In November 2003, the Senate Permanent Subcommittee on Investigations held hearings into the U.S. tax shelter industry. Several KPMG executives testified in front of the committee, including Jeffrey Eischeid, the partner in charge of the Personal Financial Planning division and Richard Smith, the vice chair of tax services.
In his prepared statement, Eischeid offered a four-part defense of KPMG: that the firm no longer markets aggressive sheltering strategies such as FLIP, OPIS, BLIPS or SC2; that when it did offer such strategies, they were "consistent with the laws in place at the time;" that the strategies underwent "intensive and thorough" internal review, which often resulted in "vigorous, sometimes even heated, debate;" and that KPMG has changed over the past three years as "the regulatory environment and marketplace conditions have changed." Eischeid also noted that no court had ruled against any of the four strategies above. Under questioning from Sen. Carl Levin (D-Mich.), he insisted that the shelters were not marketed as tax reduction strategies, but rather investment strategies with tax benefits.
Smith, in his prepared statement, also said that KPMG has stopped marketing the shelters under question by the committee. He described the firm's new formal review and oversight procedures, as well as revised procedures regarding registering its shelter products with the IRS.
In January 2004, KPMG removed Eischeid from his position and placed him on administrative leave, and transferred Smith from the firm's tax-planning unit. The firm also announced the retirement of deputy chairman Jeff Stein, who was formerly the head of KPMG tax planning. KPMG continues to deny any wrongdoing, and the firm's chairman Eugene O'Kelly maintained that the removal of the men from their positions, was "consistent with our ongoing consideration of the firm's tax practices and procedures."
Jeffrey Eischeid's statement before the committee
Mr. Chairman and members of the subcommittee, on behalf of KPMG, there are four main points that I would like to call to your attention: one, the tax strategies being discussed today represent an earlier time at KPMG and a far different regulatory and marketplace environment. None of the strategies, nor anything like these tax strategies, is currently being presented to clients by KPMG.
Today, KPMG advises our clients on the enormous range of potential outcomes under the tax laws and how to achieve the best outcomes in their individual cases. We have provided the subcommittee with materials that describe hundreds of these approaches. None of these are aggressive tax strategies like FLIP, OPIS, BLIPS and SC2.
Two, strategies presented to our clients in the past were complex and technical, but were also consistent with the laws in place at the time, which were also extremely complicated; three, the strategies did undergo intensive and thorough review, a review process that resulted in vigorous, sometimes even heated, debate; four, KPMG understands that the regulatory environment and marketplace conditions have changed. This has led to significant changes within KPMG over the past three years.
We would like to elaborate on each of these points. First, the tax strategies under review were all presented under regulatory and marketplace conditions that do not now exist. Today, KPMG does not present any aggressive tax strategies specifically designed to be sold to multiple clients, like FLIP, OPIS, BLIPS and SC2.
These strategies were presented at a time when the U.S. economic boom was creating unprecedented individual wealth and a demand for tax advice aimed at achieving tax savings. All major accounting firms, including KPMG, as well as prominent law firms, investment advisers and financial institutions gave tax advice, including presenting these types of tax strategies to clients.
In KPMG's case, other firms often provided investment advisory and other non-tax services in connection with these transactions. All of these relationships were consistent with KPMG's legal and professional requirements.
Second, it is true that these strategies were complicated and that the tax consequences turned on careful and detailed analyses of highly technical tax laws, regulations, rulings and court opinions. But all of these tax strategies were consistent with the laws in place at the time.
It is important to note that no court has found them to be inconsistent with the tax laws. In some cases, the IRS has agreed that taxpayers should be allowed to retain a portion of the tax benefits they claimed as a result of implementing a strategy.
For all of the strategies being reviewed by the subcommittee, KPMG provided our clients with a "more likely than not" opinion as to their tax consequences. In other words, we informed our clients that based on the facts and actions they took, they would have a more likely than not or a greater than 50 percent chance of prevailing if the IRS challenged the transaction.
The tax laws are complicated and often ambiguous and unsettled. As a result, KPMG's opinions regarding these tax strategies were long, detailed and technical.
Our clients were told that, in addition to a possible tax benefit, the law required a transaction to have a business purpose, profit, charitable or other non-tax motive. They were required to provide us with representations to that effect.
Our clients were sophisticated and typically had their own attorneys, accountants and investment advisers. Throughout the process, KPMG made it very clear to clients that they were undertaking complex transactions on which the law was ambiguous and often had not been clarified by either the IRS or the courts.
Our third point is that, because we understood that these tax strategies might be subject to an IRS challenge, KPMG put them through a rigorous review process before they were approved for presentation to multiple clients. The tax strategies also underwent very careful analysis of the IRS requirements for registering tax shelters in effect at the time.
Many tax partners with different areas of expertise participated in the review process. That, combined with the fact that we were dealing with a "more likely than not" opinion, is the reason there was a lively -- and often lengthy -- debate among partners over the interpretation and application of tax laws, regulations, rulings and opinions. Many of the materials provided to the subcommittee document this lively internal debate.
Finally, KPMG has changed. We learned a number of important lessons from our previous tax policies and practices. As a result, KPMG has made substantial improvements and changes in our practices, policies and procedures over the past several years. My colleague, Richard Smith, will describe these in greater detail.
In the practice I head, Personal Financial Planning, we have shifted our approach from one focused on taking solutions to clients to one that works with clients to address their individual situations. This is consistent with KPMG's current leadership philosophy and more conservative approach to the tax service practice.
We understand that simply being technically correct is not enough. We know we need to respond better to the continuing changes in the tax laws and regulations and the needs of our clients. We also need to ensure that no action taken will call into question the integrity, reliability and credibility of KPMG.
Tax Reduction Strategies or Investment Strategies?
LEVIN: Isn't it the case that all of these are primarily tax reduction strategies that have financial transactions tied to them to give them a colorable business purpose?
EISCHEID: Senator, I'm not sure that that would be how I would characterize those transactions. I mean, I certainly viewed them as investment strategies that certainly had a significant income tax component to them.
LEVIN: My question to you though is: are these not primarily tax reduction strategies?
EISCHEID: I think you would have to speak to each individual taxpayer to ascertain their primary purpose for entering into the transaction. And I think you would get different answers, depending on which taxpayer that you spoke to.
I suppose I would also just simply point out that, not to get overly technical, but "primarily" tends to be a term of art in sort of the tax professional world that is very, very difficult frankly to pin down.
LEVIN: Is it not the case that these were designed and marketed primarily as tax reduction strategies?
EISCHEID: Senator, I would not agree with that characterization.
LEVIN: Then let's look at what other parties involved in transactions said about that issue. If you look at Exhibit 1-D, [LINK] this is a compendium of how other parties involved in these shelters characterized them. And it's pretty clear what the consensus is here.
First is a UBS Bank memo regarding FLIP: "The principal design of this scheme is to generate significant capital losses for U.S. taxpayers, which can then be used to offset capital gains which would otherwise be subject to tax."
Then there is the memo of one of the investment advisory firms involved in FLIP, which was Quadra: "KPMG approached us as to whether we could affect the security trades necessary to achieve the desired tax results. The tax opportunity created is extremely complex."
Then at First Union -- now Wachovia -- regarding FLIP, "Target customers, who are the target customers? Capital gain of $20 million or more. Potential benefits? Individual capital gain elimination."
You don't see anything in there about investment, do you?
And then you've got an HVB employee, which is a German bank, regarding BLIPS, "Seven percent is the fee equity paid by investors for tax sheltering." That's the way that particular bank employee looked at it.
And then you look at Deutsche Bank internal memo: "It is imperative that the transaction be wound up due to the fact that the high net worth individual will not receive his or her capital loss or tax benefit until the transaction is wound up."
Now do you still claim that these tax strategies were primarily investment strategies and not tax reduction strategies? Is that your testimony under oath here, that they were not designed primarily as tax reduction strategies?
EISCHEID: Senator, my testimony is that these were investment strategies that were presented to individual taxpayers that had tax attributes that those investors found attractive.
LEVIN: Well, let me ask my question again then. Is it your testimony that these were not designed and marketed primarily as tax reduction strategies?
EISCHEID: Senator ...
LEVIN: I'm talking now about designing and marketing. Were these designed and marketed primarily as tax reduction strategies?
EISCHEID: Senator, I can't speak to any and all of the marketing activities. For example ...
LEVIN: Just speak to what you know.
EISCHEID: Thank you.
LEVIN: From what you know, were these designed and marketed primarily as tax reduction strategies?
EISCHEID: And what I know is that they were not, that I personally had a number of conversations with clients and prospective clients. And they were always characterized as investment transactions, with a significant pre-tax economic purpose that was embedded in the overall transaction.
Richard Smith's statement before the committee
While today's hearing is focused on certain tax strategies KPMG presented to clients in the past, I would like to describe how KPMG's policies and practices have changed since then. The business and regulatory environment are markedly different today than at the time KPMG and its competitors presented such strategies. And KPMG has moved forward as well.
KPMG has no higher priority than restoring public trust in the accounting profession. It is no longer enough to say that a strategy complies with the law or meets technical standards.
Today, the standard by which we judge our conduct is whether any action could, in any way, risk the reputations of KPMG or our clients. If it could, we will not do it.
Our reputation, our integrity and our credibility are simply too important to put at risk. Some of the more significant changes and new procedures in place at KPMG include: we have substantially changed KPMG's tax services and offerings. Today, KPMG offers our clients tax services that are tailored to address their distinct business objectives and tax planning needs. We no longer offer or implement aggressive look-alike tax strategies.
In particular, we no longer offer or implement FLIP, OPIS, BLIPS or SC2 or any similar transactions. Additionally, KPMG does not and will not accept any new engagements for advice and opinions on tax shelters that have been listed and deemed abusive by the Internal Revenue Service.
Over the past three years, KPMG has developed an increasingly more rigorous and formal review and oversight procedure within our tax practice. All tax strategies must undergo three levels of review and approval.
First, we have created the new position of partner in charge of tax risk and regulatory affairs. This partner analyzes each tax strategy proposed by the firm to determine if it could in any way put KPMG or our clients at risk.
Second, the partner in charge of our Washington National Tax practice must sign off on the technical merits of all significant tax strategies. Finally, the Department of Professional Practice - Tax reviews all tax strategies to ensure that they are in compliance with the firm's policies and procedures.
Each of these partners has veto power over any tax strategy proposed and operate independently from our operations and business development functions. If any tax strategy puts KPMG or our clients at risk, is not technically correct and defensible or is inconsistent with our s policies or procedures, it will not be approved.
We have also revised our procedures with respect to list maintenance and registration obligations under the Internal Revenue Code. In early 2000, KPMG established the Practice Procedure and Administration group in Washington National Tax as the contact point for analysis of disclosure, list maintenance and registration issues.
KPMG's procedures and training programs have been updated continuously since that time, tracking developments in the law and fine tuning our compliance processes.
Practices and positions focused on look-alike strategies are no longer part of this firm. In 2002, two practices in particular, Stratecon and Innovative Solutions, were eliminated. Many of the partners who were part of these practices are no longer with the firm.
We have abolished positions such as national deployment champions and area deployment champions, which were charged with marketing these strategies to our clients. We also eliminated the Tax Innovation Center, which was responsible for supporting the marketing of look-alike tax strategies.
Our tax training program now focuses on technical developments rather than marketing strategies. We have discontinued weekly tax partner calls, training programs and other activities that primarily focused on marketing. Tax partner calls and training now concentrate on changes in the law and technical tax developments.
In 2002, KPMG implemented a firmwide compliance and ethics hotline. This hotline is designed to encourage anyone within KPMG to report their concerns about any potentially unethical, improper or illegal conduct within the firm and is in addition to longstanding channels for employee communication.
We have put in place more stringent rules about offering tax services to executives at our SEC audit clients. Under the Sarbanes-Oxley Act, the audit committees of our SEC audit clients must pre-approve all services provided by KPMG to the company, including tax services.
We have applied this disclosure and approval discipline to tax advice offered to executives of SEC audit clients.
We are constantly looking at additional steps we can take to improve and enforce compliance with these policies and practices.
COLEMAN: I would have you summarize.
SMITH: I'll just sum up and move forward. Thank you, senator.
We encourage anyone at KPMG to bring to our attention immediately any actions that are inconsistent with these guiding principles and procedures and to suggest additional policies or procedures that would help ensure that we are providing the highest quality tax services and advice to our clients.
KPMG looks forward to being part of the solution and wants to work with Congress, as well as the IRS and other policymakers, as you consider sound and responsible approaches to better define what tax strategies are allowable under the law and to further strengthen the enforcement of the tax code.