Tax
Shelters In 2006
In January, the US government followed up its
tax shelter victory over
Big Four accounting firm
KPMG by investigating three lawyers at the prominent
Dallas-based firm, Jenkens and Gilchrist for
their alleged role in certifying abusive tax
schemes.
According
to a New York Times report, three lawyers at
the firm's Chicago practice, the centre of its
tax operations, are under investigation for
signing off so-called opinion letters testifying
to the legitimacy of tax shelters such as COBRA
(currency options bring reward alternatives),
which was outlawed by the IRS in 2000.
However,
the report said that there is no indication
that the law firm itself is a target of the
criminal investigation, and a spokesman revealed
that the company is "cooperating fully" with
the investigation.
Often
costing $75,000 or more each, investors use
opinion letters as an insurance policy if challenged
by the authorities, showing they took steps
to ensure that a particular transaction was
legally watertight.
One
of the lawyers under investigation was said
to have earned $93 million in fees from 1999
through 2003 by selling opinion letters and
by designing and selling certain shelters, the
Times reported, citing persons familiar with
sealed documents filed in connection with a
previous civil case brought by investors against
Jenkens & Gilchrist.
It
was believed by the Treasury Department that
at least $2.4 billion in artificial tax losses
have been claimed by clients of the law firm
stemming from their use of tax sheltering arrangements.
It
was not the first time that Jenkens & Gilchrist
has come under the spotlight for its role in
formulating and selling tax shelters. In 2004,
a federal judge ordered the firm to hand over
the names of clients who invested in tax schemes
formulated by its Tax and Estate Planning Practice
Group and its Structured Investment Practice,
between June 1998 and June 2003. It marked the
first such summons to have been issued to a
law firm to obtain the identities of participants
in tax shelters deemed abusive by the IRS.
In April, the IRS won a significant legal victory
in its campaign to deter the use of so-called
'abusive' tax shelter schemes, after the US
Tax Court ruled that the 'Son of Boss' scheme
is illegitimate.
The
ruling by Judge David Laro related to the sale
of R. J. Thompson Holdings, a day-trading firm
in Omaha, Nebraska, by its founder and former
chief executive Randall J. Thompson, for $13
million in cash to TD Waterhouse of Canada in
June 2001.
The
IRS believed that Thompson used a Son of Boss
scheme to create an artificial loss in order
to slash the amount of federal taxes he owed
on the sale, and disallowed more than $20 million
in tax losses. Thompson, through a partnership,
decided to challenge the IRS.
Son
of Boss evolved from an earlier scheme known
as ‘Boss’ (bond and option sales strategy).
The scheme utilises a complex set of derivative
transactions to reduce tax liability and was
commonly used in the late 1990s to offset large
one-off gains such as the sale of a business.
The
ruling is significant as it marks the first
time that a court has ruled on the Son of Boss
scheme, and Judge Laro's decision could have
an important bearing on the outcome of the aforementioned
trial of 18 individuals facing criminal charges
related to sale of tax shelters by the accounting
firm KPMG.
Lawyers
for the defendants, 16 of whom are former KPMG
executives, argued that their clients did nothing
illegal because the tax courts had not hitherto
established whether the tax shelters were improper.
The
defendants in the KPMG trial are facing conspiracy
and fraud charges for their role in creating
and selling tax shelters viewed by the IRS as
close relations to Son of Boss.
The
previous year, the IRS released the results
of its Son of Boss settlement offer, a 2004
initiative which offered users of the shelter
improved settlement terms in a limited amnesty.
More than 1,200 taxpayers qualified to participate
in this offer, and the IRS collected some $3.8
billion in taxes and penalties. However, about
600 investors did not come forward, with some
instead electing to challenge the IRS in court.
In May, in a stunning reverse for the IRS, it
was
ordered by a US Tax Court
Judge to repay millions of dollars in taxes,
fines and interest to a group of taxpayers,
after officials from the agency were found to
have effectively bribed witnesses to win a tax
shelter case.
The
case centred on the so-called Kersting tax shelter,
named after Honolulu businessman Henry Kersting,
which allowed airline pilots and their families
to purchase stock in one of Kersting's companies.
In exchange, the pilots received promissory
notes, on which they would have to pay interest,
but which allowed them to claim interest deductions
on their tax returns.
In
the early 1980s, the IRS ruled that the Kersting
tax shelter was illegal and began pursuing a
number of investors who had used the scheme.
Many of these eventually settled with the IRS.
However,
according to Colorado Attorney Declan J. O’Donnell,
who represented 100 of the 500 taxpayers who
settled with the IRS, three witnesses were effectively
bribed with cash, pre-paid expenses, tax settlements
below par, and ten years of added tax benefits
so that they would testify against six pilots.
In
its opinion, the United States Tax Court stated
that all of the settled cases in the Kersting
Tax Shelter program should receive 64% of their
monies back as a sanction.
It
is perhaps the first time that such a judgment
has been made against the federal tax collector,
certainly for such a substantial amount of money.
"Fraud
on the court is rare and has only occurred a
few times in our country’s history," Mr O'Donnell
observed in a statement.
"This
particular ruling is the only time the IRS has
ever been adjudicated with a money judgment
against them. All others were either sanctioned
or the cases were retried," he added.
Mr.
O’Donnell believes this penalty judgment against
the IRS is unique, perhaps the only large money
judgment against any national taxing authority
ever. His clients and the settled group will
receive an estimated $56 million from the IRS
in due course.
The
IRS has the right to appeal the decision, but
Mr O'Donnell stated that such an eventuality
is remote given that interest is continuing
to accrue, and that the agency cannot appeal
against liability in the case.
In
June, a federal judge granted final approval
to a settlement proposed by accounting firm
KPMG to compensate investors who made use of
its tax sheltering arrangements.
Under the settlement approved by U.S. District
Court Judge Dennis M. Cavanaugh on June 2, the
approximately 200 clients would receive $153.9
million to cover transaction costs for the tax
shelters, but not back taxes and penalties.
The
average payout would be $825,000, with the class-action
counsel Milberg Weiss Bershad & Schulman netting
$24.6 million.
The
proposed settlement was designed to cover former
clients of KPMG and the law firm of Brown &
Wood (now part of Sidley Austin) who participated
in the tax shelters known as Blips, Flip, Opis
and Short Option Strategy. These are the shelters
that were the subject of KPMG's settlement agreement
with federal prosecutors in August under which
KPMG agreed to pay $456 million in penalties,
but won't face criminal prosecution as long
as it complies with the terms of its agreement.
The
settlement was less than the initial proposal
which totaled $225 million approved last October
after about 50 tax shelter clients declined
to participate in the deal. These litigants
can pursue claims against KPMG and the Sidley
firm on their own.
Judge
Cavanaugh ruled that the offer was "fair, reasonable,
and adequate," and was keen to draw a line under
the case which he stated could extend "for at
the very least another few years.”
In
a related case pending in New York, 19 defendants,
including several senior KPMG employees and
lawyers with Sidley Austin, face criminal charges
for their roles in selling the tax shelters
which were deemed "abusive" by the Internal
Revenue Service. The agency has estimated that
the tax shelters helped investors avoid some
$2.5 billion in taxes.
So
far, only one of the defendants has entered
a guilty plea; in March, David Rivkin, a San
Diego partner in KPMG's "innovative strategies,"
group surprisingly changed his plea, and admitted
to one count of tax evasion and one count of
conspiracy.
Court
documents described how Rivkin's clients were
advised to invest money though Cayman Islands
entities or through foreign currency transactions.
In
January 2007, New York District Judge Loretta
Preska agreed to dismiss a deferred criminal
charge against KPMG resulting from the settlement
reached by KPMG and the Justice Department over
the sale of improper tax shelters in 2005.
Former
executives of KPMG who are facing separate criminal
charges attempted to prevent the dismissal,
claiming that KPMG's refusal to pay their legal
fees amounted to a breach of KPMG's agreement
with the government; but the judge did not agree.
In
August 2005, KPMG agreed to pay $456 million
in penalties to cover former clients who participated
in the tax shelters known as Blips, Flip, Opis
and Short Option Strategy. Under the agreement,
prosecution was deferred, with the government
agreeing to drop charges after 31st December
2006 if KPMG submitted to outside monitoring
and discontinued some types of tax-related activity.
The
trial of the former employees is currently delayed
after the trial judge cited concerns over the
dispute concerning who should pay the defendants'
lawyers. In an order made public in November,
US District Judge Lewis A. Kaplan stated that
questions over whether KPMG should pay legal
fees for the former executives probably wouldn't
be resolved before the criminal trial's scheduled
start date in January.
"Given
all of the current uncertainties, it is impossible
now to predict with confidence when the charges
in the indictment may be tried," he said.
Consequently, the judge delayed the trial date.
Later it was set for September, 2007.
The
16 former KPMG employees and two others are
accused of selling tax shelters which were deemed
"abusive" by the Internal Revenue
Service. The agency has estimated that the tax
shelters helped investors avoid some $2.5 billion
in taxes.
However,
the trial bogged down when in June, Judge Kaplan
found that prosecutors violated the constitutional
rights of the former KPMG partners by pressurising
them to cut off payment of legal costs to the
defense. The former executives then filed a
civil complaint against KPMG seeking advancement
of defense costs.
A
trial on the fee issue was scheduled for October,
but KPMG appealed Kaplan's ruling, saying the
matter should be dealt with by arbitrators rather
than the Courts.
In
March 2008, it was reported that the US government
was attempting to revive its case against 13
of the former KPMG partners.
The
case, billed as the largest criminal prosecution
in US legal history, was, as previously stated,
thrown out by US District Judge Lewis Kaplan
in July 2007, after he concluded that the government
had denied the defendants their constitutional
right to counsel by pressuring their former
employer to cut off payment of legal fees.
But
at a hearing in the US Second Circuit Court
of Appeals, the government argued that it had
not brought any pressure to bear on KPMG to
stop paying the defendants' legal fees, and
that any violation of their rights had only
been temporary.
While
it was normal practice for KPMG to pay the legal
costs of former employees accused of wrongdoing,
it reversed its policy in this case, fearing
that, by being seen to be helping the defendants,
it could bring about an indictment on the company
itself.
According
to the so-called 'Thompson Memorandum,' written
in 2003 by then-Deputy US Attorney General Larry
Thompson, prosecutors may consider a company's
payment of legal fees for "culpable employees
and agents" when deciding whether to indict
the company.
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