[Senate Report 109-54]
[From the U.S. Government Publishing Office]
109th Congress S. Rept.
SENATE
1st Session 109-54
_______________________________________________________________________
THE ROLE OF PROFESSIONAL
FIRMS IN THE
U.S. TAX SHELTER INDUSTRY
__________
R E P O R T
prepared by the
PERMANENT SUBCOMMITTEE ON INVESTIGATIONS
of the
COMMITTEE ON
HOMELAND SECURITY AND GOVERNMENTAL AFFAIRS
UNITED STATES SENATE
APRIL 13, 2005
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 THOMAS R. CARPER, Delaware
TOM COBURN, Oklahoma MARK DAYTON, Minnesota
LINCOLN D. CHAFEE, Rhode Island FRANK LAUTENBERG, New Jersey
ROBERT F. BENNETT, Utah MARK PRYOR, Arkansas
PETE V. DOMENICI, New Mexico
JOHN W. WARNER, Virginia
Michael D. Bopp, Staff Director and Chief Counsel
Joyce A. Rechtschaffen, Minority Staff Director and Counsel
Amy B. Newhouse, Chief Clerk
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PERMANENT SUBCOMMITTEE ON INVESTIGATIONS
NORM COLEMAN, Minnesota, Chairman
TED STEVENS, Alaska CARL LEVIN, Michigan
TOM COBURN, Oklahoma DANIEL K. AKAKA, Hawaii
LINCOLN D. CHAFEE, Rhode Island THOMAS R. CARPER, Delaware
ROBERT F. BENNETT, Utah MARK DAYTON, Minnesota
PETE V. DOMENICI, New Mexico FRANK LAUTENBERG, New Jersey
JOHN W. WARNER, Virginia MARK PRYOR, Arkansas
Raymond V. Shepherd, III, Staff Director and Chief Counsel
Leland B. Erickson, Counsel
Elise J. Bean, Minority Staff Director and Chief Counsel
Robert L. Roach, Counsel and Chief Investigator to the Minority
Laura E. Stuber, Counsel
Mary D. Robertson, Chief Clerk
C O N T E N T S
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Page
I. INTRODUCTION.................................................. 1
II. OVERVIEW OF U.S. TAX SHELTER INDUSTRY........................ 3
III. FINDINGS AND RECOMMENDATIONS................................ 5
A. Findings.................................................. 5
B. Recommendations........................................... 7
IV. EXECUTIVE SUMMARY............................................ 9
V. ROLE OF ACCOUNTANTS........................................... 11
A. KPMG...................................................... 11
(1) Developing New Tax Products........................... 13
(2) Mass Marketing Tax Products........................... 33
(3) Implementing Tax Products............................. 48
(4) Avoiding Detection.................................... 56
(5) Disregarding Professional Ethics...................... 66
(6) KPMG's Current Status................................. 73
B. ERNST & YOUNG............................................. 77
(1) Development of Mass-Marketed Generic Tax Products..... 77
(2) Ernst & Young's Curent Status......................... 85
C. PRICEWATERSHOUSECOOPERS................................... 87
(1) Mass-Marketed Generic Tax Products.................... 87
(2) PricewaterhouseCoopers' Current Status................ 93
VI. ROLE OF LAWYERS.............................................. 96
A. SIDLEY AUSTIN BROWN & WOOD................................ 96
B. SUTHERLAND ASBILL & BRENNAN............................... 100
VII. ROLE OF FINANCIAL INSTITUTIONS.............................. 104
A. DEUTSCHE BANK............................................. 105
B. HVB BANK.................................................. 109
C. UBS BANK.................................................. 113
D. FIRST UNION NATIONAL BANK................................. 114
VIII. ROLE OF INVESTMENT ADVISORS................................ 121
A. PRESIDIO ADVISORY SERVICES................................ 122
B. QUELLOS GROUP............................................. 125
IX. ROLE OF CHARTITABLE ORGANIZATIONS............................ 126
A. LOS ANGELES DEPARTMENT OF FIRE AND POLICE PENSIONS........ 127
B. AUSTIN FIRE FIGHTERS RELIEF AND RETIREMENT FUND........... 131
THE ROLE OF PROFESSIONAL FIRMS IN THE U.S. TAX SHELTER INDUSTRY
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I. INTRODUCTION
In October 2002, the U.S. Senate Permanent Subcommittee on
Investigations of the Committee on Governmental Affairs, began
an investigation into the development, marketing, and
implementation of abusive tax shelters by accountants, lawyers,
financial advisors, and bankers. The Subcommittee's Minority
Staff initiated this investigation, at the direction of Senator
Carl Levin, with the concurrence and support of Subcommittee
Chairman Norm Coleman. The information in this Report is based
upon the ensuing bipartisan investigation by the Subcommittee's
Democratic and Republican staffs.
In its broadest sense, the term ``tax shelter'' is a device
used to reduce or eliminate the tax liability of the tax
shelter user. This may encompass legitimate or illegitimate
endeavors. While there is no one standard to determine the line
between legitimate ``tax planning'' and ``abusive tax
shelters,'' the latter can be characterized as transactions in
which a significant purpose is the avoidance or evasion of
Federal, state or local tax in a manner not intended by the
law.
The abusive tax shelters investigated by the Subcommittee
were complex transactions used by corporations or individuals
to obtain substantial tax benefits in a manner never intended
by the Federal tax code. While some of these transactions may
have complied with the literal language of specific tax
provisions, they produced results that were unwarranted,
unintended, or inconsistent with the overall structure or
underlying policy of the Internal Revenue Code. These
transactions had no economic substance or business purpose
other than to reduce taxes. Abusive tax shelters can be custom-
designed for a single user or prepared as a generic tax product
sold to multiple clients. The Subcommittee investigation
focused on generic abusive tax shelters sold to multiple
clients as opposed to a custom-tailored tax strategy sold to a
single client.
Under present law, generic tax shelters sold to multiple
clients are not illegal per se. They are potentially illegal
depending on how the purchasers use them and report their tax
liability on their tax returns. Certain statutory provisions,
judicial doctrines, and IRS administrative guidance define and
identify abusive tax shelters that may violate Federal tax law.
Over the last 5 years, the IRS and the Treasury Department have
begun to publish legal guidance on transactions they consider
to be abusive. This guidance warns 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.
After a one-year investigation, the Permanent Subcommittee
on Investigations held 2 days of hearings on November 18, 2003,
and November 20, 2003, entitled U.S. Tax Shelter Industry: The
Role of Accountants, Lawyers, and Financial Professionals.
At the November 18 hearing, the Subcommittee heard
testimony from three tax experts: Debra Peterson, Tax Counsel,
California Franchise Tax Board; Mark Watson, Former Partner,
KPMG LLP; and Calvin Johnson, Professor, The University of
Texas at Austin School of Law. The Subcommittee also heard
testimony from numerous tax professionals from various
accounting firms. Tax professionals from KPMG LLP included:
Philip Wiesner, Partner in Charge, Washington National Tax
Client Services; Jeffrey Eischeid, Partner, Personal Financial
Planning; Lawrence DeLap, retired National Partner in Charge,
Department of Professional Practice-Tax; Lawrence Manth, former
West Area Partner in Charge, Stratecon; and Richard Smith Jr.,
Vice Chair, Tax Services. Accounting firm
PricewaterhouseCoopers was represented by Richard Berry, Jr.,
Senior Tax Partner. Accounting firm Ernst & Young LLP was
represented by Mark Weinberger, Vice Chair, Tax Services.
At the November 20 hearing, the Subcommittee heard
testimony from three lawyers: Raymond Ruble, former Partner,
Sidley Austin Brown & Wood LLP; Thomas Smith, Jr., Partner,
Sidley Austin Brown & Wood LLP; and N. Jerold Cohen, Partner,
Sutherland Asbill & Brennan LLP. The Subcommittee also heard
testimony from William Boyle, former Vice President, Structured
Finance Group, Deutsche Bank AG; Domenick DeGiorgio, former
Vice President, Structured Finance, HVB America, Inc.; John
Larson, Managing Director, Presidio Advisory Services; and
Jeffrey Greenstein, Chief Executive Officer, Quellos Group LLC,
formerly known as Quadra Advisors LLC. Lastly, the Subcommittee
heard testimony from three regulatory and oversight agencies:
Mark Everson, Commissioner, Internal Revenue Service; William
McDonough, Chairman, Public Company Accounting Oversight Board;
and Richard Spillenkothen, Director, Division of Banking
Supervision and Regulation, The Federal Reserve.
This Report is based upon the information gathered by the
Subcommittee during those two hearings and the course of its
investigation to date, including a report prepared by Senator
Levin and released in connection with the November hearings,
\1\ review of over 250 boxes of documents and electronic disks,
numerous interviews, three depositions, testimony presented by
the 20 witnesses at two hearings, and supplemental post-hearing
information.
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\1\ See ``U.S. Tax Shelter Industry: The Role of Accountants,
Lawyers, and Financial Professionals, Four KPMG Case Studies: FLIP,
OPIS, BLIPS, and SC2,'' Minority Staff Report of the U.S. Senate
Permanent Subcommittee on Investigations (11/18/03) (hereinafter
``Levin Report''), S. Prt. 108-34, reprinted in ``U.S. Tax Shelter
Industry: The Role of Accountants, Lawyers, and Financial
Professionals,'' Subcommittee hearings (11/18/03 and 11/20/03)
(hereinafter ``Subcommittee hearings''), S. Hrg. 108-473, at 145-274.
This Subcommittee Report confirms the factual findings of the earlier
Levin Report and draws heavily from its text.
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II. OVERVIEW OF U.S. TAX SHELTER INDUSTRY
Under current law, no single standard defines an abusive
tax shelter. Abusive tax shelters are governed by statutory
provisions, judicial doctrines, and administrative guidance
used to identify transactions in which a significant purpose is
the avoidance or evasion of income tax in a manner not intended
by the law.
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 \2\ or who knowingly aid or abet the filing of tax
return information that understates a taxpayer's tax
liability.\3\ Additional tax code provisions now require
taxpayers and promoters to disclose to the IRS information
about certain potentially illegal tax shelters.\4\
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\2\ 26 U.S.C. Sec. 6700.
\3\ 26 U.S.C. Sec. 6701.
\4\ 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); and 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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In 2003, 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.\5\ 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.\6\ 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 categories of disclosure 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.\7\ 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.'' \8\ 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.'' \9\ As of March
2004, the IRS had published 31 listed transactions.\10\
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\5\ See, e.g., Treas. Reg. Sec. 301.6112-1 and Sec. 1.6011-4, which
took effect on 2/28/03.
\6\ 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.
\7\ 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;
``Challenges Remain in Combating Abusive Tax Shelters,'' testimony by
Michael Brostek, Director, Tax Issues, General Accounting Office (GAO)
before the U.S. Senate Committee on Finance, No. GAO-04-104T (10/21/03)
(hereinafter ``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.
\8\ 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.
\9\ Id. at para. 16.
\10\ In September 2004, the number of listed transactions was
modified by the IRS and reduced to 30. See IRS Notice 2004-67 (9/23/
04).
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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, \11\
business purpose, \12\ substance-over-form, \13\ step
transaction, \14\ and sham transaction \15\ 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.\16\
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\11\ 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.'').
\12\ 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.'').
\13\ 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.'').
\14\ 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).
\15\ 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.'').
\16\ 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 long been
advocated by the Senate Finance Committee and approved by the
Senate on multiple occasions, but not adopted by the House of
Representatives. During the 108th Congress, as a result of the
Subcommittee investigation, Senators Levin and Coleman
introduced S. 2210, the Tax Shelter and Tax Haven Reform Act,
to strengthen penalties on tax shelter promoters, prevent
abusive tax shelters, deter uncooperative tax havens, and
codify the economic and business purpose doctrines. This bill
was referred to the Senate Finance Committee which subsequently
reported a more comprehensive tax bill, S. 1637. This bill
included some of the tax shelter provisions in S. 2210. In May,
the Senate considered and adopted S. 1637. During the Senate
debate, a Levin-Coleman amendment was accepted to further
strengthen Federal penalties on promoters, aiders and abettors
of abusive tax shelters. In October 2004, after a House-Senate
conference, Congress enacted into law H.R. 4520, the American
Jobs Creation Act. This tax legislation included a number of
tax shelter reforms supported by the Subcommittee's
investigation and the Senate Finance Committee, including
stronger penalties on promoters of abusive tax shelters.\17\
Other tax shelter reforms, such as the codification of the
economic substance and business purpose doctrines and stronger
penalties on aiders and abettors of tax shelters, were not
included in the final bill.
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\17\ See Amendment No. 3120 to S. 1637. The Levin-Coleman bill, S.
2210, had advocated a penalty equal to 150% of the gross income
derived, or to be derived, by a promoter, aider, or abettor of an
abusive tax shelter. S. 1637, in contrast, had proposed a 50% penalty
solely on promoters. The Levin-Coleman amendment compromised by
increasing S. 1637's penalty to 100% of the gross income derived, or to
be derived, by a promoter, aider or abettor of an abusive tax shelter.
Unfortunately, the final bill approved by Congress, H.R. 4520, adopted
only the lower 50% penalty and confined it to promoters, leaving the
penalty for aiders and abettors still in need of reform.
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In December 2004, the Public Company Accounting Oversight
Board (PCAOB) proposed rules to strengthen auditor independence
and restrict the tax services that accounting firms may provide
to their audit clients.\18\ Among other provisions, the
proposed rule would require any accounting firm that audits a
publicly traded company to maintain strict independence from
that company throughout the auditing engagement. The proposed
rule would also bar such accounting firms from: (1) entering
into a contingent fee arrangement with an audit client for tax
services; (2) providing tax services to certain executives of
an audit client; and (3) planning, marketing, or opining on
aggressive tax positions with respect to an audit client, as
further defined by the rule. The proposed rule would also
require accounting firms, before providing any tax service to
an audit client, to disclose detailed information about the tax
service to the company's audit committee and obtain the
committee's approval. This proposed rule, like the legislation
enacted by Congress, represents a renewed effort to rein in
abusive practices within the U.S. tax shelter industry.
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\18\ See PCAOB Release 2004-15 (12/14/04).
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III. FINDINGS AND RECOMMENDATIONS
The Subcommittee's investigation to date has determined
that in 2003, the U.S. tax shelter industry no longer focused
solely on providing individualized tax advice but had expanded
its focus to include generic ``tax products'' aggressively
marketed to multiple clients. The investigation also found that
numerous respected members of the American business community
were heavily involved in the development, marketing, and
implementation of generic tax products whose principal
objective was to reduce or eliminate a client's U.S. tax
liability. These tax shelters required close collaboration
between accounting firms, law firms, investment advisory firms,
and banks.
A. FINDINGS
Based upon its investigation, the Subcommittee makes the
following findings:
(1) The sale of potentially abusive and illegal tax
shelters is a lucrative business in the United States, and some
professional firms such as accounting firms, banks, law firms,
and investment advisory firms have been major participants in
the development, mass marketing, and implementation of generic
tax products sold to multiple clients.
(2) During the period 1998 to 2003, KPMG devoted
substantial resources and maintained an extensive
infrastructure to produce a continuing supply of generic tax
products to sell to clients, using a process which pressured
its tax professionals to generate new ideas, move them quickly
through the development process, and approve, at times, illegal
or potentially abusive tax shelters.
(3) KPMG used aggressive marketing tactics to sell its
generic tax products by turning tax professionals into tax
product salespersons, pressuring its tax professionals to meet
revenue targets, using telemarketing to find clients,
developing an internal tax sales force, using confidential
client tax data to find clients, targeting its own audit
clients for sales pitches, and using tax opinion letters and
insurance policies as marketing tools.
(4) KPMG was actively involved in implementing the tax
shelters which it sold 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.
(5) KPMG took steps to conceal its tax shelter
activities from tax authorities, including by claiming it was a
tax advisor and not a tax shelter promoter, failing to register
potentially abusive tax shelters, restricting file
documentation, imposing marketing restrictions, and using
improper tax return reporting to minimize detection by the IRS
or others.
(6) Since Subcommittee hearings in 2003, KPMG has
committed to cultural, structural, and institutional changes to
dismantle its abusive tax shelter practice, including by
dismantling its tax shelter development, marketing and sale
resources, dismantling certain tax practice groups, making
leadership changes, and strengthening tax services oversight
and regulatory compliance.
(7) During the period 1998 to 2002, Ernst & Young sold
generic tax products to multiple clients despite evidence that
some, such as CDS and COBRA, were potentially abusive or
illegal tax shelters.
(8) Ernst & Young has committed to cultural, structural,
and institutional changes to dismantle its tax shelter
practice, including by eliminating the tax practice group that
promoted its tax shelter sales, making tax leadership changes,
and strengthening its tax services oversight and regulatory
compliance.
(9) During the period 1997 to 1999,
PricewaterhouseCoopers sold generic tax products to multiple
clients, despite evidence that some, such as FLIP, CDS, and
BOSS, were potentially abusive or illegal tax shelters.
(10) PricewaterhouseCoopers has committed to cultural,
structural, and institutional changes intended to dismantle its
abusive tax shelter practice, including by establishing a
centralized quality and risk management process, and
strengthening its tax services oversight and regulatory
compliance.
(11) Sidley Austin Brown & Wood, through its predecessor
firm Brown & Wood, provided legal services that facilitated the
development and sale of potentially abusive or illegal tax
shelters, including by providing design assistance,
collaboration on allegedly independent tax opinion letters, and
hundreds of boilerplate tax opinion letters to clients referred
by KPMG and others, in return for substantial fees.
(12) Sutherland Asbill & Brennan provided legal
representation to over 100 former KPMG clients in tax shelter
matters before the IRS, despite a longstanding business
relationship with KPMG and without performing any conflict of
interest analysis prior to undertaking these representations.
(13) Deutsche Bank, HVB Bank, and UBS Bank provided
billions of dollars in lending critical to transactions which
the banks knew were tax motivated, involved little or no credit
risk, and facilitated potentially abusive or illegal tax
shelters known as FLIP, OPIS, and BLIPS.
(14) First Union National Bank promoted to its clients
generic tax products which had been designed by others,
including potentially abusive or illegal tax shelters known as
FLIP, BLIPS, and BOSS, by introducing and explaining these
products to its clients, providing sample opinion letters, and
introducing its clients to the promoters of the tax products,
in return for substantial fees.
(15) Some investment advisors, including Presidio
Advisory Services and the Quellos Group, helped develop,
design, market, and execute potentially abusive or illegal tax
shelters such as FLIP, OPIS, and BLIPS.
(16) Some charitable organizations, including the Los
Angeles Department of Fire and Police Pensions and Austin Fire
Fighters Relief and Retirement Fund, participated as counter
parties in a highly questionable tax shelter known as SC2,
which had been developed and promoted by KPMG, in return for
substantial payments in the future.
B. RECOMMENDATIONS
Based upon its investigation and the above factual
findings, the Subcommittee makes the following recommendations:
(1) The Internal Revenue Service and the Department of
Justice should continue enforcement efforts aimed at stopping
accounting firms and law firms from aiding and abetting tax
evasion, promoting potentially abusive or illegal tax shelters,
and violating Federal tax shelter regulations, and should
impose substantial penalties on wrongdoers to punish and deter
such misconduct.
(2) Congress should enact legislation to increase the
civil penalties on aiders and abettors of tax evasion and
promoters of potentially abusive or illegal tax shelters, to
ensure that they disgorge not only all illicit proceeds from
such activities, but also pay a substantial monetary fine to
punish and deter such misconduct.
(3) Congress should appropriate additional funds to
enable the IRS to hire more enforcement personnel and increase
enforcement activities to stop the promotion of potentially
abusive and illegal tax shelters by lawyers, accountants, and
other financial professionals.
(4) Congress should enact legislation to clarify and
strengthen the economic substance doctrine and to strengthen
civil penalties on transactions with no economic substance or
business purpose apart from their alleged tax benefits.
(5) Congress should enact legislation authorizing the
IRS to disclose relevant tax shelter information to other
Federal agencies, such as the Public Company Accounting
Oversight Board, Federal bank regulators, and the Securities
and Exchange Commission (SEC), to strengthen their efforts to
stop the entities they oversee from aiding or abetting tax
evasion or promoting potentially abusive or illegal tax
shelters.
(6) The Public Company Accounting Oversight Board should
strengthen and finalize proposed rules restricting certain
accounting firms from providing aggressive tax services to
their audit clients, charging companies a contingent fee for
providing tax services, and using aggressive marketing efforts
to promote generic tax products to potential clients.
(7) Federal bank regulators, in consultation with the
IRS, should review tax shelter activities at major banks, and
clarify and strengthen rules preventing banks from aiding or
abetting tax evasion by third parties or promoting potentially
abusive or illegal tax shelters.
(8) The SEC, in consultation with the IRS, should review
tax shelter activities at investment advisory and securities
firms it oversees, and clarify and strengthen rules preventing
such firms from aiding or abetting tax evasion by third parties
or promoting potentially abusive or illegal tax shelters.
(9) The IRS should further strengthen Federal tax
practitioner rules issued under Circular 230 regarding the
issuance of tax opinion letters to ensure that such
practitioners, including law firms and accounting firms, have
written procedures for issuing tax opinions, resolving internal
disputes over legal issues addressed in such opinions, and
preventing practitioners or their firms from aiding or abetting
tax evasion by clients or promoting potentially abusive or
illegal tax shelters.
(10) The IRS should review tax shelter activities at
charitable organizations, and clarify and strengthen rules
preventing such organizations from aiding or abetting tax
evasion by third parties or promoting potentially abusive or
illegal tax shelters.
IV. EXECUTIVE SUMMARY
This report details the Subcommittee's investigation of the
U.S. tax shelter industry. First, this report examines the
development of mass-marketed generic tax products sold to
multiple clients using prominent accounting firms, banks,
lawyers, and investment firms. Second, as a result of the
Subcommittee's investigation, this report describes the
commitments made by the accounting firms examined during this
investigation to end their involvement with abusive tax
shelters.
The investigation found that by 2003, the U.S. tax shelter
industry was 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 had moved from providing one-on-one tax advice
in response to tax inquiries to also initiating, designing, and
mass marketing tax shelter products.
Also, the investigation found that numerous respected
members of the American business community had been heavily
involved in the development, marketing, and implementation of
generic tax products whose objective was not to achieve a
specific business or economic purpose, but to reduce or
eliminate a client's U.S. tax liability. By 2003, dubious tax
shelter sales were no longer the province of shady, fly-by-
night companies with limited resources. They had become 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.
This report focuses on generic tax products developed and
promoted by KPMG, PricewaterhouseCoopers, and Ernst & Young,
auditors and tax experts comprising three of the top four
accounting firms in the United States. During the 1990's, in
response in part to the stock market boom and the proliferation
of stock options, these firms and others designed and developed
tax products used to generate large paper losses that could be
used to offset or shelter gains from taxation. Tax products
examined by the Subcommittee include: KPMG's Bond Linked Issue
Premium Structure (BLIPS), Foreign Leveraged Investment Program
(FLIP), and Offshore Portfolio Investment Strategy (OPIS);
PricewaterhouseCooper's Bond and Option Sales Strategy (BOSS);
and Ernst & Young's Contingent Deferred Swap (CDS) tax product.
Each of these products generated hundreds of millions of
dollars in phony paper losses for taxpayers, using a series of
complex, orchestrated transactions, structured finance, and
investments with little or no profit potential. All of these
tax products have been ``listed'' by the IRS as potentially
abusive tax shelters.\19\
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\19\ 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). PricewaterhouseCooper's BOSS transaction is covered
by IRS Notice 1999-59 (1999-52 IRB 761) (12/27/99). Ernst & Young's CDS
transaction is covered by IRS Notice 2002-35 (2002-21 IRB 992) (5/28/
02).
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Additionally, the Subcommittee examined a fourth tax
product, S-Corporation Charitable Contribution Strategy (SC2),
developed by KPMG. SC2 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 was 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. Recently, the IRS listed SC2 as a
potentially abusive tax shelter.\20\
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\20\ See IRS Notice 2004-30 (4/1/04).
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As a result of the Subcommittee's hearings and
investigation, each accounting firm has committed to cultural,
structural, and institutional reforms and changes to end the
promotion, development, implementation, and offering of mass-
marketed abusive tax shelters. KPMG informed the Subcommittee
that the firm has dismantled its development, marketing, and
sales infrastructure used for offering mass-marketed tax
shelters. In addition, KPMG indicated that it has dismantled
various tax practice groups, made leadership changes, and
strengthened oversight and compliance. KPMG indicated that
these changes reflect a firm-wide commitment to attain the
highest degree of trust from the firm's clients, regulators,
and the public at large. Similarly, Ernst & Young told the
Subcommittee that the firm has instituted new oversight and
leadership changes, IRS compliance and monitoring systems, and
firm-wide policies to ensure the highest standards of
professionalism. Lastly, PricewaterhouseCoopers told the
Subcommittee that the firm has instituted new leadership
positions, and a centralized product development process to
monitor all tax services to ensure that mass-marketed abusive
tax shelters would not be marketed by the firm in the future.
The investigation also examined a number of professional
firms that assisted in the development, marketing, and
implementation of tax shelters promoted by the three accounting
firms. Leading banks, including Deutsche Bank, HVB, and UBS,
provided multi-billion dollar credit lines essential to the
orchestrated transactions. Wachovia Bank, acting through First
Union National Bank, made client referrals to KPMG and
PricewaterhouseCoopers, playing a key role in facilitating the
marketing of potentially abusive or illegal tax shelters.
Leading law firms, such as Brown & Wood, which later merged
with another firm to become Sidley Austin Brown & Wood,
provided favorable tax opinions on these tax shelters, advising
that they were permissible under the law. The evidence also
suggests collaboration between Sidley Austin Brown & Wood and
KPMG on the OPIS and BLIPS tax shelters, including the issuance
of allegedly independent opinion letters on BLIPS containing
numerous virtually identical paragraphs. Two investment
advisory firms, Presidio Advisory Services and Quellos Group,
formerly doing business as Quadra Capital Management LLP and QA
Investments LLC, assisted in the design, development,
marketing, and implementation of tax shelters promoted by KPMG.
Additionally, Quellos served as the investment advisor for
PricewaterhouseCooper's version of FLIP.
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.
V. ROLE OF ACCOUNTANTS
The Subcommittee's investigation of the U.S. tax shelter
industry found that leading U.S. accounting firms were focused
on developing generic ``tax products'' aggressively marketed to
multiple clients from the late 1990's to as late as 2003,
despite increasing IRS enforcement efforts to halt the tax
shelters they were promoting. Accounting firms were devoting
substantial resources to develop, market, and implement tax
shelters, costing the Treasury billions of dollars in lost tax
revenues.\21\ To illustrate the problems, the Subcommittee
developed case histories focused on tax shelters promoted by
KPMG, PricewaterhouseCoopers, and Ernst & Young. The
investigation also uncovered evidence that these firms took
steps to conceal their tax shelter activities from tax
authorities and the public, including by failing to register
potentially abusive tax shelters with the IRS.
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\21\ According to the General Accounting Office, 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. See GA0-04-104T, at 3 (2003). GAO estimates potential tax
losses of about $33 billion from transactions listed by the IRS as
potentially abusive, and another $52 billion from non-listed abusive
transactions, for a combined total of $85 billion. Id. at 10.
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A. KPMG
The Subcommittee conducted its most detailed examination of
four potentially abusive or illegal tax shelters that were
developed, marketed, and implemented by KPMG. KPMG
International is one of the largest public accounting firms in
the world, with over 700 offices in 152 countries.\22\ In 2002,
it employed over 100,000 people and had worldwide revenues of
$10.7 billion. KPMG International, 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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\22\ 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).
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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'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 has generated more than $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.\23\ The
Tax Services Practice is headquartered in New York, has 122
U.S. offices, and maintains additional offices around the
world. The head of the Tax Service during the period of the
investigation was Vice Chairman for Tax, Richard Smith, Jr.
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\23\ Internal KPMG presentation dated 7/19/01, by Rick Rosenthal
and Marsha Peters, entitled ``Innovative Tax Solutions.'' 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 played key roles in
developing, marketing, or implementing KPMG's generic tax
products, including the four KPMG products featured in this
Report. One key group is the Washington National Tax (WNT)
Practice which provides technical tax expertise to the entire
KPMG firm. During the course of the Subcommittee's
investigation, a WNT subgroup, the Tax Innovation Center, led
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 focused on selling
``tax-advantaged'' products to high net worth individuals and
large corporations.\24\ Through a subdivision known as the
Capital Transaction Services (CaTS) Practice, later renamed the
Innovative Strategies Practice, PFP led KPMG's efforts on FLIP,
OPIS, and BLIPS.\25\ KPMG's Stratecon Practice, which focused
on ``business based'' tax planning and tax products, led the
firm's efforts on SC2. Innovative Strategies and Stratecon were
later disbanded, and their tax professionals assigned to other
groups.\26\ The Tax Innovation Center was apparently closed in
2003.
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\24\ Minutes dated 11/30/00, Monetization Solutions Task Force
Teleconference, Bates KPMG 0050624-29, at 50625.
\25\ Document dated 5/18/01, ``PFP Practice Reorganization
Innovative Strategies Business Plan--DRAFT,'' Bates KPMG 0050620-23, at
50621.
\26\ KPMG told the Subcommittee that both groups were disbanded
over time in 2002; it is unclear exactly when each ceased to function.
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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,
and, in part, due to new tax leadership that was enthusiastic
about increasing tax product sales. 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.
(1) Developing New Tax Products
Finding: During the period 1998 to 2003, KPMG devoted
substantial resources and maintained an extensive
infrastructure to produce a continuing supply of generic tax
products to sell to clients, using a process which pressured
its tax professionals to generate new ideas, move them quickly
through the development process, and approve, at times, illegal
or potentially abusive tax shelters.
During the investigation, KPMG preferred to describe itself
as a tax advisor that responded to client inquiries seeking tax
planning services to structure legitimate business transactions
in a tax efficient way. The Subcommittee investigation
determined, however, that KPMG had also developed and supported
an extensive internal infrastructure of offices, programs, and
procedures designed to churn out a continuing supply of new
generic tax products, unsolicited by a specific client, for
mass marketing to multiple clients.
Drive to Produce New Tax Products. In 1997, KPMG
established the Tax Innovation Center whose sole mission was to
push the development of new KPMG tax products. Located within
the Washington National Tax (WNT) Practice, the Center was
staffed with about a dozen full-time employees and assisted by
others who worked 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.'' \27\
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\27\ ``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 encouraged KPMG tax
professionals to propose new tax product ideas and then
provided administrative support to develop the proposals into
approved tax products and move them into the marketing stage.
As part of this effort, the Center maintained a ``Tax Services
Idea Bank'' which it used to drive and track new tax product
ideas. The Center asked 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.\28\
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\28\ ``TIC Solution Development Process,'' TIC Manual at 6.
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In recent years, the Center 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.'' \29\ On May 30, 2001, the Center reported on the Tax
Services' progress in meeting this goal as part of a larger
Powerpoint 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 showed 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.
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\29\ KPMG presentation dated 5/30/01, ``Tax Innovation Center
Solution and Idea Development--Year-End Results,'' Bates XX 001755-56,
at 1754.
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Development and Approval Process. Once ideas were deposited
into the Tax Services Idea Bank, KPMG 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 was described in its Tax Services Manual and Tax
Innovation Center Manual.\30\ Essentially, the process
consisted of three stages, each of which could overlap with
another. In the first stage, the new tax idea underwent an
initial screening ``for technical and revenue potential.'' \31\
This initial analysis was supposed to be provided by a ``Tax
Lab'' which was a formal meeting, arranged by the Tax
Innovation Center, of six or more KPMG tax experts specializing
in the tax issues or industry affected by the proposed
product.\32\ Promising proposals were 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 and later succeeded by Andrew
Atkin.
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\30\ KPMG Tax Services Manual, Sec. 24.1 to 24.7.
\31\ TIC Manual at 5.
\32\ 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 survived the initial screening, in the second
stage it underwent a thorough review by the Washington National
Tax Practice (``WNT review''), which was responsible for
determining whether the product met the technical requirements
of existing tax law.\33\ WNT personnel often spent significant
time identifying and searching for ways to resolve problems
with how the proposed product was structured or was intended to
be implemented. The WNT review also included analysis of the
product by the WNT Tax Controversy Services group ``to address
tax shelter regulations issues.'' \34\ WNT was required to
``sign-off'' on the technical merits of the proposal before it
was approved for sale to clients.
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\33\ 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).
\34\ KPMG Tax Services Manual, Sec. 24.4.1, at 24-2.
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In the third and final stage, the product underwent review
and approval by the Department of Practice and Professionalism
(``DPP review''). The DPP review had to determine that the
product not only complied with the law, but also met KPMG's
standards for ``risk management and professional practice.''
\35\ This latter review included 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 were to be structured,
whether auditor independence issues needed to be addressed, and
the potential impact of a proposed tax product on the firm's
reputation.\36\
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\35\ Id., Sec. 24.5.2, at 24-3.
\36\ Subcommittee interview of Lawrence DeLap (10/30/03). The
Subcommittee staff was told that, since 1997, DPP-Tax had very limited
resources to conduct its new product reviews. Until 2002, for example,
DPP-Tax had a total of less than 10 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, had well
over 100 employees.
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The KPMG development and approval process was 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 stated 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.'' \37\ KPMG defines ``more likely than not'' as a
``greater than 50 percent probability of success if [a tax
product is] challenged by the IRS.'' \38\ 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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\37\ KPMG Tax Services Manual, Sec. 24.5.2, at 24-3.
\38\ 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.\39\ In addition, to ``launch'' the new product
within KPMG, the Tax Innovation Center was supposed to prepare
a ``Tax Solution Alert'' which served ``as the official
notification'' that the tax product was available for sale to
clients.\40\ This Alert was 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. 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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\39\ Id., Sec. 24.4.2, at 24-2. See also TIC Manual at 10.
\40\ 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.\41\ 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.'' \42\ 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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\41\ KPMG Tax Services Manual, Sec. 41.17.1, at 41-8.
\42\ 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 tax products examined by the
Subcommittee.
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
worked. 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.\43\ After this notice was issued, KPMG
discontinued sales of the product.
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\43\ 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, and Presidio Advisory
Services, an investment advisory firm run by two former KPMG
tax professionals. Key documents written at the beginning and
during a key two-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,'' \44\
the head of the entire Tax Services Practice wrote:
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\44\ 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.\45\
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\45\ 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 postscript: ``P.S. I don't like this pressure any
more than you do.'' \46\
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\46\ 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.\47\ 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.'' \48\ 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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\47\ ``Meeting Summary'' for meeting held on 2/19/99, Bates MTW
0009.
\48\ 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.\49\
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\49\ 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.'' \50\ 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.\51\
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\50\ Email dated 5/5/99, from Larry DeLap to Mark Watson, Bates
KPMG 0011916.
\51\ 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.'' \52\
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\52\ 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 6 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???'' \53\
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\53\ 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.'' \54\
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\54\ 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? \55\
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\55\ Email dated 5/10/99, from Philip Wiesner to multiple WNT tax
professionals, Bates MTW 0031.
A few hours later, the head of WNT sent eight senior KPMG
tax professionals, including the Tax Services Practice head,
DPP head, and the WNT PFP technical reviewer, a long email
---------------------------------------------------------------------------
message urging final approval of BLIPS. He wrote in part:
Many people have worked long and hard to craft a tax
opinion in the BLIPS transaction that satisfies the more likely
than not standard. I believed that we in WNT had completed our
work a month ago when we forwarded the [draft] opinion to
Larry. . . .
[T]his is a classic transaction where we can labor over
the technical concerns, but the ultimate resolution--if
challenged by the IRS--will be based on the facts (or lack
thereof). In short, our opinion is only as good as the factual
representations that it is based upon. . . . The real ``rubber
meets the road'' will happen when the transaction is sold to
investors, what the investors' actual motive for investing the
transaction is and how the transaction actually unfolds. . . .
Third, our reputation will be used to market the transaction.
This is a given in these types of deals. Thus, we need to be
concerned about who we are getting in bed with here. In
particular, do we believe that Presidio has the integrity to
sell the deal on the facts and representations that we have
written our opinion on?! . . .
Having said all the above, I do believe the time has
come to shit and get off the pot. The business decisions to me
are primarily two: (1) Have we drafted the opinion with the
appropriate limiting bells and whistles . . . and (2) Are we
being paid enough to offset the risks of potential litigation
resulting from the transaction? . . . My own recommendation is
that we should be paid a lot of money here for our opinion
since the transaction is clearly one that the IRS would view as
falling squarely within the tax shelter orbit.\56\
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\56\ 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.'' \57\
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\57\ Email dated 5/10/99, from Jeffrey Stein to Philip Wiesner 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.\58\
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\58\ Email dated 5/10/99, from Mark Watson to John Lanning and
others, ``FW: BLIPS,'' Bates MTW 0039 (emphasis in original).
A meeting was held on May 10, to determine how to proceed.
The WNT head, the senior WNT partner, and the two WNT technical
reviewers decided to move forward on BLIPS, and the WNT head
asked the technical reviewers to draft some representations
that, when relied upon, would enable the tax opinion writers to
reach a more likely than not opinion. The WNT head reported the
---------------------------------------------------------------------------
outcome of the meeting in an email:
The group of Wiesner, R Smith, Watson and Rosenthal met
this afternoon to bring closure to the remaining technical tax
issues concerning the BLIPS transaction. After a thorough
discussion of the profit motive and who is the borrower issue,
recommendations for additional representations were made (Mark
Watson to follow up on with Jeff Eischeid) and the decision by
WNT to proceed on a more likely than not basis affirmed.
Concern was again expressed that the critical juncture will be
at the time of the first real tax opinion when the investor,
bank and Presidio will be asked to sign the appropriate
representations. Finally, it should be noted that Steve
Rosenthal expressed his dissent on the who is the investor
issue, to wit, ``although reasonable people could reach an
opposite result, he could not reach a more likely than not
opinion on that issue.'' \59\
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\59\ 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.'' \60\
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\60\ Email dated 5/11/99, from Mark Watson, WNT, to Lawrence DeLap,
Bates KPMG 0011911.
The DPP head indicated to the Subcommittee staff that he
did not consider this tepid endorsement sufficient for him to
sign off on the product. He indicated that he then met in
person with his superior, the head of the Tax Services
Practice, and told the Tax Services Practice head that he was
not prepared to approve BLIPS for sale. He told the
Subcommittee staff that the Tax Services Practice head was
``not pleased'' and instructed him to speak again with the
technical reviewer.\61\
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\61\ 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.\62\ 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.\63\
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\62\ Id.
\63\ 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.'' \64\ His superiors indicated that they were.
---------------------------------------------------------------------------
\64\ Email dated 7/22/99, from Mark Watson to Richard Smith and
Phil Wiesner, Bates MTW 0078.
---------------------------------------------------------------------------
A month later, in August, after completing a review of the
BLIPS transactional documents, the WNT PFP technical reviewer
again expressed concerns to his superiors in WNT:
However before engagement letters are signed and revenue
is collected, I feel it is important to again note that I and
several other WNT partners remain skeptical that the tax
results purportedly generated by a BLIPS transaction would
actually be sustained by a court if challenged by the IRS. We
are particularly concerned about the economic substance of the
BLIPS transaction, and our review of the BLIPS loan documents
has increased our level of concern.
LNonetheless, 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.\65\
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\65\ Email dated 8/4/99, from Mark Watson to David Brockway, Mark
Springer and Douglas Ammerman, Bates SMR 0039.
---------------------------------------------------------------------------
The other technical reviewer objecting to BLIPS wrote:
I share your concerns. We are almost finished with our
technical review of the documents that you gave us, and we
recommend some clarifications to address these technical
concerns. We are not, however, assessing the economic substance
of the transaction (ie., is there a debt? Who is the borrower?
What is the amount of the liability? Is there a reasonable
expectation of profit?) I continue to be seriously troubled by
these issues, but I defer to Phil Wiesner and Richard Smith to
assess them.\66\
---------------------------------------------------------------------------
\66\ Id.
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.'' \67\ One of the WNT technical
reviewers who had objected to the original BLIPS again
expressed his concerns:
---------------------------------------------------------------------------
\67\ 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 urging the analysis of the new
product ``so we can take this to market. Your attention over the next
few days would be most appreciated.'').
I am writing to communicate my views on the economic
substance of the Blips, Grandfathered Blips, and Blips 2000
strategies. Throughout this process, I have been troubled by
the application of economic substance doctrines . . . and have
raised my concerns repeatedly in internal meetings. The facts
as I now know them and the law that has developed, has not
---------------------------------------------------------------------------
reduced my level of concern.
LIn short, in my view, I do not believe that KPMG can
reasonably issue a more-likely-than-not opinion on these
issues.\68\
---------------------------------------------------------------------------
\68\ 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.\69\ A BLIPS Powerpoint 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.'' \70\ In response to
an email on BLIPS stating that the firm would provide a more
likely than not opinion, indicating a greater than 50 percent
chance of success on the merits, one KPMG tax professional who
refused to sell BLIPS to his clients wrote ``[j]ust so we are
clear, I personally view it no greater than 15%.'' \71\
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\69\ Subcommittee interview of Lawrence DeLap (10/30/03).
\70\ Powerpoint presentation dated June 1999, by Carol Warley,
Personal Financial Planning group, ``BLIPS AND TRACT,'' Bates KPMG
00496339-45, at 496340. Repeated capitalizations in original text not
included.
\71\ Email dated 5/5/99, from William Goldberg to Paul Kearns,
``RE: BLIPs,'' Bates KPMG 0028162.
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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.'' \72\ The IRS'
disallowance of BLIPS has not yet been tested in court. Rather
than defend BLIPS in court, however, KPMG and many BLIPS
purchasers appear to be engaged in settlement negotiations with
the IRS to reduce penalty assessments.
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\72\ 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, \73\ 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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\73\ See document dated 5/18/01, ``PFP Practice Reorganization
Innovative Strategies Business Plan--DRAFT,'' Bates KPMG 0050620-23, at
50621.
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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.\74\ 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.''
---------------------------------------------------------------------------
\74\ Memorandum dated 2/23/98, from Robert Simon to Gregg Ritchie,
Randy Bickham, and John Harris, concerning OPIS, Bates KPMG 0010729.
---------------------------------------------------------------------------
The memorandum goes on:
If, upon audit, the IRS were to challenge the
transaction, the burden of proof will be on the investor. The
investor will have to demonstrate, among other things, that the
transaction was not consummated pursuant to a firm and fixed
plan. Think about the prospect of having your client on the
stand having to defend against such an argument. The client
would have a difficult burden to overcome. . . . The failure to
use an independent 3rd party in any of the transactions
indicates that the deal is pre-wired.
It also states: ``If the risk of loss concepts of Notice 98-5
were applied to OPIS, I doubt that the investor's ownership
interest would pass muster.'' And: ``As it stands now, the
Cayman company remains extremely vulnerable to an argument that
it is a sham.'' And: ``No further attempt has been made to
quantify why I.R.C. Sec. 165 should not apply to deny the loss.
Instead, the argument is again made that because the law is
uncertain, we win.'' The memorandum observes: ``We are the firm
writing the [tax] opinions. Ultimately, if these deals fail in
a technical sense, it is KPMG which will shoulder the blame.''
This memorandum was written in February 1998. OPIS was
approved for sale to clients around September 1998. KPMG sold
OPIS to 111 individuals, conducting 79 OPIS transactions on
their behalf in 1998 and 1999.
In the case of FLIP, an email written in March 1998, by the
Tax Services Practice's second in command, identifies a host of
significant technical flaws in FLIP, doing so in the course of
discussing which of two tax offices in KPMG deserved credit for
developing its replacement, OPIS.\75\ 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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\75\ Email dated 3/14/98, from Jeff Stein to Robert Wells, John
Lanning, Larry DeLap, Gregg Ritchie, and others, ``Simon Says,''
concerning FLIP, Bates 638010, filed by the IRS on June 16, 2003, as an
attachment to Respondent's Requests for Admission, Schneider Interests
v. Commissioner, U.S. Tax Court, Docket No. 200-02.
---------------------------------------------------------------------------
Among other criticisms of FLIP, the email states: ``Simon
was the one who pointed out the weakness in having the U.S.
investor purchase a warrant for a ridiculously high amount of
money. . . . It was clear, we needed the option to be treated
as an option for Section 302 purposes, and yet in truth the
option [used in FLIP] was really illusory and stood out more
like a sore thumb since no one in his right mind would pay such
an exorbitant price for such a warrant.'' The email states:
``In kicking the tires on FLIP (perhaps too hard for the likes
of certain people) Simon discovered that there was a delayed
settlement of the loan which then raised the issue of whether
the shares could even be deemed to be issued to the Cayman
company. Naturally, without the shares being issued, they could
not later be redeemed.'' The email also observes: ``[I]t was
Greg who stated in writing to I believe Bob Simon that `the
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[ed] 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.\76\ The IRS has since audited
and penalized numerous taxpayers for using these illegal tax
shelters.\77\
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\76\ IRS Notice 2001-45 (2001-33 IRB 129) (8/13/01).
\77\ 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.
Documents preceding 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, 1 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. .
. .'' \78\
---------------------------------------------------------------------------
\78\ Email dated 3/13/00, from Phillip Galbreath to Richard
Bailine, ``FW: S-CAEPS,'' Bates KPMG 0046889.
---------------------------------------------------------------------------
On April 11, 2000, in the same email announcing SC2's
approval for sale, the head of the DPP wrote:
This is a relatively high risk strategy. You will note
that the heading to the preapproved engagement letter states
that limitation of liability and indemnification provisions are
not to be waived. . . . You will also note that the engagement
letter includes the following statement: You acknowledge
receipt of a memorandum discussing certain risks associated
with the strategy. . . . It is essential that such risk
discussion memorandum (attached) be provided to each client
contemplating entering into an SC2 engagement.\79\
---------------------------------------------------------------------------
\79\ 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.\80\
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\80\ 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.\81\
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.\82\ KPMG tax professionals identified other technical
problems as well involving assignment of income, reliance on
tax indifferent parties, and valuation issues.\83\
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\81\ See, e.g., email dated 3/13/00, from Richard Bailene to
Phillip Galbreath, ``S-CAEPS,'' Bates KPMG 0015744.
\82\ 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.
\83\ 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.\84\
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\84\ Email dated 12/20/01, from William Kelliher to David Brockway,
``FW: SC2,'' Bates, KPMG 0012723.
At the Subcommittee hearings in November 2003, Lawrence E.
Manth, KPMG's designated National Product Champion for SC2 and
the tax professional primarily responsible for its creation and
development, read a statement defending the tax product and
claiming that SC2 was ``consistent with the law.'' \85\ Certain
statements made by Mr. Manth under oath, however, regarding two
critical elements of SC2 are directly contradicted by KPMG
documents, information from SC2 participants, and the actual
implementation history of some SC2 transactions.
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\85\ See Manth testimony at the Subcommittee Hearings (11/18/03),
at 34-35.
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The first element involves distributions of income by an S
Corporation during the period in which most of its stock is
being held by a tax exempt organization. This issue is
important, because it provides evidence relevant to determining
the true nature of the SC2 transaction. If distributions of
income were limited or suspended while a tax exempt entity held
most of the S Corporation stock (and was therefore entitled to
most of the distributions), questions necessarily arise as to
whether the stock ``donation'' was a genuine transfer of
ownership to the tax exempt entity or a mere ploy to defer
taxation on retained corporate income until the original owner
of the stock redeems the shares a few years later.
As part of his testimony before the Subcommittee, Mr. Manth
made the following statement regarding the limitation or
suspension of distributions by S Corporations implementing an
SC2 transaction:
Some articles reported that S Corporations that
implemented SC2 passed resolutions to limit or suspend
dividends or other distributions to shareholders, basically to
keep the charity from getting any share of earnings. So far as
I know, a resolution limiting or suspending distributions was
not an element of SC2. In fact, KPMG recommended that S
Corporations make distributions during the period tax-exempts
held their stock.\86\
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\86\ Id., at 35.
Yet, in March 2000, when a KPMG colleague characterized the SC2
transaction as ``nothing more that a[n] old give stock to
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charity and then redeem it play,'' Mr. Manth responded:
Yes, very similar, but during the time the tax exempt
owns the stock it will be allocated 90% of the income, be paid
no distributions, and be redeemed for a small value.\87\
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\87\ Email dated 3/13/00, between Mr. Manth, Richard Baline, and
other KPMG tax personnel, ``RE: S-CAEPS,'' Bates KPMG 0015738-0015747,
reprinted in the Subcommittee Hearings as Hearing Exhibit 49, at 574-
83.
In an e-mail written on April 11, 2000, Larry DeLap, head
of KPMG's Department of Professional Practice for Tax, provided
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the following description of the SC2 transaction:
The strategy involves the transfer of a substantial
portion of S Corporation stock to a section 401(a) governmental
pension plan, with the intention that such stock be redeemed
from the pension plan after about 2 years. The intent is that
most of the earnings of the S Corporation would be allocated to
the pension plan during the period it owns the S Corporation
stock, but relatively little of the earnings would be
distributed during that period.\88\
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\88\ Email dated 4/11/00, from Larry DeLap to KPMG's Tax
Professional Practice partners, ``S-Corporation Charitable Contribution
Strategy (SC2),'' Bates KPMG 0015631, reprinted in the Subcommittee
Hearings as Hearing Exhibit 50 at 584.
On February 22, 2001, James Councill Leak, a tax
professional at KPMG who worked on the sale of the SC2 tax
product, sent an email to a large number of KPMG employees and
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included this description of the SC2 product.
SC2 is designed to allow an S Corp shareholder to obtain
a charitable deduction for a gift of non-voting stock to a
qualified tax exempt entity. After the gift, the tax exempt
will be allocated a significant portion of the S Corp taxable
income. The S Corp will curtail cash distributions that would
otherwise have been made to fund quarterly tax obligations. The
cash will build up inside the S Corp and can be used for any
corporate purpose. After 2 or 3 years, the tax exempt has the
right to ``put'' the stock back to the S Corp for redemption.
After redeeming the shares, the S Corp can resume making cash
distributions. The end result is a deferral of income tax and
the ultimate conversion from ordinary to capital gain tax rates
on S Corp income.
Mr. Manth sent the following response to Mr. Leak's memo:
Great e-mail, Councill!! Andrew [Atkin], you may
consider sending this to other regions.\89\
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\89\ Series of emails dated 3/05/2001, between Mr. Manth, Mr. Leak,
and others, ``RE: SC2 Solution--New Development,'' Bates KPMG 0048251-
54, reprinted in the Subcommittee Hearings as Hearing Exhibit 96 x.
In the spring of 2000, KPMG produced a packet of
information describing the SC2 product, its implementation, and
how to address questions raised by potential customers. Mr.
Leak advised the Subcommittee that this was the packet of
information used to train KPMG tax professionals who were going
to sell the SC2 product, and that Mr. Manth and other KPMG
employees conducted the training session. Mr. Manth informed
the Subcommittee that he had a role in the development of the
information packet. The packet includes a Powerpoint
presentation on how the SC2 transaction works, and one of the
pages in this presentation states: ``For valid business
purposes, the S-corporation will decrease its cash
distributions during the tax-exempt shareholder's stock
ownership.'' \90\
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\90\ ``SC2--Meeting Agenda June 19th, 2000,'' Bates KPMG 0013375-
96, at KPMG 0013383, reprinted in the Subcommittee Hearings as Hearing
Exhibit 21.
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Also included in the packet is a section entitled: ``SC2
IMPLEMENTATION PROCESS,'' which states the following:
c. Corporate issues--we need to review copies of
Articles of Incorporation, By Laws and any shareholder
agreements. Make sure that there are no provisions in any
corporate documents:
i. requiring the Corporation to make dividends (e.g.
to pay taxes);
ii. allowing the corporation or other shareholders to
redeem stock; or
iii. giving shareholders indemnification for any
actions;
If any of these provisions exist, we will probably
need to delete or alter them before the contribution.\91\
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\91\ Id., at KPMG 0013385.
An addendum to the KPMG ``White Paper'' description and
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analysis of the SC2 product contains similar passages:
(1) Distribution requirements. Are there any provisions
in the by-laws, articles of incorporation, shareholders'
agreements or elsewhere that mandates that the company make a
distribution to pay the shareholders' taxes? If so, these
provisions should be deleted prior to implementation. . . .
(3) The issuance of notes may also be beneficial where
the shareholders are dependent on distributions for their
primary source of income. During the transaction period,
distributions normally are not made. Therefore, if the
shareholders will need cash from the corporation during the
transaction period, a note should be distributed prior to the
transaction.\92\
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\92\ ``SC2 Outline'' and ``SC2 White Paper,'' Bates 0013397-447, at
KPMG 0013430 and 38, reprinted in the Subcommittee Hearings as Hearing
Exhibit 96 b. The addendum also states:
``WNT [Washington National Tax, the KPMG group that reviewed
the technical aspects of SC2] thinks payment of dividends would reduce
the taxpayers' level of risk by making it more difficult for the IRS to
successfully argue that the taxpayer has retained beneficial ownership
of the stock contributed to the exempt pension fund. WNT thinks it
would also bolster the taxpayers' `economic substance' argument.
Although the payment of dividends to the exempt pension fund would be
an additional cost to the taxpayer, that cost would provide a
corresponding benefit in the event of an examination challenge.''
Id., at KPMG 0013444. This advice was not, however, followed in
most of the SC2 transactions reviewed by the Subcommittee.
KPMG prepared packets containing boilerplate legal
documents that could be provided to S Corporations planning to
implement the SC2 transaction. One such packet included sample
Board and Shareholder resolutions supporting the amendment of
the shareholders agreement to provide that the S Corporation
was not obligated to make distributions to shareholders for the
payment of income tax due with respect to their S Corporation
shares.\93\
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\93\ See sample documents, Bates KPMG 0015569-89, at KPMG 0015572-
74, reprinted in the Subcommittee Hearings as Hearing Exhibit 96 l.
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Finally, as explained later in this Report, most of the SC2
transactions reviewed by the Subcommittee did not, in fact,
include any distributions of income to the tax exempt entity
holding the S Corporation stock.\94\ For example, the Los
Angeles Department of Fire and Police Pensions, which engaged
in 28 SC2 transactions, told the Subcommittee that only nine,
or less than one-third of the S Corporations in which it held
stock, actually paid any distributions of income while it held
the stock. Two-thirds of the S Corporations made no
distributions to the pension fund at all.
---------------------------------------------------------------------------
\94\ For more information, see Section IX(A) of this Report.
---------------------------------------------------------------------------
In short, KPMG documents and communications, some of which
were authored by or included Mr. Manth, as well as the actual
SC2 transactions examined by the Subcommittee, contradict Mr.
Manth's testimony that a resolution limiting or suspending
distributions was not an element of SC2. Given his active
involvement in the development, sale, and implementation of the
SC2 product, Mr. Manth should have known that his testimony on
this matter was not accurate.
A second issue of concern involves Mr. Manth's testimony at
the Subcommittee hearings in November 2003, regarding the role
of warrants in the SC2 transactions. In every SC2 transaction
examined by the Subcommittee, the transfer of S Corporation
shares to a tax exempt entity was preceded by the creation and
distribution to the existing S Corporation shareholders of
thousands of warrants, enabling these shareholders to purchase
additional S Corporation shares. If exercised, these warrants
would give the holders additional shares representing 85% to
90% of the S Corporation's entire stock, and significantly
dilute the percentage and value of the shares held by the tax
exempt, as well as the percentage of distributions to which the
tax exempt entity would have been entitled. If these warrants
were used as a means to ensure that the tax exempt entity would
re-sell the S Corporation shares to the original owner, as
planned in the SC2 transaction, this tactic would provide
evidence that the original owner had no real intent to donate
the S Corporation shares to the tax exempt entity, but only to
temporarily shift the shares to a tax exempt entity, thereby
deferring and mitigating the tax liability of the original, and
subsequent, owner of the shares.
Regarding the intended use of warrants in the SC2
transactions, Mr. Manth testified at the Subcommittee hearings
as follows:
I have also read descriptions that say that should the
charity decide not to sell its stock, other S Corporation
shareholders can exercise warrants for additional shares of
stock, thereby making the charity's share much less valuable.
Actually, just the opposite would happen. An S Corporation
shareholder who wanted to exercise the warrants would have to
come up with a substantial amount of money to pay for the new
stock. That money would be paid into the S Corporation and
raise its market value. This would reduce the charity's
percentage ownership share, but the charity would end up owning
a smaller percentage of a much more valuable company. In other
words, owning 10 percent of $1 million is a lot better than
owning 90 percent of $100,000.\95\
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\95\ Manth testimony at the Subcommittee Hearings (11/18/03), at
34-35.
Again, internal KPMG documents and communications
contradict this statement. For example, the SC2 information
packet produced by KPMG in the spring of 2000, which was used
to train KPMG tax professionals planning to sell the SC2
product, contained a section entitled: ``SC\2\--Appropriate
Answers for Frequently Asked Shareholder Questions.'' Question
---------------------------------------------------------------------------
1 reads as follows:
Q1: What happens if the tax-exempt (``TE'') does not
want to redeem the stock to the S-corp?
A1: First, the longer the TE owns the stock, the more
benefit the company will receive (assuming the company
continues to make money). Secondly, the TE would have no reason
not to sell the stock back, since the company is really its
only source of liquidity (nobody will want the stock). Third,
the only reason for the TE to accept the stock is to get cash.
Also, the TE knows the deal prior to accepting the stock. It
signs a redemption agreement that discloses the warrants as
well as the fact that no distributions are required to be made.
However, if we assume the TE gets a new board, and the
board wants to hold the company ``hostage,'' the shareholders
can exercise their warrants that can dilute the TE to less than
10%.\96\
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\96\``SC2--Meeting Agenda June 19th, 2000,'' Bates KPMG 0013375-96,
at KPMG 0013389, reprinted in the Subcommittee Hearings as Hearing
Exhibit 21.
A similar message is contained in an addendum to the KPMG
White Paper on SC2. One part of this addendum addresses a
number of implementation issues. A section entitled
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``Frequently Asked Questions'' contains the following:
(ii) What if the tax-exempt won't redeem?
(1) The tax-exempt has no reason to hold onto the stock
after the redemption period. First, it has no vote to authorize
a distribution. Secondly, the market for it to sell the stock
is severely limited because most holders of this stock would
incur more tax liability than the stock is worth. In addition,
the stock has limited appreciation potential. Therefore, the
tax-exempt has nothing to gain by holding the stock beyond the
redemption period.
(2) Still, if tax-exempt won't redeem, exercising the
warrants will immediately dilute the tax-exempt's interest.''
\97\
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\97\ ``SC2 Outline'' and SC2 White Paper, Bates KPMG 0013446-47,
reprinted in the Subcommittee Hearings as Hearing Exhibit 96 b.
These documents show that the warrants were characterized
internally at KPMG and to potential clients as a tool which
could be used, if necessary, to dilute a tax exempt entity's
interest in, and corresponding claim on, distributions from the
S Corporation. The documents also show that KPMG viewed the
possibility of the warrants being exercised to dilute the tax
exempt's holdings as a way, not only to ensure that the tax
exempt entity would resell its shares to the S Corporation
shareholders, but also prevent the tax exempt from threatening
to retain the stock in order to extract large payments or a
greater buyout price from the S-corporation shareholders. These
documents present a very different picture from the one
provided by Mr. Manth at the Subcommittee hearings. Given his
active involvement in the development, sale, and implementation
of the SC2 product, Mr. Manth should have known that his
testimony on this matter was not accurate.
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 were approved for sale and made their
way to market.
(2) Mass Marketing Tax Products
Finding: KPMG used aggressive marketing tactics to sell
its generic tax products by turning tax professionals into tax
product salespersons, pressuring its tax professionals to meet
revenue targets, using telemarketing to find clients,
developing an internal tax sales force, using confidential
client tax data to find clients, targeting its own audit
clients for sales pitches, and using tax opinion letters and
insurance policies as marketing tools.
One of the more striking aspects of the Subcommittee
investigation was its discovery of the substantial efforts KPMG
had expended to market its tax products, including extensive
efforts to target clients and, at times, use high-pressure
sales tactics. Evidence 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 was launched within the firm, the ``Tax Solution
Alert'' was 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 designated one or more persons to lead the
marketing effort for a new tax product. These persons were
referred to as the product's ``National Deployment Champions,''
``National Product Champions,'' or ``Deployment Leaders.'' With
regard to the tax products 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 were given significant
institutional support to market their assigned tax product. For
example, KPMG maintained a national marketing office that
included marketing professionals and resources ``dedicated to
tax.'' \98\ Champions could 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.\99\ These individuals
became members of the product's official ``deployment team.''
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\98\ KPMG Tax Services Manual, Sec. 2.21.1, at 2-14.
\99\ Id.
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Champions could also draw on a Tax Services group skilled
in marketing research to identify prospective clients and
develop target client lists. This group was known as the Tax
Services Marketing and Research Support group. Champions could
also make use of a KPMG ``cold call center'' in Indiana. This
center was 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
could and, at times did, make cold calls to sell specific tax
shelters such as SC2.\100\
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\100\ 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 002560.
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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.\101\
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\101\ Email dated 8/6/00 from Jeffrey Stein to 15 National
Deployment Champions, Bates KPMG 050016. The Opportunity Management
System (OMS) 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.
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
---------------------------------------------------------------------------
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.\102\
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\102\ Email dated 3/14/02, from Rick Rosenthal and other KPMG
professionals, to ``US Management Group,'' Bates XX 001730-32 (emphasis
in original).
Corporate Culture: Sell Sell Sell. After a new tax product
was ``launched'' within KPMG, one of the primary tasks of a
National Deployment Champion was to educate KPMG tax
professionals about the new product and motivate them to sell
it.
Documentation obtained by the Subcommittee shows that
National Deployment Champions and senior KPMG tax officials
expended significant effort to convince KPMG personnel to
devote time and resources to selling new products. Senior tax
professionals used 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 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!! \103\
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\103\ 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. See email dated 4/21/00, from Michael Terracina, KPMG
office in Houston, to Gary Choate, KPMG office in Dallas, Bates KPMG
0048191.
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.\104\ 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.\105\ For
example, a member of the SC2 deployment team, who also worked
for Stratecon, sent an email to a group of 60 tax professionals
urging them to try a new, more appealing version of SC2. In a
paragraph subtitled, ``Why Should You Care?'' he wrote:
---------------------------------------------------------------------------
\104\ 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.
\105\ See e.g., email dated 12/2/00, from Lawrence Manth to
multiple tax professionals, Bates XX 000021.
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.\106\
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\106\ Email dated 2/22/01, from Councill Leak to multiple tax
professionals, Bates KPMG 0050822-23.
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.\107\ The email states in part:
---------------------------------------------------------------------------
\107\ Email dated 2/3/00, from Philip Wiesner to US-WNT Tax
Partners, Bates KPMG 0050888-90.
Listed below are the tax products identified by the
functional teams as having significant revenue potential over
the next few months. . . . [T]he functional teams will need . .
. WNT champions to work with the National Product champions to
maximize the revenue generated from the respective products. .
. . Thanks for help in this critically important matter. As
Jeff said, ``We are dealing with ruthless execution--hand to
hand combat--blocking and tackling.'' Whatever the mixed
---------------------------------------------------------------------------
metaphor, let's just do it.
The evidence is clear that selling tax products was an
important part of every tax professional's job at KPMG.
Targeting Clients. KPMG's marketing efforts included
substantial efforts to identify prospective purchasers for its
tax products. KPMG developed prospective client lists by
reviewing both its own client base and seeking new clients
through referrals and cold calls.
To review its own client base, KPMG has used software
systems, including ones known as KMatch and RIA GoSystem, to
identify former or existing clients who might be interested in
a particular tax product. KMatch is ``[a]n interactive software
program that asks a user a series of questions about a client's
business and tax situation,'' uses the information to construct
a ``client profile,'' and then uses the profile to identify
KPMG tax products that could assist the client to avoid
taxation.\108\ 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.\109\ 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.\110\
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\108\ Presentation entitled, ``KMatch Push Feature Campaign,''
undated, prepared by Marsha Peters of the Tax Innovation Center, Bates
XX 001511.
\109\ 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).
\110\ Id.
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The evidence indicates that KPMG also used 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 are those requiring the combined participation of
both KPMG tax and assurance professionals to market specified
tax products.
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.\111\ 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.'' \112\ Internal KPMG documentation states that
the purpose of the new product was ``[t]o increase KPMG's
market penetration of key clients and targets by enhancing the
linkage between Assurance and Tax professionals.'' \113\
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.''
\114\ 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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\111\ 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 001567-94.
\112\ Presentation dated 10/30/00, ``Intellectual Property Services
(IPS),'' by Dut LeBlanc of Shreveport and Joe Zier of Silicon Valley,
Bates XX 001580-94.
\113\ 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 001567-94.
\114\ Presentation dated 10/30/00, ``Intellectual Property Services
(IPS),'' by Dut LeBlanc of Shreveport and Joe Zier of Silicon Valley,
Bates XX 001580-94.
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.\115\
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\115\ 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 001567-94.
Additional tax products which relied in part on KPMG audit
partners followed. In 2002, for example, KPMG launched a ``New
Enterprises Tax Suite'' product \116\ 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.'' \117\
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\116\ 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 001503-05. 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.
\117\ 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.'' \118\
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\118\ 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
KPMG client lists personally to identify clients 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? \119\
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\119\ 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 an 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.\120\ 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.\121\ 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.\122\ 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.'' \123\
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\120\ Subcommittee interview of Wachovia Bank representatives (3/
25/03).
\121\ See, e.g., Memorandum dated 9/3/99, from Karen Chovan,
Financial Advisory Services to CMG Risk Review Oversight Committee,
``Meeting Minutes of September 1 . . .,'' Bates SEN-008629-31 (``Senior
PFC Advisor and CMG Risk Review Subcommittee (`subcommittee or SC')
member Tom Newman presented an overview of an enhanced investment
strategy for OC vote to be able to present it to selected First Union
clients. KPMG brought the BLIPS strategy (referred hereafter as the
`Alpha' strategy) to First Union. . . .''); 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 V(A)(5) of this Report for more information on the auditor
independence issue.
\122\ 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).
\123\ 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.\124\ It obtained these lists from either
state governments, 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.\125\ Some of the lists
had large blocks of S Corporations associated with automobile
or truck dealers, real estate firms, home builders, or
architects.\126\ In some instances, KPMG tax professionals
instructed KPMG telemarketers to contact the corporations to
gauge interest in SC2.\127\ In other cases, KPMG tax
professionals contacted the corporations personally.
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\124\ 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).
\125\ 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).
\126\ Email dated 11/17/00, from Jonathan Pullano to US-Southwest
Tax Services Partners and others, ``FW: SW SC2 Channel Conflict,''
Bates KPMG 0048309.
\127\ 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, \128\ 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.\129\ 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.'' \130\
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\128\ See email dated 4/22/01, from John Schrier to Thomas
Crawford, ``RE: SC2 target list,'' Bates KPMG 0050029.
\129\ See email dated 4/23/01, from John Schrier to Thomas
Crawford, ``RE: SC2 target list,'' Bates KPMG 0050029.
\130\ 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.\131\ 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.\132\
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\131\ Subcommittee briefing by Jeffrey Eischeid and Timothy Speiss
(9/12/03).
\132\ Subcommittee interview of Councill Leak (10/22/03). See also
KPMG/Peat Marwick memorandum dated 11/24/98, from Jeffrey Stein to KPMG
Tax Partners, ``Tax Sales Organization and Telemarketing,'' at 5 (``The
Tax practice has also made a significant investment in building our
marketing capabilities and has expanded our telemarketing resources to
support our national services and initiatives. . . . The telemarketers
already have an impressive track record; they have played a critical
role in our SALT practice and most recently helped drive the COLI and
Export Tax Minimization product `blitzes.' '')
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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.'' \133\ The ``Sticking Points'' document provided
the following advice to KPMG tax professionals trying to sell
SC2 to prospective clients:
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\133\ ``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
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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. . . .
This document was hardly the work product of a
disinterested tax adviser. In fact, it went 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.'' 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.
Tax Shelter Sales Force. In addition to exhorting its tax
professionals to spend more time selling KPMG tax products,
beginning in 1997, KPMG established a dedicated sales position,
known as a Business Development Manager (BDM), to market its
tax shelters, as well as other KPMG products and services. The
Subcommittee interviewed former BDMs and obtained documentation
related to BDM involvement in KPMG's tax shelter activities.
A key KPMG document describing the newly established
``National BDM Tax Sales Initiative'' states that one of its
goals was to ``[h]elp create an aggressive sales culture'' at
KPMG.\134\ A document establishing the terms and conditions for
BDM compensation states that the primary duty of a BDM selling
tax products was to maximize revenue to KPMG through aggressive
sales:
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\134\ `` `The Blueprint' National BDM Tax Sales Initiative:
Objectives, Roles & Responsibilities'' (undated) at 14.
The duty of each Tax Business Development Manager is to
produce the Maximum revenue for the Firm. The Tax Business
Development Manager's contribution to maximum revenue will be
primarily via the sale of Tax Services to new and existing
Clients.\135\
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\135\ KPMG document, ``Tax Business Development Stub Fiscal Year
2001 and Full Fiscal Year 2002 (15 Months Beginning July 1, 2001 and
Ending September 30, 2003) Compensation Plan Terms & Conditions,''
(date uncertain) (hereinafter ``Tax BDM 2001-2002 Compensation Plan'')
at 2.
A 1998 memorandum to KPMG tax partners urging greater use of
BDMs declared that ``a solid sales team dedicated to Tax is
critical to our marketplace success.'' \136\
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\136\ KPMG/Peat Marwick memorandum dated 11/24/98, from Jeffrey
Stein to KPMG Tax Partners, ``Tax Sales Organization and
Telemarketing'' (hereinafter ``Stein Memorandum'') at 1.
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KPMG established an initial sales force of 6 to 10 BDMs in
1997, and increased the number of BDMs over the following 5
years to a maximum of 125 individuals. KPMG provided the
Subcommittee with these total, annual BDM employment figures:
FY1998: 34; FY1999: 84; FY2000: 88; FY2001: 98; FY2002: 125;
and FY2003: 89.\137\
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\137\ See letter dated 1/15/04, from KPMG to the Subcommittee, at
7. See also written responses to Subcommittee questions dated 4/25/04,
from a former KPMG BDM, who estimated that, in FY2000, 65 to 70 of
KPMG's BDMs sold tax products and services (``Tax BDMs''), while 15 to
20 sold assurance products and services (``Audit BDMs'').
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The BDM sales force was organized by region, using six
geographic areas: Northeast, Mid-Atlantic, Southeast, Midwest,
Southwest, and West.\138\ The BDMs within a region reported to
an Area Sales Director (ASD), who in turn reported to a
National Partner in Charge of the Business Development
Managers. Each ASD was responsible for recruiting and training
BDMs, ensuring the BDMs met specified sales quotas, leading
sales effort on at least five major accounts within their
markets, coordinating with the KPMG Area Managing Partner for
Tax, and developing national sales strategies with other
ASDs.\139\ The BDM training program consisted of a new hire
orientation, two sessions of sales ``Boot Camp,'' a course in
``Selling with Confidence,'' mock sales calls, self training
videos, and weekly national conference calls launching new
products.\140\ The program also included ``intense training in
several of the innovative Tax Products that KPMG was
marketing.'' \141\
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\138\ KPMG presentation dated 12/9/98, ``Tax Sales Organization.''
See also ANational Tax BDM Roster,'' dated 2/1/01. The documents
indicate that no ASD was appointed for the Mid-Atlantic region.
\139\ Stein Memorandum at 2.
\140\ KPMG presentation, ``BDM Training Program Components''
(undated).
\141\ Written responses to Subcommittee questions, dated 4/25/04,
by a former KPMG BDM.
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In a 1998 memorandum, the head of KPMG Tax Practice
operations instructed KPMG's tax partners to integrate BDMs
into their sales operations.\142\ The memorandum explained that
each member of the BDM sales force had been designated as
either a ``Product'' or ``Area'' BDM. Product BDMs, the
memorandum explained, Awill be dedicated to and responsible for
a select number of national tax products--that are perceived to
yield the greatest return and represent our highest
opportunities.'' \143\ With respect to Area BDMs, the
memorandum stated that Atheir primary focus will be to team
with the Tax Services Partners (TSPs) to promote a specific
portfolio of tax products including select new tax initiatives
as they are developed by the Tax Innovation Center (TIC).''
\144\
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\142\ Stein Memorandum at 1.
\143\ Id. at 4. The list of tax products available for sale by BDMs
included tax products under the jurisdiction of Capital Transaction
Strategies, the KPMG tax practice that led the efforts on FLIP, OPIS,
and BLIPS. Id. at 3. Internal KPMG emails also indicate that at least
one BDM was engaged in selling BLIPS. See email dated 2/22/00, from
KPMG BDM Tobin Gilman to Ian Harrison and Robert Wells, ``FW: Multi-
Year Engagements, Contingent Engagements, Etc.''
\144\ Stein Memorandum at 2.
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To promote tax product sales, KPMG set individual sales
quotas for each BDM \145\ and stated that it was Aexpected that
each Tax Business Development Manager shall achieve 100% of
their sales quotas.'' \146\ These individual BDM sales quotas
were apparently based upon area and national BDM revenue
targets that were also established by KPMG. For example, a KPMG
presentation entitled ``The Blueprint'' set national revenue
goals for BDMs of $50 million in FY1999, $100 million in
FY2000, and $150 million in FY2001.\147\ A later KPMG document
cites actual BDM tax sales revenue of about $33 million in
FY1999 and $109 million in FY2000, with projected FY2001 sales
revenue of $125 million.\148\
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\145\ See, e.g., Tax BDM 2001-2002 Compensation Plan at 2.
\146\ Id. at 5.
\147\ `` `The Blueprint' National BDM Tax Sales Initiative:
Objectives, Roles & Responsibilities'' (undated) at 3.
\148\ KPMG presentation dated 2001, ``BDM Tax Sales Organization
Financial Trends.''
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BDM compensation routinely included sales commissions and,
at times, also included bonuses or awards for meeting or
exceeding sales revenue targets. In general, the evidence
indicates that each BDM received a base salary and commission
based on booked fees, billed accountancy income, and collected
accountancy income.\149\ In FY 1999, for example, BDMs received
a base salary of $75,000 plus a 3% commission on sales revenue.
In FY 2000, BDMs received a base salary of $90,000 plus a 3%
commission on sales to existing clients, a 4% commission for
new sales to ``idle'' accounts, and a 6% commission on sales to
new clients. In FY 2001, the evidence indicates that the 4%
commission level was eliminated, and some experienced new hires
received base salaries of between $200,000 and $300,000.\150\
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\149\ KPMG document dated 4/20/99, ``Fiscal Year 1999 Tax Business
Development Manager Compensation Plan,'' at 4.
\150\ Written responses to Subcommittee questions, dated 4/25/04,
by a former KPMG BDM, at 2.
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According to a June 2000 compensation plan analysis, the
levels of compensation promised meant that a BDM with a base
salary of $90,000 and who met a $3 million sales target would
earn an annual income of up to $243,360. If the same BDM were
to sell $4 million worth of tax products, he or she would earn
up to $324,000.\151\ Top-selling BDMs were also offered, at
times, rewards for their sales, such as an opportunity to
attend a luxurious ``Performance Club 1999'' retreat in Carmel,
California.\152\
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\151\ KPMG document dated 6/30/00, ``BDM Comp. Plan Analysis,'' at
1.
\152\ Letter dated 9/29/99, from KPMG's Ian Harrison to a BDM.
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The BDMs were heavily involved in the marketing of tax
shelter products. A lengthy Tax Sales Organization area
analysis of 2001 sales trends, for example, demonstrates the
level of BDM involvement with KPMG tax shelter sales. It states
that ``BDMs are pushing heavily on SC2,'' one of the tax
shelters featured in this Report.\153\ It describes the sales
efforts of a top-selling BDM based in Dallas by referring to
his sales of several tax shelter products and to his working
relationship with Stratecon, a KPMG group involved in
developing and marketing tax shelter products to KPMG clients:
``Significant portion (90%) of pipeline is Stratecon, with
CLAS, SC2, and Gain Mitigation. Works extremely close with
Stratecon Partner--and is widely known as a strong
prospector.'' \154\ The analysis also states that a Seattle-
based BDM sold $5.4 million worth of tax products in FY 2000,
focusing on SALT, TAS and SC2; while a Silicon Valley-based BDM
had pending FY 2001 fees related to SC2 totaling $2
million.\155\
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\153\ KPMG presentation dated 2001, ``BDM Tax Sales Organization
Financial Trends,'' at 4.
\154\ Id. at 9.
\155\ Id. at 13.
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This sales analysis suggests that KPMG encouraged its BDMs
to engage in aggressive sales of its tax products. It describes
a Dallas-based BDM as Aa strong prospector, who has already
garnered strong praise from several Partners for his aggressive
marketing stance.'' \156\ It commends a Stamford-based BDM
projected to achieve $6 million in FY 2001 sales for being
Aextremely aggressive, as he easily averages 1 to 2 new
relationship meetings each week.'' \157\ It also singles out
BDMs with the ability to make ``cold'' sales. An Atlanta-based
BDM, for example, is cited for success with Aaccounts where
KPMG has no acquaintances, the `coldest' of category 1 gain
accounts. Several have become KPMG solution buyers.'' \158\ The
analysis notes that a number of BDMs had been deployed
exclusively against cold accounts.\159\
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\156\ Id. at 9.
\157\ Id. at 19.
\158\ Id. at 25.
\159\ Id.
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In response to a Subcommittee inquiry about the current
status of KPMG's sales force, KPMG informed the Subcommittee
that it was refocusing the BDM position by eliminating sales
commissions and training BDMs as relationship managers.\160\ In
September 2004, KPMG held a national conference call in which
it was announced that many BDMs would be terminated. Those
remaining with the firm would have their job titles changed to
``Account Relationship Managers.'' However, it appears as if
their primary job responsibility continued to be sales, albeit
primarily in audit and tax services.''
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\160\ See letter dated 1/15/04, from KPMG to the Subcommittee, at
7.
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Using Tax Opinions and Insurance as Marketing Tools.
Documents obtained during the Subcommittee's 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 an earlier 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 were former employees of the IRS.\161\
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\161\ ``SC2--Meeting Agenda'' and attachments, dated 6/19/00, 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.'' \162\ In another SC2
document, KPMG advised its tax professionals to tell clients
worried about IRS penalties:
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\162\ ``SC2--Meeting Agenda'' and attachments, dated 6/19/00, Bates
KPMG 0013394. 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.'')
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.\163\
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\163\ ``SC2--Appropriate Answers for Frequently Asked Shareholder
Questions,'' included in an SC2 information packet dated 7/19/00, Bates
KPMG 0013393.
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. 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.'' \164\
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\164\ ``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.'' \165\
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\165\ ``SC2--Meeting Agenda'' and attachments, dated 6/19/00, Bates
KPMG 0013375-96.
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According to KPMG tax professionals interviewed by
Subcommittee staff, the insurance companies offering this
insurance included AIG and Hartford.\166\ In response to
posthearing questions, KPMG produced copies of a redacted
insurance policy from Lexington Insurance Company and a sample
``fiscal event'' insurance policy prepared by AIG, both of
which related to SC2.\167\ The AIG policy, for example,
promises to reimburse the policy holder for a range of payments
made to a Federal or state taxing authority related to SC2,
including any payment made for an assessment of unpaid taxes,
interest, a fine or penalty. Once these policies became
available, KPMG tax professionals were asked to re-visit
potential clients who had declined the tax product and try
again.\168\ Evidence obtained by the Subcommittee indicates
that at least half a dozen SC2 purchasers also purchased SC2
insurance.
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\166\ See, e.g., Subcommittee interview of Lawrence Manth (11/6/
03).
\167\ See insurance policies reprinted in Subcommittee hearing
record at 2911-29.
\168\ Email dated 2/9/01, from Ty Jordan to multiple KPMG tax
professionals, ``SC2 revisit of stale leads,'' Bates KPMG 0050814.
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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.\169\ However, evidence gathered by the
Subcommittee indicates that KPMG could and did obtain specific
revenue tracking information.
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\169\ Subcommittee briefing by Jeffrey Eischeid (9/12/03);
Subcommittee interview of Jeffrey Stein (10/31/03).
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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, included 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 FY2001
revenues broken down by each of six regions in the United
States: \170\
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\170\ Internal KPMG presentation, dated 6/18/01, by Andrew Atkin
and Bob Huber, entitled ``S-Corporation Charitable Contribution
Strategy (SC2) Update,'' Bates XX 001553.
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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.\171\
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\171\ 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 FY1998, $1.001
million in FY1999, $1.184 million in FY2000, and $1.239 million in
FY2001. 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
001503.
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Another document obtained by the Subcommittee from a party
other than KPMG is a 1998 memorandum sent by a senior KPMG tax
official to all U.S. KPMG tax partners directing them to begin
using a special database to track all KPMG tax sales
activity.\172\ The memorandum states:
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\172\ KPMG/Peat Marwick memorandum by Jeffrey Stein to KPMG Tax
Partners, ``Tax Sales Organization and Telemarketing'' (11/24/98),
reprinted in Subcommittee Hearings as Hearing Exhibit 97 kk.
The Opportunity Management System (OMS) will serve as
the Tax practice's central Database for all sales activity. It
is essential that we have one system that captures the activity
of the [Business Development Managers,] Telemarketers and our
professionals. This will ensure that we leverage our
relationships and coordinate our sales efforts for increased
success. The BDMs, Telemarketers and Marketing already use OMS
as their repository for all information. And plans are to make
OMS available to all Tax partners on a read only basis by the
beginning of December. . . . You must be sure to report your
individual sales activity to your Area Marketing Leader-Tax for
input into the system. Reports are generated from OMS are the
tool the Tax Leadership Team will be using to measure
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individual partner activity.
A later email sent in August 2000, which KPMG did produce
to the Subcommittee, indicates that by the year 2000, 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.\173\
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\173\ Email dated 8/6/00 from Jeffrey Stein to 15 National
Deployment Champions, Bates KPMG 050016. See also KPMG 2001
presentation, ``Tax Sales Organization Financial Trends,'' indicating
that KPMG carefully tracked the sales revenues generated by its
Business Development Managers, not only to calculate their sales
commissions, but also to develop BDM revenue targets and sales quotas.
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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 had begun ``[p]repar[ing]
quarterly Solution Profitability reports.'' \174\ 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. These documents, as well as other information,
contradict KPMG's statement that ``the firm does not maintain
any systematic, reliable method of recording revenues by tax
product on a national basis.'' \175\
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\174\ 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.
\175\ 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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(3) Implementing Tax Products
Finding: KPMG was actively involved in implementing the
tax shelters which it sold 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 did not end with the sale itself. Many KPMG tax
products, including the four examined by the Subcommittee,
required the purchaser to carry out complex financial and
investment activities in order to realize promised tax
benefits. KPMG typically provided 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 also, at times,
caused KPMG to adjust how a tax product was structured and even
spurred development of new products.
Executing FLIP, OPIS, and BLIPS. FLIP, OPIS, and BLIPS each
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 Group to
design the complex series of financial transactions called for
by the product.\176\ Using contacts it had established in other
business dealings, Quellos 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,
where the bank referred bank clients who might be interested in
the FLIP tax product to KPMG tax professionals.\177\ In some
cases, the bank permitted KPMG and Quellos Group to make FLIP
presentations to its clients in the bank's offices.\178\ KPMG
also enlisted Sidley Austin Brown & Wood to issue a favorable
legal opinion letter on the FLIP tax product.\179\
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\176\ Quellos Group was then known and doing business as Quadra
Capital Management LLP or QA Investments, LLC.
\177\ KPMG actually did business with First Union National Bank,
which subsequently merged with Wachovia Bank.
\178\ Subcommittee interview of First Union National Bank
representatives (3/25/03).
\179\ 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 Group, 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.\180\ 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.\181\ Unlike Quellos Group, 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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\180\ 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'').
\181\ 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.\182\ Other KPMG employees were
assigned to Presidio to assist in expediting BLIPS transactions
and paperwork. KPMG also worked with Quellos Group, Presidio,
and the relevant banks to ensure that the banks established
large enough credit lines, at times in the billions of dollars,
to allow a substantial number of individuals to carry out FLIP,
OPIS, and BLIPS transactions.
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\182\ 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.\183\ 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.\184\
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\183\ Subcommittee interview of Jeffrey Eischeid (10/8/03).
\184\ 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.'' \185\
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\185\ Attachment entitled, ``Tax Exempt Organizations,'' included
in an SC2 information packet dated 7/19/00, ``SC2--Meeting Agenda,''
Bates KPMG 0013387.
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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.\186\
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\186\ Subcommittee interviews with Los Angeles Department of Fire
and Police Pensions (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.'' \187\ 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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\187\ 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.\188\
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\188\ ``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 stock 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.\189\ 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.\190\
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\189\ Subcommittee interview of Lawrence Manth (11/6/03).
\190\ 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 re-took control of the S Corporation and
distributed some or all of the income that had built up within
the company while the charity was a shareholder. The SC2
National Deployment Champion wrote the following to more than
20 of his colleagues working on SC2:
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.\191\
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\191\ 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 tax shelters 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 instance, 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. 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.\192\
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\192\ 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.'' \193\ 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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\193\ 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.\194\ 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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\194\ 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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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.'' \195\ 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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\195\ 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.\196\ 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.\197\
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\196\ 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, a KPMG tax expert states: ``the
probability of actually making a profit from this transaction is remote
(possible, but remote).'').
\197\ 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.'' \198\
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\198\ 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.\199\
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\199\ 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.\200\ 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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\200\ 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 involved decisions by KPMG to stop selling particular tax
products. In all four of the tax products examined by the
Subcommittee, KPMG stopped marketing the tax product within 1
or 2 years of its first sale.\201\ 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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\201\ 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.\202\ 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.\203\ 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.\204\
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\202\ Subcommittee interview of Lawrence DeLap (10/30/03).
\203\ Id.
\204\ See next section of this Report on ``Avoiding Detection.''
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Evidence 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.\205\ These purchasers were referred to internally at
KPMG as ``grandfathered BLIPS'' clients.\206\ 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.\207\ 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.\208\ This effort was ultimately
unsuccessful in restarting BLIPS sales.
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\205\ 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. . . .'').
\206\ See, e.g., two emails dated 10/1/99, from Larry DeLap to
multiple KPMG tax professionals, ``BLIPS,'' Bates KPMG 0011714.
\207\ Subcommittee interview of Lawrence DeLap (10/30/03).
\208\ 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.\209\ 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.\210\ 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.\211\ 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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\209\ See Section V(A)(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.
\210\ See, e.g., email dated 9/30/99, from Jeffrey Eischeid to
Wolfgang Stolz and others, ``OPIS,'' Bates QL S004593.
\211\ Subcommittee interview of Lawrence DeLap (10/30/03).
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(4) Avoiding Detection
Finding: KPMG took steps to conceal its tax shelter
activities from tax authorities, including by claiming it was a
tax advisor and not a tax shelter promoter, failing to register
potentially abusive tax shelters, restricting file
documentation, imposing marketing restrictions, and using
improper tax return reporting to minimize detection by the IRS
or others.
Evidence obtained by the Subcommittee 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 with regard to FLIP, OPIS,
BLIPS, and SC2 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 has been
it does not develop, sell or promote tax shelters. As a
consequence, as of the time of the Subcommittee hearings in
2003, KPMG had not voluntarily registered, and thereby
disclosed to the IRS, a single one of its tax products, even
after being advised by a senior tax professionals that a
particular tax product should be registered.
One glaring example of this flawed approach involves a 1998
memorandum sent by a KPMG tax professional to the second most
senior KPMG tax official at KPMG advising the firm not to
register the OPIS tax product with the IRS, even if OPIS
qualified as a tax shelter under the law.\212\ The memorandum
stated in part:
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\212\ 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.
For purposes of this discussion, I will assume that we
will conclude that the OPIS product meets the definition of a
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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. . . .
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. . . .
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. . . .
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.
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 learned that some KPMG tax professionals
agreed with this analysis, \213\ while other senior KPMG tax
professionals provided the opposite advice to the firm.\214\
The head of KPMG's Tax Services Practice, the Vice Chairman for
Tax, ultimately determined not to register the tax product as a
tax shelter. 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 Vice Chairman
for Tax.\215\
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\213\ 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).
\214\ 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). See also handwritten notes
dated 3/4/98, author not indicated, regarding ``Brown & Wood'' and
``OPIS,'' Bates KPMG 0047317 (``Must register the product. B&W
concerns--risk is too high. Confirm w/Presidio that they will
register.'' Emphasis in original.) (``B&W'' refers to Brown & Wood, the
law firm that worked with KPMG on OPIS; Presidio is the investment firm
that worked with KPMG on OPIS.).
\215\ 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.'' \216\ 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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\216\ KPMG Tax Services Manual, Sec. 24.4.1, at 24-2.
LIf 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.\217\
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\217\ 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.'').
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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.\218\ 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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\218\ 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, BLIPS, and SC2 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.\219\
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\219\ See United States v. KPMG, Case No. 1: 02MS00295 (D.D.C. 9/6/
02).
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At the November 18 hearing before this Subcommittee, KPMG
was asked directly whether its tax professionals promoted the
sale of its tax products to potential clients. Then head of
KPMG's Tax Practice avoided answering the question in sparring
that lasted more than ten minutes, before finally admitting
that KPMG did.\220\
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\220\ See Subcommittee Hearings (11/18/03), at 65-67.
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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.''
\221\ 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.'' \222\
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\221\ 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.
\222\ 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.''
\223\ He stated, ``Although KPMG has produced many documents to
the IRS, it has also withheld a substantial number.''
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\223\ 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.\224\
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\224\ Email dated 4/9/02, from Deke Carbo to Jeffrey Eischeid,
``Larry's Message,'' Bates KPMG 0024467.
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, \225\ 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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\225\ ``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.'' \226\
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\226\ 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.\227\
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\227\ 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.\228\
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\228\ 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.''
\229\
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\229\ 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.\230\
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\230\ 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. . . .\231\
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\231\ 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.\232\
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\232\ 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.'')
---------------------------------------------------------------------------
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.\233\
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\233\ 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-1's 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-1's.
David was wondering what the rationale was since the
instructions and PPC say that single member LLCs are
disregarded entities so 1099s, K-1's should use the EIN of the
single member.\234\
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\234\ 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-1's. . . . 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.\235\
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\235\ 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.\236\
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\236\ 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.\237\ 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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\237\ 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.\238\
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\238\ ``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.\239\ KPMG appears to have taken
similar precautions in FLIP, OPIS, BLIPS, and SC2.
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\239\ ``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.\240\
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\240\ 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).\241\
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\241\ 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 contained 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.''
\242\
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\242\ Handwritten notes dated 3/4/98, author not indicated,
regarding ``Brown & Wood'' and ``OPIS,'' Bates KPMG 0047317.
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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.'' \243\ 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.'' \244\
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\243\ Email dated 1/3/00, from Dale Baumann to ``Jeff,'' ``988
election memo,'' Bates KPMG 0026345.
\244\ 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.\245\ With OPIS, KPMG tax professionals were instructed
``you should NOT leave this [marketing] material with clients
or targets under any circumstances. Not only will this unduely
[sic] harm our ability to keep the product confidential, it
will DESTROY any chance the client may have to avoid the step
transaction doctrine.'' \246\ In the case of BLIPS, KMPG tax
professionals were instructed to obtain ``[s]igned
nondisclosure agreements . . . before any meetings can be
scheduled.'' \247\ 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.\248\ 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.'' \249\ In SC2, the DPP head instructed KPMG tax
professionals not to provide any ``sample documents'' directly
to a client.\250\
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\245\ 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 paragraph 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
Mr. Jacoboni (4/4/03).
\246\ Email dated 6/8/98, from Gregg W. Ritchie to multiple KPMG
tax professionals, ``RE[2]: OPIS,'' Bates XX 001932 (emphasis in
original).
\247\ Email dated 5/5/99, from Jeffrey Eischeid to multiple KPMG
tax professionals, ``Marketing BLIPS,'' Bates KPMG 0006106.
\248\ Subcommittee interview of Wachovia Bank representatives (3/
25/03); Subcommittee interview of legal counsel of Theodore C. Swartz
(9/16/03).
\249\ Email dated 5/5/99, from Jeffrey Eischeid to multiple KPMG
tax professionals, ``Marketing BLIPS,'' Bates KPMG 0006106.
\250\ 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.\251\ 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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\251\ 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 this is an appropriate
strategy to mass market? \252\
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\252\ 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.'' \253\
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\253\ 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 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.\254\
For example, KPMG made more than $124 million from just the
four tax products featured in this Report. Sidley Austin Brown
& Wood obtained fees for issuing concurring legal opinions on
these three tax products, FLIP, OPIS and BLIPS, totaling more
than $23 million.\255\
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\254\ 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).
\255\ Letter dated 1/16/04, from Sidley Austin Brown & Wood to the
Subcommittee, at 2.
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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.'' \256\ 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.\257\ 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.\258\
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\256\ KPMG Tax Services Manual, Sec. 31.11.1 at 31-6.
\257\ 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.'')
\258\ 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.). In
December 2004, the Public Company Accounting Oversight Board proposed
rules which would, among other provisions, bar any accounting firm that
audits a publicly traded company from entering into a contingent fee
arrangement with an audit client for tax services.
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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.\259\ 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.\260\ 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.''
\261\ 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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\259\ 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.
\260\ Memorandum dated 7/14/98, from Gregg Ritchie to multiple KPMG
tax professionals, ``Rule 302 and Contingency Fees--CONFIDENTIAL,''
Bates KPMG 0026555-59.
\261\ ``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 tax products examined by the Subcommittee, the fees
charged by KPMG for BLIPS, OPIS, and FLIP were clearly based
upon the client's projected tax savings.\262\ 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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\262\ 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.\263\
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\263\ Document dated 7/21/99, entitled ``Action Required,''
authored by Jeff 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
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 \264\
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\264\ 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.'' \265\ SC2 fees were set at a minimum of
$500,000, and went as high as $2 million per client.\266\
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\265\ 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).
\266\ 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.'' \267\
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\267\ 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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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.\268\
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\268\ 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 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 a fee for each client who actually
purchased a tax product.
KPMG Tax Services Manual states: ``Due to independence
considerations, the firm does not enter into alliances with SEC
audit clients.'' \269\ 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.'' \270\ KPMG policy is that ``[a]n oral business
relationship that has the effect of creating an alliance should
be treated as an alliance.'' \271\ 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.'' \272\
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\269\ KPMG Tax Services Manual, Sec. 52.1.3 at 52-1.
\270\ Id., Sec. 52.1.1 at 52-1.
\271\ 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.
\272\ Id., 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.\273\ KPMG tax professionals were
aware that doing business with an audit client raised auditor
independence concerns.\274\ 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.\275\ 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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\273\ Undated document prepared by Deutsche Bank in 1999, ``New
Product Committee Overview Memo: BLIPS Transaction,'' Bates DB BLIPS
6906-10, at 6909-10.
\274\ 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).
\275\ 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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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; \276\ tax products that were designed and explicitly
called for ``fostering cross-selling among assurance and tax
professionals''; \277\ 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.\278\ 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.''
\279\
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\276\ 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 001567-94.
\277\ 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.
\278\ See e.g. 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.
\279\ 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.\280\ 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.'' \281\ 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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\280\ 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.)
\281\ Id. at Bates XX 001369.
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The next topic in the meeting summary is: ``Financial
Statement Treatment of Aggressive Tax Positions.'' \282\ 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,'' \283\ 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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\282\ 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.
\283\ Id. at Bates XX 001370 (emphasis in original).
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Conflicts of Interest in Legal Representation. Another 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.'' \284\ 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.
---------------------------------------------------------------------------
\284\ 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. 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. In fact, although Sutherland, Asbill & Brennan
represented 39 ``matters,'' involving 113 separate clients, in
connection with a KPMG tax product or service, 17, or nearly
half of these ``matters'' were directly attributable to
referrals from KPMG.\285\ The conflict of interest issue here
involves, 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.
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\285\ Letter dated 12/19/03, from Sutherland Asbill & Brennan to
the Subcommittee. See also Section VI(B) of this Report.
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(6) KPMG's Current Status
Finding: Since Subcommittee hearings in 2003, KPMG has
committed to cultural, structural, and institutional changes to
dismantle its abusive tax shelter practice, including by
dismantling its tax shelter development, marketing and sale
resources, dismantling certain tax practice groups, making
leadership changes, and strengthening its tax services
oversight and regulatory compliance.
At the Subcommittee hearing on November 18, 2003, the head
of KPMG's Tax Practice testified that ``[i]t is no longer
enough to say that a strategy complies with the law or meets
technical standards. Today, the standard by which we judge our
conduct is whether any action could in any way risk the
reputations of KPMG or our clients.'' \286\ KPMG also told the
Subcommittee that the firm ``recognizes that certain tax
strategies previously offered, and the manner in which they
were offered, were inconsistent with the role expected of a
professional organization to which public trust and confidence
is indispensable.'' \287\
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\286\ Prepared statement of Richard Smith, Jr., Vice Chair, Tax
Services, KPMG, Subcommittee Hearings (11/18/03).
\287\ Letter dated 5/10/04 from KPMG to the Subcommittee, at 2.
---------------------------------------------------------------------------
Dismantling its Tax Shelter Development, Marketing and
Sales Infrastructure. As part of KPMG's commitment not to
engage in tax services that ``could in any way risk the
reputations of KPMG or [its] clients,'' the firm announced a
number of changes in its Tax Practice. KPMG informed the
Subcommittee that it had refocused its tax services to
emphasize advice tailored to a client's specific facts and
circumstances, rather than continue mass marketing generic tax
products to multiple clients.\288\ KPMG also told the
Subcommittee that it no longer offers, implements, or endorses
aggressive strategies such as FLIP, OPIS, BLIPS, or SC2.\289\
---------------------------------------------------------------------------
\288\ See id., at 2. See also KPMG testimony at the Subcommittee
hearing: ``[W]e have shifted our approach from one focused on taking
solutions to clients to one that works with clients to address their
individual situations.'' Testimony of Jeffrey Eischeid at Subcommittee
Hearings (11/18/03).
\289\ See testimony of Jeffrey Eischeid, Subcommittee Hearings (11/
18/03) (``None of these strategies--nor anything like these
strategies--is currently being presented to clients by KPMG. . . .
Today, KPMG does not present any aggressive tax strategies specifically
designed to be sold to multiple clients, like FLIP, OPIS, BLIPS, and
SC2.'') KPMG also stated at the hearing: ``[T]he strategies presented
to our clients in the past were complex and technical, but were also
consistent with the laws in place at the time, which were also
extremely complicated.'' Id.
---------------------------------------------------------------------------
In addition, KPMG has indicated that it has dismantled much
of the development, marketing, and sales infrastructure it had
used to mass market its tax products to multiple clients. For
example, KPMG has eliminated the Tax Innovation Center, which
was responsible for coordinating the development and deployment
of new generic tax strategies. It has closed the telemarketing
center in Fort Wayne, Indiana, which KPMG had used to market
tax products through cold calls and sales appointments.\290\
KPMG also informed the Subcommittee that it was in the process
of ``disbanding our network of business development managers,''
although the current status of these employees is unclear.\291\
KPMG told the Subcommittee that it was also re-evaluating its
personnel requirements for market research and account
management.\292\ KPMG further announced that it had ``abolished
positions such as national deployment champions and area
deployment champions,'' which had been used to facilitate
nationwide sales of its tax products to multiple clients.\293\
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\290\ Letter dated 1/15/04, from Richard Smith, Jr., to the
Subcommittee, at 8. In apparent contradiction to its action closing its
own telemarketing center, KPMG disclosed that it had also contracted
with MarketSource Corporation to perform centralized business
development telemarketing for KPMG for the purpose of scheduling face-
to-face or conference call appointments between KPMG professionals and
prospective clients. Id. at 8-9. When asked about this telemarketing
contract, KPMG subsequently informed the Subcommittee that the firm had
also terminated all contracts with Marketsource for telemarketing
services. KPMG meeting with the Subcommittee (5/12/04).
\291\ Letter dated 5/10/04, from KPMG to the Subcommittee, at 2 and
5; KPMG meeting with the Subcommittee (5/12/04).
\292\ Letter dated 5/10/04, from KPMG to the Subcommittee, at 3.
\293\ Id., at 2.
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Dismantling of Stratecon and Innovative Strategies Practice
Groups. At the November 18, 2003, Subcommittee hearing, the
head of KPMG's Tax Practice testified that two of the key
practice groups responsible for the FLIP, OPIS, BLIPS, and SC2
tax products, known as Stratecon and Innovative Solutions, had
been disbanded. Under questioning by Senator Levin, the Tax
Practice head testified that both groups had been eliminated in
April 2002, when he first assumed his position as head of the
Practice. When asked at the hearing about KPMG's FY2003
organizational chart which listed Stratecon as a functioning
office and a November 2002 document listing tax products then
being sold by Stratecon, KPMG's Tax Practice head testified
that the documents reflect ``the fact that the systems that we
had had not yet been changed at the particular point in time
when this document was produced.''
In a letter dated January 15, 2004, to the Subcommittee,
KPMG clarified that the Stratecon and Innovative Strategies
practice groups had actually been disbanded over a period of
time, although the decision to terminate these groups had been
made in April 2002.\294\ In response to a request from the
Subcommittee for contemporaneous documentation, KPMG provided a
number of documents demonstrating the process undertaken to
dismantle the Stratecon practice group. KPMG also stated,
however, that it had ``not been able to locate any specific
documentation relating to the closure or the decision to close
Innovative Strategies.'' \295\
---------------------------------------------------------------------------
\294\ Letter dated 1/15/04, from Richard Smith, Jr., to the
Subcommittee, at 2.
\295\ Id. at 3.
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The absence of any Innovative Strategies documentation is
particularly troubling in light of a draft Innovative
Strategies Business Plan for 2002, which suggests that this
group was continuing to work on abusive tax shelters. The 2002
draft business plan stated, for example, that after the IRS
listed the BLIPS transaction as potentially abusive, KPMG had
made the business decision to stay out of the loss generator
business ``for an appropriate period of time.'' \296\
Nevertheless, Innovative Strategies reported that it had
continued to work on developing a new tax shelter product known
as POPS, in which ``[t]he last significant hurdle in
aggressively taking the solution to market [SIC] will likely be
obtaining a commitment from tax leadership to re-enter the
individual `loss-generator' business.'' \297\ In addition, the
draft business plan 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.''
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.
---------------------------------------------------------------------------
\296\ PFP Practice Reorganization (5/18/01), ``Innovative
Strategies Business Plan--DRAFT,'' Bates KPMG 0050620-23.
\297\ Id. As recently as last year KPMG seemed committed to
maintaining or expanding tax services. For example, KPMG had provided
the Subcommittee a 2003 list of more than 500 active tax products for
various tax practice groups, which were intended to be offered to
multiple clients for a fee.
---------------------------------------------------------------------------
On May 10, 2004, KPMG assured the Subcommittee that
Stratecon and Innovative Strategies had been disbanded, because
the firm ``realized that these practices were not consistent
with our commitment to upholding the trust placed in us by our
clients, or with meeting the responsibilities incumbent upon us
from our regulators and the public at large.'' \298\ KPMG
indicated that of the 13 partners and professionals assigned to
Innovative Strategies, five have left the firm, two had been
transferred to the Federal Tax practice and six had been
transferred to the Personal Financial Planning practice. KPMG
stated that of the approximately 115 Stratecon professionals,
57 partners and professionals had left the firm, and the
remaining 58 had been reassigned to other practice groups
within the firm. KPMG told the Subcommittee that the
individuals transferred from Stratecon and Innovative
Strategies to other KPMG practices were ``not involved with the
development or deployment of aggressive look-alike strategies
like FLIP, OPIS, BLIPS or SC2.'' \299\
---------------------------------------------------------------------------
\298\ Letter dated 5/10/04 from KPMG to the Subcommittee, at 3.
\299\ Id.
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Leadership Changes, Strengthening Oversight and Regulatory
Compliance. In addition to dismantling various practice groups
and tax development and marketing units, KPMG has reported
taking steps to strengthen oversight and regulatory compliance
within the firm. In May 2002, to strengthen the independence
and objectivity of its regulatory compliance functions, for
example, KPMG established a new senior position of Vice Chair
for Risk and Regulatory Matters. This senior officer is
authorized to report directly to the chief executive officer of
KPMG rather than to any business unit.\300\ Another change is
the establishment of a new position of a Partner in Charge of
Risk and Regulatory Matters for Tax. This position is supposed
to work independently of tax operations, report directly to the
Vice Chair for Risk and Regulatory Matters, and wield ultimate
authority to define the parameters for acceptable tax
services.\301\
---------------------------------------------------------------------------
\300\ Id.; KPMG meeting with the Subcommittee (5/12/04).
\301\ Letter dated 5/10/04 from KPMG to the Subcommittee, at 3.
---------------------------------------------------------------------------
In addition, KPMG announced that it had strengthened the
independence of its Department of Practice and Professionalism
for Tax (DPP), which provides final approval of new KPMG tax
products, helps draft KPMG tax analysis, helps determine which
tax products should be registered with the IRS, and can take
existing KPMG tax products off the market, among other tasks.
KPMG told the Subcommittee that the head of DPP now reports
directly to the Partner in Charge of Tax Risk and Regulatory
Matters rather than to the business leaders of the Tax
Practice.\302\ In light of the instances described in this
Report in which the KPMG Tax Practice head overruled or
pressured the DPP head on matters related to tax shelters, this
institutional change appears necessary and should help ensure
that tax issues raising questions of reputational risk or legal
or ethical concerns receive scrutiny from senior KPMG officers
outside of the Tax Practice.
---------------------------------------------------------------------------
\302\ Id.
---------------------------------------------------------------------------
In addition, KPMG told the Subcommittee that it has
instituted a more rigorous and formal procedure to review its
tax services, requiring three levels of approval. Approval is
required from the Partner in Charge of Risk and Regulatory
Matters for Tax, the Washington National Tax Practice, and the
Department of Professional Practice for Tax. If any of these
three withhold approval, the Partner in Charge of Risk and
Regulatory Matters for Tax and the DPP-Tax make the ultimate
joint determination on whether a proposed tax service is
acceptable.\303\ In another change, KPMG said that it was
requiring audit clients with tax services resulting in material
financial statement benefits to obtain a ``should'' level tax
opinion from a third party before KPMG would accept the
financial statement benefits.\304\
---------------------------------------------------------------------------
\303\ Letter dated 5/10/04 from KPMG to the Subcommittee, at 3-4.
\304\ Id., at 4.
---------------------------------------------------------------------------
KPMG also told the Subcommittee that it had instituted
firm-wide enhanced training programs to strengthen regulatory
compliance.\305\ KPMG reported that this effort included
intensive training on compliance with Treasury and IRS tax
shelter regulations, compliance with Treasury and SEC auditor
independence rules, and ethics matters. KPMG also indicated to
the Subcommittee that the firm had registered a tax transaction
with the IRS last year, which the Subcommittee understands is
the first time it has done so.\306\
---------------------------------------------------------------------------
\305\ Id.
\306\ KPMG meeting with the Subcommittee (5/12/04).
---------------------------------------------------------------------------
Tax Leadership Changes. On January 12, 2004, KPMG announced
changes in its tax leadership. Jeffrey Stein, Deputy Chair of
KPMG and former Vice Chair of Tax Services, was required to
retire at the end of January, 2004. Richard Smith, Jr., then
head of the Tax Services Practice, was removed from office and
assigned to other duties within the firm. Jeff Eischeid,
Partner in Charge of KPMG's Personal Financial Planning
Practice, was placed on administrative leave and later left the
firm.
KPMG indicated to the Subcommittee that these cultural,
structural, and leadership changes reflect a firm-wide
commitment to restoring KPMG's reputation for professional
excellence and integrity. The Subcommittee was told that the
mandate to attain the highest degree of professional trust from
the firm's clients, regulators, and the public at large came
directly from Eugene O'Kelly, KPMG's Chairman and Chief
Executive Officer. KPMG told the Subcommittee, ``we are
embarrassed, and we are committed to ensuring that the past
will never happen again.'' \307\
---------------------------------------------------------------------------
\307\ Id.
---------------------------------------------------------------------------
Current Legal Proceedings. KPMG continues to be the subject
of numerous legal proceedings related to its tax shelter
activities. In February 2004, the media reported that the U.S.
Attorney for the Southern District of New York had initiated a
Federal grand jury investigation of KPMG regarding its
participation in the sale of tax shelters to corporations and
wealthy individuals used to escape at least $1.4 billion in
Federal taxes.\308\ KPMG responded in a statement that ``it is
our understanding that the investigation is related to tax
strategies that are no longer offered by the firm.'' \309\ KPMG
also stated that ``KPMG has taken strong actions as part of our
ongoing consideration of the firm's tax practices and
procedures, including leadership changes announced last month
and numerous changes in our risk management and review
processes.'' \310\
---------------------------------------------------------------------------
\308\ See, e.g., David Cay Johnson, ``Grand Jury is Investigating
KPMG's Sale of Tax Shelters,'' New York Times, Feb. 20, 2004, at C5.
\309\ Id.
\310\ Id.
---------------------------------------------------------------------------
The IRS and Department of Justice are continuing to
investigate KPMG's compliance with Federal tax shelter laws and
regulations. At the Subcommittee hearing in 2003, IRS
Commissioner Mark Everson testified that:
As you have learned some organizations have decided to
turn away from the promotion of abusive tax shelters, have
reached agreements with the IRS, and are moving on. That is
good news. I believe it reflects a reassessment by these firms
and an improvement in their professional ethics. Others, such
as KPMG and Jenkins and Gilchrist, remain in litigation with
the IRS and have not yet complied with our legitimate documents
requests.\311\
---------------------------------------------------------------------------
\311\ See Testimony of Mark Everson, Commissioner, Internal Revenue
Service, Subcommittee Hearings (11/20/03). The law firm Jenkens &
Gilchrist allegedly collaborated with The Diversified Group to create
the COBRA tax shelter and allegedly participated in the sale of at
least 600 COBRA tax shelters, bringing the law firm substantial fees
for issuing legal opinions letters. Paul Braverman, Helter Shelter,
American Lawyer, December 2003, at 65-66.
As of the date of this report, KPMG remains in civil litigation
with the IRS and Department of Justice over its tax shelter
activities. In addition, KPMG remains the subject of civil
suits filed by a number of its former clients who claim that
KPMG improperly sold them illegal tax shelters.
B. ERNST & YOUNG
(1) Development of Mass-Marketed Generic Tax Products
Finding: During the period 1998 to 2002, Ernst & Young
sold generic tax products to multiple clients despite evidence
that some, such as CDS and COBRA, were potentially abusive or
illegal tax shelters.
Ernst & Young (hereinafter ``E&Y'') was created after the
1989 merger of the two firms Ernst & Ernst and Arthur Young &
Company.\312\ A global firm with 670 locations in 140 different
countries, E&Y currently employs about 100,000 individuals,
including 20,000 tax professionals worldwide. In 2002, it
reported over $10 billion in revenues. It is managed by a 6-
member Global Executive Board, and its current Chairman and
Chief Executive Officer is James S. Turley. The current head of
E&Y's global tax practice is Vice Chair for Tax Services, Mark
A. Weinberger.
---------------------------------------------------------------------------
\312\ General information about E&Y is taken from information
provided by E&Y in response to the Subcommittee's investigation and
from Internet websites maintained by E&Y.
---------------------------------------------------------------------------
E&Y is organized into nine geographic areas, including the
Americas Area which encompasses the United States. Like KPMG
and PwC, E&Y is one of the four largest accounting firms
operating in the United States, and provides both audit and tax
services to its clients. E&Y employs more than 23,000
individuals in the United States, including over 6,000 tax
professionals. The current Chair of the Americas Area is James
S. Turley.
E&Y participated in the U.S. tax shelter industry during
the periods relevant to the Subcommittee's investigation.
During that time, E&Y marketed a number of questionable tax
products to multiple clients, including products known as the
Contingent Deferred Swap (CDS), Currency Options Bring Reward
Alternatives (COBRA), SOAP, and PICANTE.\313\ E&Y marketed
these tax products through a group of five to seven tax
professionals initially called ``VIPER'' and later renamed the
``more benign'' and ``less sinister sounding'' Strategic
Individual Solutions Group (SISG).\314\
---------------------------------------------------------------------------
\313\ See, e.g., email dated 10/26/99, from Brian L. Vaughn of E&Y
to multiple E&Y tax professionals, Bates 2003EY011 (describing current
status of seven E&Y tax products, including CDS, COBRA, SOAP, and
PICANTE). For more information about COBRA, please see ``Tax Shelters:
Who's Buying, Who's Selling, and What's the Government Doing About
It?'' before the Senate Committee on Finance, S. Hrg. 108-371 (10/21/
03) (including prepared statement of Henry Camferdam).
\314\ See 1/17/00 email from Robert Coplan to numerous recipients
re: ``CDS Lives!,'' Bates 2003EY011613-14.
---------------------------------------------------------------------------
E&Y told the Subcommittee that the tax products it sold to
multiple clients generally were not developed in-house but
originated with an outside source. E&Y explained that it
examined each such tax product to ``determine whether it was
something that SISG would offer to its clients and, if it was,
would usually take steps to restructure the strategy to enhance
the likelihood that it would be sustained on the merits.''
\315\ E&Y also acknowledged that, during the years in question,
the SISG review and approval process for new tax products was
an ``ad hoc, decentralized, and informal process.'' \316\
---------------------------------------------------------------------------
\315\ Letter dated 5/3/04, from Ernst & Young to the Subcommittee,
at 1.
\316\ E&Y meeting with the Subcommittee (5/4/04).
---------------------------------------------------------------------------
The documents show that E&Y engaged in an aggressive effort
to develop and market generic tax products to multiple clients.
For example, an internal E&Y email from October 1999, recites
seven tax products then under development and closes with the
statement: ``As you can see, we have a great inventory of
ideas. Let's keep up the R&D to stay ahead of legislation and
IRS movements.'' \317\ An E&Y email from September 1999,
promises the imminent completion of a particular tax product
and states: ``We will have until 10/31 to market the strategy.
. . . Once we roll this product out, I will travel to each area
to help you present this strategy to your clients. . . . Let's
have fun with this new strategy and kick some KPMG, PWC and
AA???'' \318\ Still another E&Y email, from May 2000, sets a
nationwide sales goal for one of the firm's tax products,
asking its tax professionals to work to generate ``$1 billion
of loss.'' \319\
---------------------------------------------------------------------------
\317\ Email dated 10/26/99, from Brian L. Vaughn of E&Y to multiple
tax professionals, Bates 2003EY011.
\318\ Email dated 9/8/99, from Brian L. Vaughn of E&Y to multiple
E&Y tax professionals, ``Capital Loss/Ordinary Loss Technique,'' Bates
2003EY011349.
\319\ Email dated 5/10/00, from Brian L. Vaughn of E&Y to multiple
E&Y tax professionals, ``CDS Update,'' Bates 2003 EY022850 (This email
also states: ``With your help we can make this goal. As of today, I
have the following list of leads that have been given to me. Please
send me your leads and the amount of potential loss. I want to help
each of you obtain your own CDS goals. Please let me know how I can
help. Also, please provide me with updates to this list. Thanks and
good luck!!!'').
---------------------------------------------------------------------------
Contigent Deferred Swap. E&Y's Contingent Deferred Swap or
CDS was a particularly lucrative tax shelter for the firm and
illustrates the firm's flawed process for developing,
marketing, and implementing potentially abusive or illegal tax
shelters.
E&Y first learned of CDS when, in 1998, it was approached
by The Private Capital Management Group (TPCMG) which was then
handling CDS transactions for PricewaterhouseCoopers.\320\ The
tax shelter involved a transfer to a partnership that generates
a level of trading activity designed to enable the partnership
to achieve trading partnership status that, in turn, allegedly
allows swap payments and other first year expenses of the
partnership to be treated as ordinary losses that can offset
the client's ordinary income in that year.\321\ Upon
termination of the transaction the following year, the taxpayer
allegedly received the additional benefit of capital gains tax
treatment generated by termination of the swap.\322\
Essentially, CDS was a conversion strategy, converting ordinary
income to capital gains income, with the additional benefit of
deferral.
---------------------------------------------------------------------------
\320\ Subcommittee interview of Robert Coplan (5/4/04). The
Subcommittee was told that David Lippman-Smith of TPCMG made the
initial contact with Richard Shapiro of E&Y.
\321\ Email dated 9/15/99, from Robert Coplan to Robert Garner,
``Subject: VIPER PRODUCTS--IRS Representation, etc.,'' Bates
2003EY011387-88.
\322\ See email dated 6/4/00, from Robert Coplan to multiple
recipients, ``SISG Solution Update--CDS Add-On,'' Bates 2003EY011874-
75; Contigent Deferred Strategy Powerpoint Slide (indicating that the
$20 million swap payment offsets ordinary income in year paid and that
termination of the swap produces a $20 million capital gain tax benefit
in the following year).
---------------------------------------------------------------------------
E&Y enlisted a number of professional firms to help carry
out CDS transactions, including two investment firms TPCMG and
Bolton Capital Planning. TPCMG acted as the general partner in
each trading partnership involved in a CDS transaction and
directed the activities of each partnership through Bolton
Capital Planning.\323\ UBS was retained for the bank loans and
swap agreements. \324\ Locke, Liddell & Sapp provided clients
with a legal opinion indicating that, if challenged by the IRS,
CDS ``should'' be upheld in court.\325\
---------------------------------------------------------------------------
\323\ Email dated 1/14/00 from [email protected] to Melinda Merk,
``Subject: Re: Quick Question re: CDS,'' (describing that David Smith
``is the Managing Director of TPCMG (which of course is the general
partner of the partnership). TPCMG has an office in California. David
Smith is the only person in it. David directed the activities of the
trading partnership through BOLTON. Bolton is located in Memphis,
Tennessee.'') Bates 2003EY011612. In 2000, TPCMG ceased its activities
with the CDS transaction, and Bolton Capital Planning took over as the
general partner of the trading partnerships. Subcommittee interview of
Robert Coplan (5/4/04).
\324\ CDS was apparently approved by UBS's internal tax, legal, and
regulatory functions. However, the bank created some ``bottlenecks''
with executing transactions as each particular transaction was required
to be submitted to the bank's Chief Credit Officer, Marco Suter, to
determine whether any specific transaction gave rise to unacceptable
reputation risk for the bank. See email dated 9/28/99, names withheld,
``Subject: Re: Fwd: CDS trades for TPCMG,'' Bates 2003EY011416. In
2000, UBS ceased its activities with CDS. In 2000-2001, Bear Sterns and
Refco Bank participated as the counter-parties for the swaps and
provided the loans. Letter dated 5/3/04, from Ernst & Young to the
Subcommittee, at 6.
\325\ Email dated 2/29/00, from Robert Garner to Robert Coplan,
``Subject: VIPER Communication,'' Bates 2003EY011660-61.
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According to E&Y, in a typical CDS $20 million loss
transaction, E&Y would receive $250,000, Bolton Capital
Planning would receive $250,000, and Locke, Liddell & Sapp
would receive $50,000.\326\ In its CDS engagement letters, E&Y
expressed its fee as a flat dollar amount to avoid contingent
fee issues; however, internal documents show that this fee was,
in fact, calculated as 1.25% of the tax loss to be generated
through the CDS transaction.\327\ In fact, E&Y's sample CDS
engagement letter stated explicitly: ``Our fee for providing
the professional services referred to above will be $[Insert
amount at 1.25% of losses to be generated. If size of
transaction is not certain at the time this letter is signed,
add `based on your investing $ million in the Partnership'] and
it will be paid by the Partnership.'' \328\
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\326\ Id.
\327\ Email dated 9/15/99, from Robert Coplan to Robert Garner,
``Subject: VIPER PRODUCTS--IRS Representation, etc.,'' Bates
2003EY011387-88.
\328\ See Sample Engagement Letter, Bates 2003EY011138 (emphasis in
original).
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The Subcommittee investigation found that the internal
process used by E&Y to review and approve CDS was marked by
dissention and dissatisfaction within the firm. E&Y indicated
that SISG tax partners had conducted their own analysis of the
technical merits of the CDS transaction in 1999, after
consulting with other E&Y tax professionals and an outside law
firm, and determined that CDS met the requirements of Federal
tax law and could be sold by the firm.\329\ E&Y also
acknowledged, however, that the firm never issued an opinion
letter supporting the CDS tax product, either as one that
``should'' survive a legal challenge or as one that would
``more likely than not'' survive such a challenge. E&Y told the
Subcommittee that it never issued a CDS opinion letter because,
as a promoter of the product, E&Y was unable to provide a
letter upon which its clients could reasonably rely to protect
them from possible IRS penalties if CDS was challenged. E&Y
said that it had, instead, arranged for an outside law firm,
Lock, Liddell & Sapp, to provide clients with a CDS opinion
letter.\330\
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\329\ E&Y meeting with the Subcommittee (5/4/04). CDS was approved
for sale in 1999. Subsequently, in 2000, E&Y required new tax products
to undergo an independent review by firm tax professionals outside
SISG.
\330\ An email from Robert B. Coplan of E&Y to [email protected],
Bates 2003EY01139, states: ``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.''
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This explanation fails to acknowledge or disclose, however,
the divergence of opinion within the firm regarding CDS'
technical merits. Internal documents show that some E&Y tax
professionals outside of SISG raised serious concerns not only
about the tax product's technical validity, but also about the
firm's failure to disclose the risks associated with the
product when marketing CDS to clients. On September 8, 1999,
for example, one E&Y tax professional sent this email
complaining how the firm had presented CDS to one of her
clients:
It has come to my attention that our firm is not at the
``should'' level opinion with respect to this transaction. I
clearly was under the impression from your references with my
client that our firm, in particular, David Garlock, was behind
this transaction. You indicated that we were not issuing an
opinion because we would be considered a promoter--not because
we would not issue a ``should'' opinion. . . .
I left the meeting, as did Meloni Hallock, with the
impression that our firm, including David Garlock was at a
``should'' level of opinion on this transaction. It has come to
my attention that the above statement is not entirely true. In
fact, I think if you speak with David directly, as I have done,
he isn't even at ``more likely than not'' let alone ``should.''
. . . \331\
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\331\ Email exchange dated 9/8/99, between Mary Sigler of E&Y and
Brian Vaughn of SISG, ``Re: CDS Transaction,'' Bates 2003EY011351-52.
The SISG representative who had made the client presentation,
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responded:
David Garlock did review [Locke, Liddell & Sapp's]
opinion on our firm's behalf. David may disagree with [the law
firm's] level of comfort, but his opinion was never needed in
this situation. I represented to your client, our firm will not
issue an opinion because the client could not rely on the
opinion. This came from a discussion between Robert Coplan and
Ron Friedman. Our firm will be considered a promoter in their
view, and therefore, our clients cannot rely upon an EY
opinion. . . .\332\
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\332\ Id.
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The E&Y tax professional replied:
[D]on't you think if you were the client it would be an
important fact for you to know if E&Y could not get to a
``should'' level on this transaction? Don't you think that my
client went away with the impression that not only the law firm
was at a ``should'' level, but so must be E&Y since we said
nothing to the contrary? Care to take any bets? \333\
---------------------------------------------------------------------------
\333\ Id.
These emails demonstrate that at least two E&Y tax
professionals lacked confidence in the CDS product; one was
uncertain whether the product reached even a ``more likely than
not'' standard. While SISG claimed that the firm did not issue
an opinion supporting CDS because of its position as a promoter
of the product, that argument appears to be inconsistent with
E&Y's actions with respect to other tax products, such as SOAP
and PICANTE, in which E&Y acted as both promoter and a writer
of favorable opinion letters.\334\
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\334\ Interview with E&Y representative (5/4/04). While E&Y wrote
opinion letters supporting its SOAP and PICANTE tax products, it
apparently did not write opinion letters for its CDS or COBRA products.
According to E&Y, the firm issued opinions for SOAP and PICANTE because
these products were less likely to give rise to a challenge by the IRS.
However, E&Y told the Subcommittee that no investors who purchased a
SOAP or PICANTE tax product were told that E&Y would be considered a
promoter and therefore they could not rely on an E&Y opinion if
challenged by the IRS.
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Locke Liddell and Sapp LLP did, however, issue legal
opinions for CDS.\335\ According to one potential investor,
however, the law firm's opinion letter was deficient in many
respects. The client's legal advisor sent the following email
to E&Y criticizing the opinion's weak legal analysis:
---------------------------------------------------------------------------
\335\ See, e.g., letter dated 10/1/99, from Brent Clifton, Locke
Liddell & Sapp LLP, to Wolfgang Stolz, UBS, Bates 2003EY011434
(disclosing that the law firm had ``undertaken a review of the proposed
contingent deferred swap strategy (``CDS'') offered by the Private
Capital Management Group (``PCMG'') and is prepared to issue a tax
opinion in connection with each such transaction executed by a PCMG
partnership following our engagement by each such partnership and our
review of all relevant documentation.'').
I have reviewed the materials you provided to me and
from all indications, the transaction appears to be a classic
``sham'' tax shelter that would be successfully challenged on
audit by IRS. The transaction apparently has little, or any,
economic significance outside the tremendous tax breaks
promised to the investors and is apparently highly tax
motivated, as opposed to being a bona fide transaction that
people would invest in regardless of the tax breaks. The
concept of a packaged tax shelter sold to investors who need
specific tax breaks is under attack by the IRS and courts. My
understanding is that IRS has a huge project underway to ferret
out these types of tax shelters and will aggressively litigate
them (expect penalties to be asserted, in addition to taxes and
---------------------------------------------------------------------------
interest owed).
The opinion provided to me did not discuss the relevant
facts, as I understand them. There was little discussion of the
hedging within the transaction that will protect the investors
against risk of loss or the high level of tax motivation behind
the concept. The analysis of the downside to the transaction
was weak and often irrelevant. Apparently, there is a dubious
loan interest deduction for funds that will be parked in
Treasuries. I understand that a very small portion of the
investment will involve trading.
The largest problem with the structure and the opinion,
however, is that the partnership is not engaged in a trade or
business as a ``trader;'' but will have the status of an
investor. Trader status is critical to claim the deductions
discussed in the opinion. The opinion states that the general
partner will delegate the actual trading to a Fund Manager. The
opinion then wrongly states that the Fund Manager's activities
will be attributed to the partnership, thus making the
partnership a trader. The opinion relies on Adda v CM (10 TC
273), 1458, a 50-year-old case that has nothing to do with
trader vs. investor status.
The opinion fails to address the relevant case law,
which includes Mayer v CM, 94 USTC Para 50, 509 (1994), a case
when [SIC] expressly states that the trading activities of
others are not attributed to the taxpayer (citing the U.S.
Supreme Court case of Higgins, 312 US 214) in support of its
conclusion. Mayer unequivocally states that the taxpayer must
personally made [SIC] the trading decisions and cannot delegate
this task to others.
Based on what I have provided, my recommendation would
be not to invest in this transaction until the issues raised in
the email are satisfactorily addressed.\336\
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\336\ Email dated 9/7/99, forwarded to Patricia Klitzke, ``FW: CDS
Transaction at Risk,'' Bates 2003EY011345-50.
This September 1999 email provides additional evidence that
E&Y knew CDS had technical problems and could qualify as an
abusive tax shelter. Despite this knowledge, E&Y made the
decision to continue selling CDS in 1999 and 2000.
E&Y apparently marketed CDS aggressively. From 1999 until
2001, E&Y sold 70 CDS transactions involving 132 taxpayers,
obtaining fees of more than $27.8 millions.\337\ The SISG group
set an explicit goal in 2000, of using CDS to shelter $1
billion of losses.\338\ In April 2000, a key E&Y tax
professional in SISG reported: ``I just wanted to update you on
the success we are having with the CDS transaction in 2000.
With the new UDS/Yen model as an option, the sales activity has
drastically increased. . . . [W]e are well on our way to
meeting the $1 billion loss goal we set at the beginning of
this year.'' \339\ E&Y continued to market CDS and other tax
products at the same time the IRS increased its efforts to stop
abusive tax shelters.
---------------------------------------------------------------------------
\337\ Letter dated 5/3/04, from Ernst & Young to the Subcommittee,
at 8.
\338\ Email dated 5/10/00, from Brian Vaughn to multiple E&Y tax
professionals, ``CDS Update,'' Bates 2003EY011850-51.
\339\ Email dated 4/26/00, from Brian Vaughn of E&Y to Robert B.
Coplan of E&Y, ``CDS Update,'' Bates 2003EY011830.
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In early 2000, PricewaterhouseCoopers announced that,
because the IRS had listed one of its tax products, the Bond
and Options Sales Strategy (BOSS), as an abusive tax shelter,
it would refund all BOSS fees to its clients. When a potential
client asked whether E&Y would refund fees if the CDS
transaction was subsequently determined to be abusive, the firm
answered ``an unequivocal no.'' One E&Y tax professional wrote:
They are a client of mine . . . I suggested CDS (with
the option add-on) as an alternative. They would like to move
forward. However, there are two issues. One, the amount of
income they wish to offset is $10 to $12 million rather than
the $20 million. Second, against my advice they did the BOSS
transaction last year. . . . They got most of their money back
since PWC could not issue the opinion. They want a similar
[deal] right here. If the opinion can't be issued because of a
change in the law they get a refund of the fee (or most of it,
e.g. trading costs would not be refunded).\340\
---------------------------------------------------------------------------
\340\ Email dated 7/18/00, from Robert Coplan, ``Re: family-
potential CDS deal,'' Bates 2003EY011938-39.
---------------------------------------------------------------------------
In response, the SISG head wrote:
Finally, on the big issue of promising to give back the
fee or some part of it if the deal doesn't work, the answer is
an unequivocal no. We are not able to do that, and I doubt PWC
had that built into their engagement letter. WE have a dispute
resolution procedure in our engagement letters that protects
the client if he doesn't receive the value he has paid for.
Obviously, a big 5 firm would not retain a fee if the client
was never put in a position to obtain the tax benefits on the
transaction. But that doesn't mean we could insert such a
provision up front that would clearly make our fee contingent
on the tax outcome of the transaction. That is nonnegotiable.
We have been down this road many times before.\341\
---------------------------------------------------------------------------
\341\ Id.
It is ironic that E&Y rejected a client's request for a
refundable fee, in part, because it would be a non-permissible
contingent fee dependent upon ``the tax outcome of the
transaction,'' when, at the same time it was charging clients a
CDS fee equal to a percentage of the client's expected tax
loss.\342\
---------------------------------------------------------------------------
\342\ E&Y contended to the Subcommittee that its CDS fee was not
dependent on the actual tax benefits received by the client and, thus,
was not a contingent fee.
---------------------------------------------------------------------------
In late 2000, CDS itself began attracting IRS attention,
but even IRS inquiries did not deter E&Y from continuing to
market the tax product to new clients. Bolton Capital Planning,
the investment firm involved in carrying out CDS transactions,
for example, informed E&Y that it had received an IRS letter
inquiring about CDS. An SISG tax professional responded in an
email to his supervisor as follows:
With regard to CDS, we all knew one day we would receive
a letter. We told our clients to expect the letter. What we
don't know at this point is whether the IRS will pursue an IRS
exam of the strategy. You ask me this afternoon would I buy the
strategy assuming the IRS was aware of the trade. The answer is
definitely ``YES.'' Remember, the IRS knew about COBRA, but our
clients still made the purchase. In fact, the clients continued
to buy the ``add-on'' trade even though we knew the IRS was
extremely familiar with the issues. If the IRS pursues and
audit and we successfully defend the strategy, then why
wouldn't our clients want to buy the trade. It would be
premature at this point to assume our clients would not buy a
strategy that the IRS has knowledge of. Why don't we let the
clients decide? Therefore, I would like to propose that CDS is
not ``stopped'' at this point. Brian Upchurch and I have a
client that is considering CDS and I would be happy to let him
know that the IRS has issued a notice to Bolton requesting
information on the trade. My belief is he would say ``so
what.''
That is my two cents worth. As I told you, I am a
fighter. I don't enjoy giving up before I get my chance to
fight. Remember our opinion on CDS is a should. Let them bring
their guns!!!! I believe they will turn their tales and run the
other direction. CDS has economic substance and has the best
promoter in the business associated with the trade. I think we
owe it to Belle and ourselves not to give up and stop the sales
process at this point. Let the clients decide.\343\
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\343\ Email dated 12/12/00, from Brian Vaughn to Robert Coplan,
``Subject: New LLC strategy,'' Bates 2003EY012125.
E&Y ultimately decided to continue selling CDS in 2001,
with some revisions designed so that the ``transaction would
not have to be registered with the IRS.'' \344\ In fact, E&Y
never registered CDS with the IRS at any time during the 3
years it sold the product. Instead, according to E&Y, it had an
oral arrangement with TPCMG in 1999, and with Bolton Capital
Planning in 2000, that the general partner of the CDS
partnerships was responsible for registering specific CDS
transactions with the IRS.
---------------------------------------------------------------------------
\344\ Email dated 1/5/01, from Robert Coplan to Quickstrike Team,
``Subject: SISG Update, 1/8 Conference Call,'' Bates 2003EY012139-41.
---------------------------------------------------------------------------
In May 2002, the IRS listed the CDS transaction.\345\ In
March 2002 and June 2003, the IRS commenced two different
investigations of E&Y's tax shelter activities occurring
between January 1, 1995 and June 30, 2003. These investigations
looked not only at CDS, but a variety of other tax products,
including COBRA, SOAP, and PICANTE. On July 2, 2003, E&Y
settled with the IRS. Along with a $15 million settlement
payment, E&Y was required to institute systemic reforms of its
tax strategies practice.
---------------------------------------------------------------------------
\345\ Ernst & Young's CDS transaction is covered by IRS Notice
2002-35 (2002-21 IRB 992) (5/28/02).
---------------------------------------------------------------------------
At the time of the E&Y settlement, IRS Commissioner Mark
Everson commented:
This represents a real breakthrough and is a good
working model for agreements with practitioners. . . . [W]e are
trying to differentiate between those who cooperate with the
IRS, who try to remedy past mistakes and who seek transparency
in their dealings with the Service, and those others who simply
refuse and continue to peddle abusive transactions. Our
intention is to differ in our approach to them based on their
behavior.\346\
---------------------------------------------------------------------------
\346\ See Discussion of the Ernst & Young Agreement with the
Internal Revenue Service.
At the November 18, 2003 Subcommittee hearing, Mark
Weinberger, Vice Chair Tax Services, Ernst & Young, testified
that the firm has ``taken, and are taking, numerous steps to
ensure that quality and professionalism are touchstones for
everything that we do.'' \347\
---------------------------------------------------------------------------
\347\ Testimony at Subcommittee Hearings (11/18/03).
---------------------------------------------------------------------------
(2) Ernst & Young's Current Status
Finding: Ernst & Young has committed to cultural,
structural, and institutional changes to dismantle its tax
shelter practice, including by eliminating the tax practice
group that promoted its tax shelter sales, making leadership
changes, and strengthening its tax oversight and regulatory
compliance.
E&Y, along with their settlement with the IRS, committed to
a number of cultural, structural, and institutional changes to
dismantle its tax shelter practice, including by eliminating
the tax practice group that promoted its tax shelter sales,
establishing a new tax product review and approval process, and
strengthening its tax services oversight and regulatory
compliance. As a first step, E&Y disbanded the VIPER/SISG group
that had taken the lead within the firm in selling CDS, COBRA,
and other tax products to multiple clients.
New IRS Registration and Compliance Monitoring Procedures.
E&Y, as part of their settlement with the IRS, proposed the
development and implementation of a Quality and Integrity
Program (QIP) to strengthen its compliance with specific
Federal requirements for tax shelter registration, client list
maintenance, and disclosure of reportable transactions. This
program, which E&Y said became operational on October 1, 2003,
is staffed by four E&Y personnel who provide centralized
national oversight to ensure compliance by E&Y tax
professionals with compliance with Federal tax shelter
regulations.\348\
---------------------------------------------------------------------------
\348\ Subcommittee meeting with Ernst & Young (5/4/04).
---------------------------------------------------------------------------
E&Y told the Subcommittee that the QIP process requires
that any tax transaction resulting in a fee in excess of
$10,000 be recorded in a centralized database, so that the firm
is aware of and can track all such transactions. The QIP
database is also tied to the firm's financial system so that,
for example, if a client billing is in excess of $10,000 and
does not have a corresponding QIP record, E&Y is able to
identify this discrepancy and correct it. E&Y said that, for
all transactions generating fees of $100,000 or more, QIP
requires a tax shelter registration analysis. A QIP review
board performs this registration analysis and, in cases where
the review board cannot reach agreement on the firm's
obligations, solicits guidance from the IRS.\349\
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\349\ Subcommittee meeting with Ernst & Young (5/4/04). According
to E&Y, the firm recently solicited guidance from the IRS with respect
to a transaction where the QIP review board was unable to determine if
a potential transaction triggered registration requirements.
---------------------------------------------------------------------------
As part of the QIP implementation, 3,100 tax professionals
were required to participate in a comprehensive review of the
requirements related to registration and list maintenance as
well as training on the QIP process. \350\ E&Y requires annual
certification of compliance with QIP by all partners,
principals, senior managers, and tax compliance engagement
managers.\351\
---------------------------------------------------------------------------
\350\ These tax professionals consist of partners, principals, and
senior managers, whose responsibilities include the engagement of
clients for tax services.
\351\ Letter dated 5/3/04, from Ernst & Young to the Subcommittee,
at 5.
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Institutional Changes. Aside from the settlement, Ernst &
Young has instituted firm-wide policies and actions to improve
E&Y professionalism. For example, E&Y established the position
of Americas Vice Chair of Quality and Risk Management, charged
with enhancing quality and compliance across all E&Y product
lines in the United States, including tax services. The current
Vice-Chair, Susan Friedman who, with a twenty person staff,
reports directly to the E&Y Chairman.\352\
---------------------------------------------------------------------------
\352\ Id., at 1.
---------------------------------------------------------------------------
E&Y also established a new position, Americas Director for
Tax Quality, charged with ensuring that all new tax products
sold by E&Y in the United States meet high standards for
professionalism and do not run afoul of Federal tax shelter
prohibitions.\353\ To correct problems identified with E&Y's
past procedures for approving new tax products, which E&Y told
the Subcommittee had been ad hoc, decentralized, and informal,
this new position was created to ensure a centralized review
processes and high standards.\354\ E&Y told the Subcommittee
that, to assist in this effort, the Director for Tax Quality
had recently created Tax Technical Review Committees for each
of E&Y's tax product functional areas, such as International
Tax, Partnerships, and Mergers and Acquisitions. E&Y explained
that these committees were charged with reviewing and approving
technical tax issues in their areas of expertise.\355\ In cases
where a Tax Technical Review Committee cannot reach consensus
on a product or issue, E&Y said that the committee is required
to notify the Director for Tax Quality to resolve the matter at
issue. The current Americas Director for Tax Quality is Joseph
Knott who reports directly to both the Vice Chair of Tax
Services and the Vice Chair of Quality and Risk
Management.\356\
---------------------------------------------------------------------------
\353\ Id.
\354\ Subcommittee meeting with Ernst & Young (5/4/04).
\355\ Letter dated 5/3/04, from Ernst & Young to the Subcommittee,
at 8-9.
\356\ Subcommittee meeting with Ernst & Young (5/4/04).
---------------------------------------------------------------------------
In addition, in 2003, E&Y established a senior advisory Tax
Review Board, whose members include senior executives from
outside the firm's Tax Practice to review the firm's tax
policies and procedures for current or proposed services and
products. The Tax Review Board is supposed to conduct an annual
review of all E&Y tax practice offerings in conjunction with
the firm's tax leadership; it may also discuss any matter
warranting review on an interim basis. The Board is advisory to
the Americas Vice Chair of Tax Services.\357\
---------------------------------------------------------------------------
\357\ Letter dated 5/3/04, from Ernst & Young to the Subcommittee,
at 1, 8.
---------------------------------------------------------------------------
Still another step taken by E&Y is the establishment of a
Tax Quality Review program to review compliance by individual
E&Y tax professionals with firm policies. E&Y told the
Subcommittee that this review is supposed to be supervised by
its National Tax Quality and Standards Group and that the
review itself is to be performed by tax professionals from a
practice unit other than the one of the individual being
reviewed.\358\ E&Y indicated that every E&Y tax partner,
principal, and senior manager providing tax advice will be
reviewed at least once every 3 years by this program, separate
and apart from E&Y's annual performance evaluation process.
---------------------------------------------------------------------------
\358\ Letter dated 5/3/04, from Ernst & Young to the Subcommittee,
at 8-9.
---------------------------------------------------------------------------
E&Y indicated to the Subcommittee that all of E&Y's
cultural, structural, and institutional changes reflect a firm-
wide commitment to quality and professionalism with the
``mandate coming directly from James S. Turley, Chairman and
Chief Executive Officer.'' \359\ E&Y communicated that these
changes are part of an on-going process designed to ensure the
highest professional standards.\360\
---------------------------------------------------------------------------
\359\ Subcommittee meeting with Ernst & Young (5/4/04).
\360\ Id.
---------------------------------------------------------------------------
Current Legal Proceedings. Although E&Y has settled with
the IRS with respect to its tax shelter registration and client
list maintenance obligations, it remains the subject of other
litigation over its tax shelter activities. In May 2004, the
U.S. Attorney for the Southern District of New York apparently
initiated a Federal grand jury investigation of E&Y regarding
its sale of tax shelters to corporations and wealthy
individuals to escape or reduce Federal taxes. That criminal
inquiry is on-going. In addition, several former E&Y clients
have sued the firm for improperly selling them illegal tax
shelters.\361\
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\361\ See, e.g., Camferdam v. Ernst & Young, (USDC SDNY) Case No.
02 Civ. 10100 (BSJ) (alleging breach of fiduciary duty, fraud,
negligence, and other misconduct by E&Y for selling COBRA to the
plaintiff).
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C. PRICEWATERHOUSECOOPERS
(1) Mass-Marketed Generic Tax Products
Finding: During the period 1997 to 1999,
PricewaterhouseCoopers sold general tax products to multiple
clients, despite evidence that some, such as FLIP, CDS, and
BOSS, were abusive or potentially illegal tax shelters.
PricewaterhouseCoopers International Ltd., was created in
1998 from the merger of two firms, Pricewaterhouse and Coopers
& Lybrand.\362\ PricewaterhouseCoopers International Ltd.
encompasses an international network of member firms using the
PricewaterhouseCoopers name. It operates in over 140 countries
with more than 750 offices worldwide. As of June 2004, it
employed more than 120,000 individuals and reported global net
revenues totaling about $16.3 billion. The company is managed
by a 19-member ``Global Board.'' The current chief executive
officer of PricewaterhouseCoopers International Ltd. is Samuel
A. DiPiazza, Jr., who is based in New York.
---------------------------------------------------------------------------
\362\ General information about PwC is drawn from documents
produced to the Subcommittee and Internet websites maintained by PwC.
---------------------------------------------------------------------------
PricewaterhouseCoopers LLP (hereinafter ``PwC'') is a U.S.
limited liability partnerhip and a member of
PricewaterhouseCoopers International Ltd. Like KPMG and Ernst
&Young, PwC is one of the four largest accounting firms
operating in the United States, and provides both audit and tax
services to its clients. PwC is managed by a U.S. Executive
Board. The current Chairman and Senior Partner heading PwC's
U.S. operations is Dennis M. Nally. The current head of PwC's
U.S. Tax Practice is Richard J. Berry who oversees more than
6,500 tax professionals.
PwC participated in the U.S. tax shelter industry during
the period relevant to the Subcommittee's investigation. With
respect to generic tax products marketed to multiple clients,
PwC was involved in selling its version of the Foreign
Leveraged Investment Program (FLIP), Contingent Deferred Swap
(CDS), and the Bond and Options Sales Strategy (BOSS). PwC sold
about 50 FLIP transactions to clients in 1997 and 1998, sold 26
CDS transactions in 1998 and 1999, and was in the process of
selling about 120 BOSS transactions in 1999, when the firm
halted product sales and later refunded all BOSS fees.\363\
Each of these tax products has been identified by the IRS as an
abusive tax shelter.\364\
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\363\ PwC prepared statement for Subcommittee Hearings (11/18/03).
\364\ FLIP is covered by IRS Notice 2001-45 (2001-33 IRB 129). CDS
transaction is covered by IRS Notice 2002-35 (2002-21 IRB 992) (5/28/
02). BOSS is covered by IRS Notice 1999-59 (1999-52 IRB 761).
---------------------------------------------------------------------------
PwC told the Subcommittee:
In the 1990's there was increasing pressure in the
marketplace for firms to develop aggressive tax shelters that
could be marketed to large numbers of taxpayers. This had not
been a traditional part of our tax practice, but regrettably
our firm became involved in three types of these
transactions.--Although the total number of transactions that
were done was limited to 76 over a 3-year period, we
acknowledge that we should not have done any. Since late 1999,
we have taken strong action to prevent our involvement in
transactions like these again.\365\
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\365\ PwC prepared statement for Subcommittee Hearings (11/18/03).
Review and Approval Process in General. According to PwC,
the firm's development and sale of abusive tax products such as
FLIP, CDS, and BOSS occurred due to a lack of a centralized
review process with proper authority, accountability, and
oversight.\366\
---------------------------------------------------------------------------
\366\ Subcommittee meeting with PricewaterhouseCoopers (5/27/04).
---------------------------------------------------------------------------
PwC told the Subcommittee, that during the 1997-1999 time
frame, its review and approval process for new tax ideas,
including FLIP, CDS, and BOSS, occurred on a decentralized and
ad hoc basis.\367\ PwC indicated that, at that time, to analyze
and develop a new tax product, individual business units within
the firm typically established an internal, ad hoc review
committee whose members were typically senior tax partners
selected by the tax partners advocating the new tax idea.\368\
PwC explained that this committee then conducted a technical
review of the proposed tax product to determine whether it
complied with Federal tax law, but did not consider such
factors as reputational risk or ethics considerations.\369\ PwC
indicated that it now recognizes that this process lacked
independence from the business unit which stood to profit if
the product was approved.
---------------------------------------------------------------------------
\367\ Id.
\368\ Id.
\369\ Id.
---------------------------------------------------------------------------
PwC explained that the review committee was supposed to
reach a consensus on whether ``it was more likely than not''
that the proposed tax idea would be upheld in court, if
challenged by the IRS. PwC explained further, however, that
individual committee members were not required personally to
determine that the tax product met the requirements of the law;
the standard was whether each member could reasonably see that
others could reach a ``more likely than not'' conclusion on the
technical merits.\370\ PwC told the Subcommittee that once a
review committee approved a new tax product, the individual
business unit that established the committee was then free to
market it, without obtaining the approval of any other PwC
authority, including PwC's tax leadership or senior PwC
partners outside of the tax practice.
---------------------------------------------------------------------------
\370\ Id.
---------------------------------------------------------------------------
PwC told the Subcommittee that the review committee
typically did not consider any issues related to the firm's
compliance with the IRS tax shelter registration or client list
maintenance obligations and that, during the 1997-1999 period,
these issues had, at times, received little or no attention in
connection with the approval of a new tax product.\371\ PwC
explained that while it had assigned these issues to its
Practice and Procedures group, that group was focused primarily
on handling audit controversies, obtaining private letter
rulings from the IRS, and assisting clients resolve accounting
issues.\372\ PwC also indicated that the Practice and
Procedures group had been subject to little oversight, and the
firm then lacked a centralized process for reviewing decisions
regarding its tax shelter registration and list maintenance
obligations.\373\
---------------------------------------------------------------------------
\371\ Id.
\372\ Id.
\373\ Id.
---------------------------------------------------------------------------
Developing, Marketing, and Implementing FLIP. PwC's
handling of the FLIP tax product demonstrates the firm's flawed
process for developing, marketing, and implementing potentially
abusive or illegal tax shelters.
FLIP, which was first developed by KPMG, apparently
migrated to PwC after a KPMG tax partner familiar with the tax
product took a position with one of PwC's predecessor firms,
Coopers & Lybrand. The Subcommittee was told that, in 1997,
Michael Schwartz, a former KPMG tax partner and member of the
KPMG development team for FLIP, \374\ was hired by Coopers &
Lybrand as an international tax partner to run the Foreign Bank
Group.\375\ The Subcommittee was told that, after the merger
between Coopers & Lybrand and Pricewaterhouse in 1998, Mr.
Schwartz worked in the resulting firm's Finance and Treasury
Group.\376\
---------------------------------------------------------------------------
\374\ Subcommittee interview of John Larson (10/3/03).
\375\ Subcommittee interview of Michael Schwartz (5/26/04).
\376\ Id.
---------------------------------------------------------------------------
PwC told the Subcommittee that Mr. Schwartz introduced the
FLIP product to various partners at the firm and was
responsible for presenting the tax product to potential
clients.\377\ By 1998, the Personal Financial Services group
within PwC had assumed the lead in marketing FLIP to potential
clients and implementing FLIP transactions.\378\ PwC told the
Subcommittee, that, altogether, in 1997 and 1998, led by Mr.
Schwartz, Coopers & Lybrand participated in 12 FLIP
transactions and PwC participated in 38, for a total of
50.\379\
---------------------------------------------------------------------------
\377\ Id. While Mr. Schwartz introduced partners to FLIP at Coopers
& Lybrand and later PwC, these activities were apparently in addition
to his primary duties serving clients within the Foreign Bank and
Finance and Treasury Groups. Id.
\378\ Id. The Subcommittee was told that, from 1998 to 1999, PwC
assigned additional staff, three managers and a tax partner, to assist
Mr. Schwartz in explaining generic tax products to potential clients.
Id.
\379\ Prepared statement of Richard J. Berry, Senior Tax Partner,
PricewaterhouseCoopers LLP during Subcommittee Hearings (11/18/03).
---------------------------------------------------------------------------
Like KPMG, PwC enlisted other professional firms in its tax
shelter activities. For example, in addition to identifying
potential FLIP clients on its own, PwC entered a client
referral arrangement with First Union National Bank, which
later merged with Wachovia National Bank. Under this
arrangement, First Union agreed to refer its banking customers
to PwC for a FLIP presentation. PwC also had an informal
agreement with an investment firm called Quadra Investments,
later renamed the Quellos Group, to carry out the complex
financial transactions called for by the FLIP transaction.
Quellos helped set up the offshore partnerships required by
FLIP, for example, and also worked with various banks to
arrange millions of dollars in required financing. Quellos
performed similar services for KPMG.
Among other actions to ensure the smooth implementation of
FLIP transactions, PwC issued opinion letters to its clients,
stating that it was ``more likely than not'' that FLIP would be
upheld, if challenged by the IRS.\380\ PwC apparently continued
to issue these favorable opinion letters even after learning
that the FLIP transactions was the subject of Federal
legislation. As PwC explained in a letter to First Union:
---------------------------------------------------------------------------
\380\ Letter dated 2/17/99 from Michael Schwartz, PwC, to Diane
Stanford, Senior Vice President, First Union National Bank, Bates SEN-
014602.
We have determined with the help of our Washington
National Office that the effective date [of the proposed
legislation barring FLIP transactions] should occur well after
any transactions currently contemplated have been completed. As
well we have taken precautions that will allow us to accelerate
the completion should we learn that the effective date could
occur in advance of our expectations. . . . I can guarantee
that we will be able to write an opinion letter for any of your
clients that engage in this transaction. . . .\381\
---------------------------------------------------------------------------
\381\ Id.
Similar to KPMG and other promoters, PwC failed to register
FLIP with the IRS as a tax shelter. The Subcommittee was told
that, instead, PwC advised Quellos Group to register the tax
shelter with the IRS.\382\ The 1998 and 1999 FLIP transactions,
based upon the advice of PwC, were registered with the
IRS.\383\ At the same time, however, Quellos failed to register
KPMG's FLIP transaction, even though the transactions were
substantially the same, because, according to Quellos, KPMG had
advised it not to register the product. Under questioning by
Subcommittee Chairman Coleman at the November 20, 2003 hearing,
the Quellos Chief Executive Officer testified that his firm had
asked KPMG about registering FLIP and KPMG's response was that
``[w]e have done our analysis and it is our opinion that it
does not need to be registered.'' \384\ The end result was that
two substantially similar tax products, both called FLIP,
received different registration treatment by Quellos, based
upon differing advice provided by the two accounting firms
using Quellos to help implement the FLIP transactions. In
addition, neither accounting firm ever completed its own
registration of FLIP, despite, in the case of PwC, advising
another party to do so.
---------------------------------------------------------------------------
\382\ Subcommittee interview of Quellos representative (11/7/03).
\383\ Letter dated 5/10/04, from PricewaterhouseCoopers to the
Subcommittee, at 2.
\384\ Quellos testimony at Subcommittee Hearings (11/20/03).
---------------------------------------------------------------------------
Developing, Marketing, and Implementing BOSS. The Bond and
Options Sales Strategy or BOSS tax product provides a second
illustration of PwC's flawed process for developing, marketing,
and implementing potentially abusive or illegal tax shelters.
The BOSS transaction was a so-called ``loss generator''
intended to produce either capital or ordinary income losses at
the end of a 2-year transaction which a client could then use
to offset other income and shelter it from taxation.\385\ It
required a series of complex financial transactions to be
undertaken in certain ways and at certain times to generate the
promised tax losses.\386\
---------------------------------------------------------------------------
\385\ See ``An Overview of the Bond & Option Sales Strategy
(`Boss'),'' Bates SEN-016966-7.
\386\ Suppose, for example, that a client's target income to be
sheltered was $10 million. The BOSS transaction required the client to
invest $850,000 from personal funds and obtain a $10 million recourse
loan from a cooperating bank. The client would then use these funds to
purchase common shares of a newly created offshore entity, referred to
here as Newco. A cooperating investment firm would then purchase
preferred shares of Newco for $10.9 million. At the same time, Newco
would borrow $10 million from the bank. Newco would then use its $31
million in capital ($10 million from the clients, $10.9 million from
the investment firm, and $10 million from the bank) to invest in two
portfolios consisting of secure investments, such as 2-year money
market obligations from the cooperating bank. Newco would also enter
into two financial transactions known as ``swaps'' involving the $10.25
million and $21.1 million portfolios. In the end, only $450,000 out of
the $30 million would be actually invested into a hedge fund with a
chance to earn profits. All $450,000 would be taken from the personal
funds contributed by the client, while the remaining $450,000
contributed by the client would be spent on fees paid to PwC, the bank,
and the investment firm. At the conclusion of 2 years, Newco would
distribute its $10.25 million portfolio to the client subject to the
bank loan. The client would claim a $10 million capital loss upon the
sale of his investment in Newco, while the client's loan of $10 million
would ultimately be paid by Newco's portfolio of secure investments.
---------------------------------------------------------------------------
Like KPMG's BLIPS transaction, the BOSS transaction
appeared to involve millions of dollars in at-risk investments
when, in fact, the vast majority of funds used in the
transaction were held in secure investments that posed little
or no risk to the participating client, investment firm, or
bank, while allegedly yielding multi-million dollar paper
losses. The transaction typically required an out-of-pocket
cash investment by the client equal to 8.5% of the target
income to be sheltered or tax loss to be achieved. About half
of that amount was used to pay fees to PwC; the investment
advisor known as The Private Capital Management Group; the
investment manager of the hedge fund trading account for the
transaction, Bolton Asset Management; and Refco Bank which
provided financing.\387\ While the transaction also required
the client to take out a large bank loan equal to the target
income to be sheltered, the transaction was structured so that
``all debt can be repaid without the advance by [client] of
additional personal funds.'' \388\ In short, the BOSS
transaction was structured to allow the client to claim
millions of dollars in tax losses, while limiting the actual
funds at risk to the initial 8.5% cash contribution minus
fees.\389\
---------------------------------------------------------------------------
\387\ ``Capital BOSS attributes,'' Bates SEN-016968. The evidence
indicates that the typical BOSS fees for a $10 million capital loss
transaction were as follows: PricewaterhouseCoopers--$150,000; The
Private Capital Management Group--$150,000; Bolton Asset Management--a
performance based fee; and Refco Bank--$100,000.
\388\ ``Capital BOSS attributes,'' Bates SEN-016968.
\389\ Id.
---------------------------------------------------------------------------
Like the FLIP shelter, PwC used First Union to obtain
referrals and access to the bank's clients. In April 1999,
senior PwC tax professionals presented the BOSS tax product to
First Union's Financial Advisory Services Due Diligence
Committee. The meeting minutes attest that both First Union and
PwC understood that ``[t]his strategy will be a tax shelter due
to the high level of leverage.'' \390\ First Union ultimately
referred 25 investors to PwC for BOSS presentations.\391\
---------------------------------------------------------------------------
\390\ Minutes dated 4/22-23/99, of a meeting of First Union's
Financial Advisory Services, Enhanced Investment Strategies, Risk
Management Process/Due Diligence Committee, (``Basis Offset Strip
Strategy (`BOSS') strategy minimizes ordinary income and/or capital
gains. . . . The strategy will be in place by July to give as much time
as possible between the steps of the strategy. This strategy will be a
tax shelter due to the high level of leverage.''), Bates SEN-014588-89.
\391\ Letter dated 5/10/04 from PricewaterhouseCoopers to the
Subcommittee, at 1.
---------------------------------------------------------------------------
In 1999, PwC was in the process of selling 120 BOSS
transactions in exchange for substantial fees.\392\ The
evidence suggests that, at the time of these sales, PwC knew
that this shelter was highly questionable. For example, a
critical issues outline for BOSS indicates that ``there exists
no statutory or regulatory authority under Section 301 that
illustrates a `reduction for liabilities' '' as assumed by the
tax product.\393\ The document also shows PwC was aware of
legislative efforts to bar further use of the BOSS tax product.
It notes ``efforts underway in Congress to clarify the
definition of `subject to a liability' as opposed to
`assumption of a liability' '' which would have caused problems
for BOSS, although ``PWC views the current strategy--as being
outside the scope of legislation being proposed.'' \394\
Despite the lack of statutory provisions supporting key
elements of the BOSS strategy and pending legislative concerns,
PwC continued to sell BOSS to its clients.
---------------------------------------------------------------------------
\392\ Prepared statement of Richard J. Berry, Senior Tax Partner,
PricewaterhouseCoopers LLP, Subcommittee Hearing (11/18/03).
\393\ BOSS--Basis Offset Strip Strategy, Critical Issues, May,
1999, Bates SEN-014599-600.
\394\ Id.
---------------------------------------------------------------------------
In December 1999, prior to any legislative change, the IRS
issued Notice 1999-59 identifying the BOSS transaction as an
abusive tax shelter.\395\ For many customers, the ``lynchpin of
the BOSS strategy was the issuance of a PwC opinion, reflecting
PwC's interpretation, on which customers could rely.'' \396\
PwC also declared in a prepared statement issued at the time of
the IRS notice that it was providing ``advice to our clients
with regard to legitimate tax-saving opportunities.'' \397\
However, after IRS Notice 1999-59 was published, PwC apparently
declined to issue new opinion letters for BOSS.\398\
---------------------------------------------------------------------------
\395\ PricewaterhouseCooper's BOSS transaction is covered by IRS
Notice 1999-59 (1999-52 IRB 761).
\396\ Letter dated 9/28/00 from Donald McMullen, First Union Vice
Chairman, Capital Management Group to James Schiro, Chief Executive
Officer, PricewaterhouseCoopers, Bates SEN-016757-58.
\397\ See John D. McKinnon, ``IRS Moves to Disallow a Tax Shelter
That Generates Paper Investment Losses,'' Wall Street Journal, December
10, 1999 at A6.
\398\ Id.
---------------------------------------------------------------------------
Moreover, in early 2000, unlike other tax shelter
promoters, PwC decided to refund clients approximately 85% of
the cash they had invested in the BOSS transaction. That
amount, according to PwC, included all fees paid by the client
to PwC in connection with the BOSS transaction.\399\
---------------------------------------------------------------------------
\399\ Letter dated 1/5/00, from PricewaterhouseCoopers to Dear
Investor, ``Re: Bond & Option Sales Strategy Investment,'' Bates SEN-
020060.
---------------------------------------------------------------------------
According to PwC, its negative experience with the BOSS tax
product convinced the firm to abandon its abusive tax shelter
activities. A senior PwC Tax Partner testified at the
Subcommittee hearing as follows:
The BOSS transaction triggered widespread public
attention and controversy in the fall of 1999. As a result, we
decided that we had made a regrettable mistake being in this
business. Our reputation was hurt, our clients and people were
embarrassed. . . .
We got out of this business immediately. We established
an independent and centralized quality control group. We
strengthened our procedures ensure that we would never again
engage in this activity. . . .
We take responsibility for our actions, and we have
learned from our mistakes.\400\
---------------------------------------------------------------------------
\400\ PwC prepared testimony at Subcommittee hearings (11/18/03),
at 54-55.
In response to questioning by Chairman Coleman, Mr. Berry
testified that, ``with respect to the BOSS transaction, . . .
that in my judgment is an abusive shelter, . . . With respect
to FLIP and CDS, if not abusive, they come very close to that
line. . . . We regret that we ever got involved in those
transactions, and we would not do them today.'' \401\
---------------------------------------------------------------------------
\401\ Id., at 59.
---------------------------------------------------------------------------
On June 26, 2002, PwC settled with the IRS regarding the
compliance and registration requirements of the tax law for the
promotion of abusive tax shelters. PwC told the Subcommittee
that it was the first accounting firm to settle with the IRS.
PwC entered into a settlement agreement with the IRS in which
PwC agreed to make a $10 million payment to the IRS, turn over
certain client lists, and allow the IRS to review not only its
quality control procedures but over 130 tax planning strategies
intended for sale to multiple clients.\402\ According to PwC,
the IRS reviewed their quality control procedures and told PwC
that they were comprehensive, thorough, and effective.\403\
---------------------------------------------------------------------------
\402\ According to PricewaterhouseCoopers, none of these tax
strategies were determined by the IRS to require tax shelter
registration. Letter dated 5/10/04 from PricewaterhouseCoopers to the
Subcommittee, at 5.
\403\ Id.
---------------------------------------------------------------------------
(2) PricewaterhouseCoopers' Current Status
Finding: PricewaterhouseCoopers has committed to
cultural, structural, and institutional changes intended to
dismantle its abusive tax shelter practice, including by
establishing a centralized quality and risk management process,
and strengthening its tax services oversight and regulatory
compliance.
According to PwC, after BOSS was identified by the IRS in
December 1999, as an abusive tax shelter, PwC's senior
management recognized that BOSS, CDS, and FLIP represented an
``institutional failure'' and undertook a number of reforms to
ensure that similar abusive tax shelters would not be marketed
by PwC in the future.\404\
---------------------------------------------------------------------------
\404\ Subcommittee meeting with PricewaterhouseCoopers (5/27/04).
---------------------------------------------------------------------------
Leadership and Institutional Changes. PwC stated that, as a
first step in late 1999, it disbanded the group of tax
professionals responsible for the sale of FLIP, CDS, and
BOSS.\405\ In 2000, PwC appointed a new head of its U.S. Tax
Practice, Richard Berry, and charged him with establishing a
centralized quality and risk management function for the firm's
tax practice. As Head of Tax Services, Richard Berry reports
directly to the Chief Executive Officer of PwC.
---------------------------------------------------------------------------
\405\ PwC prepared statement at Subcommittee Hearings (11/18/03),
at 4.
---------------------------------------------------------------------------
In the summer of 2000, PwC created a new Quality and Risk
Management group to oversee the development of new PwC tax
products and services, prevent PwC's participation in abusive
tax shelters, and protect PwC from reputational risk.\406\ The
Quality and Risk Management Group (Q&RM) was established as an
independent administrative unit within the Tax Practice
separate from its other business units.\407\ The Q&RM head
reports to the head of the U.S. Tax Practice. The Q&RM group
currently has seven full-time partners and five other
professional staff.\408\ In addition, nine tax partners in PwC
regional offices spend one-third to one-half of their time on
Q&RM duties, advancing quality and risk management policies and
procedures across the firm's nine U.S. regions.\409\
---------------------------------------------------------------------------
\406\ See id., at 4.
\407\ Subcommittee meeting with PricewaterhouseCoopers (5/27/04).
\408\ Id.
\409\ Id.
---------------------------------------------------------------------------
PwC told the Subcommittee that the Q&RM head was also made
a member of PwC's Tax Core Leadership group. This group
includes the leaders of each of PwC's tax services business
units, and PwC indicated that the Q&RM head was included to
ensure that Q&RM was aware of the tax products and services
being offered by each business unit and to place the Q&RM head
on an equal footing with PwC's other tax leaders.\410\
According to PwC, the Tax Core Leadership has weekly conference
calls, face-to-face meetings once a month, and meetings with
tax professionals three times a year.\411\
---------------------------------------------------------------------------
\410\ Subcommittee meeting with PricewaterhouseCooopers (5/27/04).
\411\ Id.
---------------------------------------------------------------------------
Centralized Product Development Process. In addition to the
Quality and Risk Management group, PwC established a new
centralized tax product development process for all tax
products and services.\412\ PwC explained that this ``quality
review process is comprehensive and has differing levels of
review depending upon the complexity of the issues involved.''
\413\ As part of this process, PwC created a new PINNACLE
database as a centralized repository for tax service offerings
that the firm may provide to more than one client.\414\ PwC
requires every proposed new tax product intended to be offered
to more than one client be entered into the database so that
senior PwC leadership could track and monitor all product
development. PwC also requires that its business unit leaders
affirm annually that all of the tax products implemented for
more than one client have been included in the PINNACLE
database.\415\ PwC further requires the authors of specific tax
products to review the PINNACLE database on a semi-annual basis
to identify any compliance problems, changes in the law, or
other matters.
---------------------------------------------------------------------------
\412\ Letter dated 5/10/04, from PricewaterhouseCoopers to the
Subcommittee, at 6-7.
\413\ PwC prepared statement at Subcommittee Hearings (11/18/03),
at 5.
\414\ Subcommittee meeting with PricewaterhouseCoopers (5/27/04).
\415\ Id.
---------------------------------------------------------------------------
In addition, PwC established a centralized review and
approval process for all new PwC tax products. For tax products
that may be applicable to more than one client but not widely
applicable, so-called ``Shared Solutions,'' PwC requires the
proposed product to be reviewed and approved by a senior tax
partner or recognized tax expert prior to submission into the
PINNACLE database. Once included in the database, PwC requires
Q&RM to review the products and determine whether Q&RM approval
or Tax Core Leadership approval is required.
For tax products deemed potentially suitable for national
distribution, so-called ``Distributed Solutions,'' PwC requires
additional levels of review. PwC told the Subcommittee that the
proposed product must first undergo a technical analysis by
``appropriate specialists,'' a preliminary ``qualification''
review by a Q&RM partner, and a preliminary review by a member
of Tax leadership to identify potential problems. PwC indicated
that Q&RM also has the authority to establish an independent
review panel of experts to review the proposal further. PwC
indicated that this panel typically consists of three tax
partners who must be independent of the tax professionals
developing the tax product and who must reach unanimous
agreement on its technical merits in order for the proposal to
advance. PwC indicated that Q&RM could also require approval of
Tax Core Leadership which considers such factors as tax policy,
firm ethics, and the risk of adverse publicity. PwC then
requires final approval of the proposed ``Distributed
Solution'' by both Q&RM and its Federal Tax Policy group.
PwC also implemented a system requiring mandatory Q&RM
training for all PwC tax professionals lasting 2 days every 4
months. The required course includes computer-based training
regarding IRS registration and list maintenance obligations.
At the Subcommittee hearing on November 18, 2003, PwC
testified:
Our experience almost 4 years ago served as a wake-up
call to the Tax practice. Our partners were adamant that we get
out of this business immediately. We shut down the largest
transaction and returned all of our fees. We settled with the
IRS. We implemented comprehensive quality control procedures to
ensure that the firm would never again be engaged in the
marketing and development of potentially abusive tax products.
As a firm, this was the best thing that could have happened to
us. We acknowledge our actions and we have learned from this
regrettable mistake.
VI. ROLE OF LAWYERS
Accounting firms were far from the only professional firms
active in the U.S. tax shelter industry. Some large, respected
law firms also played a prominent role as illustrated by the
following two case histories.\416\
---------------------------------------------------------------------------
\416\ For more information on the role of law firms in abusive tax
shelters, see e.g., ``Helter Shelter,'' American Lawyer (12/03), at 65
(Jenkins and Gilchrist's tax partner Paul Daugerdas wrote legal
opinions and participated in the sale of at least 600 COBRA tax
shelters promoted by E&Y and the Diversified Group).
---------------------------------------------------------------------------
A. SIDLEY AUSTIN BROWN & WOOD
Finding: Sidley Austin Brown & Wood, through its
predecessor firm Brown & Wood, provided legal services that
facilitated the development and sale of potentially abusive or
illegal tax shelters, including by providing design assistance,
collaboration on allegedly ``independent'' tax opinion letters,
and hundreds of boilerplate tax opinion letters to clients
referred by KPMG and others, in return for substantial fees.
Sidley Austin Brown & Wood (hereinafter ``Brown & Wood'')
provided legal services that included design assistance on
potentially abusive or illegal tax shelters as well as
collaboration on opinion letters representing to clients that a
tax product could withstand an IRS challenge. In return, Brown
& Wood received substantial fees. According to the IRS, Brown &
Wood provided approximately 600 opinions for at least 13
``listed'' or other potentially abusive tax shelters, including
KPMG's FLIP, OPIS, BLIPS, E&Y's COBRA, and PwC's BOSS.\417\
Brown & Wood's participation was coordinated and directed
largely through the efforts of one Brown & Wood tax partner,
R.J. Ruble.\418\
---------------------------------------------------------------------------
\417\ See ``Declaration of Richard E. Bosh,'' IRS Revenue Agent, In
re John Doe Summons to Sidley Austin Brown & Wood (N.D. Ill. 10/16/03).
\418\ Id.
---------------------------------------------------------------------------
The evidence shows, for example, that Brown & Wood had a
close relationship with KPMG that lasted at least 5 years and
involved at least three key KPMG tax products, FLIP, OPIS, and
BLIPS. One of the earlier communications uncovered by the
Subcommittee is a December 1997 email sent by R.J. Ruble to a
KPMG tax partner informing KPMG that Mr. Ruble knew various
people in the ``tax advantaged product'' area.\419\ While Brown
& Wood and KPMG both deny entering into a formal agreement to
develop or market tax products, \420\ some documents suggest
that an alliance did exist in practice. One 1997 KPMG email
states, for example, that KPMG and Brown & Wood had formed an
alliance or agreement ``to jointly develop and market tax
products and jointly share in the fees.'' \421\ Another 1997
KPMG memorandum proposes that a Brown & Wood strategic alliance
``can make significant contributions to the product development
process and would allow immediate brand recognition.'' \422\
Still another KPMG memorandum, in 1998, discusses an upcoming
meeting with R.J. Ruble to ``institutionalize the KPMG/B&W
relationship.'' \423\ A 1999 Brown & Wood memorandum indicates
that the law firm's management committee had specifically
approved BLIPS as a new client matter for tax advice services
to KPMG.\424\
---------------------------------------------------------------------------
\419\ See email dated 12/24/97, from R.J. Ruble to Randall S.
Bickham, ``Confidential Matters,'' Bates KPMG 0047356-57.
\420\ See, e.g., letter dated 1/16/04, from Sidley Austin Brown &
Wood to the Subcommittee at 4; Subcommittee interview of Randall
Bickham (11/17/03).
\421\ See email dated 12/15/97, from Randall Bickham at KPMG to
multiple KPMG tax professionals, ``Joint Products,'' Exhibit 116.
\422\ Memorandum dated 12/19/97, from Randall S. Bickham to Gregg
Ritchie, ``Business Model--Brown & Wood Strategic Alliance,'' Bates
KPMG 0047228-30.
\423\ See Memorandum dated 3/2/98, from Randall S. Bickham to Gregg
Ritchie, ``B&W Meeting,'' Bates KPMG 0047358-59.
\424\ Brown & Wood New Matter Memorandum dated 1/6/99, Bates SIDL-
SCGA082444.
---------------------------------------------------------------------------
Other evidence details the nature of the interactions
between Brown & Wood and KPMG. Some suggest that R.J. Ruble
participated in the development of KPMG tax products like
BLIPS. For example, an email regarding BLIPS sent on December
3, 1998 from KPMG to various KPMG employees states:
I spoke with R.J. this morning about a ``tax-focused''
meeting next week. As a first step before scheduling a meeting,
we thought that we should first draft the base of an opinion
letter in an outline format. . . . [W]e are currently working
on the document and expect to circulate it next week.\425\
---------------------------------------------------------------------------
\425\ Email dated 12/3/98, from Randall Bickham to numerous
recipients including R.J. Ruble, ``RE: Blips meeting,'' Bates KPMG
0037336.
A memorandum dated December 3, 1998, from R.J. Ruble to KPMG
demonstrates the detailed technical nature of the assistance
contributed by Mr. Ruble to the development of BLIPS. Mr. Ruble
---------------------------------------------------------------------------
writes:
In looking at the bond premium rules in another context
(i.e. a legitimate deal), I found an issue that we need to
address for BLIPS. As I read it, the treatment of bond premium
received by an issuer is governed by Treas. Reg. 161-12(c) and
Treas. Reg. 1.163-13. The latter treats the premium as an
offset to the issuer's interest deduction. The former provides
that it not included in income when received and by reference
to the latter. . . .
LWhen the investor transfers the assets subject to the
loan to the partnership, I have always assumed that the
partnership's acquisition of the property is governed solely by
section 721 etc. Is this true? Could 1.61-12 over ride. Even if
it did could we also say that the drop down of [the] amount
equal to the premium would create an offsetting deduction. Am I
worrying too much? \426\
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\426\ Memorandum dated 12/3/98, from R.J. Ruble to Randy Bickham,
George Theofel, ``Re: BLIPS,'' Bates SIDL-SCGA083244.
Such communications indicate that Mr. Ruble was part of the
development team for BLIPS at its earliest stages. In fact, the
advice offered by him in his December 1998 email was provided 3
months before KPMG initiated its formal internal review and
approval process for BLIPS in February 1999.
In addition to development assistance, Brown & Wood
provided a steady steam of concurring legal opinions to
purchasers of KPMG's FLIP, OPIS, and BLIPS tax shelters. The
evidence also suggests that the opinion writing for these tax
products was a collaborative rather than independent process.
For example one Ruble email to KPMG on BLIPS asks: ``[D]id
Shannon [KPMG employee] ever do the side by side comparison to
make sure our legal analysis were compatible? Any changes she
might suggest would be important.'' \427\ Another KPMG email on
BLIPS and OPIS states:
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\427\ Email dated 2/3/00, from R.J. Ruble to Jeffrey Eischeid,
``RE: RJ Ruble's email.'' Bates KPMG 0033591.
Client just called, do we have an ETA on when we should
be seeing the Brown & Wood OPIS opinions? It is my
understanding the [SIC] for both BLIPS and OPIS, B&W is using
our opinion as the starting point for their opinion? \428\
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\428\ Email dated 2/22/00, from Jean Monahan to Jeffrey Eischeid,
``Subject: OPIS opinions,'' Bates KPMG 0033585.
Still another KPMG email on FLIP states: ``Brown & Wood
requested a copy of the [FLIP] opinions to issue their
opinion.'' \429\ Eventually, in the case of BLIPS, KPMG and
Brown & Wood actually exchanged copies of their drafts,
eventually issuing two allegedly independent opinion letters
that contained numerous, virtually identical paragraphs. The
evidence suggesting side-by-side comparisons and Brown & Wood's
use of KPMG opinions to write its own supposedly
``independent'' legal opinions shows that Brown & Wood and KPMG
were close collaborators, rather than independent actors.
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\429\ Email dated 11/9/98, from numerous authors to numerous
recipients, ``Subject: FLIP opinions for,'' Bates KPMG 0033447.
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Brown & Wood received lucrative fees for writing opinion
letters supporting tax products like FLIP, OPIS, and BLIPS.
Brown & Wood told the Subcommittee that it estimates that that
the firm wrote 62 opinions for FLIP, 72 opinions for OPIS, and
180 opinions for BLIPS.\430\
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\430\ Letter dated 1/16/04, from Sidley Austin Brown & Wood to the
Subcommittee, at 2.
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Brown & Wood documents show that the firm was paid at least
$50,000 for each of these legal opinions. 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 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 \431\
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\431\ Email dated 5/15/00, from Angie Napier to Jeffrey Eischeid
and others, ``B&W fees and generic FLIP rep letter,'' Bates KPMG
0036342.
Brown & Wood estimates that the firm received $3,418, 290 in
fees from FLIP, $6,427,637 from OPIS, and $13,286,790 from
BLIPS for a grand total of more than $23 million.\432\
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\432\ Letter dated 1/16/04, from Sidley Austin Brown & Wood to the
Subcommittee, at 2.
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It is also important to note that most of the
``independent'' Brown & Wood opinions apparently did not
require extensive effort, but could be produced quickly. For
example, an email states: ``[i]f you have a KPMG opinion, you
should also have a B&W opinion. We do ours and they use it as a
factual template for their opinion, usually within 48 hours.''
\433\ In fact, Brown & Wood reported to the Subcommittee that,
in December 1999 alone, it issued 65 BLIPS opinions totaling
approximately $9,290,476.\434\ This data indicates that the law
firm issued an average of two or more BLIPS opinions per day,
at a cost of $142,000 per opinion--very quick and lucrative
work. Brown & Wood also estimated that, altogether, Mr. Ruble
spent about 2,500 hours preparing legal opinions for KPMG tax
products, a pace that, in light of the firm's overall $23
million in fees, generated an average hourly rate of more than
$9,000 per billable hour.\435\
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\433\ Email dated 7/20/97, from Angie Napier to Jeffrey Eischeid,
``FW: brown & wood,'' Bates KPMG 0036577.
\434\ See Billing Records, ``Cash Receipts,'' Bates SIDL-
SCGA039315; SIDL-SCGA037620; SIDL-SCBA063485; and SIDL-SCGA006056.
\435\ Letter dated 1/16/04, from Sidley Austin Brown & Wood to the
Subcommittee, at 2 (``it appears that approximately 2,500 hours were
recorded by Mr. Ruble with respect to KPMG transactions.'').
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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.'' Brown & Wood charged the same minimum fee--more in
cases of larger transactions--for each legal opinion it issued
to a FLIP, 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. These fees, with few costs after the prototype
opinion was drafted, raised questions about the firm's
compliance with ABA Model Rule 1.5.
At the Subcommittee hearings, Mr. Ruble, invoked his Fifth
Amendment right against self-incrimination in response to
questioning by the Subcommittee.\436\ Thomas R. Smith, Jr.,
former managing partner of Brown & Wood, testified that Mr.
Ruble was virtually the only lawyer within the firm engaged in
providing concurring opinions for generic tax products sold to
multiple clients.\437\ He also testified that the firm Brown &
Wood was unable to produce a copy of the firm's written
procedures for reviewing tax opinion letters prior to 2000, and
did not, until recently, maintain a central file of the letters
actually sent to clients.
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\436\ In October 2003, Sidley Austin Brown & Wood terminated R.J.
Ruble for breaches of fiduciary duty and violations of its partnership
agreements.
\437\ Prepared statement of Thomas R. Smith, Jr., Tax Partner,
Sidley Austin Brown & Wood, at Subcommittee Hearings (11/20/03).
---------------------------------------------------------------------------
Mr. Smith testified at the hearing that, before a tax
opinion letter was issued by the firm, Brown & Wood had
required approval of the draft opinion by a second tax partner,
but the firm had no procedures for tracking compliance with
that requirement. After the hearing, a letter provided by the
law firm stated that none of the partners in the tax department
considered themselves to have functioned as the requisite
reviewing partner for the Ruble opinions.\438\ The letter also
indicated that although the firm had made the decision to
discontinue the practice of issuing generic tax product
opinions in May 2001, after Brown & Wood merged with another
law firm, Sidley Austin, the firm discovered that additional
opinions by Mr. Ruble had been issued after the date of the
merger, in clear violation of the firm's policy decision.\439\
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\438\ Letter dated 1/16/04, from Sidley Austin Brown & Wood to the
Subcommittee, at 4.
\439\ Id.
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Sidley Austin Brown & Wood told the Subcommittee that to
correct the problems uncovered in connection with Mr. Ruble,
the firm hired in 2003, a tax attorney whose principal
responsibility is to monitor internal procedures respecting tax
matters and compliance with IRS requirements.\440\
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\440\ Id. at 3.
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B. SUTHERLAND ASBILL & BRENNAN
Finding: Sutherland Asbill & Brennan provided legal
representation to over 100 former KPMG clients in tax shelter
matters before the IRS, despite a longstanding business
relationship with KPMG and without performing any conflict of
interest analysis prior to undertaking these representations.
Sutherland Asbill & Brennan is a law firm that played a
very different role in the U.S. tax shelter industry. It did
not help develop, promote, or implement tax shelters; nor did
it write legal opinions supporting tax shelters. Instead,
Sutherland Asbill & Brennan's role was to defend clients
accused by the IRS of buying illegal tax shelters and
understating their tax liabilities. Because many clients bought
the same or similar tax shelter products from the same
promoter, Sutherland Asbill & Brennan at times represented
multiple clients in IRS and court proceedings, and at times
attempted to negotiate ``global settlement agreements'' with
the IRS that would allow multiple taxpayers to resolve their
desputes.
Sutherland Asbill & Brennan was one of a number of so-
called ``friendly'' law firms to which KPMG referred tax
shelter participants for legal representation after the IRS had
initiated enforcement action against them. KPMG apparently
considered Sutherland Asbill & Brennan a ``friendly'' law firm
due to the firm's longstanding and ongoing representation of
KPMG in business litigation matters unrelated to cases
involving tax shelters. In most of these cases, Sutherland
Asbill & Brennan had defended KPMG against claims of
malpractice by former clients. In fact, Sutherland Asbill &
Brennan told the Subcommittee that, for the 4-year period from
1998 to 2002, KPMG had paid the firm $13.9 million for legal
representation in matters unrelated to tax shelters.\441\ In
light of the law firm's longstanding close relationship with
KPMG, one of the issues examined by the Subcommittee was
whether a potential conflict of interest existed regarding this
law firm's representation of former KPMG clients in tax shelter
matters raising questions about the quality of advice rendered
by KPMG to those clients.
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\441\ Letter dated 12/19/03, from Sutherland Asbill & Brennan to
the Subcommittee, at Exhibit B.
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Sutherland Asbill & Brennan told the Subcommittee that it
had engaged in 39 ``matters,'' involving a total of 113
separate clients, in connection with KPMG tax products such as
FLIP, OPIS, or BLIPS.\442\ The firm also told the Subcommittee
that at least 17 of these ``matters'' had come from KPMG
referrals, while an additional 8 referrals came from Quellos
Group, which was the investment advisor for KPMG's FLIP and
OPIS transactions, or Wachovia Bank, whose subsidiary, First
Union National Bank, had referred bank customers to KPMG for
tax products.\443\ This data indicates that the majority of the
law firm's KPMG clients resulted from direct referrals by KPMG
or other professional entities affiliated with the KPMG tax
products.
---------------------------------------------------------------------------
\442\ Id.
\443\ Id., at Exhibits A and B.
---------------------------------------------------------------------------
While both KPMG and a former KPMG client have an immediate
joint interest in defending the validity of the tax product
that KPMG sold and the client purchased, the interests of these
two parties could quickly diverge if the suspect tax product is
found to be in violation of Federal tax law. This divergence in
interests has happened repeatedly since 2002, as more than a
dozen lawsuits have been filed by former KPMG clients seeking
past fees paid to the firm and additional damages for KPMG's
selling them an illegal tax shelter.
A lawyer has a professional responsibility to analyze
whether a conflict of issue may impede his or her ability to
zealously assert a client's interest. Sutherland Asbill &
Brennan, in response to the Subcommittee's request, was unable
to produce any written procedures for undertaking this type of
conflict of interest analysis prior to accepting a client
engagement. It was also unable to produce any analysis prepared
prior to entering into its representation of former KPMG
clients in matters involving KPMG tax products.\444\
---------------------------------------------------------------------------
\444\ Id., at 5.
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The firm did produce, however, engagement letters signed by
former KPMG clients, informing these clients of a possible
conflict of interest should they wish to sue the accounting
firm that sold them the illegal tax shelter. For example, each
engagement letter signed by a former KPMG client, in which the
client agreed to pay Sutherland Asbill & Brennan to represent
him before the IRS in connection with a KPMG tax product,
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).\445\
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\445\ See, e.g., engagement letter dated 7/3/02, between Sutherland
Asbill & Brennan LLP and the client, Bates SA 001964.
According to one KPMG client interviewed by the
Subcommittee, he had not understood at the time that the above
statement meant that Sutherland Asbill & Brennan 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.\446\ This client told the
Subcommittee that he had hired the law firm solely on the
recommendation of KPMG--he had never employed the firm before,
and it did not even have an office in his state. The client
told the Subcommittee that when he finally understood that the
law firm was already representing KPMG in other matters, he
switched counsel from Sutherland Asbill & Brennan to another
firm and eventually decided to sue KPMG for selling him an
illegal tax shelter.\447\
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\446\ This client asked Sutherland Asbill & Brennan LLP about the
merits of suing KPMG and was told that the firm could not represent him
in such a legal action. Subsequently, the client switched to new legal
counsel.
\447\ KPMG has told the Subcommittee that this is the only instance
it knows in which a former KPMG client has ended up suing KPMG for
selling an illegal tax shelter. Letter dated 12/9/03, from Sutherland
Asbill & Brennan to the Subcommittee, at 5.
---------------------------------------------------------------------------
This former KPMG client was apparently not the only client
unclear about the significance of the disclosure in the
engagement letter. For example, Sutherland Asbill & Brennan
wrote the following to another KPMG tax shelter participant to
clarify the significance of the disclosure:
All this paragraph is meant to tell you is that because
of a conflict, we could not represent you in the pursuit of any
claim against the parties who advised you in connection with
the transaction. It was meant to alert you to this in case you
wanted to retain someone who was not conflicted to advise you
of your rights in that respect.
LThis paragraph clearly was not meant to waive any rights
that you might have against any of the parties who advised you
to enter into the transaction. . . .\448\
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\448\ Letter dated 2/13/02, from Sutherland Asbill & Brennan LLP to
client, at 1. Bates SAB0035.
A review of Sutherland Asbill & Brennan attorney notes to
client files of other KPMG clients indicates that other KPMG
clients seemed to have expressed interest in exploring the
merits of suing KPMG and to be unaware of the law firm's
inability to pursue such claims on the client's behalf. One
attorney's notes state: ``I advise[d] him that I cannot advise
[the former KPMG client] about any rights he has vis a vis
KPMG.'' This statement was made after the former KPMG client
had signed an engagement letter with Sutherland Asbill &
Brennan.\449\ Another attorney's notes disclose: ``They also
asked [about] suits against promoters. I told them that `I need
to duck my head in the sand on these.' I purposefully try not
to know anything.'' \450\ Later, the same client ``asked again
about suing KPMG.'' \451\ Both of these conversations took
place after the former KPMG client had signed an engagement
letter with the law firm. In short, the firm's ``blanket
disclosure'' in its engagement letter seemed to leave at least
some clients uninformed about Sutherland Asbill & Brennan's
longstanding relationship with KPMG and the inability of the
law firm to consider filing suit against KPMG for selling
illegal tax shelters, due to its duty of loyalty to its
longtime client, KPMG.
---------------------------------------------------------------------------
\449\ Sutherland Asbill & Brennan LLP attorney notes to file, dated
7/14/02. Bates SAB0174.
\450\ Id., Bates SAB0052.
\451\ Id., Bates SAB0053.
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In another matter involving a former KPMG client,
Sutherland Asbill & Brennan ``engaged KPMG'' itself to assist
the law firm in its representation of the former KPMG client,
including with respect to ``investigation of facts, review of
tax issues, and other such matters as Counsel may direct.''
\452\ This engagement meant that KPMG, as Sutherland Asbill's
agent, would be given 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. Sutherland Asbill & Brennan told the
Subcommittee that, despite this engagement letter, the law firm
never actually utilized the services of KPMG in this case. In
still another matter, the law firm's notes suggest that a
former KPMG client wanted to exclude all KPMG participation
from their case, but the law firm demurred: ``The only reason I
see to cut KPMG out completely is if they want to sue. And we
cannot advise on that.'' \453\
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\452\ Engagement letter dated 9/3/02, from Sutherland Asbill &
Brennan and KPMG, Bates SAB0180-82.
\453\ Sutherland Asbill & Brennan LLP attorney notes to file, dated
11/24/03. Bates SAB0024.
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Still another disturbing document is a 2002 email from one
KPMG tax professional to another, later forwarded to numerous
additional KPMG tax professionals stating that KPMG had been
given notes taken by a Sutherland Asbill & Brennan attorney
during a meeting with the IRS.\454\ The email states: ``Notes
from Jerry Cohen's meeting w/IRS on the 9th. You may distribute
this. Please not[e] the comments on Flip/Opis.'' This email
suggests that the law firm was sharing information with KPMG
about tax shelter discussions that the law firm held with the
IRS while representing KPMG's former clients. This information
was of such interest that KPMG sent it to more than three dozen
of its tax professionals. Such information sharing--obtained on
behalf of one client and shared with a party that is not being
legally represented by the firm in the same manner \455\--
raises additional questions about the law firm's dual
loyalties.
---------------------------------------------------------------------------
\454\ Email dated 7/11/02, from Ken Jones to Jeffrey Eischeid, then
forwarded to multiple KPMG tax professionals, Bates KPMG0027990.
\455\ See, e.g., letter dated 11/18/03, from Sutherland Asbill &
Brennan LLP to the Subcommittee, at 2. Bates XX-002186.
---------------------------------------------------------------------------
The preamble to the American Bar Association (ABA) Model
Rules states ``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 with the Sutherland Asbill & Brennan
representation is the conflict of interest that arises when a
law firm attempts to represent an accounting firm's former
client at the same time it is representing the accounting firm
itself in other matters, and the issue in controversy is a tax
product that the accounting firm sold and the former client
purchased. In such a case, the issue is how the attorney can
zealously represent the interests of both its clients in light
of potential 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.\456\ The CRS analysis concluded
that, under ABA Model Rule 1.7, a law firm should decline to
represent an accounting firm's 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.''
---------------------------------------------------------------------------
\456\ 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.''
---------------------------------------------------------------------------
Alternatively, 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. Clearly, some Sutherland Asbill & Brennan clients were
less than fully aware of the firm's conflict of interest in
relation to KPMG, and did not seem to receive additional
information prior to signing an engagement letter with
Sutherland Asbill & Brennan.
VII. ROLE OF FINANCIAL INSTITUTIONS
Finding: Deutsche Bank, HVB Bank, and UBS Bank provided
billions of dollars in lending critical to transactions which
the banks knew were tax motivated, involved little or no credit
risk, and facilitated potentially abusive or illegal tax
shelters known as FLIP, OPIS, and BLIPS.
The tax shelters examined in this Report could not have
been executed without the active and willing participation of
major banks. Banks provided the requisite loans for hundreds of
these tax shelter transactions. Three major banks investigated
by the Subcommittee participated in KPMG's FLIP, OPIS, and
BLIPS.\457\ Deutsche Bank participated in 56 BLIPS transactions
in 1999, providing credit lines to KPMG clients totaling $7.8
billion.\458\ Deutsche Bank also participated in 62 OPIS
transactions from 1997 to 1999, providing credit lines that
totaled $3 billion.\459\ HVB Bank participated in 29 BLIPS
transactions in 1999 and 2000, providing BLIPS credit lines
that totaled about $2.5 billion.\460\ UBS AG participated in
100 to 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.\461\
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\457\ NatWest apparently also participated in a significant number
of BLIPS transactions in 1999 and 2000, providing credit lines totaling
more than $1 billion. 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.
\458\ See prepared statement by Deutsche Bank at Subcommittee
Hearings (11/20/03), at 2.
\459\ Id.
\460\ See prepared statement by HVB Bank at Subcommittee Hearings
(11/20/03), at 5.
\461\ 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).
---------------------------------------------------------------------------
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 makes it plain that the banks were aware that the tax
products were potentially abusive and carried a risk to the
reputation of any bank choosing to participate in it. In
exchange for their active and knowing participation, the banks
obtained lucrative fees. For example, Deutsche Bank obtained
$44 million in bank fees from the BLIPS transactions, and $35
million from OPIS, for a grand total of $79 million.\462\ HVB
obtained 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.'' \463\
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\462\ See prepared statement by Deutsche Bank at Subcommittee
Hearings (11/20/03), at 2.
\463\ 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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A. DEUTSCHE BANK
The critical role played by major banks in KPMG's tax
shelter activities is illustrated by Deutsche Bank's
participation in 56 BLIPS transactions in 1999.
A number of Deutsche Bank documents show 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 affairs. 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 [Risk & Resources]
Committee to approve reputation risk on BLIPS. This will be
dealt with directly by the Tax Department and [Deutsche Bank
Americas Chief Executive Officer] John Ross.\464\
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\464\ Email dated 7/30/99, from Ivor Dunbar of Deutsche Bank, DMG
UK, to multiple Deutsche Bank professionals, ``Re: Risk & Resources
Committee Paper--BLIPS,'' Bates DB BLIPS 6554. See also email dated 7/
29/99, from Mick Wood to Francesco Piovanetti and other Deutsche bank
personnel, ``Re: Risk & Resources Committee Paper--BLIPS,'' Bates DB
BLIPS 6556 (paper prepared for the Risk & Resources Committee ``skirts
around the basic issue rather than addressing it head on (the tax
reputational risk).'').
Another Deutsche Bank memorandum, prepared for the ``New
Product Committee'' to use in reviewing BLIPS, included the
---------------------------------------------------------------------------
following statements explaining the transaction:
BLIPS will be marketed to High Net Worth Individual
Clients of KPMG. . . . Loan conditions will be such as to
enable DB to, in effect, force (p)repayment after 60 days at
its option. . . . For tax and accounting purposes, repaying the
[loan] premium amount will ``count'' like a loss for tax and
accounting purposes. . . . At all times, the loan will maintain
collateral of at least 101% to the loan + premium amount. . . .
It is imperative that the transaction be wound up after 45-60
days and the loan repaid due to the fact that the HNW
individual will not receive his/her capital loss (or tax
benefit) until the transaction is wound up and the loan repaid.
. . . At no time will DB Private Bank provide any tax advice to
any individuals involved in the transactions. This will be
further buttressed by signed disclaimers designed to protect
and ``hold harmless'' DB. . . . DB has received a legal opinion
from Shearman & Sterling which validates our envisaged role in
the transaction and sees little or no risk to DB in the trade.
Furthermore opinions have been issued from KPMG Central Tax
department and Brown & Wood attesting to the soundness of the
transactions from a tax perspective.\465\
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\465\ 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.'' \466\
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\466\ 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 Deutsche Bank Americas' Chief Executive Officer John Ross,
who made the final decision on the bank's participation.\467\
Minutes describing the meeting in which Mr. Ross approved the
bank's participation in BLIPS state:
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\467\ 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.\468\
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\468\ 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 was fully aware of
the nature of the financial product they would be financing.
Additional evidence shows that Deutsche Bank was aware that
the BLIPS loans it had been asked to provide were not standard
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, 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.'' \469\
When the bank declined to make the requested representation,
the KPMG's 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.''
\470\ He tried a third time and reported: ``I've pushed really
hard for our original language. To say they are resisting is an
understatement.'' \471\ 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.'' \472\
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\469\ Email dated 3/20/00, from Jeffrey Eischeid to Mark Watson,
``Bank representation,'' Bates KPMG 0025754.
\470\ Email dated 3/27/00, from Jeffrey Eischeid to Richard Smith,
``Bank representation,'' Bates KPMG 0025753.
\471\ Email dated 3/28/00, from Jeffrey Eischeid to Mark Watson,
``Bank representation,'' Bates KPMG 0025753.
\472\ 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.\473\
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\473\ Email dated 6/20/00, from William Boyle to multiple Deutsche
Bank professionals, ``Updated Presidio/KPMG trades,'' Bates DB BLIPS
03280.
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. At the Subcommittee hearing on November
20, when asked about this proposal, the Deutsche Bank
representative seemed to deny that the bank had actually
presented it to HVB, while HVB testified that Deutsche Bank
had, in fact, made the proposal to HVB which declined to accept
it.\474\
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\474\ See Subcommittee Hearings (11/20/03), at 114.
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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.'' \475\ The
presentation listed as the bank's ``strengths'' its ability to
lend funds in connection with BLIPS and its ``relationships
with [the] `promoters' ''\476\ later named as Presidio and
KPMG.\477\ An internal bank email a few months earlier asked:
``What is the status of the BLIPS. Are you still actively
marketing this product[?]'' \478\
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\475\ Email dated 4/3/02, from Viktoria Antoniades to Brian McGuire
and other Deutsche Bank personnel, ``US GROUP 1 Pres,'' Bates DB BLIPS
6329-52, attaching a presentation dated 11/15/99, entitled ``Structured
Transactions Group North America,'' at 6336, 6346.
\476\ Id. at 6337.
\477\ Id. at 6346.
\478\ Email dated 7/19/99, involving multiple Deutsche Bank
employees, ``Update NY Issues,'' Bates DB BLIPS 6775.
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In light of the bank's concerns regarding the reputational
risk associated with BLIPS, the bank discussed using attorney-
client privilege to conceal its activities. In an internal
email, one Deutsche Bank employee wrote to another regarding
the BLIPS risk analysis documents: ``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).'' \479\ 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'':
---------------------------------------------------------------------------
\479\ 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.\480\
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\480\ Email dated 7/30/99, from Ivor Dunbar of Deutsche Bank, DMG
UK, to multiple Deutsche Bank professionals, ``Re: Risk & Resources
Committee Paper--BLIPS,'' Bates DB BLIPS 6554.
Despite the bank's apparent 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.\481\ At the
Subcommittee hearings, although the Deutsche Bank
representative testified that, ``it was very clear from the
opinions and everything that there were significant tax
benefits that the investor may report on its return'' from the
BLIPS transaction, he resisted characterizing BLIPS as a ``tax-
driven'' transaction, as set forth in an internal bank
document.\482\
---------------------------------------------------------------------------
\481\ Subcommittee interview of Deutsche Bank (11/10/03).
\482\ See Subcommittee Hearings (11/20/03), at 107-112.
---------------------------------------------------------------------------
Deutsche Bank told the Subcommittee that, in October 2000,
it reorganized and refocused the business strategy of the
Structured Transaction Group that had been handling tax
products like BLIPS. According to Deutsche Bank, the group is
now called the Structured Capital Markets Group and does not
execute tax advantaged transactions such as BLIPS to multiple
clients. Instead, the bank provides investment and borrowing
services to meet specific client requirements.\483\
---------------------------------------------------------------------------
\483\ Letter dated 1/9/04, from Deutsche Bank's legal counsel to
the Subcommittee, at 2.
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B. HVB BANK
HVB Bank participated in 29 KPMG BLIPS transactions during
1999 and 2000, providing credit lines totaling about $2.2
billion and generating millions of dollars in bank fees.
According to HVB, Robert Pfaff first approached HVB Bank in
late August or early September 1999 to solicit their
participation in BLIPS.\484\ Mr. Pfaff, a former KPMG tax
professional, was then an employee of Presidio, the investment
firm assisting KPMG with BLIPS transactions. During that
initial meeting, Mr. Pfaff told HVB that KPMG and Presidio
worked together to develop the structure of the investment
transaction and wanted HVB to provide financing.\485\
---------------------------------------------------------------------------
\484\ Subcommittee interview of HVB Bank (10/29/03).
\485\ Id.
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According to HVB, as a result of that meeting, HVB Bank was
put in touch with Deutsche Bank which provided HVB with copies
of draft loan documentation.\486\ Presidio then arranged a
meeting in which its staff explained the BLIPS transaction and,
according to HVB, emphasized that BLIPS was an investment
strategy. HVB told the Subcommittee, however, that it was clear
to HVB at this meeting that BLIPS had inherent tax
benefits.\487\ In addition, HVB told the Subcommittee that
Presidio had indicated that Stage I of BLIPS was to start and
end within the same calendar year, requiring HVB to participate
in the transaction by no later than October 1999.\488\
Handwritten notes stemming from this meeting with Presidio also
characterize the 7% fee charged to KPMG clients for BLIPS as
``paid by investor for tax sheltering.'' \489\
---------------------------------------------------------------------------
\486\ Id.
\487\ Id.
\488\ Id. HVB told the Subcommittee that, although BLIPS was
represented as a 7-year investment program, HVB knew that BLIPS was a
60-day transaction driven by tax benefits. In fact, HVB's credit
request documentation given to senior management for approval of BLIPS
states: ``HVB has been approached by Presidio to make the series of 7-
year premium term loans noted above to the investment vehicles of
individuals interested in investing in Presidio's product. . . . HVB
will earn a very attractive return if the deals runs to term. If,
however, the advances are prepaid within 60 days (and there is a
reasonable prospect that they will be), HVB will earn a return of 2.84%
. . .),'' BLIPS credit request dated 9/14/99, Bates HVB 000148.
\489\ Undated one-page, handwritten document outlining BLIPS
structure entitled, ``Presidio,'' which Alexandre Nouvakhov of HVB
acknowledged during his Subcommittee interview had been written by him,
Bates HVB 000204.
---------------------------------------------------------------------------
At the Subcommittee hearing, when asked whether the bank
knew that BLIPS was a transaction that had been designed to
avoid taxes, HVB's representative stated, ``I think to dispute
the notion that there were inherent and significant tax
benefits is ridiculous. However, the investment strategy was
described to us as a significant motive for these investors to
enter into this transaction.'' \490\ He also denied learning
later that BLIPS was primarily a tax avoidance scheme.\491\ HVB
Bank indicated further that, at the time it became involved
with BLIPS, KPMG had provided the bank with an opinion stating
that BLIPS complied with Federal tax law and the bank felt it
could rely on that opinion. 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:
---------------------------------------------------------------------------
\490\ Subcommittee Hearings (11/20/03), at 102.
\491\ Id. at 103.
LDisallowance 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.\492\
---------------------------------------------------------------------------
\492\ Credit request dated 9/26/99, Bates HVB 001166.
A year later, when it became clear that the IRS would list
BLIPS as an abusive tax shelter, an internal HVB memorandum
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 believes 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.\493\
---------------------------------------------------------------------------
\493\ 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 that the
apparent bank risk in lending substantial sums to a shell
company 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.\494\ The bank explained, for example,
that from the time the loan was issued, 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 low-risk bank-approved investments.\495\
These requirements 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.'' \496\ HVB also wrote: ``The Permitted Investments . .
. are either extremely conservative in nature . . . or have no
collateral value for margin purposes.'' \497\ 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.'' \498\ As indicated earlier, both Deutsche Bank and
HVB received lucrative fees in exchange for providing the low-
risk loans KPMG clients needed.
---------------------------------------------------------------------------
\494\ Subcommittee interview of HVB representative (10/29/03).
\495\ 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 60 days at its option.'').
\496\ 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.'')
\497\ BLIPS credit request dated 9/14/99, Bates HVB 000155.
\498\ Document dated 3/4/99, ``BLIPS--transaction description and
checklist,'' Bates KPMG 0003933-35.
Documents related to two transactions that allegedly took
place in 1999, involving HVB clients, raise further questions
about the investments allegedly undertaken by HVB in connection
with the BLIPS transactions. 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 Mobile
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.\499\
---------------------------------------------------------------------------
\499\ 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, HVB then
``reversed'' the referenced 1999 currency trades and executed
them the next month in early 2000.\500\ When asked about this
matter, HVB told the Subcommittee that they had been unaware of
this email exchange, that the bank could not make currency
trades ``look as though they did not occur at all,'' and they
would research the transactions to locate the paperwork and
determine whether, in fact, the trades or paperwork had been
altered.\501\
---------------------------------------------------------------------------
\500\ 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.
\501\ Subcommittee interview of HVB bank representatives (10/29/
03).
---------------------------------------------------------------------------
HVB later told the Subcommittee that it had been unable to
``locate any tickets documenting the original or reversing
trades.'' \502\ In fact, HVB said that trade tickets had not
been created for many of the currency transactions associated
with the BLIPS transactions.\503\ HVB explained that the lack
of documentation meant that the bank was unable to evaluate
either the specific trades or the paperwork. In a letter to the
Subcommittee dated January 12, 2004, HVB theorized that the
original transactions had been executed in error and the bank
had executed another foreign currency transaction to offset the
results of the first trade. HVB also told the Subcommittee
that, because the bank is not a tax advisor, it could not
explain the email's assertion that the original trades had
negative ``tax consequences'' requiring correction.\504\
---------------------------------------------------------------------------
\502\ Letter dated 1/12/04 from HVB's legal counsel, Caplin &
Drysdale, to the Subcommittee, at 3.
\503\ Subcommittee interview with HVB's legal counsel, Caplin &
Drysdale (2/20/04).
\504\ Id.
---------------------------------------------------------------------------
HVB's inability to find any of the trade tickets
documenting the currency trades discussed in the email is
disturbing. Its admission that the bank often failed to prepare
documentation for BLIPS-related currency trade raises added
concern, since such paperless trades are not only contrary to
normal banking and securities practice, but raise questions
about whether the trades actually took place or were simply
bookkeeping shams undertaken to justify a BLIPS client's
alleged tax losses.
C. UBS BANK
UBS AG, one of the largest banks in the world, participated
in 100 to 150 FLIP and OPIS transactions in 1997 and 1998,
providing credit lines for KPMG clients which, in the
aggregate, were in the range of several billion Swiss francs.
UBS told the Subcommittee that it became involved with these
tax products after being contacted by KPMG and the Quellos
Group and asked to assist in KPMG's FLIP and OPIS transactions,
referred to collectively by UBS as ``redemption transactions.''
\505\
---------------------------------------------------------------------------
\505\ Subcommittee interview of UBS representative (10/28/03).
---------------------------------------------------------------------------
UBS documentation clearly and repeatedly describes these
transactions as motivated by tax considerations. 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 emphasized 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''].\506\
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\506\ 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 UBS000009-15.
At another point, the UBS document explains the ``Economic
Rationale'' for redemption transactions to be: ``Tax benefit
for client,'' \507\ while still another UBS document states:
``The motivation for this structure is tax optimization 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.''
\508\
---------------------------------------------------------------------------
\507\ Id. at Bates UBS000010.
\508\ UBS internal document dated 11/13/97, ``Description of the
UBS `Redemption' Structure,'' Bates UBS000031.
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.
LMy 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. . . .
LP.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.\509\
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\509\ Letter dated 2/12/98, addressed to SBC Warburg Dillon Read in
London, Bates UBS000038.
In response to the letter, UBS halted all redemption trades for
several months.\510\ UBS apparently examined the nature of
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.\511\
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\510\ 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.'').
\511\ 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.
D. FIRST UNION NATIONAL BANK
LFinding: First Union National Bank promoted to its
clients generic tax products which had been designed by others,
including potentially abusive or illegal tax shelters known as
FLIP and BOSS, by introducing and explaining these products to
its clients, providing sample opinion letters, and introducing
its clients to the promoters of the tax products, in return for
substantial fees.
Deutsche Bank, HVB Bank, and UBS helped KPMG implement its
tax products by providing KPMG clients with substantial
financing and securities transactions necessitated by the tax
products. Other banks, such as, Wachovia Bank, acting through
First Union National Bank, played a different role, assisting
KPMG by providing client referrals and marketing assistance for
its tax products, in return for substantial fees. The
Subcommittee investigation determined that First Union provided
this same assistance to other tax shelter promoters, including
PricewaterhouseCoopers, and, in fact, had implemented a
systematic review and approval process for offering a variety
of third-party tax shelter products to First Union clients.
The manager of First Union's Financial Advisory Services
Group describes the development of this review and approval
process in a 1999 email:
The Financial Advisory Services Group (FAS),
specifically the Personal Financial Consulting Group within FAS
began introducing Enhanced Investment Strategies
(``Strategies'') to qualified First Union clients under the
direction of my predecessor, Ralph Lovejoy in 1997. Ralph left
First Union in April 1998 to join Quadra Investments and later
TPCMG. Both firms have been heavily involved in the creation of
leading edge strategies.
When I was appointed manager of FAS in April 1998,
Personal Financial Consulting was in the process of being
introduced to certain strategies offered by KPMG. KPMG was
offering these strategies through Quadra Investments. The law
firm of Pillsbury Madison had written a tax opinion letter on
both, but we wanted a Big 5 firm to write one if we were going
to consider introduction of these strategies to any of our
clients. As the year progressed, KPMG could not reach a
decision as to whether or not to write the tax opinion letter
on each strategy so Quadra (Ralph Lovejoy) introduced us to
PriceWaterhouseCoopers, who was also familiar with both
strategies and had been writing a tax opinion on them.
As I learned more and more about these strategies, it
was evident that a due diligence process needed to be
established to more formally evaluate and select which
strategies and/or strategy providers should be considered
before introducing any strategies to future clients. As a
result, in early 1999 we established a Due Diligence Committee
(see attached) and sent an RFP to contacts we or our integral
partners with First Union had with four of the five Big 5
firms. (see attached). We met with these firms (KPMG, PWC,
Deloitte & Touche and Arthur Andersen) and received formal
responses from KPMG and PWC indicating their interest in
presenting their strategies to the newly formed Due Diligence
Committee. After review of each strategy and strategy provider
(including review of both financial and non-financial facts),
the committee approved KPMG and PWC as strategy providers on
April 9, 1999 and, the use of three strategies for 1999, one of
which included [PwC's] BOSS. For each strategy reviewed and
approved by the Committee, the strategy provider agreed to
write a tax opinion of at least ``More likely than not.'' \512\
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\512\ Letter dated 12/17/99, from Diane Stanford to Gail Fagan,
``RE: BOSS,'' Bates SEN-016895-6.
This document shows that First Union began introducing banking
clients to third-party tax products as early as 1997. In
addition, it shows that, in 1999, the bank set up a formal
procedure to evaluate specific tax shelter promoters and their
tax product offerings. As a result, in April 1999, First Union
formally approved making client referrals to KPMG and PwC and
offering these firm's tax products to its clients.\513\
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\513\ First Union also provided referrals to strategy providers
other than KPMG and PwC. According to a former First Union employee,
the due diligence process was designed in part to centralize referrals
of various strategies and strategy providers to banking clients.
Multiple banking groups were providing referrals of various strategies
and strategy providers designed by law firms and investment advisors.
Subcommittee interview with former First Union employee (5/27/04).
---------------------------------------------------------------------------
First Union explained to the Subcommittee how its new
procedure worked in practice. It said that its relationship
managers or trust specialists who dealt with wealthy bank
customers typically identified suitable potential clients for
third-party tax products.\514\ These bank employees then
referred the clients to First Union's Financial Advisory
Services Group. The FAS Group, in turn, assigned senior
advisers within its Personal Financial Consulting Group to
explain the particular tax products to the clients and arrange
introductions to KPMG, PwC, or other tax shelter promoters such
as Quellos Group.\515\
---------------------------------------------------------------------------
\514\ Subcommittee interview with First Union representatives (5/
21/04).
\515\ Id.
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First Union told the Subcommittee that, with respect to
KPMG and PwC tax products, First Union typically received
$100,000 for each client referral.\516\ This fee was then split
between the relationship manager or trust specialist who had
identified the client and the Financial Advisory Services group
that had arranged the referral to KPMG or PwC.\517\ First Union
estimated that, for the 5-year period 1997 to 2002, the
revenues it obtained for providing client referrals on tax
products totaled about $13 million.\518\
---------------------------------------------------------------------------
\516\ Id.
\517\ Id. First Union indicated that the senior advisors in
Personal Financial Consulting were compensated indirectly through
bonuses.
\518\ These revenues included First Union referrals related to
eight other tax products provided by entities other than KPMG and PwC.
Subcommittee meeting with First Union representatives (5/21/04).
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First Union told the Subcommittee that its Financial
Advisory Services Due Diligence Committee, also known as the
Capital Management Group Risk Review Subcommittee, met
periodically with various tax shelter promoters to discuss and
approve specific tax products that could be presented to First
Union clients. For example, according to the Due Diligence
Committee's minutes, the committee met on April 27, 1999 to
review five new tax products being promoted by KPMG and
PricewaterhouseCoopers:
The committee reviewed five strategies and scored each
strategy as a committee . . .:
KPMG PWC
Name Score
--TRACT 3.85
--IDV 2.825
--CREW 3.52
PWC
Name Score
--BOSS 3.66
--PACT 3.64
Because IDV did not score a 3.0 or higher, it was
eliminated for further consideration. Reasons for the low score
included (a) long term time frame and the transaction causes
high economic risk to the client and bank, (b) projected low
demand of the product mostly due to economic risk.\519\
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\519\ First Union Due Diligence Committee Minutes, Bates SEN-
014577-78.
Tax products which received the committee's initial
approval were then sent to First Union's Capital Management
Group (CMG) Risk Review Oversight Committee, which periodically
met to discuss them and provide the final approval necessary
before a tax product could be presented to First Union clients.
For example, a CMG Risk Review Oversight Committee memorandum
---------------------------------------------------------------------------
discusses the approval of the KPMG BLIPS transaction:
The CMG Risk Review Oversight Committee (``committee or
OC'') met on September 1. . . .
Senior PFC Advisor and CMG Risk Review Subcommittee
(``subcommittee or SC'') member Tom Newman presented an
overview of an enhanced investment strategy for OC vote to be
able to present it to selected First Union clients. KPMG
brought the BLIPS strategy (referred to hereafter as the
``Alpha'' strategy) to First Union. . . .
Before the Alpha strategy was discussed, each member of
the committee signed a confidentiality agreement at KPMG's
request. In general, signing the agreement confirmed the
understanding that committee members would hold the information
about the strategy in the strictest of confidence and specific
details of Alpha would not be discussed outside the meeting. .
. .
Highlights of the Alpha discussion:
LThe Alpha strategy is a highly leveraged
investment strategy that could be used to generate either a
capital gain offset or an ordinary income offset.
LThe strategy is to be considered only for
individuals with more than $20 million in capital gains or
ordinary income in either 1999 or future year. . . .
LFirst Union's fees would be determined and
outlined in an engagement letter entered into directly with the
client and would approximate 50 basis points for non-KPMG
clients who implement the strategy (minimum fee of $100,000)
and 25 basis points for existing KPMG clients (minimum fee
amount of $50,000). . . .
When discussion concluded, members of the committee
immediately and unanimously approved the strategy.\520\
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\520\ Memorandum dated 9/3/99, from Karen Chovan, Financial
Advisory Services to CMG Risk Review Oversight Committee, ``Meeting
Minutes of September 1. . . .'' Bates SEN-008629-31.
These and other documents demonstrate that First Union had an
active and elaborate structure for the review and approval of
third-party tax shelters to be marketed to First Union clients.
The evidence also demonstrates that First Union was well aware
that it was promoting products intended to reduce or eliminate
taxes and was willing to keep these products confidential,
perhaps in an attempt to evade IRS detection. It is also worth
noting that First Union's due diligence process for approving
third-party tax products nowhere required either the bank's
legal counsel or an outside tax expert to review the technical
merits of the proposed products to ensure compliance with the
law.\521\
---------------------------------------------------------------------------
\521\ Subcommittee meeting with First Union representatives (5/21/
04). First Union's legal department was apparently limited to drafting
and approving engagement letters to banking clients.
---------------------------------------------------------------------------
Once a KPMG or PwC tax product was approved by First Union,
\522\ the bank appears to have expended considerable effort to
interest its banking clients, arrange a meeting with the
promoter, and facilitate sales. The extent of First Union's
efforts is illustrated in this letter written by a First Union
banking client who purchased a FLIP tax product but never
received a promised legal opinion supporting it. The client
wrote:
---------------------------------------------------------------------------
\522\ First Union approved KPMG's BLIPS, FLIP, and SC2 tax products
for their banking clients. See memorandum dated 9/3/99, from Karen
Chovan, Financial Advisory Services to CMG Risk Review Oversight
Committee, ``Meeting Minutes of September 1 . . .'' Bates SEN-008629-
008631 (approving BLIPS); memorandum dated 6/12/00 from Karen Chovan,
Financial Advisory Services to CMG Risk Review Oversight Committee,
``Meeting Minutes of June 2 . . .,'' Bates SEN-008637-39 (approving
SC2); letter from Thomas Newman to First Union customer, Bates SEN-
021020 (``we [First Union] brought to your attention a transaction
referred to as the Bond & Option Sales Strategy (`BOSS') developed by
Pricewaterhouse Coopers LLP (`PwC') and The Private Capital Management
Group. . . . In connection with that transaction, First Union earned a
fee as a selling agent.''). According to First Union, the total number
of bank customers that actually implemented KPMG products is as
follows: 23 FLIP; 1 OPIS, 1 BLIPS; 3 FOCUS; 3 SC2; 25 SOS. For the SOS
strategy, First Union indicated that KPMG was involved but did not
issue opinions. According to First Union, the following number of bank
customers that actually implemented PwC products is as follows: 19
BOSS; 6 CDS. Subcommittee interview of First Union representatives (5/
21/04).
[T]he Bank [First Union] prior to the Engagement Date
introduced the partnership to the investment counseling firm of
QA Investments of Seattle Washington (``Quadra''). The Bank and
Quadra together presented an Investment Strategy (the
``Strategy'') . . . which involved the organization of an off
shore partnership with a foreign entity for the purpose of
making investments in foreign corporations. The Bank and Quadra
represented the Strategy as having the foremost potential to
make a significant profit while having in a circumstance or
situation of an investment loss a significant income tax
advantage. The Bank and Quadra represented that they would
assist the Partnership in its latter efforts to engage the
services on an independent accounting firm to provide the
Partnership with tax advice and opinion which would address the
Partnership's concerns pertaining to Internal Revenue Code
---------------------------------------------------------------------------
6662.
The Bank and Quadra represented that they would cause to
have issued in a timely manner to the Partnership a Legal
Opinion which could provide the Partnership with a defense in
the event that the whole or certain aspects of the Strategy
were ever challenged by the Internal Revenue Service (the
``IRS'') or in the event that the tax returns of the
Partnership were examined as regards the transaction of the
Strategy. The Legal Opinion was to be issued by the law firm of
Pillsbury, Madison & Sutro, LLP, its successor being:
Pillsbury, Winthrop. LLP. The Bank and Quadra even supplied
Partnership council with a sample draft opinion. Needless to
say the Partnership does rely upon its receipt of the reference
Legal Opinion and did rely upon the representations made
regarding receipt of same in arriving at its decisions to
engage the services of both the Bank and Quadra. The
partnership would most likely not have invested in the Strategy
in the absence of these representations. To the best of its
knowledge at no time has the Partnership ever received a Legal
Opinion from the law firm referenced nor does the Partnership
have any knowledge of the existence of such a Legal
Opinion.\523\
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\523\ Letter from Partnership to Thomas D. Newman dated 4/6/01,
``Re: Engagement of First Union National Bank to provide financial
advisory services,'' Bates SEN-008750-52.
This letter as well as other evidence indicate that First
Union expended significant effort introducing and explaining
tax products designed by others to the bank's clients,
providing sample opinion letters, and introducing financial
advisors and accountants to their clients. Without these
activities, First Union clients might not have purchased KPMG
or PwC tax products. The $13 million in tax product fees
obtained by First Union indicate that, because of the bank's
activities, more than one hundred First Union clients purchased
these and other tax products promoted by the bank.
Because KPMG was the bank's auditor, First Union's multi-
year participation in the promotion of KPMG tax products also
raises disturbing auditor independence issues. In 2003, the SEC
opened an informal inquiry into whether the client referral
arrangement used by KPMG and Wachovia violated the SEC's
auditor independence rule. In its second quarter filing with
the SEC in August 2003, Wachovia provided 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 had issued a ``formal order of
investigation'' into this matter, and the bank is continuing to
cooperate with the inquiry.
The SEC's Business Relationship rule states: ``An
accountant is not independent if, 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. . . .'' \524\
KPMG's Tax Services Manual states: ``Due to independence
considerations, the firm does not enter into alliances with SEC
audit clients.'' \525\ 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.'' \526\ KPMG policy is that ``[a]n oral business
relationship that has the effect of creating an alliance should
be treated as an alliance.'' \527\
---------------------------------------------------------------------------
\524\ 17 C.F.R. Sec. 210.2-01(c)(3).
\525\ KPMG Tax Services Manual, Sec. 52.1.3 at 52-1.
\526\ Id., Sec. 52.1.1 at 52-1.
\527\ 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 73.
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In Subcommittee interviews, KPMG denied any alliance with
First Union with respect to tax product referrals, but evidence
uncovered by the Subcommittee suggests otherwise. For example,
an interoffice memorandum dated May 25, 1998, from First Union
to KPMG states: ``Ted, I thought I'd write to confirm our
discussions by phone on Friday regarding the alliance that
[First Union National Bank] FUNB has with KPMG/Peat Marwick on
offering Enhanced Investment Strategies (Tax Strategies) to
selected clients. . . .'' \528\ Another First Union document,
also in May 1998, sent by a First Union manager to other bank
professionals, shows the bank working directly with KPMG on an
ongoing basis to promote KPMG tax products, and its insistence
that KPMG personnel be included in all tax product
presentations to the bank's clients:
---------------------------------------------------------------------------
\528\ Memorandum dated 5/25/98, from Diane Stanford to Ted
Beringer, ``KPMG Tax Strategies,'' Bates SEN-014862-63.
As you know . . . [w]e have agreed to a process that
requires that our Personal Financial Consultant Sr. Advisors
(Castrucci, Rudolph, Newman, and Martin) be introduced to the
client FIRST and then after making a further assessment of the
client's qualification, will bring in KPMG. It is our
understanding that our ability to be paid a planning fee (which
is generally in the range of $100,000) is dependent on this
agreement with KPMG. We have been aware of some instances where
Trust Specialists and/or Trust admin are going directly to
Quadra, cutting out KPMG AND our planners. PLEASE COMMUNICATE
TO YOUR SENIOR PEOPLE THAT A PLANNER MUST BE INVOLVED IN THIS
PROCESS TO ENSURE THAT OUR ONGOING RELATIONSHIP AND AGREEMENT
WITH KPMG IS PRESERVED.\529\
---------------------------------------------------------------------------
\529\ See email dated 5/19/98, from Diane Stanford to multiple bank
personnel, ``Subject: IMPORTANT UPDATE--TAX STRATEGIES,'' Bates SEN-
014864 (emphasis in original).
Still another First Union document, written in 1999, by
First Union's Capital Management Group, to provide an overview
of the bank's client referral services states: ``CMG has
entered into agreements with outside investment advisors in
order to bring leading edge investment techniques to First
Union customers (and prospects). . . . [A]s part of this
relationship, KPMG Peat Marwick LLP will serve as the `Tax
Strategist and Consultant' with respect to all the investment
strategies to protect the interests of First Union and its
customers.'' \530\
---------------------------------------------------------------------------
\530\ Capital Management Group Enhanced Investment Strategy Series
Overview, Bates SEN-014700-02.
---------------------------------------------------------------------------
Another internal First Union document, describing a 1999
meeting between KPMG and First Union's Financial Advisory
Services Due Diligence Committee, shows that both firms were
fully aware that a formal alliance between the two businesses
raised auditor independence concerns:
Present from KPMG were Sandy Spitz and Jeff Eischeid.
Sandy answered questions regarding their proposal to be a
strategy provider, specifically regarding fee sharing and
internal overlap. Regarding a fee sharing arrangement, Sandy
stressed that KPMG and FUNB can never appear to be involved in
a joint venture. The two organizations must always be
independent, due to the audit relationship.\531\
---------------------------------------------------------------------------
\531\ Minutes dated 4/23/99, of Financial Advisory Services
``Enhanced Investment Strategies,'' ``Risk Management Process/Due
Diligence Committee Meeting,'' Bates SEN-014588-89.
While First Union and KPMG claim that each client paid
First Union directly, and there was no fee sharing arrangement
nor referral fee paid by KPMG to First Union, the evidence
suggests that such claims attempt to elevate form over
substance. The overwhelming evidence is that KPMG and First
Union had an on-going alliance to promote the sale of KPMG tax
products to First Union customers.\532\ In the Subcommittee's
view, this relationship comprised a ``direct or material
indirect business'' relationship between the bank and its
auditor.
---------------------------------------------------------------------------
\532\ First Union denies any formal agreement or alliance despite
the language used in these documents. Subcommittee meeting with First
Union representatives (5/21/04).
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VIII. ROLE OF INVESTMENT ADVISORS
Finding: Some investment advisors, including Presidio
and Quellos, assisted in the development, design, marketing,
and execution of potentially abusive or illegal tax shelters
such as FLIP, OPIS, and BLIPS.
Investment advisors also played a major role with respect
to the development, marketing, and implementation, of generic
tax shelters sold to multiple clients. The Subcommittee's in-
depth examination of KPMG tax shelters provided a detailed view
of this role with respect to two investment firms: Presidio
Advisory Services and the Quellos Group, formally known as
Quadra.
Both Presidio and Quellos assisted in the development and
design of potentially abusive or illegal tax shelters sold by
KPMG. Both assisted in the marketing of these tax shelters to
multiple clients. In addition, both assisted KPMG in the
implementation of these tax shelters by establishing
partnerships, participating in loans, and executing some of the
currency or security trades required to produce the claimed tax
benefits for KPMG clients. In addition, each had relationships
with banks that were instrumental in providing the client loans
necessary for the tax shelters, as well as certain investment
services. Presidio and Quellos were far from alone in providing
such services in the tax shelter industry. Many other
investment advisors such as the Diversified Group, Bolton
Capital Planning, The Private Capital Management Group, and
Bricolage Capital have provided similar services with respect
to tax shelters that were developed and promoted by others.
A. PRESIDIO ADVISORY SERVICES
Robert Pfaff and John Larson are two former KPMG employees
who left the firm in 1999, to form Presidio Advisory
Services.\533\ While at KPMG, Mr. Pfaff was a partner and Mr.
Larson was a senior manager. Evidence uncovered by the
Subcommittee shows that Mr. Pfaff played an instrumental role
in formulating KPMG's business plan for promoting generic tax
shelters to multiple clients. For example, in July 1997, a
month before he left KPMG, Mr. Pfaff wrote a memorandum to the
top two officials in KPMG's tax practice with a number of
suggestions for KPMG's Tax Advantaged Transaction Practice.''
\534\ The memorandum stated, for example, that KPMG needed to
reward ``idea-generators'' for tax products, a suggestion later
carried out by KPMG's Tax Innovation Center.\535\ It
recommended that KPMG ``gain entrance to the international
banking, investment and leasing community and have an alignment
with the `handful' of law firms who are skilled and respected
in this area.'' \536\ KPMG eventually formed relationships with
Deutsche Bank, HVB, First Union, Sidley Austin Brown & Wood,
and others, as chronicled in this Report.
---------------------------------------------------------------------------
\533\ Messrs. Larson and Pfaff 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'').
\534\ See email dated 7/29/97, from Larry DeLap to multiple KPMG
employees, ``Subject: Revised Memorandum,'' Bates KPMG JAC331160-69.
\535\ Id.
\536\ Id.
---------------------------------------------------------------------------
Mr. Pfaff also recommended that KPMG establish a
relationship with an investment firm, such as Presidio, to
market its tax products. He explained: ``To avoid IRS scrutiny,
KPMG had to market its tax products as investment strategies,
but if it characterized it services as providing investment
advice to clients, it could attract SEC scrutiny and have to
comply with Federal securities regulations. . . . [I]t was this
dilemma that led me to the conclusion that KPMG needs to align
with the likes of a Presidio.'' \537\ He expressed his desire
for a close relationship between KPMG and Presidio with the
``goal of developing mutually-beneficial products.'' \538\
---------------------------------------------------------------------------
\537\ Id.
\538\ Id.
---------------------------------------------------------------------------
In fact, since Presidio's inception in 1997, the vast
majority of its work has involved developing, marketing, and
implementing tax products with KPMG.\539\ The basis for this
working relationship was a formal operating agreement that
Presidio and KPMG entered into in September 1997, with respect
to the FLIP tax product. Under the terms of this agreement,
KPMG offered Presidio the right of first refusal to present
FLIP to KPMG clients.\540\ KPMG also committed to using its
best efforts to introduce Presidio to its clients, on a right
of first refusal basis.\541\ In return, Presidio offered KPMG a
right of first refusal to promote all other tax-based products
Presidio developed.\542\ In addition, Presidio committed to
using its best efforts to assist KPMG in developing tax
products that KPMG brought to Presidio's attention.\543\ KPMG
committed to using its best efforts to assist in developing and
distributing new tax products with Presidio.\544\ Also, KPMG
committed that its development costs in jointly developing tax
products with Presidio would be borne by KPMG.\545\ In July
1998, KPMG and Presidio modified and again executed this
agreement.\546\
---------------------------------------------------------------------------
\539\ Subcommittee interview with Presidio representative (6/20/
03). The Presidio representative told the Subcommittee that 95% of the
company's revenues had come from its work with KPMG.
\540\ See Letter dated 9/19/97, from Gregg Ritchie to John Larson,
Bates P41292-94.
\541\ Id.
\542\ Id.
\543\ Id.
\544\ Id.
\545\ Id.
\546\ See memorandum dated 7/2/98, from Gregg Ritchie to Larry
DeLap, ``Subject: Presidio Operating Agreement,'' Bates KPMG 0047221-
23. KPMG later determined that the original agreement was a ``Level II
alliance,'' as defined in KPMG's Tax Manual due to each of the parties
``right of first refusal'' and the provisions to ``jointly develop
products.'' See email dated 6/5/98, from Larry DeLap to Gregg Ritchie,
``Subject: Re[2]: Presidio Alliance Form,'' Bates KPMG 0047208-17
(stating that removal of provisions would create a Level I alliance not
requiring Management Committee approval). This statement implies that
the original agreement did not get the necessary Management Committee
approval in contravention of KPMG procedures. The modified 1998
agreement removed the two provisions.
---------------------------------------------------------------------------
Presidio played a key role in three of the KPMG tax
shelters examined by the Subcommittee, FLIP, OPIS, and BLIPS.
While at KPMG, both Robert Pfaff and John Larson were part of
the development team for FLIP. After they established Presidio,
they implemented six FLIP transactions for KPMG.\547\ According
to an internal KPMG email, Mr. Pfaff was also part of KPMG
discussions to re-design FLIP, which eventually led to
development of the OPIS tax product.\548\ The email indicates
that, for about 6 weeks, a senior KPMG tax professional and
Robert Pfaff 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.
---------------------------------------------------------------------------
\547\ See email dated 6/5/098, from Larry De DeLap to Gregg
Ritchie, ``Subject: Re[2]: Presidio Alliance Form,'' Bates KPMG
0047208-17, at 13.
\548\ Email dated 3/14/98, from Jeff Stein to Gregg Ritchie,
``Subject: Simon Says,'' Bates KPMG 0034380-88.
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Presidio took an even more substantial role in developing
BLIPS. According to Presidio, it initiated the development of
this product in the fall of 1998.\549\ Whereas the idea for
FLIP started within KPMG, and Presidio and KPMG co-developed
OPIS, Presidio alleges that the idea for BLIPS originated in
discussions involving Messrs. Pfaff, Larson, and two San
Francisco based attorneys.\550\ To develop the idea further,
Presidio told the Subcommittee that it hired Amir Makov,
formerly with Deutsche Bank, to provide economic and investment
expertise.\551\ Presidio told the Subcommittee that it had
wanted to present KPMG with a polished ``turn-key'' tax product
that could be easily sold to multiple clients.\552\ The
evidence suggests that, at some point in 1998, Presidio formed
a working group which also included KPMG tax professionals
Randy Bickham, and Jeff Eischeid, and Brown & Wood's R.J.
Ruble.\553\
---------------------------------------------------------------------------
\549\ Subcommittee interview with Presidio representative (10/3/
03).
\550\ Id. One attorney is believed to be George Theofel. See
Memorandum dated 12/3/98, from R.J. Ruble to Randy Bickham, George
Theofel, ``Re: BLIPS,'' Bates SIDL-SCGA083244; email dated 4/28/99,
from Francesco Piovanetti to Nancy Donohue, ``Subject: presidio--
w.revisions, I will call u in 1 min.,'' Bates DB BLIPS 6911-13 (stating
that ``Presidio, in conjunction with ICA, have developed a new product
called BLIPS.''). George Theofel was affiliated with Jackson Tufts Cole
& Black, a law firm in San Francisco, and later Integrated Capital
Associates. According to Martindale-Hubbell, George Theofel is
currently an attorney based in San Rafael, CA.
\551\ Subcommittee interview with Presidio representative (10/3/
03).
\552\ Id.
\553\ See email dated 12/3/98, from Presidio Advisors to Randy
Bickham, Jeff Eischeid, Tracie Henderson, George Theofel, and R.J.
Ruble, ``Subject: RE BLIPS meeting,'' Bates KPMG 0037336.
---------------------------------------------------------------------------
In addition to contributing to the development of the BLIPS
concept, Presidio played a critical role in KPMG's internal
evaluation of BLIPS' viability. KPMG documentation indicates
that, at a critical meeting in May 1999, Presidio described
BLIPS as presenting only a remote probability of producing a
profit for the clients who bought it, thereby causing several
KPMG tax professionals to recommend against approving the
product for sale to clients.\554\ KPMG subsequently determined
to approve BLIPS sales despite the concerns of its tax
professionals, but only after also requiring Presidio and each
BLIPS purchaser to represent in writing that BLIPS provided a
reasonable opportunity to produce a profit. At the
Subcommittee's hearing on November 18, 2003, a former KPMG tax
partner, Mark Watson, testified that Presidio had essentially
changed its analysis of BLIPS' profitability, while at the
hearing on November 20, a Presidio representative, John Larson,
testified that Mr. Watson may have misunderstood the firm's
earlier analysis. Upon further questions by Subcommittee
Chairman Coleman, however, Mr. Larson also acknowledged that
none of the BLIPS transactions executed by KPMG clients ever
actually made a profit. KPMG nonetheless claims to have relied
on Presidio's representation about BLIPS' profitability in
reaching its conclusion that BLIPS met the requirements of
Federal tax law and could be sold to KPMG clients.
---------------------------------------------------------------------------
\554\ See Levin Report, reproduced in the Senate hearing record, at
178-184.
---------------------------------------------------------------------------
In addition to contributing to the development of KPMG tax
products, Presidio also played a key role in marketing and
implementing them. For example, Presidio made numerous
presentations to KPMG clients related to FLIP, OPIS, and BLIPS.
Presidio also undertook many actions to implement the
transactions called for by the tax products, including by
forming partnerships, executing trades, and working with banks
to secure client loans and develop the trading strategies for
the tax shelter transactions. With respect to BLIPS, for
example, Presidio initiated contact with HVB Bank in the fall
of 1999, \555\ and then worked with HVB to help structure loan
terms and refine the investment strategy.\556\ Earlier in 1999,
while KPMG was still vetting BLIPS through its Washington
National Tax review and approval process, evidence indicates
that Presidio was already talking to Deutsche Bank about the
product. For example, a Deutsche Bank email dated February 28,
1999, mentions that Presidio has ``developed a new product
called BLIPS,'' and urges the need for Deutsche Bank to get
``TOP Level Global Markets Go Ahead to proceed.'' \557\ Another
Presidio document, detailing the strategic business plan for
the year 2000, suggests ``schedule[ing] a meeting with Deutsche
Bank the week of November 15, 1999 to discuss the 2000 business
plan and to introduce the `specs' for the `1001' product'' and
scheduling a ``meeting with UBS in November 1999 with the goal
of securing their buy-in as the `co-lead' bank.'' \558\
---------------------------------------------------------------------------
\555\ Subcommittee interview of HVB Bank (10/29/03).
\556\ See memorandum dated 9/14/99, from Robert Pfaff to Dom
DiGiorgio, ``Subject: BLIPS loan test case,'' Bates HVB 000202.
\557\ Email dated 4/28/99, from Francesco Piovanetti to Nancy
Donohue, ``Subject: presidio--w.revisions, I will call u in 1 min.,''
Bates DB BLIPS 6911-13.
\558\ See Presidio Year 2000 Strategic Plan, Bates KPMG 0042855-59.
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A final point concerns the legal obligation of tax shelter
promoters to register their tax products with the IRS and
maintain lists of the clients who bought them. At the
Subcommittee hearings, a former senior tax official at KPMG,
Larry DeLap, testified that he thought the BLIPS transaction
should have been registered with the IRS and that Presidio
should have completed the registration. Presidio told the
Subcommittee in an interview, however, that while it did
conduct activities rising to a level of a promoter, Presidio
did not believe the KPMG transaction met the definition of a
tax shelter under IRS regulations.\559\ Presidio failed to
register FLIP, OPIS, or BLIPS.
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\559\ Subcommittee interview of Presidio representative (10/3/03).
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B. QUELLOS GROUP
The Quellos Group, formerly known as Quadra Capital
Management, provided investment advisory services similar to
Presidio with respect to KPMG's FLIP and OPIS transactions. In
addition, Quellos promoted PwC's version of FLIP. According to
Quellos, it began its relationship with KPMG in 1994, when
structuring a portfolio for a mutual client. \560\ In May 1996,
John Larson, then still employed by KPMG, called Quellos for
assistance with structuring the investment aspects of FLIP.
Quellos told the Subcommittee that KPMG gave it specific
criteria under which to develop the financial transactions.
Quellos told the Subcommittee that it had understood at the
time that designing financial transactions with criteria such
as using a foreign corporation's stock and options, setting up
an offshore corporation, completing the transaction within a
short time frame (i.e., 51 days), purchasing a warrant, and
hedging to limit downside risk, were intended to produce
beneficial tax consequences. Quellos also noted that the tax
structure was developed first, and the investment strategy was
then incorporated into the tax structure--facts which further
demonstrate that FLIP was primarily intended as a tax
transaction.
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\560\ Subcommittee interview of Quellos representative (11/7/03).
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Like Presidio, Quellos also helped KPMG convince a major
bank, UBS AG, to provide financing to FLIP clients and
participate in specific FLIP transactions.\561\ Quellos told
the Subcommittee that, among other tasks, it worked with UBS to
fine-tune the FLIP financial transactions, helped KPMG make
client presentations about FLIP and, for those who purchased
the product, helped complete the required paperwork and
transactions, using Quellos securities brokers.
---------------------------------------------------------------------------
\561\ See, e.g., memorandum dated 8/12/96, from Jeff Greenstein to
Wolfgang Stolz, Bates UBS 000002 (stating with respect to FLIP, ``this
tax motivated transaction is designed for U.S. companies requiring a
tax loss.'').
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In addition to serving as the investment advisor for KPMG's
FLIP and OPIS transactions, Quellos also served as the
investment advisor for PwC's version of FLIP, a transaction
which was substantially similar in all material respects to the
KPMG version. At the Subcommittee hearings, however, Quellos
testified that it had taken action to register with the IRS the
FLIP transaction promoted by PwC, but not the FLIP transaction
for KPMG. When questioned by Chairman Coleman about this
disparate treatment, Quellos explained that it acted in
accordance with the guidance provided by the two accounting
firms, one of which advised it to register and the other of
which advised it that registration was unnecessary.
Quellos also told the Subcommittee that it subsequently
raised the registration issue again with KPMG. On October 9,
1997, Quellos wrote a memorandum to KPMG seeking ``a letter
confirming earlier discussions that the redemption transaction
[FLIP] was not required to be registered as a tax shelter.''
\562\ In response, KPMG wrote a memorandum on October 10, 1997,
stating that the tax shelter registration requirements
applicable to Quadra ``must be made by your Firm in conjunction
with your own tax counsel,'' and that KPMG ``has determined
that it will not register this engagement as a tax shelter.''
\563\ Quellos testified at the Subcommittee hearings that it
``deferred again to their decision, viewing [KPMG] as the
primary promoter, that if they decided that it did not need to
be registered for themselves that we would go with that
assessment.'' Quellos also stated that they viewed KPMG's
statement that Quellos had to make its own registration
decision as an attempt by KPMG ``to absolve them of any
liability that they may have for our decision.'' \564\
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\562\ Memorandum dated 10/9/97, from David L. Smith to Gregg
Ritchie, Bates KPMG JAC 329291.
\563\ Memorandum dated 10/10/97, from Gregg Ritchie to David L.
Smith, Bates KPMG JAC 328964.
\564\ Quellos testimony at Subcommittee Hearings (11/20/03), at
127.
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IX. ROLE OF CHARITABLE ORGANIZATIONS
Finding: Some charitable organizations, including the
Los Angeles Department of Fire and Police Pensions and the
Austin Fire Fighters Relief and Retirement Fund, participated
as counter parties in a highly questionable tax shelter known
as SC2, which had been developed and promoted by KPMG, in
return for substantial payments in the future.
In the case of the SC2 tax shelter examined in this Report,
KPMG and its clients could not have executed any SC2
transaction without the active and willing participation of a
special type of charitable organization, such as a governmental
pension plan, that is authorized to own S Corporation stock and
receive distributions or allocations of income from that stock
without incurring a tax on unrelated business income.\565\
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\565\ For a more detailed description of the SC2 shelter, see the
Levin Report, Appendix B, at 122-125.
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KPMG encountered difficulties in locating and convincing
appropriate charitable organizations to participate in SC2
transactions, but eventually convinced several tax-exempt
entities to do so.\566\ KPMG refused to identify to the
Subcommittee any of the tax-exempt entities it contacted in
connection with the SC2 or any of the tax-exempt entities that
actually participated in SC2 transactions by accepting S
Corporation stock, claiming their identity was Atax return
information'' that it could not disclose. The Subcommittee was
nevertheless able to identify and interview two tax exempt
organizations which, between them, participated in 33 of the 58
SC2 transactions KPMG arranged.\567\ Both turned out to be
municipal pension funds: the Los Angeles Department of Fire and
Police Pensions, and the Austin Fire Fighters Relief and
Retirement Fund.
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\566\ For more information about KPMG's efforts to locate qualified
tax-exempt entities willing to participate in SC2 transactions, see
Section V(A)(1) of this Report.
\567\ Subcommittee interviews with the Fire and Police Pensions of
Los Angeles (10/22/03) and the Austin Fire Relief and Retirement Fund
(10/14/03) confirmed their participation in the SC2 transactions. The
Subcommittee also learned of a fire fighter's pension fund in West
Virginia that participated in SC2 transaction by accepting S
Corporation stock donations.
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The evidence indicates that both of these pension funds
knew that they were participating in transactions whose primary
purpose was to provide tax benefits to each person who
``donated'' S Corporation stock to the fund.\568\ Both pension
funds also knew that the shares they received were intended to
be in their possession on a temporary basis, to be followed in
a few years by their re-sale of the shares to the original
owners. Both pension funds agreed to participate in the
transactions in exchange for what they hoped would be
substantial payments in the future. The Los Angeles pension
fund, for example, as of November 2003, had participated in 28
SC2 transactions over 3 years, re-sold ``donated'' stock to 11
of the original ``donors,'' and obtained $5.9 million in
exchange, while the ``donors'' themselves attempted to shelter
from taxation many millions of dollars in S Corporation income
earned during the period in which the pension funds held the
shares.
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\568\ While documents provided by KPMG to the pension funds made it
clear that the persons providing stock would be able to shelter income
through the SC2 transaction, the Los Angeles Department of Fire and
Police Pensions indicated that it had not realized the SC2 transactions
were elaborate tax avoidance schemes until contacted by the
Subcommittee staff about them.
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On April 1, 2004, the Internal Revenue Service declared SC2
and similar transactions to be abusive tax shelters that did
not legally exempt S Corporation income from Federal
taxation.\569\
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\569\ IRS Notice 2004-30 (4/1/04).
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A. LOS ANGELES DEPARTMENT OF FIRE AND POLICE PENSIONS
The Los Angeles Department of Fire and Police Pensions
(referred to as ``Los Angeles pension fund'' or ``pension
fund'') is a $10 billion pension fund that serves the police
and fire departments in the city of Los Angeles,
California.\570\ The Los Angeles pension fund participated in
28, or nearly 50 percent, of the 58 SC2 tax products sold by
KPMG between 1999 and 2002.
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\570\ Information about the Los Angeles pension fund and its
participation in SC2 transactions is taken from documents supplied to
the Subcommittee by the pension fund; Subcommittee staff interviews
with representatives of the pension fund; a Statement for the Record by
Thomas Lopez, Chief Investment Officer of the Fire and Police Pensions
of Los Angeles, reprinted in the Subcommittee hearings (11/18/03) at
3016 as Hearing Exhibit 153 (hereinafter ``Los Angeles pension fund
statement''); and Responses to Supplemental Questions for the Record by
the pension fund, reprinted in the Subcommittee Hearings at 3017-24
(hereinafter ``Los Angeles pension fund supplemental response'').
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At the time of the Subcommittee hearings in November 2003,
the pension fund held $7.3 million worth of S Corporation stock
received through 16 SC2 transactions, and had sold back stock
to 11 S Corporation shareholders in exchange for payments
totaling $5.9 million.\571\ Subsequently, in December 2003,
three more donors redeemed their S Corporation shares from the
pension fund, while one donor revoked a gift of stock that had
been made in an SC2 transaction.\572\
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\571\ See Los Angeles pension fund statement; documents supplied to
the Subcommittee by the pension fund. In two of the instances, the
pension fund had participated in the SC2 transactions by accepting S
Corporation stock from KPMG clients on December 31, 1999, 3 months
prior to KPMG's approving SC2 as a generic tax product in March 2000.
See e-mail dated 3/30/2000, from William Kelliher to Larry DeLap and
other KPMG personnel, ``SC2,'' Bates KPMG 0049901-03, reprinted in the
Subcommittee Hearings at 1861-63. The pension fund also told
Subcommittee staff that one of the 28 SC2 transactions, implemented on
December 31, 2001, was subsequently revoked by the taxpayer on June 18,
2002. The redemption agreement specified that redemption period did not
begin until December 31, 2004, but the pension fund returned the stock
without remuneration.
\572\ Los Angeles pension fund Supplemental Response at 8.
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The Los Angeles pension fund told Subcommittee staff that
KPMG had contacted it ``out of the blue'' about the SC2 tax
shelter in the fall of 1999, and that although it willingly
participated in the SC2 transactions, it would not have done so
absent being approached, convinced, and assisted by KPMG.\573\
The pension fund also told the Subcommittee that it never
conducted its own due diligence review into whether the SC2
transactions complied with Federal tax law.\574\ Instead, the
pension fund had relied upon representations made to it by KPMG
that the transaction met the requirements of the tax code.\575\
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\573\ See Los Angeles pension fund statement; Los Angeles pension
fund Supplemental Response at 2; and other documents supplied to the
Subcommittee by the pension fund. The Los Angeles pension fund was
contacted by Lawrence E. Manth, then a partner in KPMG's Los Angeles
office, and Douglas P. Duncan, then a manager in the same Los Angeles
office.
\574\ Subcommittee staff interviews with representatives of the Los
Angeles pension fund. The pension fund also sought and received legal
guidance from Seyfarth, Shaw, Fairweather & Geraldson, its legal
counsel. See letter dated 12/30/99, from Sayfarth, Shaw, Fairweather &
Geraldson to the pension fund, reprinted in the Subcommittee Hearings
as Hearing Exhibit 155 at 3757-66. The advice sought by the fund and
provided by the law firm did not, however, address the tax consequences
of the SC2 transaction, but merely the narrow issue of whether the fund
had the legal authority to accept a donation of S Corporation stock.
The letter stated in part:
LIt 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 on
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. Id. at 2. The law firm's letter to
the pension fund also characterized the transaction as ``very
unusual.'' Id. at 1.
\575\ Subcommittee staff interviews with representatives of the Los
Angeles pension fund. At the same time KPMG was marketing SC2 to tax
exempt organizations, as explained earlier in this Report KPMG tax
professionals were expressing uncertainty within the firm as to whether
SC2 would withstand IRS scrutiny. See, e.g., e-mail dated 12/20/01,
from William Kelliher to David Brockway, Bates KPMG 0012720-24 (``. .
.In my opinion, there was (and is) a strong risk of a successful IRS
attack on SC2 if the IRS gets wind of it.''), reprinted in Subcommittee
Hearings as Hearing Exhibit 59, at 604-608; and e-mail dated 4/11/00,
from Larry DeLap to KPMG's Tax Professional Practice Partners, AS-
Corporation Charitable Contribution Strategy (SC2),'' Bates KPMG
0015631 (``This is a relatively high risk strategy.''), reprinted in
the Subcommittee Hearings as Hearing Exhibit 50 at 584.
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The Los Angeles pension fund's lack of due diligence
extended to other matters as well. For example, the pension
fund relied upon KPMG to make sure that specific donations were
from legitimate businesses, and frequently depended upon KPMG
to screen donors and companies prior to its accepting
donations.\576\ The pension fund told Subcommittee staff that
KPMG often did not disclose the names of specific donors and
companies to the fund until shortly before a transaction was
entered into by the parties.\577\ Over a 3-year period, the Los
Angeles pension fund accepted stock donations from S
Corporations located in Arizona, California, Delaware, Georgia,
Hawaii, Kansas, and North Carolina, relying primarily on the
representations and due diligence conducted by KPMG.\578\
---------------------------------------------------------------------------
\576\ Los Angeles pension fund Supplemental Response at 2-3.
\577\ Id. at 3; Subcommittee staff interviews of representatives of
the Los Angeles pension fund.
\578\ Subcommittee staff interviews with representatives of the Los
Angeles pension fund; and documents supplied to the Subcommittee by the
pension fund related to particular transactions. The Los Angeles
pension fund also told Subcommittee staff that, after September 2002,
it dealt with a second professional firm, Meritage Financial Partners,
LLC (``Meritage''), in connection with the SC2 transaction. The
founding members of Meritage include former KPMG employees Lawrence
Manth, Douglas Duncan, Andrew A. Atkin, and Robert E. Huber, all of
whom had worked on the SC2 tax shelter. The California Secretary of
State indicates that Meritage Financial Partners, LLC, filed for
certification with the state on August 2, 2002. Meritage remains listed
as an active business.
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On paper, in each SC2 transaction, the Los Angeles pension
fund generally received 90% of an S Corporation's outstanding
shares and was entitled to 90% of the corporation's
distributions. Yet the pension fund did not manage or oversee
its S Corporation holdings as if it were a true shareholder
with a substantial financial interest in the performance of the
corporation. For example, the pension fund indicated to the
Subcommittee that it did not know whether the distributions, if
any, that were made to it while it owned the S Corporation
stock were consistent with the historical distributions of the
S Corporation; the pension fund did not keep track of the
annual income allocated but not distributed to it; and it did
not know what happened to any unallocated funds after it re-
sold the shares to the original owners. When the owners of
shares in one S Corporation asked the pension fund to redeem
their shares earlier than the time period specified in the
redemption agreement, so that the S Corporation could be
purchased by another company, the pension fund relied on KPMG's
assertion that the per share redemption price paid to the
pension fund reflected the new, higher value of the S
Corporation's shares.\579\
---------------------------------------------------------------------------
\579\ Los Angeles pension fund Supplemental Response at 4-5, 7;
Subcommittee interviews with representatives of the Los Angeles pension
fund.
---------------------------------------------------------------------------
Further, the Los Angeles pension fund told the Subcommittee
that it did not expect to obtain significant amounts of money
from the S Corporations during the period in which it was a
shareholder, but expected instead to obtain a substantial
payment when it re-sold the shares to the original owners or
their S Corporation.\580\ In fact, the pension fund disclosed
that, in many instances, the S Corporations in which it was a
shareholder had suspended all distributions during the period
of time in which the pension fund held its stock. The Los
Angeles pension fund told the Subcommittee that only nine
corporations, less than one-third of the 28 S Corporations in
which it had holdings through SC2 transactions, had made any
distributions to the pension fund while it was a
stockholder.\581\ The pension fund also disclosed that at least
six of these nine S Corporations had apparently made a
distribution to the pension fund only to take advantage of an
extension clause in the redemption agreement enabling the S
Corporation owners to shelter income for an additional year if
a distribution was made to the pension fund.\582\
---------------------------------------------------------------------------
\580\ Los Angeles pension fund Supplemental Response at 1-2;
Subcommittee staff interviews with representatives of the Los Angeles
pension fund.
\581\ In its Supplemental Response to the Subcommittee, the Los
Angeles pension fund reported eight corporations had made
distributions. The pension fund later informed the Subcommittee that an
additional S Corporation had subsequently made a distribution of income
to the fund.
\582\ Documents supplied to the Subcommittee by the pension fund
related to particular transactions; and Subcommittee staff interviews
with representatives of the Los Angeles pension fund. The six instances
in which a distribution was made by an S Corporation to the pension
fund are as follows:
(a) A redemption agreement between the pension fund and one S
Corporation extended the redemption date from June 15, 2003 to June 15,
2004, if the S Corporation made a dividend payment in the amount of
$50,000. Although the S Corporation paid a dividend of only $9,000, the
pension fund extended the redemption date to July 15, 2004. (b) A
redemption agreement automatically extended the beginning of the
redemption period date from June 30, 2002 to June 30, 2003, if the S
Corporation made dividend payments in the amount of $75,600, before
June 30, 2002, which it did. The S Corporation made a second dividend
payment of $7,600 before June 30, 2003, and the pension fund again
extended the redemption date to June 30, 2004. (c) A redemption
agreement automatically extended the beginning of the redemption period
date from June 30, 2002 to June 30, 2003, if the S Corporation made a
dividend payment of $114,975. On June 25, 2002, the corporation made a
distribution of exactly $114, 975. The S Corporation had a further
option to extend the redemption date from June 30, 2003, to June 30,
2004, if it made another distribution of $144,900, before June 30,
2003. On June 27, 2003, it made a distribution of exactly $144,900. (d)
A redemption agreement automatically extended the beginning of the
redemption period date from June 30, 2002 to June 30, 2003, if the S
Corporation made distributions of $144,900, to the pension fund before
June 30, 2002. On June 26, 2002, the S Corporation, in fact, made a
distribution of exactly $144,900. (e) A redemption agreement
automatically extended the beginning of the redemption period date from
July 15, 2003, to July 15, 2004, if the S Corporation made a dividend
payment in the amount of $135,000. The S Corporation had a further
option to extend the redemption until June 30, 2004, if it made an
additional dividend payment of $114,975, before June 30, 2003. It paid
dividends of $114,975, before June 30, 2003, and extended the
redemption agreement until June 30, 2004. (f) A redemption agreement
automatically extended the beginning of the redemption period date from
January 2004 until January 2005, as long as the S Corporation paid the
pension fund $30,000 in dividends. The pension fund did not provide the
Subcommittee with the amount of dividends it received from the S
Corporation. The pension fund did not provide information to the
Subcommittee about the redemption agreement between the pension fund
and a seventh S Corporation.
---------------------------------------------------------------------------
The pension fund told the Subcommittee that, in all of the
28 SC2 transactions in which it participated, it had expected
to retain ownership of the S Corporation stock only for a
specified period of time, generally 2 to 4 years, as
established in a redemption agreement which it entered into
with the original stock owners at the time of the stock
assignment.\583\ The pension fund indicated that every SC2
transaction had included an executed redemption agreement, and
every one of the redemption agreements had enabled the pension
fund, after holding the S Corporation stock for a specified
period of time (typically 2, 3, or 4 years), to require the
original stock owners or their S Corporation to redeem the
shares.\584\ The pension fund further indicated that the SC2
transactions had unfolded as planned, ending in a re-sale of
stock to the owners or their S Corporation, unless the owner or
corporation had asked the pension fund to return the shares
earlier or later than the specified period or had otherwise
revoked the gift. The evidence shows that there were no
instances in which the Los Angeles pension fund sold S
Corporation shares to any party other than the original owners
of the stock.\585\ In addition, in all instances in which the
pension fund returned shares to the original owners earlier or
later than the period originally established in the redemption
agreement, it was the owners who had requested the change.\586\
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\583\ Subcommittee staff interviews with representatives of the Los
Angeles pension fund.
\584\ Subcommittee staff interviews with representatives of the Los
Angeles pension fund; Los Angeles pension fund Supplemental Response at
1-3; documents provided to the Subcommittee by the pension fund related
to specific transactions. The redemption agreement also required that
if the tax exempt received a purchase offer from an outside party for
the shares, the S Corporation and its shareholders had a right of first
refusal. While none of the redemption agreements entered into by the
pension fund explicitly required the pension fund sell its non-voting
shares back to the original owners, there were no instances in which
the pension fund sold S Corporation shares to any party other than the
original owners of the stock.
\585\ Documents supplied to the Subcommittee by the Los Angeles
pension fund related to particular transactions; Subcommittee staff
interviews with representatives of the Los Angeles pension fund.
\586\ See documents supplied to the Subcommittee by the Los Angeles
pension fund related to particular transactions. In seven of the 28 SC2
transactions, the original owners of the shares or the related S
Corporation had sought an early redemption (in five instances) or
revoked the gift outright (in two instances). The pension fund
indicated that, in some instances, Douglas Duncan from KPMG's Los
Angeles office, acting on behalf of the original stock owners, had
approached the pension fund about early redemption or revocation of the
stock donation. The pension fund told Subcommittee staff that it had
agreed to these early redemptions because ``a dollar in the hand is
worth two in the bush.'' In other instances, the pension fund had
agreed to an extension of the redemption period at the request of the
original owners of the shares or the related S Corporation. In one
other instance, the pension fund indicated that the S Corporation had
asked the pension fund to retain ownership of the stock after the
redemption period had lapsed, because the original owners of the shares
did not have sufficient funds at that time to redeem the stock at fair
market value. The pension fund then retained the stock for 11 months
beyond the time period established in the redemption agreement. See Los
Angeles pension fund Supplemental Response at 4.
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B. AUSTIN FIRE FIGHTERS RELIEF AND RETIREMENT FUND
The Austin Fire Fighters Relief and Retirement Fund
(referred to as ``Austin pension fund'' or ``pension fund'') is
a $400 million pension fund that serves the fire departments of
Austin, Texas.\587\ Like the Los Angeles pension fund, the
Austin pension fund told the Subcommittee that KPMG had
contacted the pension fund ``out of the blue'' about the SC2
transaction. The pension fund administrator told Subcommittee
staff that he was ``uncertain why anyone out-of-state would be
interested in contributing to the Austin pension fund . . . but
that the fund could not look a gift horse in the mouth.'' \588\
The Austin pension fund participated in five SC2 transactions
and received stock from S Corporations in California,
Mississippi, New Jersey, and New York. The first transaction
occurred in October 2000, and the last in March 2001.
---------------------------------------------------------------------------
\587\ Information about the Austin pension fund and its
participation in SC2 transactions is taken from documents supplied to
the Subcommittee by the pension fund; and Subcommittee staff interviews
with representatives of the pension fund.
\588\ Subcommittee staff interviews with representatives of the
Austin pension fund.
---------------------------------------------------------------------------
The Austin pension fund told the Subcommittee staff that
documents it received from KPMG in connection with the SC2
transaction were referred to its legal counsel for review prior
to accepting any stock donations. The pension fund indicated
that its legal counsel conducted a due diligence review only
with respect to the materials KPMG had provided, and concluded
that KPMG had found a ``loophole'' or ``wording'' in the
Internal Revenue Code which enabled the pension fund to accept
S Corporation stock donations.\589\ However, legal counsel did
not provide the pension fund with a written legal opinion, and
the pension fund did not seek further legal advice from another
outside firm before accepting S Corporation stock. The pension
fund told the Subcommittee staff that, regardless of the advice
it had received from legal counsel, it remained skeptical that
such S Corporation stock donations would ever result in future
income to the pension fund.\590\ The pension fund nonetheless
participated in five SC2 transactions over a 6-month period.
---------------------------------------------------------------------------
\589\ Id.
\590\ Id., the Austin pension fund told the Subcommittee staff
during a telephone interview conducted on May 11, 2004, that ``it
[referring to SC2] appeared to be a tax loophole, but from the
standpoint of our members we couldn't overlook a donation.''
---------------------------------------------------------------------------
Like the Los Angeles pension fund, the Austin pension fund
conducted little, if any, due diligence related to the specific
SC2 transactions presented to the fund by KPMG. For example,
the Austin pension fund told the Subcommittee that it had
relied on KPMG or the relevant S Corporation to determine the
fair market value of the non-voting stock that was donated to
the pension fund and for the value of that same stock several
years later when the fund re-sold it to the donors or their S
Corporation. The Austin pension fund administrator told the
Subcommittee staff that the pension fund did not conduct any of
its own valuations, but simply ``took KPMG's word'' regarding
the value of the donated stock.\591\ Moreover, the fund
administrator characterized the S Corporation stock as
``basically useless'' and stated that he believed the fund
would only receive income from the stock when the original
owner repurchased it. He indicated, however, that the sentiment
at the pension fund was not to ``look a gift horse in the
mouth.'' \592\
---------------------------------------------------------------------------
\591\ Id.
\592\ Id.
---------------------------------------------------------------------------
The Austin pension fund told the Subcommittee that the SC2
transactions were, in fact, carried out as planned by KPMG. Of
the five SC2 transactions in which the pension fund had
participated, the Austin pension fund administrator indicated
that one original stock owner had redeemed the shares at the
conclusion of the period specified in the redemption agreement;
in two instances, shares were redeemed by the original owners
earlier than the period established in the redemption
agreement, at their request; and two transactions remained
outstanding.\593\
---------------------------------------------------------------------------
\593\ Id. With respect to the two transactions still outstanding,
the Austin pension fund indicated that the redemption date for one of
the transactions had been extended in a similar fashion as in the
examples cited earlier with the Los Angeles pension fund, and in the
second transaction, the original stock owner was seeking to extend the
redemption date to a future year after the distribution of dividends to
the Austin pension fund.
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On April 1, 2004, the Internal Revenue Service issued a
notice declaring the SC2 shelter and similar transactions to be
abusive tax avoidance transactions and deeming them ``listed
transactions.'' \594\ In addition, the IRS declared that tax
exempt parties in the transactions would be treated as
participants in the transactions. According to an IRS release
accompanying the 2004 notice, it was ``the first time the IRS
has exercised its authority under the tax shelter regulations
to specifically designate a tax exempt party as a participant
in a tax avoidance transaction.'' \595\
---------------------------------------------------------------------------
\594\ IRS Notice 2004-30 (4/1/04).
\595\ ``Treasury and the IRS Issue Guidance on S Corporation, Tax
Exempt Entity Transaction,'' IRS 2004-44 (4/1/04).
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KPMG stopped marketing new SC2 transactions in 2002, but
many of the 58 SC2 products it had sold previously remained
active in 2003 and 2004. Similarly, while the Los Angeles and
Austin pension funds told the Subcommittee that they had
stopped entering into new SC2 transactions, both continued to
hold S Corporation stock from earlier transactions and planned
to re-sell their S Corporation holdings to the original stock
owners for additional, substantial sums.