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interview: larry langdon

Before you went to the IRS, Mr. Langdon, you were working at Hewlett Packard. I'm wondering if you'd take me back to those days. What was your first exposure to the big new tax shelter schemes that were floating around?

... In the early- to mid-1990s at Hewlett Packard, we were visited by a whole host of investment bankers, CPA firms and other firms with regard to ideas they had to minimize tax. A lot of the ideas were legitimate. But there was an increasing number of the ideas that, as we analyzed them, we found that they would fail muster with either the IRS, or certainly if they were litigated.

I wanted to tackle the tax shelter problem.  And I found that the IRS was way behind the times with regard to what I knew was going on in the corporate sector.

In effect, we had an advantage, being on the West Coast, in that these ideas were formulated primarily in New York. I had a series of outside advisors that I could go to fairly quickly, and we could separate the good ideas from the bad ones. But I became greatly concerned, because as I talked to colleagues across the country, there were a number of firms that were, frankly, doing the bad ideas. ...

As the tax director of Hewlett Packard, did you either get pressure from your bosses or see competitive pressure from other companies using questionable tax schemes, so it put pressure on you? ...

At Hewlett Packard we had, happily, a very high moral standard. In fact, the classic rule my boss would use is, "Hey, if that idea doesn't pass the Wall Street Journal test, I don't want to use it."

Meaning?

He defined the Wall Street Journal test as, "Write all the facts up in the Wall Street Journal, and tell the truth. If Hewlett Packard still looks good in that exercise, I'll consider the idea."

However, on the other hand, as I would see what was happening among competitors -- particularly in other industries -- with regard to driving down their effective tax rate, I felt that I had to seriously consider any idea, to make sure that we weren't neglecting a proper opportunity. So I talked to a lot of people with regard to all these things, and I knew what was going on.

photo of langdon

Larry Langdon was commissioner of the Large and Mid-Size Business (LMSB) Division of the IRS from 1999 to 2003. Prior to the IRS, Mr. Langdon worked at Hewlett Packard for over 21 years, where he was vice president for the Tax, Licensing and Customs department. In this interview with FRONTLINE, Langdon discusses his perspectives, as both a businessman and an IRS regulator, on how companies shelter income in overseas tax havens. He sees the tax shelter phenomenon as a battle of "greed versus ethics" and says that the best way to deal with the problem is on a transaction by transaction basis because a broad economic substance rule would be "a gray standard that's difficult to administer." This interview was conducted on Nov. 5, 2003.

So let me get it straight. Just to summarize it quickly, you're sitting there at Hewlett Packard, and you've got investment bankers, accounting firms coming in once a month? Three, four times a month? Once a week?

Right.

With tax schemes to help you save taxes? It's a sense that this is the way things are going in the marketplace? [Tell me] where Hewlett Packard stood, because, after all, you're a highly visible -- [a] big company, and desirable client for a lot of these firms. ... Then what's the general climate in the late 1990s, when you've got this job?

It was a very competitive environment, because, in effect, in large measure, the key people in corporate America knew what was going on, and then they would talk about it at professional meetings and in small groups.

What would they say?

They'd say, "Have you seen this idea from X, Y and Z? Now, I've signed a nondisclosure agreement. But contact investment banker X, because they have a very interesting idea that will save you hundreds of millions of dollars."…

It sounds like you're talking about prepackaged products that are being marketed. What's going on?

There really was a major change, as you describe -- which is, in effect, rather than just plain off-the-current business results and tax planning with regard to that, is that during the year, you knew that you were going to have very favorable business results. You would look for tax shelter schemes to reduce your taxable income, and you spent a lot of time investigating and implementing them.

Frankly, these transactions weren't easy to implement. So you couldn't do it right at the end of the year. Typically, it would take as long as six months to form the foreign affiliates; to put all the structures in place; even do some liquidation of those affiliates in order to generate the tax advantages that they sold with regard to it.

You also have got to remember, at that point in time, there was a lot of merger and acquisition activity going on. As part of that, there was also selling off of fairly profitable businesses. So an investment banker would come in and say, "Hey, do you want to sell business X? You're going to have a billion dollars' worth of gain. We also have an idea so you don't have to pay any tax on that."

Well, at [a] 35 percent rate, that's $350 million of savings. And they said, "If your tax department doesn't buy into this, they're behind the times. We have advisors in New York that will write opinions that this stuff works. So you get your tax department on board."

So they'd approach other company officials, like the treasurer, like the person in charge of corporate development, even the CFO or the chairman with these ideas. They would do an end run around the tax department. So part of it was, frankly, a scrambling game of the tax people trying to catch up with regard to what was going on in these various arenas.

So there's a lot of pressure. Is there a sense in the late 1990s, if you're sitting in a major corporation and you're not using big tax shelter schemes, you're somehow behind the curve? You're a sucker?

It depends upon the ethics of the company. One major company in my neighborhood, the CFO went to the tax guy and said, "If you do something that ends up in the Wall Street Journal, that will cost us billions of dollars of sales because it will make us look bad. We spend millions of dollars in institutional advertising, and we need to maintain that credibility."

There were a number of CFOs, CEOs and others who realized it was going on and it was wrong. But, frankly, I would say a fair number, almost half of the major companies were succumbing to that sort of pressure and engaging in these transactions. I heard about that anecdotally.

Frankly, it concerned me, because I felt that the tax system and its integrity was really at the cusp with regard to really being undermined; and undermining the voluntary tax system -- which applies not only to corporations, but individuals. I was concerned ethically.

What's driving this? Is it the corporations that are demanding tax shelters, or is it the promoters who are looking for new business and new profits?

I think the major driver is the promoters. The promoters are out there selling these products and seeing where they can play off the demand side. So in effect, I saw very little of companies going to promoters and saying, "Sell us the most esoteric thing you have." They were actively promoting it, and they were actively promoting it because of the substantial fees. Those fees were addictive; because they were millions of dollars as well.

For the accounting firms and the investment bankers?

Exactly. In effect, it changed the whole mystique with regard to how the compensation programs work. These were people that used to be compensated on an hourly basis. They would go and sell a product to a particular company and reap a million-dollar fee, and it became addictive. It was like opium. So they drove, basically, the supply side in great excess over the demand side. They would not spend their time with people where they didn't see a serious opportunity to really market their products.

Now, what's happening to the accounting business? I mean, we think of the accounting business as the people who sort of keep the books honest, right? ...

I think what happened in the accounting industry is that they lost control of the minority of people that were selling these shadowy products. Part of it, frankly, relates to their organizational structure. All the firms were regionalized without a national review strategy with regard to selling of products. So in a lot of key offices, there was a minority of people who either created, or found out from their colleagues, that these products were out there, and they were engaged in selling them.

I'm still convinced that it was a small minority. But it was a challenge for the people that wanted to continue to do the ethical side of the business, because so much revenue was coming in with regard to selling these products.

Secondly, the IRS and Treasury had not caught up to this business. So in effect, they were living, in my view, in a fool's paradise with regard to no accountability.

I think a whole series of things [has] happened in the meanwhile -- the Enron debacle and the other companies that failed because of shadowy accounting techniques, and the actions of the IRS and Treasury with regard to aggressively going after these tax shelter schemes.

I just want to go back and pick up on that point you were making before. In effect, you were saying that there wasn't much chance of being caught by the IRS. The fees were enormous. What were the incentives? You're talking about the accounting industry, people making whopping amounts of money. Even the partners, who may not have approved of this, are getting a bigger partnership cut as a result of this stuff. So everybody's making some money off this. But what was the play of incentives and deterrents? If you're sitting there as an accounting firm or an investment banking firm and thinking about promoting these shelters, what's the upside and what's the downside? ...

The interesting thing about the economics -- and it was true not only of the accounting firms, the investment bankers and the other discrete promoters, which includes regular bankers as well, even an occasional law firm -- is that it was extremely short term. Namely, if they could show a product that would result in hundreds of millions of dollars in tax savings, they would sell that to the enterprise, maybe help them with implementation and, frankly, they would be gone.

It really was very much a short-term mind-set, just like playing off quarterly earnings and not realizing that maybe the future of the enterprise was not that solid. ...

But is there any real deterrent to keep you from doing it?

I didn't think that there was any real deterrent, other than lack of capacity in the system to buy the products. At that point in time, everybody believed that corporate America was going up, up and to the right, and there would always be profits in the future on which to sell these products. ...

That's the corporate side. But what about the promoter side -- the accounting firms and the investment banking firms? How did they look at it? What's their calculation?

Their calculation is, "This is a very attractive business to be in. We can create these products for thousands of dollars, and we can sell them for millions. The margin on this is tremendous. We've never encountered such an attractive business in our entire business." "Thank you very much. I will take that income into my return. And, by the way, is there an individual shelter I can find to protect my individual income, as well?" So, in effect, it was greed breeding on greed.

And auditing isn't making much money.

Exactly right. Auditing was the way to get in the door, but the tax shelters were where all the money was made.

Now, here you are. Everybody's riding the gravy train, and Larry Langdon decides to join the IRS. Why did you decide to join the IRS? What did you want to do with the IRS? ...

Well, [IRS Commissioner] Charles Rossotti pursued me for six months, and there were several things that I wanted to do at the IRS. One, I thought that they could really reinvent their audit process. They could speed up dispute resolution. But one of my five key objectives was I wanted to tackle the tax shelter problem. And I found that the IRS was way behind the times with regard to what I knew was going on in the corporate sector.

Rossotti wanted me to come in as, hopefully, one of the leading lights of corporate America, to help lead the change in [the] Large [and] Midsize Business Division towards customer satisfaction and improving their business results. So he was really in the middle of doing a key organizational change. ...

You mentioned to us that you and Rossotti had a conversation at the airport in Ottawa, as I recall. ...

One of the first times I met Charles Rossotti was in [the] Ottawa airport. We had both gone to the OECD meeting dealing with electronic commerce. We were chatting on a number of topics, and I asked Commissioner Rossotti, "What are you going to do about corporate tax shelters?" He looked at me, blank, saying, "What on earth are you talking about?" I did explain it a little bit that, in effect, I was concerned that the IRS was not being as proactive as it could be with regard to curtailing the selling of the products that were very much very evident in corporate America and were abusing the system.

So you agree to come; you agree to join the IRS. Why?

... The reason I joined the IRS is, one, it was a good time for me to consider what to do next with the rest of my life. It was a time for me to retire from being the chief tax officer at Hewlett Packard Company. It was an exciting venture, I thought, with regard to what Charles Rossotti was bringing to government service with regard to customer satisfaction, employee satisfaction and business results.

You get inside the IRS, and you're concerned about this problem of tax shelters. What do you find? What's the situation?

The IRS was totally behind the game because, one, they had no early warning that this was happening. Secondly, they were just beginning to see these shelters on returns, and they had very little talent from the outside that had been exposed to the shelter game. So part of what I had to do was recruit, as part of our executive team, seven or eight people who had similar experience that I did.

In the business world?

In the business world. So eight out of our team of 38 were external accountants, lawyers, corporate executives, who had experience with regard to what was happening. They were in agreement with me that we had to leapfrog ahead and catch up with the phenomenon that was going on in the shelter arena.

Talk about leapfrogging ahead. I get a sense from talking to you and to others there's a kind of a cat-and-mouse game going on here. How hard is it for an auditor to find a corporate tax shelter in a corporate tax return?

Well, I think it's very, very difficult for an auditor to detect a tax shelter transaction, especially if they had no experience with regard to dealing with these transactions in the past. A lot of times what is used is several legal entities, different corporations, both based in the United States and abroad.

What happens is, basically, money is moved around between these various corporations. Some of them are liquidated so that you get the desired tax result. Unless you see this scheme from end to end and have all the diagrams that were put together by the investment banker, you don't know yin from yang with regard to putting this all together.

So it's baffling and it's concealed. And it's in a massive--

Massive return. So the poor auditor, who's never seen this before, really doesn't understand the full transaction, because they tend to look at one return at a time, rather than say, "Give me all the returns that these people own. Tell me about the transactions that go between these returns, so that I can understand what really happened on the bottom line."

It's a very difficult exercise. You almost need the cookbook ahead of time to diagnose what went on in these returns.

How much paper is a corporate return? I mean, a truck full of paper? What are [you] dealing with?

[It depends] upon whether all the schedules are filed with the return or not, because most returns will say, "Information will be supplied later on," or "Attachments are in our offices." So even if the return is short or long, the immense amount of documentation is several feet high.

So it's overwhelming.

It's overwhelming. ... By the way, what we're talking about are new transactions that are not part of the traditional audit plan. ...

It's all hidden.

That's right. So what we had to do was reverse-engineer the process and learn what was going on, and instruct the auditors with regard to what to look for or, ultimately, force disclosure on the part of the corporations with regard to what they were doing.

So what you're talking about is that, when you got in there, the IRS really had to develop the tools to deal with the corporate tax shelter problem.

That's right. What we did was create a team of people to think through a strategy with regard to getting ahead of the curve, rather than constantly trying to play catch-up several years behind. One of the key initiatives that I think was somewhat brilliant was a disclosure initiative.

... I get the picture from talking to you and talking to other people that if somebody's got a tax shelter called BOSS and the IRS catches up with that one, then they do Son of BOSS.

Right.

The IRS catches up with Son of BOSS, and they do Cousin of BOSS. And it goes on. It doesn't matter where you are. It's like the shelter promoters are always one step ahead of the sheriff. When you're inside the IRS, does it feel like it's a cat-and-mouse game?

I think your description of a cat-and-mouse game is interesting. I have another more interesting description, which is trying to play chess in the third dimension. So what you're trying to do is, in a major corporation you're playing a chess game on three different boards at once. You're trying to counter the strategies of the individual company with regard to reducing their tax liability, and you kind of have to look at three chessboards and understand the rules in order to counter what they're doing.

Does that mean the corporation and the shelter promoters are always a couple of moves ahead of the IRS?

Exactly. More importantly, they've got to develop strategy that the IRS has not yet seen. So the nondisclosure that was occurring with regard to these transactions was a major part of the problem.

You didn't know what was going on.

Exactly. That's why the promoters marketed these schemes under confidentiality agreements. Secondly, it buys, basically, the corporate taxpayers not to disclose the various items that they came in with to market these things. So the IRS was basically [a] dollar short and many, many years late with regard to catching up with this whole phenomenon. ...

So they've had those congressional hearings of 1997, 1998. Is the IRS, at that point, an organization that's on its toes or on its heels? Where is the IRS when you come in, in terms of morale and energy?

One of the other challenges we had in late 1999 was that it followed the hearings where IRS morale was decimated. If you talked to IRS people, they frankly were very discouraged with regard to the pride that used to be part of the organization, and their estimation with regard to their neighbors and their friends -- and all of America, for that matter.

You've got to realize that, historically -- because I was in the IRS in the 1960s -- traditionally, the IRS had high morale, because they felt that they were doing good work for the government. That was pretty well all devastated.

So one of the things we, as executives and managers in LMSB and the other operating divisions, had to work on -- turning around the poor morale, because people were discouraged. They really were not working very hard, and they certainly weren't being creative with regard to dealing with the compliance problems they were facing.

We've got an organizational upheaval going on, trying to give both coherence and purpose to the organization. And yet, in spite of all this, you go down -- I guess, literally -- in the basement, and there's this meeting of these 40 people. What was going on in that meeting? Who called that meeting, and what was happening in that meeting of those 40 IRS agents? ...

Yes. There was a great deal of concern among a number of field people, including so-called specialists, technical advisors and others, that they really didn't understand fully the tax shelter phenomenon. They had conversed with one another, and ... convened a meeting in the basement of the IRS building of everybody [they] knew that [were] working on the corporate tax shelter phenomenon. ...

Obviously, that was the beginning of what became the Office of Tax Shelter Analysis, because we needed to go about this problem in an organized, structured way. That was one of the first things we did in LMSB, even before we stood up as an operating division -- create an office to determine what's going on. What do we know within the IRS, and can we have a better way of getting information from the outside? ...

Is there information coming into the IRS from people out in the private sector who are disturbed about these corporate tax shelters?

Another thing that surprised me in coming into the IRS job is I expected that there would be a lot of disclosure about these transactions. And, frankly, I found none. There were no meaningful disclosures of these transactions that were occurring in 1999. It didn't start occurring until almost a year or two later, after we'd formed our Office of Tax Shelter Analysis.

So the basic attitude of the private sector is, "Let's don't let the IRS in on anything."

Absolutely. Part of it was, even on the part of people who were very concerned about the phenomenon, that they didn't have access to documentation. Or when they did, they were reluctant to share it with the IRS, because they weren't sure that the IRS would move responsibly and kill the phenomenon -- is what I think was going on.

I'm perfectly aware that each of these shelters is different, is designed to be different, is designed to escape rules that get promulgated. But when you look at these shelters, or at least the bulk of them, are there some common elements to them? ...

Right. The interesting thing about the corporate tax shelter phenomenon is that they had series of very interesting characteristics. Perhaps the most noteworthy one is that, to skilled tax professionals, it resulted in a result that was too good to be true. If a result was too good to be true, you should be very suspicious about it, because it really meant that the tax system was being abused.

But then there were some other interesting things that kind of made for an interesting story. They were sold by a large firm that came in under a cloak of secrecy. Namely, before they'd even show it to you, you had to sign a confidentiality agreement.

Secondly, they had a humongous amount of fees. They would never sell these deals based on, "This is the hours that we've spent in developing this. We want you to pay for these hours." No, it was a fee that was tied in to the amount of tax savings, and it was a fairly high percentage.

Then, third, they really wanted to manage your dispute resolution process with the IRS. In effect, you could not handle that. You had to communicate to them if the IRS discovered what was going on.

All of these things kind of gave a real sense that this is [a] shadowy transaction, because in normal business transactions, these aren't the elements of what occurs.

... You came from business. As a businessman, did these things look like normal business?

Right. One of the key things that we tried to accomplish with regard to dealing with the shelter phenomenon was to either work on business results or economic substance as being a true test. The trouble is, those are hard to define, and it's difficult to distinguish that in the gray area.

But these were complex transactions. They typically would involve the forming of several different companies, moving money around, et cetera. But it had very little to do with the main operations of the business. It could all be done in basically the general counsel's office, with help from the tax department. So from that standpoint, it really didn't resonate as being a normal business transaction.

And they involved big paper losses -- not real losses, but paper losses?

That's right. The transactions would either take one of two different forms. If you had a large capital gain that you wanted to shelter, the transaction would generate a capital loss. If you had large earnings, it would generate an ordinary loss. So basically, it played off those two loss provisions of the Internal Revenue Code. ...

... Tell me about these lease-in, lease-out transactions. What are they, and how did you discover them?

One of the key transactions that we determined to be abusive was a lease-in, lease-out transaction. Typically, what occurs is a government -- say, in Europe -- owns a transit system, a subway system, a sewage system, and basically agrees to have a paper trail which indicates that that property is leased to a U.S. company. They can take advantage of depreciating that property for their tax return.

Nothing really changes. The asset is used for government purposes in perpetuity and the company gets the tax deduction.

So the American company leases it and then leases it back, and nothing changes in the operation or control of the asset?

Exactly right. There is no substantive change with regard to the use of this asset.

Secondly and, perhaps, more importantly, Congress never intended that the leasing provisions apply to these kind[s] of assets. So it's abuse of not only the substance of the code, but also in implementation.

Now we hear that an agent named Cary Allen was an important figure in uncovering the leasing deals. Tell me about Cary Allen.

There are a number of heroes in this whole exercise, and Cary Allen is one of them. He discovered, on the part of the IRS, the first lease-in, lease-out transaction. He discovered it as part of a question on an audit of a major taxpayer. Frankly, he was tenacious enough to pursue it, understand all of the documentation and put the jigsaw puzzle together. He deserves high marks for doing that. Then he became very assertive in running that up the chain of command, saying, "Hey, we can't allow this to continue as part of good tax administration."

So the implication is that Cary Allen broke--

The code.

But said, "Hey, this isn't just one company. This is big business?"

Yes, exactly. He realized the profile of the companies that were engaged in these transactions and uncovered a whole industry that was basically engaged in this business.

Who does engage in lease-in, lease-out -- LILO -- transactions?

Typically, financial institutions.

Big banks?

Big banks, leasing companies, et cetera. Because it's a natural addition to their portfolio, it appears logical that they should be in this business.

Does it also take big bucks to get into this business, or at least an ability to get big credit, loans from others?

Financing is a key part of it. But I think, more importantly, the ability to create a documentation trail of major leasing transactions is a discrete business within this country. You need a bank of lawyers and financing people to put together these deals.

But you have arrangers, you've got law firms, you've got financial experts, you've got people who go and supposedly evaluate the sewage system or the subway. So you're paying some pretty fancy fees to get these deals arranged, aren't you?

Yes, these deals aren't cheap, and they're not for the small company. They're certainly not for a company who's not willing to invest in the legal and other resources to put the whole transaction together.

Did you regard the questionable leasing business as a big drain on the Treasury, in terms of taxes?

When we eventually found out the extent of the lease-in, lease-out transaction, it ended up being one of the largest tax shelter phenomenons going on. But until we had basically learned, with Cary's help, that [was] what was going on, and then went through our disclosure initiative when we found out the extent of the phenomenon, did we wake up to what the whole magnitude was. ...

Ken Kies, as spokesman for the leasing industry, says, "These deals are legitimate. All we're doing is using the IRS rules against itself." What's your response to that argument?

Really, the transaction needs to be analyzed in its substance rather than its form. The people from the leasing industry that argued that it was all right really ignored the substance of what was going on. Basically, they threw down the glove to the IRS, which is, "Put a notice out that you think that it's wrong." And secondly, "Are you serious enough that you're going to go to court and sustain it?" That's where we had to get help from B. John Williams with regard to, "We need a strategy that drives these people into settlement in an effective way."

So you're saying that Ken Kies and the leasing industry are wrong in their analysis, and you had to get tough with them and get ready to go to court?

Exactly.

But how did that progress? ...

The first thing we had to do in order to get tough for the various tax shelter transactions is get Treasury and chief counsel's office to sign off on a notice that, in effect, the IRS was not going to follow this transaction. They [are] not going to permit these, in our view, bogus results. What that did was create a major chill with regard to selling any of those transactions in the future. So we killed it for the future. More importantly, we then had to come up with a litigation strategy that, if forced to do it, we would take every one of these taxpayers to court, and we would win.

But then we developed a corollary strategy, which is we don't want to litigate against everybody. We have a settlement alternative that basically will create a solution, so that they can exit out of the transactions and basically pay the bulk of the money back.

That strategy did pay off, because most of these taxpayers didn't want to take these things to court and argue about them, because it [did] affect the publicity. They realized it would not meet the Wall Street Journal test. ...

What about basis shifting? What kind of a shelter is basis shifting? What does it turn on?

It turns on a legal construct that creates a loss. In effect, what you do is you go through two legal entities and have a liquidation and generate an artificial loss. That's the substance of a basis shift.

What's the rule of the Cayman Islands? Why do the Cayman Islands show up in so many of these basis-shifting tax shelters?

The Cayman Islands is a very advantageous jurisdiction to create and liquidate a company quickly, without a great deal of oversight by regulatory bodies, and certainly no tax imposed with regard to the transaction.

So running it through a tax-free jurisdiction with regard to the part of the gain that is offset, that creates the loss, is very, very easy. You can file documentation, create companies and do all the legal niceties in the Cayman Island in a split second. ...

The Caymans is obviously becoming enormously attractive. ... They're the fifth-largest financial center in the world. ...

The Cayman Islands are also used with regard to offshore banks and financial institutions, which is basically an individual ploy to basically shift money offshore and get a so-called legitimate U.S. tax deduction and, in effect, then bring the money back on a tax-free basis. So the Caymans are used for many different purposes other than the basis shift analogy. ...

Some American officials and some people in the Cayman Islands say a lot of this has changed, because the Cayman Islands acceded to the OECD initiative against "harmful tax practices." I think that was the terminology.

Right.

Then there was an information exchange agreement that was signed with the United States in November 2001 -- doesn't actually take effect until 2004, and then 2006 for civil complaints.

You do your homework.

But what I'd like to know is, these agreements that the Cayman Islands signed with the larger financial community and the United States -- are they going to affect what you just described as being important in FLIP and OPUS and these tax shelters? These agreements and what Cayman has promised to do -- is that going to affect these tax shelters?

The exchange of information agreement that the Caymans and a lot of other countries, pursuant to the OECD directive, put in place relate to financial institutions and reporting of interest with regard to offshore bank accounts. Obviously, that's a major challenge.

But that doesn't have anything to do with regard to internal transactions in those jurisdictions with regard to creating and liquidating subsidiaries. That's another area that, frankly, has not come under the [OECD] purview as something that they view as tax haven activity. It's very hard to target what is appropriate abuse in that regard, because creating offshore entities is very, very legitimate, generally, for business purposes.

So Enron had something like 600 to 700 off-book entities in the Cayman Islands.

Right.

The Cayman Islands with the OECD and the United States don't affect that in any way?

To the best of my knowledge, there's no impact. So what you have to do is go to the U.S. parent and ask them to disclose all of that information, and also tighten up the disclosure rules in the U.S., because if it's a some minority-owned partnership, there's no requirement under the current regs to disclose that as part of your return. ...

... Let me just take you back to the tax shelter analysis. What's the job of David Harris in the Office of Tax Shelter Analysis?

We formed the Office of Tax Shelter Analysis because we wanted a central place to coordinate all of our activities nationwide. Secondly, we want[ed] a repository with regard to information that was coming in. We created a toll-free line so that people could call us up. We created a fax line so they could fax things to us. They can call us up on a discreet basis. We felt that that was very, very important.

But perhaps the biggest stroke of genius that we had was to go out with a disclosure initiative, and basically tell corporate America with regard to that point in time, "If you engaged in a tax shelter, and if you want to be free from the underpayment and penalty with regard to underpayment of tax, disclose that to us now, and give us all the documentation. We will, in effect, relieve that penalty."

So what you're saying is, you went out to corporate America and said, "If you will 'fess up on the questionable tax shelters that we've already said are not permissible, we won't penalize you. We'll settle your taxes." Is that right? ...

The reason the settlement initiative made sense to us is that we needed to get immediately all of the corporate transactions that involved tax shelters to date. So we felt that, by forgiving the underpayment penalty, that was a good price for us to pay to get in that documentation.

We got in the way of documentation all the agreements, all the promoter activities, the names of the promoters -- which was very, very key -- and an offer on the part of corporate America to settle these things up with the IRS.

How many companies came in? How many shelters did you discover?

We discovered 25 new shelters that we'd not seen before; 1,264 taxpayers came in, including a lot of individuals, and, frankly, billions of tax was put on the table for settlement.

So by offering what some people would call an amnesty -- what you're calling "disclosure" -- you got a lot of people to come forward and give you information on how tax shelters were operating.

Exactly. Perhaps the most important thing we got were lists of the promoters and the materials they were using to promote these shelters. That allowed us to go to the promoters, and start promoter audits and impose penalties on them for not registering these transactions with us. Those penalties can run to tens of millions of dollars and, basically, helped shut down the business because, in effect, it took the grease out of the promoter game. ...

You have some of the promoters come forward, and they're willing to make a deal with the IRS: Merrill Lynch, PriceWaterhouse, Ernst & Young. But you have some promoters, like KPMG, that are digging in their heels. Talk to me a little bit about the response of the promoters to your effort to crack down on that.

Looking at it from my seat, in the IRS, I thought it was very interesting what was going on with the promoters. Anecdotally, I would hear from some of my friends that worked for them that there was a battle going on for the soul of the firm with regard to what the future business would be for an investment banker like Merrill Lynch who disclosed, or PriceWaterhouseCoopers, who also disclosed, versus other promoters who were currently in court, not disclosing who they sold these various products to.

In effect, it was a battle for the future of the firm. Were they going to operate in an ethical manner for the future, or were they going to continue to resist the IRS efforts to close down this business?

This what you call "battle for the soul" of the company -- what happened in the various different promoter firms?

I think there was a very interesting debate that went on with regard to the economic reality of going after this business -- that was very, very lucrative - versus were they going to return to their ethical origins and only do things that would be acceptable to the IRS? I think that that is basically greed versus ethics in a very interesting way. Ultimately, the profession has to own up to the fact that they had an ethical problem with regard to selling a lot of those products. ...

I think Congress is watching this very carefully. I think there're going to be additional revised rules for the profession with regard to engaging in this business that will curtail this kind of activity, because it really can't be tolerated if we're going to have our tax system work the way it should.

How do you deal with a promoter like KPMG, which has dug in its heels and has gone to court to fight the IRS? ...

What you need is very close coordination between the IRS audit teams, chief counsel's office of the IRS, and the Department of Justice attorneys. So then, when we go to court, we're well prepared to support the legal argument that we are entitled to the information that we desire, which is, "Tell us the names of the people that you promoted these products to. Give us the promotional brochures. If you have legal opinions supporting your position, you've got to turn it over to us, because we need to understand your legal arguments."

Maintaining secrecy with regard to those three issues is not effective administration of the tax laws of this country.

KPMG's insisting -- and so is Jenkins & Gilchrist, the law firm -- they're insisting that they're entitled to secrecy, that this is attorney-client or accountant-client privilege. What's your answer to their argument that they're entitled to maintain this secrecy?

I think the Supreme Court has clearly ruled that, with regard to information that is used in preparing a tax return, attorney-client/accountant-client privilege does not occur. The privilege only occurs with regard to a tax dispute that occurs after a return is filed. So at the front end of this whole legal analysis, their arguments are flawed.

Now you said you think Congress is moving. But Congress has resisted, even before the current administration. But in the time you were in office, Larry Summers, when he was secretary of the Treasury, sent proposals to Congress to increase requirements for disclosure, increase requirements for registration, increase the penalties on both the taxpayers and on the tax professionals, and to pass a rule for requiring economic substance. Congress hasn't acted. Now, this is already three, four, five years.

Well, in fairness to Congress, I would submit that today the Sarbanes-Oxley legislation has created a major change in the environment, for both corporate America and the CPA profession, in ways that really help accomplish Secretary Summers's proposals. If you talk to anybody in corporate America today, or in the accounting profession, the changes that have occurred with regard to quarterly reporting -- the tax person [is] making sure that everything is fully disclosed on the tax returns.

Secondly, the review by audit committees that maybe another tax advisor, including another CPA firm or law firm needs to review the tax provision, has really driven a very dramatic change that I think is very, very positive. So I think Sarbanes-Oxley has been one of our allies.

OK. Sarbanes-Oxley has passed, but it didn't embrace what Summers recommended. So where are we on the proposals that directly address the problem of tax shelters? Congress hasn't acted.

Right. Part of it is, it's hard to codify rules that get at tax shelters that are constantly evolving. It's, again, the proverbial chess game of creating new products. So I think that it's very incumbent upon the IRS and the Treasury, with help from Justice, to continue to pursue these things and develop administrative rules as fast as these things occur because, in fairness to Congress, they can't act quick enough.

Yes, but we're talking four years now.

I know.

But you're suggesting that the IRS and Treasury can catch up with tax shelters case-by-case, example-by-example?

I don't know of any other material solution, other than using the tools of effective tax administration. …

Do you think we need to amend the laws?

I would be a little bit reluctant to amend the laws with regard to -- and this is the current position of the Treasury Department -- the economic substance and what constitutes "adequate business purpose," because we end up with is a gray standard that's difficult to administer. We really need to look at it on a transaction-by-transaction basis.

Now, maybe we need to change our ruling process, so that a promoter or company can come in and disclose a transaction, and within 60 days, the IRS has to say "yea" or "nay" with regard to whether the thing works or not. I think that may be a better way of attacking this problem on a case-by-case basis.

Given the fact that promoters can make tens of millions, or even hundreds of millions of dollars marketing shelters, are there sufficient deterrents today in the penalties on promoters?

I think the penalties on promoters are adequate for large corporations. I don't think that we have a promoter penalty scheme that works with regard to promoters that go after small companies and individuals, because they can continue to play the nondisclosure game and the audit lottery. Until we develop a solution to that, I think we're still going to have a problem with tax shelters in those groups of taxpayers because of lack of audit coverage.

... There are other people that we've talked to who think that you['ve] got to step up the penalties on the promoters, that the promoters are not being held adequately responsible. Do you agree or not?

I do agree, but, in effect, what I've seen happen -- and this is more than anecdotal -- is that individual promoters have left the big firms and are now going underground, and hanging up their shingle or having the post office box, or using the telephone to see these products. Frankly, it's hard to curtail that kind of activity.

Do you think the problem of big corporate tax shelters and these highly promoted tax shelters for high net-worth individuals has been licked?

I think, in large measure, it has been licked for listed corporations because of Sarbanes-Oxley. I think we still have a major challenge with wealthy individuals, small companies and private companies, because the lack of disclosure in those arenas still allows all the things we talked about with regard to promoters selling things to people and getting away with it occurs.

Some people say that the apparent decline in corporate activity in tax shelters is really more the result of an economic lull … and [when] the economy recovers, you're going to see a new wave of corporate shelter activity.

I don't think that, when prosperity returns to the U.S., that we're going to have the same shelter phenomenon that we dealt with in the 1990s. What I would be concerned about is a more sophisticated version of tax planning that [escapes] IRS detection. That's I would be concerned about.

Even more sophisticated than we've had?

Yes.

Why?

Because that's the nature of the tax code, which is complexity. So it's very, very important that the IRS be eternally vigilant to watch what is happening out in the promoter world, the practitioner world and the corporate world.

Does the IRS have enough resources to keep up with the private sector developing new shelters?

I don't think the IRS has the resources it needs to follow the shelter phenomenon. They don't have enough auditors in the field, and, frankly, they need more professional resources, like bringing in people from the outside, mid-career, to help them understand what's going on in the outside world.

The IRS I encountered in 1999 was a very insular institution where there was very little migration of people in and out, particularly into the IRS from the corporate and practitioner community. I think that's indispensable for them to understand what is happening out there. ...

One of the questions that has come up -- not just at the IRS, but also in the SEC -- is whether or not auditors can exercise their role as auditors if they're also marketing tax shelters to their clients. Part of what you've got here is the auditing process, what gives you the entry. ... Can an accounting firm have auditor independence if it is also marketing shelters to one of its corporate clients?

I think there is a major conflict of interest implicit in what you describe, which is the same firm basically auditing the firm, but also selling transactions that they're auditing. Sooner or later, the regulatory agencies and corporate America are wakening to the fact that they need to separate those two functions to have, basically, integrity in the process.

So you can't have an accounting firm that's doing auditing also marketing tax shelters to that corporate client?

That would be my view of where the law should be. ...

 

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posted february 19, 2004

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