U.S. Tax Shelter Industry: The Role of Accountants, Lawyers and Financial Professionals

Statement By Senator Carl Levin Before U.S. Senate Permanent Subcommittee on Investigations

Wednesday, March 22, 2006

[ report [PDF]] [ chart 1 [PDF]] [ chart 2 [PDF]]

Today is the second of two days of hearings on our year-long investigation into the role of professional firms such as accounting firms, banks, investment advisors, and law firms in the development, marketing, and implementation of abusive tax shelters.

The first day of hearings focused on KPMG, a leading accounting firm that, for the past five years, has been heavily involved in the development and marketing of generic tax products to multiple clients, including some potentially abusive or illegal tax shelters. It took some time at the last hearing before KPMG would admit that it's been promoting tax products, but in the end it did. Today's hearing will examine some of the professional firms that have joined forces and worked hand-in-glove with KPMG in the tax shelter business banks, investment advisors, and lawyers without which those abusive tax shelters would never have polluted so many tax returns and robbed Uncle Sam and average taxpayers of billions of dollars of revenues.

The Subcommittee's investigation has focused on four KPMG tax shelters known by their acronyms, BLIPS, FLIP, OPIS, and SC2. The first three have already been identified by the Internal Revenue Service (IRS) as potentially abusive or illegal tax shelters. The fourth, SC2, is under IRS review. BLIPS, FLIP, and OPIS required the participation of a bank, investment advisory firm, and law firm to work. Each of the professional firms here today had a role in one or more of these tax products and helped provide the legal or financial facade of economic substance for transactions whose only real purpose was to reduce or eliminate the buyer's taxes.

KPMG sold BLIPS, FLIP, and OPIS to about 300 people. It is no accident that the same banks, investment advisors, and law firms appear over and over again in connection with the transactions needed to implement these tax shelters. In fact, KPMG courted and built up relationships with each of these professional firms, because it couldn't implement its tax products without them. KPMG also wanted to form business "alliances" with other respected professionals to increase its stature in client contacts.

An internal KPMG memorandum we just received this week, Exhibit 137, lays it all out. In 1997, a month before he left the firm to form his own investment advisory firm called Presidio, a senior KPMG partner, Robert Pfaff, sent a memo to the top two officials in the KPMG Tax Services Practice with a number of suggestions for "KPMG's Tax Advantaged Transaction Practice." Among other suggestions, the memo argues for the development of "turn-key" tax products tax shelters that KPMG clients can use, without any changes, to reduce their taxes. The memo also states that, in most cases, it will be "difficult or impossible" for KPMG to be the "sole provider" of a "tax-advantaged product" i.e., a tax shelter "due to restrictions placed on the firm's scope of activities by authorities."

The memo described KPMG's "dilemma" as follows. To avoid IRS scrutiny, KPMG had to market its tax products as investment strategies, but if it characterized its services as providing investment advice to clients, it could attract SEC scrutiny and have to comply with federal securities regulations. The memo explains:

"[I]t is clear we cannot openly market tax results of an investment. Rather, our clients should be made aware of investment opportunities that are imbued with both commercial reality and favorable tax results. Conversely, we cannot offer investments without running afoul of a myriad of Firm and Securities rules. Ultimately, it was this dilemma that led me to the conclusion that ... [KPMG] need[s] to align with the likes of a Presidio."

In other words, KPMG recognized that, to make its tax products work, KPMG itself could not provide "investment advice." It also knew it could not issue loans or provide financing, and had no authority to practice law. It needed assistance from other professionals with these capabilities to carry out its tax schemes, and it found them:

--Law firms like Brown & Wood, which later became Sidley Austin Brown & Wood, issued favorable, boilerplate, legal opinion letters for BLIPS, FLIP, and OPIS, issuing more than 250 opinion letters in all.

--Investment advisory firms like Quellos, doing business as Quadra, and Presidio helped set up hundreds of BLIPS, FLIP, or OPIS transactions.

--Banks like Deutsche Bank, HVB Bank, and others financed hundreds of BLIPS, FLIP, or OPIS transactions. Deutsche Bank and HVB together provided more than $5 billion in financing for these transactions.

Everyone, of course, got paid lots of fees. For example, in BLIPS, clients paid a fee set at 7% of the planned tax loss. Now think about that. If anything demonstrates that the goal of these schemes was to produce paper tax losses, it is that the fee was based on the size of the planned tax loss. The higher the planned tax loss, the higher the fee.

In the case of the BLIPS fee, after certain expenses were subtracted, the remaining money was divvied up among the firms that carried out the client's BLIPS transaction. KPMG and the banks each got 1.25 %, what they called 125 basis points, and the investment advisor got 2.75% or 275 basis points. The law firm generally got $50,000, possibly more in cases where the expected tax loss was large.

Looking at just the 4 tax products examined by this Subcommittee, KPMG brought in fees totalling at least $124 million. Sidley Austin Brown & Wood, with more than 250 opinion letters raking in at least $50,000 per boilerplate letter, made more than $12 million. Deutsche Bank hauled in about $33 million from its OPIS transactions and expected to make the same again from BLIPS. HVB made over $5 million in less than three months doing BLIPS deals in 1999, and decided on doing more in 2000 due in part, in its own words, to "excellent profitability."

What exactly were these fees for? The law firm, Sidley Austin Brown & Wood, provided a so-called independent legal opinion letter finding that the tax products complied with the law. In fact, the law firm collaborated heavily with KPMG to develop the products and write the opinion letters. The banks provided financing and nominal currency transactions that acted as an investment fig leaf to disguise transactions that were really tax driven. The investment advisors provided the design and rhetoric to recast the tax dodges as investment strategies.

The facts echo what this Subcommittee uncovered during its Enron investigation respected professional organizations offering their services and making a lot of money by assisting other parties complete highly structured and deceptive transactions. In this case, the transactions are intended to help KPMG clients reduce or eliminate paying their fair share of taxes owed to Uncle Sam. By facilitating these tax schemes, these organizations also opened themselves up to possible violation of the laws against the promoting of abusive tax shelters and against aiding or abetting tax evasion.

Relative specifically to the SC2 tax product, we had planned to have at today's hearing one of the pension funds that KPMG approached and convinced to participate in SC2 transactions. None of SC2 tax products could have been sold absent a charity willing to accept S corporation stock donations under unusual circumstances. To save time, we asked the pension fund to submit a written statement instead of appearing here today. That statement sets forth these key facts: KPMG initiated the contact with the charity, the charity did not know its 28 benefactors beforehand, and the charity was asked and expected to hold the stock it was given "for several years" and would then "be able to sell the stock back to the owner and receive cash." In short, it is clear that SC2 was intended to provide only temporary stock donations.

Also relative to SC2, we did not have time at the last hearing to address a number of troubling statements made by the former KPMG tax partner, Lawrence Manth, who headed up the SC2 sales effort and who claimed that KPMG was selling SC2 to benefit police and firefighters. The documents are overwhelming in demonstrating the opposite: KPMG was not acting altruistically in selling SC2, but, again, to help its clients reduce or eliminate their taxes. If the sole objective was to make a charitable donation, SC2 donors could have simply donated cash instead of going through the exercise of first donating stock and then buying it back for cash. We plan to followup on those statements with Mr. Manth and others.

The industry which promotes abusive tax shelters should have no place in the business plans of respected legal and financial professionals. It is time to put an end to banks, investment advisors, and law firms using their talent and resources to promote, aid or abet dubious and abusive tax shelter schemes.

Finally, we will hear today from three key regulators, the IRS, the Federal Reserve, and the newly formed Public Company Accounting Oversight Board. Each has a role to play in convincing or, if necessary, forcing accounting firms, banks, investment advisors, and law firms to get out of the abusive tax shelter promotion business.

To help those efforts, Congress needs to enact stronger penalties for promoting, aiding or abetting abusive tax shelters. The current fines of $1,000 for individuals and $10,000 for corporations are useless as deterrents. We also need more enforcement dollars for the IRS to go after tax shelter promoters. We also need to put an end to auditor conflicts of interest that arise when accounting firms sell tax shelter services to their audit clients and then turn around and audit their own handiwork. We need to clarify and strengthen the "economic substance" doctrine. We need a coordinated regulators' review to identify abusive tax shelter products some accounting firms, banks, investment advisors, and law firms are selling and to stop them from assisting the purveyors of abusive tax shelters. And we need the professions themselves to adhere to higher standards of conduct.

I'd like to thank the Subcommittee Chairman, Norm Coleman, again, for all his support of this investigation.