The Senate Permanent Subcommittee on Investigations held a hearing on offshore profit shifting and the U.S. tax code, examining in particular the practices of Microsoft and Hewlett-Packard, while questioning an Ernst & Young tax partner who services HP.
“U.S. multinational corporations benefit from the security and stability of the U.S. economy, 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,” Sen. Carl Levin, D-Mich., said in his opening statement at Thursday’s hearing. “But, too often, to 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.”
Levin noted that U.S. multinational corporations have stockpiled $1.7 trillion in earnings offshore. “We will examine the actions of two U.S. companies – Microsoft and Hewlett-Packard – 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,” he added.
Levin displayed a chart showing how Microsoft uses transfer pricing agreements with two of its main offshore groups. In 2011, he noted, the two offshore groups paid Microsoft $4 billion for certain intellectual property rights. Microsoft Singapore paid $1.2 billion, and Microsoft Ireland $2.8 billion. “But look what those offshore subsidiaries received in revenue for those same rights: Microsoft Singapore group received $3 billion; and Microsoft Ireland, $9 billion,” he said. “So Microsoft USA sold the rights for $4 billion and these offshore subsidiaries collected $12 billion. This means Microsoft shifted $8 billion in income offshore. Yet, over 85 percent of Microsoft’s research and development is conducted in the United States."
Levin also called attention to Microsoft’s 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,” he said. “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 it makes from sales here in the United States. Microsoft sells the rights to market its intellectual property in the Americas (which includes the U.S.) to Microsoft Puerto Rico. Microsoft in the U.S. 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 it just sold. Why did Microsoft do this? Because under the distribution agreement, Microsoft U.S. agrees to pay Microsoft Puerto Rico a certain percentage of the sales revenues it receives from distributing Microsoft products in the United States. Last year, 47 percent of Microsoft’s sales proceeds in the U.S. were shifted to Puerto Rico under this arrangement. The result? Microsoft U.S. avoids U.S. taxes on 47 cents of each dollar of sales revenue 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 three years surveyed by the subcommittee. That’s $4 million a day in taxes Microsoft isn’t paying.”
Levin noted 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.”
Microsoft Defends Tax Strategies
Bill Sample, corporate vice president of worldwide tax at Microsoft, testified in defense of the software giant’s tax strategies. “Microsoft complies with the tax rules in each jurisdiction in which it operates and pays billions of dollars each year in total taxes, including U.S. federal, state, and local taxes and foreign taxes,” he said in his prepared testimony. “The tax rules that we follow in the U.S. generally provide for the deferral of U.S. tax on the earnings of foreign subsidiaries until those earnings are repatriated in the form of dividends. Anti-deferral rules in the Internal Revenue Code, such as Subpart F, also can operate to eliminate deferral and impose current U.S. tax on certain types of income earned by those foreign subsidiaries. Exceptions to Subpart F, such as the “controlled foreign corporation” (CFC) “look through” rule in Internal Revenue Code Section 954(c)(6), in certain cases permit continued deferral on transfers of foreign earnings between foreign subsidiaries. Microsoft has made very limited use of this exception. Similarly, Internal Revenue Code Section 956 generally ends deferral and imposes U.S. tax on foreign earnings when they are loaned by Microsoft’s foreign subsidiaries back to Microsoft, but those rules permit U.S. companies to preserve deferral on certain short-term loans from foreign subsidiaries to their U.S. affiliates. Microsoft has made very limited use of this exception."
Sample also defended the tax treatment of Microsoft’s regional operating centers, or ROCs, in Singapore, Puerto Rico, Ireland, Bermuda and other parts of the world. “Our foreign ROCs pay tax locally in the jurisdiction in which they operate, and Microsoft pays U.S. tax on the earnings of the foreign ROCs when those earnings are repatriated back to the U.S. in the form of dividends or included in income under Subpart F,” he said. “Microsoft also pays U.S. tax on royalties and cost sharing payments that are received from the foreign ROCs. Our worldwide OEM business, consisting primarily of licensing PC operating systems to computer manufacturers for pre-installation on PCs, departs from this regional model and is, with very limited exceptions, operated and supplied from our operations center in Reno, Nevada. The resulting income is reported on our consolidated U.S. income tax return as taxable in the U.S. without regard to the location of the customer.”
However, Sample was questioned closely by Levin and admitted that the company does not have any employees in Bermuda even though it claims to generate $3 billion in royalties there.
Tax Deferral and Check-the-Box
Levin noted that transfer pricing is only one strategy used by corporations to shift profits abroad. He also highlighted the use of tax deferrals and the so-called “check-the-box” rules.
“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,” he said. “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."
Levin noted that on Jan. 1, 1997, the Treasury Department implemented the “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 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,” he said. “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 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. 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, Levin added. “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,’ which excludes certain passive income, including interest, rents and royalties, from Subpart F. This provision is currently up for extension.”
Controlled Foreign Corporations and HP
Levin next highlighted another example of what he called “tax gimmickry” used by some multinationals involving controlled foreign corporations. “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 still want to bring those earnings back to the United States without paying taxes,” he said. “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. tax.
“What’s more, if a 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 doesn’t count against the aggregate 60 day limit for the fiscal year,” said Levin. “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 U.S., the rule has become a blueprint on how to get billions of dollars back into the U.S. tax free.”
Levin pointed to the example of Hewlett-Packard, which he claimed has used a loan program to return offshore profits back to the United States since as early as 2003-2004. “In 2008, Hewlett-Packard started a new loan program called the ‘staggered’ or ‘alternating’ loan program,” he said. “Funding for the loans came mainly from two H-P sources, or pools: the Belgian Coordination Center (‘BCC’) and the Compaq Cayman Holding Corp (‘CCHC’). The loans from these two offshore entities helped fund HP’s general operations in the U.S, 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 HP did not have adequate cash in the U.S. to run its operations, Levin pointed out. 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 that it would hold $17.4 billion in foreign cash and only $0.4 billion in U.S. cash.
“The loan program was designed to enable Hewlett-Packard to orchestrate a series of back to back to back to back loans to the U.S. and provide a continuous stream of offshore profits to the United States without paying U.S. taxes,” said Levin. “In fact, Hewlett-Packard even changed the fiscal year and quarter ends 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 end of either of the lending entities.”
Levin pointed to the loan schedule that was outlined in a Hewlett-Packard document. “Every single day is covered by a loan from a CFC,” he said. “In FY 2010, for example, HP’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 U.S. A similar pattern of continuous lending appears for most of the period between 2008 through 2011.
“And what were the loans used for?” he added. “One Hewlett-Packard power point characterized the loan program as ‘the most important source of liquidity for repurchases and acquisitions.’ That doesn’t 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. In fact, this is so blatant that internal Hewlett-Packard documents openly referred to this program as part of its ‘repatriation history’ and a ‘repatriation strategy’ – contrary to the notion that this was a short-term loan program.”
Levin pointed to the push by multinational corporations for a tax holiday that would allow them to repatriate their foreign profits back to the U.S. at a low tax rate. “This scheme mocks the notion that profits of U.S. multinationals are ‘locked up’ or ‘trapped’ offshore,” he said. “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 doing so without paying taxes.”
Lester Ezrati, senior vice president and tax director at Hewlett-Packard defended HP’s use of controlled foreign corporations. He noted that HP has provided Levin’s subcommittee with more than 330,000 pages of documents and allowed interviews with HP personnel by congressional staff over the past three years. He noted that most of HP’s global intellectual property is owned in the United States. The company’s blended worldwide effective tax rate in 2011 was 21.2 percent, combining both the rate on U.S. operations and on foreign operations.
“HP has always had an extremely productive and professional relationship with the Internal Revenue Service,” he noted. “As is customary for a company of our size, HP has been under continual audit by the IRS. The IRS has permanent offices at two HP facilities in the U.S.” Ezrati pointed out that HP has been an early adopter of many of the IRS’s programs to resolve corporate tax issues, including the accelerated issue resolution program, pre-filing agreements, and the IRS Advanced Pricing Agreement program. HP’s transfer pricing was subject to such an agreement with the IRS from 1993 through 2010, and the tech giant is currently working on renewing that agreement.
Levin noted that the IRS has stated that the substance—not just the form —of offshore loans such as those between HP and its subsidiaries should be reviewed, which he noted were approved by its audit firm, Ernst & Young.
APB 23 Exception for Foreign Profit Repatriation
Levin also highlighted an accounting standard known as APB 23, short for Accounting Principles Board Opinion No. 23, which among other things addresses how U.S. multinationals should account for taxes they will have to pay when they repatriate the profits currently held by their offshore subsidiaries. APB 23 has been codified in Accounting Standards Codification (ASC) 740-30-05.
Levin noted that 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,” he added. “But companies can avoid this 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 massive lobbying effort, promising to bring these billions of offshore dollars back to the United States if they are granted a ‘repatriation holiday,’ a large tax break for bringing offshore funds to the United States. On the one hand, these 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 Congress grants them a tax holiday. That’s not any definition of ‘permanent’ that I understand.”
“While this may seem like an obscure matter, it is a major issue for U.S. multinational corporations,” Levin added. “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 U.S. 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, Levin pointed out, more than 1,000 U.S. multinationals claimed this exemption in their SEC filings, reporting more than $1.5 trillion in money that they say is or is intended to be reinvested offshore.
“This buildup has started to create some problems for many companies,” he added. “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, overseas. This situation is also creating a dilemma for their auditors, who sign off on those assertions and plans.
In one document, Levin noted that an auditor at Ernst & Young wrote to a colleague, “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.’ … 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. An assertion of indefinite or permanent investment until Congress changes the law allowing cheaper repatriation again doesn't sound permanent.”
Ezrati of HP defended the company’s use of the APB 23 exception. “HP does not operate in a vacuum,” he said. “Ernst & Young, one of the Big Four accounting firms, is HP’s independent auditor and conducts extensive reviews of HP’s compliance with accounting principles such as APB 23,” he said in his prepared testimony. “E&Y also provides advice on how HP complies with its tax obligations. The IRS continuously and extensively audits HP’s U.S. tax return. In addition, the SEC reviews all of HP’s public financial reporting, including its compliance with APB 23. The financial community that analyzes companies such as HP expertly review and report to the public on issues such as HP’s compliance with APB 23, the amount of tax HP pays, and compares HP with peer companies.”
Ernst & Young Testifies
Beth Carr, an international tax services partner at Ernst & Young, defended the firm’s handling of its client HP. She noted that the firm had provided approximately 150,000 pages of documents to Congress and she and her staff had made themselves available for many hours of discussions with congressional staff.
“Our primary role and responsibility as the independent auditor of HP’s financial statements is to provide our services within the established, current legal and regulatory framework, and to evaluate HP’s activity for consistency with applicable accounting rules,” she noted. “As
the independent auditor, we provide reasonable assurance to the users of HP’s financial statements that those statements, taken as a whole, have been prepared on a basis consistent with generally accepted accounting principles (U.S. GAAP) and are free from material misstatement. Included in this responsibility is the testing, with independence, skepticism, and objectivity, of various assertions of HP to conclude, in the context of HP’s financial statements taken as a whole, whether HP has properly accounted for its foreign earnings under APB 23, among other accounting rules, and its income tax liabilities under Section 956 of the IRC.”
She noted that Ernst & Young has served as HP’s independent auditor since 2000. “At the completion of each of our audits, Ernst & Young has concluded that HP’s financial statements fairly presented its financial position and results of operations under U.S. GAAP,” said Carr in prepared testimony. “Our opinions, issued annually on those financial statements, state our conclusions, and Ernst & Young stands firmly behind the audit opinions that it has issued for HP.”
Carr also highlighted how the APB 23 exception had evolved. “The concept of indefinitely reinvested foreign earnings was established in the early 1970s with APB 23 and presently is codified in Accounting Standards Codification (ASC) 740,” she said. “To understand APB 23, it is necessary also to understand some basic tax accounting concepts. The recognition (in terms of timing and amounts) of income, losses, assets, and liabilities is not always consistent between the accounting rules under U.S. GAAP and the relevant tax laws. For example, U.S. tax rules may permit an asset to be depreciated (and tax deductions generated) on an accelerated basis, whereas U.S. GAAP requires the asset to be depreciated over its estimated useful life. This results in a difference between the book (or accounting) and tax bases of this asset during its life. Accounting for income taxes requires that most differences in the accounting and tax bases of assets and liabilities be measured and recognized for accounting purposes. This method of accounting for income taxes is commonly referred to as the ‘asset and liability approach.’ In the example above, a company will report larger deductions on its tax return than the expense recognized on its financial statements in the early years of the asset’s life, followed by larger expenses on its financial statements than deductions on its tax return as the asset ages. In the early years of the accounting for the asset, the benefit of this accelerated depreciation is reflected as a deferred tax liability under the asset and liability approach.”
Carr noted that for financial reporting purposes, foreign earnings create a book and tax basis difference in a company’s investment in a CFC. Foreign earnings are recognized when earned for book purposes. “However, for tax purposes, such earnings generally are not recognized until they are brought into the United States in the form of a dividend or deemed dividend (often referred to as a repatriation of the earnings),” she added. “As a result, a company generally records a future or deferred tax liability for those foreign earnings. APB 23 contains a presumption that all foreign earnings of CFCs will ultimately be remitted to the U.S. parent through a taxable repatriation. But under this rule, there is an exception to providing for deferred taxes attributable to foreign earnings if a company has both the “intent” and “ability” to indefinitely reinvest the foreign earnings and not to bring such earnings into the United States through a dividend or deemed dividend.”
With respect to HP, as disclosed in its financial statements for the year ended Oct. 31,
2011, the company recognized an $8.2 billion liability related to approximately $25 billion of unremitted earnings of certain CFCs that HP expects to repatriate to the United States, Carr testified. “HP has also disclosed that it intends indefinitely to reinvest outside of the United States approximately $29.1 billion of foreign earnings,” she said. “Accordingly, no deferred tax liability has been accrued with respect to such earnings. The indefinite reinvestment assertion must be both affirmative and continuing in nature. In other words, the APB 23 assertion requires that a company continuously assert that the foreign earnings are indefinitely reinvested. If at any point the U.S. multinational is no longer prepared to make and support that assertion, the presumption under the standard (that such earnings will be remitted to the U.S. parent via a dividend or deemed dividend) would apply. At that point, the foreign earnings would no longer be eligible for the APB 23 exception, and the company would be required to establish a deferred tax liability on the foreign earnings in the current period. Irrespective of the financial statement assertion and the establishment of a deferred tax liability, no U.S. taxes are due and payable unless and until the foreign earnings are repatriated to the United States through a dividend or deemed dividend.”
FASB and IRS Weigh In
Susan Cosper, technical director of the Financial Accounting Standards Board, also testified about the accounting treatment. “U.S. GAAP generally requires an entity to recognize current and deferred income taxes attributable to the earnings of a foreign subsidiary,” she said. “In certain circumstances, the earnings of a foreign subsidiary are taxable in the respective foreign jurisdiction, but the earnings are not taxable in the United States unless the earnings are repatriated to the United States. In this circumstance, U.S. GAAP requires the income taxes payable to the foreign jurisdiction to be recognized in the entity’s financial statements in the period the earnings are generated.
“It is important to note that there is a presumption in U.S. GAAP that deferred U.S. income taxes should be recognized in the financial statements in the same period in which the earnings are generated because U.S. GAAP presumes that the foreign earnings will be remitted to the U.S.-based parent company in order to distribute the earnings to shareholders,” Cosper added. “The presumption may be overcome if the entity has sufficient evidence that the foreign entity has invested or will invest the earnings in the foreign jurisdiction or if the earnings will be remitted in a tax-free liquidation.”
IRS chief counsel William J. Wilkins testified alongside IRS deputy commissioner Michael Danilack, who oversees the IRS’s Large Business and International Division. Wilkins discussed Section 482 of the Internal Revenue Code. “Loosely speaking, pursuant to Section 482 and the regulations there under, taxpayers are expected to report the results of transactions between related parties as if those transactions had occurred at arm’s length,” he said. “Thus, when a U.S. corporation sells an asset to an offshore affiliate, or licenses use of an asset to an offshore affiliate, the taxpayer is required to report a sales price, or a royalty rate, based on the price or royalty that would be expected if the transaction had occurred between the U.S. corporation and an unrelated party. A basic tenet under the Section 482 regulations, and under international transfer pricing standards, is that the determination of whether the pricing of a transaction between affiliates reflects an appropriate arm’s length result is in most cases evaluated by comparing the results of the transaction as reported by the taxpayer to the results realized by unrelated taxpayers engaged in comparable transactions under comparable circumstances.
“Applying Section 482 to establish an appropriate arm’s length price using comparable uncontrolled transactions is relatively straightforward for the vast majority of cross-border transactions, which typically involve transfers of common goods or services,” Wilkins added. “But enforcement difficulties arise in situations in which a U.S. company shifts to an offshore affiliate the rights to intangible property that is core to its business. In fact, over the course of the past decade, applying Section 482 in such circumstances has been the IRS’s most significant international enforcement challenge.”
Jack Ciesielski, president of R.G. Associates Inc. and publisher of the Analyst’s Accounting Observer, explained the problems with the APB 23 exception. “It erodes and undermines the meaning of net income as understood by investors,” he said in prepared testimony. It provides a powerful, flexible tool for managers to shape their earnings forecasts without real changes
in underlying economics, solely through changes of intention. That may lead to incentive problems.”
Ciesielski noted that the exception benefits relatively few firms: the ones with the most portable assets and the greatest global footprint. Of the $1.542 trillion of accumulated indefinitely reinvested earnings in the S&P 500, 72 percent of the amount belonged to only 50 companies, only 16 percent of the 318 firms with such balances. He added that there were 182 firms in the S&P 500 that showed no accumulated indefinitely reinvested earnings.
Elan Keller, a former tax director at the global financial bank Macquarie who recently joined the law firm Caplin & Drysdale, said in an interview with Accounting Today that what is being discussed in the Senate subcommittee hearing reflects a growing trend. “Corporations are using the tools that are legally available to them,” he said. “The U.S. corporate tax rate is among the highest in the world. Intellectual property and technology are allowing corporations to use effective and efficient tax planning. The onus is going to be on the government to stay ahead of the curve. The tax code will have to catch up and keep up with trends in IP and technology to shift profits back to the U.S.”