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45–810—PDF 2007

S. HRG. 110–677

OFFSHORE TAX EVASION:

STASHING CASH OVERSEAS

HEARING

BEFORE THE

COMMITTEE ON FINANCE

UNITED STATES SENATE

ONE HUNDRED TENTH CONGRESS

FIRST SESSION

MAY 3, 2007

(

Printed for the use of the Committee on Finance

COMMITTEE ON FINANCE

MAX BAUCUS, Montana, Chairman

JOHN D. ROCKEFELLER IV, West Virginia

KENT CONRAD, North Dakota

JEFF BINGAMAN, New Mexico

JOHN F. KERRY, Massachusetts

BLANCHE L. LINCOLN, Arkansas

RON WYDEN, Oregon

CHARLES E. SCHUMER, New York

DEBBIE STABENOW, Michigan

MARIA CANTWELL, Washington

KEN SALAZAR, Colorado

CHUCK GRASSLEY, Iowa

ORRIN G. HATCH, Utah

TRENT LOTT, Mississippi

OLYMPIA J. SNOWE, Maine

JON KYL, Arizona

CRAIG THOMAS, Wyoming

GORDON SMITH, Oregon

JIM BUNNING, Kentucky

MIKE CRAPO, Idaho

PAT ROBERTS, Kansas

RUSSELL SULLIVAN, Staff Director

KOLAN DAVIS, Republican Staff Director and Chief Counsel

(II)

C O N T E N T S

OPENING STATEMENTS

Page

Baucus, Hon. Max, a U.S. Senator from Montana, chairman, Committee

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

Grassley, Hon. Chuck, a U.S. Senator from Iowa ................................................. 2

WITNESSES

Harrington, John, Acting International Tax Counsel, U.S. Department of

the Treasury, Washington, DC ........................................................................... 4

Owens, Jeffrey, director, Center for Tax Policy and Administration, Organization for Economic Co-operation and Development, Paris, France .................... 6

Avi-Yonah, Prof. Reuven S., Irwin I. Cohn professor of law, University of

Michigan Law School, Ann Arbor, MI ................................................................ 8

Brostek, Michael, Director, Tax Issues, Strategic Issues Team, U.S. Government Accountability Office, Washington, DC .................................................... 10

ALPHABETICAL LISTING AND APPENDIX MATERIAL

Avi-Yonah, Prof. Reuven S.:

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

Prepared statement .......................................................................................... 37

Responses to questions from committee members ......................................... 46

Baucus, Hon. Max:

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

Brostek, Michael:

Testimony .......................................................................................................... 10

Prepared statement with attachment ............................................................. 48

Bunning, Hon. Jim:

Prepared statement .......................................................................................... 117

Grassley, Hon. Chuck:

Opening statement ........................................................................................... 2

Harrington, John:

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

Prepared statement .......................................................................................... 118

Owens, Jeffrey:

Testimony .......................................................................................................... 6

Prepared statement .......................................................................................... 125

Responses to questions from committee members ......................................... 142

COMMUNICATIONS

Center for Freedom and Prosperity Foundation ................................................... 149

Isle of Man ............................................................................................................... 157

States of Guernsey ................................................................................................... 166

States of Jersey ........................................................................................................ 175

(III)

(1)

OFFSHORE TAX EVASION:

STASHING CASH OVERSEAS

THURSDAY, MAY 3, 2007

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

The hearing was convened, pursuant to notice, at 10:07 a.m., in

room SD–215, Dirksen Senate Office Building, Hon. Max Baucus

(chairman of the committee) presiding.

Present: Senators Conrad, Grassley, and Bunning.

OPENING STATEMENT OF HON. MAX BAUCUS, A U.S. SENATOR

FROM MONTANA, CHAIRMAN, COMMITTEE ON FINANCE

The CHAIRMAN. The committee will come to order.

In Ecclesiastes, the preacher urged his listeners to trade overseas, for they would find a good return. He said, ‘‘Cast your bread

upon the waters, for after many days you will find it again.’’

World trade has certainly generated a good return: the world’s

pension, insurance, and mutual fund business now totals at least

$46 trillion, the world’s stock market capitalization is more than

$40 trillion, and the world’s credit derivatives market amounts to

more than $250 trillion. Foreigners now own about $12 trillion of

American stocks, bonds, and other assets, and that includes $2 trillion of Federal Government debt.

Most think international trade is a healthy exchange of goods

and services, but, as international trade becomes more complex, it

is becoming more and more difficult to track transactions legally

subject to taxation.

As a result, offshore tax evasion has become a large and growing

element of the tax gap—that share of taxes legally owed that is not

paid. For years, the Federal Government has been concerned about

U.S. taxpayers hiding behind the veil of foreign corporations, and

today the government has the added challenge of keeping up with

the $1.5 trillion in the estimated 8,000 hedge funds investing

around the globe. The IRS is increasingly outgunned in its effort

to enforce tax rules in the international economy.

Consider these offshore tax scams that have recently come to

light: two brothers from Texas set up 58 separate trusts as shell

corporations, sheltering tens of billions of dollars of assets on which

they avoided paying taxes; a car dealer from Illinois was charged

with pretending to live in the Virgin Islands just so he could get

a break on his taxes; a former U.S. Attorney from North Carolina

pleaded guilty to failing to disclose on his taxes that he had an offshore account; a dentist in California was sentenced to 2 years in

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prison for faking tax deductions and hiding money in an offshore

bank account.

These are just the scams that we know about. Common sense

dictates they are just the tip of the iceberg. I am pleased that today

we can kick off our work in this Congress on international tax evasion. Today we will hear the results of a GAO investigation into a

critical part of our offshore tax enforcement program.

GAO focuses on almost $300 billion in funds that it has identified as being transferred out of the United States every year, and

GAO considers the tax issues raised by those transfers.

The real amount transferred overseas is much higher, so this is

a good start for our oversight agenda. Frankly, one job for the Federal Government is just to nail down the amount being transferred

offshore. We need to learn what that total amount is, and after

that, we need to learn much more about how much tax is being

avoided—that is, both the denominator and the numerator.

Within the $300 billion total, we are told that the IRS has no

idea where $19 billion ends up once the funds are transferred overseas. I find this troubling.

Today we will hear the results of two GAO reports. The first

deals with qualified intermediaries, which are foreign banks and

other exchanges that process funds entering and leaving the

United States. In a second report, GAO explains that the IRS takes

much longer to finish its examination of an offshore tax evasion

case than a domestic case, but the return to the IRS from an offshore case is typically 3 times what is recovered from a domestic

case. This is a sure sign that the volume of offshore tax evasion is

huge.

GAO gives us some recommendations to consider. GAO recommends that Congress should consider extending the statute of

limitations for complicated offshore tax evasion cases. GAO recommends that qualified intermediaries need to do a better job of

identifying and tracking the money that they handle. And the GAO

recommends that the IRS needs to do a better job of tracking information about foreign financial transactions.

I want to welcome our witnesses from the Treasury Department,

the University of Michigan Law School, and the Organization for

Economic Co-operation and Development. All three can comment

on the GAO findings, and all of our witnesses can help us explore

the broader issues on offshore tax evasion.

This hearing can help us to begin thinking about how the international community will eventually structure its tax system, something I care a lot about. We have seen the outsourcing of jobs, but

now we are risking the outsourcing of our revenue base.

We have to contend with tax havens, but now even our friends

in Europe are busy lowering their corporate taxes. We have also

seen cases of American companies moving their intellectual property overseas in order to pay lower tax rates.

Part of the problem is that the Treasury, the IRS, and the American institutions know far less than they should. With international

trade increasingly flowing across national boundaries at the speed

of light, it is more and more difficult to make sure that we are collecting the taxes that are owed and the honest American taxpayers

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who work hard and do not have the ability to engage in offshore

activity are not left holding the bill.

So today we will examine the effort to combat tax evasion. In

days to come, this committee will ask where our tax system should

fit in the new global economy. So let us do what we can to ensure

that American businesses continue to find profit and trade upon

the waters. Let us also make sure that U.S. tax enforcement is not

lost at sea, and in not too many days we may once again find the

right balance.

Senator Grassley?

OPENING STATEMENT OF HON. CHUCK GRASSLEY,

A U.S. SENATOR FROM IOWA

Senator GRASSLEY. Thank you very much.

For those people who do not follow the work of this committee

over a long period of time, and maybe for a couple of our witnesses

who do not, let me say, about this issue, that in the 7 years that

Senator Baucus has led his party and the 7 years I have led my

party as leaders on this committee, there is no issue that we have

had more close cooperation and almost unanimity of opinion on

than working to close illegal tax loopholes. So, I thank Chairman

Baucus for continuing this work with this hearing on offshore tax

evasion and the international tax gap.

Like the rest of the tax gap, offshore tax evasion is not a new

issue, but it is an issue of growing importance in an increasingly

global economy. Senator Baucus gave you the figures on how large

it is in the global economy.

In the global economy, investment flows without regard to national borders, but a nation’s taxing jurisdiction is a matter of policy and in practical effect is often limited by national borders.

The focus of today’s hearing is to examine the problems of U.S.

income tax evasion by individual taxpayers who hide their assets

and income in foreign bank accounts, or for that matter any foreign

entity.

Since 1913, our tax code has subjected U.S. citizens to income tax

on their worldwide income. No matter what Internet purveyors of

tax evasion say, this principle cannot be avoided by living on a

yacht or by putting passive assets or income offshore.

The tax code has rules to prevent this, and reporting requirements to assure that the IRS is aware of the foreign activities of

U.S. taxpayers. Taxpayers that willingly violate these rules are

guilty of tax fraud.

Our existing reporting requirements regarding foreign activities

of U.S. taxpayers are largely a matter of self-reporting. As a result,

information exchanged with other jurisdictions is an important tool

for our government.

Our income tax treaties contain an article on information exchange designed to help the government obtain quality information

to enforce our tax laws. In addition, administrations past and

present have entered into over 20 tax information exchange agreements with jurisdictions that are often referred to as ‘‘tax havens.’’

An important part of the value of our information exchange network lies in its deterrent effect. In other words, transparency

makes a big difference. Taxpayers who know the IRS can get access

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to tax information from foreign jurisdictions will obviously think

twice before willingly failing to satisfy their self-reporting requirements.

As we will hear today, the OECD encourages effective information exchange, and the United States has been a leader in the

international community in this area. Offshore tax evasion is not

just a U.S. problem; it is an international problem.

Sensible solutions to the offshore tax evasion problem should aim

to improve on our tax information exchange network and not put

that network at risk. The problem of offshore evasion is not that

our laws permit it; the problem is that there are some taxpayers

who are intent on cheating and hiding their income from the Internal Revenue Service.

The IRS has been successful in catching many of these tax

cheats, but we are here to say, more can be done. So, I look forward

to today’s exchange and thank the witnesses for being here.

The CHAIRMAN. Thank you, Senator. I also want to thank you

personally for your work in trying to enforce the code, and also

your work with me, the two of us working together, on a joint

basis.

Senator GRASSLEY. Sure. Absolutely.

The CHAIRMAN. I deeply appreciate that. It means an awful lot

to an awful lot of taxpayers in this country, what you are doing.

All right. Now we want to introduce the witnesses. Thank you.

The first witness is John Harrington, Acting International Tax

Counsel for the Department of the Treasury; then Jeffrey Owens,

director of the OECD Center for Tax Policy and Administration,

who will discuss OECD’s work on offshore tax evasion and effective

information exchanges; then Mr. Reuven Avi-Yonah, professor of

tax and director of international tax at the University of Michigan;

and finally, Mr. Brostek. Michael Brostek is Director of Tax Issues

on the Strategic Issues Team at GAO, who will discuss two

projects, one on the statute of limitations, the other on the qualified intermediary program.

Thank you all for coming, gentlemen. As you know, we all get

about 5 minutes each, but I am sure you have longer statements

which will automatically be included in the record.

Mr. Harrington, why don’t you proceed?

STATEMENT OF JOHN HARRINGTON, ACTING INTERNATIONAL

TAX COUNSEL, U.S. DEPARTMENT OF THE TREASURY, WASHINGTON, DC

Mr. HARRINGTON. Mr. Chairman, Ranking Member Grassley, and

distinguished members of the committee, thank you for the opportunity to participate this morning and discuss the serious problem

of offshore tax evasion.

I have a written statement that I would request be made part

of the record, and I would like to offer some oral remarks.

My name is John Harrington, and I am Acting International Tax

Counsel at the Department of the Treasury. The Treasury Department is very concerned about the use of offshore jurisdictions to

evade U.S. tax. We have been aggressively pursuing abuses, and

we intend to continue doing so.

5

At the same time, we have sought to target our efforts on the

sources of abuse and ensure that we do not overreact, especially in

a way that hinders legitimate cross-border trade and investment

activities, which are so critical to U.S. businesses and U.S. jobs.

A one-size-fits-all approach will not work in stopping offshore tax

abuse while still permitting legitimate cross-border transactions.

This is why the Treasury Department has undertaken a multifaceted approach to deal with the problem of offshore tax evasion.

In my written statement, I describe the actions we have taken

and continue to take, especially regarding information exchange, to

deal with this difficult but important issue. This has been a longterm problem, and we must continue to take a realistic, long-term

view in combatting offshore tax evasion.

While the determined tax evaders may flaunt the tax rules, some

taxpayers opportunistically seek to take advantage of ambiguous or

outdated tax rules. Accordingly, we modify or update U.S. tax rules

when we determine that they are facilitating abuse.

For example, in the last few months we have issued three sets

of regulations dealing with misuse of the Foreign Tax Credit. We

have issued significant guidance in the area of transfer pricing,

dealing with cross-border services and cost sharing. We have also

addressed other abuses, such as those involving private annuities.

In most cases, however, the problem of offshore tax abuse lies not

with our tax rules, but with attempts to hide from them. Accordingly, to enforce our tax laws, we have to exchange information

with other countries.

In today’s global economy, countries must be able to obtain and

exchange the information needed to enforce their domestic tax

laws. Because access to information from other countries is critically important to the full and fair enforcement of U.S. tax laws,

information exchange is a priority for the United States in its tax

treaty program.

In cases where a full tax treaty is not appropriate or feasible, the

Treasury Department seeks to provide for the bilateral exchange of

tax information by entering into a Tax Information Exchange

Agreement, or TIEA, with the other country.

There are three basic types of information exchange: on request,

automatic, and spontaneous. Our tax treaties typically provide for

broad information exchange and do not limit the form or manner

in which information exchange can take place.

My written testimony describes the information exchange article

that we seek in tax-treaty negotiations and the items that are essential to the United States when negotiating a TIEA.

The United States is not the only country that has encountered

the problem of offshore tax evasion, but it has been a leader in increasing worldwide standards of information exchange to combat

such evasion.

We have worked with other countries, particularly through the

OECD, to raise international standards on information exchange.

The improvement in the quality of the information available for exchange is one of the most important developments in the last few

years.

The adoption of high standards of international information exchange facilitates our ability to obtain the information we need,

6

thereby promoting the sound and effective administration of U.S.

tax laws.

Successes in information exchange do not come overnight. We

have access to the information that we have today due to years of

patient negotiations and cultivation of information exchange relationships. Moreover, new efforts today may not bear fruit until

years from now. For that reason, we are committed to a multi-year

approach to expanding our information exchange network.

Because this is an area where steady pressure is essential and

missteps or overreaching can undo years of work, we have to be

careful not to disrupt the steady progress we have made.

It is also important to remember that information exchange is inherently voluntary. We cannot force any country to agree to exchange tax information, and a healthy information exchange relationship requires us to maintain good relations with our treaty and

TIEA partners.

We have more to do in this area. Nonetheless, we have made

great strides in recent years. Several new TIEAs have entered into

force, with jurisdictions that have figured prominently in prior documented accounts of offshore tax evasion.

Within the last 2 years alone, TIEAs have fully entered into force

with the Cayman Islands, the British Virgin Islands, the Bahamas,

the Netherlands Antilles, Jersey, Guernsey, and the Isle of Man.

We also recently signed a TIEA with Brazil, and the recently

signed tax treaty with Belgium provides greater information exchange than we previously have been able to achieve with that

country.

Although we are limited in what we can say about use of specific

TIEAs, I note in my written testimony public examples of highincome individuals whom we were able to catch, in part, through

the use of a TIEA.

As both Secretary Paulson and Assistant Secretary Solomon have

stated in recent testimony before this committee, the Treasury Department is committed to improving compliance without unduly

burdening honest taxpayers who currently meet their tax obligations.

Tax compliance with respect to offshore transactions is an important aspect of that endeavor. By focusing on information exchange,

we seek to reduce offshore tax evasion while achieving these goals.

Thank you again for the opportunity to appear before this committee today. I would be pleased to answer any questions that you

have.

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

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

The CHAIRMAN. Mr. Owens?

STATEMENT OF JEFFREY OWENS, DIRECTOR, CENTER FOR

TAX POLICY AND ADMINISTRATION, ORGANIZATION FOR

ECONOMIC CO-OPERATION AND DEVELOPMENT, PARIS,

FRANCE

Mr. OWENS. Chairman Baucus, Senator Grassley, and members

of the committee, it is an honor to be here today. I have submitted

a written statement for the record.

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Clearly, offshore tax evasion is a complex problem which requires

a response at a number of levels: at the level of the administration,

at the level of legislation, and also at the international level.

Just how big is the problem of offshore tax evasion? The honest

answer is, we do not know, in part because of the secrecy that surrounds so many of these jurisdictions that engage in it. But our

discussions at the OECD have shown that this is a big problem,

and we believe it is growing. Today there are $5 to $7 trillion of assets held offshore, and the

number of tax havens has tripled over the last 3 decades. Of

course, much of this activity is legitimate activity, but the experience of tax administrations around the world is that part of this

money is there to evade taxes.

Let me give you some examples. Ireland has recently collected $1.2 billion of revenue from Irish residents that use offshore accounts. That is roughly 30 percent of the tax that was paid by selfemployed taxpayers in Ireland, a very significant figure. South Africa estimates that it is losing something like $9 billion

to tax havens. Offshore evasion leads tax cheats to off-load their

taxes onto honest taxpayers and undermines the fairness and the

integrity of our tax system. It distorts competition and it constrains

the freedom of governments to design a tax system which reflects

their own values.

It was in this context that the OECD member countries launched

two initiatives. The first was in 1996 to work on tax havens, and

the second was work which led, in 2000, to a new international

standard on access to bank information for tax authorities, essentially, the United States’ standard.

Given time constraints, I will focus on the tax haven work. The

starting point for this initiative was to develop four objective criteria to identify tax havens. First was that a tax haven should

have no or nominal taxation, although, let me emphasize, this is

never, by itself, sufficient to characterize a country as a tax haven;

the second was that a jurisdiction lacks real activities; third, that

it lacks transparency; and fourth, and perhaps the most important,

it lacks effective exchange of information.

We spent 2 years using these criteria to draw up the OECD 2000

list of tax havens. At that point, the dialogue with these jurisdictions intensified and, by 2002, more than 30 of the havens had endorsed the standards and agreed to implement them, primarily by

means of information exchange agreements.

There were, however, five jurisdictions—Andorra, Liberia, Liechtenstein, Monaco, and the Marshall Islands—that refused to engage in this dialogue, and these were placed on the OECD list of

uncooperative tax havens.

In 2006, we evaluated how 82 on- and offshore financial centers

measured up to these standards. The survey showed, in this book

here, that, while significant progress had been made, some countries had a long way to go to meet these standards. Panama,

Nauru, and Guatemala had no access to bank information for tax

purposes. Cyprus, Hong Kong, and Singapore are severely constrained by their domestic tax interest requirements.

But the survey did show that an increasing number of offshore

jurisdictions are engaging constructively in this process, and today

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we have 21 tax information exchange agreements around the

OECD area.

So we are progressing, but I think we need to speed up the process of change, first by encouraging countries to complete the negotiations that are under way—there are roughly about 40 negotiations that are currently being carried out—and also, convincing

those jurisdictions that are refusing to negotiate, that it is in their

long-term interests to engage in this process.

We also need to convince those jurisdictions that have asked for

double taxation treaties that it is hard to justify giving them the

full double taxation treaties when they do not have an income tax

system. And certainly we must also encourage countries that are

not getting engaged in this dialogue, like Singapore and some of

the uncooperative tax havens, to do so.

Second, I think governments need to provide tax authorities with

the tools and the resources to mount effective campaigns against

offshore evasion.

Lastly, the international community should stand ready to help

some of the smaller jurisdictions to diversify their economies away

from financial activities that are dependent on tax evasion, and

also to give political recognition to those jurisdictions—for example,

Jersey and Guernsey—that are taking the important, and difficult,

steps to meet these standards and to implement them. They deserve that when they have made the changes that have been asked

of them.

Thank you very much, Mr. Chairman.

The CHAIRMAN. Thank you very much.

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

The CHAIRMAN. Now, Mr. Avi-Yonah?

STATEMENT OF PROF. REUVEN S. AVI-YONAH, IRWIN I. COHN

PROFESSOR OF LAW, UNIVERSITY OF MICHIGAN LAW

SCHOOL, ANN ARBOR, MI

Mr. AVI-YONAH. Thank you very much, Chairman Baucus.

The CHAIRMAN. Could you pronounce your name, please, so I

make sure I get it right?

Mr. AVI-YONAH. Avi-Yonah.

The CHAIRMAN. Avi-Yonah. Thank you.

Mr. AVI-YONAH. Thank you.

Senator Grassley, members of the committee, it is a real honor

and privilege to be here today to talk with you about offshore tax

evasion. I also have a report that is included in the record.

Nobody knows for sure how much offshore tax evasion there is,

as Mr. Owens just said. What we do know is—this is something

that Assistant Secretary Solomon said recently before this committee—that the enforcement ability of the IRS and the compliance

rate drop dramatically for payments that are not covered by either

withholding or information exchange. That includes both domestic

small businesses, for example, and offshore activities.

There are a few cases that have come to light recently, and

Chairman Baucus, you have mentioned some of them, and Mr.

Harrington had some in his statement. I want to highlight two.

One was that, in 1999, the IRS entered into a plea agreement with

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a single Cayman Islands banker who was caught because of money

laundering activities, not because of tax evasion.

But it turned out that most of the money in that particular bank,

once the depositor list became public, was held by U.S. citizens who

were evading tax, and that single case resulted in over $3 billion

of collection by the IRS, 1,165 cases, with an average of $1.7 million each. So, that is significant money.

The other one is a case that came to light last year as a result

of the activities of the Permanent Subcommittee on Investigations

involving the Wyly brothers that was also mentioned. Part of it

may be arguably legal. It involves something that Treasury is

doing something about, and they made an exchange of options contract on publicly traded U.S. companies for annuities held through

Isle of Man trusts.

But the part that I wanted to emphasize was the fact that, once

that exchange had taken place and the options were exercised, arguably in the hands of the unregistered trusts so there was no U.S.

tax liability, the money was then mostly funneled back into the

United States via the Cayman Islands in order to purchase real estate, and jewelry, and art works, and various other things for the

direct benefits of the people who initially gave the money.

Now, you could argue that this may be legal because if you believe that these trusts are really unrelated, then no laws were violated. The trusts were controlled by a protector who was a friend

and employee, but not formally related under our attribution rules

to the Wylys. They had, as their immediate beneficiary, a European

charity, but as a contingent beneficiary the children of the

grantors. The IRS obviously is looking into that.

But really the key issue here is that it went down to the Caymans in order to benefit from the secrecy that is provided by the

Caymans and not to be covered by the exchange of information

under the U.S.-U.K. treaty which extends to the Isle of Man.

So nobody knows for sure how much of this is going on. Joe

Guttentag and I published a paper a couple of years ago in which

we guesstimated $50 billion of taxes every year as part of the overall tax gap, and that is kind of at the mid-point of estimates that

were done by various other people, like former Commissioner

Rossotti and others. So as an order of magnitude, that may be

about right.

What can be done about it? Well, I think that the suggestions

that Mr. Owens just made are excellent. We should certainly continue to pursue information exchange agreements with all of those

jurisdictions that are currently non-cooperating.

Some other useful suggestions are contained in the bill that was

submitted by Senators Levin, Obama, and Coleman, and I would

urge this committee to take a serious look. One of their suggestions, for example, is for a list of tax havens, similar to the OECD

list. The advantage of that, of course, is that it provides an incentive for tax levies to be taken off the list.

Finally, I should highlight, I do not know if you are all aware,

that current U.S. law already includes a provision that would deny

the portfolio interest exemption, that is, the lack of withholding on

interest payments to jurisdictions that are not effectively cooperating with the exchange of information. I think that is potentially

10

a pretty big stick to wield to encourage other jurisdictions that are

not still cooperative to cooperate in the exchange of information.

Thank you very much.

The CHAIRMAN. Thank you very much. I appreciate that.

[The prepared statement of Mr. Avi-Yonah appears in the appendix.]

The CHAIRMAN. Mr. Brostek?

STATEMENT OF MICHAEL BROSTEK, DIRECTOR, TAX ISSUES,

STRATEGIC ISSUES TEAM, U.S. GOVERNMENT ACCOUNTABILITY OFFICE, WASHINGTON, DC

Mr. BROSTEK. Mr. Chairman, members of the committee, thank

you for inviting me to discuss our work on the time required to

identify and examine offshore tax cases in our review of IRS’s

qualified intermediary program.

As we have heard, offshore cases are difficult, in part, because

IRS does not have jurisdiction overseas. As covered in our report

released today, the median time between a return being filed and

the completion of an offshore examination was almost 500 days

longer than for all non-offshore examinations by IRS.

Although fewer offshore cases resulted in a tax assessment, when

they did, those tax assessments were nearly 3 times larger than for

non-offshore examinations. However, because offshore examinations need to get through to where people are hiding money, the

staff hours involved are higher for offshore examinations and, thus,

the return per staff hour is less.

Due to the 3-year civil statute of limitations, IRS sometimes prematurely ends an offshore examination or declines to open an examination when little time remains, even though the declined case

may have more assessment potential than cases that actually have

more time on the clock.

Congress has created exceptions to the 3-year civil statute of limitations. In some situations, they are similar to the offshore cases,

for instance, when a taxpayer fails to report a listed transaction.

GAO is suggesting that Congress consider a statute exception for

offshore cases in the future.

Congress established the Qualified Intermediary program, the QI

program, in 2000 to help ensure that U.S.-source income paid to

foreign persons is properly taxed. U.S.-source income includes such

things as U.S. and corporate bond debt, stock dividends, and rents.

QIs are foreign financial institutions, like banks, that contract

with the IRS to withhold taxes on U.S.-source income they pay to

their customers and to report certain information to IRS.

The QI program contains features that lead to the QIs being

more likely to properly apply withholding standards than U.S.

withholding agents. First, the QIs are located overseas. They are

more likely to have direct personal contact with their foreign customers than U.S. withholding agents would. That contact should

help them better judge whether the customers are actually qualified for reduced tax rates.

Second, QIs accept enhanced responsibility for ensuring that customers do qualify for lower taxes, such as using documentation

identified by IRS to verify the customer’s identity.

11

Finally, and importantly, the QIs agree to have their operations

reviewed by external parties and the results reported to IRS so

that IRS has some confidence that they are performing well.

Although this program has advantages, weaknesses remain in efforts to ensure that appropriate taxes are paid on U.S.-source income that goes offshore.

First, only 12.5 percent of U.S.-source income is actually handled

by QIs. Second, because corporations are taxpayers under U.S. law,

U.S. persons may be able to avoid taxes from their U.S.-source income if they set up a foreign corporation. This can make it unclear

whether they owe U.S. taxes.

In 2003, nearly 70 percent of U.S.-source income paid overseas

went to foreign corporations. You have all looked at the map that

was put up here. We may be somewhat more assured that U.S. tax

laws are being properly administered in countries with which the

U.S. has a tax treaty.

As the large area on our map shows, about 80 percent of U.S.-

source income went to persons in treaty countries, countries that

we have some confidence are going to apply the law well.

However, small percentages of U.S.-source income, although significant in dollar amount, went to countries that were not even

identified by withholding agents. In 2003, U.S. withholding agents

and QIs reported $19 billion in transactions, with unknown or unidentified jurisdictions. That represents about two-thirds of the

smaller one on the right-hand side of the map. For that $19 billion, about $505 million was withheld for taxes.

We do not know whether a higher withholding rate should have applied, but what we do know is that reduced withholding rates

should not be granted unless the withholding agent has properly

identified the recipient’s residency.

In overseeing withholding agents, IRS does not effectively use

available data. For example, withholding agents annually send IRS

tax returns and information returns on their withholding activities.

Some of these documents are submitted on paper and some are

submitted electronically.

IRS has not always transcribed the paper documents into an

electronic database. Consequently, it has not been able to verify the

accuracy of refund requests at times that withholding agents file.

When IRS did not transcribe the paper returns, they were destroyed a year later, in accordance with their paper retention policies. IRS officials cite insufficient funds for this situation.

Finally, external reviews of qualified intermediaries’ account

opening and handling procedures, while clearly valuable, do not require external auditors to follow up if they come across indications

of fraud or abuse during their audits.

This concludes my summary. I would be happy to answer questions.

The CHAIRMAN. Thank you, Mr. Brostek.

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

The CHAIRMAN. For the information of my colleagues, a vote has

started. I am going to use my 5 minutes right now, then figure out

some way to either adjourn and come right back, or maybe if you

want to, Senator, go now, then you can come back. Thank you.

12

Thank you, gentlemen. I am going to start off by showing you

something. You all have seen this. Basically, this is a picture of a

three-story building in the Cayman Islands which allegedly has

over 12,000 corporations lodged inside, a feat in and of itself. The

assumption is that these corporations are shells, whose sole purpose is to evade U.S. taxes.

The first question is, what conceivable reason could there be for

those companies to go in there, 12,000, if it is not to minimize

taxes? Second, I am going to ask, Mr. Brostek, for you, GAO, to go

down there.

Mr. BROSTEK. All right.

The CHAIRMAN. I want you to go to that building. I want you to

root around, see what you can find.

Mr. BROSTEK. All right. We will do whatever we can.

The CHAIRMAN. All right. Then come back and tell us what you

find, and the degree to which this building is what it is.

Who wants to take a crack at the first question? What are the

legitimate reasons for 12,000 corporations having offices in that

building? Who wants to give me a possible reason? Mr. Harrington,

you are kind of defending the status quo a little bit. You tell us:

what legitimate reasons could there be?

Mr. HARRINGTON. I cannot speak to the number of companies.

The CHAIRMAN. Well, it is a large number.

Mr. HARRINGTON. All right. In terms of the question as to why

one might set up a foreign corporation, the general answer is that

there are some circumstances in which one has to establish a foreign corporation simply to operate in a particular jurisdiction. So,

there could be legitimate reasons.

The CHAIRMAN. Now, what might the legitimate business reason

be?

Mr. HARRINGTON. In most countries, simply to engage in business one would have to set up a foreign corporation. So one question is——

The CHAIRMAN. Why there? Why not someplace else? Why not in

Great Britain? Why not in France? Why not in Singapore? Why

there?

Mr. HARRINGTON. Our focus has been trying to go after what we

consider the illegitimate uses. There may be a variety of business

reasons to set up a corporation.

The CHAIRMAN. Can you give me one? What is a good, legitimate

business reason? I am an American individual. I want to incorporate. I am a company. What is the reason why I might want to

go to this building? Give me an example of the reason, please.

Mr. HARRINGTON. First of all, in the Cayman Islands, or speaking of any particular jurisdiction, there is an infrastructure that exists in which one may engage in business. It is a significant financial jurisdiction.

I think for us, the question really is not just, do you have a company there, but is the income that is being reported for there, putting aside whether there should be a corporation there, if you

are——

The CHAIRMAN. There is no tax. They have no income tax, do

they?

13

Mr. HARRINGTON. No. I mean, from the U.S. standpoint. A lot of

these stories, particularly like in this particular case, the issue

raised was transfer pricing, whether or not the entities that exist,

say, for example, in that building are being used to shift income

out of the United States.

The CHAIRMAN. But transfer pricing is a whole different subject.

That is a whole different issue. That has nothing to do with my

question.

Mr. Brostek, I would just ask you another question. The GAO

says, as I understand it, about $19 billion was missing when you

examined the roughly $300 billion that has moved overseas. As you

know, Joint Tax thinks that figure is much higher, but let us use

the figure that you got from the IRS.

Mr. BROSTEK. Yes.

The CHAIRMAN. What $19 billion is missing? Where is it? What

do you think? What happened to it?

Mr. BROSTEK. Well, in this case it is not that the money is missing. The withholding agents, whether U.S. withholding agents or

qualified intermediaries, have reported to IRS that they paid $19

billion of funds to their customers. What they did not do is identify

the jurisdiction that those customers resided in.

Since the jurisdiction is controlling in many cases in terms of

whether you deserve a reduced break of withholding for tax purposes, not knowing the jurisdiction seems to be a problem in terms

of whether proper decisions were made to reduce the taxes that are

withheld.

The CHAIRMAN. Could you just give us a sense of, how much

leakage is there, in the sense that you have these qualified intermediaries, these transfer agents, and some agreements with some

countries that provide pretty tight withholding, some do not, some

aggregate, aggregate pooling, as you said in your report.

Some say we do not have to audit. I mean, there just seems to

be a large variation among all the treaties and QI agreements and

transfer agent provisions and so forth. Can you give me your sense

of how much leakage that allows?

Mr. BROSTEK. Well, I would have to go with the advice of my fellow panelists here. Actually determining how much leakage there

is, how much tax evasion is occurring internationally, is an extremely difficult endeavor, in large part because we do not know

precisely how much income goes offshore that should have been

subjected to tax. So, I am afraid I cannot give you a figure about

how much leakage there is.

The CHAIRMAN. Let me ask a general question. The world has

changed so much, and is changing so quickly. Money travels at the

speed of light anywhere in the world. It is borderless. The world

is borderless. To many degrees, nations are irrelevant. It is dated,

archaic. There is so much money that goes anywhere, for whatever

reasons. Your thoughts on how we catch up, how we deal with all

that? It seems to me there has to be much more transparency.

On a related subject, I was quite disturbed to read in the Wall

Street Journal, page 1, I think it was Monday, of the proliferation

of hedge funds and private equity, and the concern about leverage,

how much leverage there is in the system today.

14

Tim Geithner, the head of the Federal Reserve system, had to

call hedge funds and other major private equity funds to find out

what the collateral is. I mean, it seems kind of strange that the

president of the Federal Reserve branch has to call up and find out

and ask. There should be some better protection on that subject.

But that is just analogous. It is not really directly on point here.

But how do we get more transparency? What is a better way to

do it? You mentioned, Mr. Brostek, that there is less evasion where

there is more reporting, more withheld, and so forth. But in this

new world, this brave new world we are in, what advice do you

have as to how we catch up? Mr. Owens, you have thought about

this.

Mr. OWENS. I think, in part, the problem you identify is a serious

one, because in a sense it is, how do tax authorities, which must

remain national tax authorities, confront global taxpayers? That is

a difficult issue.

Our answer at the OECD is that the most effective way is by better international cooperation and by promoting high standards,

high standards in the area of transparency and high standards in

the area of exchange of information.

If we can get these jurisdictions to agree on those standards—

and we have up to a point—if we can get them to implement them,

then that means that the tax authorities will have access to the information that they need to enforce their own tax systems. I think

international cooperation is a key way of resolving this potential

conflict.

The CHAIRMAN. Mr. Brostek?

Mr. BROSTEK. We do not actually know to what extent this actually occurs, but from anecdotal evidence a lot of the situations involve individuals in the U.S. who have income that is not reported

to IRS. You gave some examples of businessmen, for instance, who

had taken their money offshore.

So it is not just a matter of meeting transparency internationally, it is also a matter of getting better transparency over the

sources of income of domestic businesses and individuals, because,

if their income is not transparent to IRS, then they can, in essence,

keep two sets of books, and the money that is not revealed to IRS

they can move offshore and make the kind of investments that we

are hearing about.

The CHAIRMAN. I am going to follow up on this, but unfortunately there is a vote going on, and I have just a couple of minutes

left to get over to the floor. When Senator Conrad gets back, he will

resume the hearing. But I am going to have to recess temporarily

until the return of Senator Conrad. Thank you.

[Whereupon, at 10:47 a.m., the hearing was recessed, reconvening at 11 a.m.]

Senator BUNNING. We will return the committee to order. Since

I am the only one here, I will be the one to ask questions first.

First of all, I would like to ask unanimous consent to put my

opening statement in the record. So ordered. [Laughter.]

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

Senator BUNNING. Mr. Avi-Yonah, in your testimony you say

there is currently $50 billion per year in illegal offshore tax evasion

15

or avoidance. You say this figure is an educated guess. I know you

are a very learned man, but this guess is based on some very big

assumptions.

It troubles me that you are willing to make this bold estimate,

while the IRS, which is in a better position to know, is unwilling

to do so. Let us look at how you came up with the number, first.

You say that residents of North America, including Canada, have

$16.2 trillion in assets and hold 10 percent of these assets offshore.

Is that correct?

Mr. AVI-YONAH. Yes.

Senator BUNNING. All right.

Next, you say that the U.S. residents earn 10 percent a year on

these assets and they are not paying any U.S. or foreign taxes. You

say that they should be paying about 33 percent of these supposed

earnings in taxes to the United States, or $50 billion. So you appear to be assuming that just about every American who holds assets outside the United States is breaking the law. Is that correct?

Mr. AVI-YONAH. No, I do not think that is entirely true. This estimate is based on figures that were independently derived by two

investment banks, and they relate to the size of holdings in offshore locations.

Senator BUNNING. That you know of.

Mr. AVI-YONAH. That they know of, yes. And I think that what

is fair to say is that, while U.S. law clearly requires U.S. taxpayers

to disclose offshore bank accounts, for example, and holdings in foreign corporations that earn primarily passive assets and similar

types of foreign holdings, the numbers that you get as to how much

is actually held and reported to the IRS are significantly lower

than $1.5 trillion.

So while it is, I think, fair to say that there are Americans who

honestly report offshore holdings and pay tax on them, the fundamental question which I think was reflected in the Chair’s question

before is, what is the reason to hold passive-type assets offshore if

not for tax evasion?

I mean, there may be other reasons, regulatory reasons or other

reasons, but I think that the figure that we came up with—yes, it

is, as I said, just an educated guess—but it is in the ballpark of

other figures that other people have guessed from different sources.

Senator BUNNING. It could be, our tax code is fairly complicated

and that may be a reason to put assets offshore.

Mr. AVI-YONAH. Yes. But that clearly does not allow people not

to report income to the IRS.

Senator BUNNING. No, no, no. I am not condoning the fact that

they do not report their assets. I am just saying that sometimes the

tax code is so complicated that it allows people to put assets offshore and requires them to report those assets.

Mr. AVI-YONAH. True. The tax code certainly allows people to put

assets offshore. It even allows people to carry luggage full of cash

offshore if they want to. They are just supposed to say if they do

that. The question is, how many people actually say it?

Senator BUNNING. A follow-up question.

Mr. AVI-YONAH. Yes?

Senator BUNNING. In your written testimony you stated that the

IRS faces an increased workload and not enough staff to keep up

16

with it. I would like to share a statistic with you from a column

that appeared in the Wall Street Journal last month.

The IRS currently has 100,000 agents. That is more than the Environmental Protection Agency, OSHA, and the FDA combined.

Would lowering tax rates and a simpler tax code not be a more effective means to achieve tax compliance than what you propose?

Mr. AVI-YONAH. Well, certainly I would be the last person to

argue—and I have written a lot about simplification—that we

should not simplify the tax code, and certainly if we had a simpler

tax code it is conceivable that we could reduce the size of the IRS

and the size of enforcement, although I do not think we will ever

get to a tax return on a postcard like has been suggested for some

extreme cases.

But nevertheless, I think there is no question that part of the

problem that the IRS has results from the fact that Congress has,

I think, pretty consistently—certainly since 1986—been making the

tax code more and more complicated than not, given its adequate

resources.

But what this hearing is about, and what my testimony is about,

is whether the IRS is able to enforce existing law given the resources that it has. In my judgment, they have serious problems

in doing that.

Senator BUNNING. Thank you.

Mr. Owens, is it true that employees at the OECD get tax-free

salaries? I have heard a rumor that the OECD even has its own

wine cellar. I do not see how an organization that evidently competes for its workers with tax-free salaries can criticize nations

that compete for capital with favorable tax policies.

Would you like to comment on this?

Mr. OWENS. Thank you, Senator. Yes. In fact, our salaries are

tax-free, but I can assure you that I could certainly increase my

salary by a factor of three if I moved to the private sector.

The wine cellar. We do not have a wine cellar at the OECD, but

we do have access, in fact, to the excellent French wines that you

can buy around the Paris region.

Senator BUNNING. And those are a matter of conjecture whether

they are better than California, Napa Valley, and all those that we

very much enjoy here in the United States.

Last question. As a person who is accountable to the people in

my State every 6 years for shaping tax policy, I have a real problem with an international organization setting standards for our

domestic tax policy, whether that is the OECD or the United Nations. Mr. Owens, is the OECD’s role as an international tax standard setter anti-democratic?

Mr. OWENS. I certainly hope not, Senator. We see our job, in fact,

as trying to help countries design their own tax systems to reflect

their own social, economic, and political values. I think what the

OECD does is to put a range of options before countries.

Then it is up to them to decide, what are the best policies in

their own context. That, I think, is something that we have now

done for 50 years. In many cases we have also, in fact, been able

to share best practices.

17

I like to think that one of the roles the OECD has had over the

last few years is taking out some of the best practices here in the

United States, particularly in the area of exchange of information.

Senator BUNNING. Mr. Chairman, I have exceeded my time, so I

would turn it back to you.

The CHAIRMAN. Thank you, Senator.

I am just curious what leverage we have. Mr. Avi-Yonah, you

said maybe there is some leverage that we have in some companies

by denying the withholding exemption from companies, perhaps,

that are not conforming, that is, countries that are tax havens or

just do not want to share information and so forth.

It gets a little bit to Mr. Owens’s point earlier. I think you said,

Mr. Owens, you identified 58 countries as tax havens, and most are

committed to addressing the problem of offshore tax evasion. However, there are 5 countries out of the 38 that are unwilling to work

with the OECD.

So how do we get countries to report? What leverage do we have?

Either of you can respond.

Mr. AVI-YONAH. Well, first, one important point, I think, in the

background of all of this relating to a previous question is that the

people who avoid taxes this way live in OECD member countries.

They live in the U.S., they live in the EU.

Their investments are also going to OECD member countries.

You do not leave the money in the Caymans unless you really are

a criminal, and then you are paying a negative tax rate for the

privilege of leaving your money in the Caymans. The money goes

into the Caymans and then it goes out.

The current situation is that we Americans can put our money

in the Caymans and invest it, let us say, in Europe, and European

tax enforcers, therefore, will not cover that because it only applies

to Europeans. Similarly, our tax enforcement efforts generally only

apply to Americans and they do not apply to Europeans putting the

money into the United States.

That is part of maybe healthy competition to capital, but fundamentally I think the whole tax haven issue could be addressed

if we cooperate more with the other rich countries in the world

through the OECD, because that is where the money has to go to.

If everybody, for example, agreed that all payments that go to

non-cooperating tax havens will be subject to X percent withholding

tax, then I think the problem could be resolved tomorrow. That

maybe will not happen, realistically, because we have to balance

that with our need to attract capital from overseas.

Nevertheless, I think that there are things that we can do in

order to increase the pressure. First of all, let me say I have also

located, using carrots first rather than sticks—and this is also

something that Mr. Owens mentioned—it is quite reasonable to say

that some of these countries rely heavily on the offshore sector for

their economic development and that we should consider ways of

making it easier for them to do other things, like free trade and

other things that they produce and other forms of aid. The EU actually puts out proposals like this on the table.

But we should also take into account the stick. The particular

stick that I mentioned is the fact that current law permits us to

suspend the payment of interest with no withholding, which now

18

applies to anybody in the world no matter where they are or where

they live.

Our current concern has to do with Americans setting up corporations in tax havens and then taking benefits from that, which

is, of course, illegal, but who is to know in the absence of information?

In those kinds of situations where a country will not tell us who

the beneficial owners of these corporations are, I think we should

seriously consider not allowing them to benefit from the withholding free flow of interest.

If you look at the numbers in the GAO report, you will see that on maybe $300 billion of flows from 2003, we collect an effective

tax rate of maybe 3.5 percent, which is mostly due to legal, legitimate exemptions that we have decided to put into the code. But

certainly it suggests how much money is flowing out.

And to the extent that some of this is going to Americans who

are hiding behind offshore corporate shells, I think that it is our

obligation to honest taxpayers who pay their taxes to do something

about it.

The CHAIRMAN. Now, my question is, I do not understand, in this

race to the bottom to some degree among various jurisdictions to

attract capital, et cetera, is that necessarily inconsistent with more

information reporting? I do not think that it is.

Mr. AVI-YONAH. No, I do not think it is either.

The CHAIRMAN. And there are four. I am a little bit perplexed as

to why OECD and the United States cannot work with other jurisdictions to have some kind of agreements on transparency. There

is a lot of transparency, even though some jurisdictions still want

to have lower tax rates in order to attract capital. The two are not

inconsistent, are they? Or are they? Mr. Owens, you are at OECD.

What do you think?

Mr. OWENS. Well, I think it is very important to distinguish between low-tax jurisdictions and tax havens.

The CHAIRMAN. Right.

Mr. OWENS. In low-tax jurisdictions it is a fact of life. Today we

live in a very competitive environment. One way in which countries

compete for mobile capital is by lowering their tax rates. That is

very different, though, from where a country competes by saying,

you come here and we offer you the secrecy that your home tax authorities will not be able to know how much assets you have here

and will not be able to know how to tax you.

The CHAIRMAN. Exactly.

Mr. OWENS. How do you deal with this problem? I think part of

the way is to get a buy-in from the tax havens to make them feel

that they are part of the international framework, to make them

feel, in fact, that they are part of the process by which we set the

standards.

That is what we have been trying to do over the last 6 years, to

say to them, come and join us, come engage in a dialogue. As a result of that dialogue, we actually now have what I think are very

high standards of transparency. We also have high standards with

respect to the exchange of information.

The means by which we are enforcing those is by bilateral tax

information exchange agreements. There, frankly, I think the

19

United States has led the world. So we need to work harder on

that. How do we deal with the five jurisdictions that have said,

well, we do not want to have that dialogue with you? I think we

just keep coming back to them, saying, do join us, come talk with

us.

Three of them actually came down to our Global Forum meeting

in Melbourne in 2006. They did not endorse the standards, they did

not say they were ready to engage in exchange of information, but

at least they were there at the table.

I think one way that the United States can help us is by passing

a very strong message to these jurisdictions and to some of the jurisdictions that are saying, well, we are not sure we want to go

down this process, we are not sure we want to have exchange of

information.

If you can say to them, look, exchange of information is very important for us, it is something we care a lot about because that is

the only way that our tax administration is going to be able to administer the U.S. tax system in a fair and effective manner.

The CHAIRMAN. So what would that strong message be?

Mr. OWENS. Sorry?

The CHAIRMAN. What would that strong message be? You said

we should send a strong message. What would that be?

Mr. OWENS. I think it is important to say that you would expect,

when negotiations begin, that they are completed in a relatively

short period of time. I think you can look at the experience of other

countries—for example, Canada—which have put in certain carrots

and sticks, the carrots being that if you engage in this exchange

of information then you would get some of the benefits that would

normally be available under a full double taxation treaty. So I

think it is important to keep this balance between the carrots that

you offer, and the sticks that are there as well.

The CHAIRMAN. But what is the incentive for a country that is

a haven, not cooperating, attracts lots of investment right now because of its secrecy provisions, people like it? What is in it for

them?

Mr. OWENS. For what I call the more mature offshore jurisdictions, they are interested in engaging in legitimate business, and

they know that, if they want to attract legitimate business, that

business will not go there unless they have strong reputations.

One of the reasons that we now have over 30 countries that have

endorsed these standards is that, by doing so, they are saying to

the world, we want to be players in this, we are prepared to play

by the same rules, and we are open for legitimate business.

The CHAIRMAN. Thank you.

Senator Conrad?

Senator CONRAD. Thank you, Mr. Chairman. And thank you very

much for holding this hearing. I think it really is important. It is

especially important to the vast majority of taxpayers in this country who are honest, who are paying what they legitimately owe.

That burden is getting shifted to them by the growing number of

people who are not, and the growing number of companies that are

not.

Let me put up a first slide that talks about what the Permanent

Subcommittee on Investigations has told us. They have told us that

20

the total loss to the Treasury from offshore tax havens approaches

$100 billion a year, including $40 to $70 billion from individuals—

Mr. Avi-Yonah, I think that is very much in keeping with your estimate of $50 billion on the individual side—and another $30 billion

from corporations engaging in offshore tax evasion. They go on to

say, abusive tax shelters add tens of billions of dollars more.

Let us go to the next slide if we could. This is a picture I have

shown before of a building in the Cayman Islands, a 5-story building there that is home to 12,748 companies.

This is the most efficient building in the world. It is quite remarkable that all this business activity is occurring out of this little 5-story building down in the Caymans. They are not engaged

in business activity out of this building, they are engaged in tax

avoidance out of that building.

Let us go to the next slide. We went on the Internet. It is amazing what you can find on the Internet. Tax havens. You punch it

in. Offshore tax planning. Punch it in. You get 1,250,000 hits. My

favorite is this one: ‘‘Live Tax Free and World-Wide on a Luxury

Yacht.’’ ‘‘Moving Offshore and Living Tax Free Just Got Easier.’’

‘‘Exciting stuff,’’ they say. I will tell you, there are hundreds of

these out on the Net. So I think, Mr. Avi-Yonah, your estimate of

$50 billion on the individual side, the estimates of the Permanent

Committee on Investigations that it is a total of somewhere in the

range of $100 billion a year—let me just say, a man, after I made

this speech on the floor of the Senate, called me anonymously, described himself as a senior member of a major accounting firm.

He said, Senator, you’ve just got the tip of the iceberg. He told

me, this is much larger than anybody understands. He said, in the

last 5 years this has absolutely exploded and that because of a lack

of real information reporting, we do not really understand the magnitude of it.

Mr. Avi-Yonah, do you think that could be the case?

Mr. AVI-YONAH. Yes, I do. I mean, I think fundamentally the

problem is, as was mentioned before, we do not really know how

much of this is going on. There are lots of reasons to suspect that

a lot of it is going on. Every time that somebody talks or divulges

information, every time the IRS catches somebody based on the existing enforcement efforts, we discover that the problem is larger

than what we have thought.

I think that there is every reason to assume, as you say, that

this is just the tip of the iceberg, and that every dollar that we invest in additional enforcement efforts will generate many, many

more dollars in return, just enforcing existing law and nothing else.

So I think this is fruitful, maybe, or possibly even more fruitful

than some of the corporate tax shelter activities which, unfortunately, involve much more complicated transactions and, therefore,

are more difficult for the IRS to enforce. Here it is just a question

of discovering what is actually going on.

Senator CONRAD. Let me just follow that up because you mentioned more resources. This is a story from the May 3 New York

Times: ‘‘The Internal Revenue Service is curtailing audits of many

people who use offshore tax havens, even when agents see signs of

tax evasion, because agents fear they can’t meet a 3-year deadline

21

for finishing an examination, Congressional investigators have

found.’’

This story goes on to talk about how the Boston Consulting

Group has identified that residents of the United States, individuals as well as corporations, are holding $1.5 trillion outside the

country. One and a half trillion. That is real money.

I would ask, Mr. Brostek, is it true that you found in your examination that IRS is backing away from audits of people who are engaged in offshore tax havens because they fear they cannot meet

the 3-year deadline?

Mr. BROSTEK. Yes. The agents did tell us that. We do not know

how often that is the case, but the agents said that there are certainly cases where, with the 3-year statute, if they are not sure

that they are going to be able to prove fraud, if they are not sure

that they are going to prove a substantial under-statement of income, they may very well close that case out with a smaller assessment than they think they could get, or not even start a case when

it is getting close to the 3-year deadline because they do not know

they are going to be able to complete it.

Senator CONRAD. My time is about expired, but just a final note

on that point. The GAO found the average audit of people with

money offshore turned up twice as much in unpaid taxes as audits

of people inside the United States.

The average assessment of unpaid taxes tripled, to $17,500 for

the limited number of audits that were allowed to run longer than

3 years, and it shot up to nearly $100,000 for the small number allowed to run 5 years. Are those your numbers?

Mr. BROSTEK. Yes, they are.

Senator CONRAD. Thank you.

The CHAIRMAN. Thank you. Thank you, Senator.

Senator Bunning?

Senator BUNNING. Mr. Brostek, I would like to follow up on Senator Conrad’s questions. In your statement, you recommended extending the 3-year statute of limitations on tax assessments for

taxpayers involved in offshore financial activities. Is that correct?

Mr. BROSTEK. Yes.

Senator BUNNING. I have a few questions about the proposal.

How would you define ‘‘offshore financial activities?’’ Would it

apply to ordinary investors in overseas stock markets?

Mr. BROSTEK. Our report did not go to the point of actually defining the specific universe that would be subject to it. We saw that

as something that needed to be worked out in consultation with the

Department of the Treasury.

Senator BUNNING. It would be defined by the Department of the

Treasury what an ordinary financial activity would be?

Mr. BROSTEK. Yes.

Senator BUNNING. All right.

How long would the statute be extended?

Mr. BROSTEK. That is a design issue that Congress would need

to make a decision on. There are lots of different options for how

this might be done. One might be to simply toll the statute, or stop

it from running, during the period of time while IRS is waiting for

a taxpayer to respond to an inquiry.

22

That way, IRS would have the pressure to work the case efficiently while their clock was running and they would not have it

counted against them when the taxpayer was failing to respond.

Senator BUNNING. And finally, without a solid estimate of the

amount of illegal offshore tax avoidance, how do we know how

much money would be saved by the Treasury with this extension?

Mr. BROSTEK. We do not know how much would be saved. I

would point out that you could think of this as an equity issue. If

you were a taxpayer who has made a relatively innocent mistake

on your tax return and you were not trying to hide anything, you

have a 3-year period in which IRS can come and audit you. If you

are a taxpayer who is setting up elaborate structures to hide what

you are doing, you have exactly the same amount of time for IRS

to come and get you.

Senator BUNNING. Let me ask you, we had a hearing—I do not

know when it was, Mr. Chairman—where we talked about the diminishing returns. The more people you put on trying to find tax

cheats, you get to an 85, 86, 87 percentile, and then as you spend

money to catch the last 13 percent, there are diminishing returns.

You are going to pay more money than you will get back in. Are

you agreeing or disagreeing with that?

Mr. BROSTEK. I absolutely agree with that proposition. I do not

know that that would immediately apply in the cases that we are

talking about. For instance, in a number of the cases for IRS, they

uncover a practice that has been going on for a number of years.

If they are able to get that defined and proven for 1 year, there

is probably not a whole lot of additional effort that they need to

prove the year before, or the year before, but those might be excluded from their purview because of the statute.

Senator BUNNING. Because of the time limit.

Mr. BROSTEK. Correct. So I think that the flexibility of having a

longer statute would allow IRS to make better decisions to maximize the return on their work.

Senator BUNNING. Do you think 100,000 people examining tax

returns is enough? How does Treasury or the IRS come to a reasonable conclusion on that number?

Mr. BROSTEK. Well, that is certainly something that has to be

balanced against an awful lot of considerations, including other demands for Federal funds. I would point out, though, that it is not

100,000 people who are investigating tax returns.

Senator BUNNING. No.

Mr. BROSTEK. A significant portion of IRS personnel are not engaged in the auditing operations.

Senator BUNNING. No, they are not.

Mr. BROSTEK. I believe it is somewhat less than half of the staff

who are actually engaged in the examination process.

Senator BUNNING. Thank you, Mr. Chairman.

The CHAIRMAN. Thank you, Senator.

I would like to just focus a little bit on, again, what we do to help

encourage countries to become part of the system. The New York

Times published an article last week on Singapore’s efforts to become a tax sanctuary for the wealthy. What can we do, an OECD

country or the United States, to bring Singapore in to the system?

23

Mr. AVI-YONAH. Singapore has a real tax system. It is not a traditional tax haven. In Mr. Owens’s distinction, it is a country that

has some taxes, even income taxes, on its own citizens—low ones.

I think in that kind of context, there is something to draw them,

for example, negotiating a tax treaty. Because if you are a Singapore businessman who actually lives in Singapore, there is much

more to be gained from having a tax treaty with the United States

than trying to attract people who do not live in Singapore, who

have nothing to do with Singapore, to put their money there in

order to hide it. Then they will be able to balance the two positions.

What is better for them, to help their own people or to try to attract money from overseas?

The CHAIRMAN. Then why do you suppose Singapore has not

opted in?

Mr. AVI-YONAH. Well, at the moment they seem to think that

they can benefit from the fact—this is what they advertise—that

they are not subject to either the EU or the OECD efforts.

The CHAIRMAN. Mr. Owens?

Mr. OWENS. I would agree with that. In fact, we have been having a dialogue with Singapore over the last 2 years. Again, Singapore actually came to the last Global Forum in Melbourne, but they

have not endorsed the standards.

It is significant, when you look at Singapore, that they are now

the third-largest private banking center in the world, after Luxembourg and Switzerland. So, we do need to engage Singapore in this

dialogue.

Part of the problem that you have with Singapore is that it has

a combination of bank secrecy—quite strict bank secrecy—and

what we call a domestic tax interest, that means that, if a country

could not show that there was Singapore tax at stake, Singapore

could not respond to a request for——

The CHAIRMAN. Say again. I did not understand that.

Mr. OWENS. If, for example, the United Kingdom asked Singapore, under its tax treaty, to help it investigate a case of tax fraud

or tax evasion, Singapore could only respond to that request if

there was Singapore tax, itself, at stake. In other words, it would

not be enough that just U.K.’s taxes were at stake. That is a very

serious limitation.

The CHAIRMAN. So what do we do, again? I am asking the question again. Mr. Harrington, you are raising your hand over there.

Mr. HARRINGTON. Thank you, Mr. Chairman. I think you raised

specific issues with respect to Singapore, and obviously Singapore

is certainly a country with which we would like to enter into an

information-exchange relationship. We have certainly had discussions in that regard. But I think to a certain extent, this circles

back to the carrot-and-stick discussion. I think it might be helpful

to draw distinctions, say, for example, in the tax-treaty context

where a tax treaty is effectively a carrot. I mean, each country derives reciprocal benefits when we enter into a tax treaty with another country. We are dealing with preventing double taxation and

reducing withholding rates. I do not think we necessarily would

need some sort of carrot for the information exchange that we get

through tax treaties. The treaty itself is an inherent carrot.

24

The issues that are really coming up are with respect to jurisdictions with which we would not enter into a tax treaty, either because there is not significant double taxation or they do not have

an income tax system.

That has led to, at least what the U.S. has taken historically, the

approach of a tax information exchange agreement, which seems to

have caught on in the rest of the world as well. We have been successful in negotiating these, at least recently.

There is an existing carrot, for example, for tax information exchange agreements, so at least with the Caribbean and Central

American countries, there is a convention benefit you get to deduct.

There is a greater ability to deduct the cost of attending conventions.

The CHAIRMAN. Do we have a treaty with the Cayman Islands?

Mr. HARRINGTON. We have a tax information exchange agreement with the Cayman Islands.

The CHAIRMAN. And can you describe that agreement, please?

Mr. HARRINGTON. It is an agreement that deals with the exchange of tax information. It allows us to get information with respect to both criminal and civil matters. It prevents the Cayman

Islands from using bank secrecy or domestic tax interests. It basically allows us to get the information that we need.

The CHAIRMAN. Do we utilize that? My understanding is that, to

some degree, IRS is not doing all that they can do.

Mr. HARRINGTON. Yes. And I think, often, this is a little bit of

an issue based on the era and time in which people look. For example, the TIEA with the Cayman Islands just entered into full effect

within the last 2 years.

It entered into force with criminal matters, I think in the beginning of 2004, and with civil matters, at the beginning of 2006. So

on a going-forward basis, and certainly from 2004 and 2006, we

have access to information with respect to the Cayman Islands.

The CHAIRMAN. What about other havens offshore?

Mr. HARRINGTON. All right. We have 22 tax information exchange agreements. Just within the last 2 years, the TIEAs have

come online with the Cayman Islands, the British Virgin Islands,

the Isle of Man, Jersey, Guernsey, and the Netherlands Antilles.

We have had one with Aruba. We have an existing one with Bermuda. We have significant numbers of these.

The CHAIRMAN. Are you satisfied with the terms of those exchanges? Should it be tighter? Would you like more information?

Should the U.S. have more information pursuant to those exchange

agreements?

Mr. HARRINGTON. Well, I think, first of all, the agreements themselves, the text of the agreements, follow our recent model, so they

are what we want. Some of these TIEAs have come online recently.

We have used, and will continue to use, all of our TIEAs with

major offshore financial centers that I described. It is a new relationship. We have been satisfied with the exchanges so far, but

they are new, so over time you have to sort of sit back and take

another look.

The CHAIRMAN. What is Treasury’s estimate on the amount of

U.S.-source income that goes overseas?

25

Mr. HARRINGTON. It goes back to the debate we had about how

much offshore——

The CHAIRMAN. No. I am asking Treasury. I am asking Treasury’s number.

Mr. HARRINGTON. We do not have a specific number with respect

to offshore evasion.

The CHAIRMAN. I am not talking about evasion. I am talking

about U.S.-source income that goes offshore.

Mr. HARRINGTON. I do not have that with me.

The CHAIRMAN. GAO says roughly $300 billion in their analysis,

and Joint Tax thinks it is $400 billion. Is that correct?

Mr. BROSTEK. The $300 billion is U.S.-source income that withholding agents have reported as from offshore.

The CHAIRMAN. Have reported. So, just that. So Treasury does

not have a number?

Mr. HARRINGTON. Senator, I would have to get back to you. It

would depend on the definitional issues. Are we talking just about

cross-border payments, for example, of interest and dividends, what

we call FDAP, the fixed or determinable——

The CHAIRMAN. I am trying to determine whether Treasury has

a handle on this or not. That is my question. It sounds like Treasury does not.

Mr. HARRINGTON. There is a tremendous amount of reporting

that does take place. I just wanted to give you a more precise number.

The CHAIRMAN. All right. In Mr. Brostek’s terms, you have $300

billion of U.S.-source income that is subject to withholding. Is that

correct?

Mr. BROSTEK. It was not all subject to withholding. That is the

total amount of income that withholding agents had passed

through them through their customers.

The CHAIRMAN. Passed through. All right.

Mr. BROSTEK. Not all of that was even properly subject to withholding.

The CHAIRMAN. All right.

Mr. BROSTEK. And that was from 2003, sir.

The CHAIRMAN. All right.

So, Mr. Harrington, does that sound about right based upon your

numbers?

Mr. HARRINGTON. I do not have the numbers in front of me.

GAO’s number sounds reasonable.

The CHAIRMAN. Does Treasury have numbers?

Mr. HARRINGTON. I do not have those numbers with me.

The CHAIRMAN. But does Treasury have numbers, even though

you do not have them before you?

Mr. HARRINGTON. I am sure that we do. I just do not have them

with me.

The CHAIRMAN. You are sure they do? You do not know that they

do?

Mr. HARRINGTON. If I do not have them with me, I simply cannot

say that——

The CHAIRMAN. I guess the real question is, obviously, your department has to get a handle on this. That is, how much U.S.-

26

source income is going overseas, what is the character of it, is income tax properly paid on it, and so forth.

I think Mr. Avi-Yonah estimated it is about $50 billion a year is

evaded, or $50 billion worth of tax evasion a year. Does Treasury

have a number on that subject? How much?

Mr. HARRINGTON. We consider the international portion to be

part of the basic tax gap number.

The CHAIRMAN. So what is the tax gap number attributable to

offshore evasion?

Mr. HARRINGTON. I do not think we have a separate breakout.

The CHAIRMAN. Why don’t you? Mr. Avi-Yonah has one.

Mr. HARRINGTON. I think the short answer——

The CHAIRMAN. You have more resources, I think, than he. I am

not sure about that, but that is my guess.

Mr. HARRINGTON. I think part of the issue, from a focus

standpoint——

The CHAIRMAN. And his are estimates. He is saying that is the

median. Do you have estimates?

Mr. HARRINGTON. Our focus has been, instead of on particular estimates, on situations where we see evasion, when we see particular abusive transactions, and going after those. This is an area

where we are learning, through our tax information exchange

agreements, to share information with other countries. We have

talked about sorts of bilateral exchanges. There is also a cooperative aspect.

The CHAIRMAN. But how can you know whether you are making

any progress if you do not know the amount of the problem?

Mr. HARRINGTON. In terms of how we know we are making

progress, for example, we issued some proposed regulations shutting down a particular foreign tax credit generator transaction. We

learned about that transaction from some other countries. They

had encountered that, and they shared the information with us.

We issued proposed regulations that we believe will effectively

eliminate what we think is a substantial amount of revenue loss.

So even in situations where there are questions as to what is the

proper baseline, the information that we learn, whether it is

through a bilateral exchange or through other types of cooperative

arrangements, we do use that.

We do not necessarily have to know what the final number is to

tell where we are making progress and where we are not. So, I

think, even as people struggle to determine what is the proper sort

of number, it is still incumbent on us to continue taking——

The CHAIRMAN. I do not know what your background is, but most

good business men and women have plans, they have data and

benchmarks to try to determine what they are doing. It sounds like

you do not have any.

Mr. HARRINGTON. We do. The Treasury has a strategy on reducing the tax gap, as the Secretary and Assistant Secretary Solomon

discussed with you. So, this is one component of that.

The CHAIRMAN. All right. But my understanding is that the IRS

is saying the offshore tax gap is not included in this so-called $345

billion tax gap that we have been working with. Is that correct? So,

really when you are saying the offshore gap, Mr. Avi-Yonah says

27

it is roughly $50 billion, so that is $50 billion on top of the $345

billion we have been talking about. Is that correct?

Mr. HARRINGTON. In terms of particular numbers, I will have to

get back to you.

The CHAIRMAN. I am just surprised you do not know more about

this subject, Mr. Secretary. I am very surprised, frankly.

I have to conclude this hearing. Now, clearly this is a very frustrating subject, so much we just do not know about. I will give each

of the three of you—or the four of you, if you want—an opportunity

to tell us what we have to do to get a better handle on this.

You have talked about information sharing and more transparency. I am just trying to get a little more precise sense of where

the information sharing should be, how we get more transparency,

how we solve this thing. I know you have already given some answers and lots of ideas, but I am giving you an opportunity to say

anything more if you want. Anybody? Mr. Brostek?

Mr. BROSTEK. I would go back to a comment I made earlier. For

a lot of U.S. persons, it is their income here in the country that

they are transferring offshore, and that can be a substantial

amount of money.

It is a difficult thing to get information reporting on, when it is

cash transactions in a business or between a professional and his

or her clients, but it is an area where we need to try to figure out

whether there are additional opportunities for getting information

reports that routinely tell us the amount of income that someone

has received in their business.

It is not our proposal, it is the President’s proposal, but one of

those proposals is that credit card companies give IRS the annual

total receipts that that company received in its business operations

during the year.

It could potentially give IRS sort of a bottom line of what the revenue in that business is. You would logically assume that there

must have been some cash transactions on top of that. It would

help them identify whether a business is under-reporting its income.

There are some concerns that have been expressed from the community about how implementable that procedure is, but that is the

kind of thing I think we have to think about in order to make sure

we have an idea what the U.S. income is that is going to be transferred offshore.

The CHAIRMAN. All right.

Yes, Mr. Owens?

Mr. OWENS. I would come back to the importance of getting other

countries to endorse these transparency and exchange of information standards. If we can have agreement on what the standards

are, if we can have a consistent application of them, that goes a

long way towards resolving the issues. I always work on the basis

that, for tax administration, information is their lifeblood. Deny a

tax administration information and it is very hard for them to do

their job.

A second thing that you could do is to encourage the Treasury

to vigorously pursue its policy of negotiating tax information exchange agreements. I say that because you have much more power

to get these countries to the table. Once they have an agreement

28

with you, then other countries can come in behind you, and that

helps a lot.

The third thing that would be important is to look at countries

that you do not have tax treaties with, countries like Singapore,

and perhaps to make this one of your priorities, to have a treaty

with Singapore with a full exchange of information. That would be

beneficial both for Singapore and the United States.

And the last thing, which we have not really talked about this

morning, is the importance of the IRS developing a media strategy.

In my paper, I describe the offshore initiatives of Ireland and the

United Kingdom, and a large part of their success was the way the

politicians went out and said why this was important, and the opportunities that were given to dishonest taxpayers to come into the

revenue services and voluntarily disclose before the investigations

began. So, media strategy is very important.

The CHAIRMAN. Thank you, Mr. Owens.

Yes?

Mr. AVI-YONAH. Just one suggestion is to have the Treasury establish a list of countries that are and are not cooperating with our

exchange of information. It is usually a great incentive for the

countries to try to jump from the list that they are not cooperating

to the list that they are.

The CHAIRMAN. That is a good idea. I like that idea.

Mr. Harrington?

Mr. HARRINGTON. Thank you, Mr. Chairman. I would go back to

Mr. Owens’s comment about the need to continue to emphasize the

entering into of information exchange agreements. That is something that we have, and will continue, to do.

Also, just in light of our discussion, I think you identified the fact

that research is critical. We are learning information through our

tax information exchange agreements. We are learning information

through cooperation with other countries. As we learn more, we get

a better handle on the types of transactions that are occurring, the

types of investments that are occurring that lead to greater evasion.

Also, just to emphasize the enforcement opportunities. I know

Senator Conrad had a list of things one can find on the Internet.

The IRS does have a well-established system to regularly monitor

the Internet so they can follow leads and so forth, because the

Internet is both a blessing and a curse.

Things like that—the fact that they are so obvious allows people

to see the scams and the dubious arguments, but at the same time

it makes it above-board and easier to go after the people. So, I’m

emphasizing enforcement that we are doing.

The CHAIRMAN. I appreciate that. I just do not get the sense of

urgency from Treasury that I think is needed. This is a huge problem. I just urge you, Mr. Harrington, Secretary Paulson, the IRS,

to go burn the midnight oil and get a handle on this.

Mr. HARRINGTON. Yes.

The CHAIRMAN. I just do not see and sense the urgency that is

needed, in my judgment, anyway, to solve it.

Mr. HARRINGTON. I certainly do not mean to convey to you that

we do not think this is important. We do think this is an important

issue.

29

The CHAIRMAN. I did not say important, I said urgent.

Senator Grassley?

Senator GRASSLEY. Thank you very much. As you know, I left in

the middle of the second testimony because I had to be down at Judiciary to make quorums, and because I had some legislation to defend.

Mr. Owens, I would like you to clarify the work of the OECD in

the area of harmful tax practices and tax cooperation. One of the

factors the OECD uses to define a tax haven is ‘‘no or nominal taxation.’’ One of the action items you listed in your testimony is to

intensify international tax cooperation.

Three questions I want to ask all at once, and I can repeat them

if you want me to: does the OECD recognize the sovereign right of

countries to set their own tax policies, and that the level of taxes

can be a legitimate competitive factor in the global economy?

Two, in the OECD’s view, if mobile capital moves from one country’s tax jurisdiction to another because of a lower tax rate, is that,

by itself, considered harmful?

Lastly, would you please clarify what you mean by the term ‘‘tax

cooperation?’’ For example, you are not referring to tax harmonization or some sort of global tax. Is that correct? Go ahead.

Mr. OWENS. Thank you, Senator. I will go to each question separately.

Senator GRASSLEY. Yes.

Mr. OWENS. On the question of, does the OECD recognize the

sovereign rights of countries to design their own tax systems, the

answer is yes. In fact, one of the basic principles that guides our

work in the tax area is that each country has the sovereign right

to design its own tax system to reflect its own economy, to reflect

its own social values, and to reflect its own political values. That

is a principle that underlies all of the work that we do at the

OECD in the tax area.

We do not tell our member countries how to design their tax system. You can see that from the diversity of tax systems within the

OECD. There are some countries that have very high taxes, there

are others that have low taxes. There are some countries that rely

very heavily on consumption taxes, there are others that rely on income taxes. Those are choices that they make and we must respect.

Similarly, in the work that we have been doing with the tax havens, we have never told them how they should design their tax

systems. Some of these countries, in fact, do not have any income

taxes at all. That is a choice that they have made, so we respect

it.

Some of them do have income taxes, very low rates. Again, that

is a choice that they make. The one thing that we do ask, though,

of all countries, both OECD and non-OECD, is that they should be

prepared to cooperate to counter abuse.

The second question on mobile capital. We have never characterized a country as harmful just because there is a low rate of tax.

We put the emphasis on whether or not a country is transparent

and whether or not it meets the exchange of information standards.

In today’s competitive world we have to recognize that countries

will use their corporate tax rates, their personal income tax rates,

to attract capital. That is something that they have the right to do.

30

Certainly, the OECD does not have any problems with them doing

that.

From our organization’s perspective, we have consistently promoted the benefits of tax competition, I would like to think not just

in the tax area, but right throughout our work.

But we do recognize that to get the full benefits of tax competition, that competition has to be transparent, it has to be nondiscriminatory, and countries have to be prepared to cooperate to

counter abuse.

The third question you asked was, what do we mean by ‘‘cooperation?’’ Basically, that is where countries agree that they are going

to cooperate to counter international abuse. When a taxpayer misuses one country to evade taxes in his home country, then those

two countries should be cooperating.

A lot of that cooperation does take place by means of exchange

of information. That is a key factor. But it is also the dialogue that

takes place at the OECD where countries come and share their experiences. They indicate what policies have been successful, and

they also indicate what policies have not been successful. That is

an important role that we have.

It is very important to distinguish between tax cooperation and

tax harmonization. I do not see that we will ever move towards a

world where we have one tax system. Even within the European

Union, with 27 countries, they no longer talk about tax harmonization, they talk about tax cooperation. That just reflects the diversity we have within tax systems across the world.

Similarly, the whole idea of moving toward some sort of global

tax is not realistic. That certainly is not on the OECD’s agenda,

and I do not think it ever will be on our agenda.

Thank you.

Senator GRASSLEY. Thank you.

I will go to Mr. Brostek now. There has been a lot of press recently about offshore tax haven jurisdictions luring hedge funds

and private equity firms. Given your testimony about how foreign

corporations may provide a way for evading U.S. tax, should we be

concerned about U.S. taxpayers or tax-exempt organizations investing in offshore hedge funds or private equity funds using structures

that allow them to more easily evade U.S. tax?

Mr. BROSTEK. It certainly is the case in many, many tax schemes

that what the taxpayer is trying to do is hide the ball so that IRS

cannot find out what is going on. So, certainly if anyone is making

investments and using a structure that is deliberately intended to

hide what is going on, we should be concerned about that. Given

the substantial amount of funds that are reported to be invested

in hedge funds, you would not need to have much non-compliance

to have real money at stake.

Senator GRASSLEY. So there is an issue of linkage of hedge funds

to offshore tax evasion issues?

Mr. BROSTEK. Well, we have not shown that in our work, but

there is certainly some potential for concern there.

Senator GRASSLEY. All right.

Mr. Harrington, Mr. Owens, Professor, this question I would like

to have the three of you consider. We have heard a lot of testimony

this morning about the U.S. information exchange network and

31

about the efforts of the international community to promote effective information exchange.

Would each of you please comment on the importance of an effective information exchange network in addressing the international

tax gap, and if possible, how tax information exchange fits into the

broader international cooperative network designed to detect and

enforce financial crimes, be they tax evasion, money laundering, or

terrorist financing? Mr. Harrington, then Mr. Owens, then the Professor.

Mr. HARRINGTON. All right. Thank you, Senator Grassley. I

would just point out, with respect to information exchange, we do

regularly use the information exchange article in our tax treaties

and tax information exchange agreements. We fully believe that information exchange is effective, and broadening this network is effective in combatting offshore tax evasion.

Obviously tax evasion is a difficult area to measure, but I would

just point out, we are not alone in the belief that increasing the information exchange network helps because I think, as Mr. Owens

pointed out in his testimony, many other countries seek to establish this information exchange network with the same belief that

this helps in thwarting offshore tax evasion.

Second—this is somewhat anecdotal. The resistance that we

sometimes encounter from a potential treaty or TIEA partner about

the need for information exchange, and the concern that it has potentially on their financial and other business sectors, is, to us, another good indication that we are really striking something here,

given the fact that it raises concerns.

It is perhaps easier to look at it from a negative context. What

would the world be like if there were no tax information exchange?

If we could not get information from offshore jurisdictions, if we

could not get it from other financial centers, we would be operating

in the dark.

So in that sense, we believe that it is not just with us, with the

United States, in terms of our bilateral relationships, but the fact

that other countries entering into additional bilateral relationships

creates a web that raises standards worldwide, which we think

very much goes to the benefit of the United States and other countries as well.

Senator GRASSLEY. All right.

Mr. Owens?

Mr. OWENS. I could only endorse what Mr. Harrington has said.

At the end of the day, you cannot operate a tax system effectively,

not in today’s global environment, unless you have good access to

information.

To get that access, you need to have the agreements in place,

whether they take the form of full tax treaties, with exchange of

information articles, or whether they take the form of information

exchange agreements.

But, for information exchange to work, you need to be sure that

the countries you are requesting the information from have access

to it, and that is why we must address this issue of bank secrecy.

Over the last 10 years, we have worked very hard to improve the

effectiveness of exchange of information. We have looked at many

32

of the practical problems that act as barriers to an effective exchange.

We provided a new legal framework in our new article 26. The

treaties that the United States has negotiated are based on a

model that was developed at the OECD. So exchange of information, you cannot over-emphasize the importance of it, not in today’s

environment.

Senator GRASSLEY. Professor?

Mr. AVI-YONAH. I would certainly think that the link that you

pointed out between information exchange for purposes of committing tax evasion and information exchange for other purposes like

money laundering and terrorist activities is a very important one

that we should emphasize. These three all go together. It is no accident that sometimes investigation in one area leads to discoveries

in another area.

So I think that, from that perspective too, since we are all committed to the other aims, we should link them together and make

sure, in particular—the other thing I want to emphasize is that we

in the United States should make sure that we have the information available to us to offer to our treaty partners in exchange for

the information that they give us.

That was something that was raised before, that there have been

some suggestions that we should be doing a better job in having

our financial institutions collect information about payments that

they make to overseas people, even if they are not U.S. people.

And similarly, in relation to the GAO report, the qualified intermediary system, which is designed to enlist foreign banks and

other institutions as partners with the IRS, should collect information that is needed in order for us to be able to exchange information with our treaty partners.

Senator GRASSLEY. All right.

Mr. Owens, the Professor mentioned the list in Senator Levin’s

bill. Many of those jurisdictions are no longer on the OECD’s list

of uncooperative tax havens, and the U.S. has entered into tax information exchange agreements with many of them. How would

putting these cooperating jurisdictions on the statutory blacklist affect the cooperating nature of the jurisdictions at the international

level?

Mr. OWENS. There is, in fact, some overlap between the OECD

list and the list that has been prepared by Senator Levin. But I

think, while it is very important to note there are some advantages

in the listing process, it is also very important to look at some of

the risks. You have to recognize that putting a country on any list

will have implications that go way beyond the tax area.

Also, if you go down the listing approach, you have to be very

clear what criteria you are using to put a country on a list, and

even more important, what criteria are you using to get the country off that list.

For the last 5 years, we have put a lot of emphasis on having

a constructive dialogue with these jurisdictions, which has resulted

in them endorsing the standards, the standards of transparency

and exchange of information and a willingness to negotiate exchange agreements. It is counterproductive to put such jurisdictions on any list.

33

Senator GRASSLEY. Mr. Harrington, the Government Accountability Office’s written testimony shows a significant portion of

U.S.-source income paid to foreign corporations as interest. Much

of this interest would qualify for the portfolio interest exception

and be exempted from withholding tax.

The portfolio interest exception enacted in 1984 was meant to remove a barrier for U.S. businesses to tap into foreign bond markets

as a source of capital, but Congress recognized this exception might

provide some U.S. taxpayers with an avenue of tax evasion, for example, by investing in U.S. debt securities through foreign corporations and then not reporting the net income on their tax returns.

One of the things Congress did to address this concern was to

give Treasury the authority to deny the exception to interest paid

to persons in jurisdictions that are determined to lack effective information exchange to prevent U.S. income tax evasion. Since 1984,

Treasury has not exercised this authority under any administration.

So, Mr. Harrington, is Treasury considering exercising this authority as it looks at ways to close the tax gap, and what issues

would Treasury need to address to exercise the authority?

Mr. HARRINGTON. Thank you, Senator Grassley. As you point

out, we do have this authority. Other countries know that we have

this authority, so it exists as a tool in our arsenal.

The thing I would point out about it, and part of the reason why

it has not been used in the past, is the fact that it is a very blunt

instrument, and we have not reached the stage with any jurisdiction in which we have found it to be appropriate to use this tool.

It would have repercussions with our broader economic relationship with a jurisdiction to suddenly single them out and impose a

withholding tax on the interest payments. We have to ask, who

would be hurt, who would be affected? Plainly this potentially affects the interest payments that the U.S. borrowers would pay.

So, its use would raise a lot of significant issues, and we have

not reached the point where we have found that we have had to

use it. But it is a tool in our arsenal, and one that we have to be

prepared to use.

Senator GRASSLEY. Yes. Of course, I can only refer to this administration for 6 years, but it seems to me, in 20 years, there may

have been an example of when it could have been used without

harming the economy or relationships with another country, et

cetera.

It might be one of those things that you would think about using

to satisfy Senator Baucus, that you are aggressively concerned

about this issue and using every tool you can.

Professor, you note in your testimony that the lack of transparency in foreign tax haven jurisdictions adversely impacts the

IRS’s ability to detect tax evasion. Of course, I agree with you and

the other witnesses here that establishing and maintaining effective information exchange programs, both in treaty partners and

non-treaty partners, is very critical to reducing the tax gap.

But this lack of transparency is not limited to shell corporations

formed offshore. We have seen news reports about the lack of

transparency in the company information processes of many U.S.

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States, which allow tax evaders to hide behind domestic shell corporations.

How do you think Congress should consider addressing that

problem?

Mr. AVI-YONAH. This issue, I think, is particularly egregious. We

are talking about things that are happening in the United States.

There are no diplomatic or other issues that pose a barrier.

I think, fundamentally, Congress should seriously consider legislation to make sure that the IRS has full access to data that States

actually possess about who sets up corporations in which States.

On a broader level, I mean, it really is a question of policy

whether we should be encouraging States who compete with each

other in lack of transparency. There are other ways in which States

can compete legitimately in terms of setting the tax rates and tax

structure, but not so much by advertising that you can set up a

shell corporation there and be able to hide your money from the

Federal IRS. I find that to be egregious.

Senator GRASSLEY. Mr. Brostek, you noted in your testimony

that there is precedent for making an exception to the 3-year statute of limitation rule when IRS is at an informational disadvantage.

In fact, an exception exists in current law that relates to offshore

activity of U.S. taxpayers. Under current law, the 3-year statute

does not begin to run until taxpayers file required information regarding their investment in foreign entities.

Did the GAO analyze the effectiveness of this or other current

law exceptions in the course of its work? Why are these existing

exceptions deficient when it comes to taxpayers involved in offshore

financial activities?

Mr. BROSTEK. We did not do a focused review of each one of the

potential statutory exceptions to the rule. We did look at that

somewhat during our work, and it appeared to be fairly narrowly

focused. In a significant number of cases for IRS, who is aware of

the provisions that allow them to go beyond the statute, they felt

they did not have adequate statutory basis to go beyond 3 years.

Senator GRASSLEY. Yes. All right.

Professor, we heard testimony from the person on your left today

about the reporting and withholding regime that applies to payment of U.S.-source income to non-U.S. persons.

The existing substantive rules and the reporting and withholding

rules attempt to strike a balance between attracting foreign investment in our capital markets and ensuring the right amount of tax

is paid on U.S.-source income.

Two of your recommendations may implicate this balance. The

first is for the Treasury to finalize regulations proposed by the

Clinton administration that require U.S. banks and financial institutions to collect information on interest payments made to overseas jurisdictions when the portfolio interest exception applies.

The second concern concerns third-party reporting by U.S. payors

of amounts to certain foreign corporations when the payor knows,

or has reason to know, that the foreign corporation is beneficially

owned by U.S. individuals. This proposal would be designed to help

the IRS detect U.S. taxpayers who disguise themselves as foreign

corporations and fail to report income on their tax returns.

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Two questions, and I will ask them both: what are your views on

how these recommendations would affect the balance that I referred to; and two, if your second proposal went into effect, to what

payments would it apply and to what payments would it not apply?

Mr. AVI-YONAH. So, on the first one, I certainly think that we

should preserve a balance between attracting investments from

overseas and maintaining the integrity of our tax system.

But it does not seem to me that requiring banks and other financial institutions to collect information that would be available, in

discussion with the Treasury, to exchange with our treaty partners

should negatively affect that balance, simply because, as I said before, the investors have to go to one OECD member country or another. The EU already has regulations that require this kind of information to be available for its own residents.

So to the extent that we do the same thing, the 16 countries’ proposal was requested by the EU. This was one of their conditions

to have the savings directive come into effect because they wanted

to make sure that the money does not flow completely from the EU

into the United States.

It seems to me, if we cooperate with them in this regard and we

can get them to cooperate with us, this will not change the balance

of investment in any meaningful way and would help both countries ensure that their tax laws are enforced in regard to their own

residents.

As to the second question as to whether this is a relatively narrow proposal, what we are talking about in this situation is where

a U.S. payor or withholding agent knows, or has reason to know,

that a payment is actually made to an entity that is, in fact, controlled by a U.S. resident.

So, while this would apply to any kind of payments that are

going overseas, this is a relatively narrow class of payments. There

is indication in the GAO report, and also in the Subcommittee on

Investigations report from last year, that in fact there are situations where U.S. payors rely on the fact that they get a statement

that a payment is being made to a foreign corporation at a time

when they actually know that that foreign corporation is really a

shell for a U.S. resident. I do not think that that is acceptable, and

I do not think it will adversely affect the balance that you discussed before.

Senator GRASSLEY. Maybe on that point, I should ask Mr. Harrington if he wants to make any remarks or reaction to what the

Professor just said. You do not have to, but I thought if you wanted

to, I ought to give you that opportunity.

Mr. HARRINGTON. When your name is invoked, sorry, it is hard

not to respond. First, on the bank deposit interest regulations, the

proposed regulations, we have issued two sets of proposed regulations. They have generated a substantial amount of comments, and

we are still evaluating the comments that we have received.

We work on a lot of issues that would kill a conversation if you

tried to raise them at a cocktail party, but these do not fall in that

category. These have engendered a substantial amount of controversy, and we are still reflecting on those comments.

As for the foreign trusts, plainly, there are a lot of proposals. We

are evaluating them and giving them consideration. But the test

36

for us ultimately in all of these is, does this assist with compliance

or not? And in some circumstances, there is a lot of reporting already.

We want to make sure that we do not lead to any additional confusion about who should be paying and who should not, so we are

studying these proposals. But again, to us, the ultimate test is,

does this assist with compliance or not? So, we are studying them.

Senator GRASSLEY. All right.

Before I ask my last question, I ought to ask, did the Chairman

want me to adjourn?

The CHAIRMAN. Yes, please.

Senator GRASSLEY. All right.

Mr. Harrington, much of our reporting regime for foreign activity

of U.S. taxpayers is one of self-reporting. For example, U.S. taxpayers are required to report investments in foreign bank accounts,

foreign corporations, foreign partnerships, and foreign trusts. As

we have seen with other areas of the tax gap, compliance is highest

when third-party reporting is involved.

Has Treasury considered whether there are areas of the international tax gap that could be addressed through third-party reporting?

Mr. HARRINGTON. We are looking at potential third-party reporting issues in the international context. I would point out that part

of the reason we have so much self-reporting in the international

area is because there is not an obvious third party. We do not have

jurisdiction over the third party who would do the reporting. That

is the difficulty we face.

In the domestic context, we have a whole series of rules where

there is reporting. Certainly with a lot of financial payments, at

each point along the line there is supposed to be either information

reporting or you know it is going to an exempt person. That works

as long as it is in a chain.

When you cross borders, you break the chain. We deal with people over whom we do not have jurisdiction. That is the difficulty

that we are dealing with. But certainly the things you pointed out,

the more information reporting, the greater the compliance, are

very important, and this is an area on which we are focusing.

Senator GRASSLEY. All right.

For the Chairman and for the committee, I thank you very much

for you participation. I am sorry I could not be with you for the

whole two hours.

The hearing is adjourned. Thank you all very much.

[Whereupon, at 12:10 p.m., the hearing was concluded.]

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