oversight

Internal Revenue Service Efforts to Detect Slush Funds in Large Corporations

Published by the Government Accountability Office on 1977-09-13.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                           DOCUMENT RESUME
 03465 -   [A2593728]

 Internal Revenue Service Efforts to Detect Slush Funds in
 Corporations. September 13, 1977. 16 pp.                  Large

 T'estimony before the House Committee on Ways and Means:
 Oversight Sukcoumittee; by Victor L. Lowe, Director, General
 Government Div.

Issue Area: Accounting and Financial eporting (2800); Tax
    policy (1500).
Contact: General Government Div.
Budget Function: Miscellaneous: Financiil Management and
    Information Systems (1002).
Organizaticn Concerned: Int*ernal Revenue Srvice:  ecurities and
    Exchange Commission.
congressional Relevance: Hcuse Committee on Ways and Means:
    Oversight Subcommittee.

           Under the Coordinated xamination Program, the Internal
 Revenue Service (IRS) audits corporations with assets over $250
 million and financial institutions and utilities with at
                                                            least
 $1 billion in assets and seeks to uncover secret slush funds
 used for such purposes as political contributions, bribery,
 lobbying, kickbacks, and diversions to personal use. Through
 effcrts of the Securities and Exchange Commissicn (SEC),        the
 approximately 400 corporations have made voluntary isclosures
 relating to such funds. In May 1976, IRS supplemented is
 instrur+ions with a standard set of 11 questions. A samplingaudit
                                                                 of
 16 cases, including a series of compliance checks other than
 11 questions, was analyzed to identify areas where slush        the
                                                           funds
or illegal payments could be initiated. Only one of the
compliance cecks was successful in uncovering possible
fraudulent activity. Slush funds were disclosed i 13 of
cases examined; mcst of these were dtected through SEC the 16
                                                          reports
and use of the 11 questions. Payments were reflected on the
books of the taxpayers as ordinary business expenses. Most
the questicnnaire responses did not disclose whether payments of
were deducted on tax returns, and additional audit work
usually needed to determine tax or criminal implications.was
Revenue agents and case managers must decide appropriate
in cases of questionable payments; there appeared to be action
of guidelines on what constitutes a prosecutable offense.a lack
                                                             (HTW)
                    United States General AountinS Office
          [5    All/\Washington, D.C. 20548


                                                       FOR RELEASE ON DELIVERY
                                                       Expected at 8:30 P.m. EDT
%D                                                     Tuesday, September 13, 1977
PCN\                               STATEMENT OF
               VICTOR L. LOWE, DIRECTOR, GENERAL GOVERNMENT DIVISION

                                    BEFORE THE
                             SUBCOMMITTEE ON OVERSIGHT
                        EOUSE COMMITTEE ON WAYS AD MEANS
                                       ON
                        INTEAL REVENUE SERVICE EFFORTS
                            TO DETECT SLUSH FUNDS IN
                               LARGE CORPORATIONS

       Mr. Chairman and Members of the Subcommittee:
               Our testimony today deals with IRS' efforts to detect
       slush funds in large corporations and some of the problems
       associated with those efforts.       Earlier this year we began
       a broad survey of IRS' corporate tax activities at the
       request of the Joint Committee on Taxation.       Subsequently,
       the Oversight Subcommittee expressed interest in holding
       hearings on IRS audits of large corporations.       At a series
       of May and June meetings between GAO staff and the staffs
       of the Joint Committee and the Oversight Subcommittee, we
       agreed to asist the Subcommittee by suspending our broad
survey work and concentrating on IRS efforts to detect slush
funds in large corporations by reviewing a sample of audit
cases.
     Although our work has allowed us to make some tentative
observations on IRS' efforts, I want to emphasize that the
severe time constraints under which we worked permitted us
to review only 16 large cases. Thus, our observations about
the entire IRS effort i~, this area are    bvlously qualified.
     In 1966, IRS established its Coordinated Examination
Program to better audit complex and large -irporations.
Using a team audit approach, all corporations with assets
over $250 million and all financial institutions and utili-
ties with at least $1 billion in assets are audited under
this program.    It   s in the course of such audits that IRS
would look to uncover secret slush funds used for such pur-
poses as corpora:e political contributions, bribery, lobbying,
kickbacks, and diversions to personal use.     The schemes some-
times involve conscious attempts to misrepresent corporate
taxable income by claiming unallowable deductions or exclu-
sions from income.
     IRS'   efforts to detect such secret funds and determine
their tax consequences have developed rapidly since 1973--
primarily as a result of revelations uncovered by the Water-
gate Special Prosecutor that many major corporations had
been making illegal or improper payments through slush funds
and other schemes not reflected in the corporations' books.


                              -2-
Few, if any, of these schemes had been uncovered previously
by the IRS because they could not be detected using routine
audit techniques.
     Indeed, it has primarily been because of the efforts
of the Securities and   xchange Commission that most corpora-
tions have revealed the existence of slush funds. SEC
recognized that many of the corporate activities disclosed
by the Special Prosecutor involved matters of significance
to public investors and that nondisclosure might entail
violations of Federal security laws.   The Commission deter-
mined that the most appropriate means of obtaining corporate
disclosure was for the corpvu.Lions to conduct thorough,
in-depth self-investigations.   The technique worked and
to date approximately 400 corporations have made voluntary
disclosures to SEC.
     As a result of such disclosures IRS, in August 1975,
provided its field offices 11 additional audit checks designed
to help identify corporate slush funds.    In May 1976 these
instructions were supplemented by a standard set of 11
questions to be asked on all corporation audits under the
Coordinated Examination Program.    The questions were to be
directed to key corporate officials, who had to answer under
the penalty of perjury.
     The use of the 11 questions by IRS has generated much
discussion and some opposition among the corporate and tax
practicing community (lawyers and CPAs).


                             - 3-
        IRS guidelines have historically called for special

checks to identify areas of noncompliance and fraud.     Many

of the schemes to accumulate slush funds and make illegal

or questionable payments involved off-book transactions

and/or the use of controlled foreign corporations located

in countries not subject to U.S. tax laws.     Since these

transactions may well have U.S. tax consequences, IRS' focus

on detecting the existence of slush funds appears proper.

        To quote IRS, "The very difficult task of discovering

slush funds in corporate examinations requires effective

planning of in-depth probes and the use of imaginative audit

techniques."     IRS maintains its most productive technique to

date to identify areas of possible noncompliance and question-

able corporate payments has been the use of the 11 questions.

        We believe IRS would have been remiss hd it not developed

techniques to expose the existence of slush funds.     Our tax

system is based on voluntary compliance and IRS' audit pro-

cedures are generally designed with the assumption that most

taxpayers do voluntarily comply with our tax laws. But when

evidence is available that certain pockets of noncompliance

exist, the Service must be able to develop audit approaches

to continually protect the Government's interest in insuring

that all appropriate income is reported and the proper tax

paid.     To greatly restrict the Service's ability to use

"imaginative" audit techniques when noncompliance is evident

would, i.> our opinion, greatly undermine the Government's



                               - 4 -
ability to foster increased compliance with our tax laws.
The extent to which slush fund disclosures can be detected
by use of surh techniques is illustrated by our sample results.
       To select our sample cases, we analyzed the workload of
the 58 IRS District offices responsible for auditing the 1,250
corporations which meet the large case criteria.     Based on this
workload analysis, we selected four IRS districts--Manhattan,
Newark, Los Angeles and San Francisco--as our key districts
since together they are responsible for 345 large case audits
or over 25 percent of the program.     Time constraints imposed
allowed us to review a total of 16 cases, four in each district.
       iRS   evelops a specific audit plan for each corporation.
EacĀ¶   of the 16 audit plans in our sample included a series of
compliance checks, other than the 11 questions, designed to
identify areas where slush funds or illegal payments could
be initiated.
       Compliance checks can be stated in general terms, which
might be applicable to any audit, or can be specifically tailored
to meet a corporation's particular situation.     A typical exam-
ple of a compliance check noted in many of the audit plans was
the examination of cancelled checks written by the corporation
during a period of the tax year under audit.     The checks would
be examined for unusual amounts, payees, and endorsees.
       The number of compliance checks listed in the audit
plans we reviewed ranged-from 3 rather general procedures to
ove;: 30 specific checks.
     Of the 16 cases we reviewed, only one of the compliance
checks--"identify and determine propriety of inventory write-

downs and abandonment losses"--was successful in uncovering

questionable transactions which may involve fraudulent
activity.     In that case, a write-down of ending inventory was
made, increasing cost of goods sold and decreasing taxable

income.     Most blush fund disclosures in our sample cases were

detected through SEC reports and through the use of the 11

questions.

     Slush funds were disclosed in 13 o;    the 16 cases.   The
original sources of disclosure were as follows:

     -- 6 cases from SEC reports;

     -- 5 cases from IRS questioning of corporate officials;

     -- 1 case from a Federal regulatory agency report; and

     -- 1 case from an Intelligence informant.

     The six corporate slush funds disclosed as a result of

SEC reports covered the period from about 1971 to 1976.      These
reports provided the first evidence to IRS that questionable

payments existed in those corporations.

     The approximate amounts, nature, and purpose of the

payments made by these 6 companies can be classified as

follows:

    -- $15 million in fees, commissions, gifts, political
      contributions, and other payments to foreign
      government officials and agents to obtain sales,
      facilitate some favorable governmental action, or
      to maintain good will in countries in which the
      company conducts business.



                              -6-
         -- $9 million in payments such as commercial bribes,
            kickbacks or rebates to foreign firms to obtain
            business with those firms.
         As explained in the SEC reports, some of the -above
transactions were not recorded in the companys' books or
records.     Those transactions that were recorded were usually
charged to various expense accounts, such as commiss ons,
advertising, or travel and entertainment.
     Only one of the disclosures indicated the payments
were treated as deductions on the company's U.S. tax return.
IRS is investigating these disclosures to document the legality
of the payments, determine the proper tax treatment, and
uncover any additional payments that have not been reported.
Although these investigations are still in process, it appears
that several of the payments were legitimate business expenses
and deducted; some were net legitimate but were not deducted
for U.S. tax purposes; others were made by controlled foreign
corporations, and while deducted on that corporation's books,
had no U.S. tax effect.     To date IRS has not proposed any
related audit adjustments.
     The 11 questions wre asked in 15 of the 16 cases we re-
viewed. The remaining case was under joint investigation by
IRS' Audit and     ntelligence Divisions from an earlier date, and
at the time of our review the 11 questions had not yet been
posed.
     In each case respondents selected to answer the 11 ques-
tions were those individuals considered by IRS in the best


                               - 7 -
position to have knowledge of illegal or improper corporate

activities, or to have access to this type of information.

The number of corporate officials to whom   .e 11 questions
were asked varied from 4 on one case to 23 on another.

     As a result, questionable payments covering the period

from about 1972 to 1975 were disclosed for the first time

in 5 of the 16 cases.   The approximate amounts, naCure,
and purpose of the payments comprising these 5 disclosures

can be classified as follows:

     -- $1.2 million in payments to foreign government
        officials, agents and political parties to obtain
        sales, facilitate favorable governmental action
        and promote good will in ountries in which the
        taxpayer conducts business.

     -- $4 million in gifts and payments to customers
        and suppliers of services to encourage continued
        business.

     -- $187,000 in domestic political contributions at
        Federal, state and local levels.

     The payments were reflected on the books of the tax-

payers as ordinary business expenses.   But most of the
questionnaire responses did not disclose whether payments

were deducted on the corporation's   .S. tax return.   Additional
audit work by revenue agents or Intelligen:e special agents

was usually needed to determine the tax implications of dis-

closed payments and any potential criminal violations.     To
date a total of about $640,000 in audit adjustments have

been proposed by IRS agents in four of these five cases.




                            --
     IRS became aware of questionable paveents through sources
other than SEC reports and the 11 questions in two of the 16
cases,    In one case, an investigation report from a Federal
regulatory agency was revealed to IRS by corporate officials.
This case involved approximately $20,000 in domestic political
contributions w.ch were deducted on the corporation's tax
return.    To    ate no audit adjustments have been proposed on
this case.
     The second case involved an Intelligence informant who
initially disclosed questionable corporate payments.         This

case involved approximately $75,000 in domestic political
contribution) which were deducted as various types of business
expenses on the corporate return.          Approximately $11,000 in

audit adjustments have been proposed to date on this case.
     The audits of all 16 corporations are still underway.
This means they are still subject to additional slush fund
findings.       But to date only 5 cases have resulted in audit
adjustments being proposed because of slush fund disclosures.
These adjustments range from about $5,000 to $540,000.         To

date, total proposed audit adjustments on the 16 cases,
including those due to disclosure of slush funds, range
from zero to $89 million.
     As of August 19, the day we stopped our field work, the
status of the 16 cases was as follows:
     -- Audits of three corporations have resulted in no
          disclosure of slush funds.


                                 -   9 -
-- Four of the 16 cases involve slush fund disclosures
  which have not been referred to the Intelligence
  Division for criminal investigation.       Two of these
  cases, both of which involve disclosures made in
  questionnaire responses, were not referred because
  IRS considered the tax consequences insignificant.
  The remaining two cases involve disclosures made
  in SEC reports.      These two cases have not been
  referred because Audit personnel ha>       not had suf-
  ficient time to document their significance.         These
  cases may ultimately be referred for criminal inves-
  tigation.
-- Nine c,| te   16 cases were referred to Intetlligence.
  Two ces were rejected--one because the payments
  were      nsidered immaterial; the other because tle
  payments were made by controlled foreign corporations
  and had no     .S.   ax impact.   Seven cases were accepted
  for joint Audit-Intelligence investigation; however,
  Intelligence has withdrawn from two of these cases
  because either the questionable payments were not
  found to be illegal or they       ere not material
  enough to be considered for further investigative
  action.     The remaining five are still under joint
  investigation.




                         - 10 -
OPINIONS OF IRS PERSONNEL
    Case managers and team coordinators responsbile for the
16 large cases we reviewed generally considered questioning
of corporate officials to be the most effective method
for detecting slush fund activity.      They noted that because

the 11 questions are answered under the threat oa     perjury,

the questionnaire format is a useful tool which provides
information otherwise unobtainable.      Normal audit and com-

pliance procedures caninot be expected to uncover fraud.
Therefore, the most direct     ay to obtain slush fund infor-
maetion is to ask people in a position to know o     its

existence.
     Some case managers ),elieve the effectiveness of the
11 questions in their present form will diminish in future
audits--taxpayers will merely submit responses identical to
those given previously.     Their suggestions on how this pro-
cedure could be changed or supplemented to produce better
results in future audits include:
        -- Reducirg the scope of each question. A new
           questionnaire with a greater number of shorter,
           more specific questions would produce more meaning-
           ful and precise answers.
     -- Providing more assurance that the taxpayer is closely
        scrutinizing his own operations by adding a question
        on what actions were taken by the respondent to develop
        the information in his answers to the questionnaire.
        IRS personnel believe the general level of audit effort
devoted to compliance as it relates to slush funds is reason-
able.     This level includes reliance on informants, voluntary


                               - 11 -
disclosure, questionnaires, limited test checking of corporate
transactions, and 'luck.'   They said substantial increases in

efforts to detect improper payments would be questionable
because:  (1) it is impossible to be completel' assured that
                                                         are
a slush fund does not exist, (2) slush fund transactions
often not recorded on the parent company's books at all, but
are hidden in the accounts of foreign subsidiaries, and

(3) the amounts involved are not material, which makes it
impractical to spend larger amounts of time looking for indi-
cations of slush funds.
OBSERVATIONS
     Although our work was limited, we were able to observe
some aspects of the slush fund program in which potential
problems may exist.
Disclosure
     IRS, in asking its 31 questions and conducting follow-
up investigations, is investing a significant amount of Audit
and Intelligence resources in documenting questionable cor-
porate practices which potentially may have tax significance.
Despite the tax adjustments which may result, many cf these
 transactions may also relate to the enforcement responsibili-
 ties of other Federal agencies. For example, there may be
 cases wher;e IRS uncovers slush fund payments during its audits
                                                           dis-
 which have not been disclosed to SEC under its voluntary
 closure program. This lack of disclosure could be of interest
 to SEC in its enforcement of Federal security laws.


                            - 12 -
     The disclosure provisions of the Tax Peform Act of 1976
preclude   RS from making information obtained from the taxpayer
or his books and records available to other Federal agencies
for nontax criminal purposes.   To be granted access, the other
agency must first know IRS mght have some useful information
and then obtain a court order from a Federal district judge.
     The burden now rests on the other Federal agency to show
why access is needed.   Because of this, we understand that

little, if any, potentially useful information developed by
IRS is being provided to agencies in a position to take action
against violators of nontax statutes.
Guidance
     In doing audits, IRS revenue agents are often faced
with a corporate taxpayer having numerous domestic and foreign
entities and millions of dollars in sales and assets.   When

the issue of questionable or illegal payments arises the
revenue agent and the case manager must decide the approp-
riate action to take.   The agent is faced with determining

the legality of the payments under current tax laws, the tax
implications to both the corporation and the recipient, and
the potential for criminal tax fraud prosecution.
     Although IRS has stressed the identification of slush
fund issues in its audits for the past two years, we noted
a possible lack of consensus and absence of guidelin=J on
what constitutes a prosecutable offense.




                            - 13 -
     Most audit personnel believed only cases having a tax
impact should be referred to Intelligence.    Many of the dis-
closed payments were not deducted for Federal tax purposes.
For example, many dealt with controlled foreign corporations
and involved payments to foreign sales agents or foreign
governmental officials.    Since these foreign corporations do
not pay U.S. taxes these disclosures are not being pursued.
     Bowever, there remains a question concerning whether the
U.S. parent corporation can be prosecuted for filing false
return info-mation.    Along with its tax return   a corporation
is required to file an information return for each controlled
foreign corporation.    This return contains financial statements
concerning the foreign corporation's operations.     Included
in these statements may be questionable or illegal payments
improperly categorized or disguised.   No one we spoke to
was aware of any National Office guidance on whether a U.S.
corporation could be criminally prosecuted for not approp-
riately disclosing questionable or illegal payments when
U.S. taxes are not involved.
     Items disclosed involving payments which were improperly
deducted on the U.S. tax return should be adjusted by IRS and
collected.   While tax adjustments will be made where appropri-
ate, there is a lack of National Office guidance as to what
constitutes a prosecutable offense.




                            - 14 -
     Initially most cases involving deducted payments were
referred by IRS audit staff to its Intelligence Division for
investigation as possible criminal tax fraud cases.     Bowever,
Intelligence agents have ultimately withdrawn or declined to
accept some cases which have apparent criminal potential.
In the four such cases we reviewed, Intelligence personnel
believed prosecution would be hampered because:
     -- "voluntary' disclosures from the SEC repcrts or
        IRS 11 questions would tend to eliminate intent
        to defraud on the part of the taxpayer, or
     -- a nominal tax deficiency was involved when viewed
        in light of the overall tax liability of the
        corporation. This would make it difficult to show
        these payments were deducted with the specific
        intent of evading the tax laws.
     The only indication we found of guidelines being used
by Intelligence agents was at one IRS district.     Bere, agents
were consulting a Regional Counsel pre-referral report relating
to one specific case as guidance for evaluating fraud refer-
ral cases.     This report noted that understatement of tax
liability must be 'substantial' in order to prove a tax
evasion case.    According to this report, no court case has
defined   substantial' in the context of a multinational
corporation.     The payments involved in this case were small
when compared to the entity in question, and negligible
when compared to the total corporate return.     The Regional
Counsel concladed, therefore, that the financial advantage
of making the deduction was minimal, thus it would be very
difficult to prove flagrant disregard for the tax law.
Penalties
     IRS can impose a 50 percent civil fraud penalty or a
5 percent negligence penalty on all tax adjustments made
during the corporate audit if the circumstances warrant.
None of the cases we reviewed were close enough to com-
pletion to establish whether either penalty would be im-
posed.
     From discussions with case managers and team coordina-
tors, we were advised that essentially the same evidence
is needed to assess the civil fraud penalty as to achieve
criminal prosecution.    Flagrant disregard for the U.S. tax

laws would be'extremely difficult to prove for reasons pre-
viously discussed.
     Concerning the negligence penalty, audit personnel
stated it might be appropriately assessed in those instances
where payments were illegally deducted.     The problem they

foresee, however, i     the 5 percent penalty covers all tax
adjustments made during an audit and not just those relating
to the improper deduction.     On large case corporations, total

tax adjustments can run into the millions of dollars, while the
improper deduction may involve a nominal amount by comparison.
Our impression is that IRS field agents will be reluctant to
assess negligence penalties without stronger guidance.
     This concludes my prepared statement.     We would be pleased

to respond to questions.




                               - 16 -