assets and 7
percent of receipts generated by all USCCs in 1991.  Thus, the
1,261,559 nontaxpaying USCCs with assets under $100 million
represented 62 percent of all USCC returns but only 4 percent of
assets and 12 percent of the gross receipts. 


   LARGE FCCS PAID LESS INCOME TAX
   RELATIVE TO GROSS RECEIPTS THAN
   LARGE USCCS
--------------------------------------------------------- Appendix V:5

As shown in table V.4, the large FCCs that did pay U.S.  income tax
paid less relative to FCCs' total gross receipts in 1991 than the
large USCCs that paid tax.  Also, for any level of U.S.  income taxes
paid, large FCCs paid, on average, fewer taxes and, except for those
paying $1 million or more in taxes, had higher gross receipts and
assets than their taxpaying U.S.  counterparts.  Finally, large FCCs
that paid no U.S.  income tax in 1991, on average, had larger assets
and more than double the receipts of the large USCCs that paid no
tax. 



                                    Table V.4
                     
                        Profile of Large Foreign-and U.S.-
                      Controlled Corporations, by Amount of
                             Income Taxes Paid, 1991



Distribu                                                                  Income
tion by                                                               taxes paid
income                                                        Income  per $1,000
taxes      Number of  Percent of      Assets    Receipts  taxes paid          of
paid         returns     returns  (millions)  (millions)    (thous.)    receipts
--------  ----------  ----------  ----------  ----------  ----------  ----------
No tax           715        46.3     $ 795.5     $ 356.7       $ 0.0          NA
 paid
Less             141         9.1     1,100.7       533.4        29.4      $ 0.05
 than
 $100,00
 0
$100,000         258        16.7       633.2       299.4       405.9        1.36
 or more
 but
 less
 than $1
 million
$1               429        27.8     1,749.1     1,175.5    10,567.2        8.99
 million
 or more
================================================================================
Total          1,543       100.0    $1,061.4     $ 590.9    $3,008.6      $ 5.09

Large U.S.-controlled corporations
--------------------------------------------------------------------------------
No tax         3,713        37.2       695.6       154.6         0.0          NA
 paid
Less             589         5.9     1,000.9       427.5        31.7        0.07
 than
 $100,00
 0
$100,000       2,429        24.4       502.7       141.9       486.7        3.43
 or more
 but
 less
 than $1
 million
$1             3,246        32.5     3,110.7     1,417.0    20,680.4       14.59
 million
 or more
================================================================================
Total          9,977       100.0    $1,452.4     $ 578.3    $6,848.7      $11.84
--------------------------------------------------------------------------------
Source:  GAO analysis of IRS data. 


   COST OF GOODS SOLD AND OTHER
   RATIOS PROVIDE INCONCLUSIVE
   EVIDENCE OF TRANSFER PRICING
   ABUSE
--------------------------------------------------------- Appendix V:6

Ratios of cost of goods sold and other expense deductions to receipts
yield interesting differences between large nontaxpaying FCCs and
USCCs but no clear evidence of transfer pricing abuse.  We calculated
various components of cost of goods sold--including purchases, cost
of labor, and inventory--and other items--including interest paid and
taxes paid--as percentages of total gross receipts, and then compared
the results for the large FCCs and USCCs.  These are factors that we
considered and reported on in our earlier reports and testimony.\3
Higher costs of goods sold and other items in relation to receipts
may indicate, but do not necessarily prove, transfer pricing abuses. 
Table V.  5 presents the factors that differed most significantly. 



                          Table V.5
           
           Ratios of Cost of Goods Sold, Purchases,
              and Interest to Receipts for Large
           Foreign-and U.S.-Controlled Corporations
               That Paid No Income Taxes, 1991

                          Large foreign-         Large U.S.-
                              controlled          controlled
                            corporations        corporations
--------------------  ------------------  ------------------
Cost of goods                      65.7%               43.0%
 sold/receipts
Purchases/receipts                  47.7                25.7
Interest paid/                       9.5                11.4
 receipts
------------------------------------------------------------
Source:  GAO analysis of IRS data. 

For the large nontaxpaying FCCs, costs of goods sold accounted for
65.7 percent of receipts, while purchases accounted for 47.7 percent
of receipts.  In contrast, costs of goods sold and purchases for
large nontaxpaying USCCs accounted for a smaller proportion of
receipts--43.0 and 25.7 percent, respectively. 

This may indicate, but is not clear evidence, that large nontaxpaying
FCCs are abusing transfer pricing--that is, shifting taxable income
by inflating the cost paid to related parties outside the United
States for goods and services.  Indeed, since one potential means of
shifting income is inflating the interest paid to a related party, we
might expect that interest paid as a percentage of receipts would be
higher for the nontaxpaying FCCs than for the USCCs.\4 But the
opposite appears to be true--that is, interest paid as a percentage
of receipts was higher (11.4 percent) for large nontaxpaying USCCs
than for their FCC counterparts (9.5 percent). 

A recent study showed various factors at work in accounting for the
depressed earnings of foreign firms in the United States.\5

It attributed these earnings to the firms having bought
underperforming U.S.  firms at top dollar, borrowed heavily, and
spent freely on investment and marketing.  The study also found some
evidence that would point to profit shifting as a contributor to the
low earnings. 


--------------------
\3 GAO/GGD-92-89, GAO/T-GGD-93-16, and GAO/GGD-93-112FS. 

\4 Grubert, Goodspeed, and Swenson, Explaining the Low Taxable Income
of Foreign-Controlled Companies in the United States, National Bureau
of Economic Research (Chicago:  University of Chicago Press, 1993)
stated that higher debt costs, either to unrelated lenders or to
related offshore companies ("earnings stripping"), will lead to low
taxable U.S.  income because interest expenses are deductible.  Yet,
they concluded that "debt and earnings stripping do not appear to be
major reasons for the low taxable income of foreign-controlled
companies." They added that about half of the differential between
rates of return for FCCs and USCCs can be explained by factors other
than transfer pricing, and that the unexplained half could be due to
transfer pricing distortions or other reasons. 

\5 David S.  Laster and Robert N.  McCauley, "Making Sense of the
Profits of Foreign Firms in the United States," Federal Reserve Bank
of New York Quarterly Review (Summer-Fall 1994). 


   DIFFERENCES IN U.S.  INCOME
   TAXES PAID BY FCCS AND USCCS
   MAY BE RELATED TO DIFFERENCES
   IN INDUSTRY
--------------------------------------------------------- Appendix V:7

The type of business may also help explain the differences observed
between FCCs and USCCs in their relative costs of goods sold,
purchases, interest paid, and income taxes paid.  Specifically, as
shown in table V.6, while more than three-quarters of the large
nontaxpaying USCCs were in finance, insurance, and real estate,
little more than one-third of the FCCs were in these businesses.  In
contrast, almost one-half of the FCCs were in manufacturing or
wholesale trade compared to less than 15 percent of the USCCs, which
may explain the large nontaxpaying FCCs' relatively higher costs of
goods sold and purchases relative to receipts. 



                          Table V.6
           
           Industry Breakdown of Large Corporations
               That Paid No Income Taxes, 1991

                                Foreign-
                              controlled     U.S.-controlled
Industry                    corporations        corporations
--------------------  ------------------  ------------------
Mining                              3.5%                1.2%
Construction                         2.1                 0.5
Manufacturing                       29.9                10.3
Transportation and                   2.0                 3.3
 public utilities
Wholesale trade                     16.9                 3.8
Finance, insurance,                 34.5                77.7
 and real estate
Services                            11.2                 3.2
Total                             100.0%              100.0%
------------------------------------------------------------
Note 1:  Because we defined large corporations in terms of asset size
rather than receipts, this industry breakdown is skewed in favor of
finance companies, which have large assets, and against trade
companies, which have large receipts. 

Note 2:  The detail may not sum to the total because of rounding
differences. 

Source:  GAO analysis of IRS data. 


MAJOR CONTRIBUTORS TO THIS REPORT
========================================================== Appendix VI


   GENERAL GOVERNMENT DIVISION,
   WASHINGTON, D.C. 
-------------------------------------------------------- Appendix VI:1

Jose R.  Oyola, Assistant Director, Tax Policy
 and Administration Issues
Lawrence M.  Korb, Assignment Manager
Michael J.  Sanchez, Evaluator
Nilsa I.  Perez, Evaluator
Patricia H.  McGuire, Senior Computer Specialist
James M.  Fields, Social Science Analyst


   BOSTON/NEW YORK FIELD OFFICE
-------------------------------------------------------- Appendix VI:2

Claire L.  Gambaccini, Evaluator-in-Charge


   PHILADELPHIA REGIONAL OFFICE
-------------------------------------------------------- Appendix VI:3

Carolyn B.  Alessi, Evaluator
