EFTA01075338.pdf

MEMORANDUM TO: Members of the Permanent Subcommittee on Investigations FROM: Senator Carl Levin, Chairman Senator John McCain, Ranking Minority Member Permanent Subcommittee on Investigations DATE: May 21, 2013 RE: Offshore Profit Shifting and the U.S. Tax Code - Part 2 (Apple Inc.) I. EXECUTIVE SUMMARY 2 A. Subcommittee Investigation 2 B. Findings and Recommendations 5 Findings: 1. Shifting Profits Offshore 5 2. Offshore Entities With No Declared Tax Jurisdiction 5 3. Cost Sharing Agreement 5 4. Circumventing Subpart F 5 Recommendations: 1. Strengthen Section 482 6 2. Reform Check-the-Box and Look Through Rules 6 3. Tax CFCs Under U.S. Management and Control 6 4. Properly Enforce Same Country Exception 6 5. Properly Enforce the Manufacturing Exception 6 II. OVERVIEW OF TAX PRINCIPLES AND LAW 7 A. U.S. Worldwide Tax and Deferral 7 B. Transfer Pricing 7 C. Transfer Pricing and the Use of Shell Corporations 9 D. Piercing the Veil — Instrumentality of the Parent 10 E. Subpart F To Prevent Tax Haven Abuse F. Subpart F To Tax Current Income 12 G. Check-the-Box Regulations and Look Through Rule 13 H. Foreign Personal Holding Company Income — Same Country Exception 15 I. Foreign Base Company Sales Income — Manufacturing Exception 15 III. APPLE CASE STUDY 17 A. Overview 17 B. Apple Background 17 1. General Information 17 2. Apple History 18 C. Using Offshore Affiliates to Avoid U.S. Taxes 19 1. Benefiting From a Minimal Tax Rate 20 2. Avoiding Taxes By Not Declaring A Tax Residency 21 3. Helping Apple Inc. Avoid U.S. Taxes Via A Cost Sharing Agreement 25 D. Using U.S. Tax Loopholes to Avoid U.S. Taxes on Offshore Income 31 1. Foreign Base Company Sales Income: Avoiding Taxation Of Taxable Offshore Income 33 2. Using Check-the-Box to Make Transactions Disappear 35 3. Using Check-the-Box to Convert Passive Income to Active Income 36 4. Other Tax Loopholes 36 E. Apple's Effective Tax Rate 37 EXHIBIT #12 EFTA01075338  2 I. EXECUTIVE SUMMARY On May 21, 2013, the Permanent Subcommittee on Investigations (PSI) of the U.S. Senate Homeland Security and Government Affairs Committee will hold a hearing that is a continuation of a series of reviews conducted by the Subcommittee on how individual and corporate taxpayers are shifting billions of dollars offshore to avoid U.S. taxes. The hearing will examine how Apple Inc., a U.S. multinational corporation, has used a variety of offshore structures, arrangements, and transactions to shift billions of dollars in profits away from the United States and into Ireland, where Apple has negotiated a special corporate tax rate of less than two percent. One of Apple's more unusual tactics has been to establish and direct substantial funds to offshore entities in Ireland, while claiming they are not tax residents of any jurisdiction. For example, Apple Inc. established an offshore subsidiary, Apple Operations International, which from 2009 to 2012 reported net income of $30 billion, but declined to declare any tax residence, filed no corporate income tax return, and paid no corporate income taxes to any national government for five years. A second Irish affiliate, Apple Sales International, received $74 billion in sales income over four years, but due in part to its alleged status as a non-tax resident, paid taxes on only a tiny fraction of that income. In addition, the hearing will examine how Apple Inc. transferred the economic rights to its intellectual property through a cost sharing agreement with its own offshore affiliates, and was thereby able to shift tens of billions of dollars offshore to a low tax jurisdiction and avoid U.S. tax. Apple Inc. then utilized U.S. tax loopholes, including the so-called "check-the-box" rules, to avoid U.S. taxes on $44 billion in taxable offshore income over the past four years, or about $10 billion in tax avoidance per year. The hearing will also examine some of the weaknesses and loopholes in certain U.S. tax code provisions, including transfer pricing, Subpart F, and related regulations, that enable multinational corporations to avoid U.S. taxes. A. Subcommittee Investigation For a number of years, the Subcommittee has reviewed how U.S. citizens and multinational corporations have exploited and, at times, abused or violated U.S. tax statutes, regulations and accounting rules to shift profits and valuable assets offshore to avoid U.S. taxes. The Subcommittee inquiries have resulted in a series of hearings and reports.' The Subcommittee's recent reviews have focused on how multinational corporations have employed various complex structures and transactions to exploit taxloopholes to shift large portions of their profits offshore and dodge U.S. taxes. See, e.g., U.S. Senate Permanent Subcommittee on Investigations, "Fishtail, Bacchus, Sundance, and Slapshot: Four Enron Transactions Funded and Facilitated by U.S. Financial Institutions," S.Prt. 107-82 (Jan. 2, 2003); "U.S. Tax Shelter Industry: The Role of Accountants, Lawyers, and Financial Professionals," S.Hrg. 108-473 (No. 18 and 20, 2003); "Tax Haven Abuses: The Enablers, The Tools and Secrecy," S.Hrg 109-797 (Aug. 1, 2006); 'Tax Haven Banks and U.S. Tax Compliance," S.Hrg. 110-614 (July 17 and 25, 2008); "Tax Haven Banks and U.S. Tax Compliance: Obtaining the Names of U.S. Clients with Swiss Accounts," S.Hrg. 111.30 (Mar. 4, 2009); "Repatriating Offshore Funds: 2004 Tax Windfall for Select Multinationals," S.Prt. 112.27 (Oct. 11, 2011); and "Offshore Profit Shifting and the U.S. Tax Code — Part 1 (Microsoft and Hewlett-Packard)," S.Hrg.112-*** (Sept. 20, 2012). EFTA01075339  3 At the same time as the U.S. federal debt has continued to grow — now surpassing $16 trillion — the U.S. corporate tax base has continued to decline, placing a greater burden on individual taxpayers and future generations. According to a report prepared for Congress: "At its post-WWII peak in 1952, the corporate tax generated 32.1% of all federal tax revenue. In that same year the individual tax accounted for 42.2% of federal revenue, and the payroll tax accounted for 9.7% of revenue. Today, the corporate tax accounts for 8.9% of federal tax revenue, whereas the individual and payroll taxes generate 41.5% and 40.0%, respectively, of federal revenue.s2 Over the past several years, the amount of permanently reinvested foreign earnings reported by U.S. multinationals on their financial statements has increased dramatically. One study has calculated that undistributed foreign earnings for companies in the S&P 500 have increased by more than 400%? According to recent analysis by Audit Analytics, over a five year period from 2008 to 2012, total untaxed indefinitely reinvested earnings reported in 10-K filings for firms comprising the Russell 3000 increased by 70.3%.° During the same period, the number of firms reporting indefinitely reinvested earnings increased by 11.4%. The increase in multinational corporate claims regarding permanently reinvested foreign earnings and the decline in corporate tax revenue are due in part to the shifting of mobile income offshore into tax havens. A number of studies show that multinational corporations are moving "mobile" income out of the United States into low or no tax jurisdictions, including tax havens such as Ireland, Bermuda, and the Cayman Islands.5 In one 2012 study, a leading expert in the Office of Tax Analysis of the U.S. Department of Treasury found that foreign profit margins, not foreign sales, are the cause for significant increases in profits abroad. He wrote: "The foreign share of the worldwide income of U.S. multinational corporations (MNCs) has risen sharply in recent years. Data from a panel of 754 large MNCs indicate that the MNC foreign income share increased by 14 percentage points from 1996 to 2004. The differential between a company's U.S. and foreign effective tax rates exerts a significant effect on the share of its income abroad, largely through changes in foreign and domestic profit margins rather than a shift in sales. U.S.-foreign tax differentials are estimated to have raised the foreign share of MNC worldwide income by about 12 percentage points by 2004. Lower foreign effective tax rates had no significant effect on a company's domestic sales or on the growth of its worldwide pre-tax profits. Lower taxes on foreign income do not seem to promote `competitiveness.'"6 2 12/8/201 ("Reasons for the Decline in the Corporate Tax Revenues" Congressional Research Service, Mark P. Keightley, at.1. See also 4/2011—Tax Havens and Treasure Hunts," Today's Economist, Nancy Folbre. 3 4/26/2011 "Parking Earnings Overseas," Zion, Varsheny, Bumap: Credit Suisse, at 3. 5/1/2013 Audit Analytics, "Foreign Indefinitely Reinvested Earnings: Balances Held by the Russell 3000." s See, e.g., 6/5/2010 —Tax Havens: International Tax Avoidance and Evasion," Congressional Research Service, Jane Gravelle, at 15 (citing multiple studies). 6 2/2012 "Foreign Taxes and the Growing Share of U.S. Multinational Company Income Abroad: Profits, Not Sales, are Being Globalized," Office of Tax Analysis Working Paper 103, U.S. Department of Treasury, Harry Gruber', at EFTA01075340  4 One study showed that foreign profits of controlled foreign corporations (CFCs) of U.S. multinationals significantly outpace the total GDP of some tax havens.s7 For example, profits of CFCs in Bermuda were 645% and in the Cayman Islands were 546% as a percentage of GDP, respectively. In a recent research report, JPMorgan expressed the opinion that the transfer pricing of intellectual property "explains some of the phenomenon as to why the balances of foreign cash and foreign earnings at multinational companies continue to grow at such impressive rates." 8 On September 20, 2012, the Subcommittee held a hearing and examined some of the weaknesses and loopholes in certain tax and accounting rules that facilitated profit shifting by multinational corporations. Specifically, it reviewed transfer pricing, deferral, and Subpart F of the Internal Revenue Code, with related regulations, and accounting standards governing offshore profits and the reporting of tax liabilities. The Subcommittee presented two case studies: (1) a study of structures and practices employed by Microsoft Corporation to shift and keep profits offshore; and (2) a study of Hewlett-Packard's "staggered foreign loan program," which was devised to de facto repatriate offshore profits to the United States to help run its U.S. operations, without paying U.S. taxes. The case study for the Subcommittee's May 2013 hearing involves Apple Inc. Building upon information collected in previous inquiries, the Subcommittee reviewed Apple responses to several Subcommittee surveys, reviewed Apple SEC filings and other documents, requested information from Apple, and interviewed a number of corporate representatives from Apple. The Subcommittee also consulted with a number of tax experts and the IRS. This memorandum first provides an overview of certain tax provisions related to offshore income, such as transfer pricing, Subpart F, and the so-called check-the-box regulations and look-through rule. It then presents a case study of Apple's organizational structure and the provisions of the tax code and regulations it uses to shift and keep billions in profits offshore in two controlled foreign corporations formed in Ireland. The first is Apple Sales International (ASI), an entity that has acquired certain economic rights to Apple's intellectual property. Apple Inc. has used those rights of ASI to shift billions in profits away from the United States to Ireland, where it pays a corporate tax rate of 2% or less. The second is Apple Operations International (AOI), a 30-year old corporation that has no employees or physical presence, and whose operations are managed and controlled out of the United States. Despite receiving $30 billion in earnings and profits during the period 2009 through 2011 as the key holding company for Apple's extensive offshore corporate structure, Apple Operations International has no declared tax residency anywhere in the world and, as a consequence, has not paid corporate income tax to any national government for the past 5 years. Apple has recently disclosed that ASI also claims to have no tax residency in any jurisdiction, despite receiving over a four year period from 2009 to 2012, sales income from Apple affiliates totaling $74 billion. 7 6/5/2010 —Tax Havens: International Tax Avoidance and Evasion," Congressional Research Service, Jane Gravelle, at 14. 8 5/16/2012 "Global Tax Rate Makers," JPMorgan Chase, at 2 (based on research of SEC filings of over 1,000 reporting issuers). EFTA01075341  5 Apple is an American success story. Today, Apple Inc. maintains more than $102 billion in offshore cash, cash equivalents and marketable securities (cash).9 Apple executives told the Subcommittee that the company has no intention of returning those funds to the United States unless and until there is a more favorable environment, emphasizing a lower corporate tax rate and a simplified tax code.10 Recently, Apple issued $17 billion in debt instruments to provide funds for its U.S. operations rather than bring its offshore cash home, pay the tax owed, and use those funds to invest in its operations or return dividends to its stockholders. The Subcommittee's investigation shows that Apple has structured organizations and business operations to avoid U.S. taxes and reduce the contribution it makes to the U.S. treasury. Its actions disadvantage Apple's domestic competitors, force other taxpayers to shoulder the tax burden Apple has cast off, and undermine the fairness of the U.S. tax code. The purpose of the Subcommittee's investigation is to describe Apple's offshore tax activities and offer recommendations to close the offshore tax loopholes that enable some U.S. multinational corporations to avoid paying their share of taxes. B. Findings and Recommendations Findings. The Subcommittee's investigation has produced the following findings of fact. 1. Shifting Profits Offshore. Apple has $145 billion in cash, cash equivalents and marketable securities, of which $102 billion is "offshore." Apple has used offshore entities, arrangements, and transactions to transfer its assets and profits offshore and minimize its corporate tax liabilities. 2. Offshore Entities With No Declared Tax Jurisdiction. Apple has established and directed tens of billions of dollars to at least two Irish affiliates, while claiming neither is a tax resident of any jurisdiction, including its primary offshore holding company, Apple Operations International (AOI), and its primary intellectual property rights recipient, Apple Sales International (ASI). AOI, which has no employees, has no physical presence, is managed and controlled in the United States, and received $30 billion of income between 2009 and 2012, has paid no corporate income tax to any national government for the past five years. 3. Cost Sharing Agreement. Apple's cost sharing agreement (CSA) with its offshore affiliates in Ireland is primarily a conduit for shifting billions of dollars in income from the United States to a low tax jurisdiction. From 2009 to 2012, the CSA facilitated the shift of $74 billion in worldwide sales income away from the United States to Ireland where Apple has negotiated a tax rate of less than 2%. 4. Circumventing Subpart F. The intent of Subpart F of the U.S. tax code is to prevent multinational corporations from shifting profits to tax havens to avoid U.S. tax. Apple has exploited weaknesses and loopholes in U.S. tax laws and regulations, particularly the "check-the-box" and "look-through" rules, to circumvent Subpart F 9 4/23/2013 Apple Second Quarter Earnings Call, Fiscal Year 2013, http://www.nasdaq.comfaspx/call- transcript.aspx?Storyld=13640418cTitle=apple-s-ceo-discusses-12q13-results-earnings-call-transcript. 1° Subcommittee interview of Apple Chief Executive Officer Tim Cook (4/29/2013). EFTA01075342  6 taxation and, from 2009 to 2012, avoid $44 billion in taxes on otherwise taxable offshore income. Recommendations. Based upon the Subcommittee's investigation, the Memorandum makes the following recommendations. 1. Strengthen Section 482. Strengthen Section 482 of the tax code governing transfer pricing to eliminate incentives for U.S. multinational corporations to transfer intellectual property to shell entities that perform minimal operations in tax haven or low tax jurisdictions by implementing more restrictive transfer pricing rules concerning intellectual property. 2. Reform Check-the-Box and Look Through Rules. Reform the "check-the-box" and "look-through" rules so that they do not undermine the intent of Subpart F of the Internal Revenue Code to currently tax certain offshore income. 3. Tax CFCs Under U.S. Management and Control. Use the current authority of the IRS to disregard sham entities and impose current U.S. tax on income earned by any controlled foreign corporation that is managed and controlled in the United States. 4. Properly Enforce Same Country Exception. Use the current authority of the IRS to restrict the "same country exception" so that the exception to Subpart F cannot be used to shield from taxation passive income shifted between two related entities which are incorporated in the same country, but claim to be in different tax residences without a legitimate business reason. 5. Properly Enforce the Manufacturing Exception. Use the current authority of the IRS to restrict the "manufacturing exception" so that the exception to Subpart F cannot be used to shield offshore income from taxation unless substantial manufacturing activities are taking place in the jurisdiction where the intermediary CFC is located. EFTA01075343  7 II. OVERVIEW OF TAX PRINCIPLES AND LAW A. U.S. Worldwide Tax and Deferral U.S. corporations are subject to a statutory tax rate of up to a 35% on all their income, including worldwide income, which on its face is a rate among the highest in the world. This statutory tax rate can be reduced, however, through a variety of mechanisms, including tax provisions that permit multinational corporations to defer U.S. tax on active business earnings of their CFCs until those earnings are brought back to the United States, i.e., repatriated as a dividend. The ability of a U.S. firm to earn foreign income through a CFC without US tax until the CFC's earnings are paid as a dividend is known as "deferral." Deferral creates incentives for U.S. firms to shift U.S. earnings offshore to low tax or no tax jurisdictions to avoid U.S. taxes and increase their after tax profits. In other words, tax haven deferral is done for tax avoidance " purposes. U.S. multinational corporations shift large amounts of income to low-tax foreign jurisdictions, according to a 2010 report by the Joint Committee on Taxation.12 Current estimates indicate that U.S. multinationals have more than $1.7 trillion in undistributed foreign is earnings and keep at least 60% of their cash overseas. In many instances, the shifted income is deposited in the names of CFCs in accounts in U.S. banks." In 2012, President Barack Obama reiterated concerns about such profit shifting by U.S multinationals and called for this problem to be addressed through tax reform.15 B. Transfer Pricing A major method used by multinationals to shift profits from high-tax to low-tax jurisdictions is through the pricing of certain intellectual property rights, goods and services sold between affiliates. This concept is known as "transfer pricing." Principles regarding transfer pricing are codified under Section 482 of the Internal Revenue Code and largely build upon the principle of arms length dealings. IRS regulations provide various economic methods that can be used to test the arm's length nature of transfers between related parties. There are several ways in which assets or services are transferred between a U.S. parent and an offshore affiliate entity: an outright sale of the asset; a licensing agreement where the economic rights are transferred to the affiliate in exchange for a licensing fee or royalty stream; a sale of services; or a cost sharing agreement, which is an agreement between related entities to share the cost of developing an intangible asset and a proportional share of the rights to the intellectual property See 12/2000 "The Deferral of Income Earned through U.S. Controlled Foreign Corporations," Office of Tax Policy, U.S. Department of Treasury, at 12. 12 7/20/2010 "Present Law and Background Related to Possible Income Shifting and Transfer Pricing," Joint Committee on Taxation, (JCX-37.10), at 7. 13 5/16/2012 "Global Tax Rate Makers," JP Morgan Chase, at 1; see also 4/26/I 1"Parking Earnings Overseas," Credit Suisse. 11 See, e.g., U.S. Senate Permanent Subcommittee on Investigations, "Repatriating Offshore Funds: 2004 Tax Windfall for Select Multinationals," S.Rpt. 112-27 (Oct. II, 201 ()(showing that of $538 billion in undistributed accumulated foreign earnings at the end of FY2010 at 20 U.S. multinational corporations, nearly half (46%) of the funds that the corporations had identified as offshore and for which U.S. taxes had been deferred, were actually in the United States at U.S. financial institutions). Is See 2/22/2012 "The President's Framework for Business Tax Reform," http://www.treasury.gov/resource- center/tax-policy/Documents/The-Presidents-Framework-for-Business-Tax-Reform-02-22-2012.pdf. EFTA01075344  8 that results. A cost sharing agreement typically includes a "buy-in" payment from the affiliate, which supposedly compensates the parent for transferring intangible assets to the affiliate and for incurring the initial costs and risks undertaken in initially developing or acquiring the intangible assets. The Joint Committee on Taxation has stated that a "principal tax policy concern is that profits may be artificially inflated in low-tax countries and depressed in high-tax countries through aggressive transfer pricing that does not reflect an arms-length result from a related- party transaction." I6 A study by the Congressional Research Service raises the same issue. "In the case of U.S. multinationals, one study suggested that about half the difference between profitability in low-tax and high-tax countries, which could arise from artificial income shifting, was due to transfers of intellectual property (or intangibles) and most of the rest through the allocation of debt." 17 A Treasury Department study conducted in 2007 found the potential for improper income shifting was "most acute with respect to cost sharing arrangements involving intangible assets."I9 Valuing intangible assets at the time they are transferred is complex, often because of the unique nature of the asset, which is frequently a new invention without comparable prices, making it hard to know what an unrelated third party would pay for a license. According to one recent study by JPMorgan Chase: "Many multinationals appear to be centralizing many of their valuable IP [intellectual property] assets in low-tax jurisdictions. The reality is that IP rights are easily transferred from jurisdiction to jurisdiction, and they are often inherently difficult to value." 19 The inherent difficulty in valuing such assets enables multinationals to artificially increase profits in low tax jurisdictions using aggressive transfer pricing practices. The Economist has described these aggressive transfer pricing tax strategies as a "big stick in the corporate treasurer's tax-avoidance annoury.a Certain tax experts, who had previously served in senior government tax positions, have described the valuation problems as insurmountable.21 Of various transfer pricing approaches, "licensing and cost-sharing are among the most popular and controversial."-2 The legal ownership is most often not transferred outside the United States, because of the protections offered by the U.S. legal system and the importance of protecting such rights in such a large market; instead, only the economic ownership of certain 16 7/20/2010 "Present Law and Background Related to Possible Income Shifting and Transfer Pricing," Joint Committee on Taxation, (JCX-37.10), at 5. 12 6/5/2010 "Tax Havens: International Tax Avoidance and Evasion," Congressional Research Service, Jane Gravelle, at 8 (citing 3/2003 "Intangible Income, Intercompany Transactions, Income Shifting and the Choice of Locations," National Tax Journal, vol. 56.2, Harry Grubert, at 221.42). 19 7/20/2010 "Present Law and Background Related to Possible Income Shifting and Transfer Pricing," Joint Committee on Taxation, (JCX-37.10), at 7 (citing November 2007 "Report to the Congress on Earnings Stripping, Transfer Pricing and U.S. Income Tax Treaties," U.S. Treasury Department). 16 5/16/2012 "Global Tax Rate Makers," JPMorgan Chase, at I. 202008 "An Introduction to Transfer Pricing," New School Economic Review, vol. 3.1, Alfredo J. Urquidi, at 28 (citing "Moving Pieces," The Economist, 2/22/2007). 21 3/20/2012 "IRS Forms `SWAT Team' for Tax Dodge Crackdown," Reuters, Patrick Temple-West. 22 5/16/2012 "Global Tax Rate Makers," JPMorgan Chase, at 20. EFTA01075345  9 specified rights to the property is transferred. Generally in a cost sharing agreement, a U.S. parent and one or more of its CFCs contribute funds and resources toward the joint development of a new product.23 The Joint Committee on Taxation has explained: "The arrangement provides that the U.S. company owns legal title to, and all U.S. marketing and production rights in, the developed property, and that the other party (or parties) owns rights to all marketing and production for the rest of the world. Reflecting the split economic ownership of the newly developed asset, no royalties are shared between cost sharing participants when the product is ultimately marketed and sold to customers."24 The tax rules governing cost sharing agreements are provided in Treasury Regulations that were issued in December 2011.25 These regulations were previously issued as temporary and proposed regulations in December 2008. The Treasury Department explained that cost sharing arrangements "have come under intense scrutiny by the IRS as a potential vehicle for improper transfer of taxable income associated with intangible assets.i26 The regulations provide detailed rules for evaluating the compensation received by each participant for its contribution to the agreement27 and tighten the rules to "ensure that the participant making the contribution of platform intangibles will be entitled to the lion's share of the expected returns from the arrangement, as well as the actual returns from the arrangement to the extent they materially exceed the expected returns.s28 Under these rules, related parties may enter into an arrangement under which the parties share the costs of developing one or more intangibles in proportion to each party's share of reasonably anticipated benefits from the cost shared intellectual asset! The regulations also provided for transitional grandfathering rules for cost sharing entered into prior to the 2008 temporary regulations. As a result of the changes in the regulations, multinational taxpayers have worked to preserve the grandfathered status of their cost sharing arrangements C. Transfer Pricing and the Use of Shell Corporations The Subcommittee's investigations, as well as government and academic studies, have shown that U.S. multinationals use transfer pricing to move the economic rights of intangible assets to CFCs in tax havens or low tax jurisdictions, while they attribute expenses to their U.S. operations, lowering their taxable income at home.30 Their ability to artificially shift income to a 23 7/20/2010 "Present Law and Background Related to Possible Income Shifting and Transfer Pricing," Joint Committee on Taxation, (JCX-37.10), at 21. 24 Id. 25 Treas. Reg. 31.482.7. 26 1/25/2012 "U.S. Department of Treasury issues final cost sharing regulations," International Tax News, Paul Flignor. " 7/20/2010 "Present Law and Background Related to Possible Income Shifting and Transfer Pricing," Joint Committee on Taxation, (JCX-37.10), at 25. 29 1/14/2009 "IRS Issues Temporary Cost Sharing Regulations Effective Immediately" International Alert, Miller Chevalier. 29 12/12/2012 "Final Section 482 Cost Sharing Regulations: A Renewed Commitment to the Income Method," Bloomberg BNA, Andrew P. Solomon. 1° U.S. Senate Permanent Subcommittee on Investigations, "Offshore Profit Shifting and the U.S. Tax Code — Part 1 (Microsoft and Hewlett-Packard)," S.Hrg. I 12.*** (Sept. 20, 2012). EFTA01075346  I0 tax haven provides multinationals with an unfair advantage over U.S. domestic corporations; it amounts to a subsidy for those multinationals. The recipient CFC in many cases is a shell entity that is created for the purpose of holding the rights. Shell companies are legal entities without any substantive existence - they have no employees, no physical presence, and produce no goods or services. Such shell companies are "ubiquitous in U.S international tax planning."3I Typically, multinationals set up a shell corporation to enable it to artificially shift income to shell subsidiaries in low tax or tax haven jurisdictions. According to a 2008 GAO study, "eighty-three of the 100 largest publicly traded U.S. corporations in terms of revenue reported having subsidiaries in jurisdictions list as tax havens or financial privacy jurisdictions....s3 Many of the largest U.S. multinationals use shell corporations to hold the economic rights to intellectual property and the profits generated from those rights in tax haven jurisdictions to avoid U.S. taxation.33 By doing this, multinational companies are shifting taxable U.S. income on paper to affiliated offshore shells. These strategies are causing the United States to lose billions of tax dollars annually. Moreover, from a broader prospective, multinationals are able to benefit from the tax rules which assume that different entities of a multinational, including shell corporations, act independently from one another. The reality today is that the entities of a parent multinational typically operate as one global enterprise following a global business plan directed by the U.S. parent. If that reality were recognized, rather than viewing the various affiliated entities as independent companies, they would not be able to benefit from creating fictitious entities in tax havens and shifting income to those entities. In fact, when Congress enacted Subpart F, discussed in detail below, more than fifty years ago in 1962, an express purpose of that law was to stop the deflection of multinational income to tax havens, an activity which is so prevalent today. D. Piercing the Veil — Instrumentality of the Parent It has long been understood that a shell corporation could be at risk of being disregarded for U.S. tax purposes "if one entity so controls the affairs of a subsidiary that it 'is merely an instrumentality of the parent.i34 Courts have applied the "piercing the corporate veil" doctrine, a common law concept, when determining whether to disregard the separateness of two related 31 Testimony of Professor Reuven S. Avi-Yonah, hearing before the U.S. Senate Committee on Finance, International Tax Issues, S.Hrg. 112-645 (9/8/2011). 32 12/4/2008 "Large U.S. Corporations and Federal Contractors with Subsidiaries in Jurisdictions Listed as Tax Havens or Financial Privacy Jurisdictions," U.S. Government Accountability Office, No. GAO.09.157, at 4. " See, e.g., 2/16/2013 "The price isn't right: Corporate profit-shifting has become big business," The Economist, Special Report. 34 2/2011 "Recent IRS determination Highlights Importance of Separation Among Affiliates," by George E. Constantine, at I, http://www.venable.com/recent-irs-determination-highlights-importance-of-separation-among- affiliates-02-24-201 I/ (originally published in February 201 I edition of Association Law and Policy, https://www.asaecenter.org/Resources/EnewsletterArticleDetail.cfm?ItemNumber=57654, (citing IRS Priv. Ltr. Rul. 2002.25.046 (Mar. 28, 2002), which cites Moline Properties v. Commissioner of Internal Revenue 319 U.S. 436, 438 (1943); Britt v. United States 431 F. 2d 227, 234 (5th Cir. 1970); and Krivo Indus. Supply Co. v. National Distillers and Chem. Corp. 483 F.2d 1098, 1106 (5th Cir. 1973)). EFTA01075347  11 entities for corporate and tax liabilities.35 It is a fact-specific analysis to determine whether the veil of a shell entity should be pierced for tax purposes. The courts over time have looked at such factors as: the financial support of the subsidiary's operations by the parent; the lack of substantial business contacts with anyone except the parent; and whether the property of the entity is used by each as if jointly owned.38 Despite the availability of this tool to "sham" a corporation and pierce the corporate veil for tax purposes, the IRS and the courts have been hesitant to take action against shell foreign corporations or attribute the activities or income of a CFC to its U.S. parent.3 E. Subpart F To Prevent Tax Haven Abuse As early as the 1960s, "administration policymakers became concerned that U.S. multinationals were shifting their operations and excess earnings offshore in response to the tax incentive provided by deferral.s38 At that time, circumstances were somewhat similar to the situation in the United States today. "The country faced a large deficit and the Administration was worried that U.S. economic growth was slowing relative to other industrialized countries."38 To help reduce the deficit, the Kennedy Administration proposed to tax the current foreign earnings of subsidiaries of multinationals and offered tax incentives to encourage investments at home. In the debates leading up to the passage of Subpart F, President Kennedy stated in an April 1961 tax message: "The undesirability of continuing deferral is underscored where deferral has served as a shelter for tax escape through the unjustifiable use of tax havens such as Switzerland. Recently more and more enterprises organized abroad by American firms have arranged their corporate structures aided by artificial arrangements between parent and subsidiary regarding intercompany pricing, the transfer of patent licensing rights, the shifting of management fees, and similar practices which maximize the accumulation of profits in the tax haven as to exploit the multiplicity of foreign tax systems and international 35 Id. See also, e.g., Moline Properties v. Commissioner of Internal Revenue, 319 U.S. 436, 439 (1943) (holding that, for income tax purposes, a taxpayer cannot ignore the form of the corporation that he creates for a valid business purpose or that subsequently carries on business, unless the corporation is a sham or acts as a mere agent). 36 Id. a Id. See also Perry Bass v. Commissioner 50 T.C. 595, 600 (1968) ("IA] taxpayer may adopt any form he desires for the conduct of his business, and ... the chosen form cannot be ignored merely because it results in a tax saving." However, the form the taxpayer chooses for conducting business that results in tax-avoidance "must be a viable business entity, that is, it must have been formed for a substantial business purpose or actually engage in substantive business activity.") 35 5/4/2006 "The Evolution of International Tax Policy- What Would Larry Say?" The Laurence Neal Woodworth Memorial Lecture in Federal Tax Law and Policy, Paul Oosterhuis, at 2, http:/Avww.taxanalysts.com/www/features.nsfiarticles/3193a0ff95196d378525726b006f4ad2?opendocument. a Id. 4" Id. (citing Ill 1/1962 "Annual Message to Congress on the State of the Union," President Kennedy 1 Pub. Papers, at 13.14). EFTA01075348  12 agreements in order to reduce sharply or eliminate completely their tax liabilities both at home and abroad."'" Although the Kennedy Administration initially proposed to end deferral of foreign source income altogether, a compromise was struck instead, which became known as Subpart F.42 Subpart F was enacted by Congress in 1962, and was designed in substantial part to address the tax avoidance techniques being utilized today by U.S. multinationals in tax havens. In fact, to curb tax haven abuses, Congress enacted anti-tax haven provisions, despite extensive opposition by the business community.43 F. Subpart F To Tax Current Income Subpart F explicitly restricts the types of income whose taxation may be deferred, and it is often referred to as an "anti-deferral" regime. The Subpart F rules are codified in tax code Sections 951 to 965, which apply to certain income of CFCs." When a CFC earns Subpart F income, the U.S. parent as shareholder is treated as having received the current income. Subpart F was enacted to deter U.S. taxpayers from using CFCs located in tax havens to accumulate earnings that could have been accumulated in the United States.43 "[S]ubpart F generally targets passive income and income that is split off from the activities that produced the value in the goods or services generating the income," according to the Treasury Department's Office of Tax Policy 46 In contrast, income that is generated by active, foreign business operations of a CFC continues to warrant deferral. But, again, deferral is not permitted for passive, inherently mobile income such as royalty, interest, or dividend income, as well as income resulting from certain other activities identified in Subpart F.47 Income reportable under Subpart F is currently subject to U.S. tax, regardless of whether the earnings have been repatriated. However, regulations, temporary statutory changes, and certain statutory exceptions have nearly completely undercut the intended application of Subpart F. 4I 1961 "President's Recommendations on Tax Revision: Hearings Before the House Ways and Means Committee," reprinted in Richard A. Gordon, Tax Havens and Their Use by United States Taxpayers — An Overview (2002), at 44. 42 5/4/2006 "The Evolution of International Tax Policy- What Would Larry Say?" The Laurence Neal Woodworth Memorial Lecture in Federal Tax Law and Policy, Paul Oosterhuis, at 3, http:/Avww.taxanalysts.com/www/features.nsfiarticlesf3193a0ff95196d378525726b006f4ad2?opendocument. i3 See, e.g., 12/2000 "The Deferral of Income Earned through U.S. Controlled Foreign Corporations," Office of Tax Policy, U.S. Department of Treasury, at 21. a A CFC is a foreign corporation more than 50% of which, by vote or value, is owned by U.S. persons owning a 10% or greater interest in the corporation by vote ("U.S. shareholders"). "U.S. persons" include U.S. citizens, residents, corporations, partnerships, trusts and estates. IRC Section 957. 15 See Koehring Company v. United States of America, 583 F.2d 313 (7th Cir. 1978). See also 12/2000 "The Deferral of Income Earned through U.S. Controlled Foreign Corporations," Office of Tax Policy, U.S. Department of Treasury, at xii. 46 12/2000 "The Deferral of Income Earned through U.S. Controlled Foreign Corporations," Office of Tax Policy, U.S. Department of Treasury, at xii. i4 IRC Section 954(c). EFTA01075349  13 G. Check-the-Box Regulations and Look Through Rule "Check-the-box" tax regulations issued by the Treasury Department in 1997, and the CFC "look-through rule" first enacted by Congress as a temporary measure in 2006, have significantly reduced the effectiveness of the anti-deferral rules of Subpart F and have further facilitated the increase in offshore profit shifting, which has gained significant momentum over the last 15 years. Treasury issued the check-the-box regulations which became effective on January 1, 1997. Treasury stated at the time that the regulations were designed to simplify tax rules for determining whether an entity is a corporation, a partnership, a sole proprietorship, branch or disregarded entity (DRE) for federal tax purposes.48 The regulations eliminated a multi-factor test in determining the proper classification of an entity in favor of a simple, elective "check-the-box" regime. Treasury explained that the rules were intended to solve two problems that had developed for the IRS. First, the rise of limited liability companies (LLCs) domestically had placed stress on the multi-factor test, which determined different state and federal tax treatment for them. Second, international entity classification was dependent upon foreign law, making IRS classification difficult and complex. Check-the-box was intended to eliminate the complexity and uncertainty inherent in the test, allowing entities to simply select their tax treatment. The regulations, however, had significant unintended consequences and opened the door to a host of tax avoidance schemes. Under Subpart F, passive income paid from one separate legal entity to another separate legal entity — even if they were both within the same corporate structure — was immediately taxable. However, with the implementation of the check-the-box regulations, a U.S. multinational could set up a CFC subsidiary in a tax haven and direct it to receive passive income such as interest, dividend, or royalty payments from a lower tiered related CFC without it being classified as Subpart F income. The check-the-box rule permitted this development, because it enabled the multinational to choose to have the lower tiered CFC disregarded or ignored for federal tax purposes. In other words, the lower tiered CFC, although it was legally still a separate entity, would be viewed as part of the higher tiered CFC and not as a separate entity for tax purposes. Therefore, for tax purposes, any passive income paid by the lower tiered entity to the higher tiered CFC subsidiary would not be considered as a payment between two legally separate entities and, thus, would not constitute taxable Subpart F income. The result was that the check-the-box regulations enabled multinationals for tax purposes to ignore the facts reported in their books — which is that they received passive income. Similarly, check-the-box can be used to exclude other forms of Subpart F income, including Foreign Base Company Sales Income, discussed below. Recognizing this inadvertent problem, the IRS and Treasury issued Notice 98-lion February 9, 1998, reflecting concerns that the check-the-box regulations were facilitating the use of what the agencies refer to as "hybrid branches" to circumvent Subpart F. "The notice defined a hybrid branch as an entity with a single owner that is treated as a separate entity under the relevant tax laws of a foreign country and as a branch (i.e., DRE) of a CFC that is its sole owner for U.S. tax purposes.s49 The Notice stated: "Treasury and the Service have concluded that the 49IRC Sections 301.7701.1 through 301.7701.3 (1997). 7/20/2010 "Present Law and Background Related to Possible Income Shifting and Transfer Pricing," Joint 49 Committee on Taxation, (JCX-37.10), at 48. EFTA01075350  14 use of certain hybrid branch arrangements [described in Examples 1 and 2 of the Notice] is contrary to the policies and rules of subpart F. This notice (98-11) announces that Treasury and the Service will issue regulations to address such arrangements."5° On March 26, 1998, Treasury and the IRS proposed regulations to close the loophole opened by the check-the-box rule to prevent the unintended impact to Subpart F. Recognizing that neither had the authority to change the tax law, the IRS and Treasury stated in the proposed rule "the administrative provision [check-the-box] was not intended to change substantive law. Particularly in the international area, the ability to more easily achieve fiscal transparency can lead to inappropriate results under certain provisions [of subpart F] of the Code." As noted by the Joint Committee on Taxation, "The issuance of Notice 98-11 and the temporary and proposed regulations provoked controversy among taxpayers and members of Congress.s52 On July 6, 1998, Treasury and the IRS reversed course in Notice 98-35, withdrawing Notice 98-11 and the proposed regulations issued on March 26, 1998. The agencies reversed course despite their expressed concern that the check-the-box rules had changed substantive tax law as set out in Subpart F. The result left the check-the-box loophole open, providing U.S. multinationals with the ability to shift income offshore without the threat of incurring Subpart F taxation