Alphabet
Soup
In
February, 2005, the
Treasury Department and the Internal Revenue
Service issued guidance that designated "sale-in/lease-out"
or "SILO" arrangements as abusive tax avoidance
transactions.
According
to the tax authorities, SILO arrangements are
designed to exploit the tax law by shifting
tax benefits from a tax-indifferent party that
cannot use them to a taxpayer that can.
Taxpayers
entering into SILO arrangements cannot claim
tax benefits as the purported owners of property
subject to a lease because they do not acquire
tax ownership of the property.
In
the American Jobs Creation Act of 2004, Congress
enacted limitations on the deductibility of
losses from future SILO transactions. The Notice
informed taxpayers that the IRS would challenge
the purported tax benefits claimed by taxpayers
entering into earlier SILO transactions on a
number of grounds. It further stated that SILOs
are considered ‘listed transactions.’
Taxpayers
who enter into SILOs and who are required to
file tax returns must disclose their participation
to the IRS. In addition, promoters of listed
transactions must keep lists of investors and,
in certain cases, register those transactions
with the IRS.
In
March of that year, the IRS announced that more
than $3.2 billion had been collected from over
1,000 taxpayers who participated in the Son
of Boss tax shelter settlement scheme, a total
that was expected to rise.
The figure included back taxes, fines and interest
paid by the 1,165 taxpayers who had participated
in the scheme at that point, and according to
the IRS, the typical taxpayer payment was almost
$1 million, with 18 taxpayers paying more than
$20 million each. One taxpayer alone was said
to have paid over $100 million.
Son of Boss evolved from an earlier scheme known
as ‘BOSS’ (bond and option sales strategy).
The scheme utilised a complex set of derivative
transactions to reduce tax liability and was
commonly used in the late 1990s to offset large
one-off gains such as the sale of a business.
Under the stringent terms of the settlement
initiative, taxpayers were required to concede
100% of the claimed tax losses and pay a penalty
of either 10% or 20% of the total, unless they
had previously disclosed the transactions to
the IRS.
“This
was a particularly bad shelter, and we’re glad
so many chose to get right with the government,”
commented IRS Commissioner at the time, Mark
W. Everson.
“Despite
the tough terms we offered, two-thirds of Son
of Boss participants have come forward and paid
up,” he added.
Based on disclosures the IRS had at that time
received from promoter investigations and from
investor lists from Justice Department litigation,
the agency believed that more than 1,800 people
participated in Son of Boss. It is predicted
that the total revenue yield from the settlement
scheme would exceed $3.5 billion.
The Son of Boss ‘amnesty’ also benefited the
coffers of various state governments, with Arizona,
Illinois, Maine, Maryland, Michigan, New York,
Ohio, Utah and Virginia having collected more
than $23.5 million from voluntary state tax
return amendments by March 2005.
Furthermore, under an information sharing initiative
between the IRS and state tax authorities, an
additional $161 million in disallowed losses,
and assessments of nearly $16 million in taxes,
interest and penalties, were uncovered by the
states of Colorado, Connecticut, Maine, Maryland,
Missouri, North Dakota, Pennsylvania, Utah and
Virginia.
Ever keen to emphasise the agency’s recent hard
line policy on tax shelters, Commissioner Everson
issued a stern warning to those yet to participate
in the Son of Boss settlement initiative.
“For
those who didn’t come forward, we know who they
are (and) we are going after them,” he stated.
In
a further development in the Son of Boss saga,
ruling
in December 2007, the United States Court of
Federal Claims found in favor of the Internal
Revenue Service, confirming that the shelter
was an abusive scheme, and that any deductions
claimed under it should therefore be disallowed.
The
closely-watched case involved Jade Trading,
which in 2003 took legal action against the
US tax authority after it ruled that millions
of dollars in artificial tax losses were not
valid.
Delivering
her verdict on the matter, Judge Mary Ellen
Coster Williams suggested, according to a New
York Times report, that the losses being claimed
by Jade Trading's principal, Robert Ervin and
his brothers, who were his business partners
at that time, were "purely fictional".
"In
sum, this transaction's fictional loss, inability
to realize a profit, lack of investment character,
meaningless inclusion in a partnership, and
disproportionate tax advantage as compared to
the amount invested and potential return, compel
a conclusion that the spread transaction objectively
lacked economic substance," the Judge was
further quoted by Reuters as observing.
The
decision was expected to have implications for
other, similar cases.
In
April 2005, Senate Finance Committee Chairman
Charles Grassley criticized tax legislation
which he helped to write for allowing firms
to take advantage of tax loopholes for an extra
year.
During
a committee hearing focusing on the US 'tax
gap,' which is estimated at $312 billion, Grassley
expressed frustration that the "watered down"
final version of the American Jobs Creation
Act had permitted firms to continue exploiting
large depreciation allowances in leasing arrangements
with state and local governments known as LILOs
and SILOs (lease in lease out, and sale in lease
out).
In
particular, Grassley was angered by a provision
allowing existing leasing arrangements to proceed
if they had been submitted for approval by the
Federal Transit Administration after June 30,
2003, and before March 13, 2004.
"Incredibly,
this provides shelter promoters another full
year to get their deals approved by the FTA.
Treasury's has been forced to grandfather in
these rotten deals because of the bill's effective
dates," Grassley remarked.
The
Senate version of the bill called for the tax
shelters to be closed down with effect from
November 17, 2003, in a measure which would
have raised more than $40 billion in revenues
over ten years.
However,
Grassley went on to argue that: "There's no
way these deals deserve another year."
Sen.
Grassley also asked the Transportation Department
for details of any corporate tax shelters involving
the leasing of bridges and sewer systems that
might be grandfathered under the American Jobs
Creation Act of 2004.
In
a letter to Transportation Secretary Norm Mineta,
Grassley asked for details of all pending requests
for approval of such tax shelters. Grassley
also urged the secretary to discourage these
deals.
“We
exerted great effort in Congress to shut down
this abuse, but the transition relief in the
American Jobs Creation Act is a sop to shelter
promoters and an insult to the American taxpayer,”
Grassley wrote. “Corporations have no right
to claim tax deductions for bridges, subways,
and sewage pipes that were built with taxpayer
dollars.”
The
text of Grassley’s letter follows:
"On
November 17, 2003, I wrote to you to enlist
the assistance of the Department of Transportation
in the Committee on Finance’s ongoing investigation
of an abusive tax shelter that has come to be
known as LILOs – an abbreviation for “lease-in-lease-out”
transactions, and SILOs – the successor to LILOs
called “service-in-lease-out” agreements. Other
variations on these transactions have involved
qualified technology equipment (QTE). A copy
of our November 17th letter is attached.
"On
January 20, 2004, you responded to our inquiry
by advising us that after the release of Revenue
Ruling 99-14 in March 1999, the Department of
Transportation’s Federal Transit Administration
(FTA) has not received, reviewed, or concurred
in any LILO transaction. You indicated, however,
that LILO promoters mutated those transactions
into SILOs, and the first notice received by
your department that SILO transactions were
under challenge by the Department of Treasury
was a November 26, 2003, letter from Treasury’s
Assistant Secretary for Tax Policy. Presumably,
the Department of Transportation ceased reviewing
and approving SILO transactions on the receipt
of Treasury’s letter, although your response
did not confirm this to be the case. In February
2004, the staff of the FTA provided the Committee
on Finance with a list of leveraged lease transactions
submitted to and reviewed by the FTA from June
1988 though September 2003.
"Subsequent
to our exchange of letters, Congress enacted
the American Jobs Creation Act of 2004, which
outlawed LILOs and SILOs, albeit not without
considerable concessions to the interests of
shelter promoters that were in the process of
setting up these abusive schemes. Under the
Senatepassed version of the American Jobs Creation
Act of 2004, LILOs and SILOs would have been
shut down as of November 17, 2003, the day that
I sent you the letter. For LILOs and SILOs involving
public assets of foreign jurisdictions, U.S.
tax deductions would have ended on February
1, 2004, regardless of whether the foreign lease
was entered into before November 17, 2003. In
conference, however, these tough effective dates
were watered down and delayed.
"The
enacted bill doesn’t take effect until March
13, 2004, nearly 4 months later than the Senate
bill. Incredibly, the enacted bill gave leasing
shelter promoters more than a year to get their
deals-inprocess approved by your department.
The bill grandfathers domestic property leases
if 1) the leases had been submitted for approval
by the FTA after June 30, 2003, and before March
13, 2004; 2) the FTA approves the leasing shelter
arrangement before January 1, 2006; and 3) the
FTA application includes a description and the
fair market value of the property.
"We
exerted great effort in Congress to shut down
this abuse, but the transition relief in the
American Jobs Creation Act is a sop to shelter
promoters and an insult to the American taxpayer.
Corporations have no right to claim tax deductions
for bridges, subways, and sewage pipes that
were built with taxpayer dollars. As part of
our continuing effort to stop this abuse, I
ask that the Department of Transportation submit
to the Committee on Finance copies of all LILOs,
SILOs, QTE leases, and similar transactions
that had been submitted for approval by the
FTA after June 30, 2003, and before March 13,
2004. I also request a list of all such transactions
that have been “approved” by the FTA as of the
date of your response.
"Notwithstanding
the grandfathering provisions of the American
Jobs Creation Act, we would welcome assurances
that FTA no longer approves SILO transactions,
effective as of the date of the letter you received
from the Assistant Secretary of Tax Policy.
We also seek assurances that FTA has not approved
any LILO transaction since the release of Revenue
Ruling 99-14 in March 1999.
"I
also request documentation regarding any other
LILO, SILO, QTE or similar transactions that
have been approved, funded, or otherwise reviewed
by the Department of Transportation from the
date of the FTA’s last response to the Finance
Committee to the date of your response to this
letter, provided that any such transactions
is not otherwise covered by the above request.
"I
appreciate your cooperation in our ongoing efforts
to combat abusive tax shelters and look forward
to receiving these materials within the next
three weeks."
In
January 2007, the IRS won a significant court
victory in its fight to outlaw the use of LILO
shelters.
Judge
Norwood Tilley ruled in the US District Court
in North Carolina that a leasing arrangement
used by financial services firm BB&T Corp.
had no other purpose than to reduce its tax
liability.
BB&T
had used a LILO arrangement to lease wood-pulp
facilities owned by a Swedish company, Sodra
Cell AB. Under LILO arrangements, companies
pay an accommodation fee to lease facilities
from another company or a municipality, but
then claim depreciation on these facilities
to reduce their tax bill.
BB&T
had attempted to claim a tax refund of $3.3
million which stemmed from a 1997 lease transaction,
but the request was denied by the IRS and the
company subsequently went to court to appeal
the agency's decision.
According
to Dow Jones Newswires, BB&T disagreed with
the court's verdict and planned a further appeal.
"We
had hoped to go to trial based on the strength
of our case," spokesman Bob Denham was
quoted as stating.
The
court's decision was welcomed by Eileen J. O'Connor
Assistant Attorney General for the Justice Department's
Tax Division.
"To
have a tax deduction for lease or interest expense,
you must actually incur them. And to incur them,
you must have a genuine lease and genuine indebtedness,
respectively," she said in a statement.
"In
BB&T vs. United States of America, the District
Court found that the Lease-In, Lease-Out tax
shelter involved neither, and therefore does
not result in the tax deductions claimed by
those who participate in it," she concluded.
Then
in May 2008, the
Court of Appeals for the Fourth Circuit agreed
with a federal district court that BB&T
Corporation should be barred from obtaining
a tax refund of approximately USD4.5mn.
The
appeals court ruled on 29th April that BB&T
was not entitled to any tax deductions relating
to the aforementioned complex leasing transaction,
agreeing with the district court’s ruling
that the transaction was in substance “a
financing arrangement, not a genuine lease and
sublease”.
In
closing, the Fourth Circuit referred to “Abe
Lincoln’s riddle...‘How many legs
does a dog have if you call a tail a leg?’...
The answer is ‘four,’ because ‘calling
a tail a leg does not make it one.’”
BB&T
Corporation stated on 30th April that it would
"not be materially affected" by the
decision.
According
to the company, it had previously recognized
all tax and interest expenses, and paid USD1.2bn
in the first quarter of 2007 to the IRS. The
payment represented the total tax and interest
due on all leveraged lease transactions for
all open years.
However,
BB&T's management has consulted with outside
legal counsel and stated that it continues to
believe that the company's treatment of its
leveraged lease transactions was "appropriate
and in compliance with applicable tax laws and
regulations".
BB&T's
management was considering its legal options,
it revealed.
Shortly
following this, financial services firm, Wachovia
Corporation announced that, as a result of its
analysis of the case, it expected to record
an after-tax non-cash charge of between USD800mn
and USD1bn in the second quarter of 2008.
Wachovia
revealed in a statement released on 30th April
that it had entered into various leasing transactions
between 1999 and 2003 involving lease-to-service
contracts and leases of qualified technological
equipment, which are widely known as sale-in,
lease-out or "SILO" transactions.
Wachovia stopped originating these transactions
in 2003.
Although
the BB&T decision involved LILOs, Wachovia
believes some portions of the decision may also
apply to SILO transactions. There had, at that
point, not been any judicial decision that directly
involved SILOs, so the tax law as applied to
SILOs remained unsettled.
However,
applicable accounting standards required Wachovia
to update the assessment of its SILO transactions
in light of the BB&T decision. The decision
had no impact on Wachovia's LILO transactions,
which were settled in their entirety in 2004.
Returning
to January 2007, in that month, the Senate Finance
Committee passed a series of measures cracking
down on tax shelter abuses.
As
previously stated, Grassley originally developed
the bipartisan measures when he was chairman;
the Senate passed them before but the House
resisted them and they were never enacted.
“We
need to keep cracking down on tax avoidance
abuse,” Grassley said. “Every taxpayer
who doesn’t pay what he owes makes a sucker
out of everyone who does. It’s appropriate
to shut down abuse and use the money from that
to help small businesses preserve jobs as they
face a minimum wage increase.”
The
committee unanimously passed the tax shelter
loophole closers as part of the Small Business
and Work Opportunity Act of 2007, which aimed
to extend tax relief for small businesses in
conjunction with an expected minimum wage increase.
The tax relief includes a tax credit to hire
disadvantaged workers and allows retailers and
restaurant owners to more quickly write off
the costs of remodeling leased buildings.
The
tax loophole closers approved as part of the
package included:
A
further crackdown on leasing tax shelters:
These leases involve companies that pretend
to sell or lease taxpayer-funded public works
systems, such as subways and sewers, and then
lease them back to the cities. The companies
claim depreciation on these taxpayer-funded
assets, while the cities get up-front money
from the tax shelter promoter that Grassley
has called “chump change”, compared
to what the companies get. Under Grassley’s
leadership, Congress in 2004 largely outlawed
tax benefits from these transactions. Grassley
and Sen. Max Baucus have argued that even in
cases of leases entered into before the 2004
law, the holders of the shelters should not
gain future benefits, especially if the lessee
is a foreign person or company, because these
deals are so abusive.
The
2004 law mainly restricted leases entered into
after March 12, 2004. The new legislation prevented
companies from receiving tax benefits for leases
entered into with foreign entities on or before
March 12, 2004.
Further
restriction on 'corporate inversions': In
this practice, US companies relocate nominally
in overseas tax havens to reduce their US taxes.
The 2004 tax law restricted such transactions
after March 4, 2003. The bill approved in committee
Wednesday moves back the effective date to March
20, 2002, when Grassley and Baucus warned companies
considering these deals to proceed at their
own peril. This change is meant to capture any
inversions that occurred in a rush to beat the
new crackdown.
A
prohibition of the deduction of civil regulatory
fines and penalties, as well as punitive damages
from a lawsuit, on federal tax returns: This
grew out of some companies’ attempts to
deduct the expense of settling cases with the
government over wrongdoing.
Encouragement
of tax whistleblowers: These further
refinements will help make sure the Internal
Revenue Service fully encourages whistleblowers
to come forward with information about tax cheats.
Grassley sees this as an effort to help close
the approximately $350 billion gap between taxes
owed and taxes paid.
Grassley
said the loophole closers are a logical follow-up
to the American Jobs Creation Act of 2004, which
under his authorship in the Senate offered the
strongest crackdown on tax shelters since 1986.
“It’s
only fair to fight tax avoidance abuse while
giving continued tax relief to encourage job
retention and creation,” Grassley said.
“Those who play by the rules deserve consideration,
and those who abuse the tax code deserve a crackdown.”
However,
in April 2007, it emerged that the provisions
had been omitted from tax cut legislation as
it moved through Congress.
"Tax
gap measures are yesterday’s news. Corporate
inversion and leasing deal crackdowns are in
the dust bin," Grassley remarked in response
to an House-Senate tax agreement, which aims
to provide tax relief to small businesses affected
by the proposal to increase the federal minimum
wage to $7.25 per hour from $5.15.
"It’s
a real headscratcher. The Democratic leaders
say they want to shut down tax shelters but
when they have a chance to do it, we get a package
that’s the toast of tax shelter hucksters,"
he added.
Included
in the pre-conference Senate bill, which Grassley
was instrumental in drafting, were the aforementioned
offset provisions which would have closed loopholes,
shelters and offshore arrangements such as sale-in
lease-out (SILO) shelters on foreign properties.
It also included measures against offshore corporate
inversions, and a doubling of some fines, penalties
and interest on underpayments related to certain
offshore financial arrangements.
However,
these were omitted from the provisions agreed
by the leaders of the Senate Finance Committee
and the House Ways and Means Committee as part
of a military spending package.
In
July 2006, an US appeals court overturned a
previous ruling in favor of Coltec Industries
Inc, a former subsidiary of Goodrich, a major
manufacturer of aircraft landing systems.
In
a ruling representing a victory for the IRS,
the three judges on the US Court of Appeals
for the Federal Circuit panel agreed with the
tax authority that Coltec had used a transaction
known as a contingent liability deal to artificially
generate capital losses which the firm then
used to offset capital gains from the sale of
a business unit in 1996.
Applying
the much-debated 'economic substance' test,
the judges wrote that the law as it stands "does
not permit the taxpayer to reap tax benefits
from a transaction that lacks economic reality”.
The judges went on to write that a lack of economic
substance "is sufficient to disqualify
the transaction without proof that the taxpayer’s
sole motive is tax avoidance”.
Their
decision overturned a judgment by Judge Susan
Branden in the US Court of Federal Claims in
2004, which rejected the IRS’s argument
that the transactions had no economic purpose.
Branden stated that, in her opinion, Coltec
had complied with all the statutory requirements
laid down by Congress and awarded the company
an $82.8 million refund.
In
February 2008, it emerged that US federal prosecutors
had widened their criminal investigation into
the alleged sale of questionable tax shelters
by the accounting firm Ernst & Young, adding
two outside defendants.
The
new indictment, filed in US District Court in
Manhattan, included charges against new defendants
David Smith and Charles Bolton, who both worked
for outside firms, and are accused of participating
in an alleged tax-shelter fraud.
Additional
charges were also laid against the other four
defendants, who included: Robert Coplan, a former
E&Y tax partner; Martin Nissenbaum, an E&Y
partner and the National Director of E&Y's
Personal Income Tax and Retirement Planning
practice; Richard Shapiro, an E&Y tax partner;
and Brian Vaughn, a former E&Y tax partner.
According
to the original indictment unsealed in the US
District Court in Manhattan in May 2007, between
1998 and 2004 the defendants and their co-conspirators
concocted and marketed tax shelter transactions
to be used by wealthy individuals with taxable
income generally in excess of $10 or $20 million,
to eliminate or reduce the taxes they would
have to pay to the IRS.
The
new indictment added fraud charges against the
original four defendants, and accused Smith
and Bolton of conspiring with them to create
and market tax shelters known as CDSs, or contingent
deferred swaps.
Ernst
& Young itself was not named as a defendant
in the case.
Then
in March 2008, it was reported that the US government
was attempting to revive its case against 13
former partners of accounting firm KPMG, who
stood accused of facilitating the use of illegal
tax shelters which allegedly cost the Treasury
billions in tax revenues.
The
case, billed as the largest criminal prosecution
in US legal history, was thrown out by US District
Judge Lewis Kaplan in July 2007, after he concluded
that the government had denied the defendants
their constitutional right to counsel by pressuring
their former employer to cut off payment of
legal fees.
But
at a hearing in the US Second Circuit Court
of Appeals, the government argued that it had
not brought any pressure to bear on KPMG to
stop paying the defendants' legal fees, and
that any violation of their rights had only
been temporary.
While
it was normal practice for KPMG to pay the legal
costs of former employees accused of wrongdoing,
it reversed its policy in this case, fearing
that, by being seen to be helping the defendants,
it could bring about an indictment on the company
itself.
According
to the so-called 'Thompson Memorandum,' written
in 2003 by then-Deputy US Attorney General Larry
Thompson, prosecutors may consider a company's
payment of legal fees for "culpable employees
and agents" when deciding whether to indict
the company.
The
defendants, of which there were initially 19,
were accused of helping to structure and sell
the tax shelters, which were deemed abusive
by the Internal Revenue Service. The agency
has estimated that the tax shelters helped investors
avoid some $2.5 billion in taxes.
However,
in August 2005, KPMG avoided indictment by agreeing
to pay $456 million in penalties to cover former
clients who participated in the tax shelters,
known as Blips, Flip, Opis and Short Option
Strategy.
Four
of the original 19 defendants were scheduled
to go on trial later that year.
|