Final paper analysis and research findings

Policy Problem & Proposal

Policy Problem

The United States faces a $1.4 trillion national deficit, and partisan debate about how to address it is threatening economic stability on top of the shaky "recovery" from the 2009 financial crisis. Yet American corporations continue to enjoy tax loopholes that reduce their taxes to unprecedented low levels. Republicans argue that corporations must retain their preferred tax status in order to maintain and create jobs. This tax policy has been known by a number of names: supply-side economics, trickle-down theory, and horse and sparrow theory. It has not been without its critics, yet, irrationally, the practice of permitting tax loopholes continues to prevail from time-to-time.

"As for the growth enhancing effects of lower tax rates, just look to the 2000s for the latest persuasive evidence to the contrary. After the Bush tax cuts on the progressive rates paid by the wealthy, GDP between 2001 and 2007 grew more slowly than over any other trough-to-peak economic period in post-World War II history. Job growth was worse" (Madrick, 2011).

One mechanism for reducing taxes is known as income shifting, which utilizes strategies commonly known to tax lawyers as the "Double Irish" and the "Dutch Sandwich." For example, Google has been able to reduce its overseas tax rate to 2.4, which is the lowest tax rate of the top five (determined by market capitalization) U.S. technology corporations.

The Double Irish strategy uses Irish subsidiaries to shuttle profits in and out, such that any corporate earnings are placed in havens that do not levy corporate income taxes. These corporate tactics are based on transfer pricing in which paper transactions between corporate subsidiaries permit income to be allocated to a tax-favorable country while expenses are attributed to countries with higher taxes. An expert estimate by Kimberly A. Clausing, who is an economics professor at Reed College in Portland, Oregon, is that the U.S. government loses out on about $60 billion in tax revenue each year as a result of income shifting. During the Reagan administration, the marginal tax rate for the highest-income tax bracket was reduced from 70% to 28%. Typical of many Republicans, U.S. Representative Dave Camp of Michigan, who is the House Ways and Means Committee ranking Republican, claims that the 35% statutory U.S. tax rate is too high compared to foreign countries -- thus tacit approval is given to the loopholes that, in effect, undermine the U.S. income tax rate.

According to filings made with the Securities and Exchange Commission (SEC), in 2006 -- after three years of negotiations -- the IRS approved the transfer pricing arrangement for Google in what is referred to as an Advanced Pricing Agreement (APA), a program that began in 2003, but that is essentially a secret pact. The IRS official language around APA is as follows:

"The Advance Pricing Agreement (APA) Program is designed to resolve actual or potential transfer pricing disputes in a principled, cooperative manner, as an alternative to the traditional adversarial process. An APA is a binding contract between the IRS and a taxpayer by which the IRS agrees not to seek a transfer pricing adjustment for a covered transaction if the taxpayer files its tax return for a covered year consistent with the agreed transfer pricing method" ("IRS," 2010).

Proponents of APA and members of the APA negotiating teams argue for relative autonomy of the Advance Pricing Agreement Program and suggest that evaluation of APA requests should be based in large part on conformity with sound tax administration. Any suggestion that a reviewing Congressional Committee should have limited visibility into APA processes and decisions is met with staunch resistance. Fees are charged when APA requests are filed: $35,000 for a new request, $25,000 for a renewal, $10,000 for an amendment, and $22,500 for a small business.

Literature Review

The Internal Revenue Code (IRC) § 482 provides that the Secretary of the Treasury may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among two or more commonly controlled businesses if necessary to reflect clearly the income of such businesses" ("Announcement and Report," 2011). The standard applied under § 482 regulations is that of "a business dealing at arm's length with an unrelated business" ("Announcement and Report," 2011). The arm's length standard has also adopted and written into the transfer pricing guidelines issued by The Organization for Economic Cooperation and Development (OECD) ("Announcement and Report," 2011). The APA process facilitates agreement between the IRS and foreign tax administration agencies with regard to appropriate pricing for transferring goods and services across international borders between business entities.

The IRS has identified transfer pricing as the "largest issue" in audits of multinational corporations. The Advance Pricing Agreement was designed to function "in a principled, cooperative manner" as an alternate dispute resolution mechanism and the traditional IRS examination process. In essence, an APA is a binding contract between a taxpayer and the IRS, that permits the taxpayer to avoid a transfer pricing adjustment under IRC § 482 for a covered transaction ("Announcement and Report," 2011). The condition on which this agreement hinges is that the taxpayer must file its covered year tax return -- and annual APA renewal requests -- consistent with the agreed transfer pricing method (TPM) ("Announcement and Report," 2011). Together, various taxpayers and the IRS worked to execute 69 APAs and 9 amended APAs in 2010 ("Announcement and Report," 2011). The tax revenue opportunity cost for these APA completions and renewals is astronomical,

In 1999, Congress enacted legislation (House Resolution No. 10 6-238-1999) to protect the confidentiality of APAs as tax return information. The House Ways and Means Committee report issued at the time of the resolution argued that the "continued confidentiality of [APAs] is vital to the APA program. Otherwise the Committee believes that some taxpayers may refuse to participate in this successful program" ("Announcement and Report," 2011).

Training materials used to prepare APA teams to review and complete the agreements suggest that the best method is determine the "location savings" and answer the question, "Do lower costs of producing in foreign locations result in higher profits?" If the answer is yes, the next question is "Who is entitled to the profits?" The training materials further suggest that the taxpayer's argument is that the profits should accrue to the foreign subsidiary in the low cost jurisdiction. The following assumptions apply: (a) The costs are lower; (b) Cost savings result in higher profits; and (c) Higher profits should accrue to foreign subsidiaries [in which applicable taxes are lower]. In addition, the APA agreements protect taxpayers from having to pay taxes to both domestic and foreign taxing bodies -- taxpayers can avoid "double-dipping." Not only do the taxpayers frequently enjoy significantly lower tax rates, but they experience substantively lower costs of doing business. Not surprisingly, the Tax Executives Institute testified before the Internal Revenue Service at the 2005 public hearings on the Advance Pricing Agreement Program that,

"Taxpayers enter into the program not because it gives them a 'better deal' on transfer pricing issues -- TEI members generally do not believe they have reduced U.S. taxes as a result of their APAs -- but because the APA provides a mechanism by which taxpayers can obtain more quickly the business certainty they need to operate effectively and efficiently on a global scale" (Zelisko, 2005, pp. 2-3).

Each quarter of a fiscal year, a summary report is issued from the Office of the Chief Counsel of the Department of Treasury of the Internal Revenue Service. The report provides a number count of APA in each of the following categories: APAs Completed (bilateral and unilateral matters); Negotiating-Position Papers (bilateral completions); Annual Reports (reviewed and completed); New Matters (bilateral, unilateral, and withdrawals); APA Inventory (bilateral and unilateral open matters). A summary APA issuance report and open inventory report, consisting of only number counts) is attached to the quarterly report. Notably, names of corporations, countries involved in the agreements, fees charged and received, and estimated tax opportunity cost are not included -- or even mentioned -- in the quarterly reports.

The Senate Finance Committee completed an inquiry into the APA Program and came forward with recommendations for modifications. The Committee recommends that the IRS associate a dollar amount with each controlled intercompany transaction that is covered by an APA, and compare bottom-line results across the prices and terms of prior years. The Committee also suggests that the Joint Committee on Taxation review and sign off on all APA transactions that are receiving a rollback, are likely to exceed a particular dollar-value range, or that were referred by the IRS field or technical staff. The overall goal of the changes appears to be a speeding up and streamlining of the APA process, such that there is quick resolution of a case or withdrawal from the APA program.

In March 2005, the Commissioner of the IRS Large and Midsize Business (LMSB) Division conveyed via memorandum that all IRS APA agents must request transfer pricing documentation from taxpayers on a consistent basis. The memo further instructed IRS APA agents to not make a determination on transfer pricing issues before documentation had been requested [and, ostensibly, considered]. The memo was triggered by the results of a survey conducted by Treasury Inspector General for Tax Administration that found documentation had not been requested by auditors in nearly one-half of the cases audited. And further, taxpayers were submitting pro forma annual reports.

APA program expansion and costs. From 2009 to 2010, the total number of hours spent by APA professional staff increased by approximately 14.5%. APA hours for attorneys, economists, and paralegal staff by year (excluding holiday and leave) consumed over the last nine years is as follows:

2002 = 61,528

2003 = 52,495

2004 = 51,170

2005 = 51,744

2006 = 54,970

2007 = 56,410

2008 = 51,077

2009 = 56,549

2010 = 64,763

These figures illustrate that efforts to reduce the costs of the APA program were of limited effectiveness, and they crept up again in 2010 to a point exceeding the first year of implementation which was characterized by start-up costs. Even with a reduction of four staff in 2010, the costs continued to climb to a new height.

The APA office structure includes four branches, two of which are staffed with APA team leaders, one branch is staffed with economists in Washington, D.C., and the West Coast branch, which is headquartered in San Francisco and has an additional office in Laguna Niguel, California, is staffed with both economists and team leaders. In addition to staff hours, then, there is the overhead cost of maintaining these branch offices.

A gross and casual calculation of the filing fee income to the Internal Revenue Service for fiscal year 2010, at its most generous -- assuming no completions or renewals of APA were small businesses, which generate a smaller fee -- comes to $2,605,000. Recall that the fees are $35,000 for a new request, $25,000 for a renewal, $10,000 for an amendment, and $22,500 for a small business. For the 69 new APA requests completed, $2,515,000 was paid in fees. The 9 amendments generated $90,000. The Advance Price Agreement doesn't pencil.

Problem Definition. As one APA team member argued, "The APA Program works for both the IRS and tax community" ("Baker & MacKenzie, LLP," n.d.). Oversight of the APA process is negligible to non-existence, yet the economic stakes for the nation as substantive. The cost of conducting the APA program creeps up year-after-year -- those costs are borne by taxpayers who do not file APA requests and do not benefit from the APA program. If a legitimate process does occur, not all requests for APA would be approved. Further, given the heavy front-loaded costs to taxpayers to file an APA, a chilling effect may occur that dissuades APA team members from denying APA requests. The benefits of the APA program are considerable -- for corporate America (referred to as "the taxpayer") and for the IRS. The filing fees are minor compared to the foreign tax savings and business profits to be made through outsourcing. However, the penalties to non-APA taxpayers are staggering. Outsourcing reduces available domestic jobs for U.S. citizens, opportunity costs for lost tax revenue are huge, and the trickle-down, supply-side economics -- Keynesian economics touted as the redeeming fiscal policy has yet to improve the domestic financial situation. Precipitous changes in the measures of national economic health indicate that the tax cuts of the Bush administration produced drastic and steady deterioration in overall real GDP. The table above shows on a year-by-year basis the dynamics of the decade beginning in 2001. It seems one of the few fiscal numbers that has increased in this dominant downward trend is the number of millionaires in the U.S. And across the globe. The total number of millionaires in the U.S. is expected to more than double, reaching 20.6 million (Strachan, 2011). These households are projected to see a 223% increase in wealth by the end of the decade, bringing that number to about $87 trillion (Strachan, 2011). In 2010, the U.S. share of millionaire wealth dropped to 42% from 55% (Strachan, 2011). Millionaire wealth in emerging economies is expected to grow by about 260%, and in developed countries, the growth is forecast to rise about 107% (Strachan, 2011). Clearly a number of vectors have coalesced to create an unhealthy economic situation in the Unites States. Continuing to subsidize what amounts to a tax relief program for large corporations with deep-pockets means continuing to misalign policy with policy needs.

Proposed policy change. The proposed policy change is as follows: Advanced Pricing Agreements should result in taxation specific to the request for an APA -- whether it is a new request, a renewal, or an amendment -- and that tax should reflect a percentage of the gain and/or savings accomplished or anticipated as a result of transfer pricing agreement. Further, the policy will have the following components: (a) Provisions that do not allow income shifting, wherein in-paper-only corporate subsidiaries cause income to be attributed to tax-favorable environments while expenses are allocated to countries with higher taxation. (b) Transparency in reporting that enables the public to review the estimated corporate tax savings / opportunity cost tax revenue lost associated with established APA agreements. (c) Adjustment of function of the APA that better reflects the role of the Internal Revenue Service as an entity created to generate revenue for the government of the United States -- based on appropriate tax laws -- and not to provide inherent supports to companies that result in gains in corporate profits.

Agenda setting. In an effort to bring about this policy that alters the function and use of the APA, the following strategies will be used: Public education in conjunction with media and communication, convening stakeholders and building coalitions. The effort to get this policy on the docket could take place during an election year when all the associated issues are already being discussed on every stump, porch, and town hall (Kingdon, 1984).

Policy adoption. During this stage in the policy lifecycle, policymakers and staffers discuss and consider options related to the policy, and ascertain whether new or amended existing policy is the best route. The strategies that may be used by policymakers and their constituents include advocacy about the issue and regulations, community organizing, and the creation of public and private partnerships. Policy makers must be able to agree that there is not an efficient frontier for policymaking wherein all the policy makers will have perfect and complete information with which to formulate policy (Wildavsky, 1979). It is essential that policy makers communicate that there is no perfect solution -- no silver bullet, no magic potion -- that can be offered up for timely utility in the policymaking stream. The case for speaking truth to power with regard to this policy problem and potential policy solution is both strong and necessary. The stakeholders who benefit from the current APA policy have every reason to maintain the status quo, and every reason to promote policy slippage.