[Senate Prints 108-34]
[From the U.S. Government Publishing Office]
108th Congress S. Prt.
COMMITTEE PRINT
1st Session 108-34
_______________________________________________________________________
U.S. TAX SHELTER INDUSTRY:
THE ROLE OF ACCOUNTANTS, LAWYERS,
AND FINANCIAL PROFESSIONALS
FOUR KPMG CASE STUDIES:
FLIP, OPIS, BLIPS, AND SC2
__________
R E P O R T
prepared by the
MINORITY STAFF
of the
PERMANENT SUBCOMMITTEE ON INVESTIGATIONS
of the
COMMITTEE ON GOVERNMENTAL AFFAIRS UNITED STATES SENATE
[GRAPHIC] [TIFF OMITTED] TONGRESS.#13
RELEASED IN CONJUNCTION WITH THE
PERMANENT SUBCOMMITTEE ON INVESTIGATIONS' HEARINGS ON
NOVEMBER 18 & 20, 2003
Printed for the use of the Committee on Governmental Affairs
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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 Rechtschaffen, Minority Staff Director and Chief Counsel
Amy B. Newhouse, Chief Clerk
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PERMANENT COMMITTEE 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
Leland Erickson, Counsel
Elise J. Bean, Minority Staff Director and Chief Counsel
Robert Roach, Counsel and Chief Investigator to the Minority
Laura Stuber, Minority Counsel
Brian Plesser, Minority Counsel
Julie Zelman Davis, Minority Professional Staff Member
Chris Kramer, Minority Professional Staff Member
Beth Merillat-Bianchi, IRS Detailee
James Pittrizzi, GAO Detailee
Frank Minore, GAO Detailee
Jessilyn Cameron, Brookings Fellow
Mary D. Robertson, Chief Clerk
C O N T E N T S
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Page
I. INTRODUCTION.................................................. 1
II. FINDINGS..................................................... 3
III. EXECUTIVE SUMMARY........................................... 5
A. Developing New Tax Products............................. 7
B. Mass Marketing Tax Products............................. 8
C. Implementing Tax Products............................... 9
D. Avoiding Detection...................................... 13
E. Disregarding Professional Ethics........................ 15
IV. RECOMMENDATIONS.............................................. 16
V. OVERVIEW OF U.S. TAX SHELTER INDUSTRY......................... 18
A. Summary of Current Law on Tax Shelters.................. 18
B. U.S. Tax Shelter Industry and Professional Organizations 20
VI. FOUR KPMG CASE HISTORIES..................................... 22
A. KPMG In General......................................... 22
B. KPMG's Tax Shelter Activities........................... 24
(1) Developing New Tax Products.......................... 28
(2) Mass Marketing Tax Products.......................... 44
(3) Implementing Tax Products............................ 62
a. KPMG's Implementation Role......................... 62
b. Role of Third Parties in Implementing KPMG Tax
Products................................................... 71
(4) Avoiding Detection................................... 91
(5) Disregarding Professional Ethics..................... 101
APPENDIX A
CASE STUDY OF BOND LINKED ISSUE PREMIUM STRUCTURE (BLIPS).... 111
APPENDIX B
CASE STUDY OF S-CORPORATION CHARITABLE CONTRIBUTION STRATEGY
(SC2)...................................................... 122
APPENDIX C
OTHER KPMG INVESTIGATIONS OR ENFORCEMENT ACTIONS............. 126
U.S. TAX SHELTER INDUSTRY:
THE ROLE OF ACCOUNTANTS, LAWYERS,
AND FINANCIAL PROFESSIONALS
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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.
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\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.
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\13\ 26 U.S.C. 6701.
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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.
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\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.
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\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
Finding: 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
Finding: 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
Finding: 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).
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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.
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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.
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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
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\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
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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
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\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
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\100\ Email dated 5/10/99, from Jeffrey Stein to Philip Weisner and
others, Bates KPMG 0011903.
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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
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\101\ Email dated 5/10/99, from Mark Watson to John Lanning and
others, ``FW: BLIPS,'' Bates MTW 0039 (Emphasis in original.).
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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
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\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
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\103\ Email dated 5/11/99, from Mark Watson, WNT, to Lawrence
DeLap, Bates KPMG 0011911.
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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
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\104\ Subcommittee interview of Lawrence DeLap (10/30/03).
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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
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\105\ Id.
\106\ Subcommittee interview of Mark Watson (11/4/03).
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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.
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\107\ Email dated 7/22/99, from Mark Watson to Richard Smith and
Phil Wiesner, Bates MTW 0078.
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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
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\108\ Email dated 8/4/99, from Mark Watson to David Brockway, Mark
Springer, and Doug Ammerman, Bates SMR 0039.
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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
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\109\ Email dated 8/4/99, from Steven Rosenthal to Mark Watson and
others, Bates SMR 0039.
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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:
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\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
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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
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\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
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\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.
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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.
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\114\ IRS Notice 2000-44 (2000-36 IRB 255) (9/5/00) at 255.
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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.
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\115\ See document dated 5/18/01, ``PFP Practice Reorganization
Innovative Strategies Business Plan--DRAFT,'' Bates KPMG 0050620-23, at
1.
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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.''
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\116\ Memorandum dated 2/23/98, from Robert Simon to Gregg Ritchie,
Randy Bickham, and John Harris, concerning OPIS, Bates KPMG 0010729.
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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.
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\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.
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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
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\120\ See Appendix B for more detailed information on SC2.
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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
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\121\ Email dated 3/13/00, from Phillip Galbreath to Richard
Bailine, ``FW: S-CAEPS,'' Bates KPMG 0046889.
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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
---------------------------------------------------------------------------
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:
``*Over 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.
``*Andrew 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.
``*Andrew 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. . . .
``*Manth 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. . . .
``*Resource[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
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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
---------------------------------------------------------------------------
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:
* Teaming with Assurance; . . .
* How clients are responding to our services and
solutions;
* Ideas for new services and solutions; and
* Best 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
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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).
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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
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\260\ Subcommittee interview of Deutsche Bank, (11/10/03).
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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.''
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\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.
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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.
---------------------------------------------------------------------------
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).
---------------------------------------------------------------------------
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).
Finding: 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.
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.
Finding: 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
---------------------------------------------------------------------------
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
---------------------------------------------------------------------------
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.
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\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.)
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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.
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\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.
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\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.'').
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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
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\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
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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
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\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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