No tax benefit.
Or the tax benefit wasn't as generous as what was claimed. In other cases, courts looked at situations that the IRS brought to them and said, "No, that is perfectly legitimate, and if policy makers don't like that, then they should go to the Congress and get the law changed. "
On many occasions, the Congress has stepped in and said, "We don't like that answer. We may not have intended it, but it may obviously work, so we're going to change the law and eliminate that tax benefit."
When I was at the Joint Committee on Taxation from 1995 to 1998, the Finance Committee and the Ways and Means Committee agreed to actually change a number of provisions that they considered were inappropriate and to close loopholes that may have existed in the code.
So Congress could take action. But what you have in the climate of the 1990s, when everybody's making a hell of a lot of money -- whether it's corporations or individuals or entrepreneurs or whatever -- the climate is one of aggressive marketing of shelters. Is that what you're saying?
... What the accounting firms did was say, "Well, OK, we're going to play that game. But we're going to try and make it up somewhere else, because we've got to function as an economic unit." So where a lot of them tried to make up the difference, if you will, is by being very aggressive in selling tax sheltering activities.
Now in today's world, that is completely changed, because [of] this passage of Sarbanes-Oxley and the scrutiny by boards of directors and the scrutiny of the SEC. The instances in which corporations are buying tax services from the same firm that audits them is very significantly on the decline, because of a concern about independence. That is, if I'm auditing you, and I'm also selling you tax services, and part of what I'm auditing is the tax provision that you've put on your financial statements, to some extent, I'm auditing what I sold you.
A little bit of a conflict of interest?
It's not a conflict of interest. It's a lack of independence. It's called a concern about independence. Is the auditor exercising independence in assessing whether your financial statements accurately present your financial picture to your investors and to the investing public generally? There it's a concern that there is not independence, if part of what I am auditing is something that I also sold you.
In today's world -- post-Sarbanes-Oxley, post-Enron -- boards of directors are very, very reluctant to even go down that road of taking the risk of buying tax services from the same entity that provides them with their audit. That's one of the reasons that I think we're seeing a decline in the level of tax sheltering activity -- because people are more cautious.
Take me back still to the late 1990s period you were describing. What's your take on the IRS at that point? Are they up to speed? Have they got modern computers, have they got the team, have they got the moxie to keep up with this market that is just exploding in the late 1990s? ...
In the case of dealing with corporate tax sheltering, having the computers is not what really it's about. You're asking a good question, which is, did they have the talent inside the IRS that can go head to head against the talent that the private sector has? [There are] a lot of very smart people in the Internal Revenue Service. Fortunately, there is a pattern of private-sector people going into the IRS at a high levels, and spending three or four years there, and then going back to private practice.
So they are not dependent on just the career people. The career people are some very good people. But it is a tough job every day for the IRS to stay up with what's happening.
Now that's only one part of this picture. The other part of the picture, though, is corporate America generally is not real good at keeping a secret. If corporations have a new fad -- and my own view is today those fads are for the most part gone -- but in the 1990s when you're talking about, there were transactions. One of them was called step-down preferred. It was a transaction that surfaced in the fall of 1996, when I was still at the Joint Committee on Taxation. Within months, we knew about that transaction and had passed and the IRS actually issued a notice. I think it was in March 1997 that shut the deal down cold.
So it had a half-life of about three to six months before the government was well aware of it and was able to take action that essentially stopped the transaction dead in its tracks. Part of the reason goes back to what I said earlier, and that is corporate America is not real good at hiding the ball. ...
[Charles Rossotti] describes a corporate return as big enough to fill half this room. I mean, our individual returns are nothing like that. Finding something in one of these corporate returns, even if you had 15 auditors working steadily, if you don't know what to look for, it's not that easy.
That's true. But that has nothing to do with the computer problems that the IRS had. ... The fact that a tax return is very large really kind of overstates the problem, because the places that the IRS auditors know to look are pretty obvious.
There's a thing called Schedule M that tells you every book-tax difference. Many of the shelters that the IRS ended up pursuing were transactions where there was a difference between the book-tax treatment, that is, how did you report it for financial reporting purposes, and how did it show up on your tax return? There is a schedule where the taxpayer has to list all of those, and that is a beginning point for an audit.
For Fortune 100 companies, the standard practice is that the IRS has a team of auditors at their headquarters pretty much 12 months out of the year, so a continual process of auditing that takes place. So for those taxpayers, the computer problems that the IRS had really were not relevant to their compliance situations or the problems the IRS was dealing with. For those taxpayers, the problem was more the sophistication of the transactions and their ability to understand them and to identify where there might be technical problems with positions take on tax returns.
You mean just not being sharp enough, and not getting what was going on?
That's part of it, but this is where the complexity of the code really is relevant. For U.S. multinationals that are invested in places all over the world, the complexities of our tax system of just how do they calculate their income. Assume for a moment you have a tax director whose only objective is to get it right, which, by the way, is the objective of most of them. Just getting it right is a very difficult thing when you realize all of the complexities that are in our tax system, about how do they calculate the liability associated with investments in a hundred countries around the world and transactions where they're bringing dividends back. We have a complicated tax system in that regard.
The complexity then feeds both confusion and differing interpretations about what is permissible and what's not.
There is no doubt that there are areas in the code where it's gray as to what the law is. The job of a good tax director is to be able to plan his company's transactions to try to minimize their tax liability legally, and if it's in an area where there is gray -- that presents potentially an opportunity for tax savings.
One of the things that was interesting is the difference in income reported by American corporations to Wall Street and the income reported to the IRS for tax purposes. What the Treasury Department says it noticed in the late 1990s was the gap between these two was widening; corporate profits reported to Wall Street were going through the roof, but corporate profits reported to the IRS for income tax purpose were staying flat and even going down, in some cases. Larry Summers, as Treasury secretary, found that alarming, and thought that the integrity of the tax system was at stake. What's your take on what Summers had to say about the problems of the tax system in the late 1990s?
I testified about this issue in front of the Senate Finance Committee. [I] pointed out that there were three very obvious explanations for the divergence between financial statement income, i.e., income reported to Wall Street, versus what was showing up on tax returns, which demonstrated that this was not the least bit surprising.
One was that the growth of markets and the growth in business in the late 1990s for many U.S. corporations was outside the U.S. That's where there were new markets and investment opportunities that created income for them. When they report to Wall Street, they report their worldwide income. For their tax return, they don't have to report the income from their foreign operations until they bring it back to the United States in the form of dividends. That's referred to as deferral. So if they make money in France, if they don't bring it back to the U.S., they can reinvest it in France. They don't have to report that to the Internal Revenue Service until they bring that revenue back.
A second reason for this difference was that there was a significant uptick in capital investment. The economy was doing well, and corporations were making new investments in plant and equipment. The depreciation rules for tax purposes are faster than they are for financial accounting, because financial accounting is conservative. So the taxable income would show up as smaller in the early years. It would show up as larger in the later years, because depreciation is a timing issue. So if I get to take depreciation on the investment I made this year, I get more of it this year. I get less of it later on, and my financial statement, my taxable income, will go up.
The third phenomenon that contributed to this difference was the treatment of stock options. During the 1990s, a lot of stock option income was realized by individuals. That meant that they had to pay a lot of tax on that. But on the corporate side, it gave rise to a deduction for tax purposes. So it will reduce their tax liability, but it was not deductible for financial statement income. There's been a big fight back and forth as to whether that's the right answer or the wrong answer.
But from the standpoint of the Treasury Department, how much money is the Treasury collecting? Having individuals exercise stock options is pretty much a wash, because it results in taxable income to the individual. In some cases, the individual's marginal tax rate was higher than the deduction taken at the corporate level.
The Treasury Department also said that tax sheltering was a major factor in this. Do you disagree with that? Do you think that's exaggerated?
Larry Summers, who I have a lot of respect for, made that assertion. He was never able to substantiate it with real numbers, real analysis. He made some speeches claiming it. He and I actually had some very interesting exchanges over it, but were never able to quantify it. We did actually quantify the three factors that I talked about: foreign investment, depreciation, and stock option exercise. When you looked at those three numbers, they explain a significant amount of the difference between the income being reported for financial statement purposes versus the income being reported for tax purposes.
At the same time, he was talking about that corporate revenues were actually hitting all-time highs in the history of the Internal Revenue Code. So this unsubstantiated assertion that this deviation between financial statement income and taxable income was really offset, if you will, by looking at how much revenue was coming in to the federal government in the form of corporate tax revenues. ...
I think Charles Rossotti's figure on losses to abusive tax shelters was $85 billion, the figure that he quotes over a five- or six- year period here. I think the IRS study by an outsider said it was something like $11 billion to $18 billion a year lost to abusive tax shelters. Do you accept those as rough ballpark figures, or do you think the IRS and Charles Rossotti are exaggerating the problem?
You know, it's kind of a hard question to answer. First off, I have no idea what he was looking at when he said $85 billion. I would point out that many of the transactions he probably was referring to are transactions where the IRS has successfully challenged the treatment and won and taxpayers have had to pay the tax back. So unless you really can like identify what are the transactions that are being referred to and what are the dollars associated with them, it's very hard to make a judgment about that.
Having said that, my view has always been about this issue very simple. There will always be people that will push the envelope, given the complexity of the tax system we have and the benefits of doing that. The real question has always been in my judgment whether the IRS has the tools that it needs to effectively deal with the bad apples -- of which there will always be some in any tax system which has the kind of complexity that ours does.
So the amount of the problem is an interesting thing to throw around. But it's not really terribly relevant to the more important question, that is, does the IRS have the resources that it needs to effectively administer our tax system?
I want to give you a chance to respond to Summers. Summers singled out cross-border leasing or LILOs -- lease-in, lease-out arrangements -- as one of the poster children of the abusive tax shelters.
I'm not sure when Larry singled it out he even knew what the transaction was, and that was back in 1999. I was in a meeting with Larry where he mentioned the transaction. I'd have to say it didn't appear to me that he really even understood what he was describing. ...
They were very complicated transactions. They are heavily negotiated. In each case, they have legal opinions from very reputable law firms. Those transactions very comfortably fit within 30 years of leasing law, tax law that has been developed both through IRS guidance and through the courts. I can assure you Secretary Summers did not understand any of what I just told you -- that these transactions were actually conservatively fit within the leasing tax law that had been around for 30 years. ...
... What is a LILO?
... Let's say you're the German rail system and you own your rail cars. A U.S. party would enter into a transaction in which they leased the rail cars from you, and then turned around and leased them back to you. Now in order for that transaction to work, the initial lease term has to be sufficiently long that the lease back has got to be sufficiently small so that the transaction is recognized as a lease for U.S. tax purposes.
What makes that work? What makes that worthwhile? What does the U.S. investor get out of a transaction like that? ...
What they're what they get is a return on their investment. This is a financing transaction. It's a form of financing. Their leasing is a way to lend money to people.
How do they get money back?
Because they get paid rent.
But the rent they get paid is equivalent to the rent they pay.
That's one of the mistakes the IRS made in 1999 when they issued their first ruling on LILOs. They didn't think there was economic profit in these transactions.
We represent a number of taxpayers who did LILO transactions. We demonstrated in excruciating detail to the Internal Revenue Service that there was economic profit independent of the tax benefits. That's what caused them to withdraw the ruling that they had issued in 1999, which depended on an assertion that the economic profit in the transaction was small or insignificant relative to the tax benefits. In the leasing role, these transactions are actually conservative, compared to your typical leveraged lease. ...
We have talked to a number of German officials. We have been to German cities, whether you're talking Frankfurt, Cologne, Dortmund, Bochum, on up and down the line. Without exception, every single German official or member of the city council we talked to said that they were told by the arrangers and by the American investors that they only way that transaction was financed was by the tax benefit that the American investor got out of it.
The tax benefit is an important part of the transaction. I'm not trying to minimize that. But what I'm telling you is in every single one of the transactions you're describing there is pre-tax profits. That's the way the transactions all work.
How does it work? The American firm is paying. What they're saying is the American firm plunks down 99 years' worth of rent for the lease or whatever the term is. Then most of that money gets put in a bank, which then pays the rent back on behalf of the German party to the American to lease it back. The money is going around, as the IRS says, in a circular flow.
What you're referring to is called defeasance, which is that money is set aside to insure that the rent that's due under the agreement does get paid. That's called minimizing risk, and there's nothing wrong with minimizing risk in a leasing transaction. One of the ways the IRS has tried to attack these transactions [is to] say, "There's no risk in the transaction."
Let me just present a very simple hypothetical. If I lease property to the federal government -- and it happens every single day -- what is the risk of my not being paid? About zero. Does that mean it's not a leasing transaction?
My point about the money as they described it was the American money was going to the German [city] and then was coming back from the German city to the American investor. So how does the American investor make any money?
They make money because they pay for the lease up front. They are getting rental payments that pay them for the use of their equity. In every single one of these transactions, the net return on their investment is significant prior to the tax benefits involved. ...
But [former IRS Chief Counsel] B. John Williams said to us that these are circular money flows; that the money flows out and it flows back. As he puts it, nothing happens.
That's just plain wrong. The U.S. investors have significant equity investments. They are significantly at risk as to the value of the property at the end of the lease term. These are very sophisticated, complicated transactions, where there are appraisals that are done. There are opinions provided by local counsel, but very sophisticated law firms that have practiced in the leasing role for years. We are highly confident if this ever goes to court, that these transactions will stand up, because they fit very comfortably within the rules that have been developed over 30 years as to how leasing tax law applies. ...
Talk for a moment about that leasing industry. [What] is a leasing industry, and how important is it to the American economy?
The leasing industry is huge. In the United States today, there are probably 2,000 companies engaged in the leasing industry. In 2001, $280 billion worth of equipment was placed in service through leasing transactions.
Just to put in context how important that is, for every $1 billion worth of new equipment placed in service, it probably translates into 30,000 new jobs. In the United States, 80 percent of all corporations acquire some or all of their property through leasing transactions. That's how they actually obtain it. Thirty percent of all new equipment that's put in service annually is probably done through a leasing transaction.
So leasing is a huge part of the U.S. economy. That's true of not only the domestic side of that, but also the cross-border part of the leasing industry. In fact, the U.S. companies are the leaders in the world in the leasing industry, and there's a simple reason for that. We have a substantial amount of the world's capital. What leasing transactions really are about is providing capital to users of capital, whether it's Lufthansa Airlines or whether it's the city of Munich or whether it's the company down the street here that needs to get a bunch of new cars because they need to provide them to their delivery people.
If you walked out on the street today and walked up to a user of equipment, whether it's a backhoe or it's an automobile or it's a front-end loader, probably 30 percent of that would be a transaction in which there is a lease involved.
When people use the term "big-ticket leasing," who are they referring to? What are they referring to?
What they're referring to is large transactions. So they're referring to leasing transactions involving power plants, rail cars, airplanes -- large pieces of equipment. That's what big-ticket leasing is about.
Who can afford to do that? Are we talking about big banks? ...
We're talking about entities that have significant supplies of capital that they're looking to deploy, so major financial institutions would all be in this category. I mean, a major bank has a lot of depositors who put money in their bank. The job of the bank is to figure out, "How do we take that capital and invest it in a way that maximizes the return to our shareholders?"
So we're talking about principally large suppliers of capital. Those are the people that have both the sophistication to enter into these transactions, and the capital available to do it. So almost every major financial institution in the United States has a leasing function. A number of major corporations who have a diversified investment profile ... would be in that situation. Another example would be companies that are major manufacturers of equipment, like a Caterpillar, or a Boeing, or GE, or people like that, because they use leasing as one of the techniques by which they are able to export their property to users. ...
I've got to admit to you my own personal confusion. When you talk about leasing the way you just were, the ability of Caterpillar or Boeing or GE to move big expensive equipment, to make big deals whether they make them with the city of Chicago or with Lufthansa, it makes sense. But I have a very hard time understanding why a Wachovia bank would get into a half-a-billion dollar deal to lease the 30-year-old sewer system in the city of Bochum; I mean, absent the tax benefit.
Yes, well, the tax benefits are part of the transaction. There's no doubt about it.
Without the tax benefit, would they get into it?
They might not. ...
So in May 1999, IRS issues regulations against LILOs. What is the leasing industry's response?
Well, they didn't do any more LILO transactions. They moved on and restructured their transactions to recognize that the tax law had changed.
You got to understand every leasing transaction is just a function of four or five key factors: what is the value of the property, what's the cost of money, what's the interest rate, what are the tax rules, and how much risk is involved. Essentially, those factors control what the nature of an leasing transaction would be, and they control what the rent is that will be paid. They control what people are willing to pay for property and so on.
So if you change the tax rules -- because leasing is fundamentally is a real economic activity -- the parties to the transaction will adjust their relationships accordingly. So if Congress wanted to come in and say, "Nobody gets any depreciation on any property," property would still get leased. It would just have a higher cost to the user.
So the leasing industry, because it's a real business and provides lots of capital, will always exist. It's just a question of what rules will they operate under. ...
So the industry moves on, and now you hear people talking about service contracts. ... We begin to hear people talk about service contracts replacing lease-in, lease-out contracts. What is a service contract?
... A service contract is a contract in which I own the property. I provide you with service. If in the case of an airplane, I may provide air transportation services to you.
What the law does is, it looks at that transaction and says, "Is the nature of the contract I have with you one in which I have actually leased you the property," in which case it's treated as a leasing transaction, or, "Is it a transaction which I am providing a service," in which case the leasing rules don't apply. So rules actually developed even before the 1984 act. But the service contract depends on what is the nature of the contractual relationship between the two parties. ...
... The position of people at the IRS is that the service contract is simply a circumvention of the 1999 rules. It replaces the old lease-in, lease-out contract. As somebody said to us, it's the same old wine in new bottles, or it's new window dressing, but the same structure underlying the deal is there.
The first point is people don't put old wine in new bottles, and this transaction doesn't represent that, either. These are different transactions. They have different terms, the economics are different and a different set of rules apply.
So I think what they're really saying to you is when the leasing industry realized that LILO transactions couldn't be done any longer because the regulations were finalized in May, the industry looked at what other ways [they can] structure transactions that make sense for both parties, the investors and the users of the property, whether it's equipment or buildings or whatever. The industry moved in the direction of long-term leases, which are essentially under U.S. tax law treated as purchases followed by a lease and a service contract. Those transactions work because of provisions enacted all the way back in 1984.
The industry moved to something.
The industry evolved, is a way to put it. They aren't doing the same economic transaction and calling it something else. They are doing a different economic transaction, which is governed by a different set of tax rules.
And still picking up a big tax benefit to drive the process?
It's part of the economics, but the economics [in] leasing transactions are essentially simple. There are suppliers of capital, and there are parties that want to use equipment or property. They will frequently structure their arrangements as leases, because that's the way to supply capital. The tax rules will be a factor in determining what is the rental payment and what are the other economics of the transaction.
It almost seems like a cat-and-mouse game. The industry comes up with one scheme and the IRS takes a while to track it down and says "No," and the industry moves on to another one.
It's a weird way, I think, of describing it. But I think a more objective way of describing it would be to say this is an industry with real economics and real suppliers of capital. If you change the tax rules, they will adapt, because there is a big demand for capital out there among parties that don't have it but who have a need to use equipment and capital. If the rules change, then the parties will adapt to that. ...
One of the things that's happened in the Senate Finance Committee last year, a couple of times, was the passage of legislation that sought to make a general rule that business transactions needed to have what was called economic substance, a business purpose -- they couldn't be done for purely tax reasons. Do you think that legislation is a good idea or not?
Where I am on that legislation is where the U.S. Treasury Department is and where a number of tax experts are. That is the consensus view of many -- that this is not good legislation, that the economic substance doctrine, which that legislation purports to codify or put into a statute, is much better off left in the hands of the courts, who have used it appropriately to disqualify transactions where the transaction was heavily motivated, if not exclusively, by tax considerations.
Any attempt to codify that statute would have unintended consequences that far outweigh the benefits of attempting to codify it. The courts have demonstrated that they're very capable of applying the doctrine in ways that are sensible. It's better off left there than any attempt by Congress to try and reduce it to statutory language.
You've said several times in our conversation, if Congress doesn't like the way some of these transactions work out, then what they should do is change the law. Yet now here is an effort by some people in Congress to change the law, and not just case by case, but to try to set a general set of rules so that taxpayers can know. ... The argument is we need to pass a more general rule that will deal with more of these problems across the board instead of dealing with it case by case.
I think the answer to that is simple, and that is that there is far more harm that can be done by passing a generic statute like that than the good that can come from it. The Internal Revenue Code is a set of specific rules that people are supposed to operate within. If you put on top of that some generic statement of the economic substance doctrine, it's going to create a lot of confusion. ...
We really have to have a tax code that's a set of statutes. My view is that there are plenty of ways for the Internal Revenue Service to deal with overly aggressive transactions, and that sometimes Congress does need to come in and legislate specific rule changes. That's the way this situation should be handled, rather than some sort of omnibus broad statute that really would create more confusion than it would do good in terms of the administration of the tax law.
If Congress tries to deal with individual tax shelter problems one by one, how do you avoid adding to the complexity of a tax code, when the complexity itself invites still further efforts to get around the tax code?
You're never going to eliminate the tax code, and there have been a number of instances where the solution to a tax shelter was a very simple legislative change. In the case of the leveraged corporate and life insurance [COLI] problem which we dealt with in 1995 and 1996, the Congress enacted a very simple tax change that shut down those transactions. So it's wrong to assume that solutions to aggressive transactions or loopholes have to be complicated. They don't necessarily have to be. It really depends on the nature.
What is your take on the other provisions of some of the efforts to deal with tax shelters -- increasing penalties on promoters of shelters, requiring disclosure and registration of shelters by law -- and not just by regulation?
Some of those proposals are probably OK, although I would point out to you that those proposals have been around now for three or four years, and they haven't been enacted. But during that same time period, the IRS has very effectively gone out and addressed a lot of the significant corporate tax shelter problems that are out there. The mood of the country, in terms of the willingness to enter into corporate tax shelters that are aggressive, has completely changed as a result of the post-Enron environment, the post-Sarbanes-Oxley.
So I would suggest to you that most of the problems that we saw in the late 1990s with respect to aggressive corporate tax planning is behind us. The [IRS] was actually pretty effective at using the tools they had available to it to go out and address the problem areas that arose, and corporate America is not that good at keeping a secret. As a consequence, the IRS discovers most of these transactions, and actually has been able to deploy its resources pretty well to address them.
I asked Larry Summers and some of the people who work with [him] why some of the proposals that they've put forward three or four years [haven't moved forward]. The response was the effective lobbying of the financial services industry -- very powerful influence with Capitol Hill key committees -- House Ways and Means, Senate Finance.
Everybody always looks for an excuse as to why you didn't accomplish something that you set out to do. I think it really overstates it to suggest that it was just because of effective lobbying. I think a number of thoughtful members of Congress said, "Lets go slow on this." Does the IRS really need more than they already have? The evidence to date is that the answer is probably, for the most part, that the IRS has very effectively under B. John Williams, when he was chief counsel, shut down a lot of corporate tax shelters that probably were inappropriate.
They did it with the powers they had, without the proposals that Secretary Summers had proposed. For the most part, I think, they really brought most of the corporate tax shelter problem under control.
But I want to reemphasize that, in a complicated tax system, there will always be people that are pushing the envelope. That's why we have an Internal Revenue Service, and we don't have a wholly voluntary system with nobody in charge of making sure taxpayers comply. We are always going to have some people out on the edge.
I think today there are less people out on the edge than there probably have been in 20 years. The publicity associated with the aggressive effort by the Internal Revenue Service to go after the offenders, the hearings in the Congress, the concerns about Sarbanes-Oxley, and the attitude within boards of directors of [having] to be much more cautious is better today than it's been in at least 20 years.
A number of people have cited the post-Enron effect in corporate America and the more vigorous efforts by the Treasury and IRS. But I will say Rossotti and a couple of others have said that they expect a new wave of tax sheltering in the corporate world when the economy recovers. Their answer to the decline in corporate interest in tax shelters is really much more economically tied. ...
I just have to say Charles Rossotti is a very bright guy. I think he's just wrong on this point. I would point to the hearings that the Senate held in November 2003, where representatives of at least a couple of the major accounting firms said, "We're out of that business. We're not going back to it. We know the world has changed, and that's not the way in which we're going to about our business." That's point number one.
Point number two, the attitude within boards of directors across America today has changed -- I think changed forever -- because of the concern about the focus that the Sarbanes-Oxley process puts on companies year in and year out. That is not going away, even if profits go back up. So the world has changed, and the problems in the future I think you're going to see are far less than what we witnessed over the past ten years.
So if people like Summers and Rossotti and others say they're worried about the integrity of the American tax system being undermined by a period of aggressive marketing of shelters, you disagree?
I categorically disagree. I would point to the fact that tax administrators from around the world come to the United States every year, because the United States has the highest compliance rate of any tax system in the world. That's true today, it will be true tomorrow, and it will be true 20 years from now. We have a compliance rate that is the envy of the rest of the world.
Do you think any changes are needed by law?
Oh, I think maybe some of the additional penalty provisions, most of the information reporting the IRS is already getting. The one caution I'll just offer you on penalties. If you get penalties too high, you will find that audit agents will not impose them, because they will have a visceral reaction that somehow it's overkill. So some people have a knee-jerk reaction if we just make penalties higher and higher and people will stop doing this stuff.
The penalties now for a promoter that promotes an abusive tax shelter is, like, $1,000, and they're making several hundred thousand dollars per deal.
What's really stopping the promoters from promoting inappropriate transactions is that reporting obligations require them [to] disclose the taxpayers that they're marketing these transactions to. That's what really stops it, because taxpayers who know their name is going to appear on the list of having bought an inappropriate tax shelter, they're not going to enter into the transaction. So my advice is don't get caught up on how high the penalty should be on the promoter. Make sure your reporting system is right and, if it is, you won't have anybody buying the transaction from the promoter.
But you've got e-mails from within accounting firms in which you have high executives saying to each other, "There is no point in our meeting the reporting requirements of the IRS, because even if we get penalized, we're making 100 times as much as we're going to get penalized." The economics say don't report it.
First off, I can assure you the accounting firms that testified in front of the Senate last November are not sending those kind of e-mails and they are not doing that anymore. They are well aware that that kind of behavior was wrong. I am confident that you're going to see people complying with these rules.
But you've got at least one of those accounting firms and two major law firms fighting the IRS, tooth and nail, to resist the court summonses of the IRS to submit them documentation.
You know what? The courts will deal with that. ...
You said that, [in] the testimony last November, accounting firms came forward and showed they had effectively had a change of heart and they were no longer saying [they] were not going to report. I'm saying in response to that one of those major accounting firms which testified last November is fighting the IRS tooth and nail not to turn over records. A couple of major law firms are doing the same thing. Does that look like a change of heart to you?
There may not be, in their particular case. There clearly is a change of heart generally across the industry. There may be a few outliers that are still not with it, but my bet is they're going to get there. But remember, my more fundamental point is on the buyer side. On the taxpayer side, in boardrooms today, there is nobody looking favorably on these kind of aggressive tax shelter transactions.
So my only point was, don't get hung up focusing on the promoter side. The more important side to look at is the buyer side of these transactions. The attitude there is truly changed -- and I believe forever -- because of the scrutiny that Sarbanes-Oxley imposes on the decision making process, and the pressure it puts on boards in terms of their role in approving these kind of transactions.
But prior to that, finding the position taken by the corporations that adopted those shelters was, "We have a legal opinion. This fits comfortably within existing law." It then was declared abusive by the IRS. It was audited and it went to court. So aren't people going to continue to do that?
I think the answer is no, and if you look at what actually happened back then, the world is different today. The legal opinions that they got, if you read them carefully, weren't worth much. The legal opinions were dependent on stipulated or assumed facts that may or may not have actually been part of the real transaction.
What I'm telling you is, in today's world, the boards of these publicly traded companies and the management just have a far different appetite for risk than existed five or 10 years ago. I don't believe the appetite for risk is going to change. But I also said that the reporting and disclosure rules that the IRS imposed, if they need additional penalties to make sure people are complying with them -- my own view is that's fine. But the more important part of this equation is on a taxpayer side, where I believe there truly is a fundamental change in the attitude of taxpayers about willingness to enter into these kind of transactions.
Several people have said to us that many of these shelters are technical tax transactions which arguably follow the letter of the tax rules. But the position taken by some of the people enforcing the tax rules is that these corporations are twisting the tax rules. They're not really following.
In some cases, that may be true. If that's true, then the IRS should challenge them, and they should force taxpayers to defend their positions. It may be up to the courts to make a decision. Once the courts have made a decision, it may be up to Congress to change the law if they don't like the decision of the courts.
But taxpayers have to operate under an Internal Revenue Code that has rules in it, and sometimes people are going to have disagreements about that. There are a lot of areas of the code where the rules are not crystal clear as to which way a transaction gets treated. So that's going to happen.
People say that in the lease-in, lease-out transactions, while you are a leasing industry, your industry was twisting the tax rules of the IRS.
I think the answer to that is clearly wrong. These transactions, by the admission of the IRS had real pretext, economic profit. Indeed, when the IRS gave up on their 1999 ruling and withdrew it, the IRS made that concession so people can make those assertions. But what the IRS did in withdrawing the 1999 rulings is really inconsistent with that. Now the IRS is still challenging the transaction. We may well end up in court. We are highly confident if we go to court, the taxpayers will prevail, because we have 30 years of leasing tax law on our side with respect to these transactions. ...
Some people are saying that protection of some of these tax benefits and their application, either by the industry or by friends and supporters in Congress, is a subtle way of gradually winnowing away the corporate tax; that protection of certain tax transactions is a method of gradually reducing the corporate tax share until it finally disappears.
The only thing I can say to that is Washington is full of people who have Machiavellian theories about why things happen. This is just another example of one that is wrong. If you look at the numbers that just came out of the Congressional Budget Office in January of this year, you'll see the corporate tax revenues are projected to climb over the next five years back over $200 billion.
But as a percentage of the total, they don't begin to compare with what they were say 20, 30 years ago.
Actually, if you look at the level of corporate revenues in the late 1990s as a percentage of GDP, it was the highest that they'd been since 1980 and 1981. Corporate revenues are again climbing. So if the theory is that this was all a carefully well-orchestrated effort to make the corporate revenue so small that everybody would give up and say, "Lets get rid of the corporate tax system," all I can say is that person has a very significant imagination. We're not getting rid of the corporate income tax. It's going to be a significant revenue generator. Given our current deficit situation, the likelihood that we will ever get rid of the corporate income tax under any scenario is about zero.
Editor's note: This portion of the transcript is excerpted from a FRONTLINE interview with Ken Kies at a conference on cross-border leasing in Paris on Oct. 14, 2003.
So it looks like leasing is doing well in Europe right now. ...
It's in the many billion of dollars, I would guess $20 billion, $30 billion, maybe bigger, because the European Community has an economy that is roughly the same size as the U.S. The U.S. economy is about $11 trillion of GDP. The EU, particularly with the new states that are being added or will have been added recently, probably has an economy roughly equivalent to that $11 trillion.
The United States and the EU both have the same problem. People need the equipment, but they don't have the ability to produce it outright. So frequently the way they get it is through the leasing transaction. ...
Who do we get here [at the conference in Paris on cross-border leasing]? Are these the big-ticket leasers? Are these the European cities? Who is represented?
The people represented here are the people who help structure the transactions. They are from all over the world. There are people here from Australia, the United States, Europe. I think that there are people from the Far East. So this is a pretty big conference, and you attract a number of players from all around the world. ...
Money represented here will be the leasing business.
In the U.S., the leasing business [brought in approximately] $216 billion in 2002. It will be probably about the same size, because it is the tool by which all the U.S. manufacturers export property. [With] major manufacturers like Caterpillar, General Electric, the users of their equipment cannot afford to buy. So the way in which they are able to export it is through a leasing transaction where a third party is providing financing. That's why it makes it so important to the U.S. economy, both domestically and internationally. ...