Bloomberg reports (in a minimal news story at this point based on an anonymous tip prior to the settlement being officially released) that the United States and Switzerland have reached an agreement that settles the dispute about Americans' use of Swiss banking secrecy to evade US taxation of undeclared accounts.
Apparently, the deal will result in some banks being permitted to voluntarily disclose activity, while others will face penalties because of undeclared assets.
Bloomberg today covers a story about another tax-shelter ploy by hedge fund billionaires to make themselves even richer at the expense of ordinary Americans who will have to pony up more (or be beset by a bigger deficit) when the billionaires don't pay their fair share of taxes. See Zachary Mider & Jesse Drucker, Simons Strategy to Shield Profit from Taxes draws IRS Attack, Bloomberg (July 1, 2013).
As the article notes, the IRS is challenging a tax-lawyer alchemy for converting ordinary hedging income to preferentially treated capital gain income by using a bank as an accommodation party to a derivative transaction--the bank buys the portfolio that the hedge fund wants to own, the bank then hires the hedge fund to manage the portfolio just as the hedge fund would do if it were the legal owner rather than the beneficial owner (which it probably should be considered under general tax principles, with the result that the hedge fund "manages" the purported bank portfolio by engaging in almost daily trades, as is a hedge fund's practice, and then the bank purports to sell an option on the portfolio to that very same hedge fund (surprise! :) !) and then the hedge fund exercises that option (quelle surprise!) more than a year after its purchase and claims thereby to have converted its trading gains (ordinary income) into an investment contract gain (Ipreferentially taxed capital gains).
This is the reason that most derivatives are such a financial scam. They are merely an artificial way for banks to make more money than they should by accommodating other parties in practicing banking alchemy--doing artificial stuff that doesn't do the economy any good, produce any goods, or create economic growth that extends to non-banksters. In fact, it does actual harm by assisting other big financial players (in this case, hedge funds and, in particular, hedge fund employees) in scamming the system for no reason other than to reduce their taxes. Simons and Renaissance employees own nearly all of the fund in this case. Id. This is what we can continue to expect from the "greed is good" and "I got everything by my own merit [HA!] but just let me get by with another scam while also subsidizing me with "too big to fail" bailouts" generation of financial institutions and "shadow" financial insitutions like the hedge funds. Hedge funds aren't very good for investors (see, e.g., this item showing that hedge funds return less than the S&P 500 on average--considerably less), but they make good money for their managers--especially when they engage in derivatives to turn ordinary income into preferentially taxed capital gain.
Thankfully, the IRS has challenged the scam, utilizing the core tax principle of "substance over form". See the November 2010 Chief Counsel Memorandum noting that the contract does not function like an option and since it provides the benefits and burdens of ownership to the hedge fund and not to the bank, the hedge fund is treated as the beneficial owner for tax purposes. But remember that the IRS Is underresourced and outmanned by the lucratively compensated tax advising teams for funds and other wealthy institutions. "If they [the hedge funds] win, that will signal to the rest of the hedge-fund community that aggressive strategies can work.," said Steven Rosenthal from the Urban Institute (a former tax partner at Ropes & Gray).
As noted in an earlier post focusing on the way intimidation of the IRS tends to lead to more tax avoidance and even tax evasion through promoted "shelters", Hewlett-Packard official Ray Lane engaged in a phony tax shelter back in 2004. He got caught and has apparently settled the $100 million tax bill. See, e.g., Reuters, H-P Board member Ray Lane Settles long-running tax bill (June 6, 2013); Tax Prof listing of assorted stories.
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.
One of the (many) ways by which rich, sophisticated taxpayers who are also ultra-greedy have managed to avoid paying their fair share of taxes is to move money offshore through trusts and "companies" set up in various no-tax/lo-tax, hi-sun jurisdictions like the Cayman Islands, British Virgin Islands, Cook Islands, Singapore, etc. I suppose for many years this scheme served multiple objectives--it stashed the cash beyond the reach of the US government, it provided a nice place to visit the cash, and it had the cachet of belonging to the exclusive jet set behind it.
That's becoming less so as the US continues to pursue tax cheats with unreported offshore accounts. The dam started bursting with the revelation of the way Swiss bankers groveled at their American clients' feet, from smuggling diamonds into the country in toothpaste tubes to secreting gold in deep, hidden vaults to setting up sham companies in the Phillipines or other countries. Over the last half decade, more people have participated in voluntary disclosure and more have been identified for more serious penalty programs (including criminal prosecution). Each voluntary disclosure included full information about those who facilitated the offshoring--bankers' names, other involved lawyers, accountants, and bankers, other entities. That groundswell of information facilitated identification of even more tax cheats, and those identifications yielded a new trove of relational data--those who had assisted them. That finally seemed to begin to put some teeth into enforcement efforts and some gnashing of teeth into the lives of the otherwise obliviously happy tax evaders.
But various commentators (including my colleague at Wayne Law, Professor Michael McIntyre) have been concerned that the offshore gambit can't be cleaned up until countries begin more automatic sharing of the tax information they have without requiring the requesting country to have already identified the accountholder well enough to ask for information specifically about that person. If they can ask specifically, of course, it means they have already been found, which makes for a catch-22 that has made pursuing secret bank account holders an overly arduous task.
That makes the IRS's announcement today of a new coordinated effort among the U.S., U.K, and Australia heartening news. They have agreed to share information about trusts and companies holding assets in tax havens like the British Virgin Islands, the Cayman Islands, and Singapore. See IRS news release IR-2013-48 (May 9, 2013). With the cache of information each country has gleaned from the recent efforts, coordination will allow them all to benefit from each one's effort. That should accelerate the effort to catch the tax cheats.
Max Baucus announced to his fellow Senators today that he will not seek re-election to the Senate in 2014. He has been the top Democrat on the Finance Committee since 2001. See Senate Finance Chairman Max Baucus Won't Run Again in 2014, Bloomberg.net (Apr. 23, 2013).
As someone who thinks that Baucus has been a hindrance to progressive reform of the tax code and financial regulation, I must admit that I do not find his retirement a loss. His chairmanship of the Finance Committee has been marked by a failure to understand the most important issues related to federal income and estate taxation and by adoption of positions that are too favorable to Big Money and Big Business (especially Big Banks). He has been tone-deaf, in other words, to the class warfare waged by the right against the middle class and the resulting growth in inequality in the country that has been worsened by the current tax provisions that support redistribution upwards to the very wealthiest owners of financial assets and businesses. In particular, he has failed to use his position to push for reasonable reform of the capital gains preference and the wealth-favoring versions of the estate tax passed by the Bush administration. He has refused to consider a reasonable financial transactions tax. In fact, Baucus was too willing to go along with the initial passage of the Bush tax agenda in 2001-2004, and he did nothing to ensure that the Bush tax cuts would fade into oblivion on the sunset date. In fact, he worked to make permanent almost all the Bush tax cuts and supported the corporate-friendly "extension" of the broad menu of corporate tax cut provisions (including a retroactive extension of the R&D credit, which cannot possibly serve the purpose it is claimed to serve when enacted retroactively). The tradeoff provided only token items on the progressive menu.
Of course, the Republicans will cast Baucus' choice to retire as a reflection of problems for Democrats. See the Bloomberg News article cited above, in which Rob Collins of the National Republican Senatorial Committee says as much. I suspect that Baucus knew he would be targeted by liberal Democrats for his failure to vote for gun control and for his failure to support progressive tax policies.
That said, he remains as Finance Chair through 2014, and he has said he intends to produce a rewrite of the tax code. He is the wrong person to do that, and so it is important that other Democrats relegate him to a position of less influence in order to come up with more progressive changes than he would support.
Is Ron Wyden (who would become the most senior member of the Finance Committee when Baucus leaves) capable of carrying the banner of progressivism? His emphasis on "tax simplification" is worrisome, because it suggests that he does not understand the relationship between complexity in the tax code and sophistication of taxpayers to whom the complexity applies. The main reasons for complexity are two-fold: (i) existing tax rules are expanded to cover abusive schemes developed by sophisticated tax advisers (attorneys and accountants), and (ii) existing tax rules are riddled with exceptions to provide subsidies (tax expenditures) favoring industries represented by heavy lobbying. To the extent that tax simplification reduces the anti-abuse rules needed to prevent various tax scams and manipulation, simplication is a policy mistake. To the extent that simplication results in changes to the tax expenditures, it can be useful but it is often also mistaken, because the easiest way to "simplify" such rules is to expand them to cover even more of heavily lobbied-for industries. Wyden needs to expand his understanding of the relationship between simplification as a goal and fair allocation of resources to the extent that resource allocation is handled through tax expenditures in the Code, reasonable rules to ensure that the most sophisticated taxpayers pay their fair share, and fair distribution of the tax burden. Baucus did not serve the publci well in regards to these issues. Let's hope that Wyden does better.
On Monday, Congressman Lloyd Doggett, a long-time member of the House Ways and Means Committee, releases a GAO report showing the continued advance of corporate tax expenditures that allow corporations to pay little or no taxes year after year.
“Of the many Americans who are right now getting their taxes ready to file, I doubt there are very many that think they will be able to pay a mere nickel on the dollar. But there are many of America’s largest corporations that continue lobbying the Administration, and this Congress to let them pay a nickel on the dollar in taxes on a significant portion of their earnings. Over a three-year period, 30 Fortune 500 companies devoted more of their monies to lobbying this Congress than they did in paying taxes to the Treasury. Some have a negative tax rate. Many of our largest corporations are paying effective rates that are single digits.
On Monday, he will again propose legislation to deal with the way corporations can so easily avoid tax liabilities in the US. A press release from Doggett's office lists the following pieces of legislation to be introduced:
The Stop Tax Haven Abuse Act aims to close several different loopholes by deterring the use of tax havens for tax evasion and strengthening the enforcement of our tax laws. The bill would also require SEC-registered corporations to report annually on the number of employees, sales, financing, tax obligations, and tax payments on a country-by-country basis, shedding more light on the extent of use of tax havens. This bill also provides for additional penalties for failing to disclose offshore holdings and for promoting abusive tax shelters.
The International Tax Competitiveness Act addresses a large and growing area of tax abuse: the practice of developing a trademark, patent, or copyright in the U.S. and then transferring that intellectual property abroad to avoid taxes on the vast income it generates. This bill would treat income from the U.S. intellectual property as U.S. income and tax it accordingly.
The Fairness in International Taxation Act would end the current practice of treaty shopping to avoid U.S. taxes. The United States has tax treaties with a number of trading partners that reduce the amount of taxes that a U.S. based entity owes on interest and royalties paid to a foreign parent. Since many of these foreign parent companies are set up in tax havens, these companies now bypass U.S. taxes by routing the payment through a tax-treaty country that then just transfers the funds to the tax-haven parent. This bill would end that legal fiction and say that you only get the tax-treaty discount if the parent company is actually located in a tax-treaty country.
Doggett has tried to get Congress to act on corporate loopholes for more than a decade. The lobbying money has enormous influence. Just as in the gun control arena, where a majority of Americans want stronger gun controls but the manufacturer of weapons want lax provisions, most Americans think that corporations ought to pay a larger share of taxes but Congress is heavily influenced by lobbyists who wine and dine staffers and provide numerous purported "educational" briefings on what Big Business wants.
Each of these legislative proposals has merit. Of particular interest is the "international competitiveness" provision, which would finally make some inroads in corporations' ability to move intangible properties developed in the US into tax haven countries in order to eliminate taxes. We have for too long relied on an outdated transfer pricing mechanism for this kind of transfer. It doesn't work, since no company would ever actually sell intellectual property that is the core of the company's business. These cross-border transfers of IP are shams, and we should finally legislate to prevent this .
In the late 90s and early 2000s, Jenkins & Gilchrist (J&G) made lots of money promoting bogus tax shelters, often using derivatives and partnerships, to generate phantom losses to offset real (economic) income or to defer recognition of income. The highly promoted but secretive deals had catchy names, like "SOS" (for "short options strategy"), and generated very high fees (based on a percentage of the tax loss generated by the shelters!) from the wealthy individual clients that considered themselves above the (tax) law. In return for the fees, the law firms promoting the shelters assisted the clients in all stages of the shelters, including setting up bank accounts and sham corporations and partnerships as needed, topping it off with a "more likely than not" "get out of jail free" tax opinion. Download Guerin Donna Sentencing PR.
As the press release notes, one such shelter, sold between 1994 and 1999 to almost 300 wealthy individuals, generated about $2.6 billion in fake tax losses. The SOS shelter, sold between 1998 and 2000 to more than 500 wealthy individuals, generated at least $3.9 billion in fake tax losses. And so on.
Donna Guerin, one of the partners at J&G (and earlier at Altheimer & Gray) during that period, was instrumental in the design and marketing of the shelters. She was originally convicted in May 2011 in a jury trial, but juror misconduct led to the scheduling of a new trial for March 2013. Guerin pled guilty instead of facing trial and was sentenced last Friday to eight years of jail time on conspiracy and tax evasion charges. She was also ordered to pay restitution of $190 million. Not only did she participate in the marketing and implementation of the tax shelters, but Guerin also "took part in the illegal back-dating of certain tax shelter transactions," making more than $17 million between 1998 and 2002 from her illegal activities. Op. Cit.
Congratulations are due to Assistant US Attorneys Stanley Okula, Jr. and Jason P. Hernancez, as well as DOJ Tax Division Assistant Chief Nanette Davis, who handled the prosecution of these tax frauds. These promoted shelters reveal the lengths to which wealthy American--and, too often, also their advisers--will go to avoid their personal responsibilities and duties to We the People. Hopefully, attorneys will pay more attention to their duties to the integrity of the courts going forward. And this should be a reminder to all those who claim that "the 47%" don't care about personal responsibility that there is a good deal of evidence about the 1% being negligent of their public responsibilities .
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.
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.
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).
A Taxing Matter has reported frequently on the scandals of offshore banks aiding and abetting US taxpayers in avoiding tax due on income from their capital held overseas. The opening of the UBS case cracked open a vast network of mostly wealthy US taxpayers who had held money overseas and avoided tax. With the exposure of the bank's role in assisting tax avoidance, and the requirement that taxpayers "come clean" about the particular bankers and banks that assisted them, the government began to create a web of information leading to tax evaders, even those who thought they had moved Swiss accounts to Liechtenstein banks to avoid capture. That web has already led to the demise of one of the oldest Swiss banks--Wegelin. See Robert Wood, FATCA Cliff: Tax Evasion Guilty Plea and Death for Oldest Swiss Bank, Forbes.com (Jan 3. 2013); Swiss Bank's Demise: Glass Half Empty or Half Full?, Jan 9, 2013.
The IRS offered a number of voluntary disclosure programs with slightly escalating penalties but, importantly, no criminal prosecution, for people who would come forward before their names/accounts turned up in the ongoing chase after tax avoiders. (There is considerable suspicion that one of the reasons Mitt Romney refused to release the usual number of tax returns is that he may well have been a participant in that voluntary disclosure program.)
For those who don't come forward soon enough and are caught by the IRS, the statutory penalties and potential for criminal punishment are very real. The statute in effect allows the government to collect amounts that could well exceed the amount left in the account, and criminal punishment for filing falsified tax returns can well mean jail time.
Mary Estelle Curran fell into that trap when she choose not to report the Swiss accounts her husband had established after he died, from 2001 through 2007, using foundations in Liechtenstein and Panama. By the time she tried to participate in the voluntary disclosure program, it was too late, because she was one of the Americans revealed by UBS in its deal to defer US prosecution. The taxes she evaded amounted to about $667,000, but the penalty under the law for this type of willful evasion is quite severe, allowing the government to take 50% of the highest account balance for each failure to report. Forbes notes that "[b]y 2007, the accounts totaled over $42 million. Her penalty? 50% of the highest balance: $21,666,929, and that’s not all. She has not yet been sentenced but faces a potential prison term up to six years." Florida Widow Guilty + $21M penalty for Inherited Swiss + Liechtenstein Accounts, Forbes.com (Jan. 8, 2013).
The moral of this tale--if you have money sequestered offshore on which you haven't filed the required FBAR reports or paid taxes, you'd better 'fess up before you get discovered in this continuing sweep. And next time, go on and pay your fair share. You really owe those taxes, you know.....
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