a

GAO

United States Government Accountability Office

This testimony was amended on July 7, 2006 to correct the graphic on 

the highlights page and the labeling of the graphs on page 6. Wording 

was also changed on pages 1 and 4 to clarify that $277 billion is the 

amount of corporate income taxes OMB estimates will be collected in 

fiscal year 2006. 

Testimony

Before the Committee on Finance, U.S. Senate

For Release on Delivery

Expected at 10:00 a.m. EDT

Tuesday, June 13, 2006

TAX COMPLIANCE

Challenges to Corporate 

Tax Enforcement and 

Options to Improve 

Securities Basis Reporting

Statement of David M. Walker

Comptroler General of the United States

GAO-06-851T
What GAO Found

United States Government Accountability Office

Why GAO Did This Study

Highlights

Accountability Integrity Reliability

June 13, 2006

TAX COMPLIANCE

Challenges to Corporate Tax 

Enforcement and Options to Improve 

Securities Basis Reporting 

Highlights of GAO-06-851T, a Testimony 

to Committee on Finance, U.S. Senate 

Corporate income taxes are

expected to bring in about 

$277 billion in 2006 to help fund the 

activities of the federal

government. Besides raising 

revenue, the tax alters investment

decisions and raises concerns 

about competitiveness in an 

environment of increasing global

interdependency. The complexity

of the tax breeds tax avoidance, 

including an estimated $32 billion 

of noncompliance detected by the 

Internal Revenue Service (IRS). 

This testimony provides

information on trends in corporate 

taxes and opportunities to improve 

corporate tax compliance. 

The committee also asked that

GAO discuss recent work on the 

misreporting of capital gains 

income from securities sales and 

options to improve compliance. 

This statement is based largely on 

previously published GAO work.

The corporate income tax is an important source of federal revenue and 

must be considered in dealing with the nation’s long-term fiscal imbalance. 

Reexamining both federal spending and revenues, including corporate tax 

policy, corporate tax expenditures and corporate tax enforcement must be 

part of a multi-pronged approach to address the imbalance. 

Corporate Income Tax Revenues as a Share of Federal Taxes, 1962-2005

0

5

10

15

20

25

19621968

1974

19801986

19921998

2005

Percentage of federal taxes

Fiscal year

Source: GAO Analysis of OMB Data. 

The total amount of corporate tax avoidance, which includes the $32 billion 

in noncompliance estimated by IRS, is unknown. A complex tax code, 

complex business transactions, and often multinational corporate structures 

make determining corporate tax liabilities and the extent of corporate tax 

avoidance a challenge. Opportunities exist to improve corporate tax 

compliance and include simplifying the tax code, obtaining better data on 

noncompliance, continuing to oversee the effectiveness of IRS enforcement, 

leveraging technology, and sending sound compliance signals through 

increased collections of taxes owed. 

In a companion report issued today, GAO found that many taxpayers 

misreport capital gains or losses, sometimes inappropriately underpaying

their taxes and sometimes overpaying them. IRS has efforts in place to help 

ensure proper reporting of capital gains and losses, but these efforts face 

several obstacles. GAO found that expanding third-party information 

reporting on the cost basis of capital assets could help mitigate this problem 

if related problems are addressed. GAO suggested that Congress consider

requiring brokers to report adjusted basis to taxpayers and IRS and requiring 

IRS to work with the securities industry to develop cost-effective ways to 

mitigate reporting challenges. GAO also recommended that IRS clarify its 

guidance on reporting capital gains and losses. 

www.gao.gov/cgi-bin/getrpt?GAO-06-851T.

To view the full product, including the scope 

and methodology, click on the link above. 

For more information, contact Michael 

Brostek at (202) 512-9110 or 

brostekm@gao.gov. 
Mr. Chairman and Members of the Committee: 

I appreciate the opportunity to discuss the corporate income tax with you

as well as our work on options for improving taxpayers’ voluntary 

compliance in reporting their capital gains or losses from the sales of 

securities. As the Committee is well aware, the U.S. position in the 

worldwide economy has fundamentally changed and the structure and 

composition of our economy has shifted. U.S. workers and firms must now 

succeed in a world of fast-paced technological change and constantly 

evolving global competition. This raises two sets of questions about the 

corporate income tax. The first is about reforming the overall U.S. tax 

system and perhaps changing the role of corporate taxes. The second set 

of questions is about how to administer and enforce the existing corporate 

income tax in a changing world. As per your request, my statement focuses 

principally on this question. 

The complexity of the corporate income tax generates opportunities for 

tax avoidance that can be categorized as clearly legal, clearly 

noncompliant (illegal), or of uncertain legality. Corporate tax base is 

reduced by statutory corporate tax expenditures, legal and illegal tax 

avoidance, and deliberate underreporting of income. The overall amount 

of tax base reduction is unknown but the Internal Revenue Service (IRS) 

has estimated the amount of clear noncompliance to total $32 billion 

for tax year 2001. Corporate tax avoidance in its various forms 

reduces overall federal revenue or, for the government to take in the same 

revenue, means that other taxpayers pay more. 

My statement today makes the following points: 

• Although less of a revenue source than it once was, the corporate 

income tax is one of the pillars of the federal tax system.1

 The $277

billion in corporate tax revenues that the Office of Management and 

Budget (OMB) estimates will be paid in fiscal year 2006 must be part of 

overall considerations for dealing with the nation’s long-term fiscal 

imbalance. More specifically, corporate tax policy, corporate tax 

expenditures and corporate tax enforcement all must be part of a 

multi-pronged approach that reexamines both federal spending and 

revenues. 

 1

 For purposes of this statement, when we refer to the corporate income tax or

corporations, we are excluding S-corporations, which are pass-through entities whose 

income or losses are generally not taxed at the corporate level, but are passed through to 

their owners. 

Page 1 GAO-06-851T 
• Determining corporate income tax liabilities and the extent of

corporate tax avoidance is a challenge because of the complex tax 

code, complex business transactions and often multinational corporate 

structures. Opportunities exist to improve corporate tax compliance, 

such as simplifying the tax code, obtaining better data to the extent 

feasible on noncompliance, continuing to oversee the effectiveness of 

IRS’s efforts, continuing to leverage technology, and sending sound 

compliance signals through such things as increased effectiveness in 

collecting taxes owed. 

Also, at your request, I have included a section in this statement that 

discusses our findings in the area of capital gains basis reporting. In 

summary, we found that many taxpayers misreport capital gains or losses, 

sometimes inappropriately underpaying their taxes and sometimes 

overpaying them. IRS has efforts in place to help ensure proper reporting 

of capital gains and losses, but these efforts face several obstacles. Finally, 

we found that expanding third-party information reporting on the cost 

basis of capital assets could help mitigate this problem if related problems 

are addressed. 

My statement today is largely drawn from previous GAO reports and 

testimonies, which were done in accordance with generally accepted 

government auditing standards. We also relied on other published 

information for the sections of this statement dealing with corporate 

taxation. The latter part of this statement discusses capital gains basis 

reporting and is drawn from the report on that subject we are releasing 

today. 

The base of the federal corporate income tax includes net income from 

business operations (receipts, minus the costs of purchased goods, labor, 

interest, and other expenses). It also includes net income that 

corporations earn in the form of interest, dividends, rent, royalties, and 

realized capital gains. The statutory rate of tax on net corporate income 

ranges from 15 to 35 percent, depending on the amount of income earned.2

Background 

 2

 In addition, present law imposes an alternative minimum tax (AMT) on corporations to 

the extent that their minimum tax liability exceeds their regular tax liability. In general, the 

AMT applies a lower tax rate to a broader tax base. Specifically, the regular tax base is 

increased for AMT purposes by adding back certain items treated as tax preferences and 

disallowing certain deductions and credits. Also, marginal rates are higher over limited 

income ranges to recapture the benefits of the rates below 35 percent. 

Page 2 GAO-06-851T 
The United States taxes the worldwide income of domestic corporations, 

regardless of where the income is earned, with a foreign tax credit for 

certain taxes paid to other countries. However, the timing of the tax 

liability depends on several factors, including whether the income is from 

a U.S. or foreign source and, if it is from a foreign source, whether it is 

earned through direct operations or through a subsidiary.3

Statutory and effective tax rates are not necessarily the same. An effective

tax rate, which is often lower—even substantially lower—than the 

statutory rate, measures the amount of tax that a corporation actually pays 

on a dollar of its economic income, when all aspects of the tax 

(deductions, credits, deferrals, etc.) are taken into account. Statutory and

effective rates may differ, for example, because depreciation allowances 

for specific types of capital investments exceed (or fall short of) the true 

(economic) depreciation. Other differences arise because income from 

foreign subsidiaries is generally not taxed until it is repatriated to the 

United States. Special incentives, such as the research tax credit, that are

designed to encourage certain behavior, also cause the effective rate of the 

tax to differ from its statutory rate. A recent Congressional Budget Office 

(CBO) study found that the United States’ statutory corporate tax rates are 

high relative to Organization for Economic Cooperation and Development 

(OECD) countries but comparable with the rates for what were then the G7 countries.4

 Comparisons of effective rates depend on the type of 

investment and the type of financing. According to CBO, U.S. effective 

corporate tax rates in 2003 were the G-7 median for equity-financed 

investments in machinery, second lowest for debt-financed investment in 

 3

 Very generally, corporations first calculate their taxable income. Taxable income is total 

income, including taxable income from foreign sources, minus deductions such as for 

salaries and wages, depreciation, and net operating loss carryovers. The next step is to 

calculate the tentative tax owed (taxable income times the applicable rate). The last step is 

to subtract any tax credits, including the foreign tax credit, to get the taxes owed. 

4

 OECD consists of 30 market democracies and its purpose is to provides member 

countries a setting where governments can compare policy experiences, seek answers to

common problems, and coordinate domestic and international policies. At the time of the

CBO study, the G-7 consisted of Canada, France, Germany, Italy, Japan, the United

Kingdom, and the United States. The G-7’s purpose is to provide a forum for the leaders of 

the largest industrialized democracies to discuss major economic and political issues.

When the Russian Federation participates at the meetings, the group is known as the G-8. 

Page 3 GAO-06-851T 
machinery, and second highest for equity-financed investment in industrial 

structures.5

Differences in effective tax rates across types and sources of income are 

pervasive, reflecting the complexity of the tax code. The corporate income 

tax (1) reduces the after tax return on capital income and, therefore, 

affects the incentive individuals have to save and invest; (2) taxes 

corporations differently than partnerships and sole proprietorships; (3) 

taxes U.S. corporations operating in foreign countries differently than 

those operating domestically and differently than foreign governments tax 

corporations; (4) taxes different types of corporate investments, such as 

machinery or structures, unevenly; and (5) taxes debt-financed investment 

at lower rates than equity-financed investment. These differences in 

effective tax rates alter both investment decisions and the reporting of 

corporate income as firms try to minimize their taxes. Such tax avoidance, 

much of it legal but some illegal, reduces tax revenue. Guiding investments 

to lightly taxed activities rather than those with high before tax 

productivity may reduce economic growth, further reducing tax revenue

from what it otherwise would have been. 

At about $277 billion, corporate income taxes are far smaller than the $841 

billion in social insurance taxes and $998 billion in individual income taxes 

that OMB estimates will be paid in fiscal year 2006 to fund the federal 

government.6

 Figure 1 shows the relative importance of federal taxes. 

Corporate Income 

Taxes Are a 

Significant Source of 

Federal Revenue and 

Must Be Part of the 

Overall 

Considerations for 

Fiscal Reform 

 5 Congressional Budget Office, Corporate Income Tax Rates: International Comparisons, 

(Washington, D.C.: November 2005). The study focuses on how corporate income taxes 

affect incentives for investment by calculating marginal effective tax rates in different

countries. The calculations include differences across countries in statutory tax rates and

depreciation rules.

6

 Office of Management and Budget. Historical Tables, Budget of the United States 

Government, Fiscal Year 2007. (Washington, D.C.: Feb. 2006). 

Page 4 GAO-06-851T 
Figure 1: Trend in Federal Taxes, 1962-2005 

Figures 1 and 2 show the trend in corporate tax revenues since 1962. Tax

experts have written that corporate tax revenues fell from the 1960s to the

early 1980s for several reasons. For example, corporate income became a 

smaller share of national income during these years, partly due to the fact 

that corporate debt, and therefore deductible interest payments, increased

relative to corporate equity, reducing the tax base. In addition, tax 

expenditures, such as more generous depreciation rules and corporate tax 

rate reductions lowered corporate taxes.7

 Since the early 1980s corporate

 7

 Steuerle, C. Eugene, Contemporary U.S. Tax Policy. Washington, D.C.: The Urban

Institute Press, 2004. 

Gravelle, Jane G., “The Corporate Tax: Where Has It Been and Where Is It Going?” National 

Tax Journal, vol. 57, no. 4 (2004): 903-23. 

Page 5 GAO-06-851T 
tax revenues have fluctuated in a narrower range, reflecting changes in 

corporate profits, tax laws, and other factors. 

Since the early 1980s the corporate tax has accounted for from about 6 to

13 percent of federal revenue, as shown in figure 2. Consequently, 

although not the largest, it remains an important source of federal 

revenue. Relative to the gross domestic product (GDP), the corporate tax

has ranged from a little over 1 percent to just under 2.5 percent during 

those same years. CBO has recently projected that despite the recent 

uptick, corporate tax revenue for the next 10 years as a percentage of GDP 

is expected to stay within this same range. 

Figure 2: Corporate Income Tax Revenues as a Share of Federal Taxes and as a Share of GDP, 1962-2005 

Source: GAO analysis of OMB data.

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

Percentage of GDP

Fiscal year

0

5

10

15

20

25

2002005

1

196219651968

19711974197719801983

19861989199219951998

196219651968

19711974197719801983

1986198919921995199820012005

Percentage of federal taxes

Fiscal year

Corporate tax revenues of the magnitude shown in figure 2 make them 

relevant to considerations about how to address the nation’s long-term 

fiscal imbalance. Over the long term, the United States faces a large and 

growing structural budget deficit primarily caused by demographic trends

and rising health care costs as shown in figure 3, and exacerbated over 

time by growing interest on the ever larger federal debt. Continuing on this 

imprudent and unsustainable fiscal path will gradually erode, if not 

suddenly damage, our economy, our standard of living, and ultimately our 

national security. 

Page 6 GAO-06-851T 
Figure 3: Composition of Federal Spending as a Share of GDP, Assuming Discretionary Spending Grows with GDP after 2006 

and That Expiring Tax Provisions Are Extended 

0 

10 

20 

30 

40 

50 

2005 2015 2030 2040 

Revenue 

Fiscal year 

Net interest 

Social Security 

Medicare & Medicaid 

All other spending

Source: GAO’s May 2006 analysis. 

Percentage of GDP 

Note: This includes certain tax provisions that expired at the end of 2005, such as the increased 

alternative minimum tax exemption amount. 

We cannot grow our way out of this long-term fiscal challenge because the 

imbalance between spending and revenue is so large. We will need to 

make tough choices using a multipronged approach: (1) revise budget

processes and financial reporting requirements; (2) restructure entitlement 

Page 7 GAO-06-851T 
programs; (3) reexamine the base of discretionary spending and other 

spending; and (4) review and revise tax policy, including tax expenditures, 

and tax enforcement programs. Corporate tax policy, corporate tax 

expenditures, and corporate tax enforcement need to be part of the overall 

tax review because of the amount of revenue at stake. 

Corporate tax expenditures reduce the revenue that would otherwise be 

raised from the corporate income tax. As already noted, to reduce their 

tax liabilities, corporations can take advantage of preferential provisions 

in the tax code, such as exclusions, exemptions, deductions, credits, 

preferential rates, and deferral of tax liability. Tax preferences—which are 

legally known as tax expenditures—are often aimed at policy goals similar 

to those of federal spending programs. For example, there are different tax 

expenditures intended to encourage economic development in 

disadvantaged areas and stimulate research and development, while there 

are also federal spending programs that have similar purposes. Also, by 

narrowing the tax base, corporate tax expenditures have the effect of 

raising either corporate tax rates or the rates on other taxpayers in order 

to generate a given amount of revenue. 

The sum of estimated forgone revenue for the federal government because

of corporate tax expenditures was $80 billion for fiscal year 2005.8

 In its 

most recent report, the Department of the Treasury (Treasury) listed 27 

tax expenditures for corporate taxpayers only and another 52 provisions 

available to both corporations and other businesses. As of fiscal year 2005, 

the two largest tax expenditures used by corporations were the 

accelerated depreciation of machinery and equipment ($15.9 billion) and 

the deferral of income of controlled foreign corporations ($10.5 billion); 

these two accounted for a third of the sum of corporate revenue losses 

estimated by Treasury. 

We reported in September 20059

 that the effectiveness of many tax 

expenditures is not subject to a level of review similar to that of programs 

 8

Summing the individual tax expenditure estimates is useful for gauging the general 

magnitude of the federal revenue involved, but it does not take into account possible 

interactions between individual provisions. See GAO, Government Performance and

Accountability: Tax Expenditures Represent a Substantial Federal Commitment and

Need to Be Reexamined, GAO-05-690 (Washington, D.C.: Sept. 23, 2005). 

9

 GAO, Government Performance and Accountability: Tax Expenditures Represent a

Substantial Federal Commitment and Need to Be Reexamined, GAO-05-690 (Washington,

D.C.: Sept. 23, 2005). 

Page 8 GAO-06-851T 
that spend money directly. Although some corporate income tax 

expenditures are reviewed by government agencies, academics, and 

others, all should be reviewed periodically to ensure they have not 

outlived their usefulness, are not redundant, or are not inefficient in 

accomplishing their intended purpose. In that report, we recommended 

that the OMB and Treasury take steps to ensure regular reexamination of 

tax expenditures, including the corporate provisions. OMB disagreed with 

the recommendations, citing methodological and conceptual issues. Our 

report discusses in detail the issues that OMB raised and why we continue

to believe that our recommendations are valid. Also, as far back as 1994, 

we have suggested that Congress should review these tax expenditures, 

considering such things as how well the corporate tax expenditures are 

achieving their purposes and whether they should remain, given the 

potential benefits of a simpler corporate tax code, possibly with reduced 

tax rates.10

Ensuring corporate income tax compliance is challenging because much 

corporate tax avoidance is legal and the true tax liability for large 

corporations is difficult to determine. A wide variety of strategies will 

undoubtedly be needed to address corporate tax compliance. 

Opportunities to pursue include simplifying the tax code, obtaining better 

data to the extent feasible on noncompliance, continuing to oversee the 

effectiveness of IRS’s efforts, continuing to leverage technology, and

sending sound compliance signals through such things as increased 

effectiveness in collecting taxes owed. 

Opportunities Exist to 

Improve Corporate 

Tax Compliance 

Corporate Tax Avoidance 

Is Bred in Part by 

Complexity 

The amount of corporate tax avoidance is unknown. A complex tax code, 

complicated business transactions, and often multinational corporate 

structures make determining corporate tax liabilities and the extent of 

corporate tax avoidance a challenge. Tax avoidance has become such a 

concern that some tax experts say corporate tax departments have 

become “profit centers” as corporations seek to take advantage of the tax

laws in order to maximize shareholder value. Some corporate tax 

avoidance is clearly legal, some falls in gray areas of the tax code, and 

some is clearly noncompliance or illegal. Tax code simplification has the 

potential to reduce at least some of this avoidance. 

 10 GAO, Tax Policy: Tax Expenditures Deserve More Scrutiny, GAO-GGD/AIMD-94-122 

(Washington, D.C.: June 3, 1994). 

Page 9 GAO-06-851T 
Often corporate tax avoidance is legal. For example, multinational 

corporations can locate active trade or business operations in jurisdictions 

that have lower effective tax rates than does the United States and, unless 

and until they repatriate the income, defer taxation in the United States on 

that income, thus reducing their effective tax rate. Similarly, making 

investments that qualify for accelerated depreciation can lower a 

corporation’s current effective tax rate, although in the future its rate 

would be higher.11

Corporate tax planners may find legal ways to exploit tax code complexity 

to play one provision of the code off another in ways that Congress never 

intended. In response, Congress has sometimes acted to address what it 

considered to be abusive tax shelters. For example, the American Jobs 

Creation Act of 200412 limited the tax benefits of leasing transactions 

involving tax-exempt entities, such as transit authorities. One type of

transaction the act limited was the sale-in/lease-out (SILO) arrangement, 

which involved a taxable entity buying assets, such as railcars, from a taxexempt entity, for example, a metropolitan transit system, and leasing 

them back to the tax-exempt entity. The estimated revenue gain from the 

2004 act’s provision covering leasing transactions with tax-indifferent 

parties was about $26.6 billion for 2005 through 2014. 

Complicating corporate tax compliance is the fact that in many cases the

law is unclear or subject to differing interpretations. In fact, some have 

postulated that major corporations’ tax returns are actually just the 

opening bid in an extended negotiation with IRS to determine a 

corporation’s tax liability. An illustration is transfer pricing. Transfer 

pricing involves setting the appropriate price for such things as goods, 

services, or intangible property (such as patents, trademarks, copyrights, 

technology, or “know-how”) that is transferred between the U.S.-based 

operations of a multinational company and a foreign affiliate. If the price 

paid by the affiliate to the U.S. operation is understated, the profits of the 

U.S. operation are reduced and U.S. taxable income is inappropriately 

reduced or eliminated. The standard for judging the correct price is the 

price that would have been paid between independent enterprises acting 

at “arm’s length.” However, it can be extremely difficult to establish what 

an arm’s length price would be. Given the global economy and the number 

 11 Accelerated depreciation lowers a corporation’s marginal effective tax rate on 

investments by increasing the present value of these deductions. 

12 Pub. L. No. 108-357 (2004). 

Page 10 GAO-06-851T 
of multinational firms with some U.S.-based operations, opportunities for 

transfer pricing disputes are likely to grow. 

Tax shelters are one example of how tax avoidance, including corporate 

tax avoidance, can shade into the illegal. Some tax shelters are legal 

though perhaps aggressive interpretations of the law, but others cross the 

line. In a 2003 testimony, we reported that IRS had identified 27 kinds of 

abusive shelter transactions—called listed transactions—promoted to 

corporations and others. As of June 2006, IRS’s web site lists 31 such listed 

transactions. IRS also had a number of other transactions that had to be 

reported to IRS and may have had some characteristics of abusive shelters

but were not, and possibly never would be, listed.

Abusive shelters often are complex transactions that manipulate many 

parts of the tax code or regulations and are typically buried among 

legitimate transactions reported on tax returns. Because these 

transactions are often composed of many pieces located in several parts of 

a complex tax return, they are essentially hidden from plain sight, which 

contributes to the difficulty of determining the scope of the abusive shelter 

problem. Often lacking economic substance or a business purpose other 

than generating tax benefits, abusive shelters have been promoted by 

some tax professionals, often in confidence, for significant fees, 

sometimes with the participation of tax-indifferent parties, such as foreign 

or tax-exempt entities. These shelters may involve unnecessary steps and 

flow-through entities, such as partnerships, which make detection of these 

transactions more difficult. 

For example, a company had a sizable gain from the sale of a subsidiary 

and wanted to avoid or minimize paying tax on the gain. An investment 

bank proposed forming an offshore partnership with a foreign corporation 

(a tax-indifferent party) for the express purpose of sheltering the capital 

gains of its corporate client. The partnership purchased and quickly resold 

notes in a contingent installment sale transaction. The partnership earned 

a large capital gain, most of which it allocated to the foreign corporate 

partner. Later, related losses were allocated to the U.S. corporation, 

generating approximately $100 million in capital loss for the investment 

bank’s client. The corporation used this capital loss to shelter its U.S.-

based capital gains. Both the Tax Court and the Third Circuit Court of 

Appeals ruled that the transaction lacked economic substance. The Third 

Circuit, in addition to requiring economic substance, held that a 

Page 11 GAO-06-851T 
transaction must have a subjective nontax business motive to be respected 

for tax purposes.13 For this transaction, the investment bank was to earn a 

fee of $2 million. 

In part because tax shelters are intentionally hidden, IRS has not been able

to produce a reliable estimate of the revenues lost because of shelters. As 

we reported in October 2003, one estimate, which had a number of 

methodological limitations, suggested an average annual tax gap because 

of tax shelters (both corporate and individual) that could have been from

about $11.6 billion to about $15.1 billion for the years 1993 through 1999.14

Because the methodological limitations were serious, the true amount of 

the revenue loss could be lower or higher than this range. Furthermore, 

this estimate does not cover non-abusive tax shelters. 

Establishing a presence in a low-tax country is another technique for 

avoiding corporate income tax. Some low-tax countries are called tax

havens. The company’s presence in a tax haven in some cases may be 

nominal, nothing more than a file in an office. Use of a tax haven can be 

questionable when combined with abusive transfer pricing or techniques, 

such as interest stripping, to artificially shift income to the tax haven. In 

several reports since 2002, we reported on federal contractors’ use of tax 

havens. We reported that 4 of the top 100 federal contractors that were 

publicly traded corporations in 2001 were located in tax havens and that 3 

of these were originally U.S.-headquartered corporations. Later, we 

reported that large tax haven contractors in both 2000 and 2001 had a tax

cost advantage compared to large domestic contractors.15

 13 ACM Partnership v. Commissioner, 157 F. 3d 231 (3d Cir. 1998), aff’g, 73 T.C.M. 2189 

(1997), cert. denied, 526 U.S. 1017 (1999). 

14 GAO, Internal Revenue Service: Challenges Remain in Combating Abusive Tax

Shelters, GAO-04-104T, (Washington, D.C.: Oct. 21, 2003). 

15 GAO, Information on Federal Contractors That Are Incorporated Offshore, 

GAO-03-194R (Washington, D.C.: Oct. 1, 2002) and International Taxation: Tax Haven 

Companies Were More Likely to Have a Tax Cost Advantage in Federal Contracting, 

GAO-04-856 (Washington, D.C.: June 30, 2004).

Page 12 GAO-06-851T 
In large part because of the complexity and uncertainty in the application

of tax laws, the actual level of corporate income tax noncompliance 

(illegal tax avoidance) is poorly understood. IRS estimates a corporate tax 

gap in the tens of billions of dollars, but also acknowledges that this 

estimate is not based on robust, recent, and reliable research.

 16

IRS’s Incomplete and 

Dated Estimates of 

Corporate Tax 

Noncompliance Can Be 

Improved 

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

difference between what corporations pay voluntarily and on time in taxes 

and what they are required to pay under the law—is $32 billion for tax 

year 2001. This is out of an overall gross tax gap of $345 billion for that 

year. Underreporting of income was the largest component of the 

corporate tax gap, contributing an estimated $30 billion. The IRS estimate 

included both small corporations (those reporting assets of $10 million or 

less) and large corporations (those reporting assets of over $10 million). 

Underpayment of taxes due accounted for $2 billion of the corporate tax 

gap for tax year 2001. IRS has no estimate for nonfiling of corporate 

income tax returns for tax year 2001.

However, the available tax gap estimates are highly uncertain and 

incomplete. IRS has not systematically measured the level of compliance 

for large corporations, and the last measure of noncompliance for small 

corporations was from the 1980s. IRS’s level of certainty with regard to the 

accuracy of the corporate tax gap estimate is low for reasons such as use 

of incomplete and old data, interpretation of complex laws, and resource 

constraints. The 2001 estimate used data from the 1970s and 1980s to 

estimate underreporting of corporate income taxes. For large corporate 

income tax underreporting, IRS based its estimate on the amount of tax 

recommended from operational examinations. As we reported in July 

2005,

17 according to IRS officials, IRS relies on the amount of tax 

recommended because it is difficult to determine the true tax liability of 

large corporations because of complex and ambiguous tax laws that 

create opportunities for differing interpretations and that complicate the 

determination. Because these examinations do not cover all firms and do 

not test all items on a tax return, the estimate produced from the 

 16 The tax gap estimate is an aggregate of estimates for three primary types of

noncompliance: underreporting of tax liabilities on tax returns; underpaying of taxes due 

from filed returns; and nonfiling, which refers to the failure to file a required tax return 

altogether or on time. 

17 GAO, Tax Compliance: Better Compliance Data and Long-term Goals Would Support a 

More Strategic IRS Approach to Reducing the Tax Gap, GAO-05-753 (Washington, D.C.

July 18, 2005). 

Page 13 GAO-06-851T 
examinations is incomplete. IRS officials also explained that because of 

these complexities and the costs and burdens of collecting complete and

accurate data, IRS has not systematically measured large corporation tax

compliance through statistically valid studies. 

As of June of this year, IRS did not have approved plans to update the 

corporate tax gap estimate. Although measuring corporate tax compliance 

can be challenging and costly, such compliance data aid in identifying new 

or growing types of noncompliance, identifying changes in tax laws and 

regulations that may improve compliance, more effectively targeting 

examinations of tax returns, understanding the effectiveness of its 

programs to promote and enforce compliance, and properly determining 

its resource needs and allocations. In order to improve efforts to reduce 

the tax gap, we have recommended that IRS develop plans to periodically

measure tax compliance for areas that have been measured, and study 

ways to cost effectively measure compliance for other components of the 

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

taxes. IRS agreed with our recommendations.18

IRS Has Strengthened 

Corporate Tax Compliance 

Efforts, but Continued 

Oversight Will Be 

Warranted 

IRS has recently increased the number of corporate audits and 

recommended tax assessments. These trends are promising. However, 

given the lack of a reliable measure of the extent of corporate 

noncompliance and other factors, continued oversight of these efforts will 

be warranted to make informed judgments about their overall

effectiveness. 

As shown in figure 4, the number of corporate income tax returns that IRS 

examined rose from its recent low of 0.71 percent in fiscal year 2004 to 

1.25 percent in fiscal year 2005. This number includes examinations of 20 

percent of large corporations in fiscal year 2005 as well as audits of all 

1,100 of the nation’s largest corporations with assets of more than $250 

million. 

 18 GAO, Tax Administration: Better Compliance Data and Long-term Goals Would

Support a More Strategic IRS Approach to Reducing the Tax Gap, GAO-05-753 

(Washington, D.C.: July 18, 2005). 

Page 14 GAO-06-851T 
Figure 4: Percentage of Corporate Tax Returns IRS Examined, Fiscal Years 2001-

2005 

0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

2001 2002 2003 2004 2005

Percentage examined

Source: IRS.

Fiscal year

Figure 5 shows that the amount of taxes that IRS recommended as a result

of examinations performed grew from its recent low of $13.5 billion in 

fiscal year 2003 to $32 billion in fiscal year 2005. 

Page 15 GAO-06-851T 
Figure 5: Amount of Taxes Recommended from Examinations of Corporations in

Billions of Dollars, Fiscal Years 2001-2005 

0

5

10

15

20

25

30

35

Large corporation

Small corporation

2001 2002 2003 2004 2005

Taxes recommended

Source: IRS.

Fiscal year

According to IRS, about a third of the increase in recommended 

assessments comes from tax shelter examinations, and nearly all of the 

increase comes from examinations of the largest corporations. IRS notes, 

not surprisingly, that a large portion of the recommended taxes were not 

agreed to by the corporations. In the past, we found that under IRS’s 

examination program of the nation’s largest corporations, the amount of 

taxes IRS actually assessed has been about 20 percent of the amount 

initially recommended during examinations.19 Further, the amounts 

assessed often are not ultimately collected after cases are reviewed in 

IRS’s Appeals function or in the courts. Because the various review and 

appeal options can be time consuming, it may be a number of years before

actual collection occurs on some cases. 

 19 GAO, Tax Administration: IRS Measures Could Provide a More Balanced Picture of

Audit Results and Costs, GAO/GGD-98-128 (Washington D.C.: June 23, 1998). 

Page 16 GAO-06-851T 
The shelter-related results come from IRS’s multiyear effort to attack tax 

shelters. In 2003 we reported that IRS had shifted resources to create a 

broad-based strategy to combat what it considered to be a high priority 

challenge—abusive tax shelters. IRS had adopted a broad-based strategy 

for addressing abusive shelters, including 

• targeting promoters to head off the proliferation of shelters; 

• making efforts to deter, detect, and resolve abuse; 

• offering inducements to businesses to disclose their use of 

questionable tax practices; and 

• using performance indicators to measure outputs and some outcomes 

and intending to go down the path it had started and develop long-term 

performance goals and measures linked to those goals. We said that 

without these latter elements, Congress would find gauging IRS’s 

progress difficult. 

In addition to examinations, IRS has undertaken a number of initiatives to

address corporate tax compliance. Some of these initiatives are intended

to resolve tax issues beyond the examination process. The Advance 

Pricing Agreement (APA) program, the Fast Track Settlement program, 

the Pre-Filing Agreement program, and the Industry Issue Resolution 

program all work to some degree to resolve contentious tax issues outside 

of the examination process. For example, the APA program is intended to 

address transfer pricing issues up front so that they do not arise during 

subsequent examinations. 

IRS has also been revising the corporate tax examination process. For 

instance, IRS reports that it has shortened the cycle time of examinations. 

According to IRS, reducing cycle time allows IRS to examine additional 

taxpayers and reduces administrative burdens on taxpayers. Similarly, 

IRS’s Limited Issue Focused Examination process seeks to have IRS and 

corporations reach a formal agreement to govern key aspects of the 

examination.

Future success in following through on these initiatives will require 

replenishment of IRS’s staff, which could be challenging given the 

increasing numbers of key employees who are eligible for retirement or 

who are otherwise leaving key occupations. The Large and Mid-Size 

Business Division (LMSB), which is responsible for the compliance of the 

largest corporations, reported in its fiscal year 2006 strategic assessment 

that it will continue to lose substantial experience as revenue agents leave. 

The Small Business and Self Employed Division, which covers the rest of 

corporations, also has growing numbers of employees eligible for 

Page 17 GAO-06-851T 
retirement or leaving their enforcement positions. Although hiring to fill 

positions is occurring, past experience suggests that training these new 

employees and giving them on-the-job experience will take time and likely 

adversely affect the divisions’ overall productivity to some extent. The 

Treasury Inspector General for Tax Administration has designated 

managing human capital a management and performance challenge for 

IRS. 

In part because IRS does not have a reliable measure of corporate tax 

compliance, it will be challenged to demonstrate the effectiveness of the 

increased audits and the various initiatives it has undertaken. The 

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

recommended are actually collected given past data showing that a 

relatively small portion of recommended assessments is ultimately 

collected. For these reasons, as well as human capital management 

challenges, IRS’s increased compliance efforts will warrant continued 

oversight. 

Continuing to Leverage 

Technology 

Judicious use of technology has already helped IRS improve its 

productivity, and continued, well-managed technology initiatives have the 

potential to further improve the use of its resources. According to IRS, 

electronic filing of individuals’ tax returns has enabled it to reduce the 

amount of staffing devoted to processing paper tax returns and to transfer 

staffing allocations to other endeavors, including compliance work. 

Further, because of the software used in electronically preparing and filing 

returns, these returns have fewer errors, thus saving IRS and taxpayers 

needless time and effort to correct avoidable errors. 

Starting in 2006, many larger corporations are now required to file their 

tax returns electronically. This is no small undertaking, and some 

transition issues are likely to occur. However, electronic returns offer the 

potential to speed examinations—if for no other reason than often very 

voluminous corporate tax returns can be moved to appropriate locations 

for review immediately. IRS believes electronically filed returns will also 

speed analysis of corporate tax returns and the identification of issues and 

taxpayers most in need of examination or other resolution of potential 

compliance issues. IRS plans to gradually expand the number of firms 

required to electronically file. This and other opportunities to leverage 

modern technology can serve to help IRS deal with the complex tax issues 

in corporate tax returns. 

Page 18 GAO-06-851T 
Improving the Collection 

of Delinquent Taxes Would 

Send a Compliance Signal 

When any taxpayer has been found to owe taxes and those amounts are no

longer in dispute, failure to collect the taxes sends an adverse compliance 

signal. While not collecting these debts may send a message to 

corporations that IRS is not serious about enforcing the tax law, 

developing and exploiting opportunities to improve collections sends the 

opposite signal and can contribute to reducing corporate noncompliance. 

In February 2004, we reported that some Department of Defense (DOD) 

contractors abuse the federal tax system with little consequence.20 We 

reported that based on our analysis of a limited number of DOD 

disbursement systems, more than 27,000 DOD contractors owed nearly $3 

billion in unpaid federal taxes. In June 2005, we reported that many 

contractors of civilian agencies throughout the federal government also 

abuse the federal tax system.21 Our analysis showed that about 33,000 

contractors that received substantial federal payments from civilian 

agencies during fiscal year 2004 owed a total of more than $3 billion in 

unpaid taxes. The unpaid taxes owed by DOD and civilian agency 

contractors included corporate income, excise, unemployment, individual 

income, and payroll taxes.22 We also found evidence of abusive and 

potentially criminal activities on the part of both DOD and civilian agency 

contractors.23

In our reports on this issue, we made numerous recommendations 

intended to improve the Federal Payment Levy Program by expanding the 

amount and type of tax debt eligible for inclusion in the program, 

expanding the volume of federal payments subject to levy, and correcting 

process and control deficiencies that hindered the program’s ability to 

 20 GAO, Financial Management: Some DOD Contractors Abuse the Federal Tax System 

with Little Consequence, GAO-04-95 (Washington, D.C.: Feb. 12, 2004). Although some of 

the contractors were corporations, we did not estimate how many were corporations. 

21 GAO, Financial Management: Thousands of Civilian Agency Contractors Abuse the

Federal Tax System with Little Consequence, GAO-05-637 (Washington, D.C.: June 16, 

2005). 

22 Payroll taxes are amounts that businesses withheld from employees’ wages for federal 

income taxes, Social Security, and Medicare but failed to remit to IRS, as well as the related 

employer matching contributions for Social Security and Medicare taxes. 

23 We considered activity to be abusive when a contractor’s actions or inactions, though not 

illegal, took advantage of the existing tax enforcement and administration system to avoid

fulfilling federal tax obligations and were deficient or improper when compared with 

behavior that a prudent person would consider reasonable. We characterized as potentially 

criminal any activity related to federal tax liability that may be a crime under a specific 

provision of the Internal Revenue Code. 

Page 19 GAO-06-851T 
maximize the amount levied from payments to contractors with unpaid 

federal taxes. In our 2004 report, we also recommended that OMB develop 

options for prohibiting federal contract awards to businesses and 

individuals that abuse the federal tax system, including designating such 

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

agencies involved did not agree with all of our recommendations. We 

discuss their views and our responses in detail in our reports, as well as 

our continued belief that our recommendations are valid. Consistent with 

our recommendation to OMB, I believe Congress should consider 

suspending government business with contractors who are delinquent on 

their taxes as of a specific and prospective effective date, with a provision 

for limited waivers if necessary in unique circumstances. 

Finally, you also asked us to testify on a report—done at your request—

that we are issuing today on individual taxpayers’ compliance in reporting 

capital gains’ income from the sale of securities.24 Misreporting such 

income25 contributes to the annual tax gap, which is the gap between tax 

amounts that taxpayers should pay under the law and do pay voluntarily 

and on time. For tax year 2001, the IRS estimated a gross tax gap of $345 

billion, of which at least $11 billion is attributed to individual taxpayers 

who misreported their income from capital gains or losses.26 Taxpayers are 

to determine their capital gains or losses by subtracting the “basis” 

amount, which is generally the cost for an asset, from the gross proceeds 

amount when selling the asset. 

Capital Gains Basis 

Reporting 

 24 GAO, Capital Gains Tax Gap: Requiring Brokers to Report Securities Cost Basis Would 

Improve Compliance if Related Challenges Are Addressed, GAO-06-603 (Washington, D.C.: 

June 13, 2006). 

25 Taxpayers are to report gains or losses from selling securities on Schedule D of the 

federal income tax returns as well as the purchase and sale dates, adjusted cost basis, and

gross proceeds from the sale. 

26 The overall capital gains tax gap could be larger than $11 billion if IRS had estimated the 

portion of the $48 billion tax gap for unfiled tax returns or unpaid taxes that is related to 

capital gains. According to an IRS research official, in mid-2006, IRS plans to publish its

final report on the 2001 tax gap that will include an updated tax gap estimate based on a 

refined methodology. It is possible that the updated tax gap figures could differ from the

current estimates. 

Page 20 GAO-06-851T 
In summary: 

• For tax year 2001, an estimated27 36 percent (over 7 million) of 

individual taxpayers who sold securities misreported capital gains or 

losses. Using the wrong cost basis for the securities was a primary type 

of noncompliance leading to this misreported income. About two-thirds 

of the misreporting taxpayers understated gains or overstated losses, 

while about one-third overstated gains or understated losses. 

Additionally, a few taxpayers with securities sales misreported whether 

their gains or losses were short-term or long-term.28

• IRS attempts to address misreported securities sales’ income through 

enforcement and taxpayer service programs, which are to find 

noncompliance or help taxpayers comply voluntarily. Various 

challenges limit the impact of these programs, such as that IRS 

enforcement programs contact relatively few taxpayers and the lack of 

cost basis information impedes efficient use of IRS’s enforcement 

resources. IRS also faces difficulties in ensuring that taxpayers 

understand their obligations for determining and reporting their capital

gains and losses. 

• Expanding information reporting29 to taxpayers and IRS on securities 

sales to include cost basis has potential to improve taxpayer voluntary 

compliance and help IRS verify securities gains or losses. Basis 

reporting would raise challenges, many of which can be mitigated to 

some extent. For example, broker costs would increase but could be 

constrained by limiting the scope of any reporting requirement and by 

building on the basis reporting to taxpayers that many brokers already 

do. For example, reporting basis for only future purchases would 

 27 Our estimates are based on a review of a probability sample of IRS examinations selected 

from the nearly 46,000 randomly selected individual tax returns for tax year 2001 in its 

National Research Program, IRS’s most recent study of individual tax compliance. We 

express our confidence in our estimates as a 95 percent confidence interval, plus or minus

the margin of error. Our estimate for the percentage of misreporting taxpayers has a 

sampling error of (+/-) 7 percent or less, and we are 95 percent confident that from 6.2

million to 8.3 million taxpayers misreported securities sales. 

28 Securities assets sold after being held for 1 year or less are considered short-term while 

others sold are considered to be long-term and are generally taxed at lower tax rates. 

29 Information reporting involves third parties filing returns with IRS and taxpayers to 

report certain income. Brokers are required to file Form 1099-B with IRS and the taxpayer 

to report such information for securities sales as the dates, number of shares, and gross 

proceeds of the sale, but not the cost basis. 

Page 21 GAO-06-851T 
mitigate challenges when brokers do not know the basis for securities 

purchased in the past. To the extent that actions to mitigate the 

challenges to basis reporting delay its implementation or limit coverage 

to only certain types of securities, the resulting improvements to 

taxpayers’ voluntary reporting compliance would be somewhat 

constrained. IRS’s broad authority to require information reporting for 

securities sales may not be enough to require all the actions necessary 

to implement cost basis reporting and mitigate the challenges.

Based on these results, our report includes matters that Congress may 

want to consider, including requiring brokers to report to both taxpayers 

and IRS the adjusted basis of sold securities and ensuring that IRS has 

sufficient authority to implement the requirement. Congress could also 

require brokers to report whether the securities sold were short- or longterm and IRS to work with brokers to develop rules that mitigate the

challenges. Further, we recommend that IRS modify the instructions for 

the individual tax return to (1) clarify the appropriate use of capital losses 

to offset capital gains or other income and (2) provide guidance on 

resources available to taxpayers to determine basis. IRS agreed with our 

recommendations. 

Mr. Chairman, this concludes my prepared statement. I would be happy to

respond to any questions you or other Members of the Committee may 

have at this time. 

For further information on this testimony, please contact Michael Brostek 

at (202) 512-9110 or brostekm@gao.gov. David Lewis, Assistant Director; 

Jeffrey Arkin; Kevin Daly; Amy Friedheim; Thomas Gilbert; Lawrence 

Korb; Signora May; Edward Nannenhorn; Cheryl Peterson; Michael Rose; 

Marylynn Sergent; Thomas Short; Michael Volpe; James White, Jennifer 

Wong; and James Wozny made key contributions to this testimony. 

Contacts and 

Acknowledgments 

Page 22 GAO-06-851T (450506) 
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