Introduction

KPMG developed artificial tax shelter arrangements for wealthy clients that led to the settlement of a legal action with the Department of Treasury and the Internal Revenue Service. On August 29, 2005, KPMG admitted to criminal wrongdoing and agreed to pay $456 million in fines, restitution, and penalties as part of an agreement to defer prosecution of the firm. In addition, nine members of the firm were criminally indicted for their role in relation to the design, marketing, and implementation of fraudulent tax shelters.

In the largest criminal tax case ever filed, KPMG admitted it engaged in a fraud that generated at least $11 billion in phony tax losses, which, according to court papers, cost the United States at least $2.5 billion in evaded taxes. In addition to KPMGs former deputy chairman, the individuals indicted included two former heads of KPMGs tax practice and a former tax partner in the New York City office of a prominent national law firm.

A summary of the facts of the tax shelter arrangement appears in Exhibit 1.

Exhibit 1Summary of Tax Shelter Transactions Developed by KPMG

KPMG developed tax shelters to generate losses of $11.2 billion for 601 wealthy clients that enabled them to avoid paying $2.5 billion in income taxes. KPMG mainly used four methods to help the wealthy clients avoid their tax liabilities or tax charges on capital gains. The shelters implemented were the Foreign Leveraged Investment Program (FLIP), Offshore Portfolio Investment Strategy (OPIS), Bond Linked Issue Premium Structure (BLIPS), and Short Option Strategy (SOS/SC 2). These shelters were designed to artificially create substantial phony capital losses through the use of an entity created in the Cayman Islands (a tax haven) for the purpose of the tax shelter transactions. The client purportedly entered into an investment transaction with the Cayman entity by purchasing purported warrants or entering into a purported swap. The Cayman entity then made a prearranged series of purported investments, including the purchase from either Bank A, which at the time was a KPMG audit client, Bank D, or both using money purportedly loaned by Bank A or Bank D, followed by redemptions of those stock purchases by the pertinent bank. The purported investments were devised to eliminate economic risk to the client beyond the cost to develop the tax shelters.

In the implementation of FLIP and OPIS, KPMG issued misleading opinion letters with assistance from its co-conspirators. The opinion letters were misleading because KPMG knew that the tax positions taken were more likely than not to prevail against the IRS, and the opinion letters and other documents used to implement FLIP and OPIS were false and fraudulent in a number of ways. For instance, the opinion letters began by falsely stating that the client requested KPMGs opinion regarding the U.S. federal income tax consequences of certain investment portfolio transactions, while the real fact is that the conspirators targeted wealthy clients based on the clients large taxable gains and offered to generate phony tax losses to eliminate income tax on that gain as well as to provide a more likely than not opinion letter.

The more likely than not opinion letters provided an ambiguous and confusing view of the tax shelters to the users, but it brought an income of $50,000 to KPMG for each such opinion letter. In addition, the opinion letter falsely stated that the investment strategy was based on the expectation that a leveraged position in the foreign bank securities would provide the investor with the opportunity for capital appreciation, when in fact the strategy was based on the expected tax benefits promised by certain conspirators in the tax frauds.

AICPA Statement on Standards for Tax Services 1 requires application of the realistic possibility of success standard in taking tax positions. This is a high standard to meet. Generally, there would need to be a 70 to 80 percent chance of prevailing if a tax position were challenged by the IRS. The more likely than not standard appears in Treasury Circular 230, which covers rules of conduct for those who practice before the IRS, including CPAs, attorneys, and enrolled agents. A tax preparer who fails to comply with Circular 230 will likely be subject to penalties and possibly other sanctions if the client is advised to take a position on a tax return or a document that does not meet the applicable tax reporting standard.

The three standards for tax positions in Treasury Circular 230, ranked from lowest to highest, are reasonable basis, substantial authority, and more likely than not. A description of each of these standards appears in Exhibit 2.

Exhibit 2Circular 230 Tax Positions and Compliance Standards

Reasonable basis: Reasonable basis is the minimum standard for all tax advice and for preparation of all tax returns and other required tax documents to avoid a penalty under Section 6694 for the underpayment of taxes. If a return position is reasonably based on at least one relevant and persuasive tax authority cited, the return position will generally satisfy this standard.

Substantial authority: Substantial authority for the tax treatment of an item exists only if the weight of the tax authorities (Internal Revenue Code, Treasury regulations, court cases, and so on) supporting the treatment is substantial in relation to the weight of authorities supporting contrary treatment. All authorities relevant to the tax treatment of an item, including the authorities contrary to the treatment, are taken into account in determining whether substantial authority exists. This standard may be measured as a greater than 40 percent likelihood of being sustained on its merits.

More likely than not: More likely than not is the standard that is met when there is a greater than 50 percent likelihood of the position being upheld. This is the standard for tax shelters under Section 6694 and reportable transactions.

KPMG admitted that its personnel took specific, deliberate steps to conceal the existence of the shelters from the IRS by, among other things, failing to register the shelters with the IRS as required by law, fraudulently concealing the shelter losses and income on tax returns, and attempting to hide the shelters using sham attorney-client privilege claims.

The information and indictment alleged that top leadership at KPMG made the decision to approve and participate in shelters, and that they issued KPMG opinion letters despite significant warnings from KPMG tax experts and others throughout the development of the shelters; and, at critical junctures, that the shelters were close to frivolous and would not withstand IRS scrutiny, that the representations required to be made by the wealthy individuals were not credible, and that the consequences of going forward with the sheltersas well as failing to register themcould include criminal investigation, among other things.

An unusual aspect to the case is the culture that apparently existed in KPMGs tax practice during the time the shelters were sold, which was to aggressively market tax shelter arrangements targeting wealthy clients by approaching them with the deals rather than the clients coming to KPMG. Back in the late 1990s, the stock market was booming, and the firm sought to take advantage of the increasing number of wealthy clients by accelerating its tax-services business. The head of KPMGs tax department at the time, Jeffrey M. Stein, and its CFO, Richard Rosenthal, created an environment that treated those who didnt support the growth at all costs effort as not being team players.

When it became clear that the firm faced imminent criminal indictment over its tax shelters, KPMG turned to its head of human resources, Timothy Flynn, to somehow persuade the government not to indict. Flynn knew that criminal charges against the firm would probably kill it, as they did Arthur Andersen after the Enron scandal.

For years, KPMG had stoutly denied any impropriety, calling its tax advice legal. But Flynn took a gamble and met with Justice Department officials to acknowledge that KPMG had engaged in wrongdoing. He got no promises in return, and the admission could have sunk the firm. Instead, it provided flexibility to the prosecutors, who were aware that the collapse of one of only four remaining accounting giants could harm the financial markets. Two months later, the government gave KPMG a deferred-prosecution deal, holding off indicting if KPMG paid a $456 million penalty and met other conditions.

The agreement between KPMG and the IRS required permanent restrictions on KPMGs tax practice, including the termination of two practice areas, one of which provided tax advice to wealthy individuals, and permanent adherence to higher tax practice standards regarding the issuance of certain tax opinions and the preparation of tax returns. In addition, the agreement banned KPMGs involvement with any prepackaged tax products and restricted KPMGs acceptance of fees not based on hourly rates. The agreement also required KPMG to implement and maintain an effective compliance and ethics program; to install an independent, government-appointed monitor to oversee KPMGs compliance with the deferred prosecution agreement for a three-year period; and to cooperate fully and truthfully in the pending criminal investigation, including the voluntarily providing information and documents.

Please address the following questions:

1. Describe the link between the tax culture at KPMG and leadership. Do you believe there is a direct correlation between dysfunctional tax decisions and culture?
2. What's wrong with a CPA firm, such as KPMG, aggressively seeking to establish tax shelters for wealthy clients? Did KPMG's role in this regard reflect a failure of leadership or a failure of judgment? Explain.
3. KPMG was in the news again in 2018 for stealing the exam and cheating. Here are just two of the many articles on this topic.
   1. US Securities and Exchange Commission. (2019, June 17). KPMG Paying $50 Million Penalty for Illicit Use of PCAOB Data and Cheating on Training ExamsLinks to an external site.
   2. Nicodemus, A. (2020, May 19). KPMG audit partners settle test cheating allegations. Compliance Week.Links to an external site.

What is your impression of the leadership of the firm as a whole? Explain.