Aggressive Tax Positions

A recent study by the Institute on Taxation and Economic Policy details how Fortune 500 Companies are holding a record $2.6 trillion offshore, thereby avoiding $767 billion in U.S. taxes.  While we believe much of this amount is the result of lawful tax planning on the companies’ international operations and the use of tax haven entities, there remains a significant amount of aggressive tax planning here which is ripe for potential IRS whistleblower cases.  For example, a byproduct of holding trillions of dollars offshore is that it is difficult to bring the money back to the U.S. to use it without paying taxes on those deferred profits.  Therefore, many taxpayers have entered into abusive repatriation transactions to bring the cash back.  Or taxpayers have used hyper aggressive tax planning strategies involving financing structures or transfer pricing to get the profits in the tax haven jurisdiction in the first place.  While Congress may eliminate deferral or make other drastic changes to the Internal Revenue Code in the coming year, the fact remains that these tax underpayments already exist and thus are subject to IRS whistleblower claims.  We suspect the transition rules to whatever new international tax regime Congress comes up with will be similarly and abusively gamed by these companies to wring out the last drop of tax savings.

While many of the Fortune 500 companies have set aside reserves for uncertain tax positions that would cover some of this tax avoidance, many other taxpayers have not reserved at all for these positions by convincing their financial auditors that the risk is minimal or by hiding the risk from them altogether. We’ve been carefully tracking these reserves since 2010 and have concluded that the answer is usually a little bit of both.  Either way, whistleblowers with access to tax accrual workpapers would be able to see what those reserved weaknesses are, and whistleblowers who have unique insight to the unreserved positions have valuable information as well about what those skeletons in the closet are.  We’ve had great success reporting both to the IRS under their tax whistleblower program, so if you know of either type of issue you should give us a call to discuss what your opportunities and rights are.

Tom Herman had an interesting article in today’s Wall Street Journal about the low chance of getting audited by the IRS. It was nice to see Tom back to writing for the Journal, he used to be the WSJ Tax Report columnist and covered IRS whistleblowing. Tom starts the article off with a bang by saying:

Those who like to be, well, creative when filing out their federal income-tax returns may take cheer from the following.”

The article goes on to cover the seemingly ever decreasing rate of enforcement by the IRS.  IRS Commissioner John Koskinen is quoted as stating that the IRS budget is down $900 million from 2010.  Koskinen stated that “Exam rates are continuing their downward trend in all categories – individuals, small businesses and large corporations….”  These are great facts if you are a tax cheat; not so great for everybody else.

Now, more than ever, the need for tax whistleblowers is vital to the efficient enforcement of tax.  People with high-quality information about the underreporting of tax are an amazing resource to the IRS, especially in these tighter times.  Issue identification, the part of an audit where the IRS determines what issues to fully examine can eat up an audit budget fast.  The IRS is constantly working to reduce issue identification cost.  The creation of Schedule UTP and the recent announcement of LB&I Compliance Campaigns are a couple examples.  When an insider can point out the areas where an audit is most likely to bear fruit, the IRS is able to hone in and make the most of its enforcement budget. 

The IRS whistleblower program works (perhaps we will do a future blog on the number of millionaires we have helped create).  If you have information on tax underpayments we encourage you to seek assistance from a tax lawyer who can help you present it to the IRS in a way that shows the issues you have identified are a smart place to put the IRS’s enforcement dollars.  Together, we can help reduce tax underpayments even in the face of fewer IRS boots on the ground.

Each year the IRS publishes a list of common tax scams that taxpayers may encounter during the tax year.  These annual lists serve as a way for the IRS to remind taxpayers to use caution during the tax season to protect themselves against a wide range of schemes.  This year’s list includes abusive tax structures, specifically mentioning misuse of trusts and captive insurance schemes.

Abusive tax structures is a staple of the “Dirty Dozen” list and generally includes any structure that is created to conceal the true nature and ownership of taxable income and/or assets.  These structures range from simple structuring of abusive domestic and foreign trust arrangements to strategies which take advantage of financial secrecy laws of some foreign jurisdictions.  IRS Criminal Investigation has a nationally coordinated program to combat abusive tax structures, which focuses on the identification and investigation of the tax scheme promoters as well as those who play an integral role in facilitating, aiding, assisting, or furthering the abusive tax scheme.  The IRS states that taxpayers should be on the lookout for tax products that are too good to be true, especially where there is a claim of eliminating or substantially reducing your tax liability.  Some things to watch out for are unnecessary steps in transaction and where the form of the transaction does not match the substance of the transaction.

The IRS highlighted abusive captive insurance schemes as an abusive tax structure this year.  Captive insurance companies can and often do serve a legitimate business purpose, a seeming tide of unscrupulous promoters have been abusing the provisions that make these captives feasible.  These promoters often market these captives as bringing something that has long been used by large companies to manage risk and reduce their tax burden to taxpayers of all size.  It has been well established that businesses are able to create captive insurance companies to insure against certain risks.  The insured operating business claims deductions for premiums paid for the insurance policies with the captive insurance company owned by the same owners of the insured.  The tax benefit for this scheme comes from section 831(b), which allows for small insurance companies, whose premium income does not exceed $1.2 million, to elect to be taxed on only the investment income from the pool of premiums.  This functionally allows for the exclusion of up to $1.2 million per year in net written premiums from taxable income by the group of companies.  However, in order to receive the tax benefits the operating business must pay premiums to an actual insurance company for insurance.  The framework for what constitutes insurance requires that there be (1) risk shifting, (2) risk distribution, (3) insurance risk; and (4) whether the arrangement meets commonly accepted notions of insurance. 

A number of unscrupulous promoters market this scheme to closely held businesses and assist these entities in creating captive insurance companies onshore or offshore, drafting organizational documents, and preparing initial filings to state insurance authorities and the IRS.  These promoters often attempt to match the premiums to the amount of income that the business owner would like to shelter from tax, up to $1.2 million, rather than price the premiums according to the actual risk of loss that is being insured.  The promoters often times poorly drafted “insurance” binders and policies to cover ordinary business risks or esoteric, implausible risks for exorbitant “premiums,” often leaving the operating business’s commercial coverage with traditional insurers largely, if not entirely, unchanged.  This leads to no real shifting of insurance risks, two requirements for insurance for Federal income tax purposes, from the insured operating business to the captive insurance company. 

Unscrupulous promoters find new products to promote as the old products are determined to be abusive by the IRS and the courts.  As such, we expect that the IRS will continue to pursue unscrupulous promoters and the latest trends in abusive tax structures.  If you have knowledge of an abusive tax structure, contact The Ferraro Law Firm to discuss filing a claim for an award for providing this information to the IRS.

Bloomberg reporters Alex Barinka and Jesse Drucker just wrote an interesting article about how one large multinational is using its tax haven structures, which are typically put in place to supercharge foreign earnings by moving them to low tax jurisdictions through aggressive transfer pricing, to boost earnings when sales slowdown.  Based on an analysis of IBM’s financials, last year IBM drove its effective tax rate down to the lowest levels in 20 years, a mere 15.6% instead of the normal corporate income tax rate of 35%.

IBM is becoming more aggressive in its tax planning tactics.  IBM fell two places on the Ferraro 500 despite the fact that its reserves increased from $5.58 billion in 2011 to $5.67 billion in 2012.  It will be interesting to see IBM’s tax reserves for 2013 once it files its 10-K.  Since we started tracking tax reserves for the Fortune 500 in 2010, using reserves from 2009, IBM has increased its tax reserves by nearly a billion dollars.  It should be noted that the tax reserves that are reported are for those position that the company does not feel will be sustained on audit.  This type of large-scale aggressive corporate tax planning is ripe for a whistleblower to come forward with information identifying the flaws in these tax schemes.

Today’s CFO Journal reported that a warning from the Public Company Accounting Oversight Board (“PCAOB”) late last year has resulted in much more stringent external audits being conducted by auditors of public companies.  PCAOB has been auditing the auditors to make sure public companies’ financials are not being rubber stamped.  Increased audit scrutiny can be a great thing for potential IRS whistleblowers.  When auditors take a closer look at uncertain tax positions this can result in far greater detail being in the tax accrual workpapers.  As we have noted in the past, Schedule UTP has done little to change company behavior.  Knowledgeable insiders with access to a company’s tax accrual workpapers could provide extremely useful information to the IRS and be rewarded handsomely.  Large companies maintain billions of tax reserves to account for tax positions where the company believes the IRS is more likely to prevail on the issue than the company.  We know firsthand that IRS whistleblowers with access to information about the tax positions that make up those reserves can successfully present a submission to the IRS.  Now, more than ever, there are great opportunities for a tax department insider to make a meaningful impact on the tax gap.

Tax shelters are an on-going battle for the IRS and the Department of Justice with large amounts of money at stake for the government, the taxpayer, and possibly for a knowledgeable whistleblower.  Tax shelter cases involve schemes that attempt to manipulate internal revenue laws in order to reduce participants tax liability and are typically marketed to a large number of taxpayers.  Tax shelters tend to involve unnecessarily complicated transactions so that the transaction appears to fit the technical requirements of a beneficial rule, but clearly lack the economic substance.  In these cases, a knowledgeable whistleblower could provide the IRS with information about the scheme allowing the IRS to engage in a promoter audit that would allow the IRS to audit and assess tax, interest, and penalties against the taxpayers that used the tax shelter and the promoter that sold or promoted the tax shelter.  The assistance of a whistleblower in a tax shelter transaction could reduce the time that it takes the IRS to discover and ultimately assess tax on the improperly sheltered income.

For example, Paul M. Daugerdas, a former partner at Jenkens & Gilcrest, was convicted for his role in a tax shelter scheme in which he and his co-conspirators designed, marketed, and implemented fraudulent tax shelters used by wealthy individuals to avoid paying taxes to the IRS from 1994 to 2004.  Over the course of a decade, the scheme generated over $7 billion of fraudulent tax losses and netted Daugerdas approximately $95 million in fees. 

Internal Revenue Service, Criminal Investigation Chief Richard Weber described the conviction saying: “Mr. Daugerdas’s use of convoluted mechanisms to conceal income from the IRS is criminal activity.  He designed and marketed tax shelters making him $95 million in illegal profits from the ten-year scheme.  Taxpayers deserve our vigilance in making sure everyone pays their fair share of tax.”  However, the jury acquitted Denis Field, the former CEO of BDO Seidman, on seven counts against him including conspiracy and tax evasion.

According to the Department of Justice, Daugerdas participated in a scheme to defraud the IRS by designing, marketing, implementing, and defending fraudulent tax shelters between 1994 and 2004.  As part of this scheme, Daugerdas and others undertook to prevent the IRS from: (i) detecting their clients’ use of these shelters; (ii) understanding how the transactions operated to produce the tax results reported by the clients; (iii) learning that the shelters were marketed as cookie-cutter products designed to eliminate or reduce large tax liabilities; (iv) learning that the clients were not seeking profit-making investment opportunities, but were instead seeking huge tax benefits; and (v) learning that, from the outset, all the clients intended to complete a pre-planned series of steps that had been designed to lead to the specific tax benefits sought by the clients. Daugerdas and others created, and assisted in creating, transactional documents and other materials that falsely and fraudulently described their clients’ motivations for entering into the tax shelters and for taking various steps in order to yield the tax benefits.  As a result of the scheme, the defendant and his co-conspirators made millions of dollars in fees and bonuses.  Specifically, Daugerdas made $95 million in profits but used tax shelters to reduce the taxes he paid to less than $8,000; without the shelters, he would have owed over $32 million in taxes.

In addition to Daugerdas and Field, five others were indicted for their roles in this scheme, including David Parse and Donna Guerin.  David Parse, a former broker at Deutsche Bank was convicted of various tax fraud charges in May, 2011 after an 11-week jury trial, and was sentenced in March, 2013 to 46 months in prison.  Donna Guerin, a former lawyer at J&G’s Chicago tax practice pled guilty for her role in the scheme to various tax fraud charges in September, 2012.  She was sentenced in March, 2013 to eight years in prison and ordered to pay $190 million in restitution.  

Thumbnail image for MartySullivan1-800x531.jpgKudos to Martin Sullivan, Chief Economist and Contributing Editor at Tax Analysts who had a nice piece in the Washington Post published about him over the weekend.  I’ve always admired Marty’s ability to cut through the political BS and revenue scoring to see the true cost and impact of our tax laws and proposed tax legislation.  In this article Marty tells it like it is and where the real money is in large corporate tax avoidance.

USA Today last week also published the results of their recent review of the Annual Statements of the Standard & Poor’s 500, and found that 57 companies had a effective tax rate of zero.  Nada.  0%  That’s zero point zero. (Some were even negative, but that often occurs temporarily with losses or significant NOL carryforwards.)  

 

They said that “The effective tax rate is a popular measure used by investors to compare how much companies pay in tax relative to profit” and it’s no surprise to us that there are so many companies paying no taxes.  We see companies paying no Federal Income taxes every year when we compile the Ferraro 500 list of companies based on the size of their uncertain tax position reserves.  

And finally, on a related note, just this morning Jesse Drucker at Bloomberg profiled an advisor in Ireland who is instrumental in helping multinationals with Irish tax avoidance strategies.  Jesse wrote: “In 2010, U.S. companies attributed $95 billion in profits to Irish subsidiaries, up more than sevenfold from $13 billion in 2000… Many of the Irish subsidiaries have no offices or employees and pay no income taxes. They are merely ways to move profits out of countries where sales take place to mailbox subsidiaries in zero-tax island havens.”  

 

I saw an interesting article today by the President and Publisher of Tax Analysts in which he drew attention to the role of tax professionals in the growing crisis over reduced corporate tax receipts in a time of record corporate profits. He focused his audience’s attention on a recently released study by The Organisation for Economic Co-operation and Development (“OECD”) which described the need for the international tax community to solve the problem of base erosion and profit shifting (“BEPS”). Sure, that’s a lot acronyms to the uninitiated, but at its heart this is a giant shell game of “where’s the income?”, and unfortunately for those of us living in civilized society, the offshore tax haven shell is where it’s at. Large multinationals frequently use abusive strategies, some of highly questionable legality, to minimize their worldwide tax bill. Many politicians have made hay over US based multinationals reporting billions of dollars of income in e.g. the British Virgin Islands, and hardly any here where their employees and a large portion of their sales actually are.

 

We agree that for the most part companies abide by, and optimize their behavior for, the rules that are set for them. However, the grey line is often crossed. In our Ferraro 500 last year we noticed that reserves for uncertain tax positions exceeded total US corporate tax collections*, and that’s just for the Fortune 500 companies. While moving the line to collect more revenue (while maintaining international competitiveness) and to make it more of a black line than a grey line should be the goal of legislators, governments need to get better at enforcing the existing rules. Utilizing valuable information obtained from knowledgeable whistleblowers should be a critical component of that enforcement. Without enforcement, a change in the rules is meaningless.

 

*Fiscal 2011 Fortune 500: Profits $824 billion & Reserves $187 billion; Total IRS Corporate Tax Collections $181 billion. Whereas in Fiscal 2010, Fortune 500: Profits $708 billion & Reserves $197 billion; Total IRS Corporate Tax Collections $191 billion.

Tax practitioners and government officials recently came together at the American Bar Association International Tax Enforcement Conference in New York to discuss international tax enforcement rules and procedures.  Among the topics of discussion was the federal government’s increased arsenal of tools available in combating offshore tax evasion, making its efforts stealthier and less predictable to practitioners and taxpayers, according to a panel of tax controversy practitioners.  These new tools include data mined from voluntary disclosures; cooperation by taxpayers and bankers; and notably, information obtained from whistleblowers.  

Thomas E. Bishop, Assistant Special Agent In Charge, IRS Criminal Investigation division in New York, referred to the 2006 IRS whistleblower law as a “game changer” for the IRS’s efforts to combat offshore evasion.  Bishop stated that the Criminal Investigation division is investigating individuals based on information provided by whistleblowers.  The use of whistleblower information was also discussed by Sandra Brown, Assistant U.S. Attorney/Tax Division Chief (Central District of California), who said that the Justice Department has ongoing investigations because of information provided by whistleblowers.  Brown continued by saying that people tend to picture the jilted ex-spouse as the whistleblower who provides information on individual taxpayers, but that view is antiquated.  Business partners and associates are providing information as well, she said, adding, “Those who lie with dogs know where the fleas are.”

Not only has whistleblower information brought specific information forward, whistleblower information, along with other tools used by the government, has created a situation where practitioners can no longer predict the next wave of enforcement, said Charles P. Rettig of Hochman, Salkin, Rettig, Toscher & Perez PC.  Practitioners used to be able to mine their own data to predict those enforcement efforts, but that’s changed, he said.  Scott D. Michel of Caplin & Drysdale agreed, citing subpoenas recently issued by the U.S. attorney’s office for the Southern District of New York to account holders of Bank Frey & Co., a Swiss bank.  Those subpoenas essentially “came out of the blue,” with no inkling by practitioners that the bank was even on the government’s radar, he said.

We note that this is anecdotal until the IRS publishes statistics on the mater, but it is encouraging to hear from Criminal Investigation and the United States Attorney’s office that they think the whistleblower program is providing them with good cases.  But this is not all together surprising as we have referred a number of cases to the IRS Criminal Investigation Division with good results.  A well-informed whistleblower can be a key asset in any tax case, not just in offshore evasion.  I will be speaking with Stephen Whitlock, Director of the IRS Whistleblower Office, at the ABA Tax Section meeting in January.  One of the talking points of our panel will be the IRS’s great successes in utilizing informant information and its impact on all levels of enforcement both civil and criminal. 

As the calendar year winds to a close we wish you and your loved ones a Merry Christmas and Happy New Year.  We look forward to another year’s hyper-aggressive tax transactions being locked in place waiting for a fresh crop of IRS Whistleblowers to bring the transgressions to justice.

Today we released our 2012 “Ferraro 500” list, which reorders Fortune 500 companies based on the size of their Unrecognized Tax Benefit reserves. This annual study always has some interesting results and outliers. For example, Fortune 500 corporate profits are up 16%, but their tax reserves are down 5% (along with total US corporate tax collections for fiscal 11 according to the Treasury Dept.):

(in millions)

Profit

Reserves 

Collections

2010  

$708,554.10

$197,725.50

$191,437.00

2011  

$824,542.70

$187,545.60

$181,085.00

$ Change 

$115,988.60

-$10,179.90

-$10,352.00

% Change 

16.37%

-5.15%

-5.41%

 

The Tax Reserves of the top five companies are Pfizer, which set aside $7.309 billion to cover potential taxes; J.P. Morgan Chase & Co., $7.189 billion; Microsoft, $6.935 billion; General Electric, $6.384 billion; and AT&T, with $5.853 billion. The details behind these Unrecognized Tax Benefit reserves, found in the tax accrual work papers and elsewhere, often make for valuable tax whistleblower submissions.