Introduction A brief review of the place of tax shelters in the American corporate landscape.

The Treasury's 2003 Offensive There was a kind of amnesty in 2002; and in 2003 the Treasury issued new guidance on tax sheltering.

In January 2007, New York District Judge Loretta Preska agreed to dismiss a deferred criminal charge against KPMG resulting from the settlement reached by KPMG and the Justice Department over the sale of improper tax shelters in 2005.

Former executives of KPMG who are facing separate criminal charges attempted to prevent the dismissal, claiming that KPMG's refusal to pay their legal fees amounted to a breach of KPMG's agreement with the government; but the judge did not agree.

The trial of the former employees was delayed after the trial judge cited concerns over the dispute concerning who should pay the defendants' lawyers. In an order made public in November, US District Judge Lewis A. Kaplan stated that questions over whether KPMG should pay legal fees for the former executives probably wouldn't be resolved before the criminal trial's scheduled start date in January.

"Given all of the current uncertainties, it is impossible now to predict with confidence when the charges in the indictment may be tried," he said. Consequently, the judge delayed the trial date. Later it was set for September, 2007.

The 16 former KPMG employees and two others are accused of selling 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, the trial bogged down when in June, Judge Kaplan found that prosecutors violated the constitutional rights of the former KPMG partners by pressurising them to cut off payment of legal costs to the defense. The former executives then filed a civil complaint against KPMG seeking advancement of defense costs.

A trial on the fee issue was scheduled for October, but KPMG appealed Kaplan's ruling, saying the matter should be dealt with by arbitrators rather than the Courts.

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 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.

In March 2008, it was reported that the US government was attempting to revive its case against 13 (of the original 19 defendants) of the former KPMG partners.

The case, billed as the largest criminal prosecution in US legal history, was, as previously stated, 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.

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.

In May, 2009, a US federal appeals court upheld a decision denying over USD50m in claimed tax losses arising from two taxpayers’ investment in a ‘Son of Boss (BLIPS)’ tax shelter.

In the case Klamath Strategic Investment Fund v United States, the Fifth Circuit Court of Appeals held that "a lack of economic substance is sufficient to invalidate the transaction regardless of whether the taxpayer has motives other than tax avoidance." The court concluded that "no reasonable possibility of profit existed" for the transaction in question.

Son of Boss tax shelter schemes evolved from an earlier incarnation known as ‘Boss’ (bond and option sales strategy). The scheme utilises 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.

In March 2005, the Internal Revenue Service announced that more than USD3.2bn was collected from over 1,000 taxpayers who had participated in a Son of Boss tax shelter settlement scheme launched almost one year earlier. This amnesty scheme also benefited the coffers of various state governments, with Arizona, Illinois, Maine, Maryland, Michigan, New York, Ohio, Utah and Virginia collecting more than USD23.5m from voluntary state tax return amendments.

The appeals court ruling affirmed an earlier decision by a district court and joins the majority of circuits which have ruled on the question.

"We are pleased that the Fifth Circuit has joined all the other appellate courts in ruling that ‘Son of Boss’ tax deductions are not permissible,” said John A. DiCicco, Acting Assistant Attorney General at the Justice Department’s Tax Division.

“We are also pleased that the court has recognized that determinations of this sort must be made on the objective evidence irrespective of the claimed motives of the individual investors," he added.

In July, 2009, Altria Group, the largest tobacco company in the US, has announced that it will seek further review of a federal court jury verdict against it in a dispute with the United States Internal Revenue Service involving tax deductions related to four leveraged lease transactions.

Altria filed a suit seeking tax refunds totalling almost USD25m for taxes paid for years 1996 and 1997.

"We believe that Altria and its subsidiary, Philip Morris Capital Corporation, fully complied with the law governing these leveraged lease transactions and that Altria is entitled to a full refund," said Murray Garnick, Altria Client Services senior vice president and associate general counsel, speaking on behalf of Altria.

"We will seek further review of the jury's verdict in the trial court and, if necessary, in the appellate court," added Garnick.

However, such transactions, known as lease-in lease-out (LILO) and sale-in lease-out (SILO) have become increasingly shaky from a legal point of view after the IRS began cracking down on them some years ago. Under these arrangements, public infrastructure companies, such as subways and power plants, lease assets to a private company for an up-front fee, enabling the new owners to take large depreciation deductions on the assets.

The US government argues that these transactions lack economic substance because they are motivated solely by the avoidance of taxation.

These tax shelters were effectively outlawed by the 2004 American Jobs Creation Act, although the legislation only applies prospectively. Recently, US Senator Chuck Grassley, the Iowa Republican who was instrumental in shutting down LILOs and SILOs, suggested that the Washington Metropolitan Area Transit Authority’s budget was constrained by a tax-advantaged lease arrangement with a foreign bank, preventing it from making safety upgrades and contributing to the recent fatal crash on its system.

The leveraged lease transactions involved in the Altria case include a Metropolitan Transportation Authority maintenance railroad yard in New York, a wastewater treatment facility in the Netherlands; and power plants operated by Oglethorpe Power Corp. in Georgia and Seminole Electric Cooperative in Florida.

The IRS challenged deductions relating to four leases in 1996 and 1997, and Altria paid the disputed amounts and filed suit against the IRS for a refund.

In August, 2009, a US federal judge decided that a wealthy banker cannot take a USD1.1bn tax deduction, the first court ruling concerning a type of tax shelter involving the purchase of foreign debt.

US district judge Ed Kinkeade stated in his 159-page decision that Andrew Beal, owner of Texas-based Beal Bank, was not entitled to take the full tax deduction claimed on his tax returns for investing in distressed Chinese debt because the transaction “lacked economic substance” and therefore must be disregarded for tax purposes.

This was the first time that a court has ruled definitively against the use of a so-called ‘distressed asses/debt’ tax shelter, otherwise known as DAD, whereby a tax indifferent party, usually a foreign company, transfers economic losses to a US taxpayer, who then attempts to offset the losses against their US income.

According to an Internal Revenue Service issue paper published in April 2007, a DAD transaction typically involves the use of a limited liability company, taxed as a partnership, to shift losses among partners entering and exiting the partnership. The partnership typically, but not always, contributes the asset to another partnership. Then the foreign party transfers within a short period of time its interest in the upper-tier partnership to a US taxpayer, who may be acting through a pass-through entity. The US taxpayer contributes other property or money to the upper-tier partnership in order to create basis in the taxpayer’s partnership interest. The lower-tier partnership sells (or exchanges) the high-basis, low-value asset to another entity related to the promoter, resulting in a significant tax loss that is allocated to the US taxpayer/partner.

Beal, who is ranked 321st on the Forbes list of the 400 richest Americans with a reputed net worth of USD1.5bn, owns 100% of Beal Bank through Beal Financial Corp. He had structured the business as an S corporation, meaning that all profits (and losses) are reported on his individual income tax return.

Beal had attempted to use the DAD losses to offset income earned in the tax years from 2002 to 2004, but was prevented from doing so by the IRS, which said that the entrepreneur was only entitled to a deduction of USD10m relating to transaction costs incurred in acquiring the Chinese debt.

While Beal has paid the taxes that the IRS believes he owes, he may be entitled to a refund of the 40% penalty he paid on the back taxes because, according to judge Kinkeade, he acted in “good faith” by obtaining two independent legal opinions on the legitimacy of the transactions. Furthermore, it was noted that Beal did not purchase an ‘off the shelf’ DAD shelter, but structured the transaction in partnership with his long-time accountant, using his experience of buying and selling the distressed debt of other US banks.

Several other cases of this type involving foreign debt instruments are said to be pending in US courts.

The economic substance doctrine used by US courts to determine whether a transaction is structured with the sole intent of avoiding tax could be codified under Democratic plans to raise money to pay for President Obama’s healthcare reforms.

Up to now, courts have not applied the doctrine uniformly, but the health reform legislation would clarify the manner in which the principle should be used by the courts.

In October, 2009, a federal court in Connecticut ruled in favor of General Electric (GE) in a long-running legal battle with the US Internal Revenue Service concerning tax benefits that the company claimed from a partnership structure set up with two Dutch banks in the early 1990s.

The case in question involves an entity known as Castle Harbour, set up by GE in partnership with ING and Rabo Merchant Bank in 1993. GE used the arrangement to shift USD310m in lease income from an old fleet of aircraft to the two Dutch banks, which enabled the aircraft to be re-depreciated for tax purposes, a method which saved GE about USD62m in tax over a five-year period. The IRS disputed the arrangement, however, and argued that the transactions were motivated solely by the desire to save tax and lacked economic substance.

GE paid the outstanding tax demanded by the IRS, but appealed the decision in the courts. After GE won the first round in 1994, the IRS counter-appealed and the ruling was overturned by a federal appeals court in 2006. The case was sent back to the original trial judge, US District Judge Stefan Underhill, who was directed to decide whether the banks were equity or debt partners of GE.

In his latest verdict, delivered on October 8, Judge Underhill concluded that the two Dutch banks were equity partners for tax purposes, and that "Castle Harbour properly allocated income among its partners."

"The final partnership administrative adjustments issued by the IRS were in error," Judge Underhill wrote.

“Even if the Dutch Banks are later held not to have been partners in Castle Harbour, the partnership’s tax position treating the banks as partners was supported by substantial authority and a reasonable basis,” he argued.

Whilst GE has naturally welcomed the latest court ruling, they should keep the champagne on hold for a while yet, as the IRS, which is currently reviewing Judge Underhill's latest ruling, is widely expected to appeal and stands a good chance winning again.

Introduction A brief review of the place of tax shelters in the American corporate landscape.

The Treasury's 2003 Offensive There was a kind of amnesty in 2002; and in 2003 the Treasury issued new guidance on tax sheltering.