ataxingmatter

The Boom and Bust Cycle of Tax Shelters and Intimidation of the IRS

[edited 6/9/13 to correct some glaring typos :) ]

In response to concern about taxpayer rights and potentially abusive tax collection activities, Congress passed two "taxpayer bill of rights" laws, in 1988 and again in 1996.  Together, these laws protect taxpayers with further notice and information, shift the burden of proof to the government in many cases, and create an office of taxpayer advocate that reports directly to Congress, among many other provisions.  The 1988 law (consolidating five different proposed bills into an "omnibus" bill under HR 4333) included provisions that sharply restricted IRS' employees' ability to ferret out tax evasion for fear of potentially violating the law. See summary of HR 2190,  "the IRS Administration Reform and Taxpayer Protection Act of 1987", incorporated in the 1988 legislation passed as HR 4333.  The 1996 law, HR 2337/ Public Law 104-506, beefed up the Taxpayer Advocate office, modified various penalty and collection provisions, and required an annual report to Congress on IRS employee misconduct.  While these laws provided important new protections for taxpayers and noteworthy additions to the law governing collection authority, some were  overgenerous to taxpayers and at the least made enforcing the tax laws more difficult for IRS employees.

It was only a short while after the 1996 law was enacted when the Senate Finance Committee held an elaborate series of hearings looking into alleged "abuses" of "innocent" taxpayers by the agency in collecting taxes and investigating potential criminal evasion of taxes:   hearings on IRS practice and procedures, Sept. 23-25, 1997;  hearings on IRS restructuring, Jan. 28-29, Feb. 5, 11, and 25, 1998; and hearings on IRS oversight, May 28-30 and June 1, 1998. Let it be clear: these  hearings targeted the IRS with an apparent objective of changing the agency's focus from enforcement and collection of taxes to "nice-guy" relations with taxpayers.  They included "sob stories" about harassment by the IRS from a priest, a divorced mother, a restauranteur and others, and alleged abuses in the collection and investigatory processes within the agency.  

Much of the inflammatory testimony in those late 90s hearings was just that--stories, hand-picked to highlight purported problems, with the result that they inflamed the citizenry against the agency.  The selected testimony was anything but balanced, in that it ignored myriad examples of just the opposite and included made-up tales of abuse.  Danshera Cords, in an article discussing the 1998 Act, describes the restaurant owner's testimony and its lack of truthfulness as follows:

John Colaprete, owner of the Jewish Mother restaurants, "told the Finance Committee that IRS agents and other law enforcement personnel forced children to the floor at gunpoint, leered at scantily clad teenage girls, and generally violated his Fourth Amendment rights against illegal search and seizure, all on the word of his felonious bookkeeper." Ryan J. Donmoyer, Judge May Dismiss Jewish Mother Lawsuit, 83 TAX NOTES 1696, 1696 (1999). Mr. Colaprete testified before the Finance Committee that, while attending his son’s first Holy Communion, "[a]rmed agents, accompanied by drug-sniffing dogs, stormed my restaurants during breakfast, ordered patrons out of the restaurant, and began interrogating my employees." IRS Oversight: Hearings Before the Senate Comm. on Finance, 105th Cong. 75–79 (1998); ROTH & NIXON, supra note 5, at 189.

Danshera Cords, How Much Process is Due? IRC Section 6320 and 6330 Collection Due Process Hearings, 29 Vermont L. Rev. 51, 52 note 7.

That sounds atrocious, until you find out that Colaprete later recanted the whole thing, when it was found that he was actually out of the country at the time it was claimed to have happened.  Id.

There were two later reviews of the testimony--the Webster Commission and a GAO study (both cited in Cords' article).  The Webster Commission found isolated abuses but no pattern of misconduct by the criminal investigation division.  Criminal Investigation Div. Review Task Force, IRS, Review of the IRS's Criminal Investigation Division (1999).  The GAO study found no evidence supporting the allegations that tax assessments were improperly handled or criminal investigations inappropriately undertaken. GAO, Tax Administration: Investigation of Allegations of Taxpayer Abuse and Employee Misconduct Raised at Senate Finance Committee's IRS Oversight Hearings (reprinted in 2000 Tax Notes Today 80-13 (Apr. 25, 2000)). David Cay Johnston, in his highly regarded book on the tax shelter business, describes those hearings as "going after the IRS".  Perfectly Legal (2003).  Bryan T. Camp describes Congress as seeing tax administration as an "inquisitorial" process.  Bryan T. Camp, Tax Administration as Inquisitorial Process and the Partial Paradigm Shift in the IRS Restructuring and Reform Act of 1998, 56 Fla. L. Rev. 1 (2004) (describing the hearings at 78-86).

The  Senate Finance hearings enabled the passage of additional legislation in 1998, the Internal Revenus Service Restructuring and Reform Act of 1998. The law reorganized the IRS, the main agency to enforce the law, into "units serving particular groups of taxpayers with similar needs"--i.e., changing its focus from law enforcement to "serving taxpayers".  It  "significantly limited" the agency's "historically broad powers".  Id. (Cords, at 51).  It created a collection due process hearing requirement before the IRS can proceed to collect on taxes due; a bureaucratic (red-tape) approval process for levies, liens and seizures; and severe limitations on examination and audit techniques and impositions of penalties.  The agency suffered not only from increased disrespect (from media attention to the inflammatory hearings) that facilitated the right's mission to spread the Reagan mantra that "government is the problem," but also from underfunding, strict limitations on methodologies, and effective intimidation that made it harder to enforce the tax laws and collect unpaid taxes, thus encouraging tax evasion and even tax fraud. Stress, time and resource constraints, and understaffing, got worse, even while Congress dumped more and more administrative responsibilities on the agency.

The always innovative tax practitioners (attorneys and CPAs) noticed.  Corporations and their high-wealth CEOs and majority shareholders were already engaging in more tax avoidance with the help of crafty lawyers finding loopholes in the interstices of the tax law and the more restrictive 1988 and 1996 laws that made it harder to enforce or collect.  Many now took advantage of the newly flourishing tax shelter schemes from the late 1990s to mid 2000s.  These were often promoted by big-money law partners at law firms like Donna Guerin at (now shut down) Jenkens & Gilchrist or Raymond Ruble at Brown & Wood (later Sidley Austin) and financed by investment banks like Deutsche Bank and others eager to profit from derivatives that made deals appear to move money around while essentially leaving it in place, with avid assistance (and sometimes design) by accounting firms like Arthur Anderson, KPMG, and BDO Seidman. The shelters usually had fancy acronyms like "COBRA" and "FLIPs."  They frequently involved invented (phantom) losses or phony deductions.  Many used purported federal income tax partnership structures to selectively pass gains to tax-exempt or tax-indifferent parties so (phantom) losses could be passed to parties that "needed" a tax loss to offset a large, expected, and real gain. 

Hitting the news today is yet another story about a top CEO who engaged in those phantom-loss- generating partnership tax shelters.  Zajac & Drucker, Ray Lane Rode Tech-Boom Tax Shelter Wave Broken by IRS, Bloomberg.com (June 7, 2013). Lane, former president of Oracle and current chair of Hewlett-Packard, used a shelter involving partnerships with long and short positions called "POPS"--put together by Sidley & Austin, Deutsche Bank, and BDO Seidman--to shield $250 million from taxation. Id.  As Chris Rizek, a tax lawyer at DC's Caplin & Drysdale told Bloomberg, the IRS slacked off on enforcement in those years after the series of bills restricting tax administration because "they were intimidated." Id.  "They could be cowed again," Rizek said, given the focus in Congress this month.

We seem to have a "boom or bust" cycle in terms of attitudes towards the IRS as the primary agency for enforcing our tax laws.  And that's unfortunate, because a country that cannot force wealthy and corporate taxpayers to pay their share of the tax burden is a country that will fail.

This history should serve as an important warning to Congress, the mainstream media, and citizens as hearings exploiting anti-IRS sentiments spread cries of alleged abuses (seemingly with as little evidentiary support for widespread patterns of abuse as the 1998 hearings) that may again lead to overly restrictive legislation.  

While any agency should avoid wasting money on unnecessary travel (and certainly luxury suites is a waste for any government employee), IRS employees should not be restricted from participating in important activities like attending and speaking at the ABA Tax Section's three annual meetings.  And while it is important to ensure that there isn't a corrupt abuse of agency power, the hearings so far into the 501(c)(4) selection of various groups (conservative and liberal) for greater scrutiny bear too strong a resemblance to the hyped-up hearings by the Finance Committee in 1997-98, which inappropriately intimidated IRS employees from doing their jobs.  Congress should not prevent the IRS from taking forceful actions to fight violations of the tax laws, such as appropriately screening applicants for 501(c)(3) and (c)(4) tax-exempt status.

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Offshore Banking Secrecy Takes Another Well-Deserved Blow

Hidden away inside the front section of the New York Times today is some good news for tax enforcement (and probably for tax compliance)--Switzerland's decision to allow its banks to disclose hidden accounts, what the article calls a "watershed move" in the ongoing saga about banking secrecy and tax avoidance.  See Browning & Werdigier, Switzerland to Allow Its Banks to Disclose Hidden Client Accounts, New York Times (May 30, 1913).

The US enactment of strong rules requiring disclosure (commonly called the FATCA rules) and its stepped up efforts of enforcement of US taxpayers' reporting of offshore assets, including voluntary disclosure initiatives and criminal prosecutions, have had an effect.  Many Americans were intentionally or inadvertently hiding millions offshore.  Switzerland was "an offshore money haven for wealthy foreigners" because of its banking secrecy.  Some Americans are still hiding their money there (and elsewhere).  But those who still have offshore accounts should recognize that the day of reckoning is drawing nearer and nearer.

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Stiglitz on globalization: the MNEs bought the law they wanted; it's time to take it back

Joseph Stiglitz has a new read-worthy article. Globalization isn't just about profits; it's about taxes, too, The Guardian (May 27, 2013).

As he notes towards the conclusion of the piece, the big MNEs aren't simply "applying the law as they find it" in order to minimize their taxes legally.  They were instrumental in making the law what it is today.

To say that Apple or Google simply took advantage of the current system is to let them off the hook too easily: the system didn't just come into being on its own. It was shaped from the start by lobbyists from large multinationals.

So what hope is there to fix the mess?  First, Stiglitz reminds us of the way American MNEs avoid paying taxes to support the very public goods that made their riches possible.

It's no surprise that a company with the resources and ingenuity of Apple would do what it could to avoid paying as much tax as it could within the law. While the supreme court, in its Citizens United case seems to have said that corporations are people, with all the rights attendant thereto, this legal fiction didn't endow corporations with a sense of moral responsibility; and they have the Plastic Man capacity to be everywhere and nowhere at the same time – to be everywhere when it comes to selling their products, and nowhere when it comes to reporting the profits derived from those sales.

Apple, like Google, has benefited enormously from what the US and other western governments provide: highly educated workers trained in universities that are supported both directly by government and indirectly (through generous charitable deductions). The basic research on which their products rest was paid for by taxpayer-supported developments – the internet, without which they couldn't exist. Their prosperity depends in part on our legal system – including strong enforcement of intellectual property rights; they asked (and got) government to force countries around the world to adopt our standards, in some cases, at great costs to the lives and development of those in emerging markets and developing countries. Yes, they brought genius and organisational skills, for which they justly receive kudos. But while Newton was at least modest enough to note that he stood on the shoulders of giants, these titans of industry have no compunction about being free riders, taking generously from the benefits afforded by our system, but not willing to contribute commensurately.  ...

It is not even true that higher corporate tax rates would necessarily significantly decrease investment. As Apple has shown, it can finance anything it wants to with debt – including paying dividends, another ploy to avoid paying their fair share of taxes. But interest payments are tax deductible – which means that to the extent that investment is debt-financed, the cost of capital and returns are both changed commensurately, with no adverse effect on investment.

Then he goes on to discuss what globalization really means and why it is time for the international community to band together to exact reasonable taxes from these global enterprises who use us to make profits but desert us when it comes to supporting continuing innovation.

It is time the international community faced the reality: we have an unmanageable, unfair, distortionary global tax regime. It is a tax system that is pivotal in creating the increasing inequality that marks most advanced countries today – with America standing out in the forefront and the UK not far behind. It is the starving of the public sector which has been pivotal in America no longer being the land of opportunity – with a child's life prospects more dependent on the income and education of its parents than in other advanced countries.

Globalisation has made us increasingly interdependent. These international corporations are the big beneficiaries of globalisation – it is not, for instance, the average American worker and those in many other countries, who, partly under the pressure from globalisation, has seen his income fully adjusted for inflation, including the lowering of prices that globalisation has brought about, fall year after year, to the point where a fulltime male worker in the US has an income lower than four decades ago. Our multinationals have learned how to exploit globalisation in every sense of the term – including exploiting the tax loopholes that allow them to evade their global social responsibilities.

 He has some specific suggestions about how to undo the mess that the MNEs' successful lobbying has gotten us into.  He suggests two actions that could work:

1. The US could lead the way with a "global minimum tax regime"  in which a corporation would be taxed on its net worldwide profits (treating corporate profits taxes paid to other regimes as a deduction, up to some cap) at a rate of about 30%; and
2. Countries would cooperate to deal with tax havens.

We've already begun to see some of Step 2 as the US stepped up its attempts to identify US taxpayers with hidden offshore bank accounts, leading to a crackdown in Europe as well and the first signs that banking secrecy jurisdictions like Switzerland will open up to information sharing practices.  We need to continue to work on those tax havens--Singapore, Caymans, Bermuda, Ireland, Netherlands--and the rules they have in place that make it possible for Apple to claim stateless income (to use Ed Kleinbard's term).

Step 1 will be much harder in this political climate.  Most of the radical right is intent on cutting taxes, in the 'starve the beast' mode of thinking that got us to debt ceiling fights, sequesters, pushes to "curb" earned benefits like Social Security and Medicare.  Legislators are particularly prone to listen to well-heeled corporate lobbyists who argue that if they would just reduce taxes on big corporations, all the tax avoidance gimmickry would go away.  That's pretty clearly not so--tax cuts just lead to demands for more tax cuts, as the "one time" repatriation provision in 2004 clearly demonstrated.  Max Baucus is also one of the "cut rates/broaden base" crowd that will pretend that the broadened base won't be shurnk again within a year or two even while rates go lower and lower.  Dave Camp belongs in that camp as well.  So getting Congress to consider deeply the possibility of a global minimum corporate tax regime won't be easy.  But hey, nothing is these days, so let's get started.  Letter campaign, anyone?

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Does Apple's Cook Cook the (U.S. tax) Books?

Apple's CEO was apparently all smiling and charming in his testimony on Apple's international tax gimmicks.  Not surprisingly, he claimed that Apple pays tax on all its US profits and doesn't shift US profits offshore.  See, e.g., Michael Shear, Torches and Pitchforks for IRS but Cheers for Apple, New York Times (May 22, 2013); Schwartz & Chen, In disarming testimony, Apple chief eases tax tensions, New York Times (May 21, 2013) (noting that Apple effectively claims a rate of about 30% but that is misleading).

Mr. Cook was especially disarming.   “It’s important to tell our story, and I’d like people to hear directly from me,” he told Mr. McCain and the other senators.  Apple, he testified, pays “all the taxes we owe — every single dollar.”  Schwartz & Chen, In disarming testimony, Apple chief eases tax tensions, New York Times (May 21, 2013) (paragraphing changed).

But that's just wordsmanship and the kind of self-interested political schmoozing at which the "best" of Big Business leaders have always been rather adept.  The fact is that Apple transfered essential intellectual property--developed with economic and other subsidies in the US--to an offshore shell that merely collects the offshore profits from that intellectual property offshore.  That resulted in a significantly lower tax rate than Apple claims. Jesse Drucker, Apple's Tax Rate Ignores Profit-Shifting Offshore, Bloomberg.com (May 23, 2013).

While nobody at the hearing questioned the figure, it provides a distorted picture of Apple’s total tax burden. Based on its public filings, the company pays just under 14 percent of its income in taxes worldwide, according to Scott D. Dyreng, an assistant professor of accounting at Duke University’s business school whose research specializes in the actual tax rates of large U.S. companies.

Cook’s statistical spin goes to the heart of the debate over corporate tax avoidance. By shifting income from countries where they operate to offshore tax havens, multinational companies such as Apple, maker of the iPhone and iPad, can manipulate their tax rates and boost their profit.

Apple’s calculation “ignores the issue of profit shifting, which is the central controversy that was the subject of the hearing,” said Martin Sullivan, a former U.S. Treasury Department economist and chief economist at Tax Analysts, a nonprofit organization. “Apple has shifted enormous amounts of profits from the United States to an untaxed entity overseas.

Our ability to handle offshoring of assets hasn't advanced enough to take into account the ready globalization of intangible assets in any way that makes sense, and our tax administrators (bludgeoned by the heavily financed corporate lobbyists and their Congressional enablers, constantly underfunded and understaffed and therefore outmanned, constantly attacked by the right, as in the craziness currently underway against the division that attempts to appropriately categorize tax exempt applicants to avoid subsidizing their political activity without at least demanding disclosure of donors) and our courts (with too many ideologically driven right-wing activist judges that favor Big Business interests, appointed mostly by GOP presidents but even some by DEM presidents) don't usually have the desire or the guts to take on the use of offshore corporate shells under well-established statutory and judicial anti-abuse doctrines. 

Those existing federal tax common law doctrines would permit courts (and therefore administrators) to disregard circular flows of cash, non- economic reality based ontax-avoidance dreams, and use of corporate shells with no or few employees and no or few actual commodities and management from a distant headquarters as conduits.  But the companies have gotten away with it for so long, and have so effectively lobbied tax administrators who have too cozy a relationship with the tax bar and legislators who have a much cozier relationship with Big Business principals, that almost everybody now talks of use of seeminglyh endless chains of empty shell corporations or corporations tweaked with "just enough" superficial semblance of an actual business function to avoid US taxes as "common practices" that "everybody" considers legal under the "letter of the law." 

This is hyper-textualism that condones doing anything you think you can get away with so long as it isn't clearly prohibited by a specific provision.  Of course, the creation of specific provisions to counter discovered abuses requires considerable effort to get through a Big-Business friendly Congress.  Those that do make it through increase the complexity of the Code.  And then the lobbyists who lose on one-in-a-hundred of these innovative interpretations of what's allowable just go to work on tax administration to get a more friendly interpretation, and then go to work on Congress to "simplify" the Code and "cut rates" so they can be "competitive."  It is a vicious cycle that is driving corporate taxes to zero, while most of the wealthy elite who own the corporate stock and business debt and business partnership interests are also driving their own rates down, as the myth of "job creation" by owners of capital who "deserve" lower capital gains rates is pushed by the same funding sources through well-funded so-called 'think tanks' and hired academic guns.

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Hedge Fund Tax Avoidance Schemes--using (purported) offshore reinsurers

It seems that billionaires think they are entitled to it all and think they should be able to run their speculative games without paying much of anything at all in taxes to the government they depend on. And none of this is good for the economy or good for the taxpayers not in "the 1%".

Case in point--John Paulson, the notorious hedge fund manager who got a CDO built to his desires with a bunch of iffy subprime mortgages and then took the short side of the bet, making a fortune off the bet against subprimes in the mortgage crashes underlying the 2007-8 Great Recession.  See, e.g., Zuckerman, Trader Made Billions on Subprime, Wall St. J. (Jan. 15, 2008). 

What has Paulson done?  He established a new "reinsurance company" in Bermuda in April, that turned around in June and put the money invested in it  back into Paulson's hedge funds in New York, as a portfolio of insurance "reserves" to be held to pay off insurance risks that go bad.   The result is tax deferment for Paulson and other executives of his hedge fund along with recharacterization of ordinary compensation income as preferentially taxed capital gains.

For a discussion of the hedge fund reinsurer gambit, see , e.g., any of the following.  The story at Bloomberg has reinvigorated media attention to this issue.

• Zachery Mider, Paulson Leads Funds to Bermuda Tax Dodge Aiding Billionaire, Bloomberg.com (Feb. 19, 2013);
• Andy Barile looks at hedge fund-backed reinsurance, World Risk and Insurance News (Feb 11-15, 2013) 

Barile notes that these hedge funds are using reinsurance premiums and investing in a very aggressive way, compared to traditional reinsurers".  This aggressive position produces a downside if there are low investment returns, especially if there are catastrophes for which they have to pay claims when their investment strategies have produced losses.  He says that "it remains to be seen" whether hedge-fund reinsurers are in it for the long haul, since they have a shorter time frame on making greater returns on their money.

• Baker, The Bank For International Settlements: Evolution and Evaluation (Greenwood Publishing 2002), at 235-237

Looking at this as a global concern, Baker ultimately suggests that the Basle Capital Accord rules should be extended to hedge fund reinsurer operations,  "Another area in which the BIS should take a leadership position," he says, "is the role in which reinsurance firms play in hedge fund operations.  The tax implications of hedge funds using reinsurance firms in their funds for tax advantages points to the need for more government regulation of this activity."

He describes the basic problem as follows:  "wealthy individuals invest in private placement offerings of offshore reinsurance companies.  These companies, many headquartered in Bermuda, buy insurance policies written by name-brand insurers...and "may then invest its stock issue returns in a hedge fund.  ...[That reinsurer] pays no taxes on the trading profits until it sells the fund shares and then the reinsurer is taxed at a lower capital gains tax.  The tax savings are passed on to the individual investor.

He goes on to say that "The problem ... is that insurers are exempt from registering as investment companies....These reinsurers do not have to make annual distribution of profits as mutual funds do and they are not taxed by the Internal Revenue Service as investment vehicles.  ...In short, the activity ... is a method for wealthy investors to reduce their tax burden as a result of a tax loophole.  Since these insurance companies are mixing insurance business with investment business, they need more supervision. 

This is especially true when hedge funds are involved.  "[H]edge funds work with reinsurers to reduce tax liabilities for their wealthy clients.  ...U.S. hedge fund managers and investors form a tax-advantaged reinsurance company offshore in...Bermuda, which has no corporate income tax.  The Bermuda-based reinsurer sends investment assets to the hedge fund to invest.  Investors return to the United States with shares of the reinsurer and pay no taxes until the company goes public.  At that time, investors [and managers] sell their shares in the reinsurer company and are taxed at a lower capital gains rate. 

These schemes are worrisome from both tax and insurer regulatory perspectives.  "Aside from the tax loophole problem, the real issue in these cases is the added underwriting risk incurred in the process. ... [Hedge funds acting as reinsurance companies] have insufficient insurance expertise.... Much of this activity has stemmed from financial engineering and deal making of the 1990s. ... [W]ithout the bailout of LTCM [Long-term Capital Management hedge fund] by national bank regulatory authorities, many banks and reinsurers might have collapsed as well."

So why do it and how does the hedge fund reinsurer gambit work?  Remember that these hedge fund execs get a ridiculous amount in compensation in the form of a "fee" (usually 2% of assets under management) and a "carry" (usually 20% of the profits).  (The fee and carry are often represented as 2 and 20, but can be much higher for some firms with status, rising to as much as 5 and 50.)  Without more, hedge fund managers don't get as much benefit from the claimed treatment of a "profits" partner as private equity fund managers do.  Though the managers claim classification as "profits" partners whose taxation is based on their share of the partnership's gains and ordinary income and not as payments of (ordinary) compensation, hedges mainly yield ordinary income so don't act directly as "converter" entities.   Private equity fund managers also claim they are "profits" partners whose income should not be classed as compensation but as pass-through shares of the  partnership items:  in their case, most of the private equity fund's gains will be deferred anyway (for several years at least until the partnership sells the leveraged company) and they claim those deferred gains should be characterized as pass-throughs characterized by the partnership rather than being characterized as ordinary compensation income to them.   

So for hedge fund managers,  gaining deferment (of what is clearly in substance their compensation as managers) can achieve  minimal current tax.  If the money is cycled through an offshore corporation that pays no taxes, that's even better because it gets preferential rates as well.  The deferrment is achieved by waiting to sell the stock, and the sale of the stock is reported as a capital gain.  Thus what is really current compensation income is recharacterized, through the reinsurer "conduit" scam, as a deferred capital gain.   So hedge fund and private equity managers ultimately both claim to get the best of all possible worlds--their wages from work are not currently taxed as wages at ordinary income rates, they pay no payroll taxes on their compensation, and their compensation is deferred and taxed at preferential capital gains rates. 

This is so obviously unfair to the vast majority of ordinary taxpayers who pay taxes on their compensation income even before the end of the tax year through the withholding mechanism that Congress should step in with legislation.   It seems hard to justify a "profits" interest in a partnership at all: it has been created by the "Wall Street Rule" that gains credence because big-money people claim it is correct.  As usual, tax administration eventually mostly went along with it (Rev. Proc. 93-27) and a few court cases (Diamond, Hale) mostly treat the notion of a profits partner who pays no taxes on his compensation as reasonable.  Congress could easily legislate away the profits interest and define partner in a partnership for tax purposes as someone who has made a genuine at-risk equity contribution of cash or property to the partnership. There really should be no such thing as a services partner with a "profits" interest who hasn't contributed up front for a capital interest.  And all compensation shares to what are currently treated as profits partners could be treated as ordinary income --i.e., compensation currently subject to the income tax and to payroll (Social Security/Medicare) taxation.

This use of reinsurers by hedge funds is itself a tax dodge that has been around a decade or so.  In 2007, the Senate Finance Committee held a hearing on Offshore Tax Issues: Reinsurance and Hedge Funds (S. Hrg. 110-875, Sept. 26, 2007) (179 pages).  In his introduction, Baucus described insurance tax avoidance schemes as follows:

Insurance companies make a living by doing two things: they assess premiums based on the prediction of the likelihood of events against which they insure—that is called underwriting—and they also make money by investing the premiums that they collect until they have to pay out claims. If they are good at those two jobs, they  make a profit.

Customers buy insurance from insurance companies to guard against the risk of fire, disaster, or some other calamity. In exchange for paying premiums, the customers shift some of their risk to the insurance companies. Insurance companies also buy insurance. Property and casualty insurance companies pay premiums to reinsurance companies in exchange for shifting some of their risk to the reinsurance company. Sometimes the reinsurance company is also the parent company of the property and casualty insurance company. In that case, the property and casualty insurance company shifts risk to their parent reinsurance company at something less than an arm’s length transaction.

Here is where the tax avoidance comes in. Some parent insurance companies set their headquarters in low-tax jurisdictions, like Bermuda. Subsidiary property and casualty insurance companies shift risk to the Bermuda parent. Because of Bermuda’s low tax burden, the Bermuda parent can get a greater after-tax return on their investment activities. As a result, subsidiary property and casualty insurance companies can charge lower premiums for their insurance. They get a competitive advantage over insurance companies doing business in jurisdictions that tax investments.

The second setting that we will examine today involves hedge funds. Foundations and other nonprofits are some of the largest investors in the world. The law requires a nonprofit investor that invests directly in hedge fund partnerships to pay the unrealized business income tax, otherwise known as UBIT. The policy behind the law is that tax-exempt entities should not be able to have an unfair advantage over taxpaying entities doing the same thing. To avoid UBIT, nonprofit investors sometimes invest in hedge funds through offshore entities incorporated in lowor no-tax jurisdictions, such as the Cayman Islands or Bermuda. These offshore entities are called blockers.

The third setting we will examine today is the compensation of hedge fund managers. Hedge fund managers receive fees from offshore blocker corporations used by nonprofits and foreign investors.Some hedge fund managers elect to defer their income, and deferring income means you pay taxes later, which is the same as a significanttax savings.

 The IRS has already noted that offshore arrangements using reinsurers for hedge fund managers may be shams that are subject to challenge on audit.  See Notice 2003-34 (indicating that "Treasury and the Internal Revenue Service have become aware of arrangements, described below, that are being used by taxpayers to defer recognition of ordinary income or to characterize ordinary income as a capital gain.  The arrangements involve an investment in a purported insurance company that is organized offshore which invests in hedge funds or investments in which hedge funds typically invest.")  Although the notice says that these purported insurers may be challenged as not insurers because they are not using their capital and efforts "primarily in earning income from the issuance of insurance", and although it states that such arrangements will be subject to close scrutiny that could result in the application of the PFIC rules (leading to current taxation), it has apparently not bothered to challenge any of the big hedge funds' reinsurer companies.

Again, why would they be subject to challenge?  On the basis that they are not real reinsurers, since the low amount of reinsurance that many provide is the less risky part of the business and provides a buffer to the very high reserves that they retain, sometimes invested solely in a single promoter's hedge funds.  And if they are not insurers, they are at the least "passive foreign investment companies" (PFICs) on which shareholders are subject to current taxation on profits.  (Or perhaps the IRS might go further and recharacterize the arrangement as a sham , causing the hedge fund executive to have current ordinary compensation income.)    In other words, there is good cause to think that for many of these, the tax haven corporation is acting as an offshore tax-avoidance pocketbook for the hedge fund executive, and not really as an insurer.

By the way, if you think these hedge fund managers who are making multi-millions and billions from managing other people's assets and hardly paying any U.S. taxes on those huge compensation payments are incredibly smart people who add to the economy's well-being and therefore merit that kind of out-sized pay or because of the returns they bring to people that then invest them in needed projects in the good ole US of A, you need to rethink that. Hedge funds typically pay out very poor returns, when all the expenses and profits to managers are taken into account. 

Roughly speaking, if the typical fund manager worked for free, and if the investment firms didn’t charge, these masters of the universe would still have underperformed a balanced index since 2003, by roughly 2.5 per cent per year. Andrew Hallam, Think you're smarter than a hedge fund manager?, The Globe and Mail (Feb. 19, 2013) (emphasis added).

 

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Dell restructuring--all for a tax advantage?

David Cay Johnston writes for Tax Analysts, in  Dell's Multiple Restructurings Aid It in Tax Avoidance (2013), about a global reorganization disclosed by Dell in its January 2007 Form 8-K filed with the SEC:  "just before the end of 2006, [Dell] issued more than 475 million shares worth $12 billion to invest in a subsidiary."  In the Form 8-k, Dell notes that "Dell has modified the corporate structure of certain of its subsidiaries to achieve more integrated global operations and to provide various financial, operational and tax efficiencies"  (as quoted in the Johnston article). 

What Dell did was remake itself in a way that lets it escape taxes on profits earned in the United States by running them through a Netherlands entity and newly formed subsidiaries in Singapore and the Cayman Islands.

Dell later quietly dropped the Singapore and Cayman Islands entities in what appears to be a pattern of remaking its corporate structure every few years. This nuanced timing pattern may have great significance as a tool for tax avoidance because IRS corporate audit practices were established on the assumption that companies tend to have stable structures. The IRS rarely audits newly formed entities.

***

The documents suggest that Dell created companies with no apparent purpose except to funnel profits into jurisdictions where they would be untaxed. In some cases, subsidiary names existed for a day or so and then were changed to the names of existing entities. The company shuffled its subsidiaries like a deck of cards -- a deck stacked against shareholders and the IRS.

Sometimes the deals used companies with identical addresses, suggesting circular flows in which what would be taxable profits in the United States were run through offshore entities with no discernible purpose except escaping tax.  Id.

Describing the work of a copule who sleuthed through Dell's state filings and court papers to examine its tax compliance, Johnston reports:

Before one restructuring, Dell Inc. sold products to domestic customers through Dell Catalog Sales Corp., which shared the same address in Texas.

The couple distilled from annual corporate ownership and sales tax filings with state governments, as well as stipulations in various civil lawsuits, that Dell then replaced this simple organizational structure with a hierarchy of tax haven holding companies.

In all, Dell inserted four new companies between the parent and operating entities, which use the same Texas street address.

The result was that a Texas company reported to a Netherlands company that reported to a Singapore company that reported to a Caymans company that reported to what appears to be another Netherlands company that then reported back to the Texas headquarters.

This makes business sense? I cannot fathom how -- except to escape taxes.

And because Dell publicly discloses its untaxed offshore profits and the expected tax rate upon repatriation of those profits, those numbers support the suggestion that the elaborate creation (and killing) of subsidiaries has one primary purpose--the reduction of taxes owed to the US.

Citizens for Tax Justice, in a report last year (Doc 2012-21457 , 2012 TNT 202-22), noted that Dell is one of the few multinationals that discloses how much untaxed profits it holds offshore and the expected tax rate if it brought the money back to the United States.

Dell said it had $15.9 billion of untaxed profits offshore on which it would owe a tax of $5.2 billion, or 33 percent. Since that is almost equal to the 35 percent corporate tax rate, it suggests Dell paid virtually no tax anywhere in the world on those profits, because Congress gives a dollar-for-dollar tax credit on corporate income taxes imposed by other countries.

So what, Johnston asks, is the public benefit of allowing this kind of corporate shell game?  He suggests tht for shareholders, the question is whether they are being told enought to evaluate the risks and rewards of holding Dell securities.  And he concludes probably not.  For the IRS, it is whether regular audit techniques will miss what they should catch. And again, he wonders if the IRS policy of letting companies know what will be audited, sticking to those points, and completing audits in fixed time periods isn't just a giveway to those who are manipulating their tax rates.  Dell's tax counsel, he notes, would undoubtedly advise that they have reviewed each reorganization step and that they are perfectly legal.  But Johnston wants an audit, and one that looks at the whay sophisticated companies are adept at working around audit policies.  Dell's reorganizations, he says, are apparently timed at two-year intervals, injecting considerable complexity into the work of any IRS auditor trying to track their impact. And "the business purpose for this management structure is elusive", he notes, on one set of slides showing a shuffle of entities that ultimately lands a company still located in Texas under a foreign sandwich of companies and ultimately avoiding US tax on the operating company income. He surmises that Dell owes a billion or more in US corporate income taxes that have escaped capture because of this endless restructuring.

 

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Goggle's Bermuda hideaway/HSBC's too-big status: time to rein in the corporations!

If you are a company that depends on IP for a lot of your revenue, you may be able to avoid considerable taxes by funnelling profits from subsidiaries in high-tax countries into a Bermuda shell company.  Google avoided about $2 billion in worldwide income taxes in 2011 by shifting about 80% of its total pretax profits-- $9.8 billion -- into Bermuda.  See Jesse Drucker, Google Royalties Sheltered in No-Tax Bermuda Soar to Nearly $10 Billion, Bloomberg.com (Dec. 10, 2012).

Meanwhile, the US decided not to take action against HSBC for its fraudulent behavior because it was considered so big that it could damage the financial system (again) to interfere with its continuing corporate existence.  See  Glenn Greenwald, HSBC, too big to jail, is the new poster child for US two-tiered justice system, guaradian.co.uk (Dec. 12, 2012) (noting that "one of the world's largest banks, HSBC, spent years committing serious crimes, involving money laundering for terrorists; 'facilitating money laundering by Mexican drug cartels'; and 'moving tainted money for Saudi banks tied to terrorist groups' " but US officials decided "not to prosecute HSBC for accepting the tainted money of rogue states and drug lorgds on Tuesday, insisting that a $1.9bn fine for a litany of offences was preferable to the 'collateral consequences' of taking the baqnk to court").

Maybe this kind of information will finally incense governments against corporate tax dodging.  What we need are laws that refuse to recognize shell companies set up in tax-haven countries to siphon profits from the countries where they originate.  What we need are fewer possibilities for companies to expand through tax-free mergers and acquisitions that allow them to get so big that they become immune to ruin when they commit major crimes. 

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Circular 230 Revisions Discussed at ABA Tax Section Today

Not quite a decade after the much-hated "covered opinion" rules, the Treasury and Service today announced proposed amendments to Circular 230 that wipe the slate clean.  See REG-138367-06.  The amendments include a few other changes that will assuage some worries about the role of OPR in discipline of attorneys.

The government panel at the ABA Tax Section Standards Committee introduced the changes.  Karen Hawkins, OPR Director, was "excited about the changes".  Section 10.1 clarifies the authority of OPR as the office with exclusive responsibility for discipline and sanctions of attorneys.  This issue had been a concern after the most recent amendments, which took out all references of OPR to accommodate the introduction of the new Return Preparer Office. 

Changes to section 10.31 make it clear that attorneys may not use "self-help" to acquire repayments from client's tax refunds.  Whether a refund is through a paper check or some electronic means, attorneys must turn it over to the client and may not deposit to their accounts, including trust accounts.  Hawkins noted that this was a "broader rewrite than some anticipated".  The result is consistent with the section 6695 regulations, and applies to all tax practitioners.

The big change was section 10.35.  The strict rules for written opinions and disclaimers are removed, with core principles of tough due diligence requirements incorporated in section 10.37, now the single provision covering written opinions.  The extensive disclaimer requirements are gone.   Why the change?  Several reasons.  While opinion practice seems to have improved (for the nonce), the government concluded that the strict rules in 10.37 were not an effective tool in squelching over-aggressive tax advice.  It had been expected the disclaimers would get the attention of clients, but instead they were generally not seen as a problem by sophisticated clients and created a confusing trap for unsophisticated ones.  Tax practitioners complained mightily about the difficulty of complying with the rules from the outset, saying the rules were too costly and too burdensome.  It's likely that oral opinions substituted for written advice as a way of avoiding having to comply. 

New 10.35 is a quite short provision that requires attorneys to have the requisite skill, knowledge and competence for the role they are undertaking.  Astonishingly, though the Model Rules have long included such a requirement, Circular 230 governing practice before the IRS had not.  This is what might be called a "no-brainer" addition.

Section 10.36 places more responsibility on the person in a firm with principal authority for overseeing Circular 230 practice.  That person must take reasonable steps to be sure that everyone understands their Circular 230 obligations.  If s/he fails, s/he will be held personally liable.  If s/he takes steps but those s/he oversees still violate the rules and s/he does not take additional steps to stop the violations, personal liability is again possible.  As Hawkins said at the meeting, this is essentially a "respondeat superior" type of obligation.   An audience member asked about the application of this rule when there are independent contractors.  Hawkins noted that there is an interrelationship here between section 10.22, which requires due diligence and allows a practitioner to rely on another, and 10.36 which requires appropriate oversight of employees or the work cannot be relied on.  Either way, she noted, poor due diligence will result in being unable to rely on the work, under either 10.22 or 10.36.  (And Section 10.37 would be relevant if the independent contractor is preparing an opinion on which the practitioner expects to rely.)

 Section 10.37 is, as noted above, now the provision that governs all written tax advice.  It is, Hawkins said, a "sensible form of regulation that everyone can understand and follow, including both practitioners and clients."  There are some significant changes beyond the elimination of the covered opinion rules.  For example, the original section 10.35 did not permit practitioners to consider settlement possibilities in giving written advice: under the proposed regulation, it is permissible to consider the hazards of litigation, but not the potential outcome of audits.  Rich Goldstein pointed out that "the regulations retain a 'heightened scrutiny' for marketed opinions, so they are not a shift back to the pre-2004 status but rather a decision to provide a rule that was easier to work with, easier to enforce and one that had the potential to be effective."  Questioners asked what heightened scrutiny is intended to mean in this context.  Hawkins reminded everyone that "the basic standard is reasonableness."  Goldstein explained that "if the opinion is marketed, it will be reviewed closely to ensure that it complies with the requirements, because the effect on tax administration is greater."   In other words, there is not a different standard or level of confidence required by the practitioner, but a difference in how it will be reviewed.

Section 10.82 provides for expedited suspension in situations where there has already been a fitness adjudication by another body, such as a tax crime conviction or the loss of a state bar license.  These amendments add the possibility for expedited suspensions when practitioners have demonstrated willful disreputable conduct by failing to comply with tax filing obligations--e.g., failing to file for 4 of the last 5 years.  Hawkins noted that with many new practitioners, it is reasonable to expect that there will be some compliance problems, and it would be a drain to have to take all of those cases before an administrative law judge when the result is clear.  Although there was a similar effort to create additional expedited process a decade ago, Hawkins suggested that this revision was "better, more thoughtful, and more confined."  But having opposed the original attempt to permit expedited process in these types of situations, she noted that she "would particularly invite the Committee to provide feedback on this issue.  She reminded that in an expedited suspension, OPR initates the process with what is now called an "order to show cause" to the practitioner, who can talk to OPR and perhaps end the process.  If not, the suspension takes place and then full due process protections apply.

The notice also withdraws the proposed regulations for state and local bonds, proposed in 2004.

There is a comment period for 60 days, which will end November 15, and a hearing will be held December 7.  Hawkins noted that it is important to let the government know if they have missed something since otherwise "in two-three years we will be back in the same place again with a variant of 10.35, if these rules are not effective."

Tax evaders (and those who aide them), not regulatory complexities, cause tax evasion

The July 24 New York Times Magazine carries an article by Adam D entitled My Big Fat Belizean, Singaporean Bank Account.

The author shows how easy it was for him to establish a secret offshore bank account that would allow him to evade US (and other nation's) taxes with ease.  It only cost around a thousand dollars, and the firms that do this for a living can set you up with a fake corporation in one tax haven and a real bank account in another, both of them sworn to secrecy about your identity as a US citizen and complicit in aiding wealthy taxpayers in avoiding required reporting to the IRS.

And that means a lot of moolah gets stashed abroad, and a lot of taxes remain unpaid.

The Tax Justice Network, a global research firm that advocates against such havens, suggests that the amount hidden offshore is between $21 trillion and $32 trillion. If properly taxed, that could yield more than $200 billion in revenue around the world. Furthermore, because a 2010 McKinsey & Company report estimated the world’s financial assets at about $200 trillion, somewhere around 10 percent or more of the world’s wealth is effectively invisible. And it’s also almost certainly in the hands of the people and institutions that most actively influence major investment decisions.  Id.

So far, so good.  But where the author goes wrong is in his ruminations about the reasons such shenanigans go on.  He thinks it is because regulations and tax laws are so complex.

One often-overlooked lesson of the financial crisis is that shenanigans don’t happen in the absence of regulation; they happen when regulations are exceedingly complex and involve confusing, overlapping regulatory authorities.

Pshaw.   This is, quite simply, garbage regulatory mythology.  Shenanigans happen in brute force capitalism--the kind we've had in place for the last few decades--until there is one dominant beast who controls everything.  Regulations ain't the cause. 

Every simple rule becomes an opportunity for "inventive" tax lawyers and those with wealth desirous of hiding it or evading taxes on it to come up with "creative" solutions that skip around, over, or under the law.  When tax administrators find out what is going on, they can sometimes take immediate steps.  Often it requires legislation and regulation, and in the time it takes to create the lock on the door that the evaders broke through, lots of taxes have been evaded.  And as soon as the lock goes on, the inventive tax lawyers and wealthy tax evaders get busy at their manipulative game again.  So there is a spiral of complexity to deal with the problem caused by sophisticated taxpayers seeking sophisticated help to avoid or evade taxes.

This "regulations and complexity are the cause of offshoring and tax cheating" nonsense sounds about like the 2001 arguments made by many on the corporatist right for reducing tax rates.  First, the proponents of lower taxes noted that there was a considerable amount of cheating via tax shelters by the wealthy and big corporations.  Then, the illogical next step was taken: if only the wealthy just had to pay a little less in taxes, they'd be good citizens and quit using tax shelters, the Republican head of the Joint Economic Committee opined.  HA.  If you lower the rate today, the greedy ones just demand a lower rate than that the next day.  We've seen that play out as the corporate lobbyists got a twenty-year-long wish list fulfilled in the 2003 Bush tax cuts, then came back for more the next year and the next (and are still demanding even more today).

Swiss Bank Weigelin Indicted

On Feb. 2, 2012, a grand jury in the Southern District of New York indicted Weigelin & Co, a Swiss bank founded in 1741 that provided various asset management and private banking services to U.S. residents without having any branch offices in the US, for helping US taxpayers hide more than a billion in secret offshore accounts.  See United States v. Wegelin, SDNY No.81-12 Cr.02(JSR) (2/2/12) (Download Wegelin indictment).  The Department of Justice has also seized more than $16 million from Wegelin's U.S. accounts under civil forfeiture laws.

 The indictment claims that more than 100 US taxpayers availed themselves of Weigelin's services to hide their assets, starting around 2002 and continuing through 2011.  In particular, it charges that the bank and its officers opened "dozens" of new undeclared accounts in 2008-09 after the investigation of UBS had brought attention to the issue.  The company's executive committee "affirmatively decided" to go after UBS's US clients, telling U.S. taxpayers that the bank's lack of U.S. branch offices would help prevent discovery.  In announcing this new policy of capturing UBS's illegal business, a bank executive noted that Weigelin was smaller and that it would be able to charge high fees for this business since taxpayers were now frightened about the prospect of criminal prosecution in the US if their accounts were discovered.

The bank used a variety of techniques to assist in the tax evasion objectives of its US taxpayer clients.  It helped them repatriate funds by drawing checks on a Stanford account held by the bank, and even extended this to assist clients of other offshore banks in repatriating their funds.   This was often done by conmingling the US taxpayers' funds with other funds, so that the IRS would have more trouble connecting the dots.   It set up their Swiss accounts in names of sham foundations and corporations--using Lichtenstein, Hong Kong and other jurisdictions' facilitative entities for this purpose. It used code names for taxpayers and numbered accounts rather than names whenever possible.  The bankers never mailed information to their clients' US addresses, but they did email and telephone them about their accounts (sometimes using personal email accounts rather than office accounts to further deter discovery).  After the bank started taking on clients that were fleeing UBS, it also changed its contact policies to require travel to the Swiss bank rather than email or phone contacts with US taxpayer clients.  The indictment notes that "various" of the bank's clients filed false 1040s and failed to file the required FBARs related to the accounts.  (We can probably expect to see more of these taxpayers facing criminal tax evasion charges as the months roll by.)

According to the indictment, the bank also solicited new US taxpayers for its asset management business, through Fed Ex and email and through a website (run by another firm, but paid for by the bank) advertising Swiss bank accounts that would not disclose information on tax evasion.  At least 70 US taxpayers moved their accounts from UBS to Weigelin in response to these solicitations.  As it became clear that voluntary disclosures by some US taxpayers was revealing information about other Swiss banks, Weigelin took measures to protect identities of advisers assisting US tax evasion, for example by removing client advisor names from records and listing merely "team international" on those records.

The indictment includes stories of US taxpayers who used the Weigelin bank to hide their assets.  One, a woman who inherited a UBS account in 1987, made a trip  with her husband to Switzerland when the UBS investigation became public and was advised to move her account to Weigelin, which she did.   When the couple wanted funds out of the account, they would call and notify the bank that they were going to Aruba. In Aruba, they would fax information to the bank.  The bank would arrange for checks (in amounts less than $10,000 each) on its Stamford account.  The couple became alarmed, however, when it learned that its account at UBS might be one of the 4500 or so disclosed under the agreement with the IRS.  Weigelin advised them not to worry, and not to voluntarily disclose the account, which held almost $2.5 million. 

Another accountholder mentioned had a larger account of about $30 million.

Of course, it would have been to the taxpayers' benefit to disclose, and the bank was acting to protect itself in persuading them not to disclose.  Surely accountholders should be able to recognize that there would be a conflict?  None of the taxpayers specifically mentioned disclosed voluntarily and, one assumes, all are likely to be under criminal indictment (ought to be at any rate).