Tax Shelters In 2005 Action and inaction at the Treasury and in Congress.

Alphabet Soup SILOs, BOSS and son, and other denizens in the zoo of shelters.

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.

Tax Shelters In 2005 Action and inaction at the Treasury and in Congress.

Alphabet Soup SILOs, BOSS and son, and other denizens in the zoo of shelters.