Tax Compliance
Challenges to Corporate Tax Enforcement and Options to Improve Securities Basis Reporting Gao ID: GAO-06-851T June 13, 2006Corporate income taxes are expected to bring in about $277 billion in 2006 to help fund the activities of the federal government. Besides raising revenue, the tax alters investment decisions and raises concerns about competitiveness in an environment of increasing global interdependency. The complexity of the tax breeds tax avoidance, including an estimated $32 billion of noncompliance detected by the Internal Revenue Service (IRS). This testimony provides information on trends in corporate taxes and opportunities to improve corporate tax compliance. Congress also asked that GAO discuss recent work on the misreporting of capital gains income from securities sales and options to improve compliance. This statement is based largely on previously published GAO work.
The corporate income tax is an important source of federal revenue and must be considered in dealing with the nation's long-term fiscal imbalance. Reexamining both federal spending and revenues, including corporate tax policy, corporate tax expenditures and corporate tax enforcement must be part of a multi-pronged approach to address the imbalance. The total amount of corporate tax avoidance, which includes the $32 billion in noncompliance estimated by IRS, is unknown. A complex tax code, complex business transactions, and often multinational corporate structures make determining corporate tax liabilities and the extent of corporate tax avoidance a challenge. Opportunities exist to improve corporate tax compliance and include simplifying the tax code, obtaining better data on noncompliance, continuing to oversee the effectiveness of IRS enforcement, leveraging technology, and sending sound compliance signals through increased collections of taxes owed. In a companion report issued today, GAO found that many taxpayers misreport capital gains or losses, sometimes inappropriately underpaying their taxes and sometimes overpaying them. IRS has efforts in place to help ensure proper reporting of capital gains and losses, but these efforts face several obstacles. GAO found that expanding third-party information reporting on the cost basis of capital assets could help mitigate this problem if related problems are addressed. GAO suggested that Congress consider requiring brokers to report adjusted basis to taxpayers and IRS and requiring IRS to work with the securities industry to develop cost-effective ways to mitigate reporting challenges. GAO also recommended that IRS clarify its guidance on reporting capital gains and losses.
GAO-06-851T, Tax Compliance: Challenges to Corporate Tax Enforcement and Options to Improve Securities Basis Reporting
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Testimony:
Before the Committee on Finance, U.S. Senate:
United States Government Accountability Office:
GAO:
For Release on Delivery Expected at 10:00 a.m. EDT:
Tuesday, June 13, 2006:
Tax Compliance:
Challenges to Corporate Tax Enforcement and Options to Improve
Securities Basis Reporting:
Statement of David M. Walker Comptroller General of the United States:
GAO-06-851T:
GAO Highlights:
Highlights of GAO-06-851T, a Testimony to Committee on Finance, U.S.
Senate.
Why GAO Did This Study:
Corporate income taxes are expected to bring in about $277 billion in
2006 to help fund the activities of the federal government. Besides
raising revenue, the tax alters investment decisions and raises
concerns about competitiveness in an environment of increasing global
interdependency. The complexity of the tax breeds tax avoidance,
including an estimated $32 billion of noncompliance detected by the
Internal Revenue Service (IRS).
This testimony provides information on trends in corporate taxes and
opportunities to improve corporate tax compliance.
The committee also asked that GAO discuss recent work on the
misreporting of capital gains income from securities sales and options
to improve compliance.
This statement is based largely on previously published GAO work.
What GAO Found:
The corporate income tax is an important source of federal revenue and
must be considered in dealing with the nation‘s long-term fiscal
imbalance. Reexamining both federal spending and revenues, including
corporate tax policy, corporate tax expenditures and corporate tax
enforcement must be part of a multi-pronged approach to address the
imbalance.
Figure: Corporate Income Tax Revenues as a Share of Federal Taxes, 1962-
2005:
[See PDF for Image]
Source: GAO Analysis of OMB Data.
[End of Figure]
The total amount of corporate tax avoidance, which includes the $32
billion in noncompliance estimated by IRS, is unknown. A complex tax
code, complex business transactions, and often multinational corporate
structures make determining corporate tax liabilities and the extent of
corporate tax avoidance a challenge. Opportunities exist to improve
corporate tax compliance and include simplifying the tax code,
obtaining better data on noncompliance, continuing to oversee the
effectiveness of IRS enforcement, leveraging technology, and sending
sound compliance signals through increased collections of taxes owed.
In a companion report issued today, GAO found that many taxpayers
misreport capital gains or losses, sometimes inappropriately
underpaying their taxes and sometimes overpaying them. IRS has efforts
in place to help ensure proper reporting of capital gains and losses,
but these efforts face several obstacles. GAO found that expanding
third-party information reporting on the cost basis of capital assets
could help mitigate this problem if related problems are addressed. GAO
suggested that Congress consider requiring brokers to report adjusted
basis to taxpayers and IRS and requiring IRS to work with the
securities industry to develop cost-effective ways to mitigate
reporting challenges. GAO also recommended that IRS clarify its
guidance on reporting capital gains and losses.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-06-851T].
To view the full product, including the scope and methodology, click on
the link above. For more information, contact Michael Brostek at (202)
512-9110 or brostekm@gao.gov.
[End of Section]
Mr. Chairman and Members of the Committee:
I appreciate the opportunity to discuss the corporate income tax with
you as well as our work on options for improving taxpayers' voluntary
compliance in reporting their capital gains or losses from the sales of
securities. As the Committee is well aware, the U.S. position in the
worldwide economy has fundamentally changed and the structure and
composition of our economy has shifted. U.S. workers and firms must now
succeed in a world of fast-paced technological change and constantly
evolving global competition. This raises two sets of questions about
the corporate income tax. The first is about reforming the overall U.S.
tax system and perhaps changing the role of corporate taxes. The second
set of questions is about how to administer and enforce the existing
corporate income tax in a changing world. As per your request, my
statement focuses principally on this question.
The complexity of the corporate income tax generates opportunities for
tax avoidance that can be categorized as clearly legal, clearly
noncompliant (illegal), or of uncertain legality. Corporate tax base is
reduced by statutory corporate tax expenditures, legal and illegal tax
avoidance, and deliberate underreporting of income. The overall amount
of tax base reduction is unknown but the Internal Revenue Service (IRS)
has estimated the amount of clear noncompliance to total $32 billion
dollars for tax year 2001. Corporate tax avoidance in its various forms
reduces overall federal revenue or, for the government to take in the
same revenue, means that other taxpayers pay more.
My statement today makes the following points:
* Although less of a revenue source than it once was, the corporate
income tax is one of the pillars of the federal tax system.[Footnote 1]
The $277 billion in 2006 corporate tax revenues must be part of overall
considerations for dealing with the nation's long-term fiscal
imbalance. More specifically, corporate tax policy, corporate tax
expenditures and corporate tax enforcement all must be part of a multi-
pronged approach that reexamines both federal spending and revenues.
* Determining corporate income tax liabilities and the extent of
corporate tax avoidance is a challenge because of the complex tax code,
complex business transactions and often multinational corporate
structures. Opportunities exist to improve corporate tax compliance,
such as simplifying the tax code, obtaining better data to the extent
feasible on noncompliance, continuing to oversee the effectiveness of
IRS's efforts, continuing to leverage technology, and sending sound
compliance signals through such things as increased effectiveness in
collecting taxes owed.
Also, at your request, I have included a section in this statement that
discusses our findings in the area of capital gains basis reporting. In
summary, we found that many taxpayers misreport capital gains or
losses, sometimes inappropriately underpaying their taxes and sometimes
overpaying them. IRS has efforts in place to help ensure proper
reporting of capital gains and losses, but these efforts face several
obstacles. Finally, we found that expanding third-party information
reporting on the cost basis of capital assets could help mitigate this
problem if related problems are addressed.
My statement today is largely drawn from previous GAO reports and
testimonies, which were done in accordance with generally accepted
government auditing standards. We also relied on other published
information for the sections of this statement dealing with corporate
taxation. The latter part of this statement discusses capital gains
basis reporting and is drawn from the report on that subject we are
releasing today.
Background:
The base of the federal corporate income tax includes net income from
business operations (receipts, minus the costs of purchased goods,
labor, interest, and other expenses). It also includes net income that
corporations earn in the form of interest, dividends, rent, royalties,
and realized capital gains. The statutory rate of tax on net corporate
income ranges from 15 to 35 percent, depending on the amount of income
earned.[Footnote 2] The United States taxes the worldwide income of
domestic corporations, regardless of where the income is earned, with a
foreign tax credit for certain taxes paid to other countries. However,
the timing of the tax liability depends on several factors, including
whether the income is from a U.S. or foreign source and, if it is from
a foreign source, whether it is earned through direct operations or
through a subsidiary.[Footnote 3]
Statutory and effective tax rates are not necessarily the same. An
effective tax rate, which is often lower--even substantially lower--
than the statutory rate, measures the amount of tax that a corporation
actually pays on a dollar of its economic income, when all aspects of
the tax (deductions, credits, deferrals, etc.) are taken into account.
Statutory and effective rates may differ, for example, because
depreciation allowances for specific types of capital investments
exceed (or fall short of) the true (economic) depreciation. Other
differences arise because income from foreign subsidiaries is generally
not taxed until it is repatriated to the United States. Special
incentives, such as the research tax credit, that are designed to
encourage certain behavior, also cause the effective rate of the tax to
differ from its statutory rate. A recent Congressional Budget Office
(CBO) study found that the United States' statutory corporate tax rates
are high relative to Organization for Economic Cooperation and
Development (OECD) countries but comparable with the rates for what
were then the G-7 countries.[Footnote 4] Comparisons of effective rates
depend on the type of investment and the type of financing. According
to CBO, U.S. effective corporate tax rates in 2003 were the G-7 median
for equity-financed investments in machinery, second lowest for debt-
financed investment in machinery, and second highest for equity-
financed investment in industrial structures.[Footnote 5]
Differences in effective tax rates across types and sources of income
are pervasive, reflecting the complexity of the tax code. The corporate
income tax (1) reduces the after tax return on capital income and,
therefore, affects the incentive individuals have to save and invest;
(2) taxes corporations differently than partnerships and sole
proprietorships; (3) taxes U.S. corporations operating in foreign
countries differently than those operating domestically and differently
than foreign governments tax corporations; (4) taxes different types of
corporate investments, such as machinery or structures, unevenly; and
(5) taxes debt-financed investment at lower rates than equity-financed
investment. These differences in effective tax rates alter both
investment decisions and the reporting of corporate income as firms try
to minimize their taxes. Such tax avoidance, much of it legal but some
illegal, reduces tax revenue. Guiding investments to lightly taxed
activities rather than those with high before tax productivity may
reduce economic growth, further reducing tax revenue from what it
otherwise would have been.
Corporate Income Taxes Are a Significant Source of Federal Revenue and
Must Be Part of the Overall Considerations for Fiscal Reform:
At about $277 billion, corporate income taxes are far smaller than the
$841 billion in social insurance taxes and $998 billion in individual
income taxes to be paid in fiscal year 2006 to fund the federal
government.[Footnote 6] Figure 1 shows the relative importance of
federal taxes.
Figure 1: Trend in Federal Taxes, 1962-2005:
[See PDF for image]
[End of figure]
Figures 1 and 2 show the trend in corporate tax revenues since 1962.
Tax experts have written that corporate tax revenues fell from the
1960s to the early 1980s for several reasons. For example, corporate
income became a smaller share of national income during these years,
partly due to the fact that corporate debt, and therefore deductible
interest payments, increased relative to corporate equity, reducing the
tax base. In addition, tax expenditures, such as more generous
depreciation rules and corporate tax rate reductions lowered corporate
taxes[Footnote 7]. Since the early 1980s corporate tax revenues have
fluctuated in a narrower range, reflecting changes in corporate
profits, tax laws, and other factors.
Since the early 1980s the corporate tax has accounted for from about 6
to 13 percent of federal revenue, as shown in figure 2. Consequently,
although not the largest, it remains an important source of federal
revenue. Relative to the gross domestic product (GDP), the corporate
tax has ranged from a little over 1 percent to just under 2.5 percent
during those same years. CBO has recently projected that despite the
recent uptick, corporate tax revenue for the next 10 years as a
percentage of GDP is expected to stay within this same range.
Figure 2: Corporate Income Tax Revenues as a Share of GDP and as a
Share of Federal Taxes, 1962-2005:
[See PDF for image]
[End of figure]
Corporate tax revenues of the magnitude shown in figure 2 make them
relevant to considerations about how to address the nation's long-term
fiscal imbalance. Over the long term, the United States faces a large
and growing structural budget deficit primarily caused by demographic
trends and rising health care costs as shown in figure 3, and
exacerbated over time by growing interest on the ever larger federal
debt. Continuing on this imprudent and unsustainable fiscal path will
gradually erode, if not suddenly damage, our economy, our standard of
living, and ultimately our national security.
Figure 3: Composition of Federal Spending as a Share of GDP, Assuming
Discretionary Spending Grows with GDP after 2006 and That Expiring Tax
Provisions Are Extended:
[See PDF for image]
Note: This includes certain tax provisions that expired at the end of
2005, such as the increased alternative minimum tax exemption amount.
[End of figure]
We cannot grow our way out of this long-term fiscal challenge because
the imbalance between spending and revenue is so large. We will need to
make tough choices using a multipronged approach: (1) revise budget
processes and financial reporting requirements; (2) restructure
entitlement programs; (3) reexamine the base of discretionary spending
and other spending; and (4) review and revise tax policy, including tax
expenditures, and tax enforcement programs. Corporate tax policy,
corporate tax expenditures, and corporate tax enforcement need to be
part of the overall tax review because of the amount of revenue at
stake.
Corporate tax expenditures reduce the revenue that would otherwise be
raised from the corporate income tax. As already noted, to reduce their
tax liabilities, corporations can take advantage of preferential
provisions in the tax code, such as exclusions, exemptions, deductions,
credits, preferential rates, and deferral of tax liability. Tax
preferences--which are legally known as tax expenditures--are often
aimed at policy goals similar to those of federal spending programs.
For example, there are different tax expenditures intended to encourage
economic development in disadvantaged areas and stimulate research and
development, while there are also federal spending programs that have
similar purposes. Also, by narrowing the tax base, corporate tax
expenditures have the effect of raising either corporate tax rates or
the rates on other taxpayers in order to generate a given amount of
revenue.
The sum of estimated forgone revenue for the federal government because
of corporate tax expenditures was $80 billion for fiscal year
2005.[Footnote 8] In its most recent report, the Department of the
Treasury (Treasury) listed 27 tax expenditures for corporate taxpayers
only and another 52 provisions available to both corporations and other
businesses. As of fiscal year 2005, the two largest tax expenditures
used by corporations were the accelerated depreciation of machinery and
equipment ($15.9 billion) and the deferral of income of controlled
foreign corporations ($10.5 billion); these two accounted for a third
of the sum of corporate revenue losses estimated by Treasury.
We reported in September 2005[Footnote 9] that the effectiveness of
many tax expenditures is not subject to a level of review similar to
that of programs that spend money directly. Although some corporate
income tax expenditures are reviewed by government agencies, academics,
and others, all should be reviewed periodically to ensure they have not
outlived their usefulness, are not redundant, or are not inefficient in
accomplishing their intended purpose. In that report, we recommended
that the Office of Management and Budget (OMB) and Treasury take steps
to ensure regular reexamination of tax expenditures, including the
corporate provisions. OMB disagreed with the recommendations, citing
methodological and conceptual issues. Our report discusses in detail
the issues that OMB raised and why we continue to believe that our
recommendations are valid. Also, as far back as 1994, we have suggested
that Congress should review these tax expenditures, considering such
things as how well the corporate tax expenditures are achieving their
purposes and whether they should remain, given the potential benefits
of a simpler corporate tax code, possibly with reduced tax
rates.[Footnote 10]
Opportunities Exist to Improve Corporate Tax Compliance:
Ensuring corporate income tax compliance is challenging because much
corporate tax avoidance is legal and the true tax liability for large
corporations is difficult to determine. A wide variety of strategies
will undoubtedly be needed to address corporate tax compliance.
Opportunities to pursue include simplifying the tax code, obtaining
better data to the extent feasible on noncompliance, continuing to
oversee the effectiveness of IRS's efforts, continuing to leverage
technology, and sending sound compliance signals through such things as
increased effectiveness in collecting taxes owed.
Corporate Tax Avoidance Is Bred in Part by Complexity:
The amount of corporate tax avoidance is unknown. A complex tax code,
complicated business transactions, and often multinational corporate
structures make determining corporate tax liabilities and the extent of
corporate tax avoidance a challenge. Tax avoidance has become such a
concern that some tax experts say corporate tax departments have become
"profit centers" as corporations seek to take advantage of the tax laws
in order to maximize shareholder value. Some corporate tax avoidance is
clearly legal, some falls in gray areas of the tax code, and some is
clearly noncompliance or illegal. Tax code simplification has the
potential to reduce at least some of this avoidance.
Often corporate tax avoidance is legal. For example, multinational
corporations can locate active trade or business operations in
jurisdictions that have lower effective tax rates than does the United
States and, unless and until they repatriate the income, defer taxation
in the United States on that income, thus reducing their effective tax
rate. Similarly, making investments that qualify for accelerated
depreciation can lower a corporation's current effective tax rate,
although in the future its rate would be higher.[Footnote 11]
Corporate tax planners may find legal ways to exploit tax code
complexity to play one provision of the code off another in ways that
Congress never intended. In response, Congress has sometimes acted to
address what it considered to be abusive tax shelters. For example, the
American Jobs Creation Act of 2004[Footnote 12] limited the tax
benefits of leasing transactions involving tax-exempt entities, such as
transit authorities. One type of transaction the act limited was the
sale-in/lease-out (SILO) arrangement, which involved a taxable entity
buying assets, such as railcars, from a tax-exempt entity, for example,
a metropolitan transit system, and leasing them back to the tax-exempt
entity. The estimated revenue gain from the 2004 act's provision
covering leasing transactions with tax-indifferent parties was about
$26.6 billion for 2005 through 2014.
Complicating corporate tax compliance is the fact that in many cases
the law is unclear or subject to differing interpretations. In fact,
some have postulated that major corporations' tax returns are actually
just the opening bid in an extended negotiation with IRS to determine a
corporation's tax liability. An illustration is transfer pricing.
Transfer pricing involves setting the appropriate price for such things
as goods, services, or intangible property (such as patents,
trademarks, copyrights, technology, or "know-how") that is transferred
between the U.S.-based operations of a multinational company and a
foreign affiliate. If the price paid by the affiliate to the U.S.
operation is understated, the profits of the U.S. operation are reduced
and U.S. taxable income is inappropriately reduced or eliminated. The
standard for judging the correct price is the price that would have
been paid between independent enterprises acting at "arm's length."
However, it can be extremely difficult to establish what an arm's
length price would be. Given the global economy and the number of
multinational firms with some U.S.-based operations, opportunities for
transfer pricing disputes are likely to grow.
Tax shelters are one example of how tax avoidance, including corporate
tax avoidance, can shade into the illegal. Some tax shelters are legal
though perhaps aggressive interpretations of the law, but others cross
the line. In a 2003 testimony, we reported that IRS had identified 27
kinds of abusive shelter transactions--called listed transactions--
promoted to corporations and others. As of June 2006, IRS's web site
lists 31 such listed transactions. IRS also had a number of other
transactions that had to be reported to IRS and may have had some
characteristics of abusive shelters but were not, and possibly never
would be, listed.
Abusive shelters often are complex transactions that manipulate many
parts of the tax code or regulations and are typically buried among
legitimate transactions reported on tax returns. Because these
transactions are often composed of many pieces located in several parts
of a complex tax return, they are essentially hidden from plain sight,
which contributes to the difficulty of determining the scope of the
abusive shelter problem. Often lacking economic substance or a business
purpose other than generating tax benefits, abusive shelters have been
promoted by some tax professionals, often in confidence, for
significant fees, sometimes with the participation of tax-indifferent
parties, such as foreign or tax-exempt entities. These shelters may
involve unnecessary steps and flow-through entities, such as
partnerships, which make detection of these transactions more
difficult.
For example, a company had a sizable gain from the sale of a subsidiary
and wanted to avoid or minimize paying tax on the gain. An investment
bank proposed forming an offshore partnership with a foreign
corporation (a tax-indifferent party) for the express purpose of
sheltering the capital gains of its corporate client. The partnership
purchased and quickly resold notes in a contingent installment sale
transaction. The partnership earned a large capital gain, most of which
it allocated to the foreign corporate partner. Later, related losses
were allocated to the U.S. corporation, generating approximately $100
million in capital loss for the investment bank's client. The
corporation used this capital loss to shelter its U.S.-based capital
gains. Both the Tax Court and the Third Circuit Court of Appeals ruled
that the transaction lacked economic substance. The Third Circuit, in
addition to requiring economic substance, held that a transaction must
have a subjective nontax business motive to be respected for tax
purposes.[Footnote 13] For this transaction, the investment bank was to
earn a fee of $2 million.
In part because tax shelters are intentionally hidden, IRS has not been
able to produce a reliable estimate of the revenues lost because of
shelters. As we reported in October 2003, one estimate, which had a
number of methodological limitations, suggested an average annual tax
gap because of tax shelters (both corporate and individual) that could
have been from about $11.6 billion to about $15.1 billion for the years
1993 through 1999.[Footnote 14] Because the methodological limitations
were serious, the true amount of the revenue loss could be lower or
higher than this range. Furthermore, this estimate does not cover non-
abusive tax shelters.
Establishing a presence in a low-tax country is another technique for
avoiding corporate income tax. Some low-tax countries are called tax
havens. The company's presence in a tax haven in some cases may be
nominal, nothing more than a file in an office. Use of a tax haven can
be questionable when combined with abusive transfer pricing or
techniques, such as interest stripping, to artificially shift income to
the tax haven. In several reports since 2002, we reported on federal
contractors' use of tax havens. We reported that 4 of the top 100
federal contractors that were publicly traded corporations in 2001 were
located in tax havens and that 3 of these were originally U.S.-
headquartered corporations. Later, we reported that large tax haven
contractors in both 2000 and 2001 had a tax cost advantage compared to
large domestic contractors.[Footnote 15]
IRS's Incomplete and Dated Estimates of Corporate Tax Noncompliance Can
Be Improved:
In large part because of the complexity and uncertainty in the
application of tax laws, the actual level of corporate income tax
noncompliance (illegal tax avoidance) is poorly understood. IRS
estimates a corporate tax gap in the tens of billions of dollars, but
also acknowledges that this estimate is not based on robust, recent,
and reliable research.[Footnote 16]
As noted above, IRS's published estimate of the corporate tax gap--the
difference between what corporations pay voluntarily and on time in
taxes and what they are required to pay under the law--is $32 billion
for tax year 2001. This is out of an overall gross tax gap of $345
billion for that year. Underreporting of income was the largest
component of the corporate tax gap, contributing an estimated $30
billion. The IRS estimate included both small corporations (those
reporting assets of $10 million or less) and large corporations (those
reporting assets of over $10 million). Underpayment of taxes due
accounted for $2 billion of the corporate tax gap for tax year 2001.
IRS has no estimate for nonfiling of corporate income tax returns for
tax year 2001.
However, the available tax gap estimates are highly uncertain and
incomplete. IRS has not systematically measured the level of compliance
for large corporations, and the last measure of noncompliance for small
corporations was from the 1980s. IRS's level of certainty with regard
to the accuracy of the corporate tax gap estimate is low for reasons
such as use of incomplete and old data, interpretation of complex laws,
and resource constraints. The 2001 estimate used data from the 1970s
and 1980s to estimate underreporting of corporate income taxes. For
large corporate income tax underreporting, IRS based its estimate on
the amount of tax recommended from operational examinations. As we
reported in July 2005,[Footnote 17] according to IRS officials, IRS
relies on the amount of tax recommended because it is difficult to
determine the true tax liability of large corporations because of
complex and ambiguous tax laws that create opportunities for differing
interpretations and that complicate the determination. Because these
examinations do not cover all firms and do not test all items on a tax
return, the estimate produced from the examinations is incomplete. IRS
officials also explained that because of these complexities and the
costs and burdens of collecting complete and accurate data, IRS has not
systematically measured large corporation tax compliance through
statistically valid studies.
As of June of this year, IRS did not have approved plans to update the
corporate tax gap estimate. Although measuring corporate tax compliance
can be challenging and costly, such compliance data aid in identifying
new or growing types of noncompliance, identifying changes in tax laws
and regulations that may improve compliance, more effectively targeting
examinations of tax returns, understanding the effectiveness of its
programs to promote and enforce compliance, and properly determining
its resource needs and allocations. In order to improve efforts to
reduce the tax gap, we have recommended that IRS develop plans to
periodically measure tax compliance for areas that have been measured,
and study ways to cost effectively measure compliance for other
components of the tax gap that have not been measured, such as excise
taxes and corporate taxes. IRS agreed with our
recommendations.[Footnote 18]
IRS Has Strengthened Corporate Tax Compliance Efforts, but Continued
Oversight Will Be Warranted:
IRS has recently increased the number of corporate audits and
recommended tax assessments. These trends are promising. However, given
the lack of a reliable measure of the extent of corporate noncompliance
and other factors, continued oversight of these efforts will be
warranted to make informed judgments about their overall effectiveness.
As shown in figure 4, the number of corporate income tax returns that
IRS examined rose from its recent low of 0.71 percent in fiscal year
2004 to 1.25 percent in fiscal year 2005. This number includes
examinations of 20 percent of large corporations in fiscal year 2005 as
well as audits of all 1,100 of the nation's largest corporations with
assets of more than $250 million.
Figure 4: Percentage of Corporate Tax Returns IRS Examined, Fiscal
Years 2001-2005:
[See PDF for image]
[End of figure]
Figure 5 shows that the amount of taxes that IRS recommended as a
result of examinations performed grew from its recent low of $13.5
billion in fiscal year 2003 to $32 billion in fiscal year 2005.
Figure 5: Amount of Taxes Recommended from Examinations of Corporations
in Billions of Dollars, Fiscal Years 2001-2005:
[See PDF for image]
[End of figure]
According to IRS, about a third of the increase in recommended
assessments comes from tax shelter examinations, and nearly all of the
increase comes from examinations of the largest corporations. IRS
notes, not surprisingly, that a large portion of the recommended taxes
were not agreed to by the corporations. In the past, we found that
under IRS's examination program of the nation's largest corporations,
the amount of taxes IRS actually assessed has been about 20 percent of
the amount initially recommended during examinations.[Footnote 19]
Further, the amounts assessed often are not ultimately collected after
cases are reviewed in IRS's Appeals function or in the courts. Because
the various review and appeal options can be time consuming, it may be
a number of years before actual collection occurs on some cases.
The shelter-related results come from IRS's multiyear effort to attack
tax shelters. In 2003 we reported that IRS had shifted resources to
create a broad-based strategy to combat what it considered to be a high
priority challenge--abusive tax shelters. IRS had adopted a broad-based
strategy for addressing abusive shelters, including:
* targeting promoters to head off the proliferation of shelters;
* making efforts to deter, detect, and resolve abuse;
* offering inducements to businesses to disclose their use of
questionable tax practices; and:
* using performance indicators to measure outputs and some outcomes and
intending to go down the path it had started and develop long-term
performance goals and measures linked to those goals. We said that
without these latter elements, Congress would find gauging IRS's
progress difficult.
In addition to examinations, IRS has undertaken a number of initiatives
to address corporate tax compliance. Some of these initiatives are
intended to resolve tax issues beyond the examination process. The
Advance Pricing Agreement (APA) program, the Fast Track Settlement
program, the Pre-Filing Agreement program, and the Industry Issue
Resolution program all work to some degree to resolve contentious tax
issues outside of the examination process. For example, the APA program
is intended to address transfer pricing issues up front so that they do
not arise during subsequent examinations.
IRS has also been revising the corporate tax examination process. For
instance, IRS reports that it has shortened the cycle time of
examinations. According to IRS, reducing cycle time allows IRS to
examine additional taxpayers and reduces administrative burdens on
taxpayers. Similarly, IRS's Limited Issue Focused Examination process
seeks to have IRS and corporations reach a formal agreement to govern
key aspects of the examination.
Future success in following through on these initiatives will require
replenishment of IRS's staff, which could be challenging given the
increasing numbers of key employees who are eligible for retirement or
who are otherwise leaving key occupations. The Large and Mid-Size
Business Division (LMSB), which is responsible for the compliance of
the largest corporations, reported in its fiscal year 2006 strategic
assessment that it will continue to lose substantial experience as
revenue agents leave. The Small Business and Self Employed Division,
which covers the rest of corporations, also has growing numbers of
employees eligible for retirement or leaving their enforcement
positions. Although hiring to fill positions is occurring, past
experience suggests that training these new employees and giving them
on-the-job experience will take time and likely adversely affect the
divisions' overall productivity to some extent. The Treasury Inspector
General for Tax Administration has designated managing human capital a
management and performance challenge for IRS.
In part because IRS does not have a reliable measure of corporate tax
compliance, it will be challenged to demonstrate the effectiveness of
the increased audits and the various initiatives it has undertaken. The
effectiveness of IRS's efforts will depend on the extent to which the
taxes recommended are actually collected given past data showing that a
relatively small portion of recommended assessments is ultimately
collected. For these reasons, as well as human capital management
challenges, IRS's increased compliance efforts will warrant continued
oversight.
Continuing to Leverage Technology:
Judicious use of technology has already helped IRS improve its
productivity, and continued, well-managed technology initiatives have
the potential to further improve the use of its resources. According to
IRS, electronic filing of individuals' tax returns has enabled it to
reduce the amount of staffing devoted to processing paper tax returns
and to transfer staffing allocations to other endeavors, including
compliance work. Further, because of the software used in
electronically preparing and filing returns, these returns have fewer
errors, thus saving IRS and taxpayers needless time and effort to
correct avoidable errors.
Starting in 2006, many larger corporations are now required to file
their tax returns electronically. This is no small undertaking, and
some transition issues are likely to occur. However, electronic returns
offer the potential to speed examinations--if for no other reason than
often very voluminous corporate tax returns can be moved to appropriate
locations for review immediately. IRS believes electronically filed
returns will also speed analysis of corporate tax returns and the
identification of issues and taxpayers most in need of examination or
other resolution of potential compliance issues. IRS plans to gradually
expand the number of firms required to electronically file. This and
other opportunities to leverage modern technology can serve to help IRS
deal with the complex tax issues in corporate tax returns.
Improving the Collection of Delinquent Taxes Would Send a Compliance
Signal:
When any taxpayer has been found to owe taxes and those amounts are no
longer in dispute, failure to collect the taxes sends an adverse
compliance signal. While not collecting these debts may send a message
to corporations that IRS is not serious about enforcing the tax law,
developing and exploiting opportunities to improve collections sends
the opposite signal and can contribute to reducing corporate
noncompliance. In February 2004, we reported that some Department of
Defense (DOD) contractors abuse the federal tax system with little
consequence.[Footnote 20] We reported that based on our analysis of a
limited number of DOD disbursement systems, more than 27,000 DOD
contractors owed nearly $3 billion in unpaid federal taxes. In June
2005, we reported that many contractors of civilian agencies throughout
the federal government also abuse the federal tax system.[Footnote 21]
Our analysis showed that about 33,000 contractors that received
substantial federal payments from civilian agencies during fiscal year
2004 owed a total of more than $3 billion in unpaid taxes. The unpaid
taxes owed by DOD and civilian agency contractors included corporate
income, excise, unemployment, individual income, and payroll
taxes.[Footnote 22] We also found evidence of abusive and potentially
criminal activities on the part of both DOD and civilian agency
contractors.[Footnote 23]
In our reports on this issue, we made numerous recommendations intended
to improve the Federal Payment Levy Program by expanding the amount and
type of tax debt eligible for inclusion in the program, expanding the
volume of federal payments subject to levy, and correcting process and
control deficiencies that hindered the program's ability to maximize
the amount levied from payments to contractors with unpaid federal
taxes. In our 2004 report, we also recommended that OMB develop options
for prohibiting federal contract awards to businesses and individuals
that abuse the federal tax system, including designating such tax abuse
as a cause for government wide debarment or suspension. The agencies
involved did not agree with all of our recommendations. We discuss
their views and our responses in detail in our reports, as well as our
continued belief that our recommendations are valid. Consistent with
our recommendation to OMB, I believe Congress should consider
suspending government business with contractors who are delinquent on
their taxes as of a specific and prospective effective date, with a
provision for limited waivers if necessary in unique circumstances.
Capital Gains Basis Reporting:
Finally, you also asked us to testify on a report--done at your
request--that we are issuing today on individual taxpayers' compliance
in reporting capital gains' income from the sale of securities[Footnote
24]. Misreporting such inco[Footnote 25]me contributes to the annual
tax gap, which is the gap between tax amounts that taxpayers should pay
under the law and do pay voluntarily and on time. For tax year 2001,
the IRS estimated a gross tax gap of $345 billion, of which at least
$11 billion is attributed to individual taxpayers who misreported their
income from capital gains or loss[Footnote 26]es. Taxpayers are to
determine their capital gains or losses by subtracting the "basis"
amount, which is generally the cost for an asset, from the gross
proceeds amount when selling the asset.
In summary:
* For tax year 2001, an estimated[Footnote 27] 36 percent (over 7
million) of individual taxpayers who sold securities misreported
capital gains or losses. Using the wrong cost basis for the securities
was a primary type of noncompliance leading to this misreported income.
About two-thirds of the misreporting taxpayers understated gains or
overstated losses, while about one-third overstated gains or
understated losses. Additionally, a few taxpayers with securities sales
misreported whether their gains or losses were short-term or long-
term.[Footnote 28]
* IRS attempts to address misreported securities sales' income through
enforcement and taxpayer service programs, which are to find
noncompliance or help taxpayers comply voluntarily. Various challenges
limit the impact of these programs, such as that IRS enforcement
programs contact relatively few taxpayers and the lack of cost basis
information impedes efficient use of IRS's enforcement resources. IRS
also faces difficulties in ensuring that taxpayers understand their
obligations for determining and reporting their capital gains and
losses.
* Expanding information reporting[Footnote 29] to taxpayers and IRS on
securities sales to include cost basis has potential to improve
taxpayer voluntary compliance and help IRS verify securities gains or
losses. Basis reporting would raise challenges, many of which can be
mitigated to some extent. For example, broker costs would increase but
could be constrained by limiting the scope of any reporting requirement
and by building on the basis reporting to taxpayers that many brokers
already do. For example, reporting basis for only future purchases
would mitigate challenges when brokers do not know the basis for
securities purchased in the past. To the extent that actions to
mitigate the challenges to basis reporting delay its implementation or
limit coverage to only certain types of securities, the resulting
improvements to taxpayers' voluntary reporting compliance would be
somewhat constrained. IRS's broad authority to require information
reporting for securities sales may not be enough to require all the
actions necessary to implement cost basis reporting and mitigate the
challenges.
Based on these results, our report includes matters that Congress may
want to consider, including requiring brokers to report to both
taxpayers and IRS the adjusted basis of sold securities and ensuring
that IRS has sufficient authority to implement the requirement.
Congress could also require brokers to report whether the securities
sold were short-or long-term and IRS to work with brokers to develop
rules that mitigate the challenges. Further, we recommend that IRS
modify the instructions for the individual tax return to (1) clarify
the appropriate use of capital losses to offset capital gains or other
income and (2) provide guidance on resources available to taxpayers to
determine basis. IRS agreed with our recommendations.
Mr. Chairman, this concludes my prepared statement. I would be happy to
respond to any questions you or other Members of the Committee may have
at this time.
Contacts and Acknowledgments:
For further information on this testimony, please contact Michael
Brostek at (202) 512-9110 or brostekm@gao.gov. David Lewis, Assistant
Director; Jeffrey Arkin; Kevin Daly; Amy Friedheim; Thomas Gilbert;
Lawrence Korb; Signora May; Edward Nannenhorn; Cheryl Peterson; Michael
Rose; Marylynn Sergent; Thomas Short; Michael Volpe; James White,
Jennifer Wong; and James Wozny made key contributions to this
testimony.
FOOTNOTES
[1] For purposes of this statement, when we refer to the corporate
income tax or corporations, we are excluding S-corporations, which are
pass-through entities whose income or losses are generally not taxed at
the corporate level, but are passed through to their owners.
[2] In addition, present law imposes an alternative minimum tax (AMT)
on corporations to the extent that their minimum tax liability exceeds
their regular tax liability. In general, the AMT applies a lower tax
rate to a broader tax base. Specifically, the regular tax base is
increased for AMT purposes by adding back certain items treated as tax
preferences and disallowing certain deductions and credits. Also,
marginal rates are higher over limited income ranges to recapture the
benefits of the rates below 35 percent.
[3] Very generally, corporations first calculate their taxable income.
Taxable income is total income, including taxable income from foreign
sources, minus deductions such as for salaries and wages, depreciation,
and net operating loss carryovers. The next step is to calculate the
tentative tax owed (taxable income times the applicable rate). The last
step is to subtract any tax credits, including the foreign tax credit,
to get the taxes owed.
[4] OECD consists of 30 market democracies and its purpose is to
provides member countries a setting where governments can compare
policy experiences, seek answers to common problems, and coordinate
domestic and international policies. At the time of the CBO study, the
G-7 consisted of Canada, France, Germany, Italy, Japan, the United
Kingdom, and the United States. The G-7's purpose is to provide a forum
for the leaders of the largest industrialized democracies to discuss
major economic and political issues. When the Russian Federation
participates at the meetings, the group is known as the G-8.
[5] Congressional Budget Office, Corporate Income Tax Rates:
International Comparisons, (Washington, D.C.: November 2005). The study
focuses on how corporate income taxes affect incentives for investment
by calculating marginal effective tax rates in different countries. The
calculations include differences across countries in statutory tax
rates and depreciation rules.
[6] Office of Management and Budget. Historical Tables, Budget of the
United States Government, Fiscal Year 2007. (Washington, D.C.: Feb.
2006).
[7] Steuerle, C. Eugene, Contemporary U.S. Tax Policy. Washington,
D.C.: The Urban Institute Press, 2004.
Gravelle, Jane G., "The Corporate Tax: Where Has It Been and Where Is
It Going?" National Tax Journal, vol. 57, no. 4 (2004): 903-23.
[8] Summing the individual tax expenditure estimates is useful for
gauging the general magnitude of the federal revenue involved, but it
does not take into account possible interactions between individual
provisions. See GAO, Government Performance and Accountability: Tax
Expenditures Represent a Substantial Federal Commitment and Need to Be
Reexamined, GAO-05-690 (Washington, D.C.: Sept. 23, 2005).
[9] GAO, Government Performance and Accountability: Tax Expenditures
Represent a Substantial Federal Commitment and Need to Be Reexamined,
GAO-05-690 (Washington, D.C.: Sept. 23, 2005).
[10] GAO, Tax Policy: Tax Expenditures Deserve More Scrutiny, GAO-GGD/
AIMD-94-122 (Washington, D.C.: June 3, 1994).
[11] Accelerated depreciation lowers a corporation's marginal effective
tax rate on investments by increasing the present value of these
deductions.
[12] Pub. L. No. 108-357 (2004).
[13] ACM Partnership v. Commissioner, 157 F. 3d 231 (3d Cir. 1998),
aff'g, 73 T.C.M. 2189 (1997), cert. denied, 526 U.S. 1017 (1999).
[14] GAO, Internal Revenue Service: Challenges Remain in Combating
Abusive Tax Shelters, GAO-04-104T, (Washington, D.C.: Oct. 21, 2003).
[15] GAO, Information on Federal Contractors That Are Incorporated
Offshore, GAO-03-194R (Washington, D.C.: Oct. 1, 2002) and
International Taxation: Tax Haven Companies Were More Likely to Have a
Tax Cost Advantage in Federal Contracting, GAO-04-856 (Washington,
D.C.: June 30, 2004).
[16] The tax gap estimate is an aggregate of estimates for three
primary types of noncompliance: underreporting of tax liabilities on
tax returns; underpaying of taxes due from filed returns; and
nonfiling, which refers to the failure to file a required tax return
altogether or on time.
[17] GAO, Tax Compliance: Better Compliance Data and Long-term Goals
Would Support a More Strategic IRS Approach to Reducing the Tax Gap,
GAO-05-753 (Washington, D.C. July 18, 2005).
[18] GAO, Tax Administration: Better Compliance Data and Long-term
Goals Would Support a More Strategic IRS Approach to Reducing the Tax
Gap, GAO-05-753 (Washington, D.C.: July 18, 2005).
[19] GAO, Tax Administration: IRS Measures Could Provide a More
Balanced Picture of Audit Results and Costs, GAO/GGD-98-128 (Washington
D.C.: June 23, 1998).
[20] GAO, Financial Management: Some DOD Contractors Abuse the Federal
Tax System with Little Consequence, GAO-04-95 (Washington, D.C.: Feb.
12, 2004). Although some of the contractors were corporations, we did
not estimate how many were corporations.
[21] GAO, Financial Management: Thousands of Civilian Agency
Contractors Abuse the Federal Tax System with Little Consequence, GAO-
05-637 (Washington, D.C.: June 16, 2005).
[22] Payroll taxes are amounts that businesses withheld from employees'
wages for federal income taxes, Social Security, and Medicare but
failed to remit to IRS, as well as the related employer matching
contributions for Social Security and Medicare taxes.
[23] We considered activity to be abusive when a contractor's actions
or inactions, though not illegal, took advantage of the existing tax
enforcement and administration system to avoid fulfilling federal tax
obligations and were deficient or improper when compared with behavior
that a prudent person would consider reasonable. We characterized as
potentially criminal any activity related to federal tax liability that
may be a crime under a specific provision of the Internal Revenue Code.
[24] GAO, Capital Gains Tax Gap: Requiring Brokers to Report Securities
Cost Basis Would Improve Compliance if Related Challenges Are
Addressed, GAO-06-603 (Washington, D.C.: June 13, 2006).
[25] Taxpayers are to report gains or losses from selling securities on
Schedule D of the federal income tax returns as well as the purchase
and sale dates, adjusted cost basis, and gross proceeds from the sale.
[26] The overall capital gains tax gap could be larger than $11 billion
if IRS had estimated the portion of the $48 billion tax gap for unfiled
tax returns or unpaid taxes that is related to capital gains. According
to an IRS research official, in mid-2006, IRS plans to publish its
final report on the 2001 tax gap that will include an updated tax gap
estimate based on a refined methodology. It is possible that the
updated tax gap figures could differ from the current estimates.
[27] Our estimates are based on a review of a probability sample of IRS
examinations selected from the nearly 46,000 randomly selected
individual tax returns for tax year 2001 in its National Research
Program, IRS's most recent study of individual tax compliance. We
express our confidence in our estimates as a 95 percent confidence
interval, plus or minus the margin of error. Our estimate for the
percentage of misreporting taxpayers has a sampling error of (+/-) 7
percent or less, and we are 95 percent confident that from 6.2 million
to 8.3 million taxpayers misreported securities sales.
[28] Securities assets sold after being held for 1 year or less are
considered short-term while others sold are considered to be long-term
and are generally taxed at lower tax rates.
[29] Information reporting involves third parties filing returns with
IRS and taxpayers to report certain income. Brokers are required to
file Form 1099-B with IRS and the taxpayer to report such information
for securities sales as the dates, number of shares, and gross proceeds
of the sale, but not the cost basis.
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