oduction

July 1990, an investigation by the House Ways and Means ht Subcommittee into alleged tax underpayment by foreign.S. subsidiaries revealed the following facts:

: least half of the companies surveyed had substantially wered or eliminated their U.S. tax liability1.

amination of income tax returns of 18 U.S. subsidiaries of reign automobile and motorcycle manufacturers revealed that tax year 1987, 10 of these companies reported gross ceipts of $38 billion. Less than 1% of this figure ($366 llion) was paid in income taxes to the federal government2.

à 1987, foreign firms paid income taxes of only $1.9 billion à total assets of $959 billion. Their true tax liability, sed upon a more realistic before tax rate of return of 15%, s been estimated to be approximately $48 billion3.

se facts lend credence to the argument that foreign turers have gained unfair advantage over their U.S. parts by under-reporting the pre-tax income of their U.S. aries, thus significantly reducing their U.S. federal income bility.

I response, the firms defend low reported rates of return by ng their traditional emphasis on market share over short ofit. However, this argument fails to account for the fact ile reported profits are either relatively static or down, ent, income and market share are up. These are clear signs ificant distributions to parent corporations.

eign cartels, especially Japanese cartels (known as u) use tax evasion and money laundering on a massive scale access to the American market and to export profits out of ited States tax-free. Transfer pricing abuses have zed American businesses which have had to compete with e subsidiaries in the United States paying little or no taxes here. The cost to American taxpayers amounts to s of dollars in lost revenues.

atrick Heck, Statement to House Ways and Means Oversight ee hearings on tax underpayment by foreign-owned U.S. aries, July 10, 1990.

Heck, p.5.

he Detroit News, August 24, 1990, p.1E.

the Duraen with a fe

to respond effectively since they Dear
taxation, are driven out of business,
resorting to off-shore production. The targeted Ame
then accepts the low-value added role of a warehouser
an assembler. Higher paying, more skilled jobs remain
other foreign countries. Once this occurs, the
begins. Distribution channels then can be inti
dominated.
And more significantly, transfer pr:
warehouser and assembler can be raised to almost any

Let's be clear about one thing: Tax evasion is a gaining and holding market share. Political resist overcome, or at least contained, by nationally lobbying, public relations and promotional efforts. just such a well-coordinated campaign against correct price abuses in recent weeks.

President Clinton made the correction of transfer a main element of his campaign. He repeated his pro this practice and get foreign corporations to pay the of taxes. Immediately after his election, the fore campaign started. News stories and op-ed pieces beg with the specific intent of preventing the new pr fulfilling his campaign pledge.

These stories alleged that the money was not th asking foreign corporations to pay their fair share of force them to relocate elsewhere; or foreign direct i this, the world's largest and most lucrative market, overnight; or that the increase in taxes would be pass American consumer, with the result of higher prices ar or finally that foreign nations would reciprocate agai corporations doing business in their countries.

C

Although none of these arguments holds any examination, the vehemence with which they are advand to conclude that there is more at issue than jus payments. Transfer pricing is not some esoteric,

2

versight ed U.S.

ses that the IRS has brought against companies udulent transfer pricing schemes, it has settled for e dollar. Abandoned by the government, American e not yet found a way to counter tax evasion schemes as part of a business strategy.

of

specific techniques

employed by foreign in order to reduce tax liability are set out in the esent.

Icing

089, Sony's U.S. subsidiary reported profits of only gross sales of $4.4 billion. Such statistics are he fact that Japanese and other foreign corporations aggressive in using transfer prices as a way of ncome tax liability. Parent companies are charging ubsidiaries artificially inflated prices for subfinished products in order to reduce the reported liability of these subsidiaries.

aw stipulates that transactions between the parent should take place at "arms-length" prices, i.e the parent would charge an independent seller in the Examples of the breach of this regulation abound. e foreign automobile manufacturer sold cars to its or at prices averaging $800 more than identical cars Canadian distributor". Prosecution for breach of tion proves difficult, however. The charges brought Motor for padding transfer prices were dropped in he absence of a rigid formula for calculating arm's Until the concept of an "arms-length" transaction y defined, the practice is sure to continue.

pus Deductions

Economic Journal, August 11, 1990.

Committe Subsidia

There is evidence that Japanese automobile manufacturers c their subsidiaries more for ocean freight than they charg unrelated companies for identical products carried aboard the vessel on the same day, arriving at the same port.

iii. Financial Accounting Practices

Japanese accounting regulations serve to increase the ince of Japanese corporations to employ transfer prices to suppress subsidiary profits. Companies without U.S. stock exchange lis present only consolidated financial statements to stockhol Income from subsidiaries is accounted for in the form of div income only'. This provides an incentive to transfer profits the subsidiaries to the parent in the interests of increasing stock price.

Furthermore, Japanese tax law offers deductions not pro under U.S. law. For example, when a Japanese corporation acq the assets of another company, the amount of goodwill record the balance sheet is tax deductible, a practice prohibited i U.S.

iv. Uncooperativeness

There is evidence of efforts by Japanese corporation obstruct IRS investigations of alleged income under-reporting.

"Heck, p.7.

"This accounting practice, referred to as the "cost metho prohibited in the U.S. by the Financial Accounting Standards B

James E. Wheeler, Statement to House Ways and Means Over Committee hearings on tax underpayment by foreign-owned subsidiaries, July 12, 1990.

¡ing'.

▸ IRS readily admits that its auditors and attorneys are :ly "outgunned" by the legal and financial expertise foreign tions employ to evade full tax liability under the U.S. L tax code. The successful development and resolution and derpayment cases requires a complex economic analysis of ite transactions. The IRS is currently understaffed in the st function, and officials must wait approximately eight for one of its 40 economists to be assigned to tax yment cases. The IRS is unable to assign 12 large transfer 1 cases in the Western region because the region's eight ists are overworked1o.

and

is, a combination of taxpayer uncooperativeness [cient resources has degraded the investigative effectiveness IRS. Given these circumstances, it is hardly surprising that gations of alleged tax underpayment by subsidiaries of se automobile manufacturers take approximately 10 years to

ce.

è above facts indicate conclusively that at a time when the nent grapples with the problem of a budget deficit and the versial issue of tax increases, aggressive tax filing by the bsidiaries of foreign companies has resulted in billions of 3 in tax revenue being denied to the U.S. Treasury. As of ry 1990, cases in appeals and litigation involved tax ayment of approximately $13 billion, this amount being ered by many to be just the tip of the iceberg".

urthermore, the de facto tax advantage enjoyed by foreign Les puts U.S. companies, such as auto manufacturers, into a on in which they are unable to turn a profit, and are unable

leck, p.11.

Heck, pp. 8-11.

Heck, p.7.