Remarks by Margaret Milner Richardson,
Commissioner of Internal Revenue, at the
International Fiscal Association,
U.S.A. Branch Annual Meeting

Thank you. I am delighted to be here with you this morning. It is truly an honor to open your annual meeting this year. In looking over your agenda for the next two days, I noticed that you have much ground to cover. In the area of international taxation, there is always a great deal that is new and exciting to talk about, as your program reflects.

Perhaps the explanation for the excitement your program promises is what is going on in the world today. Almost unbelievably, many long-standing political barriers have dramatically fallen within the last five years, and, as a result, brand new marketplaces are being developed. New legislation, such as GATT and NAFTA, is encouraging and facilitating that market development. Many businesses have begun to learn that not only can it be profitable to operate on a multinational basis, but, in some cases, it is absolutely essential to survival. At the same time, the transactional techniques used by businesses to tap into international markets are becoming increasingly sophisticated.

If this new political climate is conducive to producing economic fruit, then the new tools needed to harvest that fruit are provided by the technology we see developing every day. This technology allows businesses to communicate and transact with lightning speed and tremendous efficiency, and to work in the productive light of midday, literally around the clock.

Due to this new environment, sound tax administration now requires a new capability for handling complex tax issues arising around the world. In a burgeoning global economy, tax administration cannot simply stop at our national borders. The Internal Revenue Service must continue to carry out its mission - which is to collect the proper amount of taxes at the least cost -- not just here in the United States, but around the globe. We must ensure that all businesses and individuals, including those engaged in transactions that cross our national borders, pay their proper share of U.S. taxes -- no more, but no less.

To keep pace with sophisticated business practices and technological advances both within the United States and elsewhere, the IRS has been working hard to bring about a nationwide reorganization and a major modernization of our computer and information systems. We have made much progress in this regard, but much more needs to be done. Fundamental operational changes are absolutely essential if the Service is to be positioned to handle the difficult tax administration challenges that will come in the 21st century.

But beyond these operational changes, we must also have a plan for addressing the complex policy, legal, and enforcement issues raised as a direct result of the growing global economy. Some of you may recall that, in December 1993, the Service and Treasury's Office of Tax Policy announced a Joint Policy Statement and Action Plan on international compliance which we said we would use to guide our efforts in the global marketplace in the years to come. We also released a "whitepaper" at that time describing the Action Plan.

This morning, I would like to share with you where we stand with respect to the issues we identified in formulating our Action Plan. I want to highlight some of our most significant advances in the 5 areas covered in the December 1993 white paper, and I will indicate those areas where we think some additional work is necessary and imminent. The Action Plan focuses not only on improving international enforcement, but also on enhancing voluntary compliance by ensuring that taxpayers can understand and apply international tax laws without excessive cost or burden. Our approach is to make our tax system more understandable and to synchronize our international tax rules and procedures with the way things are done in today's business environment.

Our Action Plan identified S substantive areas in which the IRS and Treasury believe concentrated resources are needed to enhance international compliance. These areas are:

1. Transfer Pricing;

2. Bilateral Tax Treaties;

3. Foreign Tax Credits;

4. Financial Products; and

5. Individual Tax Compliance.

I would like to touch on each of these areas:

Transfer Pricing

Our Action Plan first declared the Administration's commitment to putting problems with transfer pricing compliance behind us. As you know, transfer pricing has been the most significant international compliance issue faced by the United States in recent years. The Administration is absolutely committed to ending abuses in this area.

As you all are well aware, last year we issued proposed and temporary regulations implementing the transfer pricing penalty of section 6662, and subsequently published final regulations under section 482. These regulations, working together attempt to change the basic dynamics of transfer pricing compliance through an application of the self-assessment principle. In other words, these regulations are structured to encourage taxpayers to take responsibility for complying with the arm's length standard as they initiate their cross-border transactions. The intent is to avoid having to resolve difficult, factually- pricing issues through the traditional appeals and litigation processes. We strongly believe that giving taxpayers flexible pricing guidance, backed up with a reasonable documentation requirement and appropriate penalty enforcement, is the right approach to attaining section 482 compliance.

We have supported the penalty regulations by establishing a transfer pricing Penalty Oversight Committee made up of National Office personnel from the offices of Examination, Assistant Commissioner (International), Appeals, and Associate Chief Counsel (International), as well as an international exam case manager and an international branch chief from the field. We established this Committee in response to concerns about consistency of application of the about pricing penalty. These concerns had been raised both by taxpayers and by our examiners in the field. The Committee's goal is to ensure uniform application of the documentation requirements and uniform interpretation of the reasonableness standard, nationwide.

We are confident that our new transfer pricing regulatory regime, combined with the coordination provided by the Penalty Oversight Committee, will be effective tools for bringing about the transfer pricing compliance levels we desire.

The Administration strongly believes in a sound transfer pricing regime designed to ensure that the arm's length standard is applied uniformly and cooperatively around the world. It is clear that if one country employs methods to enforce transfer pricing that are substantially different from methods used in other countries, its taxpayers inevitably will be faced with substantial double taxation problems, burdening those taxpayers as well as the government processes used to resolve double taxation issues.

For this reason, attaining international consensus on transfer pricing is absolutely essential to appropriate compliance in the area. Therefore, we were very mindful of the rules Ret forth in the OECD Discussion Draft on transfer pricing when we issued our final regulations last year. We have been extremely encouraged to see the development of a solid consensus on the arm's length standard, through the OECD, and we strongly support finalizing the OECD report substantially in its current form.

While on the topic of transfer pricing, I would like to say a few things about one of our best examples of a voluntary compliance initiative -- the Advance Pricing Agreement, or "APA," program. The APA caseload continues to grow. The ongoing cases involve business operations of many sizes, from many countries, and in a wide range of industries.

We are very pleased to have Michael Durst with us as the new Director of the program. We are confident that Michael will see to it that APA's are a continuing success story. Already, he has implemented a case planning process at the beginning of each negotiation that should prove effective in helping to manage the increasing caseload in the program. In addition, Michael and others are working to ensure that the APA process is not just a National Office phenomenon, but is well coordinated with our field offices in a way that is conducive to good long-term relationships between taxpayers and the Service.

The program is also already benefiting from the new APA Policy Board, which we first announced when we issued the Action Plan in December 1993. The Policy Board has not only provided high-level program oversight, it has also fostered multifunctional participation in the actual APA negotiations. The goal is to avoid a lengthy, serial review process by having representatives from Chief Counsel, Examination, Appeals, and often Competent Authority in the room together as the cases are being worked. This cooperative effort should lead to speedy, high-quality results.

Last April, we issued a notice discussing the methodologies used in a number of APA's relating to global trading issues. because of privacy concerns, we cannot divulge information about particular APA's we have completed, but issuing generic information about the approach taken in particular industries is something we would like to do more of. We are currently considering the issuance of additional guidance, similar to the global trading notice, that would be available to companies within a specific industry to guide them when they come in for their individual APA's. We believe this type of guidance would lead to a more streamlined and efficient process.

Another element of the APA program that you should see developing soon will be bilateral and multilateral negotiations. More and more, we have been moving towards simultaneous negotiations with some of our treaty partners with APA programs of their own. We are also seeing consideration given to the development of APA programs among countries without them. For example, a U.R. official recently announced that Inland Revenue -is considering formalizing an advanced ruling program that will facilitate APA's. To date, the U.R. has conducted APA's only on an informal basis. Canada recently issued formal APA guidelines, and last week representatives from our APA staff met with Mexican representatives to discuss coordination of bilateral pricing negotiations. The growing potential we are seeing for a multinational cooperative effort in this area is very exciting indeed.

I also would like to say a few words about the issue of obtaining third-party comparable;. The new transfer pricing regulations allow for flexibility in determining the best pricing methodology for each taxpayer, so individual circumstances are given a great deal of consideration -- and this is reflected in the cooperative negotiations of the APA program. But the new transfer pricing regulations, and consequently the APA negotiations, also emphasize comparability as an essential component of the method determination. The entire arm's length pricing regime depends upon access to meaningful third-party comparable.

Late last year, we conducted surveys of our International Examiners, Appeals Officers, and International Special Trial Attorneys to evaluate their experience in obtaining and using third-party comparable information in transfer pricing cases. are currently analyzing the results of the surveys, but preliminarily it appears that obtaining third-party data sufficient to effectively pursue section 482 issues can be a problem in certain cases. Our personnel primarily rely on public sources and voluntary sharing of information by the taxpayer and by third parties, but based on the problems reflected in the surveys, these sources have not been entirely adequate.

Recently, there has been discussion at conferences and in the tax press of the availability of comparables and the IRS' authority to issue a third-party summons to obtain this information. This discussion appears to be a result of some recent, well-publicized efforts to pursue comparables from third parties on a voluntary basis. In the past, the Service generally has not pursued third-party comparable information through its summons authority under section 7602, not because we do not have authority to do so -- we think that is very clear -- but because we have had, and will continue to have, an internal policy of seeking comparables from public sources and on a voluntary basis and of exercising restraint in using our summons power.

Because the availability of third-party comparable information is crucial to ensuring transfer pricing compliance, we intend to quickly complete our review of the adequacy of our techniques for gathering this information. We will then make any modifications to our current policies and practices that are necessary to ensure that we are getting the information we need to effectively administer the transfer pricing regime.

We have also pledged to streamline the resolution of transfer pricing disputes by emphasizing the use of other alternative dispute resolution mechanisms. You may have read recently about the development of a non-binding mediation process to be carried out in Appeals after the parties fail to come to an agreement through the normal negotiation process. At the request of both parties, an impartial mediator would be appointed to work through difficult factual issues -- like those associated with transfer pricing and valuation cases.

In December of last year, we issued a proposed revenue procedure announcing a one-year test of the mediation process and last week we held a public hearing on the proposed revenue procedure. The proposal has been extremely well-received so far and ultimately may prove to be a very effective means for avoiding costly transfer pricing litigation.

Bilateral Tax Treaties

We also announced in the whitepaper last year our commitment to preventing abuses of the United States' tax treaty network. To that end, we made great strides in 1994 towards ensuring that only bona fide residents of countries with which the U.S. has a treaty can take advantage of beneficial treaty provisions. Signed and awaiting Senate advice and consent on ratification are five new treaties and two protocols. Each of these new treaties, as well as the Canadian protocol, contains a modern limitation on benefits article that will further our anti-treaty shopping efforts.

I know that you have a session scheduled for later this morning to cover current treaty issues. I just want to emphasize the increasing importance of our tax treaty network in the global economy -- not just from the perspective of the Service, but from the perspective of private industry. Therefore, we hope the Congress will turn its attention to the pending treaties as soon as practicable.

Foreign Tax Credits

Our Action Plan noted that the amount of revenue at stake in the foreign tax credit area is enormous. For example, in 1990, U.S. taxpayers claimed roughly $25 billion in foreign tax credits. With the stakes so high, it is imperative that we cut through the complexity of subpart A.

One of our most important steps has been to obtain foreign tax credit software for our International Examiners. Because of the complexity of this area, such software is essential for IEs to conduct effective examinations of foreign tax credit positions. The software is now out in field and in use. Training was provided to Examination and Appeals personnel in all the regions.

On the regulatory front, as most of you know, in early January, we issued proposed regulations relating to the computation of the "deemed paid" credit under section 902. These regulations are a comprehensive set of rules incorporating the substantial statutory changes made in the Tax Reform Act of 1986 and replacing some very old regulations originally issued in 1957. Thus far, the regulations have not received much comment - which we take to be a good sign -- but written comments are not due until April 10.

Receiving a little bit more attention are proposed regulations we issued last May under section 904(i). As an anti-abuse provision, these regulations are naturally receiving some criticism. We have held the public hearing and are considering the comments we received. I believe you will see a project for finalizing these regulations on the list of guidance priorities for 1995 we announced yesterday.

Financial Products

As many of you know from your daily experiences by now, new financial products have thoroughly invaded the marketplace, both domestically and around the globe. Some products are even becoming household words. I am sure even the Queen of England now knows what a derivative is. When she turned from the morning paper on Monday to ask Charles about Barings' dealings in derivatives, Charles may have said, wit's some sort of calculus thing," but I am sure the Barings bankers explained it to her when she showed up to make her mortgage payment on Windsor castle.

Of course, derivatives and other financial products, like various types of hybrid instruments, raise significant tax issues. As described in the 1993 whitepaper, Treasury and the IRS believe it is essential to adapt our international tax administration to keep pace with the evolution of financial products and the rapid growth of global financial markets.

When we issued our Action Plan, we described our efforts with financial products as "embryonic." Within the last year, however, we have established a new national financial products program to provide oversight, technical field assistance, and emerging issue identification. The new program is being carried out by a new Office of Financial Products and Transactions, the Director of which reports both to the Assistant Commissioner (International) and the Assistant Commissioner (Examination).

By combining the expertise of our Industry Specialization Program and our International Field Assistance Program, and by creating the position of Office Director, we have established the stronger central management necessary to ensure that overall guidance and support on financial products is provided to the field.

One of the early-identified issues in this area is the valuation of complex derivative instruments. We have seen that some taxpayers, particularly dealers in financial products, have software programs to make their valuation computations. On audit, our Examiners have been forced to either rely on the taxpayers' computations or attempt to do manual calculations using their own basic spreadsheet software.

Because of the importance of the valuation issue, we have entered into a contract with the Los Alamos National Laboratory to research and develop models for valuing derivative transactions. Once these models are developed, the plan is for Los Alamos to help the IRS implement these models in a usable system, provide manuals and training for these systems, and provide continuing research and development of valuation models for new products as they become significant in the marketplace. Our goal is to be able to provide our Examiners with an effective tool for valuing these products quickly and more accurately.

In addition to these plans for improving the handling of financial products in the field, we also intend for our regulations and other guidance to be increasingly sensitive to the impact of derivatives and other types of financial products.

The proposed conduit regulations we issued in October are a good example of this sensitivity to the effect of financial products in the international arena. The regulations minimize the importance of a cash flow analysis, relying instead on a principal purpose test and a determination of conduit effect based on outstanding principal amounts. One of the important reasons for this approach is our understanding of the potential distortive effect that complex financial arrangements can have on cash flows.

As we move forward on other guidance projects, I believe you will see the government becoming more sensitive to the presence of derivatives in the marketplace, just as you have had to become sensitive to that presence in your practices.

Individual Tax Compliance

The whitepaper also emphasized the importance in today's global economy of ensuring tax compliance of individuals, whether domestic or foreign, engaged in cross-border transactions. International tax compliance activities have traditionally focused on major multinational corporations that have long been prominent international players. However, as a global economy takes shape, the number of individual taxpayers whose activities cross national borders is growing exponentially. We are committed to ensuring that these individuals pay their fair shares of U.S. tax. There are several projects underway in this area that are worthy of note.

First of all, we have begun to invest additional examination resources in the area of withholding on foreign payments with respect to portfolio investments. We believe that compliance in this area is dangerously below par. We will also be seeking to enhance and coordinate our use of both information returns and forms filed with withholding agents relating to foreign payments.

To develop and launch a compliance strategy in this area, we established a multifunctional Nonresident Alien Withholding Task Force. Much of the work of the Task Force is aimed at enhancing the use of the payor and payee information provided by Form 1042S filing data. We also established a new Office of Foreign Payments and appointed a new Director for that office, Carol Dorcy, who some of you may know. The Office of Foreign Payments will be responsible for formulation and oversight of our foreign payment enforcement strategies, including strategies for utilizing 1042S data. The Form 1042 itself is being revised to provide useful information more effectively. Ultimately, a data file of 1042S information will become part of our Information Reporting Program.

The enforcement strategies we are developing are dependent upon some fundamental regulatory changes that are underway. It is well known by now that we are working on new regulations under sections 1441, 1442, 1461 and other related sections. These regulations will likely be issued in proposed form within the next few months. The regulations will propose a certification system that will be based on documentation requirements. Our intention is to modify or replace current rules governing payments of both interest and dividends.

Taxpayer identification issues are at the root of not only problems in the withholding area, but also problems that arise in our treatment of claims for refund. The U.S. tax system relies on information reporting and document matching to verify compliance, using a taxpayer identification number -- typically the Social Security number -- to conduct proper matching. In the case of nonresident aliens, who usually have no Social Security number, our current information reporting system is of limited use.

Because of this situation, we are working on a system for verifying the identities of nonresident aliens 80 that our withholding, information reporting, and refund processing problems can be eliminated. Proposed regulations will be issued very shortly that will require nonresident aliens currently unable to get Social Security numbers to provide IRS-generated tax identification numbers when filing tax returns, like Form 1040NR, including returns claiming refunds. Subsequent regulations would then be necessary to identify other situations in which the new tax identification number would be required.

I also want to mention the subject of money laundering. Some of you may not know that the Service has enforcement jurisdiction over currency information reporting requirements of the Bank Secrecy Act and plays a major role in investigating money laundering activities. Recognizing the advent of a global economy and the fact that crime has no borders, our Criminal Investigation Division, or "CI" as we call it, has developed an international strategy for enforcing tax and money laundering laws.

Our current criminal investigations often take us to major foreign financial centers where massive money laundering often occurs. Under the new strategy, our CI agents will increase their efforts to gather intelligence about foreign criminal activities to support ongoing domestic investigations. For example, CI currently has a special agent in Bogota, Columbia who is working closely with the DEA in analyzing intelligence and financial information that is seized by Colombian law enforcement officials from the Cali Cartel. CI also has a special agent in Mexico City who is supporting CI domestic investigations and providing technical assistance and training to the Mexican government to strengthen their own money laundering controls.

Finally, I wanted to say a few words about the legislative proposals involving international taxation of individuals put forward in the President's budget for FY 1996.

As you may have seen last week on Prime Time Live or read about Forbes recently, some wealthy U.S. citizens and long-term residents have abandoned their U.S. citizenship or status as residents in order to avoid U.S. taxation. Current rules to prevent this type of tax avoidance have not been effective because departing taxpayers have restructured their activities to avoid those rules, and because compliance with the rules has been difficult to monitor. The proposal would provide that gains generally accruing during the time a taxpayer was a citizen or long-term resident of the United States will be subject to U.S. tax at the time the taxpayer abandons citizenship or residency. We strongly believe that the existing statutory provisions need to be enhanced by the proposed legislation to ensure that departing taxpayers pay their fair share.

We also have concerns that individuals are avoiding U.S. tax on income from tens of billions of dollars worth of assets hidden in foreign trusts. Our concerns are with both inbound and outbound transfers to trusts. On the inbound side, wealthy foreign families are establishing foreign trusts for the benefit of U.S. persons who live well in this country without paying income taxes. Under current law, the United States treats the assets held by these foreign trusts as owned by the foreign family, and any distributions of trust income to the U.S. beneficiaries are treated as nontaxable gifts. Under the proposal, foreign persons establishing this type of foreign trust would not be treated as owning the assets and earning the trust income. As a result, distributions to the U.S. beneficiaries of these trusts would be subject to tax like ordinary trust distributions.

On the outbound side, we are concerned that U.S. persons are -transferring assets to foreign trusts to protect them from U.S. creditors and are failing to pay U.S. tax on the trust income. The proposal would call for the appointment of a U.S. agent for these foreign trusts and would impose new reporting requirements to allow us to monitor their activity, supported by increased penalties for noncompliance. In addition, under current law, U.S. persons creating foreign trusts for the benefit of other U.S. persons are generally taxable on the trust income. The proposal would curtail certain loopholes that have been used to avoid tax in these circumstances.

The proposal also would provide a clear definition of a "domestic trust," and would provide that all other trusts are "foreign." Currently, the definition of what qualifies as a foreign trust is based on common law factors that are very difficult to work with. Thus, the foreign trust proposals are intended to provide definitional clarity as well as certainty as to the appropriate tax treatment of foreign trusts. These proposals are extremely important to our overall effort to ensure compliance of individuals in the new global economy.

Conclusion

As you can see, the IRS and the Office of Tax Policy are devoting a great deal of time and resources to the international arena. As I mentioned at the beginning of my talk today, we Are committed to ensuring that all taxpayers, both U.S. and foreign, pay their proper share of taxes and that our international laws and treaties are not burdensome to U.S. businesses vis-a-vis their foreign competition. We believe this approach will lead to the compliance levels that we all deserve.

We know we can accomplish only our goals if we have the benefit of the insight of the taxpayers and practitioners who regularly work in the international area. We welcome your comments on any of the issues addressed in this Conference, or any other matter you believe we should address to take us successfully into the next century. Thank you.

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