CORPORATE TAX SHELTERS

Corporate Tax Shelters

In America as nowhere else, business and the tax authorities play the 'tax shelter' game with rare dedication. From time to time, the IRS launches an all out attack on tax shelters, and the shelter industry retreats - but it is soon back again, applying all its wits to the creation of ever more intricate ways of minimising corporate tax bills.

Acceptable tax shelters make use of permitted loopholes or tax breaks which are there to encourage certain types of economic behaviour. The vast majority of tax shelters are in full compliance with the tax laws, but an increasing number of them have crossed the bounds into being what the Government terms "abusive tax shelters". These are cases where the revenue loss to the government produces little or no tax benefit to society.

The Tax Reform Act of 1986 represented the last major attack by Government on tax shelters; in 2000 it tried again, but was stymied by Congress. In 2003 the Treasury Department released a new set of rules defining what it considers to be 'abusive' tax shelters. Throughout 2003 and 2004, the IRS and the Treasury concentrated their attack, with some success, more on the advisory firms that produce and 'market' tax shelters, rather than on the corporate users of the schemes.

Proposals to close further tax 'loopholes' approved by the Senate Finance Committee in early 2007 were removed by Congress from the legislation to which they had been attached.

Many US tax shelters are business ventures in which accounting losses far exceed the accounting income. These losses are used to offset the taxpayer's income from other sources. Usually, a tax shelter also provides large deductions in its early years although the taxpayer may not have invested significant amounts of capital up front. For example, a taxpayer might purchase a rental property with a low down payment and offset his rental income with deductions for interest, taxes, and the maximum allowable depreciation.

Generally, losses are generated in the first years of existence and passed through to investors, who sometimes achieve a complete return of their original investment through tax savings in the first two or three years. But the existence of a loss does not always indicate a tax shelter. A loss may also occur as a result of business operations or from an unusual event such as a casualty loss. The key element which distinguishes a tax shelter loss from a true business loss is the substance of the event which gave rise to the loss.

Tax Shelter Techniques

There are many methods by which taxpayers shelter their losses, but these three characteristics are usually found in tax shelters, either separately or in combination:

• Taxes are deferred to later years;

• Ordinary gains (100 percent taxable) are converted to capital gains (only 40 percent taxable), or capital losses (only 50 percent deductible), are converted to ordinary losses (100 percent deductible); in both cases producing a lower tax liability;

• Leverage is obtained through various financing arrangements.

Deferral also occurs when excessive deductions are taken in the early years of a tax shelter, a practice the IRS calls "front end loading." Examples of illegal front end loading practices are:

• Deducting capital items by classifying them as advisory fees, management fees, or interest;

• Deducting prepaid interest;

• Not including prepaid income;

• Deducting excessive depreciation, amortization, or depletion by using the wrong method, too short a useful life; and/or too large a basis.

The administration's attempted legislation in 2000 included an extensive package of revenue raisers targeting perceived corporate tax shelters, corporate transactions, financial products, international transactions, and insurance. New proposals included the following:

• Tax shelter penalties. The substantial understatement penalty imposed on corporate tax shelter items (as redefined) generally was to be increased to 40% (from 20%), with no reasonable cause exception, effective for transactions entered into on or after the date of "first committee action;'

• Treasury authority to deny tax benefits. The Treasury Department would disallow deductions, credits, exclusions, or other allowances obtained in a corporate tax shelter, effective for transactions entered into on or after the date of first committee action;

• No deduction for corporate tax shelters. The proposal would deny deductions for fees and tax advice expenses related to corporate tax shelters and would impose a 25% excise tax on fees received in connection with promoting or rendering tax advice related to corporate tax shelters. The proposal would be effective for payments made and fees received on or after the date of first committee action;

• Excise tax on tax shelter "recission" provisions. The proposal would impose on the corporate purchaser of a corporate tax shelter an excise tax of 25% of the maximum payment to be made under a tax benefit "protection arrangement." These arrangements include certain recission clauses, guarantees of tax benefits, or other arrangements (e.g., insurance) protecting the purchaser. The proposal would be effective for arrangements entered into on or after the date of first committee action;

• Positions inconsistent with transaction form. The proposal generally would preclude corporate taxpayers from taking any position (on a tax return or refund claim) that the Federal income tax treatment of a transaction is different from that dictated by its form if a "tax indifferent" person has a direct or indirect interest in the transaction. Tax indifferent persons would be defined as foreign persons, tax-exempt organizations, Native American tribal organizations, and domestic corporations with expiring loss or credit carryforwards. The proposal would not apply where the taxpayer discloses the inconsistent position on its tax return. The proposal would be effective for transactions entered into on or after the date of first committee action;

• Tax-indifferent parties. Income allocable to a tax-indifferent party with respect to a corporate tax shelter would be taxable; other participants in the tax shelter would be jointly liable for the tax. The proposal would be effective for transactions entered into on or after the date of first committee action;

• Forward stock sales. A corporate issuer of stock sold through a forward sale contract would be required to recognize as interest the time-value element of the forward contract. The proposal would be effective for forward contracts entered into on or after the date of first committee action;

• Built-in losses. The proposal targets the "importation" of foreign losses and other tax attributes incurred outside the U.S. taxing jurisdiction that are used to offset income or gain otherwise subject to U.S. tax. The proposal would eliminate such attributes and require that tax basis be marked to market in certain circumstances, effective for transactions in which assets or entities become "relevant" for U.S. tax purposes on or after the date of enactment;

• S corporation ESOPs. The proposal would 1) require an ESOP to pay tax on S corporation income (including capital gains) as the income is earned and 2) allow the ESOP a deduction for distributions of such income to plan beneficiaries. The proposal would be effective for taxable years beginning, acquisitions of S corporation stock, and S corporation elections made on or after the date of first committee action;

• Serial liquidations. The proposal would impose withholding tax on any distribution made to a foreign corporation in complete liquidation of a U.S. holding company if the holding company was in existence for less than five years; the proposal also would apply with respect to serial terminations of U.S. branches. The proposal would be effective for liquidations and terminations occurring on or after the date of enactment;

• Basis shifting transactions. To prevent taxpayers from attempting to offset capital gains by generating artificial capital losses through basis-shift transactions involving foreign shareholders, the proposal would treat the portion of a dividend that is not subject to current U.S. tax as a nontaxed portion. The proposal would be effective for distributions made on or after the date of first committee action;

• Lessors of tax-exempt property. The proposal would deny a lessor the ability to recognize a net loss from a leasing transaction involving tax-exempt use property during the lease term, effective for leasing transactions entered into on or after the date of enactment. For this purpose, tax-exempt use property would include property leased to governments, tax-exempt organizations, and foreign persons;

• Mismatching of deductions and income. Deductions for amounts accrued but unpaid to related controlled foreign corporations, passive foreign investment companies, or foreign personal holding companies generally would be allowable only to the extent the amounts accrued by the payor are, for U.S. purposes, reflected in the income of the direct or indirect U.S. owners of the related foreign person. An exception would be provided for certain short-term transactions entered into in the ordinary course of business. The proposal would be effective for amounts accrued on or after the date of first committee action;

This is a useful list of tax shelters, from the taxpayers' perspective, especially since the Congress refused to pass the administration's Bill. There were further proposals:

• Control test. The proposal would conform the control requirement for tax-free incorporations, distributions, and reorganizations with the ownership test used for determining affiliation, effective for transactions on or after the date of enactment;

• Tracking stock. The proposal would give Treasury authority to treat "tracking stock" as nonstock (e.g., debt or a notional principal contract) or as stock of another entity as appropriate to prevent tax avoidance, effective for stock issued on or after the date of enactment;

• Transfers of intangibles. The transfer of an interest in intangible property constituting less than all of the substantial rights of the transferor in the property would be treated as a tax-free transfer, but the transferor would be required to allocate the basis of the intangible between the retained rights and the transferred rights based on their respective fair market values. Consistent reporting would be required. The proposal would be effective for transfers on or after the date of enactment;

• Downstream mergers. Where a target corporation holds less than 80% of the stock of an acquiring corporation, and the target combines with the acquiring corporation in a reorganization in which the acquiring corporation is the survivor, the target would have to recognize gain, but not loss, as if it distributed the acquiring corporation stock that it held immediately prior to the reorganization. The proposal would apply to transactions occurring on or after the date of enactment;

• Bank short-term obligations. The proposal would require banks to accrue interest and original issue discount on all short-term obligations, including loans made in the ordinary course of the bank's business, effective for obligations acquired or originated on or after the date of enactment;

• Current accrual of market discount. A taxpayer that uses an accrual method of accounting would be required to include market discount income as it accrues, effective for debt instruments acquired on or after the date of enactment;

• Partnership constructive ownership transactions. The proposal would treat long-term capital gain recognized from a "constructive ownership" derivative transaction as ordinary income to the extent the long-term capital gain recognized from the transaction exceeds the long-term capital gain that could have been recognized had the taxpayer invested in the partnership interest directly. The proposal would apply to gains recognized on or after the date of first committee action;

• Debt-financed portfolio stock. The proposal would tighten current-law rules requiring a corporation to reduce its dividends-received deduction with respect to dividends paid on debt-financed portfolio stock. The proposal would be effective for portfolio stock acquired on or after the date of enactment;

• Debt-for-debt exchanges. The proposal would spread the issuer's net reduction for bond repurchase premium in a debt-for-debt exchange over the term of the new debt instrument using constant yield principles, among other changes. The proposal would apply to debt-for-debt exchanges occurring on or after the date of enactment

• Straddle rules. The proposal would 1) clarify that net interest expense and carrying charges arising from structured financial products containing a leg of a straddle must be capitalized and 2) repeal the current-law exception for certain straddles of actively traded stock, effective for straddles entered into on or after the date of enactment;

• Effectively connected income. The proposal would expand the categories of foreign-source income that could constitute effectively connected income under IRC section 864(c)(4)(B)(ii) to include income that may be sourced by analogy to interest (interest equivalents) or dividends (dividend equivalents). Interest equivalents would include letter-of-credit fees, guarantee fees, and loan commitment fees. The proposal would be effective for taxable years beginning after the date of enactment;

• Overall foreign losses. For the purposes of IRC section 904(f), property subject to the recapture rules upon disposition under IRC section 904(f)(3) would include stock in a controlled foreign corporation, effective beginning on the date of enactment.

The tax-shelter industry on Wall Street moved into top gear after the proposals were anounced, pushing through large numbers of schemes before the doors shut; but in the event the Bill languished.

During 2002 the Internal Revenue Service mounted a Tax Shelter Disclosure Initiative, which it said was a success, leading to 621 disclosures covering 947 tax returns, and involving more than $16 billion in claimed losses and deductions.

The initiative was aimed at corporate taxpayers and wealthy individuals worried that tax shelters which they were using might be illegal, but afraid to come forward. In return for full disclosure regarding the transactions and details of the schemes, the IRS promised to waive accuracy-related penalties which might apply to tax shelter and other questionable items on a return at a rate as high as 20%.

'Hundreds of taxpayers came forward and took advantage of this opportunity to voluntarily disclose questionable tax transactions and submit the names of abusive tax shelter promoters,' said Larry Langdon, the IRS Commissioner of Large and Mid-Size Business.

In May, 2003, the US Treasury Department and Internal Revenue Service released a final version of their new rules designed to curb the promotion and use of abusive tax shelters.

The rules are intended to update earlier tax shelter disclosure laws which were too narrow, and allowed many tax shelter promoters to slip through the net. However, concerns were expressed that they will almost certainly lead to an additional compliance burden for individual and corporate taxpayers, who will likely be asked to disclose details of perfectly legal arrangements.

According to a Treasury statement, six categories of potential tax avoidance transactions are covered. Taxpayers will be required to disclose and promoters will be require to maintain investor lists for six categories of transactions:

• Listed transactions (i.e., transaction that have been specifically identified by the IRS as tax avoidance transactions);
• Transactions marketed under conditions of confidentiality;
• Transactions with contractual protection;
• Transactions generating a tax loss exceeding specified amounts;
• Transactions resulting in a book-tax difference exceeding $10 million; and
• Transactions generating a tax credit when the underlying asset is held for a brief period of time.

The US Treasury Department also issued new rules covering professional conduct known as 'Circular 230'. This was circulated in draft in early 2003, and late in the year the Treasury confirmed that the stiff draft rules would be put into force. Assistant Treasury Secretary for tax policy Pamela Olson explained: "We initially thought we were going to be making a lot of changes” to the draft proposals. "But after reflecting on what we've seen in the last couple of years, we don't think we should be watering these down," added Olson. "We think we should come out with a strong set of rules."

The focus during 2003 was indeed very much on professionals involved in setting up tax shelters, both in terms of attacking them directly, and in terms of trying to force them to disgorge details of shelters they have set up for taxpayers, although the IRS has had only mixed success in this latter endeavour.

In June the IRS issued a summons against a top law firm, ordering it to disclose the names of 600 wealthy clients that the agency alleged were sold tax shelter schemes. Chicago federal judge John W. Darrah approved a request by the Revenue to issue the summons against Dallas-based law firm Jenkens and Gilchrist on the grounds that the firm had supposedly taken around $72 million in fees for tax shelter advice, according to Justice Department papers. Jenkens and Gilchrist declared that it had no intention of compromising client confidentiality and would not divulge details of any of the names contained in the summons.

Then in July a three-judge panel at the United States Court of Appeals for the Seventh Circuit ruled that accounting firm BDO Seidman must turn over the names of investors in tax shelters to the IRS. The court found that under the US tax code, BDO is obliged to keep records on tax sheltering arrangements, and to report to the IRS the indentities of investors in such schemes. This, the panel explained, means that investors in the tax shelters did not have 'an expectation of confidentiality in their communications with BDO,' as the accounting firm had argued. And in October a federal court ruled that the Chicago office of law firm, Sidley Austin Brown & Wood must hand over information about clients who have invested in 13 tax minimization schemes since 1996. IRS Commissioner, Mark Everson explained that: "Our actions show that we will require attorneys who act as promoters to comply with the law's requirement that they maintain lists of investors for certain abusive transactions and furnish those lists, upon request, to the IRS."

On the other hand, one of the IRS's most prominent targets, KPMG, scored a success in October when a specially appointed Master recommended to a federal court that the company did not have to hand over all the documents requested by the IRS, according to a Wall Street Journal report. The IRS was seeking to enforce 25 summonses that it had sent to KPMG demanding tax sheltering documentation. The firm had handed over hundreds of boxes of paperwork, but had also withheld many documents, arguing that to lay them open to scrutiny would be to breach client privilege. Consequently, in December 2002, the Washington DC federal court appointed retired US Magistrate Judge Patrick Attridge to appraise KPMG's claim and examine the documents in question. In his judgement delivered on October 8, Judge Attridge ruled that whilst KPMG must hand over some of the documents, those that contained material covered by client-attorney privilege may be retained by the firm.

Congress was also been playing its part in the tax-shelter crack-down in 2003. In December, Charles Grassley, Chairman of the influential Senate Finance Committee, announced that he wanted to accelerate legislation that would crack down on so-called LILO (lease in, lease out) tax shelters which had become a popular tax saving vehicle with many corporations. Under the leasing schemes, municipalities are paid an up-front accommodation fee to lease their infrastructure to a corporation. Grassley says that the cash received by the municipality, however, pales in comparison to the federal tax benefits received by the corporations, which are able to depreciate taxpayer-funded bridges, subways, and rail systems as a result of the lease. "The shelter promoters are hiding behind the cities and are sending them to Capitol Hill to talk about what an important source of funding this is. This has nothing to do with a ‘public-private' partnership. This is just good, old-fashioned tax fraud," Grassley announced in a statement.

Hearings into tax sheltering held by the Senate Permanent Subcommittee on Investigations in November, 2003, also gained a lot of publicity, although they did not lead to much legislation since they were organised largely by Democrat senators. The Senate subcommittee came to the following conclusions: "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 US 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." Well, what a surprise!

Ominously, a member of the US Public Company Accounting Oversight Board (set up under the SEC as a result of the Sarbanes-Oxley Act) hinted in 2004 that the organisation was considering reforms that would prevent corporate auditors from offering certain tax planning and sheltering services to their audit clients. Mark Goelzer, a member of the board, advised auditors in comments prepared for the mutual fund industry to exhibit caution when offering these services to clients. "I have no problem with auditors assisting their clients with traditional tax compliance and routine planning," Goelzer explained, but added that: "Tax services that go beyond that - especially the marketing to audit clients of novel, tax-driven, financial products - raise serious issues." However, Goelzer went on to acknowledge that reforming this controversial area of tax planning was not going to be straightforward, as the boundaries between traditional tax advice and the advocation of tax shelters are often blurred. Nevertheless, given the public and political fury vented following the collapse of firms such as Enron and Worldcom, often at the accounting firms which sold tax shelters to these companies, Goelzer explained that "the board may have to try its hand at solving the problem."

New IRS rules on the registering and reporting of tax shelters also had to be taken seriously. Under the terms of the new registration rules, advisers are obliged to report to the IRS any tax minimization products and services offered which the tax agency has dubbed 'abusive tax shelters'. The reporting rules require tax professionals to file a Reportable Transaction Disclosure Statement 8886 with clients' tax returns for each year that they have participated in the tax sheltering arrangement, and with the Office of Tax Shelter Analysis for their first year of involvement in the scheme. The new list maintenance rules require that tax advisers maintain lists of participants in so-called abusive tax shelters for possible future inspection by the tax authority.

In January, 2004, the Treasury Department announced a raft of legislative proposals to be included in President Bush’s 2005 budget aimed at closing tax loopholes, nullifying tax shelters, and simplifying the taxation system.

Commenting on the series of new proposals, which aim to clamp down on tax abuse on a broad front, then-Treasury Secretary John Snow remarked: “The laws must ensure that those who would shirk their civic responsibilities cannot do so by exploiting unintended loopholes, and the IRS must ensure that taxpayers do not engage in abusive tax avoidance transactions.”

“We are committed to restoring confidence in the tax system by ending the proliferation of abusive tax avoidance transactions and simplifying the tax code,” added Treasury Assistant Secretary for Tax Policy Pam Olson. “Ultimately, there is no “silver bullet” or “one-size-fits-all” solution addressing abusive tax avoidance transactions — other than continuing to simplify the tax code and ensure that the tax results match the economic realities of the transactions,” she observed.

Meanwhile, IRS Commissioner Mark W. Everson hoped that a new policy of tougher penalties would help to drive home the administration’s zero-tolerance message, which it intends to send out with the glut of new proposals. According to the Treasury, they would seek to:

• Impose Penalties on the Failure to Disclose Potentially Abusive Transactions;
• Permit Uniform Disclosure Rules for Potentially Abusive Transactions;
• Permit Injunction Actions against Promoters who Repeatedly Disregard the Registration and List-Maintenance Requirements;
• Impose a Penalty for the Failure to Report an Interest in a Foreign Financial Account;
• Curb Abusive Income-Separation Transactions;
• Eliminate Obstacles to Disclosure;
• Increase Penalties for False or Fraudulent Statements Made to Promote Abusive Tax Avoidance Transactions;
• Eliminate Abusive Transactions Involving Foreign Tax Credits;
• Stop Abusive Leasing Transactions with Tax-Indifferent Parties;
• Require Charitable Deductions to Reflect Accurately the Value of the Donation;
• Prevent Misuse of Tax-Exempt Casualty Insurance Companies;
• Address the Tax Consequences of Changing Beneficiaries of a Section 529 College Savings Plan;
• Tighten the Deduction Limitation for Interest Paid to Related Parties;
• Prevent Avoidance of U.S. Tax on Foreign Earnings Invested in U.S. Property;
• Modify Tax Rules for Individuals Who Give Up U.S. Citizenship or Green Card Status;
• Curb Frivolous Returns and Submissions;
• Terminate Instalment Agreements when Taxpayers Fail to File Returns or Make Tax Deposits;
• Streamline the Handling of Collection Due Process Cases;
• Improve Procedures for Taxpayers Seeking to Resolve Their Tax Liabilities;
• Make the Payment of FMS (Financial Management Services) Fees for Levies More Efficient;
• Expand the Use of Electronic Filing;
• Permit Private Collection Agencies to Support the IRS’ Collection Efforts

“I’m very pleased the administration is continuing its attacks on illicit tax shelters,” noted Senator Charles Grassley. "The administration should receive high marks for its anti-tax shelter efforts. It’s issued numerous shelter regulations over the past year and laid down a solid response to attacking this problem. Congress needs to back up these efforts by passing tax shelter legislation,” he observed.

Later in January, tax collectors in twelve states, including California and New York, met with representatives from the Federation of Tax Administrators and the Multistate Tax Commission to discuss how to combat tax sheltering on a broad front.

"California is joining forces with other states to crack down on abusive tax shelters, and we're putting our collective resources to work," commented Californian State Controller Steve Westly. "We're going to use the best ideas from every state to find and prosecute tax cheats," he added.

The other participating states and cities included Colorado, Connecticut, Illinois, Massachusetts, Michigan, Minnesota, New Jersey, Ohio, Tennessee, and Wisconsin, as well as New York City.

California also offered a Voluntary Compliance Initiative for taxpayers who invested in abusive tax shelters. Taxpayers had until April 15 to correct their tax returns and make full payment of the taxes owed or face new harsh penalties. The Californian Franchise Tax Board claims the state loses $600 million to $1 billion in tax money annually through abusive tax sheltering.

In 2003, 41 states, among them New York and California, signed a Memorandum of Understanding with the IRS allowing federal and state tax collection agencies to pool their collective information on delinquent taxpayers and concentrate the battle against abusive tax shelters.

At the end of the month, the Treasury Department issued a ruling to shut down abusive transactions involving ‘S corporation ESOPs’ (employee stock ownership plans) in a ruling that will classify such investments as listed transactions for the purposes of tax shelter disclosure.

According to a Treasury statement: “An employee stock ownership plan is a type of retirement plan that invests primarily in employer stock. Congress has allowed an ‘S corporation’ to be owned by an ESOP, but only if the ESOP gives rank-and-file employees a meaningful stake in the S corporation. When an ESOP owns an S Corporation, the profits of that corporation generally are not taxed until the ESOP makes distributions to the company’s employees when they retire or leave the job. This is an important tax break which allows the company to reinvest profits on a tax-deferred basis, for the ultimate benefit of employees who are ESOP participants.

“The ruling shuts down transactions that move business profits of the S corporation away from the ESOP, so that rank-and-file employees do not benefit from the arrangement. For example, the ruling prohibits using stock options on a subsidiary to drain value out of the ESOP for the benefit of the S corporation’s former owners or key employees.”

Treasury Assistant Secretary for Tax Policy Pam Olson observed: "Congress recognized the potential for attempts to circumvent the rules and specifically authorized Treasury and IRS to prevent it. This notice does just that, imposing a 50% excise tax on the option holders in cases where rank-and-file ESOP participants are deprived of the business profits."

In May, 2004, the IRS announced a new amnesty scheme for taxpayers who may have employed a tax minimisation technique commonly referred to as ‘Son of Boss,’ which the agency claims has deprived the government of some $6 billion in tax revenues. The so-called Son of Boss scheme is derived from an earlier scheme known as ‘Boss’ (bond and option sales strategy), and was commonly used in the late 1990s to offset large one-off gains such as the sale of a business.

However, according to IRS Chief Mark W. Everson: “Son of Boss deals had only one purpose – the elimination of tax. These transactions were developed and marketed by an interlocking network of commercial interests, including leading law firms, accounting firms and investment banks.”

The IRS claims that many transactions undertaken through Son of Boss schemes generated tax losses of between $10 million and $50 million leading to a total understatement of tax in excess of $6 billion.

Under the terms of the amnesty, which are a lot less generous than previous amnesty programs, eligible taxpayers must concede 100% of the claimed tax losses, must pay all applicable interest and must accept the imposition of a penalty unless they had previously disclosed their participation in the transaction.

However, participating taxpayers will be allowed to deduct as a loss their out of pocket transaction costs, typically promoter and professional fees.

Everson points out that taxpayers will remain able to contest the IRS in court over such issues, although he warned that the government will “vigorously pursue the full tax due”, plus full interest and penalty payments owing. However, IRS officials revealed to the Washington Post that taxpayers will be barred from using the agency's normal appeals process to contest such cases. Confirming the agency's tough stance on the subject, IRS Chief Counsel Donald Korb added that taxpayers "should not expect to settle court cases on terms more favorable than those offered in the IRS settlement initiative.”

Also in May, law firm Jenkens and Gilchrist was ordered by a federal judge to hand over the names of clients who invested in tax schemes formulated by its Tax and Estate Planning Practice Group and its Structured Investment Practice, between June 1998 and June 2003. The ruling marked the conclusion of a five year battle between the firm and the Internal Revenue Service.

Ruling at the Northern District of Illinois court on Friday, US District Judge James Moran granted permission for the law firm's clients to raise claims of attorney-client privilege. However, he observed that there "does not appear to be...sustainable grounds for the assertion of privilege for the great majority of client materials", and warned that clients would be penalised for bringing frivolous privilege claims.

Despite some tactical victories, an informant for the IRS told Congress in July, 2004, that the agency is ill-equipped to win the battle against the increasingly sophisticated use of tax shelters. "From my vantage point, the IRS simply does not understand how the tax shelters work, or how the transactions and structures fit together," the Senate Finance Committee was told by the anonymous witness, who works for a Wall Street bank. The problem is being compounded by the IRS’s lack of trusted informants and confidential witnesses, the banker known as ‘Mr ABC’ testified.

The informant went on to give as an example a situation in which the IRS failed to act on his disclosure in 1999 that Enron was engaged in illegitimate tax activities in a bid to artificially drive up the company’s earnings. The witness stated that in all, he had made disclosures to the IRS on three types of tax shelters and other schemes involving around $10 billion in taxable income. He expressed dismay that the IRS had seen fit not to offer any type of reward for such substantial revelations of illegal tax dealings.  

Ruling in September in Manhattan's district court in the case of Seippel v. Jenkens and Gilchrist, Southern District Judge Shira A. Scheindlin allowed fraud and recission claims against the Sidley Austin Brown & Wood law firm to proceed. Telecommunications executive, William Seippel participated in a tax sheltering arrangement known as COBRA (Currency Options Bring Reward Alternatives), which was developed by Jenkens & Gilchrist in conjunction with Brown & Wood, prior to the latter's merger with Sidley & Austin in 2001.

Following an Internal Revenue Service investigation into the shelter which led to Mr Seippel and his wife paying more than $5 million in taxes, penalties and fees, the couple sued the law firms in question alleging fraud, infringement of the Racketeer Influenced and Corrupt Organizations (RICO) Act, legal malpractice, breach of contract, negligent misrepresentation, and breach of fiduciary duty.

Although Judge Scheindlin dismissed the RICO, malpractice, breach of contract, negligent misrepresentation and breach of fiduciary duty claims, she allowed the fraud and recission of fees actions to continue, observing that:

"The fact that the Seippels may not ultimately owe the tax authorities additional taxes does not mean that their action is not ripe. The Seippels allege that they have been damaged, and continue to be damaged, as a result of the defendants' conduct."

She continued: "Their damages include the fees paid to defendants, losses incurred in the transactions, expenses paid to accountants and attorneys that are assisting the Seippels in defending the audits, losses caused as a result of being forced to sell assets at distressed prices to meet tax obligations, and tax penalties already assessed and paid."

Towards the end of 2004, however, the IRS lost a series of tax shelter cases, although it did score one signal triumph.

In November, the US Court of Federal Claims in Washington rejected a claim by the IRS that industrial firm, Coltec Industries, used sham transactions in order to avoid taxes, representing the second defeat for the agency in a tax shelter case in the space of two weeks. The IRS argued that Coltec, a maker of aircraft landing systems, had used a transaction known as a contingent liability deal to generate capital losses which the firm used to offset capital gains from the sale of a business unit in 1996. However, Judge Susan Branden rejected the IRS’s argument that the transactions had no economic purpose, and stated that in her opinion Coltec had complied with all the statutory requirements laid down by Congress. Awarding Coltec an $82.8 million refund, Judge Branden suggested that: “The use of the 'economic substance' doctrine to trump 'mere compliance with the code' would violate the separation of powers" as laid down in the US Constitution.

Then the IRS suffered a similar defeat in a case involving Black & Decker Corp., where an US district court in Baltimore upheld the firm’s right to a $57 million refund centred on a transaction that the agency deemed abusive.

The IRS's third court defeat in the space of two weeks came when it was ordered by Judge Stefan R. Underhill of the United States District Court of Connecticut to refund TIFD III-E Inc, a subsidiary of General Electric Corp., more than $62 million. At the heart of the case was a complex set of transactions involving three GE subsidiaries which formed a partnership, Castle Harbour, in 1993, to which GE contributed a number of aircraft in addition to cash and stock worth more than $500 million in total.

The partnership’s three shareholders, of which TIFD III-E was one, then sold their stake to two Dutch banks and for tax purposes, the subsidiary's income was allocated to the banks, which did not pay US income taxes. Judge Underhill disagreed that the transactions had no economic substance, as the Dutch banks had invested in Castle Harbour, and observed that "the economic reality of such a transaction is hard to dispute." However, he also acknowledged that one of GE’s principle motives was avoidance of tax.

"In short, the transaction, though it sheltered a great deal of income from taxes, was legally permissible," he wrote in his judgement. However, he added: "Under such circumstances, the IRS should address its concerns to those who write the tax laws."

The IRS's success came in December when a federal jury convicted six people in a $120 million tax shelter scheme described by the authorities as one of the most extensive cases of its type ever tried. The case involved the Washington state-based firm Anderson Ark and Associates, which charged around 1,500 clients fees ranging from $50,000 to $250,000 for tax shelter plans that helped them take income tax deductions in the period form 1997 to 2001.

The schemes, which were sold over the internet, involved transactions using shell companies and loans connected to Costa Rican bank accounts to create the appearance that clients had legitimate tax-deductible business expenses. Six defendants were convicted of a number of offences after the seven-week trial, including filing false tax returns, mail fraud, wire fraud, and money laundering.

Welcoming the verdict, IRS Commissioner Mark W. Everson noted that the case represents “a real blow to promoters of shady offshore tax schemes." The authorities are considering re-filing charges against four defendants about whom the jury was unable to reach a verdict. 

Rounding off a busy year for the tax avoidance industry, the US government issued final regulations amending Treasury Department Circular 230, which apply to attorneys, accountants and other tax professionals who practice before the IRS, providing standards of practice for written advice that reflect current best practices, and are intended to restore and maintain public confidence in tax professionals.

The revisions aim to ensure that tax professionals do not provide inadequate advice, and to increase transparency by requiring tax professionals to make disclosures if the advice is incomplete. Welcoming the new measures, IRS Commissioner Mark W. Everson commented: “These new standards send a strong message to tax professionals considering selling a questionable product to clients. The new provisions give us more tools to battle abusive tax avoidance transactions and to rein in practitioners who disregard their ethical obligations.”

Ensuring that attorneys, accountants and other tax practitioners adhere to professional standards is one of the IRS’s top four enforcement goals, and the agency considers the Circular 230 revisions a key component of this strategy. The final regulations provide best practices for all tax advisors, mandatory requirements for written advice that presents a greater potential for concern, and minimum standards for other advice.

“These revisions to Circular 230 strike an appropriate balance between tightening practitioner standards and minimizing burden on everyday advice,” noted Assistant Secretary for Tax Policy Greg Jenner. “These rules target the types of written advice that present a significant cause for concern and avoid undue interference with the practitioner-client relationship,” he added. 

Tax Shelters In 2006

In January, 2006, Dennis B. Drapkin, Chair of the American Bar Association's Taxation Section wrote to senior US congressmen to complain about the effects of clauses in the Tax Relief Act of 2005, passed by the Senate late the previous year, which would codify the 'economic substance' doctrine in US tax law.

Mr Drapkin wrote among others to Senators Charles Grassley (Chairman of the Senate Committee on Finance) and Max Baucus (Ranking Member of the Senate Committee on Finance), as well as to House members William Thomas and Charles Rangel.

The letter identified three provisions of the Act which would:

• codify the “economic substance” doctrine and create a 40% penalty for “noneconomic substance” transactions;
• require a 20%, nonrefundable down payment for certain offers in compromise; and
• create increased penalties and restrict access to judicial review in an attempt to reduce frivolous tax submission.

'However well intended,' writes Mr Drapkin, 'these provisions may have significant ramifications for bona fide business transactions that are far removed from the tax shelter transactions that are the intended target of the legislation. Moreover, the concerns that underlie this legislation were recently addressed by the tax shelter provisions enacted in October 2004 as part of the American Jobs Creation Act of 2004'.

The ABA revealed that it supported legislation clarifying that when a court determines that the economic substance doctrine applies, the taxpayer must establish that the non-tax considerations in the transaction were substantial in relation to the potential tax benefits, and supported legislative clarification that in evaluating the potential economic profits of a transaction, all costs associated with the transaction, including fees paid to promoters and advisers, should be taken into account.

'To the extent that the legislation incorporates these concepts,' continues the letter, 'we believe it will improve the state of the law. In other respects, however, as we have previously written, we continue to oppose codification of the economic substance doctrine. We further believe that enactment of the separate penalty scheme tied to satisfaction of the economic substance doctrine would create unnecessary complexity and confusion.'

Mr Drapkin also expressed serious concerns about the requirement for a 20% non-refundable deposit: 'Because the 20 percent nonrefundable down payment requirement could dramatically reduce available outside funding for potential offers, there is a significant risk that the proposal could decrease the number of legitimate offers submitted, the number of offers accepted and the number of individuals reentering the tax system,' says the letter, which recommends that the proposal not be adopted or, at a minimum, that it be deferred for further consideration.

As regards frivolous conduct penalties, the letter suggested that they should be imposed upon taxpayers requesting CDP hearings 'only (i) where the request is based on arguments or positions the IRS has identified as frivolous in published pronouncements and (ii) after the taxpayer has been afforded the opportunity to withdraw the request or supplement it with information that would render the relevant published pronouncement inapplicable.'

Later in January, the US government followed up its tax shelter victory over Big Four accounting firm KPMG by investigating three lawyers at the prominent Dallas-based firm, Jenkens and Gilchrist for their alleged role in certifying abusive tax schemes.

According to a New York Times report, three lawyers at the firm's Chicago practice, the centre of its tax operations, are under investigation for signing off so-called opinion letters testifying to the legitimacy of tax shelters such as COBRA (currency options bring reward alternatives), which was outlawed by the IRS in 2000.

However, the report said that there is no indication that the law firm itself is a target of the criminal investigation, and a spokesman revealed that the company is "cooperating fully" with the investigation.

Often costing $75,000 or more each, investors use opinion letters as an insurance policy if challenged by the authorities, showing they took steps to ensure that a particular transaction was legally watertight.

One of the lawyers under investigation is said to have earned $93 million in fees from 1999 through 2003 by selling opinion letters and by designing and selling certain shelters, the Times reported, citing persons familiar with sealed documents filed in connection with a previous civil case brought by investors against Jenkens & Gilchrist.

It is believed by the Treasury Department that at least $2.4 billion in artificial tax losses have been claimed by clients of the law firm stemming from their use of tax sheltering arrangements.

This was not the first time that Jenkens & Gilchrist had come under the spotlight for its role in formulating and selling tax shelters. In 2004, a federal judge ordered the firm to hand over the names of clients who invested in tax schemes formulated by its Tax and Estate Planning Practice Group and its Structured Investment Practice, between June 1998 and June 2003. It marked the first such summons to have been issued to a law firm to obtain the identities of participants in tax shelters deemed abusive by the IRS.

In April, the IRS won a significant legal victory in its campaign to deter the use of so-called 'abusive' tax shelter schemes, after the US Tax Court ruled that the 'Son of Boss' scheme is illegitimate.

The ruling by Judge David Laro related to the sale of R. J. Thompson Holdings, a day-trading firm in Omaha, Nebraska, by its founder and former chief executive Randall J. Thompson, for $13 million in cash to TD Waterhouse of Canada in June 2001.

The IRS believed that Thompson used a Son of Boss scheme to create an artificial loss in order to slash the amount of federal taxes he owed on the sale, and disallowed more than $20 million in tax losses. Thompson, through a partnership, decided to challenge the IRS.

Son of Boss evolved from an earlier scheme known as ‘Boss’ (bond and option sales strategy). The scheme utilises a complex set of derivative transactions to reduce tax liability and was commonly used in the late 1990s to offset large one-off gains such as the sale of a business.

The ruling is significant as it marks the first time that a court has ruled on the Son of Boss scheme, and Judge Laro's decision could have an important bearing on the outcome of the trial of 18 individuals facing criminal charges related to sale of tax shelters by the accounting firm KPMG.

Lawyers for the defendants, 16 of whom were former KPMG executives, argued that their clients did nothing illegal because the tax courts had not hitherto established whether the tax shelters were improper.

The defendants in the KPMG trial faced conspiracy and fraud charges for their role in creating and selling tax shelters viewed by the IRS as close relations to Son of Boss.

In May, in a stunning reverse for the IRS, it was ordered by a US Tax Court Judge to repay millions of dollars in taxes, fines and interest to a group of taxpayers, after officials from the agency were found to have effectively bribed witnesses to win a tax shelter case.

The case centred on the so-called Kersting tax shelter, named after Honolulu businessman Henry Kersting, which allowed airline pilots and their families to purchase stock in one of Kersting's companies. In exchange, the pilots received promissory notes, on which they would have to pay interest, but which allowed them to claim interest deductions on their tax returns.

In the early 1980s, the IRS ruled that the Kersting tax shelter was illegal and began pursuing a number of investors who had used the scheme. Many of these eventually settled with the IRS.

However, according to Colorado Attorney Declan J. O’Donnell, who represented 100 of the 500 taxpayers who settled with the IRS, three witnesses were effectively bribed with cash, pre-paid expenses, tax settlements below par, and ten years of added tax benefits so that they would testify against six pilots.

In its opinion, the United States Tax Court stated that all of the settled cases in the Kersting Tax Shelter program should receive 64% of their monies back as a sanction.

This was perhaps the first time that such a judgment has been made against the federal tax collector, certainly for such a substantial amount of money.

"Fraud on the court is rare and has only occurred a few times in our country’s history," Mr O'Donnell observed in a statement.

"This particular ruling is the only time the IRS has ever been adjudicated with a money judgment against them. All others were either sanctioned or the cases were retried," he added.

Mr. O’Donnell believed that this penalty judgment against the IRS is unique, perhaps the only large money judgment against any national taxing authority ever. His clients and the settled group will receive an estimated $56 million from the IRS in due course.

In June, a federal judge granted final approval to a settlement proposed by accounting firm KPMG to compensate investors who made use of its tax sheltering arrangements.

Under the settlement approved by U.S. District Court Judge Dennis M. Cavanaugh on June 2, the approximately 200 clients would receive $153.9 million to cover transaction costs for the tax shelters, but not back taxes and penalties.

The average payout would be $825,000, with the class-action counsel Milberg Weiss Bershad & Schulman netting $24.6 million.

The proposed settlement was designed to cover former clients of KPMG and the law firm of Brown & Wood (now part of Sidley Austin) who participated in the tax shelters known as Blips, Flip, Opis and Short Option Strategy. These were the shelters that were the subject of KPMG's settlement agreement with federal prosecutors in August, under which KPMG agreed to pay $456 million in penalties, but would not face criminal prosecution as long as it complied with the terms of its agreement.

The settlement was less than the initial proposal which totaled $225 million approved the previous October after about 50 tax shelter clients declined to participate in the deal. These litigants would be permitted to pursue claims against KPMG and the Sidley firm on their own.

Judge Cavanaugh ruled that the offer was "fair, reasonable, and adequate," and was keen to draw a line under the case which he stated could extend "for at the very least another few years.”

In a related case, 19 defendants, including several senior KPMG employees and lawyers with Sidley Austin, faced criminal charges for their roles in selling the tax shelters which were deemed "abusive" by the Internal Revenue Service. The agency has estimated that the tax shelters helped investors avoid some $2.5 billion in taxes.

In January 2007, New York District Judge Loretta Preska agreed to dismiss a deferred criminal charge against KPMG resulting from the settlement reached by KPMG and the Justice Department over the sale of improper tax shelters in 2005.

Former executives of KPMG who are facing separate criminal charges attempted to prevent the dismissal, claiming that KPMG's refusal to pay their legal fees amounted to a breach of KPMG's agreement with the government; but the judge did not agree.

The trial of the former employees was delayed after the trial judge cited concerns over the dispute concerning who should pay the defendants' lawyers. In an order made public in November, US District Judge Lewis A. Kaplan stated that questions over whether KPMG should pay legal fees for the former executives probably wouldn't be resolved before the criminal trial's scheduled start date in January.

"Given all of the current uncertainties, it is impossible now to predict with confidence when the charges in the indictment may be tried," he said. Consequently, the judge delayed the trial date. Later it was set for September, 2007.

The 16 former KPMG employees and two others are accused of selling tax shelters which were deemed "abusive" by the Internal Revenue Service. The agency has estimated that the tax shelters helped investors avoid some $2.5 billion in taxes.

However, the trial bogged down when in June, Judge Kaplan found that prosecutors violated the constitutional rights of the former KPMG partners by pressurising them to cut off payment of legal costs to the defense. The former executives then filed a civil complaint against KPMG seeking advancement of defense costs.

A trial on the fee issue was scheduled for October, but KPMG appealed Kaplan's ruling, saying the matter should be dealt with by arbitrators rather than the Courts.

In March 2008, it was reported that the US government was attempting to revive its case against 13 (of the original 19 defendants) of the former KPMG partners.

The case, billed as the largest criminal prosecution in US legal history, was, as previously stated, thrown out by US District Judge Lewis Kaplan in July 2007, after he concluded that the government had denied the defendants their constitutional right to counsel by pressuring their former employer to cut off payment of legal fees.

But at a hearing in the US Second Circuit Court of Appeals, the government argued that it had not brought any pressure to bear on KPMG to stop paying the defendants' legal fees, and that any violation of their rights had only been temporary.

While it was normal practice for KPMG to pay the legal costs of former employees accused of wrongdoing, it reversed its policy in this case, fearing that, by being seen to be helping the defendants, it could bring about an indictment on the company itself.

According to the so-called 'Thompson Memorandum,' written in 2003 by then-Deputy US Attorney General Larry Thompson, prosecutors may consider a company's payment of legal fees for "culpable employees and agents" when deciding whether to indict the company.

In January 2007, New York District Judge Loretta Preska agreed to dismiss a deferred criminal charge against KPMG resulting from the settlement reached by KPMG and the Justice Department over the sale of improper tax shelters in 2005.

Former executives of KPMG who are facing separate criminal charges attempted to prevent the dismissal, claiming that KPMG's refusal to pay their legal fees amounted to a breach of KPMG's agreement with the government; but the judge did not agree.

The trial of the former employees was delayed after the trial judge cited concerns over the dispute concerning who should pay the defendants' lawyers. In an order made public in November, US District Judge Lewis A. Kaplan stated that questions over whether KPMG should pay legal fees for the former executives probably wouldn't be resolved before the criminal trial's scheduled start date in January.

"Given all of the current uncertainties, it is impossible now to predict with confidence when the charges in the indictment may be tried," he said. Consequently, the judge delayed the trial date. Later it was set for September, 2007.

The 16 former KPMG employees and two others are accused of selling tax shelters which were deemed "abusive" by the Internal Revenue Service. The agency has estimated that the tax shelters helped investors avoid some $2.5 billion in taxes.

However, the trial bogged down when in June, Judge Kaplan found that prosecutors violated the constitutional rights of the former KPMG partners by pressurising them to cut off payment of legal costs to the defense. The former executives then filed a civil complaint against KPMG seeking advancement of defense costs.

A trial on the fee issue was scheduled for October, but KPMG appealed Kaplan's ruling, saying the matter should be dealt with by arbitrators rather than the Courts.

Tax Shelters From 2007-2009

In a further development in the Son of Boss saga, ruling in December 2007, the United States Court of Federal Claims found in favor of the Internal Revenue Service, confirming that the shelter was an abusive scheme, and that any deductions claimed under it should therefore be disallowed.

The closely-watched case involved Jade Trading, which in 2003 took legal action against the US tax authority after it ruled that millions of dollars in artificial tax losses were not valid.

Delivering her verdict on the matter, Judge Mary Ellen Coster Williams suggested, according to a New York Times report, that the losses being claimed by Jade Trading's principal, Robert Ervin and his brothers, who were his business partners at that time, were "purely fictional".

"In sum, this transaction's fictional loss, inability to realize a profit, lack of investment character, meaningless inclusion in a partnership, and disproportionate tax advantage as compared to the amount invested and potential return, compel a conclusion that the spread transaction objectively lacked economic substance," the Judge was further quoted by Reuters as observing.

The decision was expected to have implications for other, similar cases.

In January 2007, the IRS won a significant court victory in its fight to outlaw the use of LILO shelters.

Judge Norwood Tilley ruled in the US District Court in North Carolina that a leasing arrangement used by financial services firm BB&T Corp. had no other purpose than to reduce its tax liability.

BB&T had used a LILO arrangement to lease wood-pulp facilities owned by a Swedish company, Sodra Cell AB. Under LILO arrangements, companies pay an accommodation fee to lease facilities from another company or a municipality, but then claim depreciation on these facilities to reduce their tax bill.

BB&T had attempted to claim a tax refund of $3.3 million which stemmed from a 1997 lease transaction, but the request was denied by the IRS and the company subsequently went to court to appeal the agency's decision.

According to Dow Jones Newswires, BB&T disagreed with the court's verdict and planned a further appeal.

"We had hoped to go to trial based on the strength of our case," spokesman Bob Denham was quoted as stating.

The court's decision was welcomed by Eileen J. O'Connor Assistant Attorney General for the Justice Department's Tax Division.

"To have a tax deduction for lease or interest expense, you must actually incur them. And to incur them, you must have a genuine lease and genuine indebtedness, respectively," she said in a statement.

"In BB&T vs. United States of America, the District Court found that the Lease-In, Lease-Out tax shelter involved neither, and therefore does not result in the tax deductions claimed by those who participate in it," she concluded.

Then in May 2008, the Court of Appeals for the Fourth Circuit agreed with a federal district court that BB&T Corporation should be barred from obtaining a tax refund of approximately USD4.5mn.

The appeals court ruled on 29th April that BB&T was not entitled to any tax deductions relating to the aforementioned complex leasing transaction, agreeing with the district court’s ruling that the transaction was in substance “a financing arrangement, not a genuine lease and sublease”.

In closing, the Fourth Circuit referred to “Abe Lincoln’s riddle...‘How many legs does a dog have if you call a tail a leg?’... The answer is ‘four,’ because ‘calling a tail a leg does not make it one.’”

BB&T Corporation stated on 30th April that it would "not be materially affected" by the decision.

According to the company, it had previously recognized all tax and interest expenses, and paid USD1.2bn in the first quarter of 2007 to the IRS. The payment represented the total tax and interest due on all leveraged lease transactions for all open years.

However, BB&T's management has consulted with outside legal counsel and stated that it continues to believe that the company's treatment of its leveraged lease transactions was "appropriate and in compliance with applicable tax laws and regulations".

BB&T's management was considering its legal options, it revealed.

Shortly following this, financial services firm, Wachovia Corporation announced that, as a result of its analysis of the case, it expected to record an after-tax non-cash charge of between USD800mn and USD1bn in the second quarter of 2008.

Wachovia revealed in a statement released on 30th April that it had entered into various leasing transactions between 1999 and 2003 involving lease-to-service contracts and leases of qualified technological equipment, which are widely known as sale-in, lease-out or "SILO" transactions. Wachovia stopped originating these transactions in 2003.

Although the BB&T decision involved LILOs, Wachovia believes some portions of the decision may also apply to SILO transactions. There had, at that point, not been any judicial decision that directly involved SILOs, so the tax law as applied to SILOs remained unsettled.

However, applicable accounting standards required Wachovia to update the assessment of its SILO transactions in light of the BB&T decision. The decision had no impact on Wachovia's LILO transactions, which were settled in their entirety in 2004.

In March 2008, it was reported that the US government was attempting to revive its case against 13 (of the original 19 defendants) of the former KPMG partners.

The case, billed as the largest criminal prosecution in US legal history, was, as previously stated, thrown out by US District Judge Lewis Kaplan in July 2007, after he concluded that the government had denied the defendants their constitutional right to counsel by pressuring their former employer to cut off payment of legal fees.

But at a hearing in the US Second Circuit Court of Appeals, the government argued that it had not brought any pressure to bear on KPMG to stop paying the defendants' legal fees, and that any violation of their rights had only been temporary.

While it was normal practice for KPMG to pay the legal costs of former employees accused of wrongdoing, it reversed its policy in this case, fearing that, by being seen to be helping the defendants, it could bring about an indictment on the company itself.

According to the so-called 'Thompson Memorandum,' written in 2003 by then-Deputy US Attorney General Larry Thompson, prosecutors may consider a company's payment of legal fees for "culpable employees and agents" when deciding whether to indict the company.

In February 2008, it emerged that US federal prosecutors had widened their criminal investigation into the alleged sale of questionable tax shelters by the accounting firm Ernst & Young, adding two outside defendants.

The new indictment, filed in US District Court in Manhattan, included charges against new defendants David Smith and Charles Bolton, who both worked for outside firms, and are accused of participating in an alleged tax-shelter fraud.

Additional charges were also laid against the other four defendants, who included: Robert Coplan, a former E&Y tax partner; Martin Nissenbaum, an E&Y partner and the National Director of E&Y's Personal Income Tax and Retirement Planning practice; Richard Shapiro, an E&Y tax partner; and Brian Vaughn, a former E&Y tax partner.

According to the original indictment unsealed in the US District Court in Manhattan in May 2007, between 1998 and 2004 the defendants and their co-conspirators concocted and marketed tax shelter transactions to be used by wealthy individuals with taxable income generally in excess of $10 or $20 million, to eliminate or reduce the taxes they would have to pay to the IRS.

The new indictment added fraud charges against the original four defendants, and accused Smith and Bolton of conspiring with them to create and market tax shelters known as CDSs, or contingent deferred swaps.

Ernst & Young itself was not named as a defendant in the case.

Then in March 2008, it was reported that the US government was attempting to revive its case against 13 former partners of accounting firm KPMG, who stood accused of facilitating the use of illegal tax shelters which allegedly cost the Treasury billions in tax revenues.

The case, billed as the largest criminal prosecution in US legal history, was thrown out by US District Judge Lewis Kaplan in July 2007, after he concluded that the government had denied the defendants their constitutional right to counsel by pressuring their former employer to cut off payment of legal fees.

But at a hearing in the US Second Circuit Court of Appeals, the government argued that it had not brought any pressure to bear on KPMG to stop paying the defendants' legal fees, and that any violation of their rights had only been temporary.

While it was normal practice for KPMG to pay the legal costs of former employees accused of wrongdoing, it reversed its policy in this case, fearing that, by being seen to be helping the defendants, it could bring about an indictment on the company itself.

According to the so-called 'Thompson Memorandum,' written in 2003 by then-Deputy US Attorney General Larry Thompson, prosecutors may consider a company's payment of legal fees for "culpable employees and agents" when deciding whether to indict the company.

The defendants, of which there were initially 19, were accused of helping to structure and sell the tax shelters, which were deemed abusive by the Internal Revenue Service. The agency has estimated that the tax shelters helped investors avoid some $2.5 billion in taxes.

However, in August 2005, KPMG avoided indictment by agreeing to pay $456 million in penalties to cover former clients who participated in the tax shelters, known as Blips, Flip, Opis and Short Option Strategy.

Four of the original 19 defendants were scheduled to go on trial later that year.

In May, 2009, a US federal appeals court upheld a decision denying over USD50m in claimed tax losses arising from two taxpayers’ investment in a ‘Son of Boss (BLIPS)’ tax shelter.

In the case Klamath Strategic Investment Fund v United States, the Fifth Circuit Court of Appeals held that "a lack of economic substance is sufficient to invalidate the transaction regardless of whether the taxpayer has motives other than tax avoidance." The court concluded that "no reasonable possibility of profit existed" for the transaction in question.

Son of Boss tax shelter schemes evolved from an earlier incarnation known as ‘Boss’ (bond and option sales strategy). The scheme utilises a complex set of derivative transactions to reduce tax liability and was commonly used in the late 1990s to offset large one-off gains such as the sale of a business.

In March 2005, the Internal Revenue Service announced that more than USD3.2bn was collected from over 1,000 taxpayers who had participated in a Son of Boss tax shelter settlement scheme launched almost one year earlier. This amnesty scheme also benefited the coffers of various state governments, with Arizona, Illinois, Maine, Maryland, Michigan, New York, Ohio, Utah and Virginia collecting more than USD23.5m from voluntary state tax return amendments.

The appeals court ruling affirmed an earlier decision by a district court and joins the majority of circuits which have ruled on the question.

"We are pleased that the Fifth Circuit has joined all the other appellate courts in ruling that ‘Son of Boss’ tax deductions are not permissible,” said John A. DiCicco, Acting Assistant Attorney General at the Justice Department’s Tax Division.

“We are also pleased that the court has recognized that determinations of this sort must be made on the objective evidence irrespective of the claimed motives of the individual investors," he added.

In July, 2009, Altria Group, the largest tobacco company in the US, has announced that it will seek further review of a federal court jury verdict against it in a dispute with the United States Internal Revenue Service involving tax deductions related to four leveraged lease transactions.

Altria filed a suit seeking tax refunds totalling almost USD25m for taxes paid for years 1996 and 1997.

"We believe that Altria and its subsidiary, Philip Morris Capital Corporation, fully complied with the law governing these leveraged lease transactions and that Altria is entitled to a full refund," said Murray Garnick, Altria Client Services senior vice president and associate general counsel, speaking on behalf of Altria.

"We will seek further review of the jury's verdict in the trial court and, if necessary, in the appellate court," added Garnick.

However, such transactions, known as lease-in lease-out (LILO) and sale-in lease-out (SILO) have become increasingly shaky from a legal point of view after the IRS began cracking down on them some years ago. Under these arrangements, public infrastructure companies, such as subways and power plants, lease assets to a private company for an up-front fee, enabling the new owners to take large depreciation deductions on the assets.

The US government argues that these transactions lack economic substance because they are motivated solely by the avoidance of taxation.

These tax shelters were effectively outlawed by the 2004 American Jobs Creation Act, although the legislation only applies prospectively. Recently, US Senator Chuck Grassley, the Iowa Republican who was instrumental in shutting down LILOs and SILOs, suggested that the Washington Metropolitan Area Transit Authority’s budget was constrained by a tax-advantaged lease arrangement with a foreign bank, preventing it from making safety upgrades and contributing to the recent fatal crash on its system.

The leveraged lease transactions involved in the Altria case include a Metropolitan Transportation Authority maintenance railroad yard in New York, a wastewater treatment facility in the Netherlands; and power plants operated by Oglethorpe Power Corp. in Georgia and Seminole Electric Cooperative in Florida.

The IRS challenged deductions relating to four leases in 1996 and 1997, and Altria paid the disputed amounts and filed suit against the IRS for a refund.

In August, 2009, a US federal judge decided that a wealthy banker cannot take a USD1.1bn tax deduction, the first court ruling concerning a type of tax shelter involving the purchase of foreign debt.

US district judge Ed Kinkeade stated in his 159-page decision that Andrew Beal, owner of Texas-based Beal Bank, was not entitled to take the full tax deduction claimed on his tax returns for investing in distressed Chinese debt because the transaction “lacked economic substance” and therefore must be disregarded for tax purposes.

This was the first time that a court has ruled definitively against the use of a so-called ‘distressed asses/debt’ tax shelter, otherwise known as DAD, whereby a tax indifferent party, usually a foreign company, transfers economic losses to a US taxpayer, who then attempts to offset the losses against their US income.

According to an Internal Revenue Service issue paper published in April 2007, a DAD transaction typically involves the use of a limited liability company, taxed as a partnership, to shift losses among partners entering and exiting the partnership. The partnership typically, but not always, contributes the asset to another partnership. Then the foreign party transfers within a short period of time its interest in the upper-tier partnership to a US taxpayer, who may be acting through a pass-through entity. The US taxpayer contributes other property or money to the upper-tier partnership in order to create basis in the taxpayer’s partnership interest. The lower-tier partnership sells (or exchanges) the high-basis, low-value asset to another entity related to the promoter, resulting in a significant tax loss that is allocated to the US taxpayer/partner.

Beal, who is ranked 321st on the Forbes list of the 400 richest Americans with a reputed net worth of USD1.5bn, owns 100% of Beal Bank through Beal Financial Corp. He had structured the business as an S corporation, meaning that all profits (and losses) are reported on his individual income tax return.

Beal had attempted to use the DAD losses to offset income earned in the tax years from 2002 to 2004, but was prevented from doing so by the IRS, which said that the entrepreneur was only entitled to a deduction of USD10m relating to transaction costs incurred in acquiring the Chinese debt.

While Beal has paid the taxes that the IRS believes he owes, he may be entitled to a refund of the 40% penalty he paid on the back taxes because, according to judge Kinkeade, he acted in “good faith” by obtaining two independent legal opinions on the legitimacy of the transactions. Furthermore, it was noted that Beal did not purchase an ‘off the shelf’ DAD shelter, but structured the transaction in partnership with his long-time accountant, using his experience of buying and selling the distressed debt of other US banks.

Several other cases of this type involving foreign debt instruments are said to be pending in US courts.

The economic substance doctrine used by US courts to determine whether a transaction is structured with the sole intent of avoiding tax could be codified under Democratic plans to raise money to pay for President Obama’s healthcare reforms.

Up to now, courts have not applied the doctrine uniformly, but the health reform legislation would clarify the manner in which the principle should be used by the courts.

In October, 2009, a federal court in Connecticut ruled in favor of General Electric (GE) in a long-running legal battle with the US Internal Revenue Service concerning tax benefits that the company claimed from a partnership structure set up with two Dutch banks in the early 1990s.

The case in question involves an entity known as Castle Harbour, set up by GE in partnership with ING and Rabo Merchant Bank in 1993. GE used the arrangement to shift USD310m in lease income from an old fleet of aircraft to the two Dutch banks, which enabled the aircraft to be re-depreciated for tax purposes, a method which saved GE about USD62m in tax over a five-year period. The IRS disputed the arrangement, however, and argued that the transactions were motivated solely by the desire to save tax and lacked economic substance.

GE paid the outstanding tax demanded by the IRS, but appealed the decision in the courts. After GE won the first round in 1994, the IRS counter-appealed and the ruling was overturned by a federal appeals court in 2006. The case was sent back to the original trial judge, US District Judge Stefan Underhill, who was directed to decide whether the banks were equity or debt partners of GE.

In his latest verdict, delivered on October 8, Judge Underhill concluded that the two Dutch banks were equity partners for tax purposes, and that "Castle Harbour properly allocated income among its partners."

"The final partnership administrative adjustments issued by the IRS were in error," Judge Underhill wrote.

“Even if the Dutch Banks are later held not to have been partners in Castle Harbour, the partnership’s tax position treating the banks as partners was supported by substantial authority and a reasonable basis,” he argued.

Whilst GE has naturally welcomed the latest court ruling, they should keep the champagne on hold for a while yet, as the IRS, which is currently reviewing Judge Underhill's latest ruling, is widely expected to appeal and stands a good chance winning again.