Annual conference remarks of Margaret Milner Richardson, Commissioner of Internal Revenue.

Over the past fifty years, TEI and the Service have shared a rich history, and a mutually rewarding relationship. The excellent retrospective on TEI at fifty--Serving the Profession--points out that one of the reasons TEI was created was to give "taxmen" (fortunately, Linda [Burke, TEI's first female president!, some things have changed!) the opportunity to talk to one another. To our mutual advantage, the IRS has been included in this dialogue.

Although our organizations do not always agree on specific issues, our point of departure has always been the same--a belief that voluntary compliance with the tax laws is the cornerstone of our tax administration system. Justice Oliver Wendell Holmes observed that, "Taxes are what we pay for a civilized society," and those words are carved in stone--above the entrance to the IRS headquarters in Washington, D.C. The thought behind those words is echoed in the TEI Standards of Conduct, which require that each TEI member "accept taxes as the cost of civilization."

San Francisco is so close to Napa and Sonoma that I am tempted to compare the evolution of organizations, such as mine and yours, to the maturation process of a fine wine. Both start off young and untested. With proper care, over time, they can become well-rounded, robust, more complex. If they are of high quality, they grow better with age. At fifty, I would say that TEI is well on its way to becoming an award winning vintage.

Thinking about TEI's Golden Anniversary, I thought it would be interesting to look back over the past fifty years and reflect on the path TEI and the IRS have shared together and where that path may lead over the next fifty years.

Almost exactly 50 years ago, in the Fall of 1944, General Douglas MacArthur waded ashore in the Philippines, fulfilling his promise to return. President Roosevelt was elected to an unprecedented fourth term, and the year ended with the halt of the final German offensive in the Battle of the Bulge. On the home front, the Roosevelt Administration hoped to pay for at least half the cost of the war through increased taxation. In 1942, a Victory Tax had been imposed on net income. The following year, employers for the first time were required to withhold taxes from the wages of their employees. By 1944, the excess profits tax rate had risen to 95 percent.

Because of the economic demands of World War II as well as the need to provide incentives for businesses supporting the war effort, Congress passed a record number of revenue measures and special tax credits. The result of these efforts was a dramatically expanded and complex tax law. By 1944, President Roosevelt was touting tax simplification as a major goal in his annual budget message to Congress.

The changes in the tax law between 1940 and 1945 transformed American taxation into a system affecting nearly every American. In response, the Bureau of Internal Revenue's staffing grew from 22,000 in 1941 to nearly 60,000 by 1945. During this period, corporate income tax collections rose dramatically. In 1941, the Bureau took in about $950 million in corporate tax payments. Five years later, we collected nearly five times as much, $4.7 billion. Individual income tax collections rose even more quickly during the war.

Never before had there been such a great need for tax professionals. The more complicated tax laws of World War II demanded that corporations, large and small, hire specialists to guide them through the new laws, rates, forms, and procedures.

It was in this environment that Paul Smith founded Tax Executives Institute. The Institute has grown from 12 "taxmen" at its first meeting in 1944 to 5,000 members and 47 chapters today. Over its rich 50-year history, TEI has advanced the experience and education of its membership and has facilitated a healthy interaction between its members and the Internal Revenue Service. TEI is successfully accomplishing its mission: to promote competence and professionalism in both the private and government sectors. Very early, the Bureau of Internal Revenue recognized the importance of working with private stakeholders in a cooperative manner to enhance tax administration. In 1946, the then- Commissioner recognized that "[t]he administrative practices and policies of the Bureau affect to some degree virtually every business unit. Individual businessmen and business concerns are dependent in many ways upon the cooperation of the Bureau to aid them in the lawful operation of their financial affairs."

This observation is as true today as it was fifty years ago.

Reinventing the IRS

Today, because of the growth in technology and a rapidly changing political and economic environment, sound tax administration requires cooperation between the government and the private sector. Technology is developing rapidly, and changes in world politics have led to a burgeoning global economy. No longer can business stop at national borders.

In this rapidly changing environment, governments, too, must adapt. No longer can governments focus merely on transactions within their borders. In short, as businesses have expanded their horizons, governments have had to expand theirs. There are increasing opportunities for governments around the world to discuss areas of mutual concern in tax administration. In fact, today I am on my way home from a meeting with the Pacific Association of Tax Administrators--my counterparts in Japan, Canada, and Australia. After attending a number of similar meetings, it is clear to me that tax administrators around the world have many more areas of agreement than disagreement. Also, as the global marketplace of products and ideas has expanded, the private sector has had to contend with important lessons the 1980s taught about the economy at home and abroad. In contrast to the post-World War II period where resources seemed endless, business women and men around the world have learned that growth and expansion must be guided by prudence and careful planning.

Governments have had to learn these same lessons. Just as your companies have been streamlining and thinking about better ways to serve your customers, the federal government is working to "reinvent" itself.

A little over a year ago, Vice President Gore issued the National Performance Review Report challenging federal government agencies to reinvent themselves so that government can "work better and cost less." Even before Vice President Gore's National Performance Review began, we at the IRS recognized the need to change the way we do business. When I became Commissioner a little over a year ago, the Service was basically organized the way it was in 1952, and our processing systems and technology dated from the 1960s. But those of you who have been around awhile know that the tax laws we are being asked to administer in the 1990s are very different from those we administered in the 1950s and 60s (despite President Roosevelt's plea for simplification). Indeed, some of you may have read in a recent Wall Street Journal report that, in the past forty years, the number of Internal Revenue Code sections has soared 578 percent!

But enough about the past, we at the IRS have a clear vision of how we want tax administration to look not only today but into the next century. We have begun our transformation by utilizing technology, enhancing customer service, and developing new approaches to compliance. I am proud that Vice President Gore has awarded us five National Performance Review Hammer Awards for innovations which "put people first" and make the Service "work better and cost less." In awarding the IRS a B+, the highest grade awarded to any government organization, the latest edition of Financial World pointed out that the IRS is ahead of most other government agencies in the reinvention effort--"applying genuine cost accounting," "advanced in strategic planning," and leading other government agencies in financial accounting.

From a technological perspective, we must construct our own on-ramp to the information superhighway to provide the kind of services our customers need and expect, and we must update our processing systems to increase the efficiency with which we do business, as well as to increase our "market share." Advanced technology brings an additional, very important benefit--an increased ability

to safeguard the privacy and confidentiality of tax return information. I have made protecting the privacy of taxpayer data the highest priority of the Service, for I recognize that it is the foundation of our voluntary compliance system.

Today, the most significant challenge to the Service's ability to accomplish its mission--to collect the proper amount of taxes at the least cost--is to modernize our technology. I, and many others at the Service, have spent much time during the last year and a half planning, budgeting, and implementing our Tax Systems Modernization program, or TSM. To continue implementing our TSM plans successfully, we must find a way to provide stable funding. Unfortunately, budgetary constraints brought about by the Budget Enforcement Act of 1990 are making this very difficult. But just as upgrading technology in your businesses has paid for itself, TSM will quickly pay for itself by allowing us to improve service to taxpayers, enhance voluntary compliance, and increase the effectiveness of our enforcement efforts.

I would like to take this opportunity to thank TEI for its steadfast support of Tax Systems Modernization, and I also would ask for your continued support of this essential initiative.

Although technology is an integral part of the Service's reinvention, technology alone will not enable the Service to keep pace with taxpayer needs and expectations. To truly transform the IRS from an ordinary table wine to a barrelaged, outstanding vintage, we must change not only our organization and systems, but also the way we do business with our customers.

Enhancing Voluntary Compliance

Our mission is to ensure compliance with the law. We estimate that the current voluntary compliance rate is approximately 83 percent. Each percentage point in the compliance rate represents approximately $7-10 billion in annual revenue--revenue that should be available without changes in the tax law or tax rates. A compliance level of 83 percent is simply not acceptable.

Although enforcement efforts are important in raising this level of compliance, it is costly and inefficient to rely exclusively on our enforcement tools. We must also change the way we do business in order to increase voluntary compliance. In today's complex business environment, we must educate taxpayers about their tax obligations and encourage them to "do the right thing" as they plan their transactions or file their returns.

Enhancing voluntary compliance is the thrust of the Service's Compliance 2000 strategy. Compliance 2000 combines traditional enforcement efforts with other initiatives, such as taxpayer outreach and education programs, Market Segment Understandings, Audit Technique Guides, Advanced Pricing Agreements, and our Nonfiler Program. These initiatives provide alternative ways to avoid and resolve controversies. The goal is to enable taxpayers to take an active role in the voluntary compliance process to ensure that issues are reported and resolved earlier, more cooperatively, and more efficiently.

Changes in the Large-Case Program

You should be witnessing this type of cooperative outreach in the course of your audits. As many of you know, the Coordinated Examination Program (CEP), or the large -case program, is designed to facilitate the audit of large corporations with specialized audit teams. Historically, the large-case program has focused on corporations with assets exceeding $500 million. While the CEP's primary focus will remain on the 1400 to 1600 taxpayers in this $500 million category, in May 1994, the large-case program increased its scope to include taxpayers with assets between $10 million and $400 million. This change increases CEP's audit authority to include approximately 30,000 taxpayers. These "smaller" taxpayers will gradually be brought into the CEP audit system to accomplish a more consistent and efficient use of IRS audit resources.

On October 17, the General Accounting Office released a report on the IRS's Coordinated Examination Program. We are currently studying GAO's recommendations in detail and expect to implement those recommendations that we believe will be helpful. I would note, however, that the Service has not been waiting for the GAO report to begin its work on CEP enhancement. In 1988, the IRS began a CEP Quality Improvement Project. As a result of this project and other IRS studies of the CEP, in July 1990, the Service began implementing a number of recommendations to transform the large-case program. These recommendations included, for example, the establishment of a National CEP Director, Regional CEP managers, and a National CEP Policy Board. In addition, we are working to broaden procedures to increase taxpayer cooperation, enhance CEP training programs, and expand industry and issue specialties. Much progress has been made in implementing these recommendations, and, because of these changes, the program already is producing results that we believe are better than those described in the GAO report.

Having said that, I recognize that it is important to continue improving the large-case audit program, because a cooperative and efficiently handled examination can be an effective form of alternate dispute resolution. I would like to highlight for you today two of our areas of focus. First, we are making a priority the resolution of factual issues at the examination stage. Revenue agents have always had the ability to resolve factual issues, but in the past they have not always fully exercised this authority, sometimes because they have not had access to all the relevant facts. Increased, early resolution of factual issues will go a long way in improving the examination and appeals processes.

Second, although the audit process has an adversarial element, once we recognize that each participant in the process has a job to do, these jobs can be made easier by an open and honest dialogue between the parties at all stages of the examination. The key to successfully transforming the large-case program into a program that works efficiently and effectively for both taxpayers and the IRS is early, frequent, and honest communication.

A videotape prepared jointly by the TEI Chicago chapter and the Chicago district of the IRS, which premiered yesterday afternoon, highlights the need for improved communication between IRS CEP team members and taxpayers being audited.

As the videotape illustrates, an important component of improved communication is involving the taxpayer in the examination planning process. Taxpayer participation in establishing examination priorities and time frames should result in more effective and higher quality examinations. To determine the most effective CEP planning process, a national task force comprised of IRS employees and TEI and AICPA representatives studied the issue. This cooperative effort produced recommendations that will substantially improve CEP audit planning and consequently improve the entire large-case program.

A task force comprised of stakeholders and the IRS, similar to the CEP planning task force, facilitated the development of an additional alternate dispute resolution tool, accelerated issue resolution, or AIR. A revenue procedure describing the accelerated issue resolution process was released to the public last week and is scheduled for publication in the Internal Revenue Bulletin on October 31. An AIR agreement is a closing agreement between the Service and a CEP taxpayer that resolves a specific examination issue for all taxable years ending prior to the date of the agreement. An AIR agreement creates a win-win situation. Taxpayers and the government alike will benefit because AIR agreements will resolve the issues that often recur from one examination cycle to the next. Once an agreement is reached on an issue, neither the taxpayer nor the Service will have to revisit the issue, nor incur the associated costs, in any subsequent taxable year ending prior to the date of the agreement. The use of AIR agreements should also improve the timeliness of our CEP examinations.

Another enhancement of the CEP audit process, one that is not yet formally in place, is a procedure we call "early referral." The procedure would allow taxpayers to request early referral--from Examination to Appeals--of a particular unagreed issue, while other issues continue to be developed by Examination. This process would be initiated only at the request of the taxpayer, would be subject to the approval of Appeals and the District Director, and would be available only in CEP cases. Last Spring, we published our revisions to the initial proposed procedure to take into account comments we received at a public hearing in January. The final revenue procedure describing the early referral process should be issued soon.

Since the early referral process will resolve difficult issues more expeditiously, we anticipate that the process will encourage taxpayers and the Service to quickly agree on other issues in the case. In addition, early referral should save time simply because it allows Examination and Appeals to work a case simultaneously.

In addition to saving resources, AIR and early referral provide another important benefit. Because these alternative dispute resolution mechanisms are cooperative undertakings, and because cooperation usually leads to better results than contest, we believe these mechanisms will enhance overall compliance with the tax law.

Transfer Pricing Developments

Another important initiative reflecting our new approach to doing business is the Advanced Pricing Agreement (APA) program. With the global economy, transfer pricing is the most significant international compliance issue faced by the United States, as well as other tax administrators around the world. While developing foreign markets for goods and services, some businesses have sought to minimize their tax burden by manipulating transfer prices to shift profits among jurisdictions. No one doubts that abusive transfer pricing must be addressed if we are to ensure that all taxpayers, both foreign and domestic, pay their proper share of U.S. taxes. One of the most important ways we are addressing this issue is through the APA program.

We think the results of the APA program have been outstanding, and the program inventory has grown steadily. There were 33 cases in the program at the end of 1992, 68 cases at the end of 1993, and 89 cases as of the end of last month. We anticipate that this growth will continue, and we are increasing the resources devoted to this program. APAs have been negotiated in an environment that encourages cooperation, and difficult issues have been resolved quickly and inexpensively. Flexibility has been central to this success. The program allows taxpayers to choose the transactions, affiliates, and years to which the APA will apply, and the Service has made every effort to agree with taxpayers on appropriate methodologies.

While I am discussing transfer pricing, I will mention another alternative dispute resolution mechanism used in that area. Last Fall, the Tax Court used arbitration under Rule 124 in the Apple Computer case. The Tax Court adopted Rule 124 in 1990 specifically to help resolve fact-intensive cases, and the Apple case was the first use of Rule 124 arbitration in a large transfer pricing case. (If any of you have not yet had the pleasure of reading a Tax Court opinion on transfer pricing, large transfer pricing cases can sometimes be fact-intensive!)

We at the Service view the resolution of the Apple case as a success; not because of the outcome, but because the case was put to rest quickly and efficiently. The decision was handed down within eighteen months from the time the stipulation was filed, whereas a case of this magnitude could easily have taken five years or longer to finally resolve through traditional litigation.

The philosophy underlying alternative dispute resolution and our other efforts to enhance voluntary compliance through education and cooperation also influences our formal guidance process. Regulations and other forms of guidance are essential to our system of tax administration. There are over 10,000 pages of tax regulations and, obviously, those 10,000 pages contain more than a few rules to facilitate compliance. It should be no surprise then that the approach we take to our regulations has a profound effect on our overall compliance levels.

The Proper Role of Anti-Abuse Rules

In order to improve voluntary compliance, Treasury and the IRS have adopted an approach to regulation writing that no longer focuses on detailed mechanical rules intended to cover every conceivable circumstance. In today's complex business world, comprehensive, detailed rules must also be extraordinarily complex. But our experience has told us that complex rules often inhibit compliance, rather than enhance it. Complex, mechanical rules provide an opportunity for tax planners to exploit these rules through loopholes. Extremely complicated rules purporting to address all circumstances give legitimacy to the uncovered loopholes. Moreover, even those taxpayers without the expertise or resources to take advantage of loopholes can begin to doubt a tax system that they believe facilitates noncompliance through technical gamesmanship.

To prevent taxpayers from gaming the system, the Service and Treasury are working to issue regulations setting forth simple, flexible rules that provide taxpayers with the principles needed to guide their tax planning and reporting. When necessary, these general rules are supplemented with anti-abuse provisions designed to make clear that a literal application of a rule to achieve a result that is inconsistent with the applicable statute or the relevant regulatory principle will not be respected. Generally, these regulations are all designed to encourage taxpayers to voluntarily "do the right thing" as they plan their transactions or file their returns.

There are many examples of this regulation philosophy: the section 482 transfer pricing regulations and the related penalty regulations under section 6662; the conduit regulations under section 7701(l); and the consolidated return regulations regarding deferred intercompany transactions.

However, the one regulation getting the most attention these days, which was the subject of one of your sessions yesterday, is the proposed regulation addressing abusive uses of partnerships. This regulation provides that, if a partnership is formed or availed of with a principal purpose of substantially reducing tax liability in a manner inconsistent with the intent of subchapter K, the Service may disregard the form of the transaction and recast it based on its substance.

To a great degree, the proposed regulation is a reflection of the Service's current authority to assert arguments like the common law doctrines of substance over form, step transaction, and sham transaction. In that respect, the regulation does not contain any difficult new concepts for taxpayers to grapple with. But the regulation serves another very important purpose--it reminds taxpayers and their representatives that they have a responsibility for determining whether their transactions are abuses of the tax system. The regulation should not interfere with the use of partnerships in ordinary business ventures, because these are not the abusive cases. The regulation simply says that if you set out to game the tax system with a partnership, you should open up the CFR to section 1.701-2 and think again.

We have also attempted to encourage taxpayers to do the appropriate upfront planning and analysis when we issued the section 482 transfer pricing regulations. These regulations, together with the section 6662 penalty regulations, are structured to encourage taxpayers to take responsibility for complying with the arm's length standard as they initiate their cross-border transactions. Our goal is to avoid having to resolve difficult, factually based issues through the traditional appeals and litigation processes.

Under the best method rule of the section 482 regulations, taxpayers have flexibility to use their judgment in adopting a transfer pricing method when initiating their cross-border transactions. This rule is supplemented by the documentation requirements set forth in the section 6662 penalty regulations. To avoid a valuation misstatement penalty, the regulations require that the taxpayer provide contemporaneous documentation establishing that the use of its chosen method was reasonable. Again, it is the taxpayer's responsibility to do the work at the time it is initiating its transactions. Although penalties are traditionally regarded as enforcement tools applied after the fact, the transfer pricing penalty reflects our overall effort to bring about voluntary compliance by requiring taxpayers to carry out their own compliance analysis on the front end.

Approximately two weeks ago, we issued in proposed form the long-awaited conduit regulations. These regulations are issued pursuant to authority granted to the Commissioner by section 7701(l) to disregard the participation of one or more persons in a multiple-party financing transaction when necessary to prevent the avoidance of tax. The proposed regulations represent our first rulemaking under this broad section 7701(l) authority. The regulations apply to situations in which the conduit financing arrangement reduces the section 881 withholding tax imposed on foreign corporations receiving payments of U.S. source interest, dividends, and other types of periodic income.

Multiple-party financing transactions can take on an infinite number of complex structures. In drafting the proposed conduit regulations, however, we chose not to address all of these potential structures with a set of mechanical rules. We also chose not to base our determination on a bright-line test measuring cash flows among the various parties to the transaction. We believe that such a brightline, mechanical approach would not only lead to extreme complexity, but also would be subject to avoidance by taxpayers using sophisticated transactions devised for that purpose. Instead, we proposed a rule based on the general determination whether the arrangement was made pursuant to a plan a principle purpose of which was tax avoidance. This determination would be based on all the facts and circumstances.

Again, these regulations are intended to remind taxpayers and their representatives that they have a responsibility for determining whether their transactions are consistent with the applicable statute and the relevant regulatory principles at the time they do their tax planning and reporting.

Taxpayers and practitioners often invoke Judge Learned Hand's statements to the effect that it is not wrong to arrange one's affairs to keep taxes as low as possible. While this is certainly true, we must not lose sight of the fact that Judge Hand also stated in the Gregory opinion that "the meaning of a sentence may be more than that of the separate words, as a melody is more than the notes, and no degree of particularity can ever obviate recourse to the setting in which all appear."

Concluding Thoughts

History is a great teacher. I think we all saw from the [Commissioners' Forum! panel discussion this morning that tax administration has benefitted tremendously from the passionate work of a series of very talented former Commissioners. The Service must carry on their work into the next century as we reinvent ourselves. From our technology to the rules and regulations we are promulgating, we must change the way we do business.

Like TEI, we at the IRS have come a long way over the past 50 years and are on our way to becoming a fine vintage. With your continued help, and with our new technology, a greater commitment to customer service, and new approaches to compliance, I am confident that the Service can meet the challenges of today and improve the tax administration of tomorrow.

Thank you for letting me join you and Happy Anniversary!