Step 4: Evaluate the Arguments for each Option
- Weigh the ethical reasons and arguments for each option in terms of their relative importance.
- Determine whether there are any unwarranted factual assumptions that need to be examined in each argument.
Case 8-3 KPMG Tax Shelter Scandal In e Chapter 4 we discussed the artificial tax shelter arrangements developed by KPMG LLP 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 dollars in phony tax losses, which, according to court papers, cost the United States at least $2.5 billion dollars in evaded taxes. In addition to KPMG's former deputy chairman, the individuals indicted included two former heads of KPMG's tax practice and a former tax partner in the New York City office of a prominent national law firm. The facts of the tax shelter arrangement are complicated, so we have condensed them for purposes of this case and present them in Exhibit 1. EXHIBIT 1 Summary of Tax Shelter Transactions Developed by KPMG? KPMG developed tax shelters to generate losses of $11.2 billion dollars 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 KPMG's 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 to that, the opinion letter continued by falsely stating 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. Back in Chapter 4 we discussed the realistic possibility of success standard in taking tax positions under the Statements on Standards for Tax Services of the AICPA. This is a high standard to meet. Generally, there would need to be a 70-80 percent 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 she advises a client 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 Page 521 to highest, are reasonable basis, substantial authority, and more likely than not. A description of each of these standards appears in Exhibit 2. EXHIBIT 2 Circular 230 Tax Positions and Compliance Standards2 them-could include criminal investigation, among other things. As we noted in Chapter 4, an unusual aspect to the case is the culture that Page 522 apparently existed in KPMG's 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 KPMG's tax department at the time, Jeffrey M. Stein, and its CFO, Richard Rosenthal, created an environment that treated those who didn't support the "growth at all costs" effort as not being team players. Once 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. He 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 KPMG's 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 KPMG's involvement with any prepackaged tax products and restricted KPMG's 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 KPMG's compliance with the deferred prosecution agreement for a three-year period; and its full and truthful cooperation in the pending criminal investigation, including the voluntary provision of information and documents. Questions Case 8-3 KPMG Tax Shelter Scandal In e Chapter 4 we discussed the artificial tax shelter arrangements developed by KPMG LLP 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 dollars in phony tax losses, which, according to court papers, cost the United States at least $2.5 billion dollars in evaded taxes. In addition to KPMG's former deputy chairman, the individuals indicted included two former heads of KPMG's tax practice and a former tax partner in the New York City office of a prominent national law firm. The facts of the tax shelter arrangement are complicated, so we have condensed them for purposes of this case and present them in Exhibit 1. EXHIBIT 1 Summary of Tax Shelter Transactions Developed by KPMG? KPMG developed tax shelters to generate losses of $11.2 billion dollars 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 KPMG's 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 to that, the opinion letter continued by falsely stating 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. Back in Chapter 4 we discussed the realistic possibility of success standard in taking tax positions under the Statements on Standards for Tax Services of the AICPA. This is a high standard to meet. Generally, there would need to be a 70-80 percent 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 she advises a client 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 Page 521 to highest, are reasonable basis, substantial authority, and more likely than not. A description of each of these standards appears in Exhibit 2. EXHIBIT 2 Circular 230 Tax Positions and Compliance Standards2 them-could include criminal investigation, among other things. As we noted in Chapter 4, an unusual aspect to the case is the culture that Page 522 apparently existed in KPMG's 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 KPMG's tax department at the time, Jeffrey M. Stein, and its CFO, Richard Rosenthal, created an environment that treated those who didn't support the "growth at all costs" effort as not being team players. Once 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. He 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 KPMG's 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 KPMG's involvement with any prepackaged tax products and restricted KPMG's 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 KPMG's compliance with the deferred prosecution agreement for a three-year period; and its full and truthful cooperation in the pending criminal investigation, including the voluntary provision of information and documents. Questions
