[Senate Hearing 108-473]
[From the U.S. Government Publishing Office]
S. Hrg. 108-473
U.S. TAX SHELTER INDUSTRY: THE ROLE OF ACCOUNTANTS, LAWYERS, AND
FINANCIAL PROFESSIONALS
=======================================================================
HEARINGS
before the
PERMANENT SUBCOMMITTEE ON INVESTIGATIONS
of the
COMMITTEE ON
GOVERNMENTAL AFFAIRS
UNITED STATES SENATE
ONE HUNDRED EIGHTH CONGRESS
FIRST SESSION
__________
NOVEMBER 18 AND 20, 2003
__________
VOLUME 1 OF 4
__________
Printed for the use of the Committee on Governmental Affairs
U.S. GOVERNMENT PRINTING OFFICE
91-043 WASHINGTON : DC
____________________________________________________________________________
For Sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; (202) 512�091800
Fax: (202) 512�092250 Mail: Stop SSOP, Washington, DC 20402�090001
COMMITTEE ON GOVERNMENTAL AFFAIRS
SUSAN M. COLLINS, Maine, Chairman
TED STEVENS, Alaska JOSEPH I. LIEBERMAN, Connecticut
GEORGE V. VOINOVICH, Ohio CARL LEVIN, Michigan
NORM COLEMAN, Minnesota DANIEL K. AKAKA, Hawaii
ARLEN SPECTER, Pennsylvania RICHARD J. DURBIN, Illinois
ROBERT F. BENNETT, Utah THOMAS R. CARPER, Delaware
PETER G. FITZGERALD, Illinois MARK DAYTON, Minnesota
JOHN E. SUNUNU, New Hampshire FRANK LAUTENBERG, New Jersey
RICHARD C. SHELBY, Alabama MARK PRYOR, Arkansas
Michael D. Bopp, Staff Director and Chief Counsel
Joyce A. Rechtschaffen, Minority Staff Director and Counsel
Amy B. Newhouse, Chief Clerk
------
PERMANENT SUBCOMMITTEE ON INVESTIGATIONS
NORM COLEMAN, Minnesota, Chairman
TED STEVENS, Alaska CARL LEVIN, Michigan
GEORGE V. VOINOVICH, Ohio DANIEL K. AKAKA, Hawaii
ARLEN SPECTER, Pennsylvania RICHARD J. DURBIN, Illinois
ROBERT F. BENNETT, Utah THOMAS R. CARPER, Delaware
PETER G. FITZGERALD, Illinois MARK DAYTON, Minnesota
JOHN E. SUNUNU, New Hampshire FRANK LAUTENBERG, New Jersey
RICHARD C. SHELBY, Alabama MARK PRYOR, Arkansas
Raymond V. Shepherd, III, Staff Director and Chief Counsel
Elise J. Bean, Minority Staff Director and Chief Counsel
Robert L. Roach, Minority Counsel and Chief Investigator
Mary D. Robertson, Chief Clerk
C O N T E N T S
------
Opening statements:
Page
Senator Coleman.............................................. 1, 69
Senator Levin................................................ 4, 72
Senator Lautenberg........................................... 9
WITNESSES
Tuesday, November 18, 2003
Debra S. Petersen, Tax Counsel IV, California Franchise Tax
Board, Rancho Cordova, California.............................. 11
Mark T. Watson, former Partner, Washington National Tax, KPMG
LLP, Washington, DC............................................ 13
Calvin H. Johnson, Andrews & Kurth Centennial Professor, The
University of Texas at Austin School of Law, Austin, Texas..... 14
Philip Wiesner, Partner in Charge, Washington National Tax,
Client Services, KPMG LLP, Washington, DC...................... 32
Jeffrey Eischeid, Partner, Personal Financial Planning, KPMG LLP,
Atlanta, Georgia............................................... 32
Richard Lawrence DeLap, Retired National Partner in Charge,
Department of Professional Practice-Tax, KPMG LLP, Mountain
View, California............................................... 34
Larry Manth, former West Area Partner in Charge, Stratecon, KPMG
LLP, Los Angeles, California................................... 34
Richard J. Berry, Senior Tax Partner, Pricewaterhouse Coopers,
New York, New York............................................. 54
Mark A. Weinberger, Vice Chair, Tax Services, Ernst & Young LLP,
Washington, DC................................................. 55
Richard H. Smith, Jr., Vice Chair, Tax Services, KPMG LLP, New
York, New York................................................. 57
Thursday, November 20, 2003
Raymond J. Ruble, former Partner, Sidley Austin Brown and Wood,
LLP, New York, New York, represented by Jack Hoffinger......... 76
Thomas R. Smith, Jr., Partner, Sidley Austin Brown and Wood, New
York, New York................................................. 77
N. Jerold Cohen, Partner, Sutherland Asbill and Brennan, LLP,
Atlanta, Georgia, accompanied by J.D. Fleming.................. 79
William Boyle, former Vice President, Structured Finance Group,
Deutsche Bank AG, New York, New York........................... 95
Domenick DeGiorgio, former Vice President, Structured Finance,
HVB America, Inc., New York, New York, accompanied by Brian
Skarlatos...................................................... 97
John Larson, Managing Director, Presidio Advisory Services, San
Francisco, California.......................................... 114
Jeffrey Greenstein, Chief Executive Officer, Quellos Group, LLC,
formerly known as Quadra Advisors, LLC, Seattle, Washington.... 115
Mark Everson, Commissioner, Internal Revenue Service, Washington,
DC............................................................. 128
William J. McDonough, Chairman, Public Company Accounting
Oversight Board, Washington, DC................................ 130
Richard Spillenkothen, Director, Division of Banking Supervision
and Regulation, The Federal Reserve, Washington, DC............ 131
Alphabetical List of Witnesses
Berry, Richard J.:
Testimony.................................................... 54
Prepared statement........................................... 303
Boyle, William:
Testimony.................................................... 95
Prepared statement with an attachment........................ 317
Cohen, N. Jerold:
Testimony.................................................... 79
Letter dated November 18, 2003, submitted with answers to
questions.................................................. 315
DeGiorgio, Domenick:
Testimony.................................................... 97
Prepared statement........................................... 326
DeLap, Richard Lawrence:
Testimony.................................................... 34
Eischeid, Jeffrey:
Testimony.................................................... 32
Prepared statement........................................... 298
Everson, Mark:
Testimony.................................................... 128
Prepared statement with an attached chart.................... 338
Greenstein, Jeffrey:
Testimony.................................................... 115
Prepared statement........................................... 334
Johnson, Calvin H.:
Testimony.................................................... 14
Prepared statement........................................... 286
Manth, Larry:
Testimony.................................................... 34
Larson, John:
Testimony.................................................... 114
McDonough, William J.:
Testimony.................................................... 130
Prepared statement........................................... 349
Petersen, Debra S.:
Testimony.................................................... 11
Prepared statement........................................... 275
Ruble, Raymond J.:
Testimony.................................................... 76
Smith, Richard H., Jr.:
Testimony.................................................... 57
Smith, Thomas R., Jr.:
Testimony.................................................... 77
Prepared statement........................................... 312
Spillenkotchen, Richard:
Testimony.................................................... 131
Prepared statement........................................... 361
Watson, Mark T.:
Testimony.................................................... 13
Prepared statement........................................... 285
Weinberger, Mark A.:
Testimony.................................................... 55
Prepared statement........................................... 309
Wiesner, Philip:
Testimony.................................................... 32
APPENDIX
Minority Staff Report of the Permanent Subcommittee on
Investigations entitled, ``U.S. Tax Shelter Industry: The Role
of Accountants, Lawyers, and Financial Professionals, Four KPMG
Case Studies: FLIP, OPIS, BLIPS, and SC2,'' released in
conjunction with the Permanent Subcommittee on Investigations'
hearings on November 18 and 20, 2003, S. Prt. 108-34........... 145
I. INTRODUCTION.................................................. 145
II. FINDINGS..................................................... 147
III. EXECUTIVE SUMMARY........................................... 149
A. Developing New Tax Products............................. 151
B. Mass Marketing Tax Products............................. 152
C. Implementing Tax Products............................... 153
D. Avoiding Detection...................................... 157
E. Disregarding Professional Ethics........................ 159
IV. RECOMMENDATIONS.............................................. 160
V. OVERVIEW OF U.S. TAX SHELTER INDUSTRY......................... 162
A. Summary of Current Law on Tax Shelters.................. 162
B. U.S. Tax Shelter Industry and Professional Organizations 164
VI. FOUR KPMG CASE HISTORIES..................................... 166
A. KPMG In General......................................... 166
B. KPMG's Tax Shelter Activities........................... 168
(1) Developing New Tax Products.......................... 172
(2) Mass Marketing Tax Products.......................... 188
(3) Implementing Tax Products............................ 206
a. KPMG's Implementation Role......................... 206
b. Role of Third Parties in Implementing KPMG Tax
Products................................................... 215
(4) Avoiding Detection................................... 235
(5) Disregarding Professional Ethics..................... 245
APPENDIX A
CASE STUDY OF BOND LINKED ISSUE PREMIUM STRUCTURE (BLIPS).... 255
APPENDIX B
CASE STUDY OF S-CORPORATION CHARITABLE CONTRIBUTION STRATEGY
(SC2)...................................................... 266
APPENDIX C
OTHER KPMG INVESTIGATIONS OR ENFORCEMENT ACTIONS............. 270
EXHIBIT LIST
Volume 1
1. a. BLIPS: Bond Linked Issue Premium Structure, PowerPoint
presentation with eight slides prepared by the Permanent
Subcommittee on Investigations................................. 371
b. SC\2\, PowerPoint presentation with five slides
prepared by the Permanent Subcommittee on Investigations....... 379
c. Mass Marketing of Tax Shelters, chart prepared by the
Permanent Subcommittee on Investigations....................... 384
d. Knowledge of Counter Parties, chart prepared by the
Permanent Subcommittee on Investigations....................... 385
2. KPMG Memorandum, February 1998, re: Summary and
observations of OPIS........................................... 386
3. KPMG Memorandum, May 1998, re: OPIS Tax Shelter
Registration................................................... 393
4. Gibson, Dunn & Crutcher LLP Memorandum to KPMG, March 2000,
re: BLIPS Tax Opinion.......................................... 400
5. KPMG email, April 1999, re: BLIPS (``The original intent of
the parties was to participate in all three investment stages
of the Investment Program.'' It seems to me that this is a
critical element of the entire analysis and should not be
blithely assumed as a ``fact''. If it is true, I think it
should be one of the investor's representations. However, I
would caution that if there were, say, 50 separate investors
and all 50 bailed out of at the completion of Stage I, such a
representation would not seem credible.)....................... 408
6. KPMG email, February 2000, re: Product champions needed for
S Corp strategy (I want to personally thank everyone for their
effort during the approval process of this strategy. It was
completed very quickly and everyone demonstrated true teamwork.
Thank you! Now lets SELL, SELL, SELL!!)........................ 412
7. KPMG email, February 2000, re: BLIPS/OPIS (. . . the sooner
we get them out the door the better since the law--especially
the primary profit motive test--is evolving daily and not in a
taxpayer friendly manner. * * * As I understand the facts, all
66 closed out by year-end and triggered the tax loss.)......... 415
8. KPMG email, February 2001, re: SC2 Solution--New
Development (Quick Snapshot--We are now offering a modified SC2
solution. S Corp shareholders can use the structure of direct
significant gift to 501(c)(3) tax exempts of their choice. Net
tax benefit is less than original SC2 . . . shareholder ``feel
good'' factor is higher. We need targets and ICV's. * * * Look
at the last partner scorecard. Unlike golf, a low number is not
a good thing. . . . A lot of us need to put more revenue on the
board before June 30. SC2 can do it for you. Think about
targets in your area and call me.)............................. 423
9. KPMG email, June 2000, re: Revised SC2 Script, Rosenthal/
Stein approval of SC2 calling script........................... 426
10. KPMG emails, September 1998, January 1999, and October 2000
re: Grantor Trust Issue and KPMG Memorandum of Telephone Call,
May 2000, re: Grantor Trust Issue (So our best intelligence is
that you are increasing your odds of being audited, not
decreasing your odds by filing that Grantor Trust return. So we
have discontinued doing that.)................................. 428
11. KPMG email, March 1998, re: Simon Says (. . . and yet in
truth the option was really illusory and stood out more like a
sore thumb since no one in his right mind would pay such an
exorbitant price for such a warrant.).......................... 439
12. Email, May 1999, re: Who is the Borrower in the BLIPS
transaction (Based on your analysis below, do you conclude that
the tax results sought by the Investor are NOT ``more likely
than not'' to be realized? * * * Yes.)......................... 448
13. Email, August 1999, re: BLIPS (However, before engagement
letters are signed and revenue is collected, I feel it is
important to again note that I and several other WNT
[Washington National Tax] partners remain skeptical that the
tax results purportedly generated by a BLIPS transaction would
actually be sustained by a court if challenged by the IRS.).... 450
14. KPMG email, May 1998, re: OPIS Tax Shelter Registration (If
for some reason the IRS decides to ``get tough'' with someone
vis-a-vis the old rules, I suspect it could easily pick on ANY
of the Big 6, or for that matter any number of law firms/
promoters--I don't think we want to create a competitive
DISADVANTAGE, nor do we want to lead with our chin.)........... 451
15. KPMG email, December 1998, re: OPIS (After December 31,
1998, there will be no marketing of OPIS in any circumstances.) 452
16. KPMG email, July 1999, re: National Accounts Database
(VALUE PROPOSITION: . . . The all-in cost of the program,
assuming a complete loss of investment principal, is 7% of the
targeted tax loss (pre-tax). The tax benefit of the investment
program, which ranges from 20% to 45% of the targeted tax loss,
will depend on the taxpayer's effective tax rates. FEE: BLIPS
is priced on a fixed fee basis which should approximate 1.25%
of the tax loss. Note that this fee is included in the 7%
described above.).............................................. 453
17. KPMG email, August 1999, re: BLIPs (Depicting the approval
of BLIPS and views of some at KPMG about the strategy.)........ 455
18. KPMG email, September 1999, re: BLIPS 2000 (A number of
people are looking at doing BLIPS transactions to generate Y2K
losses. We currently have bank capacity to have $1 billion of
loans outstanding at 12/31/99. This translates into
approximately $400 million of premium. This tranche will be
implemented on a first-come, first-served basis until we fill
capacity. Get your signed engagement letters in!!)............. 459
19. KPMG email, February 2000, re: Hot Tax Products (5 Month
Mission) (Thanks for help in this critically important matter.
As Jeff [Stein] said, ``We are dealing with ruthless
execution--hand to hand combat--blocking and tackling.''
Whatever the mixed metaphor, let's just do it.)................ 460
20. KPMG email, April 2000, re: SC2 (There have been several
successes--the West and South Florida with many ICV's in other
parts of the country. We are behind. This is THE STRATEGY that
they expect significant value added fees by June 30. The heat
is on. . . .).................................................. 463
21. KPMG Document, SC\2\--Meeting Agenda June 19th, 2000....... 464
22. KPMG email, July 2000, re: Attaching memorandum to Tax
Partners and Tax Management Group. re: Selling with Confidence:
Skills for Successful Selling--``Positioning.''................ 486
23. KPMG email, August 2000, re: Solution Activity Reports--SC2
(Our team of telemarketers is particularly helpful in a number
of respects: --to further qualify prospects; --to set up phone
appointments for you and your deployment team.)................ 488
24. KPMG email, November 2000, re: SW SC2 Channel Conflict
(Attached is a list of SC2 targets in the Southwest that we are
including in an upcoming telemarketing program.)............... 490
25. KPMG email, December 2000, re: STRATECON WEST--KICK OFF
PLAN FOR '01 (. . . we must aggressively pursue these high-end
strategies.)................................................... 492
26. KPMG email, March 2001, re: Friday's Stratecon Call (Due to
the significant push for year-end revenue, all West Regional
Federal tax partners have been invited to join us on this call
and we will discuss our ``Quick Hit'' strategies and targeting
criteria.)..................................................... 494
27. KPMG email, April 2001, re: Friday's Stratecon Call (The
[tax] strategies have a quick revenue hit for us, . . .)....... 495
28. KPMG email, May 1999, re: Marketing BLIPS (One does not
need to understand how the program is structured to determine
whether someone has sufficient gain and has the tax risk
appetite to do an OPIS/BLIPS type strategy.)................... 496
29. KPMG email, September 1999, re: BLIPS--managing deal flow
(As you know, we have until 10/15 at the latest to close loans
and 10/22 to activate the FX trading etc. (the 60 day
countdown).)................................................... 499
30. KPMG email, October 1999, re: BLIPS (18 OPIS ``slots'' were
reserved for the intended BLIPS participants noted in the third
paragraph below.).............................................. 500
31. KPMG email, November 1999, re: BLIPS (It occurs to me that
it would be useful to know something about the investment
performance as we call these clients to discuss their go
forward strategy. . . . * * * As you may be aware, the 60-day
anniversary of your client's participation in the Strategic
Investment Fund is November 22nd. As a reminder for you and
your client, we have summarized certain procedures that may be
of interest.).................................................. 503
32. Generating Capital Losses, A Presentation for ------, KPMG
Peat Marwick LLP, ------, 1996................................. 505
33. KPMG Memorandum, June 1998, re: June 11 OPIS Conference
Call (Use of Nondisclosure Agreements and Outside Advisors).... 517
34. Email, July 1999, re: BLIPS--Economic Substance Issue
(Gentlemen, we have completed our review of the BLIPS loan
documents. In general, these documents indicate that the loan
proceeds will be invested in very safe investments (e.g., money
market instruments). Thus it seems very unlikely that the rate
of return on the investments purchased with the loan proceeds
will equal or exceed the interest charged on the loan and the
fees incurred by the borrower to secure the loan. * * * Before
any fees are considered, the client would have to generate a
240% annual rate of return on the $2.5 million foreign
currencies investment in order to break even. If fees are
considered, the necessary rate of return to break even will be
even greater.)................................................. 521
35. KPMG email, May 2000, re: Brown & Wood BLIPS Opinion
letters (As we discussed, the B&W opinion letters touch all the
necessary bases. The fact and representation sections are
almost identical to the ones in our Opinion and many analysis
sections are exact copies of our Opinion. Please let me know if
you want further details about the ``non-critical'' typos.).... 522
36. KPMG email, July 1999, re: brown&wood (If you have a KPMG
opinion, you should also have a B&W opinion. We do ours and
they use it as a factual template for their opinion, usually
within 48 hours.).............................................. 524
37. Internal Revenue Bulletin No. 2000-36, September 5, 2000,
Notice 2000-44, Tax avoidance using artificially high basis--
describing a BLIPS-type transaction............................ 525
38. KPMG Document, PFP Practice Reorganization, Innovative
Strategies Business Plan--DRAFT (May 18, 2001)................. 528
39. KPMG email, May 1999, re: BLIPS Update (Larry [DeLap], I
don't like this product and would prefer not to be associated
with it.)...................................................... 532
40. KPMG email, December 2000, re: Weekly Tax Solutions Call
(Larry [DeLap]--Are you suggesting that we stop marketing the
solution, or that you just don't want a public discussion of
the solution in light of the IRS focus?)....................... 533
41. KPMG's Personal Financial Planning Presentation, BLIPS AND
TRACT, Carol Warley, June 1999 (BLIPS Benefit: --Avoid All Of
The Capital Gains And Ordinary Income Tax; --Net Benefit To
Client --Effective Tax Rate Less After Tax Cost of Transaction
of Approximately 5%)........................................... 536
42. KPMG email, April 1999, re: BLIPS (The underlying tax
planning is such that the investor is likely to bail out after
Stage 1; i.e., after about 60 days.)........................... 543
43. KPMG email, March 2000, re: S-corp Product (No, we don't
disclose all risks in all engagement letters. * * * . . . I
definately (sic) agree on disclosing the risks upfront and
would prefer to have the separate memo that states the risks
involved. . . . is there a way to make the risk memo be covered
under 7525?)................................................... 545
44. Sutherland Asbill & Brennan LLP correspondence, July 2002,
re: Representations of BLIPS client............................ 555
45. KPMG correspondence to Sutherland, Asbill & Brennan LLP,
September 2002, re: Contract with KPMG for tax assessment for
BLIPS client................................................... 557
46. KPMG email, November 2002, re: Script (Attached is a list
of law firms that are handling FLIP/OPIS cases. * * * Attached
is the script . . . waiver language and list of attorneys to
follow.)....................................................... 560
47. KPMG email, March 2002, re: SC2 (Given the current state of
affairs relative to the IRS and accounting firms, I think we
should not be discussing SC2 on the Monday night call at this
time.)......................................................... 563
48. KPMG email, August 1999, re: BLIPS Engagement Letter
(Attached is the engagement letter approved by Larry [DeLap].). 566
49. KPMG email, March 2000, re: S-corp Product (1. This appears
to be little more than a old give stock to charity and then
redeem it play . . . * * * Our preference is that the client
donate stock to a local 401(a), . . .)......................... 574
50. KPMG email, April 2000, re: S-Corporation Charitable
Contribution Strategy (SC2) (This is a relatively high risk
strategy.)..................................................... 584
51. KPMG email, August 2001, re: New Solutions-WNT [Washington
National Tax] (Beginning in December . . . The shareholders
will most likely want access to the cash (especially if we
could get it to them tax-free).)............................... 585
52. KPMG email, October 2001, re: SC2 Client (His ownership is
so minute, he is concerned about it being reduced any further
by the charitable contribution. We know that this reduction is
only temporary, . . .)......................................... 587
53. KPMG Document, Tax Innovation Center, Product Idea
Submission Form and KPMG Tax Solution Alert, April 24, 2000, S-
Corporation Charitable Contribution Strategy................... 589
54. KPMG document, undated, Draft PDC Talk Points 6/19, S-
Corporation Charitable Contribution Strategy (Cold call
script.)....................................................... 595
55. KPMG email, March 2001, re: Florida S corporation search
(Request to utilize database on tax return information to
identify potential SC2 clients.)............................... 597
56. KPMG email, March 2001, re: South Florida SC2 Year End Push 599
57. KPMG email, March 2001, re: SC2--Client Base Expansion..... 601
58. KPMG email, December 2001, re: SC2 (. . . working on a
back-end solution to be approved by WNT [Washington National
Tax] that will provide S-corp shareholders additional basis in
their stock which will allow for the cash built-up inside of
the S-corporation to be distributed tax-free to the
shareholders.)................................................. 602
59. KPMG email, January 2002, re: SC2 (Shelly Nance is in Fort
Wayne, which is ``cold call central''. How can she (or he) be
involved in sending out messages about SC2 if it is not being
mass marketed.)................................................ 604
60. Permanent Subcommittee on Investigations correspondence to
KPMG, LLP, November 2003, re: November hearing testimony....... 609
61. KPMG Presentation excerpts: Tax Innovation Center Solution
and Idea Development--Year-End Results, May 30, 2001; and Goal:
Deposit 150 New Ideas in Tax Service Idea Bank................. 612
62. KPMG Presentation excerpts: Innovative Tax Solutions, July
19, 2001; Tax Practice Update; and Tax Practice Growth Gross
Revenue........................................................ 614
63. KPMG Presentation, S-Corporation Charitable Contribution
Strategy (SC2 Update), June 18, 2001, showing SC\2\ Revenues... 617
64. KPMG email, May 1999, re: BLIPS--More Likely Than Not? (. .
. while I am comfortable that WNT [Washington National Tax] did
its job reviewing and analyzing the technical issues associated
with BLIPS, based on the BLIPS meeting I attended on April 30
and May 1, I am not comfortable issuing a more-likely-than-not
opinion letter wrt (sic) this product . . .)................... 621
65. KPMG email, May 1999, re: BLIPS (The real ``rubber meets
the road'' will happen when the transaction is sold to
investors, what the investors' actual motive for investing the
transaction is and how the transaction actually unfolds. * * *
My own recommendation is that we should be paid a lot of money
here for our opinion since the transaction is clearly one that
the IRS would review as falling squarely within the tax shelter
orbit.)........................................................ 623
66. KPMG email, August 1999, re: BLIPS involvement in the NE--
BDMs (KPMG's fee is 1.25% (125 basis points) of the gain to be
mitigated. This fee is included as part of the 7% investment in
strategy.)..................................................... 628
67. Deutsche Bank email, July 1999, re: Risk and Resources
Committee Paper (BLIPS Summary--The 7.7% will cover market
risks, transaction costs, and DBSI fees.)...................... 632
68. Email, September 1999, re: West (Larry [DeLap], just to
clarify, even if we have five or more investors in a single
BLIPS transaction, you don't think we need to register the
transaction as a tax shelter. Is this correct? * * * No, that
is not correct, Mark Ely has concluded there is a reasonable
basis not to register.)........................................ 641
69. Deutsche Bank/Presidio Advisors, LLC Memorandum, April
1999, re: BLIPS friction costs (On day 60, Investor exits
partnership and unwinds all trades in partnership.)............ 644
70. Deutsche Bank New Product Committee Overview Memo: BLIPS
Transaction (It is imperative that the transaction be wound up
after 45-60 days and the loan repaid due to the fact that the
HNW individual will not receive his/her capital loss (or tax
benefit) until the transaction is wound up and the loan
repaid.)....................................................... 646
71. First Union (Wachovia) Capital Management Group Enhanced
Investment Strategy Release, February 2, 1999.................. 651
72. KPMG Foreign Leveraged Investment Program, Issue and Hazard
Summary (Taxpayer not sufficiently ``at risk'' under section
465) (preliminary and final versions).......................... 652
73. KPMG email, February 1999, re: BLIPS (. . . status of the
BLIPS as an OPIS replacement strategy. . . . I would think we
can reasonably anticipate ``approval'' in another month or so.
* * * Given the marketplace potential of BLIPS, I think a month
is far too long-- . . .)....................................... 654
74. Email, February 1999, re: BLIPS Progress Report (I don't
like this pressure . . .)...................................... 655
75. KPMG MEETING SUMMARY, February 1999, re: Determine if BLIPS
is viable...................................................... 656
76. Email, April 1999, re: BLIPS (I would not characterize my
assessment of the economic substances of the ``premium
borrowing'' in the BLIPS transaction as ``positive.'')......... 660
77. Email, April 1999, re: BLIPS Analysis...................... 661
78. Email, May 1999, re: Who is the Borrower in the BLIPS
transaction.................................................... 662
79. Email, August 1999, re: BLIPS Documents--Acceptance of
Recommended Language........................................... 663
80. Email, May 1999, re: BLIPS (According to Presidio, the
probability of making a profit from this strategy is remove
(possible, but remote).)....................................... 664
81. KPMG email, May 1999, re: BLIPS (. . . my change in heart
about BLIPS was based on information Presidio disclosed to me
at a meeting on May 1. This information raised serious concerns
in my mind about the viability of the transaction, and
indicated that WNT [Washington National Tax] had not been given
complete information about how the transaction would be
structured . . .).............................................. 665
82. Email, August 1999, re: BLIPS (. . . before engagement
letters are signed and revenue is collected, I feel it is
important to again note that I and several other WNT
[Washington National Tax] partners remain skeptical that the
tax results . . . would actually be sustained by a court if
challenged by the IRS.)........................................ 666
83. Email, January 2000, re: BLIPS 2000 (The PFP guys really
need your help on the BLIPS 2000 strategy. . . . so we can take
this to market.)............................................... 667
84. Email, March 2000, re: Blips I, Grandfathered Blips, and
Blips 2000 (. . . I do not believe KPMG can reasonably issue a
more-likely-than-not opinion on the economic substance issues
for the Blips . . .)........................................... 668
85. KPMG Memoranda, February 1999, re: BLIPS................... 669
86. KPMG Memoranda, March 2000, re: Talking points on
significant tax issues for BLIPS 2000.......................... 670
87. KPMG Memoranda, S Corporation Charitable Contribution
Strategy, Summary of Certain Risks (The opinion also much be
based on all pertinent facts and the law as it relates to those
facts; must not be based upon inaccurate legal or factual
assumptions; and must not unreasonably rely upon the
representations, statements, findings, or agreements of the
taxpayer or any other person.)................................. 675
88. Email, May 1999, re: BLIPS (It was not until I heard
conflicting information that I questioned the original facts.
In the future, I will question everything Presidio and Randy
Bickham represent to me.]...................................... 677
89. KPMG Tax Leadership, 2003; KPMG Tax Practice Organization,
2002, 2001 and 2000............................................ 680
90. a. KPMG Tax Opinion Letter (Signed Final), December 1999.
[Redacted by the Permanent Subcommittee on Investigations]..... 684
b. Brown & Wood Tax Opinion Letter (Signed Final), December
1999. [Redacted by the Permanent Subcommittee on
Investigations]................................................ 781
c. SEALED EXHIBIT: Unredacted copies of Exhibit No. 90a.
and 90b (above)................................................ *
91. KPMG Memoranda, August 1998, re: Tax Products Practice (I
was responsible for KPMG's position that we should not register
OPIS as a tax shelter and insisted that we make the business
case with DPP. This was of significant benefit in marketing the
OPIS product and will establish the direction with respect to
KPMG's position on future tax products.)....................... 857
92. KPMG email, September 1998, re: OPIS (These fees relate to
approximately $1.2 billion in notional losses for approximately
25 clients.)................................................... 865
93. Email, June 1998, re: OPIS (Not only will this unduely
(sic) harm our ability to keep the product confidential, it
will DESTROY any chance the client may have to avoid the step
transaction doctrine.)......................................... 866
Volume 2
94. a.-ggg. Documents relating to FLIP/OPIS.................... 869
95. a.-BBB. Documents relating to BLIPS........................ 1240
96. a.-ll. Documents relating to SC2........................... 1692
Volume 3
97. a.-pp. Documents relating to development/marketing of tax
products....................................................... 1951
98. a.-ppp. Documents relating to registering, reporting and
filing with Internal Revenue Service........................... 2225
99. Documents relating to investment advisory firms:
a.-f. Quadra/Quellos........................................ 2473
g.-t. Presido............................................... 2485
100. Documents relating to law firms:
a.-u. Sidley Austin Brown & Wood............................ 2540
v.-gg. Sutherland Asbill & Brennan.......................... 2576
101. Quadra Capital Management, LP. facsimile, August 1996,
attaching Memorandum on UBS' involvement in U.S. Capital Loss
Generation Scheme (the ``CLG Scheme'') (As I mentioned, KPMG
approached us as to whether we could affect the security trades
necessary to achieve the desired tax results.)................. 2607
102. Deutsche Bank Memorandum, July 1999, re: GCI Risk and
Resources Committee--BLIPS Transaction......................... 2612
103. Deutsche Bank email, July 1999, re: Risk & Resources
Committee Paper--BLIPS and Comments on Blips Collateral and
Credit Terms (I would have thought you could still ensure that
the issues are highlighted by ensuring that the papers are
prepared, and all discussion held, in a way which makes them
legally privileged.)........................................... 2615
104. Deutsche Bank email, July 1999, re: Risk & Resources
Committee Paper--BLIPS (Our approach is as follows: STRUCTURE:
. . . Priviledge (sic): This is not easy to achieve and
therefore a more detailed description of the tax issues is not
advisable. REPUTATION RISK: . . . we have been asked by the Tax
Department not to create an audit trail in respect of the
Bank's tax affaires.).......................................... 2618
105. Deutsche Bank email, February 2002, re: Updated Presidio/
KPMG trades (I understand that we based our limitations on
concerns regarding reputational risk which were heightened, in
part, on the proportion of deals we have executed relative to
the other banks. * * * . . . we would like to lend an amount of
money to Hypovereinsbank equal to the amount of money
Hypovereinsbank lends to the client.).......................... 2619
106. Deutsche Bank email, April 2002, re: US GROUP 1 Pres,
attaching Structured Transactions Group North America
Presentation, November 15, 1999................................ 2622
107. HVB Document, undated, re: Presidio (7% -> fee (equity)
paid by investor for tax sheltering)........................... 2646
108. HVB email, September 1999, re: Presidio.................... 2647
109. Deutsche Bank email, April 1999, re: presidio--w. revisions
(. . . The holding period/life of the LLC will typically be 45
to 60 days. At the end of this time period, the LLC will unwind
all transactions, repay the loan par amount and premium amount.
For tax and accounting purposes, repaying the premium amount
will ``count'' like a loss for tax and accounting purposes.)... 2649
110. KPMG email, March 2000, re: Bank representation (The bank
has pushed back the loan again and said they simply will not
represent that the large premium loan is consistent with
industry standards.)........................................... 2657
111. HVB credit request for BLIPS transaction by Presidio
personnel, September 1999. (HVB will earn a very attractive
return if the deal runs to term. If, however, the advances are
prepaid within 60 days (and there is a reasonable prospect that
they will be), HVB will earn a return of 2.84% p.a. on the
average balance of funds advanced.)............................ 2660
112. KPMG Memoranda, March 1998, re: OPIS (The attached went to
the entire working group. . . . I believe that the OPIS product
(``Son of Flip'') is a stripped down version of the LLC
(partnership) structure.)...................................... 2678
113. Deutsche Bank email, October 1999, re: BLIPS (PKS reports
that a meeting with John Ross was held on August 3, 1999 in
order to discuss the BLIPS product. PKS represented PB
Management's views on reputational risk and client suitability.
John Ross approved the product, however insisted that any
customer found to be in litigation be excluded from the
product, the product be limited to 25 customers and that a low
profile be kept on these transactions.)........................ 2679
114. Deutsche Bank New Product Committee Overview Memo: BLIPS
Transaction (11-DB will have the right to approve/disapprove
all trading activity in the Company. This will allow DB to
effectively force the closure of the company and repayment of
its loan to DB.) [Note: An alternative version of this document
was previously entered into the Permanent Subcommittee on
Investigations' hearing record as Exhibit No. 70.]............. 2681
115. KPMG Minutes of Assurance/Tax Professional Practice
Meeting, September 28, 1998.................................... 2686
116. Brown & Wood email, December 1997, re: joint projects (This
morning my managing partner, Tom Smith, approved Brown & Wood
LLP working with the newly conformed tax products group at KPMG
on a joint basis in which we would jointly develop and market
tax products and jointly share in the fees, as you and I have
discussed.).................................................... 2691
117. KPMG email, September 1997, re: Flip Tax Opinion (ALSO, OUR
DEAL WITH BROWN AND WOOD IS THAT IF THERE NAME IS USED IN
SELLING THE STRATEGY, THEY WILL GET A FEE.).................... 2692
118. KPMG Memorandum, March 1998, re: B&W Meeting (What should
be the profit-split between KPMG, B&W and the tax products
group/implementor for jointly-developed products?)............. 2693
119. KPMG Memorandum, December 1997, re: Business Model--Brown &
Wood Strategic Alliance........................................ 2696
120. Brown & Wood email, December 1997, re: Confidential Matters
(On another point, as I have been mentioning with you, I do
work for a number of people who have potentially complementary
tax advantaged products. Let me state up front, I am not trying
to push any of these on KPMG, but it might be useful if you are
trying to get a repitoire of products jump started to talk to
some or all of them. In addition, each of them has a
relationship with one or more financial institutions who
provide credit, derivatives trades, etc. necessary to execute
the product.).................................................. 2699
121. KPMG email, May 2000, re: BLIPS--7 percent (The breakout
for a typical deal is as follows: . . . Trading Loss 70 * * *
Attached is Kerry's breakout of the 7 percent. [Redacted] gets
30 bpts from the Mgt. Fee. Is this detailed enough?)........... 2701
122. KPMG email, September 1999, re: BLIPS--managing deal flow
(As you know, we have until 10/15 at the latest to close loans
and 10/22 to activate the FX trading, etc. (the 60 day
countdown).)................................................... 2702
123. HVB Memorandum, October 1999, re: Presidio Credit Request
Dated September 14, 1999 (To summarize the above, the increased
limits will now permit the full amount of our facility to be
invested in EUR deposits and do related forwards.)............. 2703
124. HVB Document, Back-End Process............................. 2705
125. HVB Document, Transaction Timeline (Exchange USD Amount to
EUR Amount * * * USD 181,300,000).............................. 2711
126. PRESIDIO ADVISORY SERVICES, LLC Memorandum, April 2002, re:
Year 2000 Strategic Plan. (Over the past two years because of
delays in obtaining the requisite approvals to market the OPIS
and BLIPS products, we did not begin closing deals until
September of 1998 and 1999, respectively. * * * Both Deutsche
Bank and KPMG have requested that we replace our existing BLIPS
product with a new product in 2000.)........................... 2712
127. KPMG/Presidio Advisors email, October 1999, re: Couple of
quick questions--Liquidating distributions (Upon distribution
(at the end of the 60 day period), can the client designate
where the funds go?)........................................... 2719
128. Handwritten notes, March 1998, re: Brown & Wood (Confirm w/
Presidio that they will register.)............................. 2720
129. PRESIDIO ADVISORY SERVICES, LLC Memorandum, September 1999,
re: BLIPS loan test case (Four special purpose, single member
Delaware LLC, owned by four trusts: D. Amir Makov revocable
trust (1/3), JL capital trust (1/3), RP capital trust (1/6),
pointe du Hoc irrevocable trust (1/6))......................... 2721
130. KPMG/Presidio Advisors email, December 1998, re: BLIPS
meeting (Second, the tax analyses and opinion writing needs to
go into high gear.)............................................ 2722
131. KPMG/Presidio Advisors/Brown & Wood email, December 1998,
re: BLIPS meeting (I spoke with R.J. this morning about a
``tax-focused'' meeting next week. As a first step before
scheduling a meeting, we thought that we should first draft the
base of an opinion letter in an outline format which will be
circulated for comment before getting everyone together for a
``all-hands'' meeting. We are currently working on the document
and expect to circulate it next week.)......................... 2723
132. KPMG email, February 2000, re: Brown & Wood opinion
letter--BLIPS (Jeff Eischeid has promised the Brown & Wood
opinion template ready in two weeks and we need your analysis.) 2724
133. KPMG email, January 2001, re: blips (We're still working
with Moore & Van Allen. They've declined to write a concurring
opinion--their firm doesn't write such opinions as a matter of
policy. They are considering, this week, whether they will
write [redacted] a MLTN [More Likely than Not] penalty
opinion.)...................................................... 2726
134. IRS Form 8264, Application for Registration of a Tax
Shelter, QA Investments, LLC registration of FLIP.............. 2727
135. KPMG/Quadra Fax and Memoranda, October 1997, re:
Registration of FLIP........................................... 2729
136. Deutsche Bank email, July 1999, re: hi bill..presidio (i
informed him that you are point man on the deal and that all
comments should go through you)................................ 2734
137. KPMG email and Memorandum, July 1997, re: Revised
Memorandum ((I) KPMG's Tax Advantaged Transaction Practice;
(II) Presidio's Relationship with KPMG; (III) Transition
Issues.)....................................................... 2735
138. HVB Document, August 2000, Presidio--Plafond (Investors
have, so far, chosen to liquidate before the second (180 day)
phase. ie after 60 days.)...................................... 2745
139. a.-t. Documents relating to Ernst & Young.................. 2746
140. a.-o. Documents relating to PriceWaterhouseCoopers......... 2803
141. a.-k. Documents relating to First Union.................... 2848
142. a. WNT Solutions by Primary Functional Group--FYI 2001-
2002, November 26, 2002, reprinting first three pages of
document (other pages sealed, see Exhibit 139b.)............... 2871
b. SEALED EXHIBIT: WNT Solutions by Primary Functional
Group--FYI 2001-2002, dated November 26, 2002.................. *
143. SEALED EXHIBIT: StrateconWest email, December 2001, re:
StrateconWest/FSG Solution (Please find attached the latest and
greatest list of strategies for StrateconWest and FSG)......... *
144. SEALED EXHIBIT: Correspondence between Brown & Wood LLP and
Presidio Advisors LLC, dated October 1998 and February 1999,
regarding billing and document preparation for tax opinion..... *
145. Organizational Chart, KPMG Tax Practice Organization,
produced by KPMG LLP in response to request made by Senator
Levin at the November 18, 2003, hearing........................ 2874
146. Statement for the Hearing Record of Reuven S. Avi-Yonah,
Irwin I. Cohn Professor of Law and Director of the
International Tax Master of Law Program at the University of
Michigan Law School............................................ 2875
147. a.-b. Supplemental questions and answers for the record of
KPMG. [Note: Exhibit 147a has been redacted, full document has
been made a SEALED EXHIBIT.]................................... 2878
148. Supplemental questions and answers for the record of
Deutsche Bank.................................................. 2939
149. Supplemental questions and answers for the record of HVB
America, Inc................................................... 2949
150. Supplemental questions and answers for the record of
Quellos Group, LLC............................................. 2982
151. Supplemental questions and answers for the record of
Sutherland Asbill & Brennan LLP [Note: Submission has been
redacted, full document has been made a SEALED EXHIBIT.]....... 2984
152. Supplemental questions and answers for the record of Sidley
Austin Brown & Wood............................................ 2999
153. Statement for the Record and supplemental questions and
answers for the record of the Los Angeles Department of Fire &
Police Pensions System......................................... 3016
154. Supplemental questions and answers for the record of the
Internal Revenue Service....................................... 3025
Volume 4
155. Documents relating to Footnotes found in U.S. Tax Shelter
Industry: The Role of Accountants, Lawyers, and Financial
Professionals--Four KPMG Case Studies: FLIP, OPIS, BLIPS, and
SC2, a Report prepared by the Minority Staff of the Permanent
Subcommittee on Investigations in conjunction with the
Subcommittee hearings held November 18 and 20, 2003: [Note:
Footnotes not listed are explanative, reference Subcommittee
interviews for which records are not available to the public,
or reference a widely available public document.]
Footnote No. 1, SEALED EXHIBIT............................. *
Footnote No. 3, See Hearing Exhibit No. 38 (above)......... 528
Footnote No. 4, See Hearing Exhibit No. 16 (above)......... 453
Footnote No. 10, See Attachments (2)...................3027, 3036
Footnote No. 11, See Attachment............................ 3045
Footnote Nos. 15-16, See Hearing Exhibit No. 106 (above)... 2622
Footnote No. 47, See Hearing Exhibit No. 62 (above)........ 614
Footnote No. 48, See Attachment............................ 3047
Footnote No. 49, See Hearing Exhibit No. 38 (above)........ 528
Footnote No. 50, See Attachment............................ 3053
Footnote No. 52, See Attachment............................ 3054
Footnote No. 55, See Footnote No. 52 (above)............... 587
Footnote No. 56, SEALED EXHIBIT............................ *
Footnote No. 57, See Attachment............................ 3244
Footnote Nos. 58-59, See Footnote No. 57 (above)........... 601
Footnote No. 65, See Attachment............................ 3245
Footnote No. 66, See Hearing Exhibit No. 14 (above)........ 451
Footnote No. 68, See Attachment............................ 3248
Footnote No. 69, See Attachment............................ 3351
Footnote No. 70, See Footnote 69 (above)................... 644
Footnote No. 71, See Hearing Exhibit No. 61 (above)........ 612
Footnote No. 72, See Footnote No. 52 (above)............... 587
Footnote Nos. 73-74, See Footnote No. 69 (above)........... 644
Footnote Nos. 76-77, 79-81, See Footnote No. 52 (above).... 587
Footnote No. 82, See Footnote No. 69 (above)............... 644
Footnote No. 83, See Footnote No. 52 (above)............... 587
Footnote No. 84, See Attachment, Footnote No. 52 and
Hearing Exhibit Nos. 96ff, 96hh, and 96kk (above3375, 587, 1692
Footnote No. 87, See Hearing Exhibit No. 73 (above)........ 654
Footnote No. 88, See Hearing Exhibit Nos. 73 and 85 (abov654, 669
Footnote No. 89, See Hearing Exhibit No. 74 (above)........ 655
Footnote No. 90, See Hearing Exhibit No. 75 (above)........ 656
Footnote Nos. 92-93, See Hearing Exhibit No. 64 (above).... 621
Footnote No. 94, See Hearing Exhibit Nos. 64, and 76-79
(above)............................................621, 660-663
Footnote Nos. 95-96, See Hearing Exhibit No. 65 (above).... 623
Footnote No. 97, See Hearing Exhibit No. 12 (above)........ 448
Footnote No. 98, See Attachment............................ 3468
Footnote No. 99, See Attachment and Hearing Exhibit No. 65
(above)...............................................3469, 623
Footnote No. 100, See Hearing Exhibit No. 65 (above)....... 623
Footnote No. 101, See Hearing Exhibit No. 81 (above)....... 665
Footnote No. 102, See Hearing Exhibit No. 39 (above)....... 532
Footnote No. 103, See Attachment........................... 3472
Footnote No. 107, See Attachment........................... 3474
Footnote Nos. 108-109, See Hearing Exhibit No. 13 (above).. 450
Footnote No. 110, See Hearing Exhibit No. 83 (above)....... 667
Footnote No. 111, See Hearing Exhibit Nos. 84 and 86
(above)................................................668, 670
Footnote No. 113, See Hearing Exhibit No. 41 (above)....... 538
Footnote No. 115, See Hearing Exhibit No. 38 (above)....... 528
Footnote No. 116, See Hearing Exhibit No. 2 (above)........ 386
Footnote No. 117, See Attachment........................... 3475
Footnote No. 121, See Attachment........................... 3482
Footnote No. 122, See Attachment........................... 3492
Footnote No. 123, See Hearing Exhibit No. 87 (above)....... 675
Footnote No. 124, See Hearing Exhibit No. 49 (above)....... 574
Footnote No. 125, See Attachments (2) and Hearing Exhibit
No. 49 (above)........................................3495, 574
Footnote No. 126, See Attachments (3) and Hearing Exhibit
No. 49 (above)........................................3506, 574
Footnote No. 127, See Hearing Exhibit No. 59 (above)....... 604
Footnote Nos. 128-129, See Footnote No. 52 (above)......... 587
Footnote No. 130, See Attachment and Hearing Exhibit No. 54
(above)...............................................3517, 595
Footnote No. 131, See Hearing Exhibit No. 23 (above)....... 488
Footnote No. 132, See Attachment........................... 3519
Footnote No. 133, See Hearing Exhibit No. 6 (above)........ 412
Footnote No. 134, See Hearing Exhibit No. 20 (above)....... 463
Footnote No. 135, See Attachment........................... 3520
Footnote No. 136, See Hearing Exhibit No. 25 (above)....... 492
Footnote No. 137, See Hearing Exhibit No. 8 (above)........ 423
Footnote No. 138, See Attachment........................... 3522
Footnote No. 139, See Hearing Exhibit No. 27 (above)....... 495
Footnote No. 140, See Hearing Exhibit No. 19 (above)....... 460
Footnote No. 141, See Attachment........................... 3523
Footnote Nos. 142-143, See Hearing Exhibit No. 55 (above).. 597
Footnote No. 144, See Attachment........................... 3530
Footnote Nos. 145-148, See Footnote No. 144 (above)........ 3530
Footnote No. 149, See Attachment (Partial document
reprinted, full document SEALED EXHIBIT)................. 3557
Footnote No. 150, See Attachment (Partial document
reprinted, full document SEALED EXHIBIT)................. 3568
Footnote No. 151, See Attachment........................... 3572
Footnote No. 152, See Attachment........................... 3573
Footnote No. 154, See Attachments (2)...................... 3575
Footnote No. 155, See Footnote No. 135 (above)............. 2729
Footnote No. 156, See Attachment........................... 3579
Footnote No. 157, See Attachments (3), Footnote No. 156 and
Hearing Exhibit No. 56 (above)..................3581, 3579, 599
Footnote No. 158, See Hearing Exhibit No. 55 (above)....... 597
Footnote No. 159, See Hearing Exhibit No. 24 (above)....... 490
Footnote No. 160, See Attachments (2)...................... 3591
Footnote Nos. 161-162, See Footnote No. 157 (above)........ 3581
Footnote No. 163, See Attachment........................... 3596
Footnote Nos. 166-167, See Hearing Exhibit No. 21 (above).. 464
Footnote No. 168, See Attachment, Footnote No. 156 and
Hearing Exhibit Nos. 21 and 139m (above)..3606, 3579, 464, 2746
Footnote Nos. 169 and 171, See Hearing Exhibit No. 21
(above).................................................. 464
Footnote No. 174, See Footnote No. 152 (above)............. 3573
Footnote No. 176, See Hearing Exhibit No. 63 (above)....... 617
Footnote No. 177, See Hearing Exhibit No. 62 (above)....... 614
Footnote No. 178, See Hearing Exhibit No. 23 (above)....... 488
Footnote No. 179, See Attachment........................... 3607
Footnote No. 180, See Footnote No. 57 (above).............. 3244
Footnote No. 181, See Footnote No. 151 (above)............. 3572
Footnote No. 183, See Attachment........................... 3620
Footnote Nos. 184-185, See Footnote No. 57 (above)......... 3244
Footnote No. 186, See Attachment (Partial document
reprinted, full document SEALED EXHIBIT)................. 3621
Footnote Nos. 187-188, See Footnote 186 (above)............ 3621
Footnote No. 189, See Footnote No. 56 (above) SEALED
EXHIBIT.................................................. *
Footnote Nos. 190-191, See Hearing Exhibit No. 38 (above).. 528
Footnote No. 192, See Attachment and Hearing Exhibit No. 38
(above)...............................................3623, 528
Footnote Nos. 193-194, See Hearing Exhibit No. 38 (above).. 528
Footnote No. 200, See Hearing Exhibit No. 137 (above)...... 2735
Footnote No. 201, See Attachment (Partial document
reprinted, full document SEALED EXHIBIT)................. 3929
Footnote No. 203, See Attachment and Hearing Exhibit No.3632, 623
Footnote No. 204, See Hearing Exhibit No. 21 (above)....... 464
Footnote No. 205, See Hearing Exhibit No. 8 (above)........ 423
Footnote No. 208, See Hearing Exhibit No. 21 (above)....... 464
Footnote No. 211, See Hearing Exhibit Nos. 51 and 58
(above)................................................585, 602
Footnote No. 213, See Footnote No. 84 (above).............. 3375
Footnote No. 214, See Hearing Exhibit No. 110 (above)...... 2657
Footnote No. 217, See Footnote No. 84 (above).............. 3375
Footnote No. 218, See Hearing Exhibit No. 64 (above)....... 621
Footnote No. 220, See Hearing Exhibit No. 5 (above)........ 408
Footnote No. 221, See Hearing Exhibit No. 7 (above)........ 415
Footnote No. 222, See Hearing Exhibit Nos. 38 and 64
(above)................................................528, 621
Footnote No. 223, See Attachments (2) and Hearing Exhibit
No. 15 (above)........................................3635, 452
Footnote No. 227, See Attachment........................... 3641
Footnote No. 228, See Footnote No. 223..................... 3635
Footnote No. 230, See Hearing Exhibit No. 105 (above)...... 2619
Footnote No. 231, See Footnote Nos. 157 and 163 (above)3581, 3596
Footnote No. 232, See Attachment........................... 3643
Footnote No. 234, See Hearing Exhibit No. 105 (above)...... 2619
Footnote No. 235, See Attachments (4)...................... 3644
Footnote No. 236, See Hearing Exhibit No. 105 (above)...... 2619
Footnote No. 238, See Footnote No. 117..................... 3475
Footnote No. 239, See Attachments (2) and Hearing Exhibit
Nos. 111 and 129 (above); two addition items for this
footnote are SEALED EXHIBITS...................3660, 2660, 2721
Footnote No. 240, See Attachment and Hearing Exhibit No. 70
(above)...............................................3665, 646
Footnote No. 241, See Footnote No. 235 and Hearing Exhibit
No. 138 (above)......................................3644, 2745
Footnote No. 242, See Hearing Exhibit Nos. 103 and 104
(above)..............................................2615, 2618
Footnote No. 243, See Hearing Exhibit No. 70 (above)....... 646
Footnote No. 244, See Attachment........................... 3668
Footnote Nos. 245-246, See Hearing Exhibit No. 113 (above). 2679
Footnote Nos. 248-250, See Hearing Exhibit No. 110 (above). 2657
Footnote No. 251, See Footnote No. 84...................... 3375
Footnote No. 252, See Hearing Exhibit No. 105 (above)...... 2619
Footnote Nos. 253-255, See Hearing Exhibit No. 106 (above). 2622
Footnote No. 256, See Attachment........................... 3670
Footnote No. 257, See Attachment and Hearing Exhibit No.
106 (above)..........................................3671, 2622
Footnote No. 258, See Hearing Exhibit No. 106 (above)...... 2622
Footnote No. 261, See Footnote No. 201 (above)............. 3929
Footnote No. 262, See Attachment........................... 3672
Footnote No. 263, See Attachment........................... 3678
Footnote No. 265, See Attachment, Footnote No. 244 and
Hearing Exhibit Nos. 70 and 108 (above)...3679, 3668, 646, 2647
Footnote No. 266, See Attachments (2) (One document
partially reprinted, full document is (SEALED EXHIBIT)... 3681
Footnote No. 267, See Footnote No. 266 (above)............. 3681
Footnote No. 268, See Attachment........................... 3687
Footnote No. 270, See Footnote No. 154 (above)............. 3575
Footnote No. 271, See Footnote No. 237 (above) (Found in
the files of the Subcommittee)........................... *
Footnote No. 272, See Attachment........................... 3690
Footnote No. 273, See Footnote No. 272 (above)............. 3690
Footnote No. 274, See Attachment........................... 3697
Footnote No. 275, See Attachments (5)...................... 3703
Footnote No. 276, See Footnote No. 275 (above)............. 3703
Footnote No. 278, See Hearing Exhibit No. 101 (above)...... 2607
Footnote No. 279, See Attachment........................... 3711
Footnote No. 280, See Attachment........................... 3712
Footnote No. 281, See Footnote No. 117 and Hearing Exhibit
No. 112 (above)......................................3475, 2678
Footnote No. 282, See Hearing Exhibit Nos. 64, 69 and 81
(above)...........................................621, 644, 665
Footnote No. 283, See Hearing Exhibit No. 81 (above)....... 665
Footnote No. 284. See Attachment........................... 3714
Footnote No. 285, See Attachment........................... 3717
Footnote No. 286, See Attachment (Four additional items for
this footnote are SEALED EXHIBITS)....................... 3718
Footnote No. 293, See Hearing Exhibit No. 120 (above)...... 2699
Footnote No. 294, See Hearing Exhibit No. 119 (above)...... 2696
Footnote No. 295, See Attachment........................... 3719
Footnote No. 296, See Footnote No. 117 and Hearing Exhibit
Nos. 42 and 112 (above).........................3475, 543, 2678
Footnote No. 299, See Footnote No. 156 (above)............. 3579
Footnote No. 301, See Attachment........................... 3722
Footnote No. 302, See Attachment........................... 3754
Footnote No. 303, See Hearing Exhibit No. 21 (above)....... 464
Footnote No. 306, See Attachment........................... 3756
Footnote No. 307, See Attachment........................... 3757
Footnote No. 308, See Footnote No. 307 (above)............. 3757
Footnote No. 310, See Hearing Exhibit No. 128 (above)...... 2720
Footnote No. 312, See Footnote No. 52 (above).............. 3054
Footnote No. 313, See Attachments (3)...................... 3767
Footnote No. 314, See Hearing Exhibit No. 38 (above)....... 528
Footnote No. 319, See Attachments (2)...................... 3775
Footnote No. 320, See Attachment........................... 3779
Footnote No. 321, See Attachments (2)...................... 3795
Footnote Nos. 322-323, See Footnote No. 320 (above)........ 3779
Footnote No. 324, See Attachment and Footnote No. 320..3801, 3779
Footnote No. 327, See Attachment........................... 3812
Footnote No. 328, See Attachment.......................... 3813
Footnote No. 329, See Attachments (2)..................... 3814
Footnote No. 330, See Footnote No. 329 (above)............ 3814
Footnote No. 331, See Attachments (3)..................... 3816
Footnote No. 332, See Attachments (3)..................... 3822
Footnote No. 333, See Hearing Exhibit No. 21 (above)...... 464
Footnote Nos. 335-336, See Hearing Exhibit No. 43 (above). 545
Footnote No. 337, See Hearing Exhibit No. 128 (above)..... 2720
Footnote No. 338, See Hearing Exhibit No. 103 (above)..... 2615
Footnote No. 339, See Hearing Exhibit No. 104 (above)..... 2618
Footnote No. 340, See Footnote No. 154 (above)............ 3575
Footnote No. 341, See Attachment.......................... 3830
Footnote No. 342, See Attachments (2)..................... 3831
Footnote No. 343, See Footnote No. 203 (above)............ 3632
Footnote Nos. 344 and 346, See Hearing Exhibit No. 28
(above).................................................. 496
Footnote No. 347, See Footnote No. 122 (above)............ 3492
Footnote No. 348, See Hearing Exhibit No. 28 (above)...... 496
Footnote Nos. 349-350, See Footnote No. 163 (above)....... 3596
Footnote No. 351, See Footnote No. 117 (above)............ 3475
Footnote No. 352, See Footnote No. 52 (above)............. 3054
Footnote No. 355, See Attachment.......................... 3835
Footnote No. 356, See Footnote No. 355 (above)............ 3835
Footnote No. 359, See Attachment and Footnote No. 203
(above).................................................. 3840
Footnote No. 360, See Hearing Exhibit No. 121 (above)..... 3482
Footnote No. 361, See Attachment and Hearing Exhibit No.
58 (above)............................................3842, 602
Footnote No. 362, See Footnote No. 361 (above)............ 3842
Footnote No. 363, See Attachment.......................... 3847
Footnote No. 364, See Attachment.......................... 3848
Footnote No. 367, See Footnote No. 154 (above)............ 3575
Footnote Nos. 368-369, See Footnote No. 52 (above)........ 3054
Footnote No. 370, See Hearing Exhibit No. 115 (above)..... 2686
Footnote No. 371, See Footnote No. 52 (above)............. 3054
Footnote No. 372, See Hearing Exhibit No. 114 (above)..... 2681
Footnote No. 373, See Attachments (2) and Footnote Nos.
154 and 203 (above)............................3850, 3575, 3632
Footnote No. 374, See Footnote No. 373 (above)............ 3850
Footnote No. 375, See Footnote No. 144 (above)............ 3530
Footnote No. 376, See Footnote No. 150 (above)............ 3568
Footnote No. 377, See Footnote No. 151 (above)............ 3572
Footnote No. 378, See Footnote No. 355 (above)............ 3835
Footnote Nos. 379-382, See Hearing Exhibit No. 115 (above) 2686
Footnote No. 383, See Attachment and Hearing Exhibit No.
46 (above)............................................3853, 560
Footnote No. 384, See Hearing Exhibit No. 44 (above)...... 555
Footnote No. 385, See Attachment.......................... 3854
Footnote No. 386, See Hearing Exhibit No. 38 (above)...... 528
U.S. TAX SHELTER INDUSTRY: THE ROLE OF ACCOUNTANTS, LAWYERS, AND
FINANCIAL PROFESSIONALS
----------
TUESDAY, NOVEMBER 18, 2003
U.S. Senate,
Permanent Subcommittee on Investigations,
of the Committee on Governmental Affairs,
Washington, DC.
The Subcommittee met, pursuant to notice, at 9:02 a.m., in
room SH-216, Hart Senate Office Building, Hon. Norm Coleman,
Chairman of the Subcommittee, presiding.
Present: Senators Coleman, Levin, and Lautenberg.
Staff Present: Raymond V. Shepherd, III, Staff Director and
Chief Counsel; Joseph V. Kennedy, General Counsel; Mary D.
Robertson, Chief Clerk; Leland Erickson, Counsel; Mark
Greenblatt, Counsel; Steven Groves, Counsel; Frank J. Minore,
Detailee, GAO; Kristin Meyer, Staff Assistant; Steve D'Ettorre,
Staff Assistant; Bryan Nelson, Intern; Elise J. Bean, Staff
Director/Chief Counsel to the Minority; Bob Roach, Counsel and
Chief Investigator to the Minority; Laura Stuber, Counsel to
the Minority; Brian Plesser, Counsel to the Minority; Julie
Davis, Professional Staff Member; Christopher Kramer,
Professional Staff Member to the Minority; Beth Merillat-
Bianchi, Detailee, IRS; Jim Pittrizzi, Detailee, GAO; Rebecca
Dirks, Intern; Ken Seifert, Intern; Jessilyn Cameron, Brookings
Fellow; Grant Bosser (Senator Sununu); Nate Graham (Senator
Bennett); Kevin Carpenter (Senator Specter); Mimi Braniff
(Senator Stevens); David Berrick (Senator Lieberman); Gita
Uppal (Senator Pryor); Rudy Broiche (Senator Lautenberg); and
Mandana Parsazad (Senator Dayton).
OPENING STATEMENT OF SENATOR COLEMAN
Senator Coleman. This hearing of the Permanent Subcommittee
on Investigations is called to order.
I want to thank you for attending today's hearing. Today
and Thursday we will focus on a set of issues developed by this
Subcommittee's Ranking Member, Senator Levin. And, Senator
Levin, I would like to commend you for your tireless efforts to
prevent the abuse of our tax code by those willing to exploit
loopholes and avoid paying legitimate taxes. You have done
tremendous work in this area, and it is a pleasure for me to
work with you.
In a bipartisan fashion, PSI has developed a deeper
understanding of the history of individual tax shelters. PSI
has uncovered how those shelters work, how they were marketed
to potential investors, and how they were structured in order
to avoid scrutiny by the Internal Revenue Service. Due to the
complexity of these schemes, our hearings will focus only on a
few of the shelters, but there are many others like them.
There is an old English proverb that says, ``A clean glove
often hides a dirty hand.'' Today we will hear firsthand how
the ethical standards of the legal and accounting profession
have been pushed, prodded, bent, and in some cases broken for
enormous monetary gain. The fact is abusive and potentially
illegal tax shelters sold to corporations and wealthy
individuals rob the U.S. Treasury of billions of dollars in
lost tax revenues annually.
Let me be clear: While some of the products we discuss
today are not technically illegal, they are most certainly
ethically questionable and demonstrate a deliberate effort on
the part of the participants to fly underneath the regulatory
radar of the IRS. This is not a victimless crime. It is not the
government that loses money. It is the people of America,
average working families who will bear the brunt of lost
revenues so that a handful of rich lawyers, accountants, and
their clients can manipulate legitimate business practices to
make a profit.
According to the GAO, a recent IRS consultant estimated
that for the 6-year period 1993 to 1999, the IRS lost an
average of between $11 and $15 billion each year from abuse of
tax shelters. The GAO reports that an IRS database tracking
unresolved abusive tax shelter cases over a number of years
estimates potential tax losses of about $33 billion from listed
transactions and another $52 billion from unlisted abusive
transactions, for a total of $85 billion.
As I said, this is not a victimless crime. To put this in
context, if the IRS proactively shut down these abusive tax
shelters and collected the diverted revenue, it would have
helped to finance a substantial portion of our efforts in Iraq.
Abusive tax shelters are fashioned in the likeness of
legitimate transactions as permitted under the IRS Code. The
transactions themselves are highly complex, involving
accounting firms, major financial institutions, investment
firms, and prestigious law firms. Not only are these
participants necessary for the transaction, they provide the
added benefit of making detection by the IRS difficult.
Moreover, these entities provide a veneer of legitimacy, for
abusive tax shelters are, in fact, illusory and sham
transactions with little or no economic substance, driven
primarily for favorable tax consequences.
There are three ovearching issues that these hearings will
address. The first is the Internal Revenue Service's ability to
enforce the Nation's tax laws. There is no doubt that our tax
laws are very complex and give rise to different
interpretations. The Service's interpretation is not legally
controlling, and taxpayers have the right to ignore it if they
think a court will uphold their reading of the statutes and
regulations. But the IRS does have a right to challenge tax
strategies it thinks are invalid. In order for the Service to
challenge strategies and for the courts to rule, they must be
aware of how taxpayers are applying the law.
The Subcommittee's investigation has uncovered evidence
that the transactions studied here were deliberately designed
to avoid detection by the IRS. Even an illegal strategy works
if the government never finds out about it. Even more
disturbing, the IRS has specific rules that require the
promoters of certain tax products to notify the IRS whenever a
taxpayer uses one of them. This gives the IRS the opportunity
to review how the taxpayer has applied law to his or her
specific situation.
Evidence suggests that the accounting firms knowingly
evaded this requirement and that the IRS has not been as
forceful in its administration of this registration requirement
as it could be.
When transactions are hidden from the government, it loses
its ability to enforce the law. The perception can quickly
arise that fair application of revenue statutes is a sucker's
game, that those who are rich and powerful ignore it or
interpret it to their own benefit, and that only the average
guy gets stuck with his full share. The system that relies
primarily on voluntary compliance cannot afford to allow this
perception to seem real.
Second, for a long time both the accounting and legal
industries have been justifiably proud of their professions.
Both have held themselves up to the public as practicing a high
standard of professional ethics and giving the public honest
access to a complex body of doctrine. Given the complexity of
tax and accounting law, Americans with any wealth are
increasingly dependent on professional advice in order to
reconcile their personal interests with legal requirements. If
clients cannot have absolute confidence in the accuracy of the
advice they get, these professions no longer will merit the
high standard we have previously given them.
This leads naturally to the third major theme of these
hearings. We all know that an institution, especially one as
large as the accounting firms appearing here today, cannot be
held strictly responsible for every action of all their
employees. Individual workers often have motives and take
actions that are directly contrary to the intentions of a
company's leaders. But because we foresee these conflicts, the
existence of strong internal controls has become a key
component of modern management practices. These controls are
meant to ensure that no single employee or group of employees
is allowed to subject the firm to a large amount of risk
without the leadership's approval.
We will hear evidence that the internal controls that the
accounting and law firms seem to have had in place did not
work. The people responsible for ensuring firm quality often
raise serious questions about the transactions we will discuss
today. Yet it appears that their advice and recommendations
were often disregarded in the effort to boost revenue.
These three issues--the ability of the IRS to learn of
aggressive tax strategies, the possibility of misleading advice
to taxpayers, and the breakdown of internal controls--all raise
serious issues about future policy toward the tax industry. I
am hopeful that the information Senator Levin has helped us
uncover will lead to positive reforms.
I look forward to hearing from our panelists this morning,
and I especially look forward to Senator Levin's questioning of
the panelists. I know we will all learn a great deal today.
With that, I will turn it over to the distinguished Ranking
Member, Senator Levin.
OPENING STATEMENT OF SENATOR LEVIN
Senator Levin. Thank you, Mr. Chairman, for your comments
and for your support of this investigation that began a year
ago when I was Chairman here, but has continued with the
support of Senator Coleman. We are grateful for that and for
what this is going to lead to, hopefully, as he points out.
What we must point toward are a series of significant reforms
if we are going to change the practices which we are going to
hear described this morning.
My statement is something of a long statement because I do
want to set forth what these shelters are in detail so that we
can understand them. I know I have the understanding of our
Chairman in proceeding this way. Normally I would try to limit
an opening statement to 10 minutes, but this one could go 15
minutes or so, and I thank the Chairman for his understanding
of that, even though we have a very difficult time schedule
this morning.
Unlike legitimate tax shelters, abusive tax shelters have
no real economic substance. They are designed to provide tax
benefits not intended by the tax code and are almost always
convoluted and complex. Crimes like terrorism or murder or
fraud or embezzlement produce instant recognition of the
immorality involved. But abusive tax shelters are MEGOs--that
means ``my eyes glaze over.'' Those who cook up these
concoctions count on their complexity to escape scrutiny and
public ire.
The tax shelter industry is also fundamentally different
than it was a few years ago. Instead of individuals and
corporations going to their accountant or law firm and asking
for tax planning advice, the engine driving the industry is now
a horde of tax advisers cooking up one complex scheme after
another, so-called tax products, generally unsolicited by
clients, and then using elaborate marketing schemes to peddle
these products across the country.
In order to gain a deeper understanding of the issues
involved in the marketing of these products, the Subcommittee
conducted an in-depth case study examining four tax products
designed, marketed, and sold by a leading accounting firm,
KPMG, to individuals or corporations to help them reduce or
eliminate their U.S. taxes. These four products are known to
KPMG and its clients as BLIPS, FLIPS, OPIS, and SC2.
We are releasing a 125-page Minority Staff Report today
detailing what we found in these four case histories.\1\
---------------------------------------------------------------------------
\1\ The Minority Staff Report appears in the Appendix on page 145.
---------------------------------------------------------------------------
The testimony today will disclose a tawdry tale: A highly
compromised internal review and approval process at KPMG;
highly aggressive marketing efforts to sell tax schemes aimed
at producing paper tax losses; and schemes which attempt to
disguise tax reduction scams as business activity, in the case
of BLIPS, or a charitable donation, in the case of SC2.
An excerpt from a long e-mail by a top KPMG tax
professional on whether KPMG should approve BLIPS for sale to
clients illustrates the skewed priorities. He said that the
decision on BLIPS came down to this: ``My own recommendation is
that we should be paid a lot of money here for our opinion
since the transaction is clearly one that the IRS would view as
falling squarely within the tax shelter orbit.''
Being paid a lot of money for a dubious tax scheme--that is
what it all comes down to.
The testimony today will pull back the curtain on the
pressure-cooker environment within KPMG to mass market its tax
products to multiple clients. Again, one detail illustrates the
extent of the problem: The full-fledged telemarketing center
that KPMG maintained in Fort Wayne, Indiana, and staffed with
people trained to make cold calls to find buyers for specific
tax products. The telemarketing scripts, the thousands of cold
calls made to sell the tax product known as SC2, the revisits
to potential buyers who said no the first time, all show KPMG
pushing its so-called tax products.
The testimony today will also show the lengths to which
KPMG went to hide its tax products and its sales efforts from
the IRS. Despite its 2003 inventory of 500 active tax products,
KPMG has never registered and thereby disclosed to the IRS the
existence of a single one of its tax products. It has claimed
in court and to the Subcommittee staff that it is not a tax
shelter promoter.
Today's testimony will disclose, however, that some tax
professionals within the firm advised the firm, to no avail, to
register some of its products as tax shelters.
You will also hear about improper tax return reporting by
KPMG, file clean-ups, and other efforts to hide their
activities from the IRS and public scrutiny.
Finally, you will hear today and in the hearing on Thursday
that in ventures as large and profitable as the marketing of
these tax shelters, there were many professionals ready to join
forces with KPMG to carry out the complex financial structures
required to camouflage the tax schemes behind a facade of
economic substance. These professionals included banks, which
financed the loans for sham transactions designed to create a
veneer of economic substance; investment advisory firms, which
cooked up phony financial transactions to create the appearance
of a business purpose; and law firms, which wrote boilerplate
legal opinions to justify dubious tax schemes and to shield
taxpayers from penalties.
With such a formidable array of talent and expertise,
potential clients were persuaded to buy and use the deceptive
shelters KPMG was peddling, and the U.S. Treasury was
effectively defrauded of taxes owed as a result.
We are going to focus on two shelters, BLIPS and SC2. Let's
first look at BLIPS. We have some charts here on the screens,
and some of you have, hopefully, charts in front of you.\1\
---------------------------------------------------------------------------
\1\ See Exhibit No. 1a. which appears in the Appendix on page 371.
---------------------------------------------------------------------------
BLIPS stands for Bond-Linked Issue Premium Structure.
Inside KPMG, BLIPS was called a ``loss generator'' because the
intent of the tax product was to generate a paper loss that the
buyer could then use to offset other income and to shelter that
other income from taxation.
For this example, we will suppose the BLIPS buyer--let's
call him the taxpayer--has a taxable gain or taxable income of
$20 million that the BLIPS transaction is intended to shelter
by creating a $20 million paper loss.
On the first slide, we will see the first step is the BLIPS
taxpayer setting up a shell corporation called a limited
liability company, or LLC. The taxpayer gives this shell
company out-of-pocket cash equal to 7 percent of the $20
million paper loss that he wants to create. In this case, that
means the taxpayer provides $1.4 million. This money will be
used for fees for the firms that are part of this scheme and
for an investment program set up as the fig leaf of economic
substance to hide what is really a tax scam.
On the next slide, we will see what happens next, which is
a bank makes a so-called 7-year loan of $50 million to the
shell company, LLC. The BLIPS taxpayer agrees to pay an above-
market interest rate on the loan, say 16 percent interest.
Because he is willing to pay such a high interest rate, the
bank also credits him with a so-called $20 million loan premium
that is, not coincidentally, equal to the tax loss that the
taxpayer is buying from KPMG. If the taxpayer later pays off
the loan early, as planned, the bank will charge a prepayment
penalty that, not coincidentally, will approximate the loan
premium and make sure that it is repaid. The bank credits the
taxpayer's account, which stays at the bank, with the $50
million so-called loan and the $20 million premium, for a total
of $70 million.
There are more wrinkles. For instance, in order to get the
$70 million, the taxpayer and the shell company have to agree
to severe restrictions on how the loan proceeds can be used.
And they must maintain collateral in cash or liquid securities
in an account at the same bank equal to at least 101 percent of
the loan and premium amount, meaning about $70.8 million.
Now, think about that for a moment, because this collateral
requirement is one key to understanding why this loan is a
sham. A cash collateral requirement of 101 percent means that
none of the loan proceeds can really be put at risk. That
money, more than the amount of the loan itself, has to be kept
safe in an account at the bank which, on paper, loaned it.
The next slide: Enter Presidio. They are the investment
advisory firm that works hand in glove with KPMG and handles a
lot of the legwork of the transaction. Presidio directs two
companies it controls--Presidio Growth and Presidio Resources--
to participate in the transaction.
Next, Presidio and the taxpayer's shell company form a
partnership called a strategic investment fund or SIF. The
taxpayer's shell company, that LLC, contributes all of its
assets to the partnership: The $1.4 million in cash from the
taxpayer and the $70 million credit from the so-called loan and
loan premium. The Presidio companies contribute about $140,000.
Based on these contributions, the taxpayer has a 90-percent
interest and Presidio collectively has a 10-percent interest in
the strategic investment fund.
The next slide: Here is the switcheroo. The shell company
decides with the consent of the bank to assign or transfer the
so-called bank loan to the fund.
Next slide: Here comes the fig leaf. The fund takes the
money it has and supposedly engages in foreign currency
transactions. The fund takes the so-called loan proceeds, the
$70 million, and simply converts them into euros and puts the
euros in what one bank calls a synthetic dollar account. The
fund also signs a contract to guarantee that it can convert the
euros back to the same number of dollars at no risk in 30 or 60
days. The fund also puts at risk a very small amount of money,
never more than what the taxpayer has contributed, by shorting
foreign currencies pegged to the U.S. dollar. Not much of an
investment program.
While the BLIPS loan is supposed to last 7 years, every
taxpayer that bought it, 186 out of 186, pulled out early, as
planned. They quit. They pulled out because the point of BLIPS
is not to invest money but to generate a paper loss for tax
purposes before the end of the tax year.
The last slide on BLIPS: Now we are at the unwind. At day
60, the taxpayer pulls out of the partnership. The partnership,
the fund, repays the so-called loan to the bank, plus a
prepayment penalty to cover the premium so that the whole $70
million is returned to the bank. The fund then distributes any
remaining assets to its partners, which usually is little or
nothing. The taxpayer's $1.4 million is usually gone, mostly in
fees, but that is a price that he is more than willing to pay
for the $20 million tax loss.
Because of the way the loan was structured, KPMG told the
taxpayer he can claim that his cost basis to participate in the
partnership is equal to the $20 million loan premium and the
$1.4 million in cash that he contributed to the partnership.
That means he supposedly can claim a $21.4 million loss on his
tax return.
Now, if this does not make much sense to you, it is because
the whole transaction is an elaborate concoction to create the
impression of economic substance. The taxpayer did not use the
$70 million loan proceeds at all due to the collateral
requirement. He parked that $70 million in a synthetic dollar
account at the bank and used his own money to make a few safe
currency transactions. He could have made those without any
loan at all. The point of the loan was simply to generate a tax
loss to shelter the taxpayer's other income.
KPMG approved BLIPS for sale in October 1999 and sold it to
186 people until, in September 2000, the IRS listed it as a
potentially abusive tax shelter. In 1 year, KPMG obtained at
least $53 million in fees, making BLIPS one of KPMG's top
revenue-producing tax products.
Now let's look at the second shelter, SC2, which stands for
S Corporation Charitable Contribution Strategy.\1\
---------------------------------------------------------------------------
\1\ See Exhibit No. 1b. which appears in the Appendix on page 379.
---------------------------------------------------------------------------
An S corporation is organized under Subchapter S of the tax
code, and its income is attributed to its shareholders and
taxed as ordinary individual income instead of corporate
income. Instead of generating a phony paper loss, this tax
product generated a phony charitable donation.
The first step is that KPMG approaches an existing S
corporation, usually owned by one person, with a purported
charitable donation strategy. The corporation takes several
steps to prepare for the SC2 transaction. First, assuming that
the S corporation had, let's say, 100 shares of common stock,
on KPMG's advice, the S corporation issues and distributes to
its sole shareholder an additional 900 non-voting shares plus
7,000 warrants to buy 7,000 more shares of the company stock in
the future. The corporation also issues a non-distribution
resolution stating that the company will not distribute any of
its income to its shareholders for a specified period of time,
usually 2 or 3 years.
Next, KPMG introduces the individual shareholder to a
qualified tax-exempt charity, which KPMG has made a major
effort to identify, and the individual donates the 900 non-
voting shares to this charity. The charity signs a redemption
agreement with the corporation, which allows the charity to
require the corporation to buy back the donated stock after a
specified period of time, usually the same amount of time
specified in the corporation's non-distribution resolution.
The redemption agreement and non-distribution resolution
are the keys to understanding why SC2 is a sham. Everyone
participating in this situation knows from the outset that the
stock donation is not intended to be permanent. It is intended
to be temporary. The clear understanding of all the parties is
that the charity will be selling the donated stock back to the
donor in a few years.
But the appearance for the moment is that the S corporation
now has two shareholders: The charity owns 900 non-voting
shares, and the individual owns 100 voting shares and 7,000
warrants.
On the next slide, we will see that for the next 2 or 3
years, while the charity is a shareholder in the S corporation,
due to the non-distribution resolution the corporation
allocates but does not actually distribute 90 percent of its
net income to the charity and 10 percent to the individual
shareholder.
The difference between ``allocation'' and ``distribution''
is critical. Under Federal tax law, an S corporation
shareholder, unless tax-exempt, pays income tax on the net
income ``allocated'' to it on the company books, not on the
cash actually ``distributed.'' According to KPMG, that means
that the 90 percent of company income allocated to the charity
is tax-exempt, while the individual has to pay taxes on only
the 10 percent allocated to him. That is true even though the
charity often never sees a nickel of the money supposedly
allocated to it and agrees, indeed, to forego that income.
On the third slide, we will see the following: We are 2 or
3 years down the road after significant net income has been
accumulating inside the company, when the charity's redemption
rights kick in. The charity sells back the 900 non-voting
shares to the S corporation for cash. While this cash payment
pales in comparison to the amount of sheltered corporate
income, because of the way the shares are valued, it is,
nonetheless, a significant amount for the charity.
Now the payout, the fourth slide. This is where the
individual shareholder makes out.
The charity has sold back its shares and is no longer a
shareholder in the S corporation. All of the income that has
been built up in the corporation for the last 2 or 3 years is
distributed to the individual shareholder. KPMG advises him
that on the 90 percent of the income allocated to the charity
previously, which is now his, he can claim the income is
capital gains, taxable at the lower capital gains rate, rather
than the higher ordinary income rate.
KPMG approved SC2 for sale in March 2000, and over the next
2 years sold it to about 58 corporations. This tax product
became one of KPMG's top tax products in the years 2000 and
2001, generating more than $28 million in fees for the firm.
KPMG discontinued the sales in late 2001. In early 2002, the
IRS asked KPMG to produce documents related to SC2 and is now
reviewing the product.
We may hear this morning that KPMG has seen the light, and
that it and the other large accounting firms no longer develop
and sell these types of aggressive shelters. Let's hope that is
the case. However, the report that we are releasing today
depicts a powerful engine going at full speed, developing and
selling 500 active tax products at KPMG as of February 2003.
That was the response date for the subpoena of this
Subcommittee.
Having claimed all during this year to my staff that these
tax products are legitimate, KPMG's prepared testimony today is
that the firm not only has turned off, but dismantled, that
500-cylinder engine.
List me as skeptical. I am simply afraid we cannot trust
the industry to police itself.
We need to take strong and forceful action to stop the
pilfering of our treasury and the damage to the credibility of
our tax system. We need stronger penalties on tax shelter
promoters, an end to auditor conflicts of interest, a better
economic substance test, and more enforcement dollars for the
IRS to go after tax shelter promoters and their abusive
schemes. These and other actions are outlined in the report
that my staff has released today.
These reforms are, of course, only part of the answer. The
firms involved in designing, hawking, and implementing these
dubious tax products need to restore professional pride. KPMG
now says it has stopped selling aggressive tax products.
Pricewaterhouse Coopers has withdrawn from a number of
transactions and refunded some client fees. Ernst & Young says
it will no longer market certain transactions to its public
company audit clients and will require those clients to obtain
audit committee approval before Ernst & Young will sell tax
shelter services to their executives. That is a start.
The engine of deception and greed needs to be turned off,
dismantled, and consigned to the junkyard where it belongs.
That is what happened after the Enron collapse. Exposure helped
put an end to some deceptive financial scams. If that is the
result of this investigation, it will move the production and
promotion of abusive tax shelters out of big business, although
it may well be picked up by fly-by-night hucksters from whom
such behavior is less surprising.
Again, my thanks to you, Mr. Chairman, for your great
support of this effort.
Senator Coleman. Thank you, Senator Levin. Senator
Lautenberg, would you like to make an opening statement.
OPENING STATEMENT OF SENATOR LAUTENBERG
Senator Lautenberg. Yes, thanks very much, Mr. Chairman,
and I commend you for holding this hearing today and Thursday
regarding the tax shelter industry. These are particularly
timely subjects to review, and if Senator Levin had not so
artfully described the way you do it--and maybe sent some
people out of the room looking for a way to fulfill the pattern
that you have described--I learned something this morning, and
it is a very tough situation that we find ourselves in.
Over the past few years, our economy has been racked by
corporate and accounting scandals so big and previously
unimaginable, and I come out of the corporate world and
remember expressions like the Big Eight, diminished to
certainly lesser status and prestige and respect that these
large firms had. But in many cases, they turned out to be
conspirators with companies like Enron that have gone belly up.
People lost their jobs, their life savings, their retirement
savings, and their faith in the fundamental fairness of our
stock market.
The situation worsens as we look at other organizations
getting into places like the mutual fund industry, the New York
Stock Exchange itself, all talking about concealing the truth
from the public, hiding things. And that is where we are when
we look at what has happened here with tax sheltering.
The marketing, the use of questionable, even abusive tax
shelters for individuals with very high incomes evolved, and
many of the questionable tax shelters at issue today were
created during the biggest, longest economic expansion in our
Nation's history. I will assume that the witnesses will confirm
that the economic good times during the mid and late 1990's
created such wealth that there was enormous pressure to find
new ways to shelter that wealth. So a veritable army of the
best and the brightest accountants, lawyers, and investment
bankers went to work on behalf of their high net worth clients.
I was a corporate Chief Executive Officer for many years,
and my company, ADP, did very well, but I am a bit old-
fashioned because I believe that the better you do, the more
taxes you should pay, not less. So much for progressivity.
How much money are we talking about? According to the
General Accounting Office and the Internal Revenue Service
database, tracking unresolved abusive tax shelter cases over a
number of years, estimates potential tax losses at about $33
billion from listed transactions, and another $52 billion from
non-listed but questionable transactions. That is $85 billion.
I want to put it in perspective. We just borrowed $87 billion
from future generations to pay for the ongoing war and
reconstruction in Iraq. It may be said that these tax shelters
complied with tax laws and IRS regulations, but I think there
is something inappropriate, to say the least, about how much
time, energy and expertise is helping to save some of our very
richest to hide more of their multimillion dollar income from
taxation when we are notably short of funds to meet our
national obligations, especially with young men and women in
harm's way who do what they do regardless of some of the
economic loss that they experience as a result of being away
from their jobs, away from their community, and away from their
families.
A few weeks ago I participated in a panel discussion in New
York City hosted by Atlantic Monthly Magazine on the future of
corporate America. There were two current CEOs also on the
panel, and they complained about the burdens imposed upon them
by the Sarbanes-Oxley Corporate Accountability Bill that
Congress passed last year. My response was simply: If you tell
the truth, then it would not have been necessary to develop the
strict regime that says everybody has to report along the way
about what the results were. The fact of the matter is that if
industry and the professionals associated with it outside of
the companies, outside of the firms that are creating and
marketing these tax shelters, if they will not police
themselves, then the Congress is going to do it for them. They
will not sit by while greed-fueled corporate malfeasance wipes
out jobs, savings, and lives.
Today's hearing raises questions about the accounting
industry's role in devising and peddling tax shelters, and I
hope that it is going to shed some light on the useful things
that Congress might do with regard to definitions, disclosure
requirements and increased penalties. Clearly though, the
primary responsibility for cracking down on abusive tax
shelters rests with the accounting profession itself, and I am
heartened by the response of some firms, particularly Ernst &
Young, to this scandal. But we have a long way to go to fix
this mess.
I thank you, Mr. Chairman, for holding the hearing.
Senator Coleman. Thank you, Senator Lautenberg.
I would now like to welcome our first panel to today's
important hearing. Debra Petersen, tax counsel with the
California Franchise Tax Board; Mark Watson, a former partner
with KPMG's Washington National Tax Practice; and finally
Calvin Johnson of the University of Texas at Austin's School of
Law. For the record, let me mention that Mr. Watson is
appearing before the Subcommittee this morning under
Subcommittee subpoena.
I thank each of you for your attendance at today's hearing
and look forward to hearing your testimony.
Before we begin, pursuant to Rule 6, all witnesses who
testify before this Subcommittee are required to be sworn. At
this time I would ask you to please stand and raise your right
hand.
Do you swear that the testimony you are about to give
before the Subcommittee will be the truth, the whole truth, and
nothing but the truth, so help you, God?
Ms. Petersen. I do.
Mr. Watson. I do.
Mr. Johnson. I do.
Senator Coleman. I would note that we are using a timing
system today. When you see the lights go from green to yellow,
yellow means getting close to quitting and red means that it is
time to quit. I would like to limit the testimony to 5 minutes,
but your entire prepared testimony will become part of the
official record.
So with that, Ms. Petersen, we will have you go first this
morning, followed by Mr. Watson, and finish up with Mr.
Johnson. After we have heard all the testimony, we will turn to
questions.
Ms. Petersen, you may proceed.
TESTIMONY OF DEBRA S. PETERSEN,\1\ TAX COUNSEL IV, CALIFORNIA
FRANCHISE TAX BOARD, RANCHO CORDOVA, CALIFORNIA
Ms. Petersen. Thank you, Mr. Chairman. I am testifying
today on behalf of Controller Steve Westly and the California
Franchise Tax Board. On their behalf, I would like to thank you
for this opportunity to give testimony on some of the most
egregious tax scams that we have ever seen.
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\1\ The prepared statement of Ms. Petersen appears in the Appendix
on page 275.
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In recent years the Franchise Tax Board has seen a gross
proliferation of abusive tax schemes and tax shelters that have
been aggressively marketed to taxpayers. We have been appalled
at the positions taken to justify these transactions and
schemes. These are designed and sold as tax-saving strategies
and are veiled with a limited technical reading of the tax law
and a flimsy excuse for a valid business purpose. The
transactions are designed to create artificial losses and to
make use of losses and deductions a second time.
Based on the GAO's report that you have mentioned, the $85
billion report, we estimate that California's share of that $85
billion is $3.5 billion. So California is very concerned about
abusive tax shelters, and we are dedicated to cracking down on
tax sheets and abusive tax shelters.
In the words of Controller Steve Westly, ``California loses
hundreds of millions of State tax dollars each year as a result
of these sophisticated tax schemes. This is legitimate tax
money owed to the State of California that funds our schools,
helps our elderly, and fuels our emergency and transportation
services. With a record deficit currently plaguing our State,
we are very motivated to pursue these cases.''
We have already taken a number of steps to curb the
promotion and use of these tax avoidance schemes. First of all,
in 1998 we rolled out a computer program system that would help
us to trace the flow-through of pass-through entity income to
the ultimate person that should be reporting that income.
Then on September 13, 2003, the State of California, along
with 33 other States, signed a memorandum of understanding with
the Small Business Self-Employed Operating Division of the
Internal Revenue Service. We have been, and will continue to
cooperate with the Internal Revenue Service in the
identification and audit of tax shelters.
In October 2003, the Governor of California signed into
legislation a bill that provides for reporting requirements,
increases existing penalties, and imposes new penalties for tax
shelters. Our new law provides for a voluntary compliance
initiative, wherein taxpayers who voluntarily file amended
returns and pay the full amount of the tax and interest related
to tax shelter benefits claimed on their return can avoid the
new and increased penalties. We are hoping that many taxpayers
will be wise and take advantage of the voluntary compliance
initiative, especially since we plan not to settle tax shelter
issues. Our bill was modeled after the Tax Shelter Transparency
Act, and we hope that Congress will pass this legislation at
the Federal level in the near future.
We also passed legislation that would shut down one of the
most egregious tax avoidance scams that we have ever seen. We
saw banks form solely-owned registered investment companies for
the purpose of paying no State income tax on their earnings on
their loan portfolios. Contrary to the spirit and the intent in
the Investment Act of 1940, they have registered these
companies solely to avoid State income tax. We worked in
cooperation with the Securities and Exchange Commission on that
issue.
Our Executive Director, Gerald Goldberg, chairs the
Corporate Income Tax Shelter Working Group of the Multistate
Tax Commission. Some of the goals of the working group is to
share information among the States regarding tax shelters and
abusive tax transactions, and to develop anti-abuse legislative
tools. Apart from the MTC, the State of California has been
working directly with several States to coordinate information
about State level tax shelters that we have encountered.
While we are pleased with the progress that we have made to
identify and close down tax shelters, we think that more needs
to be done in order to prevent creative minds from formulating
new shelters and schemes that circumvent tax laws. We need to
focus more on promoters and tax return preparers who sign tax
returns without proper disclosure, and in some cases attempt to
bury transactions on tax returns. Imposing penalties, however
stiff, is not good enough. The preparers count on the audit
lottery. Even disgorgement of the profit made on the
transaction is not enough to discourage these practices. If the
preparer is caught 1 in 10 times, then 9 out of 10 times they
win. So even if they have to pay back $1 million out of $10
million that they earned on the promotion of a shelter, they
still come out $9 million ahead. In addition, the firms very
often have insurance to cover themselves on these transactions.
Second, we would like to see the registration exemptions be
examined to see whether they should be removed for these types
of transactions. Requiring registration of the 1933 Act and
other acts will provide disclosure of more information about
the transactions and will cost the promoter more. The fact that
the tax laws required registration under the Investment Act of
1940 in order to conduct the scam that they were trying to do
with their loan portfolios enabled us to see that transaction
at an early stage, and were able to shut it down.
Senator Coleman. Ms. Petersen, I ask if you could summarize
here.
Ms. Petersen. Sure. We would also like to see some
whistleblower statutes to encourage good and honest people to
come forward with information that would help us to find these
shelters.
Finally, we need to beef up the enforcement agencies. We
had one prominent California tax litigator note that the reason
that we were seeing so many shelters is that ``the enforcer had
backed off.'' Clearly we need to have enforcement activity in
order to encourage self-compliance.
Senator Coleman. Thank you, Ms. Petersen. Mr. Watson.
TESTIMONY OF MARK T. WATSON,\1\ FORMER PARTNER, WASHINGTON
NATIONAL TAX PRACTICE, KPMG, LLP, WASHINGTON, DC
Mr. Watson. Chairman Coleman, Senator Levin, and Members of
the Subcommittee, good morning.
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\1\ The prepared statement of Mr. Watson appears in the Appendix on
page 285.
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My name is Mark Watson. I am here today to provide
information to the Subcommittee regarding my experience working
at KPMG. In particular, I understand that the Subcommittee
wants me to address certain tax strategies that were approved
and implemented during my tenure at KPMG.
Before answering the Subcommittee's questions, please let
me give a brief description of my background and my role at
KPMG. I am a graduate of Texas A&M University, where I received
a bachelor's degree in finance and a master's degree in tax.
In 1992, I joined KPMG as a staff accountant in their
personal financial planning practice, and I was located in the
Houston, Texas office. In 1994, I came to Washington on a 2-
year rotation in KPMG's Washington National Tax Practice, which
was the group responsible for providing technical tax support
to KPMG's field offices. In 1996, I moved to KPMG's Dallas
Field Office, where I continued to work in the personal
financial planning practice. KPMG promoted me to partner in
1997.
I returned to Washington in 1998 as the partner in charge
of the Personal Financial Planning Group within the Washington
National Tax Practice. I developed significant experience in
the areas of individual income tax, fiduciary income tax, and
estate and gift taxes, as these were the areas of focus for the
Personal Financial Planning Group at that time, and that group
provided technical tax support to KPMG's field offices
regarding those matters.
Also at around this time, KPMG's Washington National Tax
Practice assumed the additional role of participating in the
review and analysis of potential tax strategies that were to be
sold and marketed to KPMG clients and others.
When I was in the Washington National Tax Practice I
reported to Phil Wiesner, who was the partner in charge of that
practice at that time. I also reported to Doug Ammerman, who
was the partner in charge of KPMG's Personal Financial Planning
Practice. During this time the Personal Financial Planning
Group of the Washington National Tax Practice was comprised of
approximately eight individuals, and I was responsible for
supervising those individuals.
In the summer of 2000, KPMG transferred me out of the
Washington National Tax Practice on a 2-year overseas
assignment. After I completed that overseas assignment, rather
than return to a position in the Personal Financial Planning
Practice, I decided to leave KPMG. Today, I continue to work in
the tax area, focusing on estate planning.
I would now be happy to address any questions that the
Subcommittee may have.
Senator Coleman. Thank you. Mr. Johnson.
TESTIMONY OF CALVIN H. JOHNSON,\1\ ANDREWS & KURTH CENTENNIAL
PROFESSOR, THE UNIVERSITY OF TEXAS AT AUSTIN SCHOOL OF LAW,
AUSTIN, TEXAS
Mr. Johnson. My name is Calvin Johnson, and I teach tax and
accounting at the University of Texas in Austin.
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\1\ The prepared statement of Mr. Johnson appears in the Appendix
on page 286.
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My general conclusion is that tax shelters have done real
damage to the national tax system. Former IRS Commissioner
Charles Rossotti, said that the IRS is losing the war on tax
compliance. Some 80 percent of the most sophisticated taxpayers
are avoiding their share of tax, he said. And I think that the
figures support that assessment. Real or effective tax rates
are running at a maximum of 10 percent for corporations and
investors, and these are the people that Congress wants to and
needs to tax at 35 percent. The tax system is not in healthy
shape.
Every day a cadre of well-trained, well-paid, highly-
motivated tax professionals have been launching vicious attacks
on the tax base, and they have done considerable damage. KPMG
charged over $80 million for its BLIPS and SC2 shelters. We can
be confident that they destroyed many times that in terms of
tax. Uncle Sam seems to be losing the war against tax shelters.
I have two short comments on remedies. The first one is on
retroactivity. KPMG sold a shelter called BLIP or Son of Boss,
which depended upon the creation of artificial accounting
losses by having real liabilities, real economic liabilities
assumed, be ignored for tax purposes. The tax law was said to
be blind to the assumption. Congress fixed the problem by
retroactive amendment of the Internal Revenue Code, and then
Treasury fixed the specific problems of BLIPS with a
retroactive amendment to the regulations going back for 4
years.
I applaud the retroactive cure. The statute that BLIPS
attacked was drafted by the best minds in the country right
before the Internal Revenue Code of 1954, spending a lot of
time and deliberation on this system. Sometimes a vicious
attack like BLIPS opens up a hacker's windows in the best-
designed system in the world. Sometimes it does not, but the
litigation is required and the long war of litigation prevents
full enforcement of the law. Congress has to react by fixing
the hole retroactively.
I hope that the Treasury and the Congress will also fix the
so-called SC2 shelter retroactively to deny all of KPMG's
customers any tax benefits. SC2 creates a second class of stock
which sub-S corporations are prohibited to have because it
tries to separate the tax on the income from the ownership of
the underlying capital. SC2 also separates the tax from the
real economic ownership of the income.
Going beyond the specific shelters, I would hope that the
IRS and Congress would set up a joint institution to conduct
legislative audits. The office would have the duty of fixing
the tax law when the shelters have ripped it open. Litigation
is a long and ugly process. Far better to cure the rips the
shelters have caused by retroactive fixes.
My second comment is on auditor independence. An auditor, a
CPA, has to have an attitude of extraordinary skepticism, even
hostility, to the firm that it is auditing. Nothing else will
satisfy the zealous loyalty to investors and to the capital
markets that CPAs must have. In this post-Enron world, CPAs
cannot be offering tax shelters or business advice. The CPAs
are trying to be both the cop, the FBI Task Force, and also the
consigliore to the very same don, to the very family at the
very same time, and it does not work. They are not helping the
public investors in the capital market.
The remedy is simple. Firms auditing SEC statements need to
separate their auditing and advising functions into two
unrelated companies by spinoff or sale. In fact, I believe that
under current law, the Sarbanes-Oxley Act, accounting
committees may not approve for the sale, the purchase of a tax
shelter from their auditing CPA. It is a violation of their
duty to ensure independence and none of them should ever be
approved. I think the auditing committees are going to face
personal liability every time they say yes to these under any
circumstances.
Thank you very much.
Senator Coleman. Thank you very much, Professor Johnson.
Professor Johnson, my first question will be to you. How
would you grade Senator Levin's description of BLIPS?
[Laughter.]
Mr. Johnson. I thought it was superb. This man can come
down and teach my class, and bump me for a while.
Senator Coleman. Thank you.
Senator Levin. I was going to say thanks for asking, but I
was not sure what the answer was.
Mr. Johnson. I'm on your side.
Senator Coleman. Ms. Petersen, in your prepared testimony
you talked about BLIPS transactions lacking economic substance.
Can you further explain that? What does it mean to lack
economic substance?
Ms. Petersen. Economic substance has a number of tests that
you look at. One is that there are no economic advantages other
than the tax savings. The tax benefits outweigh the economic
risks and the potential profit, and third, that there's no
business purpose separate from the tax consequences. So usually
there's just no justifiable business purpose for the
transaction other than to reduce taxes, and the transaction
usually lacks the potential to generate a profit.
Senator Coleman. We focused today on BLIPS and SC2. Clearly
though there are a range of these schemes that are out there:
COBRA, which was marketed by Ernst & Young; Son of Boss, which
was marketed by Pricewaterhouse Coopers. Do they all bear the
general characteristics that you testified to today?
Ms. Petersen. Yes. In each of those cases you can see where
they're trying to create an artificial or non-economic loss,
and very often they will use different mechanisms to be able to
inflate, in those situations, the basis of a pass-through
entity, so that the owner gets a higher basis than they should
normally be entitled to without any risks, and then they go and
claim that as a loss when they dispose of the----
Senator Coleman. So you have it within the industry--first,
let us back it up. People made a lot of money in the 1990's.
Ms. Petersen. Yes.
Senator Coleman. There is a lot of cash out there. And you
have within the industry, either a loophole in the law or
blinders on the law enforcers. A whole industry is saying, we
can come up with ways in which there is very little risk, but
an opportunity to write off massive loss. Would that be an
accurate assessment?
Ms. Petersen. That is correct.
Senator Coleman. Aside from holding the tax preparers
accountable, how do we prevent this? Many of these firms have
come and said, we do not do this any more, they have
acknowledged this as headed down the wrong path--but how do we
stop this tomorrow? What is it that we need? You talked about a
Taxpayer Transparency Act. Would it be your testimony that a
Taxpayer Transparency Act are things that we can do to prevent
this in the future?
Ms. Petersen. Yes, very definitely that would help, but we
would also like to see--I think Mr. Johnson may have touched
upon this--Sarbanes-Oxley Act, that same concept, extended to
tax return preparers, to say, if you're going to sell and
market these shelters, then you cannot sign the tax return for
the taxpayer investor that's claiming those. You need to send
them to another firm. Let another firm take an independent look
at the transactions and make the adequate disclosures on there.
We would like to see some sort of a licensing or
registration of tax return preparers, because until you are
able to take away their ability to do their profession, if
you're only looking at penalties, they're going to continue to
do what they do as long as economically it makes sense to do
that.
And we would like to see the ethical standards raised for
tax preparers. Right now they have this idea that as long as
it's not illegal or there's nothing that blatantly tells them
you cannot do this particular thing, they're going to go ahead
and try and take those positions, and so we really need to have
them come up on their standards and try to support the whole
spirit and the purpose of the laws.
Then we'd like to see publication of a list of opinion
providers, whose opinions are really inadequate. Sometimes
these opinions mislead the person that they're giving the
opinion to, to think that they're going to be able to avoid
penalties, when the reality, they're kind of circular. They
rely strictly on the taxpayer making representations. And
that's how the opinion is given. So we would like to see, as we
find these firms that give faulty opinions, to publish that,
let the public be put on alert that they can't rely on those
opinions issued by those firms.
We also see great abuse with the fee structure. Some of the
firms use contingency fees, meaning up front they'll go in and
sell the work that they're going to do and say, we'll take a
percentage of the benefits that you get derived from that----
Senator Coleman. You have any problem with firms marketing
SC2? I mean my sense is that with SC2 in particular, they are
doing cold calling out there to Subchapter S corporations. You
have a concern with that?
Ms. Petersen. Yes. You're talking about companies that
probably wouldn't otherwise be looking to get in these types of
investments, now feeling the pressure that everybody's doing
this, that they ought to take advantage of this, and they might
not have otherwise thought of this.
Senator Coleman. Let me ask you one other question. What is
the culpability to the taxpayer in these schemes?
Ms. Petersen. Well, the taxpayer is going to have to pay
back the amount of tax that they sheltered, that was
incorrectly sheltered, and then they're going to also be
subject to potential penalties. Right now California probably
has stiffer penalties than the Feds do because we enacted our
legislation and you haven't enacted that yet.
Senator Coleman. But do you absolve them of culpability if
they have an opinion from their accounting firm, they have a
legal opinion, typically from a law firm in these cases--and we
are going to examine that more on Thursday--in spite of that,
do they still have culpability?
Ms. Petersen. They may, because even though they might try
to rely on the opinions, if the opinion is faulty or if it is
issued by someone that has promoted that particular shelter,
we're going to look at it and say that your reliance is invalid
and that you can't do that.
Senator Coleman. Mr. Watson, I want to focus a little bit
on your knowledge of and involvement in dealing with BLIPS in
particular. Did you have a chance to review the BLIPS
transactions when this concept was being developed?
Mr. Watson. Yes, I did.
Senator Coleman. Who was responsible? I presume there had
to be some discussion, when you were establishing something
like BLIPS, somebody had to be saying, well, is it legal? Is it
not legal? Can you talk to me how that worked within the firm?
Mr. Watson. Sure. Perhaps I should just overview the
process that we went through to review and approve BLIPS. BLIPS
was one of the first tax strategies that was put through KPMG's
newly-structured review process, and that new review process
was implemented probably in the fall of 1998. The review
process involved KPMG's Washington National Tax Office, the Tax
Innovation Center, which was recently created, and KPMG's
Department of Professional Practice.
The Washington National Tax Office's role was to review,
and if possible, approve a tax strategy based on the applicable
tax law. So that's where the legal analysis was made.
The Tax Innovation Center was there to really facilitate
the review process in the sense of making sure that adequate
resources were available and then participating or helping with
the development of marketing materials and the deployment of
approved strategies.
And finally, the Department of Professional Practice's role
was to determine that, if a tax strategy was approved by the
Washington National Tax Office, whether the business risks
associated with that strategy were appropriate for KPMG to be
involved with, and they also made sure that the auditor
independence rules were sufficiently addressed.
So that's how we went through the review process. We really
had three different groups looking at the various issues, both
from a tax standpoint and from a business risk standpoint. And
to answer your question, yes, these issues were debated, they
were examined at some length. And in fact, the review process
with BLIPS officially started on February 11, and after
numerous meetings, numerous e-mail messages and hundreds of
hours of tax research, it was finally approved around May 10,
1999.
Senator Coleman. According to judicial precedent, there
must be reasonable opportunity to earn pre-tax profit. Do you
believe that the BLIPS transaction allowed for this, and if
not, why not?
Mr. Watson. That was my primary concern with the BLIPS
transaction. I was never comfortable that BLIPS provided a
reasonable opportunity to make a reasonable pre-tax profit, and
I didn't believe that it could make a reasonable pre-tax profit
primarily because of what Senator Levin disclosed in his
opening statement, that very little of the proceeds were going
to be invested in a manner that could generate a sufficient
rate of return.
Senator Coleman. And you in fact sent out an e-mail raising
this issue; is that correct?
Mr. Watson. Yes, sir, that's correct.
Senator Coleman. I have a copy of it. It is Exhibit 80,\1\
and if staff could give Mr. Watson a copy. It is an e-mail
dated Wednesday, May 5, 1999, 9:21 a.m. In that you say,
``According to Presidio, the probability of making a profit
from this strategy is remote, possible but remote. Thus, I
don't think a client's representation that they thought there
was a reasonable opportunity to make a profit is a reasonable
representation. If it isn't a reasonable representation, our
opinion is worthless.''
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\1\ See Exhibit No. 80 which appears in the Appendix on page 664.
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Can you talk to me about Presidio's role? Did you have an
opinion from Presidio as to what they thought of this
transaction?
Mr. Watson. Yes. This e-mail message was the result of a
meeting that I attended on April 30 and May 1, 1999, where
Presidio, members of Presidio, were present to explain the
investment strategy, in essence, to the partners who were going
to be selling this transaction.
Senator Coleman. Can you explain again Presidio's
involvement in the transaction?
Mr. Watson. Presidio was the investment adviser. They
arranged for the investment side of this transaction to take
place.
Senator Coleman. In the KPMG tax opinion that I have had a
chance to review, Presidio represents there is a reasonable
opportunity for pre-tax profit. My question is, does this
representation seem credible based on the May 5 e-mail?
Mr. Watson. It did not seem credible to me, no.
Senator Coleman. Can you explain how they got there?
Mr. Watson. Senator, I don't know how they go there on this
issue. This was my primary concern and the reason I continually
raised the issue with Mr. Wiesner and Mr. Smith, but they
decided that this was a reasonable representation and that the
opinion letter could be issued.
Senator Coleman. I also understand that you were concerned
about who was the borrower in the BLIPS transaction and the
fact that the bank required the loan to be paid in 60 days. Can
you explain the significance of these issues and why you feel
they negatively impacted KPMG's ability to issue an opinion to
its clients?
Mr. Watson. Well, the who's the borrower issue really
related to whether you could get the basis with respect to the
premium, in other words, the $20 million loss that Senator
Levin described. We were concerned that the individual taxpayer
would not be treated as the true borrower, but rather the
investment fund itself would be treated as the true borrower,
because the bank really had significant restrictions on the use
of the money. It was just really transferred from one account
at the bank to another account at the bank in a very short
period of time. So we feared that an easy attack on this
transaction was for the IRS to just argue that the taxpayer
never really borrowed the money, and therefore there is no
basis for which to claim a loss.
Senator Coleman. Were these concerns ever resolved to your
satisfaction?
Mr. Watson. Not to my satisfaction, no, and nor to Mr.
Rosenthal's satisfaction, who expressed some significant
concerns specifically on who's the borrower issue.
Senator Coleman. Two other questions, three questions. Who
is Larry DeLap?
Mr. Watson. Mr. DeLap was the partner in charge of KPMG's
Department of Professional Practice for the tax practice at
that point in time.
Senator Coleman. Do you recall a telephone conversation
with Larry DeLap, during which you indicated to him that all of
your concerns were resolved regarding the BLIPS transactions?
Mr. Watson. I don't recall that conversation, Senator. It
may very well have taken place, and in fact, I will assume that
it took place, but I'm quite certain that I did not tell Mr.
DeLap that I was comfortable with the BLIPS transactions or
that all my concerns had been resolved, and in fact that's
completely inconsistent with the e-mail messages that I wrote
both before and after the date of this purported conversation.
Senator Coleman. The last question, and we will do another
round. Do you consider it unusual for KPMG to go forward with
the strategy despite the fact that several technical partners,
yourself, apparently Mr. Rosenthal, had significant problems
with it, and if so, why do you believe they went forward with
it anyway?
Mr. Watson. Well, I was disappointed with the decision, but
again, a lot of people were involved in this review process, a
lot of smart partners with significant experience, including
Mr. Wiesner, Mr. Smith, Mr. DeLap, and Mr. Eischeid. And so,
when they decided that, despite our reservations, despite our
concerns, to move forward, there was really nothing left for me
to say.
Senator Coleman. Senator Levin.
Senator Levin. Let me go through some of those e-mails with
you. On May 7 and May 10, you and Mr. Rosenthal, that is Steve
Rosenthal, met with Mr. Wiesner and Mr. Smith to discuss your
concerns. Mr. Wiesner announced apparently at that point that
the decision was made to move forward with BLIPS. What took
place at those meetings? Did you express your problems with
this BLIPS deal?
Mr. Watson. I recall that we met to discuss my concerns and
Mr. Rosenthal's concerns regarding economic substance and who
was the borrower. I wouldn't describe the meeting as a
substantive conversation, but we did lay out our concerns, and
Mr. Smith and Mr. Wiesner did respond with why they thought it
was not a problem, cited some cases, which Mr. Rosenthal later
researched and replied that he was still not comfortable with
the who's the borrower issue.
Senator Levin. There are two distinct problems that you
had, is that correct? One was who was the borrower.
Mr. Watson. Correct.
Senator Levin. It was your conclusion that there were grave
doubts that the borrower here was the taxpayer; is that
correct?
Mr. Watson. I was concerned about that, yes.
Senator Levin. When you say you were concerned, you
indicated in your e-mails and otherwise, as I understand it,
that the borrower here was really effectively the partnership
if there was any loan at all. Is that correct?
Mr. Watson. That's what I was afraid of, yes, that the
conclusion would be that the partnership borrowed the money and
not the individual taxpayer.
Senator Levin. That would be because?
Mr. Watson. That would be because the bank controlled the
funds and the taxpayer actually never received the funds.
Senator Levin. There was, in addition to that question--
assuming there was a loan, who was the borrower--there was the
underlying question of whether or not there was a loan at all.
Is that correct?
Mr. Watson. Yes. That was a concern as well, whether this
was truly a bona fide loan.
Senator Levin. The reason that you had doubts about that
was because?
Mr. Watson. Again, because of the significant restrictions
placed on the loan proceeds.
Senator Levin. Would you list those restrictions?
Mr. Watson. I think you adequately listed it. It was the
collateral requirement that was contained in the loan documents
that in essence prohibited those loan proceeds from being
invested in any manner other than money market type
instruments.
Senator Levin. The collateral requirement was for how much?
Mr. Watson. At least 101 percent, if I recall correctly.
Senator Levin. Ms. Petersen, let me ask you about both
BLIPS and SC2. Before I do that, let me just go back.
Is it fair to say, Mr. Watson, without going through all of
the e-mails, that you expressed your problems with BLIPS on a
number of occasions in a number of ways to Mr. Wiesner, Mr.
Eischeid, and Mr. DeLap?
Mr. Watson. Yes, sir, it is, numerous times.
Senator Levin. Now let me go to Ms. Petersen.
I want to get yours and the other witness's quick
assessments of the two tax products that we are focusing on
here today, BLIPS and SC2. In your opinion, do these two tax
products comply with Federal tax law?
Ms. Petersen. No.
Senator Levin. Mr. Watson.
Mr. Watson. I think they comply with a technical reading of
Federal tax law, yes. I did not think these were fraudulent
transactions. But as to BLIPS I did not believe that it met the
standard of more likely than not primarily because of the
economic substance issue.
Senator Levin. And more likely than not would mean that you
did not believe it was more likely than not that they would be
sustained in a court?
Mr. Watson. Correct, that they would be--that the tax
results would be sustained by a court of law if challenged by
the Internal Revenue Service.
Senator Levin. Mr. Johnson, in your judgment were these two
tax products in compliance with Federal law?
Mr. Johnson. I think the IRS can beat them.
Senator Levin. Should they beat them?
Mr. Johnson. Oh, absolutely.
Senator Levin. If we look at the chart with the three mass
marketing quotes on them, I think this is Chart 3. I am sorry,
it is Chart 1c.\1\ I gave the wrong number.
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\1\ See Exhibit No. 1c. which appears in the Appendix on page 384.
---------------------------------------------------------------------------
The first line is from a KPMG e-mail: ``Look at the last
partner's scorecard. Unlike golf, a low number is not a good
thing. A lot of us need to put more revenue on the board.''
This is talking about tax shelter sales.
Another internal KPMG e-mail: ``Sell, sell, sell.''
A third KPMG e-mail: ``We are dealing with ruthless
execution, hand-to-hand combat, blocking and tackling. Whatever
the mixed metaphor, let's just do it.''
Professor Johnson, what is your reaction to that kind of
culture?
Mr. Johnson. Certainly not surprise. KPMG's assessment is
they're making a lot of fees and that the penalties that will
be incurred on them are not high enough going to stop them.
Oliver Wendell Holmes said that it's a case of holding in the
bad man. You simply can't rely on an ethical role. The
penalties of money or maybe a little bit of jail time are the
only thing that are going to do it.
Senator Levin. Ms. Petersen, what is your reaction to those
kind of comments?
Ms. Petersen. I think it is just reflective of the greed of
the firms, the desire to make as much money at any cost that
they possibly can.
Senator Levin. I want to get a little more detail from you,
Ms. Petersen, about the BLIPS shelter. You testify about it in
your written testimony, but you did not get into it in any
detail. You did in response to the Chairman's question a bit,
and I want to press you a little more on that. In your review
of BLIPS, would you go into the question of whether or not
there was economic substance in a little more detail than you
did to the Chairman's question?
Ms. Petersen. I think you described in great detail of how
the transaction is put together.
Senator Levin. Would you describe it in your words though,
whether or not you believe there was economic substance?
Ms. Petersen. I don't think there is economic substance to
that transaction. Again, the only way that they are creating
that loss is not because the investor or the taxpayer was out
$20 million, because they borrowed everything. They only got
there as a phony paper loss. So they inflated the basis of the
partnership or pass-through entity's based and then took that
as a loss. It had nothing to do with the amount of money that
was invested by the taxpayer.
Senator Levin. You have done some examinations, I believe,
of the BLIPS transactions; is that correct?
Ms. Petersen. I've looked at the BLIPS transaction, yes.
Senator Levin. Have you seen any taxpayers who made a
profit as an investment? In other words, putting aside the tax
benefit here, the tax loss, which was created by this shelter,
did you see any taxpayers who made a profit on that small
investment portion that they put in?
Ms. Petersen. I don't recall. I can tell you that these
things were very short-lived and came and went over maybe a 60-
day period of time.
Senator Levin. Was the loan ever at risk here, the so-
called loan ever at risk?
Ms. Petersen. Looking at the terms of the loan and the
restrictions on that loan, no, I don't think so.
Senator Levin. Also looking at the collateral requirement?
Ms. Petersen. The collateral requirement, that's right.
Senator Levin. Where was that loan? Was that not retained
in the bank?
Ms. Petersen. I don't know.
Senator Levin. Was the loan needed for that small
investment that was there? I know it was needed obviously to
create the tax loss, but in terms of the small investment
portion of this deal?
Ms. Petersen. No. It was only there just to create the
loss.
Senator Levin. It was what?
Ms. Petersen. Only there just to create the loss.
Senator Levin. Did you have a chance to review the opinions
that were issued by KPMG relative to this shelter?
Ms. Petersen. Yes, I did.
Senator Levin. Based on that review, do you think that the
KPMG BLIPS opinion letter was one that a client could gain some
assurance from?
Ms. Petersen. The difficulty I found with that opinion
letter is that it relied very heavily on representations, and
in particular on a representation made by the taxpayer, that
they had reviewed the economics of the transaction, and they
made a statement that they were going to be able to make a
profit. But you have to question whether the taxpayers
themselves really understood the complexities of these
transactions to be able to make that determination. In that
opinion, there's about 16 pages discussing economic substance,
and the conclusion of it is strictly based on the
representation that was made by the taxpayer.
Senator Levin. On the SC2, you mentioned in your written
testimony that the SC2 opinion letters that you reviewed were
``grossly deficient.''
Ms. Petersen. Yes.
Senator Levin. Can you elaborate on that point, to be my
final question for this round?
Ms. Petersen. Well, the opinion letters that I saw dealt
with some of the code sections, but failed to really address
any of the tax doctrines that we look at in these cases. So
they didn't talk about step transaction. They didn't talk about
assignment of income. They didn't talk about those doctrines
which is what you have to look at to say, does this thing hang
together or not? They didn't address economic substance. They
didn't address any of those types of things, just went down
through a series of code sections. Well, we can do this here.
Here's a case that we think we don't meet the facts of those
cases, and we think we're clean on this transaction.
Senator Levin. In your judgment were they grossly
deficient?
Ms. Petersen. Yes.
Senator Levin. Thank you. My time is up.
Senator Coleman. Thank you, Senator Levin. Senator
Lautenberg.
Senator Lautenberg. Thanks, Mr. Chairman.
I am a little bit more interested in how we got to where we
are because of the criticism I hear from my former colleagues
in the corporate world, that the government is complicating
life so much and interfering in many ways with their ability to
make forecasts, etc., all of which I consider as part of an
incredible conspiracy to deceive the public and the government.
I am kind of curious about how were colleagues of yours in
the accounting world seduced into cooperating with these
deceptions we saw out there? What kind of devices were
traditionally used to say, to exchange it for simply a pat on
the back as it used to be for a good job? How much of this was
affected as a result of the division of the firm into
essentially two principal parts, one the auditing side and the
other the consulting side?
Mr. Watson. First, with respect to your question about the
auditing and consulting side, I had no involvement with the
audit practice so I can't answer what kind of activity was
taking place in the audit practice. My experience was solely
limited to the tax practice.
With respect to your question about how professionals were
seduced, I don't know that professional were seduced, per se.
There certainly was a tremendous amount of pressure being
applied from the leadership at KPMG to review, and if possible,
approve these transactions, because they had tremendous
marketplace potential to generate revenue for KPMG.
Nonetheless, I feel, at least based on my experience, that,
with the exception of economic substance in the case of BLIPS,
a thorough review was applied and the professionals did act in
a professional manner to reach their conclusion.
Senator Lautenberg. Mr. Johnson, do you have any knowledge
or observation about what it is, what happened when the
accounting firms split their business? Was that then a lead in
to sharing the profits more directly, as opposed to simply the
audit function which made sure the books were presented
honestly? We saw a huge change in character during this period
of time, and I am wondering where it went wrong. I did a lot of
work for the accounting firms in my former corporate life.
Mr. Johnson. I think the bottom is obviously money. There
is an awful lot of money to be made by beating the IRS, and the
IRS is perceived increasingly as being a paper tiger that
doesn't have enough smarts, doesn't have enough ability to stop
anything. If the IRS is going to leave millions of dollars
hanging around on the table, then I think their perception is
all they're doing is going in and picking it up.
There is no question that the accounting firms are now
considerably compromised in their independence. They're
supposed to be very skeptical about the firms that they're
auditing. They are serving the investing public to ensure fair
disclosure. I think the country was utterly shocked by Arthur
Andersen, the one that had the best reputation of all, to find
out that firm was teaching Enron how to make their financial
statements absolutely meaningless by guiding them through the
elaborate mine field set up by accounting standards to protect
investors.
I don't think the accountants understand the degree of
righteous anger that investors have against firms like Arthur
Andersen. Enron went from the 7th largest company in the
country to overnight being absolutely worthless, and all who
touched Enron lost their nest eggs, lost their life savings.
And Arthur Andersen helped them do it. They were supposed to be
the cops. They were supposed to be somebody that you could
depend on. They were supposed to be the sign of absolutely
moral rectitude, and it turns out that they were co-
conspirators. They had been co-opted and captured in full.
There is no question that this making a lot of money, giving
advice, selling sleazy tax shelters to the client is utterly
inconsistent with their cop role, and I think the cop role has
been utterly compromised. I think that accountants simply have
no business having that business advisory function and the cop
function within the same firm. They've got to split up, they've
got to spin off or sell. We depend on the accountants' credibly
to ensure that we're getting good financial statements, and
those people are turning out to eat too many donuts. The cops
are eating too many donuts.
Senator Lautenberg. There is a lot of slippage here, and it
is discouraging and demoralizing for the public. What do they
do? They see their pension fund evaporating in front of their
eyes, and much of that is caused by this incredible greed
culture which has developed in the country, where a CEO comes
in and signs a 5-year contract, and is forced emotionally and
financially to say, if you do not join in you are kind of maybe
stupid. Join in. Get your stock price up. Forget about what the
company is going to look like 5 years, 10 years from now, what
you turn over to a successor when that happens, because
inevitably it does, and the bonuses are in the so many millions
that it is hard to conceive that that could be created without
permanently damaging the companies, and it has in many
instance.
There was a comment made about board members. I predict
that one day you will see a class of professional that works
exclusively boards, because otherwise you cannot get someone to
leave their regular business responsibilities, come over, join
in, take a hit if one occurs by permitting something to sneak
through, and I think that that cozy cooperation between a board
and the CEO or the chairman or whomever makes these
recommendations for board memberships is going to find that
there are not people around who they can be so proud of to come
along and join their boards unless the protections are so high
that it alters the thinking function of the board member.
What do we think about expanding, as Ms. Petersen said, the
Sarbanes-Oxley Act requirements to the accounting function? Is
it a good idea for government to get more involved at this
juncture. How do we cure the problem that we have? This is not
simply the tax shelters, and that is what I said initially, and
that is to make sure that the public is getting a fair shake on
the information on the data they receive.
Mr. Johnson. I think separating the auditing function and
business advising functions is a first step, an absolutely
mandated first step, that you can't be simultaneously trying to
help and trying to be a cop against an audited firm.
Senator Lautenberg. Ms. Petersen, do you have a view?
Ms. Petersen. I think I gave my comments, but I think you
need to remember that the firms have a tax preparer side, so
there's the tax side, there's the auditing side. They may have
business consulting. And what we're missing is looking at the
tax return preparers, and that's the concern we have, is what
are those preparers doing? What are their duties? What are the
requirements on them?
Senator Lautenberg. What are their opportunities? That is
the question, you see.
Ms. Petersen. Their opportunities are great.
Senator Lautenberg. Yes. The opportunities for deception,
there is almost a demand out there to see how clever you can be
and avoid paying tax, and I find it irritating. Again, having
spent 30 years of my life in the corporate world gives me a
little bit different insight, and I believe that if you make
it, you pay, and that is the way it ought to be, fairly
straightforward. I see the Center for Budget Policy Priorities,
a research group, said preliminary tax for this year indicate
corporate taxes account for just 7.4 percent of total tax
receipts, down from in the 1960's when it was 21 percent of
total receipt. I do not say that 21 percent should be the mark
we are trying to toe, but there has been far less required of
wealth taxpayers now than there perhaps has ever been. It is
not fair and deprives us of revenue opportunities.
The fact is that my time has expired. [Laughter.]
Thank you very much.
Senator Coleman. Thank you, Senator Lautenberg.
Mr. Watson, I think you indicated in response to Senator
Levin's question that you thought the BLIPS was thoroughly
reviewed?
Mr. Watson. With the exception of the economic substance
issue, yes.
Senator Coleman. I am trying to understand how we get from
a thorough review of very bright professionals, where there
clearly--I am not an accountant. I did not do too well in
math--and as I look at this, I ask where is the substance?
Where is the risk? I am trying to understand how we got there.
In fact, let me direct this question to Mr. Johnson. I will
come back to you, Mr. Watson.
Professor Johnson, is it your sense, Professor, that what
you have here is kind of a risk versus benefit kind of
analysis. The risk is a buck, the benefit, whether caught or
not caught is 10 bucks. So why not do it? Is that your sense?
Mr. Johnson. Absolutely. Phil Wiesner is not a rogue
elephant. He's not an unusual member of this community. He is
core to management. This is a KPMG official decision by the
core of management, and it's really unfair to consider this to
be an aberration. It's not an aberration. It is a system,
people reacting to the system in places in which the penalties
are very low, trivial, nonexistent, and the rewards of not
paying tax are very high. I'm not sure we should get
moralistic. It's just a matter of creating the right system
incentives and throwing some people in jail.
Senator Coleman. But is this because the law allows it? I
mean, again, this is not just KPMG, it is all the firms. Ms.
Petersen talked about a variation of these, opportunities for
folks to wipe their loss off the books and avoid paying taxes.
Is it because the law allows it or because the IRS does not
catch it?
Mr. Johnson. Well, it's a combination of both. They're
finding--they're creating hacker's windows. The tax law looked
like it was beautiful and a good safety net, and worked and
fully described, and then--these are very highly motivated,
very well trained, very well paid professionals who are sitting
there in a skunk works full time. The best minds of our
generation are now spent in skunk works tax shelters. Sometimes
they work, or at least they appear to work.
Senator Coleman. What is a skunk works? I am sorry, I
missed that.
Mr. Johnson. A skunk works is----
Senator Coleman. We do not have those where I grew up in
Brooklyn.
Mr. Johnson. A skunk works is a factory that creates dirty
tricks in the middle of war. It's the creative people who
figure out how to do nasty things to the Nazis or Commies or
the IRS, one or the other its kind of the same view. They are
the high-tech people that are going to do a whole bunch of
dirty tricks. Sometimes those people win, even against a well-
designed tax system.
Sometimes we have to have extensive litigation to fix
these. The only justification for litigation is that it's a
little bit better than the trial by combat that it replaced.
After 10 years of litigation, sometimes the IRS wins. So a lot
of it is that they're very creative destroyers, and they
succeed in destroying stuff. Then sometimes it's just that the
IRS doesn't have as much talent, doesn't have as many
resources. Everybody kind of hates the IRS, so they sit there
being held back, and they don't compete as well. They don't
wake up in the morning with that same sense of viciousness that
the skunk works people do. You've got to give the skunk works
credit. There are times in which in this war over money the
most talented lawyers win it. Is it compliance or is it
illegal? The answer is, well, sometimes their schemes are so
brilliant they in fact--work. They created a loophole. They
really did create it. They won. And you can take it all the way
to the Supreme Court and they've still created the loophole.
Senator Coleman. One last question. One of your
recommendations of action for the Federal Government, allow the
government to turn over the suit for damages to aggressive
plaintiff lawyers for a reasonable fraction of the return. Can
you discuss that?
Mr. Johnson. Yes. In fact, the plaintiffs' lawyers are
starting to get active in this stuff. They think that there is
a breach of contract action. You know, you promised to save me
$10 million worth of tax and the IRS caught me, and I want my
$10 million from you. And that is kind of a regular contract.
I will say if there is anybody who is as talented, vicious,
hard-driving, and smart as the skunk works tax shelter people
are, it is the plaintiffs' bar. The plaintiffs' bar are very
talented people, and in some sense, if we want our tax
enforced, maybe we ought to put talent against talent.
There is a lot of damage that has been done, just pure
uncompensated damages to Uncle Sam, to our country, and it
seems to me quite ordinary law to say if you have done damage,
then you ought to be obligated in a civil court of law to make
amends, pay compensation for the damage that you have done. The
system works in other areas. I think it might work here.
Senator Coleman. Thank you, Professor. Senator Levin.
Senator Levin. Thank you. Sometimes these very creative
schemes that the skunk works produce are found to be legal. Is
that correct? They have created a loophole, as you put it.
Mr. Johnson. Yes.
Senator Levin. Is it also true that sometimes they are
found to be illegal?
Mr. Johnson. Yes.
Senator Levin. So when you say it is a combination of both,
there are some that turn out that will be found not to be
illegal, and there are some that will be found to be illegal.
Is that accurate?
Mr. Johnson. Yes. Jerome Kurtz, who was Commissioner of
Internal Revenue Service some years ago, had to define a tax
shelter as those that did not comply with the law because the
IRS function is to force compliance with the law. But a tax
shelter goes way beyond that.
There are a lot of cases in which you rip the fabric apart
of a perfectly good system and make it into jelly, make it into
Alzheimer's networks or something completely dumb, completely
paralyzed, completely open and unable to collect tax. That is
why I think you need a legislative audit, a combination of
Congress and IRS who can go back and say, no, maybe that was
the interpretation, but it is a bad interpretation, that is not
what we intended to do. We intended to write a beautiful tax
system that worked. The Supreme Court often says the taxpayers
should win on an interpretation that is outrageous, and those
things need to be fixed retroactively very fast. You need to
repair your tax base.
The tax base is sacred. Countries decline and disappear
when their taxpayers get in bad shape, and ours is in awful
shape and it needs to be defended against this crap.
Senator Levin. I could not agree with you more, but also, I
think part of that is that some of the tax shelters which have
been created are ``abusive but found to be illegal.'' Is that
correct?
Mr. Johnson. Absolutely. I hope all these get found to be,
but, it is----
Senator Levin. Found to be illegal?
Mr. Johnson. Yes, found to be illegal. But it is still----
Senator Levin. All right. Let me now go----
Mr. Johnson. It is still up in the air. You know, on some
of these you have not decided.
Senator Levin. I think they were, and I hope they are found
to be.
Now let me go back to Mr. Watson. If you would, would you
turn to Exhibit 88? \1\ I want to go through this with you.
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\1\ See Exhibit No. 88 which appears in the Appendix on page 677.
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These are a series of e-mails, and if you look at the one
from you to a bunch of folks, Eischeid, Ammerman, relative to
BLIPS on May 5, and these two dots--do you see those two dots
there? OK. Now, I want to read these to you because it seems to
me these are very significant and come to the heart of the
matter as to what your reaction was to BLIPS.
``According to Presidio, the probability of making a profit
from this strategy is remote, possible but remote. Thus, I
don't think a client's representation that they thought there
was a reasonable opportunity to make a profit is a reasonable
representation. If it isn't a reasonable representation, our
opinion letter is worthless.''
Now, when you said that, ``according to Presidio,'' that is
what Presidio told you at a meeting, which is where you got
started really worrying about this BLIPS thing. Is that
correct?
Mr. Watson. Yes, Senator, that's correct.
Senator Levin. Because what they told you at that meeting
was different than what you had previously understood. Is that
correct?
Mr. Watson. That's correct.
Senator Levin. All right. Now, the next dot: ``The bank
will control via a veto power over Presidio how the `loan'
proceeds are invested. Also, it appears that the bank will
require this `loan' to be repaid in a relatively short period
of time, e.g., 60 days, even though it is structured as a 7-
year loan. These factors make it difficult for me to conclude
that a bona fide loan was ever made. If a bona fide loan was
not made, the whole transaction falls apart.''
Now, those were your words, right?
Mr. Watson. Yes, sir.
Senator Levin. And in your judgment--you have given us your
judgment already here this morning--you had doubts that a bona
fide loan was made.
Mr. Watson. Yes.
Senator Levin. And if it was not, this whole transaction,
in your words, falls apart. Correct?
Mr. Watson. It would not produce the tax results desired.
Senator Levin. All right. Now, if you were told by--it
would not produce it.
Mr. Watson. It would not produce the desired tax results.
Senator Levin. In other words, the IRS would not allow it
because it was not consistent with the tax code. Is that
another way to say that?
Mr. Watson. Well, if there was no bona fide loan, then
there was never any basis to claim a loss for.
Senator Levin. And, therefore, they could not properly
claim the deduction.
Mr. Watson. That's correct.
Senator Levin. All right. Now, Presidio told you, as I
understand your e-mail, that the probability of making a profit
from this strategy is remote, possible but remote. Is that
correct?
Mr. Watson. That's correct.
Senator Levin. And then when you stated your concerns to
the folks that you talked to, they said we are going to get
some additional representations from Presidio. Is that correct?
Mr. Watson. That's correct. This problem was cured through
representations.
Senator Levin. Just representations, which they obtained
from Presidio. Correct?
Mr. Watson. Correct.
Senator Levin. And here is one of the representations that
was made to ``cure the problem.'' Presidio has represented to
KPMG the following--this is dated December 31, 1999. It is not
in the exhibits. ``Presidio believed there was a reasonable
opportunity for an investor to earn a reasonable pre-tax
profit, in excess of all associated fees and costs, and without
regard to any tax benefits that may occur.'' That was exactly
the opposite of what Presidio acknowledged to you, wasn't it?
Mr. Watson. It was, yes.
Senator Levin. And yet after you told the folks at KPMG
that Presidio told you that, in fact, there was little
probability of making a profit, or to put it differently, it
was remote, they made a representation that Presidio said the
opposite, and this came after you told them what Presidio had
told you. Is that correct?
Mr. Watson. That is correct, yes.
Senator Levin. All right. My time is up. I had one more
subject.
Senator Coleman. Senator Levin, do you want to pursue one
more subject?
Senator Levin. Just one more quick subject, if I can, and
that has to do with the issue of grantor trusts, and this is
something of a separate issue.
The Subcommittee has come across some material suggesting
that with respect to OPIS and BLIPS, grantor trusts were used
to net out gains and losses and to obscure reporting at the
individual taxpayer level. Can you explain--well, let's go to
Exhibit 10 \1\ because I think time-wise we are going to have
to cut through a little quicker.
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\1\ See Exhibit No. 10 which appears in the Appendix on page 428.
---------------------------------------------------------------------------
In Exhibit 10, you appear to be expressing your views that,
with regard to your own analysis of the use of grantor trusts
relative to the OPIS transaction, that those grantor trusts, in
your words, ``Notwithstanding the conclusion reached in the
`grantor trust memo,' I don't think netting at the grantor
trust level is a proper reporting position. Further, we have
never prepared grantor trust returns in this manner. What will
our explanation be when the Service and/or courts ask why we
suddenly changed the way we prepared grantor trust return/
statements only for certain clients? When you put the OPIS
transaction together with this `stealth' reporting approach,
the whole thing stinks.''
That is in Exhibit 10. Those are your words?
Mr. Watson. Yes, sir.
Senator Levin. And is that what the firm was doing?
Mr. Watson. That was my understanding, yes, that the
grantor trusts were being used to disguise the OPIS and perhaps
the BLIPS transactions.
Senator Levin. And then you also wrote in January 1999 a
memo in which you said the following: ``You should all know
that I do not agree with the conclusion reached in the attached
memo that the capital gains can be netted at the trust level. I
believe we are filing misleading, and perhaps false, returns by
taking this reporting position.''
Was that your position then?
Mr. Watson. Yes, it was.
Senator Levin. Is it your position now?
Mr. Watson. Yes, it is.
Senator Levin. All right. And then, finally, in Mr.
Eischeid's memo, which appears at the top of the page, he
writes, relative to a conference call, ``We concluded that each
partner must review the WNT memo''--and WNT stands for
Washington----
Mr. Watson. Washington National Tax.
Senator Levin. National Tax, which is part of KPMG, right?
Mr. Watson. Correct.
Senator Levin. ``. . . memo and decide for themselves what
position to take on their returns--after discussing the various
pros and cons with their clients.''
Therefore, your conclusion was essentially ignored. Is that
correct? It was left up to each of the partners?
Mr. Watson. Yes, Senator, it was.
Senator Levin. Thank you.
Senator Coleman. Senator Levin, I am going to follow up
with one question just based on that last line of questioning
that you had, the issue of grantor trusts here. IRS Notice
2000-44, according to that notice, using a grantor trust is
criminal activity?
Mr. Watson. They threatened criminal penalties in that
notice, yes, sir.
Senator Coleman. Can you give me a sense of the time
sequence of that memo versus your communications here? Did the
memo come out before or after?
Mr. Watson. The notice came out in, I believe, August 2000.
These e-mail messages were taking place in January 1999. So
this actually related to the OPIS transaction, but the desire
was to use that same reporting position with respect to the
BLIPS transaction.
Senator Coleman. Thank you, Mr. Watson.
This panel is excused. We thank you very much.
I would now like to welcome our second panel to today's
hearing: Philip Wiesner, Partner in Charge of KPMG's Washington
National Tax Client Services, Washington, DC; Jeffrey Eischeid,
a partner in KPMG's Personal Financial Planning Office,
Atlanta, Georgia; Richard Lawrence DeLap, a retired National
Partner in Charge of KPMG's Department of Professional
Practice-Tax, Mountain View, California; and, finally, Larry
Manth, the former West Area Partner in Charge for KPMG's
Stratecon, Los Angeles, California.
I want to thank you all for your attendance at today's
hearing, and I look forward to your testimony. Before we begin,
pursuant to Rule VI, all witnesses who testify before the
Subcommittee are required to be sworn. At this time, I would
ask you to please stand and raise your right hand. Do you swear
that the testimony you are about to give before the
Subcommittee will be the truth, the whole truth, and nothing
but the truth, so help you, God?
Mr. Wiesner. I do.
Mr. Eischeid. I do.
Mr. DeLap. I do.
Mr. Manth. I do.
Senator Coleman. Again, as I noted with the other panel, we
will be using a timing system. I would like you, if you are
going to make prepared statements, to limit them to 5 minutes.
We will enter your entire written testimony into the record.
Again, I am going to give an opportunity for opening
statements, starting with Mr. Wiesner, Mr. Eischeid, Mr. DeLap,
and Mr. Manth.
TESTIMONY OF PHILIP WIESNER, PARTNER IN CHARGE, WASHINGTON
NATIONAL TAX, CLIENT SERVICES, KPMG, LLP, WASHINGTON, DC
Senator Coleman. I understand, Mr. Wiesner, that you will
not be making an opening statement?
Mr. Wiesner. That is correct, Senator.
Senator Coleman. Mr. Eischeid.
TESTIMONY OF JEFFREY EISCHEID,\1\ PARTNER, PERSONAL FINANCIAL
PLANNING, KPMG LLP, ATLANTA, GEORGIA
Mr. Eischeid. Mr. Chairman and Members of the Subcommittee,
on behalf of KPMG there are four main points that I would like
to call to your attention:
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\1\ The prepared statement of Mr. Eischeid appears in the Appendix
on page 298.
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One, the tax strategies being discussed today represent an
earlier time at KPMG and a far different regulatory and
marketplace environment. None of the strategies--nor anything
like these tax strategies--is currently being presented to
clients by KPMG.
Today, KPMG advises our clients on the enormous range of
potential outcomes under the tax laws and how to achieve the
best outcomes in their individual cases. We have provided the
Subcommittee with materials that describe hundreds of these
approaches. None of these are aggressive tax strategies like
FLIP, OPIS, BLIPS, and SC2.
Two, the strategies presented to our clients in the past
were complex and technical, but were also consistent with the
laws in place at the time, which were also extremely
complicated.
Three, the strategies did undergo an intensive and thorough
review, a process that resulted in vigorous, sometimes even
heated, debate.
Four, KPMG understands that the regulatory environment and
marketplace conditions have changed. This has led to
significant changes within KPMG over the past 3 years.
We would like to elaborate on each of these points.
First, the tax strategies under review were all presented
under regulatory and marketplace conditions that do not now
exist. Today, KPMG does not present any aggressive tax
strategies specifically designed to be sold to multiple
clients, like FLIP, OPIS, BLIPS, and SC2.
These strategies were presented at a time when the U.S.
economic boom was creating unprecedented individual wealth and
a demand for tax advice aimed at achieving tax savings. All
major accounting firms, including KPMG, as well as prominent
law firms, investment advisers, and financial institutions gave
tax advice, including presenting these types of tax strategies
to clients.
In KPMG's case, other firms often provided investment
advisory and other non-tax services in connection with these
transactions. All of these relationships were consistent with
KPMG's legal and professional requirements.
Second, it is true that these strategies were complicated
and that the tax consequences turned on careful and detailed
analyses of highly technical tax laws, regulations, rulings,
and court opinions. But all of these tax strategies were
consistent with the laws in place at the time.
It is important to note that no court has found them to be
inconsistent with the tax laws. In some cases, the IRS has
agreed that taxpayers should be allowed to retain a portion of
the tax benefits they claimed as a result of implementing a
strategy.
For all of the strategies being reviewed by the
Subcommittee, KPMG provided our clients with a ``more likely
than not'' opinion as to their tax consequences. In other
words, we informed our clients that, based on the facts and
actions they took, they would have a ``more likely than not''--
or a greater than 50 percent--chance of prevailing if the IRS
challenged the transaction.
The tax laws are complicated and often ambiguous and
unsettled. As a result, KPMG's opinions regarding these tax
strategies were long, detailed, and technical. Our clients were
told that, in addition to a possible tax benefit, the law
required a transaction to have a business purpose, profit,
charitable, or other non-tax motive. They were required to
provide us with representations to that effect. Our clients
were sophisticated and typically had their own attorneys,
accountants, and investment advisers. Throughout the process,
KPMG made it very clear to clients that they were undertaking
complex transactions on which the law was ambiguous and often
had not been clarified by either the IRS or the courts.
Our third point is that because we understood that these
tax strategies might be subject to an IRS challenge, KPMG put
them through a rigorous review process before they were
approved for presentation to multiple clients. The tax
strategies also underwent very careful analysis of the IRS
requirement for registering tax shelters in effect at the time.
Many tax partners with different areas of expertise
participated in the review process. That, combined with the
fact that we were dealing with a ``more likely than not''
opinion, is the reason there was a lively and often lengthy
debate among partners over the interpretation and application
of tax laws, regulations, rulings, and opinions. Many of the
materials provided to the Subcommittee document this internal
debate.
Finally, KPMG has changed. We learned a number of important
lessons from our previous tax policies and practices. As a
result, KPMG has made substantial improvements and changes in
our practices, policies, and procedures over the past several
years. My colleague, Richard Smith, will describe these in
greater detail.
In the practice I head, Personal Financial Planning, we
have shifted our approach from one focused on taking solutions
to clients to one that works with clients to address their
individual situations. This is consistent with KPMG's current
leadership philosophy and more conservative approach to the tax
service practice.
We understand that simply being technically correct is not
enough. We know we need to respond better to the continuing
changes in the tax laws and regulations and the needs of our
clients. We also need to ensure that no action taken will call
into question the integrity, reliability, and credibility of
KPMG.
Thank you.
Senator Coleman. Thank you, Mr. Eischeid.
TESTIMONY OF RICHARD LAWRENCE DELAP, RETIRED NATIONAL PARTNER
IN CHARGE, DEPARTMENT OF PROFESSIONAL PRACTICE-TAX, KPMG LLP,
MOUNTAIN VIEW, CALIFORNIA
Senator Coleman. Mr. DeLap, I understand that you will not
be making a prepared statement.
Mr. DeLap. That is correct.
Senator Coleman. Thank you. Mr. Manth.
TESTIMONY OF LARRY MANTH, FORMER WEST AREA PARTNER IN CHARGE,
STRATECON, KPMG LLP, LOS ANGELES, CALIFORNIA
Mr. Manth. Mr. Chairman and Members of the Subcommittee, I
had not planned to make a statement at today's hearing, but
simply to appear here to answer the Subcommittee's questions
regarding a tax strategy known as SC2, a tax strategy for which
I was primarily responsible during a portion of my time as a
partner there. But I have seen some press articles on today's
hearing, and I note that they contain some misstatements about
SC2. I wanted to take this opportunity to set the record
straight, and I appreciate the Subcommittee allowing me to do
so.
First and foremost, there is no question that there was a
real donation of S corporation stock to a tax-exempt
organization. The tax-exempt organizations involved received
real and quantifiable benefits from these donations. Tax-
exempts that redeemed their S corporation stock have received
literally millions of dollars in cash which have directly
benefited thousands of police and fire fighters. Almost all the
press reports state that under SC2, the charity sells back its
shares to the S corporation for fair market value. This is
true. But it doesn't tell the whole story.
One key element of SC2 is that the charity does not, in
fact, have any obligation to sell the shares back to the S
corporation. A number of tax-exempt organizations have not
redeemed their shares after 2 years. Some are actually seeking
a better valuation or waiting for a greater return from their
stock at some future point. Basically, the charity controls the
stock and does not have to sell it back to the S corporation.
I have also read descriptions that say that should the
charity decide not to sell its stock, other S corporation
shareholders can exercise warrants for additional shares of
stock, thereby making the charity's shares much less valuable.
Actually, just the opposite would happen. An S corporation
shareholder who wanted to exercise the warrants would have to
come up with a substantial amount of money to pay for the new
stock. That money would be paid into the S corporation and
raise its market value. This would reduce the charity's
percentage ownership share, but the charity would end up owning
a smaller percentage of a much more valuable company. In other
words, owning 10 percent of $1 million is a lot better than
owning 90 percent of $100,000.
Some articles reported that S corporations that implemented
SC2 passed resolutions to limit or suspend dividends or other
distributions to shareholders, basically to keep the charity
from getting any share of earnings. So far as I know, a
resolution limiting or suspending distributions was not an
element of SC2. In fact, KPMG recommended that S corporations
make distributions during the period tax-exempts held their
stock. Such payments made the S corporation stock even more
attractive to the charity, while still allowing substantially
more income to be reinvested in the S corporation than before
the stock was donated to the charity. There are tax-exempt
organizations that have received hundreds of thousands of
dollars in distribution income while they were holding S
corporation stock.
Finally, some articles referred to pledges that individual
S corporations made to guarantee that charities would receive
at least the original value of their stock at the time it was
redeemed. It was my experience that some SC2 transactions
involved such a pledge, but that in most transactions, no
pledge was offered or even requested.
Essentially, SC2 was a strategy that involved a gift to a
charity, a tax-free build-up of income, and a deferral of
income so that it could be subject to capital gains tax in the
future. This is virtually identical to another tax strategy
that is still widely available to taxpayers. It is called the
charitable remainder trust, and Congress wrote it into the tax
laws many years ago so that it is not only legal but encouraged
by law.
I note this because, along with all the factors I have
described, it further supports KPMG's position that SC2 was
consistent with the law and regulations governing charitable
giving and S corporations. Thank you.
Senator Coleman. Thank you, Mr. Manth.
Mr. Manth, let me just follow up as I recall listening to
Senator Levin's testimony and talking about distribution of
income. I believe his testimony was that there was not
distribution of income. This was one of the concerns. And your
testimony is to the contrary.
Do you know--and I do not have the information in front of
me. Is there a percentage of the times in which there was
distribution versus non-distribution?
Mr. Manth. I don't know. We recommended that the S
corporations make dividend distributions.
Senator Coleman. Do you have any information as to whether,
in fact, that was practiced?
Mr. Manth. I know it was done, but I don't have that in
front of me.
Senator Coleman. OK. Can I ask you about registration of
this product with the IRS as a tax shelter? Do you know whether
it was registered?
Mr. Manth. I do not believe it was registered.
Senator Coleman. Can you help me understand that? I think
that is one of the concerns here about not registering. It
would appear to me obviously if you register something and the
IRS knows it is there, they have got a better shot at taking a
look. Here it is not registered. Can you talk to me, tell me
the reason for that?
Mr. Manth. Well, I have been out of the business for a
while, and my recollection in the registration there are two
types of registrations. There was what we referred to as the
old 6111(c) registration, which was really if there were
significant deductions created in excess of an investment, then
you would have to register. And then there were the new
regulations that came out on registration, and I believe that a
thorough review of registering SC2 was done on both. And it was
concluded that it was not a registerable transaction.
Senator Coleman. And I would ask any of the individuals
from KPMG about BLIPS. Was that registered?
Mr. Eischeid. No, sir, it was not.
Senator Coleman. And as a result of not registering, I
would take it, then, the IRS would not know if an individual
taxpayer had gotten a certain amount of gain, if they had made
a lot of money on some business transactions.
My sense with BLIPS is that, in fact, by setting BLIPS up,
the IRS would not know that information.
Mr. Eischeid. Senator, that is not my impression or
understanding; that, in general, and specifically with respect
to BLIPS, the taxpayers would report on their income tax
returns their taxable income, including the income from sales
of stock or the businesses that they owned as well as the tax
effects of the BLIPS investment transaction that they entered
into.
Senator Coleman. Mr. Wiesner, were you in charge of
resolving the issues associated with economic substance?
Mr. Wiesner. Yes, Senator, I was.
Senator Coleman. And then did you ultimately approve the
BLIPS transaction despite the concerns raised by Mr. Watson and
perhaps others?
Mr. Wiesner. Yes, Senator, I did. It was after about a 5-
month review process in which we very intensively reviewed
every issue that our whole team of professionals would raise
with respect to the transaction.
Senator Coleman. One of the things, though, that concerns
me here regards the exchanges between Watson and Presidio and
then the ultimate opinion by Presidio, which seems to
contradict an earlier representation.
Did Mr. Watson ever inform you that he had met with
Presidio and that they had indicated to him the chance of
making a profit from a BLIPS transaction was--I think his words
were ``possible but remote''?
Mr. Wiesner. Yes, Senator, I believe--I don't know if he
sent me the e-mail or just informed me about it. But when he
did, we would have looked further into the issue and examined
it in greater detail in order to make ourselves comfortable
that, in fact, there was an economic profit potential in the
transaction.
Senator Coleman. And then Presidio comes back--and Senator
Levin went into this in a little more detail--with a
representation saying that there was a reasonable opportunity
to earn a pre-tax profit. Is that correct?
Mr. Wiesner. Yes, sir, that's correct. When they came--
after we had met with Presidio and gotten comfortable with
additional information that we could then rely upon their
representation.
Senator Coleman. What kind of additional information did
they give you to reverse their sense about the possibility of
pre-tax profit?
Mr. Wiesner. Senator, at this point I do not have a
specific recollection of it. I don't know if Mr. Eischeid has a
more specific recollection.
Mr. Eischeid. Senator, actually, in terms of the referenced
meeting, I believe Mr. Watson spoke to April 30 and perhaps May
1, I was physically present at that meeting, and I came away
with a distinctly different impression with respect to the
investment program outlined by the Presidio investment advisory
firm. And it was not that the possibility of obtaining a profit
from entering into those transactions was remote.
Senator Coleman. BLIPS was at least represented as a 7-year
investment strategy, marketed as such. I understand that all 66
deals in 1999 closed after the first phase of 60 days, and few
of the other remaining deals actually transitioned to stage
two. Can you help me understand how you market something as a
7-year strategy and yet all the transactions close out in the
60 days?
Mr. Eischeid. I think, Senator, as Presidio articulated the
investment program, it was a multi-stage investment that took
on varying degrees of risk as the strategy matured and
progressed. And at any point in time, the investors had a
choice as whether to contribute additional equity to the
investment program and to continue their investments in these
foreign currencies and the like. And certainly one of the
considerations that those investors undertook was what was
going to be the income tax consequences of their adoption of
this investment strategy, and, importantly, as was discussed
earlier, what would be the consequences that were anticipated
when they terminated their investment in this strategic
investment fund.
Senator Coleman. We had a 15-minute vote posted. What I am
going to do, Senator Levin, is I am going to finish my
questioning in just a couple of minutes, and then we will
adjourn the hearing and come back after the vote. The other
possibility is I could finish my questioning quickly, go vote,
you continue, and I will come back. Do you want to keep it
going?
Senator Levin. Are there two votes or one, do we know?
Senator Coleman. Could we check to see whether there are
two votes or one?
We touched upon, Mr. Eischeid, the concept of netting at
the grantor trust level, and it was just touched upon by Mr.
Watson at the end. Has KPMG engaged in transactions with
clients or provided the clients with the option of netting?
Mr. Eischeid. The netting issue was, I think, discussed at
some length within KPMG, and there was, as you can tell from
some of the documentation, a rigorous debate and disparate
views expressed. And from that documentation, you can see that
my primary objective was to make sure that our professionals
were not doing something that I would term wrong, that proper
reporting was occurring.
When it comes to that type of tax return preparation issue,
historically our firm has approached that with respect to
relying on our partners, the individual tax return preparers,
to analyze the law and to make the proper determination with
respect to the returns that they are preparing to ensure that
they are complete and accurate.
Senator Coleman. Exhibit 38,\1\ Are you the author of a
memo labeled ``PFP Practice Reorganization, Innovative
Strategies Business Plan''? Can we show the witness a copy of
the memos? I just want to know if you are the author. The piece
that I have, it talks about history, and in the last paragraph,
the fiscal 2001 IS revenue goal was $38 million, the practice
is to have $16 million through period ten, the shortfall from
plan is primarily attributed to the August 2000 issuance of
Notice 2000-44. This notice specifically described both the
retired BLIPS strategy and the current SOS strategy.
Accordingly, we made the business decision to stop
implementation of SOS transactions and stay out of the loss
generator business for an appropriate period of time. In
addition, there is no word that the softening in the overall
economy, e.g., the decline in new IPOs, the devaluation of
technology stock valuations, adversely affected our ability to
broadly sell our modernization tax advisory services suite of
solutions.
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\1\ See Exhibit No. 38 which appears in the Appendix on page 528.
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Do you recall whether you--is that your memo?
Mr. Eischeid. I believe that it was, Senator. It was a
draft that I put together as I was contemplating what business
plan that I would put forth for the innovative solutions
practice.
Senator Coleman. Let me see if I can kind of sum up the
environment, because you talk about that in your statement.
There was a lot of cash being generated and a lot of profit in
the 1990's, and I take it that you are out there, and Ernst &
Young and Pricewaterhouse, and everybody is out there and
coming up with, ``creative solutions in which folks who are
generating profits, it would mean they pay taxes on that, can
minimize their tax liability.'' A fair statement?
Mr. Eischeid. Yes, Senator, I think that our profession was
actively engaged in reviewing and evaluating and creating what
we termed solutions or strategies to help our clients minimize
their tax liability.
Senator Coleman. And there is nothing illegal about helping
folks minimize their tax liability.
Mr. Eischeid. Correct.
Senator Coleman. But help me understand. As I listened to
Senator Levin's description of BLIPS and listened to the
witnesses, it does not seem to be economic substance in there.
There does not seem to be much at risk. And so help me
understand how, with all this rigorous review, you in effect
have these transactions in which there is no real risk, there
is very limited potential to make real profit, and folks have
the capacity to write off $20 million, $30 million, or $40
million. Help me understand how it got to that place and why
folks think it is OK or thought it was OK.
Mr. Eischeid. Well, Senator, I think that, first of all, we
are talking about a period that was several years ago, and we
are talking about transactions that are admittedly, quite
aggressive in terms of the application of the tax laws. I think
that our firm, myself included, believed that those
transactions were legal and that they met the literal
requirement of the Internal Revenue Code and the regulations
and so forth.
I will tell you here today that our firm would not approve
that type of transaction to be introduced to our clients, that
we have made the determination that it is too close to the
line, so to speak, as to what is more likely than not
ultimately going to prevail once it is judicially determined.
Senator Coleman. Thank you.
We have a vote. What I am going to do is I am going to
adjourn the hearing for approximately 10 minutes until the
return of Senator Levin. He will then continue his questioning.
There are two stacked votes. I will not be back for that since
I will do the second vote, too, but then I will come back.
The hearing then will stand adjourned for approximately 10
minutes until the return of Senator Levin.
[Recess.]
Senator Levin [presiding]. We are going to proceed now, and
Senator Coleman will be back a little later. There is a second
vote going on, and he is going to wait there for the second
vote to begin.
Let me start with you, Mr. Eischeid. Three of the four
products that we are looking at--FLIP, OPIS, and BLIPS--operate
in a similar way, and my question to you is this: Isn't it the
case that all of these are primarily tax-reduction strategies
that have financial transactions tied to them to give them a
colorable business purpose?
Mr. Eischeid. Senator, I am not sure that that would be how
I would characterize those transactions. I certainly viewed
them as investment strategies that certainly had a significant
income tax component to them.
Senator Levin. My question to you, though, is: Are these
not primarily tax-reduction strategies?
Mr. Eischeid. I think you would have to speak to each
individual taxpayer to ascertain their primary purpose for
entering into the transaction, and I think you would get
different answers, depending on which taxpayer that you spoke
to. I suppose I would also just simply point out that, not to
get overly technical, but primarily it tends to be a term of
art in sort of the tax professional world that is very
difficult, frankly, to pin down.
Senator Levin. Is it not the case that these were designed
and marketed primarily as tax-reduction strategies?
Mr. Eischeid. Senator, I would not agree with that
characterization.
Senator Levin. All right. Now, let's look at what other
parties involved in transactions said about that issue. If you
look at Exhibit 1d.,\1\ this is a compendium of how other
parties involved in these shelters characterized them, and it
is pretty clear what the consensus is here.
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\1\ See Exhibit No. 1d. which appears in the Appendix on page 385.
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First is a UBS Bank memo regarding FLIP. ``The principal
design of this scheme is to generate significant capital losses
for U.S. taxpayers which can then be used to offset capital
gains which would otherwise be subject to tax.''
Then there is the memo of one of the investment advisory
firms involved in FLIP, which was Quadra: ``KPMG approached us
as to whether we could effect the security trades necessary to
achieve the desired tax results. The tax opportunity created is
extremely complex.''
Then at First Union, now Wachovia, regarding FLIP: ``Target
customers. Who are the target customers? Capital gain of $20
million or more. Potential benefits: Individual capital gain
elimination.'' You do not see anything in there about
investment, do you?
And then you have got an HVB employee--HVB is a German
bank--regarding BLIPS: ``Seven percent is the fee equity paid
by investors for tax sheltering.'' That is the way that
particular bank employee looked at it.
And then you look at a Deutsche Bank internal memo: ``It is
imperative that the transaction be wound up due to the fact
that the high-net-worth individual will not receive his or her
capital loss or tax benefit until the transaction is wound
up.''
Now, do you still claim that these tax strategies were
primarily investment strategies and not tax-reduction
strategies? Is that your testimony under oath here that they
were not designed primarily as tax-reduction strategies?
Mr. Eischeid. Senator, my testimony is that these were
investment strategies that were presented to individual
taxpayers that had tax attributes that those investors found
attractive.
Senator Levin. Well, let me ask my question again, then. Is
it your testimony that these were not designed and marketed
primarily as tax-reduction strategies?
Mr. Eischeid. Senator----
Senator Levin. I am talking now about designing and
marketing. Were these designed and marketed primarily as tax-
reduction strategies?
Mr. Eischeid. Senator, I can't speak to any and all of the
marketing activities. You know, for example, you read----
Senator Levin. Well, just speak to what you know.
Mr. Eischeid. Thank you----
Senator Levin. From what you know, were these designed and
marketed primarily as tax-reduction strategies?
Mr. Eischeid. And what I know is that they were not, that I
personally had a number of conversations with clients and
prospective clients, and they were always characterized as
investment transactions with a significant pre-tax economic
purpose that was embedded in the overall transaction.
Senator Levin. All right. Now, look at what the
professionals at KPMG said about the purpose of the
transactions. Take a look at Exhibit 32.\1\
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\1\ See Exhibit No. 32 which appears in the Appendix on page 505.
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When KPMG and the financial advisory firm Quadra pitched
FLIP to that UBS Bank, this is how the product was presented.
Here is the title: ``Generating Capital Losses.'' That is the
title of the presentation.
If this is an investment strategy, why does KPMG describe
it and pitch it to potential partners as a product designed to
generate capital losses?
Mr. Eischeid. Senator, I don't believe I've ever seen this
document before.
Senator Levin. Well, now that you look at it, can you give
me an explanation?
Mr. Eischeid. I don't know what purpose this document might
have been used for.
Senator Levin. This was the pitch of FLIP to a potential
partner bank, UBS.
Mr. Eischeid. OK.
Senator Levin. That is the purpose.
Mr. Eischeid. I'll accept your statement, sir. I have no--
--
Senator Levin. Now that you know, can you explain why it is
characterized the way it is?
Mr. Eischeid. No, sir, I cannot explain why someone used
that phrase, sir.
Senator Levin. All right. Now let's look at the strategy
that you were involved with, Exhibit 41.\1\ This is the
presentation of BLIPS prepared by Carol Warley. Do you know who
she is?
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\1\ See Exhibit No. 41 which appears in the Appendix on page 536.
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Mr. Eischeid. Yes, Senator.
Senator Levin. All right. She is the BLIPS regional
deployment champion, is she not? Or was she not?
Mr. Eischeid. I don't remember her being the regional
deployment champion, but she may have been, yes.
Senator Levin. She was intimately involved with BLIPS?
Mr. Eischeid. Yes, Senator.
Senator Levin. Now, look at the chart on page 4 of that
exhibit, if you would.
``BLIPS Benefit: Avoid all of the capital gains and
ordinary income tax. Net benefit to client--effective tax rate
less after tax cost of transaction of approximately 5
percent.''
Are you familiar with that?
Mr. Eischeid. No, Senator, I'm not.
Senator Levin. Well, this is BLIPS. You were intimately
involved with BLIPS, weren't you?
Mr. Eischeid. Yes.
Senator Levin. Well, this is your document, isn't it? This
is a KPMG document.
Mr. Eischeid. It appears to be a document prepared by Carol
Warley, yes, sir.
Senator Levin. She works for KPMG?
Mr. Eischeid. Yes, she does.
Senator Levin. Was she wrong? Was she wrong that was the
purpose of BLIPS? That is the only purpose stated: Avoid all of
the capital gains and ordinary income tax. Do you see anything
there about this investment you made reference to?
Mr. Eischeid. Senator, I have no knowledge of what Carol
Warley was trying to communicate----
Senator Levin. Have you ever seen that document before?
Mr. Eischeid. No, I have not.
Senator Levin. Is this a KPMG document? Do you know that
much?
Mr. Eischeid. It appears to be, yes, Senator.
Senator Levin. All right. But you don't--you think that is
inaccurate, that statement?
Mr. Eischeid. If the statement is that that is the sole
benefit of BLIPS, then, yes, Senator, I would say that is
inaccurate.
Senator Levin. Does BLIPS avoid all of the capital gains
and ordinary income tax? Is that a benefit of BLIPS?
Mr. Eischeid. A potential benefit of BLIPS, sir, would be
the reduction of one's income tax liabilities, yes, Senator.
Senator Levin. Well, is this accurately stated that a BLIPS
benefit is to avoid all of the capital gains and ordinary
income tax? Is that accurate or not? It is a KPMG document. Is
it an accurate statement or not?
Mr. Eischeid. When you say a KPMG document, it certainly
appears to be--to have been prepared by a KPMG professional----
Senator Levin. It says here KPMG 0049642, proprietary
material, confidentiality requested. Are you denying this is a
KPMG document?
Mr. Eischeid. Senator, at least in terms of your reference,
I think that's an indication that it is a document that KPMG
produced, and as you indicated, the cover seems to indicate
that it was prepared by Carol Warley. I have no indication as
to what purpose she might have intended to use this document
for. It does not appear to me, at least on cursory review, that
it would have been prepared for use in a discussion with a
client of KPMG.
Senator Levin. Take a look at Exhibit 18.\1\
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\1\ See Exhibit No. 18 which appears in the Appendix on page 459.
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Now, this is a document that you signed, and this says, ``A
number of people are looking at doing BLIPS transactions to
generate Y2K losses.'' That refers to year 2000 losses. Are you
familiar with that document?
Mr. Eischeid. Yes, Senator.
Senator Levin. Is that accurate?
Mr. Eischeid. I believe it was.
Senator Levin. ``We currently have bank capacity to have $1
billion of loans outstanding at 12/31/99. This translates into
approximately $400 million of premium. This tranche will be
implemented on a first-come, first-served basis until we fill
capacity. Get your signed engagement letters in!! ''
Are those your words?
Mr. Eischeid. I believe they were, yes, sir.
Senator Levin. And then take a look at Exhibit 16.\2\ This
is from you to Michael Comer. It says here at the top, look at
the last line in that first paragraph, ``Innovative Strategies
is a portfolio of value-added products that are designed to
mitigate an individual's income tax as well as estate and gift
tax burdens. BLIPS is just one of the products in the
innovative Strategies portfolio.''
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\2\ See Exhibit No. 16 which appears in the Appendix on page 453.
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So BLIPS, according to your memo, was ``designed to
mitigate an individual's income tax as well as estate and gift
tax burdens.'' Is that true? Was that true when you wrote it?
Mr. Eischeid. Yes, sir, I believe that one of the
attributes of the BLIPS strategy was the income tax mitigation.
Senator Levin. Well, I know you are trying to make it one
of the attributes, but in your words, it was that this was a
product ``designed to mitigate.'' Was BLIPS designed to
mitigate an individual's income tax and estate and gift tax
burdens? Yes or no.
Mr. Eischeid. Senator, as I previously testified, I think
that is one of the attributes that was designed into the
strategy, both the income tax consequences as well as, as we've
heard previous testimony on, the economic investment attribute.
Senator Levin. Do you see anything about investment
attributes in your memo here as to what it was designed to do?
Now, you can't blame this on Carol Warley. She wrote the other
thing. You said, well, you are not familiar with that KPMG
document, but this one you are familiar with. And here you are
saying it was ``designed to mitigate.'' My question is: Do you
see any reference here to investment strategy on that memo of
yours?
Mr. Eischeid. No, Senator, I don't. I think that you are
somewhat reading ``designed'' out of context.
Senator Levin. Give me the whole context.
Mr. Eischeid. Well, I think my intention here was to
reference the innovative strategies in general as a portfolio
of value-added products----
Senator Levin. Which are? Keep finishing the sentence.
Mr. Eischeid. In the aggregate, in general, are designed to
help mitigate an individual's income as well as estate and gift
tax burdens. So that the----
Senator Levin. That is the purpose----
Mr. Eischeid [continuing]. Entire portfolio and the purpose
of that portfolio was to aggregate in a sense in a place a
number of different strategies that taxpayers might be
interested in discussing that have some significant income tax
consequence associated with them.
Senator Levin. When it says BLIPS is one of the products in
that portfolio, now look at the context. Is there any doubt in
your mind that it is, according to that previous sentence,
therefore, a value-added product designed to mitigate an
individual's income tax as well as estate and gift tax burden?
Mr. Eischeid. Senator, I don't know how to change my answer
to----
Senator Levin. Well, try an honest answer. Just give me a
direct answer to this. You are making a reference here to a
portfolio whose purpose is to mitigate on individual's taxes.
That is what your own memo says--the other ones you said you
weren't familiar with. They were all KPMG stuff, but you are
not familiar with that. Now it is yours. You are Jeff. Now, how
do you avoid looking that straight on and saying, I did say
that, BLIPS is a product designed to mitigate an individual's
income tax because it is part of Innovative Strategies
portfolio?'' Why not just give us a straightforward answer?
Mr. Eischeid. I'm trying my best, sir.
Senator Levin. Why isn't that the straightforward answer?
Mr. Eischeid. I think the straightforward answer is that
that was one of the attributes of the BLIPS products----
Senator Levin. One of the attributes.
Mr. Eischeid [continuing]. And that we certainly recognized
that and that was one of the factors that our clients were
quite interested in.
Senator Levin. Take a look at Exhibit 16--well, let me just
ask you about the fees. How were the fees priced for BLIPS?
What fee did you charge your customers?
Mr. Eischeid. Our fees would vary depending on the
circumstances. We would negotiate a fee with our clients,
determine an amount, and put that in----
Senator Levin. Wasn't it based on the tax loss?
Mr. Eischeid. I don't believe that we looked at our fee in
that way, no, Senator.
Senator Levin. Take a look at Exhibit 16,\1\ near the
bottom. BLIPS contact, you are the contact here, too. Here is
the fee. ``BLIPS is priced on a fixed-fee basis which should
approximate 1.25 percent of the tax loss.'' Are those your
words?
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\1\ See Exhibit No. 16 which appears in the Appendix on page 453.
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Mr. Eischeid. Well, my only hesitation is really to try and
refresh my recollection with respect to this e-mail. It very
well may have been my words. I don't recall writing that.
Senator Levin. Is it true?
Mr. Eischeid. That would not be my view or my testimony,
sir.
Senator Levin. It is not your testimony. That is the whole
point. Was it true or not? Was BLIPS priced on a fixed-fee
basis approximating 1.25 percent of the net tax loss?
Mr. Eischeid. In a very indirect way, yes, sir. The fee
that we would typically use as the starting point of our
negotiation we developed a shorthand around, which we used as
1.25 percent of what we referred to as the loan premium amount.
And as you indicated earlier, that loan premium amount
translated into tax basis for the investor.
Senator Levin. And that was the intent, was it not, of that
premium?
Mr. Eischeid. I'm sorry. I don't understand the question,
sir.
Senator Levin. Was that the intent of the premium, to be
approximately the net tax loss that the investor would gain
from this whole transaction?
Mr. Eischeid. We believed that that was the appropriate tax
treatment of that loan premium, yes, sir.
Senator Levin. Was that the tax loss which you told
taxpayers that they could expect, approximately, from this
transaction?
Mr. Eischeid. We generally told taxpayers, I believe, that
the tax treatment of that loan premium, whatever that amount
would be, should translate into tax basis for them, yes, sir.
Senator Levin. Tax basis which would be then deducted from
any capital gain or income that they had?
Mr. Eischeid. Depending on what ultimately happened with
that tax basis, yes.
Senator Levin. Was it the intent to be something which
would be a deduction from their income?
Mr. Eischeid. I think the answer would generally be yes,
that the taxpayers would anticipate using that tax basis at
some point in time and reflecting that on their income tax.
Senator Levin. They were so informed of that, were they
not?
Mr. Eischeid. Yes, sir. I mean I believe they were informed
as to the tax consequences of their participation in the BLIPS
investment program.
Senator Levin. My time is up. Thank you.
Senator Coleman. Mr. DeLap, because you did not give an
opening statement, I just want to do a little background here.
Can you tell us what position you held at KPMG during the
period that FLIPS, BLIPS, OPIS and SC2 strategies were being
developed and marketed?
Mr. DeLap. In February 1997, I became a partner in charge
of a newly-created Department of Professional Practice Tax, and
I held that position until June 30, 2002, at which time I
turned it over to my successor, and then I retired from the
firm on September 15, 2002.
Senator Coleman. Could you tell us what your
responsibilities entailed?
Mr. DeLap. The responsibilities generally related to seeing
that firm personnel complied with various regulatory rules,
Internal Revenue Service, SEC, AICPA, and State accountancy
boards. It entailed helping set policy, recommending policy
changes to leadership, involved making revisions as necessary
to the firm's tax services manual, involved an annual quality
performance review of the tax personnel in the various
operating offices relative to compliance with firm policies and
procedures. It included review of all contingent fee engagement
letters to determine whether they complied with rules of the
SEC, AICPA, and State boards accountancy.
Senator Coleman. Did you have any role in the approval of
the aforementioned strategies, the FLIPS, the OPIS, or the
BLIPS?
Mr. DeLap. With respect to tax strategies intended to be
discussed with multiple clients, the rule was to review those
strategies from a policy standpoint, to determine that the
manner in which they were taken to clients, complied with the
various regulatory rules and firm policy.
Senator Coleman. So you were involved then in the process,
had a chance to raise concerns prior to approval?
Mr. DeLap. That is correct.
Senator Coleman. In regard to BLIPS strategy, during your
review is it correct that you raised over 20 points that needed
to be resolved prior to your approval?
Mr. DeLap. As I recall, I received a proposed pro forma--
proposed model tax opinion regarding BLIPS that set forth the
facts, discussion and technical analysis, I think, sometime in
April 1999. I read that proposed opinion, and as I recall I had
a list of 29 concerns that I sent back to Washington National
Tax for further development.
Senator Coleman. Did you also share the concern about the
couple mentioned before, the client ability to make a profit,
and also I think the question of who is the borrower? Did you
have concerns about those issues?
Mr. DeLap. Yes.
Senator Coleman. Do you recall whether those concerns were
ever satisfied, were ever resolved to your satisfaction?
Mr. DeLap. Ultimately I determined that the analysis
prepared by Washington National Tax, the final analysis, I
thought addressed those concerns.
Senator Coleman. Help me understand, how do you get an
opinion issued, a more likely than not opinion issued when--and
it is easy in hindsight, we are looking back at this now, and I
presume it is tough sitting down there, but we are looking back
at this and we are seeing stuff that did seem to be substance,
did not seem to be risk, did not seem to be profit, seemed to
be transactions that you can lay out on a chart, but nothing
you can put your hands around. How do you get to a more likely
than not analysis based on that? I learned in law school not to
ask more than one question, but I am asking more than one
question. See if you can pull them together. Did you get to
that more likely than not because folks simply thought the IRS
would not know or did not have the resources or would not
pursue it, or was there a valid intellectual basis for that
more likely than not opinion?
Mr. DeLap. I believe, Senator, that it was based on a
rigorous analysis of the technical rules. The analysis and the
conclusion, from a technical standpoint was reached by
Washington National Tax, so I might need to deflect that
particular question to Mr. Wiesner.
Senator Coleman. Mr. Wiesner.
Mr. Wiesner. If I can supplement Mr. DeLap's answer. We
came to the conclusion--we started in February 1999, and had
intensive meetings with the Presidio people and their economic
people. They laid out the transaction for us. At the end of the
first meeting we had everybody around a table. We had the
Presidio people leave, and put on a white board all the issues
that we saw that were raised in the discussion, assigned those
issues out to an appropriate technical resource within
Washington National Tax, and then over a series of the next 2
months, 3 months, tried as best we could to resolve the issues
that had been raised. And it was only after spending probably
about 1,000 hours of time that we were able to arrive at our
more likely than not conclusion.
Senator Coleman. From a lay person sitting here, the sense
is that there is a lot of money to be made here, and revenues
are driving outcome. How much of a factor did revenues play in
these decisions?
Mr. Wiesner. Senator, from my point of view, money was not
a consideration. We certainly were aware at Washington National
Tax that this was an item of priority for the PFP practice, but
the practice that we keep the resources assigned to the project
and deal with the issues, and tell us sooner rather than later
whether you can or cannot get to the more likely than not level
of comfort.
Senator Coleman. You did on BLIPS though, $53.2 million in
fees?
Mr. Wiesner. Being in Washington National Tax, which we are
not in the operating office, I'm not familiar with the exact
amount of fees, Senator.
Senator Coleman. I will go back to Mr. DeLap. This issue of
registration, I need to understand that. We initially
understand that you took the position that the BLIPS products
should be registered as a tax shelter with the IRS, and I heard
today and understand that BLIPS was never registered. Did you
agree with the decision not to register?
Mr. DeLap. The registration statute left the implementation
interpretation of the statutory words to regulations which were
originally prepared in the 1980's in response to the syndicated
tax shelters marketed generally by investment banks back in the
early 1980's, and it was difficult to--or close to impossible
in some cases to interpret those regulations as they might
apply to the type of strategy like BLIPS. My view at the time
was that it would have been--it would be preferable for
Presidio to register the strategy, as I viewed Presidio as the
organizer. I was told that Presidio declined to register. The
Vice Chairman of Tax discussed the registration issue with the
partner in charge of the Practice and Procedures Group in
Washington National Tax, who is the firm's expert on procedural
matters including registration. His conclusion was, at that
time, that there was a reasonable basis not to register.
Based on that technical conclusion by the partner in the
Practice and Procedures Group, I agreed to permit the strategy
to go forward without registration.
Senator Coleman. What is the hierarchy here? What is your
relationship with the partner in the PFP, Practice and
Procedures? Do you have any authority over that person? Are you
on an equal plane?
Mr. DeLap. I guess it would be parallel. Washington
National Tax reported ultimately--I don't remember the exact
layers, but ultimately to the Vice Chairman Tax. I reported to
the Vice Chairman Tax.
Senator Coleman. There was a little discussion--I came in
at the tail end of it--of confidentiality, having BLIPS clients
sign a confidentiality agreement. Did you have any problem with
that?
Mr. DeLap. At the time a nondisclosure agreement relative
to tax strategies was common in the profession, so at the time
I did not have a problem with that as such.
Senator Coleman. Let me just get to the termination of the
marketing of BLIPS, which I believe was at the end of 1999?
Mr. DeLap. Yes, it was, I think in the fall of 1999.
Senator Coleman. Did you have any involvement with KPMG's
decision to terminate the marketing of BLIPS?
Mr. DeLap. When I approved BLIPS from a policy standpoint,
I set forth a list of conditions under which it would need to
be offered. One of those conditions was that it would be
offered to a limited number of individuals who were individuals
who understood the investment and tax risk involved, and that
Doug Ammerman and I would discuss at which point the marketing
should be terminated. I believe that we had that discussion, I
think in October 1999, maybe November 1999, and determined at
that time there should be no further approaches to potential
clients regarding BLIPS.
Senator Coleman. A cynic might say that the more
transactions, the greater chance of being on the IRS's radar.
Any substance to that cynicism?
Mr. DeLap. The way--I viewed it somewhat differently. I
expected that the transactions, being large transactions, would
be picked up on audit. My concern was that if there were an
unlimited number of taxpayers entering into similar
transactions, that the likelihood that a court would invoke the
Step Transaction Doctrine, would go way up. So I thought it was
important relative to the overall analysis that there be a
limited number.
Senator Coleman. Thank you. Senator Levin, a short follow-
up round.
Senator Levin. Thank you, Mr. Chairman.
I want to go back to the way KPMG's fees were tied to the
targeted loss, Mr. Eischeid. Those fees were not tied, as I
understand it, to the total amount of money managed or the
amount of profit, if any, made by those investments. Is that
correct?
Mr. Eischeid. I suppose, Senator, in the same sense that
it's referenced to the loan premium. You could use as an
alternative reference the total amount invested in the
strategic investment fund. You just really adopt a differing
percentage to derive sort of the shorthand starting point for
those fee negotiations.
But to the second point, there was no contingency around
our fees. Once we had negotiated an amount with the client, it
was a fixed amount that the client then agreed to pay us.
Senator Levin. Typically 1.25 percent of the targeted loss;
is that correct?
Mr. Eischeid. Generally, yes, sir.
Senator Levin. Now let us talk about the comments regarding
netting and the grantor trust. Mr. Watson, who was one of the
chief technical persons there, testified that netting gains and
losses in a grantor trust would then allow individual gains and
losses to be hidden, and that was not proper.
If you will look at Exhibit 10,\1\ contains some internal
KPMG e-mails on this matter. At this point KPMG was discussing
whether its clients should use that method of netting, and Mr.
Watson reacted strongly to it. If you look at the two comments
that Watson made, ``When you put the OPIS transaction together
with this `stealth' reporting approach, the whole thing
stinks.'' And the last sentence of the second quote of this e-
mail of Mr. Watson, ``I believe we are filing misleading, and
perhaps false, returns by taking this reporting position.''
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\1\ See Exhibit No. 10 which appears in the Appendix on page 428.
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Do you agree with Mr. Watson's position, Mr. Eischeid?
Mr. Eischeid. Senator, before I answer your question, I
would like to, if I could, clarify the record. In your previous
question I had agreed to your statement before you had I think
completed it, and so I just wanted to clarify that my
affirmative response is with respect to our fee calculation and
the loan premium amount.
With respect to this question, no, I don't agree with Mr.
Watson's characterization.
Senator Levin. Here is what you wrote in that Exhibit 10.
``We concluded that each partner must review the WNT memo and
decide for themselves what position to take on their returns
after discussing the various pros and cons with their
clients.''
What I do not understand is why is the leader of the group,
on an issue of this magnitude that is raised by the top
technical professional on the issue, you tell your colleagues
that they can do as they see fit. Should not a firm adopt a
standard position on an issue as controversial as this one, and
particularly one that results in potentially fraudulent
returns? Why not a standard position in your firm?
Mr. Eischeid. Senator, first of all, the reference
memorandum, which I don't necessarily see here, was prepared by
the head of the Personal Financial Planning Practice within
National Tax at the time. And so sometime later Mr. Watson
expressed his view with respect to the issues addressed in that
opinion. So what you are witnessing here is really that
spirited debate that I referenced in my initial comments about
what is simply the right answer? What is the proper
interpretation of the law? I don't think that any of the
professionals viewed it as anything more than that, and that my
partners are tax professionals, and I trusted their judgment to
analyze the law and arrive at a correct determination.
Senator Levin. Did any KPMG clients who utilized BLIPS use
grantor trusts to net out the losses that were received from
those strategies?
Mr. Eischeid. Senator, no, not to my knowledge.
Senator Levin. Did KPMG ever suggest this to them as a
strategy? Did you ever sell BLIPS or OPIS on the basis of
netting gains or losses in a grantor trust?
Mr. Eischeid. Senator, as I indicated, I don't believe that
any of our BLIPS clients prepared or had tax returns prepared
that reflected any type of grantor trust netting.
I must also point out that when--the IRS's position with
respect to grantor trust netting--emerged, as we discussed
earlier, in August 2000, we endeavored to approach all of our
clients to ascertain whether or not this type of netting might
have occurred on one of their tax returns, and if so, we
recommended to those clients, given the articulated position of
the IRS, that they amend those returns.
Senator Levin. If you take a look at Exhibit 10 at the
second from the last page, where it says ``up in the
Northeast,'' the third line there. ``The short answer to your
inquiry is,'' see that? ``Up in the Northeast, at least, there
is quite a bit of activity in the trust area where they used to
not audit many of these kinds of trusts. They are now auditing
quite a number of them because they have figured out that
trusts are a common element in some of these shelter deals.''
Do you see that, ``trusts are a common element?'' Was that true
in the case of BLIPS?
Mr. Eischeid. Senator, I have no basis to answer that
question.
Senator Levin. You are not familiar with this KPMG
document?
Mr. Eischeid. I have seen this KPMG document, yes, sir.
Senator Levin. Is it true that trusts are a common element
in some of these shelter deals?
Mr. Eischeid. That would not be my understanding, no,
Senator.
Senator Levin. This was a call that you made, as I
understand, asking a colleague if that colleague had spoken
with a client whose name is redacted here; is that right?
Mr. Eischeid. No, Senator, I don't think I had anything to
do with this particular document.
Senator Levin. Take a look at the next page. It is a memo
from you. ``Did you have your `netting' discussions with''
blank and blank, redacted because they are clients, ``I need
copies of the memos of oral advice.'' That is your memo.
Mr. Eischeid. Yes, Senator.
Senator Levin. This is the answer to it. So how can you say
you are unaware of it?
Mr. Eischeid. My impression, Senator, is that these are two
totally unrelated documents, separated by 6 months or more.
Senator Levin. The memorandum here of May 24 is not a
response to your October document; they are not related?
Mr. Eischeid. No, Senator. I think the second memorandum
that you are referring to----
Senator Levin. Which is the second one, the one on top of--
--
Mr. Eischeid. October 20 is really referencing those kinds
of client discussions that I just testified to. After Notice
2044 came out, and we went back to our clients to ascertain
whether or not some type of netting activity had been
undertaken.
Senator Levin. So whether or not the top document was a
response to the earlier one or not, you were interested in
knowing whether there were netting discussions; is that
correct? And it related to FLIP; is that correct?
Mr. Eischeid. This particular, the dialogue between myself
and another of our partners related to a FLIP transaction, yes,
Senator.
Senator Levin. The short answer is yes. My question is,
that that document asking your colleague whether you had
netting discussions, related to FLIP; is that correct? And the
answer is yes, is it not?
Mr. Eischeid. Yes, this related to FLIP, correct.
Senator Levin. Mr. Manth--well, let me ask Mr. Wiesner. I
have a little time left. You are the partner in charge of the
Washington National Tax Office during the BLIPS review. Exhibit
65 \1\ is a May 7, 1999 e-mail from Mr. DeLap. He forwards an
e-mail from Mark Watson, who reports that based on new
information he had just learned at a meeting with Presidio on
BLIPS that he is no longer comfortable with the BLIPS product
because there is only a remote possibility of making a profit,
and the bank controls the loan proceeds, so it is doubtful it
is not even a real loan. He also reports that another technical
reviewer at WNT is concerned about who is the borrower, and Mr.
DeLap recommends not moving forward until these issues are
resolved.
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\1\ See Exhibit No. 65 which appears in the Appendix on page 623.
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Then, Mr. Wiesner, on May 7 and May 10 you meet with Mr.
Rosenthal and Mr. Watson to discuss their concerns. You
announce that the decision was made to move forward. You
overruled your technical people on this, did you not?
Mr. Wiesner. Senator, what was reflected here was on--when
we started our discussions of whether or not we could arrive at
a more likely than not opinion in January. After 2 months of
deliberation, I had believed, because I thought I had received
everyone's sign-off, that we had arrived at a more likely than
not conclusion. Mr. DeLap then began his review of the
transaction, and there were some follow up e-mails and
memorandums such as this memorandum on Friday, May 14.
To the extent that there were issues raised that were new
issues raised concerning the transaction, yes, we took those
very seriously.
Senator Levin. One of the issues is whether or not the
representations which are material to your firm's tax opinion
are credible; is that correct?
Mr. Wiesner. Yes, sir, that is correct.
Senator Levin. Whether those representations are credible.
If you take a look at Exhibit 7,\2\ you wrote this memo on
February 7.
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\2\ See Exhibit No. 7 which appears in the Appendix on page 415.
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``Last, an issue that I am somewhat reluctant to raise, but
I believe is very important going forward concerns the
representations that we are relying on in order to render our
tax opinion on BLIPS I. In each of the 66 or more deals that
were done last year, our clients represented that they
`independently' reviewed the economics and had a reasonable
opportunity to earn a pre-tax profit. Also, they had no
`agreement' to complete the transaction in any predetermined
manner, i.e., close out the deal on 12/31 and trigger the
embedded tax loss.''
Now your writing. ``As I understand the facts, all 66
closed out by year-end and triggered the tax loss. Thus, while
I continue to believe that we can issue the tax opinions on
BLIPS I, the issue going forward is can we continue to rely on
the representations in any subsequent deals if we go down that
road?''
Now, when you were confronted with that evidence--66 out of
66, that is not a coincidence--what did you do? Did you
evaluate whether KPMG should rely on the client's
representations for these BLIPS deals?
Mr. Wiesner. Senator, in the memorandum we are referring
to, the e-mail which was February 24, the first paragraph of
the e-mail was my conclusion that we still could issue a more
likely than not tax opinion. We had considered----
Senator Levin. Is this for the ones that existed, or for a
new one?
Mr. Wiesner. This was for the 66 transactions that we were
talking about for 1999.
Senator Levin. Let us separate those out for the moment.
You said later on in that memo, going forward, the issue is
whether we can continue to rely on the representations made.
Mr. Wiesner. Yes, I did, Senator, because after I made my
conclusion based on an evaluation of the law, and that is that
the fact that the 66 people got in and got out, that does not,
per se, result in the transactions of each individual not
meeting the economic substance doctrine. But then, looking
forward and worrying as a professional about the sort of--the
types of representations we are looking for here and the
reasonableness of the representations, I had a concern from a
business point of view of whether we could continue to rely on
the representations.
Senator Levin. But you did continue, did you not?
Mr. Wiesner. I am not sure on that, Senator, but if in fact
we did, a determination was--my----
Senator Levin. You are not sure whether you continued to
sell BLIPS deals?
Mr. Wiesner. Senator, this memorandum really was my last
involvement in the BLIPS transaction.
Senator Levin. Well, let me tell you, you did continue to
sell BLIPS deals. Now, does that trouble you?
Mr. Wiesner. Well, Senator, I would have to look and
examine the issue as we did for the 1999 deals and determine,
again, whether there was a reasonable basis for each of the
individuals to make their representation. And that was an issue
for 1999 as well as going forward that I and Washington
National Tax wasn't in a position to make.
What I did to follow up was talk to Mr. Eischeid and to
make sure that Mr. Eischeid and the people in the field who
were dealing with the clients would explore the issues.
Senator Levin. I don't see how in heaven's name as a tax
professional you raise an issue, 66 out of 66 representations
turn out not to be accurate. And you raise first the question
as to whether you ought to issue the opinions that you
subsequently issued. But then you say going forward. Going
forward. Now you raise an issue. What about future deals?
Should we continue to sell this? Should we continue to rely on
these representations that are unanimously disproved by the
facts?
These are not credible representations. You put them in
your client's mouth. You folks write the representations. There
is no prospect of a profit on the investment. Sixty-six times
out of 66 that turns out to be the case. You raise the
question, and then you continue to go forward as a firm anyway.
You continue to sell this tax deal.
Mr. Eischeid. Senator, I am certain that I don't agree with
your characterization. We don't believe that the
representations that our clients made to us were false and that
it is----
Senator Levin. It turned out not to be true 66 out of 66
times. Would you agree with that?
Mr. Eischeid. No, Senator, I would not. I think the
representation that we're speaking to is that the client at the
time that they entered into the transaction believed that they
had a reasonable opportunity to make a profit from their
investment transaction. I think that's the representation and--
--
Senator Levin. Mr. Wiesner, you said, ``My recommendation
is that we deliver the tax opinions in BLIPS I and close the
book on BLIPS and spend our best efforts on alternative
transactions.'' The firm did not do that. They did not follow
your advice. Should they have?
Mr. Wiesner. Senator, my responsibility was, again, as a
technical reviewer of the transaction and coming to my
conclusion with respect to the transaction and what we should
do. I made the recommendation from my own personal view and in
my own judgment, and--but I was not the person who would
ultimately make the decision.
Senator Levin. Does it trouble you the firm went forward
and continued to sell BLIPS? You were troubled when you wrote
the memo. Are you troubled now when I tell you the firm went
ahead and sold BLIPS, more BLIPS? Does that bother you?
Does anything bother you? Now I am asking you a direct
question. You made a recommendation, Mr. Wiesner. You are a
professional. You recommended to your firm that they stop
selling BLIPS. They didn't. My question: Does that bother you?
Mr. Wiesner. Senator, I was--again, in the context of the
situation, I was making my own personal recommendation in terms
of what I thought was a course of action. This is an area of
very complex, difficult interpretation of the law, application
of the facts to the law, and I made my best determination and
made my recommendation.
Mr. Eischeid. And, Senator, I might point out----
Senator Levin. Could you answer my question?
Mr. Eischeid. I am sorry.
Senator Levin. Are you going to answer my question? I know
it was a personal recommendation of yours. That is my question.
Are you personally bothered by the fact that your
recommendation was not followed?
Mr. Wiesner. Would I have preferred that my recommendation
were followed?
Senator Levin. Yes.
Mr. Wiesner. Yes.
Senator Levin. Thank you, Mr. Chairman.
Senator Coleman. Thank you. We will excuse the panel and
now call our next panel.
Senator Levin. Mr. Chairman, I do have questions for the
record for the witnesses that I did not get to, and I am
wondering if the record can be kept open for those witnesses.
Senator Coleman. Without objection.
Senator Levin. Thank you.
Senator Coleman. I would now like to welcome our third
panel to today's hearing: Richard Berry, Jr., Senior Partner
with Pricewaterhouse Coopers, New York City; Mark Weinberger,
Vice Chair of Tax Services for Ernst & Young, Washington, DC;
and, finally, Richard H. Smith, Jr., Vice Chair of Tax Services
for KPMG LLP, New York City.
Again, I want to thank you for your attendance at today's
hearing, and I look forward to hearing your testimony.
Before we begin, pursuant to Rule VI, all witnesses who
testify before the Subcommittee are required to be sworn. At
this time I would ask you to please stand and raise your right
hand. Do you swear that the testimony you are about to give
before this Subcommittee is the truth, the whole truth, and
nothing but the truth, so help you, God?
Mr. Berry. I do.
Mr. Weinberger. I do.
Mr. Smith. I do.
Senator Coleman. As I have indicated to witnesses before in
the other panels, I would like you to confine your testimony to
5 minutes in a statement but that your entire written testimony
will be entered into the record.
We will start with Mr. Berry, who will go first, followed
by Mr. Weinberger and finish up with Mr. Smith. And after we
have heard all the testimony, we will turn to questions.
Mr. Berry, you may proceed.
TESTIMONY OF RICHARD J. BERRY, JR.,\1\ SENIOR TAX PARTNER,
PRICEWATERHOUSE COOPERS LLP, NEW YORK, NEW YORK
Mr. Berry. Thank you. Good afternoon, Chairman Coleman and
Senator Levin. I am Rick Berry, and I serve as the national
leader of Pricewaterhouse Coopers tax practice. I am pleased to
be here today to discuss the important topic of abusive tax
shelters.
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\1\ The prepared statement of Mr. Berry appears in the Appendix on
page 303.
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Let me say right at the outset that we share the
Subcommittee's concerns about the impact that abusive shelters
have on our tax system. I welcome the opportunity to discuss
our own experience with the Subcommittee. I know you have had a
long day so far, so I will briefly summarize my written
testimony.
From 1997 to 1999, we had a small group of less than 10
people who worked on three tax shelters known as FLIP, CDS, and
BOSS. The BOSS transaction triggered widespread public
attention and controversy in the fall of 1999. As a result, we
decided that we had made a regrettable mistake being in this
business. Our reputation was hurt, our clients and people were
embarrassed, and it was incompatible with our core business.
We got out of this business immediately. We established an
independent and centralized quality control group. We
strengthened our procedures to ensure that we would never again
engage in this type of activity. We decided the appropriate
course of action was to shut down the BOSS transactions and
refund all the fees we had received.
Not one of the BOSS transactions was ever completed. We
also never, I repeat, never did any of the so-called Son of
BOSS transactions. We stopped doing FLIP and CDS as well. We
have now been out of this business for almost 4 years.
Not long after this, the IRS contacted our firm to review
our compliance with the registration and list maintenance
requirements of the tax law. The next step to putting this
behind us was to work with the IRS to resolve any issues
relating to our registration and list maintenance obligations.
We fully cooperated with the Service. We reached a closing
agreement in June 2002 and made a settlement payment. We agreed
to provide the IRS with over 130 tax planning strategies for
their review. They are in the final stages of this review, and
no issues have been raised.
The IRS also reviewed our quality control procedures and
told us they were comprehensive, thorough, and effective. We
continue to cooperate with the Service and fully abide by the
terms of our agreement.
Our experience almost 4 years ago served as a wake-up call
to our tax practice. Our partners were adamant that we get out
of this business immediately. We took the unusual step of
shutting down the largest transaction and returning all of our
fees. We settled with the IRS. We implemented comprehensive
quality control procedures to ensure that the firm would never
again be involved with potentially abusive tax products. We
take responsibility for our actions, and we have learned from
our mistakes. As a result, our tax practice is once again
dedicated to the core values on which our firm was founded.
Thank you for the opportunity to testify before you today.
I look forward to your questions.
Senator Coleman. Thank you, Mr. Berry. Mr. Weinberger.
TESTIMONY OF MARK A. WEINBERGER,\1\ VICE CHAIR, TAX SERVICES,
ERNST & YOUNG LLP, WASHINGTON, DC
Mr. Weinberger. Good afternoon, Chairman Coleman and
Senator Levin. My name is Mark Weinberger, and I am
representing Ernst & Young. I appreciate the opportunity to
participate in addressing the important matters being
considered by your Subcommittee.
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\1\ The prepared statement of Mr. Weinberger appears in the
Appendix on page 309.
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The subject of tax shelters is complex, and the complexity
begins with the definition of tax shelters. When I discuss tax
shelters, I am referring to products that have been widely
marketed that are intended to generate tax benefits
substantially in excess of any anticipated economic and
business benefits, generally to shelter income from other
sources. Beginning in the mid-1990's, these products were
marketed with increasing frequency by investment banks, law
firms, financial service firms, accounting firms, and other
professional service firms, including ours.
The stock market boom and the proliferation of the stock
awards in the 1990's created an unprecedented number of
individual taxpayers with large gains and significant potential
tax liabilities. Initially, in an effort to be responsive to
client needs, we and other firms looked for legitimate tax
planning to try and meet their needs. Perhaps reflecting the
tenor of the times, these efforts rapidly evolved into
competitive and widespread marketing of those ideas.
Selling and marketing are essential parts of any business,
but we should not allow any part of our tax practice to be
dominated by a sales mentality. Our past involvement in the
type of activities that are the focus of this Subcommittee's
attention is not reflective of our--and we believe your--
expectations of our role as professionals. Ernst & Young has
more than 23,000 employees in the United States. That number
includes more than 6,000 professionals in the tax practice who
provide a wide range of tax services to more than 22,000 tax
clients. The revenues derived from the work under scrutiny by
this Subcommittee never accounted for more than one-half of 1
percent of our firm's revenues. Our core tax practice was and
is assisting our clients in their efforts to comply with the
tax laws and reduce their tax liability in a manner that is
appropriate and consistent with the tax law. We are committed
to doing business in ways that embody the highest professional
standards.
To make sure that we stay true to who we are as a firm,
since I have assumed responsibilities, we have implemented a
host of policy, procedural, and organizational reforms designed
to create the highest quality professional environment. In
addition, we have entered into a settlement agreement with the
IRS regarding tax shelter registration and list maintenance
requirements. And we have disbanded the group that had been
involved in developing and marketing of tax products of the
type at issue. This has nothing to do with the merits of the
transactions; it has to do with who we want to be as a firm.
We have made a number of organizational changes that are
relevant in the context of this hearing. Ernst & Young has
established a new full-time position called Americas Director
for Tax Quality, who is a senior serving client representative
who now has full-time responsibility just to look over all of
our quality initiatives; established a Tax Technical Review
Committee for each of our key functional areas in tax to
provide detailed technical reviews of significant issues and
help assure consistency in interpretation of the tax law;
established a new tax review board, with members that include
senior executives from outside the tax practice from our
general counsel's office and our quality department, to provide
a firm-level view with respect to tax practices, services, and
relationships; and established a new tax practice hotline to
allow employees to provide anonymous input on any matter about
which they may have concerns.
In addition to our most recent initiatives, we continue to
adhere to our policies under which we do not recommend
transactions that have been listed by the IRS as potentially
abusive or substantially similar; and, furthermore, we do not
enter into confidentiality agreements with our clients for tax
services.
Finally, as part of our efforts to move forward, earlier
this year Ernst & Young executed a closing agreement with the
Internal Revenue Service resolving all issues regarding tax
shelter rules and regulations. A key aspect of that agreement
is our commitment to implement a quality and integrity program
to promote the highest standards of practice and ongoing
compliance with laws and regulations.
The agreement includes a significant investment by our firm
in education, data collection, national review, and annual
audits of our practices across the country. This will ensure
consistent quality for our firm and our clients.
In closing, we believe these initiatives, individually and
collectively, will foster the highest standards of
professionalism within Ernst & Young. We believe these policies
are the right course for our firm and our clients.
That said, in the years ahead, there surely will be
disagreements between the IRS and taxpayers. Our tax laws are
enormously complex, and there is more than ample room for
disagreement on any number of issues. Where the Service and the
taxpayers disagree, those differences should reflect well-
reasoned and good-faith interpretations of the rules as applied
to a particular taxpayer's facts and circumstances.
Let me assure you that we know who we are and who we want
to be. We have taken, and are taking, numerous steps to ensure
that quality and professionalism are the touchstones for
everything we do.
Thank you again for the opportunity to discuss our positive
changes with you, Mr. Chairman and Senator Levin, and I will
answer the Subcommittee's questions at the appropriate time.
Senator Coleman. Thank you, Mr. Weinberger. Mr. Smith.
TESTIMONY OF RICHARD H. SMITH, JR., VICE CHAIR, TAX SERVICES,
KPMG LLP, NEW YORK, NEW YORK
Mr. Smith. Thank you, Mr. Chairman.
Mr. Chairman, Senator Levin, my name is Richard Smith. I am
the Vice Chair of Tax Services for KPMG. While today's hearing
is focused on certain tax strategies KPMG presented to clients
in the past, I would like to describe how KPMG's policies and
practices have changed since then.
The business and regulatory environment are markedly
different today than at the time KPMG and its competitors
presented such strategies, and KPMG has moved forward as well.
KPMG has no higher priority than restoring public trust in the
accounting profession. It is no longer enough to say that a
strategy complies with the law or meets technical standards.
Today, the standard by which we judge our conduct is whether
any action could in any way risk the reputations of KPMG or our
clients. If it could, we will not do it. Our reputation, our
integrity, and our credibility are simply too important to put
at risk.
Some of the more significant changes and new procedures in
place at KPMG include:
One, we have substantially changed KPMG's tax services and
offerings. Today, KPMG offers our clients tax services that are
tailored to address their distinct business objectives and tax
planning needs. We no longer offer or implement aggressive
look-alike tax strategies. In particular, we no longer offer or
implement FLIP, OPIS, BLIPS, or SC2, or any similar
transactions. Additionally, KPMG does not and will not accept
any new engagements for advice and opinions on tax shelters
that have been listed and deemed abusive by the Internal
Revenue Service.
Two, over the past 3 years, KPMG has developed an
increasingly more rigorous and formal review and oversight
procedure within our tax practice. All tax strategies must
undergo three levels of review and approval.
First, we have created the new position of Partner in
Charge of Tax Risk and Regulatory Affairs. This partner
analyzes each tax strategy proposed by the firm to determine if
it could in any way put KPMG or our clients at risk.
Second, the partner in charge of our Washington National
Tax Practice must sign off on the technical merits of all
significant tax strategies.
Finally, the Department of Professional Practice-Tax
reviews all tax strategies to ensure that they are in
compliance with the firm's policies and procedures. Each of
these partners has veto power over any tax strategy proposed
and operate independently from our operations and business
development functions. If any tax strategy puts KPMG or our
clients at risk, is not technically correct and defensible, or
is inconsistent with our policies or procedures, it will not be
approved.
Three, we have also revised our procedures with respect to
list maintenance and registration obligations under the
Internal Revenue Code. In early 2000, KPMG established a
practice, procedure, and administration group in Washington
National Tax as the contact point for analysis of disclosure,
list maintenance, and registration issues. KPMG's procedures
and training programs have been updated continuously since that
time, tracking developments in the law and fine-tuning our
compliance processes.
Four, practices and positions focused on look-alike
strategies are no longer part of this firm. In 2002, two
practices in particular, Stratecon and Innovative Solutions,
were eliminated. Many of the partners who were part of these
practices are no longer with the firm. We have abolished
positions such as national deployment champions and area
deployment champions, which were charged with marketing these
strategies to our clients. We also eliminated the Tax
Innovation Center, which was responsible for supporting the
marketing of look-alike tax strategies.
Five, our tax training program now focuses on technical
developments rather than marketing strategies. We have
discontinued weekly tax partner calls, training programs, and
other activities that primarily focus on marketing. Tax
partners calls and training now concentrate on changes in the
law and technical tax developments.
Six, in 2002, KPMG implemented a firm-wide compliance and
ethics hotline. This hotline is designed to encourage anyone
within KPMG to report their concerns about any potentially
unethical, improper, or illegal conduct within the firm, and is
in addition to long-standing channels for employee
communication.
Seven, we have put in place more stringent rules about
offering tax services to executives at our SEC audit clients.
Under the Sarbanes-Oxley Act, the audit committees of our SEC
audit clients must preapprove all services provided by KPMG,
including tax services. We have applied this disclosure and
approval discipline to tax advice offered to executives of SEC
audit clients.
Eight, we are constantly looking at additional steps we can
take to improve and enforce compliance with these policies and
practices.
Senator Coleman. If you would just summarize?
Mr. Smith. I will just sum up and move forward. Thank you,
Senator.
Senator Coleman. Thank you.
Mr. Smith. We encourage anyone at KPMG to bring to our
attention immediately any actions that are inconsistent with
these guiding principles and procedures and to suggest
additional policies or procedures that would help ensure that
we are providing the highest quality tax services and advice to
our clients.
KPMG looks forward to being part of the solution and wants
to work with Congress as well as the IRS and other policymakers
as you consider sound and responsible approaches to better
define what tax strategies are allowable under the law and to
further strengthen the enforcement of the tax code.
Thank you, and I look forward to your questions.
Senator Coleman. Thank you, Mr. Smith.
First, let me say that I applaud the efforts that you have
taken and the commitment that you have made to apply the
highest standards, the sensitivity that we are hearing today
regarding the impact this has on the reputation of firms and
the industry. So I want to put on the record my appreciation
for that.
At the same time, obviously, as we look back, the past is
not a pretty past, and part of the concern, as we sit here, our
job is to figure out where we go from here. Was the past just
simply a product of the booming 1990's and being awash in cash?
And the sense I get, gentlemen, is that--and, by the way, not
just PWC and Ernst & Young and KPMG. We could have had the
table lined up with everybody in the business, it seems,
looking for ways to figure out how to wash out profit and to
limit liability. I mean, that is the reality.
So the question is: How do we make sure it does not happen
again? How do we make sure that these statements today that you
make saying, hey, we have changed our process, we have cleaned
up our act, will be the reality should this economic engine
start booming again? And that is a concern.
I do not think we need to have an IRS agent sitting there
next to you as you make your policy decisions. But as we look
at the past, clearly, there is a very sorrowful record, I
think.
Mr. Berry, I would take it that you would agree that these
FLIP, BOSS, CDS things, as you look back, lacked economic
substance.
Mr. Berry. Mr. Chairman, with respect to the BOSS
transaction, which we did not do, that in my judgment is an
abusive shelter, or would have been.
With respect to FLIP and CDS, if not abusive, they come
very close to that line. They do not meet our quality
standards. We regret that we ever got involved in those
transactions, and we would not do them today.
Senator Coleman. Would you have an opinion on BLIPS?
Mr. Berry. I am not familiar with those transactions. We
never did them.
Senator Coleman. We talked about registering a little bit,
and perhaps, Mr. Weinberger, on that issue. My concern is the
lack of registration service as the way to keep things under
the radar. Would you agree with that?
Mr. Weinberger. Senator, I agree that transparency and the
ability for the IRS to be able to identify transactions quickly
and respond is absolutely a cornerstone to being able to deal
with this process going forward. And that involves registration
on the part of promoters. It involves disclosure by taxpayers.
And it involves the list maintenance rules that the IRS also
passed.
Senator Coleman. How do we ensure that there is
transparency on a regular basis? Is it going to require more
legislation?
Mr. Weinberger. Well, Senator, since the original
transactions that were discussed today and others that are out
there have occurred, there have been significant regulatory
changes, and there are legislative changes before the Senate
Finance Committee. The environment has changed in many ways,
not the least of which is the disclosure rules are now more
aligned with the registration and list maintenance rules, which
creates a web so that not only will individuals have to
disclose transactions, but the promoters are supposed to
register them and maintain lists as a mechanism to be able to
give the IRS the information to be able to actually know when
those transactions occur and to respond appropriately.
Senator Coleman. Mr. Smith, does KPMG have internal
controls regarding to ensure that IRS registration requirements
are met?
Mr. Smith. Yes. Certainly over the years, we have improved
our policies and procedures to reflect not only the changes
that have taken place in the law and regulations, as Mr.
Weinberger described, the changes in the disclosure rules as
well as the listing requirements. But we have put in policies
and procedures that go beyond those particular rules that I
think are helpful in addressing the concerns that you are
talking about today.
For example, for us we think transparency is so important
that we are going to err on the side of registration beyond
what might be required in the law and regulations.
Senator Coleman. One of the areas of questioning that was
generated by my distinguished Ranking Member, Senator Levin,
had to do with the fee structure. To me, why not base fees on
profits that would be generated by a transaction, if you really
believe that, versus fees that are being generated due to the
amount of loss you are going to take? I mean, it is clear that
that was the standard.
Is that something that needs to be dealt with
legislatively?
Mr. Smith. I think that there are a number of different
ways that fees could be structured, and I think there have been
some significant changes that have occurred over the past
couple of years.
Mr. DeLap talked about the changes with regard to
contingent fees. We think that those were good changes and
certainly have focused on how do we bring transparency to our
fees as well as bring transparency for the government into the
transactions in which we are involved.
Senator Coleman. And, again, to note from an industry-wide
perspective, I take it, Mr. Weinberger, that Ernst & Young also
used a fee system based on taxes avoided under the shelters in
the past. Is that correct?
Mr. Weinberger. Senator, we had fixed fees that were based
on investments which were attributable to the losses.
Senator Coleman. Has that process been changed today?
Mr. Weinberger. Yes, the AICPA and the SEC have rules on
contingent fees, and obviously we need as an industry to comply
with all of those. The vast majority of work that our firm does
is hourly based. There are certain circumstances where they are
specifically allowed to have value-billing based on the
complexities of different transactions or the investment
involved.
Senator Coleman. And my last question, because I am trying
to figure out where we go from here, and I could spend a lot of
time getting very angry, as my colleague, I think justifiably,
from Michigan has been as he has looked at the amounts of tax
avoidance as a result of these schemes and the impact that it
has.
Gentlemen, I would like you all to respond. Talk to me
about the lessons you have learned what the industry as a whole
should take from what we have discussed today, and where does
the tax adviser industry go from here? Where do we go from a
legislative perspective as well as from an internal
perspective? And I take it your statements of the controls you
set in place perhaps have answered that, but I would like your
sense. Is there more legislation that we are going to have to
enact in order to keep the reins on this thing and ensure that
people meet the highest quality ethical standards? Mr. Berry.
Mr. Berry. Yes, my firm is very supportive of additional
legislation, particularly in the areas of increased disclosure,
both on the part of the taxpayer and the tax preparer, and
definitely increased penalties.
Senator Coleman. Mr. Weinberger.
Mr. Weinberger. Senator, I think that legislation will
never solely prevent individuals, if they do not step up to the
plate and do the right thing. So I think it takes our part as a
professional service firm. I think it does take the IRS
following up on the transactions they identify. I think the
transparency and disclosure rules are crucial. We have an
incredibly complex tax code. I am not Pollyanna-ish enough to
think that we are going to simplify it, but that would
certainly be a huge benefit to dealing with those who want to
aggressively use the tax code in ways that take advantage of
the complexity. And like Mr. Berry, I do think the cost/benefit
analysis of looking at whether or not when you give advice you
are following the rules, it should be further analyzed,
absolutely.
Senator Coleman. Mr. Smith.
Mr. Smith. Yes, I think all of the component pieces of the
system are important to improving compliance with the tax code.
The IRS, clients, tax advisers, Congress--I think all of those
are important in terms of the policies that they set.
At the end of the day, it is how a professional feels about
themselves and how they feel that they should conduct
themselves, and that is part of setting the tone at the top
within each of those organizations and institutions. And it is
about executing on setting the highest professional standards
and making sure that we live up to those.
So I think the internal controls and changes that have been
made by certainly the three firms before you right now, as well
as the changes with regard to listing and disclosure that apply
to the firms and apply to the taxpayers, are important
developments in the entire system.
We certainly support anything that relates to further
transparency and enforcement of that transparency.
Senator Coleman. Thank you, Mr. Smith. Senator Levin.
Senator Levin. Thank you, Mr. Chairman.
I am glad one of you mentioned the need to increase
penalties. The current penalty for promoting an abusive tax
shelter is $1,000. Now, there is no way that that is anything
other than a parking ticket. And when professionals promote
abusive tax shelters, it seems to me that the penalty has got
to be similar to what the penalty is paid by the taxpayer that
they are advising and putting documents into the hands of. And
so one of the provisions of the bill which we will be
introducing will be increased penalties, but they are going to
be significant because the current penalties of $1,000, I think
a maximum of $10,000 for a similar violation, is a joke. And it
is a pitiful joke.
Mr. Smith, your prepared statement says on page 4 at the
top that in 2002, KPMG eliminated two tax groups that ``were
responsible for developing tax strategies specifically designed
to be presented to multiple clients, Stratecon and Innovative
Solutions.'' And when did that happen in 2002?
Mr. Smith. That happened as I came on as the Vice Chair of
Tax, Senator, which would have been in April.
Senator Levin. Of last year?
Mr. Smith. Yes.
Senator Levin. Well, when you look at Exhibit 89,\1\ if you
would take a look at your exhibits, this is the organizational
chart for KPMG for 2003 that your firm supplied to the
Subcommittee in February of this year in response to the
subpoena.
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\1\ See Exhibit No. 89 which appears in the Appendix on page 680.
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Now, we asked for organizational charts for each of several
years so we could understand the way your firm is organized.
The 2003 chart still lists Stratecon. How do you explain that?
Mr. Smith. This organizational chart is inaccurate.
Senator Levin. Your own organizational chart is inaccurate?
Mr. Smith. This particular version----
Senator Levin. Your own organizational chart is inaccurate?
Is that what your testimony is?
Mr. Smith. This version that you have is not accurate in
terms of----
Senator Levin. This is your document, KPMG 000001. I mean,
this is what you supplied to us. This is the first document you
supplied to us in response to a subpoena. Are you testifying
that the document you supplied us showing your organizational
makeup for 2003 was inaccurate?
Mr. Smith. I think it reflects a change in one box in this
particular organizational chart which has me as the Vice Chair
of Tax. There are numerous--as I just perused over this
particular organizational chart before me, there are numerous
errors in terms of the organization.
Senator Levin. All right. I just want to make it clear.
This is the chart that your firm supplied to us. Is that
correct?
Mr. Smith. I suspect it is, Senator.
Senator Levin. Can you get us an accurate chart?
Mr. Smith. Yes.
Senator Levin. Because I think the Subcommittee has a right
to expect when we subpoena documents that you will give us
accurate documents. Is that a fair expectation, would you say?
Mr. Smith. I would have expected that you would have
received something other than a draft organizational chart.
Senator Levin. Was this a draft that you submitted to us?
Mr. Smith. Let me restate that, sir. This document that you
have does not reflect our organization.
Senator Levin. OK. Now, it also refers to a PFP, Personal
Financial Planning, as I understand it.
Mr. Smith. Yes.
Senator Levin. Innovative Strategies, do you see that?
Mr. Smith. I don't see----
Senator Levin. Do you see where it says PFP Inno Strat, J.
Eischeid? Do you see that, the third column?
Mr. Smith. I'm sorry. I don't.
Senator Levin. Excuse me, J. Eischeid.
Mr. Smith. Oh, I do see it, yes.
Senator Levin. OK. It doesn't refer to Innovative
Solutions, which your statement refers to.
Mr. Smith. Innovative Strategies or Innovative Solutions--
--
Senator Levin. They are the same?
Mr. Smith [continuing]. Was a practice that we no longer
had after I became Vice Chairman, notwithstanding what is
reflected on this organizational chart.
Senator Levin. We can't find Innovative Solutions, which
your testimony referred to, in any of your charts. It is always
Innovative Strategies.
Mr. Smith. Well, the two practices, Senator, that I focused
on when I became Vice Chair in terms of making some changes to
our focus and to our business were Stratecon and Innovative
Strategies or Innovative Solutions.
Senator Levin. To either name, is when you----
Mr. Smith. Either name from my perspective.
Senator Levin. I have got you.
Mr. Smith. It is the practice that was represented by this
prior organizational chart.
Senator Levin. OK. I want to ask about another document.
This is a proprietary document which we are going to put in
front of you. We did not put it in our documents because it is
proprietary. It is a long one.
Mr. Smith. Thank you.
Senator Levin. It is dated November 26. Do you see that?
Mr. Smith. Yes, Senator, I do.
Senator Levin. OK. Now, if you take a look at about the
eighth line on the left, it still shows Stratecon there. You
said that you eliminated it in April 2002.
Mr. Smith. Yes.
Senator Levin. We have a date, November 26, 2002, which
still shows Stratecon, and it still shows Solutions in
Development. How do you explain that?
Mr. Smith. Yes. As I came in to serve as the Vice Chair of
Tax, I made very clear that we were going to make changes to
our structure in terms of the organization and focused on these
two in particular, and others.
This document reflects the fact that the systems that we
had had not yet been changed at the particular point in time
when this document was produced.
Senator Levin. I thought you said you terminated--it is
just very unclear to me. I thought you said you terminated
Stratecon when you came in in April 2002. And my question is:
Why does Stratecon still show as having Solutions in
Development on November 26, 2002? It is a straightforward
question.
Mr. Smith. Yes, and----
Senator Levin. I don't understand your answer.
Mr. Smith. Let me try to elaborate on it, Senator, and that
is, we have a number of systems, accounting systems throughout
our business, and stand-alone databases in various parts of our
business, and I believe that this particular document reflects
a database that was not updated based on the changes that we
made in our practice.
Senator Levin. So this document is wrong, too. It wasn't
updated as of November 26? It was incorrect?
Mr. Smith. Systems changes in terms of databases do take
some time to implement, so it is reflective that we had had a
Stratecon practice and that certain things had been worked on,
yes.
Senator Levin. There is an e-mail from Mark Watson, Exhibit
34,\1\ Mr. Smith, on July 22, 1999.
---------------------------------------------------------------------------
\1\ See Exhibit No. 34 which appears in the Appendix on page 521.
---------------------------------------------------------------------------
Mr. Smith. That was Exhibit 34, Senator?
Senator Levin. Yes, Exhibit 34, to you and Mr. Wiesner.
This is about the BLIPS economic substance issue. It raises
questions. It says, ``It seems very unlikely that the rate of
return on the investments purchased with the loan proceeds will
equal or exceed the interest charged on the loan and the fees
incurred by the borrower to secure the loan. . . . Before any
fees are considered, the client would have to generate a 240-
percent annual rate of return on the $2.5 million foreign
currencies investment in order to break even. If fees are
considered, the necessary rate of return to break even would be
even greater.''
Mr. Watson also noted that the BLIPS client ``has a
tremendous economic incentive to get out of the loan as soon as
possible due to the large negative spread.''
And then he asked you, ``Before I submit our non-economic
substance comments on the loan documents to Presidio, I want to
confirm that you are still comfortable with the economic
substance of this transaction.'' He had told our staff that he
never heard from you following that memo. Is that correct?
Mr. Smith. Well, my recollection doesn't serve me back to
1999, Senator, but let me provide you some insights that might
be helpful.
Senator Levin. I just want to know, because in terms of
time we are running out. Do you remember responding to this
memo?
Mr. Smith. I have no particular recollection of responding
to this memo, but I know what I would do having read this memo
right now, and that would have been--he talks about a
commitment that he has, I think for the following day, and so I
either would have called him or I would have known that that
deadline was not something that we needed to meet, and I would
have gotten back to him either in a general meeting about this
matter or specifically.
Senator Levin. All right. Now, turn to Exhibit 13,\2\ if
you would. This is an August 1999 Mark Watson memo. It says
before BLIPS ``engagement letters are signed and revenue is
collected, I feel it is important to again note that I and
several other WNT partners remain skeptical that the tax
results purportedly generated by a BLIPS transaction would
actually be sustained by a court if challenged by the IRS. We
are particularly concerned about the economic substance of the
BLIPS transaction.''
---------------------------------------------------------------------------
\2\ See Exhibit No. 13 which appears in the Appendix on page 450.
---------------------------------------------------------------------------
And then if you look at the top of the page, you will see
that Steven Rosenthal responded to Mark Watson that very day as
follows: ``I share your concerns.'' And then a few lines later,
``I continue to be seriously troubled by these issues, but I
defer to Phil Wiesner and Richard Smith to assess them.''
So now your two professionals seriously question the
economic substance of BLIPS, and they appear to be identifying
you as well as Mr. Wiesner as individuals who ignored their
concern and pushed through the approval of BLIPS. You have
heard Mr. Watson's testimony. How did BLIPS get approved when
there are such serious questions about its economic substance?
Mr. Smith. Well, I certainly don't agree with the
characterization that we ignored their concerns. If we go back
and look at the entire time line here, you go back to January
or February 1999, and there was in-depth consideration of all
of the issues that were implicated within BLIPS. These are a
couple among those which where the debate continued. Certainly
it was encouraged that everybody have the opportunity to raise
concerns that they had throughout the process at any point in
the process so that those could be concerned--be considered,
excuse me.
Senator Levin. If the professionals in their positions
today had the same problems with the tax product, would you
proceed with it?
Mr. Smith. I would say that if people have technical
concerns with regard to any matters that we have, that we would
consider them seriously in our discussion. The difference----
Senator Levin. I am sure that is what your position is,
that you would seriously consider them. But given what you know
now--and I think then from these memos--of their concerns, lack
of economic substance, no real loan. Over and over again they
were told. This came to you anyway. Would you override their
concerns today?
Mr. Smith. I think our process has evolved in terms of how
we might address this today. One of the things that we have
learned in terms of how to deal with these types of issues is
that we put out as our standard that we got to ``more likely
than not.'' And we believe that we reached that standard.
The issue with that standard is that it is close to the
edge of the cliff. You are up to and--you are not to cross that
edge. But certainly once you go up there, it is often the
cautious and the right thing to do to back away and not
approach these types of issues in the same manner.
So the change in the way that we would go about this would
be to consider that and assure ourselves that we are not
conducting ourselves in a way that would have this same level
of risk associated with it.
Senator Levin. Over the last 5 years, Mr. Smith, did KPMG
encourage the sale of its tax products to potential clients?
Mr. Smith. We are in a business, Senator, and we do talk to
our clients about tax advice, and we encourage and talk to our
professionals about making sure that they represent our clients
and that they think about their industry and the issues that
face them and work to represent them fully.
Senator Levin. Well, it is not a response to the question,
and I want to ask it--I am going to try it again.
Mr. Smith. Sure.
Senator Levin. It is a very significant question. It goes
to the heart of all of the promoting that you did. You have
given us a list of all the tax products which you developed,
which were offered for sale. We have seen the marketing plans,
the telemarketing, the profiles of likely clients for your tax
products, the internal databases that were used to develop
potential client lists for some of your tax products; again,
your telemarketing center in Fort Wayne, Indiana; the
unsolicited contacts with clients to tell them of KPMG tax
products and services; the revenue goals that you set for your
tax groups; your sales opportunity center that was intended to
help its personnel sell your tax products.
I just want to talk now about tax products, and my question
to you, again, is: Have you over the last 5 years encouraged
the sale or acceptance of tax products to potential clients?
Mr. Smith. Certainly our encouragement of our professionals
to serve their clients has extended over the past 5 years as
well as before that.
Senator Levin. I have just got to keep asking it. It is my
last question. I may have to ask it two or three more times.
Have you encouraged the sale or acceptance of your tax products
to potential clients?
Mr. Smith. We have encouraged our tax professionals to
advise our clients, and we do that, have contact with----
Senator Levin. Did that include--look, I have got to just
keep asking this. Did that include encouraging the sale or
acceptance of your tax products by those clients?
Mr. Smith. Well, Senator, I think that----
Senator Levin. It is a straightforward question.
Mr. Smith. In a number of different components of our
business, we talk to our clients in many different ways, over
the telephone and in writing, in meetings face-to-face, and we
do encourage our tax professionals to meet with our clients and
talk to them about the complexities of the tax code and to talk
about their business and the things that they ought to be
thinking about from a tax perspective, yes. [Laughter.]
Senator Levin. Is ``yes'' the answer to my question?
Mr. Smith. I believe that my entire response was the answer
to your question.
Senator Levin. But is the ``yes'' at the end of it intended
to respond to my question? Did KPMG----
Mr. Smith. I'm trying to----
Senator Levin. No, I am sorry. See, you come here and you
are asking us to believe that you have basically changed your
ways, things are done differently there now for various
reasons. And, frankly, I am skeptical. And one of the reasons
which makes me skeptical is I cannot get a straight answer out
of you to a very direct question, whether or not KPMG
encouraged the sale or acceptance of its tax products to
potential clients. There is a mass of evidence that you did,
but I cannot get you to say, ``Yes, one of the things we did
was encourage the sale or acceptance of our tax products to
potential clients.'' I cannot get you to say that.
Mr. Smith. Well----
Senator Levin. Even though it is obviously true. It is as
clear as the nose on your face that it is true.
Mr. Smith. I think we are in agreement, Senator, because
what you just said was one of the things that we do is to
encourage our professionals, yes, to----
Senator Levin. No. You just say encourage professionals.
Look, Mr. Smith, I don't want to play a game with you. I want
to try to get a direct answer, and I will try one more time.
But you understand the reluctance to give a direct answer to me
raises questions about what you are saying that you are trying
to change your ways or you have changed your ways or you are
going to through a lot of procedures.
Now, unless I can get a straight answer to a question that
has overwhelming evidence in support of a yes answer, I
cannot--I am skeptical about what you are telling us otherwise.
So let me ask it one last time.
Over the last 5 years, is one of the things that KPMG did
was encourage the sale or acceptance of its tax products to
potential clients? Can you give me a yes or no answer to that?
Mr. Smith. I can, Senator.
Senator Levin. And what is it?
Mr. Smith. Yes.
Senator Levin. Thank you. Thank you, Mr. Chairman.
Senator Coleman. Thank you, Senator Levin.
With that, the hearing record will be kept open for 3
weeks. The witnesses are reminded that when answering
supplemental written questions from the Subcommittee, they will
still be under oath.
I want to thank the witnesses for appearing before us
today. This hearing is adjourned.
[Whereupon, at 1:10 p.m., the Subcommittee was adjourned.]
U.S. TAX SHELTER INDUSTRY: THE ROLE OF ACCOUNTANTS, LAWYERS, AND
FINANCIAL PROFESSIONALS
----------
THURSDAY, NOVEMBER 20, 2003
U.S. Senate,
Permanent Subcommittee on Investigations,
of the Committee on Governmental Affairs,
Washington, DC.
The Subcommittee met, pursuant to notice, at 9:05 a.m., in
room 216, Hart Senate Office Building, Hon. Norm Coleman,
Chairman of the Subcommittee, presiding.
Present: Senators Coleman and Levin.
Staff Present: Raymond V. Shepherd, III, Staff Director and
Chief Counsel; Joseph V. Kennedy, General Counsel; Mary D.
Robertson, Chief Clerk; Leland Erickson, Counsel; Mark
Greenblatt, Counsel; Steven Groves, Counsel; Frank J. Minore,
Detailee, General Accounting Office; Kristin Meyer, Staff
Assistant; Steve D'Ettorre, Staff Assistant; Kevin Carpenter
(Senator Specter); Elise J. Bean, Staff Director/Chief Counsel
to the Minority; Bob Roach, Counsel and Chief Investigator to
the Minority; Julie Davis, Professional Staff Member to the
Minority; Laura Stuber, Counsel to the Minority; Brian Plesser,
Counsel to the Minority; Christopher Kramer, Professional Staff
Member to the Minority; Beth Merillat-Bianchi, Detailee,
Internal Revenue Service; Jim Pittrizzi, Detailee, General
Accounting Office; Ken Seifert, Intern; Jessilyn Cameron,
Brookings Fellow; David Berrick (Senator Lieberman); and Rudy
Broiche (Senator Lautenberg).
OPENING STATEMENT OF SENATOR COLEMAN
Chairman Coleman. This hearing of the Permanent
Subcommittee on Investigations is called to order.
I want to begin by thanking my distinguished Ranking
Member, Senator Levin, again for his work in this area and his
deep concern for taxpayers, his concern for just kind of a
fundamental sense of right and wrong in business practices. I
think when we address those concerns, when we clear up things
that are very problematic, such as we examined last Tuesday and
which we will address today, I think we all benefit.
Senator Levin. Thank you, Senator Coleman.
Chairman Coleman. On Tuesday, this Subcommittee heard
testimony under oath concerning the role of major accounting
firms in the development, marketing, and implementation of
generic tax products with no substantial economic purpose other
than to reduce tax burdens, the result being to rob the U.S.
Treasury of billions of dollars annually.
Let me begin by saying I am troubled by what I heard on
Tuesday and troubled by what I did not hear. We had accounting
firm after accounting firm come forward and tell us, ``Mr.
Chairman, what we did was wrong.'' Yet, I remain troubled that
it wasn't some revelation that came to them after the fact that
what they did was wrong. Common sense would dictate that they
knew what they were doing was wrong when they were doing it.
Although the various firms gave tortured explanations of
multiple levels of review and hours of deliberation they
engaged in before reaching their decisions of more probable
than not legality, I think the answer is much simpler. It was
the 1990's. The surge in the market made many awash in cash.
There were millions of dollars to be made and everybody else
was doing it. But the bottom line itsthat it was wrong, it was
unethical, and in some cases was illegal.
These sham transactions clearly lacked economic substance.
Some may have believed there was a loophole that supported
these transactions, but the lure of millions of dollars in fees
clearly played a role in the decision on the part of tax
professionals to drive a Brink's truck through any purported
loophole.
Last Tuesday shined a light on a dark and shameful period
for the accounting industry. That was the past and it must
remain the past. The future is much brighter. I was bolstered
by the fact that all the firms said these abusive tax shelters
are a thing of the past. Some admitted their mistakes. All said
they would sin no more.
We heard that many of the people involved in these abusive
tax shelters are no longer working for these companies, that
they have put in place policies and procedures that will deter
such practices in the future, and that they have recommitted
themselves to the highest ethical and business standards.
It was obvious last Tuesday and it will be demonstrated
today that accounting firms did not act alone. Others,
including otherwise reputable investment advisors, banks, and
law firms were part and parcel of these fraudulent schemes.
Moreover, they also provided the added benefit of making
detection by the IRS difficult. These entities provided a
veneer of legitimacy for abusive tax shelters that were, in
fact, illusory or sham transactions with little or no economic
substance driven primarily for favorable tax consequence.
Based on PSI's investigation, investment advisors were
essential for developing and implementing the financial
transactions for these shelters. In fact, investment advisors
have been deemed to be promoters of tax shelters bought by the
IRS for certain sheltered transactions, triggering registration
obligations.
However, the Permanent Subcommittee has determined that
Presidio, an investment firm that clearly promoted at least two
abusive tax shelters, BLIPS and OPIS, did not register these
shelters with the IRS. By refusing to register these abusive
tax shelters, it is obvious that KPMG and Presidio attempted to
conceal their existence from the IRS. There are others who are
also complicit--lawyers and bankers who made money, lots of
money, and had to know what they were doing was wrong.
This Subcommittee was not playing Monday morning
quarterback when it focused on these transactions. The players
in these abusive tax shelters had to know there was no economic
substance to these transactions and that their efforts to avoid
IRS detection by failing to register them was part of a
deliberate cover-up. It seems clear to this Senator that
ethical concerns were gagged and blindfolded by the lure of big
dollars.
Major law firms are essential to the tax shelter business.
They were routinely utilized by the accounting firms to provide
tax opinions in order to protect taxpayers from penalties if
challenged by the IRS. Some firms provided hundreds of cookie
cutter opinions of various tax schemes. The other firms took on
the additional role of soliciting, developing, and marketing
tax schemes. In fact, the IRS has targeted at least two
prominent law firms as promoters of tax shelters.
As someone who practiced law for 17 years in the Minnesota
Attorney General's Office, former Solicitor General of the
State of Minnesota, I am well aware of the ethical standard
that requires attorneys to avoid even the appearance of
impropriety. Based on our investigation, it is difficult for me
to understand how that standard was not violated in these
cases.
In addition, the existence of a closed business
relationship with KPMG also raises concerns about whether any
independent analysis and advice was provided. I look forward to
hearing the testimony of the attorneys involved in these
transactions.
And the bankers, I know, take great pride in what they do
and the code of conduct they insist upon for their employees
and themselves. Most Americans may not think of bankers as
their friend next door, but for generations, Americans have
come to expect that banks are a bastion of fiscal
responsibility in possession of their money, their savings,
their hopes, and their dreams. In this case, it appears that
bankers helped facilitate these transactions for the price of
admission into a tax shelter business that allowed everyone
involved to profit.
Prominent banks provided the necessary loans for tax
shelters. While the banks have traditionally concerned
themselves primarily with credit risks, these loans were
critical for generating the artificial paper losses in the tax
shelter industry. For the banks involved, these schemes were
merely a vehicle to generate substantial profits.
Given the evidence that PSI has uncovered in the sworn
testimony the Subcommittee has heard, it is imperative to
ensure that the proper regulatory and oversight framework
exists to address the myriad of participants involved in the
tax shelter industry.
On the last panel, we will hear from the agencies charged
with enforcing the laws. The Internal Revenue Service is
primarily responsible for interpreting and enforcing the tax
laws. High rates automatically create a large incentive to find
loopholes or tax strategies. The complexity of the tax code
also reduces the transparency of returns, making it very
difficult for the regulators to follow what is going on in the
private sector.
On Tuesday, the Subcommittee heard testimony that
accounting and investment firms structured deals to
intentionally conceal their efforts from the IRS. It is
imperative that Congress not allow the IRS to become the
toothless paper tiger that is ignored by those involved in the
tax shelter industry. We must give them the tools, the
resources, and the direction necessary for the proper
enforcement of our Nation's tax laws. Congress must not allow
the IRS to be an irrelevancy.
After today's hearing, I intend to discuss with Senator
Levin what follow-up action we need to take in order to address
the problems exposed by this investigation. A number of
potential reforms were discussed at Tuesday's hearings. These
include more expansive and explicit reporting requirements,
tougher penalties for noncompliance, and more effective
internal review procedures within the professional firms
involved in these transactions. The scope of my response will
depend very much on the behavior of the professional firms and
the willingness and ability of the regulators to address these
issues.
If Congress needs to act in order to provide more resources
or to simplify tax laws and close loopholes that are being
upheld by the courts, then we will do so. Let me be very clear,
however. I am against additional regulation just for the sake
of more regulation. The preferable way is professionals who
self-impose a high ethical standard and to consistently act in
accordance with those standards without requiring Congressional
review to highlight transgressions.
But sometimes, regulations such as the Sarbanes-Oxley Act
are the only way to restore the public trust without which our
tax and financial systems cannot work. I do intend to see
public trust in the application of tax laws restored. Congress
will take the necessary steps to prevent a recurrence or the
proliferation of abusive tax shelters.
With that, the distinguished Ranking Member, Senator Levin.
OPENING STATEMENT OF SENATOR LEVIN
Senator Levin. Thank you very much, Mr. Chairman. First,
let me thank you for these hearings, thank you and your staff
for all the support that you have given to this investigation.
It has been critical and the country is very much in your debt
for doing this.
Today, as you point out, is the second of 2 days of
hearings on our year-long investigation into the role of
professional firms, such as accounting firms, banks, investment
advisors, and law firms, in the development, marketing, and
implementation of abusive tax shelters.
The purpose of the transactions that we have been looking
at and the transactions creating those shelters wasn't to make
a profit, but it was to produce a tax loss to offset or to
shelter income. These transactions were a sham, a deception, an
abuse of honest taxpayers.
The first day of hearings focused on KPMG, a leading
accounting firm that for the past 5 years has been heavily
involved in the development and marketing of generic tax
products to multiple clients, including some potentially
abusive or illegal tax shelters. It took some time at the last
hearing before KPMG would admit that it has been promoting tax
products, but in the end, they finally did.
Today's hearing will examine some of the professional firms
that have joined forces and worked hand-in-glove with KPMG in
the tax shelter business--banks, investment advisors, and
lawyers, without which those abusive tax shelters would never
have polluted so many tax returns and robbed Uncle Sam and
average taxpayers of billions of dollars of revenues.
The Subcommittee's investigation is focused on four KPMG
tax shelters known by their acronyms, BLIPS, FLIP, OPIS, and
SC2. The first three have already been identified by the
Internal Revenue Service as potentially abusive or illegal tax
shelters. The fourth, SC2, is under IRS review. BLIPS, FLIP,
and OPIS required the participation of a bank, investment
advisory firm, and law firm to work. Each of the professional
firms here today had a role in one or more of these tax
products and helped provide the legal or financial facade of
economic substance for transactions whose only real purpose was
to reduce or eliminate the buyer's taxes.
KPMG sold BLIPS, FLIP, and OPIS to about 300 people. It is
no accident that the same banks, investment advisors, and law
firms appear over and over again in connection with the
transactions needed to implement these tax shelters. In fact,
KPMG courted and built up relations with each of these
professional firms because it couldn't implement its tax
products without them. KPMG also wanted to form business
alliances with other respected professionals to increase its
stature in client contacts.
An internal KPMG memorandum that we just received this
week, which is Exhibit 137,\1\ lays it all out. In 1997, a
month before he left the firm to form his own investment
advisory firm called Presidio, a senior KPMG partner, Robert
Pfaff, sent a memo to the two top officials in the KPMG tax
services practice with a number of suggestions for, ``KPMG's
Tax Advantaged Transaction Practice.'' Among other suggestions,
the memo argues for the development of ``turnkey'' tax
products, tax shelters that KPMG clients could use without any
changes to reduce their taxes.
---------------------------------------------------------------------------
\1\ See Exhibit No. 137 which appears in the Appendix on page 2735.
---------------------------------------------------------------------------
The memo also stated that, in most cases, it will be
``difficult or impossible for KPMG to be the sole provider of a
tax advantaged product,'' in other words, a tax shelter, ``due
to restrictions placed on the firm's scope of activities by
authorities.''
The memo described KPMG's ``dilemma'' in its words, as
follows: ``To avoid IRS scrutiny, KPMG had to market its tax
products as investment strategies, but if it characterized its
services as providing investment advice to clients, it could
attract SEC scrutiny and have to comply with Federal securities
regulations.''
And this memo, again, which we just received this week,
explains it as follows: ``It is clear we cannot openly market
tax results of an investment. Rather, our clients should be
made aware of investment opportunities that are imbued with
both commercial reality and favorable tax results. Conversely,
we cannot offer investments without running afoul of a myriad
of firm and securities rules. Ultimately, it was this dilemma
that led me to the conclusion that KPMG needs to align with the
likes of a Presidio.''
In other words, KPMG recognized that to make its tax
products work, KPMG itself could not provide ``investment
advice.'' It also knew it could not issue loans or provide
financing. It had no authority to practice law. It needed
assistance from other professionals with those capabilities to
carry out its tax schemes and it found them.
Law firms like Brown and Wood, which later became Sidley
Austin Brown and Wood, issued favorable, boilerplate legal
opinion letters for BLIPS, FLIP, and OPIS, issuing more than
250 opinion letters in all.
Investment advisory firms like Quellos doing business as
Quadra, and Presidio helped set up hundreds of BLIPS, FLIP, and
OPIS transactions.
Banks like Deutsche Bank, HVB Bank, and others financed
hundreds of BLIPS, FLIP, and OPIS transactions. Deutsche Bank
and HVB together provided more than $5 billion in financing for
these transactions.
Everyone, of course, got paid lots of fees. For example, in
BLIPS, clients paid a set fee at 7 percent of the planned tax
loss. Now think about that. If anything demonstrates that the
goal of these schemes was to produce paper tax losses, it is
that the fee was based on the size of the planned tax loss. The
higher the planned tax loss, the higher the fee.
In the case of the BLIPS fee, after certain expenses were
subtracted, the remaining money was divvied up among the firms
that carried out the client's BLIPS transaction. KPMG and the
banks each got 1.25 percent, what they called 125 basis points.
The investment advisor got 2.75 percent, or 275 basis points.
The law firm generally got $50,000 for each opinion, possibly
more in cases where the expected tax loss was large.
Looking at just the four tax products examined by this
Subcommittee, KPMG brought in fees totalling at least $124
million. Sidley Austin Brown and Wood, with more than 250
opinion letters, raked in at least $50,000 per boilerplate
letter and made more than $12 million. Deutsche Bank hauled in
about $33 million from its OPIS transactions and expected to
make the same again from BLIPS. HVB made over $5 million in
less than 3 months doing BLIPS deals in 1999 and decided on
doing more in the year 2000, due in part, in its own words, to
``excellent profitability.''
Now, what exactly were these fees for? The law firm Sidley
Austin Brown and Wood provided a so-called independent legal
opinion letter finding that the tax products complied with the
law. In fact, the law firm collaborated heavily with KPMG to
develop the products and write the opinion letters. The banks
provided financing and nominal currency transactions that acted
as an investment fig leaf to disguise transactions that were
really tax driven. The investment advisors provided the design
and the rhetoric to recast the tax dodges as investment
strategies.
The facts echo what this Subcommittee uncovered during its
Enron investigation: Respected professional organizations
offering their services and making a lot of money by assisting
other parties to complete highly structured and deceptive
transactions. In this case, the transactions were intended to
help KPMG's clients reduce or eliminate paying their fair share
of taxes owed to Uncle Sam. By facilitating these tax schemes,
these organizations also opened themselves up to possible
violations of the laws against the promoting of abusive tax
shelters and against aiding or abetting tax evasion.
Now, relative specifically to the SC2 tax product, we had
planned to have at today's hearing one of the pension funds
that KPMG approached and convinced to participate in SC2
transactions. None of the SC2 tax products could have been sold
absent a charity willing to accept S Corporation stock
donations under unusual circumstances. To save time, we asked
the pension fund to submit a written statement instead of
appearing here today.
That statement sets forth these key facts. KPMG initiated
the contact with the charity. The charity did not know its 28
benefactors beforehand, and the charity was asked and expected
to hold the stock it was given ``for several years'' and would
then ``be able to sell the stock back to the owner and receive
cash.'' In short, it is clear that SC2 was intended to provide
only temporary stock donations.
Also relative to SC2, we did not have time at the last
hearing to address a number of very troubling statements made
by the former KPMG tax partner Lawrence Manth, who headed up
the SC2's sales effort and who claimed that KPMG was selling
SC2 to benefit police and firefighters. The documents are
overwhelming in demonstrating the opposite. KPMG was not acting
altruistically in selling SC2, but again, it was helping its
clients reduce or eliminate their taxes. If the sole objective
was to make a charitable donation, SC2 donors could have simply
donated cash instead of going through the exercise of first
donating stock, then buying it back for cash, and we plan to
follow up on those statements with Mr. Manth and others.
The industry which promotes abusive tax shelters should
have no place in the business plans of respected legal and
financial professionals. It is time to put an end to banks,
investment advisors, and law firms using their talent to
promote, aid, or abet dubious and abusive tax shelter schemes.
Finally, we will hear today from three key regulators: The
IRS, the Federal Reserve, and the newly formed Public Company
Accounting Oversight Board. Each has a role to play in
convincing, or if necessary forcing, accounting firms, banks,
investment advisors, and law firms to get out of the abusive
tax shelter promotion business. To help those efforts, Congress
needs to enact stronger penalties for promoting, aiding, or
abetting abusive tax shelters. The current fines of $1,000 for
individuals and $10,000 for corporations are useless as
deterrents.
We also need more enforcement dollars for the IRS to go
after tax shelter promoters. We also need to put an end to
auditor conflicts of interest that arise when accounting firms
sell tax shelter services to their audit clients and then turn
around and audit their own handiwork. We need to clarify and
strengthen the economic substance doctrine.
We need a coordinated regulators' review to identify
abusive tax shelter products some accounting firms, banks,
investment advisors, and law firms are selling, and to stop
them from assisting the purveyors of abusive tax shelters.
And, as our Chairman, I think very eloquently pointed out,
we need the professions themselves to adhere to higher
standards of conduct.
Again, my thanks to you, Mr. Chairman, and to your staff
for all the help you have given me.
Chairman Coleman. Thank you, Senator Levin.
I would now like to welcome our first panel to today's
important hearing: Raymond J. Ruble, a former partner for the
law firm of Sidley Austin Brown and Wood; Thomas R. Smith, a
current partner with Sidley Austin Brown and Wood; and finally
N. Jerold Cohen, a partner with the law firm of Sutherland
Asbill and Brennan. I thank each of you for your attendance at
today's hearing and look forward to hearing your testimony.
Before we begin, pursuant to Rule 6, all witnesses who
testify before this Subcommittee are required to be sworn. I
would ask you to each rise and raise your right hand.
Do you swear that the testimony you are about to give will
be the truth, the whole truth, and nothing but the truth, so
help you, God?
Mr. Ruble. I do.
Mr. Smith. I do.
Mr. Cohen. I do.
Chairman Coleman. Thank you, gentlemen.
Gentlemen, we do have a timing system. I would ask that you
keep your statements to 5 minutes. Your fully prepared
statements will be entered into the official record.
Mr. Ruble, we will have you go first this morning, followed
by Mr. Smith and finish up with Mr. Cohen. After we have heard
all of your testimony, we will turn to questions. Mr. Ruble, I
understand that you are accompanied by counsel. Counsel, please
identify yourself for the record.
Mr. Hoffinger. Jack Hoffinger.
Chairman Coleman. Thank you. Mr. Ruble, you may begin.
TESTIMONY OF RAYMOND J. RUBLE, FORMER PARTNER, SIDLEY AUSTIN
BROWN AND WOOD, LLP, NEW YORK, NEW YORK, REPRESENTED BY JACK
HOFFINGER
Mr. Ruble. Thank you, sir. Senator Coleman and Senator
Levin, my name is R.J. Ruble. I would very much like to respond
to your questions on the matters that are being discussed today
and I appreciate your endeavors in this regard. However, I have
been instructed by my counsel not to testify based on my Fifth
Amendment constitutional rights.
Chairman Coleman. Mr. Ruble, I would like to see if I could
just explore two matters with you. One, if you could just turn
to Exhibit 116 \1\ in the exhibit book, it appears to be an e-
mail from R.J. Ruble that reads as follows: ``This morning, my
managing partner, Tom Smith, approved Brown and Wood, LLP,
working with the newly conformed tax products group at KPMG on
a joint basis in which we would jointly develop tax products
and jointly share in the fees, as you and I have discussed.''
Is this, in fact, an e-mail that you prepared?
---------------------------------------------------------------------------
\1\ See Exhibit No. 116 which appears in the Appendix on page 2691.
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Mr. Ruble. I must respectfully decline to answer on the
grounds asserted.
Chairman Coleman. I would just ask one other question,
again, for my foundational purposes. You have in the exhibit
book Exhibits 90a. and 90b.\1\ Exhibit 90a. purports to be an
opinion by KPMG regarding some of the tax shelters that we
talked about. Exhibit 90b. purports to be a Brown and Wood
legal opinion. I would note that both opinions appear to have
substantially the same language, in fact, almost the exact
language. I would ask you again if that is a correct assertion.
---------------------------------------------------------------------------
\1\ See Exhibit No. 90a. and 90b. which appear in the Appendix on
pages 684 and 781.
---------------------------------------------------------------------------
Mr. Ruble. I have been instructed to decline to answer on
the grounds asserted.
Chairman Coleman. Given the fact that you are asserting
your Fifth Amendment right against self-incrimination to all
questions asked of you by the Subcommittee, you are excused,
Mr. Ruble.
Mr. Ruble. Thank you very much, sir.
Chairman Coleman. Mr. Smith.
TESTIMONY OF THOMAS R. SMITH, JR.,\2\ PARTNER, SIDLEY AUSTIN
BROWN AND WOOD, NEW YORK, NEW YORK, LLP
Mr. Smith. Thank you, Mr. Chairman and Senator Levin. My
name is Tom Smith. I am a partner in the law firm of Sidley
Austin Brown and Wood and I am pleased to answer your questions
to the extent that I can.
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\2\ The prepared statement of Mr. Smith appears in the Appendix on
page 312.
---------------------------------------------------------------------------
I joined Brown and Wood in 1963 and have spent my career
there as a securities lawyer. I am not a tax lawyer. But from
1996 to May 1, 2001, at the time of our merger with Sidley and
Austin, I was the managing partner of Brown and Wood.
Mr. Chairman, our firm wants to cooperate with the
Subcommittee to the maximum extent it can. The area of tax work
that brings us here today is an area that our firm no longer
participates in. Unfortunately, my personal files on these
matters were lost in the destruction of our office in the World
Trade Center on September 11, and Mr. Ruble, the person in our
firm most knowledgeable about these matters, is not available
to you or to us. Thus, we are limited in the information we can
provide.
Mr. Ruble is no longer a partner of the firm. He was
expelled from the partnership on October 24, 2003, for
activities in violation of the partnership agreement, that is,
accepting undisclosed compensation and for refusing to explain
his conduct to the firm.
As a result, we are not confident that the information Mr.
Ruble has given us in the past and upon which we have relied is
accurate, and we have so advised the Subcommittee staff, the
Internal Revenue Service, and other interested parties.
That said, let me tell you a bit about the tax practice at
Brown and Wood. Of the approximately ten tax partners at Brown
and Wood before the merger, Mr. Ruble was virtually the only
one who engaged in this practice, although he consulted with
others on discrete issues. At the time Mr. Ruble began
providing concurring opinions to individual taxpayers, Brown
and Wood had an opinion committee and expected partners to seek
the advice of that committee or of the other colleagues at the
firm of novel and unsettled legal issues. In addition, Brown
and Wood required approval of tax opinions by a second tax
partner, and as a matter of fact, during the period in 1999, we
expanded that second opinion requirement to all lawyers.
After the merger, the firm maintained and expanded the size
of the opinion committee and further enhanced its policies in
this area. The purpose of this policy was to help ensure the
quality and consistency of tax advice provided by the firm and
to provide an electronically maintained library of tax opinions
that all tax lawyers could access.
No set of procedures will stop an individual from acting
improperly if he or she is unwilling to abide by the rules of
our profession and to engage in blatant acts of deceit and
concealment. Nevertheless, we have hired a tax attorney whose
principal responsibility is to monitor our internal procedures
and our compliance with the evolving requirements of the
Internal Revenue Service.
Prior to the merger of Brown and Wood and Sidley and Austin
and as part of our transition planning, it was decided that the
combined firm would stop providing individual tax opinions that
this Subcommittee is considering and we would reorient the tax
practice to the corporate transactional work that is central to
both firms' practices. This action reflected the decision of
Brown and Wood and the combined firm to redirect the efforts of
the firm to our core tax work and did not and does not reflect
on the quality of the work performed earlier. I understand that
no court has decided that Mr. Ruble's tax opinions are wrong,
much less rendered in bad faith.
Although Mr. Ruble had confirmed that he had stopped
issuing opinions of this type, the firm discovered that
additional opinions had been issued after the merger. When
confronted with this, Mr. Ruble said that the opinions were the
last in the typewriter and were being rendered because he had
pre-merger commitments to provide them to clients. He was told
to stop issuing such opinions. He assured the firm that he had
stopped, but in fact, he lied to us. He evaded our controls we
had in place and he breached the trust we reposed in him.
We had and have procedures in place designed to ensure that
all of our lawyers, partners, associates, and others act in
compliance with applicable laws and the highest ethical
standards. In a law partnership, the effectiveness of
procedures of this sort is highly dependent upon the
trustworthiness of our partners.
Both Sidley Austin Brown and Wood and I personally want to
thank you for the open, cooperative, and professional treatment
we have received from both the Majority and Minority staff.
Chairman Coleman. Thank you, Mr. Smith.
Mr. Cohen, before we proceed, I note that you have a
gentleman with you. For the record, would you please identify
him.
Mr. Cohen. A partner, J.D. Fleming, who has come with me.
TESTIMONY OF N. JEROLD COHEN,\1\ PARTNER, SUTHERLAND ASBILL AND
BRENNAN, LLP, ATLANTA, GEORGIA, ACCOMPANIED BY J.D. FLEMING
Mr. Cohen. Mr. Chairman, Senator Levin, thank you very much
for inviting me to these hearings. I commend you on the
hearings. I think they are very important. I think if they lead
to the passage of some of the provisions that were passed in
the Senate CARE Act or to some of the provisions that are now
in the JOBS Act, I think that will be very good.
---------------------------------------------------------------------------
\1\ Letter to Senators Coleman and Levin, dated November 18, 2003,
with responses to questions appears in the Appendix on page 315.
---------------------------------------------------------------------------
I am especially pleased to hear both Senators acknowledging
that the Service needs more resources. Over the last 7 years,
its workload has gone up over 11 percent and its workforce down
by over 11 percent. You just can't keep that up and it is
showing, and it is showing in some of these things.
First of all, let me say that my firm, Sutherland Asbill
and Brennan, has not been involved in the development,
marketing, or implementation, or the promotion, aid, or
abetment of the tax shelters that you have asked us about. In
fact, the fourth of the shelters, SC2, I know nothing at all
about.
We have been engaged by clients who were under audit by the
Internal Revenue Service long after they participated in these
transactions to represent them, and we have been representing
them in that regard.
Every time we discuss with a client potential
representation, we inform them that we cannot--cannot--
participate in any suit against any promoter, whether it is the
promoter or a firm that has been involved with the transaction,
that we represent, and we have a litigation group that
represents all of the major accounting firms, five back then,
four now, in totally unrelated litigation. We tell them because
of that, we cannot represent them in any action against anyone
connected with this, these transactions, and we suggest to them
that they obtain other counsel to represent them in that
regard. We tell them that several times and we tell them to
engage other counsel sooner rather than later because there is
a statute of limitations problem in any actions that they might
want to consider.
Now, having said that, let me also commend the staff for
the Minority Report. I haven't read the whole thing, it is
awfully long, but I thought it was very good. I know they
worked long and hard at that. In fact, I called some of the
staffers a couple of times and found them working late at night
on that.
But after my letter responding to your questions and
reading the Minority Report, I found that I could make further
responses to some of your questions. I respect the pressure the
staff was under and I know that our firm is only discussed in
three pages of the large report. But I wish they had had time,
and I know they didn't, to consult with me because there are a
lot of misstatements in those three pages about my firm's
activities.
First of all, it states that KPMG referred over two dozen
clients to us. That is not true. I am not saying that I would
not have liked to have had more clients, because we shared the
costs of our representation among all the clients, and I am
sure all of the clients would have liked to have had more, but
we never had two dozen clients referred to us by KPMG to my
knowledge. I have no idea what KPMG told you. We had clients
coming in from other clients, from financial advisors, and from
law firms. In fact, the first clients we had with regard to the
three transactions, the three products, if you will, that I
knew about came from law firms.
Let me also say that I can tell you now that we have in the
three transactions that we have worked on approximately 40 such
clients. That is, reading the numbers you have in your report,
it is not an inconsiderable number to me, but it is a small
part of the landscape.
Now, the report suggests that our only disclosure to the
client was in the engagement letter, which is quite clear. Your
report does cite the engagement letter stating to the clients
that we cannot represent them before the accounting firms. It
suggests that that is all we did, and there is an opinion that
came out that cannot be correct--because it did not represent
the facts.
The facts are that is not all we did. Before undertaking
any engagement, we spoke to the client or to their financial
advisor or whoever their advisor was. Some of these clients are
so wealthy that you don't speak to the clients. They always
contact the lawyers either through their own in-house lawyer or
through their financial advisors, and all were advised,
clients, financial advisors, in-house people, that they needed
to get another lawyer to--if they contemplated any action
against anyone in connection with the products. They were told
to do that right away because there was a statute of
limitations problem.
Now, the report also suggests that representing clients
when another group in my firm represents KPMG is a conflict of
interest. I will have to tell you, that goes way beyond any
ethical responsibility I have been aware of in my 42 years of
practice, way beyond that. And even though there is not a
conflict there, we, as I said, took care to tell--KPMG knew we
could not defend them against any of these clients and the
clients knew we also could not represent them. If there is a
conflict, I would suggest that there may be a conflict in both
representing the clients before the IRS and against KPMG. It
gives you a pretty tight rope to walk in making your arguments.
Finally, I would like to mention the fact that the report
suggests that we entered into agreements hiring KPMG. We
entered into one such so-called Covell agreement. It was
entered into because the client was already being advised by
KPMG. We thought we might need to have some advice from KPMG.
We did not want to waive the client's attorney-client
privilege, the privilege with respect to our advice, and so we
entered into the one Covell letter. We never entered into
another one with connection with these transactions because we
never used that one, so it was never, ever used.
Chairman Coleman. I would ask you to summarize the rest of
your testimony, Mr. Cohen.
Mr. Cohen. Well, the summary is--I think that I will go
back to the start. I wish the staff had talked to me a little--
had time to talk to me. I know I am not a big piece of this
action, and I think I could have corrected these things. Having
read the rest of the report, I am sure they would have
corrected the record on that score.
And once again, I would say the one thing you didn't
mention, you or Senator Levin, you mentioned that you want more
disclosure. I think that is badly needed. You mentioned that
you want more resources for the IRS. I think that is badly
needed. The one thing you haven't mentioned is the one that I
think is the most important, and that is an extension of the
statute of limitations where there is no disclosure. I think
that will go a lot further. In my experience, penalties have
not done the job. Back when I was Chief Counsel of the Internal
Revenue Service, we fought tax shelters on a much broader
scale, much lower dollars, and the penalties didn't seem to
stem that tide. Thank you.
Chairman Coleman. Thank you, Mr. Cohen, and I do want to
thank you for your testimony. It has been very clarifying. I
will tell you up front that on first blush, our concerns had to
do with potential conflicts of interest with KPMG and you have
gone a long way to explaining that and helping us understand it
better, so I do thank you for that.
Let me just make sure that I do understand. First, did KPMG
refer tax audit cases to you?
Mr. Cohen. I think they did, but not in the----
Chairman Coleman. You said you never had two dozen. Do you
know what the number was?
Mr. Cohen. No, I do not at this time. I can try to find
that out and submit that number to your staff. But I would say
I have no idea whether KPMG thought that they referred more
clients to us than they actually referred, but the references--
frequently, clients come in from a number of sources. Most of
our references came from law firms, from financial advisors,
from the clients themselves who had talked to other clients.
Chairman Coleman. And I take it KPMG has an ongoing
relationship with Sutherland Asbill and Brennan?
Mr. Cohen. The firm continues to defend in malpractice
cases, other than cases involving tax shelters, KPMG and the
other three of the remaining large accounting firms.
Chairman Coleman. Could you tell us the approximate amount
of attorney fees that KPMG generated?
Mr. Cohen. I haven't the slightest idea.
Chairman Coleman. Could you provide that to us after----
Mr. Cohen. If under our professional responsibility we are
allowed to and we can go to KPMG and get that authorization,
that waiver, we would be more than happy to do so.
Chairman Coleman. I would appreciate that.
Did KPMG ever tell you they would knowingly refer clients
to your firm when the subject matter was a tax scheme/shelter
that they were deeply involved in?
Mr. Cohen. Never.
Chairman Coleman. In referring the cases that they did
refer to you, my question has to do with whether you then
turned around and retained KPMG to serve as consultants in the
case? You indicated in your testimony that happened one time.
Mr. Cohen. One Covell letter, that's right.
Chairman Coleman. And then you----
Mr. Cohen. That's it.
Chairman Coleman [continuing]. Indicated that not again?
Mr. Cohen. Not again, and let me mention this. I never--I
don't recall a client that came in just--KPMG said, go to me.
My understanding was that they gave the clients a choice of
firms.
Chairman Coleman. Thank you, Mr. Cohen.
Mr. Smith, according to IRS pleadings filed against Brown
and Wood, Brown and Wood issued approximately 600 opinion
letters regarding these 13 different tax avoidance products
during Mr. Ruble's tenure. Can you give me a sense of kind of
the knowledge, how it worked in Brown and Wood, whether folks
would know about what Mr. Ruble was doing, whether they would
know kind of the volume of what he was doing, the type of
things that he was doing? How did that work? How did that
supervision oversight work?
Mr. Smith. Senator Coleman, I will, but let me just
caution, I am sure you can tell, and I am very outraged, I can
tell you what we were told and what our understanding was and I
can go through that with you.
Mr. Ruble's practice in this area, I think, to the best of
my understanding, really started in 1997. You referred to an e-
mail in which there was a discussion--it said that there was a
discussion with me. The first I knew about that e-mail was when
I read it in the Wall Street Journal several weeks ago. I knew
nothing about that. We had never been told that there was any
sort of an alliance or proposed alliance with KPMG or anyone
else. Had he had that conversation with me, I would have
immediately talked to our executive committee about it, that I
was basically the chairman of that, and this has never happened
and we never approved any sort of an alliance with KPMG. That
would have required a lot of analysis on our part and it just
never happened.
Chairman Coleman. That e-mail is Exhibit 116,\1\ I think,
in the books in front of you, if you turn to Tab 116, the large
black book right there.
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\1\ See Exhibit No. 116 which appears in the Appendix on page 2691.
---------------------------------------------------------------------------
Mr. Smith. Yes.
Chairman Coleman. And as I indicated before, the bottom of
that e-mail, ``Subject, Joint Projects; Author, R.J. Ruble;
Date, 12/15/97, 11:08 a.m. This morning, my managing partner
Tom Smith--''
Mr. Smith. Yes.
Chairman Coleman. ``--approved Brown and Wood, LLP, working
with the newly conformed tax products group at KPMG on a joint
basis in which we would jointly develop and market tax products
and jointly share in the fees as you and I have discussed.''
You indicate that that e-mail is not true, not accurate?
Mr. Smith. We never--I never saw this and it is totally
untrue.
Chairman Coleman. Are you aware of any agreement or effort
to market tax products with KPMG?
Mr. Smith. No.
Chairman Coleman. Can you help me understand? Is that
something that would be unusual for a law firm to do?
Mr. Smith. It would be unusual for Sidley Austin Brown and
Wood to do, and at that time Brown and Wood. I would be happy
to tell you what our understanding was that we were doing. When
you asked----
Chairman Coleman. Please. I would appreciate that.
Mr. Smith. Yes. You asked how we handled this at the firm.
In 1998, the revenues increased materially in this area and as
the chairman, as the managing partner, I undertook and the
executive committee undertook to see if we could get a better
handle on what these opinions were, was this a business we
should be in, what sort of exposure to risks that we had
because of these opinions, and exactly what our role was in
supplying these opinions. And I called the practice group head,
Tom Humphries, and asked him, who was aware of what was
happening here but really had not been involved with these
opinions. Some of the partners had been involved with certain
discrete issues, but not with the total product. That was a
total opinion.
I looked at those opinions and read them. They were more
likely than not based on factual representation opinions. Quite
frankly, sir, I was really not in a position to pass on the
validity of those opinions. I think we had four or five of our
tax partners read those opinions and advise us, and the advice
we got was that they were valid opinions under the then law.
We discussed with Mr. Ruble and with our tax partners
exactly what our role was in this and we were told that our
role was to provide concurring opinions to taxpayers, and a lot
of times to their financial advisors, and Mr. Cohen testified
that you do this, and that KPMG wanted an outside law firm to
do this, that KPMG would designate to help the financial
advisors understood this.
We understood his role to be not involved in the design of
these products, but that KPMG would come to him with the
product and ask him if he could render the concurring opinion.
Now, to do that, Mr. Ruble had to do a thorough analysis of
what was in there. It was my understanding we inquired about
this, that he would perhaps make suggestions so that he could
render his opinion and perhaps he might--I guess if he saw
something there to improve the product, he might have passed
that on. That is just an assumption on my part. We thought he
was being given the product and just saying if--rendering his
opinion on them, more likely than not based on the factual
assumptions.
Chairman Coleman. My concern is, first, he issued
approximately 600 opinions, so I take it he is generating a
substantial amount of fees which I would then suspect is not
under the radar screen of Brown and Wood?
Mr. Smith. Absolutely not.
Chairman Coleman. He is generating volume here?
Mr. Smith. Absolutely not.
Chairman Coleman. If he is generating that volume, I am
just again trying to understand the internal mechanism. He was
generating a lot of money in a tax area?
Mr. Smith. Right.
Chairman Coleman. I take it he is not operating solely by
himself?
Mr. Smith. Well, that is a good question. We have all of
this under review. I think in large measure, what we most fear
in a law firm, he was a lone wolf, and this is----
Senator Levin. What?
Mr. Smith. A lone wolf, Senator Levin, not to mention a
rogue partner, which is your greatest fear.
Chairman Coleman. And you understand, though, again, having
been in the profession for a number of decades and
understanding there are lone wolves but understanding the
structure of law firms, you have a guy generating a lot of
fees----
Mr. Smith. Correct.
Chairman Coleman [continuing]. And complex issues that when
looked at are pretty clear. You look at these issues and you
have on the BLIPS cases, I believe there were 66 investors.
These are supposed to be 7-year investment schemes. Every one
of them gets out after 60 days. You look at this thing and you
can see it is being created for generating tax loss. That is
what it is about. I am still troubled by the sense that it is
just Mr. Ruble.
Mr. Smith. Well, it was Mr. Ruble who was rendering the
opinions and dealing with the clients. I know of no instance in
my understanding where any other tax lawyer at Brown and Wood
were involved in the dealings with the clients.
We had the other tax partners in the group, in a highly
esteemed group, I think we had four or five of them review
these opinions and advise us as to whether or not they were
appropriate. And as I say, I am a securities lawyer and I have
to rely on their advice in this regard.
Chairman Coleman. Senator Levin.
Senator Levin. The IRS has alleged in court that Sidley
Austin Brown and Wood issued about 600 opinion letters on 13
potentially abusive or illegal tax shelters, and it is our
understanding that about half of those letters, perhaps 250 to
300, were issued in connection with BLIPS, FLIP, and OPIS.
Would that be about right?
Mr. Smith. Yes, we did render approximately 600, and I
think it was 13 different transactions. I just don't know the
answer as to how many applied to which.
Senator Levin. You don't have any idea about how many were
issued in conjunction with BLIPS, FLIP, and OPIS?
Mr. Smith. No, sir. I can get you that----
Senator Levin. Well, we will tell you. Let us assume that
our information is correct, and if you would----
Mr. Smith. I would assume, yes.
Senator Levin [continuing]. For the purpose of discussion
say about 300. Now, we understand that your firm charged
substantially the same fee, $50,000, for each letter provided
to BLIPS, FLIP, and OPIS clients.
Mr. Smith. It was a fixed fee. I think it started at
$50,000. There may have been different amounts in different
instances.
Senator Levin. Possibly a little more----
Mr. Smith. Yes.
Senator Levin [continuing]. If the tax loss was more?
Mr. Smith. No, I don't think it was--it was my
understanding it was never based on the size of the
transaction.
Senator Levin. Well, we will get to that later in terms of
the fees.
Mr. Smith. Yes.
Senator Levin. So you got $50,000 for each letter,
approximately?
Mr. Smith. Approximately, that is my understanding in this.
Senator Levin. Now, these letters were drafted after the
initial prototype, is that correct? In other words, there was
an initial letter on each of these and then the following
letters, follow-up letters, were virtually identical to the
prototype letter, is that not correct?
Mr. Smith. Could you help me with what you mean by
prototype?
Senator Levin. The first letter that you wrote approving
BLIPS, for instance, was followed by dozens and dozens of other
letters----
Mr. Smith. That is correct.
Senator Levin [continuing]. And so the first letter was the
prototype.
Mr. Smith. OK. I understand.
Senator Levin. And then all the successive letters, 50 or
100 on each, BLIPS, FLIP, and OPIS, were then basically cookie
cutter opinions following that prototype opinion, is that
correct?
Mr. Smith. Yes. To my understanding, yes. I could not tell
you to what extent they varied based on the facts. It could
have been.
Senator Levin. All right. It could have been----
Mr. Smith. But that was my basic understanding of it.
Senator Levin. All right.
Mr. Smith. Pretty similar, basically similar, Senator, to--
--
Senator Levin. Virtually identical? Basically the same, but
use your words. Now, the clients' names were changed. In how
many cases were there client consultations?
Mr. Smith. I couldn't answer that question, Senator.
Senator Levin. Is it possible that in most cases, there
were no client consultations, you simply submitted the letter?
Mr. Smith. I couldn't answer that question.
Senator Levin. All right.
Mr. Smith. That is a question we would be interested in. We
would be interested in the answer to that question.
Senator Levin. I would hope so.
Mr. Smith. Yes.
Senator Levin. Who was your client?
Mr. Smith. Well, we were rendering these opinions to the
taxpayer. I don't think we--and that was--hopefully, we had
engagement letters with respect to this which explain this and
explain our role. But these opinions were being rendered--I
don't think we rendered more than one opinion to any taxpayer,
and that was the sole piece of legal work we did for those
taxpayers, these concurring opinions.
Senator Levin. Right.
Mr. Smith. KPMG as a national tax group were also rendering
an opinion, to my understanding.
Senator Levin. The taxpayer was supposed to be your client.
You don't know whether there was any personal contact with
those taxpayers in most cases or not, do you, for instance, in
the BLIPS transactions? Do you have any idea?
Mr. Smith. It was my understanding that Mr. Ruble was
available to consult, primarily with the financial advisors of
these taxpayers. I have no idea.
Senator Levin. You have no idea. Did you ever ask Mr.
Ruble, in all your conversations with Mr. Ruble, about this
matter, as to whether he ever met with your clients?
Mr. Smith. The tax partners would have.
Senator Levin. Did you ask your tax partners whether there
was ever any connection?
Mr. Smith. I did not, sir.
Senator Levin. Is that not an important question for a law
firm, as to whether you have any contact with your client or
not?
Mr. Smith. I think it is an important question.
Senator Levin. But you didn't ask that of these tax
partners of yours?
Mr. Smith. I don't recall asking that, yes.
Senator Levin. On the question of fees, according to the
American Bar Association Model Rule 1.5, a lawyer ``shall not
make an agreement for, charge, or collect an unreasonable
fee,'' and then cites the factors to be considered in setting a
fee amount as the time and labor required, the novelty and
difficulty of the questions involved, and the skill requisite
to perform the legal service properly.
It used to be that legal opinions were written for one
client on a particular set of facts, but mass marketed tax
products are accompanied by mass production of legal opinion
letters with boilerplate language, and this is what happened
here, according to your own testimony, and as a matter of fact,
that is what happened with these tax shelters, BLIPS, FLIP, and
OPIS. Virtually all the costs associated with the letters are
attached, therefore, to drafting the first prototype opinion,
which would be labor intensive. But after that, with the cookie
cutter follow-ups by the hundreds, the firm has very limited
costs since it used that boilerplate language to produce the
later letters and rarely even consulted with the client, or you
don't even know whether the clients were consulted.
Now, my question has to do with the fees that were charged
on these letters. Did your firm estimate in advance about how
many opinion letters would be issued for a shelter?
Mr. Smith. It is my understanding that we had no idea how
many taxpayers would be investing in these structured products.
Senator Levin. And would be referred to your firm?
Mr. Smith. That would be referred to our firm.
Senator Levin. So now how would you decide on the fee? How
can you charge $50,000 for a cookie cutter opinion letter when
you don't know if you are going to issue 1, 5, 50, 100, or 200
of those letters, same fee, $50,000? How do you decide on that
fee? What is it based on?
Mr. Smith. We would have to ask Mr. Ruble how he----
Senator Levin. Well, you asked Mr. Ruble. I am sure you had
these conversations. You ended up firing him. What did he say
when you asked him, how do you base a fee?
Mr. Smith. I never asked him how he would base the fee or--
--
Senator Levin. But you knew you were getting $50,000 for
each piece of paper that your firm was issuing?
Mr. Smith. That would be part of his----
Senator Levin. And you have an ethical obligation to charge
your clients, who you probably never even saw, a reasonable
fee. How do you base a $50,000 fee?
Mr. Smith. That would be part of the arrangement that he
would have made in the first instance, what the fees would
cost, and we had no idea whether or not we were going to make
money on this or not. If we were going to get $50,000 a
transaction and we only had two or three, we are clearly going
to lose a lot of money.
Senator Levin. So you did figure out that if there were
only two or three of these, you would lose money.
Mr. Smith. Well, obviously we would. The time would be
greater than that.
Senator Levin. So what was your break-even point?
Mr. Smith. I have no idea, Senator.
Senator Levin. Does your firm have any idea?
Mr. Smith. I can sort of do an analysis of that. I doubt if
we had much of an idea as to what the break-even point would
be, because going into this, you wouldn't know how much
research was going to be involved. You wouldn't know--I assume
that there was--Mr. Ruble was conferring with his clients or
the advisors of his clients to a certain extent. I can't tell
you to what extent.
Senator Levin. Do you know how many hours? Was there a
billing kept for this kind of----
Mr. Smith. Yes.
Senator Levin. About how many----
Mr. Smith. I do not have that with me. I would be happy to
provide you with that.
Senator Levin. So you did keep track of about how many
hours went into the preparation of that opinion?
Mr. Smith. Yes.
Senator Levin. All right. You will submit that to the
Subcommittee?
Mr. Smith. Yes.
Senator Levin. But you decided--were you involved in this
decision that no matter how many opinions were issued, they
were all going to be about $50,000 a crack?
Mr. Smith. I was not involved in that decision.
Senator Levin. Who was, besides Mr. Ruble?
Mr. Smith. Well, at this point, I am just perplexed as to
answer any of these questions. I will see what I can find out
on that.
Senator Levin. Let me turn now to Exhibit 117.\1\ This is a
KPMG employee stating that, ``Our deal with Brown and Wood is
that if their name is used in selling the strategy, they will
get a fee. We have decided as a firm that B&W opinions,'' that
is your law firm, ``should be given in all deals.'' They are
deciding that your opinion is going to be given to presumably
your client. Isn't that astounding, that some outside company
is going to decide that your opinion is going to be given to
folks who are supposed to receive independent advice and be
your clients?
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\1\ See Exhibit No. 117 which appears in the Appendix on page 2692.
---------------------------------------------------------------------------
Mr. Smith. Senator Levin, this was not our understanding.
It was our understanding on these transactions that the
taxpayer was going to be given a choice of two or three firms.
Senator Levin. So this comes as a surprise to you?
Mr. Smith. Oh, absolutely.
Senator Levin. There was no deal with Brown and Wood,
right?
Mr. Smith. Well, certainly not to my knowledge, or the
knowledge of the executive committee.
Senator Levin. And did you ask Mr. Ruble whether he had
made a deal on your behalf with KPMG?
Mr. Smith. Well, I don't know that we asked him if he had
made a deal, having had--but we inquired heavily throughout
this as to exactly what his role was.
Senator Levin. Did you ask him whether he had made a deal
with KPMG?
Mr. Smith. I didn't.
Senator Levin. Did anybody ask, as far as you know, on
behalf of your firm? Did we have some kind of an arrangement
with KPMG? Did anybody ask him that question?
Mr. Smith. Well, the arrangement----
Senator Levin. Since you got hundreds of referrals at
$50,000 a crack, did anybody ask Ruble in your presence or
otherwise whether there was an arrangement with KPMG and your
firm?
Mr. Smith. Well, as----
Senator Levin. As far as you know, did anybody----
Mr. Smith. There is an arrangement implicit in what I
described.
Senator Levin. Did anyone ask Mr. Ruble explicitly whether
or not there was a deal between your firm and KPMG that the
users of these tax shelters would be given your letter?
Mr. Smith. I have no knowledge of anyone asking him if
there was a deal.
Senator Levin. Or an agreement?
Mr. Smith. Agreement.
Senator Levin. My time is up, thank you.
Chairman Coleman. Thank you, Mr. Levin.
Let me continue and make sure I understand. The client is
the taxpayer, is that correct?
Mr. Smith. That is correct, Senator Coleman.
Chairman Coleman. Not KPMG. So how did the client come to
your attention or to Mr. Ruble's attention?
Mr. Smith. They would--it was our understanding, in
connection with KPMG marketing these investment products that
they would give the taxpayer the choice of two or three firms
and that is how we would be approached thereafter.
Chairman Coleman. So KPMG is supposed to give the taxpayer
a number of firms and it is your testimony you are not aware of
any arrangement, marketing arrangements or the other type of
interconnecting relationships that the Ruble e-mails reflect?
Mr. Smith. It was our understanding that there was
absolutely no efforts on our part to market or promote these
products.
Chairman Coleman. In Exhibits 90a. and 90b.\1\--I think
really have the first pages, but there are many page----
---------------------------------------------------------------------------
\1\ See Exhibits No. 90a. and 90b. which appear in the Appendix on
pages 684 and 781.
---------------------------------------------------------------------------
Mr. Smith. This would be in the other book?
Chairman Coleman [continuing]. Opinions. Yes. If you look
at Exhibit 90a., it would be just the first page, 90a. is on
the stationery of KPMG. I believe Exhibit 90b. would be--you
have just the first page of the opinion from Brown and Wood. So
KPMG, as I would understand it, is providing an opinion to the
taxpayer, right, and then Brown and Wood is supposed to provide
an independent analysis, is that correct?
Mr. Smith. That is correct.
Chairman Coleman. And if one looks at these opinions, the
language is in substantial portion exactly the same. Do you
work with the tax firms in developing your opinions?
Mr. Smith. It was our understanding that he--his role was
to review the product and determine whether he could give a
concurring opinion, and really the only input that he would
have would be whether or not there needed to be modifications
so that he could opine.
Chairman Coleman. Again, these opinions are being reviewed
by others in the firm?
Mr. Smith. There was a second signer requirement throughout
this provision.
Chairman Coleman. And so if the others in the firm are
seeing kind of the exact duplications of opinions and opinion
after opinion after opinion, would that shine a light or would
that raise a concern to anybody?
Mr. Smith. That, with respect to a product, the opinions
are going to be basically the same. I don't know that that
would shine a light. I must add that in terms of this second
opinion requirement, among the many things that we are looking
at is to what extent that was observed.
Chairman Coleman. I am concerned about the relationship
with KPMG, whether----
Mr. Smith. Right.
Chairman Coleman. Where is the independence in this? I can
tell you from where we are sitting, Mr. Smith, there doesn't
seem to be a heck of a lot of independence. From where we are
sitting, as a matter of fact, there isn't. Let us lay that out.
Now, the question is, is it Mr. Ruble or did it go beyond Mr.
Ruble and that is what we are trying to understand.
Mr. Smith. That what went beyond? I am sorry, Senator.
Chairman Coleman. The intertwining of relationships between
a law firm and an accounting firm, the marketing of tax
products between a law firm and an accounting firm. That is
what we are trying to understand, and we are looking at stuff
that says that it has been approved, it has been discussed. We
are looking at substantial legal opinions that are almost exact
between the accounting firm and the law firm.
Mr. Smith. With respect to these products, they would be
almost exact. I can't really tell you to what extent there
might be differences, but here again, it is something I can
find out for you.
Chairman Coleman. How do you avoid this in the future? What
is Sidley Austin Brown and Wood doing today to make sure that
rogue partners don't have the capacity to get involved in sham
relationships with accounting firms or tax products like this?
Mr. Smith. Well, I testified that we have strengthened our
opinion policy. We have been coming up with more of a
structured opinion policy. Throughout the time that we were
rendering these opinions, one specific thing that we have done
is put in--is have a tax attorney whose job is to monitor
opinions being given in the department. We have an electronic
library of these opinions, who the second opinion writer is,
and this is to avoid any tax opinions being rendered that
hasn't been reviewed.
But I must caution that law firms operate on a degree of
trust. As you know, 25 years ago, when I first joined Brown and
Wood, it was just pretty much a general partnership. We trusted
each other. Unfortunately, this has been very much eroded in
this instance.
We have this situation with Mr. Ruble under review, and as
part of that review, we are going to consider what additional
controls we have to have. I am just absolutely apoplectic that
this happened and embarrassed that this happened.
Chairman Coleman. Senator Levin.
Senator Levin. I want you to look again, Mr. Smith, at
Exhibit 116.\1\ This is a Ruble e-mail. It is dated December
15, 1997. ``This morning, my managing partner, Tom Smith,
approved Brown and Wood, LLP, working with the newly conformed
tax products group at KPMG on a joint basis in which we would
jointly develop and market tax products and jointly share in
the fees as you and I have discussed. To the extent it is
possible, it would be very beneficial from our perspective to
involve our San Francisco office and I have given Paul Pringle
and Eric Haueter of that office your name and telephone number.
Please call me when you have a chance.'' Mr. Smith, did you, in
fact, approve Brown and Wood working with the newly conformed
tax products group at KPMG as that e-mail stated?
---------------------------------------------------------------------------
\1\ See Exhibit No. 116 which appears in the Appendix on page 2691.
---------------------------------------------------------------------------
Mr. Smith. Absolutely not.
Senator Levin. Now, there were two other persons from the
law firm's San Francisco office, Mr. Pringle and Mr. Haueter--
it is a little hard to read, but any rate, Eric Haueter. So
KPMG writes--Mr. Bickham at KPMG writes Mr. Ritchie at KPMG
that the B&W initiative is moving ahead, as you can see from
the attached. Now, if you will look at Exhibit 120.\2\--got it?
---------------------------------------------------------------------------
\2\ See Exhibit No. 120 which appears in the Appendix on page 2699.
---------------------------------------------------------------------------
Mr. Smith. Yes.
Senator Levin. All right. A meeting actually took place
between KPMG and your two tax professionals.
Mr. Smith. They were not tax lawyers. Paul Pringle and Eric
Haueter are securities lawyers, corporate securities.
Senator Levin. All right.
Mr. Smith. Corporate securities.
Senator Levin. Your two lawyers.
Mr. Smith. Yes.
Senator Levin. Two lawyers for the B&W law firm. What took
place at that meeting?
Mr. Smith. I have no knowledge of that, Senator.
Senator Levin. Are they still with your firm?
Mr. Smith. Absolutely.
Senator Levin. Have you asked them?
Mr. Smith. No, I haven't, sir.
Senator Levin. You might do that.
Mr. Smith. I will.
Senator Levin. Now, if you will take a look at Exhibit
112,\1\ it is a memo dated 3 months later. By the way, before I
go to that exhibit, you say you have not talked to those two
lawyers----
---------------------------------------------------------------------------
\1\ See Exhibit No. 112 which appears in the Appendix on page 2678.
---------------------------------------------------------------------------
Mr. Smith. About that matter.
Senator Levin. About that matter. Is this the first time
you learned that those two lawyers were named as having been at
that meeting with KPMG?
Mr. Smith. The first time I have learned of that, yes.
Senator Levin. Right now?
Mr. Smith. Right now.
Senator Levin. All right. So now look at Exhibit 112, and
this is March 13, 1998, and this is from--it is a KPMG memo
saying that a working group has been formed to work on OPIS,
and this working group includes R.J. Ruble of Brown and Wood.
Is that unusual?
Mr. Smith. Well, I had----
Senator Levin. That he is part of a working group at KPMG?
Mr. Smith. I had heard that term working group, and it was
my understanding that--working group can mean any number of
things. It was my understanding that his role, as I have
testified, was to provide these concurring opinions, and to the
extent that he felt that a modification would be required for
him to do that, perhaps that was it. When I read working group,
I just had assumed that it would be something like a mailing
list or something like that. I have scratched my head as to
what working group means, but my understanding, I have said
over and over again what his role was.
Senator Levin. Now Mr. Cohen----
Mr. Cohen. Yes, sir?
Senator Levin. Is it not true that the PSI staff invited
you to come here to Washington to talk with them, you indicated
you preferred not to travel here, and that you instead would
want to talk to the staff by telephone?
Mr. Cohen. I spoke with the staff about not attending this
because I had some client conflicts.
Senator Levin. Right, that you wanted to talk to them by
phone?
Mr. Cohen. Yes.
Senator Levin. OK.
Mr. Cohen. With respect to this hearing, Senator Levin.
Senator Levin. And you spoke with our staff by phone on
several occasions, is that true?
Mr. Cohen. I did.
Senator Levin. And is it true that you told the staff that
your firm was then representing 24 KPMG clients?
Mr. Cohen. I don't believe--that we were representing 24?
Not to my recollection, but I will try to get that number for
you when I return and give that to Ms. Bean.
Senator Levin. Is it possible you told our staff, as their
notes indicate, that you were representing 24 KPMG clients?
Mr. Cohen. Well, of course, anything is possible. To my
recollection, I did not.
Senator Levin. Did you say that you were sure that KPMG was
giving your firm's name to KPMG clients that you got?
Mr. Cohen. I don't recollect that, but let me say that
having read the staff's review where Mr. Jones, who heads up
their controversy practice, was giving out the list of a
coalition which, by the way, had about 50 lawyers in it, and we
certainly would have been in that group.
Senator Levin. But in terms of your stating to our staff
that you were sure that KPMG was giving your firm's name to
KPMG clients that you got, you don't remember that?
Mr. Cohen. I don't recall stating that, but I will tell you
that I suspect that is true.
Senator Levin. All right. Now, we interviewed a KPMG client
that was referred to your firm and he told the Subcommittee
that he was not repeatedly counseled that your firm represented
KPMG and that he only understood that for the first time when
he asked your firm for advice on whether he should sue KPMG.
Mr. Cohen. Well, he did not ask the firm. He always spoke
through his financial advisor, Mr. Thornette. Mr. Thornette
was, in fact, told before the engagement that we represented--
that our litigation team represented KPMG and that his client,
Mr. Schwartz, should obtain other counsel if he intended to
pursue any cause with respect to the transaction he went into
and that he should do that sooner rather than later. And that
was repeated when Mr. Thornette called us later to say that he
had now decided to pursue that course.
Senator Levin. Now, I want you to think about this scenario
with me.
Mr. Cohen. Certainly.
Senator Levin. A client is sold a tax shelter by KPMG that
turns out to be illegal, or allegedly illegal, and he wants to
sue KPMG because the IRS is after him. Now, how do you
undertake that representation to begin with?
Mr. Cohen. How do we undertake that?
Senator Levin. Yes. In other words, you had a long
relationship, did you not, with KPMG? You had defended KPMG
against malpractice claims. In addition to the malpractice
claims, you had also represented KPMG against claims that they
had given bad accounting advice, is that correct?
Mr. Cohen. In business transactions, yes, that is correct.
Senator Levin. So now you have a question of whether or not
a client of yours with whom you had a longstanding relationship
had sold an illegal tax shelter. When that comes to your
attention, isn't that something where you would immediately
say, I can't get involved in that matter because----
Mr. Cohen. No, that I cannot defend the taxpayer----
Senator Levin. Yes.
Mr. Cohen. What comes to my mind--no, I don't see a
conflict there.
Senator Levin. In representing a taxpayer?
Mr. Cohen. No, in a tax proceeding. I could not represent
that taxpayer in a proceeding against KPMG and I so informed
the taxpayer and I advised the taxpayer, going beyond my
ethical responsibilities, to obtain other counsel and to do
that sooner rather than later.
Senator Levin. OK. Now take a look at Exhibit 45.\1\
---------------------------------------------------------------------------
\1\ See Exhibit No. 45 which appears in the Appendix on page 557.
---------------------------------------------------------------------------
Mr. Cohen. I don't have a copy of the exhibits. Are these
the exhibits?
Chairman Coleman. The white volume has Exhibit 45.
Senator Levin. This is a letter sent in September 2002 by
KPMG to your firm agreeing to assist the law firm in its
representation of a KPMG client who had bought BLIPS.
Mr. Cohen. All right.
Senator Levin. So you hired KPMG as an expert in this case
that was brought against him, is that correct?
Mr. Cohen. We hired--this is a typical Covell letter that
is used by attorneys to protect their clients' confidential
communications with them from disclosure and thereby waiver of
the attorney-client privilege. At the time, as I said, this is
the only one of these we entered into at the time we thought
that we would be conferring with the KPMG. They had been
previously the client's accounting firm. They were providing
the documents in response to some things called Information
Document Requests, or IDRs, furnished by the IRS, and we
thought we might need their advice. We never used their advice
in this connection and we therefore--we just never entered into
another Covell arrangement, in connection with these
transactions. But this is quite common in connection with
securities, antitrust, business litigation, etc.
Senator Levin. This was in a firm, however, is that not
correct, where a client of KPMG was also a client of yours?
Mr. Cohen. That is correct.
Senator Levin. And you used KPMG as the expert in the case
which was brought against your client?
Mr. Cohen. That is not correct. As I said----
Senator Levin. That is not correct? This was not a case
that was brought against your client, the taxpayer?
Mr. Cohen. We did not use KPMG as an expert. That is the
part that is not correct.
Senator Levin. That is the part that----
Mr. Cohen. That is correct. There is no----
Senator Levin. You used their services in a case.
Mr. Cohen. Well, that is actually----
Senator Levin. Is that accurate?
Mr. Cohen. Actually, the services that they provided were
primarily in response to the Information Document Requests of
the IRS, which they had already started providing to their
client. It turned out that there was no exchange of information
that needed protection via the Covell letter. Is that--have I
explained that enough?
Senator Levin. Was that the limit of any advice that you
got, of any assistance that you got from KPMG in that case?
Mr. Cohen. The limit was----
Senator Levin. Do you see the problem here? Do you see
what----
Mr. Cohen. The limit was the furnishing of documents that
had to be turned over to the IRS, yes.
Senator Levin. And you could not get those documents except
to hire them in that case and to pay them a fee? You could not
get the documents otherwise, is that what you are telling me?
Mr. Cohen. Well, we could not get the documents unless KPMG
was willing--except through one of two sources, the client or
the client's financial advisor--I guess three sources, or
through KPMG.
Senator Levin. Did you have to pay KPMG to get those
documents?
Mr. Cohen. No. All----
Senator Levin. You could have gotten them without hiring
them to provide services in that case.
Mr. Cohen. The fees that KPMG received with respect to its
services to the client were billed to the client.
Senator Levin. Well, they were also, were they not, going
to bill you?
Mr. Cohen. No.
Senator Levin. Well, what is this engagement letter which
says our fees for this engagement will be based on the
complexity of the issues? This is Exhibit 45.
Mr. Cohen. Our fees in this engagement will be based on the
complexity----
Senator Levin. It says here, we are pleased to engage KPMG
to assist Sutherland--that we are pleased you have engaged
KPMG.
Mr. Cohen. Well, since the client was being billed for
this, this was run by the client's advisor as to whether this
was the arrangement the client had with KPMG for fees.
Senator Levin. And so the fees on page 2 that they are
talking about are fees that they were charging to your joint
client, is that correct?
Mr. Cohen. These are fees that they were charging the
client for their services in responding to Information Document
Requests and the next paragraph makes it clear that our firm,
since we are not being--we are not remitting anything to KPMG,
we will only remit something to KPMG after the client sends a
check to us.
Senator Levin. And so the only funds that went to KPMG were
from your joint client? Is that correct?
Mr. Cohen. The only funds that went to KPMG were from
KPMG's client.
Senator Levin. Who was also your client?
Mr. Cohen. My client, I was representing this client in
connection with the audit and the potential settlement of his
tax matter.
Senator Levin. So joint client?
Mr. Cohen. Well, I don't----
Senator Levin. It was a client of both of yours?
Mr. Cohen. Yes.
Senator Levin. OK.
Mr. Cohen. But that is--in my--normally, Senator, I would
think of a joint client as someone you are jointly representing
before the IRS. That is not the case.
Senator Levin. I understand.
Mr. Cohen. That is not the case.
Senator Levin. It was a client of both of yours----
Mr. Cohen. Well----
Senator Levin. In different matters?
Mr. Cohen. That is true, Senator, and I will tell you that
I have a lot of----
Senator Levin. I am just asking you if that is accurate.
Mr. Cohen. That is absolutely accurate. I have a lot of
clients that are joint clients in that sense.
Senator Levin. I understand.
Mr. Cohen. In fact a number of major corporations in the
country are clients of mine for tax matters and are joint
clients in that they are clients of KPMG.
Senator Levin. Thank you.
Mr. Cohen. Certainly.
Chairman Coleman. Gentlemen, thank you for your testimony.
Mr. Smith, I know that you were reading a statement that has
not been submitted to the Subcommittee. Would you make that
available to the Subcommittee?
Mr. Smith. Yes.\1\
---------------------------------------------------------------------------
\1\ The prepared statement of Mr. Smith appears in the Appendix on
page 312.
---------------------------------------------------------------------------
Chairman Coleman. Thank you. Your testimony has been very
helpful. Thank you very much.
I would now like to welcome our second panel to today's
important hearing: William Boyle, former Vice President of the
Structured Finance Group of Deutsche Bank; and Domenick
DeGiorgio, former Vice President of Structured Finance at HVB
America. I thank each of you for your attendance at today's
hearing and look forward to hearing your testimony.
Before we begin, pursuant to Rule 6, all witnesses who
testify before the Subcommittee are required to be sworn. I
would ask at this time that you please stand and raise your
right hand.
Do you swear that the testimony you are about to give
before the Subcommittee will be the truth, the whole truth, and
nothing but the truth, so help you, God?
Mr. Boyle. I do.
Mr. DeGiorgio. I do.
Chairman Coleman. As I indicated, gentlemen, before the
previous panel, we use a timing system here. Statements should
be five minutes. If you have a more complete statement, your
entire statement will be entered into the record.
Mr. Boyle, we will have you go first, followed by Mr.
DeGiorgio. After we have heard all the testimony, we will turn
to questions. Mr. Boyle, you may proceed.
TESTIMONY OF WILLIAM BOYLE,\2\ FORMER VICE PRESIDENT,
STRUCTURED FINANCE GROUP, DEUTSCHE BANK AG, NEW YORK, NEW YORK
Mr. Boyle. Chairman Coleman, Ranking Member Senator Levin,
and members of the Subcommittee, thank you for inviting me
today. My name is William Boyle. I am a former employee of
Bankers Trust. I joined Deutsche Bank when it acquired Bankers
Trust. I left Deutsche Bank 2 years ago and am now an
independent consultant.
---------------------------------------------------------------------------
\2\ The prepared statement of Mr. Boyle with an attachment appears
in the Appendix on page 317.
---------------------------------------------------------------------------
I welcome the opportunity to speak today about a
transaction called BLIPS. The Subcommittee requested that I
appear for an interview, which I was pleased to do so last
week. The Subcommittee also requested that I appear today to
testify, and I am pleased to do so voluntarily.
Mr. Chairman, I was not involved in BLIPS at its inception.
The BLIPS transaction was first proposed to Deutsche Bank in
early 1999. Deutsche Bank played a banking role in the BLIPS
transactions. My personal involvement in BLIPS began around
June 1999, when I became a Vice President in the Structured
Transactions Group of Deutsche Bank.
BLIPS was developed for clients of KPMG. I understand it
was designed for KPMG--I am sorry. I understand it was designed
by KPMG or Presidio Advisors or both. BLIPS involved interest
rate swaps and investments in foreign currency option contracts
and foreign and domestic fixed-income securities.
As part of BLIPS, Deutsche Bank issued to investors
approximately 56 loans from September 1999 through October
1999. The stated principal amount plus premium of these loans
was approximately $7.8 billion. The average size of the loan
issued to the BLIPS investor by the bank was approximately $139
million.
The bank lent money to investors and it executed
transactions as directed by investors' investment advisors. As
a major global bank, Deutsche Bank was able to provide
financial services for such transactions. These services
included providing large loans, custody services, foreign
exchange option trading, and interest rate derivatives.
The transactions were not designed by Deutsche Bank. The
bank did not present BLIPS to investors or in any other way
market, sell, or promote it. Deutsche Bank did not provide any
tax advice to any of the investors, nor did the bank discuss
with any investor any potential tax benefits of the investment.
Deutsche Bank took several risk management steps to assure
that its actions in the BLIPS transactions were limited to its
role as the executor of the financial transactions. Let me
summarize those actions.
First, before making the loans, Deutsche Bank conducted an
internal review process. The internal groups that reviewed the
bank's provision of services were Deutsche Bank Private
Banking, Global Markets, Tax, Legal, Credit Risk Management,
Treasury, and Compliance.
Second, each of the BLIPS investors agreed in writing that
Deutsche Bank had not provided them with any tax, legal,
investment, or other advice, and that they had, in fact,
received such advice from expert professionals. One paragraph
of that agreement read, ``You have been independently advised
by your legal counsel and will comply with all Internal Revenue
laws of the United States.''
Third, the bank received written representation letters
from KPMG, Presidio, and each investor that described the
limited scope of Deutsche Bank's involvement in the BLIPS
transactions. This was done so that there would be no
misunderstanding.
Fourth, Deutsche Bank consulted with a prominent outside
independent law firm for its counsel. The law firm drafted and
reviewed the transactional documents pertaining to the bank. It
also provided Deutsche Bank with a legal opinion, which has
been provided to the committee. This opinion concluded, among
other things, that Deutsche Bank is not a promoter or organizer
of the BLIPS transactions and that Deutsche Bank had no
responsibility to register the transaction as tax shelters.
Regarding the tax treatment, Deutsche Bank understood that
the BLIPS transactions involved potentially favorable income
tax benefits that could be claimed by investors. In discussing
the tax issues, it is important to describe the role of the
bank. Deutsche Bank provides banking services for a
transaction. As such, it is not customary or appropriate to
provide legal or tax advice to its clients, nor is it customary
or appropriate to determine in advance whether a client's tax
position will later be sustained. Historically, that is not a
role that banks are authorized to play.
Deutsche Bank's role as the executor of financial
transactions meant that the determination of whether the
investor's tax position would be sustained was outside of its
banking role. Such a determination was the appropriate
responsibility of the investor's lawyers and accountants.
However, Deutsche Bank carefully considered its involvement in
BLIPS and sought independent legal advice that it was complying
with its responsibilities.
Mr. Chairman, that concludes my oral statement and I would
be pleased to answer questions.
Chairman Coleman. Thank you very much, Mr. Boyle.
Mr. DeGiorgio, I notice you have a gentleman with you.
Would he please identify himself for the record?
Mr. Skarlatos. Yes, sir. My name is Brian Skarlatos.
Chairman Coleman. You may proceed, Mr. DeGiorgio.
TESTIMONY OF DOMENICK DeGIORGIO,\1\ FORMER VICE PRESIDENT,
STRUCTURED FINANCE, HVB AMERICA, INC., NEW YORK, NEW YORK,
ACCOMPANIED BY BRIAN SKARLATOS
Mr. DeGiorgio. Thank you, Mr. Chairman. Chairman Coleman,
Ranking Member Senator Levin, and members of the Subcommittee,
my name is Domenick DeGiorgio and I am a Managing Director in
the New York City office of Bayerische Hypo-und Vereinsbank,
otherwise known as HVB. I appreciate the Subcommittee's
invitation to come before you to discuss HVB's limited
involvement with tax-oriented transactions in the late 1990's.
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\1\ The prepared statement of Mr. DeGiorgio appears in the Appendix
on page 326.
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We agree with the Subcommittee that there are important
public policy issues raised by the tax shelter phenomenon and
we support the Subcommittee's investigation into it. We look
forward to discussing with you in the future the issues it
raises.
My written testimony addresses the specific questions asked
by the staff about HVB's role in any tax-oriented transactions.
As I point out in that submission, we were only involved in one
particular series of transactions that the Subcommittee is
investigating, the so-called BLIPS transactions, and our role
there was limited to providing traditional banking services,
such as lending, foreign currency trading, and some interest
rate derivative trading.
We did not organize, promote, or market any tax shelter
transactions and we certainly did not offer tax advice or tax
opinions or any other kind of financial or investment advice to
any of the customers. We did not refer any customers to KPMG or
Presidio and we did not accept, or, for that matter, were
offered any referral fees. To reiterate, our role was strictly
as bankers in these transactions.
The Subcommittee staff has assured us that they agree HVB's
activities in connection with the BLIPS transactions were legal
and appropriate. We complied with applicable statutory and
regulatory obligations. We followed our own cautious and
conservative internal lending policies and the ``know your
customer'' requirements.
However, we recognize that the mass marketing of abusive
tax shelters is a serious problem and we agree that financial
institutions should not facilitate these types of products.
Indeed, we discontinued our participation in the BLIPS
transactions as soon as the IRS announced its position that
they were improper. Since then, we have addressed our concerns
about tax structured transactions by exiting the business
entirely. We have concluded that tax structured transactions
require extensive outside expert advice and go beyond our
expertise as banking professionals.
The staff has also told us that they appreciate HVB's
candor and openness in providing information during the
Subcommittee's investigation. Senator Levin's Minority Report
released Tuesday makes a note of that fact.
We have fully cooperated with your inquiries. We have
produced thousands of pages of documents and have given several
hours of interviews with the staff, even before my appearance
here today. We even requested a friendly subpoena before my
appearance here today so that I would be able under the
financial privacy laws to discuss any questions or respond to
any questions you may have.
As I said, my written testimony addresses the specific
issues you have asked me to discuss and I will be happy to
discuss them now.
Chairman Coleman. Thank you, Mr. DeGiorgio. I apologize.
Having lived in Brooklyn, New York, and my neighbors were
Keratanuito, Kalavido, and Camparelli, I should have been able
to handle DeGiorgio, so---- [Laughter.]
Mr. DeGiorgio. Mr. Chairman, it happens all the time.
Chairman Coleman. I apologize for that, and thank you for
your cooperation.
Did KPMG, in your discussions with KPMG--first of all, how
many of these BLIPS transactions was HVB involved in?
Mr. DeGiorgio. Over the 2-year period, approximately 30
transactions.
Chairman Coleman. Did KPMG ever indicate to you this was a
tax mitigation strategy versus an investment strategy?
Mr. DeGiorgio. We certainly were aware, as opposed to being
ignorant, regarding the inherent tax benefits associated with
the investment strategy.
Chairman Coleman. Did it ever become clear to you that this
was not going to be a 7-year collateral premium loan as
originally laid out, that this was going to be a 60-day deal?
Mr. DeGiorgio. We certainly recognized soon after the
funding date that the likelihood of going beyond a 60-day
period was less probable than the probability of this
transaction remaining through maturity.
Chairman Coleman. If I can direct your attention to Exhibit
111.\1\ This, I believe, is a Presidio credit request, and if
you look at the second page, I think it is, under background,
counterparty purpose of transaction, it reads as follows. ``HVB
will earn a very''--again, let me just back up. If you go to
page 1, under comments, it says, ``We are seeking an approval
to fund four 7-year collateralized premium loans.'' That is in
the box labeled comment. That is on the No. 1 relationship.
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\1\ See Exhibit No. 111 which appears in the Appendix on page 2660.
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If you then go to box three, it notes that ``HVB will earn
a very attractive return if the deals run to term. If, however,
the advances are prepaid within 60 days, and there is a
reasonable prospect they will be, HVB will earn a return of
two-point''--I can't read that--a certain percent ``on the
average balance of the funds advanced, and given the fact that
our collateral will most likely be cash deposits, at least for
the early stage of the transaction, we enjoy the possibility of
earning an infinite ROE,'' presumably return on investment,
``on these loans.''
So at what point did somebody tell you these things are
going to be 60-day deals and not 7-year premium high-risk
loans?
Mr. DeGiorgio. The communication regarding the likelihood
of these transactions or the investors terminating their
positions prior to the 7-year maturity rate came to the bank
through the Presidio investment firm. I don't recall the exact
verbiage used, but it went along the lines of it is likely that
if the investors do not earn a substantial return on their
investment during phase one of the investment strategy, they
are likely to terminate their positions before the end of the
year.
Chairman Coleman. I have trouble with--well, let me back it
up. Out of the 30 BLIPS transactions, how many got out after 60
days?
Mr. DeGiorgio. Eleven were funded in 1999 and all 11
terminated their positions in 1999.
Chairman Coleman. In 60 days?
Mr. DeGiorgio. Yes.
Chairman Coleman. Did that raise any question in your mind
about whether these were 7-year premium deals or 60-day deals?
Mr. DeGiorgio. Well, it certainly turned out to be 60-day
transactions, but I still believe that there was some rational
explanation and basis for entering into a 7-year facility.
Chairman Coleman. How did you come to the interest rates on
these? Do you recall what the interest rate was for these
loans?
Mr. DeGiorgio. I thought I would have that information on
the front page of this exhibit, but I don't seem to see it
there.
Chairman Coleman. Well, how do you arrive at something
generating a premium? What is the basis for that?
Mr. DeGiorgio. I am sorry, generating a premium?
Chairman Coleman. Yes. In these loans, you have a base
loan, right, then you have a premium, how does that happen?
What kind of conditions do you need for that to happen?
Mr. DeGiorgio. The rate on the premium, is that what you
are asking me?
Chairman Coleman. Yes.
Mr. DeGiorgio. That is----
Chairman Coleman. I was told, I believe, by staff that it
was right around 17 percent.
Mr. DeGiorgio. Correct.
Chairman Coleman. Is that a high rate?
Mr. DeGiorgio. I think it was closer to 18 percent, and
that is strictly a function of the net present value derived
between the difference of the loans or the funds advanced and--
over a 7-year term--and the stated or face amount of the loan.
Chairman Coleman. But again, based on a 7-year term?
Mr. DeGiorgio. Correct.
Chairman Coleman. But early on, you are noting that the
reasonable prospects that this is going to be 60 days.
Mr. DeGiorgio. Well, we certainly had some questions as to
whether or not the investors could make a substantial return on
their investment.
Chairman Coleman. What kind of credit risk was there with
these loans?
Mr. DeGiorgio. The credit risk was nominal.
Chairman Coleman. And that is----
Mr. DeGiorgio. As I am sure you see, most of the
transactions were over-collateralized.
Chairman Coleman. Is that unusual?
Mr. DeGiorgio. Not necessarily. In many situations where
trading activities or underlying investments are the motives or
basis for taking down a loan, the collateral coverage is rather
high.
Chairman Coleman. Did you have any knowledge whatsoever
that by getting out after 60 days, with the premiums that these
generated, that you were generating a tax loss for an investor?
Mr. DeGiorgio. Again, we certainly were not ignorant of the
resultant tax benefits. It is part of our due diligence.
Chairman Coleman. And you realize our concern that these
resulting tax benefits couldn't have come about unless you
participate in this.
Mr. DeGiorgio. Well, we certainly also recognized that a
loan needed to be funded and you needed banks to fund those
loans. But I think with permission, I would like to just
elaborate on that for a moment and make it clear to the
Subcommittee that for the tax advice and the tax analysis and
the tax aspects of this transaction, our due diligence included
understanding what support or level of support firms such as
KPMG could and was willing to provide to its client base. And
having received a copy of the draft of the opinion that was
authored by KPMG, we certainly felt comfortable that based on
the letter of the law and the analysis, that the opinion was
well reasoned and it was supported by case study and we had no
expertise or ability to challenge the conclusions reached in
that opinion.
Chairman Coleman. Mr. Boyle, let me get back to this issue
about getting out in 60 days. Did Deutsche Bank expect that the
taxpayers would likely terminate the BLIPS after only 60 days,
even though the stated term of the loan was 7 years?
Mr. Boyle. I think that Deutsche Bank understood there was
a strong likelihood of that happening, and, in fact, it did
happen.
Chairman Coleman. I think strong likelihood may be an
understatement. Will you turn to Exhibit 69,\1\ please. By the
way, how many BLIPS transactions did Deutsche Bank process?
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\1\ See Exhibit No. 69 which appears in the Appendix on page 644.
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Mr. Boyle. I believe approximately 56.
Chairman Coleman. How many is that?
Mr. Boyle. I believe 56.
Chairman Coleman. Fifty-six. Exhibit 69 is from Presidio
Advisors.
Mr. Boyle. OK.
Chairman Coleman. And it is to John Rolfes at Deutsche
Bank. Can you identify who John Rolfes is?
Mr. Boyle. John Rolfes, I believe, is a Managing Director
in the Private Bank.
Chairman Coleman. And this says, ``John, further to our
Friday phone conversation, I would like to describe the
necessary financing steps the BLIPS program will require,'' and
it lays it out. Day one, investor borrows a certain amount for
7 years, 16 percent annual rate. On day two, and I'm going to
go now to the fourth paragraph, excuse me, day 7. On day 60,
investor exits partnership and unwinds all trades in
partnership. So Deutsche Bank up front knew that even though
you were issuing what was a 7-year loan with an interest rate
predicated on that, in fact, this was a 60-day deal.
Mr. Boyle. Well, clearly, the credit agreement was 7 years,
but you can see everyone got out of the loans we were involved
in in a 60-day period, yes.
Chairman Coleman. And again with Deutsche Bank, as with
HVB, collateral here was more than the amount of the loan and
the premium combined, is that correct?
Mr. Boyle. Yes.
Chairman Coleman. Deutsche Bank didn't have much risk in
this.
Mr. Boyle. Deutsche Bank had risk depending upon what the
underlying assets were. I believe in the first stage, as you
had seen, they elected to invest them in kind of short-term
money market fund-type investments, so those were fairly very
low risk, yes.
Chairman Coleman. And didn't Deutsche Bank insist that if
collateral ever dipped below the 100 percent--101 percent
figure, Deutsche Bank would be entitled to get its money back
immediately?
Mr. Boyle. Yes. Well, I think that is a normal provision. I
don't think that provision itself is unusual because your
recourse is to the assets that are there, so you want to ensure
that you can dispose of the assets and repay the loan, yes.
Chairman Coleman. So tell me again the reason for the 16
percent interest. How do you arrive at that figure?
Mr. Boyle. My understanding is the client requested a
premium loan, and once again, you determine the 16 percent rate
would--you would basically discount that back and ensure that
you received all the payments----
Chairman Coleman. So the client requests a premium loan and
it is a premium loan that feeds into the tax consequences, the
opportunity to get a tax loss, is that correct?
Mr. Boyle. That is my understanding, yes.
Chairman Coleman. And that is what happened in all of these
situations?
Mr. Boyle. Yes.
Chairman Coleman. Senator Levin.
Senator Levin. Mr. DeGiorgio, looking at this straight,
would you not agree that this was basically intended to be a
tax deal for the taxpayer? Just to cut through all this stuff
before--I am going to go through all of it with you anyway----
Mr. DeGiorgio. OK.
Senator Levin [continuing]. To prove it, but----
[Laughter.]
In your heart of hearts, is this not clearly intended to be
a tax deal?
Mr. DeGiorgio. I think to dispute the notion that there
were inherent and significant tax benefits is ridiculous.
However, the investment strategy was described to us as a
significant motive for these investors to enter into this
transaction.
Senator Levin. Could there be any profit in this
transaction? I mean, is there any way? Just take a look at it.
The only thing which was at risk was 7 percent of the premium,
correct?
Mr. DeGiorgio. During phase one, which is the first 60-day
period?
Senator Levin. Right.
Mr. DeGiorgio. Correct.
Senator Levin. The only thing that was at risk, and they
all bailed out after 60 days----
Mr. DeGiorgio. Right.
Senator Levin [continuing]. And we will go through that
just to show that is what the intention was. That is what the
plan was, to finish at 60 days and then collect your tax loss.
So assuming that is what happened, the only possible money that
had any risk attached to it was that 7 percent that the
taxpayer put up to pay all the fees, is that correct?
Mr. DeGiorgio. Again, at least initially during phase one--
--
Senator Levin. During the 60 days.
Mr. DeGiorgio. Yes.
Senator Levin. OK. Is that correct?
Mr. DeGiorgio. Yes.
Senator Levin. All right. Now, within 1 week after this
loan was taken out by the taxpayer, the loan was assigned to an
investment fund, right?
Mr. DeGiorgio. Correct.
Senator Levin. And you were aware of that fact?
Mr. DeGiorgio. Yes.
Senator Levin. Why wasn't the loan just made to the
investment fund?
Mr. DeGiorgio. That, I don't know. I am not sure why there
was a two-tiered fund.
Senator Levin. Why there was an assignment?
Mr. DeGiorgio. Correct.
Senator Levin. You don't know why these loans were just not
made to the investment fund? Would there have been a tax
advantage if it had been made to the investment fund?
Mr. DeGiorgio. There probably was, if I recall some of the
aspects of the KPMG opinion, it did refer to a shifting of
liability from one entity to another.
Senator Levin. Assignment of----
Mr. DeGiorgio. Being correlated with the tax benefit.
Senator Levin. Of course. From what you now know, would you
agree the only way that the tax benefit, the tax loss, would be
created is if the loan originally went to the taxpayer and then
was almost immediately assigned to that so-called investment
fund? Is that what you now are aware of?
Mr. DeGiorgio. I am--the only way is a strong statement and
I probably couldn't make that. But I can certainly ascertain
that it is one way of creating a tax loss.
Senator Levin. All right. If you could think of the other
reason for doing that, let the Subcommittee know, will you, for
the record?
Mr. DeGiorgio. Sure.
Senator Levin. We haven't been able to find one yet, but if
you can find one, let us know.
Now, did you eventually come to understand, at least, that
BLIPS was primarily a tax avoidance scheme?
Mr. DeGiorgio. No, I did not.
Senator Levin. Let us go to Exhibit 107.\1\ Is it Alex
Nouvakhov--am I pronouncing his name correctly?
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\1\ See Exhibit No. 107 which appears in the Appendix on page 2646.
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Mr. DeGiorgio. Very close.
Senator Levin. All right. He is with your bank?
Mr. DeGiorgio. Yes, he is.
Senator Levin. Now, he acknowledged to us that he knew that
BLIPS was a tax shelter and here is what his notes read, if you
could take a look at his notes. They are a little bit hard to
read, but you will see on the right-hand side, right in the
middle where there is a 7 percent and then there is an arrow
up. Do you see that?
Mr. DeGiorgio. I am with you.
Senator Levin. OK. It says, ``Seven percent fee equity paid
by the investor for tax sheltering.'' Do you see that?
Mr. DeGiorgio. Yes, I do.
Senator Levin. Well, he was aware of it, then, right?
Mr. DeGiorgio. Well, certainly--I certainly was present at
the meeting where this presentation was made.
Senator Levin. Is that an accurate note?
Mr. DeGiorgio. The note reflects the cost and how Presidio
had intended on charging its investors for participating in the
investment structure.
Senator Levin. He didn't say investment structure. He says
tax sheltering. Was that an accurate note or wasn't it?
Mr. DeGiorgio. Actually, what Alex Nouvakhov thought at the
point in time, I don't recall Presidio mentioning or referring
to this as a tax shelter, but they certainly described to us
how the calculation of the cost to the investor was being made.
Senator Levin. Did you understand it basically to be a tax
sheltering effort?
Mr. DeGiorgio. I am sorry, can you repeat that, Senator?
Senator Levin. Did you understand this at that point, then,
to be basically a tax sheltering effort?
Mr. DeGiorgio. No. I still referred to this----
Senator Levin. I know you referred to it. I am talking
about what you understand as a knowledgeable business person.
Mr. Nouvakhov referred to it as a tax shelter and that the 7
percent fee was for that purpose. Now I am asking you, under
oath, did you understand this to be and believe it to be
basically a tax sheltering effort?
Mr. DeGiorgio. No, I did not. I still viewed it as an
investment strategy with inherent tax benefits.
Senator Levin. Now take a look at Exhibit 124.\1\ This is
an HVB document. This begins on day 48. And then if you look at
the second line on page one, it says, ``Day 48, ten business
days prior to the withdrawal date.'' That is your document,
right?
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\1\ See Exhibit No. 124 which appears in the Appendix on page 2705.
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Mr. DeGiorgio. Yes, it is.
Senator Levin. So it was obvious to you when you prepared
this document that the withdrawal was going to occur on day 60,
was it not?
Mr. DeGiorgio. Not exactly.
Senator Levin. What does it mean, ten business days prior
to withdrawal date? It doesn't say possible withdrawal date. It
says withdrawal date, right? Are you familiar with this
document?
Mr. DeGiorgio. Absolutely.
Senator Levin. Does it say prior to withdrawal date? Am I
reading it right, or is this something subject to
interpretation like Mr. Nouvakhov's notes?
Mr. DeGiorgio. No, not at all. I can explain it fully.
Senator Levin. All right.
Mr. DeGiorgio. Given the time of year, obviously it was
fourth quarter 1999 going into a Y2K event, we as an
institution--since we had reasonable expectations that the
transactions would terminate within a 60-day period--prepared
our back office and operations teams for the reasonable
expectation of an unwind.
Senator Levin. Within 60 days?
Mr. DeGiorgio. Within 60 days. But I have to say, Senator,
if this were a different time of the year, in other words, if
these transactions were funded in January and the 60-day period
occurred within the first quarter of that year, this process
would never have been put in place. It was simply a function of
year-end constraints in addition to the Y2K events.
Senator Levin. To summarize your testimony, you had the
reasonable expectation that the withdrawal would occur by day
60 and then that happened in every case?
Mr. DeGiorgio. Correct.
Senator Levin. There was a theoretical possibility that it
wouldn't occur within 60 days, is that correct?
Mr. DeGiorgio. Theoretical possibility.
Senator Levin. And your bank could force it to end at 60
days, couldn't it?
Mr. DeGiorgio. No.
Senator Levin. You didn't have the power to end it at 60
days?
Mr. DeGiorgio. No, unless there were violations in the
collateral ratio.
Senator Levin. And the collateral ratio was 100 percent-
plus, right?
Mr. DeGiorgio. Hundred-and-one-point-two-five.
Senator Levin. Pretty solid collateral there?
Mr. DeGiorgio. Absolutely.
Senator Levin. No risk for the bank?
Mr. DeGiorgio. No credit risk. Plenty of execution and
operational and administrative risks.
Senator Levin. There were operational risks. Didn't you
control the fund? Wasn't it in your custody?
Mr. DeGiorgio. The funds were not necessarily at risk
because you are absolutely correct. The funds remained in an
account under the customer's name at the bank.
Senator Levin. At your bank?
Mr. DeGiorgio. Correct. The risks I am referring to, again,
are operational regarding the trading activities----
Senator Levin. Which was limited to the 7 percent that the
customer put up, right?
Mr. DeGiorgio. During the first 60 days, correct.
Senator Levin. And you had the reasonable expectation when
it would end, right?
Mr. DeGiorgio. Yes. I said that.
Senator Levin. I now want you to say it, though, in
connection with this point, which is that since there was an
expectation that it would end within 60 days and there was no
risk to the bank of its funds at all within that 60 days,
because you were more than fully collateralized, that therefore
the reasonable expectation was there would never be a risk to
the bank.
Mr. DeGiorgio. Certainly the likelihood of there being
credit risk to the bank was low, as we have ensured to protect
ourselves with the over-collateralization measures.
Senator Levin. And if you look at Exhibit 125,\1\ you have
a chart showing that all the loan proceeds--not the equity, not
that 7 percent, the taxpayer's equity--is converted into Euros
and will be converted back 30 days later. So this is a Euro
account. This is not the loan, the premium loan or the basic
loan. This is just the 7 percent, is that correct, or is this
the whole loan?
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\1\ See Exhibit No. 125 which appears in the Appendix on page 2711.
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Mr. DeGiorgio. This is the whole loan proceeds.
Senator Levin. This is the loan proceeds?
Mr. DeGiorgio. Right.
Senator Levin. So the so-called loan, and there is a great
question as to whether there was a loan here at all since, for
all the reasons that have been given the other day, but
basically it was in your control, fully collateralized, and
expected to be terminated at 60 days during which there was no
risk, but in any event, during that period, there was a deposit
into a Euro account, is that basically correct?
Mr. DeGiorgio. That is correct.
Senator Levin. Were any of the loan proceeds during that
period put at risk during the investment scheme, as part of the
investment scheme?
Mr. DeGiorgio. Not during the first 60-day period.
Senator Levin. That is the period we are talking about,
right?
Mr. DeGiorgio. Yes.
Senator Levin. My time is up. Thank you.
Chairman Coleman. We will come back to a second round,
Senator Levin.
Senator Levin. Thank you.
Chairman Coleman. Mr. Boyle, on the issue about whether the
loan was at risk in terms of the Deutsche Bank transactions,
did Deutsche Bank lay out some requirement that the loan had to
be invested in certain types of securities?
Mr. Boyle. There was a list of permitted investments, yes.
Chairman Coleman. And these, it is my understanding, they
generate a lower rate of return than the interest that the
Deutsche Bank was charging?
Mr. Boyle. I believe that the investment that they chose
for the first days was an investment that----
Chairman Coleman. So Deutsche Bank knew up front there was
going to be no profit generated within this 60-day period.
Mr. Boyle. To the--you mean with--after----
Chairman Coleman. Investor.
Mr. Boyle. After he made the investment, yes.
Chairman Coleman. And again, at least the Deutsche Bank
clearly got from Presidio a memo saying this is a 60-day deal.
Mr. Boyle. Like I said before, there was an expectation
that it may very well wind up at 60 days, and in fact, did
unwind.
Chairman Coleman. I mean, again, expectation. On day 60,
investor exits partnership and unwinds all trades in
partnership. That is Exhibit 69. That is not an equivocal
expectation, is it?
Mr. Boyle. That language is clearly not, no, sir.
Chairman Coleman. Exhibit 113.\1\ This is a memo, Deutsche
Bank Private Bank management committee meeting talking about
the BLIPS product, is that correct?
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\1\ See Exhibit No. 113 which appears in the Appendix on page 2679.
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Mr. Boyle. Yes.
Chairman Coleman. And on page two, it indicates that KGT
suggests that 25 customers be selected from different
geographic areas. PKS will ensure that written agreements be
prepared. Can you help me understand why you would want to
select 25 customers from different geographic areas?
Mr. Boyle. I don't know precisely. That was a Private Bank
recommendation, I guess, to John Rolfes. I don't believe that
applied to us per se in the Structured Transactions Group.
Chairman Coleman. Is that unusual, to put those kinds of
geographic limitations on this?
Mr. Boyle. I don't know, to be honest with you, sir. No.
Chairman Coleman. Our concern here, is this an effort to
keep this under the radar screen?
Mr. Boyle. I don't know.
Chairman Coleman. Have you heard of any other similar
restrictions being placed in any other Deutsche Bank
transactions?
Mr. Boyle. Not that I am aware of, no.
Chairman Coleman. And Deutsche Bank ultimately engaged in
56 of these deals. Senior management said 25. What is the
reason for the difference?
Mr. Boyle. The reason for the difference. A different--
originally, we were focusing on the amount that we may
potentially loan and we wanted to do things in different stages
to make sure we were comfortable executing the transactions,
and I believe the initial stage, we were approached with the
idea of doing up to 25 investors.
Chairman Coleman. Again, I go back to this question that
Senator Levin asked of Mr. DeGiorgio. Looking at this, is there
any question in your mind that these were tax shelters that
were going to be used to provide opportunities for taxpayers to
generate loss and write it off?
Mr. Boyle. Well, it is very clear from the opinions and
everything that there were significant tax benefits that the
investor may report on its return, yes.
Chairman Coleman. Were you concerned? Is Deutsche Bank
concerned at all about the reputational risk for being involved
in this stuff?
Mr. Boyle. You know, like all investments, we are very
concerned in terms of reviewing, going through a very thorough
internal review.
Chairman Coleman. Have you changed your practices today?
Mr. Boyle. I am no longer an employee, so--I am certain
they adjusted everything accordingly, but I am not there
anymore.
Chairman Coleman. And Mr. DeGiorgio, you have indicated
that HVB has, in fact, changed its practices?
Mr. DeGiorgio. That is correct, and it is DeGiorgio.
[Laughter.]
Chairman Coleman. And it changed its practices because
these are abusive tax shelters?
Mr. DeGiorgio. Well, when it became abundantly clear to the
bank that the IRS had issues with the strategy, as was
reflected, I believe, in a notice in August 2000, we
immediately discontinued our participation in the transaction.
Chairman Coleman. And again, it is your testimony here
today that in spite of the fact that you had--how many BLIPS
accounts did you have?
Mr. DeGiorgio. Approximately 30.
Chairman Coleman. Thirty, that you had 30 BLIPS accounts,
that all of these were purported to be 7-year loans at 16
percent interest rate, even though it was clear they were going
to be exiting in 60 days and they were all exited on 60 days,
and at the time, you weren't aware that these were abusive tax
shelters?
Mr. DeGiorgio. That is correct.
Chairman Coleman. Senator Levin.
Senator Levin. Mr. Boyle, take a look at Exhibit 70,\1\ if
you would. This is a bank document relative to BLIPS. It is
called a new product committee overview memo. Take a look at
page three, if you would, and it is point 12. ``It is
imperative that the transaction be wound up after 45 to 60 days
and the loan repaid due to the fact that the HNW individual
will not receive his or her capital loss or tax benefit until
the transaction is wound up and the loan repaid.'' Is that
correct?
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\1\ See Exhibit No. 70 which appears in the Appendix on page 646.
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Mr. Boyle. Excuse me?
Senator Levin. Is that--did I read that correctly?
Mr. Boyle. Well, you read it correctly, yes.
Senator Levin. So it was imperative that this be wound up
in 45 to 60 days in order that the person get their tax
benefit? Am I reading it right?
Mr. Boyle. Well, like I said before, the loan itself was a
7-year loan that people had the option of repaying at any time
within that particular 7 years. And based upon the tax opinion,
if they wanted to potentially take that tax benefit in the
current year----
Senator Levin. Not potentially. Forget the potentially.
Mr. Boyle. OK.
Senator Levin. If they wanted to get the tax benefit.
Mr. Boyle. If they wanted to get the tax benefit, they
would have had to unwind it in the current year, yes.
Senator Levin. And that was 60 days?
Mr. Boyle. Yes, sir.
Senator Levin. OK. Now, in Exhibit 106,\2\ this is your
PowerPoint presentation about this transaction. This is your
Structured Transaction Group. That is the group that
implemented BLIPS. You were part of that group, were you not?
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\2\ See Exhibit No. 106 which appears in the Appendix on page 2622.
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Mr. Boyle. Yes, sir.
Senator Levin. Page 7 of the exhibit describes the client
environment for the group. It says that your group was doing
``tax driven deals.''
Mr. Boyle. Those are the words, yes.
Senator Levin. Is that a lie? Is your own PowerPoint
presentation a lie?
Mr. Boyle. No. I mean, the group was involved in complex
financial transactions in which there were significant tax
benefits, yes.
Senator Levin. No. Not significant tax benefits. Let us put
that aside. We have heard that rhetoric two or three times. We
are talking about your own PowerPoint that says these were
``tax driven deals.'' Were those words a lie?
Mr. Boyle. I did not prepare the document.
Senator Levin. Were they accurate?
Mr. Boyle. That there were significant tax benefits?
Senator Levin. No, that they were tax driven.
Mr. Boyle. I don't know the precise context that they are
using tax driven, but clearly, if you believe that----
Senator Levin. Give me a context for that. These are three
words, tax driven deals.
Mr. Boyle. Yes. If you----
Senator Levin. That doesn't mean some tax benefits. That
means these were tax driven deals. That is your document. That
is your bank's document.
Mr. Boyle. Yes.
Senator Levin. Was that accurate or not, that these were
tax driven deals?
Mr. Boyle. If they are referring to the fact that there
were significant tax benefits, yes.
Senator Levin. Otherwise, if they were driven by those
benefits--driven?
Mr. Boyle. Well, you have to look at----
Senator Levin. Driven means that is the principal point.
That is the driver. You know what the word means.
Mr. Boyle. Yes, sir.
Senator Levin. Let us not fiddle around with words. Were
these tax driven deals?
Mr. Boyle. I don't know which ones--I don't know which
deals they were referring to in that----
Senator Levin. BLIPS.
Mr. Boyle. BLIPS?
Senator Levin. Was BLIPS a tax driven deal?
Mr. Boyle. I am not sure they are referring to BLIPS in
that transaction.
Senator Levin. Well, was BLIPS a tax driven deal?
Mr. Boyle. BLIPS had a very significant tax benefit, yes,
sir.
Senator Levin. Yes. And so you are denying it was a tax
driven deal?
Mr. Boyle. No, I am saying if tax driven means significant
tax benefits, yes.
Senator Levin. And if it means that the principal purpose
of it was tax benefits, it was not?
Mr. Boyle. That is something we weren't involved in
deciding or reviewing.
Senator Levin. You weren't involved in reviewing? I am
asking you, you are saying that there were tax benefits. You
knew that much.
Mr. Boyle. Yes. We understood that----
Senator Levin. But you can't say that it was driven by tax
benefits, is that correct?
Mr. Boyle. Yes.
Senator Levin. You are not saying that?
Mr. Boyle. No. I mean, you are asking me what the
investors' intentions were. We did not talk to the investors,
no, sir.
Senator Levin. I am talking about your chart at your bank,
your PowerPoint presentation.
Mr. Boyle. Right.
Senator Levin. You were part of the committee that prepared
it. I am asking you, are those words accurate, that you were
looking at tax driven deals. You are not going to--you are
going to basically tell me today that if it means something
that it doesn't mean, then yes. Now I am asking you, if it
means what it says, is the answer yes or no? Was your bank
engaged in tax driven deals?
Mr. Boyle. Like I said before, if it means transactions
that may have significant tax benefits, yes. And I did not
prepare this----
Senator Levin. If it means that the principal purpose was
tax benefits, then yes or no?
Mr. Boyle. I don't--I am not aware of that.
Senator Levin. The other word is ``gain mitigation
strategies,'' by the way. Take a look now at page 17 of that
same exhibit. You will see that BLIPS is listed as one of the
deals implemented by the group.
Mr. Boyle. Yes.
Senator Levin. Were you aware of the fact, Mr. Boyle, that
the premium part of the so-called loan when it was repaid would
generate a tax loss for the taxpayer?
Mr. Boyle. I was aware that may be the position they took,
yes, I was.
Senator Levin. Thank you. Now, it was designed as a 7-year
investment program, but I think you indicated that the
reasonable likelihood was that the taxpayer would get out after
60 days. Is it not true that it was anticipated that taxpayers
would get out at 60 days?
Mr. Boyle. We understood that they made that choice, yes.
Senator Levin. Was it anticipated the taxpayers would get
out, not possibly get out, but was it anticipated that they
would get out at 60 days?
Mr. Boyle. I would say it was anticipated that they would
get out, yes.
Senator Levin. Thank you. You said anticipated they get
out, yes, you meant, I assume, that they would get out in 60
days?
Mr. Boyle. In 60 days, yes, sir.
Senator Levin. Thank you. Now, was the amount of funds that
were at risk limited to the funds contributed by the taxpayer,
that 7 percent?
Mr. Boyle. No. They had a series of permitted investments
that they could choose from. In the first stage, my
understanding is they all invested in what you would refer to
as low-risk investments.
Senator Levin. So that if the 60-day period was the limit
of the loan, then the risk in the foreign currency transactions
would be limited to the funds contributed by the taxpayer, that
7 percent?
Mr. Boyle. I believe so, yes.
Senator Levin. Was the 7 percent approximately that was
contributed by the taxpayer in Presidio that was held in your
bank until the investment fund was closed, is that also true?
Mr. Boyle. I am sorry?
Senator Levin. Your bank held the funds?
Mr. Boyle. I believe so, yes. Well, yes. It went into a
custody account in the Private Bank.
Senator Levin. So the funds were held in your custody?
Mr. Boyle. For the benefit of the client, yes.
Senator Levin. Yes. And the 7.7 percent was intended to
cover market risks, transaction costs, and Deutsche Bank fees,
is that correct?
Mr. Boyle. Yes.
Senator Levin. Now, there was an Exhibit 103,\1\ if you
take a look at that. It is from Mick Wood. He worked at the
bank?
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\1\ See Exhibit No. 103 which appears in the Appendix on page 2615.
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Mr. Boyle. Yes.
Senator Levin. In response to a memo that you wrote to him
about BLIPS, this is, I think, similar to the question that our
Chairman raised, and if I am duplicating it exactly, then
forgive me. I may have missed your exhibit reference here, Mr.
Chairman. But Exhibit 103 is a reply to a memo that you wrote
about BLIPS, and he said, ``I would have thought you could
still ensure that the issues are highlighted by ensuring that
the papers are prepared and all discussion held in a way which
makes them legally privileged.'' It sounds like he is
suggesting that Deutsche Bank should hide the program behind
the claim of privilege, is that correct?
Mr. Boyle. You may possibly interpret it that way. My
understanding--I don't know--I don't recall much of what was
hidden. I think the only things I recall was trying to limit
the tax discussion with our attorneys to the appropriate
professionals in the bank to review that. I think everything
else is fairly well laid out, including any potential tax
benefits that the investor may receive from the transaction.
Senator Levin. You are saying that the purpose for the
privilege was not to hide this program behind such a claim?
Mr. Boyle. I think the purpose--I don't remember precisely,
but I think generally my recollection is that the reference to
privilege was more to--as you recall, we were advised--not
advised, but we were counseled by an outside law firm and they
were preparing a tax opinion with respect to our role in the
transaction and it was, I believe, to limit the access people
had internally to that document to the appropriate
professionals that should be reviewing it.
Senator Levin. And the purpose of limiting access to the
document?
Mr. Boyle. To the tax opinion, yes.
Senator Levin. The tax opinion?
Mr. Boyle. Yes.
Senator Levin. Take a look at Exhibit 104.\1\ This is an e-
mail from Ivor Dunbar----
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\1\ See Exhibit No. 104 which appears in the Appendix on page 2618.
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Mr. Boyle. Yes.
Senator Levin. Co-head of your Structured Transaction Group
who implemented BLIPS, and that again was your group, I gather,
and here is what he says under point two, privilege.
Mr. Boyle. Yes.
Senator Levin. ``This is not easy to achieve, and therefore
a more detailed description of the tax issues is not
advisable.'' Don't describe the tax issues.
Mr. Boyle. Yes.
Senator Levin. Keep those out of any paper trail.
Mr. Boyle. Right.
Senator Levin. Is that right?
Mr. Boyle. That is clearly what he said there, yes.
Senator Levin. Yes. Now look at point three in that same e-
mail, reputation risk. ``In this transaction, reputation risk
is tax related and we have been asked by the tax department not
to create an audit trail.'' The tax department, don't create an
audit trail in respect to the bank's tax affairs. ``The tax
department assumes primary responsibility for controlling tax
related risks, including reputation risk, and will brief senior
management accordingly. We are therefore not asking risk and
resources committee to approve the reputation risk.'' Boy,
isn't that unusual?
Mr. Boyle. I don't----
Senator Levin. Not to approve a reputation risk because we
want to do this orally?
Mr. Boyle. I don't believe that is what he was getting at.
I think what they were doing is in terms of reviewing the tax--
the transaction, they were restricting that to the tax
professionals, the attorneys, and senior management. I don't
believe that--when you go through the internal documents in
terms of the approvals and that, I mean, it was always clear
that there were tax benefits that may arise to the investor in
the transaction. I don't believe that was hidden or kept low
profile at any point in time.
Senator Levin. No, but it was hidden. Not the tax benefits.
What was hidden is what you are so unwilling to say but which
is so obviously true, which is that was the principal purpose
of the transaction. That is what the effort was. Obviously,
there are tax impacts of every transaction. But this, the fact
that this was intended to be a tax shelter, and that was its
principal purpose, which is obvious from everything, is what
they didn't want to say there, because there would be a
reputational risk at that point.
And let me go on to that reputational risk. By the way,
would there not be a reputational risk if, in fact, your
papers--every time your papers say that the principal purpose
of this was a tax deal, does that not create a reputational
risk?
Mr. Boyle. If that is, in fact, true. I don't recall
anything----
Senator Levin. Yes, it would create a reputational risk
every time you would say, this is a tax deal primarily, right?
You would agree that creates a reputational risk?
Mr. Boyle. Yes, I would--yes, but I don't recall those
words out there anywhere in terms of----
Senator Levin. Well, we have gone through a lot of
documents which quite clearly talk about this being a tax deal.
Mr. Boyle. Yes, sir.
Senator Levin. Having to be wound up in a certain number of
days and so forth. So what we see here is the tax department at
Deutsche Bank saying that the reputational risk here was so
great that it pulled the review of the BLIPS program out of
your risk and resources committee because there would have been
a paper trail, as you just indicated, and it instead personally
briefed Mr. John Ross, who is the CEO of Deutsche Bank
Americas.
Now, how many times do you think that that would have
happened, where there were these kind of tax deals that were
pulled away from that committee and orally discussed with the
CEO instead because of a statement that there is a reputational
risk in having this reviewed by your committee? Do you think
that happened frequently or would this be unusual?
Mr. Boyle. No. My understanding is that it was not pulled
away from that committee because of BLIPS. I think that was a
general policy that the bank was going through, that the tax
aspects would be reviewed by the tax professionals and senior
management.
Senator Levin. But it says here, though, in Exhibit 104
again that we are, therefore, not asking risk and resources
committee to approve reputational risk on BLIPS. This will be
dealt with directly by the tax department and John Ross. I am
asking you, was that common?
Mr. Boyle. With respect to any tax related transaction,
yes.
Senator Levin. It was?
Mr. Boyle. I believe so.
Senator Levin. OK. I believe that the chairman is covered
in Exhibit 113,\1\ where that same type of issue was raised--
where it says, John Ross approved the product, however,
insisted that any customer found to be in litigation be
excluded from the product, the product be limited to 25
customers, and that a low profile be kept on these
transactions. Again, try me on this one. Why a low profile? Why
limit it to 25?
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\1\ See Exhibit No. 113 which appears in the Appendix on page 2679.
---------------------------------------------------------------------------
Mr. Boyle. My recollection of the conversations, we were
sitting down and taking Mr. Ross through the transaction,
particularly our role in the transaction, and because it
involved a more likely than not opinion for the potential tax
benefit to the investor, we wanted to make very clear what our
role was just in terms of banking, that we are not out there
marketing or providing tax advice and that type of thing. So I
am--my guess is he was referring to that conversation.
Senator Levin. My final line of questions, if I ask the
indulgence of the Chair, who has been very generous in many
ways. Exhibit 105,\2\ if you take a look at that, is an e-mail
from you, Mr. Boyle, to John Wadsworth, and this is going to
take a couple of minutes to work through this.
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\2\ See Exhibit No. 105 which appears in the Appendix on page 2619.
---------------------------------------------------------------------------
Mr. Boyle. Actually, I don't have Exhibit 105. Oh, here it
is.
Senator Levin. You have it? OK. Here is what you wrote.
``During 1999, we executed $2.8 billion of loan premium deals
as part of BLIPS approval process. At that time, NetWest and
HVB Bank had executed approximately a half-billion dollars of
loan premium deals. I understand that we based our limitations
on concerns regarding reputational risk which were heightened
in part on the proportion of deals we have executed relative to
the other banks.'' You had done a lot of this, compared to the
other banks, and here is what you proposed.
``In addition to the execution of the underlying FX
transactions, we would like to lend an amount of money to HVB
Bank equal to the amount of money HVB Bank lends to the client.
We could potentially make a market interest rate loan secured
by HVB high coupon loan to the client which would be secured by
the underlying FX transactions. The loan we fund HVB Bank with
could be differentiated from the underlying loan to the client
because of the market coupon versus high coupon, the date the
loans are made, and the fact that we do not face the client as
HVB Bank does.''
So in other words, Mr. Boyle, the reputational risk to
Deutsche Bank for doing additional BLIPS deals was so great
that the bank is not permitting any additional transactions,
and in response to that situation, your solution is not to halt
BLIPS transactions. Rather, you propose to fund and execute
additional BLIPS transactions through the front of another
bank, HVB.
Now, if the reputational risk is that great, shouldn't
Deutsche Bank stop its participation rather than try to hide
its involvement in more of these transactions?
Mr. Boyle. I think we have to put this note in context from
what I remember. The bank itself had reached the conclusion
back in November or October 1999 they didn't want to
participate anymore with these particular transactions. My
understanding is that there may have been other opportunities
to do some more. We approached Mr. Wadsworth with respect to
revisiting this, and he clearly was not interested in doing any
more of these deals, and it stopped at that point.
Senator Levin. Mr. DeGiorgio, did Deutsche Bank approach
HVB about this idea?
Mr. DeGiorgio. Yes, it did.
Senator Levin. And did you or HVB accept the idea?
Mr. DeGiorgio. No, we did not.
Senator Levin. You rejected it?
Mr. DeGiorgio. Yes, we did.
Senator Levin. And why?
Mr. DeGiorgio. Because we were concerned with the
operational and execution risks associated with the transaction
that would not have been alleviated in the structure that had
been proposed, as you see in this e-mail.
Senator Levin. Thank you. Thank you, Mr. Chairman.
Chairman Coleman. Thank you. Mr. DeGiorgio and Mr. Boyle,
you are excused.
I would now like to welcome our third panel to today's
hearing: John Larson, Managing Director of Presidio Advisory
Services; and Jeffrey Greenstein, Chief Executive Officer of
Quellos Group, formerly known as Quadra Advisors. I thank each
of you for your attendance at today's hearing and look forward
to your testimony.
Before we begin, pursuant to Rule 6, all witnesses who
testify before the Subcommittee are required to be sworn. At
this time, I would ask you to please stand and raise your right
hand.
Do you swear that the testimony you are about to give
before this Subcommittee is the truth, the whole truth, and
nothing but the truth, so help you, God?
Mr. Larson. I do.
Mr. Greenstein. I do.
Chairman Coleman. Again, as you have seen with the earlier
panels, I would like testimony to be 5 minutes. Your written
testimony will be entered into the record in its entirety.
Mr. Larson, we will have you go first this morning,
followed by Mr. Greenstein. After we have heard all the
testimony, we will then turn to questions. Mr. Larson.
TESTIMONY OF JOHN LARSON, MANAGING DIRECTOR, PRESIDIO ADVISORY
SERVICES, SAN FRANCISCO, CALIFORNIA
Mr. Larson. I have no advance statement.
Chairman Coleman. Mr. Greenstein.
TESTIMONY OF JEFFREY GREENSTEIN,\1\ CHIEF EXECUTIVE OFFICER,
QUELLOS GROUP, LLC, FORMERLY KNOWN AS QUADRA ADVISORS, LLC,
SEATTLE, WASHINGTON
Mr. Greenstein. Mr. Chairman, Senator Levin, my name is
Jeff Greenstein and I appreciate the opportunity to be here
today. I am the Chief Executive Officer of Quellos Group, based
in Seattle, and since our founding in 1994, we have focused on
providing both asset management services to institutional and
private clients worldwide.
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\1\ The prepared statement of Mr. Greenstein appears in the
Appendix on page 334.
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We understand and very much respect the Subcommittee's
responsibility in this area and its interest in ascertaining
whether there is a need to change public policy.
You have asked me to address tax advantaged investments or
strategies with names like BLIPS, SC2, FLIP, and OPIS. With
respect to BLIPS and SC2, we have no experience in these areas
whatsoever and, therefore, I cannot comment. With respect to
the latter two strategies, I am able to discuss the investment
and structural aspects with the Subcommittee today, although
let me emphasize that I do not have any tax expertise and thus
am not able to provide meaningful input on the tax aspects of
either strategy.
As you have heard, prior to our involvement, the
international accounting firm of KPMG developed FLIP in the
mid-1990's to provide its clients with a tax savings investment
strategy. In the course of many conversations and meetings,
KPMG advised us that its senior tax experts, many of whom had
direct Treasury or IRS experience, had carefully researched the
existing statutes and regulations and that KPMG's national tax
office had concluded that these transactions would likely yield
favorable tax treatment for its investors under the Internal
Revenue Code.
By way of history, our introduction to KPMG occurred in
1995 in a matter completely unrelated to what we are here today
to discuss. We were working with one of our clients to
restructure a portion of their portfolio to meet their
investment objectives. Given the importance of analyzing any
investment portfolio on an after-tax basis, our client asked to
review our portfolio recommendations with its tax advisor,
KPMG, and therefore, at the client's request, we did.
As a result of this prior interaction, KPMG later contacted
us to see if we would apply our investment expertise to help
with the security transactions related to one of its
strategies. This strategy later became known as FLIP. KPMG
presented us with a set of predefined criteria that it had
designed for FLIP and told us that transactions meeting these
criteria would likely result in favorable tax consequences. Our
role as investment advisor was to identify, analyze, implement,
and manage the specific stock and option transactions that were
required to execute FLIP.
These transactions gave investors a reasonable prospect of
earning an economic profit which, in fact, was very real as a
number of FLIP and OPIS investors did indeed realize an overall
profit. The profit potential was directly linked to the gradual
appreciation in the public shares of one of the world's major
financial institutions. KPMG specifically approved all of the
stock and option transactions after it had determined that the
transactions met the criteria for obtaining favorable tax
consequences.
Our role as investment advisor was formalized in 1997 with
an agreement between KPMG and Quadra that defined our different
roles. In the agreement, KPMG confirmed its responsibility for
the tax aspects of the strategy while agreeing that Quadra had
responsibility for only providing investment advice. KPMG was
and remains an international accounting firm with an excellent
reputation and deep resources and we relied on its tax
analysis, conclusions and advice. Additionally, a prominent
national law firm concurred with their opinion.
KPMG began introducing FLIP to potential investors during
1996, and subsequently, Pricewaterhouse Coopers, PWC, developed
a similar strategy with similar tax attributes. They sought and
received our assistance in providing investment-related advice
and execution services. PWC also provided a detailed opinion of
this strategy which was consistent with KPMG's earlier
conclusion that the Internal Revenue Code likely afforded
favorable tax treatment.
In 1998, we were approached again by KPMG with respect to a
variation of the FLIP transaction known as OPIS. It was our
understanding that KPMG had been offering this strategy to its
clients through another investment advisor, the Presidio Group,
but that the Presidio Group had exhausted its capacity. At that
time, KPMG requested our assistance with executing OPIS. For
OPIS, all of the investment and structural aspects of the
strategy were fully developed, the nature of the financial
instruments and security transaction had been fully specified,
and our role was simply to implement the trades and execute the
documents required as prescribed by KPMG.
Chairman Coleman. I would ask you to summarize the rest of
your testimony, Mr. Greenstein.
Mr. Greenstein. Thank you. I want to reiterate that our
focus has been on meeting the financial and investment
objectives of our clients through thoughtful, sophisticated,
disciplined, and well-researched portfolio management. This
presented us with the opportunity to work with some of the most
respected groups in the industry, and I think it is important
to note that we have not been working with the accounting firms
in strategies along these lines for years.
And with that, that is an abridged version of my prepared
remarks and I would be happy to address any questions you might
have.
Chairman Coleman. Thank you, Mr. Greenstein. Your complete
remarks will be entered into the record, without objection.
Mr. Larson, you were originally--at one point, you were
Senior Manager at KPMG, is that correct?
Mr. Larson. That is correct, yes.
Chairman Coleman. And when did you move over to Presidio?
Mr. Larson. In the summer of 1997.
Chairman Coleman. And, in fact, were you involved in
forming Presidio Advisory Services?
Mr. Larson. I was.
Chairman Coleman. And was that with another member of KPMG?
Mr. Larson. Yes, Robert Pfaff.
Chairman Coleman. So would it be fair to say that you knew
the ins and outs of these kinds of transactions, you had
experience and history?
Mr. Larson. Yes, that would be fair.
Chairman Coleman. And, in fact, I believe you were involved
in developing FLIP's transactions?
Mr. Larson. I was one of the team of developers, yes.
Chairman Coleman. Now, it is fair to state, Mr. Larson,
that Presidio knew the BLIPS transaction was specifically
designed so that investors would exit on day 60 of the
transaction, regardless of the fact that BLIPS was a financing
structure as a 7-year loan, is that correct?
Mr. Larson. I would--I do not agree with that.
Chairman Coleman. Would you turn to Exhibit 69,\1\ please.
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\1\ See Exhibit No. 69 which appears in the Appendix on page 644.
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Mr. Larson. The black one or the white one?
Chairman Coleman. Sixty-nine is in the white one. It is a
memo, Presidio Advisors Group. It is from Amir Makov. Do you
know who that is?
Mr. Larson. Yes. He is my other business partner.
Chairman Coleman. He is a partner? He has certain authority
and can speak for Presidio with authority?
Mr. Larson. Yes, correct.
Chairman Coleman. And this is a memo to John Rolfes, CEO at
Deutsche Bank?
Mr. Larson. John was the Managing Director.
Chairman Coleman. Managing Director, I am sorry. And in the
memo, it lays out, ``John, further to our Friday conversation,
I would like to describe the necessary financing steps the
BLIPS program will require,'' and it lays out--it starts with
the day one, investor LLC borrows $100,000, and then principal
amount for 7 years at 16 percent annual. So 7 years at 16
percent annual. And then you go down, day 7 and the last
paragraph, beginning of the last paragraph on that page, ``On
day 60, investor exits partnership and unwinds all trades in
partnership.'' Is that what the document states?
Mr. Larson. That is what it states, yes, sir.
Chairman Coleman. And is there anything equivocal about
saying that the investor exits the partnership and unwinds all
trades in partnership?
Mr. Larson. No, that is what it says.
Chairman Coleman. So Presidio understood this was a 60-day,
get out in 60-day deal?
Mr. Larson. What Presidio understood, even as the two
previous speakers said, that there was a significant likelihood
that investors would want to exit after 60 days, but in no way
did we understand that this was unequivocally a 60-day
investment.
Chairman Coleman. In this document, there is no indication
of significant likelihood. It says, ``on day 60, investor exits
partnership and unwinds all trades in partnership,'' not
significant possibility.
Mr. Larson. I agree that that is what it says.
Chairman Coleman. Can you tell me what step transactions
are?
Mr. Larson. Well, there is a tax doctrine which you might
be referring to called the step transaction doctrine.
Chairman Coleman. Is there a prohibition in the tax code
against step transactions designed to produce artificial
losses?
Mr. Larson. I am not quite sure what you are referring to.
Chairman Coleman. In testimony on Tuesday, we heard that
there was a remote chance--remote chance--that BLIPS investors
would make a profit of a transaction because they were
structuring it, and I believe if you turn to Exhibit 80,\1\
that testimony came from Mark Watson, who appeared under
subpoena before this Subcommittee. He says, ``According to
Presidio, the probability of making a profit from this strategy
is remote.'' Was that a fair representation of Presidio's
conversations with Mr. Watson?
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\1\ See Exhibit No. 80 which appears in the Appendix on page 664.
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Mr. Larson. No, it is not.
Chairman Coleman. So did Mr. Watson make this up?
Mr. Larson. I think Mr. Watson may have misunderstood the
presentation and information that was provided to him.
Chairman Coleman. Can you tell me how many BLIPS
transactions Presidio was involved in?
Mr. Larson. My recollection is 65 to 70.
Chairman Coleman. Do you know if anyone made a profit?
Mr. Larson. No, the trades were not profitable.
Chairman Coleman. So Mr. Watson is saying Presidio says
there is a remote possibility. You are saying zero. Of all you
were involved in, zero transactions made a profit.
Mr. Larson. That is correct, although I am also saying that
it was our view at the time when we were planning the program
and executing it that, in fact, there was a significant
possibility of profit. That did not come to pass, but I think
we had a well-reasoned view that our strategies could be highly
profitable.
Chairman Coleman. Was the market in trouble at that time?
Mr. Larson. We were--under our--the trading strategies that
we were implementing were foreign currency transactions, so I
guess I am not sure what market you are referring to.
Chairman Coleman. I am just trying to understand how you
have every transaction in which you are involved, none makes a
profit, but you are saying there was a reasonable possibility
for profit.
Mr. Larson. The trading strategies, the primary ones that
we were implementing were, I guess, based on our expectation
that a specific event would take place in the market, and by
that, what I mean is the largest positions that we took in the
BLIPS trades, we were shorting the Argentina peso and we were
shorting the Hong Kong dollar and we were taking positions of
very significant size. By taking those positions, what we were
speculating was that one or both of those currencies would be
forced to break its trading peg and devalue, and if that took
place, then we had an expectation that, in particular that with
Argentina, that Argentina was likely--in fact, we thought very
nearly certain--to devalue its currency. Had that happened
while our trades were open, the profits would have been
extremely significant.
Chairman Coleman. And what percentage of the loans were at
risk, of the loans that were involved in these transactions?
Mr. Larson. The expected risk, but not the certain risk,
was approximately equal to the equity invested by the
investors. However, there was always a possibility of a
catastrophic loss in any of the partnerships.
Chairman Coleman. Let me ask the question this way. An
investor took out a $15 million loan--a $20 million loan from
Deutsche Bank, or a $50 million loan from Deutsche Bank. How
much of that was at risk? How much of that was involved in the
risk of loss?
Mr. Larson. The most likely scenarios and the ones that
came to pass was that amount would not be at significant risk
during the initial part of the trade.
Chairman Coleman. Sixty days?
Mr. Larson. Yes. That was the most likely.
Chairman Coleman. The period in which they got out.
Mr. Larson. Yes. However, what I would go on to say is that
there was also a possibility, not a likelihood by any means,
but a possibility that if our foreign currency trades had moved
against us, and in particular if the value of the either Hong
Kong or Argentina currencies had gone up, then there could have
been very significant losses which would have hit the
collateral.
Chairman Coleman. So the standard now is not a likelihood.
Mr. Larson. Standard--I am sorry.
Chairman Coleman. You were saying that there was not a
likelihood of profit being made.
Mr. Larson. I am sorry, could you repeat the question?
Chairman Coleman. I am trying to use the phrase there. I
was trying to understand what the expectation was during 60
days. In other words, how much of a $50 million loan, how much
was at risk? A very minimal amount. What was then the
likelihood of the investor suffering any loss?
Mr. Larson. Using your example, during the initial 60-day
period of our trading program, it was unlikely that there would
be any loss that would affect the $50 million of collateral.
Chairman Coleman. Let me ask you one other question. I will
pursue this line of questioning afterwards. According to the
testimony of KPMG's Lawrence DeLap on Tuesday, he was of the
view that BLIPS transactions should be registered and Presidio
should have registered the transactions. Did Presidio register
their BLIPS transactions?
Mr. Larson. We did not.
Chairman Coleman. Mr. Greenstein, did Quadra--at that time,
you were Quadra--did you register the FLIP transactions with
Pricewaterhouse Coopers?
Mr. Greenstein. Yes, we did. We took registration very
seriously and followed the advice of the tax advisor.
Chairman Coleman. Mr. Larson, did Presidio do some FLIP
transactions?
Mr. Larson. Yes, we did.
Chairman Coleman. Did you register those?
Mr. Larson. We did not.
Chairman Coleman. I will turn the questioning over to
Senator Levin at this time, but there will be a second round.
Senator Levin. Thank you. If you take a look at Exhibit
137,\1\ Mr. Larson, this is the memo that was written by Mr.
Pfaff shortly before he left KPMG. When he wrote that memo, he
went, as you have indicated, to join you at Presidio. You were
partners with him. This is the road map that KPMG followed in
its efforts to mass market tax shelters, or as Mr. Pfaff notes,
develop a turnkey package tax product business and that
Presidio was the instrument to do that.
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\1\ See Exhibit No. 137 which appears in the Appendix on page 2735.
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Now, Mr. Larson, was there a ``Tax Advantaged Transaction
Practice'' at KPMG at the time that this memo was written, in
July 1997? Do you see that? There was a ``Tax Advantaged
Transaction Practice''?
Mr. Larson. I do. There may have been an informal group
that used that acronym, but I am not certain.
Senator Levin. Well, you were there, weren't you?
Mr. Larson. Yes, but I think this was written 6 or 7 years
ago.
Senator Levin. So you are saying that--was it called TAT?
Mr. Larson. KPMG loved acronyms and----
Senator Levin. Was it called TAT?
Mr. Larson. I am not sure whether I remember a TAT group,
although I see it referred to here.
Senator Levin. All right. Were you part of a Tax Advantaged
Transaction Practice, formal or informal, at KPMG?
Mr. Larson. I was certainly part of a tax products--some
informal groups, yes.
Senator Levin. But you are not familiar with the term Tax
Advantaged Transaction Practice? That is not something you
remember participating in at KPMG?
Mr. Larson. I was personally assigned to the international
tax services group during virtually my entire career.
Senator Levin. Was there also this informal or formal group
called Tax Advantaged Transaction Practice that you were part
of?
Mr. Larson. I may have seen this acronym or name before or
not. I don't really recall.
Senator Levin. All right. Were you part of the effort to
complete the FLIP tax opinion before you left KPMG to go with
Presidio?
Mr. Larson. I was one of the people that worked on the
initial opinion, yes.
Senator Levin. Was FLIP designed primarily for tax
reduction?
Mr. Larson. I would say the FLIP was designed with two
purposes in mind, one for the significant expected tax
benefits, and second, to make money, for the investment
possibility.
Senator Levin. And was that true with other products,
including BLIPS?
Mr. Larson. Yes, that was.
Senator Levin. The question then becomes as to whether the
primary purpose was the tax loss that was created or the
possibility, which was indicated as remote, of making a profit,
and that becomes, of course, the whole issue.
Now, take a look at page three of that Exhibit 137.
``Logically,'' Mr. Pfaff wrote, ``we would simply issue an
edict that any client with an imminent gain of a threshold
amount,'' large enough, in other words, ``should contact the
Tax Advantaged Transaction Practice. However,'' he wrote,
``after reading this case called Colgate Palmolive, it appears
that we cannot openly market tax results of an investment.
Rather, our clients should be made aware of investment
opportunities that are imbued with both commercial reality and
favorable tax results. Conversely, we cannot offer investments
without running afoul of a myriad of firm and security rules.
Ultimately, it was this dilemma that led me to the conclusion
that I was in the wrong industry to play the role I enjoy the
most, and hence, the firm's need to align with the likes of a
Presidio.''
Now, this clearly shows that Mr. Pfaff and others at KPMG
knew they were marketing tax advantaged products, that key
court cases said that you can't market tax shelters as such, so
KPMG had to create a facade of investment around the tax
advantaged products. And the investments that were part of
these products were back-fitted, then, into the transactions
after the tax schemes were worked out, simply to try to make it
look like there was an investment purpose to them.
Now, if you take a look at Exhibit 137 from Mr. Pfaff,
again, your partner, which you received a copy of, he talked
about approaching only clients who had an ``imminent gain.''
Now, if this is an investment strategy, why would you limit it
to approaching clients that were confronting a gain? If its
purpose, any significant purpose, was to make a profit, why
wouldn't you approach folks who would want to make a profit?
Mr. Larson. I would say that that is consistent with the
dual purpose of the transaction in that since we understood
that one of the valuable aspects of this product was the hoped-
for tax benefits, it would make sense that logical people to
talk to about the combined package would be those who might be
receptive to tax planning.
Senator Levin. But making a profit would run the other
direction. Then they would have to be sold another tax product
to create a tax loss.
Mr. Larson. I think that the two can certainly be
reconciled, but you are correct that to the extent that you
make a profit on one of these transactions, then your tax
benefit shrinks, so I agree with that.
Senator Levin. You had two cross-purposes here.
Mr. Larson. To a degree.
Senator Levin. Now, let us look at the financing of the
BLIPS deals. This is Exhibit 1Aa.,\1\ but there is a chart
which I think we can put on here, page 7, that contains a
typical BLIPS deal. You were the principal marketer of BLIPS,
is that not correct?
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\1\ See Exhibit No. 1a. which appears in the Appendix on page 371.
---------------------------------------------------------------------------
Mr. Larson. I am sorry, which exhibit?
Senator Levin. That is Exhibit 1a., page 7.
Mr. Larson. Excuse me.
Senator Levin. Do I have that right? Is that the right
number?
Chairman Coleman. It is in the white book.
Senator Levin. I am sorry, yes, in the white book.
Mr. Larson. I don't think the pages are numbered, so I am
not sure what page you are on.
Senator Levin. Well, just go through them and----
Mr. Larson. Yes. I see.
Senator Levin. Now, you were a principal marketer of BLIPS,
is that not correct?
Mr. Larson. I was.
Senator Levin. Now, why was it that the loan was initially
taken out by the taxpayer? This so-called loan, this purported
loan was initially taken out by the taxpayer and almost
immediately assigned to this other entity. Why was the loan
just not made to the investment group directly?
Mr. Larson. I think it could have been.
Senator Levin. Well, the tax advantages would have been
lost, wouldn't they?
Mr. Larson. Certainly one way of structuring this for the
tax advantage was to have the loan drawn down the way it was
outside the partnership.
Senator Levin. But if the loan were made directly to the
partnership instead of to the taxpayer, there wouldn't have
been the tax benefit, right? There wouldn't have been that
premium.
Mr. Larson. That is correct.
Senator Levin. OK. So it had to go that way. Now, that is
for tax reasons. The taxpayer's capital contribution was 7
percent of the loss that was planned to be generated by the
BLIPS transaction, is that correct?
Mr. Larson. That was normally the case.
Senator Levin. And if you look at Exhibit 67,\1\ this is a
page from the Deutsche Bank PowerPoint presentation on the
BLIPS program. If you look at the last three lines on that
page, it reads as follows. ``Seven-point-seven percent of the
premium amount will be held in full by Deutsche Bank until the
LLC account is closed and the Deutsche Bank has a legal claim
on that amount in the credit agreement.'' Then it says the
following. ``The 7.7 percent will cover market risks,
transaction costs, and DBSI fees.''
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\1\ See Exhibit No. 67 which appears in the Appendix on page 632.
---------------------------------------------------------------------------
I think that is fairly clear. So the 7.7 percent put in by
the taxpayer in Presidio was the amount set aside and held by
Deutsche Bank to cover the risks associated with any currency
trades, transaction costs, and Deutsche Bank fees. Now, would
you not agree that within that 60-day period that the risk was
limited to the capital funds put up by the investor?
Mr. Larson. Not exactly, no.
Senator Levin. Was it true what you told our staff on
October 3, that the intent was that the maximum amount put at
risk was the cash that the investor had contributed? Was that
the intent?
Mr. Larson. That was the expectation, but what I also told
the staff, and I would say here now, is that there was always
the possibility which we in the banks were aware of that
something could go wrong and that there could be a catastrophic
trading loss on the FX positions in excess of that amount.
Senator Levin. In the absence of a catastrophe, that was
the intention. Did that ever happen, that catastrophe?
Mr. Larson. It did not.
Senator Levin. And in the case of every BLIPS transaction,
the loss was no more than the amount that was put up by the
taxpayer, is that correct?
Mr. Larson. That is correct.
Senator Levin. My time is up. Are we going to have another
round?
Chairman Coleman. Thank you, Senator Levin.
Mr. Greenstein, according to your statement, Quadra is an
investment advisor in clients referred to you by KPMG?
Mr. Greenstein. Pardon me?
Chairman Coleman. Clients referred to you by KPMG in
connection with the transactions known as FLIP and OPIS, is
that correct?
Mr. Greenstein. They were referred, and in many cases, KPMG
was their financial advisor based on a power of attorney that
the client had executed.
Chairman Coleman. It is very clear that advisors cannot be
involved in abusive tax shelters, you understood that? There is
no question about that?
Mr. Greenstein. Yes.
Chairman Coleman. You have KPMG advising a client, issuing
opinions, and you are relying on those. Did Quadra ever take
any steps to have an independent, uninterested account review
the transactions to ensure that you were not engaging in
anything that ran afoul of the tax laws?
Mr. Greenstein. At that point, we knew of multiple
unrelated premier tax advisory groups, both two accountants and
two nationally recognized law firms, that had concluded the
same tax issue, and at that point in time, KPMG and
Pricewaterhouse Coopers, had tens--potentially tens of
thousands of tax professionals and we respected the opinion and
the work that they did, and there was no need for us to look
elsewhere.
Chairman Coleman. What is your understanding of the
requirement that a promoter of a tax shelter register such
transactions with the IRS?
Mr. Greenstein. My understanding is very limited, and on
that issue, we deferred aggressively to the tax advisor, be it
KPMG or Pricewaterhouse, for their conclusion on the matter.
Chairman Coleman. Did you consider yourself to be a
promoter of FLIP and OPIS under your understanding of the term?
Mr. Greenstein. I don't understand the legal definition of
the term, and I know there is one. We were certainly involved
on certain marketing aspects, but I would say we were not the
primary promoter.
Chairman Coleman. You were involved in marketing?
Mr. Greenstein. We were involved in describing the
investment and structural aspects, yes.
Chairman Coleman. Now, for some or all of the FLIP and OPIS
transactions that you engaged in with Pricewaterhouse Coopers,
I think you indicated that you registered those transactions,
is that correct?
Mr. Greenstein. I believe that to be the case, yes.
Chairman Coleman. But it is my understanding that for the
same transactions that Quadra engaged in with KPMG, Quadra did
not register those transactions.
Mr. Greenstein. That is correct, under the guidance of
KPMG.
Chairman Coleman. Did you ever talk to KPMG and say, hey,
we are doing it for Pricewaterhouse, why not you?
Mr. Greenstein. We did, yes.
Chairman Coleman. And the response?
Mr. Greenstein. We have done our analysis and it is our
opinion that it does not need to be registered and we will not
be registering it, they told us.
Chairman Coleman. You weren't uncomfortable with that?
Mr. Greenstein. We weren't uncomfortable because it was
common certainly in the investment world for two well-respected
organizations to reach different conclusions on the same
matter, and we had respect for the work that they did in this
regard.
Chairman Coleman. You know by not registering them, you are
not bringing it to the attention of the IRS, right?
Mr. Greenstein. I was aware of that, and again, I would
stress how seriously we took the issue, because when PWC told
us to register, we did register immediately.
Chairman Coleman. But felt you didn't have to do it with
KPMG because they told you that they didn't want to do it?
Mr. Greenstein. They told us that they concluded it did not
need to be registered as a tax shelter.
Chairman Coleman. Are you still involved in tax shelter
transactions now, and that would be under, what is it, Quellos,
because Quadra is no longer in existence?
Mr. Greenstein. We always focus on maximizing a client's
after-tax investment objectives, so in some cases, a simple
shelter could be using municipal bonds. So that term, broadly
defined, we are always trying to do that. But in terms of the
types of strategies that we are talking about here today, no,
we are not involved.
Chairman Coleman. Help me understand. I have to say, with
Presidio, it is very clear. They knew BLIPS was a 60-day
transaction. It was very clear what the purpose was. I don't
have the paper trail, I must say, Mr. Greenstein, with you, but
I have got to believe at the time you were doing this, was
there any red light that went on? Pricewaterhouse says register
and KPMG says don't register. Isn't there any red light that
went on and said, hey, we may be involved in something here
that is just not right?
Mr. Greenstein. Again, from our perspective, it was not
uncommon for two well-respected firms, after thorough research,
to come to different conclusions and we would see that all the
time in the investment world where one well-respected group
might say a stock is going up and someone else is saying it is
going down, looking at the same facts. So no, it was not
unusual to receive different opinions.
Chairman Coleman. Senator Levin.
Senator Levin. Mr. Larson, I think you have already
testified that none of the BLIPS taxpayers, the folks who
bought BLIPS, made a profit, is that correct?
Mr. Larson. That is correct.
Senator Levin. Is it then true that it was unlikely, based
on that experience, that investors would earn a pre-tax profit?
Mr. Larson. Based on our expectation and observation of the
foreign currency markets, and in particular the situation in
1999 with Argentina, we were expecting a devaluation of the
Argentina peso at any time and, hence, it was our expectation
that very significant profits would be forthcoming. Did we know
exactly when Argentina was going to devalue? No, we did not,
although within about 12 months, after additional support by
the International Monetary Fund eventually failed, Argentina
did, in fact, devalue. But we were a little ahead of ourselves.
Senator Levin. So that taxpayers who bought BLIPS--taxpayer
after taxpayer after taxpayer--how many were there?
Mr. Larson. I believe we did about 65----
Senator Levin. Sixty-five----
Mr. Larson [continuing]. Or 70.
Senator Levin. And every single one of them did not get a
profit on the investment. They all made out as they should not
have made out in terms of the tax loss, that they made huge
gains in terms of their tax losses. But in terms of that
investment of that 7 percent, over 60 in a row did not make a
profit, right?
Mr. Larson. Many of those were going on simultaneously.
Senator Levin. But 60 of them did not make a profit?
Mr. Larson. That is correct.
Senator Levin. And yet you represented that there was still
the reasonable opportunity to make a profit?
Mr. Larson. Yes, we did.
Senator Levin. Now finally, in terms of your fee, Exhibit
121 \1\ has at the bottom an e-mail from Kerry Bratton at
Presidio. The title of the e-mail message here is, ``Regarding
BLIPS, seven percent.'' And as her message states--is Kerry
Bratton a man or a woman?
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\1\ See Exhibit No. 121 which appears in the Appendix on page 2701.
---------------------------------------------------------------------------
Mr. Larson. She is a she.
Senator Levin. As her message states, the e-mail shows how
in a typical BLIPS deal the 7 percent put in by the taxpayer
gets divided up, and here is what the typical deal does. Ten
percent of the taxpayer's money, 0.7 percent, in other words,
went to currency trading losses. Most of the 7 percent, as a
matter of fact, 5.5 percent of the 7 percent, went to the
fees--your fees, the bank's fees, KPMG's fees. So only a small
part of the taxpayer's funds went to the currency transactions,
is that correct, went to pay the losses on the currency
transactions? Most of that 7 percent went for fees?
Mr. Larson. In her example, yes.
Senator Levin. Not in her example, typically. They were
typical.
Mr. Larson. Yes.
Senator Levin. OK. So that was the typical breakdown of the
7 percent? Was she right?
Mr. Larson. Actually, I think she left out the financing
cost on the loan.
Senator Levin. Well, it says here the breakout for a
typical deal is as follows. Do you see that in the middle of
that page----
Mr. Larson. I do.
Senator Levin. OK. Was this a typical breakout?
Mr. Larson. I would say yes.
Senator Levin. OK. Now, the bottom line, then, is this,
that the greater the loss, the greater the fees that you would
receive, is that true?
Mr. Larson. Correct.
Senator Levin. Your fee wasn't part of the profit. It
wasn't based on profit.
Mr. Larson. Actually, excuse me. Greater--which loss, the
tax loss or----
Senator Levin. Yes. Is that right? The greater the loss
that this taxpayer had in this deal, this paper loss, the
greater your fee, is that correct?
Mr. Larson. I think our--the advisory fee, I believe was
charged as a percentage of the assets under management inside
the strategic investment funds.
Senator Levin. And that typically was the premium?
Mr. Larson. Yes, correct.
Senator Levin. All right. And that premium was the same as
the loss, is that correct, to the taxpayer?
Mr. Larson. It would be close----
Senator Levin. Close enough?
Mr. Larson. Yes.
Senator Levin. And the greater that loss would be, the
greater your premium would be, the greater your fee would be,
is that not correct?
Mr. Larson. That is correct.
Senator Levin. Your fee was not based on profit from an
investment, is that correct?
Mr. Larson. That is correct.
Senator Levin. Your fee was based on what that loss would
be to the taxpayer, is that correct?
Mr. Larson. Correct.
Senator Levin. And the greater the loss, the greater your
fee?
Mr. Larson. I agree.
Senator Levin. If anything demonstrates the purpose of this
whole transaction simply--I think all these other documents
prove it as well--but it is that the whole structure of the
fees that went to the folks who cooked up this tax transaction
was that the tax loss which the taxpayer achieved would
determine the fee, and the greater the loss, the greater your
fee. That, it seems to me, dramatizes what this is all about.
I am not going to ask you to respond because I think you
would probably give me some rhetoric about profit was possible
and there was always a possibility that something would happen.
But just strip away all of the gobbledy-gook and just take a
look at how the fees of the folks who designed this tax shelter
were achieved, and the fees were based on the loss to the
taxpayer and the fees increased as the losses increased. They
weren't related to the profit for obvious reasons. There were
no profits. None were expected. In fact, if it were based on
profits, there wouldn't have been any fees.
I just have one more question of Mr. Greenstein, Mr.
Chairman. I don't know if you want to----
Chairman Coleman. No, we are not going to have another
round. I was going to make a comment, and I would give you an
opportunity to make the last comment, the last question,
Senator. I just wanted to make sure--I never did too well in
math and I just want to make sure we understand this, because
we have talked a lot about the taxpayer didn't make a profit
and generated a loss, and so if you are short-selling Argentine
pesos and there isn't a catastrophe, in fact, none of these
taxpayers made a profit. They made a loss.
But the loss we are talking about here is not the loss in
the transactions about pesos. The loss is when you set this
deal up, if you got a $50 million loan, you got a $20 million
premium. The loss is the loss you are going to write off when
you cash out after 60 days of $20 million. So I don't want to
be confused then, right. The loss is not the loss that the
transaction--your fee is not a percentage of what was lost in
the Argentina peso transaction. Your fee is a percentage of
what the taxpayer was able to write off, is that correct?
Senator Levin. Is that a yes?
Chairman Coleman. Is that a yes?
Mr. Larson. Yes.
Chairman Coleman. Senator Levin.
Senator Levin. Just one question, Mr. Greenstein. I don't
have the exhibit handy. Perhaps my staff can get it. But you
basically were told, were you not, by KPMG that whether or not
you registered the FLIP was your decision?
Mr. Greenstein. They did mention that to us and we deferred
again to their decision, viewing them as the primary promoter,
that if they decided that it did not need to be registered for
themselves that we would go with that assessment.
Senator Levin. And then you wrote them in Exhibit 135,\1\ I
believe, on the last page--excuse me, they wrote you. Gregg
Ritchie wrote you that the analysis of the tax shelter
registration requirements which may be applicable to Quadra
must be made by your firm in conjunction with your own tax
counsel. You didn't do that, did you?
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\1\ See Exhibit No. 135 which appears in the Appendix on page 2729.
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Mr. Greenstein. We did not, and I think this letter was--
they had communicated other things to us different than what
this letter said and I think this was to absolve them of any
liability that they may have for our decision.
Senator Levin. Do you know what CYA means?
Mr. Greenstein. Yes, sir. [Laughter.]
Senator Levin. Was this a CYA letter, in your judgment?
Mr. Greenstein. I believe it was.
Senator Levin. Thank you, Mr. Chairman.
Chairman Coleman. Thank you. The witnesses are excused.
I would now like to welcome our last panel to today's
important hearing: The Honorable Mark Everson, Commissioner at
the Internal Revenue Service; William McDonough, Chairman of
the Public Company Accounting Oversight Board; and Richard
Spillenkothen, Director of Banking Supervision and Regulation
of the Federal Reserve. I thank each of you for your attendance
at today's hearing and look forward to hearing your testimony.
Before we begin, pursuant to Rule 6, all witnesses who
testify before the Subcommittee are required to be sworn. At
this time, I would ask you to please stand and raise your right
hand.
Do you swear that the testimony you give before the
Subcommittee will be the truth, the whole truth, and nothing
but the truth, so help you, God?
Mr. Everson. I do.
Mr. McDonough. I do.
Mr. Spillenkothen. I do.
Chairman Coleman. As you would have heard from the earlier
panels, we would like all statements to be 5 minutes. Your
entire written statement will be entered as part of the
permanent record.
Mr. Everson, we will have you go first this morning,
followed by Mr. McDonough, and finish up with Mr.
Spillenkothen. After we have heard all your testimony, we will
proceed to questions. You may proceed, Mr. Everson.
TESTIMONY OF MARK EVERSON,\1\ COMMISSIONER, INTERNAL REVENUE
SERVICE, WASHINGTON, DC
Mr. Everson. Thank you. Good morning, Mr. Chairman and
Senator Levin. I commend you for your interest in this
important subject of abusive tax shelters.
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\1\ The prepared statement of Mr. Everson with an attached chart
appears in the Appendix on page 338.
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Abusive tax avoidance transactions have a corrosive
influence on our tax administration system and the very rule of
law itself. Senator Grassley recently noted, ``The IRS should
be able to enforce the tax code and respect taxpayer rights at
the same time. We can't have people abusing the tax code and we
can't have the IRS abusing taxpayers. It is as simple as
that.''
I agree. The IRS must demonstrate and execute a balanced
approach of service and enforcement if taxpayers are to remain
faithful to our system of self-assessment, and we can't allow
manipulation of the tax system through abusive shelters to
undermine taxpayers' faith that if they pay their share of
taxes, others will, as well.
I would like to mention four factors which I believe have
contributed to the proliferation of abusive tax shelters and
are depicted on that chart.\2\
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\2\ Chart entitled ``Son of Boss Promoter Relationships'' attached
to Commissioner Everson's prepared statement which appears in the
Appendix on page 348.
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First, the complexity of the tax code. Abusive tax
avoidance transactions are designed to take advantage of the
complexity of the tax code to obtain benefits that Congress
never intended. Complexity becomes the shelter promoters'
camouflage. Promoters hope that both the taxpayer and the IRS
will be confused by a shelter's complexity, while the
transaction's apparent viability is bolstered by legal opinions
secured from reputable law firms.
To address this complexity, the Treasury Department and the
IRS have significantly increased and accelerated the issuance
of published guidance concerning potentially abusive
transactions and the IRS has vigorously pursued compliance with
the promoter registration, list maintenance, and disclosure
rules. These measures complement our increased examinations of
tax shelters in taxpayer returns.
Second, the cozy relationship among sophisticated
promoters. You have identified the relationships that exist
among the various promoters and facilitators who peddle abusive
tax transactions. I would like to draw your attention to this
chart, which depicts promoter relationships for just one type
of transaction, in this case, the Son of Boss.
The chart shows the reinforcing network of commercial
interests that design, develop, and market these sophisticated
products, including investment advisors, CPA firms, law firms,
banks, and brokers. At the bottom, the chart indicates the
linkages of these players to other tax shelter products of
concern to the IRS.
The IRS is currently investigating over 100 promoters,
including accounting firms, law firms, and financial
institutions. Most have complied with our request for
documents, but some have not, so in the last 6 months, the
Department of Justice has filed summons enforcement actions
against six of these promoters, including accounting firms and,
for the first time, law firms. In addition, we are auditing
thousands of individuals and corporations who have entered into
questionable transactions.
Third, the erosion in professional ethics. At my
confirmation hearing last March, I stated that attorneys and
accountants should be the pillars of our system of taxation,
not the architects of its circumvention. Based on what I have
seen while on the job since May and what you have uncovered in
your own investigation, I believe as strongly as ever in that
statement.
As you have learned some organizations have decided to turn
away from the promotion of abusive tax shelters, have reached
agreements with the IRS, and are moving on. That is good news.
I believe it reflects a reassessment by these firms and an
improvement in their professional ethics. Others, such as KPMG
and Jenkens and Gilchrist, remain in litigation with the IRS
and have not yet complied with our legitimate document
requests.
Fourth, nominal penalties undermine the regulation of
abusive transactions. The penalties that are currently on the
books with respect to the promotion of abusive tax transactions
constitute a nominal cost of doing business to organizations
determined to generate large fees by promoting abusive tax
avoidance transactions. De minimis penalties are no more than a
speed bump on a single-minded road to professional riches.
Legislative proposals were announced in March 2002 to
establish meaningful penalties for failure to comply with the
promoter registration, disclosure, and list maintenance
requirements of the code. We need significantly increased
penalties to hit the promoters who don't get the message where
it counts, in their wallets.
Mr. Chairman, I want to assure you and Senator Levin that
the problem of abusive tax transactions is and will remain a
high priority for the IRS. Thank you.
Chairman Coleman. Thank you very much, Commissioner.
Chairman McDonough.
TESTIMONY OF WILLIAM J. McDONOUGH,\1\ CHAIRMAN, PUBLIC COMPANY
ACCOUNTING OVERSIGHT BOARD, WASHINGTON, DC
Mr. McDonough. Chairman Coleman, Ranking Member Senator
Levin, and Members of the Subcommittee, I am pleased to appear
before you today on behalf of the Public Company Accounting
Oversight Board, and I would like to begin by commending the
Subcommittee's investigation of the role of professional firms,
including accounting firms, in the development and marketing of
abusive tax shelters. Indeed, the evidence you have accumulated
has served as a wake-up call that we all, whether corporate
leader, legislator, or regulator, must heed.
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\1\ The prepared statement of Mr. McDonough appears in the Appendix
on page 349.
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The financial scandals at Enron, Adelphia, WorldCom,
HealthSouth, and elsewhere left the impression that public
company financial reporting is not to be trusted and that
professional advisors, including investment bankers, lawyers,
and even a company's independent auditors, will help
unscrupulous executives cook the books.
Congress responded to that breach of trust by enacting the
Sarbanes-Oxley Act of 2002. That Act established the PCAOB and
charged it with ``oversee[ing] the audit of public companies
that are subject to the securities laws, and related matters,
in order to protect the interests of investors and further the
public interest in the preparation of informative, accurate,
and independent audit reports.''
To carry out that charge, the Act gives the Board
significant powers over the practice of auditing the financial
statements of public companies, including: To register public
accounting firms that audit public companies; to inspect the
audits and quality controls of such firms; to conduct
investigations and disciplinary proceedings; and to establish
auditing quality control, ethics, independence, and other
standards relating to the preparation of audit reports or
issuers.
Now, of course, much of the tax work done by accounting
firms falls outside of the audit-oriented focus that Congress
has assigned to the PCAOB. Nevertheless, the PCAOB has a
variety of tools that may help address some of the problems
caused by those abusive tax shelters that are designed to make
financial statements look better.
First, the Board will be conducting a program of annual
inspections of the largest registered firms' audits of public
companies' financial statements and triennial inspections of
smaller registered firms. In those inspections, we will conduct
reviews of engagement work papers, which will put us in a
position to identify and examine how firms audit questionable,
tax-oriented transactions that are reflected in public
companies' financial statements. We will also look for
auditors' involvement in structuring such transactions for
public company audit clients.
Because we are only beginning our inspections program, we
cannot today assess the current extent of promotion and use of
corporate tax shelters and products to public company audit
clients. We will, however, scrutinize the accounting and
presentation of the transactions that we discover through our
inspections program, specifically through our reviews of
selected audit engagements.
In addition, by looking at auditor compensation, promotion,
and retention, our inspections will identify a firm's policies
and practices that create incentives for firm audit personnel
to promote such transactions to their public company clients.
Therefore, while existing laws and regulations may not ban
auditors from promoting and giving tax opinions on such
transactions to their audit clients, both auditors and public
companies should expect heightened scrutiny of such
transactions. The prospect of that scrutiny may give pause to
corporate management, audit committees, and auditors that may
consider such transactions.
Second, through our authority to discipline registered
firms and associated persons, we may impose stiff penalties for
failing to adequately and impartially audit such transactions
undertaken by public companies.
Finally, the Board has the authority to commence a
standard-setting project to address at least a part of the
problem. Specifically, the Board has authority to add to the
statutory list of non-audit services that a registered firm may
not provide to audit clients. Such regulation, of course, would
not prohibit a registered firm from selling tax shelters to
non-audit clients.
The Board also has the authority to develop and impose
additional auditing procedures. While ferreting out tax
avoidance is not directly within our purview, auditors ought to
follow appropriate standards for identifying and auditing
transactions whose main purpose is to create the impression of
enhanced earnings in the financial statements.
Congress gave the PCAOB the responsibility and the tools to
build a new future for auditing through independent standard
setting, registration inspection, investigations, and
discipline. As we move forward to employ those tools in the
public interest, my fellow Board members and I look forward to
a long and constructive relationship with this Subcommittee.
Thank you.
Chairman Coleman. Thank you, Chairman McDonough. Mr.
Spillenkothen.
TESTIMONY OF RICHARD SPILLENKOTHEN,\1\ DIRECTOR, DIVISION OF
BANKING SUPERVISION AND REGULATION, THE FEDERAL RESERVE,
WASHINGTON, DC
Mr. Spillenkothen. I, too, thank you, Mr. Chairman, for the
opportunity to testify today on the Federal Reserve's
continuing efforts to advance corporate governance, risk
management, and internal controls at banking organizations.
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\1\ The prepared statement of Mr. Spillenkothen appears in the
Appendix on page 361.
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Numerous corporate governance and legal compliance failings
over the last 2 years, including those delineated by this
Subcommittee, highlight once again the critical need for
effective risk management and internal controls to guide
firms', both banks' and commercial firms', business practices
and activities.
Federal Reserve staff have not reviewed the specific tax
structures that I understand to be the focus of today's
hearings, and as you know, bank supervisors are not tax experts
nor are they responsible for the oversight of tax compliance by
banking organizations or their customers.
However, I appreciate the opportunity to talk to you today
about our supervisory requirements and expectations for banks
involved in complex transactions and about some of the steps we
have taken to address banks' risk management and internal
control infrastructures.
At the outset, I should point out that the primary focus of
the Federal Reserve's supervision is promoting an institution's
safety and soundness, as well as compliance with banking and
consumer laws and regulations in a way that protects
depositors, the FDIC insurance fund, and the rights of
consumers.
Some basic principles and expectations for banking
organizations guide our work in assessing business activities
and risks, including banks' involvement in complex structured
transactions.
First, and obviously most important, banking organizations
must obey the law. They must have policies and procedures in
place to ensure compliance with all laws and regulations and
that they are not knowingly facilitating illegal activities by
their customers or business associates. Banks should not engage
in borderline transactions that are likely to result in
significant reputational or operational risk to the
organization.
Second, banks should perform thorough due diligence on the
transactions or business activities that they are involved in
and check with key legal, accounting, and tax authorities
within their organizations, as well as independent third party
experts, when appropriate. Banking organizations ordinarily
should not be held legally responsible for the judgments,
actions, or malfeasance of their customers or third party
professional advisors. Such an expectation would require banks
to assume management responsibilities outside their span of
control, create potential legal liabilities that would
compromise their ability to perform as financial
intermediaries, or threaten their safety and soundness, and
place additional significant cost on banking organizations.
Finally, banking organizations must recognize that although
they are not directly accountable for the actions of their
customers or third party legal and accounting professionals, to
the extent that their names or products are implicitly
associated with misconduct by those parties, additional legal
and reputational risks may arise.
With these principles in mind and in light of recent events
of the last couple of years, the Federal Reserve has taken
steps to enhance the supervision of complex structured
transactions and refine its supervisory programs.
During the past year, we have conducted special reviews of
banking organizations engaged in complex structured
transactions. Where we have found deficiencies, we have been
clear on the need for banks to develop effective internal
controls that comprehensively assess the risks associated with
legal compliance. Formal Enron-related supervisory enforcement
actions taken publicly by the Federal Reserve last summer
underscore the expectations of bank supervisors on the need for
banks to address internal weaknesses relating to complex
structured transactions.
In addition to these efforts, we are working with our
colleagues at the other bank agencies and the SEC to develop
supervisory guidance on appropriate controls and risk
management systems pertaining to complex structured
transactions, including those that may have a tax component or
dimension. During this period, we have increased our
supervisory emphasis on the management of legal and
reputational risks.
We are focusing increased attention on the adequacy of new
product approval processes, the management of large or highly
profitable customer relationships, and controls over the use of
special purpose entities. Examiners are also stepping up
efforts to review corporate governance and internal control
infrastructures, including board and management oversight,
corporate-wide compliance activities, and internal audit
functions.
Banks appear to be responding to the lessons of recent
years and the actions of supervisors. They are implementing
better processes for subjecting transactions with heightened
risk profiles to additional levels of scrutiny. This includes
more thorough written policies and procedures, as well as
processes for due diligence reviews by appropriate internal
control functions, including accounting, legal, tax, prior to
the execution of more complex or risky transactions. Most
organizations have established new or reconstituted senior-
level review committees and have fortified their new product
approval processes.
Firms have also increased staff training around the
identification and control of legal and reputational risks.
Where necessary, banks should continue to strengthen these
systems and bank management must work to ensure that the new
processes are effective over time.
In closing, supervisors will continue to focus on risk
management and control processes in order to foster safety and
soundness, financial stability, and compliance with applicable
laws and regulations. Supervisory activities will reinforce
recent actions taken by banks to address weaknesses, and where
necessary, supervisors will take appropriate corrective and
enforcement action.
Of course, no system of official oversight is failsafe and
supervisors cannot detect and prevent all control or management
failures. However, strong and effective supervision, including
the use of supervisory enforcement tools, management steps to
strengthen corporate governance, risk management, and internal
control infrastructures, and the incentives provided by
marketplace discipline can contribute to better compliance and
continued improvements in management of legal and reputational
risks.
Chairman Coleman. I would ask you to summarize.
Mr. Spillenkothen. Thank you. I am finished, Mr. Chairman,
and I would be happy to attempt to answer any questions you
have.
Chairman Coleman. Thank you very much, Mr. Spillenkothen.
Let me just kind of go in reverse order here. Did you have
a chance, Mr. Spillenkothen, to listen to the testimony today?
Mr. Spillenkothen. I did not have a chance to listen to all
of it, Mr. Chairman. I tried to stay involved in some of it,
but not all of it.
Chairman Coleman. If I can do a very brief summary,
basically we have a situation where banks are issuing loans for
these BLIPS, FLIP, and OPIS transactions, issuing loans
ostensibly for 7-year periods but clearly being informed that
these folks are getting out in 60 days. There is a premium
piece in the loan structure, that when it is then part of an
investment package, of which, by the way, very little is at
risk, when it is pulled out, the investor claims loss. So you
have folks, in effect, putting in very little. And, by the way,
all these bank loans are collateralized at 101 percent.
So these are clearly tax shelters. There is no question
about them. These are not 7-year high-interest loans, they are
60-day deals, in and out. And yet the banks' basic assertion
is, well, we are not tax experts. We relied upon the KPMGs of
the world.
Do you see any problems with that kind of operation?
Mr. Spillenkothen. Mr. Chairman, I have not had a chance to
look at the specifics of these transactions and so I would be
reluctant to try to opine on them.
Chairman Coleman. I am not asking you to opine on the
transaction. I am asking you to opine on the actions of the
bank. I mean, how much more do they have to know?
Mr. Spillenkothen. I think banks, as I tried to say, need
to have internal systems to make sure that they are in
compliance with all laws, including tax laws. I think the
lesson of the last couple of years, which I think many banks
have learned in part through the assistance of this
Subcommittee and other market events, is that banks should
avoid borderline transactions or transactions that have a high
probability of resulting in legal problems or significant
reputational risk. Banks need to ensure that they have systems
in place to comply with the law, and ensure that they are not
facilitating illegal activities by outside third parties.
Chairman Coleman. One of the kind of common denominators of
all these transactions is that they are not registered. In some
cases, they are limiting the scope of them. They are
geographically distributing them, keeping everything below the
radar. Talk to me about expanding reporting requirements in a
way that would allow IRS to identify loans that are being used
for questionable tax shelters. Can you talk to me about that
imposing burdensome additional costs? How would you evaluate
the efficacy and cost impact of such requirements? Mr.
Spillenkothen.
Mr. Spillenkothen. Well, I think whenever you impose
additional reporting requirements, there is potential burden,
but one of the things that you have to do when you are
developing reporting requirements is to be able to define what
you are trying to collect information on. You have to be able
to define the activity or transactions that you are trying to
collect information on. I would leave it to my colleagues at
other agencies, the IRS, to describe and deal with how you
would define some of these things, but a clearly important
element of getting reporting is to be able to define what
activities one is trying to collect information on.
Chairman Coleman. Commissioner Everson, how do you react to
the IRS being described as a toothless paper tiger?
Mr. Everson. I am sure that everyone who has come before
this Subcommittee or before the Finance Committee in the
hearing several weeks ago would not agree with that
characterization, given their current problems. But I think
what you are perhaps suggesting is that there has been concern
that we need to have increased tools to do our job and perhaps
more resources.
I will comment on both of these areas, I have mentioned the
penalties. I think the penalties are central to assuring that
we learn what is going on in this whole arena. The question you
just asked to my colleague gets to getting information from yet
another source. If we can just get the information from the
practitioners and from the taxpayers themselves, I think that
will be very helpful.
In terms of the resource question, I would point out both
you and Senator Levin have spoken to this question most
recently in your speech in New York. We are not an agency that
gets topped up in the appropriations process. Yet again, we are
sitting with a mark before the Senate right now that is $245
million below the President's request, and this is something
that has happened under Republican Presidents, Democratic
Presidents, Republican Congresses, and Democratic Congresses.
We tend to fall short.
This is compounded in this case, because some 70 percent of
our costs are personnel related and the pay raise is 2 percent
greater than was budgeted. So we are more squeezed. And if
there is an across-the-board non-defense, non-homeland recision
of a percent or two on discretionary spending, that will cause
further problems that are very significant for us.
So in this area, the first thing I would like to see is for
the funding request to be honored.
Chairman Coleman. I think one of the concerns in dealing
with the IRS is always about focus. I know you have the server,
the wait person who worried about getting audited for her tips.
You have the small business person worried about getting
audited for whatever. And we are sitting at this hearing here
and we are hearing about, over 6 years, $80-something billion
potentially lost to taxpayers and the IRS being a toothless
paper tiger in regard to these kinds of transactions. So I
would say the issue is focus and what the policy makers would
want to say is, yes, we are going to focus on those things that
generate maximum return for the people who are massively
committing tax fraud.
Mr. Everson. I agree with that 100 percent, and in fact, if
you look at the request that the President made for the 2004
budget, he did provide for additional funds particularly in
this area. The first priority of the budget request was to
devote more enforcement resources to high-end taxpayers and to
address these corporate shelters, and we are prioritizing.
We have shifted over a lot of our resources into this area,
as the GAO and others have noted, in tracking all of our
efforts, which include, as I mentioned, accelerating guidance.
It includes enhancement of audits. We have got thousands of
audits working right now for the taxpayers, businesses, and
individuals alike in this area, including criminal
investigations.
We are also extending our leverage and our reach. We have
reached an agreement with 42 States around the country. I think
you heard testimony from the State of California about this
agreement. We are sharing information, jointly managing the
caseload. Already, California has given us information, for
instance, that gave us new participants in one of the shelters
we are investigating. So we are really trying to provide the
focus to this subject that you have suggested is appropriate.
Chairman Coleman. Just for me to try to get a sense of the
scope of this, from your perspective, there was an article, I
believe, in American Lawyer entitled ``Still in the Shadows,''
October 1, 2003. It says, ``as of June 2002, according to the
IRS, 186 people had avoided $4.4 billion in taxes from BLIPS
transactions. Another 57 people had avoided $1.4 billion from
FLIP and OPIS.'' Are these numbers accurate, to the best of
your knowledge?
Mr. Everson. I won't comment on particular numbers because
the way some of these transactions are tracked by the
originator of the transaction are a little bit different from
the way we track them, sir. But overall, clearly, this problem
runs into the billions of dollars.
The difficulty here, if you will, is that there are
potentially abusive transactions, families of transactions that
we have identified. We have already listed over two dozen of
them. There are general criteria based on the amount of tax
avoided vis-a-vis the investment, the same kinds of questions
you have been asking, that also compel disclosure. And clearly,
some of those disclosure requirements are now just coming into
effect for the tax year, calendar year 2003. We will see a lot
of that information next year. But this problem runs into the
billions of dollars.
Chairman Coleman. And there are a range of these, COBRA,
BOSS, Son of Boss, and other things that you laid out.
Mr. Everson. Yes, sir.
Chairman Coleman. One other question and then I will turn
it over to my colleague, and there will be a second round. I
have other questions I want to get to.
I am concerned about the finger pointing that we saw here
in regard to reporting, almost as if there was some lack of
clear, common definition. Ernst & Young says, or PWC says we
should report FLIP, but KPMG doesn't. And then the advisors
say, well, we are advised by these big accounting firms. It
just seems obvious that the purpose of reporting--the ethical
thing, the right thing to do is to give you notice and then
people can make judgments about that. But there appears to be
some legal basis or question, however questionable, that says
you don't have to report. How do you clarify that to make sure
it is very clear that these kind of transactions have to be
reported?
Mr. Everson. I am not sure we need to clarify it. I do
believe we need to increase the penalties so that the guidance
which is already out there and in law is taken seriously.
Chairman Coleman. Switch, being the switch that you may use
to hit somebody, that kind of switch.
Mr. Everson. I hate to say it, but not everybody has
approached this from a point of view of the first objective
which is to comply with the law.
Chairman Coleman. I appreciate that. Senator Levin.
Senator Levin. Let me first join you in welcoming our
witnesses, thanking you for your work. It is critically
important, and that is dramatized every day, but in 2 days of
hearings here by what has been presented, pretty shocking,
disturbing, sorry testimony.
I also would urge you, if you haven't had a chance, to read
our staff report. It is an extraordinary report. I think
perhaps your staffs have already had a chance to look at it,
but in any event, we would be interested in your comments on
the factual material which is set forth in that report. Perhaps
for the record, Mr. Chairman, if it is appropriate, I would ask
that they give us a comment about what they read in that report
after they or their staffs have had a chance to do so.
Chairman Coleman. That request will be made and the answers
will become part of the official record.
Senator Levin. I thank you.
First, Mr. Everson, the fines that you made reference to, I
couldn't agree with you more. The current fine structure is
really absurd, a $1,000 fine. It is not even a slap on the
wrist. It is a slap on the finger or a slap on a nail on the
finger. It is nothing. It is not even a cost of doing business.
It is nothing compared to the rip-off that is going on and the
amount of money that is made by those rip-offs.
So just looking here at Section 6700, a person who
organizes or assists in the organization of a partnership, any
investment plan, causes to make another person to make or
furnish an arrangement which the person knows or has reason to
know is false or fraudulent shall pay a penalty equal to
$1,000. It might as well not be here. In fact, I would prefer
it not be there.
Mr. Everson. It is chump change.
Senator Levin. Yes. What we have got to do is find a way to
move in the direction that you have talked about, and I will be
introducing a bill to do exactly that which will even go beyond
what Senator Grassley and others have done, because what they
do is take away part or all of the rip-off amount, but they
don't penalize people.
So if somebody makes money they should not have made, a fee
of $50 million, to say that you have to give back part of what
you improperly got, or even all as the maximum penalty, which
is what is in the other bill, seems to me isn't truly a
penalty. It just says, give part of your ill-begotten gain back
to us, or pay it to the government. It seems to me there has
got to be a real penalty above and beyond what that person got
improperly if we are going to really have a deterrent.
But in any event, I welcome the comment that you made,
because we are going to need support to go at least as far as
the Grassley bill and, I hope, beyond that. I happen to believe
that, for instance, the promoter of these illegal schemes
should pay the same as the taxpayer to whom they sold the
illegal scheme, and if the taxpayer has to pay Uncle Sam $40
million because that is what they cheated Uncle Sam of, that
the promoter of that tax scheme that resulted in that cheating
pay the same amount. That will be a deterrent if we can go that
far. That is a real deterrent.
Again, I won't ask you to comment on specific penalties,
but I do hope you will take a look at these various approaches
to penalties.
Now, Commissioner Everson, let me ask you this question
relative to the enforcement problems that exist. Let us assume
that the IRS gets wind of an illegal tax shelter, one that does
not comply with Federal law, and it finds out that it is being
promoted by a certain bank, a certain accounting firm, a
certain investment advisory firm. Can the IRS tell the Federal
Reserve about the bank's involvement?
Mr. Everson. Senator, one of the very important premises of
the tax code is the confidentiality of taxpayer information. We
respect that and we think that is very important. One of the
results of that standard is that we are precluded from sharing
information with others unless it reaches a point where we take
it over, say, to the Justice Department because it becomes a
full-fledged criminal matter.
Senator Levin. If it is a crime that there is evidence of,
you can take it to the FBI or the Justice Department, is that
correct?
Mr. Everson. We have a Criminal Investigations Division. If
you may remember, they took care of Al Capone some decades ago.
Senator Levin. Right.
Mr. Everson. They would do the work and then they would
bring it over. After it is ready, it goes over to the Tax
Division at Justice and they look at it and they make the
determination, and we do work with other agencies, yes, exactly
as we did in the Scruchie indictment last week in corporate
governance.
Senator Levin. But you cannot, for instance, share
information about civil violations----
Mr. Everson. That is correct.
Senator Levin [continuing]. With, for instance, the SEC
relative to an investment advisor. You can't do it with the
Public Company Accounting Oversight Board relative to an
accounting firm's involvement, and you can't do it with the
Federal Reserve relative to a bank's involvement, even though
you think the law has been violated, is that correct?
Mr. Everson. That is correct. To use one of your examples,
if my fellow panelist, Chairman of the Public Company
Accounting Oversight Board, if we are working on one of the
firms, the accounting firms, and we have discovered or we
believe that there is a pattern of abuse in this area, I can't
turn to Bill and say, you ought to consider this in your risk
assessment and your approach as to how you are governing the
agency.
Likewise, we audit thousands of companies every year, and
if we determine that 10 or 20 or whatever, some small
percentage, are operating at the edge from a corporate
governance point of view in the tax arena, we cannot originate
a discussion with the SEC.
I do believe that what you are putting your finger on is an
important subject that merits discussion because it is a gap in
the governance structure. I want to make clear, however, that I
do not believe in the routine sharing of individual tax return
information. But in the case of some of these large
corporations or the firms that you are discussing, I believe
that there is a gap there that should be considered to be
addressed.
Senator Levin. I think we would welcome any thoughts,
further comments that you have on that subject, and the same
from our other witnesses. It is a very important subject. I
agree with you. You don't want any routine sharing here or else
we are going to lose the great benefit, it seems to me, of our
tax system, which is that we have got the confidence of
taxpayers that they can pay their taxes and not worry about
being turned over to the SEC, generally, unless they are
committing a crime, in which case they will be turned over to
the FBI. But short of that, there is an understanding among our
taxpayers that is important to maintain. On the other hand, you
point out there is a gap here, which perhaps can be addressed
in an appropriate way.
The Federal Reserve has done a review of financial products
and I just am wondering, who should be doing the same kind of
review here of these tax shelters that you did of the financial
products? It requires a review here, and I think if you have
any of your staff that were here during this hearing or the
Finance Committee hearings, I think you probably got more than
a drift as to how deep and significant a problem that we have.
I am just wondering, who would be the appropriate agency to
do the same kind of review of these kind of tax shelters, the
ones that do not have a business purpose but whose primary
purpose is to create a tax deduction? Would that be the Federal
Reserve, would it be the Oversight Board, or would it be the
IRS, or all three of you, or the SEC?
Mr. McDonough. Senator, we at the PCAOB would certainly
think that we have a piece of the action. Anything that an
accounting firm is doing vis-a-vis its audit clients, we feel
would fall within our purview and we would be, through our
inspection process, pursuing it very aggressively.
Even in the area which is not our direct responsibility,
that is, the activities of accounting firms with their non-
audit clients, what we are saying to them is that their real
task is to restore the faith of the American people in their
profession, and if you are running a firm, well, the place to
start is in restoring public confidence in your firm.
What we are saying as a Board, and what I am saying as a
rather outspoken Chairman of the Board, is if you really want
the American people to restore their confidence in your
profession, you should be very thoughtful about what kinds of
products you are offering, and if it is likely to hurt the
reputation of your firm or not rebuild the reputation of your
firm, you shouldn't be doing it, even if it is legal.
Senator Levin. OK. Mr. Spillenkothen, can you make a
commitment to us that you would work with the Accounting Board
and with the IRS to make a thorough review of these kinds of
transactions which spawn these abusive tax shelters? Could you
give us that kind of commitment?
Mr. Spillenkothen. Senator Levin, we have, as you
indicated, in the last year looked at bank involvement in
complex structured transactions, a subset of which is
transactions that have a tax component. We have, in doing that,
focused on the banks' internal controls and systems for
identifying risky or suspect transactions; for having internal
checks and balances that involve review by independent tax
accounting, and legal people; for escalating questionable
transactions to appropriate decisionmakers, and for ensuring
adequate documentation and controls. As I indicated in my
statement, where we found some deficiencies, we have given
feedback to organizations. We have also taken some formal
enforcement actions.
So we have endeavored to focus on the risk management and
internal controls of these organizations and I think we have
already reviewed these transactions and we have worked into our
ongoing supervisory processes procedures to focus on complex
structured transactions. So I think we have tried to do that.
We are working, as I indicated, on additional guidance that
would provide risk management guidance on structured
transactions, including those that have a tax dimension to
them.
So we have focused on complex structured transactions.
Obviously, our expertise is not taxes and our focus is on
safety and soundness and internal controls for compliance with
all laws and regulations.
Chairman Coleman. Thank you, Mr. Spillenkothen.
Mr. McDonough, just a few things I would like to focus on.
First, I totally agree in this post-Enron world, restoring
confidence is absolutely critical. It is critical for the
economy, critical obviously just on a personal level, you would
think, for the firms involved. The question is, how do we do
that and how do we ensure it and what role?
My question, in part, is for you. The Public Company
Accounting Oversight Board gets set up. Principally, you are
looking at the quality of company audits, and the issues here
that affect the reputation of these companies go beyond the
audits.
Mr. McDonough. Sure.
Chairman Coleman. And I think we need more hands on deck in
order to deal with this. I would hope that you would give some
thought to how you can play a greater role in this. You have
the bully pulpit, and that is important. You can remind people
again and again. But beyond that, I just think the non-audit
role of accounting firms today has certainly been called into
great question, and though we have received a number--and I was
certainly pleased to hear the companies come forth and say, we
have changed our practice and changed our standards and changed
personnel, but is that enough? So I would just hope that you
would give that thought.
The other question, and I think you addressed it somewhat
in your testimony but I would like to kind of go back over it,
Senator Levin raised questions about the degree to which
accounting firms should be allowed to offer tax advice to the
offices and the directors of the companies they audit. We have
got this whole issue of you are auditing and you are offering
tax advice. Could you describe the Board's current views on
that subject?
Mr. McDonough. Right. Well, as you are aware and as you
have just said, Mr. Chairman, the accounting firms have long
provided tax advice to their audit clients and both the
Sarbanes-Oxley Act and what the SEC had to say in January in a
rule continue to make that possible.
But having said that, we will use our inspections to do as
much as we conceivably can. We will watch for whenever firms
put pressure on auditors to sell non-audit services, including
tax services, to executives. We will get at this issue through
our examination of auditor compensation and promotion
practices, and when we find inappropriate influences that may
have an effect on audit quality, we will call the firm to bear
on it.
Essentially, what we are trying to say is we want audit
firms to reward really good, tough auditors for being good
tough auditors, not for other stuff. If we see that they are
rewarding auditors or getting a little tax advice work or
anything else, we will be very heavy-handed in our discussions
with them.
Chairman Coleman. Getting back to one other of the kind of
the non-audit functions that came into question here, and that
is fee generated by the percentage of loss that could be
written off, is there anything inherently questionable about
that? Perhaps, Commissioner, you might want to address this.
Clearly, it raised red flags, it should have for the banks, it
should have for the advisors, and certainly for the accounting
firms. But is there anything inherently questionable about that
and how would you deal with that issue in the future?
Mr. Everson. One of the things that the Subcommittee
report, and I have had a chance to read at least the summary of
it, correctly highlights is the revision in fee structures over
time at the accounting firms, which I think has very much
contributed to this decline in ethics. That is to say that
instead of billing for time, they bill for value added. That is
a change in the professional construct.
When I started out in accounting, you had the investment
banks. They took fees and they had a stake in the action and
they took, in many of these transactions, commercial risk,
whereas the lawyers and the accountants were compensated based
on time. That has drifted and changed over the decades so that
the incentive, if you will, to gain riches as a professional is
to change the value creation for the client. The last witness
you had, the discussion you were having, in this case, it is
not really value creation, it is value destruction from the
government's interest. That is a different construct for
lawyers and accountants than what it once was and I don't think
it is a healthy one.
Chairman Coleman. Chairman McDonough, would you respond to
that?
Mr. McDonough. Yes. I think it is clearly completely
inappropriate for such arrangements to exist between an
accounting firm and its audit clients. You mentioned earlier
that we have the bully pulpit to deal with the accounting firms
in areas which do not involve audit clients. That is being
used, if I may say so, Mr. Chairman, very broadly and very
effectively.
I was down in Atlanta, Georgia, last night talking to the
Georgia State Society of CPAs. I am spending a lot of my time
out and I can tell you the message is very direct and it is not
very subtle. It is, ``we will have to have the accounting
profession reach a new standard of culture, ethics,
responsibility so they regain the confidence of the American
people, and they can either do it voluntarily, which is the
best way, or if they don't do it voluntarily, we will make them
do it.'' That is pretty direct.
Chairman Coleman. I appreciate those efforts, Mr.
McDonough. Senator Levin.
Senator Levin. Thank you. Mr. McDonough, you have indicated
you are looking at adopting a national rule prohibiting the
contingent fee. Is that where you are at?
Mr. McDonough. I believe that all of the rules necessary to
prohibit contingent fees for audit clients already exist. I
will do a double-check and if they don't, you can be very sure
that we will be looking at any new audit standard setting or
rulemaking we will need in the area, but I think it is already
there.
Senator Levin. I think most States have it, but I don't
know that there is a national rule. But in any event, if you
could double-check that----
Mr. McDonough. We will do that.
Senator Levin [continuing]. And your commitment that it
should be a national prohibition is helpful.
Mr. McDonough. Yes.
Senator Levin. Now, Senators Baucus, McCain, and I have
introduced S. 1767, which would ban auditors from providing tax
shelter services to clients that they audit. I am wondering
whether you have had a chance to examine that legislation, and
if so, what your reaction is to it.
Mr. McDonough. Senator, I haven't had an opportunity to
review the legislation, but based on just the brief description
you gave of it, it seems to me that it is highly unlikely that
an accounting firm could be giving an audit client tax shelter
advice and not flunk the independence test. Independence, as
you know, is an absolute requirement for an auditor to maintain
in order to carry out his or her professional responsibilities.
But even if permitted by the audit committee, which all tax
work really has to be and should be, if it came into the area
of actually recommending and advising tax shelters, I think it
would be quite clear. We would have to look at it in the
individual case, but generically, that auditor would be
evaluating his or her own work and that would flunk the
independence test.
Senator Levin. That is what we are trying to get at and
trying to prohibit--that exact activity, where the accountant
is auditing his own product, his own work product. If you could
take a look at that bill and give us a response to it, that
would be very helpful.
The only thing I really want to say in conclusion, if I
could just take a minute here, Mr. Chairman, is that basically,
Uncle Sam is getting ripped off by the promoters of sham
transactions which produce tax deductions and tax losses as
their principal goal. These are abusive. They are costing us
perhaps $10 or $15 billion a year.
We have had really an extraordinary staff report, and I
want to thank my staff, and your staff has been very
supportive, Mr. Chairman, and I want to thank them for that
support.
The report that we have issued is probably the most
detailed report on these sham transactions that we are aware
of. In any event, it is a very disturbing picture. I think if
the average taxpayer out there could somehow or other get
through these complicated machinations, that the level of
disgust and abhorrence would be so high that you as regulators
and we as legislators would be forced to take very strong, very
urgent action against the people who promote these shelters.
They are aided and abetted in that process by
professionals. It is similar to what happened with Enron. Enron
was the engine, but professionals, including banks,
stockbrokers, and lawyers, aided and abetted Enron. It could
not have happened without them.
In this case, we have the aiders and abetters. We also have
the engine here being the designers of the tax shelters who are
professional people.
So we are going to do, I hope, everything that we can do
legislatively to tighten up the law on economic substance, if
necessary--there is a bill which does that which has passed the
Senate--to adopt penalties, I won't say stricter penalties
because I consider the ones that are in existence a joke and,
for all intents and purposes, nonexistent, so adopt really
tough penalties and real penalties for people who aid and abet
these sham transactions which produce these tax shelters.
The regulatory agencies that you represent are playing a
critical role and we need you to work together to coordinate
better, to use your resources in a targeted way, as I think our
Chairman pointed out.
But we also, frankly, need the professions to help clean up
their own act. This is a pretty shameful exposition that we
have witnessed here of professional failure. If it is a true
profession, the immorality that we have seen, the shocking
testimony of purposeful deceptive transactions which have no
real purpose other than to create a tax deduction should really
shake up our professions. But I don't think we can count on
that, unhappily. Even if the top-level folks who run these
professions adopt good codes of ethics and enforce them, there
are still going to be those folks who will try to evade those
codes of ethics, and for that we need regulators, and for that,
we need tough penalties.
I am determined to do whatever I can, and I know our
Chairman joins me in this, to do whatever we can to put an end
to the kind of abuses that we have seen dramatized this week.
Thank you, Mr. Chairman.
Chairman Coleman. Thank you, Senator Levin. Senator Levin,
I want to also reiterate my commitment to doing what we need to
do to make sure that these sham abusive transactions are a
thing of the past.
I do want to thank our staffs, and thank my staff for all
the work they have done to catch up with all the work that your
staff did. They did an extraordinary job. These are complex
transactions and that is one of the challenges certainly the
IRS has in dealing with them. But they are also pretty simple.
I mean, you don't need to be a rocket scientist to figure out
if somebody made $20 million and somebody comes up to you and
says, hey, we will get that as a loss and then you will not
have to pay taxes, limit tax liability on it. The complexity is
how you get from A to Z, but the concept is very simple.
What struck me, Senator Levin, as I listened, where
otherwise very bright, smart people, not just in the accounting
firms but all the others involved who just turned a blind eye
to what was so obvious, and to me, it was obvious. I think
everybody knew what they were doing and what they did was
wrong, and it is not just Uncle Sam that gets ripped off. It is
the little guy. The fact that there is $85 billion less being
paid into the government coffers over 6 years means that those
folks who are paying the taxes, doing the right thing, working
hard, they are the ones who are really suffering and we have
got to make sure that doesn't happen.
You have a lot of responsibility. You have a lot of
challenges. We will certainly work with you and support your
efforts. Clearly, I look forward to working with you, Senator
Levin, on your legislation and some of the recommendations
proposed by the Commissioner.
Hopefully, what we saw was a thing of the past. I think we
have a responsibility to make sure it doesn't happen again. I
fear that, in part, we are nowhere out of the high-flying
1990's. We are not generating just barrels of cash anymore from
all these transactions, and in part, that may be why the
activity has slowed up. I do accept the statements from the
firms involved they have changed their ways, but the climate is
different.
I just want to make sure that--and I hope we get back to
the economy rolling. I don't want to get back to the ethical
standards or the lack thereof, but when we get back to the
economy rolling, I just want to make sure that if that should
happen, that we don't face the same problems. That is our
challenge and we will do everything we can to make sure it
doesn't happen and still do the things we can to promote growth
and promote economy and promote opportunity in this country.
Before adjourning, I would like to add for the record a
written statement submitted by Tom Lopez, the Chief Investment
Officer with the Fire and Police Pension System of Los
Angeles.\1\
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\1\ The prepared statement of Mr. Lopez appears in the Appendix as
Exhibit No. 153 on page 3016.
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With that, this hearing is adjourned.
[Whereupon, at 1:10 p.m., the Subcommittee was adjourned.]
A P P E N D I X
U.S. TAX SHELTER INDUSTRY:
THE ROLE OF ACCOUNTANTS, LAWYERS,
AND FINANCIAL PROFESSIONALS
----------
FOUR KPMG CASE STUDIES: FLIP, OPIS, BLIPS, AND SC2
I. Introduction
In 2002, the U.S. Senate Permanent Subcommittee on
Investigations of the Committee on Governmental Affairs, at the
direction of Senator Carl Levin, then its Chairman, initiated
an in-depth investigation into the development, marketing, and
implementation of abusive tax shelters by professional
organizations such as accounting firms, banks, investment
advisors, and law firms. The information in this Report is
based upon the ensuing bipartisan investigation conducted
jointly by the Subcommittee's Democratic and Republican staffs,
with the support of Subcommittee Chairman Norm Coleman.
During the course of its investigation, the Subcommittee
issued numerous subpoenas and document requests, and the
Subcommittee staff reviewed over 235 boxes, and several
electronic compact disks, containing hundreds of thousands of
pages of documents, including tax product descriptions,
marketing material, transactional documents, manuals,
memoranda, correspondence, and electronic mail. The
Subcommittee staff also conducted numerous, lengthy interviews
with representatives of accounting firms, banks, investment
advisory firms, and law firms. In addition, the Subcommittee
staff reviewed numerous statutes, regulations, legal pleadings,
reports, and legislation, dealing with federal tax shelter law.
The staff consulted with federal and state agencies and various
accounting, tax and financial experts, including the U.S.
Department of the Treasury, U.S. Internal Revenue Service
(IRS), Public Company Accounting Oversight Board (PCAOB),
California Franchise Tax Board, tax experts on the staffs of
the Joint Commission on Taxation, Senate Committee on Finance,
and House Committee on Ways and Means, various tax
professionals, and academic experts, and other persons with
relevant information.
The evidence reviewed by the Subcommittee establishes that
the development and sale of potentially abusive and illegal tax
shelters have become a lucrative business in the United States,
and professional organizations like major accounting firms,
banks, investment advisory firms, and law firms have become
major developers and promoters. The evidence also shows that
respected professional firms are spending substantial
resources, forming alliances, and developing the internal and
external infrastructure necessary to design, market, and
implement hundreds of complex tax shelters, some of which are
illegal and improperly deny the U.S. Treasury of billions of
dollars in tax revenues.
The term ``tax shelter'' has come to be used in a variety
of ways depending upon the context. In the broadest sense, a
tax shelter is a device used to reduce or eliminate the tax
liability of the tax shelter user. Some tax shelters are
specific tax benefits explicitly enacted by Congress to advance
a legitimate endeavor, such as the low income housing tax
credit. Those types of legitimate tax shelters are not the
focus of this Report. The tax shelters under investigation by
the Subcommittee are complex transactions used by corporations
or individuals to obtain significant tax benefits in a manner
never intended by the tax code. These transactions have no
economic substance or business purpose other than to reduce or
eliminate a person's tax liability. These abusive tax shelters
can be custom-designed for a single user or prepared as a
generic ``tax product'' available for sale to multiple clients.
The Subcommittee investigation focuses on the abusive tax
shelters sold as generic tax products available to multiple
clients.
Under current law, generic tax shelters are not illegal per
se; they are potentially illegal depending upon how purchasers
actually use them and calculate their tax liability on their
tax returns. Over the last 5 years, the IRS has begun
publishing notices identifying certain generic tax shelters as
``potentially abusive'' and warning taxpayers that use of such
``listed transactions'' may lead to an audit and assessment of
back taxes, interest, and penalties for using an illegal tax
shelter. As used in this Report, ``potentially abusive'' tax
shelters are those that come within the scope of an IRS
``listed transaction,'' while ``illegal'' tax shelters are
those with respect to which the IRS has taken actual
enforcement action against taxpayers for violating federal tax
law.
The Subcommittee investigation perceives an important
difference between selling a potentially abusive or illegal tax
shelter and providing routine tax planning services. None of
the transactions examined by the Subcommittee derived from a
request by a specific corporation or individual for tax
planning advice on how to structure a specific business
transaction in a tax-efficient way; rather all of the
transactions examined by the Subcommittee involved generic tax
products that had been affirmatively developed by a firm and
then vigorously marketed to numerous, in some cases thousands,
of potential buyers. There is a bright line difference between
responding to a single client's tax inquiry and aggressively
developing and marketing a generic tax shelter product. While
the tax shelter industry of today may have sprung from the
former, it is now clearly driven by the latter.
In order to gain a deeper understanding of the issues, the
Subcommittee conducted four in-depth case studies examining tax
products sold by a leading accounting firm, KPMG, to
individuals or corporations to help them reduce or eliminate
their U.S. taxes. KPMG is one of the largest accounting firms
in the world, and it had built a reputation as a respected
auditor and expert tax advisor. KPMG vigorously denies being a
tax shelter promoter, but the evidence obtained as a result of
the Subcommittee investigation is overwhelming in demonstrating
KPMG's active and, at times, aggressive role in promoting and
profiting from generic tax products sold to individuals and
corporations, including tax products later determined by the
IRS to be potentially abusive or illegal tax shelters.
Earlier this year, KPMG informed the Subcommittee that it
maintained an inventory of over 500 ``active tax products''
designed to be offered to multiple clients for a fee. The four
KPMG case studies featured in this Report are the Bond Linked
Issue Premium Structure (BLIPS), Foreign Leveraged Investment
Program (FLIP), Offshore Portfolio Investment Strategy (OPIS),
and the S-Corporation Charitable Contribution Strategy (SC2).
KPMG sold these four tax products to more than 350 individuals
from 1997 to 2001. All four generated significant fees for the
firm, producing total revenues in excess of $124
million.1 The IRS later determined that three of the
products, BLIPS, FLIP, and OPIS, were potentially abusive or
illegal tax shelters, while the fourth, SC2, is still under
review. As of June 2002, an IRS analysis of just some of the
tax returns associated with BLIPS, FLIP, and OPIS had
identified 186 people who had used BLIPS to claim losses on
their tax returns totaling $4.4 billion, and 57 people who had
used FLIP or OPIS to claim tax losses of $1.4 billion, for a
grand total of $5.8 billion.2 Evidence made
available to the Subcommittee suggests that lost tax revenues
are also significant, including documents which show that, for
169 out of 186 BLIPS participants for which information was
recorded, federal tax revenues were reduced by $1.4 billion.
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\1\ Letter dated 9/12/03, from KPMG's legal counsel, Wilkie Farr &
Gallagher, to the Subcommittee, at 2. According to KPMG information
provided to the Subcommittee in this letter and a letter dated 8/8/03,
FLIP was sold to 80 persons, in 63 transactions, and produced total
gross revenues for the firm of about $17 million over a 4-year period,
1996-1999. OPIS was sold to 111 persons in 79 transactions, and
produced about $28 million over a 2-year period, 1998-1999. BLIPS, the
largest revenue generator, was sold to 186 persons in 186 transactions,
and produced about $53 million over a 1-year period from about October
1999 to about October 2000. SC2 was sold to 58 S corporations in 58
transactions, and produced about $26 million over an 18-month period
from about March 2000 to about September 2001. Other information
presented to the Subcommittee suggests these revenue figures may be
understated and that, for example, BLIPS generated closer to $80
million in fees for the firm, OPIS generated over $50 million, and SC2
over $30 million.
\2\ United States v. KPMG, Case No. 1:02MS00295 (D.D.C. 7/9/02),
``Declaration of Michael A. Halpert,'' Internal Revenue Agent, at para.
37.
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Some members of the U.S. tax profession are apparently
claiming that the worst tax shelter abuses are already over, so
there is no need for investigations, reforms, or stronger laws.
The Subcommittee investigation, however, indicates just the
opposite: while a few tax shelter promoters have ended their
activities, the tax shelter industry as a whole remains active,
developing new products, marketing dubious tax shelters to
numerous individuals and corporations, and continuing to
wrongfully deny the U.S. Treasury billions of dollars in
revenues, leaving average U.S. taxpayers to make up the
difference.
II. Findings
Based upon its investigation to date, the Subcommittee
Minority staff recommends that the Subcommittee make the
following findings of fact.
(1) The sale of potentially abusive and illegal tax
shelters has become a lucrative business in the United
States, and some professional firms such as accounting
firms, banks, investment advisory firms, and law firms
are major participants in the mass marketing of generic
``tax products'' to multiple clients.
(2) Although KPMG denies being a tax shelter
promoter, the evidence establishes that KPMG has
devoted substantial resources to, and obtained
significant fees from, developing, marketing, and
implementing potentially abusive and illegal tax
shelters that U.S. taxpayers might otherwise have been
unable, unlikely or unwilling to employ, costing the
Treasury billions of dollars in lost tax revenues.
(3) KPMG devotes substantial resources and maintains
an extensive infrastructure to produce a continuing
supply of generic tax products to sell to multiple
clients, using a process which pressures its tax
professionals to generate new ideas, move them quickly
through the development process, and approve, at times,
potentially abusive or illegal tax shelters.
(4) KPMG uses aggressive marketing tactics to sell
its generic tax products, including by turning tax
professionals into tax product salespersons, pressuring
its tax professionals to meet revenue targets, using
telemarketing to find clients, using confidential
client tax data to identify potential buyers, targeting
its own audit clients for sales pitches, and using tax
opinion letters and insurance policies as marketing
tools.
(5) KPMG is actively involved in implementing the tax
shelters which it sells to its clients, including by
enlisting participation from banks, investment advisory
firms, and tax exempt organizations; preparing
transactional documents; arranging purported loans;
issuing and arranging opinion letters; providing
administrative services; and preparing tax returns.
(6) Some major banks and investment advisory firms
have provided critical lending or investment services
or participated as essential counter parties in
potentially abusive or illegal tax shelters sold by
KPMG, in return for substantial fees or profits.
(7) Some law firms have provided legal services that
facilitated KPMG's development and sale of potentially
abusive or illegal tax shelters, including by providing
design assistance or collaborating on allegedly
``independent'' opinion letters representing to clients
that a tax product would withstand an IRS challenge, in
return for substantial fees.
(8) Some charitable organizations have participated
as essential counter parties in a highly questionable
tax shelter developed and sold by KPMG, in return for
donations or the promise of future donations.
(9) KPMG has taken steps to conceal its tax shelter
activities from tax authorities and the public,
including by refusing to register potentially abusive
tax shelters with the IRS, restricting file
documentation, and using improper tax return reporting
techniques.
III. Executive Summary
The Subcommittee's investigation into the role of
professional organizations in the tax shelter industry has
identified two fundamental, relatively recent changes in how
the industry operates.
First, the investigation has found that the tax shelter
industry is no longer focused primarily on providing
individualized tax advice to persons who initiate contact with
a tax advisor. Instead, the industry focus has expanded to
developing a steady supply of generic ``tax products'' that can
be aggressively marketed to multiple clients. In short, the tax
shelter industry has moved from providing one-on-one tax advice
in response to tax inquiries to also initiating, designing, and
mass marketing tax shelter products.
Secondly, the investigation has found that numerous
respected members of the American business community are now
heavily involved in the development, marketing, and
implementation of generic tax products whose objective is not
to achieve a business or economic purpose, but to reduce or
eliminate a client's U.S. tax liability. Dubious tax shelter
sales are no longer the province of shady, fly-by-night
companies with limited resources. They are now big business,
assigned to talented professionals at the top of their fields
and able to draw upon the vast resources and reputations of the
country's largest accounting firms, law firms, investment
advisory firms, and banks.
The four case studies featured in this Report examine tax
products developed by KPMG, a respected auditor and tax expert
and one of the top four accounting firms in the United States.
In the latter half of the 1990's, according to KPMG employees
interviewed by Subcommittee staff, KPMG's Tax Services Practice
underwent a fundamental change in direction by embracing the
development of generic tax products and pressing its tax
professionals to sell them. KPMG now maintains an inventory of
more than 500 active tax products and routinely presses its tax
professionals to participate in tax product marketing
campaigns.
Three of the tax products examined by the Subcommittee,
FLIP, OPIS, and BLIPS, are similar in nature. In fact, BLIPS
was developed as a replacement for OPIS which was developed as
a replacement for FLIP.3 All three tax products
function as ``loss generators,'' meaning they generate large
paper losses that the purchaser of the product then uses to
offset other income, and shelter it from taxation.4
All three products have generated hundreds of millions of
dollars in phony paper losses for taxpayers, using a series of
complex, orchestrated transactions involving shell
corporations, structured finance, purported multi-million
dollar loans, and deliberately obscure investments.5
All three also generated substantial fees for KPMG, with BLIPS
and OPIS winning slots among KPMG's top ten revenue producers
in 1999 and 2000, before sales were discontinued. All three tax
products are also covered by the ``listed transactions'' that
the IRS has published and declared to be potentially abusive
tax shelters.6 In all three cases, the IRS has
already begun requiring taxpayers who used these products to
pay back taxes, interest, and penalties. Over a dozen taxpayers
penalized by the IRS for using these tax products have
subsequently filed suit against KPMG for selling them an
illegal tax shelter.7
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\3\ See, e.g., document dated 5/18/01, ``PFP Practice
Reorganization Innovative Strategies Business Plan--DRAFT,'' authored
by Jeffrey Eischeid, Bates KPMG 0050620-23, at 1.
\4\ Id. See also document dated 7/21/99, entitled ``Action
Required,'' authored by Jeffrey Eischeid, Bates KPMG 0006664 (In the
case of BLIPS, ``a key objective is for the tax loss associated with
the investment structure to offset/shelter the taxpayer's other,
unrelated, economic profits.'').
\5\ See Appendix A for a more detailed explanation of BLIPS.
\6\ FLIP and OPIS are covered by IRS Notice 2001-45 (2001-33 IRB
129) (8/13/01); while BLIPS is covered by IRS Notice 2000-44 (2000-36
IRB 255) (9/5/00). See also United States v. KPMG, Case No. 1:02MS00295
(D.D.C. 9/6/02).
\7\ See, e.g., Jacoboni v. KPMG, Case No. 6:02-CV-510 (M.D. Fla. 4/
29/02) (OPIS); Swartz v. KPMG, Case No. C03-1252 (W.D. Wash. 6/6/03)
(BLIPS); Thorpe v. KPMG, Case No. 5-030CV-68 (E.D.N.C. 1/27/03) (FLIP/
OPIS).
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The fourth tax product, SC2, is described by KPMG as a
``charitable contribution strategy.'' 8 It is
directed at individuals who own profitable corporations
organized under Chapter S of the tax code (hereinafter ``S
corporations''), which means that the corporation's income is
attributed directly to the corporate owners and taxable as
personal income. SC2 is intended to generate a tax deductible
charitable donation for the corporate owner and, more
importantly, to defer and reduce taxation of a substantial
portion of the income produced by the S corporation,
essentially by ``allocating'' but not actually distributing
that income to a tax exempt charity holding the corporation's
stock. Like BLIPS, FLIP, and OPIS, SC2 requires a series of
complex, orchestrated transactions to obtain the promised tax
benefits. Among other measures, these transactions involve the
issuance of non-voting stock and warrants, a corporate non-
distribution resolution, and a stock redemption agreement; a
temporary donation of the non-voting stock to a charity; and
various steps to ``allocate'' but not distribute corporate
income to the tax exempt charity.9 Early in its
development, KPMG tax professionals referred to SC2 as ``S-
CAEPS,'' pronounced ``escapes.'' The name was changed after a
senior tax official pointed out: ``I think the last thing we or
a client would want is a letter in the files regarding a tax
planning strategy for which the acronym when pronounced sounds
like we are saying `escapes.' '' 10 In 2000 and
2001, SC2 was one of KPMG's top ten revenue producers. SC2 is
not covered by one of the ``listed transactions'' issued by the
IRS, but is currently undergoing IRS review.11
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\8\ The formal title of the tax product is the S-Corporation
Charitable Contribution Strategy.
\9\ See Appendix B for a more detailed explanation of SC2.
\10\ Email dated 3/24/00, from Mark Springer to multiple KPMG tax
professionals, ``RE: S-corp Product,'' Bates KPMG 0016515. See also
email dated 3/24/00, from Mark Springer to multiple KPMG tax
professionals, ``Re: S-corp Product,'' Bates 0016524 (suggesting
replacing ``all S-CAEPS references with something much more benign'').
\11\ See email dated 4/10/02, from US-Tax Innovation Center to
multiple KPMG tax professionals, ``IRS Summons Information Request for
SC2,'' Bates XX 001433 (``The IRS has requested certain information
from the Firm related to SC2.''); undated KPMG document entitled,
``April 18 IRS Summons Response.''
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Together, these four case histories, BLIPS, FLIP, OPIS, and
SC2, provide an in-depth portrait of how a professional
organization like KPMG, and the professional organizations it
allies itself with, end up developing, marketing, and
implementing highly questionable or illegal tax products. The
evidence also sheds light on the critical roles played by other
professional organizations to make suspect tax products work.
A. Developing New Tax Products
The Subcommittee investigation has found that the tax
product development and approval process used at KPMG was
deeply flawed and led, at times, to the approval of tax
products that the firm knew were potentially abusive or
illegal. Among other problems, the evidence shows that the KPMG
approval process has been driven by market considerations, such
as consideration of a product's revenue potential and ``speed
to market,'' as well as by intense pressure that KPMG
supervisors have placed on subordinates to ``sign-off'' on the
technical merits of a proposed product even in the face of
serious questions about its compliance with the law.
The case of BLIPS illustrates the problems. Evidence
obtained by the Subcommittee discloses an extended, unresolved
debate among KPMG tax professionals over whether BLIPS met the
technical requirements of federal tax law. In 1999, the key
KPMG technical reviewer resisted approving BLIPS for months,
despite repeated expressions of dismay from superiors. He
finally agreed to withdraw his objections to the product in
this email sent to his supervisor: ``I don't like this product
and would prefer not to be associated with it [but] I can
reluctantly live with a more-likely-than-not opinion being
issued for the product.'' This assessment is not exactly the
solid endorsement that might be expected for a tax product sold
by a major accounting firm.
The most senior officials in KPMG's Tax Services Practice
exchanged emails which frankly acknowledged the problems and
reputational risks associated with BLIPS, but nevertheless
supported putting it on the market for sale to clients. One
senior tax professional summed up the pending issues with two
questions:
``(1) Have we drafted the opinion with the appropriate
limiting bells and whistles . . . and (2) Are we being
paid enough to offset the risks of potential litigation
resulting from the transaction? . . . My own
recommendation is that we should be paid a lot of money
here for our opinion since the transaction is clearly
one that the IRS would view as falling squarely within
the tax shelter orbit.''
No one challenged the analysis that the risky nature of the
product justified the firm's charging ``a lot of money'' for a
tax opinion letter predicting it was more likely than not that
BLIPS would withstand an IRS challenge. When the same KPMG
official observed, ``I do believe the time has come to shit and
get off the pot,'' the second in command at the Tax Services
Practice responded, ``I believe the expression is shit OR get
off the pot, and I vote for shit.''
BLIPS, like its predecessors OPIS and FLIP, was sold by
KPMG to numerous clients before the IRS issued notices
declaring them potentially abusive tax shelters that did not
meet the requirements of federal tax law. Other professional
firms have also sold potentially abusive or illegal tax
products such as the Currency Options Brings Reward
Alternatives (COBRA) and Contingent Deferred Swap (CDS) sold by
Ernst & Young, the FLIP tax product and Bond and Option Sales
Strategy (BOSS) sold by PricewaterhouseCoopers, the Customized
Adjustable Rate Debt Facility (CARDS) sold by Deutsche Bank,
the FLIP tax product sold by Wachovia Bank, and the Slapshot
tax product sold by J.P. Morgan Chase.12 The sale of
these abusive tax shelters by other firms clearly demonstrates
that flawed approval procedures are not confined to a single
firm or a single profession. Many other professional firms are
also developing and selling dubious tax products.
---------------------------------------------------------------------------
\12\ Slapshot is an abusive tax shelter that was examined in a
Subcommittee hearing last year. See ``Fishtail, Bacchus, Sundance, and
Slapshot: Four Enron Transactions Funded and Facilitated by U.S.
Financial Institutions,'' S. Prt. 107-82 (107th Congress 1/2/03).
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B. Mass Marketing Tax Products
A second striking aspect of the Subcommittee investigation
was the discovery of the substantial effort KPMG has expended
to market its tax products to potential buyers. The
investigation found that KPMG maintains an extensive marketing
infrastructure to sell its tax products, including a market
research department, a Sales Opportunity Center that works on
tax product ``marketing strategies,'' and even a full-fledged
telemarketing center staffed with people trained to make cold
calls to find buyers for specific tax products. When
investigating SC2, the Subcommittee discovered that KPMG used
its telemarketing center in Fort Wayne, Indiana, to contact
literally thousands of S corporations across the country and
help elevate SC2 to one of KPMG's top ten revenue-producing tax
products.
The evidence also uncovered a corporate culture in KPMG's
Tax Services Practice that condoned placing intense pressure on
the firm's tax professionals--CPAs and lawyers included--to
sell the firm's generic tax products. Numerous internal emails
by senior KPMG tax professionals exhorted colleagues to
increase their sales efforts. One email thanked KPMG tax
professionals for a team effort in developing SC2 and then
instructed these professionals to ``SELL, SELL, SELL!!''
Another email warned KPMG partners: ``Look at the last partner
scorecard. Unlike golf, a low number is not a good thing. . . .
A lot of us need to put more revenue on the board.'' A third
email asked all partners in KPMG's premier technical tax group,
Washington National Tax (WNT), to ``temporarily defer non-
revenue producing activities'' and concentrate for the ``next 5
months'' on meeting WNT's revenue goals for the year. The email
stated: ``Listed below are the tax products identified by the
functional teams as having significant revenue potential over
the next few months. . . . Thanks for help in this critically
important matter. As [the Tax Services Practice second in
command] said, `We are dealing with ruthless execution--hand to
hand combat--blocking and tackling.' Whatever the mixed
metaphor, let's just do it.''
The four case studies featured in this Report provide
detailed evidence of how KPMG pushed its tax professionals to
meet revenue targets, closely monitored their sales efforts,
and even, at times, advised them to use questionable sales
techniques. For example, in the case of SC2, KPMG tax
professionals were directed to contact existing clients about
the product, including KPMG's own audit clients. In a written
document offering sales advice on SC2, KPMG advised its
employees, in some cases, to make misleading statements to
potential buyers, such as claiming that SC2 was no longer
available for sale, even though it was, apparently hoping that
reverse psychology would then cause the client to want to buy
the product. KPMG also utilized confidential and sensitive
client data in an internal database containing information used
by KPMG to prepare client tax returns in order to identify
potential targets for its tax products.
KPMG also used opinion letters and insurance policies as
selling points to try to convince uncertain buyers to purchase
a tax product. For example, KPMG tax professionals were
instructed to tell potential buyers that opinion letters
provided by KPMG and Sidley Austin Brown & Wood would protect
the buyer from certain IRS penalties, if the IRS were later to
invalidate the tax product. In the case of SC2, KPMG tax
professionals were instructed to tell buyers that, ``for a
small premium,'' they could buy an insurance policy from AIG,
Hartford Insurance, or another firm that would reimburse the
buyer for any back taxes or penalties actually assessed by the
IRS for using the tax product. These selling points suggest
KPMG was trying to present its tax products as a risk free
gambit for its clients. They also suggest that KPMG was
pitching its tax products to persons with limited interest in
the products and who likely would not have used them to avoid
paying their taxes, absent urging by KPMG to do so.
C. Implementing Tax Products
Developing and selling a tax product to a client did not,
in many cases, end KPMG's involvement with the product, since
the product often required the purchaser to carry out complex
financial and investment activities in order to realize the
promised tax benefits. In the four cases examined by the
Subcommittee, KPMG enlisted a bevy of other professionals,
including lawyers, bankers, investment advisors and others, to
carry out the required transactions. In the case of SC2, KPMG
actively found and convinced various charitable organizations
to participate. Charities told the Subcommittee staff that KPMG
had contacted the organizations ``out of the blue,'' convinced
them to participate in SC2, facilitated interactions with the
SC2 ``donors,'' and supplied drafts of the transactional
documents.
The Subcommittee investigation found that BLIPS, OPIS,
FLIP, and SC2 could not have been executed without the active
and willing participation of the law firms, banks, investment
advisory firms, and charitable organizations that made these
products work. In the case of BLIPS, OPIS, and FLIP, law firms
and investment advisory firms helped draft complex
transactional documents. Major banks, such as Deutsche Bank,
HVB, UBS, and NatWest, provided purported loans for tens of
millions of dollars essential to the orchestrated transactions.
Wachovia Bank initially provided client referrals to KPMG for
FLIP sales, then later began its own efforts to sell FLIP to
clients. Two investment advisory firms, Quellos Group LLC
(``Quellos'') and Presidio Advisory Services (``Presidio''),
participated directly in the FLIP, OPIS, or BLIPS transactions,
even entering into partnerships with the clients. In the case
of SC2, several pension funds agreed to accept corporate stock
donations and sign redemption agreements to ``sell'' back the
stock to the corporation after a specified period of time. In
all four cases, Sidley Austin Brown & Wood agreed to provide a
legal opinion letter attesting to the validity of the relevant
tax product. Other law firms, such as Sherman and Sterling,
prepared transactional documents and helped carry out specific
transactions. In return, each of the professional firms was
paid lucrative fees.
In the case of BLIPS, documents and interviews showed that
banks and investment advisory firms knew the BLIPS transactions
and ``loans'' were structured in an unusual way, had no
reasonable potential for profit, and were designed instead to
achieve specific tax aims for KPMG clients. For example, the
BLIPS transactions required the bank to lend, on a non-recourse
basis, tens of millions of dollars to a shell corporation with
few assets and no ongoing business, to give the same shell
corporation an unusual ``loan premium'' providing additional
tens of millions of dollars, and to enter into interest rate
swaps that, in effect, reduced the ``loan's'' above-market
interest rate to a much lower floating market rate.
Documents and interviews also disclosed that the funds
``loaned'' by the banks were never really put at risk. The so-
called loan proceeds were instead deemed ``collateral'' for the
``loan'' itself under an ``overcollateralization'' provision
that required the ``borrower'' to place 101% of the loan
proceeds on deposit with the bank. The loan proceeds serving as
cash collateral were then subject to severe investment
restrictions and closely monitored by the bank. The end result
was that only a small portion of the funds in each BLIPS
transaction was ever placed at risk in true investments.
Moreover, the banks were empowered to unilaterally terminate a
BLIPS ``loan'' under a variety of circumstances including, for
example, if the cash collateral were to fall below the 101%
requirement. The banks and investment advisory firms knew that
the BLIPS loan structure and investment restrictions made
little economic sense apart from the client's tax objectives,
which consisted primarily of generating huge paper losses for
KPMG clients who then used those losses to offset other income
and shelter it from taxation.
Documents and interviews showed that the same circumstances
existed for the FLIP and OPIS transactions--banks and
investment advisory firms financed and participated in
structured and tightly controlled financial transactions and
``loans'' primarily designed to generate tax losses on paper
for clients, while protecting bank assets.
A professional organization that knowingly participates in
an abusive tax shelter with no real economic substance violates
the tax code's prohibition against aiding or abetting tax
evasion.13 A related issue is whether and to what
extent lawyers, bankers, investment advisors, tax exempt
organizations, and others have an obligation to evaluate the
transactions they are asked to carry out and refrain from
participating in potentially abusive or illegal tax shelters.
Another issue is whether professional organizations that
participate in these types of transactions qualify as tax
shelter promoters and, if so, are obliged under U.S. law to
register the relevant transactions as tax shelters and maintain
client lists.
---------------------------------------------------------------------------
\13\ 26 U.S.C. 6701.
---------------------------------------------------------------------------
These issues are particularly pressing for several
professional firms involved in the KPMG transactions that may
be tax shelter promoters in their own right. For example,
Sidley Austin Brown & Wood is under investigation by the IRS
for issuing more than 600 legal opinion letters supporting 13
questionable tax products, including BLIPS, FLIP, and
OPIS.14 Deutsche Bank has sponsored a Structured
Transactions Group that, in 1999, offered an array of tax
products to U.S. and European clients seeking to ``execute tax
driven deals'' or ``gain mitigation'' strategies.15
Internal bank documents indicate that Deutsche Bank was
aggressively marketing its tax products to large U.S.
corporations and individuals, and planned to close billions of
dollars worth of transactions.16 At least two of the
tax products being pushed by Deutsche Bank, BLIPS and the
Customized Adjustable Rate Debt Facility (CARDS), were later
determined by the IRS to be potentially abusive tax shelters.
---------------------------------------------------------------------------
\14\ See ``Declaration of Richard E. Bosch,'' IRS Revenue Agent, In
re John Doe Summons to Sidley Austin Brown & Wood (N.D. Ill. 10/16/03).
\15\ Email dated 4/3/02, from Viktoria Antoniades to Brian McGuire
and other Deutsche Bank personnel, ``US GROUP 1 Pres,'' DB BLIPS 6329-
52, attaching a presentation dated 11/15/99, entitled ``Structured
Transactions Group North America,'' at 6336.
\16\ Id. at 6345-46.
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Another set of issues arising from KPMG's enlistment of
other professionals to implement its tax products involves the
role played by tax opinion letters. A tax opinion letter,
sometimes called a legal opinion letter when issued by a law
firm, is intended to provide written advice to a client on
whether a particular tax product is permissible under the law
and, if challenged by the IRS, how likely it would be that the
challenged product would survive court scrutiny. Traditionally,
such opinion letters were supplied by an independent tax expert
with no financial stake in the transaction being evaluated, and
an individualized letter was sent to a single client. The mass
marketing of tax products to multiple clients, however, has
been followed by the mass production of opinion letters by a
professional firm that, for each letter sent to a client, is
paid a handsome fee. The attractive profits available from such
an arrangement have placed new pressure on the independence of
the tax opinion letter provider.
In the four case histories featured in this Report, the
Subcommittee investigation uncovered disturbing evidence
related to how tax opinion letters were being developed and
used in connection with KPMG's tax products. In each of the
four case histories, the Subcommittee investigation found that
KPMG had drafted its own prototype tax opinion letter
supporting the product and used this prototype as a template
for the letters it actually sent to its clients. In addition,
in all four case histories, KPMG arranged for an outside law
firm to provide a second favorable opinion letter. Sidley
Austin Brown & Wood, for example, issued hundreds of opinion
letters supporting BLIPS, FLIP, and OPIS.17 The
evidence indicates that KPMG either directed its clients to
Sidley Austin Brown & Wood to obtain the second opinion letter,
or KPMG itself obtained the client's opinion letter from the
law firm and delivered it to the client, apparently without the
client's actually speaking to any of the lawyers at the firm.
---------------------------------------------------------------------------
\17\ In the case of SC2, KPMG also arranged for Bryan Cave to issue
a legal opinion supporting the tax product, but it is unclear whether
Bryan Cave ever issued one.
---------------------------------------------------------------------------
The evidence raises serious questions about the independent
status of Sidley Austin Brown & Wood in issuing the legal
opinion letters supporting the KPMG tax products. The evidence
indicates, for example, that KPMG collaborated with the law
firm ahead of time to ensure it would supply a favorable
opinion letter. In the case of BLIPS, KPMG and Sidley Austin
Brown & Wood actually exchanged copies of their drafts,
eventually issuing two, allegedly independent opinion letters
that contain numerous, virtually identical paragraphs.
Moreover, Sidley Austin Brown & Wood provided FLIP, OPIS, and
BLIPS clients with nearly identical opinion letters that
included no individualized legal advice. In many cases, the law
firm apparently issued its letter without ever speaking with
the client to whom the tax advice was directed. By routinely
directing its clients to Sidley Austin Brown & Wood to obtain a
second opinion letter, KPMG produced a steady stream of income
for the law firm, further undermining its independent status.
One document even indicates that Sidley Austin Brown & Wood was
paid a fee in every case in which a client was told during a
FLIP sales pitch about the availability of a second opinion
letter from an outside law firm, whether or not the client
actually purchased the letter. This type of close, ongoing, and
lucrative collaboration raises serious questions about the
independence of both parties and the value of their opinion
letters in light of the financial stake that both firms had in
the sale of the tax product being analyzed.
A second set of issues related to the tax opinion letters
involves the accuracy and reliability of their factual
representations. The tax opinion letters prepared by KPMG and
Sidley Austin Brown & Wood in BLIPS, FLIP, and OPIS typically
included a set of factual representations made by the client,
KPMG, the participating investment advisory firm, and the
participating bank. These representations were critical to the
accounting firm's analysis upholding the validity of the tax
product. In all three cases, the Subcommittee investigation
discovered that KPMG had itself drafted the factual
representations attributed to other parties. The evidence shows
that prior to attributing factual representations to other
professional firms involved in the transactions, KPMG presented
draft statements to the parties beforehand and negotiated the
wording. But in the case of the factual representations
attributed to its client, the evidence indicates KPMG did not
consult with the client beforehand and, in some cases, even
refused, despite client objections, to allow the client to
alter the KPMG-drafted representations.
Equally disturbing is that some of the key factual
representations that KPMG made or attributed to its clients
appear to contain false or misleading statements. For example,
KPMG wrote in the prototype BLIPS opinion letter that the
client ``has represented to KPMG . . . [that the client]
independently reviewed the economics underlying the [BLIPS]
Investment Fund before entering into the program and believed
there was a reasonable opportunity to earn a reasonable pre-tax
profit from the transactions.'' In fact, it is doubtful that
many BLIPS clients ``independently reviewed'' or understood the
complicated BLIPS transactions or the ``economics'' underlying
them. In addition, KPMG knew there was only a remote
possibility--not a reasonable possibility--of a client's
earning a pre-tax profit in BLIPS. Nevertheless, since the
existence of a reasonable opportunity to earn a reasonable
profit was central to BLIPS' having economic substance and
complying with federal tax law, KPMG included the client
representation in its BLIPS tax opinion letter.
D. Avoiding Detection
In addition to the many development, marketing, and
implementation problems just described, the Subcommittee
investigation uncovered disturbing evidence of measures taken
by KPMG to hide its tax product activities from the IRS and the
public. Despite its 500 active tax product inventory, KPMG has
never registered, and thereby disclosed to the IRS the
existence of, a single one of its tax products. KPMG has
explained this failure by claiming that it is not a tax
promoter and does not sell any tax products that have to be
registered under the law. The evidence suggests, however, that
KPMG's failure to register may not be attributable to a good
faith analysis of the technical merits of the tax products.
Five years ago, in 1998, a senior KPMG tax professional
advocated in very explicit terms that, for business reasons,
KPMG ought to ignore federal tax shelter requirements and not
register the OPIS tax product with the IRS, even if required by
law. In an email sent to several senior colleagues, this KPMG
tax professional explained his reasoning. In that email, he
assumed that OPIS qualified as a tax shelter, and then
explained why the firm should not, even in this case, register
it with the IRS as required by law. Among other reasons, he
observed that the IRS was not vigorously enforcing the
registration requirement, the penalties for noncompliance were
much less than the potential profits from selling the tax
product, and ``industry norms'' were not to register any tax
products at all. The KPMG tax professional coldly calculated
the penalties for noncompliance compared to potential fees from
selling OPIS: ``Based upon our analysis of the applicable
penalty sections, we conclude that the penalties would be no
greater than $14,000 per $100,000 in KPMG fees. . . . For
example, our average [OPIS] deal would result in KPMG fees of
$360,000 with a maximum penalty exposure of only $31,000.'' The
senior tax professional also warned that if KPMG were to comply
with the tax shelter registration requirement, this action
would place the firm at such a competitive disadvantage in its
sales that KPMG would ``not be able to compete in the tax
advantaged products market.'' In short, he urged KPMG to
knowingly, purposefully, and willfully violate the federal tax
shelter law.
The evidence obtained by the Subcommittee indicates that,
over the following 5 years, KPMG rejected several internal
recommendations by tax professionals to register a tax product
as a tax shelter with the IRS. For example, the Subcommittee
investigation learned that, on at least two occasions, the head
of KPMG's Department of Professional Practice, a very senior
tax official, had recommended that BLIPS and OPIS be registered
as tax shelters, only to be overruled each time by the head of
the entire Tax Services Practice.
Instead of registering tax products with the IRS, KPMG
instead apparently devoted resources to devising rationales for
not registering them. For example, a fiscal year 2002 draft
business plan for a KPMG tax group described two tax products
that were under development, but not yet approved, in part due
to tax shelter registration issues. With respect to the first
product, POPS, the business plan stated: ``We have completed
the solution's technical review and have almost finalized the
rationale for not registering POPS as a tax shelter.'' With
respect to the second product, described as a ``conversion
transaction . . . that halves the taxpayer's effective tax rate
by effectively converting ordinary income to long term capital
gain,'' the business plan states: ``The most significant open
issue is tax shelter registration and the impact registration
will have on the solution.''
KPMG's concealment efforts did not stop with its years-long
refusal to register any tax shelter with the IRS. KPMG also
appears to have used improper reporting techniques on client
tax returns to minimize the return information that could alert
the IRS to the existence of its tax products. For example, in
the case of OPIS and BLIPS, some KPMG tax professionals advised
their clients to participate in the transactions through
``grantor trusts'' and then file tax returns in which all of
the capital gains and losses from the transactions were
``netted'' at the grantor trust level, instead of each gain or
loss being reported individually on the return. The intended
result was that only a single, small net capital gain or loss
would appear on the client's personal income tax return.
A key KPMG tax expert objected to this netting approach
when it was first suggested within the firm in 1998, writing to
his colleagues in one email: ``When you put the OPIS
transaction together with this `stealth' reporting approach,
the whole thing stinks.'' He wrote in a separate email: ``You
should all know that I do not agree with the conclusion . . .
that capital gains can be netted at the trust level. I believe
we are filing misleading, and perhaps false, returns by taking
this reporting position.'' Despite these strongly worded emails
from the KPMG tax professional with authority over this tax
return issue, several KPMG tax professionals apparently went
ahead and prepared client tax returns using grantor trust
netting. In September 2000, in the same notice that declared
BLIPS to be a potentially abusive tax shelter, the IRS
explicitly warned against grantor trust netting: ``In addition
to other penalties, any person who willfully conceals the
amount of capital gains and losses in this manner, or who
willfully counsels or advises such concealment, may be guilty
of a criminal offense.'' In response, KPMG apparently contacted
some OPIS or BLIPS clients and advised them to re-file their
returns.
KPMG used a variety of tax return reporting techniques in
addition to grantor trust netting to avoid detection of its
activities by the IRS. In addition, in the four cases examined
by the Subcommittee, KPMG required some potential purchasers of
the tax products to sign ``nondisclosure agreements'' and
severely limited the paperwork used to explain the tax
products. Client presentations were done on chalkboards or
erasable whiteboards, and written materials were retrieved from
clients before leaving a meeting. Another measure taken by
senior KPMG tax professionals was to counsel staff not to keep
certain revealing documentation in their files or to clean out
their files, again, to limit detection of firm activity. Still
another tactic discussed in several KPMG documents was
explicitly using attorney-client or other legal privileges to
limit disclosure of KPMG documents. For example, one
handwritten document by a KPMG tax professional discussing OPIS
issues states under the heading, ``Brown & Wood'': ``Privilege
B&W can play a big role at providing protection in this area.''
None of these actions to conceal its activities seems
consistent with what should be the practices of a leading
public accounting firm.
E. Disregarding Professional Ethics
In addition to all the other problems identified in the
Subcommittee investigation, troubling evidence emerged
regarding how KPMG handled certain professional ethics issues,
including issues related to fees and auditor independence. The
fees charged to KPMG clients raise several concerns. Some
appear to be ``contingency fees,'' meaning fees which are paid
only if a client obtains specified results from the services
offered, such as achieving specified tax savings. More than 20
states prohibit the payment of contingency fees to accountants,
and SEC, AICPA, and other rules constrain their use in various
ways. Internal KPMG documents suggest that, in at least some
cases, KPMG deliberately manipulated the way it handled certain
tax products to circumvent contingency fee prohibitions. A
document discussing OPIS fees, for instance, identifies the
states that prohibit contingency fees and, then, rather than
prohibit OPIS transactions in those states or require an
alternative fee structure, directs KPMG tax professionals to
make sure the OPIS engagement letter is signed, the engagement
is managed, and the bulk of services is performed ``in a
jurisdiction that does not prohibit contingency fees.''
In the case of BLIPS, clients were charged a single fee
equal to 7% of the ``tax losses'' to be generated by the BLIPS
transactions. The client fee was typically paid to Presidio, an
investment advisory firm, which then apportioned the fee amount
among various firms according to certain factors. The fee
recipients typically included KPMG, Presidio, a participating
bank, and Sidley Austin Brown & Wood. This fee splitting
arrangement may violate restrictions on contingency fees,
client referral fees, and fees paid jointly to lawyers and non-
lawyers.
KPMG's tax products also raise auditor independence issues.
Three of the banks involved in BLIPS, FLIP, and OPIS (Deutsche
Bank, HVB, and Wachovia Bank), employ KPMG to audit their
financial statements. SEC rules state that auditor independence
is impaired when an auditor has a direct or material indirect
business relationship with an audit client. KPMG apparently
attempted to address the auditor independence issue by giving
its clients a choice of banks to use in the transactions,
including at least one bank that was not a KPMG audit client.
It is unclear, however, whether individuals actually could
choose what bank to use. Moreover, it is unclear how providing
clients with a choice of banks alleviated KPMG's conflict of
interest, since it still had a direct or material, indirect
business relationship with a bank whose financial statements
were certified by KPMG auditors.
A second set of auditor independence issues involves KPMG's
decision to market tax products to its own audit clients. By
engaging in this marketing tactic, KPMG not only took advantage
of its auditor-client relationship, but also created a conflict
of interest in those cases where it successfully sold a tax
product to an audit client. The conflict of interest arises
when the KPMG auditor reviewing the client's financial
statements is required, as part of that review, to examine the
client's tax return and its use of unusual tax strategies. In
such situations, KPMG is, in effect, auditing its own work.
A third set of professional ethics issues involves conflict
of interest concerns related to the legal representation of
clients who, after purchasing a tax product from KPMG, have
come under IRS scrutiny. The issues include whether KPMG should
be referring these clients to a law firm that represents KPMG
itself on unrelated matters, and whether a law firm that has a
longstanding, close, and ongoing relationship with KPMG,
representing it on unrelated matters, should also represent
KPMG clients. While KPMG and the client have an immediate joint
interest in defending the tax product that KPMG sold and the
client purchased, their interests could quickly diverge if the
suspect tax product is found to be in violation of federal tax
law. This divergence in interests has been demonstrated
repeatedly since 2002, as growing numbers of KPMG clients have
filed suit against KPMG seeking a refund of past fees they paid
to the firm and additional damages for KPMG's selling them an
illegal tax shelter.
The following pages provide more detailed information about
these and other problems uncovered during the Subcommittee
investigation into the role of professional firms in the tax
shelter industry.
The tax products featured in this Report were developed,
marketed, and executed by highly skilled professionals in the
fields of accounting, law, and finance. Historically, such
professionals have been distinguished by their obligation to
meet a higher standard of conduct in business than ordinary
occupations. When it came to decisions by these professionals
on whether to approve a questionable tax product, employ
telemarketers to sell tax services, or omit required
information from a tax return, one might have expected a
thoughtful discussion or analysis of the firm's fiduciary
duties, its ethical and professional obligations, or what
should be done to protect the firm's good name. Unfortunately,
evidence of those thoughtful discussions was virtually non-
existent, and considerations of professionalism seem to have
had little, if any, effect on KPMG's mass marketing of its tax
products.
IV. Recommendations
Based upon its investigation to date and the above
findings, the Subcommittee Minority staff recommends that the
Subcommittee make the following policy recommendations.
(1) Congress should enact legislation to increase
penalties on promoters of potentially abusive and
illegal tax shelters, clarify and strengthen the
economic substance doctrine, and bar auditors from
providing tax shelter services to their audit clients.
(2) Congress should increase funding of IRS
enforcement efforts to stop potentially abusive and
illegal tax shelters, and the IRS should dramatically
increase its enforcement efforts against tax shelter
promoters.
(3) The IRS and PCAOB should conduct a joint review of
tax shelter activities by accounting firms, and take
steps to clarify and strengthen federal and private
sector procedures and prohibitions to prevent
accounting firms from aiding or abetting tax evasion,
promoting potentially abusive or illegal tax shelters,
or engaging in related unethical or illegal conduct.
The PCAOB should consider banning public accounting
firms from providing tax shelter services to their
audit clients and others.
(4) The IRS and federal bank regulators should conduct
a joint review of tax shelter activities at major
banks, clarify and strengthen bank procedures and
prohibitions to prevent banks from aiding or abetting
tax evasion, promoting potentially abusive or illegal
tax shelters, or engaging in related unethical or
illegal conduct.
(5) The U.S. Department of Justice and IRS should
conduct a joint review of tax shelter activities at
major law firms, and take steps to clarify and
strengthen federal and private sector rules to prevent
law firms from aiding or abetting tax evasion,
promoting potentially abusive or illegal tax shelters,
or engaging in related unethical or illegal conduct.
The U.S. Treasury Department should clarify and
strengthen professional standards of conduct and
opinion letter requirements in Circular 230 and
explicitly address tax shelter issues.
(6) Federal and private sector regulators should
clarify and strengthen federal and private sector rules
related to opinion letters advising on tax products,
including setting standards for letters related to mass
marketed tax products, requiring fair and accurate
factual representations, and barring collaboration
between a tax product promoter and a firm preparing an
allegedly independent opinion letter.
(7) The American Institute of Certified Public
Accountants (AICPA), American Bar Association, and
American Bankers Association should establish standards
of conduct and procedures to prevent members of their
professions from aiding or abetting tax evasion,
promoting abusive or illegal tax shelters, or engaging
in related unethical or illegal conduct, including by
requiring a due diligence review of any tax-related
transaction in which a member is asked to participate.
Tax exempt organizations should adopt similar standards
of conduct and procedures.
(8) The AICPA, American Bar Association, and American
Bankers Association should strengthen professional
standards of conduct and ethics requirements to stop
the development and mass marketing of tax products
designed to reduce or eliminate a client's tax
liability, and should prohibit their members from using
aggressive sales tactics to market tax products,
including by prohibiting use of cold calls and
telemarketing, explicit revenue goals, and fees
contingent on projected tax savings.
(9) The AICPA and American Bar Association should
strengthen professional standards of conduct and ethics
requirements to prohibit the issuance of an opinion
letter on a tax product when the independence of the
author has been compromised by providing accounting,
legal, design, sales, or implementation assistance
related to the product, by having a financial stake in
the tax product, or by having a financial stake in a
related or similar tax product.
V. Overview of U.S. Tax Shelter Industry
A. Summary of Current Law on Tax Shelters
The definition of an abusive tax shelter has changed and
expanded over time to encompass a wide variety of illegal or
potentially illegal tax evasion schemes. Existing legal
definitions are complex and appear in multiple sections of the
tax code.18 These tax shelter definitions refer to
transactions, partnerships, entities, investments, plans, or
arrangements which have been devised, in whole or significant
part, to enable taxpayers to eliminate or understate their tax
liability. The General Accounting Office (GAO) recently
summarized these definitions by describing ``abusive shelters''
as ``very complicated transactions promoted to corporations and
wealthy individuals to exploit tax loopholes and provide large,
unintended tax benefits.'' 19
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\18\ See, e.g., 26 U.S.C. Sec. Sec. 461(i)(3) (defining tax shelter
for certain tax accounting rules); 6111(a), (c) and (d) (defining tax
shelter for certain registration and disclosure requirements); and
6662(d)(2)(C)(iii) (defining tax shelter for application of
understatement penalty).
\19\ ``Challenges Remain in Combating Abusive Tax Shelters,''
testimony by Michael Brostek, Director, Tax Issues, GAO, before the
U.S. Senate Committee on Finance, No. GAO-04-104T (10/21/03)
(hereinafter ``GAO Testimony'') at 1.
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Over the past 10 years, Federal statutes and regulations
prohibiting illegal tax shelters have undergone repeated
revision to clarify and strengthen them. Today, key tax code
provisions not only prohibit tax evasion by taxpayers, but also
penalize persons who knowingly organize or promote illegal tax
shelters 20 or who knowingly aid or abet the filing
of tax return information that understates a taxpayer's tax
liability.21 Additional tax code provisions now
require taxpayers and promoters to disclose to the IRS
information about certain potentially illegal tax
shelters.22
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\20\ 26 U.S.C. Sec. 6700.
\21\ 26 U.S.C. Sec. 6701.
\22\ See, e.g., 26 U.S.C. Sec. Sec. 6011 (taxpayer must disclose
reportable transactions); 6111 (organizers and promoters must register
potentially illegal tax shelters with IRS), 6112 (promoters must
maintain lists of clients who purchase potentially illegal tax shelters
and, upon request, disclose such client lists to the IRS).
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Recently, the IRS issued regulations to clarify and
strengthen the law's definition of a tax shelter promoter and
the law's requirements for tax shelter disclosure.23
For example, these regulations now make it clear that tax
shelter promoters include ``persons principally responsible for
organizing a tax shelter as well as persons who participate in
the organization, management or sale of a tax shelter'' and any
person who is a ``material advisor'' on a tax shelter
transaction.24 Disclosure obligations, which apply
to both taxpayers and tax shelter promoters, require disclosure
to the IRS, under certain circumstances, of information related
to six categories of potentially illegal tax shelter
transactions. Among others, these disclosures include any
transaction that is the same or similar to a ``listed
transaction,'' which is a transaction that the IRS has formally
determined, through regulation, notice, or other published
guidance, ``as having a potential for tax avoidance or
evasion'' and is subject to the law's registration and client
list maintenance requirements.25 The IRS has stated
in court that it ``considers a `listed transaction' and all
substantially similar transactions to have been structured for
a significant tax avoidance purpose'' and refers to them as
``potentially abusive tax shelters.'' 26 The IRS has
also stated in court that ``the IRS has concluded that
taxpayers who engaged in such [listed] transactions have failed
or may fail to comply with the internal revenue laws.''
27 As of October 2003, the IRS had published 27
listed transactions.
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\23\ See, e.g., Treas. Reg. Sec. 301.6112-1 and Sec. 1.6011-4,
which took effect on 2/28/03.
\24\ Petition dated 10/14/03, ``United States' Ex Parte Petition
for Leave to Serve IRS `John Doe' Summons on Sidley Austin Brown &
Wood,'' (D.N.D. Ill.), at para. 8.
\25\ Id. at para. 11. See also ``Background and Present Law
Relating to Tax Shelters,'' Joint Committee on Taxation (JCX-19-02), 3/
19/02 (hereinafter ``Joint Committee on Taxation report''), at 33; GAO
Testimony at 7. The other five categories of transactions subject to
disclosure are transactions offered under conditions of
confidentiality, including contractual protections to the ``investor'',
resulting in specific amounts of tax losses, generating a tax benefit
when the underlying asset is held only briefly, or generating
differences between financial accounts and tax accounts greater than
$10 million. GAO Testimony at 7.
\26\ Petition dated 10/14/03, ``United States' Ex Parte Petition
for Leave to Serve IRS `John Doe' Summons on Sidley Austin Brown &
Wood,'' (D.N.D. Ill.), at para.para. 11-12.
\27\ Id. at para. 16.
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In addition to statutory and regulatory requirements and
prohibitions, federal courts have developed over the years a
number of common law doctrines to identify and invalidate
illegal tax shelters, including the economic
substance,28 business purpose,29
substance-over-form,30 step
transaction,31 and sham transaction 32
doctrines. A study by the Joint Committee on Taxation concludes
that ``[t]hese doctrines are not entirely distinguishable'' and
have been applied by courts in inconsistent ways.33
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\28\ See, e.g., Gregory v. Helvering, 293 U.S. 465 (1935); ACM
Partnership v. Commissioner, 157 F.3d 231 (3d Cir. 1998), cert. denied
526 U.S. 1017 (1999); Bail Bonds by Marvin Nelson, Inc. v.
Commissioner, 820 F.2d 1543, 1549 (9th Cir. 1987) (``The economic
substance factor involves a broader examination of . . . whether from
an objective standpoint the transaction was likely to produce economic
benefits aside from a tax deduction.'').
\29\ See, e.g., Gregory v. Helvering, 293 U.S. 465 (1935);
Commissioner v. Transport Trading & Terminal Corp., 176 F.2d 570, 572
(2nd Cir. 1949), cert. denied 339 U.S. 916 (1949) (Judge Learned Hand)
(``The doctrine of Gregory v. Helvering . . . means that in construing
words of a tax statute which describe commercial or industrial
transactions we are to understand them to refer to transactions entered
upon for commercial or industrial purposes and not to include
transactions entered upon for no other motive but to escape
taxation.'')
\30\ See, e.g., Weiss v. Stearn, 265 U.S. 242, 254 (1924)
(``Questions of taxation must be determined by viewing what was
actually done, rather than the declared purpose of the participants;
and when applying the provisions of the Sixteenth Amendment and income
laws . . . we must regard matters of substance and not mere form.'')
\31\ See, e.g., Commissioner v. Court Holding Co., 324 U.S. 331,
334 (1945) (``The transaction must be viewed as a whole, and each step,
from the commencement of negotiations to the consummation of the sale,
is relevant. A sale by one person cannot be transformed for tax
purposes into a sale by another using the latter as a conduit through
which to pass title.''); Palmer v. Commissioner, 62 T.C. 684, 692
(1974).
\32\ See, e.g., Gregory v. Helvering, 293 U.S. 465 (1935); Rice's
Toyota World v. Commissioner, 752 F.2d 89, 91-92 (4th Cir. 1985);
United Parcel Service of America, Inc. v. Commissioner, 78 T.C.M. 262
at n. 29 (1999), rev'd 254 F.3d 1014 (11th Cir. 2001) (``Courts have
recognized two basic types of sham transactions. Shams in fact are
transactions that never occur. In such shams, taxpayers claim
deductions for transactions that have been created on paper but which
never took place. Shams in substance are transactions that actually
occurred but which lack the substance their form represents.'').
\33\ Joint Committee on Taxation report at 7.
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Bipartisan legislation to clarify and strengthen the
economic substance and business purpose doctrines, as well as
other aspects of federal tax shelter law, has been developed by
the Senate Finance Committee. This legislation has been twice
approved by the Senate during the 108th Congress, but has yet
to become law.34
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\34\ See, e.g., S. 476, the CARE Act of 2003 (108th Congress, first
session), section 701 et seq.
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B. U.S. Tax Shelter Industry and Professional Organizations
LFinding: The sale of potentially abusive and illegal
tax shelters has become a lucrative business in the
United States, and some professional firms such as
accounting firms, banks, investment advisory firms, and
law firms are major participants in the mass marketing
of generic ``tax products'' to multiple clients.
Illegal tax shelters sold to corporations and wealthy
individuals drain the U.S. Treasury of billions of dollars in
lost tax revenues each year. According to GAO, a recent IRS
consultant estimated that for the 6-year period, 1993-1999, the
IRS lost on average between $11 and $15 billion each year from
abusive tax shelters.35 In actual cases closed
between October 1, 2001, and May 6, 2003, involving just 42
large corporations, GAO reports that the IRS proposed abusive
shelter-related adjustments for tax years, 1992 to 2000,
totaling more than $10.5 billion.36 GAO reports that
an IRS database tracking unresolved, abusive tax shelter cases
over a number of years estimates potential tax losses of about
$33 billion from listed transactions and another $52 billion
from nonlisted abusive transactions, for a combined total of
$85 billion.37
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\35\ GAO Testimony at 12.
\36\ Id. at 11.
\37\ Id. at 10.
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GAO has also reported that IRS data provided in October
2003, identified about 6,400 individuals and corporations that
had bought abusive tax shelters and other abusive tax planning
products, as well as almost 300 firms that appear to have
promoted them.38 According to GAO, as of June 2003,
the IRS had approved investigations of 98 tax shelter
promoters, including some directed at accounting or law
firms.39
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\38\ Id. at 11.
\39\ Id. at 16.
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IRS Commissioner Mark Everson testified at a recent Senate
Finance Committee hearing that: ``A significant priority in the
Service's efforts to curb abusive transactions is our focus on
promoters.'' 40 He stated, ``The IRS has focused its
attention in the area of tax shelters on accounting and law
firms, among others. The IRS has focused on these firms because
it believes that, in the instances in which the IRS has acted,
these firms were acting as promoters of tax shelters, and not
simply as tax or legal advisers.''
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\40\ Testimony of Mark Everson, IRS Commissioner, before the Senate
Committee on Finance, ``Tax Shelters: Who's Buying, Who's Selling and
What's the Government Doing About It?'' (10/21/03), at 7.
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Mr. Everson also described the latest generation of abusive
tax shelters as complex, difficult-to-detect transactions
developed by extremely sophisticated people:
``The latest generation of abusive tax transactions has
been facilitated by the growth of financial products
and structures whose own complexity and non-
transparency have provided additional tools to allow
those willing to design transactions intended to
generate unwarranted tax benefits. . . . [A]busive
transactions that are used by corporations and
individuals present formidable administrative
challenges. The transactions themselves can be
creative, complex and difficult to detect. Their
creators are often extremely sophisticated, as are many
of their users, who are often financially prepared and
motivated to contest the Service's challenges.''
41
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\41\ Id. at 2.
The Commissioner stated that due to the ``growth in the
volume of abusive transactions'' and ``a disturbing decline in
corporate conduct and governance,'' among other factors, the
IRS has enhanced its response to abusive transactions in
general, and abusive tax shelters in particular.42
He said that the Office of Tax Shelter Analysis (OTSA), first
established in February 2000 within the Large and Mid-Size
Business Division, is continuing to lead IRS tax shelter
efforts. He stated that, ``OTSA plans, centralizes and
coordinates LMSB's tax shelter operations and collects,
analyzes, and distributes within the IRS information about
potentially abusive tax shelter activity.'' 43 Mr.
Everson described a number of ongoing IRS tax shelter
initiatives including efforts to increase enforcement
resources, conduct promoter audits, enforce IRS document
requests against accounting and law firms, implement global
settlements for persons who used certain illegal tax shelters,
develop proposed regulations to improve tax opinion letters and
ethics rules for tax professionals appearing before the IRS,
and issue additional notices to identify illegal tax shelters.
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\42\ Id. at 3.
\43\ Id. at 8.
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The Commissioner warned:
``[A]busive transactions can and will continue to pose
a threat to the integrity of our tax administration
system. We cannot afford to tolerate those who
willfully promote or participate in abusive
transactions. The stakes are too high and the effects
of an insufficient response are too corrosive.''
44
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\44\ Id. at 16.
Professional organizations like accounting firms, banks,
investment advisers, and law firms are now key participants in
the tax shelter industry. These firms specialize in producing
tax shelters that utilize complex structured finance
transactions, multi-million dollar loans, novel tax code
interpretations, and expensive professional services requiring
highly skilled professionals. These firms routinely enlist
assistance from other respected professional firms and
financial institutions to provide the accounting, investment,
financing or legal services needed for the tax shelters to
work.
During the past 10 years, professional firms active in the
tax shelter industry have expanded their role, moving from
selling individualized tax shelters to specific clients, to
developing generic tax products and mass marketing them to
existing and potential clients. No longer content with
responding to client inquiries, these firms are employing the
same tactics employed by disreputable, tax shelter hucksters:
churning out a continuing supply of new and abusive tax
products, marketing them with hard sell techniques and cold
calls; and taking deliberate measures to hide their activities
from the IRS.
VI. Four KPMG Case Histories
A. KPMG In General
KPMG International is one of the largest public accounting
firms in the world, with over 700 offices in 152
countries.45 In 2002, it employed over 100,000
people and had worldwide revenues of $10.7 billion. KPMG
International is organized as a Swiss ``non-operating
association,'' functions as a federation of partnerships around
the globe, and maintains its headquarters in Amsterdam.
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\45\ The general information about KPMG is drawn from KPMG
documents produced in connection with the Subcommittee investigation;
Internet websites maintained by KPMG LLP and KPMG International; and a
legal complaint filed by the U.S. Securities and Exchange Commission
(SEC) in SEC v. KPMG LLP, Civil Action No. 03-CV-0671 (D.S.D.N.Y. 1/29/
03), alleging fraudulent conduct by KPMG and certain KPMG audit
partners in connection with audits of certain Xerox Corporation
financial statements.
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KPMG LLP (hereinafter ``KPMG'') is a U.S. limited liability
partnership and a member of KPMG International. KPMG is the
third largest accounting firm in the United States, and
generates more than $4 billion in annual revenues. KPMG was
formed in 1987, from the merger of two long-standing accounting
firms, Peat Marwick and Klynveld Main Goerdeler, along with
their individual member firms. KPMG maintains its headquarters
in New York and numerous offices in the United States and other
countries. KPMG is run by a ``Management Committee'' made up of
15 individuals drawn from the firm's senior management and
major divisions.46 KPMG's Chairman and CEO is Eugene
O'Kelly, who joined KPMG in 1972, became partner in 1982, and
was appointed Chairman in 2002. KPMG's Deputy Chairman is
Jeffrey M. Stein, who was also appointed in 2002. From 2000
until 2002, Mr. Stein was the Vice Chairman for Tax heading
KPMG's Tax Services Practice, and prior to that he served as
head of operations, or second in command, of the Tax Services
Practice.
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\46\ The 15 Management Committee members are the Chairman, Deputy
Chairman, Chief Financial Officer, General Counsel, head of the
Department of Professional Practice, head of the Department of
Marketing and Communications, head of the Department of Human
Resources, the two most senior officials in the Tax Services Practice,
the two most senior officials in the Assurance Practice, and the most
senior official in each of four industry-related ``lines of business,''
such as telecommunications and energy. Subcommittee interview of
Jeffrey Stein (10/31/03).
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KPMG's Tax Services Practice is a major division of KPMG.
It provides tax compliance, tax planning, and tax return
preparation services. The Tax Services Practice employs more
than 10,300 tax professionals and generates approximately $1.2
billion in annual revenues for the firm. These revenues have
been increasing rapidly in recent years, including a 45%
cumulative increase over 4 years, from 1998 to
2001.47 The Tax Services Practice is headquartered
in New York, has 122 U.S. offices, and maintains additional
offices around the world. The current head of the Tax Service
is Vice Chairman for Tax, Richard Smith.
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\47\ Internal KPMG presentation dated 7/19/01, by Rick Rosenthal
and Marsha Peters, entitled ``Innovative Tax Solutions,'' Bates XX
001340-50. A chart included in this presentation tracks increases in
the Tax Service's gross revenues from 1998 until 2001, showing a
cumulative increase of more than 45% over the 4-year period, from 1998
gross revenues of $830 million to 2001 gross revenues of $1.24 billion.
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The Tax Services Practice has over two dozen subdivisions,
offices, ``practices'' or ``groups'' which over the years have
changed missions and personnel. Many have played key roles in
developing, marketing, or implementing KPMG's generic tax
products, including the four products featured in this Report.
One key group is the Washington National Tax Practice (WNT)
which provides technical tax expertise to the entire KPMG firm.
A WNT subgroup, The Tax Innovation Center, leads KPMG's efforts
to develop new generic tax products. Another key group is the
Department of Professional Practice (DPP) for Tax, which, among
other tasks, reviews and approves all new KPMG tax products for
sale to clients. KPMG's Federal Tax Practice addresses federal
tax compliance and planning issues. KPMG's Personal Financial
Planning (PFP) Practice focuses on selling ``tax-advantaged''
products to high net worth individuals and large
corporations.48 Through a subdivision known as the
Capital Transaction Services (CaTS) Practice, later renamed the
Innovative Strategies (IS) Practice, PFP led KPMG's efforts on
FLIP, OPIS, and BLIPS.49 KPMG's Stratecon Practice,
which focuses on ``business based'' tax planning and tax
products, led the firm's efforts on SC2. Innovative Strategies
and Stratecon were disbanded in 2002, and their tax
professionals assigned to other groups.50
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\48\ Minutes dated 11/30/00, Monetization Solutions Task Force
Teleconference, Bates KPMG 0050624-29, at 50625.
\49\ Document dated 5/18/01, ``PFP Practice Reorganization
Innovative Strategies Business Plan--DRAFT,'' Bates KPMG 0050620-23, at
1.
\50\ Stratecon appears to have been very active until its
dissolution. See, e.g., email dated 4/8/02, from Larry Manth to
multiple KPMG tax professionals, ``Stratecon Final Results for March
2002,'' Bates XX 001732 (depicting Stratecon's March 2002 revenues and
operating expenses).
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Several senior KPMG tax professionals interviewed by the
Subcommittee staff, when asked to describe KPMG's overall
approach to tax services, indicated that the firm made a
significant change in direction in the late 1990's, when it
made a formal decision to begin devoting substantial resources
to developing and marketing tax products that could be sold to
multiple clients. The Subcommittee staff was told that KPMG
made this decision, in part, due to the success other
accounting firms were experiencing in selling tax products; in
part, due to the large revenues earned by the firm from selling
a particular tax product to banks; 51 and, in part,
due to new tax leadership that was enthusiastic about
increasing tax product sales. Among other actions to carry out
this decision, the firm established the Tax Innovation Center
which was dedicated to generating new generic tax products. One
senior KPMG tax professional told the Subcommittee staff that
some KPMG partners considered it ``important'' for the firm to
become an industry leader in producing generic tax products. He
said that, of the many new products KPMG developed, some were
``relatively plain vanilla,'' while others were ``aggressive.''
He said that the firm's policy was to offer only tax products
which met a ``more likely than not'' standard, meaning the
product had a greater than 50 percent probability of
withstanding a challenge by the IRS, and that KPMG deliberately
chose a higher standard than required by the AICPA, which
permits firms to offer tax products with a ``realistic
possibility of success,'' or a one-in-three chance of
withstanding an IRS challenge.52
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\51\ For information about this tax product, see Appendix C, ``Sham
Mutual Fund Investigation.''
\52\ KPMG's policy is included in the KPMG Tax Services Manual--
U.S., May 2002, KPMG Accounting & Reporting Publication, (hereinafter
``KPMG Tax Services Manual''), Sec. 24.5.2, at 24-3.
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In recent years, KPMG has become the subject of IRS, SEC,
and state investigations and enforcement actions in the areas
of tax, accounting fraud, and auditor
independence.53 These enforcement actions include
ongoing litigation by the IRS to enforce tax shelter related
document requests and a tax promoter audit of the firm; SEC,
California, and New York investigations into a potentially
abusive tax shelter involving at least 10 banks that are
allegedly using sham mutual funds established on KPMG's advice;
SEC and Missouri investigations or enforcement actions related
to alleged KPMG involvement in accounting fraud at Xerox
Corporation or General American Mutual Holding Co.; and auditor
independence concerns leading to an SEC censure of KPMG for
investing in AIM mutual funds while AIM was an audit client,
and to an ongoing SEC investigation of tax product client
referrals from Wachovia Bank to KPMG while Wachovia was a KPMG
audit client. In addition, a number of taxpayers have filed
suit against KPMG for allegedly selling them an illegal tax
shelter or improperly involving them in work on illegal tax
shelters.
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\53\ Brief summaries of some of these matters are included in
Appendix C.
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B. KPMG's Tax Shelter Activities
LFinding: Although KPMG denies being a tax shelter
promoter, the evidence establishes that KPMG has
devoted substantial resources to, and obtained
significant fees from, developing, marketing, and
implementing potentially abusive and illegal tax
shelters that U.S. taxpayers might otherwise have been
unable, unlikely or unwilling to employ, costing the
Treasury billions of dollars in lost tax revenues.
KPMG has repeatedly denied being a tax shelter promoter.
KPMG has denied it in court when opposing IRS document requests
for information related to tax shelters,54 and
denied it in response to Subcommittee questions. KPMG has never
registered any tax product with the IRS as a potentially
abusive tax shelter.
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\54\ See United States v. KPMG, Case No. 1:02MS00295 (D.D.C. 9/6/
02), ``Answer to Petition to Enforce Internal Revenue Summonses,'' at
para. 1 (``KPMG asserts that it is not a tax shelter organizer, but a
professional firm whose tax professionals provide advice and counseling
on a one-on-one basis to clients and prospective clients concerning the
clients' tax situations.'')
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KPMG does not refer to any of its tax products as ``tax
shelters'' and objects to using that term to describe its tax
products. Instead, KPMG refers to its tax products as ``tax
solutions'' or ``tax strategies.'' The KPMG Tax Services Manual
defines a ``tax solution'' as ``a tax planning idea, structure,
or service that potentially is applicable to more than one
client situation and that is reasonable to believe will be the
subject of leveraged deployment,'' meaning sales to multiple
clients.55
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\55\ KPMG Tax Services Manual, Sec. 24.1.1, at 24-1.
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In response to a Subcommittee inquiry, KPMG provided the
Subcommittee with a list of over 500 ``active tax products''
designed to be offered to multiple clients for a
fee.56 When the Subcommittee asked KPMG to identify
the ten tax products that produced the most revenue for the
firm in 2000, 2001, and 2002, KPMG denied having the ability to
reliably track revenues associated with individual tax products
and thus to identify with certainty its top revenue
producers.57 To respond to the Subcommittee's
request, KPMG indicated that it had ``undertaken a good faith,
reasonable effort to estimate the tax strategies that were
likely among those generating the most revenues in the years
requested.'' 58 KPMG identified a total of 19 tax
products that were top revenue-producers for the firm over the
3-year period.
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\56\ Untitled document, produced by KPMG on 2/10/03, Bates KPMG
0000009-91.
\57\ See chart entitled, ``Good Faith Estimate of Top Revenue-
Generating Strategies,'' attached to letter dated 4/22/03, from KPMG's
legal counsel to the Subcommittee, Bates KPMG 0001801 (``[B]ecause each
tax strategy is tailored to a client's particular circumstances, the
firm does not maintain any systematic, reliable method of recording
revenues by tax product on a national basis, and therefore is unable to
provide any definitive list or quantification of revenues for a `top
ten tax products', as requested by the Subcommittee.'').
\58\ Id.
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The Subcommittee staff's preliminary review of these 19 top
revenue-producing tax products determined that six, OPIS,
BLIPS, 401(k)ACCEL, CARDS, CLAS, and CAMPUS, are either within
the scope of ``listed transactions'' already determined by the
IRS to be potentially abusive tax shelters or within the scope
of IRS document requests in an ongoing IRS review of KPMG's tax
shelter activities.59 The Subcommittee determined
that many, if not all, of the 19 tax products were designed to
reduce the tax liability of corporations or individuals, and
employed features such as structured transactions, complex
accounting methods, and novel tax law interpretations, often
found in illegal tax shelters. The Subcommittee staff briefly
reviewed a number of other KPMG tax products as well
60 and found that they, too, carried indicia of a
potentially abusive tax shelter.
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\59\ Compare 19 tax products listed in the chart produced by KPMG
on 8/8/03, Bates KPMG 0001801, to the tax products identified in United
States v. KPMG, Case No. 1:02MS00295 (D.D.C. 7/9/02), ``Petition to
Enforce Internal Revenue Service Summonses.''
\60\ These tax products included OTHELLO, TEMPEST, RIPSS, and
California REIT.
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KPMG insists that all of its tax products are the result of
legitimate tax planning services. In legal pleadings seeking
KPMG documents, however, the IRS has stated that a number of
KPMG's tax products appear to be ``tax shelters'' and requested
related documentation to determine whether the firm is
complying with federal tax shelter laws.61 The IRS
specifically identified as ``tax shelters'' FLIP, OPIS, BLIPS,
TRACT, IDV, 401(k) ACCEL, Contested Liabilities, Economic
Liability Transfer, CLAS, CAMPUS, MIDCO, certain ``Tax Treaty''
transactions, PICO, and FOCUS.62 The IRS also
alleged that, according to information from a confidential
source, ``KPMG continues to hide from the IRS information about
tax shelters it is now developing and marketing'' and ``KPMG
continues to develop and aggressively market dozens of possibly
abusive tax shelters.'' 63
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\61\ United States v. KPMG, Case No. 1:02MS00295 (D.D.C. 7/9/02),
``Petition to Enforce Internal Revenue Service Summonses.''
\62\ Id.
\63\ United States v. KPMG, Case No. 1:02MS00295 (D.D.C. 7/9/02),
``Declaration of Michael A. Halpert,'' Internal Revenue Agent, at para.
38.
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The Subcommittee staff selected three of KPMG's 19 top
revenue producing tax products for more intensive study, OPIS,
BLIPS and SC2, as well as an earlier tax product, FLIP, which
KPMG had stopped selling after 1999, but which was the
precursor to OPIS and BLIPS, and the subject of lawsuits filed
in 2002 and 2003, by persons claiming KPMG had sold them an
illegal tax shelter. All four of these tax products were
explicitly designed to reduce or eliminate the tax liability of
corporations or individuals. Three, FLIP, OPIS, and BLIPS, have
already been determined by the IRS to be illegal or potentially
abusive tax shelters, and the IRS has penalized taxpayers for
using them. A number of these taxpayers have, in turn, sued
KPMG for selling them illegal tax shelters.64 It is
these four products that are featured in this Report.
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\64\ See, e.g., Jacoboni v. KPMG, Case No. 6:02-CV-510 (M.D. Fla.
4/29/02) (OPIS); Swartz v. KPMG, Case No. C03-1252 (W.D. Wash. 6/6/03)
(BLIPS); Thorpe v. KPMG, Case No. 5-030CV-68 (E.D.N.C. 1/27/03) (FLIP/
OPIS). In addition, a KPMG tax professional has sued KPMG for
defamation in ``retaliation for the Plaintiff's refusal to endorse or
participate in [KPMG's] illegal activities and for his cooperation with
government investigators.'' Hamersley v. KPMG, Case No. BC297905 (Los
Angeles Superior Court 6/23/03).
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The dispute over whether KPMG sells benign ``tax
solutions'' or illegal ``tax shelters'' is more than a
linguistic difference; it goes to the heart of whether
respected institutions like this one have crossed the line of
acceptable conduct. Shedding light is a memorandum prepared 5
years ago, in 1998, by a KPMG tax professional advising the
firm not to register what was then a new tax product, OPIS, as
a ``tax shelter'' with the IRS.65 Here is the advice
this tax professional gave to the second most senior Tax
Services Practice official at KPMG:
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\65\ Memorandum dated 5/26/98, from Gregg Ritchie to Jeffrey Stein,
then head of operations in the Tax Services Practice, ``OPIS Tax
Shelter Registration,'' Bates KPMG 0012031-33. Emphasis in original.
``For purposes of this discussion, I will assume that
we will conclude that the OPIS product meets the
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definition of a tax shelter under IRC section 6111(c).
``Based on this assumption, the following are my
conclusions and recommendations as to why KPMG should
make the business/strategic decision not to register
the OPIS product as a tax shelter. My conclusions and
resulting recommendation [are] based upon the immediate
negative impact on the Firm's strategic initiative to
develop a sustainable tax products practice and the
long-term implications of establishing . . . a
precedent in registering such a product.
``First, the financial exposure to the Firm is minimal.
Based upon our analysis of the applicable penalty
sections, we conclude that the penalties would be no
greater than $14,000 per $100,000 in KPMG fees. . . .
For example, our average deal would result in KPMG fees
of $360,000 with a maximum penalty exposure of only
$31,000.
``This further assumes that KPMG would bear 100 percent
of the penalty. In fact . . . the penalty is joint and
several with respect to anyone involved in the product
who was required to register. Given that, at a minimum,
Presidio would also be required to register, our share
of the penalties could be viewed as being only one-half
of the amounts noted above. If other OPIS participants
(e.g., Deut[s]che Bank, Brown & Wood, etc.) were also
found to be promoters subject to the registration
requirements, KPMG's exposure would be further
minimized. Finally, any ultimate exposure to the
penalties are abatable if it can be shown that we had
reasonable cause. . . .
``To my knowledge, the Firm has never registered a
product under section 6111. . . .
``Third, the tax community at large continues to avoid
registration of all products. Based upon my knowledge,
the representations made by Presidio and Quadra, and
Larry DeLap's discussions with his counterparts at
other Big 6 firms, there are no tax products marketed
to individuals by our competitors which are registered.
This includes income conversion strategies, loss
generation techniques, and other related strategies.
``Should KPMG decide to begin to register its tax
products, I believe that it will position us with a
severe competitive disadvantage in light of industry
norms to such degree that we will not be able to
compete in the tax advantaged products market.
``Fourth, there has been (and, apparently, continues to
be) a lack of enthusiasm on the part of the Service to
enforce section 6111. In speaking with KPMG individuals
who were at the Service . . . the Service has
apparently purposefully ignored enforcement efforts
related to section 6111. In informal discussions with
individuals currently at the Service, WNT has confirmed
that there are not many registration applications
submitted and they do not have the resources to
dedicate to this area.
``Finally, the guidance from Congress, the Treasury,
and the Service is minimal, unclear, and extremely
difficult to interpret when attempting to apply it to
`tax planning' products. . . .
``I believe the rewards of a successful marketing of
the OPIS product . . . far exceed the financial
exposure to penalties that may arise. Once you have had
an opportunity to review this information, I request
that we have a conference with the persons on the
distribution list . . . to come to a conclusion with
respect to my recommendation. As you know, we must
immediately deal with this issue in order to proceed
with the OPIS product.''
This memorandum assumes that OPIS qualifies as a tax
shelter under federal law and then advocates that KPMG not
register it with the IRS as required by law. The memorandum
advises KPMG to knowingly violate the law requiring tax shelter
registration, because the IRS is not vigorously enforcing the
registration requirement, the penalties for noncompliance are
much less than the potential profits from the tax product, and
``industry norms'' are not to register any tax products at all.
The memorandum warns that if KPMG were to comply with the tax
shelter registration requirement, this action would place the
firm at such a competitive disadvantage that KPMG would ``not
be able to compete in the tax advantaged products market.''
The Subcommittee has learned that some KPMG tax
professionals agreed with this analysis,66 while
other senior KPMG tax professionals provided the opposite
advice to the firm.67 but the head of the Tax
Services Practice, the Vice Chairman for Tax, ultimately
decided not to register the tax product as a tax shelter. KPMG
authorized the sale of OPIS in the fall of 1998.68
Over the next 2 years, KPMG sold OPIS to more than 111
individuals. It earned fees in excess of $28 million, making
OPIS one of KPMG's top ten tax revenue producers in 2000. KPMG
never registered OPIS as a tax shelter with the IRS. In 2001,
the IRS issued Notice 2001-45 declaring tax products like OPIS
to be potentially abusive tax shelters.
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\66\ See, e.g., email dated 5/26/98, from Mark Springer to multiple
KPMG tax professionals, ``Re: OPIS Tax Shelter Registration,'' Bates
KPMG 0034971 (``I would still concur with Gregg's recommendation. . . .
I don't think we want to create a competitive DISADVANTAGE, nor do we
want to lead with our chin.'' Emphasis in original.)
\67\ Lawrence DeLap, then DPP head, told the Subcommittee he had
advised the firm to register OPIS as a tax shelter. Subcommittee
interview of Lawrence DeLap (10/30/03).
\68\ See email dated 11/1/98, from Larry DeLap to William Albaugh
and other KPMG tax professionals, ``OPIS,'' Bates KPMG 0035702.
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The following sections of this Report describe the systems,
procedures, and corporate culture behind KPMG's efforts to
develop, market, and implement its tax products, as well as
steps KPMG has taken to avoid detection of its activities by
tax authorities and others. Each of these sections includes
specific evidence drawn from the BLIPS, SC2, OPIS, and FLIP
case histories. Appendices A and B provide more detailed
descriptions of how BLIPS and SC2 worked.
(1) Developing New Tax Products
LFinding: KPMG devotes substantial resources and
maintains an extensive infrastructure to produce a
continuing supply of generic tax products to sell to
multiple clients, using a process which pressures its
tax professionals to generate new ideas, move them
quickly through the development process, and approve,
at times, potentially abusive or illegal tax shelters.
KPMG prefers to describe itself as a tax advisor that
responds to client inquiries seeking tax planning services to
structure legitimate business transactions in a tax efficient
way. The Subcommittee investigation has determined, however,
that KPMG has also developed and supports an extensive internal
infrastructure of offices, programs, and procedures designed to
churn out a continuing supply of new tax products unsolicited
by a specific client and ready for mass marketing.
Drive to Produce New Tax Products. In 1997, KPMG
established the Tax Innovation Center, whose sole mission is to
push the development of new KPMG tax products. Located within
the Washington National Tax (WNT) Practice, the Center is
staffed with about a dozen full-time employees and assisted by
others who work for the Center on a rotating basis. A 2001 KPMG
overview of the Center states that ``[t]ax [s]olution
development is one of the four priority activities of WNT'' and
``a significant percentage of WNT resources are dedicated to
[t]ax [s]olution development at any given time.'' 69
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\69\ ``Tax Innovation Center Overview,'' Solution Development
Process Manual (4/7/01), prepared by the KPMG Tax Innovation Center
(hereinafter ``TIC Manual''), at i.
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Essentially, the Tax Innovation Center works to get KPMG
tax professionals to propose new tax product ideas and then
provides administrative support to develop the proposals into
approved tax products and move them successfully into the
marketing stage. As part of this effort, the Center maintains a
``Tax Services Idea Bank'' which it uses to drive and track new
tax product ideas. The Center asks KPMG tax professionals to
submit new ideas for tax products on ``Idea Submission Forms''
or ``Tax Knowledge Sharing'' forms with specified information
on how the proposed tax product would work and who would be
interested in buying it.70 The Idea Submission Form
asks the submitter to explain, for example, ``how client
savings are achieved,'' ``the tax, business, and financial
statement benefits of the idea,'' and ``the revenue potential
of this idea,'' including ``key target markets,'' ``the typical
buyer,'' and an estimated ``average tax fee per engagement.''
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\70\ ``TIC Solution Development Process,'' TIC Manual at 6.
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In recent years, the Center has established a firm-wide,
numerical goal for new tax idea submissions and applied ongoing
pressure on KPMG tax professionals to meet this goal. For
example, in 2001, the Center established this overall
objective: ``Goal: Deposit 150 New Ideas in Tax Services Idea
Bank.'' 71 On May 30, 2001, the Center reported on
the Tax Services' progress in meeting this goal as part of a
larger power-point presentation on ``year-end results'' in new
tax solutions and ideas development. For each of 12 KPMG
``Functional Groups'' within the Tax Services Practice, a one-
page chart shows the precise number of ``Deposits,'' ``Expected
Deposits,'' and ``In the Pipeline'' ideas which each group had
contributed or were expected to contribute to the Tax Services
Idea Bank. For example, the chart reports the total number of
new ideas contributed by the e-Tax Group, Insurance Group,
Passthrough Group, Personal Financial Planning Group, State and
Local Tax (SALT) Group, Stratecon, and others. It shows that
SALT had contributed the most ideas at 32, while e-Tax had
contributed the least, having deposited only one new idea. It
shows that, altogether, the groups had deposited 122 new ideas
in the idea bank, with 38 more expected, and 171 ``in the
pipeline.''
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\71\ KPMG presentation dated 5/30/01, ``Tax Innovation Center
Solution and Idea Development--Year-End Results,'' Bates XX 001755-56,
at 4.
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In addition to reporting on the number of new ideas
generated during the year, the Center reported on its efforts
to measure and improve the profitability of the tax product
development process. The year-end presentation reported, for
example, on the Tax Innovation Center's progress in meeting its
goal to ``Measure Solution Profitability,'' noting that the
Center had developed software systems that ``captured solution
development costs and revenue'' and ``[p]repared quarterly
Solution Profitability reports.'' It also discussed progress in
meeting a goal to ``Increase Revenue from Tax Services Idea
Bank.'' Among other measures, the Center proposed to ``[s]et
deployment team revenue goals for all solutions.''
Development and Approval Process. Once ideas are deposited
into the Tax Services Idea Bank, KPMG has devoted substantial
resources to transforming the more promising ideas into generic
tax products that could be sold to multiple clients.
KPMG's development and approval process for new tax
products is described in its Tax Services Manual and Tax
Innovations Center Manual.72 Essentially, the
process consists of three stages, each of which may overlap
with another. In the first stage, the new tax idea undergoes an
initial screening ``for technical and revenue potential.''
73 This initial analysis is supposed to be provided
by a ``Tax Lab'' which is a formal meeting, arranged by the Tax
Innovations Center, of six or more KPMG tax experts
specializing in the tax issues or industry affected by the
proposed product.74 Promising proposals are also
assigned one or more persons, sometimes referred to as
``National Development Champions'' or ``Development Leaders,''
to assist in the proposal's initial analysis and, if warranted,
shepherd the proposal through the full KPMG approval process.
For example, the lead tax professional who moved BLIPS through
the development and approval process was Jeffrey Eischeid,
assisted by Randall Bickham, while for SC2, the lead tax
professional was Lawrence Manth, assisted by and later
succeeded by Andrew Atkin.
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\72\ KPMG Tax Services Manual, Chapter 24, pages 24-1 to 24-7.
\73\ TIC Manual at 5.
\74\ The TIC Manual states that a Tax Lab is supposed to evaluate
``the technical viability of the idea, the idea's revenue generation
potential above the Solution Revenue threshold, and a business case for
developing the solution, including initial target list, marketing
considerations, and preliminary technical analysis.'' TIC Manual at 5.
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If a proposal survives the initial screening, in the second
stage, it must undergo a thorough review by the Washington
National Tax Practice (``WNT review''), which is responsible
for determining whether the product meets the technical
requirements of existing tax law.75 WNT personnel
often spend significant time identifying and searching for ways
to resolve problems with how the proposed product is structured
or is intended to be implemented. The WNT review must also
include analysis of the product by the WNT Tax Controversy
Services group ``to address tax shelter regulations issues.''
76 WNT must ``sign-off'' on the technical merits of
the proposal for it to be approved for sale to clients.
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\75\ In an earlier version of KPMG's tax product review and
approval procedure, WNT did not have a formal role in the development
and approval process, according to senior tax professionals interviewed
by the Subcommittee. This prior version of the process, which was
apparently the first, firm-wide procedure established to approve new
generic tax products, was established in 1997, and operated until mid
1998. In it, a three-person Tax Advantaged Product Review Board, whose
members were appointed by and included the head of DPP-Tax, conducted
the technical review of new proposals. In 1998, when this
responsibility was assigned to the WNT, the Board was disbanded. The
earlier process was used to approve the sale of FLIP and OPIS, while
the existing procedure was used to approve the sale of BLIPS and SC2.
Subcommittee interview of Lawrence DeLap (10/30/03).
\76\ KPMG Tax Services Manual, Sec. 24.4.1, at 24-2.
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In the third and final stage, the product must undergo
review and approval by the Department of Practice and
Professionalism (``DPP review''). The DPP review must determine
that the product not only complies with the law, but also meets
KPMG's standards for ``risk management and professional
practice.'' 77 This latter review includes
consideration of such matters as the substantive content of
KPMG tax opinion and client engagement letters, disclosures to
clients of risks associated with a tax product, the need for
any confidentiality or marketing restrictions, how KPMG fees
are to be structured, whether auditor independence issues need
to be addressed, and the potential impact of a proposed tax
product on the firm's reputation.78
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\77\ Id., Sec. 24.5.2, at 24-3.
\78\ Subcommittee interview of Lawrence DeLap (10/30/03). The
Subcommittee staff was told that, since 1997, DPP-Tax has had very
limited resources to conduct its new product reviews. Until 2002, for
example, DPP-Tax had a total of less than ten employees; in 2003, the
number increased to around or just above 20. In contrast, DPP-
Assurance, which oversees professional practice issues for KPMG audit
activity, has well over 100 employees.
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Each of the three stages takes time, and the entire
development and approval process can consume 6 months or
longer. The process is labor-intensive, since it requires tax
professionals to examine the suggested product, which is often
quite complex, identify various tax issues, and suggest
solutions to problems. The process often includes consultations
with outside professionals, not only on tax issues, but also on
legal, investment, accounting, and finance issues, since many
of the products require layers of corporations, trusts, and
special purpose entities; complex financial and securities
transactions using arcane financial instruments; and multi-
million-dollar lending transactions, all of which necessitate
expert guidance, detailed paperwork, and logistical support.
The KPMG development and approval process is intended to
encourage vigorous analysis and debate by the firm's tax
experts over the merits of a proposed tax product and to
produce a determination that the product complies with current
law and does not impose excessive financial or reputational
risk for the firm. All KPMG personnel interviewed by the
Subcommittee indicated that the final approval that permitted a
new tax product to go to market was provided by the head of the
DPP. KPMG's Tax Services Manual states that the DPP ``generally
will not approve a solution unless the appropriate WNT
partner(s)/principal(s) conclude that it is at least more
likely than not that the desired tax consequences of the
solution will be upheld if challenged by the appropriate taxing
authority.'' 79 KPMG defines ``more likely than
not'' as a ``greater than 50 percent probability of success if
[a tax product is] challenged by the IRS.'' 80 KPMG
personnel told the Subcommittee that the WNT's final sign-off
on the technical issues had to come before the DPP would
provide its final sign-off allowing a new tax product to go to
market.
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\79\ KPMG Tax Services Manual, Sec. 24.5.2, at 24-3.
\80\ Id., Sec. 41.19.1, at 41-10.
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Once approved, KPMG procedures required a new tax product
to be accompanied by a number of documents before its release
for sale to clients, including an abstract summarizing the
product; a standard engagement letter for clients purchasing
the product; an electronic powerpoint presentation to introduce
the product to other KPMG tax professionals; and a
``whitepaper'' summarizing the technical tax issues and their
resolution.81 In addition, to ``launch'' the new
product within KPMG, the Tax Innovation Center is supposed to
prepare a ``Tax Solution Alert'' which serves ``as the official
notification'' that the tax product is available for sale to
clients.82 This Alert is supposed to include a
``digest'' summarizing the product, a list of the KPMG
``deployment team'' members responsible for ``delivering'' the
product to market, pricing information, and marketing
information such as a ``Solution Profile'' of clients who would
benefit from the tax product and ``Optimal Target
Characteristics'' and the expected ``Typical Buyer'' of the
product. The four case histories demonstrated that KPMG
personnel sometimes, but not always, complied with the
paperwork required by its procedures. For example, while SC2
was the subject of a ``Tax Solution Alert,'' BLIPS was not.
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\81\ Id., Sec. 24.4.2, at 24-2. See also TIC Manual at 10.
\82\ TIC Manual at 10.
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In addition to or in lieu of the required ``whitepaper''
explaining KPMG's position on key technical issues, KPMG often
prepared a ``prototype'' tax opinion letter laying out the
firm's analysis and conclusions regarding the tax consequences
of the new tax product.83 KPMG defines a ``tax
opinion'' as ``any written advice on the tax consequences of a
particular issue, transaction or series of transactions that is
based upon specific facts and/or representations of the client
and that is furnished to the client or another party in a
letter, a whitepaper, a memorandum, an electronic or facsimile
communication, or other form.'' 84 The tax opinion
letter includes, at a minimum under KPMG policy, a statement of
the firm's determination that, if challenged by the IRS, it was
``more likely than not'' that the desired tax consequences of
the new tax product would be upheld in court. The prototype tax
opinion letter is intended to serve as a template for the tax
opinion letters actually sent by KPMG to specific clients for a
fee.
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\83\ KPMG Tax Services Manual, Sec. 41.17.1, at 41-8.
\84\ Id., Sec. 41.15.1, at 41-8. A KPMG tax opinion often addresses
all of the legal issues related to a new tax product and provides an
overall assessment of the tax consequences of the new product. See,
e.g., KPMG tax opinion on BLIPS. Other KPMG tax opinions address only a
limited number of issues related to a new tax product and may provide
different levels of assurance on the tax consequences of various
aspects of the same tax product. See, e.g., KPMG tax opinions related
to SC2.
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In addition to preparing its own tax opinion letter, in
some cases KPMG seeks an opinion letter from an outside party,
such as a law firm, to provide an ``independent'' second
opinion on the validity of the tax product. KPMG made
arrangements to obtain favorable legal opinion letters from an
outside law firm in each of the case studies examined by the
Subcommittee.
The tax product development and approval process just
described is the key internal procedure at KPMG today to
determine whether the firm markets benign tax solutions that
comply with the law or abusive tax shelters that do not. The
investigation conducted by the Subcommittee found that, in the
case of FLIP, OPIS, BLIPS, and SC2, KPMG tax professionals were
under pressure not only to develop the new products quickly,
but also to approve products that the firm's tax experts knew
were potentially illegal tax shelters. In several of these
cases, top KPMG tax experts participating in the review process
expressed repeated concerns about the legitimacy of the
relevant tax product. Despite these concerns, all four products
were approved for sale to clients.
BLIPS Development and Approval Process. The development and
approval process resulting in the marketing of the BLIPS tax
product to 186 individuals illustrates how the KPMG process
works.85 BLIPS was first proposed as a KPMG tax idea
in late 1998, and the generic tax product was initially
approved for sale in May 1999. The product was finally approved
for sale in August 1999, after the transactional documentation
required by the BLIPS transactions was completed. One year
later, in September 2000, the IRS issued Notice 2000-44,
determining that BLIPS and other, similar tax products were
potentially abusive tax shelters and taxpayers who used them
would be subject to enforcement action.86 After this
notice was issued, KPMG discontinued sales of the product.
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\85\ See Appendix A for more information about BLIPS.
\86\ IRS Notice 2000-44 (2000-36 IRB 255) (9/5/00).
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Internal KPMG emails disclose an extended, unresolved
debate among WNT and DPP tax professionals over whether BLIPS
met the technical requirements of federal tax law, a debate
which continued even after BLIPS was approved for sale. Several
outside firms were also involved in BLIPS' development
including Sidley Austin Brown & Wood, a law firm, and Presidio
Advisory Services, an investment advisory firm run by two
former KPMG tax partners. Key documents at the beginning and
during a key 2-week period of the BLIPS approval process are
instructive.
BLIPS was first proposed in late 1998, as a replacement
product for OPIS, which had earned KPMG substantial fees. From
the beginning, senior tax leadership put pressure on KPMG tax
professionals to quickly approve the new product for sale to
clients. For example, after being told that a draft tax opinion
on BLIPS had been sent to WNT for review and ``we can
reasonably anticipate `approval' in another month or so,''
87 the head of the entire Tax Services Practice
wrote:
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\87\ Email dated 2/9/99, from Jeffrey Eischeid to John Lanning,
Doug Ammerman, Mark Watson and Larry DeLap, ``BLIPS,'' Bates MTW 0001.
``Given the marketplace potential of BLIPS, I think a
month is far too long--especially in the spirit of
`first to market'. I'd like for all of you, within the
bounds of good professional judgement, to dramatically
accelerate this timeline. . . . I'd like to know how
quickly we can get this product to market.''
88
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\88\ Email dated 2/10/99, from John Lanning to multiple KPMG tax
professionals, ``RE: BLIPS,'' Bates MTW 0001. See also memorandum dated
2/11/99, from Jeffrey Zysik of TIC to ``Distribution List,'' Bates MTW
0002 (``As each of you is by now aware, a product with a very high
profile with the tax leadership recently was submitted to WNT/Tax
Innovation Center. We are charged with shepherding this product through
the WNT `productization' and review process as rapidly as possible.'')
Five days later, the WNT technical expert in charge of
Personal Financial Planning (PFP) tax products--who had been
assigned responsibility for moving the BLIPS product through
the WNT review process and was under instruction to keep the
head of the Tax Services Practice informed of BLIPS' status--
wrote to several colleagues asking for a ``progress report.''
He added a postcript: ``P.S. I don't like this pressure any
more than you do.'' 89
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\89\ Email dated 2/15/99, from Mark Watson to multiple KPMG tax
professionals, ``BLIPS Progress Report,'' Bates MTW 0004.
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A few days later, on February 19, 1999, almost a dozen WNT
tax experts held an initial meeting to discuss the technical
issues involved in BLIPS.90 Six major issues were
identified, the first two of which posed such significant
technical hurdles that, according to the WNT PFP technical
reviewer, most participants, including himself, left the
meeting thinking the product was ``dead.'' 91 Some
of the most difficult technical questions, including whether
the BLIPS transactions had economic substance, were assigned to
two of WNT's most senior tax partners who, despite the
difficulty, took just 2 weeks to determine, on March 5, that
their technical concerns had been resolved. The WNT PFP
technical reviewer continued to work on other technical issues
related to the project. Almost 2 months later, on April 27,
1999, he sent an email to the head of DPP stating that, with
respect to the technical issues assigned to him, he would be
comfortable with WNT's issuing a more-likely-than-not opinion
on BLIPS.
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\90\ ``Meeting Summary'' for meeting held on 2/19/99, Bates MTW
0009.
\91\ Subcommittee interview of Mark Watson (11/4/03).
---------------------------------------------------------------------------
Three days later, at meetings held on April 30 and May 1, a
number of KPMG tax professionals working on BLIPS attended a
meeting with Presidio to discuss how the investments called for
by the product would actually be carried out. The WNT PFP
technical reviewer told the Subcommittee staff that, at these
meetings, the Presidio representative made a number of
troubling comments that led him to conclude that the review
team had not been provided all of the relevant information
about how the BLIPS transactions would operate, and re-opened
concerns about the technical merits of the product. For
example, he told the Subcommittee staff that a Presidio
representative had commented that ``the probability of actually
making a profit from this transaction is remote'' and the bank
would have a ``veto'' over how the loan proceeds used to
finance the BLIPS deal would be invested. In his opinion, these
statements, if true, meant the investment program at the heart
of the BLIPS product lacked economic substance and business
purpose as required by law.
On May 4, 1999, the WNT PFP technical reviewer wrote to the
head of the DPP expressing doubts about approving BLIPS:
``Larry, while I am comfortable that WNT did its job
reviewing and analyzing the technical issues associated
with BLIPS, based on the BLIPS meeting I attended on
April 30 and May 1, I am not comfortable issuing a
more-likely-than-not opinion letter [with respect to]
this product for the following reasons:
``. . . [T]he probability of actually making a
profit from this transaction is remote (possible, but
remote);
``The bank will control how the `loan' proceeds are
invested via a veto power over Presidio's investment
choices; and
``It appears that the bank wants the `loan' repaid
within approximately 60 days. . . .
``Thus, I think it is questionable whether a client's
representation [in a tax opinion letter] that he or she
believed there was a reasonable opportunity to make a
profit is a reasonable representation. Even more
concerning, however, is whether a loan was actually
made. If the bank controls how the loan proceeds are
used and when they are repaid, has the bank actually
made a bona fide loan?
``I will no doubt catch hell for sending you this
message. However, until the above issues are resolved
satisfactorily, I am not comfortable with this
product.'' 92
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\92\ Email dated 5/4/99, from Mark Watson to Larry DeLap, Bates
KPMG 0011916.
The DPP head responded: ``It is not clear to me how this
comports with your April 27 message [expressing comfort with
BLIPS], but because this is a PFP product and you are the chief
PFP technical resource, the product should not be approved if
you are uncomfortable.'' 93 The WNT PFP technical
reviewer responded that he had learned new information about
how the BLIPS investments would occur, and it was this
subsequent information that had caused him to reverse his
position on issuing a tax opinion letter supporting the
product.94
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\93\ Email dated 5/5/99, from Larry DeLap to Mark Watson, Bates
KPMG 0011916.
\94\ Email dated 5/5/99, from Mark Watson to Larry DeLap, Bates
KPMG 0011915-16. Mr. Watson was not the only KPMG tax professional
expressing serious concerns about BLIPS. See, e.g., email dated 4/6/99,
from Steven Rosenthal to Larry DeLap, ``RE: BLIPS,'' Bates MTW 0024;
email dated 4/26/99, from Steven Rosenthal to Larry DeLap, ``RE: BLIPS
Analysis,'' Bates MTW 0026; email dated 5/7/99, from Steven Rosenthal
to multiple KPMG professionals, ``Who Is the Borrower in the BLIPS
transaction,'' Bates MTW 0028; email dated 8/19/99, from Steven
Rosenthal to Mark Watson, Bates SMR 0045.
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On May 7, 1999 the head of DPP forwarded the WNT PFP
technical expert's email to the leadership of the tax group and
noted: ``I don't believe a PFP product should be approved when
the top PFP technical partner in WNT believes it should not be
approved.'' 95
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\95\ Email dated 5/7/99, from Larry Delap to three KPMG tax
professionals, with copies to John Lanning, Vice Chairman of the Tax
Services Practice, and Jeffrey Stein, second in command of the Tax
Services Practice, Bates KPMG 0011905. In the same email he noted that
another technical expert, whom he had asked to review critical aspects
of the project, had ``informed me on Tuesday afternoon that he had
substantial concern with the `who is the borrower' issuer [sic].''
Later that same day, May 7, the two WNT technical reviewers expressing
technical concerns about BLIPS met with the two senior WNT partners who
had earlier signed off on the economic substance issue, to discuss the
issues.
---------------------------------------------------------------------------
On May 8, 1999, the head of KPMG's Tax Services Practice
wrote: ``I must say that I am amazed that at this late date
(must now be six months into this process) our chief WNT PFP
technical expert has reached this conclusion. I would have
thought that Mark would have been involved in the ground floor
of this process, especially on an issue as critical as profit
motive. What gives? This appears to be the antithesis of `speed
to market.' Is there any chance of ever getting this product
off the launching pad, or should we simply give up???''
96
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\96\ Email dated 5/8/99, from John Lanning to four KPMG tax
professionals, Bates KPMG 0011905.
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On May 9, one of the senior WNT partners supporting BLIPS
sent an email to one of the WNT technical reviewers objecting
to BLIPS and asked him: ``Based on your analysis . . . do you
conclude that the tax results sought by the investor are NOT
`more likely than not' to be realized?'' The technical reviewer
responded: ``Yes.'' 97
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\97\ Email exchange dated 5/9/99, between Richard Smith and Steven
Rosenthal, Bates SMR 0025 and SMR 0027.
---------------------------------------------------------------------------
On May 10, the head of the WNT sent an email to five WNT
tax professionals:
``Gentlemen: Please help me on this. Over the weekend
while thinking about WNT involvement in BLIPS I was
under the impression that we had sent the transaction
forward to DPP Tax on the basis that everyone had
signed off on their respective technical issues(s) and
that I had signed off on the overall more likely than
not opinion. If this impression is correct, why are we
revisiting the opinion other than to beef up the
technical discussion and further refine the
representations on which the conclusions are based. I
am very troubled that at this late date the issue is
apparently being revisited and if I understand
correctly, a prior decision changed on this technical
issue?! Richard, in particular, jog my memory on this
matter since I based my overall opinion on the fact
that everyone had signed off on their respective
areas.?'' 98
---------------------------------------------------------------------------
\98\ Email dated 5/10/99, from Philip Wiesner to multiple WNT tax
professionals, Bates MTW 0031.
A few hours later, the head of WNT sent eight senior KPMG
tax professionals, including the Tax Services Practice head,
DPP head, and the WNT PFP technical reviewer, a long email
---------------------------------------------------------------------------
message urging final approval of BLIPS. He wrote in part:
``Many people have worked long and hard to craft a tax
opinion in the BLIPS transaction that satisfies the
more likely than not standard. I believed that we in
WNT had completed our work a month ago when we
forwarded the [draft] opinion to Larry. . . .
``[T]his is a classic transaction where we can labor
over the technical concerns, but the ultimate
resolution--if challenged by the IRS--will be based on
the facts (or lack thereof). In short, our opinion is
only as good as the factual representations that it is
based upon. . . . The real `rubber meets the road' will
happen when the transaction is sold to investors, what
the investors' actual motive for investing the
transaction is and how the transaction actually
unfolds. . . . Third, our reputation will be used to
market the transaction. This is a given in these types
of deals. Thus, we need to be concerned about who we
are getting in bed with here. In particular, do we
believe that Presidio has the integrity to sell the
deal on the facts and representations that we have
written our opinion on?! . . .
``Having said all the above, I do believe the time has
come to shit and get off the pot. The business
decisions to me are primarily two: (1) Have we drafted
the opinion with the appropriate limiting bells and
whistles . . . and (2) Are we being paid enough to
offset the risks of potential litigation resulting from
the transaction? . . . My own recommendation is that we
should be paid a lot of money here for our opinion
since the transaction is clearly one that the IRS would
view as falling squarely within the tax shelter orbit.
. . .'' 99
---------------------------------------------------------------------------
\99\ Email dated 5/10/99, from Philip Wiesner to John Lanning and
eight other KPMG tax professionals, ``RE: BLIPS,'' Bates KPMG 0011904.
See also email response dated 5/10/99, from John Lanning to Philip
Wiesner and other KPMG tax professionals, ``RE: BLIPS,'' Bates MTW 0036
(``you've framed the issues well'').
Later the same day, the Tax Services operations head wrote
in response to the email from the WNT head: ``I think it's shit
OR get off the pot. I vote for shit.'' 100
---------------------------------------------------------------------------
\100\ Email dated 5/10/99, from Jeffrey Stein to Philip Weisner and
others, Bates KPMG 0011903.
---------------------------------------------------------------------------
The same day, the WNT PFP technical reviewer wrote to the
head of the Tax Services Practice: ``John, in my defense, my
change in heart about BLIPS was based on information Presidio
disclosed to me at a meeting on May 1. This information raised
serious concerns in my mind about the viability of the
transaction, and indicated that WNT had not been given complete
information about how the transaction would be structured. . .
. I want to make money as much as you do, but I cannot ignore
information that raises questions as to whether the subject
strategy even works. Nonetheless, I have sent Randy Bickham
four representations that I think need to be added to our
opinion letter. Assuming these representations are made, I am
prepared to move forward with the strategy.'' 101
---------------------------------------------------------------------------
\101\ Email dated 5/10/99, from Mark Watson to John Lanning and
others, ``FW: BLIPS,'' Bates MTW 0039 (Emphasis in original.).
---------------------------------------------------------------------------
A meeting was held on May 10, to determine how to proceed.
The WNT head, the senior WNT partner, and the two WNT technical
reviewers decided to move forward on BLIPS, and the WNT head
asked the technical reviewers to draft some representations
that, when relied upon, would enable the tax opinion writers to
reach a more likely than not opinion. The WNT head reported the
outcome of the meeting in an email:
``The group of Wiesner, R Smith, Watson and Rosenthal
met this afternoon to bring closure to the remaining
technical tax issues concerning the BLIPS transaction.
After a thorough discussion of the profit motive and
who is the borrower issue, recommendations for
additional representations were made (Mark Watson to
follow up on with Jeff Eischeid) and the decision by
WNT to proceed on a more likely than not basis
affirmed. Concern was again expressed that the critical
juncture will be at the time of the first real tax
opinion when the investor, bank and Presidio will be
asked to sign the appropriate representations. Finally,
it should be noted that Steve Rosenthal expressed his
dissent on the who is the investor issue, to wit,
`although reasonable people could reach an opposite
result, he could not reach a more likely than not
opinion on that issue'.'' 102
---------------------------------------------------------------------------
\102\ Email dated 5/10/99, from Philip Wiesner to multiple KPMG tax
professionals, Bates KPMG 0009344.
After receiving this email, the DPP head sent an email to
the WNT PFP technical reviewer asking whether he would be
comfortable with KPMG's issuing a tax opinion supporting BLIPS.
The WNT PFP technical reviewer wrote: ``Larry, I don't like
this product and would prefer not to be associated with it.
However, if the additional representations I sent to Randy on
May 9 and 10 are in fact made, based on Phil Wiesner's and
Richard Smith's input, I can reluctantly live with a more-
likely-than-not opinion being issued for the product.''
103
---------------------------------------------------------------------------
\103\ Email dated 5/11/99, from Mark Watson, WNT, to Lawrence
DeLap, Bates KPMG 0011911.
---------------------------------------------------------------------------
The DPP head indicated to the Subcommittee staff that he
did not consider this tepid endorsement sufficient for him to
sign off on the product. He indicated that he then met in
person with his superior, the head of the Tax Services
Practice, and told the Tax Services Practice head that he was
not prepared to approve BLIPS for sale. He told the
Subcommittee staff that the Tax Services Practice head was
``not pleased'' and instructed him to speak again with the
technical reviewer.104
---------------------------------------------------------------------------
\104\ Subcommittee interview of Lawrence DeLap (10/30/03).
---------------------------------------------------------------------------
The DPP head told the Subcommittee staff that he then went
back to the WNT PFP technical reviewer and telephoned him to
discuss the product. The DPP head told the Subcommittee staff
that, during this telephone conversation, the technical
reviewer made a much clearer, oral statement of support for the
product, and it was only after obtaining this statement from
the technical reviewer that, on May 19, 1999, the DPP head
approved BLIPS for sale to clients.105 The WNT PFP
technical reviewer, however, told the Subcommittee staff that
he did not remember receiving this telephone call from the DPP
head. According to him, he never, at any time after the May 1
meeting, expressed clear support for BLIPS' approval. He also
stated that an oral sign-off on this product contradicted the
DPP head's normal practice of requiring written product
approvals.106
---------------------------------------------------------------------------
\105\ Id.
\106\ Subcommittee interview of Mark Watson (11/4/03).
---------------------------------------------------------------------------
Over the course of the next year, KPMG sold BLIPS to 186
individuals and obtained more than $50 million in fees, making
BLIPS one of its highest revenue-producing tax products to
date.
The events and communications leading to BLIPS' approval
for sale are troubling and revealing for a number of reasons.
First, they show that senior KPMG tax professionals knew the
proposed tax product, BLIPS, was ``clearly one that the IRS
would view as falling squarely within the tax shelter orbit.''
Second, they show how important ``speed to market'' was as a
factor in the review and approval process. Third, they show the
interpersonal dynamics that, in this case, led KPMG's key
technical tax expert to reluctantly agree to approve a tax
product that he did not support or want to be associated with,
in response to the pressure exerted by senior Tax Services
professionals to approve the product for sale.
The email exchange immediately preceding BLIPS' approval
for sale also indicates a high level of impatience by KPMG tax
professionals in dealing with new, troubling information about
how the BLIPS investments would actually be implemented by the
outside investment advisory firm, Presidio. Questions about
this outside firm's ``integrity'' and how it would perform were
characterized as questions of risk to KPMG that could be
resolved with a pricing approach that provided sufficient funds
``to offset the risks of potential litigation.'' Finally, the
email exchange shows that the participants in the approval
process--all senior KPMG tax professionals--knew they were
voting for a dubious tax product that would be sold in part by
relying on KPMG's ``reputation.'' No one challenged the
analysis that the risky nature of the product justified the
firm's charging ``a lot of money'' for a tax opinion letter
predicting it was more likely than not that BLIPS would
withstand an IRS challenge.
Later documents show that key KPMG tax professionals
continued to express serious concerns about the technical
validity of BLIPS. For example, in July, 2 months after the DPP
gave his approval to sell BLIPS, one of the WNT technical
reviewers, objecting to the tax product, sent an email to his
superiors in WNT noting that the loan documentation
contemplated very conservative instruments for the loan
proceeds and it seemed unlikely the rate of return on the
investments would equal or exceed the loan and fees incurred by
the borrower. He indicated that his calculations showed the
planned foreign currency transactions would ``have to generate
a 240% annual rate of return'' to break even. He also pointed
out that, ``Although the loan is structured as a 7-year loan,
the client has a tremendous economic incentive to get out of
loan as soon as possible due to the large negative spread.'' He
wrote: ``Before I submit our non-economic substance comments on
the loan documents to Presidio, I want to confirm that you are
still comfortable with the economic substance of this
transaction.'' 107 His superiors indicated that they
were.
---------------------------------------------------------------------------
\107\ Email dated 7/22/99, from Mark Watson to Richard Smith and
Phil Wiesner, Bates MTW 0078.
---------------------------------------------------------------------------
A month later, in August, after completing a review of the
BLIPS transactional documents, the WNT PFP technical reviewer
again expressed concerns to his superiors in WNT:
``However before engagement letters are signed and
revenue is collected, I feel it is important to again
note that I and several other WNT partners remain
skeptical that the tax results purportedly generated by
a BLIPS transaction would actually be sustained by a
court if challenged by the IRS. We are particularly
concerned about the economic substance of the BLIPS
transaction, and our review of the BLIPS loan documents
has increased our level of concern.
``Nonetheless, since Richard Smith and Phil Wiesner--
the WNT partners assigned with the responsibility of
addressing the economic substance issues associated
with BLIPS--have concluded they think BLIPS is a
``more-likely-than-not'' strategy, I am prepared to
release the strategy once we complete our second review
of the loan documents and LLC agreement and our
comments thereon (if any) have been incorporated.''
108
---------------------------------------------------------------------------
\108\ Email dated 8/4/99, from Mark Watson to David Brockway, Mark
Springer, and Doug Ammerman, Bates SMR 0039.
---------------------------------------------------------------------------
The other technical reviewer objecting to BLIPS wrote:
``I share your concerns. We are almost finished with
our technical review of the documents that you gave us,
and we recommend some clarifications to address these
technical concerns. We are not, however, assessing the
economic substance of the transaction (ie., is there a
debt? Who is the borrower? What is the amount of the
liability? Is there a reasonable expectation of
profit?) I continue to be seriously troubled by these
issues, but I defer to Phil Wiesner and Richard Smith
to assess them.'' 109
---------------------------------------------------------------------------
\109\ Email dated 8/4/99, from Steven Rosenthal to Mark Watson and
others, Bates SMR 0039.
---------------------------------------------------------------------------
The senior partners in WNT chose to go forward with BLIPS.
About 6 months after BLIPS tax products had begun to be
sold to clients, an effort was begun within KPMG to design a
modified ``BLIPS 2000.'' 110 One of the WNT
technical reviewers who had objected to the original BLIPS
again expressed his concerns:
---------------------------------------------------------------------------
\110\ Senior KPMG tax professionals, again, put pressure on its tax
experts to quickly approve the BLIPS 2000 product. See, e.g., email
dated 1/17/00, from Jeff Stein to Steven Rosenthal and others, ``BLIPS
2000,'' Bates SMR 0050 (technical expert is urged to analyze new
product ``so we can take this to market. Your attention over the next
few days would be most appreciated.'').
``I am writing to communicate my views on the economic
substance of the Blips, Grandfathered Blips, and Blips
2000 strategies. Throughout this process, I have been
troubled by the application of economic substance
doctrines . . . and have raised my concerns repeatedly
in internal meetings. The facts as I now know them and
the law that has developed, has not reduced my level of
---------------------------------------------------------------------------
concern.
``In short, in my view, I do not believe that KPMG can
reasonably issue a more-likely-than-not opinion on
these issues.'' 111
---------------------------------------------------------------------------
\111\ Email dated 3/6/00, from Steven Rosenthal to David Brockway,
``Blips I, Grandfathered Blips, and Blips 2000,'' Bates SMR 0056. See
also memorandum dated 3/28/00, to David Brockway, ``Talking points on
significant tax issues for BLIPS 2000,'' Bates SMR 0117-21 (identifying
numerous problems with BLIPS).
When asked by Subcommittee staff whether he had ever
personally concluded that BLIPS met the technical requirements
of the federal tax code, the DPP head declined to say that he
had. Instead, he said that, in 1999, he approved BLIPS for sale
after determining that WNT had ``completed'' the technical
approval process.112 A BLIPS power point
presentation produced by the Personal Financial Planning group
in June, a few weeks after BLIPS' approval for sale, advised
KPMG tax professionals to make sure that potential clients were
``willing to take an aggressive position with a more likely
than not opinion letter.'' The presentation characterized BLIPS
as having ``about a 10 risk on [a] scale of 1-10.''
113
---------------------------------------------------------------------------
\112\ Subcommittee interview of Lawrence DeLap (10/30/03).
\113\ Power point presentation dated June 1999, by Carol Warley,
Personal Financial Planning group, ``BLIPS AND TRACT,'' Bates KPMG
0049639-45, at 496340. Repeated capitalizations in original text not
included.
---------------------------------------------------------------------------
In September 2000, the IRS identified BLIPS as a
potentially abusive tax shelter. The IRS notice characterized
BLIPS as a product that was ``being marketed to taxpayers for
the purpose of generating artificial tax losses. . . . [A] loss
is allowable as a deduction . . . only if it is bona fide and
reflects actual economic consequences. An artificial loss
lacking economic substance is not allowable.'' 114
The IRS' disallowance of BLIPS has not yet been tested in
court. Rather than defend BLIPS in court, KPMG and many BLIPS
purchasers appear to be engaged in settlement negotiations with
the IRS to reduce penalty assessments.
---------------------------------------------------------------------------
\114\ IRS Notice 2000-44 (2000-36 IRB 255) (9/5/00) at 255.
---------------------------------------------------------------------------
OPIS and FLIP Development and Approval Process. OPIS and
FLIP were the predecessors to BLIPS. Like BLIPS, both of these
products were ``loss generators'' intended to generate paper
losses that taxpayers could use to offset and shelter other
income from taxation,115 but both used different
mechanisms than BLIPS to achieve this end. Because they were
developed a number of years ago, the Subcommittee has more
limited documentation on how OPIS and FLIP were developed.
However, even this limited documentation establishes KPMG's
awareness of serious technical flaws in both tax products.
---------------------------------------------------------------------------
\115\ See document dated 5/18/01, ``PFP Practice Reorganization
Innovative Strategies Business Plan--DRAFT,'' Bates KPMG 0050620-23, at
1.
---------------------------------------------------------------------------
For example, in the case of OPIS, which was developed
during 1998, a senior KPMG tax professional wrote a 7-page
memorandum filled with criticisms of the proposed tax
product.116 The memorandum states: ``In OPIS, the
use of debt has apparently been jettisoned. If we can not
structure a deal without at least some debt, it strikes me that
all the investment banker's economic justification for the deal
is smoke and mirrors.'' At a later point, it states: ``The only
thing that really distinguishes OPIS (from FLIPS) from a tax
perspective is the use of an instrument that is purported to be
a swap. . . . However, the instrument described in the opinion
is not a swap under I.R.C. Sec. 446. . . . [A] fairly strong
argument could be made that the U.S. investor has nothing more
than a disguised partnership interest.''
---------------------------------------------------------------------------
\116\ Memorandum dated 2/23/98, from Robert Simon to Gregg Ritchie,
Randy Bickham, and John Harris, concerning OPIS, Bates KPMG 0010729.
---------------------------------------------------------------------------
The memorandum goes on:
``If, upon audit, the IRS were to challenge the
transaction, the burden of proof will be on the
investor. The investor will have to demonstrate, among
other things, that the transaction was not consummated
pursuant to a firm and fixed plan. Think about the
prospect of having your client on the stand having to
defend against such an argument. The client would have
a difficult burden to overcome. . . . The failure to
use an independent 3rd party in any of the transactions
indicates that the deal is pre-wired.''
It also states: ``If the risk of loss concepts of Notice 98-5
were applied to OPIS, I doubt that the investor's ownership
interest would pass muster.'' And: ``As it stands now, the
Cayman company remains extremely vulnerable to an argument that
it is a sham.'' And: ``No further attempt has been made to
quantify why I.R.C. Sec. 165 should not apply to deny the loss.
Instead, the argument is again made that because the law is
uncertain, we win.'' The memorandum observes: ``We are the firm
writing the [tax] opinions. Ultimately, if these deals fail in
a technical sense, it is KPMG which will shoulder the blame.''
This memorandum was written in February 1998. OPIS was
approved for sale to clients around September 1998. KPMG sold
OPIS to 111 individuals, conducting 79 OPIS transactions on
their behalf in 1998 and 1999.
In the case of FLIP, an email written in March 1998, by the
Tax Services Practice's second in command, identifies a host of
significant technical flaws in FLIP, doing so in the course of
discussing which of two tax offices in KPMG deserved credit for
developing its replacement, OPIS.117 The email
states that efforts to find a FLIP alternative ``took on an air
of urgency when [DPP head] Larry DeLap determined that KPMG
should discontinue marketing the existing product.'' The email
indicates that, for about 6 weeks, a senior KPMG tax
professional and a former KPMG tax professional employed at
Presidio worked ``to tweak or redesign'' FLIP and ``determined
that whatever the new product, it needed a greater economic
risk attached to it'' to meet the requirements of federal tax
law.
---------------------------------------------------------------------------
\117\ Email dated 3/14/98, from Jeff Stein to Robert Wells, John
Lanning, Larry DeLap, Gregg Ritchie, and others, ``Simon Says,''
concerning FLIP, Bates 638010, filed by the IRS on June 16, 2003, as an
attachment to Respondent's Requests for Admission, Schneider Interests
v. Commissioner, U.S. Tax Court, Docket No. 200-02.
---------------------------------------------------------------------------
Among other criticisms of FLIP, the email states: ``Simon
was the one who pointed out the weakness in having the U.S.
investor purchase a warrant for a ridiculously high amount of
money. . . . It was clear, we needed the option to be treated
as an option for Section 302 purposes, and yet in truth the
option [used in FLIP] was really illusory and stood out more
like a sore thumb since no one in his right mind would pay such
an exorbitant price for such a warrant.'' The email states:
``In kicking the tires on FLIP (perhaps too hard for the likes
of certain people) Simon discovered that there was a delayed
settlement of the loan which then raised the issue of whether
the shares could even be deemed to be issued to the Cayman
company. Naturally, without the shares being issued, they could
not later be redeemed.'' The email also observes: ``[I]t was
Greg who stated in writing to I believe Bob Simon that the `the
OPIS product was developed in response to your and DPP tax's
concerns over the FLIP strategy. We listened to your input
regarding technical concerns with respect to the FLIP product
and attempt to work solutions into the new product. . . .' ''
This email was written in March 1998, after the bulk of
FLIP sales, but it shows that the firm had been aware for some
time of the product's technical problems. After the email was
written, KPMG sold FLIP to ten more customers in 1998 and 1999,
earning more than $3 million in fees for doing so. In August
2001, the IRS issued a notice finding both FLIP and OPIS to be
potentially abusive tax shelters.118 The IRS has
since audited and penalized numerous taxpayers for using these
illegal tax shelters.119
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\118\ IRS Notice 2001-45 (2001-33 IRB 129) (8/13/01).
\119\ See ``Settlement Initiative for Section 302/318 Basis-
Shifting Transactions,'' IRS Announcement 2002-97 (2002-43 IRB 757)
(10/28/02).
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SC2 Development and Approval Process. The Subcommittee
investigation also obtained documentation establishing KPMG's
awareness of flaws in the technical merits of
SC2.120
---------------------------------------------------------------------------
\120\ See Appendix B for more detailed information on SC2.
---------------------------------------------------------------------------
Documents proceeding the April 2000 decision by KPMG to
approve SC2 for sale reflect vigorous analysis and discussion
of the product's risks if challenged by the IRS. The documents
also reflect, as in the BLIPS case, pressure to move the
product to market quickly. For example, one month before SC2's
final approval, an email from a KPMG professional in the Tax
Innovation Center stated: ``As I was telling you, this Tax
Solution is getting some very high level (Stein/Rosenthal)
attention. Please review the whitepaper as soon as possible. .
. .'' 121
---------------------------------------------------------------------------
\121\ Email dated 3/13/00, from Phillip Galbreath to Richard
Bailine, ``FW: S-CAEPS,'' Bates KPMG 0046889.
---------------------------------------------------------------------------
On April 11, 2000, in the same email announcing SC2's
approval for sale, the head of the DPP wrote:
``This is a relatively high risk strategy. You will
note that the heading to the preapproved engagement
letter states that limitation of liability and
indemnification provisions are not to be waived. . . .
You will also note that the engagement letter includes
the following statement: You acknowledge receipt of a
memorandum discussing certain risks associated with the
strategy. . . . It is essential that such risk
discussion memorandum (attached) be provided to each
client contemplating entering into an SC2 engagement.''
122
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\122\ Email dated 4/11/00, from Larry DeLap to Tax Professional
Practice Partners, ``S-Corporation Charitable Contribution Strategy
(SC2),'' Bates KPMG 0052581-82. One of the KPMG tax partners to whom
this email was forwarded wrote in response: ``Please do not forward
this to anyone.'' Email dated 4/25/00, from Steven Messing to Lawrence
Silver, ``S-Corporation Charitable Contribution Strategy (SC2),'' Bates
KPMG 0052581.
The referenced memorandum, required to be given to all SC2
clients, identifies a number of risks associated with the tax
product, most related to ways in which the IRS might
successfully challenge the product's legal validity. The
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memorandum states in part:
``The [IRS] or a state taxing authority could assert
that some or all of the income allocated to the tax-
exempt organization should be reallocated to the other
shareholders of the corporation. . . . The IRS or a
state taxing authority could assert that some or all of
the charitable contribution deduction should be
disallowed, on the basis that the tax-exempt
organization did not acquire equitable ownership of the
stock or that the valuation of the contributed stock
was overstated. . . . The IRS or a state taxing
authority could assert that the strategy creates a
second class of stock. Under the [tax code], subchapter
S corporations are not permitted to have a second class
of stock. . . . The IRS or a court might discount an
opinion provided by the promoter of a strategy.
Accordingly, it may be advisable to consider requesting
a concurring opinion from an independent tax advisor.''
123
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\123\ Undated KPMG document entitled, ``S Corporation Charitable
Contribution Strategy[:] Summary of Certain Risks,'' marked ``PRIVATE
AND CONFIDENTIAL,'' Bates KPMG 0049987-88.
Internally, KPMG tax professionals had identified even more
technical problems with SC2 than were discussed in the
memorandum given to clients. For example, KPMG tax
professionals discussed problems with identifying a business
purpose to explain the structure of the transaction--why a
donor who wanted to make a cash donation to a charity would
first donate stock to the charity and then buy it back, instead
of simply providing a straightforward cash
contribution.124 They also identified problems with
establishing the charity's ``beneficial ownership'' of the
donated stock, since the stock was provided on the clear
understanding that the charity would sell the stock back to the
donor within a specified period of time.125 KPMG tax
professionals identified other technical problems as well
involving assignment of income, reliance on tax indifferent
parties, and valuation issues.126
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\124\ See, e.g., email dated 3/13/00, from Richard Bailene to
Phillip Galbreath, ``S-CAEPS,'' Bates KPMG 0015744.
\125\ See, e.g., email dated 3/13/00, from Richard Bailene to
Phillip Galbreath, ``S-CAEPS,'' Bates KPMG 0015745; KPMG document dated
3/13/00, ``S-Corporation Charitable Contribution Strategy--Variation
#1,'' Bates KPMG 0047895 (beneficial ownership is ``probably our
weakest link in the chain on SC2.''); memorandum dated 3/2/00, from
William Kelliher to multiple KPMG tax professionals, ``Comments on S-
CAEPS `White Paper,' '' Bates KPMG 0016853-61.
\126\ See, e.g., email dated 3/13/00, from Richard Bailene to
Phillip Galbreath, ``S-CAEPS,'' Bates KPMG 0015746, and email from Mark
Watson, ``S-CAEPS,'' Bates KPMG 0013790-93 (raising assignment of
income concerns); emails dated 3/21/00 and 3/22/00, from Larry DeLap
and Lawrence Manth, Bates KPMG 0015739-40 (raising tax indifferent
party concerns); various emails between 7/28/00 and 10/25/00, among
KPMG tax professionals, Bates KPMG 0015011-14 (raising tax indifferent
party concerns); and memorandum dated 2/14/00, from William Kelliher to
Richard Rosenthal, ``S-Corp Charitable and Estate Planning Strategy
(`S-CAEPS'),'' Bates KPMG 0047693-95 (raising valuation concerns).
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More than a year later, in December 2001, another KPMG tax
professional expressed concern about the widespread marketing
of SC2 because, if the IRS ``gets wind of it,'' the agency
would likely mount a vigorous and ``at least partially
successful'' challenge to the product:
``Going way back to Feb. 2000, when SC2 first reared
its head, my recollection is that SC2 was intended to
be limited to a relatively small number of large S
corps. That plan made sense because, in my opinion,
there was (and is) a strong risk of a successful IRS
attack on SC2 if the IRS gets wind of it. . . . Call me
paranoid, but I think that such a widespread marketing
campaign is likely to bring KPMG and SC2 unwelcome
attention from the IRS. If so, I suspect a vigorous
(and at least partially successful) challenge would
result.'' 127
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\127\ Email dated 12/20/01, from William Kelliher to David
Brockway, ``FW: SC2,'' Bates KPMG 0012723.
Together, the BLIPS, OPIS, FLIP, and SC2 evidence
demonstrates that the KPMG development process led to the
approval of tax products that senior KPMG tax professionals
knew had significant technical flaws and were potentially
illegal tax shelters. Even when senior KPMG professionals
expressed forceful objections to proposed products, highly
questionable tax products received technical and reputational
risk sign-offs and made their way to market.
(2) Mass Marketing Tax Products
LFinding: KPMG uses aggressive marketing tactics to
sell its generic tax products, including by turning tax
professionals into tax product salespersons, pressuring
its tax professionals to meet revenue targets, using
telemarketing to find clients, using confidential
client tax data to identify potential buyers, targeting
its own audit clients for sales pitches, and using tax
opinion letters and insurance policies as marketing
tools.
Until recently, accounting firms were seen as traditional,
professional firms that waited for clients to come to them with
concerns, rather than affirmatively targeting potential clients
for sales pitches on tax products. One of the more striking
aspects of the Subcommittee investigation was discovery of the
substantial efforts KPMG has expended to market its tax
products, including extensive efforts to target clients and, at
times, use high-pressure sales tactics. Evidence in the four
case studies shows that KPMG compiled and scoured prospective
client lists, pushed its personnel to meet sales targets,
closely monitored their sales efforts, advised its
professionals to use questionable sales techniques, and even
used cold calls to drum up business. The evidence also shows
that, at times, KPMG marketed tax shelters to persons who
appeared to have little interest in them or did not understand
what they were being sold, and likely would not have used them
to reduce their taxes without being approached by KPMG.
Extensive Marketing Infrastructure. As indicated in the
prior section, KPMG's marketing efforts for new tax products
normally began long before a product was approved for sale.
Potential ``revenue analysis'' was part of the earliest
screening efforts for new products. In addition, when a new tax
product is launched within the firm, the ``Tax Solution Alert''
is supposed to include key marketing information such as
potential client profiles, ``optimal target characteristics''
of buyers, and the expected ``typical buyer'' of the product.
KPMG typically designates one or more persons to lead the
marketing effort for a new tax product. These persons are
referred to as the product's ``National Deployment Champions,''
``National Product Champions,'' or ``Deployment Leaders.'' In
the four case studies investigated by the Subcommittee, the
National Deployment Champion was the same person who served as
the product's National Development Champion and shepherded the
product through the KPMG approval process. For example, the tax
professional who led the marketing effort for BLIPS was, again,
Jeffrey Eischeid, assisted by Randall Bickham, while for SC2 it
was, again, Larry Manth, assisted and succeeded by Andrew
Atkin.
National Deployment Champions have been given significant
institutional support to market their assigned tax product. For
example, KPMG maintains a national marketing office that
includes marketing professionals and resources ``dedicated to
tax.'' 128 Champions can draw on this resource for
``market planning and execution assistance,'' and to assemble a
marketing team with a ``National Marketing Director'' and
designated ``area champions'' to lead marketing efforts in
various regions of the United States.129 These
individuals become members of the product's official
``deployment team.''
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\128\ KPMG Tax Services Manual, Sec. 2.21.1, at 2-14.
\129\ Id.
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Champions can also draw on a Tax Services group skilled in
marketing research to identify prospective clients and develop
target client lists. This group is known as the Tax Services
Marketing and Research Support group. Champions can also make
use of a KPMG ``cold call center'' in Indiana. This center is
staffed with telemarketers trained to make cold calls to
prospective clients and set up a phone call or meeting with
specified KPMG tax or accounting professionals to discuss
services or products offered by the firm. These telemarketers
can and, at times, have made cold calls to sell specific tax
shelters such as SC2.130
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\130\ See, e.g., SC2 script dated 6/19 (no year provided, but
likely 2000) developed for telemarketer calls to identify individuals
interested in obtaining more information, Bates KPMG 0050370-71. A
telemarketing script was also developed for BLIPS, but it is possible
that no BLIPS telemarketing calls were made. BLIPS script dated 7/8/99,
Bates KPMG 0025670.
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In addition to a cadre of expert marketing support
personnel, National Deployment Champions are supported by
powerful software systems that help them identify prospective
clients and track KPMG sales efforts across the country. The
Opportunity Management System (OMS), for example, is a software
system that KPMG tax professionals have used to monitor with
precision who has been contacted about a particular tax
product, who made the contact on behalf of KPMG, the potential
sales revenue associated with the sales contact, and the
current status of each sales effort.
An email sent in 2000, by the Tax Services operations and
Federal Tax Practice heads to 15 KPMG tax professionals paints
a broad picture of what KPMG's National Deployment Champions
were expected to accomplish:
``As National Deployment Champions we are counting on
you to drive significant market activity. We are
committed to providing you with the tools that you need
to support you in your efforts. A few reminders in this
regard.
``The Tax Services Marketing and Research Support is
prepared to help you refine your existing and/or create
additional [client] target lists. . . . Working closely
with your National Marketing Directors you should
develop the relevant prospect profile. Based on the
criteria you specify the marketing and research teams
can scour primary and secondary sources to compile a
target list. This will help you go to market more
effectively and efficiently.
``Many of you have also tapped into the Practice
Development Coordinator resource. Our team of
telemarketers is particularly helpful . . . to further
qualify prospects [redaction by KPMG] [and] to set up
phone appointments for you and your deployment team. .
. .
``Finally tracking reports generated from OMS are
critical to measuring your results. If you don't
analyze the outcome of your efforts you will not be in
a position to judge what is working and what is not.
Toward that end you must enter data in OMS. We will
generate reports once a month from OMS and share them
with you, your team, Service Line leaders and the [Area
Managing Partners]. These will be the focal point of
our discussion with you when we revisit your solution
on the Monday night call. You should also be using them
on your bi-weekly team calls. . . .
``Thanks again for assuming the responsibilities of a
National Deployment Champion. We are counting on you to
make the difference in achieving our financial goals.''
131
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\131\ Email dated 8/6/00 from Jeff Stein and Rick Rosenthal to 15
National Deployment Champions, Bates KPMG 050016.
In 2002, KPMG opened a ``Sales Opportunity Center'' to make
it easier for its personnel to make use of the firm's extensive
marketing resources. An email announcing this Center stated the
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following:
``The current environment is changing at breakneck
speed, and we must be prepared to respond aggressively
to every opportunity.
``We have created a Sales Opportunity Center to be the
`eye of the needle'--a single place where you can get
access to the resources you need to move quickly,
knowledgeably, and effectively.
``This initiative reflects the efforts of Assurance
(Sales, Marketing, and the Assurance & Advisory
Services Center) and Tax (Marketing and the Tax
Innovation Center), and is intended to serve as our
`situation room' during these fast-moving times. . . .
``The Sales Opportunity Center is a powerful
demonstration of the Firm's commitment to giving you
what you need to meet the challenges of these momentous
times. We urge you to take advantage of this resource
as you pursue marketplace opportunities.''
132
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\132\ Email dated 3/14/02, from Rick Rosenthal and other KPMG
professionals, to ``US Management Group,'' Bates XX 000141 (Emphasis in
original.).
Corporate Culture: Sell, Sell, Sell. After a new tax
product has been ``launched'' within KPMG, one of the primary
tasks of a National Deployment Champion is to educate KPMG tax
professionals about the new product and motivate them to sell
it.
Champions use a wide variety of tools to make KPMG tax
professionals aware of a new tax product. For example, they
include product information in KPMG internal newsletters and
email alerts, and organize conference calls and video
conferences with KPMG tax offices across the country. Champions
have also gone on ``road shows'' to KPMG field offices to make
a personal presentation on a particular product. These
presentations include how the product works, what clients to
target, and how to respond to particular concerns. On some
occasions, a presentation is videotaped and included in an
office's ``video library'' to enable KPMG personnel to view the
presentation at a later date.
Documentation obtained by the Subcommittee shows that
National Deployment Champions and senior KPMG tax officials
expend significant effort to convince KPMG personnel to devote
time and resources to selling new products. Senior tax
professionals use general exhortations as well as specific
instructions directed to specific field offices to increase
their sales efforts. For example, after SC2 was launched, the
head of KPMG's Federal Practice sent the following an email to
the SC2 ``area champions'' around the country:
``I want to personally thank everyone for their efforts
during the approval process of this strategy. It was
completed very quickly and everyone demonstrated true
teamwork. Thank you! Now let[']s SELL, SELL, SELL!!''
133
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\133\ Email dated 2/18/00, from Richard Rosenthal to multiple KPMG
tax professionals, Bates KPMG 0049236.
The Federal Tax head also called specific KPMG offices to
urge them to increase their SC2 sales. This type of instruction
from a senior KPMG tax official apparently sent a strong
message to subordinates about the need to sell the identified
tax product. For example, a tax professional in a KPMG field
office in Houston wrote the following after participating in a
conference call on SC2 in which the Federal Tax head and the
SC2 National Deployment Champion urged the office to improve
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its SC2 sales record:
``I don't know if you were on Larry Manth's call today,
but Rosenthal led the initial discussion. There have
been several successes. . . . We are behind.
``This is THE STRATEGY that they expect significant
value added fees by June 30.
``The heat is on. . . .'' 134
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\134\ Email dated 4/21/00, from Michael Terracina, KPMG office in
Houston, to Gary Choate, KPMG office in Dallas, Bates KPMG 0048191.
In the SC2 case study examined by the Subcommittee,
National Deployment Champions did not end their efforts with
phone calls and visits urging KPMG tax professionals to sell
their tax product, they also produced detailed marketing plans,
implemented them with the assistance of the ``deployment
team,'' and pressured their colleagues to increase SC2 sales.
For example, one email circulated among two members of the SC2
deployment team and two senior KPMG tax professionals
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demonstrates the measures used to push sales:
``To memorialize our discussion, we agreed the
following:
``*LOver the next two weeks, Manth [SC2 National
Deployment Champion] will deploy [Andrew] Atkin [on the
SC2 deployment team] to call each of the SC2 area
solution champions.
``*LAndrew will work with the champion to establish a
specific action plan for each opportunity. To be at all
effective, the plans should [be] very specific as to
who is going to do what when. . . . There should be
agreement as to when Andrew will next follow-up with
them to create a real sense of urgency and
accountability.
``*LAndrew will involve Manth where he is not getting
a response within 24 hours or receiving inappropriate
`pushback.' Manth will enlist [David] Jones or Rick
[Rosenthal, senior KPMG tax officials,] to help
facilitate responsiveness where necessary given the
urgency of the opportunity. . . .
``*LManth believes inadequate resources are currently
deployed to exploit the Midwest SCorp client and target
population. Craig Pichette has not yet been able to
dedicate enough time to this solution. . . . John
Schrier (NE Stratecon) or Councill Leak (SE Stratecon)
could be effective. . . .
``*LResource[s] will be assigned to adequately
address the market opportunity in Florida. . . . Goals
must be explicit . . . including a percentage weighting
based on expected time commitment. . . .
``Manth will explore with Rick the opportunity to form
alliances with other accounting firms to drive
distribution.'' 135
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\135\ Email dated 1/30/01, from David Jones to Larry Manth, Richard
Rosenthal, and Wendy Klein, ``SC2--Follow-up to 1/29 Revisit,'' Bates
KPMG 0050389.
Senior KPMG tax officials also set overall revenue goals
for various tax groups and urged them to increase their sales
of designated tax products to meet those goals. For example, in
an email alerting nearly 40 tax professionals in the
``Stratecon West'' group to a conference call on a ``Kick Off
Plan For '01,'' a senior Stratecon professional, who was also
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the SC2 National Deployment Champion, wrote:
``Hello everyone. We will be having a conference call
to kick-off our Stratecon marketing efforts to
aggressively pursue closed deals by 6/30/01. The main
purpose of the call is to discuss our marketing and
targeting strategy and to get everyone acquainted with
a number of Stratecon's high-end solutions. If you have
clients, at least one of these strategies should be
applicable to your client base. As you all know, to
reach plan in the West, we must aggressively pursue
these high-end strategies.'' 136
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\136\ Email dated 12/2/00, from Lawrence Manth to multiple tax
professionals, Bates XX 000021.
Two months later, a member of the SC2 deployment team, who
also worked for Stratecon, sent an email to an even larger
group of 60 tax professionals, urging them to try a new, more
appealing version of SC2. In a paragraph subtitled, ``Why
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Should You Care?'' he wrote:
``In the last 12 months the original SC2 structure has
produced $1.25 million in signed engagements for the SE
[Southeast]. . . . Look at the last partner scorecard.
Unlike golf, a low number is not a good thing. . . . A
lot of us need to put more revenue on the board before
June 30. SC2 can do it for you. Think about targets in
your area and call me.'' 137
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\137\ Email dated 2/22/01, from Councill Leak to multiple tax
professionals, Bates KPMG 0050822-23.
The steady push for tax product sales continued. For
example, three weeks later, the Stratecon tax professional sent
an email to his colleagues stating, ``Due to the significant
push for year-end revenue, all West Region Federal tax partners
have been invited to join us on this [conference] call and we
will discuss our `Quick Hit' strategies and targeting
criteria.'' 138 Six weeks after that, the same
Stratecon official announced another conference call urging
Stratecon professionals to discuss two ``tax minimization
opportunities for individuals'' which will ``have a quick
revenue hit for us.'' 139
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\138\ Email dated 3/13/01, from Larry Manth to multiple KPMG tax
professionals, ``Friday's Stratecon Call,'' Bates XX 001439.
\139\ Email dated 4/25/01, from Larry Manth to multiple KPMG tax
professionals, ``Friday's Stratecon Call,'' Bates XX 001438.
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Stratecon was not alone in the push for sales. For example,
in 2000, the former head of KPMG's Washington National Tax
Practice sent an email to all ``US-WNT Tax Partners'' urging
them to ``temporarily defer non-revenue producing activities''
and concentrate for the ``next 5 months'' on meeting WNT's
revenue goals for the year.140 The email states in
part:
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\140\ Email dated 2/3/00, from Philip Wiesner to US-WNT Tax
Partners, Bates KPMG 0050888-90.
``Listed below are the tax products identified by the
functional teams as having significant revenue
potential over the next few months. . . . [T]he
functional teams will need . . . WNT champions to work
with the National Product champions to maximize the
revenue generated from the respective products. . . .
Thanks for help in this critically important matter. As
Jeff said, `We are dealing with ruthless execution--
hand to hand combat--blocking and tackling.' Whatever
---------------------------------------------------------------------------
the mixed metaphor, let's just do it.''
The evidence is clear that selling tax products was an
important part of every tax professional's job at KPMG.
Targeting Clients. KPMG's marketing efforts included
substantial efforts to identify prospective purchasers for its
tax products. KPMG developed prospective client lists by
reviewing both its own client base and seeking new clients
through referrals and cold calls.
To review its own client base, KPMG has used software
systems, including ones known as KMatch and RIA-GoSystem, to
identify former or existing clients who might be interested in
a particular tax product. KMatch is ``[a]n interactive software
program that asks a user a series of questions about a client's
business and tax situation,'' uses the information to construct
a ``client profile,'' and then uses the profile to identify
KPMG tax products that could assist the client to avoid
taxation.141 KPMG's Tax Innovation Center conducted
a specific campaign requiring KPMG tax professionals to enter
client data into the KMatch database so that, when subsequent
tax products were launched, the resulting client profiles could
be searched electronically to identify which clients would be
eligible for and interested in the new product. RIA-GoSystem is
a separate internal KPMG database which contains confidential
client data provided to KPMG to assist the firm in preparing
client tax returns.142 This database of confidential
client tax information can also be searched electronically to
identify prospective clients for new tax products and was
actually used for that purpose in the case of
SC2.143
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\141\ Presentation entitled, ``KMatch Push Feature Campaign,''
undated, prepared by Marsha Peters of the Tax Innovation Center, Bates
XX 001511.
\142\ See, e.g., email dated 3/6/01, from US-GoSystem
Administration to Andrew Atkin of KPMG, ``RE: Florida S corporation
search,'' Bates KPMG 0050826; Subcommittee interview of Councill Leak
(10/22/03).
\143\ Id.
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The evidence indicates that KPMG also uses its assurance
professionals--persons who provide auditing and related
services to individuals and corporations--to identify existing
KPMG audit clients who might be interested in new tax products.
Among other documents evidencing the role of KPMG assurance
professionals is the development and marketing of tax products
that require the combined participation of both KPMG tax and
assurance professionals. In 2000, for example, KPMG issued what
it called its ``first joint solution'' requiring KPMG tax and
assurance professionals to work together to sell and implement
the product.144 The tax product is described as a
``[c]ollection of assurance and tax services designed to assist
companies in . . . realizing value from their intellectual
property . . . [d]elivered by joint team of KPMG assurance and
tax professionals.'' 145 Internal KPMG documentation
states that the purpose of the new product is ``[t]o increase
KPMG's market penetration of key clients and targets by
enhancing the linkage between Assurance and Tax
professionals.'' 146 Another KPMG document states:
``Teaming with Assurance expands tax team's knowledge of client
and industry[.] Demonstrates unified team approach that
separates KPMG from competitors.'' 147 Another KPMG
document shows that KPMG used both its internal tax and
assurance client lists to target clients for a sales pitch on
the new product:
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\144\ Presentation dated 7/17/00, ``Targeting Parameters:
Intellectual Property--Assurance and Tax,'' with attachment dated
September 2000, entitled ``Intellectual Property Services,'' at page 1
of the presentation, Bates XX 001567-93.
\145\ Presentation dated 10/30/00, ``Intellectual Property Services
(IPS),'' by Dut LeBlanc of Shreveport and Joe Zier of Silicon Valley,
Bates XX 001580-93.
\146\ Presentation dated 7/17/00, ``Targeting Parameters:
Intellectual Property--Assurance and Tax,'' with attachment dated
September 2000, entitled ``Intellectual Property Services,'' at page 1
of the attachment, Bates XX 001567-93.
\147\ Presentation dated 10/30/00, ``Intellectual Property Services
(IPS),'' by Dut LeBlanc of Shreveport and Joe Zier of Silicon Valley,
Bates XX 001580-93.
``The second tab of this file contains the draft target
list [of companies]. This list was compiled from two
sources an assurance and tax list. . . . [W]e selected
the companies which are assurance or tax clients, which
resulted in the 45 companies on the next sheet. . . .
What should you do? Review the suspects with your
assurance or tax deployment counterpart. . . .
Prioritize your area targets, and plan how to approach
them.'' 148
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\148\ Presentation dated 7/17/00, ``Targeting Parameters:
Intellectual Property--Assurance and Tax,'' with attachment dated
September 2000, entitled ``Intellectual Property Services,'' at page 1
of the attachment, Bates XX 001567-93.
Additional tax products which relied in part on KPMG audit
partners followed. In 2002, for example, KPMG launched a ``New
Enterprises Tax Suite'' product 149 which it
described internally as ``a cross-functional element of the Tax
Practice that efficiently mines opportunities in the start-up
and middle-market, high-growth, high-tech space.'' A
presentation on this new product states that KPMG tax
professionals are ``[t]eaming with Assurance . . . [and]
fostering cross-selling among assurance and tax
professionals.'' 150
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\149\ See WNT presentation dated 9/19/02, entitled ``Innovative Tax
Solutions,'' which, at 18-26, includes a presentation by Tom Hopkins of
Silicon Valley, ``New Enterprises Tax Suite,'' Tax Solution Alert 00-
31, Bates XX 001636-1706. The Hopkins presentation states that the new
product is intended to be used to ``[l]everage existing client base
(pull-through),'' ``[d]evelop and use client selection filters to
refine our bets and reach higher market success,'' and ``[e]nhance
relationships with client decisionmakers.'' As part of a ``Deployment
Action Plan,'' the presentation states that KPMG ``[p]artners with
revenue goals are given subscriptions to Venture Wire for daily lead
generation'' and that ``[t]argeting is supplemented by daily lead
generation from Fort Wayne'' where KPMG's telemarketing center is
located.
\150\ Presentation dated 3/6/00, ``Post-Transaction Integration
Service (PTIS)--Tax,'' by Stan Wiseberg and Michele Zinn of Washington,
D.C., Bates XX 001597-1611 (``Global collaborative service brought to
market by tax and assurance . . . May be appropriate to initially
unbundle the serves (`tax only,' or `assurance only') to capture an
engagement'').
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Other tax products explicitly called on KPMG tax
professionals to ask their audit counterparts for help in
identifying potential clients. For example, a ``Middle Market
Initiative'' launched in 2001, identified seven tax products to
be marketed to mid-sized corporations, including SC2. It
explicitly called upon KPMG tax professionals to contact KPMG
audit partners to identify appropriate mid-sized corporations,
and directed these tax professionals to pitch one or more of
the seven KPMG tax products to KPMG audit clients. ``In order
to maximize marketplace opportunities . . . national and area
champions will coordinate with and involve assurance partners
and managers in their respective areas.'' 151
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\151\ Email dated 8/14/01, from Jeff Stein and Walter Duer to
``KPMG LLP Partners, Managers and Staff,'' ``Stratecon Middle Market
Initiative,'' Bates KPMG 0050369.
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In addition to electronic searches, National Deployment
Champions regularly exhorted KPMG field personnel to review
their client lists personally to identify those that might be
interested in a new product. In the case of SC2, deployment
team members asked KPMG tax professionals to review their
client lists, not once, but twice:
``Attached above is a listing of all potential SC2
engagements that did not fly over the past year. In an
effort to ensure we have not overlooked any potential
engagement during the revenue push for the last half of
[fiscal year] 2001, please review the list which is
sorted by estimated potential fees. I'd like to revisit
each of these potential engagements, and gather
comments from each of you regarding the following. . .
. Would further communication/dialogue with any listed
potential engagement be welcome? What were the reasons
for the potential client's declining the strategy?''
152
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\152\ Email dated 2/9/01, from Ty Jordan to multiple KPMG tax
professionals, ``SC2 revisit of stale leads,'' Bates KPMG 0050814.
In addition to reviewing its own client base, KPMG worked
with outside parties, such as banks, law firms, and other
accounting firms, to identify outside client prospects. One
example is the arrangement KPMG entered into with First Union
National Bank, now part of Wachovia Bank, in which Wachovia
referred clients to KPMG in connection with FLIP. In this case,
Wachovia told wealthy clients about the existence of the tax
product and allowed KPMG to set up appointments at the bank or
elsewhere to make client presentations on FLIP.153
KPMG apparently did not pay Wachovia a direct referral fee for
these clients, but if a client eventually agreed to purchase
FLIP, a portion of the fees paid by the client to Quellos, a
investment advisory firm handling the FLIP transactions, was
forwarded by Quellos to Wachovia. KPMG also made arrangements
for Wachovia client referrals related to BLIPS and SC2, again
using First Union National Bank, but it is unclear whether the
bank actually made any referrals for these tax
products.154 In the case of SC2, KPMG also worked
with a variety of other outside parties, such as mid-sized
accounting firms and automobile dealers, to locate and refer
potential clients.155 A large law firm headquartered
in St. Louis expressed willingness not only to issue a
confirming tax opinion for the SC2 transaction, but also to
introduce KPMG ``to some of their midwestern clients.''
156
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\153\ Subcommittee interview of Wachovia Bank representatives (3/
25/03).
\154\ See, e.g., email dated 8/30/99, from Tom Newman to multiple
First Union professionals, ``next strategy,'' Bates SEN 014622 (BLIPS
``[f]ees to First Union will be 50 basis points if the investor is not
a KPMG client, 25 bps if they are a KPMG client.''); email dated 11/30/
01, from Councill Leak to Larry Manth, ``FW: First Union Customer
Services,'' Bates KPMG 0050842-44 (``I provide my comments on how we
are bringing SC2 into certain First Union customers.''). Because KPMG
is also Wachovia's auditor, questions have arisen as to whether their
client referral arrangements violate SEC's auditor independence rules.
See Section VI(B)(5) of this Report for more information on the auditor
independence issue.
\155\ See, e.g., email dated 1/30/01, from David Jones to Larry
Manth, Richard Rosenthal, and Wendy Klein, ``SC2--Follow-up to 1/29
Revisit,'' Bates KPMG 0050389 (working to form accounting firm
alliances).
\156\ Memorandum dated 2/16/01, from Andrew Atkin to SC2 Marketing
Group, ``Agenda from Feb 16th call and goals for next two weeks,''
Bates KPMG 0051135.
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In addition to reviewing its own client base and seeking
client referrals, KPMG used a variety of other means to
identify prospective clients. In the case of SC2, for example,
as part of its marketing efforts, KPMG obtained lists of S
corporations in the states of Texas, North and South Carolina,
New York, and Florida.157 It obtained these lists
from either state government, commercial firms, or its own
databases. The Florida list, for example, was compiled using
KPMG's internal RIA-GoSystem containing confidential client
data extracted from certain tax returns prepared by
KPMG.158 Some of the lists had large blocks of S
corporations associated with automobile or truck dealers, real
estate firms, home builders, or architects.159 In
some instances, KPMG tax professionals instructed KPMG
telemarketers to contact the corporations to gauge interest in
SC2.160 In other cases, KPMG tax professionals
contacted the corporations personally.
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\157\ See, e.g., email dated 8/14/00, from Postmaster-US to unknown
recipients, ``Action Required: Channel Conflict for SC2,'' Bates KPMG
0049125 (S corporation list purchased from Dun & Bradstreet);
memorandum dated 2/16/01, from Andrew Atkin to SC2 Marketing Group,
``Agenda from Feb 16th call and goals for next two weeks,'' Bates KPMG
0051135 (Texas S corporation list); email dated 3/7/01, from Councill
Leak to multiple KPMG tax professionals, ``South Florida SC2 Year End
Push,'' Bates KPMG 0050834 (Florida S corporation list); email dated 3/
26/01, from Leonard Ronnie III, to Gary Crew, ``RE: S-Corp Carolinas,''
Bates KPMG 0050818 (North and South Carolina S corporation list); email
dated 4/22/01, from Thomas Crawford to John Schrier, ``RE: SC2 target
list,'' Bates KPMG 0050029 (New York S corporation list).
\158\ Email dated 3/6/01, from US-GoSystem Administration to Andrew
Atkin of KPMG, ``RE: Florida S corporation search,'' Bates KPMG
0050826. Subcommittee interview of Councill Leak (10/22/03).
\159\ Email dated 11/17/00, from Jonathan Pullano to US-Southwest
Tax Services Partners and others, ``FW: SW SC2 Channel Conflict,''
Bates KPMG 0048309.
\160\ See, e.g., email dated 6/27/00, from Wendy Klein to Mark
Springer and Larry Manth, ``SC2: Practice Development Coordinators
Involvement,'' Bates KPMG 0049116; email dated 11/15/00, from Douglas
Duncan to Michael Terracina and Gary Choat, ``FW: SW SC2 Progress,''
Bates KPMG 0048315-17.
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The lists compiled by KPMG produced literally thousands of
potential SC2 clients, and through telemarketing and other
calls, KPMG personnel made uncounted contacts across the
country searching for buyers of SC2. In April 2001, the DPP
apparently sent word to SC2 marketing teams to stop using
telemarketing calls to find SC2 buyers,161 but
almost as soon as the no-call policy was announced, some KPMG
tax professionals were attempting to circumvent the ban asking,
for example, if telemarketers could question S corporations
about their eligibility and suitability to buy SC2, without
scheduling future telephone contacts.162 In December
2001, after being sent a list of over 3,100 S corporations
targeted for telephone calls, a senior KPMG tax professional
sent an email to the head of WNT complaining that the list
appeared to indicate ``the firm is intent on marketing the SC2
strategy to virtually every S corp with a pulse.''
163
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\161\ See email dated 4/22/01, from John Schrier to Thomas
Crawford, ``RE: SC2 target list,'' Bates KPMG 0050029.
\162\ Email dated 4/23/01, from John Schrier to Thomas Crawford,
``RE: SC2 target list,'' Bates KPMG 0050029.
\163\ Email dated 12/20/01, from William Kelliher to David
Brockway, WNT head, Bates KPMG 0013311. A responsive email from Mr.
Brockway on the same document states, ``It looks like they have already
tried over 2/3rds of possible candidates already, if I am reading the
spread sheet correctly.''
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When KPMG representatives were first asked about KPMG's use
of telemarketers, they initially told the Subcommittee staff
that telemarketing calls were against firm
policy.164 When asked about the Indiana cold call
center which KPMG has been operating for years, the KPMG
representatives said that the center's telemarketers sought to
introduce new clients to KPMG in a general way and did little
more than arrange an appointment so that KPMG could explain to
a potential client in person all of the services KPMG offers.
When confronted with evidence of telemarketing calls for SC2,
the KPMG representatives acknowledged that a few calls on tax
products might have been made by telemarketers at the cold call
center, but implied such calls were few in number and rarely
led to sales. In a separate interview, when shown documents
indicating that, in the case of SC2, KPMG telemarketers made
calls to thousands of S corporations across the country, the
KPMG tax professional being interviewed admitted these calls
had taken place.165
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\164\ Subcommittee briefing by Jeffrey Eischeid and Timothy Speiss
(9/12/03).
\165\ Subcommittee interview of Councill Leak (10/22/03).
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Sales Advice. To encourage sales, KPMG would, at times,
provide written advice to its tax professionals on how to
answer questions about a tax product, respond to objections, or
convince a client to buy a product.
For example, in the case of SC2, KPMG sponsored a meeting
for KPMG ``SC2 Team Members'' across the country and emailed
documents providing information about the tax product as well
as ``Appropriate Answers for Frequently Asked Shareholder
Questions'' and ``Suggested Solutions'' to ``Sticking Points
and Problems.'' 166 The ``Sticking Points'' document
provided the following advice to KPMG tax professionals trying
to sell SC2 to prospective clients:
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\166\ ``SC2--Meeting Agenda'' and attachments, dated 6/19/00, Bates
KPMG 0013375-96.
``1) `Too Good to be true.' Some people believe that if
it sounds too good to be true, it's a sham. Some
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suggestions for this response are the following:
``a) This transaction has been through KPMG's WNT
practice and reviewed by at least 5 specialty groups. .
. . Many of the specialists are ex-IRS employees.
``b) Many sophisticated clients have implemented the
strategy in conjunction with their outside counsel.
``c) At least one outside law firm will give a co-
opinion on the transactions. . . .
``e) Absolutely last resort--At least 3 insurance
companies have stated that they will insure the tax
benefits of the transaction for a small premium. This
should never be mentioned in an initial meeting and
Larry Manth should be consulted for all insurance
conversations to ensure consistency and independence on
the transaction.
``2) `I Need to Think About it.' . . . We obviously do
not want to seem too desperate but at the same time we
need to keep this moving along. Some suggestions:
``a) `Get Even' Approach. Perhaps a good time to
revisit the strategy is at or near estimated tax
payment time when the shareholder is making or has made
a large estimated tax payment and is extremely
irritated for having done so. . . .
``b) Beenie Baby Approach. . . . We call the client
and say that the firm has decided to cap the strategy .
. . and the cap is quickly filling up. `Should I put
you on the list as a potential?' This is obviously a
more aggressive approach, but will tell you if the
client is serious about the deal.
``c) `Break-up' Approach. This is a risky approach
and should only be used in a limited number of cases.
This approach entails us calling the client and
conveying to them that they should no longer consider
SC2 for a reason solely related to KPMG, such as the
cap has been reached with respect to our city or region
or . . . the demand has been so great that the firm is
shutting it down. This approach is used as a
psychological tool to elicit an immediate response from
the client. . . .
``5) John F. Brown Syndrome. This is named after an
infamous attorney who could not get comfortable with
anything about the strategy. We have had a number of
clients with stubborn outside counsel with respect to
the strategy itself, the engagement letter, or other
aspects of the transaction. Here are some approaches:
``a. If we . . . know he will not approve of the
transaction we should tell this to the client and
either walk or convince the client not to use the
attorney or law firm for this deal. . . .
``c. If the fee is substantial . . . the last resort
is to summarize a transaction with all the possible
bells and whistles to make the deal as risk-free as
possible. For example: The client does SC2 with the
following elements: 1) option to reacquire stock from
[tax exempt organization], 2) insurance covering the
tax benefits plus penalties . . ., and 3) outside
opinion from an independent law firm. If the attorney
is still uncomfortable, we need to convey this to the
client and they can decide.''
This document is hardly the work product of a disinterested
tax adviser. In fact, it goes so far as to recommend that KPMG
tax professionals employ such hard-sell tactics as making
misleading statements to their clients--claims that SC2 will be
sold to only a limited number of people or that it is no longer
being sold at all in order to ``elicit an immediate response
from the client.'' The document also depicts attorneys raising
technical concerns about SC2 as ``stubborn'' naysayers who need
to be circumvented, rather than satisfied. In short, rather
than present KPMG as a disinterested tax adviser, this type of
sales advice is evidence of a company intent on convincing an
uninterested or hesitant client to buy a product that the
client would apparently be otherwise unlikely to purchase or
use.
Using Tax Opinions and Insurance as Marketing Tools.
Several documents obtained during the investigation demonstrate
that KPMG deliberately traded on its reputation as a respected
accounting firm and tax expert in selling questionable tax
products to corporations and individuals. As described in the
prior section on designing new tax products, the former WNT
head acknowledged that KPMG's ``reputation will be used to
market the [BLIPS] transaction. This is a given in these types
of deals.'' In the SC2 ``Sticking Points'' document, KPMG
instructed its tax professionals to respond to client concerns
about the product by pointing out that SC2 had been reviewed
and approved by five KPMG tax specialty groups and by
specialists who are former employees of the IRS.167
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\167\ ``SC2--Meeting Agenda'' and attachments, dated June 19, 2000,
at Bates KPMG 0013394.
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KPMG also used opinion letters as a marketing tool. Tax
opinion letters are intended to provide written advice
explaining whether a particular tax product is permissible
under the law and, if challenged by the IRS, the likelihood
that the tax product would survive court scrutiny. A tax
opinion letter provided by a person with a financial stake in
the tax product being analyzed has traditionally been accorded
much less deference than an opinion letter supplied by a
disinterested expert. As shown in the SC2 ``Sticking Points''
document just cited, if a client raised concerns about
purchasing the product, KPMG instructed its tax professionals
to respond that, ``At least one outside law firm will give a
co-opinion on the transactions.'' 168 In another SC2
document, KPMG advises its tax professionals to tell clients
worried about IRS penalties: ``The opinion letters that we
issue should get you out of any penalties. However, the Service
could try to argue that KPMG is the promoter of the strategy
and therefore the opinions are biased and try and assert
penalties. We believe there is very low risk of this result. If
you desire additional assurance, there is at least one outside
law firm in NYC that will issue a co-opinion. The cost ranges
between $25k-$40k.'' 169
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\168\ Id. Another document identified Bryan Cave, a law firm with
over 600 professionals and offices in St. Louis, New York, and
elsewhere, as willing ``to issue a confirming tax opinion for the SC2
transaction.'' Memorandum dated 2/16/01, from Andrew Atkin to SC2
Marketing Group, ``Agenda from Feb 16th call and goals for the next two
weeks,'' Bates KPMG 0051135. See also email dated 7/19/00, from Robert
Coplan of Ernst & Young to ``[email protected],'' Bates 2003EY011939
(``As you know, we go to great lengths to line up a law firm to issue
an opinion pursuant to a separate engagement letter from the client
that is meant to make the law firm independent from us.'')
\169\ ``SC2--Appropriate Answers for Frequently Asked Shareholder
Questions,'' included in an SC2 information packet dated 7/19/00, Bates
KPMG 0013393.
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KPMG was apparently so convinced that an outside legal
opinion increased the marketability of its tax products, that
in the case of FLIP, it agreed to pay Sidley Austin Brown &
Wood a fee in any sale where a prospective buyer was told that
the law firm would provide a favorable tax opinion letter,
regardless of whether the opinion was actually provided. A KPMG
tax professional explained in an email: ``Our deal with Brown
and Wood is that if their name is used in selling the strategy
they will get a fee. We have decided as a firm that B&W opinion
should be given in all deals.'' 170 This guaranteed
fee arrangement also provided an incentive for Sidley Austin
Brown & Wood to refer clients to KPMG.
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\170\ ``Declaration of Richard E. Bosch,'' IRS Revenue Agent, In re
John Doe Summons to Sidley Austin Brown & Wood (N.D. Ill. 10/16/03) at
para. 18, citing an email dated 10/1/97, from Gregg Ritchie to Randall
Hamilton. (Capitalizations in original omitted.)
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On occasion, KPMG also used insurance as a marketing tool
to convince reluctant buyers to purchase a KPMG tax product. In
the case of SC2, the ``Sticking Points'' document advised KPMG
tax professionals to tell clients about the existence of an
insurance policy that, for a ``small premium,'' could guarantee
SC2's promised ``tax benefits'':
``At least 3 insurance companies have stated that they
will insure the tax benefits of the transaction for a
small premium. This should never be mentioned in an
initial meeting and Larry Manth should be consulted for
all insurance conversations to ensure consistency and
independence on the transaction.'' 171
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\171\ ``SC2--Meeting Agenda'' and attachments, dated June 19, 2000,
Bates KPMG 0013375-96.
According to KPMG tax professionals interviewed by
Subcommittee staff, the insurance companies offering this
insurance included AIG and Hartford.172 KPMG
apparently possessed sample insurance policies that promised to
reimburse the policy holder for a range of items, including
penalties or fines assessed by the IRS for using SC2,
essentially insuring the policy holder against being penalized
for tax evasion.173 Once these policies were
available, KPMG tax professionals were asked to re-visit
potential clients who had declined the tax product and try
again:
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\172\ See, e.g., Subcommittee interview of Lawrence Manth (11/6/
03).
\173\ Id.
``Attached above is a listing of all potential SC2
engagements that did not fly over the past year. . . .
We now have a number of Insurance companies which would
like to underwrite the tax risk inherent in the
transaction. We may want to revisit those potential
clients that declined because of audit risk.''
174
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\174\ Email dated 2/9/01, from Ty Jordan to multiple KPMG tax
professionals, ``SC2 revisit of stale leads,'' Bates KPMG 0050814.
Evidence obtained by the Subcommittee indicates that at least
half a dozen SC2 purchasers also purchased SC2 insurance.
Tracking Sales and Revenue. KPMG repeatedly told the
Subcommittee staff that it did not have the technical
capability to track the sales or revenues associated with
particular tax products.175 However, evidence
gathered by the Subcommittee indicates that KPMG could and did
obtain specific revenue tracking information.
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\175\ Subcommittee briefing by Jeffrey Eischeid (9/12/03);
Subcommittee interview of Jeffrey Stein (10/31/03).
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The Subcommittee learned, for example, that once a tax
product was sold to a client and the client signed an
engagement letter, KPMG assigned the transaction an
``engagement number,'' and recorded in an electronic database
all revenues resulting from that engagement. This engagement
data could then be searched and manipulated to provide revenue
information and totals for individual tax products.
Specific evidence that revenue information was collected
for tax products was obtained by the Subcommittee during the
investigation from parties other than KPMG. For example, an SC2
``update'' prepared in mid-2001, includes detailed revenue
information, including total nationwide revenues produced by
the tax product since it was launched, total nationwide
revenues produced during the 2001 fiscal year, and FY01
revenues broken down by each of six regions in the United
States: 176
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\176\ Internal KPMG presentation, dated 6/18/01, by Andrew Atkin
and Bob Huber, entitled ``S-Corporation Charitable Contribution
Strategy (SC2) Update,'' Bates XX 001553.
``Revenue since solution was launched:
$20,700,000
``Revenue this fiscal year only:
$10,700,000
``Revenue by Region this Fiscal Year
* West $7,250,000
* Southeast $1,300,000
* Southwest $850,000
* Mid-Atlantic $550,000
* Midwest $425,000
* Northeast $300,000
KPMG never produced this document to the
Subcommittee.177 However, one email related to SC2
that KPMG did produce states that monthly OMS ``tracking
reports'' were used to measure sales results for specific tax
products, and these reports were regularly shared with National
Deployment Champions, Tax Service Line leaders, and Area
Managing Partners.178
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\177\ Another document provided to the Subcommittee by parties
other than KPMG carefully traces the increase in the Tax Services
Practice's ``gross revenue.'' It shows a ``45.5% Cumulative Growth'' in
gross revenue over a 4-year period, with $829 million in FY98, $1.001
million in FY99, $1.184 million in FY00, and $1.239 million in FY01.
See chart entitled, ``Tax Practice Growth Gross Revenue,'' included in
a presentation dated 7/19/01, entitled, ``Innovative Tax Solutions,''
by Marsha Peters of Washington National Tax, Bates XX 001340.
\178\ Email dated 8/6/00 from Jeffrey Stein to15 National
Deployment Champions, Bates KPMG 050016.
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Moreover, KPMG's Tax Innovation Center reported in 2001,
that it had developed new software that ``captured solution
development costs and revenue'' and that it had begun
``[p]repar[ing] quarterly Solution Profitability reports.''
179 This information suggests that KPMG was refining
its revenue tracking capabilities to be able to track not only
gross revenues produced by a tax product, but also net
revenues, and that it had begun collecting and monitoring this
information on a regular basis. KPMG's statement, ``the firm
does not maintain any systematic, reliable method of recording
revenues by tax product on a national basis,'' 180
was contradicted by the evidence.
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\179\ Internal KPMG presentation, dated 5/30/01, by the Tax
Innovation Center, entitled ``Tax Innovation Center Solution and Idea
Development--Year-End Results,'' Bates XX 001490-1502.
\180\ Letter from KPMG to Subcommittee, dated 4/22/03, attached
one-page chart entitled, ``Good Faith Estimate of Top Revenue-
Generating Strategies,'' n.1.
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No Industry Slow-Down. Some members of the U.S. tax
profession have asserted that professional firms are beginning
to turn away from marketing illegal tax shelters, so there is
no need for investigations, reforms, or stronger laws in this
area. KPMG has claimed that it is no longer marketing
aggressive tax products designed to be sold to multiple
clients. The Subcommittee investigation, however, found that,
while a few professional firms have reduced or stopped selling
generic tax products in the last 2 years, KPMG and other
professional firms appear to be committed to continuing and
deepening their efforts to develop and market generic,
potentially abusive, tax products to multiple clients.
Evidence of KPMG's commitment to ongoing tax product sales
appears throughout this Report. For example, KPMG provided the
Subcommittee with a 2003 list of more than 500 ``active tax
products'' it intends to offer to multiple clients for a fee.
Just last year, in 2002, KPMG established a ``Sales Opportunity
Center'' which the firm itself has characterized as ``a
powerful demonstration of the Firm's commitment to giving''
KPMG professionals ready access to marketing tools to sell
products and services to multiple clients. Also in 2002, the
Tax Innovation Center helped develop new software to enable
KPMG to track tax product development costs and net revenues,
and issue quarterly tax product profitability reports. In 2003,
KPMG's telemarketing center in Indiana continued to be staffed
and ready for tax product marketing assistance.
Evidence of marketing campaigns shows KPMG sought to expand
its tax product sales by targeting new market segments. In
August 2001, for example, KPMG launched a ``Middle Market
Initiative'' to increase its tax product sales to mid-sized
corporations:
``Consistent with several other firm initiatives . . .
we are launching a major initiative in Tax to focus
certain of our resources on the Middle Market. A major
step in this initiative is driving certain Stratecon
high-end solutions to these companies . . . through a
structured, proactive program. . . . National and area
champions of this initiative will meet with leadership
. . . to discuss solutions, agree on appropriate
targets, and develop an area strategy. . . . In order
to maximize marketplace opportunities . . . national
and area champions will coordinate with and involve
assurance partners and managers in their respective
areas. . . . [C]hampions will also coordinate with the
tax practice's proposed strategic alliance with mid-
tier accounting firms. The goal for Stratecon is to
close and implement engagements totaling $15 M in
revenues over the next 15 month period (FY ending 9/
02).'' 181
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\181\ Email dated 8/14/01, from Jeff Stein and Walter Duer to
``KPMG LLP Partners, Managers and Staff,'' ``Stratecon Middle Market
Initiative,'' Bates KPMG 0050369.
The Middle Market Initiative identified seven KPMG tax products
to be marketed to mid-sized corporations, including SC2. It
explicitly called upon KPMG tax professionals to contact KPMG
audit partners to identify appropriate mid-sized corporations,
and then to pitch one or more of the seven KPMG tax products to
KPMG audit clients. It is the Subcommittee staff's
understanding that this marketing campaign is ongoing and
successfully increasing KPMG tax product sales to mid-sized
corporations across the United States.182
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\182\ Subcommittee interview of Jeffrey Stein (10/31/03).
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In December 2001, KPMG held a ``FY02 Tax Strategy
Meeting,'' to discuss ``taking market leadership'' in 2002. One
email described the meeting as follows:
``Thank you for attending the FY02 Tax Strategy
Meeting. It's now time to take action. As you enter the
marketplace armed with the knowledge of `Taking Market
Leadership,' please remember to share your thoughts and
experiences with us so we can better leverage the three
key market pillars--Market Share, Client Centricity,
and Market-Driven Solutions. . . .
``[W]e want to hear more about:
* LTeaming with Assurance; . . .
* LHow clients are responding to our services and
solutions;
* LIdeas for new services and solutions; and
* LBest practices.'' 183
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\183\ Email dated 12/12/01, from Dale Affonso to ``Tax Personnel--
LA & PSW,'' Bates XX 001733.
Additional evidence of KPMG's continued involvement in the
marketing of generic tax products comes from the chart prepared
by KPMG, at the Subcommittee's request, listing its top ten
revenue producing tax products in 2000, 2001, and
2002.184 The list of ten tax products for 2002
includes, among others, the ``Tax-Efficient Minority Preferred
Equity Sale Transaction'' (TEMPEST) and the ``Optional Tax-
Deductible Hybrid Equity while Limiting Local Obligation''
(OTHELLO).185 Another KPMG chart, listing Strat
econ's tax products as of January 1, 2002, describes TEMPEST as
a product that ``creates capital loss,'' 186 while
OTHELLO ``[c]reates a basis step-up in built-in gain asset and
potential for double benefit of built-in losses.''
187 The minimum fee KPMG intends to charge clients
for each of these products, TEMPEST and OTHELLO, is $1
million.188 KPMG has also indicated that each of the
tax products listed on the Stratecon chart remained an ``active
tax product'' as of February 10, 2003.189
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\184\ KPMG chart entitled, ``Good Faith Estimate of Top Revenue-
Generating Strategies,'' attached to letter dated 4/22/03, from KPMG's
legal counsel to the Subcommittee, Bates KPMG 0001801.
\185\ Id.
\186\ KPMG chart entitled ``StrateconWest/FSG Solutions and
Solution WIP--As of January 1, 2002,'' Bates XX 001009-25.
\187\ Id. at 2.
\188\ Id. at 2 and 4.
\189\ See undated document provided by KPMG to the Subcommittee on
2/10/03, ``describing all active tax products included in Tax Products
Alerts, Tax Solutions Alerts and Tax Service Ideas,'' Bates KPMG
0000089-90.
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A final example of evidence of KPMG's ongoing commitment to
selling generic tax products is a draft business plan for
fiscal year 2002, prepared for the Personal Financial Planning
(PFP) tax practice's Innovative Strategies (IS)
group.190 This business plan indicates that, while
the IS group's marketing efforts had decreased after IRS
issuance of new tax shelter notices, it had done all the
preparatory work needed to resume vigorous marketing of new,
potentially abusive tax shelters in 2002. The IS business plan
first recounts the group's past work on FLIP, OPIS, and BLIPS,
noting that the millions of dollars in revenue produced from
sales of these tax products had enabled IS to exceed its annual
revenue goals in each year from 1998 until 2000. The business
plan then states:
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\190\ Document dated 5/18/01, ``PFP Practice Reorganization
Innovative Strategies Business Plan--DRAFT,'' Bates KPMG 0050620-23, at
1. This document was authored by Jeffrey Eischeid, according to Mr.
Eischeid. Subcommittee interview of Jeffrey Eischeid (11/3/03).
``The fiscal [2001] IS revenue goal was $38 million and
the practice has delivered $16 million through period
10. The shortfall from plan is primarily attributable
to the August 2000 issuance [by the IRS] of Notice
2000-44. This Notice specifically described both the
retired BLIPS strategy and the then current
[replacement, the Short Option Strategy or] SOS
strategy. Accordingly, we made the business decisions
to stop the implementation of `sold' SOS transactions
and to stay out of the `loss generator' business for an
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appropriate period of time.''
The business plan then identified six tax products which
had been approved for sale or were awaiting approval, and which
were ``expected to generate $27 million of revenue in fiscal
'02.'' 191 Two of these strategies, called
``Leveraged Private Split Dollar'' and ``Monetization Tax
Advisory Services,'' were not explained, but were projected to
generate $5 million in 2002 fees each.192 Another
tax product, under development and projected to generate $12
million in 2002 fees, is described as:
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\191\ Id. at 3.
\192\ Id. But see minutes dated 11/30/00, Monetization Solutions
Task Force Teleconference, Bates KPMG 0050624-29, at 50627 (advocating
KPMG design and implementation of ``sophisticated entity structures
that have elements of both financial product technology and tax
technology,'' including ``monetization solutions that have been
traditionally offered by the investment banks'' such as ``prepaid
forwards, puts and calls, short sales, synthetic OID conveyances, and
other derivative structures.'')
``a gain mitigation solution, POPS. Judging from the
Firm's historic success in generating revenue from this
type of solution, a significant market opportunity
obviously exists. We have completed the solution's
technical review and have almost finalized the
rationale for not registering POPS as a tax shelter.''
193
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\193\ Document dated 5/18/01, ``PFP Practice Reorganization
Innovative Strategies Business Plan--DRAFT,'' Bates KPMG 0050620-23, at
2.
Still another tax product, under development and projected to
generate $5 million in 2002 fees, is described as a
``conversion transaction . . . that halves the taxpayer's
effective tax rate by effectively converting ordinary income to
long term capital gain. . . . The most significant open issue
is tax shelter registration and the impact registration will
have on the solution.'' The business plan estimates that, if
the projected sales occur, ``the planned revenue per [IS]
partner would be $3 million and the planned contribution per
partner would equal or exceed $1.5 million.''
The business plan provides this analysis:
``[T]here has been a significant increase in the
regulation of `tax shelters.' Not only is this
regulatory activity dampening market appetite, it is
changing the structural nature of the underlying
strategies. Specifically, taxpayers are having to put
more money at risk for a longer period of time in order
to improve the business purpose economic substance
arguments. All things considered, it is more difficult
today to close tax advantaged transactions.
Nevertheless, we believe that the Innovative Strategies
practice is a sustainable business opportunity with
significant growth opportunity.'' 194
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\194\ Id. at 2.
This and other evidence obtained by the Subcommittee during the
past year indicate an ongoing, internal effort within KPMG to
continue the development and sale of generic tax products to
multiple clients.
(3) Implementing Tax Products
(a) KPMG's Implementation Role
LFinding: KPMG is actively involved in implementing
the tax shelters which it sells to its clients,
including by enlisting participation from banks,
investment advisory firms, and tax exempt
organizations; preparing transactional documents;
arranging purported loans; issuing and arranging
opinion letters; providing administrative services; and
preparing tax returns.
In many cases, KPMG's involvement with a tax product sold
to a client does not end with the sale itself. Many KPMG tax
products, including the four examined by the Subcommittee,
require the purchaser to carry out complex financial and
investment activities in order to realize promised tax
benefits. KPMG typically provided such clients with significant
implementation assistance to ensure they realized the promised
tax benefits on their tax returns. KPMG was also interested in
successful implementation of its tax products, because the
track record that built up over time for a particular product
affected how KPMG could, in good faith, characterize that
product to new clients. Implementation problems have also, at
times, caused KPMG to adjust how a tax product is structured
and even spurred development of a new product.
Executing FLIP, OPIS, and BLIPS. FLIP, OPIS, and BLIPS
required the purchaser to establish a shell corporation, join a
partnership, obtain a multi-million dollar loan, and engage in
a series of complex financial and investment transactions that
had to be carried out in a certain order and in a certain way
to realize tax benefits. The evidence collected by the
Subcommittee shows that KPMG was heavily involved in making
sure the client transactions were completed properly.
As a first step, KPMG enlisted the participation of
professional organizations to help design its products and
carry them out. In the case of FLIP, which was the first of the
four tax products to be developed, KPMG sought the assistance
of investment experts at a small firm called Quellos to design
the complex series of financial transactions called for by the
product.195 Quellos, using contacts it had
established in other business dealings, helped KPMG convince a
major bank, UBS AG, to provide financing and participate in the
FLIP transactions. Quellos worked with UBS to fine-tune the
financial transactions, helped KPMG make client presentations
about FLIP and, for those who purchased the product, helped
complete the paperwork and transactions, using Quellos
securities brokers. KPMG also enlisted help from Wachovia Bank,
convincing the bank to refer bank clients who might be
interested in the FLIP tax product.196 In some
cases, the bank permitted KPMG and Quellos to make FLIP
presentations to its clients in the bank's
offices.197 KPMG also enlisted Sidley Austin Brown &
Wood to issue a favorable legal opinion letter on the FLIP tax
product.198
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\195\ Quellos was then known and doing business as Quadra Capital
Management LLP or QA Investments, LLC.
\196\ KPMG actually did business with First Union National Bank,
which subsequently merged with Wachovia Bank.
\197\ Subcommittee interview of First Union National Bank
representatives (3/25/03).
\198\ KPMG actually worked with Brown & Wood, a large New York law
firm which subsequently merged with Sidley & Austin.
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In the case of OPIS and BLIPS, KPMG, again, enlisted the
help of Sidley Austin Brown & Wood, but used a different
investment advisory firm. Instead of Quellos, KPMG obtained
investment advice from Presidio Advisory Services. Presidio was
formed in 1997, by two former KPMG tax professionals, one of
whom was a key participant in the development and marketing of
FLIP.199 These two tax professionals left the
accounting firm, because they wanted to focus on the investment
side of the generic tax products being developed by
KPMG.200 Unlike Quellos, which had substantial
investment projects aside from FLIP, virtually all of
Presidio's work over the following 5 years derived from KPMG
tax products. Presidio's principals worked closely with KPMG
tax professionals to design OPIS and BLIPS. Presidio's
principals also helped KPMG obtain lending and securities
services from three major banks, Deutsche Bank, HVB, and
NatWest, to complete OPIS and BLIPS transactions.
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\199\ The two former KPMG tax professionals are John Larson and
Robert Pfaff. They also formed numerous other companies, many of them
shells, to participate in business dealings including, in some cases,
OPIS and BLIPS transactions. These related companies include Presidio
Advisors, Presidio Growth, Presidio Resources, Presidio Volatility
Management, Presidio Financial Group, Hayes Street Management, Holland
Park, Prevad, Inc., and Norwood Holdings (collectively referred to as
``Presidio'').
\200\ Subcommittee interview of John Larson (10/21/03); email dated
7/29/97, from Larry DeLap to multiple KPMG tax professionals, ``Revised
Memorandum,'' Bates KPMG JAC 331160, forwarding memorandum dated 7/29/
97, from Bob Pfaff to John Lanning, Jeff Stein and others, ``My
Thoughts Concerning KPMG's Tax Advantaged Transaction Practice,
Presidio's Relationship with KPMG, Transition Issues.''
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In addition to enlisting the participation of legal,
investment, and financial professionals, KPMG provided
significant administrative support for the FLIP, OPIS, and
BLIPS transactions, using KPMG personnel to help draft and
prepare transactional documents, and assist the investment
advisory firms and the banks with paperwork. For example, when
a number of loans were due to be closed in certain BLIPS
transactions, two KPMG staffers were stationed at HVB to assist
the bank with closing and booking issues.201 Other
KPMG employees were assigned to Presidio to assist in
expediting BLIPS transactions and paperwork. KPMG also worked
with Quellos, Presidio, and the relevant banks to ensure that
the banks established large enough credit lines, with hundreds
of millions of dollars, to allow a substantial number of
individuals to carry out FLIP, OPIS, and BLIPS transactions.
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\201\ Credit Request dated 9/26/99, Bates HVB 001166; Subcommittee
interview of HVB representatives (10/29/03).
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When asked about KPMG's communications with the banks, the
OPIS and BLIPS National Deployment Champion initially denied
ever contacting bank personnel directly, claiming instead to
have relied on Quellos and Presidio personnel to work directly
with the bank personnel.202 When confronted with
documentary evidence of direct contacts, however, the
Deployment Champion reluctantly admitted communicating on rare
occasions with bank personnel. Evidence obtained by the
Subcommittee, however, shows that KPMG communications with bank
personnel were not rare. KPMG negotiated intensively with the
banks over the factual representations that would be attributed
to the banks in the KPMG opinion letters. On occasion, KPMG
stationed its personnel at the banks to facilitate transactions
and paperwork. The BLIPS National Deployment Champion met with
NatWest personnel regarding the BLIPS transactions. In one
instance in 2000, documents indicate that, when clients had
exhausted the available credit at Deutsche Bank to conduct OPIS
transactions, the Deployment Champion planned to meet with
senior Deutsche Bank officials about increasing the credit
lines so that more OPIS products could be sold.203
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\202\ Subcommittee interview of Jeffrey Eischeid (10/8/03).
\203\ See, e.g., memorandum dated 8/5/98, from Doug Ammerman to
``PFP Partners,'' ``OPIS and Other Innovative Strategies,'' Bates KPMG
0026141-43 at 2; email dated 5/13/99, sent by Barbara Mcconnachie but
attributed to Doug Ammerman, to John Lanning and other KPMG tax
professionals, ``FW: BLIPS,'' Bates KPMG 0011903 (``Jeff Eischeid will
be attending a meeting . . . to address the issue of expanding capacity
at Deutsche Bank given our expectation regarding the substantial volume
expected from this product.'') It is unclear whether this meeting
actually took place.
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Executing SC2. In the case of SC2, the tax product could
not be executed at all without a charitable organization
willing to participate in the required transactions. KPMG took
on the task of locating and convincing appropriate charities to
participate in SC2 transactions. The difficulty of this task
was evident in several KPMG documents. For example, one SC2
document warned KPMG personnel not to look for a specific
charity to participate in a specific SC2 transaction until
after an engagement letter was signed with a client because:
``It is difficult to find qualifying tax exempts. . . . [O]f
those that qualify only a few end up being interested and only
a few of those will accept donations. . . . We need to be able
to go to the tax-exempt with what we are going to give them to
get them interested.'' 204 In another email, the SC2
National Deployment Champion wrote:
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\204\ Attachment entitled, ``Tax Exempt Organizations,'' included
in an SC2 information packet dated 7/19/00, ``SC2--Meeting Agenda,''
Bates KPMG 0013387.
``Currently we have five or six tax exempts that have
reviewed the transaction, are comfortable they are not
subject to UBIT [unrelated business income tax] and are
eager to receive gifts of S Corp stock. These
organizations are well established, solid
organizations, but generally aren't organizations our
clients and targets have made gifts to in the past.
This point hit painfully home when, just before signing
our engagement letter for an SC2 transaction with a $3
million fee, an Atlanta target got cold feet.''
205
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\205\ Email dated 2/22/01, from Councill Leak to multiple KPMG tax
professionals, ``SC2 Solution--New Development,'' Bates KPMG 0050822.
KPMG refused to identify to the Subcommittee any of the
charities it contacted about SC2 or any of the handful of
charities that actually participated in SC2 stock donations,
claiming this was ``tax return information'' that it could not
disclose. The Subcommittee was nevertheless able to identify
and interview two charitable organizations which, between them,
participated in more than half of the 58 SC2 transactions KPMG
arranged.206
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\206\ Subcommittee interviews with Los Angeles Department of Fire &
Police Pension System (10/22/03) and the Austin Fire Relief and
Retirement Fund (10/14/03).
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Both charities interviewed by Subcommittee staff indicated
that they first learned of SC2 when contacted by KPMG
personnel. Both used the same phrase, that KPMG had contacted
them ``out of the blue.'' 207 Both charities
indicated that KPMG personnel explained SC2 to them, convinced
them to participate, introduced the potential SC2 donors to the
charity, and supplied draft transactional documents. Both
charities indicated that, with KPMG acting as a liaison, they
then accepted S corporation stock donations from out-of-state
residents whom they never met and with whom they had never had
any prior contact.
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\207\ Id.
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KPMG also distributed to its personnel a document entitled,
``SC2 Implementation Process,'' listing a host of
implementation tasks they should complete in each transaction.
These tasks included technical, administrative, and logistical
chores. For example, KPMG personnel were told they should
evaluate the S corporation's ownership structure and
incorporation documentation; work with an outside valuation
firm to determine the corporation's enterprise value and the
value of the corporate stock and warrants; and physically
deliver the appropriate stock certificates to the charity
accepting the client's stock donation.208
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\208\ ``SC2 Implementation Process,'' included in an SC2
information packet dated 7/19/00, Bates KPMG 0013385-86.
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Both charities said that KPMG often acted as a go-between
for the charity and the corporate donor, shuttling documents
back and forth and answering inquiries on both sides. KPMG
apparently also drafted and supplied draft transactional
documents to the S corporations and corporate
owners.209 One of the pension funds informed the
Subcommittee staff that, when one corporate donor needed to re-
take possession of the corporate stock due to an unrelated
business opportunity that required use of the stock, KPMG
assisted in the mechanics of selling the stock back to the
donor.210
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\209\ Subcommittee interview of Lawrence Manth (11/6/03).
\210\ Subcommittee interview of William Stefka, Austin Fire Relief
and Retirement Fund (10/14/03).
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The documentation shows that KPMG tax professionals also
expended significant effort developing a ``back-end deal'' for
SC2 donors, meaning a tax transaction that could be used by the
S corporation owner to further reduce or eliminate their tax
liability when they retake control of the S corporation and
distribute some or all of the income that built up within the
company while the charity was a shareholder. The SC2 National
Deployment Champion wrote to more than 20 of his colleagues
working on SC2 the following:
``Our estimate is that by 12/31/02, there will be
approximately $1 billion of income generated by S-corps
that have implemented this strategy, and our goal is to
maintain the confidentiality of the strategy for as
long as possible to protect these clients (and new
clients). . . .
``We have had our first redemption from the LAPD.
Particular thanks to [a KPMG tax professional] and his
outstanding relationship with the LAPD fund
administrators, the redemption went smooth. [Three KPMG
tax professionals] all worked together on structuring
the back-end deal allowing for the shareholder to
recognize a significant benefit, as well as getting
KPMG a fee of approx. $1 million, double the original
SC2 fee!!
``[Another KPMG tax professional] is in the process of
working on a back-end solution to be approved by WNT
that will provide S-corp shareholders additional basis
in their stock which will allow for the cash build-up
inside of the S-corporation to be distributed tax-free
to the shareholders. This should provide us with an
additional revenue stream and a captive audience. Our
estimate is that if 50% of the SC2 clients implement
the back-end solution, potential fees will approximate
$25 million.'' 211
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\211\ Email dated 12/27/01, from Larry Manth to Andrew Atkin and
other KPMG tax professionals, ``SC2,'' Bates KPMG 0048773. See also
email dated 8/18/01, from Larry Manth to multiple KPMG tax
professionals, ``RE: New Solutions--WNT,'' Bates KPMG 0026894.
This email communication shows that the key KPMG tax
professionals involved with SC2 viewed the strategy as a way to
defer and reduce taxes on substantial corporate income that was
always intended to be returned to the control of the stock
donor. It also shows that KPMG's implementation efforts on SC2
continued long past the sale of the tax product to a client.
Preparing KPMG Opinion Letters. In addition to helping
clients complete the transactions called for in FLIP, OPIS,
BLIPS, and SC2, when it came time for clients to submit tax
returns at the end of the year or in subsequent years, KPMG was
available to help its clients prepare their returns. In
addition, whether a client's tax return was prepared by KPMG or
someone else, KPMG supplied the client with a tax opinion
letter explaining the tax benefits that the product provided
and could be reflected in the client's tax return. In three of
the cases examined by the Subcommittee, KPMG also arranged for
its clients to obtain a second favorable opinion letter from an
outside law firm. In the fourth case, SC2, KPMG knew of law
firms willing to issue a second opinion letter, but it is
unclear whether any were actually issued.
A tax opinion letter, sometimes called a legal opinion
letter when issued by a law firm, is intended to provide
written advice to a client on whether a particular tax product
is permissible under the law and, if challenged by the IRS, how
likely it would be that the challenged product would survive
court scrutiny. The Subcommittee investigation uncovered
disturbing evidence related to how opinion letters were being
developed and used in connection with KPMG's tax products.
The first issue involves the accuracy and reliability of
the factual representations that were included in the opinion
letters supporting KPMG's tax products. In the four case
histories, KPMG tax professionals expended extensive effort
drafting a prototype tax opinion letter to serve as a template
for the opinion letters actually sent by KPMG to its clients.
One key step in the drafting process was the drafting of
factual representations attributed to parties participating in
the relevant transactions. Such factual representations play a
critical role in the opinion letter by laying a factual
foundation for its analysis and conclusions. Treasury
regulations state:
``The advice [in an opinion letter] must not be based
on unreasonable factual or legal assumptions (including
assumptions as to future events) and must not
unreasonably rely on the representations, statements,
findings, or agreements of the taxpayer or any other
person. For example, the advice must not be based upon
a representation or assumption which the taxpayer
knows, or has reason to know, is unlikely to be true,
such as an inaccurate representation or assumption as
to the taxpayer's purposes for entering into a
transaction or for structuring a transaction in a
particular manner.'' 212
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\212\ Treas. Reg. Sec. 1.6664-4(c)(1)(ii).
KPMG stated in its opinion letters that its analysis relied
on the factual representations provided by the client and other
key parties. In the BLIPS prototype tax opinion, for example,
KPMG stated that its ``opinion and supporting analysis are
based upon the following description of the facts and
representations associated with the investment transactions
undertaken by Investor.'' 213 The Subcommittee was
told that Sidley Austin Brown & Wood relied on the same factual
representations to compose the legal opinion letters that it
drafted.
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\213\ Prototype BLIPS tax opinion letter prepared by KPMG, (12/31/
99), Bates KPMG 0000405-417, at 1.
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Virtually all of the FLIP, OPIS, and BLIPS opinion letters
contained boilerplate repetitions of the factual
representations attributed to the participating parties. For
example, virtually all the KPMG FLIP clients made the same
factual representations, worded in the same way. The same was
true for KPMG's OPIS clients and for KPMG's BLIPS clients. Each
of the banks that participated in BLIPS made factual
representations that varied slightly from bank to bank, but did
not vary at all for a particular bank. In other words, Deutsche
Bank and HVB attested to slightly different versions of the
factual representations attributed to the bank participating in
the BLIPS transactions, but every BLIPS opinion letter that,
for example, referred to Deutsche Bank, contained the exact
same boilerplate language to which Deutsche Bank had agreed to
attest.
The evidence is clear that KPMG took the lead in drafting
the factual representations attributed to other parties,
including the client or ``investor'' who purchased the tax
product, the investment advisory firm that participated in the
transactions, and the bank that provided the financing. In the
case of the factual representations attributed to the
investment advisory firm or bank, the evidence indicates that
KPMG presented its draft language to the relevant party and
then engaged in detailed negotiations over the final
wording.214 In the case of the factual
representations attributed to a client, however, the evidence
indicates KPMG did not consult with its client beforehand, even
for representations purporting to describe, in a factual way,
the client's intentions, motivations, or understanding of the
tax product. KPMG alone, apparently without any client input,
wrote the client's representations and then demanded that each
client attest to them by returning a signed letter to the
accounting firm.
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\214\ See, e.g., email dated 3/27/00, from Jeffrey Eischeid to
Richard Smith, ``Bank representation,'' and email dated 3/28/00, from
Jeffrey Eischeid to Mark Watson, ``Bank representation,'' Bates KPMG
0025753 (depicting negotiations between KPMG and Deutsche Bank over
factual representations to be included in opinion letter).
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The evidence indicates that KPMG not only failed to consult
with its clients before attributing factual representations to
them, it also refused to allow its clients to deviate from the
KPMG-drafted representations, even when clients disagreed with
the statements being attributed to them. For example, according
to a court complaint filed by one KPMG client, Joseph Jacoboni,
he initially refused to attest to the factual representations
sent to him by KPMG about a FLIP transaction, because he had no
first hand knowledge of the ``facts'' and did not understand
the FLIP transaction.215 According to Mr. Jacoboni,
KPMG would not alter the client representations in any way and
would not supply him with any opinion letter until he attested
to the specific factual representations attributed to him by
KPMG. After a standoff lasting nearly 2 months, with the
deadline for his tax return fast approaching, Mr. Jacoboni
finally signed the representation letter attesting to the
statements KPMG had drafted.216
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\215\ Jacoboni v. KPMG, Case No. 6:02-CV-510 (M.D. Fla. 4/29/02)
Complaint at para.para. 16-17 (``[I]t seemed ridiculous to ask Mr.
Jacoboni to sign the Representation Letter, which neither he [Mr.
Jacoboni's legal counsel] nor Mr. Jacoboni understood. Moreover, Mr.
Jacoboni had no personal knowledge of the factual representations in
the letter and could not verify the facts as KPMG requested.'' Emphasis
in original.); Subcommittee interview of Mr. Jacoboni's legal counsel
(4/4/03).
\216\ Id. at para.para. 18-19. Mr. Jacaboni also alleges that,
despite finally signing the letter, he never received the promised tax
opinion letter from KPMG.
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Equally disturbing is that some of the key factual
representations KPMG attributed to its clients appear to
contain false or misleading statements. For example, in the
BLIPS prototype letter, KPMG wrote: ``Investor has represented
to KPMG . . . [that the] Investor independently reviewed the
economics underlying the [BLIPS] Investment Fund before
entering into the program and believed there was a reasonable
opportunity to earn a reasonable pre-tax profit from the
transactions.'' 217 The existence of a client profit
motive and the existence of a reasonable opportunity to earn a
reasonable pre-tax profit are central factors in determining
whether a tax product like BLIPS has a business purpose and
economic substance apart from its tax benefits. It is the
Subcommittee's understanding that this client representation
was repeated substantially verbatim in every BLIPS tax opinion
letter KPMG issued.
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\217\ Prototype BLIPS tax opinion letter prepared by KPMG, (12/31/
99), Bates KPMG 0000405-417, at 9.
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The first stumbling block is the notion that every client
who purchased BLIPS ``independently'' reviewed its
``economics'' beforehand, and ``believed'' there was a
reasonable opportunity to make a reasonable profit. BLIPS was
an enormously complicated transaction, with layers of
structured finance, a complex loan, and intricate foreign
currency trades. A technical analysis of its ``economics'' was
likely beyond the capability of most of the BLIPS purchasers.
In addition, KPMG knew there was only a remote possibility--not
a reasonable possibility--of a client's earning a profit in
BLIPS.218 Nevertheless, since the existence of a
reasonable opportunity to earn a reasonable profit was critical
to BLIPS' having economic substance, KPMG included that
questionable client representation in its BLIPS tax opinion
letter.219
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\218\ See email dated 5/4/99, from Mark Watson, WNT, to Larry
DeLap, DPP, Bates KPMG 0011916 (Quoting Presidio investment experts who
set up the BLIPS transactions, KPMG tax expert states: ``the
probability of actually making a profit from this transaction is remote
(possible, but remote).'').
\219\ KPMG required the investment advisory firm, Presidio, to make
this same factual representation, even though Presidio had informed
KPMG personnel that ``the probability of actually making a profit from
this transaction is remote (possible, but remote).'' The evidence
indicates that both KPMG and Presidio knew there was only a remote
possibility--not a reasonable possibility--of a client's earning a
profit in the BLIPS transaction, yet both continued to issue and stand
behind an opinion letter attesting to what both knew was an inaccurate
factual representation.
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BLIPS was constructed so that the potential for client
profit from the BLIPS transactions increased significantly if
the client participated in all three phases of the BLIPS loan,
which required a full 7 years to finish. The head of DPP-Tax
observed that KPMG had drafted a factual representation for
inclusion in the prototype BLIPS tax opinion letter stating
that, ``The original intent of the parties was to participate
in all three investment stages of the Investment Program.'' He
cautioned against including this factual representation in the
opinion letter: ``It seems to me that this [is] a critical
element of the entire analysis and should not be blithely
assumed as a `fact.' . . . I would caution that if there were,
say, 50 separate investors and all 50 bailed out at the
completion of Stage I, such a representation would not seem
credible.'' 220
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\220\ Email dated 4/14/99, from Larry DeLap to multiple KPMG tax
professionals, ``RE: BLIPS,'' Bates KPMG 0017578-79.
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The proposed representation was not included in the final
version of the BLIPS prototype opinion letter, and the actual
BLIPS track record supported the cautionary words of the DPP
head. In 2000, the KPMG tax partner in charge of WNT wrote:
``Lastly, an issue that I am somewhat reluctant to
raise but I believe is very important going forward
concerns the representations that we are relying on in
order to render our tax opinion in BLIPS I. In each of
the 66 or more deals that were done at last year, our
clients represented that they `independently' reviewed
the economics of the transaction and had a reasonable
opportunity to earn a pretax profit. . . . As I
understand the facts, all 66 closed out by year-end and
triggered the tax loss. Thus, while I continue to
believe that we can issue the tax opinions on the BLIPS
I deals, the issue going forward is can we continue to
rely on the representations in any subsequent deals if
we go down that road? . . . My recommendation is that
we deliver the tax opinions in BLIPS I and close the
book on BLIPS and spend our best efforts on alternative
transactions.'' 221
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\221\ Email dated 2/24/00, from Philip Wiesner to multiple KPMG tax
professionals, ``RE: BLIPS/OPIS,'' Bates KPMG 0011789.
This email and other documentation indicate that KPMG was
well aware that the BLIPS transactions were of limited duration
and uniformly produced substantial tax losses that
``investors'' used to offset and shelter other income from
taxation.222 This growing factual record, showing
that BLIPS investors invariably lost money, made it
increasingly difficult for KPMG to rely on an alleged client
representation about BLIPS' having a reasonable profit
potential. KPMG nevertheless continued to sell the product and
to issue tax opinion letters relying on a critical client
representation that KPMG had drafted without client input and
attributed to its clients, but which KPMG knew or had reason to
know, was unsupported by the facts.
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\222\ Email dated 5/4/99, from Mark Watson, WNT, to Larry DeLap,
DPP, Bates KPMG 0011916. See also document dated 5/18/01, ``PFP
Practice Reorganization Innovative Strategies Business Plan--DRAFT,''
authored by Jeffrey Eischeid, Bates KPMG 0050620-23, at 1-2 (referring
to BLIPS and its predecessors, FLIP and OPIS, as a ``capital loss
strategy,'' ``loss generator'' or ``gain mitigation solution'').
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Discontinuing Sales. Still another KPMG implementation
issue involves decisions by KPMG to stop selling particular tax
products. In all four of the case studies examined by the
Subcommittee, KPMG stopped marketing the tax product within 1
or 2 years of its first sale.223 The decision was
made in each case by the head of DPP-Tax, after consultation
with the product's Deployment Champion and other senior tax
professionals.
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\223\ See, e.g., email dated 12/29/01, from Larry DeLap to multiple
KPMG tax professionals, ``FW: SC2,'' Bates KPMG 0050562 (discontinuing
SC2); email dated 10/1/99, from Larry DeLap to multiple KPMG tax
professionals, ``BLIPS,'' Bates KPMG 0011716 (discontinuing BLIPS);
email dated 12/7/98, from Larry DeLap to multiple KPMG tax
professionals, ``OPIS,'' Bates KPMG 0025730 (discontinuing OPIS).
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When asked to explain why sales were discontinued, the DPP
head offered several reasons for pulling a tax product off the
market.224 The DPP head stated that he sometimes
ended the marketing of a tax product out of concern that a
judge would invalidate the tax product ``as a step
transaction,'' using evidence that a number of persons who
purchased the product engaged in a series of similar
transactions.225 Limiting the number of tax products
sold limited the evidence that each resulted in a similar set
of transactions orchestrated by KPMG. Limiting the number of
tax products sold also limited information about them to a
small circle and made it more difficult for the IRS to detect
the activity.226
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\224\ Subcommittee interview of Lawrence DeLap (10/30/03).
\225\ Id.
\226\ See Section VI(B)(4) of this Report on ``Avoiding
Detection.''
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Evidence in the four case studies shows that internal KPMG
directives to stop sales of a particular tax product were, at
times, ignored or circumvented by KPMG tax professionals
marketing the products. For example, the DPP head announced an
end to BLIPS sales in the fall of 1999, but allowed KPMG tax
professionals to complete numerous BLIPS sales in 1999 and
2000, to persons who had been approached before the marketing
ban was announced.227 These purchasers were referred
to internally at KPMG as ``grandfathered BLIPS''
clients.228 A handful of additional sales took place
in 2000, over the objection of the DPP head, after his
objection was overruled by head of the Tax Services
Practice.229 Also in 2000, some KPMG tax
professionals attempted to restart BLIPS sales by developing a
modified BLIPS product that would be sold to only extremely
wealthy individuals.230 This effort was ultimately
unsuccessful in restarting BLIPS sales.
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\227\ See, e.g., email dated 10/13/99, from Carl Hasting to Dale
Baumann, ``RE: Year 2000 Blips Transactions,'' Bates KPMG 0006485 (``I
thought we were told to quit marketing 200[0] BLIPS transactions.'');
email dated 10/13/99, from Dale Baumann to Carl Hasting and others,
``RE: Year 2000 Blips Transactions,'' Bates KPMG 0006485 (``No
marketing to clients who were not on the BLIPS 2000 list. The BLIPS
2000 list were for those individuals who we approached before Larry
told us to stop marketing the strategy. . . .'').
\228\ See, e.g., two emails dated 10/1/99, from Larry DeLap to
multiple KPMG tax professionals, ``BLIPS,'' Bates KPMG 0011714.
\229\ Subcommittee interview of Lawrence DeLap (10/30/03).
\230\ See, e.g., email dated 6/20/00, from William Boyle of
Deutsche Bank to other Deutsche Bank personnel, ``Updated Presidio/KPMG
trades,'' Bates DB BLIPS 03280 (``Presidio and KPMG are developing an
expanded version of BLIP's which it will execute on a limited basis for
its wealthy clientele. They anticipate executing approximately 10-15
deals of significant size (i.e. in the $100-300m. Range).'').
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In the case of SC2, KPMG tax professionals simply did not
comply with announced limits on the total number of SC2
products that could be sold or limits on the use of
telemarketing calls to market the product.231 In the
case of FLIP and OPIS, additional sales, again, took place
after the DPP head had announced an end to the marketing of the
products.232 The DPP head told Subcommittee staff
that when he discontinued BLIPS sales in 1999, he was pressed
by the BLIPS National Deployment Champion and others for an
alternative product.233 The DPP head indicated that,
because of this pressure, he relented and allowed KPMG tax
professionals to resume sales of OPIS, which he had halted a
year earlier.
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\231\ See Section VI(B)(2) of this Report on ``Mass Marketing Tax
Products.'' See also, e.g., email dated 4/23/01, from John Schrier to
Thomas Crawford, ``RE: SC2 target list,'' Bates KPMG 0050029; email
dated 12/20/01, from William Kelliher to David Brockway, ``FW: SC2,''
Bates KPMG 0013311; and email response dated 12/29/01, from Larry DeLap
to William Kelliher, David Brockway, and others, ``FW: SC2,'' Bates
KPMG 0013311.
\232\ See, e.g., email dated 9/30/99, from Jeffrey Eischeid to
Wolfgang Stolz and others, ``OPIS,'' Bates QL S004593.
\233\ Subcommittee interview of Lawrence DeLap (10/30/03).
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(b) Role of Third Parties in Implementing KPMG Tax Products
FLIP, OPIS, BLIPS, and SC2 could not have been executed
without the active and willing participation of the banks,
investment advisors, lawyers, and charitable organizations that
made these products work. The roll call of respected
professional firms with direct and extensive involvement in the
four KPMG case studies includes Deutsche Bank, HVB, NatWest,
UBS, Wachovia Bank, and Sidley Austin, Brown & Wood. Smaller
professional firms such as Quellos, and charitable
organizations such as the Los Angeles Department of Fire &
Police Pensions and the Austin Fire Fighters Relief and
Retirement Fund, while less well known nationally, are
nevertheless respected institutions who played critical roles
in the execution of at least one of the four tax products.
LFinding: Some major banks and investment advisory
firms have provided critical lending or investment
services or participated as essential counter parties
in potentially abusive or illegal tax shelters sold by
KPMG, in return for substantial fees or profits.
The Role of the Banks. Five major banks participated in
BLIPS, FLIP, and OPIS. Deutsche Bank participated in more than
50 BLIPS transactions in 1999 and 2000, providing credit lines
that totaled as much as $2.8 billion.234 Deutsche
Bank also participated in about 60 OPIS transactions in 1998
and 1999. HVB participated in more than 30 BLIPS transactions
in 1999 and 2000, providing BLIPS credit lines that apparently
totaled nearly $2.5 billion.235 NatWest apparently
also participated in a significant number of BLIPS transactions
in 1999 and 2000, providing credit lines totaling more than $1
billion.236 UBS AG participated in 100-150 FLIP and
OPIS transactions in 1997 and 1998, providing credit lines
which, in the aggregate, were in the range of several billion
Swiss francs.237
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\234\ See, e.g., email dated 6/20/00, from William Boyle of
Deutsche Bank to other Deutsche Bank personnel, ``Updated Presidio/KPMG
trades,'' Bates DB BLIPS 03280; chart entitled, ``Presidio Advisory
Services. Deal List 1999,'' Bates HVB000875 (BLIPS transactions for
1999); chart entitled, ``Presidio Advisory Services. Deal List 2000,''
Bates HVCD00018-19 (BLIPS transactions for 2000).
\235\ See, e.g., memorandum dated 8/19/03 (this date is likely in
error), from Ted Wolf and Sylvie DeMetrio to Christopher Thorpe and
others, ``Presidio,'' Bates HVCD 00001; chart entitled, ``Presidio
Advisory Services. Deal List 1999,'' Bates HVB000875 (BLIPS
transactions for 1999); chart entitled, ``Presidio Advisory Services.
Deal List 2000,'' Bates HVCD00018-19 (BLIPS transactions for 2000). See
also credit request dated 1/6/00, Bates HVB 003320-30 (seeking approval
of $1.5 billion credit line for 2000, and noting that, in 1999, the
bank ``booked USD 950 million (out of USD 1.03 billion approved) . . .
all cash collateralized.'')
\236\ See, e.g., email dated 6/20/00, from William Boyle of
Deutsche Bank to other Deutsche Bank personnel, ``Updated Presidio/KPMG
trades,'' Bates DB BLIPS 03280.
\237\ See, e.g., UBS memorandum dated 12/21/99, from Teri Kemmerer
Sallwasser to Gail Fagan, ``Boss Strategy Meetings . . .,'' Bates SEN-
018253-57; Subcommittee interview of UBS representatives (4/4/03).
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Two investment advisory firms also participated in the
development, marketing and implementation of BLIPS, FLIP, and
OPIS. Quellos participated in the development, marketing, and
execution of FLIP. It participated in over 80 FLIP transactions
with KPMG, as well as similar number of these transactions with
PricewaterhouseCoopers and Wachovia Bank. It also executed some
OPIS transactions for KPMG. Presidio participated in the
development, marketing, and implementation of OPIS and BLIPS
transactions, including the 186 BLIPS transactions related to
186 KPMG clients.238 The Presidio principals even
conducted a BLIPS transaction on their own
behalf.239
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\238\ See, e.g., email dated 3/14/98, from Jeff Stein to Robert
Wells, John Lanning, Larry DeLap, Gregg Ritchie, and others, ``Simon
Says,'' Bates 638010, filed by the IRS on June 16, 2003, as an
attachment to Respondent's Requests for Admission, Schneider Interests
v. Commissioner, U.S. Tax Court, Docket No. 200-02, (describing the
role of Presidio principal, Robert Pfaff, in the development of OPIS);
Subcommittee interviews of John Larson (10/3/03 and 10/21/03).
\239\ Subcommittee interviews of John Larson (10/3/03 and 10/21/
03). Presidio discussed completing a BLIPS transaction on its own
behalf with the assistance of HVB, but ultimately completed the
transaction elsewhere. See, e.g., ``Corporate Banking Division--Credit
Request'' dated 9/14/99, Bates HVB 000147-64; ``Corporate Banking
Division--Credit Request'' dated 4/28/00, Bates HVB 004148-51;
memorandum dated 9/14/99, from Robert Pfaff of Presidio to Dom
DiGiorgio of HVB, ``BLIPS loan test case,'' Bates HVB 000202; chart
dated 9/14/99 entitled, ``Presidio Ownership Structure,'' Bates HVB
000215; undated document entitled, ``Structural Differences in the
Transaction for Presidio Principals,'' Bates HVCD 00007; undated
diagrams depicting BLIPS loans to Presidio principals, Bates HVB
004272-75.
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The banks and investment advisory firms interviewed by the
Subcommittee staff acknowledged obtaining lucrative fees for
their participation in FLIP, OPIS, or BLIPS. Deutsche Bank
internal documents state that the bank earned more than $33
million from OPIS and expected to earn more than $30 million
for BLIPS.240 HVB earned over $5.45 million for the
BLIPS transactions it completed in less than 3 months in 1999,
and won approval of increased BLIPS transactions throughout
2000, ``based on successful execution of previous transactions,
low credit risk and excellent profitability.'' 241
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\240\ See undated document entitled, ``New Product Committee
Overview Memo: BLIPS Transaction,'' Bates DB BLIPS 01959; email dated
4/28/99, from Francesco Piovanetti to Nancy Donohue, ``presidio--w.
revisions, I will call u in 1 min.,'' Bates DB BLIPS 6911.
\241\ See HVB credit request dated 1/6/00, Bates HVB 003320-30 (HVB
``earned USD 4.45 million'' from BLIPS loan fees and ``approximately
USD 1 million'' from related foreign exchange activities for BLIPS
transactions completed from October to December 1999); HVB document
dated 8/6/00, from Thorpe, marked ``DRAFT,'' Bates HVB 001805.
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The Subcommittee interviewed four of the five banks, most
of which cooperated with the inquiry and were generally open
and candid about their interactions with KPMG, their
understanding of FLIP, OPIS, and BLIPS, and their respective
roles in these tax products. Evidence obtained by the
Subcommittee shows that the banks knew they were participating
in transactions whose primary purpose was to provide tax
benefits to persons who had purchased tax products from KPMG.
Some of the documentation also make it plain that the bank was
aware that the tax product was potentially abusive and carried
a risk to the reputation of any bank choosing to participate in
it.
For example, a number of Deutsche Bank documents make it
clear that the bank knew BLIPS was a tax related transaction
and posed a reputational risk to the bank if the bank chose to
participate in it. One Deutsche Bank official working to obtain
bank approval to participate in BLIPS wrote:
``In this transaction, reputation risk is tax related
and we have been asked by the Tax Department not to
create an audit trail in respect of the Bank's tax
affaires. The Tax department assumes prime
responsibility for controlling tax related risks
(including reputation risk) and will brief senior
management accordingly. We are therefore not asking R&R
[Reputation & Risk] Committee to approve reputation
risk on BLIPS. This will be dealt with directly by the
Tax Department and [Deutsche Bank Chief Executive
Officer] John Ross.'' 242
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\242\ Email dated 7/30/99, from Ivor Dunbar of Deustche Bank, DMG
UK, to multiple Deutsche Bank professionals, ``Re: Risk & Resources
Committee Paper--BLIPS,'' unreadable Bates number. See also email dated
7/29/99 from Mick Wood to Francesco Piovanetti and other Deutsche bank
personnel, ``Re: Risk & Resources Committee Paper--BLIPS,'' Bates DB
BLIPS 6556 (paper prepared for the Risk & Resources Committee ``skirts
around the basic issue rather than addressing it head on (the tax
reputational risk).'').
Another Deutsche Bank memorandum, prepared for the ``New
Product Committee'' to use in reviewing BLIPS, included the
---------------------------------------------------------------------------
following statements explaining the transaction:
``BLIPS will be marketed to High Net Worth Individual
Clients of KPMG. . . . Loan conditions will be such as
to enable DB to, in effect, force (p)repayment after 60
days at its option. . . . For tax and accounting
purposes, repaying the [loan] premium amount will
`count' '' like a loss for tax and accounting purposes.
. . . At all times, the loan will maintain collateral
of at least 101% to the loan + premium amount. . . . It
is imperative that the transaction be wound up after
45-60 days and the loan repaid due to the fact that the
HNW individual will not receive his/her capital loss
(or tax benefit) until the transaction is wound up and
the loan repaid. . . . At no time will DB Private Bank
provide any tax advice to any individuals involved in
the transactions. This will be further buttressed by
signed disclaimers designed to protect and `hold
harmless' DB. . . . DB has received a legal opinion
from Shearman & Sterling which validates our envisaged
role in the transaction and sees little or no risk to
DB in the trade. Furthermore opinions have been issued
from KPMG Central Tax department and Brown & Wood
attesting to the soundness of the transactions from a
tax perspective.'' 243
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\243\ Undated document entitled, ``New Product Committee Overview
Memo: BLIPS Transaction,'' Bates DB BLIPS 01959-63.
Still another Deutsche Bank document states: ``For tax and
accounting purposes, the [loan] premium amount will be treated
as a loss for tax purposes.'' 244
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\244\ Email dated 7/1/99 from Francesco Piovanetti to Ivor Dunbar,
`` `Hugo' BLIPS Paper,'' with attachment entitled, ``Bond Linked
Indexed Premium Strategy `BLIPS,' '' Bates DB BLIPS 6585-87 at 6587.
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Bank documentation indicates that a number of internal bank
departments, including the tax, accounting, and legal
departments, were asked to and did approve the bank's
participation in BLIPS. BLIPS was also brought to the attention
of the bank's Chief Executive Officer John Ross who made the
final decision on the bank's participation.245
Minutes describing the meeting in which Mr. Ross approved the
bank's participation in BLIPS state:
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\245\ See email dated 10/13/99, from Peter Sturzinger to Ken Tarr
and other Deutsche Bank personnel, ``Re: BLIPS,'' attaching minutes
dated 8/4/99, from a ``Deutsche Bank Private Banking, Management
Committee Meeting'' that discussed BLIPS, Bates DB BLIPS 6520-6521.
``[A] meeting with John Ross was held on August 3, 1999
in order to discuss the BLIPS product. [A bank
representative] represented [Private Banking]
Management's views on reputational risk and client
suitability. John Ross approved the product, however
insisted that any customer found to be in litigation be
excluded from the product, the product be limited to 25
customers and that a low profile be kept on these
transactions. . . . John Ross also requested to be kept
informed of future transactions of a similar nature.''
246
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\246\ Id. at 6520.
Given the extensive and high level attention provided by the
Bank regarding its participation in BLIPS, it seems clear that
the bank had evaluated BLIPS carefully and knew what it was
getting into.
Other evidence shows that Deutsche Bank was aware that the
BLIPS loans were not run-of-the-mill commercial loans, but had
unusual features. Deutsche Bank refused, for example, to sign a
letter representing that the BLIPS loan structure, which
included an unusual multi-million dollar ``loan premium''
credited to a borrower's account at the start of the
loan,247 was consistent with ``industry standards.''
The BLIPS National Deployment Champion had asked the bank to
make this representation to provide ``comfort that the loan was
being made in line with conventional lending practices.''
248 When the bank declined to make the requested
representation, the BLIPS National Deployment Champion tried a
second time, only to report to his colleagues: ``The bank has
pushed back again and said they simply will not represent that
the large premium loan is consistent with industry standards.''
249 He tried a third time and reported: ``I've
pushed really hard for our original language. To say they are
resisting is an understatement.'' 250 The final tax
opinion letter issued by KPMG contained compromise language
which said little more than the loan complied with the bank's
own procedures: ``The loan . . . was approved by the competent
authorities within [the Bank] as consistent, in the light of
all the circumstances such authorities consider relevant, with
[the Bank's] credit and documentation standards.''
251
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\247\ See Appendix A.
\248\ Email dated 3/20/00, from Jeffrey Eischeid to Mark Watson,
``Bank representation,'' Bates KPMG 0025754.
\249\ Email dated 3/27/00, from Jeffrey Eischeid to Richard Smith,
``Bank representation,'' Bates KPMG 0025753.
\250\ Email dated 3/28/00, from Jeffrey Eischeid to Mark Watson,
``Bank representation,'' Bates KPMG 0025753.
\251\ KPMG prototype tax opinion letter on BLIPS, dated 12/31/99,
at 11.
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A year after Deutsche Bank began executing BLIPS
transactions, a key bank official handling these transactions
wrote an email which acknowledged the ``tax benefits''
associated with BLIPS and noted, again, the reputational risk
these transactions posed to the bank:
``During 1999, we executed $2.8b. of loan premium deals
as part of the BLIP's approval process. At that time,
NatWest and [HVB] had executed approximately $0.5 b. of
loan premium deals. I understand that we based our
limitations on concerns regarding reputational risk
which were heightened, in part, on the proportion of
deals we have executed relative to the other banks.
Since that time, [HVB], and to a certain extent
NatWest, have participated in approximately an
additional $1.0-1.5 b. of grandfathered BLIP's deals. .
. . [HVB] does not have the same sensitivity to and
market exposure as DB does with respect to the
reputational risk from making the high-coupon loan to
the client. . . . As you are aware, the tax benefits
from the transaction potentially arise from a
contribution to the partnership subject to the high-
coupon note and not from the execution of FX positions
in the partnership, activities which we perform in the
ordinary course of our business.'' 252
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\252\ Email dated 6/20/00, from William Boyle to multiple Deutsche
Bank professionals, ``Updated Presidio/KPMG trades,'' Bates DB BLIPS
03280.
This document shows that Deutsche Bank was fully aware of
and had a sophisticated understanding of the tax aspects of
BLIPS. To address the issue of reputational risk, the email
went on to propose that, because HVB had a limited capacity to
issue more BLIPS loans, and Deutsche Bank did not want to
expose itself to increased reputational risk by making
additional direct loans to BLIPS clients, ``we would like to
lend an amount of money to [HVB] equal to the amount of money
[HVB] lends to the client. . . . We would like tax department
approval to participate in the aforementioned more complex
trades by executing the underlying transactions and making
loans to [HVB].'' In other words, Deutsche Bank wanted to be
the bank behind HVB, financing more BLIPS loans in exchange for
fees and other profits.
Other Deutsche Bank documents suggest that the bank may
have been helping KPMG find clients or otherwise marketing the
BLIPS tax products. A November 1999 presentation by the bank's
``Structured Finance Group,'' for example, listed BLIPS as one
of several tax products the group was offering to U.S. and
European clients seeking ``gain mitigation.'' 253
The presentation listed as the bank's ``strengths'' its ability
to lend funds in connection with BLIPS and its ``relationships
with [the] `promoters' '' 254 later named as
Presidio and KPMG.255 An internal bank email a few
months earlier asked: ``What is the status of the BLIPS. Are
you still actively marketing this product[?]'' 256
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\253\ Email dated 4/3/02, from Viktoria Antoniades to Brian McGuire
and other Deutsche Bank personnel, ``US GROUP 1 Pres,'' DB BLIPS 6329-
52, attaching a presentation dated 11/15/99, entitled ``Structured
Transactions Group North America,'' at 6336, 6346.
\254\ Id. at 6337.
\255\ Id. at 6346.
\256\ Email dated 7/19/99, involving multiple Deutsche Bank
employees, ``Update NY Issues,'' Bates DB BLIPS 6775.
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The same document suggests that Deutsche Bank may have been
a tax shelter promoter in its own right. For example, the
document indicates that, in 1999, the Structured Transactions
Group was offering over a dozen sophisticated tax products to
U.S. and European clients seeking to ``execute tax driven
deals'' or ``gain mitigation'' strategies.257 The
document indicates that Deutsche Bank was aggressively
marketing these tax products to large U.S. corporations and
individuals, and planning to close billions of dollars worth of
transactions.258 At least two of the tax products
listed by Deutsche Bank, BLIPS and the Customized Adjustable
Rate Debt Facility (CARDS), were later determined by the IRS to
be potentially abusive tax shelters. During the late 1990's and
early 2000, Deutsche Bank was also involved, either directly or
through Bankers Trust (which Deutsche Bank acquired in June
1999), in a number of tax-driven transactions with Enron
Corporation, including Project Steele, Project Cochise, Project
Tomas, and Project Valhalla.259
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\257\ Email dated 4/3/02, from Viktoria Antoniades to Brian McGuire
and other Deutsche Bank personnel, ``US GROUP 1 Pres,'' DB BLIPS 6329-
52, attaching a presentation dated 11/15/99, entitled ``Structured
Transactions Group North America,'' at 6336. See also undated document
entitled, ``Update on the Private Exchange Fund,'' Bates DB BLIPS 6433
(describing the packaging of another tax product offered by the
Structured Transactions Group).
\258\ Id. at 6345-46.
\259\ See ``Report of Investigation of Enron Corporation and
Related Entities Regarding Federal Tax and Compensation Issues, and
Policy Recommendations,'' Joint Committee on Taxation Staff (Report No.
JCS-3-03, February 2003).
---------------------------------------------------------------------------
Despite the bank's involvement in and sophisticated
knowledge of generic tax products, when asked about BLIPS
during a Subcommittee interview, the Deutsche Bank
representative insisted that BLIPS was an investment strategy
which, like all investment products, had tax implications. The
bank representative also indicated that, despite handling BLIPS
transactions for the bank, he did not understand the details of
the BLIPS transactions, and downplayed any reputational risk
that BLIPS might have posed to the bank.260
---------------------------------------------------------------------------
\260\ Subcommittee interview of Deutsche Bank, (11/10/03).
---------------------------------------------------------------------------
In contrast to Deutsche Bank's stance, in which its
representative's oral information repeatedly contradicted its
internal documentation, HVB representatives provided oral
information that was fully consistent with the bank's internal
documentation. HVB's representative acknowledged, for example,
that HVB knew BLIPS had been designed and was intended to
provide tax benefits to KPMG clients. The bank indicated that,
at the time it became involved, it felt it had no obligation to
refrain from participating in BLIPS, since KPMG had provided
the bank with an opinion stating that BLIPS complied with
federal tax law. For example, in one document seeking approval
to provide a significant line of credit to finance BLIPS loans,
HVB wrote this about the tax risks associated with BLIPS:
``Disallowance of tax attributes. A review by the IRS could
potentially result in a ruling that would disallow the [BLIPS]
structure. . . . We are confident that none of the foregoing
would affect the bank or its position in any meaningful way for
the following reasons. . . . KPMG has issued an opinion that
the structure will most likely be upheld, even if challenged by
the IRS.'' 261 A handwritten document prepared by
HVB personnel is even more direct. It characterizes the 7% fee
charged to KPMG clients for BLIPS as ``paid by investor for tax
sheltering.'' 262 This document also states that the
bank ``amortizes premium over the life of loan for tax
purposes.''
---------------------------------------------------------------------------
\261\ Credit request dated 9/26/99, Bates HVB 001166.
\262\ Undated one-page, handwritten document outlining BLIPS
structure entitled, ``Presidio,'' which Alex Nouvakhov of HVB
acknowledged during his Subcommittee interview had been written by him,
Bates HVB 000204.
---------------------------------------------------------------------------
When it became clear that the IRS would list BLIPS as an
abusive tax shelter, an internal HVB memorandum again
acknowledged that BLIPS was a tax transaction and ordered a
halt to financing the product, while disavowing any liability
for the bank's role in carrying out the BLIPS transactions:
``[I]t is clear that the tax benefits for individuals
who have participated in the [BLIPS] transaction will
not be grandfathered because Treasury believe that
their actions were contrary to current law. . . . It is
not likely that KPMG/Presidio will go forward with
additional transactions. . . . As we have stated
previously, we anticipate no adverse consequences for
the HVB since we have not promoted the transaction. We
have simply been a lender and nothing in the notice
implies a threat to our position.
``In view of the tone of the notice we will not book
any new transactions and will cancel our existing
unused [credit] lines prior to the end of this month.''
263
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\263\ Memorandum dated 8/16/00, from Dom DeGiorgio and Richard
Pankuch to Christopher Thorpe and others, ``Presidio BLIPS
Transactions,'' Bates HVB 003346.
HVB's representative explained to the Subcommittee staff
that the apparent bank risk in lending substantial sums to a
shell corporation had been mitigated by the terms of the BLIPS
loan which gave the bank virtually total control over the BLIPS
loan proceeds and enabled the bank to ensure the loan and loan
premium would be repaid.264 The bank explained, for
example, that from the start of the loan, the borrower was
required to maintain collateral equal to 101% of the loan
proceeds and loan premium and could place these funds only in a
narrow range of bank-approved investments.265 That
meant the bank treated not only all of the loan proceeds and
loan premium as collateral, but also additional funds supplied
by the KPMG client to meet the 101% collateral requirement. HVB
wrote: ``We are protected in our documentation through a
minimum overcollateralization ratio of 1.0125 to 1 at all
times. Violation of this ratio triggers immediate acceleration
under the loan agreements without notice.'' 266 HVB
also wrote: ``The Permitted Investments . . . are either
extremely conservative in nature . . . or have no collateral
value for margin purposes.'' 267 KPMG put it this
way: ``Lender holds all cash as collateral in addition to being
custodian and clearing agent for Partnership. . . . All
Partnership trades can only be executed through Lender or an
affiliate. . . . Lender must authorize trades before
execution.'' 268
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\264\ Subcommittee interview of HVB representative (10/29/03).
\265\ See, e.g., email dated 10/29/99, from Richard Pankuch to
Erwin Volt, ``KWG I capital treatment for our Presidio Transaction,''
Bates HVB 000352 (``Our structure calls for all collateral to be placed
in a collateral account pledged to the bank.''); email dated 9/24/99,
from Richard Pankuch to Christopher Thorpe and other HVB professionals,
``Re: Presidio,'' Bates HVB 000682 (``all collateral is in our own
hands and subject to the Permitted Investment requirement''). Compare
undated Deutsche Bank document, likely prepared in 1999, ``New Product
Committee Overview Memo: BLIPS Transaction,'' Bates DB BLIPS 01959-63,
at 1961 (``At all times, the loan will maintain collateral of at least
101% to the loan + loan premium amount. If the amount goes below this
limit, the loan will be unwound and the principal + premium repaid.'');
email dated 7/1/99, from Francesco Piovanetti to Ivor Dunbar, `` `Hugo'
BLIPS Paper,'' with attachment entitled, ``Bond Linked Indexed Premium
Strategy `BLIPS','' Bates HVB DB BLIPS 6885-87 (``The loan proceeds
(par and premium) will be held in custody at DB in cash or money market
deposits. . . . Loan conditions will be such as to enable DB to, in
effect, force prepayment after sixty days at its option.'').
\266\ BLIPS credit request dated 9/14/99, Bates HVB 000155. See
also Memorandum dated 7/29/99, from William Boyle to Mick Wood and
other Deutsche Bank personnel, ``GCI Risk and Resources Committee--
BLIPS Transaction,'' Bates DB BLIPS 06566, at 3 (The BLIPS loan ``will
be overcollateralized and should the value of the collateral drop below
a 1.0125:1.0 ratio, DB may liquidate the collateral immediately and
apply the proceeds to repay amounts due under the Note and swap
agreements.'')
\267\ BLIPS credit request dated 9/14/99, Bates HVB 000155.
\268\ Document dated 3/4/99, ``BLIPS--transaction description and
checklist,'' Bates KPMG 0003933-35.
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Deutsche Bank and HVB were not the only banks involved in
executing KPMG tax products. Another was Wachovia Bank, acting
through First Union National Bank, which not only referred bank
clients to KPMG to purchase FLIP, but also directly sold FLIP
to many of its clients, and considered becoming involved with
BLIPS and SC2 as well.269 A 1999 Wachovia internal
email demonstrates that the bank was fully aware that it was
being asked to facilitate transactions designed to reduce or
eliminate tax liability for KPMG clients:
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\269\ See Section VI(2) of this Report for discussion of Wachovia's
client referral activities.
``[A] KPMG investment/tax strategy . . . was voted and
approved by the due diligence subcommittee last week.
This means that the Risk Oversight Committee will have
this particular strategy on its agenda at its Wednesday
meeting. . . . The strategy will service to offset
either ordinary income or capital gains ($20 million
---------------------------------------------------------------------------
minimum).
``There are several critical points that should be
noted with respect to this strategy if we get it
approved. Many of these points related to Sandy Spitz'
concern (and KPMG's concern) that First Union has a
very high profile across our franchise for being
associated with `tax' strategies: namely, FLIP and
BOSS. Sandy does not want this kind of high profile to
be associated with this new strategy.
``In order to address some of Sandy's concerns and
lower our profile . . .
``* The strategy has an KPMG acronym which will not
be shared with the general First Union community. We
will probably assign a generic name. . . .
``* No one-pager will be distributed to our referral
sources describing the strategy. . . .
``* Fees to First Union will be 50 basis points if
the investor is not a KPMG client, 25 bps if they are a
KPMG client. . . .
``I have written up a technical summary of the tax
opinion since Sandy will only allow us to read a draft
copy of the opinion in his office without making a
copy.'' 270
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\270\ Email dated 8/30/99, from Tom Newman to multiple First Union
professionals, ``next strategy,'' Bates SEN-014622.
Clearly, First Union was well aware that it was handling
products intended to help clients reduce or eliminate their
taxes and was worried about its own high profile from being
``associated with `tax' strategies'' like FLIP.
In addition to its participation in KPMG-developed tax
products, First Union helped develop and market the BOSS tax
product sold by PricewaterhouseCoopers (``PWC''), which was
later determined by the IRS to be a potentially abusive tax
shelter. First Union had in its files the following document
advocating the bank's involvement with BOSS:
``The proposed transaction takes advantage of an
anomaly in current tax law which we expect will be
closed down by legislation as soon as Congress finds
out about it. We make this investment available only to
select clients in order to limit the number of people
who know about it. We hope that will delay the time
Congress finds out about it, but at some point, it is
likely that they will find out and enact legislation to
shut it down. First Union acts as sales agent for PwC
with respect to this transaction, since the bankers are
in a very good position to know when a client has
entered into a significant transaction which might have
generated significant taxable income.
PricewaterhouseCoopers would provide a Tax Opinion
Letter which would say that if the entity were examined
by the IRS, the transaction would `more likely than
not' be successfully upheld.'' 271
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\271\ Memorandum dated 12/21/99, from Teri Kemmerer Sallwasser to
Gail Fagan, ``Boss Strategy Meetings . . .'' Bates SEN-018253-57.
This document provides additional, unmistakable evidence that
First Union knew it was participating in transactions whose
primary purpose was to reduce or eliminate clients' taxes.
Still another bank that handled KPMG tax products is UBS
AG, now one of the largest banks in the world. UBS was
convinced by Quellos and KPMG to participate in numerous FLIP
and OPIS transactions in 1997 and 1998, referred to
collectively by UBS as ``redemption transactions.''
UBS documentation clearly and repeatedly describes these
transactions as tax-related. For example, one UBS document
explaining the transactions is entitled: ``U.S. Capital Loss
Scheme--UBS `redemption trades.' '' It states:
``The essence of the UBS redemption trade is the
creation of a capital loss for U.S. tax purposes which
may be used by a U.S. tax resident to off-set any
capital gains tax liability to which it would otherwise
be subject. The tax structure was originally devised by
KPMG. . . . In October 1996, UBS was approached jointly
by Quadra . . . and KPMG with a view to it seeking UBS'
participation in a scheme that implemented the tax loss
structure developed by KPMG. The role sought of UBS was
one purely of execution counterparty. . . . It was
clear from the outset--and has been continually
emphasised since--that UBS made no endorsement of the
scheme and that its connection with the structure
should not imply any implicit confirmation by UBS that
the desired tax consequences will be recognized by the
U.S. tax authorities. . . . UBS undertook a thorough
investigation into the propriety of its proposed
involvement in these transactions. The following steps
were undertaken: [redacted by UBS as `privileged
material'].'' 272
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\272\ UBS internal document dated 3/1/99, ``Equities Large/Heavily
Structured Transaction Approval,'' with attachment entitled, ``U.S.
Capital Loss Scheme--UBS `redemption trades,' '' Bates UBS 000009-15.
At another point, the UBS document explains the ``Economic
Rationale'' for redemption transactions to be: ``Tax benefit
for client,'' 273 while still another UBS document
states: ``The motivation for this structure is tax optimisation
for U.S. tax residents who are enjoying capital gains that are
subject to U.S. tax. The structure creates a capital loss from
a U.S. tax point of view (but not from an economic point of
view) which may be offset against existing capital gains.''
274
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\273\ Id. at UBS 000010.
\274\ UBS internal document dated 11/13/97, ``Description of the
UBS `Redemption' Structure,'' Bates UBS 000031.
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In February 1998, an unidentified UBS ``insider'' sent a
letter to UBS management in London ``to let you know that [UBS
unit] Global Equity [D]erivatives is currently offering an
illegal capital gains tax evasion scheme to US tax payers,''
meaning the redemption transactions. The letter continued:
``This scheme is costing the US Internal Revenue
[S]ervice several hundred million dollars a year. I am
concerned that once IRS comes to know about this scheme
they will levy huge financial/criminal penalties on UBS
for offering tax evasion schemes. . . . In 1997 several
billion dollars of this scheme was sold to high
networth US tax payers, I am told that in 1998 the plan
is continu[ing] to market this scheme and to offer
several new US tax avoidance schemes involving swaps.
``My sole objective is to let you know about this
scheme, so that you can take some concrete steps to
minimise the financial and reputational damage to UBS.
. . .
``P.S. I am sorry I cannot disclose my identity at this
time because I don't know whether this action of mine
will be rewarded or punished.'' 275
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\275\ Letter dated 2/12/98, addressed to SBC Warburg Dillon Read in
London, Bates UBS 000038.
In response to the letter, UBS halted all redemption trades for
several months.276 UBS apparently examined the
nature of the transactions as well as whether they should be
registered in the United States as tax shelters. UBS later
resumed selling the products, stopping only after KPMG
discontinued the sales.277
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\276\ See email dated 3/27/98, from Chris Donegan of UBS to Norm
Bontje of Quadra and others, ``Re: Redemption Trade,'' UBS 000039
(``Wolfgang and I are presently unable to execute any redemption
transactions on UBS stock. The main reason for this seems to be a
concern within UBS that this trade should be registered as a tax
shelter with the IRS.'').
\277\ Subcommittee interview with UBS representative (10/28/03).
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The UBS documents show that the bank was well aware that
FLIP and OPIS were designed and sold to KPMG clients as ways to
reduce or eliminate their U.S. tax liability. The bank
apparently justified its participation in the transactions by
reasoning that its participation did not signify its
endorsement of the transactions and did not constitute aiding
or abetting tax evasion. The bank then proceeded to provide the
financing that made these tax products possible.
The Role of the Investment Advisors. Bank personnel were
not the only financial professionals assisting KPMG with BLIPS,
FLIP, and OPIS. Investment experts also played key roles in
designing, marketing, and implementing the three tax products,
working closely with KPMG tax professionals throughout the
process. For example, the investment experts involved with
BLIPS, FLIP, and OPIS helped KPMG with designing the specific
financial transactions, making client presentations, obtaining
financing from the banks, preparing the transactional
documents, establishing the required shell corporations and
partnerships, and facilitating the completion of individual
client transactions. In the case of FLIP, investment experts at
Quellos, then known as Quadra, provided these services. In the
case of OPIS, both Quellos and Presidio provided these
services. In the case of BLIPS, these services were generally
provided by Presidio.
A memorandum sent by a Quellos investment expert to a
banker at UBS explained the investment company's role in FLIP
and the nature of the tax product itself as follows:
``KPMG approached us as to whether we could affect the
security trades necessary to achieve the desired tax
results. I indicated that I felt we could and they are
currently not looking elsewhere for assistance in
executing the transaction.
``The tax opportunity created is extremely complex, and
is really based more on the structuring of the entities
involved in the securities transactions rather than the
securities transactions themselves. KPMG has assured me
that prior to spending much time, beyond just
conceptually seeing if we can do it, they would provide
Quadra and any counterparty (UBS) with the necessary
legal opinions and representatives letters as to why
they are recommending this transaction to their
clients. Assuming their tax analysis is complete, our
challenge is to design a series of securities/
derivatives trades that meet the required objectives.
``In summary, this tax motivated transaction is
designed for U.S. companies requiring a tax loss. The
way this loss is generated is through the U.S. company
exercising a series of options to acquire majority
ownership in a Foreign investment (Fund). The tax
benefits are created for U.S. Co. based on the types of
securities transactions done in the foreign investment
Fund and shifting the cost basis to the parent U.S.
Company. . . .
``If a U.S. company/individual has a $100 million
dollar capital gain they owe taxes, depending on their
tax position, ranging from $28 million to $35 million.
As a result, they are more than willing to pay $2 to $4
million to generate a tax loss to offset the capital
gain and corresponding taxes. . . .
``I have told KPMG that we should be able to execute
the transaction once they have a commitment from a
potential client. KPMG has already had a number of
preliminary meetings with potential clients and one of
their challenges was to identify a party that can
manage the Fund level and facilitate the transactions
with Foreign Co. Given your ability to act as Foreign
Co., and facilitate the securities trades, I have told
them to stop looking. Once they have a firm client,
then we can map out the various details to execute the
transaction.'' 278
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\278\ Memorandum dated 8/12/96, from Jeff Greenstein of Quellos to
Wolfgang Stolz of UBS, Bates UBS 000002.
This document leaves no doubt that Quellos was fully aware that
FLIP was a ``tax motivated transaction'' designed for companies
or individuals ``requiring a tax loss.''
Quellos was successful in convincing UBS to participate in
not only FLIP, but also OPIS transactions throughout 1997 and
1998, as described earlier. Quellos may also have been a tax
shelter promoter in its own right. For example, in addition to
its dealings with KPMG on FLIP and OPIS, Quellos teamed up with
First Union National Bank and PWC to execute about 80 FLIP
transactions for them. In addition, Quellos held discussions
with KPMG regarding at least two tax products that Quellos
itself had developed, but it is unclear whether sales of these
products actually took place.279 A UBS document
states that Quellos' ``specialty is providing tax efficient
investment schemes for high net worth U.S. individuals and
their investment vehicles.'' 280
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\279\ See, e.g., email dated 12/10/99, from Douglas Ammerman to
multiple KPMG tax professionals, ``Innovative Strategy Development,''
Bates KPMG 0036736 (discusses KPMG working with Quellos on two products
that Quellos had developed, called FORTS, a ``loss generating
strategy,'' and WEST, a ``conversion strategy.'').
\280\ Undated UBS internal document, ``Memorandum on USB'
involvement in U.S. Capital Loss Generation Scheme (the `CLG
Scheme'),'' Bates UBS 000006.
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Presidio played a similar role in the design, marketing,
and implementation of OPIS and BLIPS. Two of Presidio's
principals are former KPMG tax professionals who knew the KPMG
tax professionals working on OPIS and BLIPS. These Presidio
principals were repeatedly identified by KPMG as members of
``the working group'' developing OPIS and were described as
having contributed to the design and implementation of
OPIS.281 Moreover, Presidio initially brought the
idea for BLIPS to KPMG, and was thoroughly involved in the
development, marketing, and implementation of the product. On
May 1, 1999, prior to the final approval of BLIPS, Presidio
representatives made a detailed presentation to KPMG tax
professionals on how the company was planning to implement the
BLIPS transactions.282 During the presentation,
among other points, Presidio representatives disclosed that
there was only a ``remote'' possibility that any investor would
actually profit from the contemplated foreign currency
transactions, and that the banks providing the financing
planned to retain, under the terms of the contemplated BLIPS
``loans,'' an effective ``veto'' over how the ``loan proceeds''
could be invested. These statements, among others, caused
KPMG's key technical reviewer in the Washington National Tax
group to reconsider his approval of the BLIPS product, in part
because he felt he had ``not been given complete information
about how the transaction would be structured.'' 283
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\281\ See , e.g., memorandum dated 3/13/98, from Robert Simon to
Jeff Stein and Sandy Smith, all of KPMG, ``OPIS,'' Bates KPMG 0010262
(``The attached went to the entire working group (Pfaff, Ritchie, R.J.
Ruble of Brown & Wood, Bickham, and Larson).''); email dated 3/14/98
from Jeff Stein to multiple KPMG tax professionals, ``Simon Says,''
Bates 638010, filed by the IRS on June 16, 2003, as an attachment to
Respondent's Requests for Admission, Schneider Interests v.
Commissioner, U.S. Tax Court, Docket No. 200-02 (``By the way--anybody
who does not have a copy of the Pfaff letter, let me know and I will
fax it over to you. In addition in case you want a copy of the November
6, 1997 memo detailing the proposed LLC structure written by Simon to
`The Working Group' which included Ritchie, Pfaff, Larson, Bickahm
[sic] and R.J. Ruble of the law firm of Brown & Wood let me know and I
will fax it over to you as well.''). Robert Pfaff and John Larson are
the former KPMG tax professionals who left the firm to open Presidio.
\282\ See, e.g., email dated 5/10/99, from Mark Watson to John
Lanning and others, ``FW: BLIPS,'' Bates MTW 0039; email dated 5/5/99,
from Mark Watson to Larry DeLap, Bates KPMG 0011915-16. See also, e.g.,
memorandum dated 4/20/99, from Amir Makov of Presidio to John Rolfes of
Deutsche Bank, ``BLIPS friction costs,'' Bates DB BLIPS 01977 (showing
Presidio's role in planning the BLIPS transactions; includes statement:
``On day 60, Investor exits partnership and unwinds all trades in
partnership.'')
\283\ See Section VI(B)(1) of this Report discussing the BLIPS
development and approval process; email dated 5/10/99, from Mark Watson
to John Lanning and others, ``FW: BLIPS,'' Bates MTW 0039.
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When BLIPS was eventually approved over the objections of
the WNT technical reviewer, Presidio played a key role in
making client presentations to sell the product and in
executing the actual BLIPS transactions. One of the most
important roles Presidio played in BLIPS was, in each BLIPS
transaction, to direct two of the companies it controlled,
Presidio Growth and Presidio Resources, to enter into a
``Strategic Investment Fund'' partnership with the relevant
BLIPS client. This partnership was central to the entire BLIPS
transaction, since it was this partnership that assumed and
repaid the purported ``loan'' that gave rise to the BLIPS
client's ``tax loss.'' In each BLIPS transaction, a Presidio
company acted as the managing partner for the partnership and
contributed a small portion of the funds used in the BLIPS
transactions. Presidio also performed administrative tasks
that, while more mundane, were critical to the success of the
the tax product. For example, when BLIPS was just starting to
get underway, Presidio took several steps to facilitate the
transactions, including stationing personnel at one of the law
firms preparing the transactional documents.284
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\284\ Email dated 5/13/99, from Barbara Mcconnachie to multiple
KPMG tax professionals, ``FW: BLIPS,'' Bates MTW 0045 (``Presidio has 2
individuals permanently housed at Sherman & Sterling to assist in the
necessary documentation.''). Sherman & Sterling prepared many of the
key transactional documents for BLIPS transactions involving Deutsche
Bank.
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When a problem arose indicating that currency conversions
in two BLIPS transactions had been timed in such a way that
they would create negative tax consequences for the BLIPS
clients, Presidio apparently took the lead in correcting the
``errors.'' An email sent by Presidio to HVB states:
``I know that Steven has talked to you regarding the
error for Roanoke Ventures. I have also noted an error
for Mobil Ventures. None of the Euro's should have been
converted to [U.S. dollars] in 1999. Due to the tax
consequences that result from these sales, it is
critical that these transactions be reversed and made
to look as though they did not occur at all.''
285
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\285\ Email dated 12/28/99, from Kerry Bratton of Presidio to
Alexandre Nouvakhov and Amy McCarthy of HVB, ``FX Confirmations,''
Bates HVB 002035.
Other documents suggest that, as Presidio requested, the
referenced 1999 currency trades were somehow ``reversed'' and
then executed the next month in early 2000.286 HVB
told Subcommittee staffers that they had been unaware of this
matter and would have to research the transactions to determine
whether, in fact, trades or paperwork had been
altered.287
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\286\ See, e.g., memorandum dated 12/23/99, from Kerry Bratton of
Presidio to Amy McCarthy of HVB, ``Transfer Instructions,'' Bates HVB
001699; memorandum dated 1/19/00, from Steven Buss at Presidio to Alex
Nouvakhov at HVB, ``FX Instructions--Mobile Ventures LLC,'' Bates HVB
001603; email dated 1/19/00, from Alex Nouvakhov at HVB to Matt Dunn at
HVB, ``Presidio,'' Bates HVB 001601 (``We need to sell Euros for
another Presidio account and credit their [U.S. dollar] DDA account. It
is the same deal as the one for Roanoke you did earlier today.'');
email dated 1/19/00, from Alex Nouvakhov at HVB to Steven Buss at
Presidio, ``Re: mobile,'' Bates HVB 001602; memorandum dated 1/19/00,
from Steven Buss at Presidio to Timothy Schifter at KPMG, ``Sale
Confirmation,'' Bates HVB 001600.
\287\ Subcommittee interview of HVB bank representatives (10/29/
03).
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Presidio has worked with KPMG on a number of tax products
in addition to the four examined in this Report. A Presidio
representative told the Subcommittee staff that 95% of the
company's revenue came from its work with KPMG.288
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\288\ Subcommittee interview of John Larson (6/20/03).
LFinding: Some law firms have provided legal services
that facilitated KPMG's development and sale of
potentially abusive or illegal tax shelters, including
by providing design assistance or collaborating on
allegedly ``independent'' opinion letters representing
to clients that a tax product would withstand an IRS
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challenge, in return for substantial fees.
The Role of the Law Firms. The evidence obtained by the
Subcommittee during the course of the investigation determined
that one law firm, Sidley Austin Brown & Wood, played a
significant and ongoing role in the development, marketing, and
implementation of the four KPMG tax products featured in this
Report.
Sidley Austin Brown & Wood is currently being audited by
the IRS to evaluate the firm's ``role . . . in the organization
and sale of tax shelters'' and compliance with federal tax
shelter requirements.289 In court pleadings, the IRS
has alleged the following:
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\289\ ``Declaration of Richard E. Bosch,'' IRS Revenue Agent, In re
John Doe Summons to Sidley Austin Brown & Wood (N.D. Ill. 10/16/03) at
para. 5.
``[I]t appears that [Sidley Austin Brown & Wood] was
involved in the organization and sale of transactions
which were or later became `listed transactions,' or
that may be other `potentially abusive tax shelters.'
The organization and sale of these transactions appears
to have been coordinated by [primarily] . . . Raymond
J. Ruble. . . . During the investigation, I learned
that [Sidley Austin Brown & Wood] issued approximately
600 opinions with respect to certain listed
transactions promoted (or co-promoted) by, among
others, KPMG, Arthur Andersen, BDO Seidman, Diversified
Group, Inc., and Ernst & Young. . . . The IRS has
identified transactions for which [Sidley Austin Brown
& Wood] provided opinions, . . . FLIPS, OPIS, COBRA,
BLIPS and CARDS, as `listed transactions.'
''290
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\290\ Id. para.para. 9, 10, 12.
The IRS also alleges that, in response to a December 2001
disclosure initiative in which taxpayers obtained penalty
waivers in exchange for identifying their tax shelter
promoters, 80 disclosure statements named Sidley Austin Brown &
Wood as ``promoting, soliciting, or recommending their
participation in certain tax shelters.'' 291 The IRS
also alleges that the law firm provided approximately 600
opinions for at least 13 tax products, including FLIP, OPIS,
and BLIPS.292
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\291\ Id. at para. 14.
\292\ Id. at para. 27(a).
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Information obtained by the Subcommittee indicates that
Sidley Austin Brown & Wood, through the efforts of Mr. Ruble,
did more than simply draft opinion letters supporting KPMG tax
products; the law firm formed an alliance with KPMG to develop
and market these tax products. IRS court pleadings, for
example, quote a December 1997 email in which Mr. Ruble states:
``This morning my managing partner, Tom Smith, approved Brown &
Wood LLP working with the newly conformed tax products group at
KPMG on a joint basis in which we would jointly develop and
market tax products and jointly share in the fees.''
293 An internal KPMG memorandum around the same time
states: ``[W]e need to consummate a formal strategic allicance
with Brown & Wood.'' 294
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\293\ Id. at para. 15, citing an email dated 12/15/97, from R.J.
Ruble. This email also references a meeting to be set up between KPMG
and two partners at Sidley Austin Brown & Wood, Paul Pringle and Eric
Haueter. See also email dated 12/24/97, from R.J. Ruble to Randall
Brickham at KPMG, ``Confidential Matters,'' Bates KPMG 0047356
(``Thanks again . . . for spending time with Paul and Eric. Their
meeting you all helps me immensely with the politics here.'').
\294\ Memorandum dated 12/19/97, from Randall Bickham to Gregg
Ritchie, ``Business Model--Brown & Wood Strategic Alliance,'' Bates
KPMG 0047228.
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Three months later, an internal KPMG memorandum discussing
an upcoming meeting between KPMG and Brown & Wood states that
KPMG tax professionals intended to discuss ``how to
institutionalize the KPMG/B&W relationship.'' 295
Among other items, KPMG planned to discuss ``the key profit-
drivers for our joint practice,'' citing in particular KPMG's
``Customer list'' and ``Financial commitment'' and Brown &
Wood's ``Institutional relationships within the investment
banking community.'' The memorandum states that KPMG also
planned to discuss ``[w]hat should be the profit-split between
KPMG, B&W and the tax products group/implementor for jointly-
developed products,'' and suggesting that in ``a 7% deal''
KPMG, B&W and the ``Implementor'' should split the net profits
evenly, after awarding a ``finder's allocation'' to the party
who found the tax product purchaser. Still other documents
indicate that Sidley Austin Brown & Wood, through Mr. Ruble,
became a member of a working group that jointly developed
OPIS.296 Evidence obtained by the Subcommittee also
indicates that Sidley Austin Brown & Wood, through Mr. Ruble,
was an active participant in the development of BLIPS,
expending significant time working with KPMG tax professionals
to author their respective opinion letters.
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\295\ Memorandum dated 3/2/98, from Randall Bickham to Gregg
Ritchie, ``B&W Meeting,'' Bates KPMG 0047225-27.
\296\ See , e.g., memorandum dated 3/13/98, from Robert Simon to
Jeff Stein and Sandy Smith, all of KPMG, ``OPIS,'' Bates KPMG 0010262
(``The attached went to the entire working group (Pfaff, Ritchie, R.J.
Ruble of Brown & Wood, Bickham, and Larson).''); email dated 3/14/98
from Jeff Stein to multiple KPMG tax professionals, ``Simon Says,''
Bates 638010, filed by the IRS on June 16, 2003, as an attachment to
Respondent's Requests for Admission, Schneider Interests v.
Commissioner, U.S. Tax Court, Docket No. 200-02 (``By the way--anybody
who does not have a copy of the Pfaff letter, let me know and I will
fax it over to you. In addition in case you want a copy of the November
6, 1997 memo detailing the proposed LLC structure written by Simon to
``The Working Group'' which included Ritchie, Pfaff, Larson, Bickahm
[sic] and R.J. Ruble of the law firm of Brown & Wood let me know and I
will fax it over to you as well.'').
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In the case histories examined by the Subcommittee, once
the design of a KPMG tax product was complete and KPMG began
selling the product to clients, Sidley Austin Brown & Wood's
primary implementation role became one of issuing legal opinion
letters to the persons who had purchased the products. Sidley
Austin Brown & Wood, through Mr. Ruble, wrote literally
hundreds of legal opinions supporting FLIP, OPIS, and
BLIPS.297 In the case of SC2, KPMG had apparently
made arrangements for clients to obtain a second opinion from
either Sidley Austin Brown & Wood 298 or Bryan Cave,
another major law firm,299 but it is unclear how
many SC2 buyers, if any, took advantage of these arrangements
and bought a second opinion.
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\297\ See ``Declaration of Richard E. Bosch,'' IRS Revenue Agent,
In re John Doe Summons to Sidley Austin Brown & Wood (N.D. Ill. 10/16/
03) at para. 18, citing an email by KPMG tax professional Gregg
Ritchie.
\298\ Subcommittee interview of Lawrence Manth (11/6/03).
\299\ See memorandum dated 2/16/01, from Andrew Atkin to SC2
Marketing Group, ``Agenda from Feb 16th call and goals for next two
weeks,'' Bates KPMG 0051135.
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Traditionally, second opinion letters are supplied by a
disinterested tax expert with no financial stake in the
transaction being evaluated, and this expert sends an
individualized letter to a single client. Certain IRS
penalties, in fact, can be waived if a taxpayer relies ``in
good faith'' on expert tax advice.300 The mass
marketing of tax products to multiple clients, however, has
been followed by the mass production of opinion letters that,
for each letter sent to a client, earns its author a handsome
fee. Since there are few costs associated with producing new
opinion letters, once a prototype opinion letter has been
completed for the generic tax product, the mass production of
largely boilerplate opinion letters has become a lucrative
business for firms like Sidley Austin Brown & Wood. The
attractive profits available from these letters have also
created new incentives for law firms to team up with tax
product promoters to become the preferred source for a second
opinion letter. This profit motive undermines an arms-length
relationship between the two opinion writers.
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\300\ See 26 U.S.C. Sec. 6662(d)(2)(C)(i); Treas.Reg.
Sec. Sec. 1.6662-4(g)(4)(ii) and 1.6664-4(c)(1).
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Actions taken by Sidley Austin Brown & Wood and KPMG to
collaborate on their respective opinion letters raises
additional questions about the law firm's independent status.
The evidence indicates that the law firm collaborated
extensively with KPMG in the drafting of the BLIPS, FLIP, and
OPIS opinion letters. This collaboration included joint
identification, research, and analysis of key legal and tax
issues; discussions about the best way to organize and present
the reasoning used in their respective letters; and joint
efforts to identify necessary factual representations by the
participating parties in the transactions being analyzed. In
the case of FLIP, Mr. Ruble faxed a copy of his draft opinion
letter to KPMG before issuing it.301 In the case of
BLIPS, Sidley Austin Brown & Wood and KPMG actually exchanged
copies of their respective draft opinion letters and conducted
a detailed ``side-by-side'' review ``to make sure we each cover
everything the other has.'' 302 The result was two,
allegedly independent opinion letters containing numerous,
virtually identical paragraphs.
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\301\ Facsimile cover sheet dated 2/26/97, from R.J. Ruble to David
Lippman and John Larson at KPMG, Bates XX 001440.
\302\ Email dated 9/24/99, from R.J. Ruble of Brown & Wood, to
Jeffrey Eischeid and Rick Bickham of KPMG, Bates KPMG 0033497; followed
by other emails exchanged between Brown & Wood and KPMG personnel, from
9/25/99 to 10/29/99, Bates KPMG 0033496-97.
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KPMG used the availability of a second opinion letter from
Sidley Austin Brown & Wood as a marketing tool to increase
sales of its tax products, telling clients that having this
second letter would help protect them from accuracy-related
penalties if the IRS were to later invalidate a tax
product.303 Many clients were apparently swayed by
this advice and sought an opinion letter from the law firm.
Evidence obtained by the Subcommittee indicates that the
opinion letters provided by the law firm were, like KPMG's
opinion letters, virtually identical in content and reflected
little, if any, individualized client interaction or legal
advice. In some cases, KPMG arranged to obtain a client's
opinion letter directly from the law firm and delivered it to
the client, apparently without the client's ever speaking to
any Sidley Austin Brown & Wood lawyer. One individual told the
Subcommittee staff that after KPMG sold him FLIP, KPMG arranged
for him to obtain a favorable opinion letter from Sidley Austin
Brown & Wood without his ever contacting the law firm or
directly speaking with a lawyer.304 An individual
testifying at a recent Senate Finance Committee hearing
testified that he had received a Sidley Austin Brown & Wood
opinion letter for COBRA, a tax product he had purchased from
Ernst & Young, by picking up the letter from the accounting
firm's office. He testified that he never communicated with
anyone at the law firm.305 This type of evidence
suggests that the law firm's focus was not on providing
individualized legal advice to clients, but on churning out
boilerplate opinion letters for a fee.
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\303\ See, e.g., KPMG document dated 6/19/00, entitled ``SC2--
Meeting Agenda,'' Bates KPMG 0013375-96, at 13393; see also Section
VI(B)(2) of this Report on using tax opinion letters as a marketing
tool.
\304\ Jacoboni v. KPMG, Case No. 02-CV-510 (D.M.D. Fla. 4/29/02),
at para. 19 (``Mr. Jacoboni later received a copy of a `concurring
opinion' dated August 31, 1998, from the law firm Brown & Wood, LLP,
which was requested by Dale Baumann of KPMG. The Brown & Wood
concurring opinion was mailed from New York to Mr. Jacoboni in
Florida.''); Subcommittee interview of legal counsel to Joseph Jacoboni
(4/4/03).
\305\ See testimony of Henry Camferdam regarding his purchase of
COBRA, Senate Finance Committee hearing, ``Tax Shelters: Who's Buying,
Who's Selling, and What's the Government Doing About It?'' (10/21/03)
(Camferdam: ``I never talked to anyone at Brown & Wood. In fact, all of
their documents were sent to us via [Ernst & Young]--not directly to
us.'').
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By routinely directing clients to Sidley Austin Brown &
Wood to obtain a second opinion letter, KPMG produced a steady
stream of income for the law firm. In the case of BLIPS, FLIP,
and OPIS, Sidley Austin Brown & Wood was apparently paid at
least $50,000 per opinion. One document indicates that Sidley
Austin Brown & Wood was paid this fee in every case where its
name was mentioned during a sales pitch for BLIPS, whether or
not the client actually purchased the law firm's opinion
letter. Other evidence indicates that in some BLIPS
transactions expected to produce a very large ``tax loss'' for
the client, Sidley Austin Brown & Wood was paid more than
$50,000 for its opinion letter.
Sidley Austin Brown & Wood provided opinion letters not
only to KPMG, but also to other firms selling similar tax
products. For example, the law firm also issued favorable
opinion letters for COBRA, a tax product similar to OPIS, but
sold by Ernst & Young. An email seems to suggest that when a
client sought a tax opinion letter for a product from Ernst &
Young and was turned down, Sidley Austin Brown & Wood may have
advised the client to try KPMG instead. The internal Ernst &
Young email states:
``[Redacted name] told me that during the January
meeting, Richard Shapiro gave him the name of R.J.
Rubell [sic] at Brown and Wood and said that they could
contact him directly regarding the tax opinion and
other issues. He did that. Rubell said that Brown and
Wood stands by the deal and is willing to issue the
same opinion letter as before. They and others do not
see the risk that E&Y sees. Apparently, B&W is also
working with Diversified and KPMG and Rubell steered
them in that direction.'' 306
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\306\ Email dated 2/11/00, from Alexander Eckman to David G.
Johnson and others, subject line redacted, Bates 2003EY011640.
It is unclear exactly what problem is being addressed, but this
email raises concerns about opinion letter shopping and about
the propriety of the law firm's steering clients away from
Ernst & Young, apparently because that firm refused to issue a
requested letter, and toward KPMG.
In short, in exchange for substantial fees, Sidley Austin
Brown & Wood provided legal services that facilitated KPMG's
development and sale of potentially abusive or illegal tax
shelters such as FLIP, OPIS, and BLIPS, including by providing
design assistance and collaborating on allegedly
``independent'' opinion letters representing to clients that
the KPMG tax products would withstand an IRS challenge.
LFinding: Some charitable organizations have
participated as essential counter parties in a highly
questionable tax shelter developed and sold by KPMG, in
return for donations or the promise of future
donations.
The Role of the Charitable Organizations. SC2 transactions
could not have taken place at all without the willing
participation of a charitable organization. To participate in
SC2 transactions, a charity had to undertake a number of non-
routine and potentially expensive, time-consuming tasks. For
example, the charity had to agree to accept an S corporation
stock donation, which for many charities is, in itself,
unusual; make sure it is exempt from the unrelated business
income tax (hereinafter ``UBIT'') and would not be taxed for
any corporate income earned during the time when the charity
was a shareholder; sign a redemption agreement; determine how
to treat the stock donation on its financial statements; and
then hold the stock for several years before receiving any cash
donation for its efforts. Moreover, relatively few charities
are exempt from the UBIT, and those that are--like pension
funds--do not normally receive large contributions from private
donors.
KPMG approved SC2 for sale to clients in March 2000, and
discontinued all sales 18 months later, around September 2001,
after selling the tax product to about 58 S corporations. The
SC2 sales produced fees exceeding $26 million for KPMG, making
SC2 one of KPMG's top ten revenue producers in 2000 and 2001.
Although KPMG refused to identify the charities that
participated in the SC2 transactions, the Subcommittee was able
to identify and interview two which, between them, participated
in more than half of the SC2 transactions KPMG arranged.
The two charities interviewed by the Subcommittee staff
indicated that they would not have participated in the SC2
transactions absent being approached, convinced, and assisted
by KPMG. The Los Angeles Department of Fire & Police Pensions
System is a $10 billion pension fund that serves the police and
fire departments in the city of Los Angeles in California. The
Austin Fire Fighters Relief and Retirement Fund is a much
smaller pension fund serving the fire departments in Austin,
Texas.
Based upon information provided to the Subcommittee, it
appears that, out of the about 58 SC2 tax products sold by KPMG
in 2000 and 2001, the Los Angeles pension fund participated in
29 of the SC2 transactions, while the Austin pension fund
participated in five. The Los Angeles pension fund indicated
that, as a result of the SC2 transactions, it is currently
holding stock valued at about $7.3 million from 16 S
corporations, and has sold back donated stock to 13
corporations in exchange for cash payments totaling about $5.5
million. Both pension funds told the Subcommittee that the SC2
stock donors and their corporations had generally been from
out-of-state. The Los Angeles pension fund indicated that it
had received stock from S corporations in Arizona, Georgia,
Hawaii, Missouri, and North Carolina. The Austin pension fund
indicated that it had received stock from S corporations in
California, Mississippi, New Jersey, and New York. Both pension
funds indicated that they had not met any of the SC2 donors
until KPMG introduced them to the charities.
Both charities indicated to the Subcommittee staff that, in
determining whether to participate in the SC2 transactions,
they relied on KPMG's representation that the transactions
complied with federal tax law. The Los Angeles pension fund
also obtained from an outside law firm a legal opinion letter
on the narrow issue of whether the charity had the legal
authority to accept a donation of S corporation stock. In
analyzing this issue, the law firm notes first in the legal
opinion letter that all of the facts recited about the
transaction had been provided to the law firm by a KPMG tax
professional.307 The letter concludes that the
pension fund may accept an S corporation stock donation from an
unrelated third party: ``Although this is a very unusual
transaction, and there is almost no statutory, regulatory or
other authority addressing the issue, we believe the Plan is
permitted to accept a contribution.'' The letter also states,
however, that the law firm had not been asked to provide any
legal advice about the substance of the SC2 transaction itself,
that it had not been given any documentation to review, and
that it was not offering any opinion on ``the impact of the
transaction on the `donor' from a tax or other standpoint.''
308
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\307\ Letter dated 12/30/99, from Seyfarth, Shaw, Fairweather &
Geraldson to the Los Angeles pension fund, at 3.
\308\ Id. The letter states: ``You have asked us to advise you
concerning the ability of the L.A. Fire & Police Pension System (the
`Plan') to accept a contribution from an unrelated third party in the
form of nonvoting stock of a closely held California S corporation. . .
. It should be noted that, from a procedural and due-diligence
standpoint, (1) we have not been asked to conduct, and we have not
conducted, any investigation into the company and/or the individual
involved, (2) we have not yet reviewed any of the underlying
documentation in connection with the donation or the possible future
redemption of the stock, and offer no opinion on such agreements or
their impact on any of the views expressed in this letter, (3) we have
not examined, or opined in any way about, the impact of the transaction
on the `donor' from a tax or other standpoint, and (4) we have not
checked the investment against any investment policy guidelines that
may have been adopted by the Board.''
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Apparently, neither charity obtained a legal or tax opinion
letter or other written legal advice, from KPMG or any other
firm, on whether the SC2 tax product and related transactions
complied with federal tax law or whether the charity's
participation in SC2 transactions could be viewed as aiding or
abetting tax evasion. The two pension funds told the
Subcommittee that they simply relied on KPMG's reputation as a
reputable firm in assuming the donation strategy was within the
law.
Both pension funds told the Subcommittee that, in every SC2
transaction, it was their expectation that they would not
retain ownership of the donated stock, but would sell it back
to the stock donor after the expiration of the period of time
indicated in the redemption agreement. They also indicated that
they did not expect to obtain significant amounts of money from
the S corporation during the period in which the charity was a
stockholder but expected, instead, to obtain a large cash
payment at the time the charity sold the stock back to the
donor. Moreover, the charities told the Subcommittee staff that
their expectations have, in fact, been met, and the SC2
transactions have been carried out as planned by KPMG, the
donors, and the charities. These facts and expectations raise
serious questions about whether the SC2 transactions ever truly
passed ownership of the stock to the charity or acted merely as
an assignment of income for a specified period time to the
charitable organization.
In the case of BLIPS, FLIP, OPIS, and SC2, major banks,
investment advisory firms, law firms, and charitable
organizations provided critical services or acted as essential
counterparties in the transactions called for by the tax
products. Each obtained lucrative fees, often totaling in the
millions of dollars, for their participation. Despite the
complexity, frequency, and size of the transactions and their
clear connection to tax avoidance schemes, none of the
participating organizations presented to the Subcommittee a
reasoned, contemporaneous analysis of the tax shelter,
reputational risk, ethical, or professional issues justifying
the organization's role in facilitating these highly
questionable and abusive tax transactions.
(4) Avoiding Detection
Finding: KPMG has taken steps to conceal its tax
shelter activities from tax authorities and the public,
including by refusing to register potentially abusive
tax shelters with the IRS, restricting file
documentation, and using improper tax return reporting
techniques.
Evidence obtained by the Subcommittee in the four KPMG case
studies shows that KPMG has taken a number of steps to conceal
its tax shelter activities from IRS, law enforcement, and the
public. In the first instance, it has simply denied being a tax
shelter promoter and claimed that tax shelter information
requests do not apply to its products. Second, evidence in the
FLIP, OPIS, BLIPS, and SC2 case histories indicate that KPMG
took a number of precautions in the way it designed, marketed,
and implemented these tax products to avoid or minimize
detection of its activities.
No Tax Shelter Disclosure. KPMG's public position is that
it does not develop, sell or promote tax shelters, as explained
earlier in this Report. As a consequence, KPMG has not
voluntarily registered, and thereby disclosed to the IRS, a
single one of its tax products. A memorandum quoted at length
earlier in this Report 309 establishes that, in
1998, a KPMG tax professional advised the firm not to register
the OPIS tax product with the IRS, even if OPIS qualified as a
tax shelter under the law, citing competitive pressures and a
perceived lack of enforcement or effective penalties for
noncompliance with the registration requirement. Another
document discussing registration of OPIS had this to say:
``Must register the product. B&W concerns--risk is too high.
Confirm w/Presidio that they will register.'' 310
The head of DPP-Tax told the Subcommittee staff that he had
recommended registering not only OPIS, but also BLIPS, but was
overruled in each instance by the top official in charge of the
Tax Services Practice.311
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\309\ See Section VI(B) of this Report.
\310\ Handwritten notes dated 3/4/98, author not indicated,
regarding ``Brown & Wood'' and ``OPIS,'' Bates KPMG 0047317. Emphasis
in original. ``B&W'' refers to Brown & Wood, the law firm that worked
with KPMG on OPIS. Presidio is an investment firm that worked with KPMG
on OPIS.
\311\ Subcommittee interview of Lawrence DeLap (10/30/03).
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Other documents show that consideration of tax shelter
registration issues was a required step in the tax product
approval process, but rather than resulting in IRS
registrations, KPMG appears to have devoted resources to
devising rationales for not registering a product with the IRS.
KPMG's Tax Services Manual states that every new tax product
must be analyzed by the WNT Tax Controversy Services group ``to
address tax shelter regulations issues.'' 312 For
example, one internal document analyzing tax shelter
registration issues discusses the ``policy argument'' that
KPMG's tax ``advice . . . does not meet the paradigm of 6111(c)
registration'' and identifies other flaws with the legal
definition of ``tax shelter'' that may excuse registration. The
email also suggests possibly creating a separate entity to act
as the registrant for KPMG tax products:
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\312\ KPMG Tax Services Manual, Sec. 24.4.1, at 24-2.
``If we decide we will be registering in the future,
thought should be given to establishing a separate
entity that meets the definition of an organizer for
all of our products with registration potential. This
entity, rather than KPMG, would then be available
through agreement to act as the registering organizer.
. . . If such an entity is established, KPMG can avoid
submitting its name as the organizer of a tax shelter
on Form(s) 8264 to be filed in the future.''
313
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\313\ Email dated 5/11/98, from Jeffrey Zysik to multiple KPMG tax
professionals, ``Registration,'' Bates KPMG 0034805-06. See also email
dated 5/12/98, from Jeffrey Zysik to multiple KPMG tax professionals,
``Registration requirements.,'' Bates KPMG 0034807-11 (reasonable cause
exception, tax shelter definitions, number of registrations required);
email dated 5/20/98, from Jeffrey Zysik to multiple KPMG tax
professionals, ``Misc. Tax Reg. issues,'' Bates KPMG 0034832-33
(``reasonable cause exception for not registering''; application of
regulatory ``tax shelter ratio'' to identify tax shelters;
``establishing a separate entity to act as the entity registering ALL
tax products. . . . Otherwise we must submit our name as the tax
shelter organizer.'').
Another KPMG document, a fiscal year 2002 draft business
plan for the Personal Financial Planning Practice, describes
two tax products under development, but not yet approved, due
in part to pending tax shelter registration
issues.314 The first, referred to as POPS, is
described as ``a gain mitigation solution.'' The business plan
states: ``We have completed the solution's technical review and
have almost finalized the rationale for not registering POPS as
a tax shelter.'' The second product is described as a
``conversion transaction . . . that halves the taxpayer's
effective tax rate by effectively converting ordinary income to
long term capital gain.'' The business plan notes: ``The most
significant open issue is tax shelter registration and the
impact registration will have on the solution.''
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\314\ Document dated 5/18/01, ``PFP Practice Reorganization
Innovative Strategies Business Plan--DRAFT,'' Bates KPMG 0050620-23, at
2.
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The IRS has issued ``listed transactions'' that explicitly
identify FLIP, OPIS, and BLIPS as potentially abusive tax
shelters. Due to these tax products and others, the IRS is
investigating KPMG to determine whether it is a tax shelter
promoter and is complying with the tax shelter requirements in
Federal law.315 KPMG continues flatly to deny that
it is a tax shelter promoter and has continued to resist
registering any of its tax products with the IRS.
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\315\ See United States v. KPMG, Case No. 1:02MS00295 (D.D.C. 9/6/
02).
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A second consequence of KPMG's public denial that it is a
tax shelter promoter has been its refusal fully to comply with
the document requests made by the IRS for lists of clients who
purchased tax shelters from the firm. In a recent hearing
before the Senate Finance Committee, the U.S. Department of
Justice stated that, although the client-list maintenance
requirement enacted by Congress ``clearly precludes any claim
of identity privilege for tax shelter customers regardless of
whether the promoters happen to be accountants or lawyers, the
issue continues to be the subject of vigorous litigation.''
316 The Department pointed out that one circuit
court of appeals and four district courts had already ruled
that accounting firms, law firms, and a bank must divulge
client information requested by the IRS under the tax shelter
laws, but certain accounting firms were continuing to contest
IRS document requests. At the same hearing, the former IRS
chief counsel characterized the refusal to disclose client
names by invoking either attorney-client privilege or Section
7525 of the tax code as ``frivolous,'' while also noting that
one effect of the ensuing litigation battles ``was to delay
[promoter] audits to the point of losing one or more tax years
to the statute of limitations.'' 317
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\316\ Testimony of Eileen J. O'Connor, Assistant Attorney General
for the Tax Division, U.S. Department of Justice, before the Senate
Committee on Finance, ``Tax Shelters: Who's Buying, Who's Selling and
What's the Government Doing About It?'' (10/21/03), at 3.
\317\ Testimony of B. John Williams, Jr. former IRS chief counsel,
before the Senate Committee on Finance, ``Tax Shelters: Who's Buying,
Who's Selling and What's the Government Doing About It?'' (10/21/03),
at 4-5.
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IRS Commissioner, Mark Everson, testified at the same
hearing that the IRS had filed suit against KPMG in July 2002,
``to compel the public accounting firm to disclose information
to the IRS about all tax shelters it has marketed since 1998.''
318 He stated, ``Although KPMG has produced many
documents to the IRS, it has also withheld a substantial
number.''
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\318\ Testimony of Mark W. Everson, IRS Commissioner, before the
Senate Committee on Finance, ``Tax Shelters: Who's Buying, Who's
Selling and What's the Government Doing About It?'' (10/21/03), at 11.
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Some of the documents obtained by the Subcommittee during
its investigation illustrate the debate within KPMG over
responding to the IRS requests for client names and other
information. In April 2002, one KPMG tax professional wrote:
``I have two clients who are about to file [tax
returns] for 2001. We have discussed with each of them
what is happening between KPMG and IRS and both do not
plan to disclose at this time. Since Larry's message
indicated the information requested was to respond to
an IRS summons, I am concerned we are about to turn
over a new list of names for transactions I believe IRS
has no prior knowledge of. I need to know immediately
if that is what is happening. It will obviously have a
material effect on their evaluation of whether they
wish to disclose and what positions they wish to take
on their 2001 returns. Since April 15th is Monday, I
need a response. . . . [I]f we are responding to what
appears to be an IRS fishing expedition, it is going to
reflect very badly on KPMG. Several clients have
seriously questioned whether we are doing everything we
can to protect their interests.'' 319
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\319\ Email dated 4/9/02, from Deke Carbo to Jeffrey Eischeid,
``Larry's Message,'' Bates KPMG 0024467. See also email dated 4/19/02,
from Ken JOnes to multiple KPMG tax professionals, ``TCS Weekly
Update,'' Bates KPMG 0050430-31 (``We have just hand-carried the lists
of investors over to the IRS, for the following deals: . . . SC2. . . .
Note that not all cilents names were turned over for each of these
Solutions . . . so if you need to find out if a company or individual
was on the list . . . call or email me.'').
Tax Return Reporting. KPMG also took a number of
questionable steps to minimize the amount of information
reported in tax returns about the transactions involved in its
tax products in order to limit IRS detection.
Perhaps the most disturbing of these actions was first
taken in tax returns reporting transactions related to OPIS. To
minimize information on the relevant tax returns and avoid
alerting the IRS to the OPIS tax product, some KPMG tax
professionals advised their OPIS clients to participate in the
transactions through ``grantor trusts.'' These KPMG tax
professionals also advised their clients to file tax returns in
which all of the losses from the OPIS transactions were
``netted'' with the capital gains realized by the taxpayer at
the grantor trust level, instead of reporting each individual
gain or loss, so that only a single, small net capital gain or
loss would appear on the client's personal income tax return.
This netting approach, advocated in an internally-distributed
KPMG memorandum,320 elicited intense debate within
the firm. KPMG's top WNT technical tax expert on the issue of
grantor trusts wrote the following in two emails over the span
of 4 months:
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\320\ ``Grantor Trust Reporting Requirements for Capital
Transactions,'' KPMG WNT internal memorandum (2/98).
``I don't think netting at the grantor trust level is a
proper reporting position. Further, we have never
prepared grantor trust returns in this manner. What
will our explanation be when the Service and/or courts
ask why we suddenly changed the way we prepared grantor
trust returns/statements only for certain clients? When
you put the OPIS transaction together with this
`stealth' reporting approach, the whole thing stinks.''
321
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\321\ Email dated 9/2/98, from Mark Watson to John Gardner, Jeffrey
Eischeid, and others; ``RE:FW: Grantor trust memo,'' Bates KPMG
0035807. See also email dated 9/3/98, from Mark Watson to Jeffrey
Eischeid and John Gardner, ``RE:FW: Grantor trust memo,'' Bates KPMG
0023331-32 (explaining objections to netting at the grantor trust
level).
``You should all know that I do not agree with the
conclusion reached in the attached memo that capital
gains can be netted at the trust level. I believe we
are filing misleading, and perhaps false, returns by
taking this reporting position.'' 322
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\322\ Email dated 1/21/99, from Mark Watson to multiple KPMG tax
professionals, ``RE: Grantor trust reporting,'' Bates KPMG 0010066.
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One of the tax professionals selling OPIS wrote:
``This `debate' . . . [over grantor trust netting]
affects me in a significant way in that a number of my
deals were sold giving the client the option of
netting. . . . Therefore, if they ask me to net, I feel
obligated to do so. These sales were before Watson went
on record with his position and after the memo had been
outstanding for some time.
``What is our position as a group? Watson told me he
believes it is a hazardous professional practice issue.
Given that none of us wants to face such an issue, I
need some guidance.'' 323
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\323\ Email dated 1/21/99, from Carl Hasting to Jeffrey Eischeid,
``FW: Grantor trust reporting,'' Bates KPMG 0010066.
The OPIS National Deployment Champion responded: ``[W]e
concluded that each partner must review the WNT memo and decide
for themselves what position to take on their returns--after
discussing the various pros and cons with their clients.''
324
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\324\ Email dated 1/22/99, from Jeffrey Eischeid to Carl Hasting,
``FW: Grantor trust reporting,'' Bates KPMG 0010066. Other OPIS tax
return reporting issues are discussed in other KPMG documentation
including, for example, memorandum dated 12/21/98, from Bob Simon/
Margaret Lukes to Robin Paule, ``Certain U.S. International Tax
Reporting Requirements re: OPIS,'' Bates KPMG 0050630-40.
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The technical reviewer who opposed grantor trust netting
told the Subcommittee staff that it was his understanding that,
as the top WNT technical expert, his technical judgment on the
matter should have stopped KPMG tax professionals from using or
advocating the use of this technique and thought he had done
so, before leaving for a KPMG post outside the United States.
He told the Subcommittee staff he learned later, however, that
the OPIS National Deployment Champion had convened a conference
call without informing him and told the participating KPMG tax
professionals that they could use the netting technique if they
wished. He indicated that he also learned that some KPMG tax
professionals were apparently advising BLIPS clients to use
grantor trust netting to avoid alerting the IRS to their BLIPS
transactions.325
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\325\ Subcommittee interview of Mark Watson (11/4/03).
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In September 2000, the IRS issued Notice 2000-44,
invalidating the BLIPS tax product. This Notice included a
strong warning against grantor trust netting:
``[T]he Service and the Treasury have learned that
certain persons who have promoted participation in
transactions described in this notice have encouraged
individual taxpayers to participate in such
transactions in a manner designed to avoid the
reporting of large capital gains from unrelated
transactions on their individual income tax returns
(Form 1040). Certain promoters have recommended that
taxpayers participate in these transactions through
grantor trusts and . . . advised that the capital gains
and losses from these transactions may be netted, so
that only a small net capital gain or loss is reported
on the taxpayer's individual income tax return. In
addition to other penalties, any person who willfully
conceals the amount of capital gains and losses in this
manner, or who willfully counsels or advises such
concealment, may be guilty of a criminal offense. . .
.'' 326
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\326\ IRS Notice 2000-44 (2000-36 IRB 255) (9/5/00) at 256.
The technical reviewer who had opposed using grantor trust
netting told the Subcommittee that, soon after this Notice was
published, he had received a telephone call from his WNT
replacement informing him of the development and seeking his
advice. He indicated that it was his understanding that a
number of client calls were later made by KPMG tax
professionals.327
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\327\ Subcommittee interview of Mark Watson (11/4/03). See also
Memorandum of Telephone Call, dated 5/24/00, from Kevin Pace regarding
a telephone conversation with Carl Hastings, Bates KPMG 0036353
(``[T]here is quite a bit of activity in the trust area . . . because
they have figured out that trusts are a common element in some of these
shelter deals. So our best intelligence is that you are increasing your
odds of being audited, not decreasing your odds by filing that Grantor
Trust return. So we have discontinued doing that.'')
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Other tax return reporting concerns also arose in
connection with BLIPS. In an email with the subject line, ``Tax
reporting for BLIPS,'' a KPMG tax professional sent the
following message to the BLIPS National Deployment Champion:
``I don't know if I missed this on a conference call or if
there's a memo floating around somewhere, but could we get
specific guidance on the reporting of the BLIPS transaction. .
. . I have `IRS matching' concerns.'' The email later
continues:
``One concern I have is the IRS trying to match the
Deutsche dividend income which contains the Borrower
LLC's FEIN [Federal Employer Identification Number][.]
(I understand they're not too efficient on matching K-
1's but the dividends come through on a 1099 which they
do attempt to match). I wouldn't like to draw any
scrutiny from the Service whatsoever. If we don't file
anything for Borrower LLC we could get a notice which
would force us to explain where the dividends
ultimately were reported. Not fatal but it is scrutiny
nonetheless.'' 328
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\328\ Email dated 2/15/00, from Robert Jordan to Jeffrey Eischeid,
``Tax reporting for BLIPS,'' Bates KPMG 0006537.
About a month later, another KPMG tax professional wrote to
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the BLIPS National Deployment Champion:
``We spoke to Steven Buss about the possibility of re-
issuing the Presidio K-1s in the EIN of the member of
the single member [limited liability corporations used
in BLIPS]. He said that you guys hashed it out
on Friday 3/24 and in a nutshell, Presidio is
not going to re-issue K-1s.
``David was wondering what the rationale was since the
instructions and PPC say that single member LLCs are
disregarded entities so 1099s, K-1s should use the EIN
of the single member.'' 329
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\329\ Email dated 3/28/00, from Jean Monahan to Jeffrey Eischeid
and other KPMG tax professionals, ``presidio K-1s,'' Bates KPMG
0024451. See also email dated 3/22/00, unidentified sender and
recipients, ``Nondisclosure,'' Bates KPMG 0025704.
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She received the following response:
``It was discussed on the national conference call
today. Tracey Stone has been working with Mark Ely on
the issue. Ely has indicated that while the IRS may
have the capability to match ID numbers for
partnerships, they probably lack the resources to do
so. While technically the K-1's should have the social
security number of the owner on them, it is my
understanding that Mark has suggested that we not file
a partnership for the single member LLC and that
Presidio not file amended K-1s. . . . Tracey indicated
that Mark did not like the idea of having us prepare
partnership returns this year because then the IRS
would be looking for them in future years.''
330
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\330\ Email dated 3/27/00, unidentified sender and recipients,
``presidio K-1s,'' Bates KPMG 0024451.
Additional emails sent among various KPMG tax professionals
discuss whether BLIPS participants should extend or amend their
tax returns, or file certain other tax forms, again with
repeated references to minimizing IRS scrutiny of client return
information.331
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\331\ See, e.g., emails dated 4/1/00-4/3/00 among Mark Ely, David
Rivkin and other KPMG tax professionals, ``RE: Blips and tax filing
issues,'' Bates KPMG 0006481-82; emails dated 3/23/00, between Mark
Watson, Jeffrey Eischeid, David Rivkin and other KPMG tax
professionals, ``RE: Blips and tax filing issues,'' Bates KPMG 0006480.
See also email dated 7/27/99, from Deke Carbo to Randall Bickham,
Jeffrey Eischeid, and Shannon Liston, ``Grouping BLIPS Investors,''
KPMG Bates 0023350 (suggests ``grouping'' multiple, unrelated BLIPS
investors in a single Deutsche Bank account, possibly styled as a joint
venture account, which might not qualify as a partnership required to
file a K-1 tax return); email response dated 7/27/99, unidentified
sender and recipients, ``Grouping BLIPS Investors,'' KPMG Bates 0023350
(promises followup on suggestion which may ``[solve] our grouping
problem'').
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In the case of FLIP, KPMG tax professionals devised a
different approach to avoiding IRS detection.332
Again, the focus was on tax return reporting. The idea was to
arrange for the offshore corporation involved in FLIP
transactions to designate a fiscal year that ended in some
month other than December in order to extend the year in which
the corporation would have to report FLIP gains or losses on
its tax return. For example, if the offshore corporation were
to use a fiscal year ending in June, FLIP transactions which
took place in August 1997, would not have to be reported on the
corporation's tax return until after June 1998. Meanwhile, the
individual taxpayer involved with the same FLIP transactions
would have reported the gains or losses in his or her tax
return for 1997. The point of arranging matters so that the
FLIP transactions would be reported by the corporation and
individual in tax returns for different years was simply to
make it more difficult for the IRS to detect a link between the
two participants in the FLIP transactions.
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\332\ See email dated 3/11/98 from Gregg Ritchie to multiple KPMG
tax professionals, ``Potential FLIP Reporting Strategy,'' Bates KPMG
0034372-75. See also internal KPMG memorandum dated 3/31/98, by Robin
Paule, Los Angeles/Warner Center, ``Form 5471 Filing Issues,'' Bates
KPMG 0011952-53; and internal KPMG memorandum dated 3/6/98, by Bob
Simon and Margaret Lukes, ``Potential FLIP Reporting Strategy,'' Bates
KPMG 0050644-45.
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In the case of SC2, KPMG advised its tax professionals to
tell potential buyers worried about being audited:
``[T]his transaction is very stealth. We are not
generating losses or other highly visible items on the
S-corp return. All income of the S-corp is allocated to
the shareholders, it just so happens that one
shareholder [the charity] will not pay tax.''
333
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\333\ ``SC2--Meeting Agenda'' and attachments, dated 6/19/00, Bates
KPMG 0013375-96, at 13394.
No Roadmaps. A Subcommittee hearing held in December 2002,
on an abusive tax shelter sold by J.P. Morgan Chase & Co. to
Enron presented evidence that the bank and the company
explicitly designed that tax shelter to avoid providing a
``roadmap'' to tax authorities.334 KPMG appears to
have taken similar precautions in FLIP, OPIS, BLIPS, and SC2.
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\334\ ``Fishtail, Bacchus, Sundance, and Slapshot: Four Enron
Transactions Funded and Facilitated by U.S. Financial Institutions,''
Report prepared by the U.S. Senate Permanent Subcommittee on
Investigations of the Committee on Governmental Affairs, S. Prt. 107-82
(1/2/03), at 32.
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In the case of SC2, in an exchange of emails among senior
KPMG tax professionals discussing whether to send clients a
letter explicitly identifying SC2 as a high-risk strategy and
outlining certain specific risks, the SC2 National Deployment
Champion wrote:
``[D]o we need to disclose the risk in the engagement
letter? . . . Could we have an addendum that discloses
the risks? If so, could the Service have access to
that? Obviously the last thing we want to do is provide
the Service with a road map.'' 335
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\335\ Email dated 3/25/00, from Larry Manth to Larry DeLap, Phillip
Galbreath, Mark Springer, and Richard Smith, ``RE: S-corp Product,''
Bates KPMG 0016986-87.
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The DPP head responded:
``. . . If the risk has been disclosed and the IRS is
successful in a challenge, the client can't maintain he
was bushwhacked because he wasn't informed of the risk.
. . . We could have a statement in the engagement
letter that the client acknowledges receipt of a
memorandum concerning risks associated with the
strategy, then cover the double taxation risk and
penalty risks (and other relevant risks) in that
separate memorandum. Depending on how one interprets
section 7525(b), such a memorandum arguably qualifies
for the federal confidential communications privilege
under section 7525(a).'' 336
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\336\ Email dated 3/27/00, from Larry DeLap to Larry Manth, Phillip
Galbreath, Mark Springer and Richard Smith, ``RE: S-Corp Product,''
Bates KPMG 0016986.
This was not the only KPMG document that discussed using
attorney-client or other legal privileges to limit disclosure
of KPMG documents and activities related to its tax products.
For example, a 1998 document containing handwritten notes from
a KPMG tax professional about a number of issues related to
OPIS states, under the heading ``Brown & Wood'': ``Privilege[:]
B&W can play a big role at providing protection in this area.''
337
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\337\ Handwritten notes dated 3/4/98, author not indicated,
regarding ``Brown & Wood'' and ``OPIS,'' Bates KPMG 0047317.
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Other parties who participated in the KPMG tax products
also discussed using attorney-client privilege to conceal their
activities. One was Deutsche Bank, which participated in both
OPIS and BLIPS. In an internal email, one Deutsche Bank
employee wrote to another regarding BLIPS: ``I would have
thought you could still ensure that . . . the papers are
prepared, and all discussion held, in a way which makes them
legally privileged. (. . . you may remember that was one of my
original suggestions).'' 338 Earlier, when
considering whether to participate in BLIPS initially, the bank
decided to limit its discussion of BLIPS on paper and not to
obtain the approval of the bank committee that normally
evaluates the risk that a transaction poses to the reputation
of the bank, in order not to leave ``an audit trail'':
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\338\ Email dated 7/29/99, from Mick Wood to Francesco Piovanetti
and other Deutsche Bank professionals, ``Re: Risk & Resources Committee
Paper--BLIPS,'' Bates DB BLIPS 6556.
``1. STRUCTURE: A diagramatic representation of the
deal may help the Committee's understanding--we can
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prepare this.
``2. PRIVILEDGE [sic]: This is not easy to achieve and
therefore a more detailed description of the tax issues
is not advisable.
``3. REPUTATION RISK: In this transaction, reputation
risk is tax related and we have been asked by the Tax
Department not to create an audit trail in respect of
the Bank's tax affaires. The Tax department assumes
prime responsibility for controlling tax related risks
(including reputation risk) and will brief senior
management accordingly. We are therefore not asking R&R
Committee to approve reputation risk on BLIPS. This
will be dealt with directly by the Tax Department and
John Ross.'' 339
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\339\ Email dated 7/30/99, from Ivor Dunbar to multiple Deutsche
Bank professionals, ``Re: Risk & Resources Committee Paper--BLIPS,''
unreadable Bates DB BLIPS number.
Another bank that took precautions against placing tax
product information on paper was Wachovia Bank's First Union
National Bank. A First Union employee sent the following
instructions to a number of his colleagues apparently in
connection with the bank's approving sales of a new KPMG tax
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product:
``In order to . . . lower our profile on this
particular strategy, the following points should be
noted: The strategy has an KPMG acronym which will not
be shared with the general First Union community. . . .
Our traditional sources of client referrals inside
First Union should not be informed of which Big 5
accounting firm we will choose to bring in on a
strategy meeting with a client. . . . No one-pager will
be distributed to our referral sources describing the
strategy.'' 340
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\340\ Email dated 8/30/99, from Tom Newman to multiple First Union
professionals, ``next strategy,'' Bates SEN-014622.
Other documents obtained by the Subcommittee include
instructions by senior KPMG tax professionals to their staff
not to keep certain revealing documentation in their files or
to clean out their files, again to avoid or limit detection of
firm activity. For example, in the case of BLIPS, a KPMG tax
professional sent an email to multiple colleagues stating:
``You may want to remind everyone on Monday NOT to put a copy
of Angie's email on the 988 elections in their BLIPS file. It
is a road map for the taxing authorities to all the other
listed transactions. I continue to find faxes from Quadra in
the files . . . in the two 1996 deals here which are under CA
audit which reference multiple transactions--not good if we
would have to turn them over to California.'' 341 In
the case of OPIS, a KPMG tax professional wrote: ``I have quite
a few documents/papers/notes related to the OPIS transaction. .
. . Purging unnecessary information now pursuant to an
established standard is probably ok. If the Service asks for
information down the road (and we have it) we'll have to give
it to them I suspect. Input from (gulp) DPP may be
appropriate.'' 342
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\341\ Email dated 1/3/00, from Dale Baumann to ``Jeff,'' ``988
election memo,'' Bates KPMG 0026345.
\342\ Email dated 9/16/98, from Bob to unknown recipients,
``Documentation,'' Bates KPMG 0025729. Documents related to other KPMG
tax products, such as TEMPEST and OTHELLO, contain similar information.
See, e.g., message from Bob McCahill and Ken Jones, attached to an
email dated 3/1/02, from Walter Duer to multiple KPMG tax
professionals, ``RE: TCS Review of TEMPEST and OTHELLO,'' Bates KPMG
0032378-80 (``There is current IRS audit activity with respect to two
early TEMPEST engagements. One situation is under fairly intense
scrutiny by IRS Financial Institutions and Products specialists. . . .
Although KPMG has yet to receive a subpoena or any other request for
documents, client lists, etc. we believe it is likely that such a
request(s) is inevitable. Since TEMPEST is a National Stratecon
solution for which Bob McCahill and Bill Reilly were the Co-Champions .
. . it is most efficient to have all file reviews and ``clean-ups''
(electronic or hard copy) performed in one location, namely the FS NYC
office. This effort will be performed by selected NE Stratecon
professionals . . . with ultimate review and final decision making by
Ken Jones. . . . [W]e want the same approach to be followed for OTHELLO
as outlined above for TEMPEST. Senior tax leadership, Jeff Stein and
Rick Rosenthal concur with this approach.'')
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Marketing Restrictions. KPMG also took precautions against
detection of its activities during the marketing of the four
products studied by the Subcommittee. FLIP and OPIS were
explained only after potential clients signed a confidentiality
agreement promising not to disclose the information to anyone
else.343 In the case of BLIPS, KMPG tax
professionals were instructed to obtain ``[s]igned
nondisclosure agreements . . . before any meetings can be
scheduled.'' 344 KPMG also limited the paperwork
used to explain the products to clients. Client presentations
were done on chalkboards or erasable whiteboards, and written
materials were retrieved from clients before leaving a
meeting.345 KPMG determined as well that
``[p]roviding a copy of a draft opinion letter will no longer
be done to assist clients in their due diligence.''
346 In SC2, the DPP head instructed KPMG tax
professionals not to provide any ``sample documents'' directly
to a client.347
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\343\ See, e.g., memorandum dated 8/5/98, from Doug Ammerman to PFP
Partners, ``OPIS and Other Innovative Strategies,'' Bates KPMG 0026141-
43, at 2-3 (``subject to their signing a confidentiality agreement'');
Jacoboni v. KPMG, Case No. 6:02-CV-510 (District Court for the Middle
District of Florida) Complaint (filed 4/29/02), at para. 9 (``KPMG
executives told [Mr. Jacoboni] he could not involve any other
professionals because the investment `strategy' [FLIP] was
`confidential.' '' Emphasis in original.); Subcommittee interview of
legal counsel of Mr. Jacoboni (4/4/03).
\344\ Email dated 5/5/99, from Jeffrey Eischeid to multiple KPMG
tax professionals, ``Marketing BLIPS,'' Bates KPMG 0006106.
\345\ Subcommittee interview of Wachovia Bank representatives (3/
25/03); Subcommittee interview of legal counsel of Theodore C. Swartz
(9/16/03).
\346\ Email dated 5/5/99, from Jeffrey Eischeid to multiple KPMG
tax professionals, ``Marketing BLIPS,'' Bates KPMG 0006106.
\347\ Email dated 4/11/00, from Larry DeLap to Tax Professional
Practice Partners, ``S-Corporation Charitable Contribution Strategy
(SC2),'' Bates KPMG 0052582.
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KPMG also attempted to place marketing restrictions on the
number of products sold so that word of them would be
restricted to a small circle. In the case of BLIPS, the DPP
initially authorized only 50 to be sold.348 In the
case of SC2, a senior tax professional warned against mass
marketing the product to prevent the IRS from getting ``wind of
it'':
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\348\ Email dated 5/5/99, from Jeffrey Eischeid to multiple KPMG
tax professionals, ``Marketing BLIPS,'' Bates KPMG 0006106.
``I was copied on the message below, which appears to
indicate that the firm is intent on marketing the SC2
strategy to virtually every S corp with a pulse (if S
corps had pulses). Going way back to Feb. 2000, when
SC2 first reared its head, my recollection is that SC2
was intended to be limited to a relatively small number
of large S corps. That plan made sense because, in my
opinion, there was (and is) a strong risk of a
successful IRS attack on SC2 if the IRS gets wind of
it. . . . [T]he intimate group of S corps potentially
targeted for SC2 marketing has now expanded to 3,184
corporations. Call me paranoid, but I think that such a
widespread marketing campaign is likely to bring KPMG
and SC2 unwelcome attention from the IRS. . . . I
realize the fees are attractive, but does the firm's
tax leadership really think that his is an appropriate
strategy to mass market?'' 349
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\349\ Email dated 12/20/01, from William Kelliher to WNT head David
Brockway, ``FW: SC2,'' Bates KPMG 0013311.
The DPP head responded: ``We had a verbal agreement following a
conference call with Rick Rosenthal earlier this year that SC2
would not be mass marketed. In any case, the time has come to
formally cease all marketing of SC2. Please so notify your
deployment team and the marketing directors.'' 350
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\350\ Email dated 12/29/01, from Larry DeLap to Larry Manth, David
Brockway, William Kelliher and others, ``FW: SC2,'' Bates KPMG 0013311.
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(5) Disregarding Professional Ethics
In addition to all the other problems identified in the
Subcommittee investigation, troubling evidence emerged
regarding how KPMG handled certain professional ethics issues,
including issues related to fees, auditor independence, and
conflicts of interest in legal representation.
Contingent, Excessive, and Joint Fees. The fees charged by
KPMG in connection with its tax products raise several
concerns. It is clear that the lucrative nature of the fees
drove the marketing efforts and helped convince other parties
to participate.351 KPMG made more than $124 million
from just the four tax products featured in this Report. Sidley
Austin Brown & Wood made millions from issuing concurring legal
opinions on the validity of the four tax products. Deutsche
Bank made more than $30 million in fees and other profits from
BLIPS.
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\351\ See, e.g., email dated 3/14/98, from Jeff Stein to multiple
KPMG tax professionals, ``Simon Says,'' Bates 638010, filed by the IRS
on June 16, 2003, as an attachment to Respondent's Requests for
Admission, Schneider Interests v. Commissioner, U.S. Tax Court, Docket
No. 200-02 (addressing a dispute over which of two tax groups, Personal
Financial Planning and International, should get credit for revenues
generated by OPIS).
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Traditionally, accounting firms charged flat fees or hourly
fees for tax services. In the 1990's, however, accounting firms
began charging ``value added'' fees based on ``the value of the
services provided, as opposed to the time required to perform
the services.'' 352 In addition, some firms began
charging ``contingent fees'' that were paid only if a client
obtained specified results from the services offered, such as
achieving specified tax savings.353 Many states
prohibit accounting firms from charging contingent fees due to
the improper incentives they create, and a number of SEC, IRS,
state, and AICPA rules allow their use in only limited
circumstances.354
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\352\ KPMG Tax Services Manual, Sec. 31.11.1 at 31-6.
\353\ See AICPA Code of Professional Conduct, Rule 302 (``[A]
contingent fee is a fee established for the performance of any service
pursuant to an arrangement in which no fee will be charged unless a
specified finding or result is attained, or in which the amount of the
fee is otherwise dependent upon the finding or result of such
service.'')
\354\ See, e.g., AICPA Rule 302; 17 C.F.R. Sec. 210.2-01(c)(5) (SEC
contingent fee prohibition: ``An accountant is not independent if, any
point during the audit and professional engagement period, the
accountant provides any service or product to an audit client for a
contingent fee.''); KPMG Tax Services Manual, Sec. 32.4 on contingent
fees in general and Sec. 31.10.3 at 31-5 (DPP head determines whether
specific KPMG fees comply with various rules on contingent fees.)
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Within KPMG, the head of DPP-Tax took the position that
fees based on projected client tax savings were contingent fees
prohibited by AICPA Rule 302.355 Other KPMG tax
professionals disagreed, complained about the DPP
interpretation, and pushed hard for fees based on projected tax
savings. For example, one memorandum objecting to the DPP
interpretation of Rule 302 warned that it ``threatens the value
to KPMG of a number of product development efforts,'' ``hampers
our ability to price the solution on a value added basis,'' and
will cost the firm millions of dollars.356 The
memorandum also objected strongly to applying the contingent
fee prohibition to, not only the firm's audit clients, but also
to any individual who ``exerts significant influence over'' an
audit client, such as a company director or officer, as
required by the DPP. The memorandum stated this expansive
reading of the prohibition was problematic, because ``many, if
not most, of our CaTS targets are officers/directors/
shareholders of our assurance clients.'' 357 The
memorandum states: ``At the present time, we do not know if
DPP's interpretation of Rule 302 has been adopted with the full
awareness of the firm's leadership. . . . However, it is our
impression that no one other than DPP has fully considered the
issue and its impact on the tax practice.''
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\355\ Subcommittee interview of Lawrence DeLap (10/30/03);
memorandum dated 7/14/98, from Gregg Ritchie to multiple KPMG tax
professionals, ``Rule 302 and Contingency Fees--CONFIDENTIAL,'' Bates
KPMG 0026557-58.
\356\ Memorandum dated 7/14/98, from Gregg Ritchie to multiple KPMG
tax professionals, ``Rule 302 and Contingency Fees--CONFIDENTIAL,''
Bates KPMG 0026555-59.
\357\ ``CaTS'' stands for KPMG's Capital Transaction Services Group
which was then in existence and charged with selling tax products to
high net worth individuals.
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In the four case studies examined by the Subcommittee, the
fees charged by KPMG for BLIPS, OPIS, and FLIP were clearly
based upon the client's projected tax savings.358 In
the case of BLIPS, for example, the BLIPS National Deployment
Champion wrote the following description of the tax product and
recommended that fees be set at 7% of the generated ``tax
loss'' that clients would achieve on paper from the BLIPS
transactions and could use to offset and shelter other income
from taxation:
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\358\ If a client objected to the requested fee, KPMG would, on
occasion, negotiate a lower, final amount.
``BLIPS . . . [A] key objective is for the tax loss
associated with the investment structure to offset/
shelter the taxpayer's other, unrelated, economic
profits. . . . The all-in cost of the program, assuming
a complete loss of investment principal, is 7% of the
targeted tax loss (pre-tax). The tax benefit of the
investment program, which ranges from 20% to 45% of the
targeted tax loss, will depend on the taxpayer's
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effective tax rates.
``FEE: BLIPS is priced on a fixed fee basis which
should approximate 1.25% of the tax loss. Note that
this fee is included in the 7% described above.''
359
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\359\ Document dated 7/21/99, entitled ``Action Required,''
authored by Jeffrey Eischeid, Bates KPMG 0040502. See also, e.g.,
memorandum dated 8/5/98, from Doug Ammerman to ``PFP Partners,'' ``OPIS
and Other Innovative Strategies,'' Bates KPMG 0026141-43 at 2 (``In the
past KPMG's fee related to OPIS has been paid by Presidio. According to
DPP-Assurance, this fee structure may constitute a contingent fee and,
as a result, may be a prohibited arrangement. . . . KPMG's fee must be
a fixed amount and be paid directly by the client/target.'' Emphasis in
original.)
Another document, an email sent from Presidio to KPMG,
provides additional detail on the 7% fee charged to BLIPS
clients, ascribing ``basis points'' or portions of the 7% fee
to be paid to various participants for various expenses. All of
these basis points, in turn, depended upon the size of the
client's expected tax loss to determine their amount. The email
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states:
``The breakout for a typical deal is as follows:
Bank Fees 125
Mgmt Fees 275
Gu[aran]teed Pymt. 8
Net Int. Exp. 6
Trading Loss 70
KPMG 125
Net return to Class A 91'' 360
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\360\ Email dated 5/24/00, from Kerry Bratton of Presidio to Angie
Napier of KPMG, ``RE: BLIPS--7 percent,'' Bates KPMG 0002557.
Virtually all BLIPS clients were charged this 7% fee.
In the case of SC2, which was constructed to shelter
certain S corporation income otherwise attributable and taxable
to the corporate owner, KPMG described SC2 fees as ``fixed'' at
the beginning of the engagement at an amount that ``generally .
. . approximated 10 percent of the expected average taxable
income of the S Corporation for the 2 years following
implementation.'' 361 SC2 fees were set at a minimum
of $500,000, and went as high as $2 million per
client.362
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\361\ Tax Solution Alert for S-Corporation Charitable Contribution
Strategy, FY00-28, revised as of 12/7/01, at 2. See also email dated
12/27/01, from Larry Manth to Andrew Atkin and other KPMG tax
professionals, ``SC2,'' Bates KPMG 0048773 (describing SC2 fees as
dependent upon client tax savings).
\362\ Id.
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The documents suggest that, at least in some cases, KPMG
deliberately manipulated the way it handled certain tax
products to circumvent state prohibitions on contingent fees.
For example, a document related to OPIS identifies the states
that prohibit contingent fees. Then, rather than prohibit OPIS
transactions in those states or require an alternative fee
structure, the memorandum directs KPMG tax professionals to
make sure the OPIS engagement letter is signed, the engagement
is managed, and the bulk of services is performed ``in a
jurisdiction that does not prohibit contingency fees.''
363
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\363\ Memorandum dated 7/1/98, from Gregg Ritchie and Jeffrey Zysik
to ``CaTS Team Members,'' ``OPIS Engagements--Prohibited States,''
Bates KPMG 0011954.
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Another set of fee issues related to the fees paid to the
key law firm that issued concurring legal opinions supporting
the four KPMG tax products, Sidley Austin Brown & Wood. This
law firm was paid $50,000 for each legal opinion it provided in
connection with BLIPS, FLIP, and OPIS. Documents and interview
evidence obtained by the Subcommittee indicate that the law
firm was paid even more in transactions intended to provide
clients with large tax losses, and that the amount paid to the
law firm may have been linked directly to the size of the
client's expected tax loss. For example, one email describing
the fee amounts to be paid to Sidley Austin Brown & Wood in
BLIPS and OPIS deals appears to assign to the law firm ``basis
points'' or percentages of the client's expected tax loss:
``Brown & Wood fees:
Quadra OPIS98--30 bpts
Quadra OPIS99--30 bpts
Presidio OPIS98--25 bpts
Presidio OPIS99--25 bpts
BLIPS--30 bpts'' 364
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\364\ Email dated 5/15/00, from Angie Napier to Jeffrey Eischied
and others, ``B&W fees and generic FLIP rep letter,'' Bates KPMG
0036342.
American Bar Association (ABA) Model Rule 1.5 states that
``[a] lawyer shall not make an agreement for, charge, or
collect an unreasonable fee,'' and cites as the factors to
consider when setting a fee amount ``the time and labor
required, the novelty and difficulty of the questions involved,
and the skill requisite to perform the legal service
properly.'' Sidley Austin Brown & Wood charged substantially
the same fee for each legal opinion it issued to a FLIPS, OPIS,
or BLIPS client, even when opinions drafted after the initial
prototype opinion contained no new facts or legal analysis,
were virtually identical to the prototype except for client
names, and in many cases required no client consultation. As
mentioned earlier, in BLIPS, Sidley Austin Brown & Wood was
also paid a fee in any sale where a prospective buyer was told
that the law firm would provide a favorable tax opinion letter
if asked, regardless of whether the opinion was later requested
or provided.365 These fees, with few costs after the
prototype opinion was drafted, raise questions about the firm's
compliance with ABA Model Rule 1.5.
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\365\ See ``Declaration of Richard E. Bosch,'' IRS Revenue Agent,
In re John Doe Summons to Sidley Austin Brown & Wood (N.D. Ill. 10/16/
03) at para. 18, citing an email dated 10/1/97, from Gregg Ritchie to
Randall Hamilton, ``Flip Tax Opinion.''
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Still another issue involves joint fees. In the case of
BLIPS, clients were charged a single fee equal to 7% of the tax
losses to be generated by the BLIPS transactions. The client
typically paid this fee to Presidio, an investment advisory
firm, which then apportioned the fee amount among various firms
according to certain factors. The fee recipients typically
included KPMG, Presidio, participating banks, and Sidley Austin
Brown & Wood, and one of the factors determining the fee
apportionment was who had brought the client to the table. This
fee splitting arrangement may violate restrictions on
contingency and client referral fees, as well as an American
Bar Association prohibition against law firms sharing legal
fees with non-lawyers.366
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\366\ See ABA Model Rule 5.4, ``A lawyer or law firm shall not
share legal fees with a non-lawyer.'' Reasons provided for this rule
include ``protect[ing] the lawyer's professional independence of
judgment.''
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Auditor Independence. Another professional ethics issue
involves auditor independence. Deutsche Bank, HVB, and Wachovia
Bank are all audit clients of KPMG, and at various times all
three have played roles in marketing or implementing KPMG tax
products. Deutsche Bank and HVB provided literally billions of
dollars in financing to make OPIS and BLIPS transactions
possible. Wachovia, through First Union National Bank, referred
clients to KPMG and was paid or promised a fee for each client
who actually purchased a tax product. For example, one internal
First Union email on fees stated: ``Fees to First Union will be
50 basis points if the investor is not a KPMG client, and 25
bps if they are a KPMG client.'' 367
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\367\ Email dated 8/30/99, from Tom Newman to multiple First Union
employees, ``next strategy,'' Bates SEN-014622.
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KPMG Tax Services Manual states: ``Due to independence
considerations, the firm does not enter into alliances with SEC
audit clients.'' 368 KPMG defines an ``alliance'' as
``a business relationship between KPMG and an outside firm in
which the parties intend to work together for more than a
single transaction.'' 369 KPMG policy is that ``[a]n
oral business relationship that has the effect of creating an
alliance should be treated as an alliance.'' 370
Another provision in KPMG's Tax Services Manual states: ``The
SEC considers independence to be impaired when the firm has a
direct or material indirect business relationship with an SEC
audit client.'' 371
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\368\ KPMG Tax Services Manual, Sec. 52.1.3 at 52-1.
\369\ Id., Sec. 52.1.1 at 52-1.
\370\ Minutes dated 9/28/98, of KPMG ``Assurance/Tax Professional
Practice Meeting'' in New York, ``Summary of Conclusions and Action
Steps,'' Bates XX 001369-74, at 1373.
\371\ KPMG Tax Services Manual, Sec. 52.5.2 at 52-6 (Emphasis in
original.). The SEC ``Business Relationships'' regulation states: ``An
accountant is not independent if, at any point during the audit and
professional engagement period, the accounting firm or any covered
person in the firm has any direct or material indirect business
relationship with an audit client, or with persons associated with the
audit client in a decision-making capacity, such as an audit client's
officers, directors, or substantial stockholders.'' 17 C.F.R.
Sec. 210.2-01(c)(3).
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Despite the SEC prohibition and the prohibitions and
warnings in its own Tax Services Manual, KPMG worked with audit
clients, Deutsche Bank, HVB, and Wachovia, on multiple BLIPS,
FLIP, and OPIS transactions. In fact, at Deutsche Bank, the
KPMG partner in charge of Deutsche Bank audits in the United
States expressly approved the bank's accounting of the loans
for the BLIPS transactions.372 KPMG tax
professionals were aware that doing business with an audit
client raised auditor independence concerns.373 KPMG
apparently attempted to resolve the auditor independence issue
by giving clients a choice of banks to use in the OPIS and
BLIPS transactions, including at least one bank that was not a
KPMG audit client.374 It is unclear, however,
whether individuals actually could choose what bank to use. It
is also unclear how providing clients with a choice of banks
alleviated KPMG's conflict of interest, since it still had a
direct or material, indirect business relationship with banks
whose financial statements were certified by KPMG auditors.
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\372\ Undated document prepared by Deutsche Bank in 1999, ``New
Product Committee Overview Memo: BLIPS Transaction,'' Bates DB BLIPS
6906-10, at 6909-10.
\373\ See, e.g., memorandum dated 8/5/98, from Doug Ammerman to
``PFP Partners,'' ``OPIS and Other Innovative Strategies,'' Bates KPMG
0026141-43 (``Currently, the only institution participating in the
transaction is a KPMG audit client. . . . As a result, DPP-Assurance
feels there may be an independence problem associated with our
participation in OPIS . . .''); email dated 2/11/99, from Larry DeLap
to multiple KPMG tax professionals, ``RE: BLIPS,'' Bates KPMG 0037992
(``The opinion letter refers to transactions with Deutsche Bank. If the
transactions will always involve Deutsche Bank, we could have an
independence issue.''); email dated 4/20/99, from Larry DeLap to
multiple KPMG tax professionals, ``BLIPS,'' Bates KPMG 0011737-38
(Deutsche Bank, a KPMG audit client, is conducting BLIPS transactions);
email dated 11/30/01, from Councill Leak to Larry Manth, ``FW: First
Union Customer Services,'' Bates KPMG 0050842 (lengthy discussion of
auditor independence concerns and First Union).
\374\ See, e.g., email dated 4/20/99, from Larry DeLap to multiple
KPMG tax professionals, ``BLIPS,'' Bates KPMG 0011737-38 (discussing
using Deutsche Bank, a KPMG audit client, in BLIPS transactions).
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In 2003, the SEC opened an informal inquiry into whether
the client referral arrangements between KPMG and Wachovia
violated the SEC's auditor independence rules. In its second
quarter filing with the SEC in August 2003, Wachovia provides
the following description of the ongoing SEC inquiry:
``On June 19, 2003, the Securities and Exchange
Commission informally requested Wachovia to produce
certain documents concerning any agreements or
understandings by which Wachovia referred clients to
KPMG LLP during the period January 1, 1997 to the
present. Wachovia is cooperating with the SEC in its
inquiry. Wachovia believes the SEC's inquiry relates to
certain tax services offered to Wachovia customers by
KPMG LLP during the period from 1997 to early 2002, and
whether these activities might have caused KPMG LLP not
to be `independent' from Wachovia, as defined by
applicable accounting and SEC regulations requiring
auditors of an SEC-reporting company to be independent
of the company. Wachovia and/or KPMG LLP received fees
in connection with a small number of personal financial
consulting transactions related to these services.
During all periods covered by the SEC's inquiry,
including the present, KPMG LLP has confirmed to
Wachovia that KPMG LLP was and is `independent' from
Wachovia under applicable accounting and SEC
regulations.''
In its third quarter filing with the SEC, Wachovia stated that,
on October 21, 2003, the SEC issued a ``formal order of
investigation'' into this matter, and the bank is continuing to
cooperate with the inquiry.
A second set of auditor independence issues involves KPMG's
decision to market tax products to its own audit clients.
Evidence appears throughout this Report of KPMG's efforts to
sell tax products to its audit clients or the officers,
directors, or shareholders of its audit clients. This evidence
includes instances in which KPMG mined its audit client data to
develop a list of potential clients for a particular tax
product; 375 tax products that were designed and
explicitly called for ``fostering cross-selling among assurance
and tax professionals''; 376 and marketing
initiatives that explicitly called upon KPMG tax professionals
to contact their audit partner counterparts and work with them
to identify appropriate clients and pitch KPMG tax products to
those audit clients.377 A KPMG memorandum cited
earlier in this Report observed that ``many, if not most, of
our CaTS targets are officers/directors/shareholders of our
assurance clients.'' 378
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\375\ See, e.g., Presentation dated 7/17/00, ``Targeting
Parameters: Intellectual Property--Assurance and Tax,'' with attachment
dated September 2000, entitled ``Intellectual Property Services,'' at
page 1 of the attachment, Bates XX 001567-93.
\376\ Presentation dated 3/6/00, ``Post-Transaction Integration
Service (PTIS)--Tax,'' by Stan Wiseberg and Michele Zinn of Washington,
D.C., Bates XX 001597-1611.
\377\ Email dated 8/14/01, from Jeff Stein and Walter Duer to
``KPMG LLP Partners, Managers and Staff,'' ``Stratecon Middle Market
Initiative,'' Bates KPMG 0050369.
\378\ Memorandum dated 7/14/98, from Gregg Ritchie to multiple KPMG
tax professionals, ``Rule 302 and Contingency Fees--CONFIDENTIAL,''
Bates KPMG 0026555-59. CaTS stands for the Capital Transaction Services
Group which was then in existence and charged with selling tax products
to high net worth individuals.
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By using its audit partners to identify potential clients
and targeting its audit clients for tax product sales pitches,
KPMG not only took advantage of its auditor-client
relationship, but also created a conflict of interest in those
cases where it successfully sold a tax product to an audit
client. This conflict of interest arises when the KPMG auditor
reviewing the client's financial statements is required, as
part of that review, to examine the client's tax return and its
use of the tax product to reduce its tax liability and increase
its income. In such situations, KPMG is, in effect, auditing
its own work.
The inherent conflict of interest is apparent in the
minutes of a 1998 meeting held in New York between KPMG top tax
and assurance professionals to address topics of concern to
both divisions of KPMG.379 A written summary of this
meeting includes as its first topic: ``Accounting
Considerations of New Tax Products.'' The section makes a
single point: ``Some tax products have pre-tax accounting
implications. DPP-Assurance's role should be to review the
accounting treatment, not to determine it.'' 380
This characterization of the issue implies not only a tension
between KPMG's top auditing and tax professionals, but also an
effort to diminish the authority of the top assurance
professionals and make it clear that they may not ``determine''
the accounting treatment for new tax products.
---------------------------------------------------------------------------
\379\ Minutes dated 9/28/98, of KPMG ``Assurance/Tax Professional
Practice Meeting'' in New York, ``Summary of Conclusions and Action
Steps,'' Bates XX 001369-74. (Capitalization in original omitted.)
\380\ Id. at Bates XX 001369. (Emphasis in original.)
---------------------------------------------------------------------------
The next topic in the meeting summary is: ``Financial
Statement Treatment of Aggressive Tax Positions.''
381 Again, the section discloses an ongoing tension
between KPMG's top auditing and tax professionals on how to
account for aggressive tax products in an audit client's
financial statements. The section notes that discussions had
taken place and further discussions were planned ``to determine
whether modifications may be made'' to KPMG's policies on how
``aggressive tax positions'' should be treated in an audit
client's financial statements. An accompanying issue list
implies that the focus of the discussions will be on weakening
rather than strengthening the existing policies. For example,
among the policies to be re-examined were KPMG's policies that,
``[n]o financial statement tax benefit should be provided
unless it is probable the position will be allowed,''
382 and that the ``probable of allowance'' test had
to be based solely on technical merits and could not consider
the ``probability'' that a client might win a negotiated
settlement with the IRS. The list also asked, in effect,
whether the standard for including a financial statement tax
benefit in a financial statement could be lowered to include,
not only tax products that ``should'' survive an IRS challenge,
which KPMG interprets as having a 70% or higher probability,
but also tax products that are ``more-likely-than-not'' to
withstand an IRS challenge, meaning a better than 50%
probability.
---------------------------------------------------------------------------
\381\ Minutes dated 9/28/98, of KPMG ``Assurance/Tax Professional
Practice Meeting'' in New York, ``Summary of Conclusions and Action
Steps,'' Bates XX 001369-74.
\382\ Id. at Bates XX 001370. (Emphasis in original.)
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Conflicts of Interest in Legal Representation. A third set
of professional ethics issues involves legal representation of
clients who, after purchasing a tax product from KPMG, have
come under the scrutiny of the IRS for buying an illegal tax
shelter and understating their tax liability on their tax
returns. The mass marketing of tax products has led to mass
enforcement efforts by the IRS after a tax product has been
found to be abusive and the IRS obtains the lists of clients
who purchased the product. In response, certain law firms have
begun representing multiple clients undergoing IRS audit for
purchasing similar tax shelters.
One key issue involves KPMG's role in referring its tax
shelter clients to specific law firms. In 2002, KPMG assembled
a list of ``friendly'' attorneys and began steering its clients
to them for legal representation. For example, an internal KPMG
email providing guidance on ``FLIPS/OPIS/BLIPS Attorney
Referrals'' states: ``This is a list that our group put
together. All of the attorneys are part of the coalition and
friendly to the firm. Feel free to forward to a client if they
would like a referral.'' 383 The ``coalition''
referred to in the email is a group of attorneys who had begun
working together to address IRS enforcement actions taken
against taxpayers who had used the FLIP, OPIS, or BLIPS tax
products.
---------------------------------------------------------------------------
\383\ Email dated 4/9/02, from Erin Collins to multiple KPMG tax
professionals, ``FLIPS/OPIS/BLIPS Attorney Referrals,'' Bates KPMG
0050113. See also email dated 11/4/02, from Ken Jones to multiple KPMG
tax professionals, ``RE: Script,'' Bates KPMG 0050130 (``Attached is a
list of law firms that are handling FLIP/OPIS cases. Note that there
are easily another 15 or so law firms . . . but these are firms that we
have dealt with in the past. Note that we are not making a
recommendation, although if someone wants to talk about the various
strengths/weaknesses of one firm vs. another . . . we can do that.'').
---------------------------------------------------------------------------
One concern with the KPMG referral list is that at least
some of the clients being steered to ``friendly'' law firms
might want to sue KPMG itself for selling them an illegal tax
shelter. In one instance examined by the Subcommittee, for
example, a KPMG client under audit by the IRS for using BLIPS
was referred by KPMG to a law firm, Sutherland, Asbill &
Brennan, with which KPMG had a longstanding relationship but
with which the client had no prior contact. In this particular
instance, the law firm did not even have offices in the
client's state. The client was also one of more than two dozen
clients that KPMG had steered to this law firm. While KPMG did
not obtain a fee for making those client referrals, the firm
likely gained favorable attention from the law firm for sending
it multiple clients with similar cases. These facts suggest
that Sutherland Asbill would owe a duty of loyalty to KPMG, not
only as a longstanding and important client, but also as a
welcome source of client referrals.
The engagement letter signed by the KPMG client, in which
he agreed to pay Sutherland Asbill to represent him before the
IRS in connection with BLIPS, contained this disclosure:
``In the event you desire to pursue claims against the
parties who advised you to enter into the transaction,
we would not be able to represent you in any such
claims because of the broad malpractice defense
practice of our litigation team (representing all of
the Big Five accounting firms, for example).''
384
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\384\ Engagement letter between Sutherland Asbill & Brennan LLP and
the client, dated 7/23/02, at 1, Bates SA 001964.
The KPMG client told the Subcommittee that he had not
understood at the time that this disclosure meant that
Sutherland Asbill was already representing KPMG in other
``malpractice defense'' matters and therefore could not
represent him if he decided to sue KPMG for selling him an
illegal shelter. The client signed the engagement letter on
July 24, 2002.
On September 8, 2002, Sutherland Asbill ``engaged KPMG''
itself to assist the law firm in its representation of KPMG's
former client, including with respect to ``investigation of
facts, review of tax issues, and other such matters as Counsel
may direct.'' This engagement meant that KPMG, as Sutherland
Asbill's agent, would have access to confidential information
related to its client's legal representation, and that KPMG
itself would be providing key information and analysis in the
case. It also meant that the KPMG client would be paying for
the services provided by the same accounting firm that had sold
him the tax shelter. When a short while later, the client asked
Sutherland Asbill about the merits of suing KPMG, he was told
that the firm could not represent him in such a legal action,
and he switched to new legal counsel.
The conflict of interest issues here involve, not only
whether KPMG should be referring its clients to a ``friendly''
law firm, but also whether the law firm itself should be
accepting these clients, in light of the firm's longstanding
and close relationship with KPMG. While both KPMG and the
client have an immediate joint interest in defending the
validity of the tax product that KPMG sold and the client
purchased, their interests could quickly diverge if the suspect
tax product is found to be in violation of federal tax law.
This divergence in interests has been demonstrated repeatedly
since 2002, as growing numbers of KPMG clients have filed suit
against KPMG seeking a refund of past fees paid to the firm and
additional damages for KPMG's selling them an illegal tax
shelter.
The preamble to the American Bar Association (ABA) Model
Rules states that ``a lawyer, as a member of the legal
profession, is a representative of clients, an officer of the
legal system and a public citizen having special responsibility
for the quality of justice. . . . As (an) advocate, a lawyer
zealously asserts the client's position under the rules of the
adversary system.'' The problem here is the conflict of
interest that arises when a law firm attempts to represent an
accounting firm's client at the same time it is representing
the accounting firm itself, and the issue in controversy is a
tax product that the accounting firm sold and the client
purchased. In such a case, the attorney cannot zealously
represent the interests of both clients due to conflicting
loyalties. A related issue is whether the law firm can
ethically use the accounting firm as the tax expert in the
client's case, given the accounting firm's self interest in the
case outcome.
At the request of the Subcommittee, the Congressional
Research Service's American Law Division analyzed the possible
conflict of interest issues.385 The CRS analysis
concluded that, under American Bar Association Model Rule 1.7,
a law firm should decline to represent an accounting firm
client in a tax shelter case if the law firm already represents
the accounting firm itself on other matters. The CRS analysis
identified ``two possible, and interconnected, conflicts of
interest'' that should lead the law firm to decline the
engagement. The first is a ``current conflict of interest'' at
the time of engagement, which arises from ``a `substantial
risk' that the attorney . . . would be `materially limited' by
his responsibilities to another client'' in ``pursuing certain
relevant and proper courses of action on behalf of the new
client'' such as filing suit against the firm's existing
client, the accounting firm. The second is a ``potential
conflict of interest whereby the attorney may not represent the
new client in litigation . . . against an existing, current
client. That particular, potential conflict of interest could
not be waived.''
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\385\ Memorandum dated 11/14/03, by Jack Maskell, Legislative
Attorney, American Law Division, Congressional Research Service,
``Attorneys and Potential Conflicts of Interest Between New Clients and
Existing Clients.''
---------------------------------------------------------------------------
The CRS analysis also recommends that the law firm fully
inform a potential client about the two conflicts of interest
prior to any engagement, so that the client can make a
meaningful decision on whether he or she is willing to be
represented by a law firm that already represents the
accounting firm that sold the client the tax product at issue.
According to ABA Model Rule 1.7, informed consent must be in
writing, but ``[t]he requirement of a writing does not supplant
the need in most cases for the lawyer to talk with the client,
to explain the risks and advantages, if any, of representation
burdened with a conflict of interest, as well as reasonably
available alternatives, and to afford the client a reasonable
opportunity to consider the risks and alternatives and to raise
questions and concerns.'' The CRS analysis opines that a
``blanket disclosure'' provided by a law firm in an engagement
letter is insufficient, without additional information, to
ensure the client fully understands and consents to the
conflicts of interest inherent in the law firm's dual
representation of the client and the accounting firm.
APPENDICES
----------
APPENDIX A
CASE STUDY OF BOND LINKED ISSUE PREMIUM STRUCTURE (BLIPS)
KPMG approved the Bond Linked Issue Premium Structure
(BLIPS) for sale to multiple clients in 1999. KPMG marketed
BLIPS for about 1 year, from about October 1999 to about
October 2000. KPMG sold BLIPS to 186 individuals, in 186
transactions, and obtained more than $53 million in revenues,
making BLIPS one of KPMG's top revenue producers in the years
it was sold and the highest revenue-producer of the four case
studies examined by the Subcommittee.
BLIPS was developed by KPMG primarily as a replacement for
earlier KPMG tax products, FLIP and OPIS, each of which KPMG
has characterized as a ``loss generator'' or ``gain mitigation
strategy.'' 386 In 2000, the IRS issued a notice
declaring transactions like BLIPS to be potentially abusive tax
shelters.387
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\386\ See, e.g., document dated 5/18/01, ``PFP Practice
Reorganization Innovative Strategies Business Plan--DRAFT,'' authored
by Jeffrey Eischeid, Bates KPMG 0050620-23, at 1.
\387\ BLIPS is covered by IRS Notice 2000-44 (2000-36 IRB 255) (9/
5/00).
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BLIPS is so complex that a full explanation of it would
take more space that this Report allows, but it can be
summarized as follows. Charts depicting a typical BLIPS
transaction are also provided.388
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\388\ A detailed explanation of these charts is included in the
opening statement of Senator Carl Levin at the hearing before the
Senate Permanent Subcommittee on Investigations, ``U.S. Tax Shelter
Industry: The Role of Accountants, Lawyers, and Financial
Professionals'' (11/18/03).
1) The Gain. Individual has ordinary or capital gains
---------------------------------------------------------------------------
income (e.g., $20 million).
2) The Sales Pitch. Individual is approached with a ``tax
advantaged investment strategy'' by KPMG and Presidio, an
investment advisory firm, to generate an artificial ``loss''
sufficient to offset the income and shelter it from taxation.
Individual is told that, for a fee, Presidio will arrange the
required investments and bank financing, and KPMG and a law
firm will provide separate opinion letters stating it is ``more
likely than not'' the tax loss generated by the investments
will withstand an IRS challenge.
3) The Shell Corporation. Pursuant to the strategy,
Individual forms a single-member limited liability corporation
(``LLC'') and contributes cash equal to 7% ($1.4 million) of
the tax loss ($20 million) to be generated by the strategy.
4) The ``Loan.'' LLC obtains from a bank, for a fee, a non-
recourse ``loan'' (e.g., $50 million) with an ostensible 7-year
term at an above-market interest rate, such as 16%. Because of
the above-market interest rate, LLC also obtains from the bank
a large cash amount up-front (e.g., $20 million) referred to as
a ``loan premium.'' The ``premium'' equals the net present
value of the portion of the ``loan'' interest payments that
exceed the market rate and that LLC is required to pay during
the full 7-year ``loan.'' The ``loan premium'' also equals the
tax loss to be generated by the strategy. LLC thus receives two
cash amounts from the bank ($50 million plus $20 million
totaling $70 million).
5) The ``Loan'' Restrictions. LLC agrees to severe
restrictions on the ``loan'' to make it a very low credit risk.
Most importantly, LLC agrees to maintain ``collateral'' in cash
or liquid securities equal to 101% of the ``loan'' amount,
including the ``loan premium'' (e.g., $70.8 million). LLC also
agrees to severe limits on how the ``loan proceeds'' may be
invested and gives the bank unilateral authority to terminate
the ``loan'' if the ``collateral'' amount drops below 101% of
the ``loan'' amount.
6) The Partnership. LLC and two Presidio affiliates form a
partnership called a Strategic Investment Fund (``Fund'') in
which LLC has a 90% partnership interest, one Presidio
affiliate holds a 9% interest, and the second Presidio
affiliate has a 1% interest. The 1% Presidio affiliate is the
managing partner.
7) The Assets. The Fund is capitalized with the following
assets. The LLC contributes all of its assets, consisting of
the ``loan'' ($50 million), ``loan premium'' ($20 million), and
the Individual's cash contribution ($1.4 million). Presidio's
two affiliates contribute cash equal to 10% of the LLC's total
assets ($155,000). The Fund's capital is a total of these
contributions ($71.6 million).
8) The Loan Transfer. LLC assigns the ``loan'' to the Fund
which assumes LLC's obligation to repay it. This obligation
includes repayment of the ``loan'' and ``loan premium,'' since
the ``premium'' consists of a portion of the interest payments
owed on the ``loan'' principal.
9) The Swap. At the same time, the Fund enters into a swap
transaction with the bank on the ``loan'' interest rate. In
effect, the Fund agrees to pay a floating market rate on an
amount equal to the ``loan'' and ``loan premium'' (about 8% on
$70 million), while the bank agrees to pay the 16% fixed rate
on the face amount of the ``loan'' (16% on $50 million). The
effect of this swap is to reduce the ``loan'' interest rate to
a market-based rate.
10) The Foreign Currency Investment ``Program.'' The Fund
converts most of its U.S. dollars into euros with a contract to
convert the funds back into U.S. dollars in 30-60 days. This
amount includes most or all of the loan and loan premium
amount. Any funds not converted into euros remain in the Fund
account. The euros are placed in an account at the bank. The
Fund engages in limited transactions which involve the
``shorting'' of certain low-risk foreign currencies and which
are monitored by the bank to ensure that only a limited amount
of funds are ever placed at risk and that the funds deemed as
101% ``collateral'' for the bank ``loan'' are protected.
11) The Unwind. After 60 to 180 days, LLC withdraws from
the partnership. The partnership unwinds, converts all cash
into U.S. dollars, and uses that cash to repay the ``loan''
plus a ``prepayment penalty'' equal to the unamortized amount
of the ``loan premium,'' so that the ``loan'' and ``loan
premium'' are paid in full. Any remaining partnership assets
are apportioned and distributed to the LLC and Presidio
partners, either in cash or securities. LLC sells any
securities at fair market value.
12) Tax Claim for Cost Basis. For tax purposes, the LLC's
income or loss passes to its owner, the Individual. According
to the opinion letters, the Individual can attempt to claim,
for tax purposes, that he or she retained a cost basis in the
partnership equal to the LLC's contributions of cash ($1.4
million) and the ``loan premium'' ($20 million), even though
the partnership later assumed the LLC's ``loan'' obligation and
repaid the ``loan'' in full, including the ``premium amount.''
According to the opinion letters, the individual can attempt to
claim a tax loss equal to the cost basis ($21.4 million),
adjusted for any gain or loss from the currency trades, and use
that tax loss to offset ordinary or capital gains income.
13) IRS Action. In 2000, the IRS issued a notice declaring
that the ``purported losses'' arising from these types of
transactions, which use an ``artificially high basis,'' ``do
not represent bona fide losses reflecting actual economic
consequences'' and ``are not allowable as deductions for
federal income tax purposes.'' IRS Notice 2000-44 listed this
transaction as a potentially abusive tax shelter.
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APPENDIX B
CASE STUDY OF S-CORPORATION CHARITABLE CONTRIBUTION STRATEGY (SC2)
KPMG approved the S-Corporation Charitable Contribution
Strategy (SC2) for sale to multiple clients in 2000. KPMG
marketed SC2 for about 18 months, from about March 2000 to
about September 2001. KPMG sold SC2 to 58 S-corporations, in 58
transactions, and obtained more than $26 million in revenues,
making SC2 one of KPMG's top ten revenue producers in 2000 and
2001. SC2 is not covered by a ``listed transaction'' issued by
the IRS, but is currently under IRS review.
SC2 can be summarized as follows. A chart depicting a
typical SC2 transaction is also provided.389
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\389\ A detailed explanation of this chart is included in the
opening statement of Senator Carl Levin at the hearing before the
Senate Permanent Subcommittee on Investigations, ``U.S. Tax Shelter
Industry: The Role of Accountants, Lawyers, and Financial
Professionals'' (11/18/03).
1) The Income. Individual owns 100% of S-corporation which
---------------------------------------------------------------------------
earns net income (e.g., $3 million annually).
2) The Sales Pitch. Individual is approached by KPMG with a
``charitable donation strategy'' to shelter a significant
portion (often 90%) of the S-corporation's income from taxation
by ``allocating,'' with little or no distribution, the income
to a charitable organization. Individual is told that, for a
fee, KPMG will arrange a temporary ``donation'' of corporate
non-voting stock to the charity and will provide an opinion
letter stating it is ``more likely than not'' that nonpayment
of tax on the income ``allocated'' to the charity while it
``owns'' the stock will withstand an IRS challenge, even if the
allocated income is not actually distributed to the charity and
the individual regains control of the income. The individual is
told he can also take a personal tax deduction for the
``donation.''
3) Setting Up The Transaction. The S-corporation issues
non-voting shares of stock that, typically, equal 9 times the
total number of outstanding shares (e.g., corporation with 100
voting shares issues 900 non-voting shares). Corporation gives
the non-voting shares to the existing individual-shareholder.
Corporation also issues to the individual-shareholder warrants
to purchase a substantial number of company shares (e.g., 7,000
warrants). Corporation issues a resolution limiting or
suspending income distributions to all shareholders for a
specified period of time (e.g., generally the period of time in
which the charity is intended to be a shareholder, typically 2
or 3 years). Prior to issuing this resolution, corporation may
distribute cash to the existing individual-shareholder.
4) The Charity. A ``qualifying'' charity (one which is
exempt from federal tax on unrelated business income) agrees to
accept S-corporation stock donation. KPMG actively seeks out
qualified charities and identifies them for the individual.
5) The ``Donation.'' S-corporation employs an independent
valuation firm to analyze and provide a valuation of its non-
voting shares. Due to the non-voting character of the shares
and the existence of a large number of warrants, the non-voting
shares have a very low fair market value (e.g., $100,000).
Individual ``donates'' non-voting shares to the selected
charity, making the charity the temporary owner of 90% of the
corporation's shares. Individual claims a charitable deduction
for this ``donation.'' At the same time, the corporation and
charity enter into a redemption agreement allowing the charity,
after a specified period of time (generally 2 or 3 years), to
require the corporation to buy back the shares at fair market
value. The individual also pledges to donate an additional
amount to the charity to ensure it obtains the shares' original
fair market value in the event that the shares' value
decreases. The charity does not receive any cash payment at
this time.
6) The ``Allocation.'' During the period in which the
charity owns the non-voting shares, the S-corporation
``allocates'' its annual net income to the charity and original
individual-shareholder in proportion to the percentage of
overall shares each holds (e.g., 90:10 ratio). However,
pursuant to the corporate resolution adopted before the non-
voting shares were issued and donated to the charity, little or
no income ``allocated'' to the charity is actually distributed.
The corporation retains or reinvests the non-distributed
income.
7) The Redemption. After the specified period in the
redemption agreement, the charity sells back the non-voting
shares to the S-corporation for fair market value (e.g.,
$100,000). The charity obtains a cash payment from the
corporation for the shares at this time. Should the charity not
resell the stock, the individual-shareholder can exercise the
warrants, obtain additional corporate shares, and substantially
dilute the value of the charity's shares. Once the non-voting
shares are repurchased by the corporation, the corporation
distributes to the individual-shareholder, who now owns 100% of
the corporation's outstanding shares, all of the undistributed
cash from previously earned income.
8) Taxpayer's Claim. Due to its tax exempt status, the
charity pays no tax on the corporate income ``allocated'' or
distributed to it. According to the KPMG opinion letter, for
tax purposes, the individual can claim a charitable deduction
for the ``donated'' shares in the year in which the
``donation'' took place. During the years in which the charity
``owned'' most of the corporate shares, individual will pay
taxes on only that portion of the corporate income that was
``allocated'' to him or her. KPMG also advised that all income
``allocated'' to the charity is then treated as previously
taxed, even after the corporation buys back the non-voting
stock and the individual regains control of the corporation.
KPMG also advised the individual that, when the previously
``allocated'' income was later distributed to the individual,
the individual could treat some or all as long-term capital
gains rather than ordinary income, taxable at the lower capital
gains rate. The end result is that the individual owner of the
S-corporation was told by KPMG that he or she could defer and
reduce the rate of the taxes paid on income earned by the S-
corporation.
9) IRS Action. This transaction is under review by the IRS.
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APPENDIX C
OTHER KPMG INVESTIGATIONS OR ENFORCEMENT ACTIONS
In recent years, KPMG has become the subject of IRS, SEC,
and state investigations and enforcement actions in the areas
of tax, accounting fraud, and auditor independence. These
enforcement actions include ongoing litigation by the IRS to
enforce tax shelter related document requests and a tax
promoter audit of the firm, which are described in the text of
the Report. They also include SEC, California, and New York
investigations examining a potentially abusive tax shelter
involving at least ten banks that are allegedly using sham
mutual funds established on KPMG's advice; SEC and Missouri
enforcement actions related to alleged KPMG involvement in
accounting fraud at Xerox and General American Mutual Holding
Co.; an SEC censure of KPMG for violating auditor independence
restrictions by investing in AIM mutual funds while AIM was a
KPMG audit client; and a bankruptcy examiner report on
misleading accounting at Polaroid while KPMG was Polaroid's
auditor.
SHAM MUTUAL FUND INVESTIGATION
KPMG is currently under investigation by the SEC and tax
authorities in California and New York for advising at least
ten banks to shift as much as $17 billion of bank assets into
shell regulated investment companies, allegedly to shelter more
than $750 million in income from taxation.
A regulated investment company (RIC), popularly known as a
mutual fund, is designed to pool funds from at least 100
investors to purchase securities. RIC investors, also known as
mutual fund shareholders, are normally taxed on the income they
receive as dividends from their shares, while the RIC itself is
tax exempt. In this instance, KPMG allegedly advised each bank
to set up one or more RICs as a bank subsidiary, to transfer
some portfolio of bank assets to the RIC, and then to declare
any income as dividends payable to the bank. Citing KPMG tax
advice, the banks allegedly claimed that they did not have to
pay taxes on the dividend income due to state laws exempting
from taxation money transferred between a subsidiary and its
corporate parent. Zions Bancorp., for example, has stated to
the press: ``These registered investment companies were
established upon our receiving tax and accounting guidance from
KPMG and the securities law counsel from the Washington, D.C.
firm of Ropes & Grey.'' 390
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\390\ ``Zions Among Banks Accused of Scheme,'' Desert News (8/8/
03).
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The RICs established by the banks are allegedly sham mutual
funds whose primary purpose was not to establish an investment
pool, but to shelter bank income from taxation. The evidence
allegedly suggests that the funds really had one investor--the
parent bank--rather than 100 investors as required by the SEC.
Press reports state, for example, that some of the RICs had
apparently sold all 100 shares to the employees of the parent
bank. Also according to press reports, the existence of this
tax avoidance scheme was discovered after a bank was approached
by KPMG, declined to participate, and asked its legal counsel
to alert California officials to what the bank saw as an
improper tax shelter. When asked about this matter, California
Controller Steve Westly has been quoted as saying, ``We do not
believe this is appropriate.'' 391 RICs established
by the ten banks participating in this tax shelter have since
been voluntarily de-registered, according to press reports,
with the last removed from SEC records in 2002.
---------------------------------------------------------------------------
\391\ ``Banks Shifted Billions Into Funds Sheltering Income From
Taxes,'' Wall Street Journal (8/7/03).
---------------------------------------------------------------------------
KPMG ACCOUNTING FRAUD AT XEROX
On January 29, 2003, the SEC filed suit in federal district
court charging KPMG and four KPMG partners with accounting
fraud for knowingly allowing Xerox to file 4 years of false
financial statements which distorted Xerox's filings by
billions of dollars.392 The prior year, in 2002,
without admitting or denying guilt, Xerox paid the SEC a $10
million civil penalty, then the highest penalty ever paid to
the SEC for accounting fraud, and agreed to restate its
financial results for the years 1997 through 2000. In July
2003, six former Xerox senior executives paid the SEC civil
penalties totaling over $22 million in connection with the
false financial statements.
---------------------------------------------------------------------------
\392\ SEC v. KPMG, Case No. 03-CV-0671 (D.S.D.N.Y. 1/29/03).
---------------------------------------------------------------------------
KPMG is contesting the SEC civil suit and denies any
liability for the accounting fraud. Two of the named KPMG
partners remain employed by the firm. The SEC complaint
includes the following statements:
``KPMG and certain KPMG partners permitted Xerox to
manipulate its accounting practices and fill a $3-
billion `gap' between actual operating results and
results reported to the investing public from 1997
through 2000. The fraudulent scheme allowed Xerox to
claim it met performance expectations of Wall Street
analysts, to mislead investors and, consequently, to
boost the company's stock price. The KPMG defendants
were not the watch dogs on behalf of shareholders and
the public that the securities laws and the rules of
the auditing profession required them to be. Instead of
putting a stop to Xerox's fraudulent conduct, the KPMG
defendants themselves engaged in fraud by falsely
representing to the public that they had applied
professional auditing standards to their review of
Xerox's accounting, that Xerox's financial reporting
was consistent with Generally Accepted Accounting
Principles and that Xerox's reported results fairly
represented the financial condition of the company. . .
.
``In the course of auditing Xerox for the years 1997
through 2000, defendants KPMG [and the four KPMG
partners] knew, or were reckless in not knowing, for
each year in which they were responsible for the Xerox
audit, that Xerox was preparing and filing quarterly
and annual financial statements and other reports which
likely contained material misrepresentations and
omissions in violation of the antifraud provisions of
the federal securities laws. . . .
``In the summer or early fall of 1999, Xerox complained
to KPMG's chairman, Stephen Butler, about the
performance of [one of the defendant KPMG audit
partners], who questioned Xerox management about
several of the topside accounting devices that formed
the fraudulent scheme. Although KPMG policy was to
review assignments of an engagement partner after five
years, and [the KPMG partner] had been assigned to
Xerox less than two years, Butler responded to Xerox's
complaints by offering [the KPMG partner] a new
assignment in Finland. After [the KPMG partner]
declined the new assignment, KPMG replaced [him] as the
worldwide lead engagement partner with [another of the
defendant KPMG partners] for the 2000 audit. This was
the second time in six years in which KPMG removed the
senior engagement partner early in his tenure at
Xerox's request.''
KPMG was Xerox's auditor for approximately 40 years,
through the 2000 audit. KPMG was paid $26 million for auditing
Xerox's financial results for fiscal years 1997 through 2000.
It was paid $56 million for non-audit services during that
period. When Xerox finally restated its financial results for
1997-2000, it restated $6.1 billion in equipment revenues and
$1.9 billion in pre-tax earnings--the largest restatement in
U.S. history to that time.
MISSOURI DEPARTMENT OF INSURANCE V. KPMG
On December 10, 2002, the Director of the Missouri
Department of Insurance, acting as the liquidator for an
insurance firm, General American Mutual Holding Company
(``General American''), sued KPMG alleging that: (1) KPMG,
acting in conflicting roles as consultant and auditor,
misrepresented the financial statements of its client, General
American, and (2) KPMG failed to disclose substantial risks
associated with an investment product called Stable Value
which, with KPMG's knowledge and assistance, was sold by
General American during the 1990's.393
---------------------------------------------------------------------------
\393\ Lakin v. KPMG, (MO Cir. 12/10/02).
---------------------------------------------------------------------------
Stable Value was an investment product that, in essence,
allowed General American to borrow money from investors and
reinvest it in high-risk securities to obtain a greater return.
In the event General American was downgraded by a ratings
agency, however, the terms of the Stable Value product allowed
investors to withdraw their funds. In 1999, General American,
in fact, suffered a ratings downgrade, and hundreds of Stable
Value holders redeemed their shares, forcing General American
to go into receivership and subjecting its investors to huge
losses. KPMG is alleged to have never disclosed the risks of
the Stable Value product to General American and, according to
the Missouri Department of Insurance, actively attempted to
conceal this risk.
The following excerpts are taken from a complaint filed by
the Director of the Missouri Department of Insurance against
KPMG in the Jackson County Circuit Court:
``In the 1990's, with KPMG knowledge, and assistance,
General American management developed and grew to
obscene proportions a high-risk product known as Stable
Value. In essence, certain General American management,
with KPMG's help, bet the very existence of General
American on its Stable Value business segment and lost.
. . . With KPMG's knowledge, General American
management forced an otherwise conservative company to
engage in an ever-increasing extremely volatile
product. When this scheme failed, it was General
American's innocent members who were harmed. . . .
``KPMG consciously chose to: (a) misrepresent General
American's financial position; (b) not require the
mandated disclosures regarding the magnitude and risks
associated with the Stable Value product; and (c)
conceal from and misrepresent to the Missouri
Department of Insurance and General American's members
and outside Board of Directors, the true nature of the
Stable Value product. And during this same time, when
KPMG was setting up General American's innocent members
for huge financial losses, KPMG kept scooping up as
much money in fees as possible. . . . KPMG abandoned
and breached its professional obligations owed to
General American, General American's members and the
Missouri Department of Insurance. KPMG's failures
include a lack of independence, conflicts of interest,
breaches of ethical standards, and other gross
departures from the most basic of auditing and other
professional obligations. . . .
``To further the cover-up of its wrongful acts, KPMG
engaged in a continued pattern of deceit during the
Missouri Department of Insurance's investigation into
General American's liquidity crisis. The record is
replete with KPMG witnesses giving false testimony,
evasive answers and just `playing dumb' in an apparent
hope to avoid State of Missouri regulatory scrutiny and
the filing of this Petition. What KPMG wanted to hide
from the regulators was its misrepresentations, gross
breaches of its professional obligations and numerous
failures regarding full and fair financial reporting
for General American.''
SEC CENSURES KPMG
On January 14, 2002, the SEC censured KPMG for engaging in
improper professional conduct in violation of the SEC's rules
on auditor independence and in violation of Generally Accepted
Auditing Standards. KPMG consented to the SEC's order but did
not admit or deny the SEC's findings.
The following is taken from the SEC's press release
announcing the censure of KPMG: 394
---------------------------------------------------------------------------
\394\ Press Release by the SEC, ``SEC Censures KPMG for Auditor
Independence Violation,'' (No. 2002-4 1/14/02), available at
www.sec.gov/news/press/2002-4.txt.
``The SEC found that, from May through December 2000,
KPMG held a substantial investment in the Short-Term
Investments Trust (STIT), a money market fund within
the AIM family of funds. According to the SEC's order,
KPMG opened the money market account with an initial
deposit of $25 million on May 5, 2000, and at one point
the account balance constituted approximately 15% of
the fund's net assets. In the order, the SEC found that
KPMG audited the financial statements of STIT at a time
when the firm's independence was impaired, and that
STIT included KPMG's audit report in 16 separate
filings it made with the SEC on November 9, 2000. The
SEC further found that KPMG repeatedly confirmed its
putative independence from the AIM funds it audited,
including STIT, during the period in which KPMG was
---------------------------------------------------------------------------
invested in STIT.
`` `This case illustrates the dangers that flow from a
failure to implement adequate polices and procedures
designed to detect and prevent auditor independence
violations,' said Paul R. Berger, Associate Director of
Enforcement.''
In addition to censuring the firm, the SEC ordered KPMG to
undertake certain remedies designed to prevent and detect
future independence violations caused by financial
relationships with, and investments in, the firm's audit
clients.
POLAROID AND KPMG
Polaroid Corporation filed for bankruptcy protection in
October 2001. In February 2003, a federal bankruptcy court
named Perry Mandarino, a tax expert, as an independent examiner
for Polaroid. In August 2003, the bankruptcy examiner issued a
report stating that Polaroid and its accounting firm, KPMG, had
engaged in improper accounting procedures and failed to warn
investors of Polaroid's impending bankruptcy. KPMG attempted to
keep the report sealed, but the court made the report available
to the public. Since the issuance of the examiner's report,
shareholders have filed a class action lawsuit against Polaroid
and KPMG alleging violations of the Securities and Exchange Act
for filing false financial statements.
Both the report and the lawsuit allege that KPMG and
Polaroid engaged in a series of fraudulent accounting
transactions, including overstating the value of assets and
issuing financial statements that made the company appear
healthier than it was. The examiner determined that KPMG should
have provided a qualified opinion on the corporation's
financial statements and included a warning about its status as
a ``going concern.'' The examiner found that KPMG had been
considering such a warning, but decided against issuing it
after a telephone call was made by Polaroid's chief executive
to KPMG's chairman.395 KPMG has charged that the
report is ``unfounded'' and ``incorrect.'' 396
---------------------------------------------------------------------------
\395\ See, e.g., ``KPMG Defends Audit Work for Polaroid,'' Wall
Street Journal (8/25/03).
\396\ ``Polaroid Hit with Lawsuit After Report,'' Boston Globe (8/
27/03).
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