S. HRG. 109–916

TUNE -UP ON CORPORATE TAX ISSUES:

WHAT’S GOING ON UNDER THE HOOD?

HEARING

BEFORE THE

COMMITTEE ON FINANCE

UNITED STATES SENATE

ONE HUNDRED NINTH CONGRESS

SECOND SESSION

JUNE 13, 2006

(

Printed for the use of the Committee on Finance

TUNE-UP ON CORPORATE TAX ISSUES: WHAT’S GOING ON UNDER THE HOOD?

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35–704—PDF 2006

S. HRG. 109–916

TUNE -UP ON CORPORATE TAX ISSUES:

WHAT’S GOING ON UNDER THE HOOD?

HEARING

BEFORE THE

COMMITTEE ON FINANCE

UNITED STATES SENATE

ONE HUNDRED NINTH CONGRESS

SECOND SESSION

JUNE 13, 2006

(

Printed for the use of the Committee on Finance

COMMITTEE ON FINANCE

CHARLES E. GRASSLEY, Iowa, Chairman

ORRIN G. HATCH, Utah

TRENT LOTT, Mississippi

OLYMPIA J. SNOWE, Maine

JON KYL, Arizona

CRAIG THOMAS, Wyoming

RICK SANTORUM, Pennsylvania

BILL FRIST, Tennessee

GORDON SMITH, Oregon

JIM BUNNING, Kentucky

MIKE CRAPO, Idaho

MAX BAUCUS, Montana

JOHN D. ROCKEFELLER IV, West Virginia

KENT CONRAD, North Dakota

JAMES M. JEFFORDS (I), Vermont

JEFF BINGAMAN, New Mexico

JOHN F. KERRY, Massachusetts

BLANCHE L. LINCOLN, Arkansas

RON WYDEN, Oregon

CHARLES E. SCHUMER, New York

KOLAN DAVIS, Staff Director and Chief Counsel

RUSSELL SULLIVAN, Democratic Staff Director

(II)

(III)

C O N T E N T S

OPENING STATEMENTS

Page

Grassley, Hon. Charles E., a U.S. Senator from Iowa, chairman, Committee

on Finance ............................................................................................................ 1

Baucus, Hon. Max, a U.S. Senator from Montana ................................................ 3

ADMINISTRATION WITNESSES

Everson, Hon. Mark, Commissioner, Internal Revenue Service, Washington,

DC .......................................................................................................................... 4

Walker, Hon. David, Comptroller General, U.S. Government Accountability

Office, Washington, DC ....................................................................................... 8

O’Connor, Hon. Eileen J., Assistant Attorney General, Tax Division, U.S.

Department of Justice, Washington, DC ............................................................ 11

PUBLIC WITNESSES

Plesko, Dr. George A., associate professor, Department of Accounting, University of Connecticut School of Business, Storrs, CT ............................................ 14

Kleinbard, Edward D., partner, Cleary, Gottlieb, Steen & Hamilton, LLP,

New York, NY ...................................................................................................... 16

Sullivan, Dr. Martin A., contributing editor, Tax Analysts, Falls Church,

VA .......................................................................................................................... 18

ALPHABETICAL LISTING AND APPENDIX MATERIAL

Baucus, Hon. Max:

Opening statement ........................................................................................... 3

Bunning, Hon. Jim:

Prepared statement .......................................................................................... 45

Everson, Hon. Mark:

Testimony .......................................................................................................... 4

Prepared statement with attachments ........................................................... 46

Responses to questions from committee members ......................................... 68

Grassley, Hon. Charles E.:

Opening statement ........................................................................................... 1

Prepared statement .......................................................................................... 106

Letters from:

Jay D. Adkisson, dated October 27, 2005 ................................................ 108

J.J. MacNab, dated March 15, 2006 ........................................................ 116

Hon. Mark Everson, dated May 19, 2006 ................................................ 130

Kleinbard, Edward D.:

Testimony .......................................................................................................... 16

Prepared statement with attachments ........................................................... 146

Responses to questions from committee members ......................................... 156

O’Connor, Hon. Eileen J.:

Testimony .......................................................................................................... 11

Prepared statement with attachment ............................................................. 191

Responses to questions from committee members ......................................... 214

Plesko, Dr. George A.:

Testimony .......................................................................................................... 14

Prepared statement with attachments ........................................................... 235

Responses to questions from committee members ......................................... 250

Smith, Hon. Gordon:

Prepared statement .......................................................................................... 263

Page

IV

Sullivan, Dr. Martin A.:

Testimony .......................................................................................................... 18

Prepared statement .......................................................................................... 264

Responses to questions from committee members ......................................... 273

Walker, Hon. David:

Testimony .......................................................................................................... 8

Prepared statement with attachment ............................................................. 288

Responses to questions from committee members ......................................... 362

COMMUNICATIONS

American Council of Life Insurers ......................................................................... 373

De Filipps, Willard J., CPA, P.C. ........................................................................... 382

ESOP Association .................................................................................................... 414

(1)

TUNE-UP ON CORPORATE TAX ISSUES:

WHAT’S GOING ON UNDER THE HOOD?

TUESDAY, JUNE 13, 2006

U.S. SENATE, COMMITTEE ON FINANCE, Washington, DC.

The hearing was convened, pursuant to notice, at 10:05 a.m., in

Room SD–215, Dirksen Senate Office Building, Hon. Charles E.

Grassley (chairman of the committee) presiding.

Present: Senators Hatch, Kyl, Thomas, Bunning, Crapo, Baucus,

Bingaman, and Wyden.

OPENING STATEMENT OF HON. CHARLES E. GRASSLEY, A U.S.

SENATOR FROM IOWA, CHAIRMAN, COMMITTEE ON FINANCE

The CHAIRMAN. Before I start, from the Kenya government’s

Committee on Finance, Planning, Trade, and Tourism, we have Dr.

Oburu Oginga. And I am not going to pronounce this second name

right, so I am not even going to try to pronounce it, but they are

standing up there. We welcome you very much. Thank you.

[Applause.]

The CHAIRMAN. Today’s hearing will be primarily focused on the

current state of our corporate tax system, but we will also touch

on basic issues to consider in the context of business tax reform—

lowering rates and broadening the base.

The continued globalization of our economy, and of course the

complexity of our business activity, presents significant challenges

to our corporate tax system as a whole, but also to problems related to the administration of that system.

The complexity of the tax code itself creates burdens and inefficiencies for taxpayers, as well as for the Internal Revenue Service,

although some taxpayers may view that complexity as creating opportunities for tax avoidance.

According to the Congressional Budget Office, corporate income tax receipts were a record $278 billion in 2005, up 47 percent over

the prior year, representing, as a part of Gross Domestic Product,

2.3 percent. That is also the highest percentage since 1980.

The first 8 months of 2006 show the trend continuing, with corporate tax receipts up 30 percent over last year. The recent surge

in corporate tax receipts is due in large part to the strong performance of our economy. Corporate tax receipts have gone up, along

with rising corporate profits resulting from a growing economy.

Now, in addition to the growing economy, I think some of that

increase is also because of continuing efforts to combat corporate

tax abuse and improve corporate tax compliance.

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As an example, in the year 2004, Congress enacted my package

of legislation, cracking down on tax shelters and requiring companies to publicly disclose, in SEC filings, penalties for failing to report a tax shelter so investors will know whether a company is violating tax shelter laws.

These provisions provided the Internal Revenue Service with

tools to combat tax abuse, and also to work to deter tax shelter activity. We need to do all we can to ensure tax compliance by corporations and individuals alike to maintain the fairness and integrity of our tax system.

To that end, I look forward to hearing from Mark Everson, Commissioner of IRS, and David Walker, Comptroller General of the

Government Accountability Office, about the current state of play

in corporate tax compliance and what is known about the corporate

tax gap.

Tied into corporate profits is the taxation of appreciated investment in corporations. In May of 2005, Senator Baucus and I requested the Government Accountability Office to conduct a study

on the capital gains tax gap. Today, Mr. Walker will also discuss

his Agency’s findings from that study and its recommendations as

to how we can close that capital gains tax gap.

The Department of Justice also plays a key role in enforcing tax

laws. Eileen O’Connor, the Assistant Attorney General, Tax Division, will help us and fill us in on the current issues in corporate

tax from that division’s perspective. She will also discuss some related matters, including the civil and criminal laws at issue with

stock options being back-dated.

As promised earlier this year, we will examine the tax policy behind the LIFO method of inventory accounting with the help of Dr.

Plesko, associate professor of accounting, University of Connecticut

School of Business.

Dr. Plesko’s scholarship in the area of bridging the reporting gap

for the many differences between financial accounting standards

and the tax code supports recent changes in the Internal Revenue

Service’s form Schedule M–3.

The IRS recently came out with a new Schedule M–3, which will

provide examiners of that Agency much more detail regarding

these differences.

One of the panelists, Mr. Edward Kleinbard, a New York partner

at the law firm of Cleary, Gottlieb, Steen & Hamilton, has recommended public disclosure of the M–3 to promote transparency in

financial reporting.

Confidentiality of tax returns, of course, is a fundamental part of

our self-assessment system. It is important to balance taxpayers’

interests and privacy with the need for tax law compliance.

Commissioner Everson has publicly stated that corporate tax return disclosure is something that merits serious debate. This hearing will provide a forum for that debate.

In addition to tax compliance and enforcement matters, we will

also hear testimony on the basic aspects of our current corporate

system, the tax rate, as well as the tax base, that we should consider revisiting in the context of business tax reform.

It is obvious that, in the global economy, tax policy is not so

neatly put into domestic and international categories. Our corVerDate 11-MAY-2000 15:48 Jun 25, 2007 Jkt 095484 PO 00000 Frm 00010 Fmt 6633 Sfmt 6633 35704.000 SFIN1 PsN: SFIN1
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porate tax rate is typically thought of as domestic tax policy, but

when it ranks at or near the top among OECD countries, it influences international business decisions like, obviously, where to

build a plant, and it gives companies incentives to shift income offshore.

As this committee turns to tax reform, a key objective should be

to make the system one that is fair and allows businesses to make

decisions based more on economic merit and less on distortions

generated by the tax code.

The recent global trend has been to lower corporate tax rates and

to broaden the tax base. This is no longer an abstract idea. Our

last panelist, then, Dr. Martin Sullivan, economist and contributing

editor at Tax Analysts, will discuss this new era in corporate taxation that has arrived in many countries, particularly across Europe. I look forward to hearing our panelists discuss each of these

important issues.

I now have the opportunity to turn to Senator Baucus, our Ranking Democrat.

OPENING STATEMENT OF HON. MAX BAUCUS,

A U.S. SENATOR FROM MONTANA

Senator BAUCUS. Thank you, Mr. Chairman. Thank you very

much.

Woodrow Wilson once said, ‘‘Every great man of business has got

somewhere the touch of an idealist in him.’’ Well, based on many

Montana business owners whom I have met, I believe that is true.

They take care of their workers, they pay their taxes, because it

is the right thing to do.

Unfortunately, there are other people in business as well. The IRS estimates that, every year, taxpayers fail to pay $350 billion

in taxes that they owe. That is every year.

That number is growing. About 40 percent of that tax gap is attributed to corporate and other business income, 40 percent of the

$350 billion each year. The term ‘‘tax gap,’’ I think, grossly understates the problem. We have gone far beyond a gap. That $350 billion a year is more like a tax gulf.

The tax gap is not just the IRS’s problem; it is our problem. It

is the problem of all taxpayers in America who pay their fair share.

Former IRS Commissioner Charles Rossotti called it the ‘‘free

rider tax.’’ Those who do not pay get a free ride on the backs of

everyone who does.

On September 7, Treasury Secretary Snow testified before this

committee, and I asked him about the administration’s plan for

closing the $350 billion annual tax gap. I did not get a satisfactory

answer.

He said, ‘‘IRS continues to work on it. They are aware of it.’’ He

referred me to five legislative proposals in the President’s budget.

The Secretary argued that these five proposals were going to help

close the gap.

Well, I have studied those proposals, and they are very modest,

to give them the most credit. According to the administration’s own

projections, these proposals will raise $3.5 billion over 10 years.

The yearly tax gap is $350 billion. So over 10 years, that is $3.5

trillion. The gap is $3.5 trillion. The administration’s proposals will

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raise $3.5 billion over the same period of time, so the administration is proposing a $3.5 billion fix for a $3.5 trillion problem.

Well, I told Secretary Snow at the hearing that I wanted results.

I wanted a plan within 30 days. That deadline has come and gone,

yet the tax gap—the tax gulf—keeps expanding.

The IRS says that it gets a 4 to 1 return on investment in tax

enforcement. For every one dollar it spends, it gets four dollars

back in additional taxes collected. So it makes sense for the administration to propose an IRS budget that would take advantage of

the 4 to 1 return, but they have not, and the tax gulf just keeps

growing.

Two years ago, I issued a challenge. I called on the IRS to

achieve a 90 percent voluntary compliance rate by the year 2010.

At the time, the tax gap was $311 billion a year. Two years later,

we are looking at a gap of $350 billion a year. If we continue at

this rate, by the year 2010 the tax gap will be more than $500 billion a year.

We need effective enforcement efforts to detect and stop abuse

and fraud. It is critical that tax cheats know they are going to get

caught. We need to stop winking at this problem.

This problem has been raised by me especially, and by others,

many times. I have given challenges to the administration, to Secretaries, to IRS Commissioners. Nothing happens. Nothing of consequence happens.

So we need to stop winking at this problem and we need to stare

it down, to solve it. We need to make sure that all taxpayers are

on a level playing field. We need to ensure that some do not gain

a competitive edge because they have gamed the tax system. Protecting taxpayers’ rights, providing quality of service, and enforcing

the law effectively are obligations this IRS should meet, and exceed.

So, Mr. Chairman, I am glad we are holding this hearing today

to examine the corporate tax gap, and hope that these hearings will

produce solid recommendations to close that gap.

I, for one, have about had it. I am not going to rest until this

thing is solved. Maybe not every penny, but that we solve it so we

know that, by and large, we have gotten the job done.

I am astounded, frankly, that the administration has not done

more about it. I am embarrassed that the Congress has not done

more about it, and, by gosh, if I have anything to do with it, we

are going to do something about this.

The CHAIRMAN. Thank you very much, Senator Baucus.

We are going to now go to our witnesses in the way that you are

lined at the table. For the benefit of our committee members, the

three government witnesses will have 10 minutes each, contrary to

our tradition of 5-minute turns. So Mr. Everson, Mr. Walker and

Ms. O’Connor will have 10 minutes apiece.

Would you proceed?

STATEMENT OF HON. MARK EVERSON, COMMISSIONER,

INTERNAL REVENUE SERVICE, WASHINGTON, DC

Mr. EVERSON. Good morning, Mr. Chairman, Ranking Member

Baucus, other members of the Finance Committee. It is my pleasVerDate 11-MAY-2000 15:48 Jun 25, 2007 Jkt 095484 PO 00000 Frm 00012 Fmt 6633 Sfmt 6633 35704.000 SFIN1 PsN: SFIN1
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ure to be with you this morning to discuss corporate compliance

issues.

I want to thank the committee for its interest in the issues I am

going to talk about today, and for the support you have provided

for our efforts to rebuild IRS enforcement programs, including, in

particular, some very helpful provisions that were contained in the

American Jobs Creation Act, and subsequent tax legislation. As always, I also appreciate your efforts to secure adequate resources for

the IRS.

Turning to today’s subject, corporate compliance challenges, the

IRS faces new and more challenging tax administration problems

resulting from globalization, complexity of the code, complexity of

business transactions, and the growing book tax gap.

Let me briefly outline these environmental factors.

Globalization. Globalization and cross-border activity continue to

challenge tax administration. With multiple domestic and global

tiered entities, it is often difficult to determine the full scope, and

resulting tax impact, of a single transaction or series of transactions. Complexities of globalization and cross-border activity create opportunities for aggressive tax planning, demonstrated in several of the compliance issues mentioned in my letter to Chairman

Grassley of May 19.

Complexity of the Internal Revenue Code. The code itself continues to expand, becoming more complex and challenging to administer. Large businesses utilize every available resource to explore opportunities to reduce their tax liability by entering into

transactions which take advantage of the most intricate and complicated code provisions.

Complexity of transactions. Large businesses engage in sophisticated transactions that result in complex relationships with multiple filing requirements. The increasing volume and complexity of

these transactions make it difficult for us to identify them and to

effectively address them in a timely manner.

Growing book tax differences. Companies strive to reflect the

highest possible after-tax profits in their financial statements,

while at the same time they are incentivized to report the lowest

possible taxable income and tax liability.

Research indicates that book tax differences sometimes indicate

significant compliance risk. When the details of business transactions and book tax differences are not visible, the accurate determination of shareholder value, the efficiency of capital markets,

and the correct determination of tax can be jeopardized.

Let me now turn to specific areas of concern.

Transfer of intangibles offshore and cost-sharing arrangements.

Taxpayers, especially in the high-technology and pharmaceutical

industries, are shifting profits offshore, often to low- or no-tax

countries, through a variety of arrangements resulting from the

transfer of valuable intangibles to related foreign entities for inadequate consideration. Cost-sharing arrangements are often the

method of choice for this activity. The buy-in amount in cost-sharing arrangements is often understated, resulting in the improper

shifting of income offshore.

Abusive foreign tax credit transactions. Taxpayers are manipulating the code to create and claim foreign tax credits, where the

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associated foreign-source income is not taxed in the United States.

These structured financing transactions often result in the unintended realization and duplication of tax benefits through the use

of certain structures designed to exploit inconsistencies between

U.S. and foreign laws.

Abusive hybrid instrument transactions. Taxpayers can use hybrid instruments, hybrid entities, and similar structures to capitalize on differences between foreign and domestic tax laws because these structures are often treated differently for U.S. and foreign tax purposes. This leads to transactions with results that in

many cases are unintended by Congress, though technically compliant.

Transfer pricing. Taxpayers are continuing to shift significant

profits offshore. Taxpayers often manipulate the price of related

transactions so that the income of an economic group is ostensibly

earned in a low-tax jurisdiction, or in no jurisdiction at all, rather

than the U.S., thus lowering the enterprise’s world-wide tax burden

with an unwarranted loss to the U.S. FSC.

R&E credit claims. Taxpayers are filing refund claims, often marketed to them on a contingency fee basis, to claim additional research credits. These claims are frequently based on insupportable

amounts, non-qualified expenditures, or estimates for which the

taxpayers do not have contemporaneous documentation.

The universal service fund. Federal and State governments impose taxes on telecommunications service consumers to fund subsidies to the telecommunications carriers for universal service programs. The issue is whether amounts received by telecommunications carriers from Federal and State universal service programs

constitute non-shell older contributions to capital. Some telecom

taxpayers are receiving significant subsidies and are not reporting

them as income.

Mixed service costs. Some electric and gas utility companies have

changed their method of accounting to allow them to consider certain large self-constructed assets ‘‘routine and repetitive’’ under the

simplified service cost method, which allows a much faster, and on

occasion even immediate, write-off.

Section 199 issues. This JOBS Act provision provides a deduction

for certain manufacturing activities conducted in the United States.

We are concerned that mass marketed contingency fee-based refund claims and other excessive deductions will become a problem

under section 199.

Foreign earnings repatriation. This JOBS Act provision provided

a limited opportunity for companies to repatriate foreign earnings

to the U.S., provided they satisfied certain requirements and conditions. Audit issues are likely to include compliance and boardapproved reinvestment plans and the compliance of repatriated

funds with regulatory requirements.

Executive compensation. Section 409A of the JOBS Act provides

that the executive or other service provider must include all deferred amounts under a non-qualified deferred compensation plan

for all taxable years, to the extent that they are not subject to a

substantial risk of forfeiture and not previously included in income,

unless certain requirements are met.

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The IRS is working actively on each of these issues. Some are

being addressed through guidance, others by increased audit activities, and even enhanced cooperation with other national tax administrations.

Before closing, let me mention a few areas which I believe merit

review by this committee. We think the Finance Committee should

reexamine the increase in book tax differences in greater depth in

order to fully understand its impact on compliance and to consider

appropriate remedies.

The R&E credit should be made permanent. Record-keeping and

substantiation requirements need to be more comprehensive to improve our ability to effectively administer the code for R&E credit

refund claims.

These claims continue to have a substantial adverse effect on

compliance and produce substantial administrative burdens. The

temporary nature of the credit, its repeated renewals, and its incremental nature each contribute to these difficulties.

Penalties are needed for improper refund claims. The accuracyrelated penalties in the code apply only in the case of an underpayment of tax and provide no disincentive to taxpayers who file

frivolous or negligent claims for refund.

We believe this encourages promoters, including accounting

firms, to market improper refund claim schemes with very limited

down-side risks. The Finance Committee should consider how the

accuracy-related penalty could be expanded to cover abusive refund

claims.

Let me just close by showing you two charts on this point. This

shows you the growth in the refund claims that we are examining

for a 4-year period, from $10 billion to $15 billion.

This is what we are disallowing upon examination, and this is

what we are allowing. This percentage has actually decreased,

through resource constraints, to about 50 percent over time due to

the growth, really, of what is being claimed.

This shows you what happens when we make the disallowance.

In 85 percent of the cases, the taxpayer just rolls over; they do not

fight it, because they knew what they did was bogus. There is no

penalty for this action.

In contrast, there are complicated issues on a regular examination, and there is a reversal. About a third of the time or more the

taxpayer agrees on the large corporate examination, but more often

than not they slug it out through appeals or through the courts because they think they are right.

Clearly, what you have here is a case of ambulance-chasing by

the big accounting firms, trying to get contingent fees, because

there is no consequence when they make a claim.

Thank you.

The CHAIRMAN. Thank you very much, Mr. Everson.

[The prepared statement of Mr. Everson appears in the appendix.]

The CHAIRMAN. Now, General Walker?

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STATEMENT OF HON. DAVID WALKER, COMPTROLLER GENERAL, U.S. GOVERNMENT ACCOUNTABILITY OFFICE, WASHINGTON, DC

Mr. WALKER. Thank you, Mr. Chairman and members of the

committee. I assume that my entire statement will be included in

the record, Mr. Chairman, therefore, I will move to summarize.

I appreciate the opportunity to be before you to discuss corporate

income tax compliance issues, as well as options for improving taxpayers’ voluntary compliance in the reporting of capital gains or

losses on their sales of securities.

The complexity of the corporate income tax generates opportunities for tax avoidance that can be categorized as either clearly

legal, clearly illegal, or of uncertain legality.

Although bringing in less revenue than used to occur, the corporate income tax is one of the pillars of the Federal tax system.

The $277 billion in estimated 2006 corporate tax revenues must be

a part of the overall consideration in dealing with our Nation’s

large and growing long-term fiscal imbalance.

Determining corporate income tax liabilities and the extent of

corporate tax avoidance is a challenge because of the complexity of

the tax code, coupled with business transactions that are often extremely complex and involve multinational corporate structures.

Frankly, in many regards, Mr. Chairman, the government is simply outgunned when it comes to corporate income tax compliance.

Since the early 1980s and through 2005, the corporate income

tax has accounted for from 6 to 13 percent of total Federal revenues, or from 1 percent to 2.5 percent, approximately, of the economy during those same years. Consequently, while it is not the

largest part of our Federal revenue, it is an important part of our

Federal revenue.

Corporate tax expenditures serve to reduce the amount of revenue that otherwise would be raised through the corporate income

tax. The sum of estimated foregone revenue for the Federal Government because of corporate tax expenditures was $80 billion for

fiscal year 2005.

We reported, in September of 2005, that the effectiveness of

many tax expenditures is not subject to the level of review similar

to programs that spend money directly.

To a large extent, they are off the radar screen. They are not

part of the budget process, they are not part of the appropriations

process, and they are not subject to a periodic review and reexamination, as should be the case.

In our September, 2005 report we recommended that the Office

of Management and Budget and the Treasury Department take

steps to ensure regular reexamination of tax expenditures, including various corporate tax preferences.

As far back as 1994, we have also suggested that Congress

should review these tax expenditures, considering such things as

how well the corporate tax expenditures are achieving their stated

purpose, who is benefitting from them, and whether they should remain, given the potential benefits of moving to a simpler corporate

tax code, possibly with a broader base and reduced rates.

Ensuring corporate income tax compliance is challenging because

much of the corporate tax avoidance is legal. Also, the true tax liVerDate 11-MAY-2000 15:48 Jun 25, 2007 Jkt 095484 PO 00000 Frm 00016 Fmt 6633 Sfmt 6633 35704.000 SFIN1 PsN: SFIN1
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ability for large corporations is extremely difficult to determine,

and often subject to negotiation. The amount of corporate tax

avoidance, candidly, is unknown.

As noted, IRS’s published estimate of the corporate tax gap, the

difference between what corporations pay voluntarily on time in

taxes and what they are required to pay under the law, was $32

billion for tax year 2001. That is compared to an overall gross tax

gap of $345 billion for that year.

Under-reporting of income was the largest single component of

the corporate tax gap, contributing an estimated $30 billion out of

the $32 billion. Importantly, the IRS does not have an estimate for

non-filing of corporate income tax returns for fiscal year 2001.

IRS has not systematically measured the level of compliance for

large corporations, and the last measure of non-compliance for

small corporations was in the 1980s.

In order to improve efforts to reduce the tax gap, we have recommended that IRS develop plans to periodically measure tax compliance for areas that have been measured and study ways to costeffectively measure compliance for other components of the tax gap

that have not been measured, such as excise taxes and corporate

taxes. IRS has agreed with our recommendations.

IRS has recently increased the number of corporate audits and

recommended tax assessments. These trends are both positive and

promising. However, given the lack of reliable measures to assess

the extent of corporate non-compliance and other factors, continued

oversight of these efforts will be warranted in order for Congress

to be able to make informed judgments on their overall effectiveness.

In addition to examinations, the IRS has taken a number of initiatives, some of which are new, to help ensure corporate tax compliance. IRS has also been revising the corporate tax examination

process. For example, IRS reports that it has shortened the cycle

time for examinations.

Future success in following through on these initiatives will require replenishment of IRS staff, which could be challenging given

the increasing number of employees who are eligible to retire, and

who are otherwise leaving key occupations within the IRS.

In part, because the IRS does not have a reliable measure of corporate tax compliance, it will be a challenge to demonstrate the effectiveness of increased audits and various initiatives it has undertaken.

The effectiveness of IRS’s efforts will depend on the extent to

which the taxes recommended are actually collected, given past

data showing that a relatively small portion of recommended assessments is ultimately collected.

For these reasons, as well as for human capital management and

other reasons, IRS’s increased compliance efforts will warrant continued oversight. Judicious use of technology has already helped

the IRS to improve its productivity, and continued well-managed

technology initiatives have the potential to further improve the use

of its resources and to increase its productivity and effectiveness.

The IRS plans to gradually expand the number of firms that are

required to electronically file. This effort and other opportunities to

10

leverage modern technology can serve to help IRS deal with the

complex issues in the corporate tax environment.

When any taxpayer is found to owe taxes—and these amounts

are no longer in dispute—failure to collect the taxes sends an adverse compliance signal. In February of 2004, we reported that

some Department of Defense contractors abused the Federal tax

system with little consequence.

In June of 2005, we reported that many contractors of civilian

agencies in the Federal Government also abused the Federal tax

system. Our analysis showed that 33,000 Federal contractors received substantial Federal payments from civilian agencies during

fiscal year 2004 but also owed more than $3 billion in unpaid Federal taxes.

In our reports on this issue we made numerous recommendations

intended to improve the Federal payment levy program by expanding the amount and type of tax debt eligible for inclusion in the

program, expanding the volume of Federal payments subject to

levy, and correcting process and control deficiencies that hinder the

program’s ability to maximize the amount levied for payments to

contractors with unpaid Federal taxes.

In our 2004 report, we also recommended that OMB develop options for prohibiting Federal contract awards to businesses and individuals that abuse the Federal tax system, including designating

such tax abuse as a cause for government-wide debarment or suspension.

Consistent with our recommendation to OMB, I believe that Congress should consider suspending government business with contractors who are delinquent on their taxes as of a specific prospective effective date, with a provision for limited waivers in unique

circumstances. The same concept could also be applied for Federal

grantees where there are similar problems.

Finally, Mr. Chairman and members of the committee, you asked

GAO to testify on a report, done at your request, that we are

issuing here today on individual taxpayers’ compliance in reporting

capital gains income from the sale of securities.

For tax year 2001, an estimated 36 percent, or over 7 million, of

individual taxpayers who sold securities misreported their capital

gains or losses. Using the words ‘‘wrong cost basis for securities’’

was the primary type of non-compliance leading to this misreported

income.

IRS’s attempts to address misreported security sales income

through enforcement and taxpayer service programs, which are to

help taxpayers voluntarily comply, have had mixed success. Expanding information-reporting to taxpayers and IRS on security

sales to include the cost basis has the potential to improve, not

only taxpayer voluntary compliance, but also to help IRS enforcement.

Our new report includes several matters for Congressional consideration, including requiring brokers to report to both taxpayers

and the IRS the adjusted basis of securities and to ensure that the

IRS has sufficient authority to pursue actions in this area.

Furthermore, we recommend that the IRS modify the instructions for individual income tax returns to clarify the appropriate

use of capital gains to offset capital gains or other income, and to

11

provide guidance on resources available to taxpayers to determine

their basis. IRS has agreed with our recommendations.

So in summary, Mr. Chairman, IRS is agreeing with most of our

recommendations and is pursuing administrative implementation,

but some of our recommendations require Congressional action.

Thank you very much, Mr. Chairman.

The CHAIRMAN. Thank you, General Walker.

[The prepared statement of Mr. Walker appears in the appendix.]

The CHAIRMAN. Now, Ms. O’Connor?

STATEMENT OF HON. EILEEN J. O’CONNOR, ASSISTANT ATTORNEY GENERAL, TAX DIVISION, U.S. DEPARTMENT OF

JUSTICE, WASHINGTON, DC

Ms. O’CONNOR. Mr. Chairman, Ranking Member, members of the

committee, thank you very much for your interest in these issues

and for inviting me to be with you today. It is my honor to testify

today on behalf of the more than 500 men and women of the Justice Department’s Tax Division.

As you know, their mission is the fair and consistent enforcement

of the laws that provide the funds our government needs to do

what we ask of it. Your focus in today’s hearing is corporate tax

issues, by which I understand you to mean not only tax issues presented by large corporate taxpayers, but also large-dollar issues

presented by the tax shelters many individuals have used to virtually eliminate their tax on large amounts of taxable income. You

also suggested I might comment on recent developments concerning

tax fraud scams.

It is appropriate to consider these together. Abusive tax shelters

for corporations and wealthy individuals are at one end of the illegal tax avoidance spectrum. At the other end are the scams that

cost the Federal Treasury less per person who uses them, but that

can be used by many thousands of people.

Until 2001, the scamsters who sold these low-end tax fraud

schemes often went for years without apparent government attention. They used the fact that they had been selling their schemes

out in the open and the government had not sought to shut them

down as proof of their legitimacy.

Likewise, the developers, peddlers, and enablers of the high-end

tax schemes, the so-called sophisticated tax shelters, believed they

too could evade detection, and failing that, they could use an attorney’s opinion letter as a ‘‘get out of jail’’ or ‘‘get out of penalties

free’’ card.

I am pleased to report that, as a result of the work the Tax Division has undertaken during the past 5 years, these expectations

are changing. From the high end to the low end, these scams and

shelters are major contributors to the $350-billion tax gap to which

Ranking Member Baucus referred.

A quick peek under the hood of the Tax Division reveals that

Federal refund litigation involving tax shelters has burgeoned in

the last several years, and will continue to do so in the foreseeable

future.

At this moment, the Tax Division has 80 to 100 attorneys, nearly

one-third of our attorney workforce, working in various combinaVerDate 11-MAY-2000 15:48 Jun 25, 2007 Jkt 095484 PO 00000 Frm 00019 Fmt 6633 Sfmt 6633 35704.000 SFIN1 PsN: SFIN1
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tions on a great many trial teams engaged in more than 100 highstakes cases in 23 Federal trial courts.

I hasten to add, they are excited and eager, these attorneys,

about defending the integrity of our Federal tax laws and doing all

they can to put a stop to the abusive tax shelter phenomenon that

drains the Federal Treasury and shames the legal, accounting, and

banking professions.

Let me mention just a few of the types of sophisticated tax shelters the Tax Division is presently litigating. Each of these shelters

is used by corporations and wealthy individuals and carries with

it, according to the best estimates, a cost to the Federal Treasury

of approximately $5 billion.

You will recall the Tax Division’s victory in the Long-Term Capital Holdings case in the District of Connecticut year before last.

Last fall, the U.S. Court of Appeals for the Second Circuit upheld

the IRS’s application of the 40-percent penalty. So in addition to the $40 million in taxes held to be due, the

principals in this entity are subject to $16 million in penalties, this

notwithstanding opinion letters vouching for the tax consequences

of the deal. Forty percent penalties are significant; there should be

harm in trying.

Similarly, notwithstanding the more-likely-than-not opinion letters from a Washington, DC law firm and a major accounting firm,

Judge Rodriguez of the Western District of Texas recently ruled in

one of the Trans-Capital Leasing Associates cases that ‘‘the 1991

mainframe investment was a transaction solely shaped by tax

avoidance objectives and completely lacking in profit potential’’ and

entered judgment in favor of the government. The court noted that,

for a half-million-dollar fee, the taxpayer received $11 million in

tax deductions, with no corresponding taxable income.

The U.S. Court of Appeals for the Sixth Circuit recently held that

Dow Chemical’s corporate-owned life insurance program had ‘‘no

practicable economic effect, other than the creation of income tax

losses,’’ and it denied Dow Chemical the $33 million in deductions

it had claimed from the plan.

Even people who do not watch tax developments closely sat up

and took notice last year when a District Court in Maryland granted summary judgment for Black & Decker in a contingent liability

tax shelter.

The Tax Division appealed that loss to the U.S. Court of Appeals

for the Fourth Circuit in February and won a reversal. The Court

of Appeals remanded that case to the District Court for a trial on

the merits of the government’s economic substance arguments. We

expect that trial to take place next spring.

Finally, the Son-of-BOSS tax shelter cases. Proving the probable

accuracy of the $5-billion estimate that is attached to these tax

shelters is the fact that, of the two-thirds or so of the Son-of-BOSS

participants—of whom there are approximately 1,800 identified

through Tax Division’s aggressive summons enforcement litigation—of the 1,200 or so who participated in the IRS settlement initiative, the IRS has already received about $3.7 billion from those

1,200, and last I heard the IRS was still counting.

The first of these cases to be tried, Jade Trading, that trial concluded in December in the U.S. Court of Claims, and the decision

13

in that case is pending. The Tax Division presently has 45 other

Son-of-BOSS cases in various stages of litigation, and we understand there are many, many more on their way. These are a few

of the cases in which the United States, in a refund suit, is the defendant.

Let me now turn to some of the criminal prosecutions that have

arisen from the development and sale of sophisticated tax shelters.

The United States entered into a deferred prosecution agreement

with KPMG LLP in which the firm admitted that it marketed and

sold fraudulent tax shelters, and it agreed to pay $456 million in

penalties.

Domenick DeGiorgio, a former HVB accountant, pleaded guilty to

defrauding the United States by helping promoters of the so-called

BLIPS shelter.

HVB Group itself, Germany’s second-largest bank, agreed to pay $29.6 million in fines and restitution and entered into an 18-month

deferred prosecution agreement in connection with its role in tax

shelters.

Eighteen former KPMG partners, and Raymond Ruble, a former

partner at the law firm Sidley Austin Brown & Wood, were indicted by a grand jury in the Southern District of New York on

charges of conspiracy to defraud the United States in connection

with their efforts to market, sell, and conceal a series of fraudulent

tax shelters. That trial is scheduled for September of this year.

Former KPMG partner David Rivkin has pleaded guilty to

charges of conspiracy and tax evasion and agreed to cooperate with

prosecutors in the case against the 18 other defendants. Rivkin admitted that he conspired with the others to prepare and execute

false documents so that clients could file false returns.

Let me now mention two brief examples of criminal prosecutions

arising from what I referred to earlier as the low-end tax schemes.

You might call them tax shelters for the less wealthy, and you

might note some common features between these and the more sophisticated schemes.

Royal Lamarr Hardy was sentenced to 13 years in prison for promoting a scheme that cost the U.S. Treasury more than $8.5 million, and a Federal jury convicted Hardy and four co-defendants of

conspiracy and other tax offenses for promoting what they called

the Reliance Defense.

Perhaps taking a leaf from the opinion letters rendered by law

and accounting firms in the more sophisticated deals I mentioned

earlier, the Reliance Defense consisted of books and binders filled

with materials purporting to show a studied conclusion that the

purchaser had no duty to file a return or pay tax.

Daniel Fisher, a Dallas, TX resident, was sentenced to 20 years

in prison and fined $1 million for preparing false returns for

wealthy clients. His scheme created sham business entities and

transactions—much like the sophisticated tax shelter transactions

except less sophisticated—to give the appearance of losses. Fisher

is believed to have caused a loss of approximately $10 million to

the U.S. Treasury.

The increasing ease and invisibility with which money can flow

from one jurisdiction to another increases the challenges to tax law

enforcement. Tax Division attorneys actively participate in soluVerDate 11-MAY-2000 15:48 Jun 25, 2007 Jkt 095484 PO 00000 Frm 00021 Fmt 6633 Sfmt 6633 35704.000 SFIN1 PsN: SFIN1
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tions to these challenges. We assist in the drafting and negotiation

of Tax Information Exchange Agreements and Mutual Legal Assistance Treaties, we perform reciprocal evidence gathering to meet

tax law enforcement needs, and we participate in international

training programs to improve other countries’ tax administration

and enforcement programs. In these and other ways, we work to

foster international cooperation of tax enforcement, money laundering, and counter-terrorist financing matters.

Finally, Mr. Chairman, in our view, justice must not only be

done, it must be seen to be done. For our tax system to succeed,

it must be enforced. The Tax Division and the Internal Revenue

Service work hand-in-glove on matters requiring litigation, including summons enforcement, civil injunctions, criminal prosecution,

and tax refund suit defense.

Since I last had the opportunity to address the committee, we

have made significant progress. Also, since then, however, it has

become apparent that our litigation challenges will continue to

grow during the next few years. For the sake of the law-abiding

taxpayer and the law-abiding tax advisor, as well as for the sake

of the Federal Treasury, it is our obligation to rise to these challenges.

Thank you again for inviting me to be with you today. I look forward to responding to your questions.

The CHAIRMAN. Thank you, Ms. O’Connor.

[The prepared statement of Ms. O’Connor appears in the appendix.]

The CHAIRMAN. Now, Dr. Plesko?

STATEMENT OF DR. GEORGE A. PLESKO, ASSOCIATE PROFESSOR, DEPARTMENT OF ACCOUNTING, UNIVERSITY OF

CONNECTICUT SCHOOL OF BUSINESS, STORRS, CT

Dr. PLESKO. Chairman Grassley, Ranking Member Baucus, members of the committee, thank you for inviting me to testify today.

My remarks will primarily deal with the Last In/First Out inventory method and touch on conformity in financial and tax accounting. My written testimony provides greater detail of these issues,

as well as some figures and a table I will refer to in my presentation.

When discussing inventory accounting, it is important to keep in

mind that inventory accounting methods are cost-flow assumptions

and are not meant to reflect physical inventory.

Under LIFO, the costs of the most recent purchases are recognized first. If prices are rising over time, LIFO firms will report

higher costs of sales and lower profit. To maximize reported profit,

however, inventory choice seems straightforward: choose the method that allows the firm to recognize the least amount of cost. However, this decision is complicated by the tax code’s allowance of

LIFO, provided that the firm also uses LIFO for financial reporting.

Figure 1 on page 14 of my testimony shows the trend in the use

of LIFO among the largest publicly traded firms. Firms are not required to use the same method for all of their inventories, so the

solid line in Figure 1 shows firms using LIFO for at least part of

15

their inventory, while the dashed line reports the percentage that

use LIFO for a majority.

Both lines show the same pattern. The use of LIFO rose dramatically during the mid-1970s, a period of high inflation, peaked in the

early 1980s, and has generally declined since. At the end of 2004,

only 40 percent of these large firms used LIFO at all, and only 21

percent used it for a majority of their inventory.

Going beyond the largest firms, however, an analysis of all publicly traded firms shows that fewer than 10 percent with inventory

report LIFO-related reserves. Treasury’s 1984 tax reform study

(‘‘Treasury I’’) reported that 95 percent of all tax filings use First

In/First Out or FIFO.

The primary advantage of LIFO is the tax benefit that LIFO provides firms experiencing increases in input prices. For electing

firms, LIFO can provide an indefinite deferral of profits that would

otherwise be reported.

Indeed, since the effect of LIFO conformity is to require companies to report lower earnings to their shareholders, the tax benefits

to the firms that use LIFO must be larger than the sum of the administrative costs incurred to maintain LIFO records and any financial reporting costs they might incur through reporting lower

profits.

Figure 2 provides some information on the magnitude of the tax

benefits of deferral based on data from publicly traded firms. This

data is taken from firms’ LIFO reserve and represents the cumulative amount of additional costs that have been expensed by the

firm because of a choice of LIFO.

Similar to the pattern in Figure 1, the dollar value of the LIFO

reserve—the gray bars—has generally declined. For 2004, the last

year for which data is readily available, the aggregate value of the

reserve was nearly $60 billion, and I expect it was higher at the

end of 2005.

This $60 billion represents the amount of additional net income

publicly traded firms would report on their tax returns if a change

required them to recognize this reserve as income, less any operating loss carried forwards to offset.

Assuming this income was to be taxed at an average rate of 30

percent, the implied potential revenue gain is approximately $18

billion before credits. By contrast, the Joint Committee estimated

the revenue effects of the LIFO provision in H.R. 4297, affecting

only oil companies, to be $4.3 billion.

The use of LIFO raises many concerns. Because a firm knows

both the current costs of new inventory and the presumably lower

cost of selling existing inventory, firms have a greater opportunity

to manage the earnings they report to their shareholders.

If a firm wants to report higher earnings, it can choose to sell

from older, lower-priced existing inventory rather than acquire

new, or purchase additional inventory at the end of the year to

avoid additional tax liabilities.

If the financial reporting benefits of LIFO were superior to any

other available method, we would expect to see more widespread

use of LIFO by both U.S. firms and in other countries.

However, international accounting standards generally prohibit

the use of LIFO. Given the trend to harmonize accounting standVerDate 11-MAY-2000 15:48 Jun 25, 2007 Jkt 095484 PO 00000 Frm 00023 Fmt 6633 Sfmt 6633 35704.000 SFIN1 PsN: SFIN1
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ards, it is not clear that LIFO will remain an acceptable method

for U.S. reporting purposes, and, given the conformity requirement,

for tax reporting purposes.

In these circumstances, Congress could repeal LIFO conformity

and allow firms to continue to choose LIFO for tax reporting only.

But doing so would only create additional administrative complexity, as well as increased book tax reporting differences. Such an

action would appear to generate no benefit, other than provide a

tax benefit to these firms.

The fundamental question, therefore, is whether the tax code

should allow use of an inventory accounting method that would

likely not be used in the absence of a tax preference.

Related to this, there has been substantial discussion on increasing book tax conformity, if not convergence. I do not agree that

more book tax conformity is always desirable, and I advise careful

study of these proposals.

Tax and financial accounting serve related, but distinct, functions, and the measure of income for one cannot be assumed to be

an appropriate measure for the other. LIFO, as discussed above,

does conform, but it may not yield the best financial reporting outcome.

Such a conclusion goes to the heart of the economic analysis of

the tax system. If the tax system is to be neutral, firms should

make the same decisions in the presence of the tax as they would

make in its absence. LIFO appears to violate this.

Thank you again for the opportunity to be here today. I look forward to further discussion of these issues.

The CHAIRMAN. Yes. Thank you.

[The prepared statement of Dr. Plesko appears in the appendix.]

The CHAIRMAN. Mr. Kleinbard?

STATEMENT OF EDWARD D. KLEINBARD, PARTNER, CLEARY,

GOTTLIEB, STEEN & HAMILTON, LLP, NEW YORK, NY

Mr. KLEINBARD. Chairman Grassley, Ranking Member Baucus,

members of the committee, thank you for inviting me to testify on

the advisability of public disclosure of U.S. corporate Federal income tax returns.

In brief, I believe that there are strong policy and practical reasons not to mandate the public disclosure of the entirety of corporate tax returns.

On the other hand, I believe that there is a completely persuasive case for requiring public companies to release to the public

their consolidated Schedule M–3s, a new IRS schedule whose purpose is to reconcile a corporation’s financial statement and taxable

incomes.

So what exactly is this Schedule M–3? You can understand it as

kind of a tax Rosetta Stone. It maps the relationship between a

corporation’s financial statement on the one hand, and its income

tax return on the other.

It does so by dividing a company’s income and deductions into 30

or so categories, and then requires the taxpayer to reconcile the

amount in each category, for tax purposes, with a comparable

amount available to that category for financial statement purposes.

17

My first observation is to urge that this committee not mandate

the release of the entirety of corporate tax returns. A recent IRS

news release revealed that General Electric’s 2005 tax return was

the electronic equivalent of a 24,000-page document. I hope that

Commissioner Everson knows what to do with these 24,000 pages;

I know that I would not, and I doubt very much that any public

investor or securities analyst would either. Making returns of this

kind of heft public thus would sacrifice the confidentiality of a taxpayer’s commercial information for very little benefit to the public.

My second fundamental observation is that the Schedule M–3 is

different from the entirety of the return. The M–3 is relatively

short. It is unlikely to contain confidential commercial data, and its

public release would convey useful information to investors and

policymakers alike.

My first sub-point within that is simply that I believe that investors could directly benefit from the publication of M–3s. Investors

today are conditioned to view the financial performance of publicly

held companies solely through the prism of financial accounting

conventions, and corporate managers, of course, manage with a

view to achieving financial accounting targets.

In the absence of any other viewpoint, investors and managers

alike often confuse a corporation’s financial statements with the

underlying economic reality that those accounting principles seek

to model. That is, they treat the model as if it were reality.

By virtue of the M–3, the IRS now enjoys a stereoscopic insight

into corporate economic performance through tax and financial accounting. Investors in public companies deserve the same. The public disclosure of Schedule M–3s would permit just that.

At the same time, the public release of M–3s should not expose

companies to the risk of revealing proprietary commercial information to competitors, especially when compared to the information

already available to the public in SEC filings.

The public release of the consolidated M–3 thus would not expose

material proprietary commercial information to public scrutiny, but

would still have direct and material financial benefits for investors.

In addition, investors today know shockingly little about the actual cash tax liabilities of public companies, because the financial

statement current tax liability provision is not equivalent, and has

only a casual relationship to, the cash taxes paid and payable in

respect of a year.

To address this point, I recommend that the release of public corporation Schedule M–3s be accompanied by a simple reconciliation

of the cash taxes actually paid and payable by a company to its financial tax provisions.

My second subpoint is that the public release of Schedule M–3s

can be expected to have a modestly helpful impact on curbing corporate tax shelter activities.

The development of the M–3 was an enormously important step

forward for the administration of the corporate tax system, but the

direct beneficiary of this development, the IRS, does not need public disclosure in order to reap the benefits of using the M–3.

At the margin, however, public M–3 disclosure might dampen

some corporate enthusiasm for tax shelter transactions by making

18

plain to investors that the source of a company’s enhanced aftertax earnings was the wholesale pursuit of aggressive tax trades.

My final subpoint is, simply, that public M–3s will improve the

quality of tax and accounting systems as a whole. Many of you

today are troubled by the fact that the gap between corporate pretax financial statement income and taxable income, as reported to

the IRS, is said to have exceeded $200 billion in 2002.

The simple fact is, no one knows the source—all the sources—of this $200-billion book tax earnings gap. Some of the reasons are benign, others are possibly malignant, but we lack good data to distinguish between the two.

If the Schedule M–3s of publicly held companies were available

to the public, the current collective uncertainties for the reason for

this gap would dissipate, and we could replace wild suppositions

with actual facts, susceptible of being catalogued and analyzed.

In sum, the combined public disclosure of the consolidated Schedule M–3 and company reconciliation schedule of taxes paid through

the financial statement tax provisions would permit investors to

bring stereoscopic vision to bear on corporate financial performance.

It would reduce any potential for corporate earnings management through the timing of additions to tax reserves, and it would

permit a more pointed analysis of the quality of a company’s tax

expenses and appetite for tax risk.

The public release of the Schedule M–3 would modestly help tax

administration, it would improve public dialogue on the corporate

tax system, and it would encourage the recalibration of the tax or

financial accounting model when either is seen to produce noneconomic results. These are powerful reasons to proceed with the

idea.

Thank you.

The CHAIRMAN. Thank you, Mr. Kleinbard.

[The prepared statement of Mr. Kleinbard appears in the appendix.]

The CHAIRMAN. Now, Dr. Sullivan?

STATEMENT OF DR. MARTIN A. SULLIVAN, CONTRIBUTING

EDITOR, TAX ANALYSTS, FALLS CHURCH, VA

Dr. SULLIVAN. Mr. Chairman, Ranking Member Baucus, and

members of the committee, thank you for the opportunity to appear

before you today.

This morning I will discuss developments in international corporate taxation that truly mark a new era. I will explain their underlying causes and suggest how the United States should respond.

Mr. Chairman, the forces of globalization are reshaping corporate

taxes around the world. Consider three basic facts about Europe,

which is home to 5 of the world’s 10 largest economies.

Fact number one. Over the last decade, statutory corporate tax

rates in Europe have declined dramatically. The average top statutory corporate tax rate in the European Union fell from 43 percent

in 1996 to 33 percent in 2006. And it is not just the newer members of the EU with their flat taxes and their low rates; over the

last decade, 22 out of the 25 countries in the EU have cut their corporate tax rates.

19

Meanwhile, the top U.S. corporate tax rate has not budged. Taking into account State taxes, in order to make the U.S. data consistent with the EU data, the top rate in the U.S. is 39.5 percent,

higher than the corporate tax rate in all 25 EU countries. Around

the world, only Japan has a higher corporate tax rate, and it is

only slightly higher.

Mr. Chairman, by standing still, we have fallen behind. Ten

years ago, our corporate tax rate was 3.7 percent below the EU average. In 2004, it was 6.9 percent above the EU average.

Fact number two. Despite the large rate cuts, European corporate tax revenue has not declined. Corporate tax revenue should

have fallen, for two reasons: first, the lower rates; second, because

of the profit-shifting from high-tax to low-tax countries. Yet, revenue has not fallen, which leads me to my next point.

Fact number three. To offset the revenue costs of rate cuts, European governments have broadened their corporate tax bases. As the

EU reported last month, corporate rate cuts in Austria, Belgium,

Cyprus, France, Germany, Hungary, Portugal, Slovakia, and the

United Kingdom, all these rate cuts coincided with cutbacks in corporate tax breaks. Depreciation schedules across Europe have become less generous. In fact, the United Kingdom and Ireland have

both eliminated expensing.

Now, why is this happening? Tax reform that involves rate cutting and base broadening is always a big plus for competitiveness.

It reduces government’s role in the economy, it reduces economic

distortions, it increases efficiency, productivity, and wages.

But it is more important now than ever, for three reasons. First,

as the economy moves away from manufacturing, and intangible

assets take the place of plant and equipment, rates play a larger

role than conventional investment incentives in determining aftertax profits.

Second, as transportation and communication costs have

dropped, there is more cross-border investment, so now the governments concentrate their efforts on trying to influence the location

decisions of multinationals. In these decisions, tax rates, not investment credits or accelerated depreciation, matter.

Third, as mobile as capital may be, profits are more mobile.

When multinationals are deciding where to channel profits, tax

rate differentials are all-important, and conventional incentives do

not matter at all.

Now, what should the United States do? We should reduce our

corporate tax rate significantly—I would suggest from 35 to 25 percent—and offset the revenue loss by broadening the corporate tax

base. This would boost economic growth, and that growth would

raise revenues from all sources, not just the corporate tax.

Plant closings would decline. Inbound investment would increase,

artificial profit-shifting out of the United States would slow, and

we would create an incentive to begin shifting profits into the

United States.

To broaden the tax base, I am going to make five concrete suggestions. First, reduce depreciation allowances. Bringing tax depreciation into conformity with true economic depreciation would raise

tens of billions of dollars annually.

20

Second, eliminate the deduction for domestic production activities. That would save the Federal Government another $10 billion

a year.

Third, tighten transfer pricing rules, particularly those pertaining to cost-sharing arrangements. The revenue gains here could

be enormous. I have estimated that profit-shifting out of the United

States to a single country—that is, Ireland—in a single year cost

the U.S. Treasury at least $2 billion.

Fourth, eliminate profit-shifting to low-tax countries through related-party loans, through the hybrid entities that the Commissioner mentioned. These loans are not like real loans, but the tax

code treats them that way. We could see significant revenue by disallowing deductions for interest from related-party loans.

Fifth, eliminate, or at least reduce, tax credits. Most tax credits

are well-intentioned, but they are ineffective. We could eliminate

energy credits and employment credits and cause no great harm to

the national well-being. Even the venerable Research Credit could

use a good trimming.

Mr. Chairman and members of the committee, that concludes my

remarks.

The CHAIRMAN. Thank you, Dr. Sullivan.

[The prepared statement of Dr. Sullivan appears in the appendix.]

The CHAIRMAN. We will have 5-minute rounds. The first four or

five people on the list would be: Grassley, Baucus, Hatch, Thomas,

Bunning, Bingaman.

I am going to start with Commissioner Everson. One of the compliance issues you raised related to abusive hybrid instruments, financial instruments that may be characterized differently in the

United States and foreign tax jurisdictions as either debt or equity.

You recommend that this committee examine the increase in

book tax differences. I suppose the term ‘‘hybrid instrument’’ could

also be used to describe financing structures that are characterized

as debt for tax purposes, but equity for financial accounting purposes.

So, a two-part question. Dr. Sullivan, you might pay attention,

because I might ask you a follow-up depending on what the Commissioner says.

Commissioner Everson, do you think that debt equity issues are

a significant part of the book tax gap? And second, could you please

comment on the significance of the distinction between debt and

equity from a tax administration point of view?

Commissioner EVERSON. Sure. Let me make one broad point, if

I might. What we are getting to now is a discussion of things that

fall outside this tax gap. We are talking about things that are a

manipulation of the code, and looking at comparison points between our system and the systems of other countries.

So it is not included, in many instances, in the strict non-compliance issues. So if you take a look at the problems that we talk

about in the gap, $350 billion, this goes beyond that. It is changes

in practices that involve, if you will, the coordinated work of investment banks, accounting firms, and commercial banks in terms of

structuring transactions.

21

Oftentimes they are complicated financing, they are hard for us

to find. Debt and equity is subject, in our system, to substantive

tests; we make judgments depending on the circumstances. My understanding is, overseas it much more closely follows questions of

form.

Therefore, this presents opportunities for the financial institutions to structure deals—and they are in the business of structuring deals so these are a small part of their volume, but this is

very helpful for tax avoidance—where one instrument will be treated as debt here and equity overseas, or equity here and debt overseas.

The way they come together, they come together with no tax. I

think it is fine if a company wants to go to a lower tax jurisdiction

if they are really doing business there. But the idea that a company could be doing business here and in the U.K. and not paying

tax in either place, I do not think that is what is intended. So this

is an issue. I understand the Tax Reform Panel has highlighted

this as something to look at.

I think the committee would be well-served to address this issue,

and also what I talked about, Mr. Chairman, the foreign tax credit

generators, which are much the same, in my view. They are, I

would say, even more abusive, where you get circular financing

streams and you are taking advantage of setting up the same sort

of complicated hybrid instruments.

The CHAIRMAN. Dr. Sullivan, you proposed to prevent income

shifting to low-tax countries through related-party loans. In a

broader sense, what are your views on the economic implications

of reducing the disparity and tax treatment between debt and

equity?

Dr. SULLIVAN. Mr. Chairman, the corporate income tax is not a

principled tax, it is an arbitrary tax. The distinction between debt

and equity is an arbitrary distinction.

When the tax laws make that distinction, they create all types

of economic distortions that are bad for the economy, and every

economist would agree it is bad. I think the committee, as it continues its study of corporate issues, should look seriously at tax

proposals that would treat debt and equity equally.

The 1992 Treasury comprehensive business income tax is one of

those proposals. And recently, Belgium has enacted a proposal to

neutralize the treatment of debt and equity that provides equity a

notional interest deduction. These are very big changes. They

would involve enormous transition costs and would be very controversial. In the meantime, I would suggest lowering the corporate

tax rate as helping alleviate the problems caused by the distinction

between debt and equity.

The CHAIRMAN. Commissioner Everson, do you think that basis

reporting would reduce, or help to reduce, the tax gap?

Commissioner EVERSON. I certainly do think it would, sir. We

want to look at this. I have to go back to Senator Baucus for a

minute. I would disagree with your characterization as to the thirdparty reporting proposals that we have. I think that, while you are

right, they are modest in the amount in terms of the revenue generated, I believe, in fact, some of them are probably understated,

very conservatively stated.

22

They are the first third-party reporting proposals that have been

made in 20 years, since 1986. If we can get these through—and

some of them are quite controversial because of the impact on

small businesses—I believe we can look at other issues like the

basis reporting. That is about $11 billion a year, based on the 2001

statistics.

I do want to point out, though, we have to be very careful with

transition issues because, as you all know, people change brokers,

and some of the information on securities held for many years

would be hard to retrieve, so we would want to make sure that we

do this wisely and over a period of time going forward.

But I would be happy to take a look at this, but I would really

ask the committee to take a good look at the administration’s proposals. Let us get those done as a starting point, demonstrate that

we can increase some of the third-party reporting, and then go forward, potentially, looking at these other issues.

The CHAIRMAN. Senator Baucus, it is your turn now.

Senator BAUCUS. Thank you, Mr. Chairman.

As you know, Mr. Everson, this committee—at least Senator

Grassley and I—sent a letter to you asking about what appears to

be the failure of the IRS to look at foreign-source information returns, or at least foreign-source information reports.

That is, IRS has asked for certain data that come from other

countries be sent to the United States with respect to, I guess,

American citizens or something that is relevant to the United

States. It is my understanding that these were sent to a repository

in Philadelphia, basically, since 1976. It is further my understanding that generally the IRS has not done much with this information.

Commissioner EVERSON. That is correct, sir.

Senator BAUCUS. And also it is my understanding that the paper

reports have been destroyed and some of it has been uploaded—I

do not know how much—electronically.

But when we asked in the letter why more had not been done

about this, why did you not mention this, why are you not seeing

what is going on here? The response we got back was, well, it is

hard, it is difficult. There are currency issues, exchange rate issues,

language issues.

In some cases, IRS did not know who the real ‘‘business owner’’

was. So it seems, therefore, that not much was done about this;

that is, that the IRS did not assign somebody to try to solve this

problem with the exchange rate issues, or currency, or language, et

cetera. There are even computer problems there, too.

It is further my understanding that the Inspector General at

Treasury has done a cost-benefit and figured that if these were

looked at, just the information reports only, a lot of revenue could

be discovered.

I am, frankly, kind of stunned that all this material, since 1976,

has just sat there and nobody looked at it, or if they did it was just

too difficult and did not do anything about it. I mean, how could

that have happened?

Commissioner EVERSON. Well, I was just finishing college in

1976. I just went back to my 30th reunion. So, I do not want to

take responsibility for 1976.

23

Senator BAUCUS. How about 2004, 2005, 2006?

Commissioner EVERSON. I am happy to take responsibility for the

last 3 years. I think that the focus you provided on it, and the

Chairman, is appropriate. I do think this is an area where we can,

and need, to do more.

You list some of the problems. The problems are real. I gather

that in something like 90 percent of the cases, the identifying information, the TINS, is not there. As you indicated, there are currency issues, there are timing issues, different fiscal years.

So I think the intervention that you have made is important. I

give you my commitment, we are going to take a very strong look

at this and do what we can to improve the use of this information.

A lot of this gets back to systems investment as well, though, I

would point out. Some of it goes back to the funding issue, where

in our base budget we have a lot of processing monies, about $1.6

billion, that sort of keep the system going. That money has not

grown over a period of years.

The Congress actually brought that down a little tiny bit from

the administration’s request last year. We got all the money we requested overall, but a little was taken out of this. It is very important that we work on the technology elements of this to solve this

as well.

Senator BAUCUS. But your own inspector at the Treasury, the Inspector General, says that you get $168 million in return for a few

thousand dollars in investment.

Commissioner EVERSON. Well, if it is a few thousand, I did not

see that ratio. But if it is only a few thousand to get $168 million,

we will do that.

Senator BAUCUS. That raises a sort of deeper question for me.

That is, it is astounding that we have this huge gap.

Commissioner EVERSON. Yes.

Senator BAUCUS. It is astounding to me that not a lot, really, has

been done about it in the last several years, though we have known

that this gap exists.

I sense that the failure to sufficiently address the gap is because

of lack of resources, lack of intent, lack of sufficient computer technology, lack of matching. There are a lot of issues that I think the

IRS is competent to address.

So, what stuns me, frankly, is that we have not heard a bigger

hew and cry from IRS saying, my gosh, we have a problem here,

we have to do something about this, and we need these extra resources and whatnot to get the job done.

We need to hire better personnel for the IRS because we need

smarter people. We need more resources. There is too much inertia

down there at the IRS. We have to do whatever it takes—whatever

it takes—to solve this. I am just surprised that I have not heard

more. Why have we not heard more in terms of urgency and getting this thing done?

Commissioner EVERSON. I have to, with all due respect, disagree

entirely with that characterization. If we can go to the enforcement

revenue chart, I think an awful lot has been done, in part through

the actions of this committee. In the 1990s, the enforcement efforts

of the IRS were drawn down. Everybody knows that.

24

When I got on the watch 3 years ago, I set out to rebuild the enforcement programs. Not at the expense of services; we have improved services along the way. But if you look at what we have

done, the enforcement revenues have increased dramatically in just

a few short years.

That does not capture the indirect effect. That is the monies that

come in from collections, document matching, which you were talking about, and our examinations. Those have gone up steadily over

the last few years, and quite dramatically, considering the investment that has been made. So I believe a lot is happening.

Now, I agree with you 100 percent, sir, that more needs to be

done. We are doing that. If I could ask for your help on the funding

side. The Budget Committee was helpful on the Senate side. They

wanted to go beyond the administration’s bill in enforcement. That

will be helpful. But already in the House so far, we have received

a cut of $100 million in our funding request. So, I am hopeful we

will get our money.

Senator BAUCUS. But how much have you asked OMB for in this

current go-around?

Commissioner EVERSON. I do not get into——

Senator BAUCUS. How much?

Commissioner EVERSON. I cannot comment on what I asked for

from OMB, but you can safely assume that I asked for more than

I got. That is the way the system works.

Senator BAUCUS. Are you stomping your feet, threatening to resign if you do not get it?

Commissioner EVERSON. No. [Laughter.] I need the job. [Laughter.]

Senator BAUCUS. I do not think you do need the job. You are

doing a good job, and you have a lot of credibility. You have a lot

of credibility in this town about how hard you have worked and so

forth, and I think you have a lot of leverage that you could use to

get the job done. My time has expired.

Commissioner EVERSON. All right. Thank you, sir. As always, it

is a healthy exchange.

Senator BAUCUS. But I am serious about that.

Commissioner EVERSON. I know. I know.

The CHAIRMAN. I think you can conclude he likes you. [Laughter.]

Senator BAUCUS. But I want to get the problem solved.

Commissioner EVERSON. I agree. I agree.

The CHAIRMAN. Senator Hatch?

Senator HATCH. We all like you. [Laughter.] Except the people

out there. [Laughter.]

Commissioner EVERSON. That is it.

Senator HATCH. Dr. Sullivan, let me just start with you. You discussed in your testimony the fact that the U.S. has a very high corporate tax rate compared with most developed economies.

What do you see as the societal and economic cost of this? That

is number one. To what extent does it encourage firms to push certain income abroad, number two? And number three, specifically,

how does our relatively high rate hurt the competitiveness of U.S.

firms?

25

Dr. SULLIVAN. Senator Hatch, if I may, I’ll take one and three

and put them together in the same answer.

Senator HATCH. That is fine.

Dr. SULLIVAN. The societal cost is an economic cost. The corporate tax is a bad tax, from an economic point of view. It creates

distortions between debt and equity and between corporate and

non-corporate investment. It keeps government in the hair of businesses. It interferes with the free market.

The flow of investment is outward from the United States because we have the highest rates. This hurts us in terms of productivity, this hurts us in terms of competitiveness, and ultimately it

hurts us in terms of wages and standard of living.

In addition to that, if that was not enough to incentivize lower

tax rates, we lose quite a bit of revenue—Commissioner Everson

mentioned this—through profit-shifting.

Multinational corporations are able, through transfer pricing,

through cost-sharing arrangements, and through the use of hybrid

entities, with the assistance of some very good accountants and attorneys, to shift profits across international borders.

So we see, for example, in Ireland, where the tax rate is 12.5 percent, a tremendous amount of profit—billions of dollars of revenue

every year—is shifted easily into Ireland and out of the United

States.

One way of attacking that problem is to try to tighten the transfer pricing rules. The other way is to lower the rates and provide

incentive to bring some of that revenue back.

Senator HATCH. Thank you.

Mr. Walker, let me ask you a question. Why is our corporate tax

revenue falling as a percentage of GDP, while corporate profits increase and the tax rate stays the same? Number two, how is our

corporate tax base shrinking?

Number three, what role have corporate tax shelters had in this,

and how much of this is due to lower tax rates abroad and the

shifting of liabilities to other tax jurisdictions?

Mr. WALKER. First, Senator, my understanding is that the corporate tax revenues went up in 2005. Corporate taxes, as a percentage of the budget and as a percentage of the economy went up

in recent years, especially 2005, in large part because of increased

corporate profits.

There is absolutely no question, however, that I believe that if

you really want to deal with the so-called tax gap, then one of the

things that this Congress is going to have to do is to streamline

and simplify the tax code in order to promote economic efficiency,

enhance voluntary compliance, reduce administrative burdens, facilitate compliance and enforcement, and potentially, depending

upon how you do it, enhance our international competitiveness.

You are correct in noting that this is not merely a domestic issue,

it is also an issue of, how does it affect our economic growth and

how does it affect our competitive posture with regard to other

major countries? So, those would be my thoughts.

The other thing I would say, related to your questions, is the government is always going to be outgunned, in my opinion, with regard to major corporate tax filers. That is all the more reason why

you need streamlining and simplification.

26

Senator HATCH. Well, thank you.

Dr. Plesko, I have heard some suggest that we could make our

corporate tax system much simpler by having publicly traded corporations merely use the income they report to shareholders as the

base for paying Federal income taxes rather than having income

defined by the Internal Revenue Code. Why would this be a good,

or not-so-good, idea? Would this not have the potential to save billions in tax compliance costs?

Dr. PLESKO. I think there are a couple of key issues we have to

deal with as we address those proposals. Let me start by saying I

am against them. I do not think that we want to move to a system

where we only have one set of accounting rules, both for financial

and for tax.

The data needs of financial statement users and of investors and

the types of information they need is separate and distinct from the

type of information that the tax authorities need in order to administer the tax code. Recognizing that the reporting and the use of

that information is for different purposes, we should recognize that

what gets reported should not necessarily be the same.

That said, one of the things that I think is important to recognize, as Mr. Kleinbard pointed out, is that the two systems reinforce each other. As I point out in my testimony, there may be

times when conformity is the right thing to do.

To the extent that there is conformity between book and tax, if

a company decides to do something for tax purposes, it will be

transparent to investors. So, very aggressive decisions made by the

firm on a tax basis would have to be reflected in lower profits reported to the shareholders.

But overall, because the users want to do different things with

that data, I think that having one set of books does not serve either

party effectively.

The other thing is administrative. Whose rules? I do not think

that this committee would want to defer to the Financial Accounting Standards Board or any other non-legislative body the decision

to set what the definition of income is by allowing someone else to

say this is how we are going to measure income, nor, again, should

it necessarily be the case that the best information for tax purposes

is what investors need.

I think that conformity needs to be thought about on an issueby-issue basis, but as a general rule, having the same rules is not

going to be effective.

Senator HATCH. Well, thank you. My time is up.

The CHAIRMAN. Thank you.

Senator Thomas?

Senator THOMAS. Thank you, Mr. Chairman.

Ms. O’Connor, this is a very complicated issue, but, in general

terms, what would you think are the most significant areas of the

corporate tax gap and what do you think are the general enforcement changes that should be made?

Ms. O’CONNOR. The gist of your question was, what are the

major areas that give rise to the corporate tax gap?

Senator THOMAS. What do you think are the most significant

areas of the tax gap?

27

Ms. O’CONNOR. Well, the one that we see in the Tax Division is

the use of tax shelters. As Commissioner Everson pointed out in

his testimony, the elements of the corporate tax gap, ones that we

see in the Tax Division, would be the items that are given rise to

by the corporate tax shelters.

We do a lot of litigation on corporate tax issues in the Tax Division, but many of those cases involve legitimate questions of interpretation and application of the tax laws.

On the tax gap, I do not know whether the Commissioner’s numbers include this, but I would imagine that the billions of dollars

that are lost to tax shelters are an element of that.

I think, also, as the Commissioner alluded to, and I mentioned

in my remarks, that the absence of meaningful penalties for promoting and using tax shelters cannot help but make the problem

worse than it ought to be.

Senator THOMAS. Very good. Thank you.

Dr. Plesko, the LIFO method has been part of the Generally Accepted Accounting Principles, the GAAP principles, since the 1930s.

As I understand it, the Financial Accounting Standards Board has

no plans to disallow that. So why, at this point, when it has been

acceptable practice for 75 years, or close to that, would we consider

disallowing this method?

Dr. PLESKO. I think, again, if we want to consider the reasons

for dealing with the appropriate measurement of inventory cost

flow assumptions, the fundamental question is that, under the current system, in looking at the research, it appears that the only

reason that companies choose this method is for its tax reporting

benefit.

When we think about neutral tax policy, when we think about

the idea of setting up a tax system that tries to neither encourage

nor discourage any particular type of activity, absent the tax benefit, the evidence seems to be that no one would do this.

So the financial reporting or other benefits that are often argued

to be out there as in favor of using LIFO are not there by the vote

of companies. We do not see large numbers of companies choosing

to use LIFO. We see companies using other methods.

The second issue is historical. It is not clear that all of the reasons that motivated the original use of LIFO and its increased

growth during the 1970s, appear now. That is, a high inflationary

period where LIFO was designed to try to mitigate the tax on the

gain on profits that would otherwise arise because of the change

in the value of the inventory.

Senator THOMAS. Yes. Of course, if there is not high inflation,

then it does not make that much difference. It seems like the practical effect of repeal would be to immediately recognize the

amounts of profit, along with the tax liability, that you passed

along, completely divorced from the actual realization of the profit

in a short time. In any event, I do not agree with your evaluation

of this particular issue.

So, thank you, Mr. Chairman.

The CHAIRMAN. Thank you.

Mr. WALKER. Mr. Chairman, could I come back on that, real

quickly, on the issue of LIFO? I think one of the issues that one

has to consider in the broader context, with just-in-time inventory

28

management and with a movement towards improving supply

chain management, today corporations are trying to minimize their

inventory.

That was not always the case in the past, where there were large

accumulated inventories that were maintained, especially when we

were primarily a manufacturing-based economy back in the 1930s

and the 1940s.

So my understanding is, and having been in the private sector

for over 20 years, including with two of the largest public accounting firms in the world, that LIFO is used primarily now for tax

purposes, but that the whole way that management has changed

means that it is less of an issue than it was back in the 1930s and

1940s.

The CHAIRMAN. Senator Bunning?

Senator BUNNING. Thank you, Mr. Chairman. I would also like

to have my opening statement included in the record.

The CHAIRMAN. Without objection, yes.

Senator BUNNING. Thank you.

[The prepared statement of Senator Bunning appears in the appendix.]

Senator BUNNING. Dr. Plesko, there has been some discussion of

the fact that international accounting standards generally do not

recognize the LIFO method. I understand that FASB and the IASB

are having a number of discussions about the possible convergence

of U.S. and international accounting standards.

However, I understand that the issue of inventory accounting

generally, and the LIFO particularly, is not on any current agenda.

Is this true that inventory accounting is not on the FASB-IASB

agenda?

Dr. PLESKO. Where it stands in line, on the specifics of the order

in which they are discussing, I cannot attest to.

Senator BUNNING. You do not know, in other words?

Dr. PLESKO. Again, in listening to the general trend of what is

going on, the long-term trend appears to be FASB and the IASB

working towards one set of standards.

Senator BUNNING. Well, would it not be more reasonable or better for this committee to at least hold hearings on the two different

methods that are used presently before we are considering legislation to do away with one of them?

Dr. PLESKO. Again, Senator, more information and more discussion on LIFO is——

Senator BUNNING. But as you well know, there are bills out to

do away with that.

Dr. PLESKO. They are out there.

Senator BUNNING. Without any discussion on the Finance Committee or any discussion in any committee prior to us moving on

these issues.

Dr. PLESKO. Senator, I would hope that my written statement

and the testimony today at least helps initiate that discussion

among the committee members and the rest.

Senator BUNNING. All right.

Dr. Sullivan, your discussion on the types of changes that the

Europeans are making in their corporate tax system is very interesting. This year marks the 20th anniversary of the 1986 Act—

29

thank God I was not in the Congress at that time—which was an

attempt in the USA to reach this same goal, lower rates with a

broad base.

How successful was that change here in the United States? What

was the general reaction of the business community to those reforms?

Dr. SULLIVAN. I think the 1986 Tax Reform Act was landmark

legislation that was enormously successful. It is hard to imagine

what our tax code would be like now with a 46-percent tax rate,

investment tax credits, and more accelerated depreciation. We

would be even further out of line with the rest of the world than

we are now.

With respect to the reaction of the business community, it did

not like tax reform when it started, and it hated it more after it

was enacted. But may I respectfully suggest that, on the Hill, you

are going to hear a lot more complaints from people who are not

satisfied than compliments from those who are.

Senator BUNNING. But, sir, what has happened on rates since the

1986 tax code was enacted?

Dr. SULLIVAN. Since 1986, when the rate was lowered from 46 to

34 percent, the United States took a step backwards when the

Clinton administration proposed raising rates from 34 to 36 percent in 1993, and the Congress only raised them to 35 percent.

Senator BUNNING. But, in fact, there are some people right now

currently paying 39-plus percent?

Dr. SULLIVAN. Certainly. Yes.

Senator BUNNING. All right.

Dr. SULLIVAN. On the margin.

Senator BUNNING. On the margin.

Dr. SULLIVAN. On the margin.

Senator BUNNING. All right.

Mr. WALKER. Senator Bunning, if I might, for the record, based

on your question: if you look on page 6 of my testimony, you will

see that, since 1986, corporate income tax revenues, as a percentage of the economy and as a share of Federal income taxes, have

generally gone up.

Senator BUNNING. That is because, thank God for our economy

progressing and corporate profits being higher, and therefore paying more taxes into the treasury, even though the rates were reduced.

Mr. WALKER. I understand. But we also have to look at the overall fiscal situation. Just dealing with the corporate, the facts are

the facts.

Senator BUNNING. But if we wait just a little bit, maybe with the

current Federal Reserve reacting as they have reacted, maybe we

will have the same problems that we had prior to 1986.

Mr. WALKER. Well, let us hope not. But let us also note that,

while this hearing is on corporate taxes, we are short 3 percent of

GDP as it relates to the overall Federal budget, and it is going to

get worse when boomers start retiring.

Senator BUNNING. Well, let us give our Finance Committee credit

for complicating the tax code also. Since I have been on Ways and

Means and the Finance Committee, we have added a lot of pages

30

to the code; rather than simplifying the code, we have made it more

complicated.

My time has expired. Thank you.

The CHAIRMAN. I hope you are around when we try to make it

less complicated and see how paralyzed we are.

Senator BUNNING. I will, Mr. Chairman.

The CHAIRMAN. Thank you.

Senator Bingaman?

Senator BINGAMAN. Thank you all very much for testifying. Let

me ask about this issue about taxes that are owed but not collected. Everyone agrees, there is no continuing dispute about the

payment of taxes.

Comptroller General, you have said that your recommendation is

that we change the law by improving the Federal payment levy

program, expand the amount and type of tax debt eligible for inclusion in the program, expand the volume of Federal payment subject

to levy, and a variety of things.

I would like to ask the IRS Commissioner, is that your view of

the solution to this problem? What do you think the solution to this

is? It seems as though, from an investment point of view, this

would be like shooting fish in a barrel. Once you got a determination that the tax is owed, it ought to be reasonably straightforward

to go ahead and collect the tax. What is the problem there?

Commissioner EVERSON. If we can go to the tax gap map, to sort

of just set the picture here. What you are speaking about—you will

see when the map gets up there—the piece out at the right of the

chart, the biggest portion of the tax gap, is under-reporting, which

means under-reporting of income and overstatement of deductions.

Out at the left, you have non-filing. Non-filing is less than 10 percent. The smaller piece, like that size, is what you are talking

about, sir.

Senator BINGAMAN. Right.

Commissioner EVERSON. It is the underpayment when you agree

you owe us $20,000, but you only send us $12,000, or you do not

send us anything at all.

Senator BINGAMAN. Right.

Commissioner EVERSON. We are doing a variety of things to attack that. We are increasing our collection efforts rather significantly. We are modernizing our processes there. This takes investment. So our collection numbers are up. I showed before this enforcement revenue chart. The bulk of that increase is in the collections area, so we are making headway.

The other thing we are doing, which is somewhat controversial,

particularly on your side of the aisle, is we have authority that we

received a little over a year and a half ago or so to have private

collection agencies assist us in the collection of certain kinds of

debts. There are some things we do not get after. I try to run a

balanced system. If you gave me all the money in the world, I

would not put it all into collections.

As you say, it may be easier, relatively speaking, but we have to

work on a whole series of issues, including tax-exempt organizations, where it is not about revenue generation at all, but it is consistent with our responsibilities. So we are using private collection

31

agencies now to go after a portion of the debt. That should help us

as well.

Senator BINGAMAN. Let me ask Mr. Walker, if you could expand

on your comments here or respond to that.

Mr. WALKER. Well, Senator, one of the things that I added in my

testimony today is the government, frankly, ought to be leading by

example in not doing business with contractors and grantees who

do not pay their taxes. There are billions of dollars involved.

I would respectfully suggest that the Congress may want to consider setting a prospective date to say that, as of X date, if you are

not current on your taxes, possibly with narrow exceptions for national security or some unusual circumstances, we are not going to

do business with you.

So, we have a situation now where we are providing taxpayer

money to contractors and others where they have not discharged

their obligation to the taxpayers.

Senator BINGAMAN. Let me just ask on that, I think that is a

good suggestion, but could that not be done by executive order?

Could the President not issue an executive order saying, effective

the 1st of January, 2007, no Federal agency shall sign a contract

with any corporation that is not up-to-date on its taxes?

Mr. WALKER. My understanding, Senator—and I will check with

our counsel and provide something for the record—there may be

some privacy issues here as to what type of taxpayer information

can and cannot be shared with other agencies under current law.

I will provide something for the record. If that is an impediment,

that is what would require legislation.

[The information appears in the appendix on p. 371.]

Commissioner EVERSON. If I could comment, sir.

Senator BINGAMAN. Yes.

Commissioner EVERSON. There have been a series of hearings on

this. Senators Coleman and Levin have chaired three over the period of several years with the government reform subcommittee,

the Permanent Subcommittee on Investigations. This does get a little complex.

You want to be careful here because many individuals and companies have legitimate disputes with the government over the payment of taxes. The degree to which you say, if something is at issue

that you cannot bid on government work, that could be a standard

that would potentially be very burdensome and incorrect because

the taxpayer can be in the right.

So we have talked about this with your colleagues, and we just

need to be careful and consider, as the Comptroller General is saying, some of these privacy issues as well.

Senator BINGAMAN. I was trying to focus in on this area that the

Comptroller General is talking about where the amounts are no

longer in dispute. In those circumstances, it seems to me that either we should be legislating the prohibition on doing business

with those companies—the government doing business with them—

or we should be doing it by executive order.

Commissioner EVERSON. I do not disagree with that element.

Senator BINGAMAN. Thank you, Mr. Chairman.

The CHAIRMAN. Could I add something to this issue of contractors? That is that we, including this committee, plus the Senate,

32

did pass, in a recent bill, withholding in this area so that we have

some record of these people, to help our efforts to close this tax gap.

Senator Wyden?

Senator WYDEN. Thank you. Thank all of you.

To me, the reality is, for the last 20 years, Democratic Congresses and Republican Congresses, Democratic Presidents and Republican Presidents have just poured on more tax breaks, more

rules and regulations, and produced more migraines for the American people who are trying to comply.

What I am trying to do—I have talked to both the Chairman and

Senator Baucus about it—is to see if we can jump-start bipartisan

tax reform once again. I have made a proposal called the Fair Flat

Tax Act, and others have proposals. I think you have given us some

good arguments for why we do need comprehensive reform.

Let me ask you about one area. The corporate tax, as far as I

can tell, is just a roller coaster of seven different rates. The one

that, to me, just defies logic is the rate is 35 percent for companies

with income between $10 million and $15 million. Then it goes up

to 38 percent for income between $15 and $18 million. So in effect,

what has happened, again, in a bipartisan way, is that the country

has said, we are going to sock it to the medium-sized businesses

harder than the large businesses.

Do any of you think that this roller coaster of rates on the corporate side makes sense, or should we just try, on a bipartisan

basis, to have a flat tax for business. Let us debate what the percentage ought to be, in other words, a lot of different points of view,

but let us get away from the roller coaster.

Does anybody on this panel think that the roller coaster of corporate tax rates today is a defensible proposition? I will start with

you, Mr. Commissioner.

Commissioner EVERSON. Senator, I make it a policy not to comment on rates. That gets into the responsibility of the Treasury Department and others in terms of pure policy. What I will say is, I

am absolutely in agreement with you that simplification is essential to achieving better compliance.

That is because, as the Chairman indicated in his opening remarks, as the code gets more complex, individuals and corporations

use that to find the pockets where they can escape detection. So I

am very much in favor of looking at tax reform, and particularly

tax reform and simplification.

Senator WYDEN. Mr. Walker? The roller coaster.

Mr. WALKER. It is illogical. I do think it is absolutely essential,

in order to maximize economic efficiency, assure our competitiveness, promote voluntary compliance, and help enhance enforcement, for us to streamline and simplify the tax code across the

board, including in the corporate area.

Senator WYDEN. Let us go right down.

Ms. O’CONNOR. I am here representing the Tax Division of the

U.S. Department of Justice, and we defer to the Treasury Department for things like that.

Senator WYDEN. Very good. All right.

Dr. PLESKO. The fundamental principle of having as low a rate

as possible on as broad a base as possible is one that I think is alVerDate 11-MAY-2000 15:48 Jun 25, 2007 Jkt 095484 PO 00000 Frm 00040 Fmt 6633 Sfmt 6633 35704.000 SFIN1 PsN: SFIN1
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most universally accepted. I am going to defer to Mr. Kleinbard on

the rate structure, because I think we both have the same answer.

Mr. KLEINBARD. Yes. Let me give sort of a two-part answer, Senator, if you do not mind. The first part is, there is a logic to it. It

may not be ultimately convincing, but the logic is that large companies should pay a flat rate of 35 percent on their incomes. Smaller

companies should get a break so they have a lower rate than 35

percent.

How do you get back to a flat rate of 35 percent corporate income

of large companies? Well, you have to capture in some fashion the

lower rate on their first X million dollars of income. That is why

the bump that you describe exists in the code. So there is a logic

to it. But I completely appreciate your point, that it exposes midsized companies to higher tax rate.

Senator WYDEN. Let me just amplify on that. The rate is 35 percent for companies with income between $10 and $15 million. Then

it goes up to 38 for income between $15 and $18 million. Finally,

the rate drops down to 35 percent for income above $18 million.

Mr. KLEINBARD. Yes, sir.

Senator WYDEN. So we are sticking it to the middle-income company in a more extensive way than we are the high-income.

Mr. KLEINBARD. Yes. One can imagine moving the bump further

up the income curve. But the idea of it—and I am not here to defend this particular structure—is that large companies should not

get a benefit from the lowest rates. So maybe the bump should be

at $100 million and not where it is now. That is a fair point.

Senator, if I could just add, it seems to me, when you move to

the topic of corporate tax reform, the Chairman has emphasized

the problems of debt versus equity characterization. We have all

talked about the problems of high rates.

We have talked about the problems of burden neutrality, of making sure that when a business is going to decide to locate a plant,

whether it locates that plant in Des Moines or Dublin should be

based on commercial considerations and not tax considerations. We

have talked about the problems of transfer pricing, which I think

is the number-one issue in corporate tax compliance today. And we

talk about keeping America competitive.

It is possible to imagine corporate tax reform that addresses all

of those issues: debt equity, high rates, burden neutrality, transfer

pricing. I had the pleasure of participating in the President’s Advisory Panel on Tax Reform in that process. In fact, there was a proposal made that accomplished all of those results that I thought

was very well-reasoned, but that was principally because it was my

proposal. [Laughter.]

Senator WYDEN. Let me just, if we could, have Dr. Sullivan, since

he was my biggest sympathizer, I think.

The CHAIRMAN. Then when Dr. Sullivan is done, Senator Baucus

has some questions.

Senator WYDEN. Would it be possible then, Mr. Chairman—because I have some additional questions—after Senator Baucus has

another round, can I have another round?

The CHAIRMAN. Yes. We will have another round.

Senator WYDEN. Great.

Dr. Sullivan?

34

Dr. SULLIVAN. Senator, because I am just a U.S. citizen, I can

say whatever I want. [Laughter.] High corporate tax rates are

strangling the business community, and that is becoming ever

more apparent in this international environment.

As a regular citizen, I sort of resent that our tax system has gotten so convoluted. It provides special breaks for many different constituencies, and it makes our economy less efficient with the higher

tax rates that are necessary to pay for that.

Senator WYDEN. I am going to come back on this. It just seems

to me to go from 35 to 38 to 35 is just a portion of this roller coaster. I think David Walker, in calling it illogical, essentially hits the

key point. There are no private sector entities that would make

their strategy based on something like that roller coaster, and that

is why I want to change it.

I look forward to our next round. Thank you.

The CHAIRMAN. Senator Baucus?

Senator BAUCUS. Thank you. It has been brought to my attention, Mr. Everson, that several States are utilizing data warehouses in order to make sure that they, the States, are collecting

the revenue that is legally owed and paid.

The people I have talked to about this, of course, they have an

axe to grind because they do not like doing this. I say that if we,

the Federal Government, were to do the same, there are enormous

opportunities here, again, to close this tax gap.

Commissioner EVERSON. Sure.

Senator BAUCUS. Basically it is getting data from driver’s licenses, business, all kinds of data and normalizing it into one sort

of format. There are not too sophisticated computer programs to do

this. I wonder how much you know about these States’ efforts, and

the degree to which that could be utilized by the IRS.

Commissioner EVERSON. I am not familiar with particular State

efforts. Let me make a comment, though, on the use of systems and

technology that I think is an important one in the context——

Senator BAUCUS. I would just suggest——

Commissioner EVERSON. I will certainly take a look at that.

Senator BAUCUS. And look pretty aggressively on that.

Commissioner EVERSON. Yes.

Senator BAUCUS. Because I was impressed from what I heard in

talking to these people.

Commissioner EVERSON. Sure. I would like to see whatever materials you have.

Senator BAUCUS. There are States that are doing this.

Commissioner EVERSON. I have a point that I think is directly related to this. One thing that was already referenced earlier today:

we mandated at the end of 2004 the electronic filing of corporate

tax returns and returns of the largest nonprofits.

This was over the objections of corporations who said that we

could not get it done. We have gotten it done. As was indicated just

several weeks ago, the largest corporate taxpayer, General Electric,

filed their return electronically.

This will cut about a year and a half off the audit cycle, so we

will bring the return examination process much more current. But

it will do exactly what you are talking about.

35

You and the Chairman have raised questions about the oil industry. We will be able, instead of looking at just one return, to compare an array of data across an industry, and instead of looking at

Exxon-Mobil every year, we might look at elements of the return

based on things that are outliers from what BP is doing. This is

exactly the capability you are talking about. We are aggressively

moving on that. We can look and see what other applications——

Senator BAUCUS. Mr. Chairman, this might make some sense,

that is, for the IRS to tell this committee, in a certain reasonable

period of time, say by the end of this fiscal year, a plan, with

benchmarks and so forth, as to what resources are needed and

spent over what period of time to achieve what percent of our objective, that is, elimination of the tax gap.

What would you need to get the job done, either resources, or

changing the law, or whatever is necessary? There are probably

three or four leverage points, or five or six that, if utilized much

more effectively, could help us address and solve this tax gap. Now,

it will not be done immediately. It will probably take maybe a year

or two, or something. But if you could give us a time line.

Commissioner EVERSON. Why do you not ask me to get it done

by May 4 of 2008? That is when I am done.

Senator BAUCUS. All right. That is the deadline. I think it might

make sense, Mr. Chairman, that we have a hearing on this proposal that you come up with, this plan that you come up with.

After you give us the plan, we will have a hearing on it and help

make it work. It is a partnership here, the executive branch and

legislative. But we need to solve this.

Commissioner EVERSON. I agree, we do need to solve it.

Senator BAUCUS. And we need a plan to solve it. If you could give

us the outlines of a plan, what it takes to solve it, and be aggressive—reasonable but aggressive—then we will have a hearing on

that plan and just see how far along we are, what is good about

it, and maybe people have some suggestions, and so forth.

Mr. Walker?

Mr. WALKER. Senator Baucus, I am somewhat familiar with some

of those State efforts. As you know, GAO has previously recommended an area of opportunity for closing the tax gap, which is

to pursue additional data matching and data mining. But in some

cases, we have also noted that there is a need for enhanced transparency for certain information.

Two things I would like to note for the record there. One, what

I said today and what is included in this report, is additional transparency with regard to the basis of securities transactions, and second, Schedule M–3. I think there is strong conceptual merit to providing public transparency with regard to Schedule M–3.

Senator BAUCUS. And that is a very good point. In fact, Commissioner Everson, I think items like this should be included in your

plan. That is, M–3 made public, for example. The basis issue we

discussed might be another example. It is, what needs to be done

to solve this thing?

Mr. WALKER. Could I mention one other thing, Senator Baucus?

Senator BAUCUS. Yes.

36

Mr. WALKER. Sometimes the Congress, in its intent to do a positive thing, can place handcuffs or constraints on the ability of agencies to get their job done.

For example, Congress has placed certain constraints on the ability of the IRS to reallocate resources from taxpayer service to enhance enforcement activities.

I can understand that the Congress would be concerned not to

reduce taxpayer services, but that inhibits the ability to leverage

technology and engage in process improvements where you can still

provide the same amount of service, but free up resources that can

be focused on the tax gap.

I think that is something that the Commissioner should also

think about as well, where you can leverage whatever dollars you

get to maximum effectiveness, but also address some of the statutory constraints.

Senator BAUCUS. I am asking you to address that as well.

Mr. WALKER. Thank you, Senator.

Senator BAUCUS. You bet. Those are all very valid points, and I

am sure there are others that we have not yet discussed. But the

basic point is, what does it take to get the job done?

The CHAIRMAN. Thank you.

Senator BAUCUS. Thank you. Thank you, Mr. Chairman.

The CHAIRMAN. I think, if you just wanted 5 minutes more, I

would rather have you take your 5 minutes now. Then I have a

longer list of questions that I want to go probably longer than 5

minutes on, and I do not want to hold you up, Senator Wyden.

Senator WYDEN. Great. Thanks, Mr. Chairman.

Continuing again on this question of the clutter of the code and

how it affects our country, it seems to me what you all have been

able to spell out is that the current corporate code hurts our competitiveness in two ways.

First, it distorts business decisions in the marketplace. Second,

with all the clutter in the code, all of these breaks, we are not driving the rates down as low as we possibly can. I think we have consensus on that.

I would like to go a little bit further and ask you, Mr. Walker,

could giving special tax breaks for certain businesses and activities

not potentially undermine competitiveness?

Because if somebody has a really good idea with great promise

for the economy but no lobbyists, they do not get their break into

the tax code; somebody with an idea that does not make as much

sense for our long-term future has the good lobbyists, and off they

go with their little break tucked away in the code.

Mr. WALKER. There are complexities and risks that occur when

Congress tries to target tax preferences. You are, in effect, trying

to pick winners and losers or you are trying to encourage certain

types of activities. You may be right, you may be wrong.

But I think one of the other things we have to keep in mind here

is, in the end, in addition to promoting economic efficiency, in addition to ensuring equity, in addition to maintaining our international competitiveness, we have to raise an adequate amount of

revenue to pay our current bills and deliver on our future promises.

37

Senator WYDEN. We are going to have less revenue to honor our

promises and our future obligations if we continue to reward foolish practices with breaks in the tax code.

Let me ask you one other area, Mr. Walker. The Congress has

now decided to take action with respect to foolish spending, what

are called these ‘‘earmarks’’ that get tucked into the tax code and

items that you cannot possibly justify.

Do you think Congress should look at changes along those lines

with respect to the tax code? The tax code is, again, the people’s

money. The money does not belong to the government, it belongs

to the people.

So if the Congress fritters it away with foolish tax breaks, that

is wasting the people’s money. Should Congress take a look at

cracking down on these breaks in the tax code along the lines of

what is being done to crack down on foolish spending on pork barrel projects?

Mr. WALKER. Senator, my comments here have been clear and

consistent: Congress needs to look at both the spending side and

the tax side of the ledger. A vast majority of the Federal Government’s spending programs and tax policies are based upon conditions that existed in the United States and the world from the

1940s to the 1970s. They need to be subject to a fundamental review, reexamination, and reprioritization. We have a tremendous

amount of complexity, duplication, and inefficiency. The tax side,

including tax preferences, needs to be on the table and under the

microscope.

Senator WYDEN. Dr. Sullivan, I know you wanted to respond.

I will just say, Mr. Walker, to me, it is still the people’s money.

If the people’s money is being wasted on spending projects that do

not have a good cost-benefit analysis, that is something that ought

to be stopped. The same is true on the tax side. I am interested

in following this up with you because it is still the people’s money

any way you look at it, and it is being wasted.

Dr. Sullivan, did you want to add anything to that?

Dr. SULLIVAN. Thank you. Sometimes, but rarely, there is good

economic justification for any tax incentive; most of the tax incentives in the law have no economic justification. They distort market

decision-making and they hurt the economy.

Even when there is a good justification for them, there is very

little economic evidence that they actually provide the incentive to

increase the target of activity, so then all you are doing is giving

a subsidy to a politically favored group. On top of that, because you

have no money left over, the rates are high. So, for all those reasons, most tax incentives are not justified, and we should have

lower rates.

Senator WYDEN. Mr. Chairman, you have been kind to give me

a second round.

I want to close by saying, I was looking at the title of today’s

hearing, ‘‘A Tune-Up on Corporate Tax Issues.’’ I just wanted to

say in wrapping up, I am looking forward to working with you in

a bipartisan way, and other colleagues on this committee, to do

more than tune up a system that I think is broken.

I think we need to look at a big-time overhaul of this. This tax

code needs major body work, folks. It needs more than a tune-up.

38

I am looking forward to working with you and Senator Baucus and

our colleagues in a bipartisan way.

The CHAIRMAN. This is just the first of a series of hearings that

we have planned. There will be more hearings in July.

Commissioner Everson, you noted the worldwide income reported

by public companies to their shareholders, and then that on taxes,

and I think the difference was $266 billion, up from $79 billion just

10 years ago.

Based on information that is currently available to the IRS, can

you give this committee an idea of what the top three book tax differences would be in terms of the use of IRS resources?

Commissioner EVERSON. Certainly, Senator. What we are looking

at is, generally, shelters. One of the biggest numbers that is in this

reconciliation of the M–3, is reportable transactions. You are familiar with that. It is, in fact, over $40 billion, what is in that gap

in terms of what has been produced so far.

Now, let me say this. The M–3 information we have asked for,

we have not gotten all of it. We have gotten about 86 percent of

the companies that have provided it. We have to figure out what

we are going to do to pursue those who have not provided it.

Another big number that is in there is in the compensation area.

Executive compensation is increasingly complex. That is a large

number. We need to be looking at that as well.

Another piece that is in these gaps, the book gaps, is what we

have been talking about earlier today: the difference between what

is picked up in book earnings in the worldwide consolidation of the

financial statements, but is excludable because it is from a foreign

subsidiary.

This takes, in terms of the tax return, an awful lot of work in

terms of looking at the comparison line there, and it starts to get

into a lot of the issues we have been talking about this morning.

So, those are three areas that are very important that we work on.

The CHAIRMAN. Mr. Kleinbard, in regard to your M–3 discussion

that you have had, would a disclosure regime that applies only to

U.S. corporations not put U.S. corporations at a disadvantage relative to foreign competitors?

Mr. KLEINBARD. Well, Senator, that is an excellent question. In

a perfect world, we would have identical disclosures between U.S.

and foreign firms because we do not want to disadvantage U.S.

firms through more burdensome disclosure obligations.

But I have to conclude that that goal is probably unattainable in

the world in which we live because foreign firms are subject to U.S.

tax only in respect to a fraction of their operations, or not at all,

and the foreign firms can sell securities in the United States, in appropriate circumstances, without preparing U.S. GAAP financial

statements.

So the M–3 is designed to reconcile U.S. GAAP to tax, but we do

not have U.S. GAAP financial statements, and we do not have the

entirety of the parent company being subject to U.S. tax. We have

a very difficult time figuring out what it is that, in fact, we could

compare.

The purpose of the M–3 is to provide a line-by-line comparison

between accounting items and tax items applied to the common

base of the U.S. tax consolidated group, but, when the U.S. tax conVerDate 11-MAY-2000 15:48 Jun 25, 2007 Jkt 095484 PO 00000 Frm 00046 Fmt 6633 Sfmt 6633 35704.000 SFIN1 PsN: SFIN1
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solidated group is just one subsidiary of a multinational that is not

based in the United States, the value of that public disclosure

would be limited.

I do think it is fair, however, to demand that foreign firms that

have access to the U.S. securities market comply with the cash tax

reconciliation that we have discussed before, so that, in particular,

tax cushions—that is, the hidden reserves for tax disputes—would

be made more explicit so that we could get a better picture of the

company’s actual financial results.

The CHAIRMAN. Regarding your proposal to reconcile cash taxes

to the company’s book tax provisions, the main objective seems to

be for companies to disclose more information about their tax reserves. What is your reaction to complaints by companies that they

should not be required to give the IRS a road map to this issue?

Mr. KLEINBARD. Well, I guess I have two reactions to this question of providing a road map to the Internal Revenue Service by

publishing an explicit cash tax reconciliation.

My first reaction is that the IRS, in fact, already has, by virtue

of the M–3, all, or nearly all, of the information that would be provided by the cash tax reconciliation table that I described. It is investors who do not have the information.

My second reaction, frankly, is that it is completely fair that the

IRS in fact be furnished with a road map. How else is the IRS supposed to navigate the 24,000-page return that we described earlier?

Companies can, and companies should, disagree with the IRS, it

seems to me, as to the application of the law to their facts; after

all, that is how I make my living. But I have no patience, frankly,

with the view that hide-the-ball strategies should be encouraged, or

even tolerated.

The CHAIRMAN. All right.

Ms. O’Connor, I wanted to discuss with you about corporate executives back-dating their stock options. Of course, this ought to be

very troubling, about using this to maximize their profits.

I would like you to tell me what the Federal Government is doing

to prosecute cases, the priority that these prosecutions have in the

Federal Government, and, particularly, I would like to know what

are the maximum civil and criminal tax and related penalties that

these corporate executives could be facing who engage in these actions.

Ms. O’CONNOR. Certainly, Mr. Chairman. Thank you for that

question. Stock options give employees the right to purchase shares

later at the price of the stock on the date of the grant. The issue

to which you refer is the highly suspicious award of stock options

to executives at a low point in stock value.

In several districts around the country, the Department of Justice is investigating allegations that certain stock option grants

were back-dated to provide the executive a lower price at which to

exercise the option, or that other unfair—and perhaps illegal—

practices were employed to price options at a low dollar amount,

like awarding options based on insider information about a pending

event that was going to send the stock price upwards. Such conduct

would be a fraud on the market. It would boost the executive’s compensation at the expense of other investors.

40

If investigations reveal criminal behavior, charges that might be

brought would include securities fraud, mail fraud, wire fraud, and

possibly various tax charges against both the individuals and the

corporations.

Information more detailed than that I am not at liberty to disclose. I can tell you, however, that the Department considers allegations of this nature to be very serious.

The criminal penalties, if the crime occurred after July 30, 2002, would be: for mail fraud, 20 years incarceration and a $250,000

fine; for securities fraud, 25 years incarceration and a $250,000

fine; tax evasion would bring 5 years incarceration and a $250,000

fine; a conviction on filing a false return could bring 3 years incarceration and a $250,000 fine. Penalties under the Securities Act of

1934 would bring 20 years incarceration and a $5 million fine.

Successful prosecutions are going to require careful and detailed

investigations. Until those investigations are concluded, it is difficult to assess whether, and what, charges will be brought.

The CHAIRMAN. All right.

Dr. Plesko and Mr. Kleinbard, in regard to LIFO, it has been discussed quite a bit this morning. Could you give us your opinion on

whether there is a tax policy justification for retaining LIFO for tax

purposes? A second question. If LIFO is repealed, what method

would you suggest to replace it? To both of you.

Dr. PLESKO. My first reaction is, there better be, otherwise it

should not be in the code and we should not have had it this long.

However, the fact that it has been in the code for a long period

of time, by itself, does not mean that it is still good tax policy.

Whatever the reasons were in the 1930s and 1940s, and its increased use, they do not necessarily fit, as General Walker has

pointed out, the tax system we have in place right now.

It appears that the primary reason why firms choose this accounting method is the tax benefit and not any of the financial or

other aspects that we care about when it comes to financial reporting.

In terms of alternatives to LIFO, I think this is a situation where

the earlier questions Senator Hatch had on book tax conformity

come into play. I would not think that we necessarily have to pick

one particular method for tax accounting and say you must, for example, only use FIFO.

There are many other methods that are permitted: average cost,

which would mitigate some of the recapture, as well as FIFO. The

basic issue here should not be to say you must use one of these

other methods, but rather that LIFO would not be permitted.

That said, the tax code should probably still maintain book tax

conformity for inventory so that we would still get the benefits of

having similar reporting for both tax and financial.

Mr. KLEINBARD. Mr. Chairman, I think that Dr. Plesko is convincing on the first point, which is that there is no policy justification for LIFO beyond the tax advantages that are obtained through

it. It is quite interesting to see its selective use in the business

community, which is consistent, I think, with the view that it is

primarily driven by tax considerations.

Second, there are lots of outmoded ideas in the Internal Revenue

Code. Because an idea has been there for decades does not necVerDate 11-MAY-2000 15:48 Jun 25, 2007 Jkt 095484 PO 00000 Frm 00048 Fmt 6633 Sfmt 6633 35704.000 SFIN1 PsN: SFIN1
41

essarily mean that it is hallowed by age; it could just be a barnacle

on the ship that needs removal. I think this is an example.

For example, in an area that I worked on, we had ‘‘lower of cost

or market’’ accounting for securities inventories for many decades.

In 1993, we came to the realization—this committee did—that that

was not appropriate, and we went to mark-to-market systems for

securities inventories. So we do need, from time to time, to review

the methods applied to inventories.

A final thought on this question, coming back to the theme of

book tax transparency. I find it quite ironic that corporations prepare disclosure of their tax liabilities in their financial statements

that are impenetrable to me and to most securities analysts, but

when it comes to this issue, where there is conformity that is required between tax and book as a way of sort of punishing the corporation for using LIFO accounting, in that case corporations that

use LIFO accounting are pellucidly clear in their financial disclosure about what the income would have been had only they used

FIFO, because they want, in fact, to make it very clear to investors

that their real book income is the larger number.

So when it is in their interests, corporations know how to write

crystal clear disclosure. I think you see that in the FIFO footnotes

for those companies that do employ LIFO accounting.

Dr. PLESKO. Senator Grassley, if I could quickly add, again, looking at the literature, it appears that even the firms that use LIFO

for tax and financial reporting do not use it for other decisionmaking.

The evidence suggests that they do not use it for internal compensation and bonuses, they do not use it for planning internally.

The use of LIFO, based on the reading of the literature, appears

to be solely to get its tax benefits and plays no other role in the

design or the operation of the corporation.

Mr. KLEINBARD. If I could just add, this is a very good point that

Dr. Plesko is making. One of the reasons why this committee and

the Congress required the securities industry to go to mark-to-market accounting was because it was demonstrably true that for all

decision-making purposes, for risk assessment purposes, for capital

allocation purposes, firms operated in a mark-to-market environment. That was the world in which they lived as a commercial matter.

If you want to ask whether an inventory method is an appropriate method, Dr. Plesko’s last observation is a very powerful one.

You should ask, what are people doing for commercial and business

purposes? If they are not using it for those purposes, then you

have, I think, good evidence that it is an artifice of tax planning.

The CHAIRMAN. Senator Kyl?

Senator KYL. Thank you, Mr. Chairman.

Mr. Sullivan, I read with interest your statement. I would like

to ask you to respond to a point that was just made: more than one

thing can be true at the same time.

In other words, it is not necessarily the case that a particular

method of tax accounting is appropriate in one context, and therefore must be appropriate in all other contexts, and that the converse would also be true.

42

The question I have about this method of accounting is whether

it makes good tax policy to tax inflationary gain. We are looking

at a time when we may be seeing inflationary pressures in our

economy, and, if that occurs, the question is whether or not the effect of repealing LIFO on industries, especially those that are susceptible to inflationary gain on the inventory, what the effect of

that would be, and in fact whether it would result in simply taxing

them on the inflation.

Dr. SULLIVAN. Senator Kyl, you are exactly correct that inflation

would have a detrimental impact. I am going to leave it up to Ed

and George to provide details about how we should address the inflation problem with LIFO versus FIFO.

Senator KYL. Actually, the reason I was calling on you is because

I wanted to ask you the next question. If we have time, I would

be happy to do that.

The general issue of a manufacturing credit and changing the tax

rate for manufacturing corporations vis-a`-vis all others was one

that troubled both Senator Nichols and me when that occurred.

What problems are you aware of that have resulted from this

second method of taxation? Are there compliance problems? Is it

more difficult to administer, from your experience?

Dr. SULLIVAN. As the Commissioner mentioned, there are massive compliance problems with the production activity credit. On

top of that, it is either, you can say, unfair or inefficient from an

economic point of view to give one part of the economy a tax break

and not the other part. We should get government out of the business of picking winners and losers.

Senator KYL. Just a third question for you, then I would like to

call on the other members of the panel. In your testimony, you note

that the U.S. corporate rate, in effect by standing still, has lost

ground vis-a`-vis all of the 25 European Union countries, and that

only Japan, fractionally, has a higher rate than the United States.

By doing nothing, we have fallen from the point of 3.7 percent

below the EU average to a point of 6.9 percent above the EU average. But, interestingly enough, by lowering their rates they have

not decreased revenue. Now, we have seen the same thing with

dividends, we have seen the same thing with capital gains in this

country. Why does the same thing not apply to corporate rates

here, or does it?

Dr. SULLIVAN. It does apply. When we lower the rate, of course,

by arithmetic we should expect less revenue, but by behavioral effects, through increased investment, which is real activity, through

profit-shifting, which is more of a paper transaction, and through

economic growth, that will partially offset the direct revenue losses

from a rate cut. Yes.

Senator KYL. Does anybody on the panel have an observation on

that that is contrary?

Mr. WALKER. Senator, I think it is very important to reinforce

what was just said. Certain types of tax cuts can be stimulative

and they can help to offset the amount of revenue that otherwise

you would lose if you did not have the stimulation; however, very

few tax cuts pay for themselves.

43

The idea that you have more revenues after the transaction than

you would have otherwise had before the transaction is a whole different issue. I think there is a lot of confusion about that.

But, clearly, as has been said by this panel, efforts designed to

minimize rates by broadening the base can serve to help enhance

our competitive posture, improve compliance, and promote economic efficiency.

Senator KYL. Yes, Mr. Everson?

Commissioner EVERSON. Senator, I would just add that, beyond

the economic impact, the economic impact presumably creates real

value somewhere. That is a good thing. If it is not a good thing

here, it is a good thing for people in another country.

What you really have, with all of these disparate rates and in the

tax haven countries, is you have the parking of income in countries

where nothing is happening. That is in nobody’s interests, except

to enrich those who are not really creating any additional value

there.

Senator KYL. Just in the last 58 seconds or so, Mr. Kleinbard

and Dr. Plesko, would you like to comment on the first question I

asked?

Mr. KLEINBARD. Sure. On inflation, I believe, as a citizen, that

inflation is a great evil. It is pernicious to the democracy.

But the question you have to ask yourselves is, is LIFO the way

to deal with inflation? In effect, LIFO is a kind of ersatz indexation

of some assets, but not all assets. Why would you choose, if you believe that indexation is a good idea, to index cost basis for inflation?

Why would you do it only in this case? Investors, for example,

have to pay a tax on gains recognized from sales, even attributable

solely to inflationary pressures. So if indexation is the right idea,

then this kind of ersatz selective indexation seems to me simply to

convey benefits to some parts of the economy and not to others.

Senator KYL. Could I just interrupt for one second? We have a

few minutes left on a vote and my time is about to expire.

But the treatment should not be disparate for different segments

of business. Is that a correct statement?

Mr. KLEINBARD. Yes, sir. The other is that LIFO, in particular,

creates opportunities for earnings management. This is not a good

thing, it is a bad thing. It is a way of massaging earnings results.

LIFO is like the layers of an onion. Your inventories are different

layers, like an onion, and you decide how much income you want

to report by deciding how big a bite of the onion you are going to

take. By peeling down the layers you can increase or decrease the

amount of taxable and financial profits you report. Earnings management like that is not a good idea.

Dr. PLESKO. I will steal a couple of seconds here before they are

claimed by somebody else. One of the questions that has to be

raised, especially with LIFO being around so long, is, if it has generated a substantial amount of deferral, it appears that much of

this deferral is infinite.

If you look even during the low inflationary times of the 1990s,

we did not see substantial reductions in the reserves. There is evidence that firms will manage their inventory purchases if they do

not want to show increased earnings. If they are concerned about

44

a tax loss of the LIFO reserve, they will buy additional inventory

at the end of the year just to avoid that.

That is another situation where the tax code gets in the way—

going back to General Walker’s comment about just-in-time inventory or other types of business practices. This is an action that

firms would not take but for the existence of a particular tax preference.

Senator KYL. Thank you, Mr. Chairman.

The CHAIRMAN. All right.

I have just three points that I want to make in closing. I will put

a longer statement in the record.

One, of course, obviously, is to thank the very expert panel we

have, and everybody, particularly on the government side, working

hard to help us implement some of these things to close the tax

gap.

I think we found some ideas today that need to be reviewed further, but we have also had lots of ideas—I think maybe a repeat

of ideas we have already known—that need to be done, and I intend to take some action in those areas.

Lastly, I intend to have hearings further yet in July on individual tax reform—when I say ‘‘individual tax reform’’ I mean hearings on individual tax reform—and yet this fall, more detailed corporate tax reform hearings. So we are going to continue down this

road. I think the admonition of Senator Wyden is well-taken by all

of us, and that is what we intend to pursue.

Thank you all very much.

[The prepared statement of Senator Grassley appears in the appendix.]

[Whereupon, at 12:27 p.m., the hearing was concluded.]

(45)

A P P E N D I X

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COMMUNICATIONS

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Æ