Tax Administration: Diesel Fuel Excise Tax Change (Letter Report,
01/16/96, GAO/GGD-96-53).

Pursuant to a congressional request, GAO reviewed the collection of
diesel fuel excise taxes, focusing on: (1) changes in diesel fuel tax
collections in 1994; (2) concerns about Internal Revenue Service (IRS)
changes to diesel fuel taxation requirements; and (3) fraudulent claims
involving excise tax refunds.

GAO found that: (1) IRS determined that diesel excise tax collections
increased about $1.2 billion from 1993 to 1994; (2) this increase did
not include amounts collected as a result of the Omnibus Budget
Reconciliation Act 1993 fuel tax rate increase; (3) increased tax
compliance accounted for between $600 million and $700 million of the
increase; (4) IRS has addressed the two major concerns regarding the
Environmental Protection Agency's dyeing requirements, but has not
addressed concerns about the concentration of dye required and the
impact of the requirements on fuel availability at marinas; (5) IRS has
not addressed concerns about tax collection on products added to diesel
fuel after leaving the terminal; and (6) the new diesel fuel taxation
approach remains vulnerable to fraudulent excise tax refund claims, but
IRS has not determined the extent of such fraud.

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

 REPORTNUM:  GGD-96-53
     TITLE:  Tax Administration: Diesel Fuel Excise Tax Change
      DATE:  01/16/96
   SUBJECT:  Proposed legislation
             Fuel gas industry
             Government collections
             Collection procedures
             Tax administration
             Fraud
             Fuel taxes
             Kerosene
             Tax refunds
             Tax credit
IDENTIFIER:  Highway Trust Fund
             Leaking Underground Storage Tank Fund
             Earned Income Tax Credit
             Alaska
             
******************************************************************
** This file contains an ASCII representation of the text of a  **
** GAO report.  Delineations within the text indicating chapter **
** titles, headings, and bullets are preserved.  Major          **
** divisions and subdivisions of the text, such as Chapters,    **
** Sections, and Appendixes, are identified by double and       **
** single lines.  The numbers on the right end of these lines   **
** indicate the position of each of the subsections in the      **
** document outline.  These numbers do NOT correspond with the  **
** page numbers of the printed product.                         **
**                                                              **
** No attempt has been made to display graphic images, although **
** figure captions are reproduced.  Tables are included, but    **
** may not resemble those in the printed version.               **
**                                                              **
** Please see the PDF (Portable Document Format) file, when     **
** available, for a complete electronic file of the printed     **
** document's contents.                                         **
**                                                              **
** A printed copy of this report may be obtained from the GAO   **
** Document Distribution Center.  For further details, please   **
** send an e-mail message to:                                   **
**                                                              **
**                                            **
**                                                              **
** with the message 'info' in the body.                         **
******************************************************************


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


Report to the Ranking Minority Member, Committee on Finance, U.S. 
Senate

January 1996

TAX ADMINISTRATION - DIESEL FUEL
EXCISE
TAX CHANGE

GAO/GGD-96-53

Diesel Fuel Excise Tax Change

(268644)


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

  EPA - Environmental Protection Agency
  FAA - Federal Aviation Administration
  FHWA - Federal Highway Administration
  IRS - Internal Revenue Service
  OBRA - Omnibus Budget Reconciliation Act
  SSN - Social Security number

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


B-260143

January 16, 1996

The Honorable Daniel Patrick Moynihan
Ranking Minority Member
Committee on Finance
United States Senate

Dear Senator Moynihan: 

In 1993, we briefed your office on potential improvements in the
administration of diesel fuel excise taxes that could result from
moving the tax collection point from the wholesale level to the
terminal level in the distribution system and dyeing fuel not subject
to the tax.  The Federal Highway Administration (FHWA) and certain
motor fuel industry representatives also presented Congress
information on the merits of these changes to diesel fuel excise
taxation.  Congress adopted this revised approach for diesel fuel
excise taxation in the Omnibus Budget Reconciliation Act (OBRA) of
1993. 

Subsequently, you asked us to report on the changes in tax
collections since the OBRA 1993 requirements were enacted.  You also
asked that we evaluate whether the most prominent concerns of
stakeholders regarding the Internal Revenue Service's (IRS)
regulations implementing the new diesel fuel taxation requirements
had been adequately addressed in the regulations, or whether
additional regulatory or statutory changes may be needed. 
Accordingly, this report discusses (1) changes in diesel fuel excise
taxes collected in calendar year 1994, (2) IRS' responses to
prominent concerns raised in comments to IRS on its regulations
implementing the OBRA 1993 changes to the taxation of diesel fuel,
and (3) unaddressed concerns regarding the regulations.  In addition,
we provide information on recent fraudulent claims for motor fuels
excise tax refunds. 

In doing our work, we reviewed the comments provided to IRS in
response to its proposed regulations implementing the OBRA 1993
diesel excise tax requirements and interviewed IRS and other federal
officials, as well as representatives of selected organizations that
commented on the regulations.  We did our work from July 1994 through
October 1995 in accordance with generally accepted government
auditing standards.  See appendix I for further details on our
objectives, scope, and methodology.  We obtained oral comments from
IRS on a draft of this report, and these comments are discussed on
page 14. 


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

The federal government generally imposes an excise tax of 24.4 cents
per gallon on diesel fuel that is used on highways.  In calendar year
1994, diesel excise tax collections totaled about $6.7 billion. 
Although most of the funds collected by IRS are transferred to the
Federal Highway Trust Fund, 6.8 cents per gallon goes to Treasury's
general fund\1 and 0.1 cent goes to the Leaking Underground Storage
Tank Fund.  Diesel fuel for off-highway use, such as home heating or
construction, is not taxed.  Certain entities--for example, state and
local governments--are exempt from paying tax on diesel fuel they use
on highways. 

In order to strengthen the enforcement of diesel fuel tax collection,
OBRA 1993 provisions moved the tax collection point from the
wholesale to the terminal level and required that any diesel fuel
removed from the terminal for tax-free use must be dyed.\2 (See
figure 1.) Under this system, the position holder--the party that has
contracted with the terminal operator to store fuel in a terminal--is
liable for the diesel fuel tax when the fuel is removed from the
terminal, which frequently occurs when the fuel is sold to a
distributor who then picks it up at the terminal.  The position
holder is to forward the taxes to IRS.  If this tax-paid fuel is
subsequently sold for a tax-free use, IRS is to refund the tax to
purchasers or sellers, or provide credits against other taxes,
depending on the specific situation. 

   Figure 1:  Diesel Fuel
   Distribution System

   (See figure in printed
   edition.)

The OBRA 1993 changes were made in an effort to curtail diesel fuel
tax evasion schemes that had been estimated by FHWA, within the
Department of Transportation, to cost the federal government several
hundred million dollars a year.  Environmental Protection Agency
(EPA) regulations also require dyeing of high sulfur diesel fuel to
help assure that only low sulfur diesel fuel is used on the highways. 

IRS issued temporary regulations to implement the OBRA provisions on
November 30, 1993.  In response to these temporary regulations, IRS
received comments from various groups representing sectors of the
agriculture, petroleum, transportation, and recreation industries. 
In addition, FHWA, Federal Aviation Administration (FAA), EPA, and
some Department of Defense groups expressed concerns about IRS'
temporary regulations.  Subsequent changes implemented on October 1,
1994, provided that all tax-exempt diesel fuel is to be dyed one
color and revised the language specifying the concentration level of
the dye. 


--------------------
\1 As of October 1, 1995, 4.3 cents per gallon will go to the general
fund, and the difference, 2.5 cents, will be added to the amounts
transferred to the Highway Trust Fund. 

\2 In the case of high sulfur diesel fuel, the dye is usually added
at the refinery. 


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

The new diesel excise taxation approach appears to be having the
desired effect.  IRS' preliminary data indicate that diesel excise
tax collections increased about $1.2 billion, or 22.5 percent, in
calendar year 1994 as compared with 1993.  This increase does not
include additional revenues due to the OBRA 1993 increase of 4.3
cents per gallon in the tax rate.  After adjusting for increased
refund and credit amounts, and for a portion of the increase that may
be due to economic growth, the Treasury Department estimated that an
increase of $600 million to $700 million was solely the result of
increased compliance. 

IRS has addressed two of the prominent concerns about the dyeing
requirements that stakeholders expressed in their comments on IRS'
November 30, 1993, temporary regulations.  IRS settled on one dye
color (red) rather than two and, for the time being, declined to
require the use of colorless markers.  Perhaps the most significant
unaddressed concern that could affect tax collection relates to the
definition of, and collection of excise taxes on, products (chiefly
kerosene) that are added to on-highway diesel fuel after the fuel
leaves the terminal.  The Treasury Department has expressed support
for a legislative proposal that would treat kerosene as if it were
diesel fuel--i.e., by mandating the dyeing of nontaxed kerosene. 
However, before this proposal could be implemented, a system would be
needed to account for kerosene sales for use in home space heaters. 
In addition, concerns remain about such things as the concentration
of dye required by IRS and the impact of the dyeing requirements on
diesel fuel availability at marinas, especially at those that have
only one diesel fuel tank. 

Although the new diesel taxation approach appears to be raising
significant additional revenue, those who wish to defraud the system
continue to have significant incentives to do so.  IRS has detected
several fraudulent schemes involving refunds of gasoline or diesel
fuel excise taxes.  IRS does not know how extensive this fraud may
be.  Evasion problems may persist because the incentives to evade are
so great. 


   DIESEL EXCISE TAX COLLECTIONS
   INCREASED SIGNIFICANTLY
------------------------------------------------------------ Letter :3

Moving the point at which taxes are collected to the terminal level
and dyeing diesel fuel on which the full excise taxes have not been
paid, together with concerted enforcement on the highways, appear to
have increased diesel excise tax collections.  IRS' data for calendar
year 1994 show that the excise tax collected on diesel fuel increased
about $1.2 billion, or about 22.5 percent, as compared with 1993,
while total highway usage increased only about 2.2 percent in the
same period, according to preliminary data.  This increase does not
include amounts collected as a result of the 4.3 cent per gallon
increase in the tax rate itself.  Treasury's Deputy Assistant
Secretary for Tax Policy testified that, after taking into account
increased refunds and credits and an estimate for increased
collections due to economic growth, diesel fuel excise tax
collections increased $600 to $700 million due to improved compliance
alone. 


   IRS ADDRESSED TWO DIESEL FUEL
   DYEING CONCERNS
------------------------------------------------------------ Letter :4

Several groups expressed concern in their comments on IRS' regulatory
proposal about the color of the dye and whether colorless markers\3
would also need to be added to diesel fuel.  In its final
regulations, IRS changed the color of the dye added to tax-free
diesel fuel and delayed any decision to use colorless markers until
the effectiveness of the current program is determined.  As discussed
below, we believe that IRS' responses reasonably addressed
stakeholders' concerns about these issues. 

Pursuant to its responsibilities for implementing provisions of the
Clean Air Act, EPA had issued regulations, effective October 1, 1993,
requiring that all high sulfur diesel fuel be dyed blue.  This dyed
fuel was prohibited for use in vehicles on the nation's highways, but
was permitted for various off-highway uses.  IRS, in its November 30,
1993, temporary regulations, similarly required that untaxed high
sulfur diesel fuel be dyed blue and also required that untaxed low
sulfur diesel fuel be dyed red.  Thus, diesel fuel dyed either blue
or red would have been tax-exempt and not allowed for highway use. 

Concerns were expressed by FAA and others that blue-dyed diesel fuel
might be mistaken for blue or green aviation fuel.  The potential
existed for misfueling aircraft in remote locations where fuels are
dispensed into nonstandard containers or where different fuels are
stored in similar containers in close proximity to each other.  EPA
and IRS agreed that, after September 30, 1994, all tax-exempt diesel
fuel, both low and high sulfur, would be dyed red. 

OBRA 1993 also permits IRS to require the use of colorless markers,
which like dye would be used to differentiate between taxed and
untaxed diesel fuel.  In its November 1993 regulations, IRS asked for
comments on the use of such markers.  Several stakeholders said that
adding a colorless marker requirement to the dyeing requirement would
be overly burdensome and complex.  IRS officials told us that they
are monitoring compliance with the current tax scheme and will
consider requiring colorless markers in the future if necessary. 


--------------------
\3 The preamble to IRS' regulations states that a colorless marker
"is a material that does not reveal its presence until the fuel into
which it is introduced is subjected to a special test."


   UNADDRESSED CONCERNS
------------------------------------------------------------ Letter :5

Some concerns expressed by stakeholders remain.  For example, IRS is
studying how to address what may be the principal open concern that
could affect tax collections--the taxation of diesel fuel additives. 
In July 1995, the Treasury Department expressed support for applying
the same dyeing regime to kerosene as is applied to diesel fuel.  For
this and other concerns, proposals have been offered in Congress or
suggested to IRS, but tradeoffs must be considered by policymakers. 


      CONCERNS OVER ADDITIVES TO
      DIESEL FUEL
---------------------------------------------------------- Letter :5.1

According to IRS officials, the most complex diesel fuel excise tax
regulatory problem is the definition and collection of excise taxes
on products--primarily kerosene--that are added to diesel fuel for
use on the highway.  Generally, such products are added to diesel
fuel after the fuel leaves the terminal.  Fuel excise taxes are
intended to be collected on each gallon of fuel used on the highway,
including any additives, so that the tax revenues can be used to
maintain and improve the highway system.  Consequently, IRS requires
any party mixing additives into diesel fuel to be used on highways to
pay tax on those additives. 

Under current federal excise tax regulations, kerosene is not treated
as a diesel fuel and is generally neither taxed nor dyed when removed
from the terminal.  The final IRS regulations do not define kerosene. 
Industry sources tell us that kerosene, as used in commerce and as
regulated by state governments, generally must meet the requirements
of American Society of Testing and Materials Standard D 3669,
Standard Specification for Kerosene.\4

Fuels such as No.1 fuel oil (No.1 furnace or heating oil), No.1
diesel fuel, and jet fuel, may be formulated to satisfy all the
requirements for kerosene, as well as the requirements specific to
these fuels.  Many refiners produce a multipurpose No.1 fuel that is
refined to meet requirements for one or more of the fuel types listed
above--all of which may be referred to generically as kerosene. 

However, undyed tax-free kerosene or waste oil (i.e., used crankcase
oil) can be used in blending schemes (called "cocktailing") that
could result in excise tax evasion.  For example, a dishonest
retailer could take two gallons of tax-paid diesel fuel and mix it
with one gallon of undyed kerosene on which no tax has been paid. 
The retailer now has three gallons of cocktailed diesel fuel, but has
only paid tax on two gallons of the product.  The retailer can sell
the cocktailed diesel fuel at full normal retail price and pocket the
avoided tax as profit.  Alternatively, the retailer could reduce the
retail price somewhat, draw business from honest competitors, and
still pocket that portion of the avoided tax not used to discount the
fuel price. 

Deliberate attempts to avoid taxation by blending untaxed kerosene
into diesel fuel aside, the many legitimate on- and off-highway uses
of kerosene make its taxation in the case of highway use difficult to
regulate and enforce.  Industry sources say over 90 percent of the
kerosene/No.1 fuel produced in the United States is used either for
home heating or as aviation jet fuel, neither of which is subject to
the excise tax.  However, in the winter months, kerosene is also used
to lower the cloud point\5 for No.2 diesel in diesel engines used
both on and off the highway.  During the cold winter months, the No.2
diesel fuel normally used in diesel engines may require more than 30
percent kerosene or other No.1 fuel so that it will not clog fuel
lines and filters.  Kerosene also may be mixed with diesel fuel in
outdoor storage tanks for furnaces used to heat buildings.  Finally,
kerosene is also used in indoor, unvented home space heaters that,
for safety reasons, require "clear" kerosene--another nontaxable use. 

Recognizing the potential difficulties for diesel fuel excise
taxation arising from the mixing of kerosene and other additives into
taxable diesel fuel, IRS established a task force to fully explore
the issues and options involved.  In July 1995, the Treasury
Department's Deputy Assistant Secretary for Tax Policy, expressed
support for subjecting kerosene to the same dyeing requirements as
now apply to diesel fuel.  However, the Deputy Assistant Secretary
said that Treasury would need to work with Congress to develop a
system for handling tax-free sales of clear kerosene to consumers for
use in home space heaters.  Treasury and IRS officials believed that
retailers would be authorized to apply for refunds of the taxes on
their sales of kerosene for tax-exempt uses.  Because thousands of
retailers could apply for these refunds, IRS would be faced with
large numbers of refunds to process and taxpayers to monitor and
audit. 


--------------------
\4 These requirements include flash point, distillation requirements,
viscosity, total sulfur content, mercaptan sulfur content, copper
corrosion rating, freezing point, color, and burning quality. 

\5 Kerosene is used as a winter blend component for diesel fuel and
heating oil throughout the industry.  As much as 20 percent of diesel
fuel can consist of heavy paraffin hydrocarbons that, when cooled,
will form wax.  The cloud point is the temperature at which wax
crystals start to form in the fuel.  The lower the cloud point the
less likely that the fuel filter will get plugged, stopping fuel
flow. 


      DYE CONCENTRATION CONCERNS
---------------------------------------------------------- Letter :5.2

In addition to the foregoing concerns, several stakeholders commented
that IRS had required too high a concentration of red dye.  These
stakeholders were concerned that the high concentration of dye might
adversely affect engines and be difficult to remove from storage
tanks.  In its June 30, 1994, final regulations, IRS did not reduce
the concentration of dye.\6

IRS officials maintained the original dye level because dilution of
dyed fuel was considered to be a likely tax-evasion tactic. 

Some industry officials, however, said that the required dye
concentration continues to impose an unnecessary burden on the
petroleum industry.  A major pipeline company, for example, explained
that, when diesel fuel dyed at IRS' required concentration is pumped
through a pipeline, the dye contaminates adjacent products in the
pipeline.  Once contaminated, the adjacent product may have to be
sold for a less valuable use.  This pipeline company also said that
on several occasions its aviation kerosene had been rejected by
purchasers due to tinting with red dye.  Aviation companies will not
accept kerosene containing dye due to concerns about the dye's
possible adverse effect on jet engines. 

To respond to these concerns, some petroleum industry members want
IRS to reduce the required concentration of dye.  Both IRS and some
industry members have diluted samples of dyed diesel by adding undyed
fuel, to determine whether the fuel still maintains a visible dye
presence.  IRS believes that its demonstrations support the current
dye concentration, while industry members believe that their diluted
fuel samples show that a visible dye presence remains after dilution
even when the initial dye concentration is considerably lower.  This
difference of opinion about the acceptability of a lower dye
concentration seems to center on "dark" diesel fuel.  Diesel fuel
that is naturally dark in color may not show a visible dye presence
upon dilution unless the initial dye concentration is at the IRS
standard.  Although such dark diesel fuel may not play a large part
in the diesel fuel market, IRS officials are concerned that those
intent on evading the law could darken other diesel fuel by adding
some agent. 

One stakeholder proposal is for IRS to reduce the dye concentration
for a 1-year trial period.  During this period, IRS would monitor the
effect on compliance levels and on the petroleum industry.  Based on
this trial, dye concentrations might then be permanently lowered. 


--------------------
\6 IRS restated how the dye concentration would be determined, but
this did not affect the actual concentration of dye required to be
present in nontaxed diesel fuel. 


      RECREATIONAL BOATERS'
      CONCERNS ABOUT AVAILABILITY
      OF TAX PAID DIESEL FUEL
---------------------------------------------------------- Letter :5.3

Another unresolved concern is that the excise taxes may reduce the
availability of diesel fuel for recreational boating use.  Before the
OBRA 1993 requirements were enacted, fuel used in diesel-powered
boats was not subject to the federal diesel fuel excise tax. 
Congress then extended the excise tax to apply to diesel fuel used in
noncommercial boats. 

Pleasure boat owners and builders are concerned about the
availability of clear tax-paid diesel fuel.  Pleasure boat owners
that use diesel fuel now must use undyed fuel and pay the 24.4 cent
per gallon federal excise tax.  On the other hand, commercial boats,
which include chartered fishing boats and cruise boats, may use dyed
(tax-free) diesel fuel.  Marinas that choose to serve both commercial
and noncommercial users thus need separate storage tanks for each
fuel. 

According to representatives of the recreational boat industry, many
marine fuel retailers have only one storage tank for diesel fuel. 
Various stakeholders told IRS that physical, environmental, and
economic restrictions may make the cost of adding another diesel
storage tank prohibitive.  If retailers were unable to add a second
storage tank, they would be forced to choose between selling undyed
(tax-paid) diesel fuel and selling the dyed (tax-free) variety.  As a
result, undyed (tax-paid) diesel fuel might not be available to the
recreational user, or the commercial user might have to buy tax-paid
fuel and then apply for a refund. 

While recreational boating industry representatives suggested to IRS
that locating undyed diesel fuel would be a major problem for
recreational boaters, we were unable to find databases that
quantified the availability of undyed fuel at marinas.  During the
summer of 1995, the Treasury Department did a limited survey of
portions of the country that were thought to have the greatest
problem with diesel fuel availability for recreational boaters. 
According to Treasury, clear diesel fuel generally was available in a
marina retail fuel outlet in each of these areas.  We did not verify
the survey results. 

Legislation has been introduced (H.R.  2491) to delay the tax on
diesel fuel for recreational boating for 2 years while a solution is
worked out.  Such a solution might either allow recreational boaters
to use dyed fuel and require the retailer to collect the excise tax,
or exempt the recreational boating community from the tax altogether. 
Allowing recreational boaters to use dyed fuel and requiring
retailers to collect and remit the tax would both impose a burden on
the retailers and present IRS with the difficult task of monitoring
retailers' compliance.  However, under this scenario, the potential
for evasion might be limited largely to inaccurate collection or
remittance of the tax by retailers. 


      REQUEST TO EXEMPT ALASKA
      FROM DIESEL DYEING
---------------------------------------------------------- Letter :5.4

Some Alaskan residents asked IRS to exempt their state from the
diesel-dyeing requirements.  The requesters explained that Alaska is
exempt from the Clean Air Act of 1990 requirement that high sulfur
diesel be dyed,\7 and they indicated that 90 percent of all diesel
used in the state was used for nontaxable purposes.  The Alaska
Income and Excise Audit Department provided us with data that showed
that over 90 percent of all diesel fuel used in the state in fiscal
year 1994 was used for tax-exempt purposes.\8

Legislation would be required to exempt Alaska from OBRA 1993
diesel-dyeing requirements. 

In July 1995, the Deputy Assistant Secretary of the Treasury said
that the department supports exempting Alaska from the diesel-dyeing
requirement.  Should Congress grant this request for exemption from
the dyeing requirement for diesel used for off-highway purposes,
there would be a potential for evasion of a modest amount of federal
excise taxes in Alaska, a potential that would not exist in other
states.  During fiscal year 1994, Alaska used over 61 million gallons
of diesel fuel for on-highway purposes.  Thus, the potential to evade
some portion of the $14.6 million in federal diesel fuel excise taxes
paid in Alaska would exist. 

In addition to the potential for some evasion of diesel fuel taxes
within Alaska itself, an IRS official said that potential for
interstate evasion existed as well.  One possible evasion tactic
consists of loading clear, untaxed diesel fuel instead of water as
ballast in barges returning to the mainland United States.  The IRS
official said that IRS would work with the Coast Guard and Customs to
prevent such evasions. 


--------------------
\7 The Clean Air Act permits EPA to temporarily exempt Alaska and
Hawaii from the dyeing requirement if asked.  Alaska requested an
exemption.  The exemption was granted, but it expires at the end of
1996. 

\8 This does not include 787.8 million gallons of jet fuel (probably
kerosene). 


      INTERCITY BUS COMPANIES'
      CONCERNS
---------------------------------------------------------- Letter :5.5

Intercity bus companies have been concerned that the diesel-dyeing
requirements may adversely affect both their ability to comply with
EPA regulations and their operating costs. 

IRS requires that any diesel fuel on which the full federal tax rate
of 24.4 cents per gallon has not been paid be dyed when it is removed
from a terminal.  The requirement does not differentiate between high
and low sulfur fuels.  However, intercity buses are required by EPA
regulation to use low sulfur diesel fuel on the highway.  Intercity
buses also qualify for a reduced diesel tax rate of 7.4 cents per
gallon.  Thus, if companies were to purchase tax-free diesel and pay
the 7.4 cent per gallon tax to IRS, the diesel fuel would be dyed
red, and neither the bus companies nor EPA would know from the fuel
color whether it was low or high sulfur diesel fuel.  In this case,
the companies might have difficulty ensuring that they were in
compliance with the EPA regulations. 

In practice, according to the American Bus Association, the diesel
vendors used by intercity bus companies generally have chosen to sell
undyed diesel fuel only.\9 Since their vendors do not sell dyed low
sulfur diesel fuel, bus companies must purchase clear tax-paid diesel
fuel--which is low sulfur fuel.  The companies' costs may increase
somewhat because they must pay the full 24.4 cent per gallon excise
tax and then apply for a refund of the 17 cent per gallon overpayment
from IRS.  These refunds can be claimed on the taxpayer's annual
income tax return; or quarterly estimated income taxes, if any, may
be reduced by the refund claim; or, if the total amount of refund due
a bus company exceeds $1,000 at the end of any of the first three
quarters in a tax year, the company can file a separate refund claim
at that time. 

Legislation has been introduced in H.R.  4483 to modify section
6427(l)(5)(A) of the Internal Revenue Code by adding intercity bus
operators to the group (including farmers and state and local
governments) entitled to use clear fuel without, to the extent that
they are exempt, paying the federal excise tax.  Under this
amendment, wholesalers or retailers would collect the 7.4 cent per
gallon tax that intercity bus operators owe and file for an expedited
refund for the remainder, following the same procedure that vendors
use for farmers and state and local governments.  Although this
approach would help alleviate the intercity bus companies' concerns,
it would increase the workload and cost imposed on wholesalers and
retailers.  According to IRS officials, this change could lead to
hundreds or even thousands of retail vendors becoming eligible for
expedited refunds, which is contrary to OBRA 1993's strategy of
reducing the number of entities that IRS must monitor.  In addition,
officials said that the expedited timeframe would complicate IRS'
efforts to identify incorrect or fraudulent refund claims. 

House Conference Report language for IRS' 1996 appropriation calls on
IRS to work with appropriate congressional committees to resolve
expeditiously the intercity bus companies' problem. 


--------------------
\9 Wholesale vendors have little incentive to sell dyed low sulfur
diesel fuel for buses because some of their other customers (for
example, farmers and state and local governments) can purchase clear
fuel on a tax-exempt basis.  For these sales, the wholesale vendor
can apply for a refund under the 20-day expedited refund process that
was mandated in OBRA 1993. 


   INCENTIVE TO EVADE MOTOR FUELS
   TAXES OR OBTAIN FALSE REFUNDS
   REMAINS
------------------------------------------------------------ Letter :6

Although increased diesel excise tax collections suggest that
legislative and administrative changes have improved motor fuels
excise tax compliance, there continues to be an incentive to evade
fuel excise taxes or obtain fraudulent excise tax refunds.  Combined
federal and state taxes on fuels have risen in recent years and can
now total $0.40 or more per gallon.  Evading just the federal tax on
an 8,000-gallon truckload of diesel fuel would yield an illicit
profit of $1,920.  Thus, although the government has taken steps to
better assure compliance with motor fuels taxes, a strong incentive
to evade these taxes remains. 

One approach IRS is considering to help deter future evasion is the
development of a database that would track each transaction involving
motor fuels, starting at the refinery and continuing on to the lowest
point in the distribution system where taxes are collected on the
fuel.  An August 1993 study, done for FHWA by the Volpe National
Transportation System Center, estimated that the hardware and
software for a nationwide tracking system would cost over $5 million
to develop and about $3.6 million per year to operate.\10 The study
also estimated that private sector costs for this system would total
about $18.6 million annually.  According to the study, of the eight
alternatives examined, a nationwide tracking system was the best
approach because (1) the cost to implement is among the lowest, (2)
its effectiveness in terms of reduced evasion should be high, and (3)
administrative obstacles do not appear substantial.  IRS has funded
the development of a working model in partnership with the state of
Michigan and the petroleum industry.  IRS officials estimate that a
nationwide system would cost IRS between $12 and $15 million. 
However, these officials said that IRS does not have funds for the
system, and funds that FHWA was to provide to develop the full system
have not been appropriated. 


--------------------
\10 We did not evaluate this study. 


      REFUND FRAUD SCHEMES
---------------------------------------------------------- Letter :6.1

Since 1991, IRS has identified schemes in which individuals claimed
fuel tax credits and obtained refunds when they neither purchased nor
used the fuel.  Although these schemes generally seem to have
involved false diesel fuel tax credit claims, some may have involved
gasoline.  Taxpayers can claim a refundable credit for federal excise
tax paid on fuel (gasoline, diesel, and other fuels) used for certain
purposes.  Categories of use for which fuel tax credit claims can be
filed include farming, off-highway business use, exports, commercial
fishing vessels, intercity or local buses, school buses, and
commercial aviation.  The credit is claimed by filing IRS Form 4136,
Credit for Federal Tax on Fuels, with the taxpayer's Form 1040,
Individual Income Tax return. 

IRS identified one refund scheme involving several defendants who
filed approximately 800 returns in the Houston area during 4 months
in 1991.  The promoters of the scheme recruited individuals to
provide their names and Social Security numbers (SSN).  The
individuals were told that the government had programs through which
they could obtain financial assistance by providing their names and
SSNs.  The promoters prepared false returns claiming $1.8 million in
refunds, of which $1.3 million was paid to the promoters.  Thirteen
defendants were tried and convicted, and four defendants pleaded
guilty. 

The IRS Internal Audit unit located at the Fresno Service Center has
identified other fraudulent fuel tax credit refund schemes operating
in Southern California.  In 1993 and 1994, Internal Audit identified
Form 1040 returns that claimed a fuel tax credit over a specified
threshold.  During 1993, about 4,500 returns were identified. 
Between January 1 and June 3, 1994, about 10,500 returns were
identified.  IRS estimates that 87 percent (9,100) of these returns
and 88 percent ($23 millon) of the fuel tax credit dollars were
fraudulent-scheme-related.  Internal Audit believes that only about
$3 million of the scheme-related refunds were issued to the
taxpayers.  Most of the fraudulent fuel tax credit return schemes
included business income or losses reported on Schedule C.  Verifying
the accuracy of such income is difficult for IRS because it lacks
independent corroborating documentation for the income.  This
purported income or loss was generally used as the basis for claiming
both the fuel tax credit and Earned Income Tax Credits.\11 We were
told that these cases were referred to IRS' Criminal Investigation
Division. 


--------------------
\11 These same return schemes also claimed $6.5 million worth of
false Earned Income Tax Credits--refundable tax credits available to
certain low-income working taxpayers. 


   AGENCY COMMENTS AND OUR
   EVALUATION
------------------------------------------------------------ Letter :7

We provided a draft of this report to the Commissioner of IRS for
comment.  On September 20, 1995, we met with IRS National Office
officials, including the National Director, Office of Specialty
Taxes, and other officials from the offices of Specialty Taxes and
the Chief Counsel.  Officials from the Chief Counsel's office were
generally satisfied with the discussion of the regulations
implementing the diesel fuel taxation changes.  Officials from the
Office of Specialty Taxes said that the draft should have assessed
how well the changes required by OBRA 1993 had been implemented. 
They said that the diesel taxation changes had required considerable
administrative change within IRS and extensive cooperation with state
tax departments and others.  They also noted that IRS had received an
award from the Federation of Tax Administrators that was, in part,
based on IRS' extensive work with state tax officials to implement
the diesel fuel excise tax changes.  Fully assessing how well IRS
implemented the changes to the diesel fuel taxation scheme would have
required an evaluation of such things as IRS' internal and external
training programs and its enforcement programs.  However, such an
assessment was beyond the scope of our assignment, which focused on
the promulgation of implementing regulations.  Officials from both
offices suggested several changes to improve the report's accuracy,
which we have incorporated where appropriate. 


---------------------------------------------------------- Letter :7.1

As arranged with your office, unless you publicly release its
contents earlier, we plan no further distribution of this report
until 14 days after the date of this letter.  At that time, we will
send copies of this report to the Senate Committee on Finance, the
House Committee on Ways and Means, other interested congressional
committees, the Secretary of the Treasury, the Commissioner of IRS,
and other interested parties.  We will make copies available to
others upon request. 

The major contributors to this report are listed in appendix II.  If
you or your staff have any questions, please call me on (202)
512-5407. 

Sincerely yours,

Lynda D.  Willis
Associate Director, Tax Policy
 and Administration Issues


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

Our objectives were to (1) discuss changes in diesel fuel excise
taxes collected in calendar year 1994, (2) identify the most
prominent complaints about IRS' regulations implementing OBRA 1993
diesel dyeing requirements, and (3) determine whether these
complaints have been adequately addressed in the regulations or
whether further regulatory or statutory changes may be needed. 

To identify the most prominent concerns of those commenting on IRS'
proposed regulations, we reviewed letters sent to IRS in response to
the November 30, 1993, diesel dyeing temporary regulations.  To
further understand their concerns and their level of satisfaction
with possible changes, we interviewed selected industry and other
stakeholder officials.  We judgmentally selected officials to
interview in order to obtain coverage of all the prominently raised
issues and of the industry segments commenting on the temporary
regulations.  We also sought to canvass organizations of various
sizes.  When several stakeholders raised the same issue, we
interviewed officials from organizations that represented broad
portions of the affected industry and that had most fully explained
their concerns in the comment letters they provided to IRS. 

We interviewed officials from (1) IRS, FHWA, EPA, and FAA; (2) the
state of Alaska; and (3) the American Bus Association, the American
Trucking Association, the American Petroleum Institute, the
Association of American Railroads, the Independent Fuel Terminal
Operators Association, the Independent Liquid Terminals Association,
the Petroleum Marketers Association of America, and the Society of
Independent Marketers of America. 


MAJOR CONTRIBUTORS TO THIS REPORT
========================================================== Appendix II

GENERAL GOVERNMENT DIVISION,
WASHINGTON, D.C. 

Michael Brostek, Assistant Director, Tax Policy and Administration
 Issues
Mary G.  Phillips, Assignment Manager

SAN FRANCISCO REGIONAL OFFICE

Ralph T.  Block, Assistant Director

George A.  Zika, Evaluator-in-Charge
*** End of document. ***