Tax shelter case.

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, or 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.

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 issue 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 the consequences of going forward with the sheltersas well as failing to register themcould include criminal investigation, among other things.

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.

KPMG had for years stoutly denied any impropriety, calling its tax advice legal. But Flynn took a gamble and met with Justice Department officials and acknowledged 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:

1. Evaluate the characteristics of ethical leadership with respect to the actions taken by KPMG, as described in the case. Link your discussion to the tax standardstax practitioners under the AICPA Code.