Tax
Shelters In 2005
In
February, President Bush’s budget document contained
clauses seeking to restrict the use of a corporate
tax shelter in which companies attempt to reduce
tax by buying back their stock held by other
companies.
The
scheme, known as a ‘cash-rich split-off,’ allows
firms to use cash for up to 90% of the buyback
value, while the remaining 10% can be paid for
by selling a small business asset, which has
to have been operated for five years or more.
However,
under the revenue-raising and tax compliance
measures contained in the 2006 budget proposals,
firms could only use cash for a maximum of half
the value of the buyback, with a significant
asset having to be traded for the remainder.
According
to the Wall Street Journal, the Treasury Department
estimated that the proposed change would raise
$87 million in tax revenue over the next 10
years.
Although
this figure is relatively small, a Treasury
Department official explained to the Journal
that this was because firms are likely to be
deterred from using the structure.
In
the same month, a new report by the Government
Accountability Office found that more than 10%
of Fortune 500 firms bought tax shelter advice
from the same accounting firms they hired to
independently audit their financial statements
over a five year period to 2003.
Using
data compiled by Standard & Poor’s and the Internal
Revenue Service, the GAO found that between
1998 and 2003, 207 of the Fortune 500 companies,
(or 40%) purchased tax shelter services from
a third party, of which 114 obtained them from
an accounting firm, and 61 from their own auditors.
The
findings were expected to intensify calls for
tougher rules to ensure that the independence
of financial auditors is maintained, and that
conflicts of interest are reduced. They also
came two months after the accounting industry
regulator, the Public Company Accounting Oversight
Board, released proposals that would restrict
the ability of auditors to offer tax advice
to their clients.
According
to Senator Carl Levin (D – Michigan) who released
the GAO report, the findings revealed that tax
shelters are being “mass marketed by major accounting
firms,” and strengthened the argument that the
PCAOB proposals should be introduced to curb
these conflicts of interest.
“Today’s
GAO report provides further evidence of accounting
firm involvement in tax shelters and why the
new rules are needed. If we are going to restore
public confidence in the financial statements
of our public companies, auditors of those companies
can’t be selling them abusive tax shelters that
distort and misrepresent the companies’ tax
liabilities and income,” Levin commented.
The
PCAOB proposals would bar accounting firms from
obtaining contingent fees from their audit clients,
providing tax services to audit client executives,
and promoting aggressive tax positions to the
public companies they audit.
In
a 13-page letter supporting the proposed rules,
Levin argued that the proposals should be strengthened
so that firms can avoid the appearance of a
conflict of interest as well as actual conflicts.
Levin
also recommended allowing accounting firms to
promote only those tax products which would
be very likely to be upheld in court.
Also
in February, the Treasury Department and the
Internal Revenue Service issued guidance that
designated "sale-in/lease-out" or "SILO" arrangements
as abusive tax avoidance transactions.
According
to the tax authorities, SILO arrangements are
designed to exploit the tax law by shifting
tax benefits from a tax-indifferent party that
cannot use them to a taxpayer that can.
Taxpayers
entering into SILO arrangements cannot claim
tax benefits as the purported owners of property
subject to a lease because they do not acquire
tax ownership of the property.
In
the American Jobs Creation Act of 2004, Congress
enacted limitations on the deductibility of
losses from future SILO transactions. The Notice
informed taxpayers that the IRS would challenge
the purported tax benefits claimed by taxpayers
entering into earlier SILO transactions on a
number of grounds. It further stated that SILOs
are considered ‘listed transactions.’
Taxpayers
who enter into SILOs and who are required to
file tax returns must disclose their participation
to the IRS. In addition, promoters of listed
transactions must keep lists of investors and,
in certain cases, register those transactions
with the IRS.
In
March, the IRS announced that more than $3.2
billion had been collected from over 1,000 taxpayers
who participated in the Son of Boss tax shelter
settlement scheme, a total that was expected
to rise.
The figure included back taxes, fines and interest
paid by the 1,165 taxpayers who had participated
in the scheme at that point, and according to
the IRS, the typical taxpayer payment was almost
$1 million, with 18 taxpayers paying more than
$20 million each. One taxpayer alone was said
to have paid over $100 million.
Son of Boss evolved from an earlier scheme known
as ‘BOSS’ (bond and option sales strategy).
The scheme utilised 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.
Under the stringent terms of the settlement
initiative, taxpayers were required to concede
100% of the claimed tax losses and pay a penalty
of either 10% or 20% of the total, unless they
had previously disclosed the transactions to
the IRS.
“This
was a particularly bad shelter, and we’re glad
so many chose to get right with the government,”
commented IRS Commissioner at the time, Mark
W. Everson.
“Despite
the tough terms we offered, two-thirds of Son
of Boss participants have come forward and paid
up,” he added.
Based on disclosures the IRS had at that time
received from promoter investigations and from
investor lists from Justice Department litigation,
the agency believed that more than 1,800 people
participated in Son of Boss. It is predicted
that the total revenue yield from the settlement
scheme would exceed $3.5 billion.
The Son of Boss ‘amnesty’ also benefited the
coffers of various state governments, with Arizona,
Illinois, Maine, Maryland, Michigan, New York,
Ohio, Utah and Virginia having collected more
than $23.5 million from voluntary state tax
return amendments by March 2005.
Furthermore, under an information sharing initiative
between the IRS and state tax authorities, an
additional $161 million in disallowed losses,
and assessments of nearly $16 million in taxes,
interest and penalties, were uncovered by the
states of Colorado, Connecticut, Maine, Maryland,
Missouri, North Dakota, Pennsylvania, Utah and
Virginia.
Ever keen to emphasise the agency’s recent hard
line policy on tax shelters, Commissioner Everson
issued a stern warning to those yet to participate
in the Son of Boss settlement initiative.
“For
those who didn’t come forward, we know who they
are (and) we are going after them,” he stated.
Also
in March, US Internal Revenue Service chief
at the time, Mark W. Everson said that an international
tax force established to monitor tax avoidance
by multinational corporations had provided national
tax authorities with invaluable information
on aggressive corporate tax planning techniques.
The
task force, which came into being in 2004 and
is known as the Joint International Tax Shelter
Information Centre, is an information sharing
initiative involving the governments of the
United States, United Kingdom, Canada and Australia.
The
main focus of the group is the scrutiny of corporate
tax arbitrage and transfer pricing arrangements.
However, it is also examining the role played
by accountants, bankers and lawyers who dispense
advice to multinationals on tax planning issues.
"We
have seen things we either would never have
picked up or would have picked up years down
the road," Mr Everson told the Financial Times.
"We
have seen a series of kinds of transactions,
or in some cases particular transactions, that
merit follow-up by the individual taxing authorities,"
he added.
"There
are some indications in what we are seeing now
that entities are trying to structure transactions
which result in the payment of no tax at all.
That is clearly of concern," Mr Everson observed.
In
April, Senate Finance Committee Chairman Charles
Grassley criticized tax legislation which he
helped to write for allowing firms to take advantage
of tax loopholes for an extra year.
During
a committee hearing focusing on the US 'tax
gap,' which is estimated at $312 billion, Grassley
expressed frustration that the "watered down"
final version of the American Jobs Creation
Act had permitted firms to continue exploiting
large depreciation allowances in leasing arrangements
with state and local governments known as LILOs
and SILOs (lease in lease out, and sale in lease
out).
In
particular, Grassley was angered by a provision
allowing existing leasing arrangements to proceed
if they had been submitted for approval by the
Federal Transit Administration after June 30,
2003, and before March 13, 2004.
"Incredibly,
this provides shelter promoters another full
year to get their deals approved by the FTA.
Treasury's has been forced to grandfather in
these rotten deals because of the bill's effective
dates," Grassley remarked.
The
Senate version of the bill called for the tax
shelters to be closed down with effect from
November 17, 2003, in a measure which would
have raised more than $40 billion in revenues
over ten years.
However,
Grassley went on to argue that: "There's no
way these deals deserve another year."
Sen.
Grassley also asked the Transportation Department
for details of any corporate tax shelters involving
the leasing of bridges and sewer systems that
might be grandfathered under the American Jobs
Creation Act of 2004.
In
a letter to Transportation Secretary Norm Mineta,
Grassley asked for details of all pending requests
for approval of such tax shelters. Grassley
also urged the secretary to discourage these
deals.
“We
exerted great effort in Congress to shut down
this abuse, but the transition relief in the
American Jobs Creation Act is a sop to shelter
promoters and an insult to the American taxpayer,”
Grassley wrote. “Corporations have no right
to claim tax deductions for bridges, subways,
and sewage pipes that were built with taxpayer
dollars.”
The
text of Grassley’s letter follows:
"On
November 17, 2003, I wrote to you to enlist
the assistance of the Department of Transportation
in the Committee on Finance’s ongoing investigation
of an abusive tax shelter that has come to be
known as LILOs – an abbreviation for “lease-in-lease-out”
transactions, and SILOs – the successor to LILOs
called “service-in-lease-out” agreements. Other
variations on these transactions have involved
qualified technology equipment (QTE). A copy
of our November 17th letter is attached.
"On
January 20, 2004, you responded to our inquiry
by advising us that after the release of Revenue
Ruling 99-14 in March 1999, the Department of
Transportation’s Federal Transit Administration
(FTA) has not received, reviewed, or concurred
in any LILO transaction. You indicated, however,
that LILO promoters mutated those transactions
into SILOs, and the first notice received by
your department that SILO transactions were
under challenge by the Department of Treasury
was a November 26, 2003, letter from Treasury’s
Assistant Secretary for Tax Policy. Presumably,
the Department of Transportation ceased reviewing
and approving SILO transactions on the receipt
of Treasury’s letter, although your response
did not confirm this to be the case. In February
2004, the staff of the FTA provided the Committee
on Finance with a list of leveraged lease transactions
submitted to and reviewed by the FTA from June
1988 though September 2003.
"Subsequent
to our exchange of letters, Congress enacted
the American Jobs Creation Act of 2004, which
outlawed LILOs and SILOs, albeit not without
considerable concessions to the interests of
shelter promoters that were in the process of
setting up these abusive schemes. Under the
Senatepassed version of the American Jobs Creation
Act of 2004, LILOs and SILOs would have been
shut down as of November 17, 2003, the day that
I sent you the letter. For LILOs and SILOs involving
public assets of foreign jurisdictions, U.S.
tax deductions would have ended on February
1, 2004, regardless of whether the foreign lease
was entered into before November 17, 2003. In
conference, however, these tough effective dates
were watered down and delayed.
"The
enacted bill doesn’t take effect until March
13, 2004, nearly 4 months later than the Senate
bill. Incredibly, the enacted bill gave leasing
shelter promoters more than a year to get their
deals-inprocess approved by your department.
The bill grandfathers domestic property leases
if 1) the leases had been submitted for approval
by the FTA after June 30, 2003, and before March
13, 2004; 2) the FTA approves the leasing shelter
arrangement before January 1, 2006; and 3) the
FTA application includes a description and the
fair market value of the property.
"We
exerted great effort in Congress to shut down
this abuse, but the transition relief in the
American Jobs Creation Act is a sop to shelter
promoters and an insult to the American taxpayer.
Corporations have no right to claim tax deductions
for bridges, subways, and sewage pipes that
were built with taxpayer dollars. As part of
our continuing effort to stop this abuse, I
ask that the Department of Transportation submit
to the Committee on Finance copies of all LILOs,
SILOs, QTE leases, and similar transactions
that had been submitted for approval by the
FTA after June 30, 2003, and before March 13,
2004. I also request a list of all such transactions
that have been “approved” by the FTA as of the
date of your response.
"Notwithstanding
the grandfathering provisions of the American
Jobs Creation Act, we would welcome assurances
that FTA no longer approves SILO transactions,
effective as of the date of the letter you received
from the Assistant Secretary of Tax Policy.
We also seek assurances that FTA has not approved
any LILO transaction since the release of Revenue
Ruling 99-14 in March 1999.
"I
also request documentation regarding any other
LILO, SILO, QTE or similar transactions that
have been approved, funded, or otherwise reviewed
by the Department of Transportation from the
date of the FTA’s last response to the Finance
Committee to the date of your response to this
letter, provided that any such transactions
is not otherwise covered by the above request.
"I
appreciate your cooperation in our ongoing efforts
to combat abusive tax shelters and look forward
to receiving these materials within the next
three weeks."
In
August, Sen. Carl Levin, D-Mich., and Sen. Norm
Coleman, R-Minn. introduced a bill in the Senate
to combat what they termed 'abusive tax shelters
and uncooperative offshore tax havens used by
businesses and individuals to dodge payment
of their US taxes'.
Levin and Coleman introduced a similar bill
in 2004, The Tax Shelter and Tax Haven Reform
Act, S. 2210, which was read twice and referred
to the Committe on Finance, where it died in
December, 2004. The 2004 bill was very similar
to the subsequent one.
Although it was unsuccessful, some of its provisions
made it into law by being attached to other
pieces of legislation, including stronger penalties
for failing to report interests in foreign financial
accounts, civil fines for tax practitioners
such as accountants and attorneys who violate
specified standards of practice, stronger penalties
for failing to register or provide to the IRS
required information regarding a potentially
abusive tax shelter, and stronger penalties
for failing to maintain a list of participants
in potentially abusive tax shelters.
The
2004 bill also sought to stiffen the penalties
imposed on abusive tax shelter promoters from
$1,000 per offense to a penalty equal to 150%
of the promoter’s profits from selling the abusive
shelter. The penalty was raised to 50%, but
did not go as far as provided in the Levin-Coleman
bill. The Senators said: “The penalty increase
enacted by Congress in 2004 was a significant
improvement over prior law, but letting promoters
of abusive tax shelters keep 50% of their ill-gotten
gains doesn’t make sense. Congress needs to
take stronger action by denying persons who
promote tax cheating not only all of their illegal
profits, but also requiring their payment of
a stiff fine on top of that.”
For the last few years, Levin and Coleman, the
senior Democrat and Chairman of the Senate Permanent
Subcommittee on Investigations respectively,
have been pursuing an investigation into tax
shelters developed, marketed, and carried out
by accounting firms, banks, investment advisors,
and lawyers.
“These
tax advisors are getting hundreds of millions
of dollars in fees, while robbing the U.S. Treasury
of billions of dollars in revenues each year,”
said Levin. “We need to strengthen the laws
and enforcement mechanisms to stop promoters
of abusive tax shelters. We also need to take
stronger measures to stop use of offshore tax
havens for tax dodges.”
“Abusive
tax shelters and uncooperative tax havens undermine
our tax system, forcing honest taxpayers to
pay more than their fair share,” Coleman said.
“We need to give honest, hardworking Americans
a better deal – by cracking down on those who
choose not to pay their fair share in taxes.”
The
Tax Shelter and Tax Haven Reform Act of 2005
proposed the following measures, among others,
to clamp down on tax abusers:
- Increase
penalties to 150% on persons who promote abusive
tax shelters or knowingly aid or abet taxpayers
to understate their tax liability.
- Prevent
abusive tax shelters by prohibiting tax advisors
from charging fees linked to alleged tax savings,
mandating examination procedures to identify
banks contributing to abusive tax shelters,
encouraging whistleblowers who report tax
schemes, and authorizing the IRS to work with
federal agencies like the SEC and bank regulators
to strengthen abusive tax shelter enforcement.
- Clarify
and codify the economic substance doctrine
and by strengthening the penalties for tax
transactions lacking economic substance.
- Authorize
the Treasury to publish an annual list of
uncooperative tax havens, and by ending U.S.
tax benefits and requiring greater disclosure
for taxpayers transferring funds to such uncooperative
tax havens.
In
September, Minnesota offered a voluntary compliance
program for taxpayers who had participated in
potentially abusive tax shelters and transactions
as determined by the Internal Revenue Service
(IRS).
By
participating in this program, taxpayers could
avoid substantial new penalties authorized under
a new Minnesota law, Minnesota's Department
of Revenue explained at the time. Minnesota
expected the program to generate $57 million
in additional tax revenue during 2006 and 2007.
The
program, which followed similar programs conducted
in California and Illinois, gave residents who
had used abusive tax shelters until Jan. 31
to amend their tax returns without facing new
penalties passed during the 2005 special legislative
session.
Under
the voluntary compliance program, taxpayers
could escape the newly created penalties, which
authorize the department to assess stiff punishment
on taxpayers who participate in, or promote,
tax avoidance schemes. After the six-month window
of opportunity, the department pledged to officially
step up enforcement efforts in the area.
"These
abusive shelters typically have no business
or economic purpose, and are employed only to
reduce taxes," said Revenue commissioner Dan
Salomone, in a statement. "If you've participated
in one of these shelters, this is your last
chance to make things right. The stakes will
be much higher later."
In
October, the US Internal Revenue Service announced
a broad-based, limited-in-time opportunity for
taxpayers to come forward and settle an array
of transactions the IRS considers abusive.
Taxpayers
who undertook these deals would have until January
23, 2006 to submit their settlement papers to
the IRS.
The
initiative identified 21 transactions eligible
for the program. Consisting of both listed and
non-listed transactions, they included a wide
cluster of schemes involving funds used for
employee benefits, charitable remainder trusts,
offsetting foreign currency option contracts,
debt straddles, lease strips and certain abusive
conservation easements.
All
eligible transactions carry the same settlement
terms except the applicable penalty level.
“People
entered into these deals often at the behest
of lawyers and accountants peddling flaky tax
products,” explained then IRS Commissioner Mark
W. Everson, continuing:
“Times
have changed. The IRS has acted to shut down
these deals, as has the Congress, in passing
stiffer disclosure requirements and promoter
penalties last fall. We’re offering taxpayers
a quick, quiet and cost effective way to put
these deals behind them.”
The
IRS had at that point identified more than 4,000
taxpayers involved in the 21 transactions, and
continues to uncover additional participants
through tax return examinations and the agency’s
promoter audit program.
Under
the settlement terms, participants, both individuals
and companies, were required to pay 100 percent
of the taxes owed, interest and, depending on
the transaction, either a quarter or a half
of the penalty the IRS would otherwise have
sought. There was, however, penalty relief for
transactions disclosed to the IRS or where the
taxpayer got a tax opinion from an independent
tax advisor.
In
November, a report by the US federal government
spending watchdog highlighted the continuing
risk to the tax system of complex, so-called
'abusive' tax sheltering schemes, which it noted
were being sold through smaller, less accountable
outlets.
"Recent
trends indicate that the tax shelter population
will continue to expand to small- to mid-sized
corporations where issues will be more difficult
to identify and examine," the Government Accountability
Office observed in a report on its financial
audit of the Internal Revenue Service.
The
GAO went on to note that tax shelter promoters
were migrating from the large accounting firms
to businesses that specialize in tax matters.
These
so-called 'boutique promoters', the GAO observed,
were "less compliant in their business registrations
and less stable in the business operations"
and are consequently more difficult for the
authorities to pursue for information or penalties.
Moreover,
the GAO found that promoters of tax shelters
were continuing to modify their products to
stay one step ahead of the IRS. It also found
that the number of fraudulent tax refund claims
continues to rise and now stands at a five-year
high.
"For
the 2005 processing year, the IRS identified
approximately $451 million of fraudulent refund
claims for individuals," the GAO reported.
Tax
Shelters In 2006
In January, 2006, Dennis B. Drapkin, Chair of
the American Bar Association's Taxation Section
wrote to senior US congressmen to complain about
the effects of clauses in the Tax Relief Act
of 2005, passed by the Senate late the previous
year, which would codify the 'economic substance'
doctrine in US tax law.
Mr
Drapkin wrote among others to Senators Charles
Grassley (Chairman of the Senate Committee on
Finance) and Max Baucus (Ranking Member of the
Senate Committee on Finance), as well as to
House members William Thomas and Charles Rangel.
The
letter identified three provisions of the Act
which would:
-
codify the “economic substance” doctrine and
create a 40% penalty for “noneconomic substance”
transactions;
-
require a 20%, nonrefundable down payment
for certain offers in compromise; and
-
create increased penalties and restrict access
to judicial review in an attempt to reduce
frivolous tax submission.
'However
well intended,' writes Mr Drapkin, 'these provisions
may have significant ramifications for bona
fide business transactions that are far removed
from the tax shelter transactions that are the
intended target of the legislation. Moreover,
the concerns that underlie this legislation
were recently addressed by the tax shelter provisions
enacted in October 2004 as part of the American
Jobs Creation Act of 2004'.
The ABA revealed that it supported legislation
clarifying that when a court determines that
the economic substance doctrine applies, the
taxpayer must establish that the non-tax considerations
in the transaction were substantial in relation
to the potential tax benefits, and supported
legislative clarification that in evaluating
the potential economic profits of a transaction,
all costs associated with the transaction, including
fees paid to promoters and advisers, should
be taken into account.
'To
the extent that the legislation incorporates
these concepts,' continues the letter, 'we believe
it will improve the state of the law. In other
respects, however, as we have previously written,
we continue to oppose codification of the economic
substance doctrine. We further believe that
enactment of the separate penalty scheme tied
to satisfaction of the economic substance doctrine
would create unnecessary complexity and confusion.'
Mr Drapkin also expressed serious concerns about
the requirement for a 20% non-refundable deposit:
'Because the 20 percent nonrefundable down payment
requirement could dramatically reduce available
outside funding for potential offers, there
is a significant risk that the proposal could
decrease the number of legitimate offers submitted,
the number of offers accepted and the number
of individuals reentering the tax system,' says
the letter, which recommends that the proposal
not be adopted or, at a minimum, that it be
deferred for further consideration.
As regards frivolous conduct penalties, the
letter suggested that they should be imposed
upon taxpayers requesting CDP hearings 'only
(i) where the request is based on arguments
or positions the IRS has identified as frivolous
in published pronouncements and (ii) after the
taxpayer has been afforded the opportunity to
withdraw the request or supplement it with information
that would render the relevant published pronouncement
inapplicable.'
Later 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 is 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
is 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.
This
was
not the first time that Jenkens & Gilchrist
had 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, 2006, 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 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 were 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 faced conspiracy
and fraud charges for their role in creating
and selling tax shelters viewed by the IRS as
close relations to Son of Boss.
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.
This
was 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 believed that 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.
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 were 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 would not face criminal prosecution as long
as it complied with the terms of its agreement.
The
settlement was less than the initial proposal
which totaled $225 million approved the previous
October after about 50 tax shelter clients declined
to participate in the deal. These litigants
would be permitted to 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, 19 defendants, including several
senior KPMG employees and lawyers with Sidley
Austin, faced 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.
In July 2006, an US appeals court overturned
a previous ruling in favor of Coltec Industries
Inc, a former subsidiary of Goodrich, a major
manufacturer of aircraft landing systems.
In
a ruling representing a victory for the IRS,
the three judges on the US Court of Appeals
for the Federal Circuit panel agreed with the
tax authority that Coltec had used a transaction
known as a contingent liability deal to artificially
generate capital losses which the firm then
used to offset capital gains from the sale of
a business unit in 1996.
Applying
the much-debated 'economic substance' test,
the judges wrote that the law as it stands "does
not permit the taxpayer to reap tax benefits
from a transaction that lacks economic reality”.
The judges went on to write that a lack of economic
substance "is sufficient to disqualify
the transaction without proof that the taxpayer’s
sole motive is tax avoidance”.
Their
decision overturned a judgment by Judge Susan
Branden in the US Court of Federal Claims in
2004, which rejected the IRS’s argument
that the transactions had no economic purpose.
Branden stated that, in her opinion, Coltec
had complied with all the statutory requirements
laid down by Congress and awarded the company
an $82.8 million refund.
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