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Federal Document Clearing House
Congressional Testimony
March 08, 2000
SECTION: CAPITOL HILL HEARING TESTIMONY
LENGTH: 8040 words
HEADLINE:
TESTIMONY March 08, 2000 KENNETH J. KIES SENATE FINANCE TAX
PENALTIES AND INTEREST
BODY:
STATEMENT OF KENNETH
J. KIES THE SENATE FINANCE COMMITTEE PENALTY AND INTEREST PROVISIONS MARCH 8.
2000 I. INTRODUCTION Price water house Coopers appreciates the opportunity to
submit this written testimony to the Finance Committee. This testimony focuses
on the issue of "corporate tax shelters," specifically on the question whether
there is a problem with "corporate tax shelters" that requires broad legislative
action. Price water house Coopers, the world's largest professional services
organization, provides a full range of business advisory services to
corporations and other clients, including audit, accounting, and tax consulting.
The firm, which has more than 6,500 tax professionals in the United States and
Canada, works closely with thousands of corporate clients worldwide, including
most of the companies comprising the Fortune 500. These comments reflect the
collective experiences of many of our corporate clients. We believe there is no
demonstrated problem with "corporate tax shelters" that would require sweeping
legislation. Economic data does not suggest any systemic erosion of the
corporate income tax base attributable to "corporate tax shelters." Moreover,
current- law administrative tools, if used properly, are more than adequate to
deter, detect and penalize abuses. II. "MOST SERIOUS COMPLIANCE ISSUE"9 Rhetoric
in the "corporate tax shelter" debate has reached a fever pitch. Treasury
Secretary Summers on February 28 said "corporate tax shelters" may be the "most
serious compliance issue threatening the American tax system today." This
characterization seems overblown, especially in light of a new General
Accounting Office (GAO) audit of the IRS's 1999 financial statements that found
that the IRS fails to collect tens of billions of dollars each year from
taxpayers where there is no question that taxes are in fact owed. The GAO audit
states that this failure by the IRS to pursue such cases could "adversely affect
future compliance." Specifically, the audit found that the IRS in fiscal 1999
had $231 billion in unpaid assessments, of which $127 billion was simply written
off. Of the amount not written off, $56 billion was categorized as
"uncollectible." Until recently, this term typically was reserved for cases
where the taxpayer owing the outstanding taxes was experiencing financial
difficulties or other hardships that made collection highly unlikely. In fiscal
1999, however, the definition of uncollectible taxes was broadened to include
tax that could not be collected because of increasing IRS workloads and
judgments that resource constraints would not allow the IRS to pursue actively
the case. The GAO report notes that these cases were not pursued even though
information in the case files indicated that the taxpayer had financial
resources available to pay at least some of the amounts owed. Thus, taxpayers
are escaping tens of billions of dollars in taxes owed each year simply because
the IRS does not have time to follow Up. Furthermore, the IRS in its last study
of the "tax gap" found that individual noncompliance with the income tax cost
the government more than $95 billion a year. The tax gap is defined as the
difference between income taxes owed and those voluntarily paid. Key components
of the tax gap that were identified include unreported income by sole
proprietors, overstated deductions, and failures to file. These facts illustrate
that there are far larger tax administration problems facing the IRS than any
problems perceived to be posed by "corporate tax shelters." 111. EROSION OF THE
CORPORATE INCOME TAX BASE? A key question in this debate is whether "corporate
tax shelters" are eroding the corporate income tax base. We see no credible
evidence of such a phenomenon. Since 1992, corporate federal income tax payments
have grown by 84 percent, from $100.3 billion in fiscal 1992 to $184.7 billion
in fiscal 1999. By point of comparison, GDP has grew by 47 percent over this
period. Over the past six fiscal years, corporate income tax payments have been
at their highest levels of GDP since 1980. Moreover, corporate income taxes in
fiscal 1999 stood at 10.1 total federal receipts - higher than the average 9.7
percent for the 1981 - 99 period. Despite this high level of corporate income
tax payments, some commentators have pointed to a two-percent drop in corporate
income tax receipts in fiscal 1999, as compared to the prior year, as possibly
indicating "corporate tax shelter" activity. Possible explanations for this drop
include a relative decline in taxable corporate income attributable to
depreciation deductions associated with higher levels of investment and
increases in employee compensation. The Congressional Budget Office (CBO) in its
January 2000 budget outlook noted depreciation as among the factors putting
downward pressure on corporate tax receipts. It also should be noted that the
slight falloff in corporate profits was not unforeseen - the Office of
Management and Budget (OMB) last year projected that corporate income tax
payments would fall in FY 1999, before rising again in FY 2000." It also should
be noted that the decline in corporate tax receipts between fiscal years 1998
and 1999 was entirely due to an increase in refunds of taxes overpaid in prior
years - gross tax payments actually increased from $213 billion to $216 billion
over this period. Since the Joint Committee on Taxation reviews all refund
claims in excess of $1 million, there is no reason to believe that the growth in
tax refunds is due to undetected or inappropriate transactions. If unusually
high levels of corporate tax shelter activity had been occurring over the last
few years, we would expect to see a drop in corporate tax liability relative to
normative measures of pre-tax corporate income. To test this hypothesis,
PricewaterhouseCoopers has measured corporate effective tax rates using data
from the National Income and Product Accounts and audited financial statements.
We found no suspicious drop in tax liabilities relative to corporate income; to
the contrary, we found flat or rising corporate effective tax rates over the
last five years. In a paper presented October 24, 1999, at the National Tax
Association's 92 d Annual Conference on Taxation, a Treasury Department
economist presented an independent study of corporate average tax rates that
specifically commented on the question whether there was any evidence of a
problem with "corporate tax shelters." Using a different measure of corporate
profits than was used by PricewaterhouseCoopers, the Treasury economist found a
slight drop in the average corporate tax rate over the 1990-98 period. However,
the economist found that this decline was "largely unrelated to corporate tax
shelters." The economist concluded, "Rather than shelters, it is the decline in
corporate losses that accounts for most of the decline in the average tax rate
in the 1 990s. The Treasury Department has not presented any compelling evidence
to support its contention that "corporate tax shelters" are eroding the
corporate income tax base. Rather, Treasury has cited statements made Joseph
Bankman of Stanford University that "corporate tax shelters" are responsible for
$1 0 billion in lost corporate income tax revenues each year. Bankman
essentially admits he has no data supporting his $1 0 billion figure in his
Internet tax policy chatroom, where he answers a question from a reader as to
the references for his $ 1 0 billion figure as follows: "The $ 1 0 billion
figure that I am quoted on is obviously just an estimate." This unsubstantiated
claim hardly represents the type of serious economic analysis that should be
undertaken before adopting sweeping tax policy changes of the scope envisioned
by Treasury. IV. BOOK INCOME AND TAXABLE INCOME Treasury officials also have
cited as evidence of tax shelter activity the gap between corporate income
reported to shareholders (book income) and to the IRS on tax returns (taxable
income). This section describes the different concepts used to measure book and
taxable income, reviews Treasury's analysis, and presents some new data on
book-tax differences. A. Background Corporations with assets of $25,000 or more
are required to reconcile book income to taxable income on Schedule M- I of the
corporate tax return (Form 1120). The starting point for Schedule M- I is the
taxpayer's book income. As reported on financial statements, however, book
income may reflect a different group of legal entities than are included in the
taxpayer's return. This occurs as a result of difference in book and tax
consolidation rules (the percentage ownership threshold for tax consolidation
generally is higher than for book consolidation). Because it is not meaningful
to compare income across different legal entity groups, companies typically
adjust the book income figure they report on Schedule M-1 to a tax consolidation
concept. Book income is reported net of federal and state income taxes, while
taxable income is reported before federal and after state income taxes.
Consequently, to reconcile book and taxable income, federal income tax expense
must be added back to book income. Differences in pre-tax book income and
taxable income can be classified as permanent or temporary. Permanent
differences are items of income or expense that are recognized under one of
these accounting systems and not the other, and do not reverse over time.
Examples of permanent differences include tax-exempt interest and nonqualified
stock option expense (which are included in book income but not taxable income)
and non- deductible travel and entertainment expenses (which are included in
taxable income but not book income). Temporary differences are items of income
or expense that are recognized in different fiscal years for tax and book
purposes. The periods and methods of capital cost recovery (i.e., depreciation,
amortization and depletion) generally differ between financial and tax
accounting, with typically faster cost recovery for tax purposes. Another
important temporary difference is foreign source income. Book
income includes foreign source
income net of foreign tax; by contrast, the
taxable income concept used by Treasury excludes income earned
by foreign affiliates from sources outside the United States unless this income
is distributed to the U.S. parent. The excess of book over taxable income
arising from net foreign earnings is a temporary difference because it reverses
when foreign earnings are distributed (causing an increase in taxable but not
book income). B. Treasury Analysis Treasury analyzed Schedule M- I data for 81 1
corporations, with mean asset size in excess of $1 billion (in 1992 dollars),
over the 1991-1996 period. Treasury compared adjusted pre-tax book income (book
income plus federal income taxes less tax-exempt interest as reported on
Schedule M-1) with taxable income (taxable income before net operating loss
deduction and special deductions) reported on corporate tax returns as filed.
Treasury found that in real terms, taxable income for the 811 corporations
roughly doubled between 1991 and 1996, but that book income- increased even
faster. While acknowledging that "it is unclear how much of the divergence
between tax and book income reflects tax shelter activity," Treasury
nevertheless views the more rapid growth of book than taxable income as evidence
of a growing shelter problem." Treasury recognizes that book and taxable income
can diverge for reasons that are unrelated to tax shelters,
including depreciation, foreign source income,
and nonqualified stock options." However, Treasury only considers one of these
factors - depreciation - and makes no attempt to adjust for the other potential
causes of book-tax differences. Treasury finds that book-tax depreciation
differences cannot explain the growth in the book-tax income gap over the 1991 -
96 period, and suggests that growing tax shelter activity is a likely
explanation. In summary, Treasury finds that adjusted pre-tax book income has
grown more rapidly than taxable income for a sample of corporations over the
1991-1996 period, and that this difference cannot be attributed to book-tax
depreciation differences. Although Treasury recognizes that book and taxable
income can diverge for many differences unrelated to tax shelter activity, its
testimony nevertheless concludes that "the data are clearly consistent with
other evidence that the problem tax shelter activity is significant." C.
PricewaterhouseCoopers Analysis This section extends Treasury's analysis in
several ways: (1) data is collected for all public companies (not just the 81 1
corporations analyzed by Treasury); (2) book-tax depreciation differences are
calculated from several sources back to 1985; (3) the foreign component of book
income is calculated back to 1984; and (4) the available data on stock option
awards is reviewed. 1. Depreciation Figure la shows the excess of tax
depreciation over book depreciation. Tax depreciation is based on published IRS
data on corporate income tax returns, while book depreciation is calculated
based on the Standard and Poors Compustat database, which excludes privately
held companies. The excess of tax over book depreciation is likely overstated
because the book depreciation measure excludes privately held companies." As
shown in Figure 2a, the tax- book depreciation gap increased after 1992,
mirroring the rise in the book-tax income difference over this period. Thus,
these data suggest that the growing tax-book depreciation gap is part of the
explanation for the book-tax income difference.'9 This analysis can, of course,
be criticized because the measure of book depreciation excludes privately held
companies. One solution to this data limitation is to use the Capital
Consumption Allowance (CCA) adjustment estimated by the Bureau of Economic
Analysis (BEA). The CCA adjustment represents the excess of tax depreciation
over BEA's definition of economic depreciation for all U.S. corporations. 2' The
CCA adjustment likely understates the actual tax-book depreciation difference
because economic depreciation is based on replacement cost accounting, while
historic cost accounting is required for financial reporting. Figure 1b shows
the CCA adjustment. These data suggest that the growing tax-book depreciation
gap is part of the explanation for the book-tax income difference after 1992. In
summary, we find that both measures of the corporate tax-book depreciation gap -
one based on Compustat data and the other based on the CCA adjustment - indicate
that the tax-book depreciation gap increased over the 1992-96 period (by between
$19 billion and $28 billion). This difference thus helps explain the faster
growth of book income than taxable income over this period. 2. Foreign source
income Figure 2 isolates the foreign component of book income over the 1984-1996
period based on Compustat data. To the extent this foreign income is not
distributed to U.S. shareholders, it results in a book-tax
difference. Foreign source income in 1992 was
$47 billion according to financial statement data, which compares closely with
Treasury data indicating after-tax foreign earnings and profits were $51 billion
in 1992, of which $41 billion was distributed. Thus, undistributed foreign
earnings contributed about $ 1 0 billion ($51 billion minus $41 billion) to the
book-tax income difference in 1992. By 1996, foreign source book income had
increased to $106 billion, from $47 billion in 1992. Treasury has not published
data on the distribution rate of foreign earnings and profits in 1996. However,
it is likely that the distribution rate is closer to the 41 percent level
recorded in 1984 and 1986, than the 81 percent rate in 1992 - a year with heavy
foreign losses. If the distribution rate of foreign income is estimated at 50
percent in 1996, this would imply undistributed foreign earnings contributed $53
billion (50 percent of $106 billion) of the book- tax income difference in 1996.
Thus, the growth in foreign income between 1992 and 1996 reasonably can explain
$43 billion ($53 billion of undistributed foreign income in 1996 less $1 0
billion in 1992) of the growth in the excess of book over taxable income during
this period. 3. Stock options Figure 3 shows that the value of all unexercised
in-the-money stock options owned by top executives at Forbes 800 companies
increased from $2.4 billion in 1994 to $10.6 billion in 1998. The growth in the
value of stock option grants is in part due to a rise in the overall level of
the stock market and in part due to an increase in share awards. Figure 4 shows
that shares authorized for stock option plans increased from 6.9 percent of all
shares outstanding in 1989 to 13.2 percent in 1997. The overwhelming majority of
stock option awards are nonqualified stock options (NSOs). Because NSOs
generally are not treated as an expense for financial reporting purposes, the
exercise of NSOs by employees gives rise to a permanent book-tax difference. The
rapid growth in NSOs clearly has contributed to the growing book- tax income
gap, although it is difficult to estimate the magnitude of the effect. Any
reduction in the corporate tax base due to NSOs, however, is offset by an
increase in the individual income tax base (because the gain on exercise is
deducted by the employer and included by the employee). D. Conclusion While
corporations' taxable and book income have both increased at an extraordinarily
rapid rate since 1 99 1, Treasury has expressed concern that book income has
grown more rapidly than taxable income over this period. As Treasury itself
acknowledges, book-tax income differences can arise for many reasons unrelated
to tax shelter activities, including foreign
source income, depreciation, and stock options. While it is
difficult to allocate book-taxable income differences among each of these
factors, we find evidence that they account for much of the difference. This new
data cast doubt on Treasury's conclusion that recent trends in book-tax income
differences are evidence of increasing "corporate tax shelter" activity. V. ARE
CURRENT-LAW IRS TOOLS SUFFICIENT? Another key question in this debate is whether
tools currently available to the IRS are sufficient to enforce compliance with
the corporate income tax. Proponents of sweeping new legislation to address
"corporate tax shelters" are quick to dismiss the formidable array of tools the
government now has to deter, detect, and attack transactions considered as
abusive. In our view, these tools are more than sufficient. A. Reporting and
disclosure requirements The Treasury Department recently has taken steps to
expand reporting and disclosure of shelter- like transactions. On February 28,
Treasury issued regulations activating the rules that had been enacted by
Congress in 1997 requiring promoters to register certain "corporate tax
shelters" with the IRS. Treasury also issued regulations requiring corporations
to disclose shelter-like transactions, and expanding rules requiring organizers
of "potentially abusive tax shelters" to maintain lists of investors in such
arrangements. These recent actions taken by Treasury further reinforce the point
that the government can address perceived problems with respect to "corporate
tax shelters" without additional legislation. In enacting the "corporate tax
shelter" registration requirements three years ago, Congress stated that this
reporting would "improve compliance by discouraging taxpayers from entering into
questionable transactions. Now that these reporting requirements finally have
been implemented by Treasury, Congress will have an opportunity to assess their
impact and determine whether they have been effective. Further action should not
be taken, particularly action that would create vague standards and broad new
powers, until the efficacy of the existing legislative rules can be evaluated.
B. Use of "common-law" doctrines Pursuant to several "common-law" tax doctrines,
Treasury and the IRS can challenge a taxpayer's treatment of a transaction if
they believe the treatment is inconsistent with statutory rules and the
underlying Congressional intent. For example, these doctrines may be invoked
where the IRS believes that (1) the taxpayer has sought to circumvent statutory
requirements by casting the transaction in a form designed to disguise its
substance, (2) the taxpayer has divided the transaction into separate steps that
have little or no independent life or rationale, (3) the taxpayer has engaged in
"trafficking" in tax attributes, or (4) the taxpayer improperly has accelerated
deductions or defer-red income recognition. The common-law doctrines - known as
the business purpose doctrine, the substance over form doctrine, the step
transaction doctrine, and the sham transaction and economic substance doctrine -
give the IRS considerable leeway to recast transactions based on economic
substance, to treat apparently separate steps as one transaction, and to
disregard transactions that lack business purpose. Recent applications of those
doctrines have demonstrated their effectiveness and cast doubt on Treasury's
asserted need for additional tools. The recent decisions in ACM v. Commissioner
and ASA Investerings v. Commissioner illustrate the continuing force of these
long- standing judicial doctrines. In ACM, the Third Circuit, affirming the Tax
Court, relied on the sham transaction and economic substance doctrines to
disallow losses generated by a partnership's purchase and resale of notes. The
Tax Court similarly invoked those doctrines in ASA Investerings to disallow
losses on the purchase and resale of private placement notes. Both cases
involved complex, highly sophisticated transactions, yet the IRS successfully
used common-law principles to prevent the taxpayers from realizing tax benefits
from the transactions. More recent examples of use of common-law doctrines by
the IRS are the Tax Court's decisions in United Parcel Service v. Commissioner
(8/9/99), Compaq Computer Corp. v. Commissioner (9/21/99), and Winn-Dixie v.
Commissioner (10/19/99). In United Parcel Service, the court agreed with the
IRS's position that the arrangement at issue - involving the taxpayer, a
third-party U.S. insurance company acting as an intermediary, and an offshore
company acting as a reinsurer - lacked business purpose and economic substance.
In Compstat, the court agreed with the IRS's contention that the taxpayer's
purchase and resale of certain financial instruments lacked economic substance
and imposed accuracy-related penalties under section 6662(a). In Winn-Dixie, the
court held that an employer's leveraged corporate-owned life insurance program
lacked business purpose and economic substance. This recent line of cases and
the IRS's increasingly successful use of common-law doctrines in these cases
argue against any need for expanding the IRS's tools at this time or (as the
Treasury Department has suggested) for codifying the doctrines. C. Threat of
penalties As an initial matter, the Tax Code includes significant disincentives
to engage in potentially abusive behavior. Present law imposes 20-percent
accuracy-related penalties under section 6662 in the case of negligence,
substantial understatements of tax liability, and certain other cases. In
considering a proposed transaction that may turn on a debatable reading of the
tax law, a corporate tax executive must weigh the potential for imposition of
these penalties, which could have a negative impact on shareholder value and on
the corporation. Furthermore, it should be noted that Congress, in the 1997
Taxpayer Relief Act, strengthened the substantial understatement penalty as it
applies to "tax shelters." Under this change, which was supported and encouraged
by the Treasury Department, an entity, plan, or arrangement is treated as a tax
shelter if it has tax avoidance or evasion as just one of its significant
purposes. These changes have made it even more important for chief tax
executives to weigh carefully the risks of penalties and even more difficult to
deter-mine which transactions might trigger penalties. At this time, there is no
demonstrated justification for making these penalties even harsher. D.
Anti-abuse rules The Code includes numerous provisions that arm Treasury and the
IRS with broad authority to prevent tax avoidance, to reallocate income and
deductions, to deny tax benefits, and to ensure taxpayers clearly report income.
These rules long have provided powerful ammunition for challenging tax avoidance
transactions. For example, section 482 authorizes the IRS to reallocate income,
deductions, credits, or allowances between controlled taxpayers to prevent
evasion of taxes or to clearly reflect income. While much attention has been
focused in recent years on the application of section 482 in the international
context, section 482 also applies broadly in purely domestic situations.
Further, the IRS also has the authority to disregard a taxpayer's method of
accounting if it does not clearly reflect income under section 446(b). In the
partnership context, the IRS has issued regulations under subchapter K aimed at
arrangements the IRS considers as abusive." The IRS states that these rules
authorize it to disregard the existence of a partnership, to adjust a
partnership's methods of accounting, to reallocate items of income, gain, loss,
deduction, or credit, or otherwise to adjust a partnership's or partner's tax
treatment in situations where a transaction meets the literal requirements of a
statutory or regulatory provision, but where the IRS believes the results are
inconsistent with the intent of the Code's partnership tax rules. The IRS also
has issued a series of far-reaching anti-abuse rules under its legislative grant
of regulatory authority in the consolidated return area. For example, under
Treas. Reg. Sec. 1. 1 502-20, a parent corporation is severely limited in its
ability to deduct any loss on the sale of a consolidated subsidiary's stock. The
consolidated return investment basis adjustment rules also contain an
anti-avoidance rule." The rule provides that the IRS may make adjustments "as
necessary" if a person acts with "a principal purpose" of avoiding the
requirements of the consolidated return rules. The consolidated return rules
feature several other anti-abuse rules as well. E. Treasury action Treasury on
numerous occasions has issued IRS Notices stating an intention to publish
regulations that would preclude favorable tax treatment for certain
transactions. Thus, a Notice allows the government (assuming that the particular
action is within Treasury's rulemaking authority) to move quickly, without
having to await development of the regulations themselves - often a time-
consuming process - that provide more detailed rules concerning a particular
transaction. Examples of the use of this authority include Notice 97-2 1, in
which the IRS addressed multiple-party financing transactions that used a
special type of preferred stock; Notice 95-53, in which the IRS addressed the
tax consequences of "lease strip" or "stripping transactions" separating income
from deductions; and Notices 94-46 and 94-93, addressing so-called corporate
inversion" transactions viewed as avoiding the 1986 Act's repeal of the General
Utilities doctrine. Moreover, section 7805(b) of the Code expressly gives the
IRS authority to issue regulations that have retroactive effect "to prevent
abuse." Although many Notices have set the date of Notice issuance as the
effective date for forthcoming regulations, Treasury has used its authority to
announce regulations that would be effective for periods prior to the date the
Notice was issued. Alternatively, Treasury in Notices has announced that it will
rely on existing law to challenge abusive transactions that already have
occurred. F. Targeted legislation To the extent that Treasury and the IRS may
lack rulemaking or administrative authority to challenge a particular type of
transaction, one other highly effective avenue remains open - that is, enactment
of legislation. In this regard, over the past 30 years dozens upon dozens of
changes to the tax code have been enacted to address perceived abuses. For
example, Congress last year enacted legislation (H.R. 435) addressing
"basis-shifting" transactions involving transfers of assets subject to
liabilities under section 357(c). These targeted legislative changes often have
immediate, or even retroactive, application. The section 357(c) provision, for
example, was made effective for transfers on or after October 19, 1998 - the
date House Ways and Means Committee Chairman Bill Archer introduced the proposal
in the form of legislation. Chairman Archer took this action, in part, to stop
these transactions earlier than would have been accomplished under the effective
date originally proposed by Treasury (the date of enactment). G. IRS National
Office Activities Regarding "Corporate Tax Shelters" The question whether broad
legislative action regarding "corporate tax shelters" is warranted at this time
should be considered in view of current administrative initiatives now being
undertaken at the IRS. Larry Langdon, Commissioner of the IRS's new Large and
Mid-Size Business Division, has announced that the IRS is establishing a special
office to coordinate IRS efforts to address corporate tax shelter issues. The
new office will allow for quick communication between IRS examiners, the IRS
Chief Counsel, and the Treasury Department in identifying and addressing abuses.
These IRS efforts will serve as a strong deterrent to abusive transactions and
further call into question the need for legislative action at this time. VI.
CONCLUSION Congress should reject the broad legislative proposals regarding
"corporate tax shelters" that have been advanced by the Treasury Department and
others. The economic data indicate no need for these radical changes. Further,
the proposals that have been advanced to date are completely unnecessary in
light of the array of legislative, regulatory, administrative, and judicial
tools available to curtail perceived abuses. Finally, these proposals would
create an unacceptably high level of uncertainty and burdens for corporate tax
officials while potentially imposing penalties on legitimate transactions
undertaken in the ordinary course of business.
LOAD-DATE: March 13, 2000 
