Conducting business in a tax haven means that there are no taxes whatsoever.

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Which of the following are the three E's of state requirements for the CPA certification?
What is the firms financial position at a designated point in time?
Which of the following external users would require financial statement information specifically information?
Which is the lowest level of authoritative accounting literature?

[Senate Hearing 112-781] [From the U.S. Government Publishing Office] S. Hrg. 112-781 OFFSHORE PROFIT SHIFTING AND THE U.S. TAX CODE--PART 1 (MICROSOFT AND HEWLETT-PACKARD) ======================================================================= HEARING before the PERMANENT SUBCOMMITTEE ON INVESTIGATIONS of the COMMITTEE ON HOMELAND SECURITY AND GOVERNMENTAL AFFAIRS UNITED STATES SENATE ONE HUNDRED TWELFTH CONGRESS SECOND SESSION ---------- SEPTEMBER 20, 2012 ---------- Available via the World Wide Web: http://www.fdsys.gov/ Printed for the use of the Committee on Homeland Security and Governmental Affairs U.S. GOVERNMENT PRINTING OFFICE 76-071 WASHINGTON : 2012 ----------------------------------------------------------------------- For sale by the Superintendent of Documents, U.S. Government Printing Office Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; DC area (202) 512-1800 Fax: (202) 512-2104 Mail: Stop IDCC, Washington, DC 20402-0001 OFFSHORE PROFIT SHIFTING AND THE U.S. TAX CODE-- PART 1 (MICROSOFT AND HEWLETT-PACKARD) For sale by the Superintendent of Documents, U.S. Government Printing Office, http://bookstore.gpo.gov. For more information, contact the GPO Customer Contact Center, U.S. Government Printing Office. Phone 202�09512�091800, or 866�09512�091800 (toll-free). E-mail, [email protected] COMMITTEE ON HOMELAND SECURITY AND GOVERNMENTAL AFFAIRS JOSEPH I. LIEBERMAN, Connecticut, Chairman CARL LEVIN, Michigan SUSAN M. COLLINS, Maine DANIEL K. AKAKA, Hawaii TOM COBURN, Oklahoma THOMAS R. CARPER, Delaware SCOTT P. BROWN, Massachusetts MARK L. PRYOR, Arkansas JOHN McCAIN, Arizona MARY L. LANDRIEU, Louisiana RON JOHNSON, Wisconsin CLAIRE McCASKILL, Missouri ROB PORTMAN, Ohio JON TESTER, Montana RAND PAUL, Kentucky MARK BEGICH, Alaska JERRY MORAN, Kansas Michael L. Alexander, Staff Director Nicholas A. Rossi, Minority Staff Director Trina Driessnack Tyrer, Chief Clerk Patricia R. Hogan, Publications Clerk ------ PERMANENT SUBCOMMITTEE ON INVESTIGATIONS CARL LEVIN, Michigan, Chairman THOMAS R. CARPER, Delaware TOM COBURN, Oklahoma MARY L. LANDRIEU, Louisiana SUSAN M. COLLINS, Maine CLAIRE McCASKILL, Missouri SCOTT P. BROWN, Massachusetts JON TESTER, Montana JOHN McCAIN, Arizona MARK BEGICH, Alaska RAND PAUL, Kentucky Elise J. Bean, Staff Director and Chief Counsel Robert L. Roach, Counsel and Chief Investigator David H. Katz, Senior Counsel Daniel J. Goshorn, Counsel Christopher Barkley, Staff Director to the Minority Keith B. Ashdown, Chief Investigator to the Minority Mary D. Robertson, Chief Clerk C O N T E N T S ------ Opening statements: Page Senator Levin................................................ 1 Senator Coburn............................................... 8 Prepared statements: Senator Levin................................................ 77 WITNESSES Thursday, September 20, 2012 Stephen E. Shay, Professor of Practice, Harvard Law School, Cambridge, Massachusetts....................................... 10 Reuven S. Avi-Yonah, Irwin I. Cohn Professor of Law, University of Michigan School of Law, Ann Arbor, Michigan................. 12 Jack T. Ciesielski, President, R.G. Associates, Inc., Baltimore, Maryland....................................................... 14 William J. Sample, Corporate Vice President, Worldwide Tax, Microsoft Corporation, Redmond, Washington..................... 29 Lester D. Ezrati, Senior Vice President, Tax, Hewlett-Packard Company, Palo Alto, California, accompanied by John N. McMullen, Senior Vice President and Treasurer, Hewlett-Packard Company, Palo Alto, California................................. 39 Beth Carr, Partner, International Tax Services, Ernst & Young LLP, New York, New York........................................ 41 Hon. William J. Wilkins, Chief Counsel, Internal Revenue Service, accompanied by Michael Danilack, Deputy Commissioner (International), Large Business and International Division, Internal Revenue Service....................................... 59 Susan M. Cosper, Technical Director, Financial Accounting Standards Board, Norwalk, Connecticut.......................... 62 Alphabetical List of Witnesses Avi-Yonah, Reuven S.: Testimony.................................................... 12 Prepared statement........................................... 97 Carr, Beth: Testimony.................................................... 41 Prepared statement........................................... 119 Cosper, Susan M.: Testimony.................................................... 62 Prepared statement........................................... 150 Ciesielski, Jack T.: Testimony.................................................... 14 Prepared statement........................................... 103 Ezrati, Lester D.: Testimony.................................................... 39 Prepared statement........................................... 135 McMullen, John N.: Prepared statement........................................... 135 Sample, William J.: Testimony.................................................... 29 Prepared statement........................................... 112 Shay, Stephen E.: Testimony.................................................... 10 Prepared statement........................................... 87 Wilkins, Hon. William J.: Testimony.................................................... 59 Prepared statement........................................... 147 EXHIBIT LIST 1. a. GMemorandum from Permanent Subcommittee on Investigations. 160 b. GCorporate Income Tax as a Percent of Total Revenue, chart prepared by the Permanent Subcommittee on Investigations....... 187 c. GUndistributed Foreign Earnings, 2001-2010, S&P 500, chart prepared by the Permanent Subcommittee on Investigations, Source: Credit Suisse.......................................... 188 d. G2011 Microsoft Intellectual Property Payments (Puerto Rico), chart prepared by the Permanent Subcommittee on Investigations....... 189 e. G2011 Microsoft Intellectual Property Payments (Two Examples), chart prepared by the Permanent Subcommittee on Investigations................................................. 190 f. GHewlett-Packard Offshore Alternating Loan Program, chart prepared by the Permanent Subcommittee on Investigations....... 191 g. GImpact of Check the Box, chart prepared by the Permanent Subcommittee on Investigations................................. 192 h. GSummary of CFC Cash Pool Loans to HP Co. US--Fiscal Year 2009, prepared by the Permanent Subcommittee on Investigations. 193 2. GCharts prepared by Jack Ciesielski, R.G. Associates, Inc. a. GS&P 500: Cumulative Indefinitely Reinvested Earnings, 2004-2008...................................................... 196 b. GS&P 500: Cumulative Indefinitely Reinvested Earnings, 2001 Vs. 2006.................................................. 197 3. GDocuments related to Hewlett-Packard a. GHewlett-Packard E&P and Tax for Materials Entities (FY10) 198 b. GHewlett-Packard Short Term Liquidity Update, including slides entitled, Offshore cash pools and Access to offshore cash, dated October 7, 2008................................................ 199 c. GHewlett-Packard Co. Repatriation History, including slides entitled, Repatriation History and Alternating Loans, undated............ 203 d. GHewlett-Packard Company Cash Profile, dated May 23, 2011. 206 e. GHewlett-Packard spreadsheet of inter-comany loans for FY 2009-2011...................................................... 209 f. GHewlett-Packard Company Historical APB 23 Summary........ 212 g. GHewlett-Packard Average Alternating Loan Summary for FY 2010-2012...................................................... 213 h. GExcerpt from Hewlett-Packard 2011 Walkthrough Template-- SOX Process Review................................................. 214 i. GHewlett-Packard/KPMG email, dated March 2010, re: apb 23 question....................................................... 218 j. GHewlett-Packard US Cash Forecast, FY 11.................. 219 k. GHewlett-Packard/Sandford C. Bernstein & Co. email, dated June 2006, re: Questions on Cash............................... 221 4. GDocuments related to Ernst & Young a. GErnst & Young internal email, dated September 2007, re: 956 issues..................................................... 223 b. GErnst & Young/HP email, dated April 2010, re: Your 956 Question ...................................................... 226 c. GErnst & Young internal email, dated September 2011, re: APB 23 and Congress............................................ 230 5. GDocuments related to Microsoft a. GSelected Microsoft Financial Data........................ 231 b. GSelected Microsoft Tax Information....................... 236 c. GMicrosoft Distribution Agreement......................... 238 6. GLetter clarifying testimony of Beth Carr, Ernst & Young LLP. 240 7. GResponses to supplemental questions for the record from Stephen E. Shay, Harvard Law School............................ 242 8. GResponses to supplemental questions for the record from Reuven S. Avi-Yonah, Irwin I. Cohn Professor of Law, The University of Michigan School of Law......................................... 250 9. GResponses to supplemental questions for the record from Bill Sample, Corporate Vice President for Worldwide Tax, Microsoft Corporation.................................................... 252 10. a. GResponses to supplemental questions for the record from Beth Carr, Partner, International Tax Services, Ernst & Young LLP............................................................ 255 b. GSEALED EXHIBIT: Responses to supplemental questions 8 and 9 for the record from Ernst & Young LLP........................ 260 11. a. GResponses to October 17, 2013 supplemental questions for the record from Lester Ezrati, Senior Vice President and Tax Director; and John N. McMullen, Senior Vice President and Treasurer, Hewlett-Packard Company............................. 261 b. GPermanent Subcommittee on Investigations' February 6, 2013 followup questions and Hewlett-Packard's March 1, 2013 responses, with attachments.................................... 358 c. GPermanent Subcommittee on Investigations' March 22, 2013 followup questions and Hewlett-Packard's April 12, 2013 responses, with attachments.................................................... 612 12. GResponses to supplemental questions for the record from the Honorable William J. Wilkins, Chief Counsel, Internal Revenue Service, and Michael Danilack, Deputy Commissioner (International) of the Large Business and International Division, Internal Revenue Service............................. 622 OFFSHORE PROFIT SHIFTING AND THE U.S. TAX CODE--PART 1 (MICROSOFT AND HEWLETT-PACKARD) ---------- THURSDAY, SEPTEMBER 20, 2012 U.S. Senate, Permanent Subcommittee on Investigations, of the Committee on Homeland Security and Governmental Affairs, Washington, DC. The Subcommittee met, pursuant to notice, at 2:09 p.m., in room G-50, Dirksen Senate Office Building, Hon. Carl Levin, Chairman of the Subcommittee, presiding. Present: Senators Levin and Coburn. Staff Present: Elise J. Bean, Staff Director and Chief Counsel; Mary D. Robertson, Chief Clerk; Robert L. Roach, Counsel and Chief Investigator; David H. Katz, Senior Counsel; Daniel J. Goshorn, Counsel; Brian Egger, Detailee; Allison F. Murphy, Counsel; Eric Walker, Detailee; Noah Czarny, Law Clerk; Brittany Hilbert, Law Clerk; Christopher Barkley, Staff Director to the Minority; and Keith B. Ashdown, Chief Investigator to the Minority. OPENING STATEMENT OF SENATOR LEVIN Senator Levin. Good afternoon, everybody. The Subcommittee will come to order. Senator Coburn will be joining us a little bit later. We have a vote on now in the Senate also. America stands on the edge of a fiscal cliff, and this challenge lends new urgency to a topic that this Subcommittee has long investigated: How U.S. citizens and corporations have used loopholes and gimmicks to avoid paying taxes. This Subcommittee has demonstrated in hearings and comprehensive reports how various schemes have helped to shift income to offshore tax havens and avoid U.S. taxes. The resulting loss of revenue is one significant cause of the budget deficit and adds to the tax burden that ordinary Americans bear. U.S. multinational corporations benefit from the security and stability of the U.S. economy, from the productivity and expertise of U.S. workers, and the strength of U.S. infrastructure to develop enormously profitable products here in the United States. But, too often, too many of these corporations use complex structures, dubious transactions, and legal fictions to shift the profits from those products overseas, avoiding the taxes that help support our security, stability, and productivity. The share of Federal tax revenue contributed by corporations has plummeted in recent decades. That places an additional burden on other taxpayers. The massive offshore profit shifting that is taking place today is doubly problematic in an era of dire fiscal crisis. Budget experts across the ideological spectrum are unified in their belief that any serious attempt to address the deficit must include additional Federal revenue. Federal revenue as a share of our economy has plummeted to historic lows--about 15 percent of gross domestic product (GDP) compared to a historic average of roughly 19 percent. The Simpson-Bowles report sets a goal for Federal revenue at 21 percent of gross domestic product. The fact that we are today so far short of that goal is, in part, due to multinational corporations avoiding U.S. taxes by shifting their profits offshore. More than 50 years ago, President Kennedy warned that ``more and more enterprises organized abroad by American firms have arranged their corporate structures aided by artificial arrangements . . . which maximize the accumulation of profits in the tax haven . . . in order to reduce sharply or eliminate completely their tax liabilities.'' So this problem is not new. But it has gotten worse, far worse. And what is the result? Today U.S. multinational corporations have stockpiled $1.7 trillion in earnings offshore. That is not a pretty picture, and it is not an unacceptable one. Today we are going to try to shine some light on some of the transactions and gimmicks that multinationals use to shift income overseas, exploiting tax loopholes and an ineffective regulatory framework. We are going to examine the actions of two U.S. companies-- Microsoft and Hewlett-Packard (HP)--as case studies of how U.S. multinational corporations, first, exploit the weaknesses in tax and accounting rules and lax enforcement; second, effectively bring those profits to the United States while avoiding taxes; and, third, artificially improve the appearance of their balance sheets. The first step in shifting profits offshore takes place when a U.S. company games the transfer pricing process to sell or license valuable assets that it developed in the United States to its subsidiary in a low-tax jurisdiction for a price that is lower than fair market value. Under U.S. tax rules, a subsidiary must pay arm's-length prices for these assets, but valuing assets such as intellectual property is complex, so it is hard to know what an unrelated third party would pay. These transactions transfer valuable intellectual property to wholly owned subsidiaries. Multinational companies and the legions of economists and tax lawyers advising them take full advantage of this situation to set an artificially low sale price to minimize the U.S. parent company's taxable income. The result is that the profits from assets developed in the United States are shifted to subsidiaries in tax havens and other low- tax jurisdictions. It is generally accepted that the transfer pricing process is widely abused and has resulted in significant revenue loss to the U.S. Government. In a 2010 report, the Congressional Joint Committee on Taxation wrote that a ``principal tax policy concern is that profits may be artificially inflated in low-tax countries and depressed in high-tax countries through aggressive transfer pricing that does not reflect an arms- length result from a related-party transaction.'' We have a chart here which depicts Microsoft's transfer pricing agreements with two of its main offshore groups.\1\ As we can see from the chart, in 2011 these two offshore groups paid Microsoft $4 billion for certain intellectual property rights; Microsoft Singapore paid $1.2 billion, and Microsoft Ireland paid $2.8 billion. But look at what those offshore subsidiaries received in revenue for those same rights: Microsoft Singapore received $3 billion; and Microsoft Ireland, $9 billion. So Microsoft USA sold those rights for $4 billion, and those offshore subsidiaries collected $12 billion. That means that Microsoft shifted $8 billion in income offshore. Yet over 85 percent of Microsoft's research and development is conducted in the United States. --------------------------------------------------------------------------- \1\ The chart referenced appears as Exhibit No. 1e and can be found in the Appendix on page 190. --------------------------------------------------------------------------- Another maneuver by Microsoft deserves attention: Its transfer pricing agreement with a subsidiary in Puerto Rico. Generally, transfer pricing agreements involve the rights of offshore subsidiaries to sell the assets in foreign countries. The U.S. parent generally continues to own the economic rights for the United States, sell the related products here, collect the income here, and pay taxes here. However, in the case of Microsoft, it has devised a way to avoid U.S. taxes even on a large portion of the profit that it makes from sales here in the United States. Microsoft sells the rights to market its intellectual property in the Americas--which includes the United States--to Microsoft Puerto Rico. Microsoft in the United States then buys back from Microsoft Puerto Rico the distribution rights for the United States. The U.S. parent buys back a portion of the rights that it just sold, and it does so at the same time. Now, why did Microsoft do that? Because under the distribution agreement, Microsoft U.S. agrees to pay Microsoft Puerto Rico a certain percentage of the sales revenues that it receives from distributing Microsoft products in the United States. Last year, 47 percent of Microsoft's sales proceeds in the United States were shifted to Puerto Rico under this arrangement. And the result? Microsoft U.S. avoids U.S. taxes on 47 cents of each dollar of sales revenue that it receives from selling its own products right here in this country. The product is developed here. It is sold here, to customers here. And yet Microsoft pays no taxes here on nearly half the income. By routing its activity through Puerto Rico in this way, Microsoft saved over $4.5 billion in taxes on goods sold in the United States during the 3 years surveyed by the Subcommittee. That is $4 million a day in taxes that Microsoft is not paying. It is also important to note that Microsoft's U.S. parent paid significantly more for just the U.S. rights to this property than it received from the Microsoft Puerto Rico for a much broader package of rights. Now, that is the first step: Shifting assets and profits out of the United States to a low- tax jurisdiction. Next, we move to a second realm of tax alchemy, featuring structures and transactions that require a suspension of belief to be accepted. Once again, the basic rule is pretty straightforward. If a company earns income from an active business activity offshore, it owes no U.S. tax until the income is returned to the United States. This is known as ``deferral.'' However, as established under Subpart F of the Tax Code, deferral is not permitted for passive, inherently mobile income such as royalty, interest, or dividend income. Subpart F should result in a significant tax bill for a U.S. parent company's offshore income. Once the offshore subsidiaries acquire the rights to the assets, they sublicense those rights and collect license fees or royalties from their lower-tier related entities--exactly the kind of passive income that is subject to U.S. tax under the anti- deferral provision of Subpart F. But this straightforward principle has been defeated by regulations, exclusions, temporary statutory changes, and gimmicks by multinational corporations and by weak enforcement by the IRS. On January 1, 1997, the Treasury Department implemented the so-called check-the-box regulations, which allow a business enterprise to declare what type of legal entity it wanted to be considered for Federal tax purposes and to do so by simply checking a box. This opened the floodgates for the U.S. multinational corporations trying to get around the taxation of passive income under Subpart F. They could set up their offshore operations so that an offshore subsidiary which holds the company's valuable assets could receive passive income such as royalty payments and dividends from other subsidiaries and still defer the U.S. taxes owed on them. The loss to the U.S. Treasury is enormous. During its current investigation, the Subcommittee has learned that for fiscal years 2009, 2010 and 2011, Apple, for instance, has been able to defer taxes on over $35.4 billion in offshore passive income covered by Subpart F; Google has deferred over $24.2 billion in the same period; and for Microsoft, the number is $21 billion. In March 1998, a little over a year after it issued the check-the-box regulations, the Treasury Department issued a proposed regulation to end the check-the-box option. The proposal was met with such opposition from Congress and industry groups that it was never adopted. In 2006, in response to corporate pressure to protect this lucrative tax gimmick, Congress enacted the ``Look-through Rule for Related CFCs,'' and that excludes certain passive income, including interest, rents, and royalties, from Subpart F. This provision is up actually right as we speak for extension. Now we come to a third level of tax gimmickry. After multinational corporations transfer their assets and profits offshore and place them in a complex network of offshore structures to shelter them from U.S. taxes, some companies still want to bring those earnings back to the United States without paying taxes. A U.S. parent is supposed to be taxed on any profits that its offshore subsidiaries send to it. If a foreign subsidiary loans money to a related U.S. entity, that money also is subject to U.S. taxes. But once again, that simple concept is subverted in practice. The Tax Code includes a number of exclusions and limitations in the rule governing loans. Short-term loans are excluded if they are repaid within 30 days, as are all loans made over the course of a year if they are outstanding for less than 60 days in total. This exclusion allows offshore profits to be used for short-term lending--no matter how large the amount--without being subject to U.S. taxes. What is more, if a controlled foreign corporation (CFC)-- makes a loan to a related U.S. entity that is initiated and concluded before the end of the CFC's quarter, the loan is not subject to the 30-day limit and does not count against the aggregate 60-day limit for the fiscal year. In addition, the IRS declared that the limitations on the length of loans apply separately to each CFC of a company. So when aggregated, all loans for all CFCs could be outstanding for more than 60 days in total. Companies have used these loopholes to orchestrate a constant stream of loans from their own CFCs without ever exceeding the 30- and 60-day limits or extending over the end of a CFC's quarter. Instead of being a mechanism to ensure taxes are paid for offshore profits returned to the United States, the rule has become a blueprint on how to get billions of dollars back into the U.S. tax free. Take a look at Hewlett-Packard. It has used a loan program to return offshore profits back to the United States since as early as 2003 and 2004. In 2008, Hewlett-Packard started a new loan program called the ``staggered'' or ``alternating'' loan program. Funding for the loans came mainly from two Hewlett- Packard sources or pools: First, the Belgian Coordination Center (BCC); and the second, the Compaq Cayman Holding Corp (CCHC). The loans from these two offshore entities helped fund HP's general operations in the United States, including payroll and repurchases of HP stock. HP documents indicate that the lending by these two entities was essential for funding U.S. operations because Hewlett-Packard did not have adequate cash in the United States to run its operations. In 2009, HP held $12.5 billion in foreign cash and only $0.8 billion in U.S. cash and projected that in the following year it would hold $17.4 billion in foreign cash and only $400 million in U.S. cash. The loan program, the so-called staggered or alternating loan program, was designed to enable Hewlett-Packard to orchestrate a series of back-to-back-to-back-to-back loans to the United States and to provide a continuous stream of offshore profits to the United States without paying U.S. taxes. In fact, Hewlett-Packard even changed the fiscal year and quarter endings of one of the lending entities. That way, there could be a continuous flow of loans through the whole year without extending over the quarter ending of either of the lending entities. Now, we will take a look now at the loan schedule that was outlined in a Hewlett-Packard document, and there is a copy of this in front of us. Every single day is covered by a loan from a CFC, from a Hewlett-Packard CFC. In fiscal year 2010, for example, Hewlett-Packard's U.S. operations borrowed between $6 and $9 billion, primarily from BCC and CCHC, without interruption throughout the first three quarters. There does not appear to be a gap of even a single day during that period where the loaned funds of either BCC or CCHC were not present in the United States. A similar pattern of continuous lending appears for most of the period between 2008 through 2011. Now, what were the loans used for? One Hewlett-Packard PowerPoint characterized the loan program as ``the most important source of liquidity for repurchases and acquisitions.'' That does not sound like a short-term loan program. It was closely coordinated by the Hewlett-Packard treasury and tax departments to systematically and continually fund Hewlett-Packard's U.S. operations with billions of dollars each year since 2008, and likely before that. This loan program is the ultimate example of form over substance. This is so blatant that internal Hewlett-Packard documents openly referred to this program as part of its ``repatriation history,'' part of its ``repatriation strategy''--and, of course, repatriation is totally contrary to the notion that this was a short-term loan program and, indeed, leads to paying U.S. taxes. Now, this scheme mocks the notion that profits of U.S. multinationals are ``locked up'' or ``trapped'' offshore. Rather, some of them have effectively and systematically been bringing those offshore profits back by the billions for years through loan schemes like the one described here, and are doing so without paying taxes. The IRS has stated that the substance, not the form, of offshore loans should be reviewed. So it will be interesting to hear today from the IRS about this loan scheme, from HP's auditors at Ernst & Young who approved it. The Subcommittee has examined a fourth level of offshore shenanigans. It involves an accounting standard known as APB 23, which, among other things, addresses how U.S. multinationals should account for taxes that they will have to pay when they repatriate the profits currently held by their offshore subsidiaries. Under APB 23, when corporations hold profits offshore, they are required to account on their financial statements for the future tax bill they would face if they repatriate those funds. Doing so would result in a big hit to earnings. But companies can avoid that requirement and claim an exemption if they assert that the offshore earnings are permanently or indefinitely reinvested offshore. Multinationals routinely make such an assertion to investors and the Securities and Exchange Commission on their financial reports. And yet many multinationals have at the same time launched a lobbying effort, promising to bring these billions of offshore dollars back to the United States if they are granted a ``repatriation holiday,'' which is a tax break for bringing offshore funds to the United States. So, on the one hand, those companies assert they intend to indefinitely or permanently invest this money offshore. Yet they promise, on the other hand, to bring it home as soon as it is granted a tax holiday. That is not my definition of ``permanent.'' While this may seem like an obscure matter, it is a major issue for U.S. multinational corporations. A 2010 survey of nearly 600 tax executives reported that ``60 percent of the respondents indicate that they would consider bringing more cash back to the United States even if it meant incurring the U.S. cash taxes upon repatriation, if their company had to record financial accounting tax expense on those earnings regardless of whether they repatriate.'' In 2011, more than 1,000 U.S. multinationals claimed this exemption in their Securities and Exchange Commission (SEC) filings, reporting more than $1.5 trillion in money that they say is intended to be reinvested offshore. Now, this build-up has started to create some problems for many companies. With such a large percentage of their earnings offshore--and a lot of those designated as indefinitely reinvested--they need to figure out ways to finance operations here in the United States without drawing on those earnings. But as the amount of earnings stashed overseas has reached $1.5 trillion, and the need for financing grows back home, there is a real question whether companies can continue to defend their assertions that they have legitimate plans and the intent to continue to indefinitely reinvest those funds, and billions and billions more to come, overseas. This situation is also creating a dilemma for their auditors, who sign off on those assertions and plans. In one document, an auditor at Ernst & Young wrote to a colleague the following: ``Under the APB 23 exception, clients are presumed to repatriate foreign earnings but do not need to provide deferred taxes on those foreign earnings that are `indefinitely or permanently reinvested.' '' And he continued: ``If Congress enacts a similar law and companies repatriate earnings that it previously had needed to be permanently reinvested in foreign operations, what effect does that second repatriation have on a future assertion that any remaining earnings are indefinitely or permanently reinvested?'' And he continued: ``An assertion of indefinite or permanent investment until Congress changes the law allowing cheaper repatriation again does not sound permanent.'' The issue that is raised by that account is not theoretical. Another chart provided by one of the expert witnesses that we will hear from today shows what happened to the indefinitely reinvested earnings of the Standard & Poor's 500 companies after the repatriation holiday was passed in 2004. It shows that the total amount of permanently reinvested earnings declined by $84 billion after the repatriation bill passed. And then, as soon as the repatriation period ended, the total amount of offshore earnings these companies claimed as permanently or indefinitely reinvested skyrocketed again-- increasing by 20 percent or more in almost every year since 2005. Well, what does that say about the true intent of those companies? To me, it says that this money is not held offshore for permanent reinvestment. It is there to avoid taxes. Yet the auditors who must pass off on the validity of a company's assertion and the Financial Accounting Standards Board (FASB), have appeared to go along, and that is an issue that we will discuss today with those witnesses. The bottom line of our investigation is that some multinationals use our current tax system to engage in gimmicks to avoid paying the taxes that they owe. It is a system that multinationals have used to shift billions of dollars of profit offshore and avoid billions of dollars in U.S. taxes, to their enormous benefit. Who are the losers in this shell game? There are many. It is our government, which provides the services and security that help many of those multinational corporations grow and prosper and then watches them shift their profits offshore to avoid paying taxes. It is other citizens and businesses who must shoulder a greater tax burden. And it is our domestic industries that do not exploit the Tax Code to shift profits offshore and avoid U.S. taxes. And, finally, it is the integrity and the viability of our tax system. So today we will be taking a look at how this system works, the legal contortions on which it is based, its gimmicks and charades, and hopefully, we can generate some enthusiasm to fix it. Now let me call on Dr. Coburn, with thanks again for his, as always is the case, strong support, himself personally and his staff, so that these reports of ours and in this case the memorandum of ours can, in fact, emanate on a bipartisan basis. Dr. Coburn. OPENING STATEMENT OF SENATOR COBURN Senator Coburn. Mr. Chairman, thank you. I do have some concerns with the haste at which we accomplished this memorandum. I would also say that, by training, I was trained and graduated with a degree in accounting, and tax avoidance is not illegal. The Congress has created this situation. Our problem is we have the highest corporate tax rate in the world. It is, on average, double 90 other countries' in the world. And we have a Tax Code that is miles long, that is complicated, and we are talking about symptoms of that code today, not solutions of the real disease, which is reforming the code and lowering the rates. We are one of the few countries that has a worldwide tax system which double taxes corporate profits, and we have smart businessmen who know what the rules are, what the IRS has said. They hire smart people to make and maximize their profits, their liquidity, and their assets. There is nothing wrong with that. There is nothing immoral with that. It is the system that Congress has set up. As a member of the Finance Committee, one of the things we have to do if we are going to fix our country is we have to change that code. We have to change those rates. We have to make it simpler. We have to make it more straightforward. And all in the process of this, we have transferred growth out of this country. We have incentivized investment overseas. We have incentivized capital formation overseas instead of capital formation at home. And then we are critical when people take advantage of the very statutes, rules, and regulations that we ourselves have created. What it does is it calls blatantly and honestly for tax reform in this country. It is the key to getting out of the economic doldrums that we are in. It is the key to quit misdirecting investment capital. It is the key to increasing jobs in our country. So, Mr. Chairman, our report is about the symptoms of the disease, not the real disease. And I agree on face that many of these do not look great, but they are legal. They are properly legal tax avoidance. I do not like them. I understand how they work. The short-term loans, I understand that. But under the technicalities of the law, they are accurate. So they spend a lot of money with accountants and auditing firms to take advantage of every loophole that we have created in the tax system, to take advantage of a corporate tax rate that is twice the world's average, to lessen that impact as good fiduciaries. There is nothing heinous in that. There is nothing illegal in that. And, in fact, if we want to change it, what I would invite my Chairman is come join us on the Finance Committee and help me change it. The other thing that I would note, Mr. Chairman, is that I will be in and out of this hearing with other obligations and will try to be here as much as I can. I thank you again for holding the hearing. I think it is a good precursor to getting real tax reform for our country. Senator Levin. Thank you so much, Dr. Coburn. We will be exploring today a number of the gimmicks and the practices that have been used by these two companies, and it will then be determined by others as to whether or not they are in compliance with our Tax Code. You mentioned, for instance, this loan program. I think it is highly dubious, frankly, that the loan program complies with our current tax law. But that is not for me or us to say. That is going to be hopefully for the IRS to review. But there is an awful lot of evidence which we are going to be presenting here today relative to that loan program, for instance, that Hewlett-Packard has put into place as to whether that is in compliance with the existing law and regulation. And we will be presenting evidence which will raise, I think, significant questions as to whether or not, in fact, it does comply. As to the transfer pricing issue, whether or not these are, in fact, fair prices that are paid for these assets will be determined by others. We have witnesses today that I think are going to testify that, in fact, they are not fair, arm's-length prices that are being paid. But, again, that will be either demonstrated or not by the testimony and the exhibits that we are going to be bringing forward today. But I agree with Dr. Coburn, our code is far too complex, and I also agree that the fact that you try to lower your taxes is not illegal in and of itself. However, there are ways that you can try to reduce your taxes that do not comply with our tax law, and that is up to the IRS and the courts to determine, and I think we will be presenting evidence today which raises some very serious questions as to whether or not some current practices, in fact, do comply with our existing tax law, as complicated as they are. So I heartily agree on the complexity point, but, again, I think that our report lays out some very significant evidence that it is highly dubious that some of these practices comply with existing IRS regulations or existing law. Finally, as I mentioned I think before you came, Dr. Coburn, the Congress is to blame for some of this. There is no doubt about that. I believe failure to enforce compliance by the IRS is to blame for part of this. But I also believe that some of the loopholes that have been used, in fact, are not true loopholes, that they are not true allowances; quite to the contrary, that the practices are using form over substance, and under court decisions the IRS is able to pierce through forms which are phony and get to the substance. They do that in many cases which have been decided, and it is very important that the IRS continue on that course. Having said all that, I will now call on our first panel of witnesses: Professor Stephen Shay, Harvard Law School in Cambridge; Professor Reuven Avi-Yonah, the Irwin Cohn Professor of Law at the University of Michigan Law School; and Jack Ciesielski, who is a Certified Public Accountant and President of R.G. Associates, Inc., of Baltimore, Maryland. I appreciate all of you coming here today. We look forward to your testimony. We very much appreciate your legal and accounting expertise being shared with us. Pursuant to Rule VI, all witnesses who testify before the Subcommittee are required to be sworn, and so at this time I would ask all of you to please stand and raise your right hand. Do you swear that the testimony you are about to give will be the truth, the whole truth, and nothing but the truth, so help you, God? Mr. Shay. I do. Mr. Avi-Yonah. I do. Mr. Ciesielski. I do. Senator Levin. We will use our traditional timing system today. One minute before a red light comes on, you will see the lights change from green to yellow, giving you an opportunity to conclude your remarks. While your written testimony will be printed in the record in its entirety, we ask that you limit your oral testimony to no more than 7 minutes. We will start with Professor Shay, followed by Professor Avi-Yonah, and then Mr. Ciesielski. Then we will turn to questions. So, Professor Shay, please proceed. TESTIMONY OF STEPHEN E. SHAY,\1\ PROFESSOR OF PRACTICE, HARVARD LAW SCHOOL, CAMBRIDGE, MASSACHUSETTS Mr. Shay. Thank you, Chairman Levin, Ranking Member Coburn, and Members of the Subcommittee, for the opportunity to testify. I am a professor of practice at Harvard Law School, but the views I am expressing are my personal views. Thank you for putting the testimony in the record. I will just summarize some of the key points in my testimony, taking account of your summary of the law in your opening statement. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Shay appears in the Appendix on page 87. --------------------------------------------------------------------------- The combination of deferral of U.S. taxes on earnings earned and reinvested at low foreign tax rates and current deductions for expenses contributing to earning this deferred income is a powerful incentive to shift income offshore. Financial accounting rules contribute to that, but that is going to be the subject of another witness. Statistics of Income data for 2006 show that approximately 80 percent of controlled foreign corporate earnings are retained and deferred from U.S. taxation, roughly 8 percent are distributed as dividends and 12 percent are currently taxed under Subpart F. But one should recognize that in that 12 percent is Subpart F income that is generated deliberately either to avoid foreign withholding tax or to bring back other foreign tax credits to use to offset U.S. taxes on other income. Once the income is deferred, there are a set of rules, the investment in U.S. property rules, that restrict a controlled foreign corporation from making its offshore earnings available to its affiliated U.S. group other than through a taxable distribution or income inclusion. The objective of these rules is to protect the U.S. income tax base by preventing a U.S. multinational from using earnings not taxed by the United States in its business in the United States. They also restrict the advantage that a multinational would have competing against a domestic U.S. business that will not have available to it the opportunity to earn low-tax foreign earnings. I note in my testimony that today's discussion is largely about U.S. multinationals. I think it is equally important that we worry about the treatment of non-U.S. multinationals investing in the United States, but that is a subject for a different day. The transfer pricing rules of Section 482 attempt to ensure that taxpayers clearly reflect income attributable to controlled transactions and to prevent the avoidance of taxes with respect to such transactions. They are intended to place a controlled taxpayer transaction on tax parity with an uncontrolled taxpayer transaction. In 2010, at the same hearing as the Joint Committee study that was referenced by the Chairman, the Treasury Department described increased tax-induced shifting of offshore U.S. corporate income documented in studies that were reviewed in its testimony. The Subcommittee staff 's investigation of Microsoft provides support for the Treasury's conclusions which were based on aggregate data by looking at a single company. In both cases, the issue is tax-induced income shifting to zero or low- tax jurisdictions, including countries that purport to tax but allow income allocations to low-tax areas, provide exemptions, or other special deductions to achieve a low effective tax rate. I am not going to repeat the Microsoft structure in business, and Professor Avi-Yonah will talk a little bit more about the specific techniques. But I wanted to summarize salient information from partial consolidating financial information that was provided to the Subcommittee staff in relation to the companies in Ireland, Singapore, and Puerto Rico. I also am not going to talk about specific companies. I have simply aggregated the results from the companies in those jurisdictions as shown in the information provided to the Subcommittee staff. So, first to set the stage, in fiscal year 2011, which is the year from which we have comparative information, Microsoft had global revenues of $69.9 billion and earnings before tax of $28 billion. This is all financial data. The global book tax rate was approximately 17.5 percent. Microsoft had approximately 90,000 employees. Based on its consolidating financials, in fiscal year 2011 the Irish, Singapore, and Puerto Rican companies combined earned approximately $15.4 billion in earnings before tax, or approximately 55 percent of global EBT. The average effective foreign tax rate for these companies combined on a book basis--because that is all we have--was approximately $15 billion, effective rate of 4 percent. In order to give one measure of this scale that is involved, the companies in these low-tax jurisdictions employed approximately 1,900 of Microsoft's 90,000 employees, yet these 1,914 employees earned $15.4 billion in EBT or over $8 million per employee, compared with the average for the global Microsoft employees, if you just take the average over the whole thing, of $312,000. I have not shown or seen sufficiently granular information to form a view as to whether these could be argued to be consistent with the current transfer pricing regulations. But whether they are or not, they are not consistent with a common- sense understanding of where the locus of Microsoft's economic activity, carried out by its 90,000 employees, is occurring. The tax motivation of the income location is evident. The incentive for multinational businesses to shift income abroad is increased when multinationals are able to use deferred earnings for investment in the United States. The investment in U.S. property rules are a firewall. They are intended to allow the continued benefit of deferral when the deferred earnings are reinvested in a multinational's non-U.S. business or in portfolio investments awaiting redeployment abroad. But they are intended to protect against a multinational's benefiting from deferral in its foreign businesses and then using the pre-U.S. tax earnings in its domestic business. Whether or not the particular HP transactions pass muster under current law, the structural objective of the investment in U.S. property rules is circumvented. And may I just add to that comment. The guidance that is referred to that was put out in 2009 that refers to loans from separate subsidiaries uses the word ``independent'' throughout, not ``concerted'' and ``prearranged.'' So I think that we need to be cautious about saying that you can do things from separate subsidiaries without adding that it cannot be prearranged, concerted, without running afoul or risking running afoul of the anti-abuse rules. Mr. Chairman, I think I have exhausted my time. I will be happy to take questions. Senator Levin. Thank you so much, Professor Shay. Professor Avi-Yonah. TESTIMONY OF REUVEN S. AVI-YONAH,\1\ IRWIN I. COHN PROFESSOR OF LAW, UNIVERSITY OF MICHIGAN SCHOOL OF LAW, ANN ARBOR, MICHIGAN Mr. Avi-Yonah. Thank you, Chairman Levin, for inviting me, and thanks, Ranking Member Coburn, as well. It is a pleasure to be here and to talk a little bit about, supplementing what Professor Shay just said, the ways in which U.S. multinationals achieve these pretty astonishing results. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Avi-Yonah appears in the Appendix on page 97. --------------------------------------------------------------------------- Going back to a period before 1986, it was standard practice for U.S. multinationals to conduct research and development in the United States, deduct the costs, and then transfer the resulting intangibles overseas to places such as Puerto Rico where all the profit was accumulated. Congress explicitly tried in 1986 to close this loophole by adopting a rule that said that when an intangible is transferred, a royalty has to be paid that is ``commensurate with the income'' attributable to that intangible which was designed to transfer all the income back onshore. The results of this Subcommittee's investigation show that we are back to where we were before 1986, and I think something needs to be done about it like it was back then. So how is this possible today? Well, there are two major issues that have been mentioned by the Chairman's remarks in the beginning, and I will just focus on those. The first one is the cost-sharing rules which were developed by the Treasury and the IRS primarily in the period after the 1986 rule change. And what those do is essentially allow a multinational to shift the economics of its intangibles offshore if various CFCs contribute to the development of those intangibles. Now, it is important to emphasize that nothing actually happens offshore. The money just goes into the CFCs and then back again, and you are allowed to then pay tax on those profits as if they were actually earned overseas in the same proportion as the CFC had contributed to the development of the intangible. Now, why is this problematic? It is problematic for a couple of reasons. The theory behind it is that you would be risking losing the deduction for the R&D to the extent that you put too much of the deduction in the CFCs and, therefore, you will not do too much of that. But there are two issues involved. The first one is the disproportion between the cost of development and the profits, and that you can see from the Microsoft case. The payments that were made under cost sharing to Microsoft U.S. are a very low percentage compared to the very significant profits that resulted from these same intangibles. And, again, remember there is nothing actually happening offshore, so there is no reason for these profits to be offshore at all. The assumption is that the multinationals will not know whether the R&D will be successful or not when it entered into the cost-sharing agreement and, therefore, would actually run a risk of losing the deduction if the development is unsuccessful. But the reality of the matter is that multinationals do know that the development will be successful. They enter into these agreements at the point where the intangible is, in fact, on the verge of being profitable, and they are the only ones that have this information. It is very hard for outsiders to get that information, and that has resulted in significant litigation, some of which the IRS has lost, over the valuation of so-called buy-in payments, which is what the CFCs have to pay for the parent earlier development before they enter into cost sharing. Second, as was mentioned in the beginning, there is this whole elaborate scheme of check the box and Subpart F and the CFC look-through rule. Essentially, the standard practice now is that the U.S. multinational will have single top CFC which is treated as a corporation under check the box, and that CFC will participate in the cost sharing and will be in a low-tax jurisdiction so it will hold the intangibles such as Ireland, Singapore, Puerto Rico, and the like. And then every other CFC that the multinational has below that top CFC will be check the box, be disregarded, and that as a result payments of, for example, royalties that go up to the top-level CFC from all the other very elaborate structure below that will be disregarded for Subpart F purposes and simply not exist. And it is that structure that is the standard tax planning device that all the multinationals use. Now, it has been said, since Treasury tried to check the box back in 1998, as was mentioned, that this is only about reducing foreign taxes because essentially the payments are shifted from high-tax foreign jurisdictions to low-tax foreign jurisdictions. But it is not only about reducing foreign taxes. What the Subcommittee data show is that essentially it is this device that enables the profits to accumulate in the low-tax jurisdiction offshore, and that is in turn what is making it possible and enticing for the multinationals to engage in the initial shifting of the profit. So that even in a situation where the sales, let us say, of the intangibles are in other countries rather than in the United States--and we have seen it in the case of Microsoft that some of them are, in fact, in the United States--the shifting is not costless to the U.S. Treasury. So those are the two main loopholes that we will discuss today. The third one, as was mentioned, was the fact that the earnings are not actually kept offshore. They are, in fact, brought back onshore by a variety of schemes, and the short- term loan is only one of them. There were lots of other ones which the IRS has been trying to fight. So what can be done about it? Well, I think overall we do need overall tax reform, as Senator Coburn has mentioned, and Senator Levin as well. We do need some kind of broader reform of the system, which at the same time as enabling us maybe to cut the corporate tax rate will also prevent particularly further profit shifting by adopting some rule that will not enable multinationals to locate their profits in places where they do not have any real activity. But at the very least, I would say that these two particular schemes, which I think are based on current Treasury and IRS regulations, need to be addressed. That is, I would recommend that Congress take steps to both eliminate check the box and the CFC look-through rule and at the same time restrict the ability to use cost sharing in order to shift profits offshore. Thank you very much. Senator Levin. Thank you very much, Professor Avi-Yonah. Mr. Ciesielski. TESTIMONY OF JACK T. CIESIELSKI,\1\ PRESIDENT, R.G. ASSOCIATES, INC., BALTIMORE, MARYLAND Mr. Ciesielski. Thank you, Chairman Levin and Dr. Coburn. I appreciate you inviting me to take part in this important hearing today. I will now present my views as summarized from my testimony, and I look forward to taking your questions afterwards. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Ciesielski appears in the Appendix on page 103. --------------------------------------------------------------------------- Senator Levin. And all the testimony will be made part of the record. Mr. Ciesielski. Right. Thank you. The APB 23 indefinite reinvestment exception has been part of generally accepted accounting principles in the United States for many years. It is an exception to the principle of providing income taxes on earnings of all of a company's subsidiaries based on the intentions of a firm's managers and the geographic location of the subsidiaries involved. Because the earnings of certain subsidiaries may be included in earnings reported to investors without income taxes accrued upon them, a dollar earned in foreign countries may be worth more than an after-tax dollar earned in the United States as long as the firm's managers have an intention to indefinitely reinvest the earnings. It should be noted that this exception affects only investor financial reporting. It does not affect tax law. Yet its availability to managers can exert influence and decisions as to where capital investments should be made. If a dollar earned overseas will still be worth a dollar after taxes compared to a dollar earned in the United States which will be worth 65 cents after taxes, where is a firm likely to invest? Net income and growth in net income is the scorecard by which firms and their managers are judged in the capital markets. So there will be a managerial bias to invest overseas and use this exception. While those indefinitely reinvested earnings may plump the firm's bottom line, there is a catch. To stay within the confines of the exception, indefinitely reinvested earnings are not available to investors, and investors have no way of knowing the degree to which net income is off limits to them. There is no segregation of such indefinitely reinvested earnings from all other earnings. Net income is one figure. Investors may flock to a firm with earnings that are essentially trapped by managerial intentions. Managers may use back-door approaches to moving cash between subsidiaries by intercompany loans, but this would appear to be an in substance violation of the intention to reinvest earnings indefinitely. The exception is not based on robust reasoning. What manager would not intend to minimize their firm's tax burden? Heavy industries continually reinvest in capital projects to obtain accelerated depreciation benefits and reduce their current income tax burden. They accrue deferred income taxes even though they intend to indefinitely reinvest their earnings this way. Would anyone suggest that they should not accrue deferred income taxes? The exception provides a powerful, flexible tool for managers to shape their earnings forecasts without real changes in underlying economics, mainly through changes of their intentions. Most managers have equity-based compensation awards, and they may also be incentivized by bonus programs for achieving particular earnings targets. Giving such a powerful tool to managers for shaping net income can lead to incentive problems. The indefinite reinvestment exception dates back to at least 1959. What may have been a minor distortion in financial reporting at that time has grown tremendously in an era of global markets, instant communications, and the ability to move cash around the world in seconds. Standard setters have not been in a hurry to revisit the issue. In their convergence efforts, the FASB and the International Accounting Standards Board (IASB) had a chance to eliminate the indefinite reinvestment exception in 2004. They decided not to act. Likewise, the SEC has done some letter writing to individual companies, but has done nothing in terms of setting standards of disclosure on the matter. Disclosure is not the solution to the problem, but greater disclosure would at least bring more attention to the problem. The extent to which the indefinite reinvestment exception affects any given company's earnings is not disclosed. Investors do not have a clear idea of how much this kind of encumbered income comprises net income and have little idea of how it will affect future earnings and cash flow. The exception benefits a relatively few firms, the ones with the most portable assets and the greatest global footprint. At the end of 2011, there was $1.5 trillion of accumulated indefinitely reinvested earnings in the S&P 500 firms. Of that total, 72 percent of the amount belonged to only 50 companies, 16 percent of the 318 companies showing such balances. There were 182 firms in the S&P 500 that showed no accumulated indefinitely reinvested earnings, and I would mention that some of them were more or less geographically landlocked, financial institutions that operate domestically, which calls into question if this is actually something that benefits a small group of select companies. To the extent that the indefinite reinvestment exception distorts earnings reporting, it introduces inefficiencies into the capital allocation process of markets. If these earnings influence investors to favor securities of such companies, they may not be getting what they expect, and they may have forgone other opportunities. Accounting rules shape management behavior. This exception to the rule encouraged firms to make investments that produce one kind of special income that really is not in substance very special at all. It may encourage firms to take on more complex management tasks than they really need to take in order to show a kind of earnings pattern that may be more of an optical illusion than anything while serving to buffer management from critical market scrutiny. That concludes my opening statement. I look forward to your questions. Senator Levin. Thank you very much, Mr. Ciesielski. Let us try a 10-minute round of questions, if that is all right. Professor Shay, in your written testimony, you stated that the IRS in the past has applied the arm's-length standard that is involved in transfer pricing mechanically, which has given rise to results that do not pass a common-sense reality test. Can you be more specific? I think you started to give us an example, but can you be more explicit? Mr. Shay. Yes, and I think in the testimony it was not limiting it to the IRS. In fact, taxpayers have been most aggressive at asserting that if something is done between unrelated parties, then they can just import it into a related- party case even if the results of importing it to the circumstances of the related-party case are nonsensical in ultimate outcome. In other words, the arm's-length standard sets an objective. The objective is to create neutrality in the outcome that would occur, in a related-party transaction, had unrelated parties being in the same circumstances. So there are a number of instances where taxpayers--I can think of one court case where there is too literal an application--if an unrelated party does it, then it must work here. So the outcome is you will justify allocations in a related-party case that had the two parties actually been unrelated they just would not have agreed to. One example is executive compensation. In cost-sharing agreements, it has now been changed by regulations, but there was a strong argument by companies, well, in a cost-sharing agreement between unrelated parties, they would not take into account the stock option compensation. And they might not. But the fact is that when--if the cost-sharing agreement is between a parent and a subsidiary, everybody is subject to the same equity stream, and then they may well and probably should take into account, the idea being that is it really the case that a company would allow a cost-sharing agreement--if unrelated companies used a cost-sharing agreement, one used heavy stock options and the other one used none, would they really ignore that? Absolutely they would not. They would make it work out in some other respect, maybe not through just looking at the stock option compensation. So when you are in a related-party case, you should be thinking the same way. It is a subtle and sophisticated approach. But the arm's-length standard does not work unless it is applied with that sensitivity. Senator Levin. Well, how can an arm's-length standard be applied when you have a wholly owned subsidiary, a controlled foreign corporation, where you are setting some kind of a price for an asset that is being transferred, the value of an asset that is being transferred, and where there is a huge tax benefit if you can sell something and get very few dollars back for it where your offshore wholly owned subsidiary or controlled financial company or corporation is going to get a huge amount, for instance, in royalties for that same asset? How can there be an arm's-length transaction? It is being negotiated inside the same company, isn't it? Mr. Shay. There is not in many cases going to be an arm's- length comparable in the circumstances you describe. So the objective is to take as much of the interaction between the two companies that you can find a market comparable for, work on that basis to that extent. Then there is this residual, and the residual is the challenge for particularly governments but also taxpayers to allocate as though they were operating on an arm's-length basis. The difficulty with the current rules is procedurally you can sometimes only look at one side of the transaction. We should be always testing those with profit splits. That is not always required today under the current rules, or it is not done that way in every case. We give too much weight to just the contractual relationships in circumstances where, as I think you are suggesting, there is no adversity, there is no cost purportedly allocating risk contractually. We have to look at other indicia of whether risk is really allocated. Senator Levin. We see in the Microsoft case a very significant transfer of revenue and profit overseas to a wholly owned subsidiary in some cases that has no employees whatever. And then there is a large amount of profit which is shifted. Let me ask Professor Avi-Yonah, does that not create in and of itself, that kind of a gap between the revenue received for the same royalties by that offshore CFC and what the U.S. company, ``received from its own subsidiary, where that gap is as huge as we have seen in our exhibits.'' Does that not create a common-sense question that this is not an arm's-length transaction, this is a transaction that is done very clearly to shift profits overseas and avoid paying taxes? Mr. Avi-Yonah. I think it clearly does. You have to ask yourself what is it that is actually happening in these low-tax jurisdictions. It is not the R&D. It is not the development of the intangibles. It is not the sales. It is not even any significant manufacturing. If you compare, let us say, the salary paid to the average Microsoft employee in Puerto Rico of $44,000 with the $22 million that they are alleged to have earned there, it is pretty clear that there is nothing substantive that is happening in the location, and it is the rules that we have been discussing that allow the shifting of this profit from the location where it is actually earned, where actually economic activity is taking place to the low-tax jurisdiction. And the only reason to put it there is basically because it is low tax. Senator Levin. Now, I think that Professor Shay used the figures in the case of Microsoft that they had 90,000 employees, I believe you said. That was your statistic, or was that yours, Professor Avi-Yonah? Nineteen hundred of the 90,000 were in those three jurisdictions. So 2 percent of Microsoft's employees are in those jurisdictions, and I believe you said they have 55 percent of the income attributed to them. Mr. Avi-Yonah. Right. Senator Levin. Now, does that not create a presumption that this is obviously not a fair price that is being paid? Should not the IRS be going after that kind of a gap pretty aggressively to try to find out what the justification is for that other than to try to shift income overseas? Mr. Avi-Yonah. I think they should. I mean, the problem is that I think that these possibilities are made possible under the rules adopted by the IRS itself, which is why I think the rules need to be changed. The attribution of the same percentage of profit to the location as the cost of development that they contributed is something that is embodied in the IRS rules. And, yes, they can argue with the taxpayer about valuation of, let us say, buying payments and other payments that are being made, but by itself I do not think they would recognize that the discrepancy between the profits and the percentages that are contributed is giving rise to a problem. And so that is why I think that you need to do something beyond just asking for more IRS enforcement. Senator Levin. Are they rules of the IRS or is it our rules that need to be changed? Mr. Avi-Yonah. I think it is your rules in this case---- Senator Levin. What rule would you change? Mr. Avi-Yonah. I would override two things. I would override cost sharing, that is, I would say notwithstanding any cost-sharing agreement, Section 482 applies as written, which means that you need to pay a royalty commensurate. Some of the suggestions that have been made is specifically intangibles, that is, for example, if there is too much of a disproportion between the cost of the development of an intangible and the profits, then that becomes a part of the income. That was the Obama Administration's suggestion. Senator Levin. Would that address this gap, this discrepancy? Mr. Avi-Yonah. That would address this particular gap, yes. And the other one would be to do away with the CFC-to-CFC look- through rule and check the box, because if you cannot concentrate everything in the low-tax jurisdiction, there is less of an incentive to profit shift to it. Senator Levin. Is there any limit under the current regulations to what percentage could be attributed to an offshore wholly owned corporation? I mean, let us assume instead of 40 percent they said 80 percent. Does that in and of itself create a problem? Mr. Avi-Yonah. No. Senator Levin. Under the current regulations? Mr. Avi-Yonah. No. They can set a percentage any---- Senator Levin. Any way they want, they can shift all that income overseas? Mr. Avi-Yonah. Yes. Senator Levin. Do you agree with that, Professor Shay? Mr. Shay. The rules require a taxpayer to justify it, and part of their justification would be if they had substantial operations there, functions and real activity. Senator Levin. Well, there is none in one of these. There are no employees whatsoever in Singapore, let us say. Mr. Shay. And their justification in that circumstance is that they claim they have paid for the rights to use a valuable intangible and they paid fair value. That is the claim. The difficulty is when you look at the bottom-line outcome, it is not credible. It just does not line up with what is actually going on there. Senator Levin. And if they paid for it with the same corporation's money, does that have any difference? Does that make a difference? Mr. Shay. No. They can get the money---- Senator Levin. In other words, they can take money from the parent---- Mr. Shay. Yes. Senator Levin [continuing]. And then pay the parent back for it. That does not make a difference. Mr. Shay. That does not make a difference. Senator Coburn. Thank you, Prosecutor. Dr. Shay, in your testimony, you noted that deferral of U.S. taxes and low foreign tax rates are incentives to move income offshore. Would you also say that an additional incentive to move income offshore is the fact that we have the highest tax rate in the world? Mr. Shay. I would say that it is that differential between whatever the U.S. rate is--and I think the relevant rate is the rate that would be taxed--would be paid by the U.S. taxpayer on the earnings when repatriated. So I think of the difference between the two effective rates. I do not think it is a nominal rate in either case. Senator Coburn. So the average rate in the 90 leading countries in the world is 18.5 or 19 percent. Mr. Shay. That may be an average of nominal rates, sir. Senator Coburn. It is. And our nominal rate is 35 percent. Mr. Shay. But our average effective rate on corporate income I think is closer to 27 percent. Senator Coburn. OK. So, anyhow, we have a difference of 9 percent, so that 9 percent you would agree is an incentive for people to move earnings offshore. Mr. Shay. What I am describing in the testimony is the difference between whatever the U.S. effective rate would be, which I did not specify, and the rate that can be achieved in a foreign jurisdiction. What the Microsoft facts appear to show is, on average--I am trying to put all the companies together, not to cherrypick--their effective rate in these three jurisdictions was somewhere in the range of 4 percent. But let us say it is 5 percent. That differential is enormous and creates an incentive for shifting the income. Senator Coburn. If Congress followed your recommendations and eliminated two of these three and did not adjust rates commensurately, what do you think the result of that would be, Dr. Avi-Yonah? Mr. Avi-Yonah. I am in favor of reducing the rate---- Senator Coburn. I know, but what is your opinion with the result? Mr. Avi-Yonah. I think that it is problematic to just address the loophole without doing something about comprehensive tax reform precisely because you would then have more pressure to find other loopholes, which is not a reason not to close the ones that we have. Senator Coburn. Right. Or to move some of the 90,000 employees actually out of the country to the low-tax jurisdiction. You know, it is a zero sum game. We are in a race to the bottom in the world on corporate tax rates because of the economic situation we find ourselves in. And we are losing the race both through our complexity but also our rates. And I am with the Chairman in wanting to clean this up, but I do not want to clean it up if the end result is going to be the reaction is to the domestic corporation of this country because we have cleaned up these loopholes that their decision now is they are going to put all their investment capital overseas, and they are going to grow their businesses overseas, and they are going to move their jobs overseas. So it has to be a combination of smart tax reform plus elimination of the loopholes and the incentives to find loopholes to be able to solve this problem. Mr. Avi-Yonah. At least in these cases that we are talking about when there is almost nothing there, I do not think that closing the loopholes would incentivize anybody to move actual operations to some of these locations, because it is very hard to actually have real operations in places that are real tax havens. You do not have the services, you do not have the education, and you do not have the infrastructure. There are reasons that these things are happening in the United States, and I think that closing the loopholes would not by itself incentivize taxpayers to move these operations offshore. But I do agree that it should be done in the context of broader tax reform. Senator Coburn. All right. Your statement in your verbal testimony was that these companies almost always know when their R&D is profitable. My experience in business would lead me to say they do not almost always know. Now, maybe in these two businesses you were referring to, but generally corporate culture--take the pharmaceutical industry, for example. They do not almost always know, and yet we see some of this cost shifting. We have created a special thing for them called the ``Puerto Rico tax set-up.'' So we eliminated for a whole industry this problem by a specific law for them. I guess I am questioning your statement as to the fact that they almost always know. I am having trouble understanding that. Mr. Avi-Yonah. No, it is a question of timing. I certainly agree with you that companies do not know necessarily when their R&D will be successful when they engage in it. The point is that at the point where they decide to enter into the profit-shifting arrangements, they are in the best position to know whether it is likely to succeed. And as a result, there is no downside, because the reason that--as I mentioned to Senator Levin earlier--you can put any percentage on there that you want. The theory is that you are going to lose the deduction if it is not successful. But if you have the internal knowledge that something is likely to be successful, even if it is not documented, even if it is not something that the IRS can find, at that point you can enter into the cost-sharing agreement, and you are not really risking losing the deduction. That was my point. It is not necessarily from the beginning. Senator Coburn. Thank you very much. Mr. Ciesielski, you mentioned incentive problems, and I actually understand--a couple of incentive problems you mentioned, especially that with foreign earnings that actually generate a dollar based on a dollar, versus a dollar versus 65 cents. But don't we have incentive problems in terms of moving money offshore right now? Take the medical device industry for an example. Both incentive from a regulatory standpoint of approval, but also from a tax standpoint, we are seeing the medical device industry leave this country and go to both Europe and China. So we are already seeing incentives to move business out of here, both by our Tax Code and our regulatory code. And this hearing is not about regulatory, and I did not mean to actually get into it. But don't we already have incentives to move money offshore just given the low tax rates of other areas, the comparable differential? Mr. Ciesielski. Certainly there are incentives. I think we are talking about all different kinds of incentives in this situation. First of all, I cannot speak to the tax side. I can tell you that a 15-percent rate would be much more attractive than a 35-percent rate. But as for moving all operations offshore, as Mr. Avi-Yonah has said, there are other issues that have to do with infrastructure, and I am not sure that is possible for all industries. And also I think that if you did move all things manufacturing to some other countries where they have attractive rates, there may be a VAT involved that taxes things at the manufacturing level as you move things through a process. So, there are varying levels of incentives, and I really would probably not be the best person to talk about with the differing approaches of different countries and what the incentives to moving things offshore would be. Yes, there are incentives, but the incentives that I was speaking of are more of financial reporting incentives. For example, when you think about back to the early to mid-1990s, companies did not account for stock options. They had incentives to give them to managers, and they had incentives to gin up earnings as much as they could so the managers would profit at the expense of shareholders without ever recording a cost. That is a misincentive. That is not a fair reporting to the people that actually own the company, who are the shareholders. Senator Coburn. Yes, it is a lack of transparency. Mr. Ciesielski. It is a lack of transparency. And, we know that there are bonus programs designed to reward managers for producing operating income and after-tax income. And when you have something that is as flabby and soft as the intention of moving earnings offshore or not offshore just by massaging a profit forecast or a working capital forecast, I think that the temptation to managers to meet targets that might benefit them at the same time that they are defending it by benefiting their shareholders through raising income, I am not sure that is the most fair system of capital markets that we can come up with. Senator Coburn. All right. Thank you. Senator Levin. Professor Avi-Yonah, I think you answered this question, but let me ask you again if you have. I think everybody would love to reform the Tax Code and reduce tax rates if we can in the process. In the meantime, some of these tax loopholes which we have identified here it seems to me are pretty egregious. Would you agree? Mr. Avi-Yonah. Yes. Senator Levin. Should they be reformed in the meantime, closed? Mr. Avi-Yonah. Yes. I mean, you can always say about every loophole, well, if you close this, there will be another loophole, let us wait until we have an overall reform of the system. That is no reason not to close loopholes. I think these loopholes need to be closed. Senator Levin. And in terms of the tax rates question, there is also another factor, that we are not going to be able to compete with a zero or a 2-percent or a 4-percent tax rate, are we? Mr. Avi-Yonah. Right. And that is not what anybody is talking about, and those countries where they have the zero or the 2- or 4-percent tax rates are not countries in which any American company would ever put real operations in. These are shells. They are not real operations. Senator Levin. So if some of these transfer pricing agreements are arranged for a wholly owned subsidiary to be located in one of these tax havens and then there is a shifting of income or profit to that wholly owned subsidiary and then that money is transferred offshore, is that something which we ought to address and end? Mr. Avi-Yonah. Yes. Senator Levin. Now, we have a couple of examples which we have used here relative to Microsoft, and I want to just go through a couple of these. I think in your testimony, Professor Avi-Yonah, you said that the idea of research and development cost shares is flawed for two reasons, and you also went into those here in your oral testimony. Now, in 2005, Microsoft's Puerto Rican affiliate entered into a cost-share agreement with Microsoft U.S. to make a cost- sharing payment of around $1.9 billion. Microsoft Puerto Rico then records profits of around $4 billion. Does that agreement strike you as being appropriately priced? Mr. Avi-Yonah. That is the thing that I meant was problematic. There is no reason for not shifting the entire thing back to the United States if there is nothing real happening in Puerto Rico, or at least the vast majority of it. What is the justification for this disparity? Just the fact that they make a large cost-sharing payment does not mean that you can then accumulate about two-thirds of the entire profit in a place where there is nothing really happening, when everything is happening somewhere else. Senator Levin. And the justification for that under current law should be required, should it not? Mr. Avi-Yonah. Yes. Senator Levin. And the IRS should aggressively require that. Mr. Avi-Yonah. Yes. I agree. Senator Levin. And is the same thing true with the other two examples that we have used here, the Singapore example and the Ireland cost-share example? I think you looked at both of them. Mr. Avi-Yonah. Yes. Senator Levin. Is the same thing true there? Take Ireland. There is a cost-share agreement with Microsoft U.S. and Ireland. Ireland makes an annual cost-share contribution of $2.8 billion. Then they re-license these rights for $9 billion. That is a huge shift. Mr. Avi-Yonah. There is nothing to justify this disparity that is actually happening there. Senator Levin. Under current law. Mr. Avi-Yonah. Under current law, yes. Senator Levin. And so if they are required or should be required to justify it and you cannot see anything that would justify it, shouldn't the IRS then aggressively require a justification for that kind of a gap? Mr. Avi-Yonah. Yes. Senator Levin. Now, Professor Shay, would you agree with that? Mr. Shay. The observation I would make is that cost sharing is supposed to be paying the current costs of R&D. That is supposed to be paying for the right to use the future developments. The problem that arises is when you enter into it, you need to pay at that time the value of all the prior developments, and I think conventionally it is believed that is by far the most difficult pricing element, and if you do not pay that full amount, then you are getting the kind of outcomes that you are describing. But I think analytically it is not quite correct to compare the current payment of the cost which is supposed to relate to the future with the current earnings. The current earnings you are getting are the benefit of the prior R&D that you should have paid for at the buy-in, and just, I think, the evidence is historically we have not done well at all--the government has not--at collecting the full amount. And now there are new regulations, and the new regulations are more robust in seeking to do that. And my understanding is although we do not have good information at this point, it is having a substantial impact on companies' decisions to move into cost sharing. But then you are just going to shift the royalties. So make no mistake, there is no panacea in transfer pricing, which is why, Mr. Chairman, we need aggressive enforcement. We need to keep making the rules better than they are today with respect to transfer pricing. But we also need to restrict and make changes that limit the incentives for aggressive transfer pricing because we are never going to completely address transfer pricing under any mechanism, whether it is an arm's-length standard or any other standard. So we need to take on the issue of incentive, and one thing I note in my testimony is the Administration has proposals, Representative Dave Camp has proposals, Senator Michael Enzi has proposals, all of that would indirectly entail a minimum tax, a nature of a minimum tax in order not to be taxed currently on your income. My personal view is there are loopholes in the Enzi proposal. There are fewer loopholes in the Camp proposal. But something can be designed out of that that could be much more effective than what we have today. We should not just try and go back and rebuild Subpart F from 1962. We should take an approach that works today. And my personal view is it is too urgent a problem to wait for tax reform--I respectfully differ with Senator Coburn--because tax reform is an enormous and complicated task. It is going to take years. If we take the numbers we are looking at in front of us for one company, let us say it takes us 3 years, that is a lot of potential revenue lost. We need it. And we also need to be a leader to the other countries in the world. This is not something that we should do solo. We should do it because we need to do it, but historically when we do things like this, other countries follow. Their deficit needs in many cases are worse than ours. It is only rational to think if they see us doing something that works, we should be able to persuade them to do it as well. I did happen to look before I came here at the list of per capita income of countries of the world. The United States is 11th. Let me read you the top 10, and this is from the CIA facts site. It has some different years, there is a little noise in this data, but let me just entertain you for a moment. Liechtenstein is No. 1. Qatar is No. 2. Luxembourg is No. 3. Bermuda is No. 4 in per capita income. Singapore is No. 5. Jersey is No. 6. Falkland Islands is No. 8. Norway is No. 8 because of their oil wealth. Brunei is No. 9. Hong Kong is No. 10. The United States is number 11. There is a race to the bottom, but we do not have to let this occur, and I think we should exercise leadership to prevent it. Senator Levin. And you are talking about what kind of leadership in terms of having a tax--connect that to the subject of today's hearing. Mr. Shay. I think having leadership involves resisting the arguments that because other countries do it and do not collect the tax they should from their corporations, we should not collect the tax we should from our corporations. I have some considerable question whether we overestimate the extent to which activity will move if we are getting companies to pay more of their fair share of their income. I do not think as much activity will move as is threatened, certainly. And I think in addition to that, given the fiscal situations of other countries, it is rational for them to follow a sensible approach that cuts off income shifting to low-tax countries. It hurts them as well as us. Senator Levin. Thank you. Dr. Coburn. Senator Coburn. Thank you. A couple of questions. Just specifically, Dr. Shay, in terms of the example you are talking about on transfer pricing, let us say Company X expensed all their R&D for Product Y. So they show no value in it. They have already expensed that, both on their financial books and their tax books. What is the value of that when they go to do transfer pricing to a CFC? If they show no value on their books, they have already expensed all their R&D associated with this product, what is the value of that when you go to transfer pricing? Why isn't it zero since they show zero on the books? Mr. Shay. Well, because books are not purporting to show fair market value. They show the investment. And when you expense it, that does not mean that you do not know--you can add up all of the money that you expended. The difficulty with R&D is you expend much more, some of it results in products that do not go forward. So some R&D is failed R&D. Some R&D is successful R&D. What is transferred is the rights to the successful R&D. So you have multiple layers of valuation issues. One is you do not have the starting point of a book value, and even if you did, you would change it to fair market value. Two is if you try and construct the book value, you have to go back to the expenditures and you have to either say you are going to look at a broad base of expenditures, including those that failed in the same product area, which I think you end up having to do, but you have that as an issue. And then you have to determine what would be fair value for something for which there is, because of its uniqueness, not an easy market comparable. All of these are the difficulties, but it is not impossible, and it is what is required to be done on the buy-in at the beginning of the cost-sharing payment. We have the same issue, though, with licensing. Let us be sure we understand. This issue does not go away with licensing. Licensing, you need to make sure you are paying the amount that will capture the value that was expended earlier. So it is also hard. Senator Coburn. So I am a little bit confused because one of the principles of accounting is matching revenues with expenses, right? That is what our goal is when we account for things. We want to timely match revenues with expenses. But if we have totally depleted or amortized all our costs in Product Y, we have totally matched them against revenues, and now we are going to sell it in a new market, where do you get a basis from an accounting standpoint that says it has value? It may have value once it is sold, but the R&D has already been expensed. So now you are talking about good will. You are talking about a total intangible cost, and I think the testimony of almost all three of you is that is a very difficult--there is trouble in valuing intangibles. It is hard. Mr. Shay. It is difficult, but I do not think that the fact is expensing. The fact you have expensed it does not mean it has been matched with the income earned from that expense. That is an accounting convention that started because of the difficulty of associating it with a particular amount of income and because of the conservatism of accounting. It is the opposite incentive we should have in tax. But tax follows accounting for this purpose. That does not reduce the importance if we are going to have a coherent tax system, if you are going to shift the right to earn that from a full tax environment to a deferred tax environment or, even worse, an exempt tax environment, then at that point the system is forced to make that valuation analysis. Senator Coburn. So why wouldn't the accounting rule be the following: That if you are going to do the transfer pricing, what happens is, because you have already allocated the expense for that asset, that R&D, that potential, why shouldn't that be taken back off your books in this country as a penalty for transferring that asset somewhere else? In other words, thinking about it in reverse, we have given the tax benefit through the amortization already, and now what we are saying is we really want to match some revenues, so, therefore, you took a deduction for amortizing an R&D that, in fact, is not matching the revenues that are going to come. Why wouldn't we do that as a rule to disincentivize this? Mr. Shay. That is an alternative, so let us just compare. What the law currently today would say is you need to pay an amount for fair value, and if you could determine that, I think we would all agree that would be optimal. But what I think you are suggesting is in the face of a very difficult valuation analysis, could you not at least try and identify the expenditures that relate to the asset that you are shifting, recapture it, to use a phrase, in other words, reverse those so you have to pay income on that amount. That is another alternative, and I think it would be interesting to see where the numbers would come out from that. One comment, though. We have this core problem of cherrypicking and that problem, I think, does not go away. So I think we have a lot to think about with the issue you are raising. Senator Coburn. OK. Mr. Ciesielski, you described the APB 23 accounting rule as a loophole and also say that this APB 23 exception is a way to manipulate the rules to achieve an outcome the rules were intended to discourage. Explain that. Mr. Ciesielski. Certainly. The general principle is that you accrue income taxes on the earnings of all of your subsidiaries. This one says in a special case where you intend to indefinitely reinvest, you do not accrue because you are not intending to pay taxes. That to me is what I think most people would call a loophole. More technically, it is an exception. The general rule is you earn, you accrue taxes, whether you are going to pay them this year or not. They may be deferred income taxes, but that is really what is at issue here in the financial reporting arena--accrual of deferred income taxes. Once that accrual has been levied on the earnings, obviously they are going to be 35 percent less, but management would be less inclined to be worried about moving cash in and out of a particular country because they have already taken a tax charge on them that is on the books. It is the way they would handle earnings from Kansas and Maine. They would be taxed at the same rate. Move your subsidiary from Kansas to Maine and it would not make any difference. That exception, like I said, the farthest back I could find it in accounting literature was 1959, a much different world, and I am not sure where it originated. I could not find anything further back than that. Senator Coburn. Thank you very much. Thank you, Mr. Chairman. Senator Levin. I just have one additional question, and that is having to do with Hewlett-Packard's staggered loan program. Now, we found that HP used two controlled foreign corporations over a 30-month period to continuously loan without interruption on an alternating basis to HP U.S. for general operations, including making payroll and buying back shares. So there are two cash pools, controlled corporations that HP has out there offshore, billions of dollars day after day. The loan schedules were set up in advance by Hewlett- Packard's tax department. The timing of the loans was orchestrated to be made and then to be retired at specific times. And let me ask you, Professor Avi-Yonah, first perhaps: Is this the type of transaction that should be excluded from Section 956 as a temporary loan? Mr. Avi-Yonah. I do not think it can be. I think that in a situation where the money is always available to the parent every single day of the year, that is certainly not what Section 956 or the exception was intended to provide. Section 956 says that if you reinvest the deferred earnings back into the United States, even in the form of a loan to the parent, that triggers an inclusion. And I think that when the money is always available, regardless of which CFC it comes from, it should be included. Senator Levin. And you made reference to the fact it is supposed to be independent. Is that correct? In other words, you have here a parent corporation who structures a program, instead of putting it all into one CFC overseas, offshore, you have a cash pool that is divided into two, but they are linked, they are structured together, the timing of the loans going in and coming back, being paid back is together so there is no gaps whatsoever. Does that not just clearly violate what the whole exception is supposed to be for short terms? Mr. Avi-Yonah. I think that given those facts and the fact that it is not independent, it violates even current IRS guidance. But I think even if they were independent, the fact that both CFCs are the same company and the money is always available, that for me should be enough. And the guidance in a way, if it says that if they are both independent from each other, that is OK. When the same parent company controls both of them, I do not think that guidance should be out there in those terms. Senator Levin. Do you have any comment on that, Professor Shay? Mr. Shay. Yes, I agree that the materials that I have seen so far suggest a prearranged, concerted action. Courts are not going to be fooled that is independent if that is the case. Senator Levin. Even though there are two technically separate corporations that are working together---- Mr. Shay. Even though there are two technically separate corporations, they are under common control. The IRS has broad authority in other respects under Section 482 with respect to companies under common control. This is an area that so far has had fairly mechanical rules with some anti-abuse rules. Those anti-abuse rules need to be--they have been drafted too narrowly, and people are taking a view that maybe they do not apply. But I would identify one other issue. Even if, as I think would be the case in a pre-concerted arrangement, this is considered a single loan, you still have the question of maybe the earnings and profits are hidden in other companies--or not hidden, but this has all been manipulated so that the companies making a loan do not have earnings and profits. There is an anti-abuse regulation intended to go after that, but it is drafted fairly narrowly. So you also need to make sure that the overall intent of these rules, which is it cannot be avoided by just using separate boxes and separating things out and avoiding the mechanics of the Section 956 rules, the fact is that the amounts that are being loaned back are ultimately the product of the offshore business that has earned low-tax foreign earnings. We should find a way not to allow it to be circumvented when they are brought back for use in a U.S. business, when that neighboring domestic business or small business would not be able to do that. Senator Levin. Thank you. I guess I have one other question of you, Mr. Ciesielski, and that is about the APB 23. One of the problems with the accounting standard is that FASB, which is the organization that sets accounting standards, has not provided much guidance. In terms of plans for reinvestment, they have not described the type of assets that qualify for this exception. They have not put out guidance about the expected duration of the investments. Would you agree with that? Mr. Ciesielski. I would agree, yes. Senator Levin. And would it be helpful if they did do those things? Mr. Ciesielski. I think it would be helpful if they eliminated the exception. Senator Levin. But assuming they do not eliminate--I do not disagree at all, but assuming that exception is going to remain, would it not be essential that FASB put out some guidance? Mr. Ciesielski. There could be a lot more disclosures that would be informative to investors, yes. Senator Levin. Thank you. We thank you all very much, and now we will move to our second panel: Bill Sample, the corporate vice president for worldwide tax at Microsoft. We very much appreciate your being with us today. Senator Coburn. I am going to have to be absent for about an hour or two for an intel briefing. I will submit questions for Microsoft to the record. If perhaps you are still here when I come back, I will ask them. Hopefully you will not be. Senator Levin. Thank you very much, Dr. Coburn. Let me first welcome you, Mr. Sample, but I also want to thank Microsoft--and this is also true for Hewlett-Packard--for the cooperation with our inquiry and our investigation. Both companies have cooperated with our Subcommittee. You have provided documents that we have asked for. You have appeared here willingly, and we very much appreciate that cooperation. So while we have obviously some basic questions and basic differences with our two companies in that regard, we are very much open about our appreciation to you. Under Rule VI, our witnesses who testify before the Subcommittee are required to be sworn, so I would ask that you please stand and raise your right hand? Do you swear that the testimony that you are about to give will be the truth, the whole truth, and nothing but the truth, so help you, God? Mr. Sample. I do. Senator Levin. OK. We would ask you then to proceed. Were you here when I described the timing system? Mr. Sample. Yes, Senator. Senator Levin. OK. Thank you. Then please proceed. TESTIMONY OF WILLIAM J. SAMPLE,\1\ CORPORATE VICE PRESIDENT, WORLDWIDE TAX, MICROSOFT CORPORATION, REDMOND, WASHINGTON Mr. Sample. Chairman Levin, Ranking Member Coburn, and Members of the Subcommittee, good afternoon. My name is Bill Sample, and I am the Corporate Vice President for Worldwide Tax at Microsoft Corporation. I am here voluntarily today at the request of Chairman Levin and Ranking Member Coburn. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Sample appears in the Appendix on page 112. --------------------------------------------------------------------------- I would like to provide some information on Microsoft and its global footprint. Microsoft is incorporated and headquartered in Washington State. We develop and market software services and hardware that deliver new opportunities, greater convenience, and enhanced value to people's lives. We do business worldwide and have offices in more than 100 countries. Our footprint is biggest in the United States and growing. From 2007 to 2009, Microsoft increased its employment by 13.2 percent, to almost 54,000 employees in the United States. According to a recent 2009 study, Microsoft's operations supported roughly 462,000 U.S. jobs. Since 1990, Microsoft has been the single largest contributor to economic growth in Washington State. Its impact on the State accounted for 32.4 percent of the total gain in State employment. Despite our size and growth in the United States, one of the business imperatives we face as a company in the global economy is that we must operate in foreign markets in order to compete and succeed. Almost half of our fiscal year 2012 revenue is foreign revenue, and foreign revenue continues to grow faster than U.S. revenue, but we do not view U.S. and foreign growth as mutually exclusive. Our foreign revenue growth is one of the main reasons why we can continue to grow our U.S. operations and create additional U.S. jobs. Our worldwide operations are divided into regions, with significant investment and employees in each region. Our regional operating centers support operations in their respective geographic regions, including software production and distribution, customer contract and order processing, credit and collections, information processing, and vendor management and logistics. Our worldwide Original Equipment Manufacturer (OEM) business, consisting primarily of the licensing of the Windows operating system to computer manufacturers for pre-installation on PCs, is primarily supplied from our regional operating center in Reno, Nevada. The resulting income is fully taxable in the United States. Our non-OEM retail business is generally supplied by our regional operating centers located in three different regions around the world. Our tax reporting follows the global nature of our operations. Microsoft complies with the tax rules in each jurisdiction in which it operates and pays billions of dollars in U.S. Federal, State, local, and foreign taxes each year. For example, our worldwide effective tax rate for fiscal year 2012 was 24 percent. In dollar terms, we paid $3.5 billion in taxes worldwide in fiscal year 2012. Our foreign regional operating centers pay tax locally in the jurisdiction in which they operate. Microsoft pays U.S. tax on their earnings when repatriated back to the United States as provided by U.S. law. Microsoft also pays significant U.S. tax on buy-in royalties and cost-sharing payments it receives from the foreign regional operating centers. Microsoft develops most of its software products and services internally. This allows us to maintain competitive advantages that come from closer technical control over our products and services. The legal ownership of intellectual property developed as a result of our R&D activities generally resides in the United States. In accordance with Internal Revenue Code Section 482 and applicable Treasury regulations, our three foreign regional operating center groups--Ireland, Singapore, and Puerto Rico-- license the rights to use the relevant intellectual property to produce and sell Microsoft software products in their respective regions. The foreign regional operating center groups make multi- billion-dollar initial and annual compensation payments back to the United States for these license rights. One component of these payments requires the three foreign regional operating center groups to fund the majority of Microsoft's annual worldwide R&D expenditures. These payments increase our U.S. taxable income. In conclusion, Microsoft's tax results follow from its global business. In conducting our business at home and abroad, we comply with U.S. and foreign tax laws. That is not to say that the rules cannot be improved. To the contrary, we believe they can and should be. We support U.S. international tax reform efforts that would help American businesses compete in global markets and invest in the United States. Thank you. Senator Levin. Thank you very much, Mr. Sample. Let me start with Microsoft in Puerto Rico. Microsoft products are primarily developed in the United States. They benefit from U.S. research and development tax credits. They are sold throughout the United States, as you mentioned, from an office in Nevada. Every time, though, a Microsoft product is sold, 47 percent of the sales price is sent to Puerto Rico where Microsoft pays no tax. Now, that is because Microsoft USA has entered into an arrangement with one of its own companies called Microsoft Operations Puerto Rico. It has a small facility with 177 employees. Microsoft USA sold Microsoft PR-- Puerto Rico--the right to sell Microsoft products in the Americas. Microsoft Puerto Rico paid money for those rights-- Microsoft money but, nonetheless, Microsoft Puerto Rico paid money for the rights, but it does not actually sell Microsoft products to any customers. It sells instead the products right back to Microsoft USA, which then arranges for them to be sold to customers. So Microsoft USA sells its intellectual property rights to Puerto Rico, turns around and buys some of those rights back at a substantial markup, and agrees to transfer 47 percent of net revenues from U.S. sales to Puerto Rico. Now, if you will look at Exhibit 1d \1\--and I hope the exhibits are there in front of you--this is a chart showing how Microsoft transferred its intellectual property rights to Puerto Rico. One of the first steps was that Microsoft USA entered into a cost-share agreement with Microsoft Puerto Rico. The idea behind cost-share agreements is that if two companies share the development and market risk of a new product, they are then allowed to share the profits. --------------------------------------------------------------------------- \1\ See Exhibit No. 1d, which appears in the Appendix on page 189. --------------------------------------------------------------------------- In 2005, when Microsoft U.S. and Microsoft Puerto Rico entered into the cost-share agreement, Microsoft's products were some of the most successful in the world, so it was not a very risky proposition; 85 percent of the development of Microsoft products is done in the United States, so all Puerto Rico had to do to share in the development cost is write a check. And, by the way, that is Microsoft money. It did not have to contribute any know-how. Where did Microsoft Puerto Rico get the money to contribute to the cost-share agreement? Where did it get that money from, do you know? Mr. Sample. Well, Senator, the original funding for the current Microsoft Puerto Rico facility was a result of an equity contribution from the Irish regional operating center group in the amount of about $1.6 billion. That equity contribution enabled the construction of a very expensive production and distribution facility in Puerto Rico, including Microsoft's most advanced product release lab anywhere in the world. And so Microsoft Puerto Rico is fully equipped and staffed to perform all the production and distribution of Microsoft's retail software products in the Americas. Senator Levin. All right. Now, back to the United States. So Microsoft Puerto Rico got $1.6 billion from Microsoft's Irish subsidiary called Round Island One. Is that correct? Mr. Sample. That is correct, Senator. Senator Levin. All right. So now Microsoft money goes to Microsoft Puerto Rico, and here is what it unleashes. If you will take a look at that Exhibit 1d, $1.9 billion comes each year for intellectual property payments to the United States, to the Microsoft intellectual property pool. But for those same intellectual property assets, Microsoft Puerto Rico gets revenues of $6.3 billion, not taxed in the United States. So of the $6.3 billion in revenues that come in from sales in the United States, $1.9 billion goes to the United States and the rest stays in Puerto Rico. Is that correct? Mr. Sample. Senator, you are also missing a $400 to $500 million buy-in payment made by Microsoft Puerto Rico to the United States that year. Senator Levin. All right. That still exists, so we will add that. Mr. Sample. That still exists. Senator Levin. All right. Mr. Sample. And what is also missing from your financial analysis. As described by Professor Shay on the last panel is Microsoft Puerto Rico was also required to make a buy-in payment for pre-existing Microsoft technology in existence at the time it entered into the cost-sharing agreement. Senator Levin. All right. Mr. Sample. As reported in the memo that your staff released today, the cumulative amount of that buy-in payment from the inception of the cost-sharing agreement to date is $17 billion. Senator Levin. OK. Mr. Sample. Which, when added to the cumulative amount of cost-sharing payments, inception to date, amount to approximately $30 billion. Senator Levin. And how much money do they get each year for these in revenues from the United States? Mr. Sample. I think on average Microsoft Puerto Rico has received less than 50 percent of the revenue from retail product sales in the Americas market. Senator Levin. And that totals how much a year, about? Mr. Sample. It is probably in the neighborhood--started out initially at probably $6 or $7 billion a year, and increasing up to the current amount. Senator Levin. About how much? Mr. Sample. I would say about $8 to $9 billion. Senator Levin. Per year? Mr. Sample. Per year. Senator Levin. OK. And when you total all the things you want to total for Puerto Rico, then that is a total, that $30 billion that you got to, right? Mr. Sample. Correct, and that is an ongoing requirement. Senator Levin. Yes, but the total amount of money that has gone to Puerto Rico, the way you calculate, is $30 billion, and they are now getting half of the sales from the United States. What is the justification for that except to save tax money? And that is perfectly legitimate, right? Nothing wrong with reducing your taxes. But is there any justification for transferring half of that retail sale money to Puerto Rico other than to reduce taxes and to shift that income offshore? Mr. Sample. Yes, there is. Under the U.S. transfer pricing rules, specifically the cost-sharing agreements, Microsoft Puerto Rico has agreed to share approximately 25 percent of Microsoft's worldwide R&D expenses every year. And again, as pointed out in the last panel, when you share those expenses, you do not know if you are going to realize any benefits from the expenses. And under the rules, because you are taking that risk, you are entitled to an expected return on that risk. And under the transfer pricing rules, we believe that the expected return in exchange for taking that risk is approximately currently 47 percent of the Americas retail sales revenue. Senator Levin. And so the risk that you say was taken was with Microsoft Ireland money. Is that correct? Mr. Sample. Well, the original $1.6 billion equity investment---- Senator Levin. Was with Microsoft money? Mr. Sample. It came from Microsoft Ireland. Senator Levin. Yes. That is Microsoft money, is it not? Mr. Sample. Well, that money was actually earned from operating Microsoft's business in EMEA. Senator Levin. Well, wherever it was earned, it was Microsoft money, right? Mr. Sample. On a consolidated basis, it was part of Microsoft's total worldwide revenue. Senator Levin. So Microsoft takes some of the money that it has and sends it over to Puerto Rico. They build a $1.6 billion plant, and then they start collecting--half of the retail sales from the United States goes--funneled into Puerto Rico under a transfer agreement. So using its own money, so if there is any risk here, it is risking its own money in any event. It is all Microsoft money. Every bit of it is Microsoft money. And so now you have this huge shift of $8 to $10 billion a year to Puerto Rico from U.S. retail. It was shifted back and forth at one time, was it not? The same time this transfer pricing agreement was entered into with Puerto Rico, is it not true that when the $1.6 billion was agreed to that the 50 percent retail--the 46 percent retail transfer was also agreed to at the same time? Mr. Sample. I cannot be sure. They were roughly within the same year. Senator Levin. OK. Now, let me ask you about a couple other entities. Let us talk about Microsoft in Singapore. The key entity in Microsoft Asia Island Limited--where is Microsoft Singapore located? Mr. Sample. Well, the Microsoft Singapore Roc Group consists of three entities: The parent company in Singapore, and two subsidiaries--the operating company, which is also in Singapore, and the IP holding company, which is in Bermuda. Senator Levin. OK. So Microsoft Asia Island Limited (MAIL), is located in Bermuda. Is that correct? Mr. Sample. That is correct. Senator Levin. And Microsoft Asia Island Limited located in Bermuda owns the rights to sell Microsoft products in Asia. Is that correct? Mr. Sample. Senator, it licenses the rights from Microsoft U.S. in exchange for an annual cost-sharing payment plus the initial buy-in. Senator Levin. And is the reason it is located in Bermuda to reduce taxes? Mr. Sample. That is correct. Senator Levin. Does it have any employees in Bermuda? Mr. Sample. No. Senator Levin. The sole function of this entity in Bermuda then is to enter into a cost-share agreement, re-license the rights to a subsidiary in Asia. Is that correct? Mr. Sample. Correct. Senator Levin. Now, how is it that Microsoft Asia can pay the United States $1.2 billion for intellectual property and then immediately re-license it and get $3 billion for those same rights? Mr. Sample. Microsoft Asia Island Limited is realizing the premium return because of the risk it takes in agreeing to fund roughly 10 percent of Microsoft's worldwide R&D. Senator Levin. And the risk that it took was with Microsoft money. Mr. Sample. With money earned by the Asia group from sales to customers. Senator Levin. So Microsoft, which globally put a consolidated bank account there and balance sheet, is, you say, risking some of its own money--fair enough--assigning some of that risk to a Bermuda entity to reduce taxes, and every year is shifting about $1.8 billion--is that not correct?--from the United States into a tax-free area. Does that sound about right? Mr. Sample. Senator, I respectfully disagree with your characterization. The revenue and profits that fund MAIL's cost-sharing payments come from producing, distributing, marketing, and selling products in Asia Pacific. Those functions are performed by our Asia Pacific subsidiaries, and the operating expenses of that business are funded primarily by the Singapore group. Senator Levin. But Microsoft Asia Island Limited, located in Bermuda, has no employees. Is that correct? Let us go through that again. Mr. Sample. That is correct. Senator Levin. It has no employees, and, nonetheless, it receives $3 billion for intellectual property rights and pays Microsoft U.S., where all of this intellectual property was created, about 85 percent of the R&D, pays $1.2 billion to Microsoft U.S., which means that it is getting $3 billion for that asset, but $1.8 billion stays offshore in a tax-free entity instead of coming back to Microsoft U.S. where 85 percent of the R&D was carried out. Are my numbers correct? Mr. Sample. Your numbers are correct. Senator Levin. And you agreed, I believe, that this was located where it is for tax purposes. Mr. Sample. That is correct. Senator Levin. All right. Now, is it then clearly in Microsoft's interest in terms of reducing U.S. taxes to have its offshore subsidiaries pay as little as possible to the United States and then sub-license the intellectual property to others for as much as possible? Is that in Microsoft's tax interest? Mr. Sample. Senator, again, I would respectfully disagree with your characterization---- Senator Levin. But that is a question, though. Is the answer--you can say, no, it is not in Microsoft's interest, if you want, to reduce its taxes. Mr. Sample. Well, it is in Microsoft's interest to reduce its worldwide tax burden. Senator Levin. And then in terms of reducing its U.S. taxes, I am talking about, is it not in its interest to have its offshore subsidiaries pay as little as possible to the United States when it sub-licenses intellectual property to others? Mr. Sample. It is in our interest to comply with the transfer pricing laws of the United States. Senator Levin. No, I know that. But I am saying does that not contribute to tax reduction and paying less tax in the United States with those numbers? Three billion is received by Microsoft, that wholly owned subsidiary with no employees, and $1.2 billion is paid to the United States Microsoft, which means you have shifted and left in a non-taxpaying jurisdiction, Bermuda, $1.8 billion. Does that not reduce Microsoft's tax bill to the United States? Mr. Sample. Senator, again, I would respectfully---- Senator Levin. OK. The answer is no. If you want to say it does not reduce its burden, that is OK. You are under oath. If you want to say that Microsoft's tax burden in the United States is not reduced when Microsoft overseas with no employees in that particular entity gets $3 billion a year for its intellectual property, and then sends $1.2 billion of that to the United States and that is the deal that has been entered into. You have agreed that is aimed at reducing taxes, and my question to you is: Is it not then in Microsoft's tax interest in terms of reducing its taxes to enter into an agreement which has little coming back to the United States and has much staying in Bermuda? Mr. Sample. Senator, it is in Microsoft's interest to minimize its foreign tax burden on the profits earned by its business operations in foreign markets. Senator Levin. And is it also in Microsoft's interest to reduce its tax burden in the United States? Mr. Sample. Yes. Senator Levin. Now, when a company infringes on Microsoft's patents, what court does Microsoft go to for relief? Mr. Sample. I am not familiar with our patent licensing group, Senator, so I do not know the answer to that question. Senator Levin. OK. You do not know that it goes to U.S. courts? Mr. Sample. Well, our patent rights are generally owned by the U.S. company. I do not think that necessarily means that all patent infringement claims would be litigated in the U.S. courts. Senator Levin. Are they litigated in Bermuda? Mr. Sample. I do not know, Senator. Senator Levin. OK. By the way, going back to this previous question, if Microsoft did not sell the economic rights offshore, you could still do the same business around the world, could you not? Mr. Sample. Senator, the licenses are generally--and they are required to be under the cost-sharing rules--exclusive to a geographic region. Senator Levin. Could you sell from the United States without those kind of cost-sharing agreements with yourself? Mr. Sample. Our business people believe that in order to succeed and compete in foreign markets, we need to have significant local operations and people in order to sell Microsoft products in foreign markets. Senator Levin. You do not have any people in Bermuda, do you? Mr. Sample. We do not have any Microsoft employees in Bermuda. Senator Levin. All right. Mr. Sample. But those sales that generate the $3 billion you are talking about, Senator, were made to Asia Pacific customers and the sales and marketing was done by Microsoft Asia Pacific subsidiaries with Asia Pacific employees. Senator Levin. I understand. Does Microsoft Asia Island Limited have any source of income other than its royalty payments? Mr. Sample. MAIL's only source of income that I am aware of is the royalty payment from its operating subsidiary twin in Singapore. Senator Levin. Do you know if Microsoft Asia Island Limited is a disregarded entity? Mr. Sample. Microsoft Asia Island Limited and its twin operating subsidiary in Singapore are both disregarded entities, Senator. Senator Levin. And if they were not disregarded, would the $3 billion royalty payment it received from Microsoft Singapore operations be considered passive income and be immediately taxable in the United States, do you know? Mr. Sample. I believe it would, Senator. Senator Levin. All right. So that by simply checking the box there and disregarding Microsoft Asia Island Limited its royalty payment of $3 billion from Microsoft Singapore operations is also disregarded, so that the tax on that $3 billion royalty, which is $610 million in 2011, does not have to be paid to the United States. Is that correct? Mr. Sample. Yes. Senator, with respect to the check-the-box groups we have, we are essentially creating the foreign equivalent of a U.S. consolidated group. And if you look at the U.S. consolidated group rules, they permit members of the U.S. consolidated group to move profits from one entity to another with no adverse tax consequences. All the profits that are moved in the Singapore group are earned by active operations by our Asia Pacific subsidiaries and employees selling to customers in Asia. All those profits remain within the Asia Pacific ROC group. So it is really just the equivalent of a consolidated group for the Asian ROC. Senator Levin. Does the U.S. group that you just referred to pay U.S. taxes? Mr. Sample. Our U.S. consolidated group pays U.S. taxes. Senator Levin. And does the Singapore group pay U.S. taxes? Mr. Sample. The Singapore group pays U.S. taxes to the extent it has passive Subpart F income within the group. Senator Levin. And you have taken care of that by disregarding it? Mr. Sample. Again, I do not have the details in front of me---- Senator Levin. Well, that is what you just said. It was disregarded within the group. You analogized it to a U.S. group. And now the analogy fails because the U.S. group pays U.S. taxes and the Singapore group does not pay U.S. taxes, and so your analogy does not relate to the U.S. tax reality. It relates to a theoretical reality. It is a pretty big difference, isn't it, between those two groups? Mr. Sample. Senator, I respectfully disagree with your characterization. Senator Levin. But didn't you analogize it to the U.S. group a minute ago, twice? Mr. Sample. No. I analogized it to the U.S. consolidated return rules. Senator Levin. Right. Mr. Sample. This is essentially a Singapore consolidated return group, and the earnings of the Singapore consolidated return group under the U.S. rules are not required to be taxed in the United States until they are repatriated back to the United States. Senator Levin. And that is because you have checked the box and because it is disregarded. Mr. Sample. That is correct. But the profits were earned from operating an active trade or business outside the United States. Senator Levin. Is it just basically a fair statement to say that tax considerations are a significant factor influencing Microsoft's decision regarding its cost-sharing agreements and where it locates offshore entities that are the parties to those agreements? Is that a fair statement? Mr. Sample. Senator, cost and tax consequences are a consideration with respect to all our subsidiaries and all our operations worldwide. They are certainly a consideration where we have decided to locate our regional operating centers. Senator Levin. And is it also a significant factor in your decisions regarding cost-sharing agreements? Mr. Sample. The primary---- Senator Levin. No. Is it a significant factor that influences Microsoft's decisions regarding cost-sharing agreements? Mr. Sample. Senator, I am not sure I understand the question. Are you asking relative to other forms of transfer pricing methods or is it a different question? Senator Levin. I think it is a clear question. Mr. Sample. Well, when we operate---- Senator Levin. Does it influence your decisions regarding cost-sharing agreements? Are tax considerations a significant factor influencing your decisions regarding cost-sharing agreements? It is a very straightforward question. You are a tax expert. I cannot state it more clearly. And I think you know it. I am just asking you is it a significant factor. Mr. Sample. Our transfer pricing policies always involve significant consideration of the tax consequences. Senator Levin. I think that means the answer is yes. Mr. Sample. It is a significant factor in all our transfer pricing policies, cost sharing or not. Senator Levin. I think that was my question, wasn't it? Mr. Sample. I have tried to answer to the best of my ability, Senator. Senator Levin. Is the straightforward answer to that then just simply yes? Mr. Sample. Well, Senator, again, respectfully---- Senator Levin. That is OK. If you cannot give me a yes or no, but just repeat the question and say that is what it is, that to me is a yes. But if you do not want to utter the word ``yes,'' that is your decision. Again, we thank you for your cooperation with this inquiry of ours. We thank you for your appearance. We are great fans of Microsoft and other companies in this country which are as creative and entrepreneurial as you are. We are not fans of your pricing agreements and what you do with our tax laws. But a whole lot of other companies do the same thing, if that gives you any solace. It should not give the American public any solace, but you are to be congratulated, it seems to me, for what you have been able to produce. But this tax system of ours which results in the kind of transfer and the drive to transfer U.S. funds and profits and income to low-tax jurisdictions is not in anybody's interest. It may be in your temporary interest as a corporation. It increases your profits and reduces your taxes. But there is a heavy cost to the United States. But, again, we thank you for your appearance here today. Thank so much. Mr. Sample. Thank you, Senator. Senator Levin. Let us now call our third panel of witnesses: Lester Ezrati, Senior Vice President and Tax Director, and John McMullen, Senior Vice President and Treasurer, at Hewlett-Packard Company; and also Beth Carr, a partner at Ernst & Young in International Tax Services. Let me thank our witnesses and the companies they represent, both Hewlett-Packard and Ernst & Young. The last time I was thanking our companies for their cooperation, I failed to mention Ernst & Young, but you are included in that group that cooperated with us. We appreciate that. Under our Rule VI, as you know, all of our witnesses need to be sworn, so we would ask that you please stand and raise your right hand. Do you swear that the testimony you are about to give will be the truth, the whole truth, and nothing but the truth, so help you, God? Mr. McMullen. I do. Mr. Ezrati. I do. Ms. Carr. I do. Senator Levin. OK. Do you want to begin with your opening statements? I think you were here before when you heard what our ground rules are in terms of time. Were you here, all of you? Should I repeat the rule? Mr. McMullen. No. Mr. Ezrati. I was here, Senator. Senator Levin. OK. Ms. Carr, were you here? Did you hear the rule about timing of your statement? Ms. Carr. I did. Thank you. Senator Levin. Thank you. Do you have any preference as to who begins? I guess Mr. Ezrati is going to be presenting the Hewlett-Packard testimony, so why don't we have you go first, and then Ms. Carr. TESTIMONY OF LESTER D. EZRATI,\1\ SENIOR VICE PRESIDENT, TAX, HEWLETT-PACKARD COMPANY, PALO ALTO, CALIFORNIA, ACCOMPANIED BY JOHN N. MCMULLEN, SENIOR VICE PRESIDENT AND TREASURER, HEWLETT- PACKARD COMPANY, PALO ALTO, CALIFORNIA Mr. Ezrati. Certainly, Senator. Chairman Levin, my name is Lester Ezrati, and I am the Senior Vice President of Tax at Hewlett-Packard Company. I have spent nearly my entire three- decade professional career at HP. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Ezrati and Mr. McMullen appears in the Appendix on page 135. --------------------------------------------------------------------------- I am an attorney, and my duties include providing tax advice to HP. My group provides advice regarding HP's tax obligations in over 100 countries, including the United States, and prepared the relevant documents. I am accompanied by my colleague John McMullen, Senior Vice President and Treasurer of HP. Mr. McMullen has held this position since 2007. One of Mr. McMullen's responsibilities is to provide HP with the cash it needs in the United States and abroad. HP produced over 330,000 pages of documents, voluntarily permitted interviews of executives, and cooperated fully for the past 3 years with the Subcommittee's inquiry. Over 1 billion people rely on HP technology. We operate in approximately 170 countries with a workforce of over 320,000, including approximately 80,000 U.S. employees. Many of these U.S. jobs are highly skilled, high-value, and high-wage jobs. In 2011, HP paid approximately $10.3 billion in salaries and wages to U.S. employees. HP spent $3.3 billion on R&D during its 2011 fiscal year, and about two-thirds of this R&D was conducted in the United States. In recent years, HP made several strategic acquisitions of companies with substantial foreign assets, including Autonomy, 3Com, Mercury Interactive, and Indigo. For example, funds from HP's foreign operations supplied approximately $4 billion for the purchase price of U.K.-based Autonomy. HP's fiscal year 2011 Generally Accepted Accounting Principles (GAAP) effective tax rate (ETR), was 21.2 percent. ETR is the blended worldwide effective tax rate which incorporates tax rates on U.S. and foreign operations. Most of our foreign competitors have much lower effective tax rates, such as Lenovo, 13.8 percent; Samsung, 16.5 percent; and Wipro, 13.9 percent. The Subcommittee requested that HP address APB 23 dealing with indefinitely reinvested earnings. Examples of indefinitely reinvested earnings include the value of overseas facilities, inventory, and many other types of assets. In 2011, HP earned approximately 65 percent of its revenue from non-U.S. sources. Based on this large and increasing global footprint, it is both logical and necessary that HP's indefinitely reinvested APB 23 amount has increased. HP's representation of what is indefinitely reinvested is ultimately made by me and reflected in a representation letter provided to Ernst & Young, who audits HP on an annual basis. In determining the amount of indefinitely reinvested earnings, I consult with Treasury, chief financial officer (CFO), and others within HP, and I consider many factors, including: Prior years' history, working capital forecasts, long-term liquidity plans, capital improvement programs, merger and acquisition, and other investment plans, U.S. cash needs, the expected business cycle, restrictions on distributions in certain countries, and country risk. Ernst & Young reviews internal HP data that supports this representation and can ask for additional information to test my decision. Year over year changes in HP's APB 23 reporting are in HP's financials and are visible to the public and regulators. The Subcommittee also asked about HP's loans from foreign subsidiaries and the potential application of Internal Revenue Code Section 956 to these loans. Under applicable rules, a loan from a controlled foreign corporation (CFC) to its U.S. parent will only be treated as an investment in U.S. property if it is outstanding at the close of the CFC's fiscal quarter. A series of loans that collectively span over the CFC's quarter may be treated as a single loan by the IRS or the courts under general tax principles. Based on IRS guidance, if the period of time between separate loans is not brief compared to the overall period the debt obligations are outstanding, such loans will not be aggregated in this manner. HP's non-U.S. structure includes our Belgian Coordination Center (BCC). In effect, the BCC serves as HP's internal bank and receives cash from most of HP's non-U.S. subsidiaries by way of capital contributions and loans. BCC's funds may be used in part to buy a foreign company, for example. BCC's funds can be used to fund distributions to HP U.S. entities, which are fully taxed in the U.S. BCC can lend money within the HP corporate family, and is paid market interest rates on those loans. Pre-merger Compaq also had a foreign subsidiary in the Cayman Islands, CCHC, which served a similar function as BCC, and HP continues to use that entity for the same purposes as the BCC. All loans from these subsidiaries, including the alternating loans identified by the Subcommittee, are in compliance with Internal Revenue Code Section 956, IRS guidance, and case law. In its most recently completed audit of HP's tax returns, the IRS reviewed detailed information regarding these loans and did not find that the tax treatment of them was contrary to the Internal Revenue Code, relevant IRS guidance, or case law. To be clear, however, alternating loans are only one of several sources of liquidity to HP's U.S. entities. Indeed, there have been times when no alternating loans were made, including a 90-day period that began at the end of fiscal year 2010. In addition, there were 72 days in the last two fiscal years where there was no alternating loan balance.\1\ --------------------------------------------------------------------------- \1\ Subsequent to the hearing, Hewlett-Packard informed the Subcommittee that it researched this matter and now corrects this to 86 days. --------------------------------------------------------------------------- HP's commercial paper (CP), program has always been available to augment short-term liquidity in the United States. For example, in 2010, over a 3-day period, HP raised over $3 billion in commercial paper, part of which funded the Palm acquisition. For the last 2 fiscal years, the average balance for our commercial paper program was approximately $1.9 billion. By way of comparison, during the same time period our outstanding alternating loan balance averaged approximately $1.6 billion. HP also uses capital market debt for longer-term needs. HP has issued a cumulative amount of long-term U.S. debt totaling approximately $16.6 billion for the last 2 fiscal years. In addition to CP and long-term debt, HP has $7.5 billion in revolving credit facilities with our bank group. The average value of alternating loans in use over the past 2 fiscal years represents only 9 percent of the liquidity provided by CP and new U.S. long-term debt combined for the period. Additionally, the average value of alternating loans in use over the past 2 fiscal years represents only 5 percent of the total HP debt outstanding at the end of our most recent fiscal third quarter. Clearly, over this period the alternating loans were a modest contribution to HP's liquidity. I can assure the Subcommittee that HP takes seriously its obligations to accurately follow accounting principles and to pay the taxes that it owes. Mr. McMullen and I are available for your questions. Thank you very much. Senator Levin. Thank you very much. Ms. Carr. TESTIMONY OF BETH CARR,\1\ PARTNER, INTERNATIONAL TAX SERVICES, ERNST & YOUNG LLP, PALO ALTO, CALIFORNIA Ms. Carr. Good afternoon, Chairman Levin. My name is Beth Carr. I am a certified public accountant and an international tax partner with Ernst & Young LLP. I am appearing today representing the firm. --------------------------------------------------------------------------- \1\ The prepared statement of Ms. Carr appears in the Appendix on page 119. --------------------------------------------------------------------------- I have been with Ernst & Young for more than 11 years and am responsible for leading the Ernst & Young team that performs tax-related work for Hewlett-Packard, for which we serve as the independent auditor. I have been working as a tax professional in the area of public accounting since 1994 when I graduated from the University of Pennsylvania with a bachelor of science degree with a concentration in accounting. Since 1996, my focus has been international taxation. I joined Ernst & Young in March 2001 and have been an international tax partner since 2004. I have been the lead tax partner on the Hewlett-Packard account since 2006. I could not be prouder of the fact that I am a mother of two young boys, a wife of a wonderful and supportive husband, and a partner at Ernst & Young where I have the opportunity to work with a team of extremely knowledgeable, ethical, and intelligent individuals in the complex areas of tax and accounting. I truly enjoy working with my colleagues and clients, and I am honored to represent Ernst & Young before the Subcommittee today. My firm and I have sought to be helpful in our responses and input to the Subcommittee. The policy issues being explored are important. I have participated in many hours of questioning by the Subcommittee staff relating to my and my firm's work for Hewlett-Packard. Ernst & Young in turn has provided to the Subcommittee approximately 150,000 pages of documents in a highly compressed time frame. Today's hearing addresses complex technical issues relating to companies' tax and accounting treatment of their foreign earnings. As it is difficult to address with brevity the substance of the issues the Subcommittee is reviewing, I refer the Subcommittee to my written statement which sets forth the underlying framework that is central to my and Ernst & Young's perspective on these topics. The Subcommittee has asked about Hewlett-Packard's application of an accounting standard formerly referred to as ``APB 23,'' which is now codified in ASC 740. In general terms, APB 23 is the accounting standard for temporary differences between the book and tax basis in a company's investment in a foreign subsidiary, often referred to as ``the outside basis difference.'' The most significant outside basis difference typically relates to book earnings. The accounting rules generally require that a company account for the future taxation of this outside basis difference even if no tax is currently due. APB 23, however, provides an exception to recording this future tax liability if the company asserts and demonstrates that it has the ability and intent to indefinitely reinvest such earnings outside the United States and, therefore, does not expect that any tax will be due for the foreseeable future. The Subcommittee has also asked about Hewlett-Packard's short-term intercompany loans, their consistency with its indefinite reinvestment assertion, and whether these short-term loans are compliant with the applicable Internal Revenue Code provisions. Our written statement outlines the complex legal and regulatory framework for evaluating these issues. As Hewlett-Packard's independent auditor, we spend tens of thousands of hours forming a conclusion on whether Hewlett- Packard's financial reports are fairly presented under U.S. GAAP. As a part of that effort, my team and I spend more than 7,000 hours each year reviewing the various aspects of Hewlett- Packard's accounting for income taxes. We test with independence, skepticism, and objectivity the various assertions of Hewlett-Packard. Ernst & Young has concluded each year that Hewlett- Packard's financial statements fairly presented its financial position and results of operations under U.S. GAAP, and Ernst & Young stands firmly behind the audit opinions that it has issued for Hewlett-Packard. As part of our independent audit, we expend considerable effort in evaluating HP's loans from its foreign subs, or CFCs. In general, during the period under review by the Subcommittee, the test for whether CFC loans are deemed a taxable dividend has entailed a comprehensive facts-based analysis of whether there has been a repatriation to the United States of an individual CFC's earnings. IRS guidance also acknowledges the important role that CFC loans may serve as a short-term alternative source to provide liquidity to a U.S. multinational. Indeed, during the recent credit crisis, when corporate liquidity was suffering greatly, the IRS temporarily relaxed the short-term loan requirements in an attempt to encourage expansion of the scope of companies' intercompany lending to help facilitate liquidity while not triggering repatriation of earnings and associated U.S. income tax liabilities. In addition to the guidance that the IRS has issued regarding the application of Section 956, the IRS regulations require that intercompany loan balances between a CFC and its U.S. parent or a domestic corporation controlled by the parent be included on the taxpayer's Form 5471 or Form 8858. Many large companies, including Hewlett-Packard, are subject to continuous IRS audit during which some intercompany loans may be examined. My colleagues and I at Ernst & Young work hard to comply with all existing rules and regulations and aspire to the highest professional standards in doing so. While the policies embodied in the tax law and accounting principles, including Section 956 and APB 23, may be questioned or challenged, our role as independent auditor is to evaluate whether HP properly applies the rules that exist at the time of its financial reports. On behalf of Ernst & Young, I appreciate the opportunity to provide input in connection with the Subcommittee's review, and I welcome your questions. Senator Levin. Thank you very much, Ms. Carr. Let me start with you, Mr. Ezrati. You have maintained most of your cash as a company offshore. Is that true? Mr. Ezrati. So, Senator, 65 percent of our revenue is offshore, and a good chunk of the cash is kept offshore. Senator Levin. About what percentage of the cash? Mr. Ezrati. It varies at different times. There are certain reasons why U.S. cash is depleted more quickly than foreign cash, and I can enumerate them for you. Senator Levin. At the end of 2009, is it true you had $12.5 billion of your $13.3 billion offshore? Mr. Ezrati. I will have to defer to Mr. McMullen on that. Senator Levin. Is that about right? Mr. McMullen. Yes, Senator. Senator Levin. That would be about, what, 90 percent, 85 percent? Mr. McMullen. I do not have the specific for that period, but in the ballpark of 90 percent makes sense. Senator Levin. OK. And so you say about 65 percent of your earnings offshore, you have about 90 percent of your cash offshore. Is that about right? Mr. McMullen. Yes. Mr. Ezrati. And, Senator, there is a reason why U.S. cash gets depleted. There are certain expenses and certain funds you can only use U.S. funds to pay those expenses and funding. For example, dividends to U.S. shareholders can only be paid from U.S. funds. The U.S. pension plan can only be funded by U.S. funds. You can only retire debt in the United States using U.S. funds. U.S.-based companies can only be acquired with U.S. funds. And so there are reasons why U.S. funds get depleted more quickly than foreign funds. At the same time, foreign funds are reserved for foreign acquisitions or for expansion, and we have expanded greatly outside the United States. So there is a reason why you are reserving foreign funds for that expansion. Senator Levin. Does tax strategy influence the location of cash balances? Mr. Ezrati. What influences the location---- Senator Levin. I just asked you, does tax strategy influence the location of cash balances? Mr. Ezrati. HP has an overall strategy to minimize expenses, and that is what generates where the cash is located. One of those expenses is taxes, just like every other expense. Senator Levin. Does tax strategy influence the location of cash balances? Mr. Ezrati. In part, yes. Senator Levin. Well, take a look at Exhibit 3d,\1\ would you? Do you see on page 2 there where it says ``Cash Profile''? --------------------------------------------------------------------------- \1\ See Exhibit No. 3d, which appears in the Appendix on page 206. --------------------------------------------------------------------------- Mr. Ezrati. Yes, Senator. Senator Levin. Am I reading that correctly? ``HP's tax strategy influences the location of cash balances.'' Is that your document? Mr. Ezrati. Senator, I did not prepare this document, but I just acknowledged that HP's tax strategy in part influences the location of cash balances. Senator Levin. All right. I asked you whether HP's tax strategy influences location of cash balances. I am reading your document, and you will not give me a ``yes'' to that? Mr. Ezrati. I gave you a ``yes'' to that. Senator Levin. You qualified it. You said ``in part.'' Mr. Ezrati. It is true. It is only in part. I do not want to answer the question without telling you exactly what the answer is. Senator Levin. So there are other influences. Is that correct? Mr. Ezrati. Oh, absolutely. Senator Levin. Yes, but tax strategy influences the location. Mr. Ezrati. I said yes. Senator Levin. The record will show you did not say yes. But that is OK. Mr. Ezrati, in 2008, HP began what it called a staggered loan program. Now, this loan program was designed to allow HP through the use of two non-U.S. cash pools called CCHC and BCC, one being Belgian and one having the word ``Cayman'' in it, to use those two cash pools and to fund U.S. operations with billions of dollars yearly since at least 2008. I believe you said that alternating loans made a modest contribution to HP's U.S. operations. Were those loans as large as $5.9 billion in 2010? Mr. Ezrati. That is correct, Senator. Senator Levin. OK. Now, do you agree that the loan program that we are talking about contained a prescribed schedule from HP's treasury and tax departments for when loans could be made and when they needed to be repaid in order to comply with Section 956? Mr. Ezrati. That is correct. The tax department did tell the Treasury Department how to comply with the Internal Revenue Code. Senator Levin. And so you agree that there was a prescribed schedule--take a look, if you would, at 3h.\2\ --------------------------------------------------------------------------- \2\ See Exhibit No. 3h, which appears in the Appendix on page 214. --------------------------------------------------------------------------- Mr. Ezrati. I am sorry, Senator. I did not understand which exhibit you wanted me to look at. Senator Levin. On page 2, where it says from CCHC, January 2 to February 17, from BCC, February 17 to April 2, from CCHC, April 2 to May 17,'' and then to the other cash pool, May 17 to July 2, back to the first cash pool, July 2 to August 17. Do you see all those dates there? Mr. Ezrati. I do see those dates. Senator Levin. Does that cover every date in the year? Mr. Ezrati. It does cover every date of the year. I was trying to answer your original question about the prescribed schedule. So the word ``schedule'' there does not say this is a schedule of loans. It is a following schedule, meaning the chart that appears underneath that word. Senator Levin. OK. Does it define the windows for loans? Mr. Ezrati. They are the windows when loans can be made. It is not a prescription as to when loans have to be made or should be made. Senator Levin. Must they be made within those windows? Mr. Ezrati. Not ``must''; can only be made within that window. Senator Levin. All right. And were there loans continually made within those windows? Mr. Ezrati. During which fiscal year? Every year? Senator Levin. In 2009, 2010, and 2011. Mr. Ezrati. No. Senator Levin. In 2008, 2009, 2010, 30 straight months during those 3 years? Mr. Ezrati. I am not familiar with the 30-month period you are talking about. I know that in fiscal year 2010, as you said in your opening statement, that there was a period when the loans were made during the first three quarters of fiscal year 2010. I will take you with that. Senator Levin. OK. And how about 30 months during those years, straight months? Mr. Ezrati. In 2008, 2009, and 2010? I am not familiar with that. Senator Levin. All right. So every single period during that three quarters there was an outstanding loan from one of those two companies, and this schedule had been designed, was it not, by the parent company? In other words, they did not design their own schedules, did they? They took schedules from the tax department and treasury department of HP. Is that right? Mr. Ezrati. That schedule was designed by the U.S. tax department to conform to the U.S. Internal Revenue Code. Senator Levin. I understand. But it was designed by your tax department. One tax department said we have two pools, we have to break them up into two different pools. Would you agree that if this were one pool it would not comply with Section 956? Would you agree with that? Mr. Ezrati. I would agree with you that it would be a different understanding of the law if it was one pool. I want to talk about your characterization of ``breaking it up.'' We did not break this---- Senator Levin. All right. It came at different times. Forget the breaking---- Mr. Ezrati. No, you have to understand me. These two pools existed independently of each other. It was not one pool that we broke into two. Senator Levin. Fine. Mr. Ezrati. There always were two pools. Senator Levin. OK. Two pools then were given a common schedule. Is that correct? Mr. Ezrati. The treasury department was given the schedule, yes. Senator Levin. Two pools, both HP pools, were given a common schedule. That pool was told if you are going to make loans--which they did every day for three quarters, and we will get to the 30 quarters later on. But they were told by the tax department if you are going to make loans, they have to be in this particular time period; then they alternate to the other pool. OK? If you are going to make loans, you cannot make them between the same period pool one is doing it; you got to do it during the next sequential period. Now, the first pool is told, OK, the third sequential period, now if you are going to make loans, that is when you have to make them and you have to collect them that time, too. Then the second pool is told, you are next in sequence, back and forth, back and forth, back and forth, back and forth, for a whole year, each year. They are given a sequence by the tax department. Now, you can call that independent if you want, but it is dictated by the tax department; HP dictates the sequence for two pools that are HP pools as to when they are going to make loans. Would you agree with that? Mr. Ezrati. I would agree with you that the tax department told the treasury department when they could make loans from each of the pools. Senator Levin. And they determined the sequence when those loans could be made. Mr. Ezrati. Exactly what I said. The tax department determined---- Senator Levin. How about what I said? Mr. Ezrati [continuing]. When the loans could be made from each of those pools and when they could not be made. If that is the way you define a sequence, when a loan can be made and when a loan cannot be made, if that is what you mean by sequence, I am agreeing with you. Senator Levin. Is that what you mean by sequence? Mr. Ezrati. I do not know what the word ``sequence'' means in this case. Senator Levin. OK. Now, did those two entities have different quarter endings so that they would be able to provide a continuous series of loans without crossing over the end quarter of either of them? Mr. Ezrati. Those two entities, they each have a different fiscal quarter end. That is correct. Senator Levin. And were they given a different quarter ending so that they would be able to provide a continuous series of loans without crossing over the end quarter? Mr. Ezrati. They were given a different fiscal quarter so that they would have a different fiscal quarter for U.S. tax purposes and the application of Section 956. Senator Levin. How about my question? It is a straightforward question. Were they given different quarter endings so they would be able to provide a continuous series of loans without crossing over the end quarter of either one? That is a very direct question. Mr. Ezrati. The answer to that is no, it was not so that they could have a continuous series of loans. Senator Levin. No. Without crossing over the end quarter. Mr. Ezrati. Right. They were given different quarter ends so that they could be lending at different times and so that their loans would not cross over their end quarter. I was just quarreling with your use of the word ``continuous.'' Senator Levin. All right. So, anyway, there is no possibility with these sequences of there being a gap between available pools. Is that correct? Mr. Ezrati. I am not sure I understand what you mean--there is always a gap between the available pools. There is always a large gap between when the BCC can be lending and when it cannot, and there is a gap between when CCHC can be lending and when it cannot. Senator Levin. I said a gap between the pools. I did not say within the pool. Mr. Ezrati. I think, if I understand you correctly, you mean---- Senator Levin. Between the pools, there cannot be a gap. In other words, money could always be loaned by one or the other, and if there were loans made, there could not be a gap if they were made according to the prescribed sequence. Is that right? Mr. Ezrati. If loans were made in accordance with the prescribed sequence, there would not be a gap, right. Senator Levin. OK. So by using two pools, was it your aim to effectively have an uninterrupted, ongoing loan program to assist operations in the United States? Mr. Ezrati. As I testified, there were gaps in those, depending on what cash was needed. The schedule you are looking at is not an actual schedule of loans, Senator. There were gaps in the loans. Senator Levin. I did not say it was a schedule of loans. Mr. Ezrati. There was a period of time in fiscal year 2010 when there were no loans from---- Senator Levin. I said it was a schedule when loans could be made and, if they were made, must be made, and must be repaid. Mr. Ezrati. They could be made and they must be repaid, that is correct. Senator Levin. OK. Mr. Ezrati. And, in fact, when they were made, they were repaid within that schedule. Senator Levin. And now, I do not know if you answered this before, would you agree that if they were in one pool that they would be taxed as a long-term loan? Mr. Ezrati. So, Senator, if there were only one pool and it had made a loan for the entire year---- Senator Levin. No, made all the loans that were made from these two pools. Mr. Ezrati. Yes, I guess one way to look at it is there had only been one entity and it made all the loans there, it would have a different treatment probably subject to tax in the United States. Senator Levin. OK. Was there an ability to move funds from one pool to the other? Mr. Ezrati. There is no commingling of funds from one pool--no commingling of the funds in those pools. [Pause.] Senator Levin. Take a look at Exhibit 3c,\1\ would you? And it is under ``Alternating Loans.'' --------------------------------------------------------------------------- \1\ See Exhibit No. 3c, which appears in the Appendix on page 203. --------------------------------------------------------------------------- Mr. Ezrati. You mean the last page of Exhibit 3c? Senator Levin. Yes, the heading ``Alternating Loans,'' starting with the words, ``The majority of our offshore cash . . .'' Are we on the same page? Mr. Ezrati. I am, Senator. Senator Levin. OK. Take a look at the third dot: ``We have the ability to move cash from BCC to CCHC in fiscal year 10.'' Was that true? Mr. Ezrati. We were definitely exploring possibilities of moving cash from the BCC to CCHC in fiscal year 2010. Senator Levin. How about my question? Mr. Ezrati. Is what true? Senator Levin. What I read to you. Was it true that you had the ability to move cash from BCC to CCHC in fiscal year 2010? Mr. Ezrati. What I do know is that in fiscal year 2010 we did not move cash from the BCC to CCHC. Senator Levin. My question? Mr. Ezrati. We may have had the ability to. We did not. Senator Levin. OK. So you may have had the ability to move cash from BCC to CCHC in fiscal year 2010. Mr. Ezrati. I can easily think of ways you could have moved cash from the BCC to the CCHC. A simple way would have been to have one lend money to another. We did not do that. Senator Levin. All right. But you had the ability to do it. That is not what I called--I did not say ``commingle.'' When I asked you that first question, I said to transfer cash---- Mr. Ezrati. I understand. Yes, Senator, we definitely had the ability to move cash from one pool to the other. We did not. Senator Levin. OK. Now, in 2009, your records show that HP U.S. borrowed on average from the two alternating pools about $5 billion, and there was no gap of a single day for the year that we can see. In 2010, your records show that HP U.S. borrowed an average from the two alternating pools nearly $6 billion without a gap of a single day for more than 9 months in 2010. Ms. Carr, were you aware of the extent and breadth and regularity of the staggered loan program? Ms. Carr. We certainly were aware of the inter-company loans that were made by the BCC and CCHC to HP CO. Senator Levin. Were you aware of the extent and the breadth and the regularity of the staggered loan program? Ms. Carr. Again, we were aware of the loans that were made by BCC and CCHC. Senator Levin. Let me just ask, Ms. Carr, though, is that different from a ``yes'' answer? Ms. Carr. I do not believe so. We were aware of the loans that were made. Senator Levin. And the extent and the regularity of those loans? Ms. Carr. We were aware of the dates and length of the notes. Senator Levin. OK. Mr. Ezrati. Senator, I think you have misstated the extent of the loans. Because of the way the Subcommittee staff asked for the data, they have miscalculated the average amount outstanding at any particular time. I would respectfully disagree with the amount you have recharacterized as ``outstanding'' on average? Senator Levin. Did I say ``outstanding''? I do not think I used the word ``outstanding,'' did I? Mr. Ezrati. I am sorry then. I will withdraw my objection. Senator Levin. I believe that you said, Mr. Ezrati, that you did not depend heavily upon these funds for your liquidity. Is that true? Mr. Ezrati. I said that during the last 2 fiscal years they represented a modest amount of our liquidity. Senator Levin. Now, take a look at the last 2 fiscal years. You mean these last two. How about in October 2008? Mr. Ezrati. I think Mr. McMullen can help me with that one as to why the loans may have been greater in 2008. Mr. McMullen. Sure. Yes, Senator, just for context, in 2008, in the October time frame, that was shortly after we had done the acquisition of EDS, and it was also the point in time, if you recall, in mid-September of that same year that the capital markets essentially froze. Tier 2 CP market essentially froze, and there was some question as to how reliable CP was going to be even as a Tier 1 provider, as we were. So the alternating loan was absolutely an important aspect of liquidity in the United States. Senator Levin. Was it the most important source? Mr. McMullen. It was the most predictable and at that point extremely important, because we were not---- Senator Levin. Was it just flat out the most important source of U.S. liquidity? Mr. McMullen. At that point in time, very important. ``Most'' is not the word I would use, Senator. Senator Levin. You are resisting that word, but now let me take a look at your own documents. Take a look at Exhibit 3b.\1\ I understand your resistance to the word ``most,'' but let me refer you to an HP document, October 7, 2008, ``Access to Offshore''--no, I am wrong. ``Offshore Cash Pools,'' do you see that heading? Do you see the second sentence: ``The pools alternately loan to HP UP for 45-day periods. This is the most important source of US liquidity.'' Do you see that? --------------------------------------------------------------------------- \1\ See Exhibit No. 3b, which appears in the Appendix on page 199. --------------------------------------------------------------------------- Mr. McMullen. I do. Senator Levin. It does not say ``an important,'' ``one of the most.'' It says ``the most.'' Was that accurate when it was written? Mr. McMullen. I understand, Senator. I did not create that slide. Senator Levin. You just do not agree with it. Mr. McMullen. I agree that at that point it was incredibly important. Senator Levin. ``Incredibly important.'' Mr. McMullen. Now, the most important---- Senator Levin. That is all right. I think that is as much as we are going to get on that one. Now, were the decisions that were made about when and how much of the offshore cash pools in this staggered loan program, was that closely coordinated by both treasury and the tax offices? Mr. Ezrati. I think your question, Senator, is the decision on how much---- Senator Levin. When and how much of the offshore cash pools would be utilized closely coordinated by both of those offices? Mr. McMullen. The guidelines come from the tax department, but the decision relative to the amounts and the execution of those amounts within the guidelines are done by the treasury department. Senator Levin. By the treasury. So the treasury decided within each fund how much and when? Mr. McMullen. Yes, sir. Senator Levin. That was, therefore, coordinated in one person, was it not? Was there one person head of the treasury office? Mr. McMullen. In terms of determining the value, there would be input from many people, sir. Senator Levin. But was there one office that made that decision? Mr. McMullen. Yes, the one team that makes that decision is the U.S. Treasury Operations Group. Senator Levin. OK, so that one group made decisions for both funds. Mr. McMullen. Yes. They make the decision from period to period. Senator Levin. For both funds? Mr. McMullen. Yes, sir. Senator Levin. Now, was this alternating loan program part of HP's repatriation strategy? Mr. McMullen. No, sir. The alternating loan is a loan, so repatriation is not a loan. Senator Levin. OK. Take a look at Exhibit 3c,\1\ would you? Under ``Repatriation History,'' do you see that? On page 2, it says, ``In addition to the permanently repatriated cash, HP has increased it's [sic] alternating loans from offshore cash pools by approximately $6 [billion] over the last 3 years.'' Do you see that? --------------------------------------------------------------------------- \1\ See Exhibit No. 3c, which appears in the Appendix on page 203. --------------------------------------------------------------------------- Mr. McMullen. I do. Senator Levin. OK. So under the heading ``Repatriation History,'' you say in addition to permanently repatriated cash, you have increased your alternating loans. And then if you look at the next page, under ``Alternating Loans,'' where it says, ``We have the ability to move cash from BCC to CCHC in fiscal year 10, which would result in increased access over quarter end--the amount we move, if any, will depend on the outlook of other tax repatriation strategies . . .'' And then it says, ``. . . all the repatriation strategies are ultimately funded by BCC.'' But putting that one aside--this was looked at as a tax repatriation strategy, at least in the language of that document, was it not? Mr. McMullen. Senator, I can understand the confusion in the language. If I were to create those slides, I would have flipped the two bullets on both slides. Senator Levin. All right. Mr. McMullen. It is very clear in the treasury department that the loan is a short-term and alternating loan and that repatriation represents something completely different. It is also true that---- Senator Levin. It is kind of lumped together, though, in that slide. Mr. McMullen. In this slide. That is not the way I would have done it, sir. Senator Levin. All right. Now, Ms. Carr, if a controlled foreign corporation lends its earnings to its parent U.S. company that owns it, and it is only interrupted by brief periods of repayment, you said there exists in substance, did you not, a repatriation of the earnings? Or were you not told in an email that if a controlled foreign corporation lends earnings to its parent U.S. shareholder interrupted only by brief periods of repayment, which include the last day of the controlled corporation's taxable year, that there exists in substance a repatriation of the earnings, right? Is that something that you were informed of? Look at Exhibit 4b.\1\ --------------------------------------------------------------------------- \1\ See Exhibit No. 4b, which appears in the Appendix on page 226. --------------------------------------------------------------------------- Ms. Carr. Thank you. [Pause.] Ms. Carr. I am sorry, Senator. Can you point to exactly what page you are on? Senator Levin. Yes. It is Exhibit 4b, and it is page 3 or 4. These pages are not numbered. The page, the heading of it is, ``A few thoughts on why I would argue we are OK.'' Do you see that line? Ms. Carr. I do. Thank you, Mr. Chairman. Senator Levin. And then about three paragraphs down, it says, ``The facts and circumstances of each case must be reviewed to determine if, in substance''--in substance--``there has been a repatriation of the earnings of the controlled foreign corporation. If a controlled foreign corporation lends earnings to its U.S. shareholder interrupted only by brief periods of repayment, which include the last day of the controlled foreign corporation's taxable year, there exists, in substance, a repatriation of the earnings to the U.S. shareholder within the objectives of Section 956.'' Do you see that? Ms. Carr. I do. Thank you. Senator Levin. That was your memo? Ms. Carr. That is actually--well, yes, it was my email, Mr. Chairman. Senator Levin. It is from you. Ms. Carr. Yes. Senator Levin. Now, if you will take a look at Exhibit 4a,\2\ this is where you were seeking advice from your national office concerning HP's loan program in 2007. You received some written guidance concerning the Section 956 issues in an email, that is Exhibit 4a, and I want to just read to you from the concluding paragraph at the end of the email. So that is going to be on page 2. Are you with me? --------------------------------------------------------------------------- \2\ See Exhibit No. 4a, which appears in the Appendix on page 223. --------------------------------------------------------------------------- Ms. Carr. I am with you. Thank you. Senator Levin. ``Thus, it appears that both courts and the IRS may seek to apply substance over form to transactions that it views as abusive. However, we do believe that we can get comfortable with a `should' level of opinion, assuming''--this is the assumption--``that HP avoids behavior that could be interpreted as abusive. Documents and/or work papers that indicate an intention to circumvent or otherwise abuse the spirit of Section 956 could prove particularly troublesome and thus should be avoided.'' Would you agree there are all kinds of documents here which say that there is an intent here to circumvent Section 956? Ms. Carr. Mr. Chairman, I do not know that I would agree with that characterization with respect to the documents. Senator Levin. OK. Ms. Carr. I certainly can explain this, the correspondence, if you would like. Senator Levin. All right. Then let me keep going. ``Furthermore, there would be no loans between the two CFCs themselves.'' Do you see that? Ms. Carr. I do. Senator Levin. Did you hear Mr. Ezrati say that he had the ability to lend to each other? You were sitting right there, weren't you? Ms. Carr. I was. I heard him say that. Senator Levin. Shouldn't that be avoided? Ms. Carr. Yes. He did not say it occurred. Senator Levin. I know, but he said---- Ms. Carr. He said it was possible. Senator Levin. Right. Ms. Carr. He did not say that there could or could not have been a U.S. tax consequence if there was a loan made, which I think is why he used the term ``commingling.'' Senator Levin. I see. So, in other words, what you are saying is that it is OK to say in these documents that we can lend to each other without violating Section 956? Ms. Carr. No---- Senator Levin. That is what the point is here, trying to avoid Section 956. So you should not put in your documents that you might lend to each other. Ms. Carr. Again, I think what this is saying is that there should be no loans between the two funds, and, again, forgive us for using tax terms, tax people will typically use the word ``commingling.'' There should be no commingling by the CFCs of their funds. If there is, there is an anti-abuse rule which exists within Section 956 which would cause you to trigger a U.S. tax. Senator Levin. Now, how about cash pooling? Ms. Carr. Mr. Chairman, do you mean in the next sentence? Senator Levin. Yes. It says, ``There should be no loans between the two as that might give the IRS the argument that the CFC was merely a conduit for repatriating funds from other foreign sources.'' It sure sounds like that to me. In the next sentence, ``We should probably give this more thought as there has been some cash pooling.'' What was that all about? Ms. Carr. Again, I think this was a reference to, Mr. Chairman, specifically loans or a loan from one individual CFC to another CFC. Both of those sentences in my mind, in my understanding, and in discussions with the person from national tax who wrote this, that is what that was referring to. Senator Levin. So there had been some cash pooling. Ms. Carr. No. There was no loans from one of the CFCs to another CFC. Senator Levin. What was there? Cash pooling, what is that? Ms. Carr. Again, the use of the term ``cash pooling'' here was meant to--I will use a slightly different tax term, a commingling of the funds, in other words, a loan from one CFC to the other. Senator Levin. You just said there could be a loan from one---- Ms. Carr. Legally, you certainly could make a loan---- Senator Levin. Without violating Section 956? Ms. Carr. No, I did not say that. Senator Levin. That is what this says. Ms. Carr. Again, I do not---- Senator Levin. You said that they had the ability to do it. I assume he means without paying taxes on it, or otherwise it would be kind of silly in this context to be saying that. That is what we are talking about, is avoiding Section 956. So we just heard Mr. Ezrati say we can lend from one to another---- Mr. Ezrati. I did not say that, Mr. Chairman. I said we could lend from one to--I did not say ``and avoid Section 956.'' Ms. Carr. Right. Senator Levin. Well, what are we talking about here except avoiding Section 956? That is what this is all about. Mr. Ezrati. And that is why there was no lending---- Senator Levin. Of course you could lend---- Mr. Ezrati. There was no loan from one to the other. Senator Levin. Of course you could lend from one to another. But that would violate Section 956. Mr. Ezrati. And that is what I said. Senator Levin. No. Mr. Ezrati. That is why there was no lending from one to the other. Senator Levin. OK. We are going to let the record speak for itself as to exactly what the context of your comment was. Mr. Ezrati. I am just trying to clarify so that you do not get the record misstated. Senator Levin. The record is going to speak for itself on that statement of yours. Now, ``We should probably give this more thought as there has been some cash pooling.'' And you are saying--``there has been some cash pooling.'' And you are saying what, again? Was there cash pooling? Ms. Carr. No, Mr. Chairman. Again, I think what---- Senator Levin. Excuse me. Had there been cash pooling? Ms. Carr. As I understand the word, there was no---- Senator Levin. Was there cash pooling? Ms. Carr. There was no loan from one CFC to the other, Mr. Chairman. Senator Levin. And my only question is: As you understand the word ``cash pooling''---- Ms. Carr. Yes. Senator Levin [continuing]. Had there been some cash pooling? Ms. Carr. Again, using--I will substitute it, if you do not mind, Mr. Chairman, with the word ``commingling,'' and, again, there was no commingling or loans made from one CFC to the other. Senator Levin. I am just asking you, as you understand the term ``cash pooling,'' had there been cash pooling? Is your answer no? Ms. Carr. My answer is no, I am not aware of loans from one of the CFCs to the other. Senator Levin. All right. Now, ``There should also not have been a loan schedule.'' Had there been a loan schedule contemplating a series of loans to be made and retired at specific times? Ms. Carr. Mr. Chairman, what I believe this is referencing is to, there should not be a single master loan agreement where the loans are dependent upon one another. And, again, you will note the date of this particular email, as you had referenced earlier, was 2007. As we have talked about, Section 956 is a very mechanical test, and while it is a mechanical test and certainly there are specific anti-abuse rules within Section 956, there is no general anti-abuse rule. But as you will note, we always need to consider the policy, and this was actually before there was a GLAM that was issued in 2009, and, again, in fact, that GLAM referred to the dependency of loans and talked about there being potentially a single loan agreement, a dependency, and referred to the need for independence, as I think you did in the written report that was issued. Senator Levin. Now, would you consider Exhibit 3h,\1\ which said pool one, January 2 to February 17, that loans would need to be made, if made, in that period; second pool, from February 17 to April 2; first pool, April 2 to May 17; pool two, May 17 to July 2; pool one, July 2 to August 17; pool two--and so forth. Do you consider that a schedule? --------------------------------------------------------------------------- \1\ See Exhibit No. 3h, which appears in the Appendix on page 214. --------------------------------------------------------------------------- Ms. Carr. I apologize, Mr. Chairman. Did you say Exhibit 3a? I know it was the exhibit---- Senator Levin. No. Exhibit 3h. Well, you have seen this before today, haven't you? Ms. Carr. I did, and you referenced it, and I want to be clear---- Senator Levin. That is OK. Ms. Carr. Mr. Chairman, I just want to clarify one point. When you said that I have seen this before---- Senator Levin. No. Today. Ms. Carr. I actually had not seen this document before your staff had shown it to me. Senator Levin. OK. You saw it before today---- Ms. Carr. When your staff had shown it to me during one of the interviews 2 weeks ago, that was the first time I had seen the document. Senator Levin. OK. Does that look like a schedule to you? Ms. Carr. No, again, I think I would characterize this very similarly to how Mr. Ezrati characterized it. This is a listing of guidelines for when the treasury department can choose to borrow on a short-term basis from individual CFCs. I would not consider that a master loan agreement, as was referenced in the email. Senator Levin. I am asking you whether or not you consider that a schedule. Ms. Carr. I would consider those guidelines, Mr. Chairman. Senator Levin. The word says ``schedule.'' Read that to me. ``The following schedule.'' Why don't you read it? Ms. Carr. I understand what you are saying---- Senator Levin. No. Did I read it correctly? Ms. Carr. You certainly read the words correctly. Senator Levin. What did I not read correctly? Ms. Carr. Well, I think Mr. Ezrati explained that the following where it says the words, ``I think that what this is referring to is guidelines,'' and I think Mr. Ezrati clarified this. These were guidelines that were provided by the tax department to treasury of periods of time when the treasury department could choose to loan from individual CFCs. Senator Levin. I understand. In order to avoid the application of Section 956, these were guidelines. Was it also a schedule? That is all I am asking you. Does the word ``schedule'' appear right above those dates? Do you see that word? Ms. Carr. Yes, Mr. Chairman. Senator Levin. Did I read it correctly? Ms. Carr. I do see the word ``schedule.'' Senator Levin. Could you read it for us? Ms. Carr. I certainly could, but I do see the word ``schedule.'' Senator Levin. Would you read it for us? Ms. Carr. It says, ``The following schedule defines the `windows' for loans to HP Company.'' Senator Levin. Thank you. I was not sure we could actually get you to read the word that was right there, which is ``schedule.'' OK. Was this schedule ever not followed? Ms. Carr. I am sorry, Mr. Chairman? Senator Levin. Was it ever violated? Was that schedule, the word ``schedule''---- Ms. Carr. Mr. Chairman---- Senator Levin. Were those eight dates, dividing a year into eight different periods, was that ever violated? Ms. Carr. Mr. Chairman, can you clarify the period of time which you are talking about? Senator Levin. Any time you know of was it violated? Ms. Carr. Certainly I think Mr. Ezrati pointed to there were different periods of time in which there were no loans that were made from any individual---- Senator Levin. I am asking you, was it ever violated? That is my question. Was that schedule ever violated? If there were no loans made, it was not violated. I am saying, was there ever a loan made during any time you know of that violated that schedule? Ms. Carr. Well, I apologize. Was there ever a loan made---- Senator Levin. That you know of. Ms. Carr [continuing]. That I know of. I do not recall a loan being made that was not in accordance with the guidelines that the tax department gave to treasury. I do not recall any. Senator Levin. During the last 2 years, 2010 and 2011, did I hear you correctly, Mr. Ezrati, there were how many days where there was no loan outstanding, did you say? Mr. Ezrati. I will have to look at my statement again. Mr. McMullen. May I help, Senator? Senator Levin. Sure. Mr. McMullen. The 90-day period was between the end of 2010---- Senator Levin. No, my question is how many days were there not loans outstanding during those 2 years. Mr. McMullen. During those 2 years? Senator Levin. Yes. Mr. Ezrati. My statement says 72 days.\1\ --------------------------------------------------------------------------- \1\ Subsequent to the hearing, Hewlett-Packard informed the Subcommittee that it researched this matter and now corrects this to 153 days. --------------------------------------------------------------------------- Senator Levin. Seventy-two days out of 700 days. Is that correct? Mr. Ezrati. I think we are including fiscal year 2012, which has not ended yet. Senator Levin. OK. I thought it was just 2010 and 2011. Mr. Ezrati. No. It is 2011 and 2012 year to date. Senator Levin. OK. So there would be about, what, 500 days, something like that? Mr. Ezrati. Something like that. Senator Levin. And there was no loan outstanding for about 70 of those days. Is that right? Mr. Ezrati. For 365 days and however many days we have had this year. Senator Levin. I rounded it off. So in about a year and a half or a little more, there were 70 days, approximately, when there was no outstanding loan from one of those two funds. Is that correct? One of those two pools? Mr. Ezrati. Am I getting that right? Seventy-two days is what we wrote. Mr. McMullen. I just want to be clear on dates, Senator, if you do not mind. If you go from the period near the end of calendar 2010, and you go all the way to the beginning of calendar year 2012, there was a total of 162 days where there were not any loan balance outstanding. And it included two periods---- Senator Levin. How many days were there loans outstanding? Mr. McMullen. Well, I will do a little math here. That would be about 365 days and 2 months, 435 days. Senator Levin. OK. So about---- Mr. McMullen. About 435 days total, right? Senator Levin. Yes, so you have about 350 days, roughly, there were loans outstanding? Is that what you said? Mr. McMullen. Yes, of that---- Mr. Ezrati. I think we are making a mistake here. You have to add the 90 days and the 72 days---- Senator Levin. Add whatever you want. Give me a period of time and tell me how many loans were---- Mr. Ezrati. [Addressing Mr. McMullen] So the 162 days out of how many days, is what Senator Levin wants to know? Mr. McMullen. Yes, so 365 days, 10/1/10 to 11/1/11, right? And then roughly 2 more months. That would be approximately 435 days. Mr. Ezrati. Approximately 162 days out of 435.\1\ --------------------------------------------------------------------------- \1\ Subsequent to the hearing, Hewlett-Packard informed the Subcommittee that it researched this matter and now corrects this to 169 days. --------------------------------------------------------------------------- Mr. McMullen. Yes, approximately 162 days out of 435. Senator Levin. OK. So it is about--that says it. Mr. Ezrati. A little more than a third. Senator Levin. And then is it also true, as our staff has determined, that from February 19, 2008, to July 2, 2010, which is a 30-month period, there was a loan outstanding every day. Is that correct? Mr. Ezrati. I would have to go back and look at the schedules we gave you. I do not quarrel with your staff. They are very capable. Senator Levin. OK. Mr. Ezrati. I will check the material we provided and clarify if I need to. Senator Levin. Why don't you do that. Anyway, unless you correct that, I am going to assume that is a correct statement. Is that fair enough? Mr. Ezrati. Certainly.\2\ --------------------------------------------------------------------------- \2\ Subsequent to the hearing, Hewlett-Packard informed the Subcommittee that it determined that there were 31 days where there was no loan balance during the relevant time period. As a result, Hewlett- Packard wrote that it does not agree that there was a period of 30 months with an alternating loan outstanding every day. --------------------------------------------------------------------------- Senator Levin. Finally, to Ms. Carr, did you and another colleague provide consulting and auditing services to HP contemporaneously, at the same time? Were you both an auditor and a consultant? Ms. Carr. We certainly provided tax services to Hewlett- Packard. In addition, the firm was the auditor, and I worked on the audit of the income tax provision. Senator Levin. Did you audit your own work and your own recommendations? Ms. Carr. No, Mr. Chairman, we did not. And in our role as tax advisers, the company would come and ask Ernst & Young for advice, as well as other advisers. They would then make accounting judgments with respect to how to account on their financial statements with any transactions or operations that they might enter into. In addition, we would then audit the accounting for any operations or transactions that the company might have chosen to enter into. In addition, as you may be aware, there are certain standards and guidelines that the PCAOB has issued with respect to whether or not you are considered to audit your own work. All of the services that we have provided have been approved by Hewlett-Packard's audit committee. In addition to that, we did not provide any proscribed services. Senator Levin. All right. So you never audited your own tax advice and the implementation of that advice in HP's operations? Ms. Carr. We never audited our own work within the guidelines of the PCAOB. That is correct. Senator Levin. When did the PCAOB come into existence? Ms. Carr. I know it is Rule 3522.\1\ I do not know when that came in. --------------------------------------------------------------------------- \1\ See Exhibit No. 6, October 18, 2012 correspondence clarifying Ms. Carr's testimony appears in the Appendix on page 240. --------------------------------------------------------------------------- Senator Levin. Was that rule in existence during the entire time you were acting as auditor? Ms. Carr. I do not believe that the PCAOB guidelines existed for the entire time in which Ernst & Young audited Hewlett-Packard. Senator Levin. How about you personally? Ms. Carr. I had been involved in the account before that standard, but we would always follow similar guidelines. Senator Levin. So the answer to the question is, even before the PCAOB guideline, you never audited work where you had made recommendations or consulted with HP. Is that fair? Ms. Carr. Yes. If you will forgive me, Mr. Chairman, I might say it slightly differently. We were always in compliance with the PCAOB guidelines under Rule 3522 with respect to the services that we always provided to the company since I have been involved with the account. Senator Levin. Even before the guidelines were in existence. Ms. Carr. Correct. Senator Levin. OK. Thank you. Dr. Coburn. Senator Coburn. I will submit my questions for the record. Senator Levin. Thank you. We appreciate your appearance here today and the cooperation of both your firms with this investigation. Ms. Carr. Thank you, Mr. Chairman. Mr. Ezrati. Thank you, Mr. Chairman. Senator Levin. The final panel is William J. Wilkins, Chief Counsel of the Internal Revenue Service. He is accompanied by Michael Danilack, Deputy Commissioner (International) of the Large Business and International Division of the IRS; and Susan Cosper, Technical Director for the Financial Accounting Standards Board. We thank you for your appearance and for your patience, and we would ask you to stand and raise your right hands, if you would. Do you swear that you will tell the truth, the whole truth, and nothing but the truth, so help you, God? Mr. Wilkins. I do. Mr. Danilack. I do. Ms. Cosper. I do. Senator Levin. Were you here when I described the timing system. Ms. Cosper. Yes. Senator Levin. So you know there is a 7-minute time limit, and we ask you to keep within that limit. Even though I violated it all afternoon, that is no excuse for you to violate it. And that was said in a light-hearted manner, by the way, for the record, since it does not always get my jokes. Then a minute before the red light will go on, you will be given a yellow light. Mr. Wilkins, why don't we have you go first and then Mr. Danilack and then Ms. Cosper. TESTIMONY OF HON. WILLIAM J. WILKINS,\1\ CHIEF COUNSEL, INTERNAL REVENUE SERVICE, ACCOMPANIED BY MICHAEL DANILACK, DEPUTY COMMISSIONER (INTERNATIONAL), LARGE BUSINESS AND INTERNATIONAL DIVISION, INTERNAL REVENUE SERVICE Mr. Wilkins. Chairman Levin and Ranking Member Coburn, thank you for this opportunity to testify on the issue of offshore profit shifting. Accompanying me today, as you mentioned, is Michael Danilack, who serves as Deputy Commissioner (International) of IRS's Large Business and International Division. In this capacity, he leads our international tax enforcement efforts with respect to large business taxpayers who operate in a global environment. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Wilkins appears in the Appendix on page 147. --------------------------------------------------------------------------- Today I would like to present the Subcommittee with a broad overview of our changing approach to international tax issues, especially in the area of transfer pricing. Mr. Danilack will then provide a description of the specific challenges the IRS faces in dealing with profit-shifting cases. Because transfer pricing among related entities is important for tax purposes on virtually every cross-border transaction within a controlled group, the IRS had to devote substantial enforcement resources in this area. Moreover, because transfer pricing is not an exact science, companies themselves are often left with uncertainty about whether or not their transfer pricing positions will survive IRS scrutiny. In fact, transfer pricing issues are among the most frequently disclosed issues for companies filing the IRS Schedule UTP on which large companies report issues giving rise to financial reserves. Where aggressive income shifting through transfer pricing is involved, the IRS has taken a focused enforcement approach. As cross-border business restructurings involving shifts of intangible property rights became more commonplace in the early 2000s, the IRS responded by forming teams of experts known as issue management teams (IMTs). These teams were comprised of IRS transfer pricing specialists and chief counsel attorneys. They were led by IRS executives, and they centrally managed the inventory of examinations involving transactions in their respective areas. The teams ensured that IRS resources were appropriately dedicated to these examinations, that best practices and processes were shared, and that the IRS position on the underlying issues was applied uniformly to cases under similar facts and circumstances. In addition, in recent years the Treasury Department has worked with the IRS to adopt revised regulations in this area. In 2008, a new set of Section 482 regulations pertaining to cost-sharing transactions were issued. These temporary regulations were effective on January 5, 2009, and were finalized in 2011. They clarify a number of issues that had been contentious under the previous set of cost-sharing regulations and better define the scope of intangible property contributions that are subject to taxation in connection with cross-border business restructurings. While to date the IRS has had limited experience in auditing transactions covered by the new regulations, early anecdotal information indicates that the regulations have had a positive impact on taxpayers' reporting positions in that area. As an important complement to the cost-sharing regulations, in 2009 the Treasury Department and the Office of Chief Counsel also finalized regulations covering service transactions, including services performed using high-value intangibles. Beyond these regulatory efforts, the IRS has continued to marshal, coordinate, and augment its resources dedicated to transfer pricing enforcement. In 2011, a IRS new executive position was created to oversee all transfer pricing functions, to set overall strategy in the area, and to coordinate work on our most important cases. In building a new function devoted exclusively to tackling our transfer pricing challenges, within the past year we have been able to recruit dozens of transfer pricing experts and economists with substantial private sector experience who are now working hard to help us stay on the cutting edge of enforcement and issue resolution. This new transfer pricing operation will operate as a single, integrated team with a global focus, a unified strategy, and a robust knowledge base. With this new function focusing on all strategic transfer pricing matters, we were able to disband the more discrete, ad hoc issue management teams that I mentioned earlier. So we now have a single, fully integrated transfer pricing program overseen by Mr. Danilack and his direct reports. So let me now turn to Mr. Danilack to address the specific administrative challenges associated with the income-shifting phenomenon. Mr. Danilack. Chairman Levin, Ranking Member Coburn, and Members of this Subcommittee, I add my thanks to that of Mr. Wilkins' for the opportunity to testify on tax compliance issues related to shifting of profits offshore by U.S. multinational corporations. As has already been mentioned, my name is Michael Danilack, and I am the Deputy Commissioner at IRS in the Large Business and International Division. There I serve as the U.S. competent authority under our bilateral tax conventions, and I have responsibility for international tax enforcement with respect to large business taxpayers. The subject of today's hearing, the shifting of profits offshore by U.S. companies, is multifaceted, somewhat complex, and as we have heard already today, can raise tax administration, tax accounting, and tax policy considerations. Given my role at the IRS, however, I will limit my comments to the tax administration challenges raised in the area. The IRS enforcement power in this area arises from Section 482 of the Internal Revenue Code under which the IRS is charged with ensuring that taxpayers report results of transactions between related parties as if those transactions had occurred at arm's length. So, for example, when a U.S. corporation licenses the use of an asset to an offshore affiliate, the corporation is required to report a royalty for tax purposes based on a royalty rate that would be expected if the transaction had occurred between the corporation and an unrelated party. Under the Section 482 regulations, as well as under multinational transfer pricing guidelines, the determination of whether the pricing of a transaction reflects an arm's-length result is generally evaluated under the so-called comparability standard, and under this standard, the results of the transaction as reported by the taxpayer are compared to results that would be obtained by unrelated taxpayers in comparable transactions under comparable circumstances. Now, establishing an appropriate arm's-length price by reference to comparable transactions is relatively straightforward for the vast majority of cross-border transactions that involve transfers of common goods or services where there are third-party transactions to compare to. But enforcing the arm's-length standard becomes much more difficult in situations in which the U.S. company shifts to an offshore affiliate the rights to intangible property that are at the very heart of its business, what we might refer to as the company's ``core intangibles.'' In fact, over the past decade, applying Section 482 in these types of cases has been the IRS's most significant international enforcement challenge. When the rights of a business' core intangibles are shifted offshore, enforcement of the arm's-length standard is challenging for two basic reasons. First, transfers of a company's core intangibles outside of a corporate group rarely occur in the market. So comparable transactions are difficult, if not impossible to find. So the IRS has had to resort to other valuation methods which are often referred to as ``income-based methods,'' and these are fairly common valuation methods. Under these types of methods, the IRS typically has to conduct an ex ante discounted cash flow analysis. Now, this means that we are required to evaluate the projections of the anticipated cash flows the taxpayer used in setting its intercompany price. Then we must further evaluate how the taxpayer discounted those projected cash flows, depending upon the risk that is associated with earning those cash flows. This is where our economists and other valuation experts will come in to assist us, and as you might imagine, evaluating the underlying assumptions made by the taxpayer with respect to its future cash flows without the benefit of any hindsight under the ex ante approach is not an exact science, and it can be a difficult exercise. The second but related reason that this area is particularly challenging for us is because when you are talking about the business' core intangible property rights, by their very nature these assets are so-called risky assets, if you will. So projecting cash flows from these types of assets and the appropriate discount rate requires an inherently challenging assessment of the underlying risk and how and by which party that risk is borne. And these obviously can be very difficult assessments to make, at least in some cases. So this is my brief summary of our challenges in evaluating the so-called profit shift. Now let me turn briefly to other parts of the overall equation because, as most international tax specialists know, outbound international tax planning involves not only locating profits in low-tax jurisdictions but also managing exposures to the anti-deferral provisions, managing foreign tax credits and earnings and profit pools, and in what might be thought of as the final step in the overall equation, determining whether the offshore cash can be invested in the United States with minimal U.S. tax consequences. This last step, of course, we have been referring to as ``repatriation.'' Each of these other three areas beyond the income shift comes replete with its own complexities and its own challenges from an international enforcement perspective. That said, I can assure you that the IRS is well aware of the underlying stakes in each of these areas and has been vigilant and forceful in addressing compliance issues we have seen. Now, focusing on the repatriation, because this has been raised at today's hearing, within the past 6 years I will note that Treasury and the IRS have issued several anti-abuse notices, one as recently as July of this year, making clear that a variety of transaction types give rise to inappropriate repatriation results. In several of these cases, Treasury and the IRS have already followed up with regulatory changes necessary to make clear what the appropriate results should be. In general, these transactions were designed to take advantage of mechanical rules pertaining to determinations of either tax basis or earnings and profits, mechanical rules that can be found scattered throughout the code and regulations. In other words, the rules that are used to accomplish low- or no- tax repatriation results often are not written as anti- repatriation rules; rather, the transactions in which the rules have been used may not look at all like repatriation transactions at first blush, so they can be difficult to find. But we are finding them, and when we have, we have acted pretty quickly. Further, we well know the importance of augmenting this focus, and, in fact, just about 3 months ago, we assembled a network of experts that will be devoted entirely to developing repatriation training for all of our international examiners and otherwise spreading the word that these types of transactions must be carefully evaluated. Mr. Chairman, thank you again for this opportunity to testify regarding the IRS's efforts to enforce our laws as they relate to the subject of today's hearing. While we know that enforcing our international tax law certainly will present for us significant challenges in the future, we believe the agency has made great strides in recent years and will continue to do so. Mr. Wilkins and I, of course, would be happy to answer any questions you may have at this time. Senator Levin. Thank you very much. Ms. Cosper. TESTIMONY OF SUSAN M. COSPER,\1\ TECHNICAL DIRECTOR, FINANCIAL ACCOUNTING STANDARDS BOARD, NORWALK, CONNECTICUT Ms. Cosper. Chairman Levin and Ranking Minority Member Coburn, my name is Susan Cosper, and I am the Technical Director of the Financial Accounting Standards Board (FASB). I oversee the staff work associated with the projects on the board's technical agenda. I would like to thank you for this opportunity to participate in today's important hearing. --------------------------------------------------------------------------- \1\ The prepared statement of Ms. Cosper appears in the Appendix on page 150. --------------------------------------------------------------------------- I have been invited to appear before this Subcommittee to explain U.S. Generally Accepted Accounting Principles for deferred U.S. income taxes attributable to the unremitted earnings of a foreign subsidiary. I will do my best to do so, but first I would like to give you a brief overview of the FASB and the manner in which accounting standards are developed. The FASB is an independent, private sector organization which operates under the oversight of the Financial Accounting Foundation and the Securities and Exchange Commission. Since 1973, the FASB has established standards of financial accounting and reporting for public and private entities and for not-for-profit organizations. Those standards are recognized as authoritative Generally Accepted Accounting Principles (GAAP) by the SEC for public companies and by the American Institute of Certified Public Accountants for other nongovernmental entities. An independent standard-setting process is the best means of ensuring high-quality accounting standards since it relies on the collective judgment and input of all interested parties through a thorough, open, and deliberative process. The FASB sets accounting standards through processes that are open, afford due process to all interested parties, and allow for extensive input from all stakeholders. Before I explain the standard, I would like to make two basic points. First, it is important to note that while FASB sets the accounting standards, it is a company's responsibility to apply U.S. GAAP to its financial statements; it is the auditor's responsibility to audit those financial statements; and it is the Public Company Accounting Oversight Board's responsibility to ensure that auditors of public companies have performed an audit in accordance with auditing standards. The SEC has the ultimate authority to analyze whether public companies have complied with accounting standards. Second, accounting standards are not intended to drive behavior in a particular way; rather, they seek to present financial information so that financial statement users can make informed decisions about how best to deploy their capital. The role of accounting standards is to reflect in the financial statement when taxes will be paid. It is not to determine when those taxes should be paid. That is set by tax law. Now I would like to turn to an explanation of the accounting standard. As I just said, one of the primary objectives of accounting for income taxes under U.S. GAAP is to reflect the amount of income taxes associated with income generated in that reporting period. In the case of the earnings of a foreign subsidiary of a U.S. company, under existing tax law the U.S. company will not pay tax until those earnings are repatriated. However, under the accounting standard, when the financial statements for that U.S. company recognize in the current year a liability for a tax payment that will be made in a future year, this is referred to in the financial statements as a deferred tax liability. Under the accounting standards, it is presumed that foreign earnings will be repatriated and that taxes will be accounted for and reflected in the financial statements in the same period in which they are generated. The presumption may be overcome if the U.S. company has sufficient evidence that the earnings from the foreign subsidiary are or will be indefinitely invested in the foreign jurisdiction or the earnings will be remitted in a tax-free liquidation. Of course, even though a U.S. company may be required to recognize in its financial statements deferred U.S. income taxes in a particular period for the unremitted earnings of a foreign subsidiary, such taxes are not payable to the United States under existing tax law unless the company actually repatriates the earnings to the United States. In other words, the recognition of deferred U.S. income taxes in financial statements does not mean U.S. tax law requires the company to actually pay the income taxes in that period. Finally, I want to note that in those cases where a company has evidence of a plan to indefinitely reinvest the earnings in that foreign jurisdiction, U.S. GAAP still requires disclosures in the financial statements. These disclosures include the amount of U.S. tax that would have been paid related to the unremitted earnings of that subsidiary. We have found from our extensive stakeholder outreach that users of financial statements believe that the existing recognition guidance along with the disclosures and the notes to the financial statements provide them with transparent, decision-useful information. Thank you. Senator Levin. Thank you very much, Ms. Cosper. First, let us talk about transfer pricing. We have had a good bit of testimony on that today. Mr. Shay, in our first panel, pointed out that about 1,900 of Microsoft's 90,000 employees work in Microsoft's subsidiaries in the low-tax jurisdictions of Ireland, Singapore, and Puerto Rico. That is about 2 percent of their employees. About 55 percent of Microsoft's total earnings are attributed to those entities. He said that ``these results are not consistent with a common- sense understanding of where the locus of Microsoft's economic activity, carried out by its 90,000 employees, is occurring. The tax motivation of the income location is evident.'' Now, when you look at transfer pricing, where does common sense come in? Where does that kind of a factual situation come into play when you look at these situations? Are those facts relevant to you when you look at Microsoft, for instance, without singling them out? In that kind of a situation, are those relevant facts to you? Mr. Danilack. Mr. Chairman, I should preface by making clear that I think neither Mr. Wilkins nor myself will be able to answer questions that pertain to Microsoft or pose with reference to Microsoft or with respect to any other taxpayers, for that matter. Senator Levin. Let me rephrase the question. Let us assume you have a company where you have 100,000 employees that are working here in the United States, and you have 2 percent of their employees in three particular tax havens which have 50 percent of the total earnings of the company. I have changed the facts a little bit so it is not directly asking about Microsoft. Are those kind of facts relevant to you? Mr. Danilack. Frankly, when you pose the question as relevant to me, I assume you mean as relevant to an international examiner who may be looking at a particular case because this is what I could speak to here today. Senator Levin. Right. Mr. Danilack. If you are posing it as a policy-like question, whether I am---- Senator Levin. Try it both ways. Mr. Danilack. Whether I am personally offended or whether it is a significant policy---- Senator Levin. No. I am not interested in whether you are personally offended. Mr. Danilack. OK. Senator Levin. I am interested in whether I am personally offended, which I am, but I am not asking you that. Mr. Danilack. OK. Senator Levin. I am asking you, is it relevant to the examiner? And split it up. Is it relevant as a policy question, those kind of facts? Mr. Danilack. OK. I can answer the first one but not the second because, as a tax administrator, which is my role, I do not opine on policy. Mr. Wilkins and myself would need to have with us someone from the Treasury Department to opine on tax policy matters. But with respect to what an examiner might look at, examiners are trained to look at the law. Senator Levin. Are those kind of facts relevant to an examiner? That is a pretty straightforward question. Mr. Danilack. Yes, and I would say no. Senator Levin. OK. Why? Mr. Danilack. Because there is nothing in the law that requires that one look at the number of employees and the total profit as compared to the distribution of the employees. Senator Levin. And that does not get to the question as to whether or not the agreement on transfer was an arm's-length agreement? Mr. Danilack. The exercise on determining whether the agreement is at arm's length depends on the value of the property being exchanged, whether the price that was set in an arm's-length price. And it is very much focused on the assets in question, what those assets are, and what their value is. And as I indicated in my oral statement, these are very difficult questions. The broader context, how one feels about the company's position overall, does not come into play. Senator Levin. Let me ask you a slightly different question. Take a look at Exhibit 1e.\1\ Never mind. I do not even want you to look at exhibits because they are too specific to Microsoft. --------------------------------------------------------------------------- \1\ See Exhibit No. 1e, which appears in the Appendix on page 190. --------------------------------------------------------------------------- Mr. Danilack. Yes, I think that is right. Senator Levin. So let us forget that. Now you have a company that has no employees in a wholly owned subsidiary of that company. It transfers intellectual property rights, including the right to receive royalties, to that wholly owned subsidiary. And let us assume that it is paid--of course, it is all its own funds, but put that aside. It is paid, let us assume, $2 billion for those rights. That is the amount of money which is coming back to the United States. And the offshore company is receiving $10 billion in royalties. Are those facts relevant to whether or not there was an arm's-length agreement which led to a transfer agreement which resulted in the $2 billion payment? Mr. Danilack. All right. The facts that would be relevant are the numerical facts that you laid out. I cannot recite them for you, but the flows of profit and whether the flows are commensurate with respect to the entity receiving that profit, whether it can support that profitability based on what functions it may perform, what assets it may own from a tax perspective, and what risks it is bearing in taking on the ownership of that asset. Senator Levin. How many of these transfer pricing matters has the IRS litigated over the last 10 years? Mr. Danilack. I could not provide you with that number today, but we would be happy to provide it to you afterwards. Senator Levin. Would Mr. Wilkins have an idea? Mr. Wilkins. You mentioned two cases that were recently litigated, so there are at least those two in terms of cases that have gone all the way through trial. Senator Levin. I mentioned two? Mr. Wilkins. Yes, the Veritas and Zylings cases are the ones I am thinking of. Senator Levin. Are there more than a handful in the last few years that have gone to trial on transfer pricing issues? Mr. Wilkins. Not to trial. Senator Levin. A lot of them have been settled? Mr. Wilkins. Yes. Senator Levin. Hundreds? Mr. Wilkins. I do not have that information. Senator Levin. Did you hear the discussion here about the short-term loans that HP got involved in? Mr. Wilkins. Yes, sir. Senator Levin. Let me read to you your criteria. Relative to offshore CFC loans that are supposed to ensure that they do not circumvent the law, these are some of the standards. If loans are provided by different CFCs, were they independent of each other? Now, would you consider putting aside the precise facts, would you consider two CFCs which are part of the same company, wholly owned, directed by the same desk, as to when loans would be made or could not be made, and were to be directed as to when those loans would have to be repaid, would you consider those two entities to be independent of each other? Mr. Danilack. Senator, when we would address a question like that, we would look at it very closely and take into account all of the facts and circumstances that surround the overall arrangement. I cannot answer a broad question. Senator Levin. Would the facts I gave you be relevant, that you have one desk that controls the loans of both those entities, that the schedule is created by a single desk in the parent corporation that owns the two CFCs; they schedule when those loans can be made and cannot be made; that they are scheduled in a way so that there is always the possibility of a loan coming back to the American parent? Are those relevant facts so far? Mr. Danilack. Yes, sir. Senator Levin. OK. My time is up. Thank you. Dr. Coburn. Senator Coburn. Mr. Wilkins, you mentioned a moment ago that you had noted anecdotal evidence since the changes of 2009. Could you give us some examples of that in terms of improvement? Mr. Wilkins. I do not have specific examples, but, I think, there were the cost-sharing regulations update was based on some experience in the field where some things had been unclear, for example, on the employee compensation set of issues. And I think the revised regulations removed some abilities of taxpayers to make arguments that we did not agree with under the prior set of regulations. So that is an example. Senator Coburn. So anecdotally you are seeing some change in compliance back to the directions that you put out in terms of your directives. Mr. Wilkins. That is correct. Senator Coburn. Mr. Danilack, I want to go back where the Chairman went. Just walk me through simply what are the factors that you direct those under you to consider in making an assessment of an arm's-length transaction? I am not talking about any case. I am just saying what is it that is taught for those that are actually doing this work, what are the factors they are supposed to consider in terms of what is an arm's- length transaction? Mr. Danilack. Yes. I will try to take that at a relatively high level because the potential factors that could come into play in making this determination are a very large population of factors that I could start to reel off. Senator Coburn. Well, go by category, then. Mr. Danilack. We would start with what is called for in transfer pricing generally, which is the basic paradigm that profits are driven off of functions performed by the entity earning the profit, driven off of possibly the assets that entity is able to employ in its business, and the risks that the entity may be able to or has borne in the overall business enterprise. So it becomes rather quickly an economic type of an analysis, and it is really hard to even go one level deeper than what I have just said without knowing, well, what industry are you talking about. Is this a high-tech industry where copyright rights might be a real important part of the drivers in terms of profitability? Or is it a very labor-intensive type of an industry where you will look at where key employees are working from a functional perspective. I think coming back to the subject of the hearing today, the profit shift I think has been acknowledged by virtually everyone who has spoken. The profit shift that we are struggling with administratively is usually associated with intellectual property rights--or intangible property rights, better stated. And when you are dealing with these types of very high value, center to the business type intangible properties, you are attempting to value this asset, but in the equation is the riskiness of supporting that asset going forward. Which entity is really bearing the risk associated with the asset? And we have heard different statements from different folks about the risk factor. The risk factor is something that really is very difficult to deal with because one might conceive of just simply assuming a risk through a contractual arrangement. One might then bring in, well, where does the money come from that allows you to bear the risk. And then the other factor that we take into account in risk bearing is where are the decisionmakers. Who is making the decisions to further develop that particular intangible property and deploy it? So these are all factors that come into play. Mr. Wilkins. It may be helpful, as a legal background-- valuation in the tax world is--for example, for a sale of property, it is the price at which a willing buyer would pay a willing seller, neither one being constrained. You know, that familiar mantra. And in this area, it is just playing out that concept in a very sophisticated setting. If it is a property sale, what would a willing buyer pay a willing seller? If it is a contract, what would two independent parties---- Senator Coburn. So that brings up the question, if there is no market for this particular intangible, how do you have a market price? Mr. Danilack. Yes, and this is where we bring in other valuation methods, which we loosely describe as income-based analysis, where you look at projected cash flows on that asset. And then, of course, you need to discount the cash flow that you expect to present value, but the discount factors are dependent on the riskiness of the asset. Senator Coburn. I know you cannot comment on tax policy, but maybe you can comment on this. Senator Levin has a pure goal here, and the goal is to have a tax policy that is transparent, that is reproducible, that is fair, that does not allow people to avoid taxes that should not be avoiding taxes, and at the same time wants us to be competitive internationally. So what is it that we might be able to do that would give you greater tools to accomplish Senator Levin's goal? Mr. Wilkins. Senator, if I might try and respond, from the point of view of the tax administrator and without getting too much into tax policy, I could say that a couple of things would be helpful. One is stable and predictable funding for the organization. I know you are working on appropriations for the coming fiscal year. Having a full year appropriation ahead of the start of the fiscal year is tremendously helpful. Having steady levels of funding would be very helpful. And having stability in the tax law from our point of view as a tax administrator, not having to respond to sort of herky-jerky changes in the statutory basis for what we do would be helpful. Senator Coburn. What other tools? Nothing? There is nothing that Senator Levin and I could reach across the aisle together and change that would, in fact, make it easier for you to either make an evaluation on one of these or determine whether or not transfer pricing was--whether or not there is an arm's length--there is not anything that we can do that you can comment on? Mr. Danilack. There may well be something you can do, and I was encouraged to hear some of the discussion that took place earlier today about working together to look for ways in which this particular area can be more easily addressed, because as I have described several times now, it is a difficult area, and it makes for controversy and it makes for disagreement. And it is hard to say to predict that there may be a bright-line-type rule that could resolve issues like this, but if folks sat down and worked on it, I would have some confidence that some solutions might be found, and we would be happy to work with it. But it is not anything that I could--I mean, if there were a handy ``if only you would do that,'' we certainly would have identified it already. Senator Coburn. Yes, you would have. I understand. Well, what I would request is if you have those ideas, that you forward them to the Chairman and myself, because we are going to go into tax reform, and these are legitimate areas of concern. There may not be any evasion here. There may be just smart avoidance based on the loophole. But I think Senator Levin is on to some areas that we need to clean up. Ms. Cosper, I wanted to ask you, APB 23 was written 50 years ago, modified slightly in 1972, and I think in your testimony you kind of said that the people that use your standards, when they look at financial statements, think that they are clear enough. Is that your testimony? Ms. Cosper. That is right. Senator Coburn. So when we have $1.7 trillion parked overseas, is it your organization's intent that these are clear enough in terms of the accounting standards, FASB standards, that no changes, no new look needs to be done in terms of APB 23? Ms. Cosper. The FASB always strives to improve their accounting standards---- Senator Coburn. No, but that is not what I asked you. What I am asking you is: Is it your testimony that, in fact, nothing needs to be changed with this APB 23? Ms. Cosper. When we had the short-term convergence project in 2004 with the International Accounting Standards Board, we looked at this area quite extensively. We evaluated the costs. We had extensive outreach with users. Users actually told us to record a deferred tax liability when a company has absolutely no intention to actually pay the tax was more misleading; and to provide adequate disclosures that gave them the information that they needed. Senator Coburn. OK. If FASB knows that some auditing firm is abusing these standards or stretching it through their recommendations on tax policies, what is your action? Ms. Cosper. We do not really have visibility to how the PCAOB regulates the audit firms or whether the PCAOB has identified a problem with a particular auditing firm on how they have, justified a way a company has applied the accounting guidance. Senator Coburn. One last question on APB 23. When you issued the guidance in 1972--and I am going to assume you were not there--according to the history that we have looked at, it was quite controversial. Why was that? Ms. Cosper. I think it was controversial--the original guidance was in ARB 51, and that guidance was pretty vague. And so in 1972, that is when the actual accounting standard came into play. It was revisited again when we readdressed income taxes as a whole within FAS 96. In the exposure draft for that particular standard, we actually thought about changing it. But we had to do, again, extensive research at that time. The complexities of trying to estimate what that deferred tax liability is, if you think about all of the complexities that have been discussed today about all the different transactions and how to apply the Tax Code and then to think about how far out in the future you have to actually estimate when that would be, what the foreign tax credits are, and then to apply it back, lends itself to be pretty complex. Senator Coburn. So what would happen---- Ms. Cosper. So the number could actually be quite small after it has been discounted back, if somebody might be so far out. Senator Coburn. So what would happen if this country went to a true territorial tax system and reformed the corporate code and broadened the base and lowered the rate and had a true territorial tax system? What would happen to APB 23? It would not be applied, would it? Ms. Cosper. Well, I think the accounting for income taxes-- and APB 23 is codified in ASC 740. Senator Coburn. Yes. Ms. Cosper. But the accounting for income taxes is a principles-based standard. So, for example, if the Tax Code says that you have to pay tax, you have to recognize it in the financial statements. Senator Coburn. Right. Ms. Cosper. So you would not be necessarily---- Senator Coburn. So, if we had a territorial system and X company has a company located, whether it is in Bermuda or wherever it is, and they put all their assets over there, and we allow them to do that, if we did that, and they pay whatever tax was in that area, they could move that capital wherever they wanted, correct? Ms. Cosper. So let me make sure---- Senator Coburn. In other words, you would not put a statement in the financial statement that there was a tax due because the tax would have been paid, and since we have a territorial tax system, there would not be any deferred tax liability on money coming back to the country. Ms. Cosper. So what you are saying is that it would not have to be distributed back. Senator Coburn. They could move it wherever they want. Ms. Cosper. That would be right. Senator Coburn. And so there would be no disclosure because there would be no deferred tax liability. Ms. Cosper. For that particular item, yes. Senator Coburn. That is right. Thank you, Mr. Chairman. Senator Levin. Thank you. One of our expert panelists today said that many of the rules regarding the transfer pricing and deferral can be corrected and improved by regulation. One of the questions is whether or not the check-the-box approach has effectively gutted Subpart F. You are not in a position to tell us what the policy is of the Treasury Department, I gather, Mr. Wilkins. Is that correct? Mr. Wilkins. That is right. Senator Levin. But from an enforcement standard, I guess I will ask you then, Mr. Danilack, would that make your life easier from an enforcement point of view if we eliminated check the box? Mr. Danilack. I think the best way I could answer the question is that if check the box were eliminated, there would be more taxation under Subpart F. I think that is straightforward. I do not know that it would make our lives more simple. By asking it that way, it presumes that we measure the simplicity of our lives by how much tax is collected, which is not the case. We measure it based on how challenging the job is. I am not sure that eliminating check the box would make our lives simpler. I think it would result in additional Subpart F taxation, which I think is why you are asking the question. Senator Levin. There would not be less complexity in tax enforcement if there were no---- Mr. Danilack. Well, it is pretty straightforward when you have a check-the-box entity paying a royalty that is disregarded. There is nothing to look at. Senator Levin. All right. Section 956, as you heard--and I have already asked you about the staggered loan issue. And I have to tell you, this form over substance issue which is so important in implementing tax law really goes to the heart of that matter. If any company can get away with having an effective repatriation of money overseas--without paying taxes, in other words--it is effective repatriation. In effect, they get the use of the money through a loan program where the loan program is designed, implemented, it is controlled, it is coordinated by the parent company. But because there are two pools instead of one, even though those pools are coordinated in terms of when the loans have to be made, if they are made, when they have to be repaid, if that form--because there are two pools, one direction, one coordination, one supervision, one decision, one schedule, but because it is two pools instead of one, and if that is able then to allow an exclusion under Section 956, the IRS is honoring form over substance to a degree that is beyond anything I think that I have ever seen. I thought this was an incredibly clear case, by the way. Even in their own documents I thought it was a clear case. I am not asking you to judge the case. But I am asking you to go back and look at your own guidelines, rules, whatever they are, in this area where you got money that is supposed to be overseas that is being lent here and that if it were lent by one company would clearly be a dividend and would be taxable. But because it is two companies, although they are coordinated, directed, guided, instructed and so forth by one office in the parent company, is able to say that they complied with your exclusion from Section 956, I hope you will take a look at that. It just violates, it seems to me, everything which you folks should be about, which is trying to get to substance and trying to get through form, which is what a whole bunch of courts have told you you should do in a whole bunch of ways. So will you take a look at that issue? I am not telling you to look at the one case. I am asking you to look at the one issue, that exclusion issue from Section 956 on short-term loans and as to whether or not under the kinds of circumstances which I have just outlined you ought to pierce the form and get to the substance. Will you take a look at that? Mr. Wilkins. Yes, sir. Senator Levin. Let me ask you just a couple questions, Ms. Cosper. Under APB 23, under that exception, you have to assert that the company has invested or will invest the undistributed earnings indefinitely. Is there any time period associated with the term ``indefinitely invested'? Ms. Cosper. ``Indefinitely'' is not defined within the standard. Senator Levin. How does that help? In other words, if it is invested for a minute, a day, a week, a year---- Ms. Cosper. I think ``indefinitely'' is intended to mean a sufficient period, a sufficiently long period of time. But the standard itself requires that there be evidence that there is a plan to indefinitely reinvest it. Senator Levin. But ``indefinitely'' could mean no definition. ``Indefinite,'' the way you define it, means for a time that does not have a limit on it. Ms. Cosper. If you looked at it the alternative way, you could say you have no plan to remit it. Senator Levin. No. I am talking about the investment. The word ``indefinite,'' as you interpret it, and your guidelines intend, the word is for a period which does not have a time limit on it. Ms. Cosper. That is correct. Senator Levin. It cannot be a short period. Ms. Cosper. It is not intended to be a short period. Senator Levin. It is intended to be a long period. Ms. Cosper. But it is not prescribed. Senator Levin. It does not prescribe how long, but it is intended to be a long period. Is that fair? Ms. Cosper. An indefinite period. Senator Levin. But you interpret that to mean a long period, relatively long period? Ms. Cosper. An indefinite period would be you---- Senator Levin. Is a month a long period? If you intend to invest it for a month, is that an indefinite investment? Ms. Cosper. One would not expect that to be indefinite. Senator Levin. Can't you give some guidance, though, to people? I mean, this is being used all the time, and there is a problem either way, as you have defined it. You can mislead folks either way. But can't you give more guidance than just ``indefinitely invested'' as to what you would have in mind as to what would constitute indefinite, or a range, it has got to be at least 2 years or---- Ms. Cosper. I think the challenge here is that because of the way the Tax Code works, the financial statements are intended to reflect the economics that are actually occurring. And so what users have told us is that if there is a plan for a company to indefinitely reinvest, then they are not interested in having that information reflected in the financial statements. But they are happy with the disclosures that are there. Senator Levin. Well, for obvious reasons, I am sure they are. I think it works to their advantage to do that, to have something that vague that they are able to sign up to. Do you require evidence to support whatever the plan is? Ms. Cosper. That is correct. Senator Levin. And you list the types of investments that qualify? Ms. Cosper. We do not. Senator Levin. So you do not have a time period on what ``indefinite'' is. You do require evidence to support a plan for indefinite reinvestment or investment, and you do not list the types of investments. I think that is just too ambiguous, and I know there has been a long debate on this, but I have to tell you, I think it is just way too ambiguous. Ms. Cosper. The standard does indicate--there are two examples in the standard of evidence. The standard says that experience of the entities and indefinite future programs of operations and remittances are examples of the types of evidence required to substantiate the parent entities' representation of indefinite postponement of remittances from a subsidiary. Now, we develop accounting standards, and dependent upon the Tax Code, there are many different circumstances, and so it would be very difficult for us to put all examples of evidence in here, and the auditors have the responsibility to audit whether companies have applied the standard appropriately and that they do have sufficient evidence and that there is a plan. Senator Levin. If you believed, if FASB believed that APB 23 was being used by multinational corporations as a way of managing their earnings, would you view that as a problem? Ms. Cosper. Back in 2004, when we actually had the short- term convergence project, one of the topics that the board at the time discussed was whether APB 23 was used to manage earnings. There were extensive discussions. There was outreach to stakeholders and users. And what the board at the time said was that it would actually be a very mediocre way of trying to manage earnings simply because if a company changed their plans such that they chose to remit earnings, it would be very transparent within the financial statements because of the disclosures around deferred tax liabilities, around the effective rate reconciliation, and for disclosures as it relates to those earnings that have been unremitted, the tax associated with it. Senator Levin. Is it appropriate to use it as a tool to manage earnings? Ms. Cosper. I do not think it would be---- Senator Levin. I know it is not effective, but is it appropriate to use it as a tool? Ms. Cosper. Well, the board at the time, when it discussed managing earnings, in their view managing earnings was really an audit issue, not an accounting standard setter issue. Senator Levin. So, in other words, you do not have a position as to whether it is appropriate or not appropriate. Ms. Cosper. That is correct. The Tax Code dictates whether companies are allowed to repatriate--whether companies repatriate and are taxed on that repatriation. Senator Levin. One of the partners of a large accounting firm said the following--well, actually it is Exhibit 3i.\1\ This is an HP employee writing to a KPMG partner. He is asking whether tax considerations can be referenced when making the assertion under APB 23, and the partner says, ``Sitting on cash to avoid tax costs on repatriation doesn't equate to reinvestment plans, in our view. . . . It can be a lightning rod for a reviewer . . . to second guess the deferral.'' --------------------------------------------------------------------------- \1\ See Exhibit No. 3i, which appears in the Appendix on page 218. --------------------------------------------------------------------------- Do you agree with that? Ms. Cosper. As I read this particular email--and I am not familiar with it, the context of it--it reads to me as though there is no plan for indefinite reinvestment. Senator Levin. That would not be a plan? Ms. Cosper. It does not appear to me to be a plan. Senator Levin. You said that you are neutral on using FASB standards to manage earnings. Isn't the whole point of an accounting standard to reflect accurate financial results and to prevent management of earnings? Ms. Cosper. I think accounting standards reflect the economic realities of what is occurring, and if a company is applying the Tax Code appropriately, then the accounting should reflect that. Senator Levin. But in terms of FASB standards, you indicated you were neutral. Ms. Cosper. We set standards in order to reflect economics, and so we do not see managing earnings as an accounting issue. That is an auditing issue. If a company inappropriately applies the guidance in order to manage earnings, it is an auditing issue. Senator Levin. But the absence of an accounting standard to guide people, is not troubling to you when your job is to put out standards? Ms. Cosper. I am not sure I am following. Senator Levin. OK. Well, I may not be stating it very clearly. Ms. Cosper. I mean, we always strive to improve our accounting standards, but in this particular area, in preparation for this hearing, we went and looked to see what kinds of questions we had gotten on this particular provision, and, quite frankly, we have not gotten any. And usually an indication that there is a lack of clarity around a particular accounting rule or how it is being applied or whether there is diversity, we would address if there seemed to be a problem associated with it. Senator Levin. If there were a problem here in the misuse of this assertion, in fact, it is being used routinely to avoid the disclosure in that report in APB 23. It has been used to avoid having to disclose how much money is being held abroad and what is being held until there is the desire to bring it back. But in order to avoid any kind of tax liability, potential liability, indicate on your books, there is no question. Who is going to ask you the question? Who would be troubled by this? Ms. Cosper. So that is a compliance issue. Senator Levin. Except the IRS. Ms. Cosper. So that would be a compliance issue. So the question is: Is the company appropriately applying the accounting standard? The standard requires disclosure. If you do not--if you have a plan to indefinitely reinvest, you are required to disclose the amount of the tax that you would have paid on that unremitted earnings in the financial statements. Senator Levin. Who is it that would complain? The companies love the status quo. They are not going to complain. Ms. Cosper. We regularly meet with folks from the PCAOB, the SEC, and the regulators. We have advisory groups and user groups that we meet with that would provide--would tell us that they do not think that they are getting the appropriate amount of information. Senator Levin. From the companies. Ms. Cosper. Right. Senator Levin. But you do not expect that companies who would have a better bottom line because they do not have to set aside funds, you do not expect to get complaints from them, I hope. Ms. Cosper. Well, the users would indicate whether---- Senator Levin. The users being the---- Ms. Cosper. The investors, the folks---- Senator Levin. I am talking about the companies, though. You would not expect to get complaints---- Ms. Cosper. Companies may, from time to time, provide us questions about how to apply certain provisions of our accounting guidance. So, for example, maybe they would ask about what ``indefinite'' means, or perhaps they would ask about other elements of the standard, what is evidence, or what have you. We just simply do not get those questions. Senator Levin. But you got one from me today. I want you to tell me for the record what ``indefinite'' means. What is the minimum length of time that ``indefinite'' means? Ms. Cosper. It is not defined. Senator Levin. No. I am asking you, though, for guidance. Ms. Cosper. I do not have an answer. It would depend on the facts and circumstances of the individual situation. Senator Levin. Could it be as little as 2 months? Ms. Cosper. It is not defined in the accounting standard. Senator Levin. But if you have a word that is that vague, how good is the standard? Ms. Cosper. ``Indefinite'' would be construed to be a significantly long period of time. Senator Levin. OK. That is helpful. Well, we have covered a lot of ground, and the issues are complex. We know that. The bottom line, though, is not complex. We have a fiscal crisis in this country. Loss of tax revenue is a key cause of the problem. Shifting of profits offshore by multinational corporations is a major contributor to that problem, and we have to do something about it. So we have a major multinational transfer of intellectual property abroad going on, using gimmicks to direct most of these profits, as it turns out, to tax havens. We have another major multinational that keeps 90 percent of its cash offshore on paper, then brings it back to the United States through coordinated, serial loans that it pretends are short term but acts as one of the primary sources of cash to run its operations. We have other multinationals that keep billions of dollars offshore on paper, but then use that offshore cash to buy U.S. Treasury notes, stocks, and bonds. That was an earlier hearing of this Subcommittee. We have auditors and tax regulators and accounting standard setters that have not done an adequate job of clamping down on transfer pricing abuses and hidden repatriation strategies. We do not see an aggressive action in that area at all. We have a Tax Code that is full of loopholes and makes enforcing general principles of taxing foreign income almost unenforceable. That is the Congress' problem. We are major contributors to the problems that I have outlined, so we have to do better, particularly facing a fiscal disaster, but even if we were not, it is just simply not fair to your average taxpayer that pays his taxes to see these kind of loopholes that are both used and created where they do not exist, and then companies getting away with it. So we want our corporations, our multinationals to pay their fair share if this country is going to support their businesses in a way that they deserve to be supported, and paying 4 percent or 2 percent or nothing at all is just simply not good enough. Obviously, our tax system is in need of reform, and one area that we clearly need to focus reform efforts is on these multinationals that shift profits offshore. I hope our hearing today has identified some of the problems that need to be fixed to mitigate the loss of tax revenue, the shifting of profits offshore that cause that loss. We hope that the information, the facts that we brought out today in the memorandum which we have issued, both Senator Coburn and I, that have sent this memorandum to our colleagues,\1\ which will be made part of the record, that this will motivate Congress and other parties and the executive agencies to move much more aggressively in this area, craft some solutions to this problem and these problems. --------------------------------------------------------------------------- \1\ The memorandum appears in the Appendix on page 160. --------------------------------------------------------------------------- The Subcommittee has been on this area of the use of offshore tax havens to avoid paying taxes for about 10 years now. We are going to continue to make an effort in that direction because it is unconscionable that money which is really owed to the U.S. Treasury is not going to the U.S. Treasury because of the gimmicks and because of these tax structures, which are extreme, soaking up funds and moving them in places where they are not subject to our tax system. So we thank our witnesses. We thank Dr. Coburn and his staff for their great support on this effort. We worked together as a team. We have different views on lots of issues, but on a lot of other issues, we very much agree. And I hope that comes through and will come through for those who read that memorandum, which was sent to our colleagues and which is available to the public. It will be on our Web site. With that, we will thank again our witnesses and stand adjourned. 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Which of the following are the three E's of state requirements for the CPA certification?

The CPA Exam is one of the “Three E's” — Education, Examination and Experience — that constitute the requirements for CPA licensure. Of these three requirements, only the CPA Exam is uniform and accepted for CPA licensure by all U.S. jurisdictions.

What is the firms financial position at a designated point in time?

A balance sheet reports a company's financial position as of a specific date. The balance sheet reports the company's assets, liabilities, and equity, and the financial statement rolls over from one period to the next. Financial accounting guidance dictates how a company records cash, values assets, and reports debt.

Which of the following external users would require financial statement information specifically information?

Investors. Investors will likely require financial statements to be provided, since they are the owners of the business and want to understand the performance of their investment.

Which is the lowest level of authoritative accounting literature?

On the lowest level are FASB implementation guides, AICPA Accounting Interpretations, and AICPA Industry Audit and Accounting Guides and Statements of Position not cleared by the FASB.