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92–279—PDF 2004

S. HRG. 108–371

TAX SHELTERS: WHO’S BUYING, WHO’S SELLING,

AND WHAT’S THE GOVERNMENT DOING

ABOUT IT?

HEARING

BEFORE THE

COMMITTEE ON FINANCE

UNITED STATES SENATE

ONE HUNDRED EIGHTH CONGRESS

FIRST SESSION

OCTOBER 21, 2003

(

Printed for the use of the Committee on Finance

COMMITTEE ON FINANCE

CHARLES E. GRASSLEY, Iowa, Chairman

ORRIN G. HATCH, Utah

DON NICKLES, Oklahoma

TRENT LOTT, Mississippi

OLYMPIA J. SNOWE, Maine

JON KYL, Arizona

CRAIG THOMAS, Wyoming

RICK SANTORUM, Pennsylvania

BILL FRIST, Tennessee

GORDON SMITH, Oregon

JIM BUNNING, Kentucky

MAX BAUCUS, Montana

JOHN D. ROCKEFELLER IV, West Virginia

TOM DASCHLE, South Dakota

JOHN BREAUX, Louisiana

KENT CONRAD, North Dakota

BOB GRAHAM, Florida

JAMES M. JEFFORDS (I), Vermont

JEFF BINGAMAN, New Mexico

JOHN F. KERRY, Massachusetts

BLANCHE L. LINCOLN, Arkansas

KOLAN DAVIS, Staff Director and Chief Counsel

JEFF FORBES, Democratic Staff Director

(II)

(III)

C O N T E N T S

OPENING STATEMENTS

Page

Grassley, Hon. Charles E., a U.S. Senator from Iowa, chairman, Committee

on Finance ............................................................................................................ 1

Baucus, Hon. Max, a U.S. Senator from Montana ................................................ 2

CONGRESSIONAL WITNESS

Levin, Hon. Carl, ranking member, Permanent Subcommittee on Investigations, U.S. Senate ................................................................................................. 4

AGENCY WITNESSES

Brostek, Mike, Director, Strategic Issues, U.S. General Accounting Office,

Washington, DC ................................................................................................... 32

Olson, Hon. Pamela, Assistant Secretary for Tax Policy, U.S. Department

of Treasury ............................................................................................................ 34

Everson, Hon. Mark, Commissioner, Internal Revenue Service, Washington,

DC .......................................................................................................................... 36

O’Connor, Hon. Eileen, Assistant Attorney General, Tax Division, U.S. Department of Justice, Washington, DC ................................................................ 38

PUBLIC WITNESSES

Hamersley, Michael, former employee of KPMG, Fair Oaks, CA ........................ 9

Walsh, Thomas, former employee, Levi Strauss & Co., San Jose, CA ................ 11

Schmidt, Robert, former employee, Levi Strauss & Co., San Jose, CA ............... 12

Camferdam, Henry, Jr., tax shelter investor, Indianapolis, IN ........................... 14

Lally, Robert V., accountant, Federman, Lally & Remis, LLC, Farmington,

CT .......................................................................................................................... 16

‘‘Mr. Janet,’’ an anonymous witness to speak on SILOs and LILOs and abuses

in the leasing industry ......................................................................................... 18

Cook, Philip, attorney, Alston & Bird, Atlanta, GA ............................................. 29

McDonough, William J., chairman, Public Company Accounting Oversight

Board, Washington, DC ....................................................................................... 40

Williams, Hon. John B., Shearman and Sterling, LLP, Washington, DC ........... 41

ALPHABETICAL LISTING AND APPENDIX MATERIAL

Baucus, Hon. Max:

Opening statement ........................................................................................... 2

Prepared statement .......................................................................................... 51

Brostek, Mike:

Testimiony ......................................................................................................... 32

Prepared statement .......................................................................................... 53

Bunning, Hon. Jim:

Prepared statement .......................................................................................... 85

Camferdam, Henry, Jr.:

Testimony .......................................................................................................... 14

Prepared statement .......................................................................................... 85

Cook, Philip:

Testimony .......................................................................................................... 29

Prepared statement .......................................................................................... 90

Responses to questions from Senator Grassley .............................................. 99

Page

IV

Everson, Hon. Mark:

Testimony .......................................................................................................... 36

Prepared statement .......................................................................................... 105

Grassley, Hon. Charles E.:

Opening statement ........................................................................................... 1

Hamersley, Michael:

Testimony .......................................................................................................... 9

Prepared statement .......................................................................................... 122

Responses to questions from Senator Baucus ................................................ 134

‘‘Mr. Janet’’:

Testimony .......................................................................................................... 18

Prepared statement w/attachment .................................................................. 145

Lally, Robert V.:

Testimony .......................................................................................................... 16

Prepared statement .......................................................................................... 153

Levin, Hon. Carl:

Testimony .......................................................................................................... 4

Prepared statement .......................................................................................... 158

McDonough, William J.:

Testimony .......................................................................................................... 40

Prepared statement .......................................................................................... 161

Responses to questions from Senators Baucus and Graham ........................ 172

O’Connor, Hon. Eileen:

Testimony .......................................................................................................... 38

Prepared statement .......................................................................................... 176

Olson, Hon. Pamela:

Testimony .......................................................................................................... 34

Prepared statement .......................................................................................... 185

Responses to questions from Senators Baucus, Graham, and Kerry ........... 194

Schmidt, Robert:

Testimony .......................................................................................................... 12

Prepared statement .......................................................................................... 218

Walsh, Thomas:

Testimony .......................................................................................................... 11

Prepared statement .......................................................................................... 220

Williams, Hon. John B.:

Testimony .......................................................................................................... 41

Prepared statement .......................................................................................... 225

COMMUNICATIONS

KPMG ....................................................................................................................... 233

(1)

TAX SHELTERS: WHO’S BUYING, WHO’S SELLING, AND WHAT’S THE GOVERNMENT

DOING ABOUT IT?

TUESDAY, OCTOBER 21, 2003

U.S. SENATE,

COMMITTEE ON FINANCE,

Washington, DC.

The hearing was convened, pursuant to notice, at 10:05 a.m., in

room SD–50, Dirksen Senate Office Building, Hon. Charles E.

Grassley (chairman of the committee) presiding.

Also present: Senators Nickles, Snowe, Bunning, Baucus, and

Bingaman.

OPENING STATEMENT OF HON. CHARLES E. GRASSLEY, A U.S.

SENATOR FROM IOWA, CHAIRMAN, COMMITTEE ON FINANCE

The CHAIRMAN. Thank you, everybody. We appreciate very much

the kind attendance of people at this hearing, particularly our witnesses, particularly our colleague Senator Levin, who is with us, to

look into a very important issue before Congress.

It is not a new issue. It may be new evidence, but it is an ongoing issue that we have. So we are meeting today to provide an update on the issue of tax shelters. My guess is that the first tax shelter was created before the ink on any of the legislation ever became

dry in the first Tax Code. So, as I have already indicated, it is a

continual and constant effort to fight these shelters.

The administration has taken good steps to address the latest

wave of shelters, committing additional resources and looking to

using those resources more effectively.

However, it is very clear that we have a long road ahead of us,

and we need to give the administration additional power and authority to do its job. The Finance Committee and the Senate have

answered the bell.

Several times already we have passed bipartisan legislation that

will provide the executive branch the tools that are needed to help

address the current wave of tax shelters.

There is hardly a bill passed by this committee that has not contained anti-shelter legislation. I know that the administration supports core parts of our anti-shelter legislation. I would encourage

the administration to join us in pressing hard to ensure that the

Congress passes this much-needed legislation, and to do it quickly.

The focus of this hearing is on the current situation with tax

shelters. We are here today to consider and hear accounts of where

we are in the battle against abusive tax shelters.

2

The hearing today will revisit Enron, but we will also hear similar, equally troubling accounts. Particularly gripping will be the inside account of the abuses in the leasing industry.

This hearing will show that Enron was not an exception, and

that Enron did not act alone. Enron was not the ‘‘lonely Maytag repairman’’ when it comes to creating tax shelters and buying tax

shelters. Enron had a lot of help from investment bankers, law

firms, and accounting firms. These tax shelter hucksters sold tax

shelters not only to Enron, but to other companies as well, and

they continue to do so today.

I know the administration recognizes that there is work to be

done, and has begun the tough job of putting these hucksters out

of work. However, my hope is that the Finance Committee’s continued oversight will focus the government’s work and ensure that

this remains a top priority with people having that responsibility.

Finally, I say to the hucksters, it is time to find an honest living.

The Finance Committee, on a bipartisan basis, remains committed

to addressing the issues of tax shelters, and particularly promoters.

We will continue to press in this area and to ensure that the government continues to realize results in putting the hucksters out

of business.

I now turn to my colleague who has been very cooperative in this

effort over a long, long period of time, including the period of time

that he was Chairman of the committee, Senator Baucus.

OPENING STATEMENT OF HON. MAX BAUCUS, A U.S. SENATOR

FROM MONTANA

Senator BAUCUS. Thank you, Mr. Chairman.

Mr. Chairman, the proliferation of abusive tax shelters has been

referred to as ‘‘our Nation’s most significant tax compliance problem.’’ The development, selling, and buying of tax shelters has also

been characterized as a ‘‘race to the bottom.’’

The New York Bar Association said, ‘‘The constant promotion of

these frequently artificial transactions breeds significant disrespect

for the tax system, encouraging responsible corporate taxpayers to

extend this type of activity to be the norm, and to follow the lead

of other taxpayers who have engaged in taxed-advantaged transactions.

Simply put, this is unacceptable. This is why the Finance Committee, under Senators Moynihan and Roth, as well as under

Chairman Grassley and myself, have pushed for legislation to put

the breaks on these tax-engineered schemes.

The purpose of today’s hearing is to make it clear that the tax

shelter problem is not just an Enron/Arthur Andersen problem.

The tax shelter problem is widespread, developed and promoted by

accounting firms, law firms, investment banks, and purchased by

many other corporations and individuals.

Now, as Judge Learned Hand said, ‘‘There is nothing sinister in

arranging one’s affairs as to keep taxes as low as possible. Everybody does so, rich or poor, for nobody owes any public duty to pay

more than the law demands. To demand more in the name of morals is mere cant.’’

3

But we are here, not talking about legitimate tax planning. Abusive tax shelters are illegitimate tax avoidance schemes that create

a tax benefit without any corresponding economic benefit.

There is no new product, no technological innovation, just a tax

break. Those engaged in this tax shelter business are doing this at

the expense of those taxpayers who are paying their fair share of

taxes.

To give you an idea of the burden they are placing on these honest taxpayers, during the 1990’s alone, actions taken to shut down

the tax shelters that we knew about saved the American taxpayer

$80 billion.

A recent study commissioned by the IRS estimated that the current cost to honest taxpayers ranged from $14 billion to $18 billion

a year, and it is up to $180 billion over 10 years.

Every spring, Americans sit down at their kitchen table at their

home computer to figure out their taxes. With quiet patriotism,

these Americans step up and pay their fair share. They are counting on us to make sure that sophisticated corporations pay their

fair share as well.

I am simply unwilling to tell a schoolteacher in Montana that he

needs to pony up a little more because Congress is unwilling to

shut down a loophole that is costing tens of billions every year.

Today’s hearing is critical, highlighting the magnitude of the

problem. Congress cannot ignore the problem any longer. It has

been 2 years since the collapse of Enron, yet not one piece of tax

legislation to curb tax shelter abuses has been enacted.

I look forward to continuing to work with you, Mr. Chairman, to

see the Tax Shelter Transparency Act through to enactment. I also

urge all of my Congressional colleagues in the House and the Senate to join forces to send tax shelter legislation to the President for

his signature by the end of this year.

Thank you.

The CHAIRMAN. Thank you, Senator Baucus.

Now we have the privilege of hearing from one of our colleagues.

We are hearing from him in his capacity as a Senator from Michigan who has been very active in this for a long period of time, and

now also is Ranking Member of the Permanent Subcommittee on

Investigations, and, when his party was in the Majority, Chairman.

He is also very well-known for his activities as spokesperson for the

Democratic Party on the Armed Services Committee as the Ranking Member of that committee.

You have been very active, I know, Senator Levin, in working to

curb the abuse of tax shelters. So, we look forward to your testimony today. Your entire statement will be included in the record.

I think I should make that announcement for other people as

well. So you do not take the time to ask that your statement be

put in the record, all statements longer than 5 minutes will be included in the record so that we can keep inside of the five-minute

time period.

Senator Levin?

4

STATEMENT OF HON. CARL LEVIN, RANKING MEMBER, PERMANENT SUBCOMMITTEE ON INVESTIGATIONS, U.S. SENATE

Senator LEVIN. Mr. Chairman, thank you. Thank you, Senator

Baucus and members of the Finance Committee for your determination to try to put an end to tax shelters, the tax shelters

which cheat the American taxpayers who are honest of billions of

dollars each year need to be exposed. They need to be stopped, and

it is going to take legislation, obviously, in order to do that.

One of the advantages of that will not only be additional money

coming to the Treasury which is owing the Treasury, but it will be

an aid to the honest tax professionals who do not hawk these abusive tax schemes, but have to compete against those who do.

In some parts of the world, tax cheating is a way of life. Some

governments do very little to curb that. In this country, however,

taxpayers are being asked to pay billions of dollars to strengthen

our homeland security, to support our troops, to take care of the

sick, to improve our schools, to rebuild Iraq, to look out for our seniors, and the use of these farfetched and abusive tax schemes to

avoid payment of tax need to be exposed for really what it is: unfair, and indeed, unpatriotic.

As the Chairman mentioned, last year our Permanent Subcommittee on Investigations opened an in-depth investigation into

the development and marketing of abusive tax shelters by professional firms, like accounting firms, banks, investment advisors, and

law firms.

This was part of the Enron investigation which, like your investigations, disclosed that one of the things Enron did was to use

these elaborate tax dodges. One of the tax schemes that we exposed

was a tax scheme called ‘‘slapshot,’’ in which J.P. Morgan/Chase—

and I emphasize, these are legitimate firms that helped Enron

carry out their fraud—designed and sold this tax shelter to Enron

for $5 million. Enron calculated that this tax shelter scheme called

‘‘slapshot’’ would produce tax benefits exceeding $120 million for

their payment of $5 million to Chase.

As detained in a subcommittee report, this tax shelter relied primarily on a sham $1 billion loan that was arranged and financed

by J.P. Morgan/Chase. It concealed within a mind-boggling array

of loans, stock swaps, structured finance transactions, many of

which occurred within minutes of each other. That shelter’s complexity was designed to prevent tax authorities from finding out

what really happened.

We pierced that veil by subpoenaing hundreds of boxes of documents, reading thousands of e-mails, conducted numerous interviews, and spent months unraveling how that tax shelter worked.

We figured out slapshot, but the larger issue, which we are now

investigating with the support of our subcommittee chairman,

Norm Coleman, is how respected U.S. financial institutions end up

hawking abusive tax shelters and enlisting the help of so many

other respected professionals to make them work.

This is a target-rich environment. Numerous respected accounting firms, investment advisors, banks, and law firms spend resources, form alliances, and develop the internal and external infrastructure necessary to aggressively design, market, and impleVerDate 11-MAY-2000 13:56 Mar 23, 2004 Jkt 000000 PO 00000 Frm 00008 Fmt 6633 Sfmt 6633 92279.000 SFINANC2 PsN: SFINANC2
5

ment hundreds of complex tax shelters that U.S. taxpayers would

otherwise be unable, unlikely, or unwilling to employ.

They are doing it in exchange for hundreds of millions of dollars

and it cost the Treasury billions of dollars each year.

One of the common features of these tax shelters is the reliance

on highly-skilled professionals, these layers of corporations, trusts,

special-purpose entities that only a trained financial professional

could devise and establish.

Now, some people, Mr. Chairman and Senator Baucus, claim

that the tax shelter abuses are already over, that there is no need

for further investigations, reforms, or stronger laws.

But our investigation indicates that, while a few promoters are

calling it quits, the tax shelter industry as a whole is still going

strong, targeting new opportunities and market segments, hawking

tax shelters like late-night cut-rate TV bargains, and victimizing

honest taxpayers, communities, and honest tax professionals.

Next month, our Permanent Subcommittee on Investigations is

going to hold the first in what we hope will be a series of hearings,

presenting detailed case histories, demonstrating how respected

U.S. tax and financial professionals develop, market, and implement abusive, highly questionable tax shelters.

We are going to present an inside look at the attitudes and operations underlying these tax shelter activities, including documentary evidence illustrating the aggressive approach that some respected firms have taken in selling their tax shelters.

I want to just cite one example for this committee this morning.

A leading accounting firm that develops and markets tax shelters,

but denies being a promoter of tax shelters, had this e-mail circulating among its tax professionals. This is what the internal e-mail

said. This is in a company which denies promoting tax shelters.

‘‘I want to personally thank everyone for their efforts during the

approval and process of this strategy.’’ This is a tax shelter marketing strategy. ‘‘It was completed very quickly. Everyone demonstrated true teamwork. Thank you. Now, let us capitalize: sell,

sell, sell!!’’

What they are selling are these strategies. What they are selling

are these tax shelters that are so deceptive, so unfair to the American public.

Finally, Mr. Chairman and Senator Baucus, I commend you for

the bill which you have co-sponsored repeatedly, which have passed

the Senate twice. We hope that we can get this passed in the

House, as well as in the Senate.

I am introducing a companion bill with Senator Baucus and Senator McCain today which will add one additional feature to the bill

which you have introduced which tightens up the rules on tax shelters.

What my bill does, is it would bar an accounting firm from auditing the books of any publicly traded company to which it has sold

a tax shelter. This has been recommended by the highest authorities, by our most trustworthy authorities. You should not sell a

shelter and then audit your own work. It is an inherent conflict of

interest. Getting rid of this conflict of interest is what our bill will

do.

6

Getting rid of this conflict has been supported by the Conference

Board’s Blue Ribbon Commission on Public Trust and Private Enterprise, co-chaired by John Snow before he became Secretary of

the Treasury, which says, in summary, ‘‘Public accounting firms

should limit their services to their clients to performing audits and

to providing closely-related services that do not put the auditor in

an advocacy position such as novel and debatable tax strategies

and products that involve income tax shelters and extensive offshore partnerships or affiliates.’’

I want to thank you again, Mr. Chairman, Senator Baucus, and

this committee for your leadership. I hope your efforts at both exposing these abusive shelters and getting the bill passed, and hopefully getting our companion bill passed will be complemented by

the efforts of the Permanent Subcommittee on Investigations,

which Senator Coleman and I lead.

[The prepared statement of Senator Levin appears in the appendix.]

The CHAIRMAN. Senator Levin, you asked me last week if I would

take a look at your bill, and I have not completed my study of that

yet. But I really compliment you for being out in front and for the

very overwhelming testimony that you give.

More importantly, thank you for our committees’ working together in mutual support of this effort, because I think it is very

mutually supportive. So, I thank you for that.

I do not have any questions, but I want to ask my colleagues if

they have any questions. I will go to Senator Baucus first, and then

to Senator Bingaman.

Senator BAUCUS. Well, I have no questions, Mr. Chairman, except to very heartily thank our colleague from Michigan. He has

done yeoman’s work in this area, much more than most members

of the Senate.

As you have said, Mr. Chairman, his committee, the subcommittee, has worked very well with this committee also, and

that is to be commended. We’re not trying to fight each other for

turf reasons, or whatnot, but rather are working together. I also

thank him for his legislation. I think it is very much needed.

I think the separation of the auditors auditing versus promoting

and selling transactions is a no-brainer. Clearly, that is important.

I also think it is a good idea to codify the five principles that the

Senator codifies in his legislation.

This has got to stop, plain and simple. We have talked way too

much and done too little in the U.S. Congress. It has been 2 years

since Enron and not one piece of tax shelter legislation has passed.

I think that does not sit too well with the American people. We

do a lot of talking, we do not do a lot of acting. I just very much

hope that not only the Congress, but the relevant agencies, the

IRS, Justice, and the other agencies, will step up their actions, too.

As I said in my testimony, about $180 billion over 10 years is

lost through known tax shelters. $180 billion over 10 years. That

is a lot of money. That is to say nothing about some of the other

uncollected tax revenues that we are faced with.

We have got a problem here, a big problem, and we have a huge

opportunity. Just think what confidence the American public would

have in the U.S. Government if they knew that these shelters were,

7

in fact, shut down and that unreported revenue was being collected? Basically, that these shelters are being shut down, pure and

simple. That they do not exist. Boy, that would be something. It is

up to us to try to do something about it.

Thank you very, very much.

The CHAIRMAN. Senator Bingaman, then the Senator from Kentucky.

Senator BINGAMAN. Thank you very much.

Let me thank Senator Levin for his leadership on this. I did

want to ask. I obviously strongly support the legislation that this

committee has reported several times to deal with the issue.

But to what extent do you believe that the authority currently

exists, either with the Internal Revenue Service or with this new,

Public Company Accounting Oversight Board, or with any other

part of the administration to deal with these problems?

I mean, it does not seem to me that Congress should have to legislate in order to be sure that this kind of thing does not happen.

I do not know what your perception of that is. Maybe there is

something that could be done, even if the legislation is not fully enacted.

Senator LEVIN. I think it is important that the bill which has

been introduced by the leadership of this committee be passed,

which will strengthen and simplify the Economic Substance Doctrine that is defined more clearly in that bill. It would increase the

penalties for violation of the law’s requirements relative to tax

shelters, so I very much support the bill.

But in terms of what could be done now, surely one of the things

we can do now is give the IRS the tools that they need to enforce

the current law. They are able to do enforcement in this area.

It is not as sharp or as strong as it should be, and that is what

the bill is introduced for. But it does exist. There is some authority

which exists, and they have been able to go after some of these tax

shelters.

But they should not be cut in terms of their enforcement personnel. I am afraid that that very well could happen this year unless we act to avoid that happening.

Senator BINGAMAN. Just to follow up. Your view is that there is

also a problem of inadequate resources being provided to the folks

who are tasked with the job of ferreting out and dealing with these

abuses.

Senator LEVIN. I do. I believe they are inadequate. They should

be increased and not reduced.

Senator BINGAMAN. All right. Thank you very much.

The CHAIRMAN. The Senator from Kentucky.

Senator BUNNING. Thank you. I am sorry I missed your testimony. I have been involved in certain kinds of tax shelters in the

past 25 years of investments. I can only tell you this, that more average people have lost more money in tax shelters than any other

investments that they have ever made.

All of a sudden, those tax shelters become phantom income and

they are required to pay income tax on money they never earned.

Anything we can do to correct that problem, I am going to be for.

Thank you very much.

The CHAIRMAN. Senator Levin, thank you very much.

8

Senator LEVIN. Thank you so much.

The CHAIRMAN. I am going to ask the next panel to come while

I introduce you.

We are going to hear from Michael Hamersley, senior manager

at KPMG. Mr. Hamersley is responsible for providing technical

guidance at that firm in their tax and audit practice regarding the

structuring of proposed corporate transactions in connection with

tax provisions reviews performed in the course of their firm’s audits.

Our next two witnesses, Robert Schmidt and Thomas Walsh, are

former employees who were senior tax counsels at Levi Strauss &

Co.

Then we will hear from Mr. Henry Camferdam, Jr., who purchased a tax shelter. Then Mr. Robert Lally. He will share his experience as a partner in charge of tax practice in Hartford, Connecticut for Deloitte and Touche, as well as more recently with his

firm in Farmington, Connecticut.

Finally, we are going to hear testimony from a former leasing executive who, in order to protect his identity, will be referred to as

Mr. Janet during the hearing. In regard to that, I had an admonition that I wanted to read.

Before our first panel was here, I wanted to inform everybody

that, for special security precautions, we are going to take caution

to protect the identity of this Mr. Janet. That is not his real name.

In regard to that, we would ask that staff leave the area behind

us, except if your member is present. We do have chairs out in the

audience reserved for those staff people, because we know you need

to hear what is going on here. Everyone else would remain in their

seats during the testimony of the first panel, because we do want

to protect this witness.

Now, in regard to Mr. Janet, I extend a special thanks to him.

He has risked much by appearing here today and by exposing a

massive fraud. Mr. Janet has done the Nation a great service. On

behalf of the committee, we thank Mr. Janet for appearing.

Again, I would remind everybody to remain seated and keep all

cameras pointed to the floor until Mr. Janet has left the room.

Now, in regard to Mr. Janet coming in, are we in a secured position to do that? All right. My staff informs me we are not going to

bring him out until we get to the point of his testimony. But I have

introduced him, and I am not going to introduce him again, obviously.

So we start, then, with Mr. Hamersley. Would you please start?

I think we are going to go in the order as I introduced you, from

my left to my right.

I think all of you have been told about the five-minutes, but let

me emphasize it, because we have got a lot of witnesses to go

through. And, particularly, Senator Baucus and I have a lot of

questions that we are going to have to ask. I might ask colleagues

to give Senator Baucus and me some leeway in the five-minute

rule, because we are working together as a team on this and we

would like to complete that.

So, Mr. Hamersley, would you start out?

9

STATEMENT OF MICHAEL HAMERSLEY, FORMER EMPLOYEE

OF KPMG, FAIR OAKS, CALIFORNIA

Mr. HAMERSLEY. Thank you, Chairman Grassley. Good morning,

Senators.

My name is Mike Hamersley. This is a return to DC for me. I

graduated from law school here at Georgetown in 1995 and got an

MBA and BBA degrees before going to law school.

I joined KPMG, LLP in 1998 in their Washington national tax

practice here in town. I relocated to the Los Angeles office in 2000.

I am a mergers and acquisition tax specialist and work in the

area of corporate restructuring, acquisitions, dispositions, and corporate restructuring, which is in the environment that many of

these tax shelters takes place, the corporate tax shelters.

I was not directly involved in promoting tax shelters, but I was

very often contacted by partners who others, including KPMG tax

shelter promoters, were selling tax shelters to their clients and

they were interested in finding out whether they worked. I also

worked in close geographic proximity to some of the most prolific

tax shelter promoters in the firm.

While at KPMG in Los Angeles, I received exceptional performance ratings. However, my career came to a sudden end in late

2002 involving a re-audit of a former Arthur Andersen audit client

when I raised a number of doubts and concerns about some of the

tax shelters, the off-balance sheet transactions, and the conduct of

many of the KPMG tax partners that were involved on the audit,

particularly on the tax provision work.

I eventually refused to endorse what I believed to be illegal conduct of KPMG tax partners involved in the audit and I was involuntarily placed on administrative leave of absence shortly after

confirming that I had communicated with Federal investigators.

There seems to be some confusion about my employment status.

I noticed in the program that I am listed as a former KPMG employee. KPMG insists that I am a current employee, despite the

fact that I am not allowed to come in the office, and have not been

for over a year now. They still list me as a current employee. The

only thing that could possibly render me a current employee, is I

receive a paycheck.

I would like to just touch upon a few of the major issues that

were in my written testimony. Abusive tax shelters. These are really not just a mere contortion of the law. Changing the law to shut

them down is a good first step.

But these are contortions of fact. These are lying, deceiving, and

concealing true facts and really trying to be taxed on hypothetical

transactions that never took place. They are not legitimate business transactions. These are tax benefits that drive the transactions, not vice versa.

Any purported business purpose or economic substance is just a

facade. It is economic substance that is engineered in by the tax

shelter promoters, not the financial advisors. So, I think that is an

important distinction.

In the area of concealment of fact and fact contortion. Most tax

shelters include a tax shelter opinion, which include representations from the client. Typically, some of those representations include business purpose and step transaction representations. Were

10

the many steps of this transaction part of a single plan? And they

represent that they were not in order to achieve the tax results.

If you look through that, there are other mechanisms in the

transactions. For instance, netting to avoid the detection of the

transactions at the taxpayers’ level, side agreements, and the like.

There are definitely legislative changes needed to increase the

likelihood of disclosure and stiffer penalties for those who intentionally conceal the facts and distort them. Enforcement needs to

be aimed at finding more of this concealment and punishing it.

Some of the specific practices that I observed while at KPMG associated with abusive tax shelters were such contortion of the law,

contortion and concealment of facts. The transactions that were effective in concealing the facts from the IRS were often referred to

by the promoters as having ‘‘good optics.’’

In other words, these are not easily detected, similar to the

slapshot transaction that Senator Levin mentioned. I believe in the

hearing they referred to that as ‘‘not leaving a road map.’’ It is the

same concept. There is also some concealment that takes place in

the controversy work that may follow not disclosing the facts.

The tax shelter promoters were pretty brazen about this stuff.

Some of the quotes that I included in my statement, ‘‘it’s like stealing candy from a baby,’’ ‘‘you’ll never pay tax again,’’ ‘‘our clients

do not pay Federal income tax,’’ ‘‘paying Federal income tax is optional,’’ these are comments that promoters made.

The reasoning behind some of this attitude and the favorable cost

benefit analysis that these promoters were making was that there

is less chance and less penalty of getting caught than there is

money to be made by selling these.

They believed the IRS would not discover them, and even if they

did, that the enforcement would be prospective, therefore, the penalties would be minimal. There was a ‘‘too few to fail’’ attitude, that

‘‘all of the firms, the Big Four and Big Five accounting firms are

doing this and they cannot shut down all of us.’’

I see my time is running out. I did want to touch upon the auditor independence issues. There are four problems which I briefly

want to reference.

One, the problem that Senator Levin’s legislation addressed,

audit firms selling tax shelters to their own audit clients. That is

the most abusive situation because the auditor is placed in a position of auditing the tax shelter that was sold by the audit firm, and

the benefits on the financial statements were promised when it was

sold. How can he not approve it?

The second one is a desire to sell tax shelters to the audit client.

The cozying up with the audit client to be able to sell tax shelters

in the future is a big problem.

Third. I think this is a problem I think the legislation needs to

address. Even if you have not sold the tax shelter to your audit client, you may have sold similar shelters or identical shelters to nonaudit clients and have promised financial statement benefit.

You can hardly not sign off on an identical strategy for somebody

else’s audit client and expect people to believe that your same

strategy can be benefitted on the clients that you sold the strategy

to.

11

Finally, in the review of transactions on what is called the tax

provision review of an audit, there is a trade-off that goes on in

those sign-offs, that very issue I just mentioned.

If another firm has sold a tax strategy to your audit client, there

is pressure put on you to sign off because if you do not, they threaten that they will not sign off on yours that were sold to their audit

clients.

I am sorry I went over, and I will wrap it up. Thank you.

The CHAIRMAN. Thank you, Mr. Hamersley.

[The prepared statement of Mr. Hamersley appears in the appendix.]

The CHAIRMAN. Mr. Walsh?

STATEMENT OF THOMAS WALSH, FORMER EMPLOYEE OF

LEVI STRAUSS & CO., SAN JOSE, CA

Mr. WALSH. My name is Tom Walsh. I am a Canadian chartered

accountant and I have a master’s degree in taxation from Golden

Gate University.

From September, 1999 to December of 2002, I was employed in

the Global Tax Department of Levi Strauss & Co., first as a manager, then as a senior manager, then from February 2001 until my

termination in December of 2002, as a director of International

Tax.

I was one of five directors who reported to the vice presidents,

Ms. Laura Liang and Mr. Vince Fong. My responsibilities as tax director included calculating LS & Co.’s worldwide tax provision for

the 2001 and 2002 year.

That process required the calculation of historical data, including

the tax accounting reserves established and released, and the availability and prior use of foreign tax credits, and the application of

a valuation allowance against those credits.

My efforts began in an unusual context, as LS & Co. had 16 open

tax years, meaning the company’s consolidated tax returns had not

been completely audited by the IRS for 16 years.

With respect to the reserves, I discovered that from 1995 forward, large amounts of tax reserves had been systematically released into earnings. From 1995 to 2001, LS & Co. released approximately $200 million of tax reserves into its earnings.

Because I was aware that the timed release of reserves violates

GAAP and FASB rules, I looked for documentation that would tie

the reserve release to the termination of specific tax liabilities. I

found no such documentation. I was equally unable to find any

lawful justification for the release of the tax reserves.

I concluded that LS & Co. was engaged in systematic time release of tax reserves to lower its effective tax rate, that it was releasing unallocated reserves to lower its effective tax rate and boost

its income.

Any doubts I had were removed when I was told by Vice Presidents Vince Fong and Laura Liang that the company set its tax

rate targets and it released reserves in order to achieve that particular tax rate.

In addition to releasing the unsubstantiated reserves, LS & Co.

failed to set meaningful tax reserves against potential exposures

for a number of extremely aggressive tax schemes.

12

Setting reserves has the effect of reducing the effective tax rate.

Approximately $3 million was set as a reserve against those exposures.

Myself and others in the Global Tax Department, including Mr.

Schmidt, had calculated that these reserves should have been at

least $100 million in respect of those aggressive tax positions taken

by Levi Strauss during those years.

A similar scenario existed with respect to the foreign tax credits.

From 1995 to 2002, LS & Co. claimed the benefit of foreign tax

credits and tax on unadmitted foreign earnings on its balance sheet

in the aggregate of approximately $200 million.

Unless LS & Co. can show that it is more likely than not that

it will be able to utilize these tax credits in a carry-forward period,

valuation allowance should be established to reduce the benefit of

those credits on its balance sheet. LS & Co. failed to book any valuation allowance, therefore, on its balance sheets its deferred tax assets were overstated by up to $200 million.

These issues were deeply troubling to me, as I believed that LS

& Co.’s conduct was unlawful. I raised these concerns to the VP of

Tax, the CFO, Bill Chasen, and the Human Resource manager,

among others.

I also raised my concerns that one of the vice presidents, Mr.

Fong, had instructed the leadership team to show the new auditors

who replaced Arthur Andersen, KPMG, ‘‘we will only show what we

want them to see.’’

When I raised the issues through the chain, the response of the

company was to issue me a written warning threatening me with

my termination. Ultimately, the threat was carried out 1 week

prior to KPMG’s arrival to do the field work for their first year-end

audit of Levi Strauss’ books.

In addition, KPMG had placed several tax partners to do the

audit of the tax provision, and two of those partners started to

raise issues with regards to the reserves and the foreign tax credits. At Levi Strauss & Co.’s request, KPMG complied and removed

those two partners, replacing them with other partners.

The CHAIRMAN. Thank you, Mr. Walsh. I should not assume you

were done. You were done?

Mr. WALSH. I was done.

The CHAIRMAN. All right. Thank you very much. Very compelling

testimony.

Mr. Schmidt?

STATEMENT OF ROBERT SCHMIDT, FORMER EMPLOYEE OF

LEVI STRAUSS & CO., SAN JOSE, CA

Mr. SCHMIDT. Good morning, Mr. Chairman, Senators. My name

is Rob Schmidt. I am an attorney, licensed in California, licensed

in 1990. I have an LLM from Georgetown University in tax and

international comparative. I think it speaks to Georgetown’s ethics

policy that both Mr. Hamersley and myself are sitting on this panel

today.

I was employed as an international senior manager at Levi

Strauss & Company in June of 2001. I was promoted to director

of International Tax in June of 2002, and summarily fired on DeVerDate 11-MAY-2000 13:56 Mar 23, 2004 Jkt 000000 PO 00000 Frm 00016 Fmt 6633 Sfmt 6633 92279.000 SFINANC2 PsN: SFINANC2
13

cember 10, 2002 for, among other things, giving the IRS certain

pieces of information that they had directly asked me to give them.

Among my responsibilities while I was at Levi Strauss & Company was to be the project leader and issue manager for the technical review and factual review for a Brazilian partnership that the

company wholly owned.

The company was held by two U.S. corporations that had no employees, no income, and were established primarily and solely for

the purpose of holding a partnership interest with the Brazilian

partnership.

The Brazilian partnership was named Levi Strauss Latin America. An investment of $100,000 was made into the equity of this

partnership in 1986. Over the next 8 years, approximately $138

million in deductions were claimed against Levi Strauss’ U.S. income.

The IRS, who had not audited Levi Strauss for 17 years, had

commenced an audit in approximately 1999, before I arrived, and

had paid particular attention to Levi Strauss Latin America, the

Brazilian partnership.

When I arrived, I was taking responsibility for reviewing and answering audit questions. As part of my investigation, I traveled to

Brazil on two separate occasions. While in Brazil, I discovered approximately 50 boxes of primary documentation that I had been led

to believe did not exist.

In an initial review of those documents, I noticed that much of

the information that I was discovering had not been handed over

to the IRS in response to information document requests that had

been previously asked and answered before my employment.

When I returned from Brazil on my first trip, I informed my superior, Vince Fong and Laura Liang, that there was additional information that was material and Levi Strauss had an obligation

and needed to supplement the information document request.

At that time, I was also asked directly by an IRS agent to turn

over certain information that she had learned existed. At that point

I called a meeting with both of my superiors, Mr. Fong and Ms.

Liang.

I told them that I was in possession of this information and that

this information was material and relevant and was not privileged,

and that there was an ethical obligation to turn this information

over to the IRS in response to their request. I was told directly not

to turn over any information to the IRS.

I told them that that was a violation of my ethical responsibility

and I would be doing so, in which case I was told by Mr. Fong directly that he would go to the IRS ‘‘higher-ups’’ and have the request for the information withdrawn.

The next day, my responsibilities for working with the IRS directly on this issue were taken from me and, within a very short

period of time, I was sent back to Brazil for 3 weeks.

While in Brazil, I copied and collected approximately four boxes

of primary material documents. I returned from Brazil with those

documents. I had them in my office for all of about 4 days, when

Fenwick and West law firm, who had been hired to replace me as

the direct contact with the IRS, came into my office and took everyVerDate 11-MAY-2000 13:56 Mar 23, 2004 Jkt 000000 PO 00000 Frm 00017 Fmt 6633 Sfmt 6633 92279.000 SFINANC2 PsN: SFINANC2
14

thing that I had as far as relevant material documentation and

took it to their office.

I would like to tell you more details about this transaction. However, both Mr. Walsh and myself are in civil litigation on this issue.

We have also proceeded under the Sarbanes-Oxley Act for Federal

remedy. I know the IRS is continuing to investigate the Brazilian

partnership.

Just this morning I received a letter from Levi Strauss counsel

threatening me with my bar license and with future financial problems if I say too much and do not assert a privilege, which I believe

has been waived by their fraudulent activity.

I would stress, though, that for the partnership in Brazil, the

claimed justification for this partnership is, in my opinion, fraudulent.

Let me say one other thing. I have been contacted twice by investigators working for the board of directors of Levi Strauss & Company. In both situations, I cooperated, spoke with them, and told

them as much as I knew about these topics.

I also told them quite directly that I was told to withhold documents and information from the IRS, and that that is, in my opinion, fraudulent.

Yet, in a recent press release from Levi Strauss & Company,

they claim that these investigations found no evidence of fraud.

Now, that astounds me, considering what my experiences were.

With that, I think will pass. Thank you.

The CHAIRMAN. Thank you, Mr. Schmidt.

Now, Mr. Camferdam?

STATEMENT OF HENRY CAMFERDAM, JR., TAX SHELTER

INVESTOR, INDIANAPOLIS, IN

Mr. CAMFERDAM. Thank you, Senator.

I would like to take a few moments to talk about my involvement

with the tax shelter COBRA and my relationship with Ernst &

Young.

Our first contact with Ernst & Young came in 1995 This was 13

years after I started my business, Support Net, and we were a privately-held, $200 million company wholesaling computer hardware.

We were selling in all the States across the United States and we

were having sales tax issues on how to process it.

So one of my partners had a friend at Ernst & Young and we

retained Ernst & Young to help us with our sales tax issues. That

was 1995.

In 1996, our company grew. We needed a chief financial officer.

Ernst & Young recommended a former E&Y employee to be our tax

auditor, or tax CFO, and we hired her. Her name was Carol

Trigilio. Ernst & Young began doing the personal returns for myself and another one of my partners, so we had a relationship built

with them beginning in the mid-1990’s.

Around that time, we decided that, as our company grew, we

needed additional capital or potentially a partner in our business

and we retained Ernst & Young to assist us on that.

In 1997, this resulted in us selling our business to Arrow Electronics out of Melville, New York, a Fortune 500 company. We paid

Ernst & Young a fee of $900,000 to help us do that. The terms of

15

the sale were, we sold half of our business in the fall of 1997 and

we paid capital gains taxes on that sale, with the assistance of

Ernst & Young. They were involved, as I mentioned, with the sale.

They also represented Arrow Electronics.

Then it was a 5-year agreement to buy the rest of the company.

The agreement was accelerated, for various reasons. We sold the

remainder of the company in August of 1999.

Ernst & Young assisted us with that, obviously, and we were

preparing to pay our capital gains taxes in the beginning of 2000.

So, we had a very long relationship and a very trusted relationship

with Ernst & Young.

In late October of 1999, Ernst & Young called and said they had

a tax strategy that could virtually eliminate our capital gains

taxes, and it was called COBRA.

We met with them in early November of 1999 and they gave us

a two-hour presentation on COBRA. We had to sign nondisclosure

agreements and it was a very secretive plan, primarily, as they described it, because they felt they had a real competitive advantage

in developing this plan.

During the meeting it was obvious there was no business purpose for this shelter other than tax reduction. There was no risk

possibility. We were not going to lose our money. Ernst & Young

helped us determine what our loss would be. The fees we paid for that transaction were $3 million to Ernst

& Young and a law firm we had never heard of called Jenkins &

Gilchrist, who wrote an opinion supporting this transaction. We paid another $75,000 to a law firm called Brown & Wood,

which we had never met, and still have not met, for a second opinion on this tax shelter. We ended up paying $3 million to Deutsche

Bank to handle this 30-day options transaction. We paid this

money to save $14 million in taxes.

In September of 2000, IRS issued, as you know, 2000–44. We

were not notified of this by Ernst & Young. In March of 2002,

Ernst & Young sent us a letter suggesting that we might want to

consider amnesty.

When we had conferences with Ernst & Young on our particular

situation, they encouraged us not to come forward because our tax

shelter, in their words, was ‘‘different,’’ and that we were only 9

months away from our 3-year statute of limitations.

In June of 2002, we got a form letter from Ernst & Young saying

they were in the process of turning our names over to the IRS. We

again called and asked what was going on and we asked them not

to do this, obviously. They said they would not until they notified

us. Then in September of 2002, they did turn our names over to

the IRS.

In December of last year, we got audit notification around the

same time we got written notification from Ernst & Young that

they had, in fact, turned our names over to the IRS.

We, shortly after that, filed suit against Ernst & Young, Brown

& Wood, Jenkins & Gilchrist, and Deutsche Bank for various

things, and we have since then cooperated with the IRS fully in

terms of documents. We have had interviews with both the civil

and criminal investigators for the IRS, and we are doing what we

can to help them in this process.

16

I will summarize by saying that Ernst & Young had always been

to us the group of people that would say no. When we did a business transaction and opportunity, if it was not above the letter of

the law or was not clear to us, Ernst & Young always said, no, do

not do it. We had complete faith and trust in what they told us.

When this COBRA transaction came up and we sat in the room

with them listening to it, no one in that room said no. They were

very high on this strategy. They encouraged us to do it, and we did

it.

I thank you, Senator.

The CHAIRMAN. Thank you.

[The prepared statement of Mr. Camferdam appears in the appendix.]

The CHAIRMAN. Now, Mr. Lally.

STATEMENT OF ROBERT V. LALLY, ACCOUNTANT, FEDERMAN,

LALLY & REMIS, LLC, FARMINGTON, CT

Mr. LALLY. Thank you, Mr. Chairman and members of the committee. My name is Robert Lally. I am honored and pleased to be

before you today to talk about a subject which has been my life’s

work and about which I am truly passionate: tax practice. I have

practiced tax and public accounting for 27 years.

I am a CPA and an attorney. My comments will be brief. I hope

to make three observations to your committee. First, tax law must

be the same on Farmington Avenue, our street address, as it is on

Fifth Avenue. Tax law must be perceived to be the same everywhere. It is a Federal system. We all read the same cases, we all

read the same revenue procedures. An answer in Hartford should

be the same as an answer in San Francisco.

It is a self-assessment system. It will not work if clients perceive

that in New York they can get a better answer, or worse yet, a

magical answer. To us in the field, standards of practice must have

some uniformity.

Second, I have seen standards of practice degrade over time. As

a former partner in a Big Four accounting firm, I remember days

when we had very definite notions of what was and what was not

done.

We did not play the audit lottery, although we were certainly

aware of its mathematics of chance. We did not rely on hyper-technical interpretations of the code or regulations, even though we

were very good technicians. We did not take contingent fees.

Finally, we never, in my 16 years of practice with big firms,

structured a transaction around a side agreement, a hidden buysell, or disguised ownership. In my detailed text, I have some observations on, I think, some of the causes of this trend.

Finally, tax practice has changed by the introduction of tax products. A tax product is an idea, or a position, or an integrated shelter which seeks to avoid tax with little or no business purpose. It

is not a structuring of existing client matters to reduce or to defer

tax, but a sojourn into a purely tax-motivated realm.

These products are typified by the following four common features: a confidentiality agreement, because the idea is supposed to

be proprietary; contingent fees based on the tax savings; a technical position that is either based on a hyper-technical reading of

17

the tax law, but which makes little common or economic sense, or

in the alternative, a technical position which is based on all of the

facts not being disclosed, such as a hidden buy-sell; and, finally,

marketing to taxpayers outside of the existing client base.

I have a few suggestions. Regulation. The fact remains that tax

practice is largely unregulated and unlicensed. One needs a license

in Connecticut to cut hair, but not to prepare a tax return for a

fee.

The signature of a CPA or a lawyer qualified to practice in the

tax area—and not all are—should mean something about the technical quality and compliance accuracy of a return.

Only by limiting practice can sanctions against unreasonable

practice have any meaning. Right now, anyone with a pencil and

a photocopier can prepare and sign tax returns.

Enforcement. The IRS audits the same issues time and time

again. Agents often avoid the difficult technical areas. I should perhaps be a little careful what I wish for, because, of course, I spend

most of my life working the other side of the street.

This lack of enforcement encourages complex, hyper-technical positions, secure in the knowledge that no one is going to challenge

them.

In 27 years, I have yet to have an agent raise a LIFO issue, an

accounting methods issue, an inter-company pricing issue. It is always the same: lunches and cars.

Only in arcane specialty areas which have dedicated IRS

groups—for instance, insurance—do we see substantive technical

areas raised.

As a practitioner, the recent IRS efforts at John Doe subpoenas

should be applauded. It sounds like I am giving aid to the enemy,

but I am actually defending thoughtful clients and practitioners.

It is helpful out in the field to be able to say to clients that some

law firm in New York or Washington does not have a magic answer, and that, in fact, far from playing the audit lottery you are

about to play the audit certainty. Even the limited activity in John

Doe subpoenas so far has actually been very sobering out in the

field.

Finally, fees. I do not believe that contingent fees should be permitted in tax practice. The prohibitions in Circular 230 do not appear to be strong enough to stop the practice.

I thank you for this chance to testify.

The CHAIRMAN. Thank you, Mr. Lally.

[The prepared statement of Mr. Lally appears in the appendix.]

The CHAIRMAN. Now we are going to go to a person whose real

name is not Mr. Janet, but we are going to refer to him as Mr.

Janet. He is over here and he is protected, as I said.

I have already introduced you, Mr. Janet, but I do want to take

a second opportunity to thank you for going to this extreme and extraordinary way of giving us very important information for this

committee on writing tax policy.

So would you proceed at this point, Mr. Janet?

18

STATEMENT OF ‘‘MR. JANET,’’ AN ANONYMOUS WITNESS TO

SPEAK ON SILOs AND LILOs AND ABUSES IN THE LEASING

INDUSTRY

Mr. JANET. Good morning, Senators. This morning I will describe

a massive scandal that allowed major U.S. companies to have huge

tax reductions by pretending to lease the infrastructure of foreign

countries such as dams, bridges, and subways, and then pretending

to lease that infrastructure back to that country or municipality

that owned the infrastructure.

This scheme is so pervasive that much of the old and new infrastructure throughout Europe has been leased to, and leased back,

from American corporations. The sole purpose of this scheme is to

generate a tax shelter for U.S. corporations that invest in these

schemes.

These structures are about the greed of senior management of

large U.S. corporations and their financial advisors. The intent is

to steal money, just like a bank robber.

I know first-hand what I am talking about. I am a former leasing

executive with between 10 and 25 years of industry experience. The

best way to explain the scheme is by example of a simple car lease.

Under a normal car lease, you pay a set amount of money each

month and at the end of the lease you either buy the car or give

it back to the leasing company.

In this structure, let us say you are a foreign person who owns

the car. An investment bank comes in and says, I will give you

$1,000 if you agree to sign a stack of documents, and then it is

leased to an American corporation. You will have no continuing financial responsibility or loss exposure.

You will make no lease payments. You will continue to own the

car as you always have. No one can take it from you, and you can

dispose of the car as you please once the lease is over. In effect,

you are still the owner.

We are just going to pay you a fee to sign some papers that back

up our deduction claim to the IRS. What would you say to such an

offer? If you are an American taxpayer you might hesitate, but if

you were a European or foreign person, what risk do you have?

Well, that is the scenario that has played out over the past 10

years on a much larger scale.

The only risk in these transactions is whether the IRS will let

tax that have depreciation deductors of the U.S. investors. All too

often, the IRS will settle rather than risk loss at trial. Even if settlement requires a U.S. investor to disgorge 50 percent of their tax

deductions, they are way ahead of the game by keeping the remaining 50 percent.

What is even more shocking, is that these transactions are arranged by some of the largest, multi-national financial advisors in

Europe and the U.S., and investors include major U.S. money center banks and Fortune 500 companies.

There is one more development you need to know about. I said

earlier that U.S. municipalities have historically been hesitant to

enter into these deals. This is no longer the case.

Faced with local budget deficits, State and local governments are

leasing off infrastructure at a record rate. The subway systems of

19

Boston, Chicago, and Washington, DC have been leased, and leased

back to U.S. corporations.

I have reason to believe that the New York and Chicago water

authorities are about to engage in a scheme to lease the water lines

under their streets. Consider the irony of the situation. Infrastructure is built with taxpayer dollars of working men and women with

taxes and bond funds.

They are then leased, and leased back in phony transactions to

provide tax deductions for the most profitable companies in America. I cannot believe this is what Congress intended in writing its

tax leasing laws.

One final point I want to make. Not all leasing companies participate in this. The leasing industry is represented primarily by

the Equipment Leasing Association here in Washington. Not all of

their members are doing this. It is mostly ones belonging to the

big-ticket leasing group within the ELA.

You will hear a lot of banter about how leasing lowers the cost

of capital, stimulates the economy, and drives economic efficiency.

In fact, allowing this loophole to stay in place reduces U.S. economic stimulus, and this is why. In doing these deals, U.S. lease

companies can shelter income without the risk of having to take

possession of leased equipment or without any credit risk.

So why in the world would they take a risk by leasing to a capital-starved U.S. company? There is no incentive whatsoever to

take that kind of risk, and they get these juicy, risk-free terms by

doing LILOs and SILOs, and they can shelter their income.

Moreover, I fail to see how the U.S. economy is stimulated by

giving U.S. tax deductions for assets built by the French, funded

by the French, and used by the French. I do not see how the economy is stimulated by taking the subways that are built by taxpayer

dollars and allowing corporations deductions for them. These transactions lack canny economic substance or business purpose and

should be shut down.

Thank you for this opportunity. I look forward to your questions.

The CHAIRMAN. Thank you, Mr. Janet.

I am going to start with asking you a series of questions, then

I am going to turn to Senator Baucus.

Let me make sure I get what you are saying right. If a U.S. city

would build a bridge, a subway, or pipes using taxpayers’ dollars

and exempt bond financing, then a U.S. corporation would pretend

to lease the property and will get a tax depreciation deduction,

even though the city still owns the property? Is that what you are

telling us?

Mr. JANET. Yes. Because in most cases, the bonds are issued on

an unsecured basis. So, the ability of the city or State to lease it

does not interfere with their bond issuance.

The CHAIRMAN. All right.

Let us talk about the LILOs. There is a chart behind you that

shows Germany building a subway with German taxes and German laborers. The Germans use the subway. But under the LILO,

a U.S. company gets to depreciate the subway even though they do

not own it.

Mr. JANET. That is correct. Yes, that is what happens.

The CHAIRMAN. All right.

20

You said that most of Europe’s infrastructure has been leased

through these LILOs. Does that mean that the United States taxpayer is subsidizing Europe’s infrastructure costs?

Mr. JANET. Absolutely.

The CHAIRMAN. You said that major banks and corporations are

doing these deals. Could you tell me who they are?

Mr. JANET. I feel uncomfortable using their names, but, yes, I

could tell you between the two of us.

The CHAIRMAN. All right.

Would you explain why you cannot tell us their names?

Mr. JANET. With the deep pockets these companies have, I am

afraid of lawsuits against myself and my family.

The CHAIRMAN. Could you confirm that Washington, DC’s subway system has, in fact, been leased out for corporate tax deductions? Do you know who leased it out and who the investors are?

Mr. JANET. Yes. I believe it has been leased out. Again, for my

concern over litigation with these large firms, I am concerned about

giving you a name.

The CHAIRMAN. You stated that you think our legislation in what

we call the FSC/ETI bill will stop these abuses. Do you think that

it will impair legitimate leasing and harm the economy?

Mr. JANET. It will not impair legitimate leasing. In fact, it will

help legitimate leasing because corporations will have an incentive

to enter into real transactions where they take real credit risks and

real asset risks.

The CHAIRMAN. You said the companies buy assets instead of

leasing them because of low interest rates. What would be the effect of rising interest rates on LILOs and SILOs? Would they go

up?

Mr. JANET. In fact, rising interest rates would have the opposite

impact. You would have a large growth in these transactions. As

interest rates rise, the benefit, the shelter is thrown off and the

timing benefits become more valuable. Therefore, the issuer, the

municipality, would get a larger up-front benefit.

The CHAIRMAN. You said that we should revisit the treatment of

qualified technology equipment. Would you expand on what you

said about that?

Mr. JANET. I am not an expert on QTEs, but my understanding

is they have been used in the same manner a LILOs and SILOs

where the transactions are entered into strictly for the purpose of

shelter with no goal of new equipment financing.

The CHAIRMAN. Is that also the way that the Bank of America

leased and depreciates the Canadian air traffic control system?

Mr. JANET. That is my understanding from the article that is

here as an exhibit.

The CHAIRMAN. Where does the $20 to $30 billion estimate of annual leased assets come from?

Mr. JANET. Based on my previous experience, I have looked at

the transactions in the marketplace over the years. I think that is

a conservative estimate.

The CHAIRMAN. Is there any advice that you could give us to help

the Treasurer attack these deals?

Mr. JANET. I think it is quite simple. The Sarbanes-Oxley Act,

as it came to accounting fraud, put the CEOs and CFOs having to

21

sign their financial statements and tell the shareholders those financial statements were honest and fair.

I think if the same CEOs, CFOs, and board members had to sign

onto their tax returns that the transactions they enter into have

a legitimate economic purpose, not solely in title to avoid paying

tax, that would help solve the problem.

The CHAIRMAN. All right.

The leasing industry is opposed to economic substance codification contained in our tax shelter proposals. Do you think that

LILOs are the reason that they might oppose it?

Mr. JANET. This is the primary reason they oppose it.

The CHAIRMAN. Do you think that leverage leases have economic

substance?

Mr. JANET. Yes, they do.

The CHAIRMAN. Do promoters bribe foreign officials to get these

sorts of deals?

Mr. JANET. I am not sure what you call a trip to an island for

the summer. There is no cash, but what do you call a trip?

The CHAIRMAN. All right.

Let me see. The next person on the list is Senator Bingaman,

since Senator Baucus had to temporarily leave.

Senator BINGAMAN. Thank you very much, Mr. Chairman. Let

me ask Mr. Janet a question on his testimony.

You say that all too often the IRS will settle the case rather than

risk a loss at trial. If I were the head of the IRS, why would I fear

that I would lose this case at trial?

Mr. JANET. These are very difficult transactions for laymen to

understand. They have been structured so it makes it even difficult

for an IRS agent who is not specializing to understand. If you believe that the best and brightest have structured these transactions, do you really believe that an IRS agent who is doing this

part-time is going to keep up with that knowledge?

Senator BINGAMAN. So you are really saying that the IRS is not

properly staffed or trained to prosecute.

Mr. JANET. They are being out-gunned by the best and brightest

in tax shelters.

Senator BINGAMAN. All right. So we need to hire the best and

brightest to work for the IRS to go after these cases. Would that

be a reasonable conclusion or not?

Mr. JANET. Well, I think having the best and brightest would be

important. But having legislation that completely eliminates these

structures would avoid the problem to start with.

Senator BINGAMAN. And you think that the legislation on the

books today does not adequately eliminate the possibility of these

kinds of abuses?

Mr. JANET. The reason I came forth to this committee was the

fact that the Economic Substance Act was pulled out of the last tax

bill. That is when I said it was time for me to stand up.

Senator BINGAMAN. All right.

So you think that, clearly, that piece of the legislation that was

passed out of this committee needs to become law?

Mr. JANET. Yes, sir.

Senator BINGAMAN.

22

Mr. Lally, if I could ask you, if we are able to either legislate,

or by rule, establish that firms that give tax advice and sell these

tax products cannot audit anyone that they have given advice to or

sold a product to, how much of the problem will that fix?

Mr. LALLY. The hard part with limiting tax practice, is that it

is very hard to draw the line between tax advice and tax compliance work preparing the returns in these more sophisticated products. I am a little concerned that if we further constrain the product line of the industry, that the industry itself may be so impaired.

Accounting firms have a lot of trouble now economically with

audit-only services. Typically, the audit is the loser of the practice

economically and they hope to recoup that or to have better economic results through consulting and tax work.

So, again, I think it is a definitional problem of, where would we

draw that line, what is a product and what is legitimate tax planning? If we completely forbid firms from consulting in tax work,

what is going to be left to the industry?

Can the industry really stand on its own if it is an audit-only

practice, and would anybody be willing to pay that much for an

audit? There are a bunch of tough economic questions for the firms,

I think.

Senator BINGAMAN. Clearly, it is appropriate for accounting firms

and tax advisors to engage in tax planning and advice to clients

about how to structure their business so that they do not pay any

more tax than they are required to. So, that is appropriate.

But clearly there is a problem with when you go the next step

and say we, as an accounting firm or a tax advisory firm are going

to develop products which we then will go out and sell, do you

think that there is some way to draw that line or is that a false

or impossible line to draw as well?

Mr. LALLY. I think it is going to be a difficult line. I would not

say that it is impossible because, again, I think there are characteristic features of products that perhaps, again, someone with

careful draftsmanship would delineate.

Some of that is already on the books, again, the economic substance transactions and some of that legislation that is proposed,

and the concept of sham transactions. I mean, again, some of that

already exists and some of it would turn, as the prior witness just

said, on better enforcement and better technical people on the IRS

side.

Senator BINGAMAN. Well, thank you very much, Mr. Chairman.

The CHAIRMAN. Before I go to Senator Bunning, I want to re-ask

you, Mr. Janet, a question that we asked, because Senator Bingaman touched on it, just to emphasize.

I asked you about whether or not our legislation that is in the

FSC/ETI bill would stop these abuses, and at the same time not

impair legitimate leasing. I think your answer to me was that that

would solve the problem and it would not harm legitimate business

activity.

Mr. JANET. That is correct. I want to make sure this committee

understands that, in fact, these transactions are harming legitimate economic activity today.

23

If you are a leasing company and you can enter into a transaction where you take no credit risk, you take no residual risk, the

only thing you are betting on is what settlement you can get with

the IRS, why would you enter into transactions where you have to

make other decisions?

The CHAIRMAN. All right.

Now, Senator Bunning?

Senator BUNNING. Thank you, Mr. Chairman.

I would like to just follow-up on what Senator Bingaman was

talking about. In the 25 years that I was in the investing business,

there were many tax shelters that I saw come and go. The 1986

tax changes really stung the ordinary investor out of the tax sheltering business.

What you have described as a panel is something that has come

after the normal tax shelter that was used for individual investors.

In other words, it was done at the corporate level.

My question to all of you is, does the Sarbanes-Oxley legislation

address the problems that we are faced with currently? Do any of

you care to answer that? In other words, maybe the folks who were

formerly Ernst & Young, or whatever you want to call yourselves.

Mr. HAMERSLEY. Yes. I was actually formerly with Ernst &

Young and then formerly with KPMG, my most recent employer.

Or currently, I guess. I am a little confused on my status as well.

Has Sarbanes-Oxley really hit and prevented the corporate tax

shelters as opposed to the individual tax shelters? Do I understand

that?

Senator BUNNING. Well, it does not seem like we have, according

to our guest behind the screen, addressed the real problem in Sarbanes-Oxley.

Mr. HAMERSLEY. Yes. No, the problems persist. The problem is,

Sarbanes-Oxley has, I think, had an impact. It shifted the cost benefit analysis on the problems with financial accounting, the pure

accounting scandals.

To the extent that corporate tax shelters, and the reason they

are done most of the time, in addition to saving taxes, is the same

incentive that the officers and the management of the company has

with the financial accounting scandals, financial statement improvement strategies, that that tax shelter will improve their financial statement results and, thus, if they hold stock, will improve

their compensation. It is the same kinds of problems.

Senator BUNNING. Mr. Lally, you mentioned the fact of how difficult it might be to draw the line between the auditors and those

that are giving financial advice to different corporations. In other

words, if I am an investment tax advisor and I also audit, or did

audit the same firm, Sarbanes-Oxley has kind of put a damper on

and separated that?

Mr. LALLY. I believe drawing the line around the audit services

is an easy bright line to draw. Again, my concern is if we draw that

line, if we make that line so clear that we do not permit accounting

firms to provide the other services, is it really a viable economic

business where its only product is the audit?

Senator BUNNING. Fine. I understand that part. But are you telling me that we then cannot create a situation where the Big Four,

24

or the Big Six, or whatever is left of the auditing firms must do

tax and financial advising or they cannot be profitable?

Mr. LALLY. Now, let me be open. I am heading in that direction.

It is hard to say for sure.

Senator BUNNING. That is very unfortunate if you are heading in

that direction.

Mr. LALLY. Again, it is only my opinion. But I think if all of the

accounting firms had to solely rise and fall on audit-only practice,

I think they would be very challenged and the prices of audits

would go way up, perhaps to the point where society did not want

to pay for them any more.

Senator BUNNING. Well, if we are going to have an investing public that has any confidence in what is put down on an audited return or audited financial statement, maybe we have to pay up and

make the people that are doing the correct audits accountable for

those audits.

I get the feeling that the board of directors and the audit committee of the board of directors are just not really involved in the

audit of the company at all, and just kind of sign off on what the

public auditors are doing with their firms’ statements. Is that a

consensus out here?

Mr. LALLY. I would not say that. I think, certainly, SarbanesOxley has brought the quality and technical ability of the audit

committee into the forefront. Certainly, we used to see instances

where you have whole audit committees, but, for instance, no CPAs

on them. I would say that is definitely on the wane.

Of course, if you look at the requirements and the SAS rules on

communications between audit committees and the auditor, the responsibilities are actually very specific.

For instance, they are supposed to review all of the major accounting assumptions. They are supposed to review all the past

audit adjustments. I mean, there are very definite rules on that

communication between the audit committee and the outside auditor.

I think a lot of that architecture is in place and I think we probably have fixed much of that. But, as the other gentleman said, I

think we have largely fixed that on the financial accounting side,

but this element of tax practice is still, again, a little bit off to the

side.

Senator BUNNING. This is my last question. What is the matter

with corporations looking at the Tax Code and using the Tax Code

as it is written to advantage that corporation by the Tax Code? In

other words, to save money.

Mr. HAMERSLEY. That’s my point, nothing. They should be doing

that.

Senator BUNNING. And you are saying we do not have enough

laws right now to prevent them from violating, or enough enforcement?

Mr. HAMERSLEY. I am saying, one, that corporations are not satisfied with fitting——

Senator BUNNING. I understand what you said. But why should

I not, as General Motors, or Ford, or whoever I might be, look at

the Tax Code and say, you know, here is a legitimate way we can

save some money, if it is legal?

25

Mr. HAMERSLEY. Right. If you have the transaction that is intended by Congress to receive that favorable benefit, absolutely,

you should. If you do not, you should not be getting the benefit either.

Senator BUNNING. No, you should not be getting the benefit. All

right.

Thank you, Mr. Chairman.

The CHAIRMAN. Thank you. I have some questions, because I

asked all my questions of Mr. Janet.

Several of you have talked about the concealment of facts. It is

more a question of emphasis than it is to bring out new information. But particularly you, Mr. Hamersley. You indicated that these

tax shelters are based not just upon the reading of the law, but on

the distortion or concealment of facts.

I would like your, and others’, view on that, that tax is being

avoided through distortion and concealment and just not some arcane reading of the law.

Mr. HAMERSLEY. Yes. That is the point I was trying to make. I

think you see some of that in the Levi Strauss matter as well, that

these corporations are not satisfied with the benefits that are clearly intended by Congress.

They cannot do the economic transaction they need to get into

that benefit, so you have to lie about the facts and say you did it

to get the benefit. There is often a difference between what you

want and need or can do economically, or from a regulatory perspective, and the transaction you need to have to get the tax benefits.

The CHAIRMAN. Yes. And to all of you, in your opinion, how widespread is the corporate tax shelter problem, and what makes these

tax shelters attractive to public companies? Any of you.

Mr. WALSH. I actually do not think that corporations and accounting firms are afraid of the IRS, so they do not think there is

very much to lose from doing it. The up side is, on the individual

management level, huge bonuses. So, as was stated earlier, they

play the audit lottery.

To the extent that their number does not come up to get audited,

or in the event that it is a large corporation that does get audited,

whether or not the facts are uncovered becomes the issue. They are

just not afraid of the IRS.

Mr. SCHMIDT. In my experience in law firms, accounting firms,

and in corporations, it is widespread.

Mr. HAMERSLEY. I agree. Enron is clearly not isolated either on

the tax shelter side or the non-tax financial statement improvement strategies. On the cost benefit analysis mentioned, that they

do not fear the IRS, they also have mechanisms in place to keep

anyone who knows the real facts from coming forward. I think you

see some of that testified to here today.

The CHAIRMAN. This is probably a question that is difficult to answer, but what is your gut feeling? Is this a case where one of the

Fortune 500’s goes out and says to these accounting firms, we are

paying too many taxes. You have got to find a way that we are not

going to pay taxes.

Or is this where these accounting firms and investment banks,

et cetera, et cetera, are going to one of the big Fortune 500’s or ForVerDate 11-MAY-2000 13:56 Mar 23, 2004 Jkt 000000 PO 00000 Frm 00029 Fmt 6633 Sfmt 6633 92279.000 SFINANC2 PsN: SFINANC2
26

tune 1,000’s and saying, we have got a way here to fix it so you

do not have to pay tax?

Mr. CAMFERDAM. I can tell you, Senator, from my experience,

Ernst & Young came to us. We were fully prepared to pay our 20

percent capital gains taxes on that. One issue is, big, big corporations can afford to have their own tax people to look at the Tax

Code and figure out how things work. But smaller companies like

myself, and my understanding is that a large number of these shelters were sold to small companies, the only advice we have is from

our tax advisors, and in our case it was Ernst & Young.

For us to figure out the Tax Code and the best way to save tax

money is a virtual impossibility. We cannot do it, and cannot afford

it. But they came to us, to answer your question.

The CHAIRMAN. Do you have some evidence then that a Fortune

1,000 company has their own insight, counsel and tax advisors that

are going this far?

Mr. CAMFERDAM. Do I?

The CHAIRMAN. Well, any of you.

Mr. HAMERSLEY. I think they do, but most of these are so sophisticated. When I saw many of the Enron things, you know right off

the bat that they must have had help from an investment banker,

lawyers, accountants. They are too sophisticated.

Mr. SCHMIDT. That being said, however, I think that corporations

who are looking for ways to lower their effective tax rate or boost

their income will go shopping.

The CHAIRMAN. All right.

Now, a question for Mr. Hamersley, and anybody else, for that

matter. I sponsored legislation years ago that brought the False

Claims Act back into a major tool of the Federal Government to

fight fraudulent activity on the use of taxpayers’ money.

In a nutshell, the False Claims Act allows certain individuals to

bring an action in court to recover, on behalf of the government if

the government is not doing it on their own initiative.

If the individual prevails, then they could keep a portion of the

recovery. This law has allowed the government to recover billions

of dollars from fraud in areas such as health care and defense contracting.

The IRS has the authority to similarly reward individuals who

bring to the attention of the government potential tax issues. For

a lot of reasons, this program is not nearly as successful as the

False Claims Act.

My question is, what financial or personal hardship did you face

in coming forward, and do you think that a more vigorous reward

system would encourage others to come forward and talk about

what they know about tax shelters? I would like to start with Mr.

Hamersley, but anybody else that can answer.

Mr. HAMERSLEY. Well, frankly, to whistle-blow, you make the

choice that you are almost certainly going to have to leave the industry. Not only will you, with the Big Four, not work for that firm

any more, you probably will not work for any others because of the

black-balling that goes on in the industry.

My choice was easy. My choice was, participate in what I believed to be a felony, or whistle-blow. In most situations, that is not

the case. It is not that cut-and-dried.

27

The choice you make, you are almost certainly financially ruined.

If there were some mechanism, with obvious concerns for the merit

of the claim, for people, first of all, have the court, their case see

the light of day. There are equal problems of those facts coming to

the court as there are with the tax shelter facts.

But if those can see the light of day, and certainly if you have

the government helping you make that happen in the discovery

process, yes, I think that would increase the incidence of whistle

blowing. People are worried that their families will be jeopardized

by coming forward.

The CHAIRMAN. Any of the rest of you?

Mr. WALSH. I think the decision on whether or not you are going

to whistle blow does not come down the amount of money that you

are going to get out of it. It comes down to the morals that you

have and the ethics. I am unemployed now, I have been for 10

months.

I do not really have a whole lot of prospects for employment, either. But I knew that when I first started this process to raise the

issue and to bring it to light. But it had nothing to do with money,

it had to do with right and wrong and, I guess, defrauding the investors.

Mr. SCHMIDT. In my experience, I think that to encourage whistle blowing and people to come forward, rules similar to the Sarbanes-Oxley rules for attorneys representing for the SEC need to

be in place for tax issues as well.

Those rules do not exist and, therefore, there is a privilege and

confidential issue for attorneys which puts their bar license in jeopardy. But I would concur that my choice was very simple: either

participate in a fraud and potentially go to jail or not participate

and risk termination and financial ruin. By the way, Mr. Walsh

and I are being sued for $10 million each by Levi Strauss & Company for breach of fiduciary duty.

Mr. CAMFERDAM. From my standpoint, Senator, I would just like

to see legislation that would not allow a company like Ernst &

Young to sell these tax products. If they had not walked into our

office with this, we would not have bought it.

From a whistle blower standpoint, my understanding is it is a

fairly complex procedure to go through. The rewards are not very

good, but our life would have been better if Ernst & Young had

never sold us this, or been allowed to sell us this product.

The CHAIRMAN. Robert?

Mr. LALLY. I have to applaud the courage of my panelists. Again,

I am not a whistle blower. It is a remarkable thing to share a panel

with gentlemen who have put so much on the line.

The CHAIRMAN. All right. Senator Bingaman had one question.

All right. Senator Bunning?

Senator BUNNING. Yes. Given the huge financial gains to be

made if illegal shelters are done, not only to those who are selling

them but to the corporations that are using them, what type of

penalties would be enough to deter these type of things being done?

Mr. LALLY. Well, perhaps I will start. As I mentioned in my remarks, the John Doe summons is an amazing thing. Again, it creates the specter that this product that has been sold, the whole list

28

of people who have bought it are now suddenly in trouble because

they bought it.

Again, I think the IRS has actually used the John Doe summons

twice in connection with tax shelters recently. But, again, that is

a considerable and very powerful tool, and as I said, kind of very

helpful out in the field in creating some sanity and a level playing

field between practitioners.

Senator BUNNING. Will you answer my question, though?

Mr. LALLY. I am sorry. I thought I did. I tried.

Senator BUNNING. What type of penalties would be enough to

deter both the corporation and the auditor?

Mr. WALSH. One hundred percent of the gain that they have gotten from it.

Senator BUNNING. Well, that is not enough.

Mr. WALSH. If they saved $10 million in tax, they have to pay

back $10 million.

Senator BUNNING. That could not possibly be enough because

they are going to be liable for that anyway if they lose. So what

is the penalty?

Mr. WALSH. One hundred percent of the tax that they did not

pay. So they would have to pay back the tax. In addition, the penalty would be 100 percent.

Senator BUNNING. Oh, all right. In other words, if it is $10 million, it would be $10 million on top of that.

Mr. SCHMIDT. I think the Internal Revenue Code has very aggressive penalties. They just need to be applied.

Senator BUNNING. Well, if we do not have enough players on the

Internal Revenue side to compete with the players on the other

side, we are not ever going to get a settlement.

Mr. LALLY. I mean, I think the existing fraud penalty is 75 percent, plus all the other ones. I mean, you get to 100 percent pretty

quickly.

Senator BUNNING. All right.

Do you think the law as it is written presently, if enforced properly, has enough penalties in it?

Mr. CAMFERDAM. In my opinion, yes.

Mr. SCHMIDT. Me, too. I think it is enforcement and aggressiveness by the IRS.

Senator BUNNING. All right.

Mr. HAMERSLEY. From a taxpayer’s perspective. From a

promotor’s perspective, if he can shift that liability to the taxpayer

through representations made by the taxpayer and claim——

Senator BUNNING. Well, any signed document that leaves the

person off the hook.

Mr. HAMERSLEY. Yes. Yes. Then the cost benefit analysis is shifted.

Senator BUNNING. Then you had better have good tax lawyers inside rather than just outside. Thank you very much.

The CHAIRMAN. Thank you.

I have no more questions. I should announce to you and the next

panel that sometimes members who are here, as well as, more importantly, members that are not here, submit questions for answer

in writing. If you get questions like that, we would like to have

29

those responded to in about 2 weeks, if you would, please. So, consequently, we will leave the record open.

I would ask the second panel to come. You know who you are.

But while you are coming, I am going to introduce you.

We are going to have the second panel to get their thoughts

about the Federal Government’s ability to crack down on abusive

tax shelters.

First, we hear from Mr. Philip Cook, from the law firm of Alston

& Bird. Mr. Cook represents one of his partners, Neal Batson, who

is a court-appointed examiner in the Enron bankruptcy proceeding.

Then we will hear from Mike Brostek, Director of Strategic

Issues, U.S. General Accounting Office. Then Pamela Olson, Assistant Secretary of Treasury, Tax Policy, followed by Mark Everson,

Commissioner of the Internal Revenue Service.

Then Assistant Attorney General Eileen O’Connor will present

testimony on behalf of the Justice Department’s Tax Division.

Then Mr. William McDonough, chairman of the Public Company

Accounting Oversight Board, which was created by Sarbanes-Oxley.

Then Mr. B. John Williams from the law firm of Shearman and

Sterling. Mr. Williams is a former chief counsel at IRS.

I am going to be able to hear just a little bit of the testimony

of this panel. Senator Bunning has said that he would chair it for

me. I want to explain to you, because you are a very distinguished

group of people and your responses are the other half of this problem that we face.

But I want to explain that I, in the capacity of chairman of this

committee, am leading Senate negotiations on the energy bill finance portion and we are going to meet from 12:00 to 1:00 on that,

continuing a meeting we had last night from 8:00 until 10:15. Then

later on, we have to meet with the Medicare prescription drug

panel. So, that is why I am not going to be able to hear this testimony. But I will very much, obviously, read the testimony and responses to questions.

So, in advance, I am going to give up the chair now to Senator

Bunning and sit here for a few minutes, because I can run over

there and be there by 12:00. But I might as well change places

with Senator Bunning right now. So, I thank Senator Bunning.

Then we are going to start with you, Mr. Cook, and go across

from my left to right.

Senator BUNNING. Go ahead, Mr. Cook.

STATEMENT OF PHILIP COOK, ATTORNEY, ALSTON & BIRD,

ATLANTA, GA

Mr. COOK. Good morning, Senators. My name is Philip Cook. I

am a partner in the law firm of Alston & Bird. As the Chairman

said, my partner, Neal Batson, was appointed by the U.S. Trustee

and approved by the Dr. Bankruptcy Court as examiner in the

Enron bankruptcy proceeding.

Because of the restrictions that we are under in reference to our

investigation for the Bankruptcy Court, I am appearing here under

a subpoena that was worked out with the staff of the committee

and that outlines the areas in which I will testify.

Under the Bankruptcy Court’s order, the examiner was asked to

investigate Enron’s numerous and highly publicized transactions

30

involving special purpose entities, which are sometimes called

SPEs.

Among the scores of SPE transactions investigated by the examiner were 11 transactions consummated within Enron’s corporate

tax department which I will refer to today as the tax transactions.

I led the examiner’s team who investigated the tax transactions.

The examiner’s report shows that Enron’s tax transactions may

have had some characteristics that are somewhat different from

the tax-related transactions entered into by many public companies.

Enron did not need to generate tax deductions on its Federal income tax returns during the years 1996 through 2000 to reduce

any current Federal tax bill. In fact, Enron’s tax returns for those

years showed net operating losses of nearly $5 billion for tax purposes.

Even though Enron was not paying current taxes, it was required to record a tax expense provision in its financial statements

based on its pre-tax book income, or financial accounting income.

The goal of Enron’s tax transactions was to generate future tax

deductions that could be used to reduce current tax expense for

book purposes under the deferred tax accounting rules of FAS–109,

and thereby increase Enron’s book net income. The tax transactions often would not result in tax deductions for Enron until five

or more years following the transaction.

As a general rule, the tax transactions were artificial transactions that had no connection to Enron’s ordinary business activities. Instead, they generally involved the transfer of substantial assets already owned by Enron and intercompany instruments, often

stock or debt of Enron or one of its affiliates, to an SPE for the purpose of generating current financial accounting income from speculative future tax benefits.

Assets or financial instruments created or acquired in one transaction would be reused in later transactions or sold between structures to trigger reporting of financial accounting gain. An SPE entity created for one structure would be reused in a later structure.

The unusual nature of Enron’s tax transactions is illustrated by

the Teresa Transaction. This transaction was designed to engineer

a non-economic increase of more than $1 billion and the tax basis

of Enron’s headquarters office building in Houston, which we refer

to as the Enron North Building.

This was to be accomplished by contributing the Enron North

Building, which was already owned by Enron and subject to existing financing, to a partnership SPE structure that was also receiving investments from the investment bank that promoted the structure to Enron.

The business of the SPE structure was to lease the Enron North

Building to Enron. The only other business activities conducted by

the partnership were releasing certain corporate jets to Enron for

use by Enron executives and purchasing certain stock interests in

various Enron affiliates.

Ultimately, the Enron North Building was to be distributed out

of the partnership and Enron would claim a tax basis step-up in

the building of more than $1 billion.

31

The examiner concluded the transaction had no business purpose

other than to achieve the tax and financial accounting results.

The Teresa Transaction did not generate any current tax deductions for Enron. Instead, the deconsolidation of the Teresa SPE entities from Enron’s consolidated return caused Enron to incur and

pay taxes of approximately $131 million during the period from

1997 through 2001 that it would not have otherwise paid. However,

Enron immediately began recording much greater deferred tax assets related to the expected future basis step-up of the building.

Enron entered into two other tax basis transactions similar to

Teresa. In the Condor Transaction, Enron sought to step up the

basis of a fully depreciated oil and gas storage facility known as

the Bammell facility by approximately $1 billion.

In the Tammy I Transaction, Enron sought to create a non-economic basis step-up in its new headquarters building, the Enron

South Building, which it was then constructing in Houston.

Again, it was contemplated that the basis of the step-up would

exceed $1 billion. These three tax basis step-up transactions were

expected to provide a net income boost to Enron’s financial statements of nearly $1 billion over the life of the three transactions.

The examiner found that there is a significant possibility that

each of these three transactions ran afoul of various Internal Revenue Code anti-abuse rules. The examiner also concluded that the

transactions were accounted for in violation of GAAP.

In terms of the original of the tax transactions, seven of the tax

transactions were presented to Enron by investment banking units

of major banks. The investment banking firms received fees ranging from $6 million to $15 million for advising Enron on the tax

transactions.

Three of the tax transactions were brought to Enron by major

public accounting firms. One transaction was implemented internally by Enron based on the pattern of a prior transaction that it

had implemented on the advice of a public accounting firm.

In order to market the transactions to Enron, the investment

banks found that it was helpful to receive an accounting opinion

known as a SAS 50 opinion, describing the accounting treatment

of hypothetical facts.

The investment banks typically went to Enron’s accountants in

the transactions that were actually done by Enron for such a SAS

50 letter prior to the transactions. Banks also went to tax firms for

‘‘should’’ level tax opinions in relation to the transactions to establish the accounting requirement that the deferred tax assets were

‘‘probable’’ of recognition.

The examiner found that Enron relied upon a smaller group of

law firms to issue the tax opinions and the tax transactions. Several of the firms who gave tax opinions to Enron in the transactions had previously been employed by the investment banking

firm that promoted the transaction to Enron.

Certain firms rotated their engagements, representing Enron in

one transaction and representing the investment banking firm in

the next transaction. In certain instances, Enron paid the tax law

firm fixed fees of as much as $1 million for representing it in a single transaction.

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The examiner’s report in January expresses skepticism with respect to the conclusion reached in the tax opinions that Enron

should prevail in the tax transactions if the tax results were contested by the IRS. Generally, the tax transactions pertained to future tax events that will now never occur because of Enron’s bankruptcy.

In summary, the examiner has concluded in his reports filed to

date that the tax transactions entered into by Enron distorted its

financial statement net income in violation of GAAP.

Enron could not have implemented the tax transactions without

the assistance it received from investment banks, from its accounting firm, and the law firms that issued tax opinions.

Thank you.

[The prepared statement of Mr. Cook appears in the appendix.]

Senator BUNNING. Mr. Brostek?

STATEMENT OF MIKE BROSTEK, DIRECTOR, STRATEGIC

ISSUES, U.S. GENERAL ACCOUNTING OFFICE, WASHINGTON,

DC

Mr. BROSTEK. Good morning. Thank you for inviting me to testify

today on IRS’s efforts to address abusive tax shelters. I will cover

the scope of shelters, IRS’s strategy and enforcement mechanisms

to combat them, and how IRS has allocated resources to address

abusive shelters.

In terms of scope, no entirely reliable measure exists of the extent to which abusive shelters have been used and the amount of

tax losses that have been experienced by the Federal Treasury.

However, IRS and Treasury have been identifying a growing number of transactions that they believe are abusive, as the chart

shows.

This is a chart of the listed transactions that have been discovered by IRS and Treasury over the past several years. You can see

the growing trend line.

Several IRS measures suggest that the tax losses from abusive

shelters have totaled in the tens of billions over about a decade. In

perhaps the most systematic effort to assess the scope of the tax

shelter problem, IRS contracted for a study.

That study reported a lower and an upper bound estimate for

each year’s tax losses between 1993 and 1999. Estimated losses

ranged from a low of about $9 billion in 1993 to a high of about

$18.4 billion in 1999. The average lower amount estimate per year

was about $11.6 billion, and the average upper bound estimate was

around $15 billion.

This study, however, has a number of limitations that cause

GAO, Treasury, and IRS concern. Thus, its results are only broadly

indicative of the scope of shelters during the 1990’s. This study

does not estimate the current losses due to tax shelters.

Regarding IRS’s strategy, IRS has a broad-based strategy that is

comprehensive in the sense of pursuing multiple, simultaneous

means of identifying abusive shelters and resolving them. The

strategy involves a wide variety of IRS offices, as well as Treasury

and the Justice Departments.

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Given the efforts of those using abusive shelters to obscure them

from view, as we heard earlier, IRS and Treasury’s efforts have

stressed disclosure by taxpayers and promoters of the tax shelters.

In part, because these cases can be very time-consuming to investigate, IRS has also used various means to expedite closure of

cases, for example, through settlement initiatives.

These strategies can facilitate case resolutions, but may work

best when a taxpayer sees a record of IRS success against others

before a settlement initiative is undertaken. IRS’s strategy generally does not include performance goals or measures to track its

progress. Officials expect to develop such measures.

Such goals and measures are difficult to establish, given the elusive nature of shelters and IRS’s lack of experience in dealing with

the current varieties that are now being discovered.

In order to pursue abusive shelters, IRS has shifted, and plans

to continue shifting, resources from other enforcement efforts. As

this next graph shows, IRS has shifted substantial numbers of examination personnel into abusive shelter work.

Given relatively fixed enforcement resources, these shifts have

meant that other examination areas have fewer resources. That is,

IRS has reduced staff devoted to examining other taxpayers, including other taxpayers strongly suspected of being non-compliant.

IRS hopes to mitigate the effect of diverting these resources by

making more efficient use of the remaining resources.

Despite shifting substantial resources to deal with abusive shelters, it is by no means clear that IRS will be able to address all

the abusive shelter cases that it is finding.

The uncertainty stems from the lack of experience with these

complex cases that complicates predicting how much time its examiners will need to devote to each case, and from uncertainty about

the future volume of shelter cases IRS will uncover.

Since calendar year 2000, the database of listed and reportable

transactions disclosed by the taxpayers and promoters grew from

about 50 to a total of about 2,800 such transactions now.

The total of all listed and non-listed transactions, including those

identified by IRS without taxpayer disclosure was about 4,900, as

of September 30.

Given that IRS was conducting 98 promoter examinations as of

June of this year, it seems likely that IRS will continue, at least

for the near term, to identify more abusive transactions that will

need to be resolved. Thus, at least for the short term, IRS appears

to continue to face a significant challenge in addressing abusive

shelters.

We encourage IRS to continue its efforts to obtain a better analytic basis for determining the number of resources its needs to address to shelters, while providing sufficient attention to other tax

compliance challenges and to develop goals and measures that it

and Congress can use to gauge IRS’s progress.

That concludes my statement.

Senator BUNNING. Thank you.

[The prepared statement of Mr. Brostek appears in the appendix.]

Senator BUNNING. Ms. Olson?

34

STATEMENT OF HON. PAMELA OLSON, ASSISTANT SECRETARY

FOR TAX POLICY, U.S. DEPARTMENT OF THE TREASURY,

WASHINGTON, DC

Ms. OLSON. Good morning, Senator. Thank you for inviting the

Treasury Department to testify today on the efforts of Treasury

and IRS to stem abusive tax avoidance transactions.

I have to begin by thanking the committee for the leadership you

have shown on this issue. You have kept a focus on the issue and,

in doing so, have lent support to the administration’s efforts to put

words into action.

Without the committee’s unrelenting support for the administration’s actions, the aggressive steps the IRS has taken to clamp

down on the marketing and sale of dubious tax avoidance transactions and devices would have been more difficult.

I also want to thank the committee for your willingness to work

with us as we identify transactions that require a legislative fix

and administrative impediments to effective enforcement of the tax

laws.

We believe the legislation this committee has approved—several

times now, it should be noted—is better legislation for having carefully considered the IRS’s experience in stemming the tide of abusive tax avoidance transactions.

We are well aware of the fact that the committee’s support for

the IRS’s actions is dependent on it acting judiciously, using its resources wisely, and treating taxpayers with respect.

The Treasury Department is committed to continuing to work

with the IRS to ensure the American public has delivered the service, use of resources, and judicious conduct that will continue to

earn this committee’s support.

My written testimony and the testimony of Commissioner

Everson highlight the actions we have taken since March, 2002 to

address abusive tax avoidance transactions and the importance of

the legislative proposals made then that have been passed by this

committee, but not yet enacted into law.

The IRS’s experience since March of 2002 confirms the continuing need for the enactment of that legislation. Let me quickly

review why. The IRS’s compliance efforts indicated the need for

more disclosure. Disclosure brings transactions out of the shadows

and into the sunshine, and sunshine, as we know, is a powerful

disinfectant.

The cultural laxity of the 1990’s, however, left some believing

that burying the transactions where the IRS was unlikely to find

them was acceptable. As a result, we concluded the IRS needed additional tools to increase the likelihood of it discovering the transactions that taxpayers and promoters did not disclose.

In its audits, the IRS found that the web created by Congress to

address tax shelters in the 1980’s might serve as that tool. The

web, however, was full of holes, holes created by a system that was

too complex, holes created by a system with differing rules, holes

created by vagueness, and holes created by the lack of effective

penalties for failing to follow the rules.

Through regulatory action, we have been able to fill some of the

holes that allowed taxpayers to slip through without disclosing. We

35

have expanded the disclosure rules beyond corporations to individuals, partnerships, and trusts.

This serves three purposes. First, it provides for disclosure for a

segment of taxpayers who, the IRS’s audit experience confirmed,

had become active targets of shelter promotions.

Second, it provides for disclosure for types of returns that some

promoters use to further conceal abusive transactions. Third, it increases the likelihood of potentially abusive transactions being disclosed by a participating taxpayer.

On that point, I would note that it takes only one disclosing taxpayer for the IRS to be able to find the promoter of the transaction

and, through the customer list-keeping requirement, any other participating taxpayers. In short, a little bit of disclosure can create

a lot of transparency.

We have also made the rules for tax return disclosure and customer list keeping uniform, simplifying them and eliminating confusion as a reason for non-compliance. That means that if a transaction is required to be disclosed on a return, the promoter will be

required to keep a list of the taxpayers to whom the transaction

is sold, and the IRS will be able to locate other taxpayers more

readily.

Perhaps most important, we have converted the rules into clear,

objective—not subjective—triggers for what must be disclosed to

the IRS. In doing so, we have expanded what must be disclosed to

the IRS beyond what may constitute a problematic transaction.

That may burden some taxpayers with a requirement to make

unnecessary disclosures to the IRS, which is unfortunate. But with

it comes clarity and certainty about what must be disclosed to the

IRS, and we believe that, in the long run, will better serve the tax

system. It may also allow us to more readily identify problems deserving regulatory or statutory correction.

We have also proposed regulations that would increase the cost

of non-disclosure. Some tax advisors told their clients to ignore disclosure requirements because there was no up side to disclosure

and no down side, since the advisor’s opinion would protect them

from any liability for penalties, even where the opinion was based

on the invalidity of a regulation.

The proposed regulations would eliminate a taxpayer’s ability to

rely on an opinion as a defense to a penalty if the taxpayer did not

disclose the transaction, as required by the regulations.

We expect that this regulation, if finalized, will make tax advisors think twice about counseling their clients to lie in the weeds.

But we need the Congress to act to close the web. The information

the IRS gathers now tells us what happened last year.

Acting promptly allows Treasury and IRS to close down a transaction before it becomes a bigger problem. But this is a lot like

navigating a course through your rear-view mirror: so long as the

road does not bend you may stay on it, but if it does you will quickly leave the road.

We need enacted the change to Section 6111 that would conform

the registration rules to the rules for tax return disclosure and customer list keeping. We also need enacted changes to the penalties

to make clear to taxpayers that the Congress is serious about

transparency on the part of taxpayers and promoters.

36

It seems likely that the cultural laxity of the 1990’s has contributed to the problems we have seen. Anecdotal evidence suggests

the IRS’s aggressive enforcement efforts and sunshine have combined to stem the problem, but we do not, in fact, know whether

the problem is abating or whether we are merely at a lull in the

action.

Whatever the case, it is clear that some in the tax professional

community let us down. We are looking for opportunities to engender a return to the best practices that should define the tax profession.

Additional compliance tools are needed, but they are not enough.

In many ways, our actions in the pending legislation are like applying Band-Aids to the problem. As time has passed, we have gotten

better at applying the Band-Aids. Indeed, I believe our actions in

the legislation will be quite effective Band-Aids. But Band-Aids will

not cure the disease.

Moreover, there is no silver bullet, legislative or administrative,

that will rid the system of abusive transactions. To cure the disease, we must devote efforts to rationalizing and simplifying our

tax laws. Making the necessary changes will not be easy, but it is

a task we must begin.

Thank you, again.

[The prepared statement of Ms. Olson appears in the appendix.]

Senator BUNNING. Mr. Everson?

STATEMENT OF HON. MARK EVERSON, COMMISSIONER,

INTERNAL REVENUE SERVICE, WASHINGTON, DC

Mr. EVERSON. Good morning, Senator. I am pleased to be before

the committee today to discuss the IRS’s efforts to curb abusive tax

shelters.

Since becoming Commissioner this past May, I have set three

priorities for the IRS during my 5-year term as Commissioner of

Internal Revenue.

The first, is to continue to improve service to taxpayers, helping

them to understand their tax obligations and facilitating compliance.

The second area of emphasis, is information technology modernization. The third area of focus, a core element of which is the

subject of your hearing today, is to strengthen the integrity of the

Nation’s tax system through enhanced enforcement activities.

I have said, and firmly believe, that service plus enforcement

equals compliance. The IRS must demonstrate and execute a balanced approach if taxpayers are to remain faithful to our system

of self-assessment.

As Senator Grassley said in the March, 2002 hearings on the

subject of corporate tax shelters, ‘‘All taxpayers should be operating

under the same set of rules.’’ Or, as Senator Baucus said in the

same hearing, abusive tax shelters can cause ‘‘serious harm’’ if they

make average taxpayers feel like chumps. I concur with these sentiments and I believe the IRS has made progress in meeting these

concerns. Certainly much, however, remains to be done.

Let me also note that expanding efforts to enforce fair tax compliance among high-income taxpayers and businesses is the first

37

priority of the President’s 2004 budget request for the IRS, which

is currently before the Congress.

The actions taken by the government over the past two years

have established a regulatory scheme which has sent a strong signal of our resolve to choke off these efforts to profit from the complexities of the Tax Code through the creation of products tailored

to generate unwarranted tax benefits.

Improved disclosure, registration, and list maintenance requirements, together with prompt, published guidance, are having, and

will continue to have, a positive effect.

Where necessary, we have relied, and will continue to depend, on

the actions of our colleagues at the Department of Justice to compel production of information which the law requires be shared

with the IRS, and to take other actions against those who choose

not to comply with our regulation.

The IRS is currently pursuing well over 100 promoter investigations, including accounting firms, law firms, and many boutique

promoters. In addition, we have launched thousands of audits of individuals and corporations who have entered into questionable

transactions. Many of these are in their early stages.

Beyond these steps, and in order to build upon the work already

under way, the IRS needs to do the following. We must re-engineer

and improve our enforcement processes, much as we have with our

business processes on the service side of the Agency.

Our audits take too long, as do our criminal investigations. While

much has already been done, we also need to further shorten the

time it takes to identify new abusive transactions and issue appropriate guidance.

We need to appropriately prioritize our enforcement efforts and,

where necessary, augment our resources. Our 2004 operating plan

devotes more resources to the corporate and high-income areas. I

would note that it does so without compromising our service levels.

We need to continue to emphasize and increase our focus on promoters of abusive transactions. We also need to strengthen Circular 230, which sets professional standards, an under-utilized tool

in the battle against the creation of abusive transactions.

Under the able leadership of newly-arrived Deputy Commissioner for Services and Enforcement Mark Matthews, I expect the

Service to make measurable strides during the fiscal year just

started.

Before closing, I do wish to ask for the committee’s help in two

areas. One, the administration’s legislative proposals to address

abusive shelters, and others which this committee has actively supported over the previous year and a half, need to be put in place

in order to strengthen the hand of the IRS.

Two, I also ask that you help us secure the full funding included

in the President’s 2004 budget request for the IRS. Thank you.

[The prepared statement of Mr. Everson appears in the appendix.]

Senator BUNNING. Ms. O’Connor?

38

STATEMENT OF HON. EILEEN O’CONNOR, ASSISTANT ATTORNEY GENERAL, TAX DIVISION, U.S. DEPARTMENT OF JUSTICE, WASHINGTON, DC

Ms. O’CONNOR. Good afternoon, Senator. Thank you so much for

the invitation to be with you here today. Thank you for the work

of the committee to help in the fight against abusive tax shelters.

My over-arching goal as Assistant Attorney General for the Tax

Division of the U.S. Department of Justice is quite simple: to restore respect for the tax laws.

People who comply with the laws and pay the bills of this great

Nation should have the assurance that the government is doing

something about those who are not, whether they are doing it by

simple means or sophisticated means.

Let me begin by a brief description of the work of the Tax Division in tax enforcement generally, and then go specifically to what

I referred to as the information litigation and merits litigation that

we undertake in the Tax Division.

Under the authority of the Attorney General, the Justice Department’s Tax Division is responsible for the conduct of virtually all

litigation involving the Federal tax laws. The only exception is

cases brought in the U.S. Tax Court. IRS attorneys handle those.

The Tax Division of the U.S. Department of Justice is responsible

for all other litigation, trial and appellate, in any other court,

Bankruptcy Court, Court of Federal Claims, U.S. District Courts,

and U.S. Courts of Appeals. This is affirmative litigation or defensive litigation. Our work in the Tax Division includes appeals from

decisions of the United States Tax Court.

We defend Federal tax claims in bankruptcy, we defend IRS

agents in suits brought against them for actions they took in the

performance of their duties. We bring legal actions to collect taxes

due. We bring injunction suits to stop illegal activities before they

can do further harm to the Treasury.

The Tax Division also assists the Solicitor General of the United

States in Supreme Court cases that involve or affect the administration or enforcement of Federal tax laws, whether or not they actually involve a provision of Title 26.

To promote nationwide consistency and criminal enforcement of

the tax laws, Tax Division authorization is required before the Department of Justice investigates or prosecutes a tax charge. We delegate authority to U.S. attorneys to handle most grand jury investigations and criminal tax prosecutions, with Tax Division prosecutors often supervising or assisting.

Tax Division prosecutors also personally litigate a small proportion of tax prosecutions. At any given time, we have about 7,000

civil cases in progress, and about 700 cases before the U.S. Courts

of Appeals.

This past fiscal year, we authorized prosecution of more than

1,100 defendants. This was an increase of 17 percent over the prior

year, which in itself was an increase of 16 percent over the year

before that. To accomplish all this, the Tax Division employs about

550 people, about 350 of whom are attorneys.

Of all the Tax Division activities, the most relevant to the subject

of today’s hearing are these. We help the IRS obtain information

that it needs to accomplish its examination function by obtaining

39

judicial enforcement of administrative summonses, or obtaining

leave of the court for the Internal Revenue Service to serve a John

Doe summons. We defend the United States in refund suits, tax

claims, and in bankruptcy.

The comments that follow address these two areas of endeavor.

Abusive tax shelter cases, as the testimony of the prior panel illustrates, involve both corporations and individuals.

A coordinated and effective effort is essential to prevent substantial losses of revenue to the Federal FSC and to deter other taxpayers from using such shelters in the future.

The Tax Division coordinates very closely at every level within

the Tax Division and at every operational and leadership level with

the Internal Revenue Service and IRS Chief Counsel’s Office.

We, within the Department of Justice, have a summons enforcement team which is engaged in the summons enforcement activity

I just mentioned. We also have a tax shelter litigation coordinator

who is making sure that the nearly 60 attorneys we have in the

Tax Division devoted to the litigation of merits of tax shelters are

working together and marshalling our resources effectively so that

we win these cases.

The Tax Division has brought summons enforcement actions

against some of the Nation’s largest accounting firms. The District

Courts have enforced orders against BDO Seidman and Arthur Andersen, requiring those entities to turn documents over to the Internal Revenue Service so the Internal Revenue Service could analyze the liability of those firms for promoter penalties, and could

commence, where appropriate, examinations of the individuals who

engaged in the shelters.

Although we have obtained these court orders, the privileged

issues are still being litigated. Mr. Camferdam, earlier, alluded to

the fact that Ernst & Young first told him not to cooperate in the

voluntary disclosure program, and then told him they were about

to turn over their names.

After Ernst & Young agreed to turn over the names, several

John Does sued Ernst & Young to prevent just that from happening. So, our victories in the courts are step-by-step, one-by-one.

On the substantive litigation, the Tax Court also plays an important role there because, as I mentioned, unless a case is brought

in the U.S. Tax Court, the Tax Division attorneys are going to handle it.

We have had a number of substantive successes on the merits of

tax shelter litigation, but there is still very much to do. We presently have in-house about 27 cases in various stages of litigation.

The Tax Division is fully committed to restoring and maintaining

the integrity of the Federal tax system. This means succeeding in

our summons enforcement litigation and in our tax shelter litigation. We have made progress, but considerable challenges remain.

The IRS has made shutting down abusive tax shelters one of its

major strategic initiatives. The IRS cannot do it alone. The Tax Division itself cannot initiate the necessary actions.

Through legal necessity and shared commitment, the Tax Division and the IRS are partners in these efforts. We are very pleased

at the committee’s interest in this issue, and for your support of

the administration’s efforts to shut down abusive tax shelters.

40

Thank you, again.

[The prepared statement of Ms. O’Connor appears in the appendix.]

Senator BUNNING. Mr. McDonough?

STATEMENT OF WILLIAM J. McDONOUGH, CHAIRMAN, PUBLIC

COMPANY ACCOUNTING OVERSIGHT BOARD, WASHINGTON,

DC

Mr. MCDONOUGH. Thank you, Senator. I am pleased to appear

before you today on behalf of the Public Company Accounting Oversight Board.

I would like to begin by commending the committee’s thoughtful

and deliberative review of the Enron debacle. Your work helped expose Enron’s abusive tax shelters and misuse of executive compensation arrangements.

Indeed, the evidence accumulated by this committee and the

Joint Committee on Taxation has served as a wake-up call that we

all, whether corporate leader, legislator, or regulator, must heed.

The financial scandals at Enron, Adelphia, WorldCom, Health

South, and elsewhere left the impression that public company financial reporting is not to be trusted and that professional advisors, including investment bankers, lawyers, and even a company’s

accountants will help unscrupulous executives cook the books.

Congress responded to that breach of trust by enacting the Sarbanes-Oxley of 2002. The act established the PCAOB and charged

it with overseeing the audit of public companies that are subject to

the securities laws and related matters in order to protect the interests of investors, and further the public interest, in the preparation of informative, accurate, and independent audit reports.

To carry out this charge, the act gives the board significant powers in relation to the audits of public companies, including to register public accounting firms that audit public companies, to inspect the audits and quality control of such firms, to conduct investigations in disciplinary proceedings concerning such firms’ audits,

and to establish auditing quality control ethics, independence, and

other standards relating to the preparation of audit reports for

issuers. Our job, in short, is to oversee the auditing of public companies’ financial statements.

The PCAOB will have a variety of tools that may help address

problems caused by at least those abusive tax shelters that are designed to make financial statements look better.

First, as part of the board’s inspections of registered firms’ audits

of public companies’ financial statements, we will identify and examine how firms audit questionable tax-oriented transactions. We

will also look for auditors’ involvement in structuring such transactions.

Now, because we are only beginning our inspections program we

cannot, today, assess the current extent of promotion and use of

corporate tax shelters and products. We will, however, scrutinize

the accounting and presentation of the transactions that we discover through our inspections program, including specifically

through our reviews of selected audit engagements.

In addition, by looking at auditor compensation, promotion and

retention, our inspections will identify a firm’s policies and pracVerDate 11-MAY-2000 13:56 Mar 23, 2004 Jkt 000000 PO 00000 Frm 00044 Fmt 6633 Sfmt 6633 92279.000 SFINANC2 PsN: SFINANC2
41

tices that create incentives for firm audit personnel to promote

such transactions to their clients.

Therefore, while existing laws and regulations may not ban auditors from promoting and giving tax opinions on such transactions,

at least to their audit clients, both auditors and companies should

expect heightened scrutiny of such transactions.

The prospect of that scrutiny may give pause to corporate management, audit committees, and auditors that may consider such

transactions. Indeed, some accounting firms have already announced that they will no longer promote or give tax opinions on

certain types of structured transactions to their audit clients.

Second, through our authority to discipline registered firms and

associated persons, we may impose stiff penalties for failing to adequately and impartially audit such transactions undertaken by

public companies. Those penalties may include revocation of a

firm’s registration and banning individual accountants from working on audits of public companies.

Finally, the board has the authority to commence a standard setting project to address at least a part of the problem. Specifically,

the board has authority to add to the statutory list of non-audit

services that a registered firm may not provide to audit clients.

Such regulation, of course, would not prohibit a registered firm

from selling tax shelters to non-audit clients. That is outside our

purview under the statute.

The board also has the authority to develop and impose additional auditing procedures. While ferreting out tax avoidance is not

directly within our purview, auditors ought to follow appropriate

standards for identifying and auditing transactions whose main

purpose is to make financial statements look rosier.

Congress gave the PCAOB the responsibility and the tools to

build a new future for auditing through independent standard setting, registration, inspection, investigations, and discipline.

My fellow board members and I look forward to a long and constructive relationship with this committee, Senator. Thank you.

Senator BUNNING. Thank you.

[The prepared statement of Mr. McDonough appears in the appendix.]

Senator BUNNING. Mr. Williams, please?

STATEMENT OF HON. B. JOHN WILLIAMS, SHEARMAN AND

STERLING, LLP, WASHINGTON, DC

Mr. WILLIAMS. Senator Bunning, it is a special privilege for me

to appear here with you presiding. I wanted you to know that I was

an undying fan of the 1964 Phillies. [Laughter.]

Senator BUNNING. So was I!

Mr. WILLIAMS. And Chris Short.

I would ask you to convey my thanks to the Chairman and Senator Baucus for inviting me to testify today on the subject of the

government’s efforts to curtail abusive tax avoidance transactions.

This is the third occasion on which I have had the privilege of

testifying on this subject before this committee. There are two necessary and sufficient parts to interdicting abusive tax avoidance

transactions. One, legislation that creates a disclosure regime, supVerDate 11-MAY-2000 13:56 Mar 23, 2004 Jkt 000000 PO 00000 Frm 00045 Fmt 6633 Sfmt 6633 92279.000 SFINANC2 PsN: SFINANC2
42

ported by strong penalties. Two, tax administration that pursues

promoter audits and income tax examinations strategically.

The committee should be commended for its work on both parts

of the solution. On the first part, the committee has marked proposed legislation that adopts an effective information reporting requirement, supported by strong penalties, and significant penalties

for taxpayers who fail to disclose reportable transactions and for

promoters who fail to maintain lists of investors, and limits the applicability of Code Section 7525, the Tax Practitioners Privilege.

The new information reporting and disclosure requirements

would permit the Service to connect either the investor to the promoter, and thus to all other investors, or the transaction to the investor. This web of information should enable the Service to regain

credibility that the Service will knock on the door of the taxpayer.

On the second part, the committee enabled Commissioner

Rossotti to redesign the administrative apparatus of the Service in

a way that permits it to act strategically on a national basis in a

way that the old organizational structure never could have.

This strategic use of audit resources, however, requires, one, a

new flexibility at the Service, and two, a willingness to reassure

taxpayers that the Service is not engaged in chest thumping.

Additional flexibility is needed in both promoter examinations

and in follow-up ordinary income tax audits in three important respects: one, in organizing agents to pursue an audit; two, in encouraging examination teams to seek counsel’s advice earlier and

more frequently; and three, in giving the team time to develop the

issues. The foundation for the Service’s success is to proceed analytically rather than emotively.

In describing tax avoidance transactions, the term ‘‘abusive’’ reflects the indignation that the Service feels. But the Service’s feelings about a transaction do not state a legal basis for determining

a deficiency. Abusive is not analytical term, it is an emotive term.

The mission of the Service is to apply the tax law fairly and impartially. I believe the Service has an institutional tendency to

apply the law in a manner that is biased toward a result the government wants, based upon their feelings about the transaction.

In this connection, the institution does not need to be reminded

that it is an enforcement agency. Instead, the Service needs to be

encouraged to use its enforcement tools in a way that helps taxpayers comply with the law.

Taxpayer service is far more than processing returns quickly or

answering phone calls pleasantly and accurately. It is the bedrock

attitude that the Service should bring to its dealings with taxpayers.

In this respect, as Commissioner Everson just testified, there

need to be no pendulum swings between taxpayer service and enforcement.

Taxpayers who do not pay the tax that the government says they

owe are not always wrong. Indeed, on occasion the Service has had

legal fees imposed on it for taking unreasonable positions.

More to the point, however, is that the complexity and intricacy

of the tax law is often murky or uncertain. And even if not unreasonable, the government’s position may not be right.

43

The Service does not always determine a correct deficiency. The

deficiencies, as determined by examining agents, may be used to

measure compliance, but they are not a fair yardstick.

I would caution the committee against proceeding with strict liability penalties. First, with regard to disclosure, the size and complexity of many businesses and the returns they file will inevitably

result in missed items. In my view, the disclosure regimes need

some tolerance for inadvertent mistakes.

Second, strict liability penalties tend to suffer one of two extremes in tax administration. Either they are employed too sparingly because they are viewed as too draconian, or they are used

as threats to force resolutions that are not appropriate. Neither

should be acceptable to sound tax administration.

In particular, the special penalty for engaging in a transaction

that lacks economic substance, in my opinion, is fraught with potential arbitrariness.

The proposed changes in penalties, both regarding disclosure and

Code Section 6662 penalties, require personal involvement of the

Commissioner in those limited circumstances in which a penalty

can be rescinded. I think it is a mistake to require involvement of

the Commissioner personally in any case.

While the Service still has much work to do, the shelter problem

is manageable with strategic use of resources and a disclosure regime in place. The Service must, however, demonstrate a continued

respect for taxpayers who disagree with it, or place at risk its

credibility with the American public as a fair and impartial tax collector.

Thank you again for the invitation to speak today. I will gladly

answer any questions the committee might have.

[The prepared statement of Mr. Williams appears in the appendix.]

Senator BUNNING. Thank you all for your testimony. If, after my

first round, we do not get all the questions in, I would like to have

the staff submit written questions to each and every one that we

do not get in.

So, we are going to start out with Mr. Everson. How do the complex relationships among investment advisors, accountants, lawyers, brokers, and clients complicate your efforts to identify and

take action against the abusive transactions? What will you do to

address this problem?

Mr. EVERSON. I have a chart, Senator, if I may show it to you.

What this depicts is a network of reinforcing commercial relationships amongst investment advisors, CPA firms and law firms, with

execution activities by brokers.

Together, what these entities do is create a market and execute

abusive shelters. The letters across the top of this chart indicate

the players in one shelter, something called Son of Boss, which

helps to create a different basis for the taxpayer which comes

through three different vehicles which are depicted at the top.

The As, Bs, and Cs here are the names of law firms or accounting firms that you and others will recognize. What it shows, is all

the interrelationships in terms of the creation, marketing, and executing of this particular transaction, which is one that the TreasVerDate 11-MAY-2000 13:56 Mar 23, 2004 Jkt 000000 PO 00000 Frm 00047 Fmt 6633 Sfmt 6633 92279.000 SFINANC2 PsN: SFINANC2
44

ury Department and the IRS have listed as one requiring disclosure. It is one of the 27 where we have serious questions.

The links at the bottom. This shows that these players are actually working on five other products, five other kinds of transactions. The point of showing this gets to what has already been

commented on today.

In order for us to address this transaction or others, we need to

have the information about what the transaction is. That is what

makes it so important for the committee and the Congress to pass

into law the proposals that require stiffer penalties for these very

entities to register these transactions and to provide lists to us of

who is participating in these transactions.

Unraveling the shelters can only be done effectively if we know

about player E, or player D, or player C. Unfortunately, some of

these entities have demonstrated a tendency in some instances to

make business decisions about whether they would give the information to the IRS based on inadequate penalty structures.

Senator BUNNING. Thank you very much. It seems to me, in looking at the chart, that the bottom line, ‘‘Other Shelter Products,’’

seems to be, if you do not catch the original Son of Boss promoter

relationships, that there are at least 10 to 15 others that are about

to begin, or have begun.

Mr. EVERSON. That is a fair observation. One of the problems

here is that, as Secretary Olson was indicating, we are looking in

the rear-view mirror here. We need to get on these things as the

products are created and developed, because everybody is trying to

stay one step ahead of the IRS.

Senator BUNNING. Mr. Brostek and Mr. Everson, as we learned

so often with Enron, you need to pay attention to what is in the

footnotes and in the appendix. That is certainly the case with the

GAO report today. The appendix has some very disturbing numbers regarding Schedule K1 and compliance.

The report states the preliminary profiling efforts identify over 227,000 business entities with almost $64 billion in Schedule K1

income for tax year 2000 that potentially did not file tax returns.

I would like your response to this in more detail, and your views

on the matter, Mr. Everson. Well, let me get Mr. Brostek, first.

Mr. EVERSON. Sure.

Mr. BROSTEK. This is coming out of IRS’s effort that was begun

2 years ago to reinstitute a process of matching the K1 information

document that is generated by a partnership or other flow-through

entity to the recipients of that income to see whether the individuals are claiming the income on their tax return.

This is fairly preliminary information. This is the first time IRS

has done this in a fair amount of time. But, as indicated, there is

a fairly substantial amount of money involved and a fairly substantial number of individuals that IRS has preliminary reason to believe did not file a tax return, and they identified that through this

matching process.

Senator BUNNING. Two hundred and twenty-seven thousand, and over $64 billion?

Mr. BROSTEK. Correct. And there may be some shrinkage in that

as IRS gets behind those numbers and tries to understand what

really happened.

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Senator BUNNING. Mr. Everson?

Mr. EVERSON. The amount of monies that pass through to individual returns that should be depicted or are depicted on these K1s

are actually, in total, over $1.2 trillion a year.

Our indications are that, for the average taxpayer who has an in- come of $1 million or more, they actually have 10 to 15 of these

pass-through entities that are associated with their return.

What we have started to do, is to compile this information. It

was not compiled until 2001 for the 2000 returns. Before that, it

would only be looked at if we selected an individual for an audit.

So what we have started to do in the last 2 years, is to enter that

information into the system so that we will be able to better match

the transactions to the individual.

Because what is happening here in some instances—and I would

stress, in some—is that through additional layers of transactions

and complexity, individuals can make it harder for the IRS to see

the substance of what is going on in their return.

Senator BUNNING. Mr. Cook, what role did Enron’s management

and compensation incentive pay cause in Enron’s decisions to enter

into the tax transactions that they entered into, or at least in your

opinion?

Mr. COOK. Well, our reports filed to date show that management

gave strong incentive to the tax department to originate these

transactions. They developed a special unit within the tax department.

The vice president who headed that unit really had significantly

higher bonuses than the bonuses received by his contemporaries,

indeed, higher bonuses even than the head of the whole department. So, it was clearly a situation where Enron placed a lot of emphasis on obtaining these results and paid its people accordingly.

Senator BUNNING. Well, tell me this, because it has always intrigued me that the tax department would come up with these

schemes. But there had to be direct contact with a broker/dealer

and a financial institution to make these phantom things work. Did

you find that?

Mr. COOK. Well, we did find that most of the ideas were brought

to Enron from an outside party. Often it was the investment banking unit of a major bank. We did find that those outside parties

would frequently employ accountants and lawyers to develop the

structures.

Our report showed that there is evidence that when the investment bank brought the structure to Enron, the tax advisors that

had helped develop the structure were present at those meetings.

Our reports show that, on occasion, those tax advisors were ultimately hired by Enron to give the tax opinions and to implement

the structure. So, there is the web that really is reflected in that

chart very much in play, reflected in the reports we filed to date.

Senator BUNNING. Any one of the three, or all three can answer

this, Mr. Everson, Mr. Williams, or Ms. Olson. I asked the earlier

panel whether current penalties are sufficient to police the shelters

and the tax promoters. What are your views, particularly Mr.

Everson and Ms. Olson?

Ms. OLSON. I will go first and let the Commissioner add to my

statement. We proposed, in March of 2002, increases to penalties

46

for promoters. There were two kinds of penalties, one that would

increase the penalty for failing to register transactions, and included in that penalty is the fact that we need greater clarity and

an expansion of what is required to be registered, and then in addition a time-sensitive penalty for failure on the part of the promoter

to turn customer lists over to the IRS.

Recognizing that statutes of limitation can continue to run while

the IRS does its investigation, it is really very important that the

IRS get its information on a timely basis. So, those are two penalty

changes that we think should be made.

We also proposed, on the taxpayer, a penalty for failing to disclose abusive tax avoidance transactions on their returns. So, it

would be just a flat penalty for any failure to disclose.

We also proposed an increase in the under-statement penalty

that would apply to a taxpayer if the penalty otherwise applied and

they had not disclosed on a return.

That is all reflected in the legislation that has been approved by

this committee in the past, and we very much appreciate the opportunities we have had to work with the committee staff on that.

Senator BUNNING. Mr. Everson?

Mr. EVERSON. I very much agree with what Secretary Olson just

indicated, and support what the committee has already been trying

to do over the last year and a half in this regard.

As to the promoters, as I indicated a moment ago, it is very unfortunate. There was an erosion of standards in the professional

community, in some instances, in recent years. They have not

sought to comply with the law. Therefore, it is clear that penalties

need to be increased so that they have a respect for the consequences if they do not comply by their own design.

Senator BUNNING. I have another question for you, Mr. Everson,

and for anybody else who wishes to comment. As you well know,

the IRS already audits every major corporation.

The problem, as we have heard today, is even though the IRS audits, it always is the same song: travel records, cars, luncheons,

things that are not really at the heart of what we are looking at.

In sum, the IRS spends too much effort on the low-hanging,

small-dollar fruit. What is the IRS doing to ensure that existing

audits’ efforts are better focused and targeted for going where the

big money is, such as tax shelters and more substantive tax issues?

Mr. EVERSON. Senator, I think that we can, and do need to do

more to have our audits be risk assessed. We need to follow the

kinds of transactions where the Treasury Department and ourselves have indicated there is higher risk for noncompliance. I

think we have been moving in that direction.

I am disturbed to hear that there is a feeling that we are looking

more at travel and entertainment expenses in these big companies

than the inter-company pricing transactions, and leasing, and some

of the other matters that have already been discussed before this

panel. There is a constant effort to improve our procedures here.

Debra Nolan is behind me. She is the Commissioner of the Large

and Mid-Sized Business Division. We have a number of programs

where we have limited issue focused examinations where we are

looking at areas of mutual concern. We are doing pre-filing agreements where we have companies come before us with transactions

47

that are potentially significant. But this is subject to an ongoing set

of changes.

The only additional comment I would make, is that I have asked

Commissioner Nolan and others to try to bring these audits to conclusion sooner. Several comments have been made today about

things being open for long periods of time. I think that this contributes to the efforts on the part of some that they can count on the

fact that it will take us a long time to discover potential problems.

Your observation earlier about these other products at the bottom of the chart, well, they can be on to something else by the time

we finally catch up with them. So, one thing we are definitely trying to do, is reduce the time that some of these audit issues are

open.

Senator BUNNING. Well, if the registration is required on shelters, that would surely help.

Mr. EVERSON. Absolutely, sir. That is very much the intent of everything that the Treasury Department and the IRS are doing together. As we identify these transactions, it is not just a question

of registering certain of the transactions we have already identified.

There are criteria that are delineated as to other kinds of transactions or benefit that is provided, or confidentiality. If they follow

those guidelines, then we will know where to look.

Senator BUNNING. Mr. McDonough, your written testimony indicates that your board will focus, in its inspections, on partner compensation and promotion. Could you expound on this? How will you

examine these issues? How do you expect your findings will impact

the firms you are overseeing?

Mr. MCDONOUGH. Senator, the approach that we are taking with

the accounting profession is that they have a great deal of work to

do to restore the confidence of the American people in their profession.

I believe that they are fully aware that that is exactly what we

have in mind, and it is their responsibility, to put it in Biblical

terms, to save themselves. If they do not save themselves, we will

make sure that they get saved and the approach will not be a

pleasant one.

Why are we looking at compensation? If the people at the top of

the firm are saying, terrific, we are going to restore the confidence

of the American people, we are going to do great audits, but in fact

they are paying the super salesman partner three times what they

are paying the very good audit partner, then I am not believing it.

So, we will look into the economic reality of how they are running the firm, and I think there is no better indicator of that than

relative compensation. If we think that the relative compensation

is not what it ought to be, we will sit down with the head of the

firm and have some very frank discussions about changing the approach.

It is an interesting business we are in. We have a very limited

scope. We have just got the area of the part of an accounting firm

that does the audit of public companies. That is a chunk of the

firm, but there is a fair bit left.

On the other hand, our approach to the firm is, we are your spiritual guide and we are going to help you turn the firm around. This

48

is a particular area where I am not sure that they thought that we

would look, but we will.

We are. We are conducting inspections, rather thorough inspections of the four big firms right now, and we will wrap up that

work about the end of November. Among the very important things

we are looking at is the economic reality within the firm, whether

they are behaving in the way that they are saying they are behaving.

Senator BUNNING. One more question. I appreciate your testimony and willingness to take the lead in the difficult process for

restoring the faith of the public in the accounting industry.

In your testimony, you indicate that the PCAOB plans to examine how a firm audits questionable tax transactions and any involvement the auditors may have in structuring such transactions.

As a member of this committee, I am interested to know whether

the board plans to hire personnel with tax expertise to assist in

this important function, which crosses both the financial accounting and tax law disciplines?

Mr. MCDONOUGH. The way, Senator, that we will see if something is going wrong, is especially when we get into the inspection

of particular engagements. We will be looking very closely at the

work papers.

Part of the work papers will have to do with the relationship between the tax books and the public books. There should be a discussion in there of the appropriateness of the size of the reserves,

and so on.

We think that there will be a fair likelihood that we could spot

in there, if the audit partners, the audit people involved, thought

that one of the transactions was a bit smelly.

That is not certain that it will be the case, but that will give us

an opportunity. Once we get into an investigation, that we really

think there is something we need to delve into even more fully

than these very thorough inspections, then we can get even deeper

in. If we see something that ought to be turned over to the IRS or

the Justice Department, we will do so.

You have got a tremendous demand these days by the people on

this panel for tax experts. We are a start-up situation. Frankly, I

think I would like to leave the tax expertise to the Treasury, the

Justice Department, and the IRS rather than be out competing

with them in hiring tax experts when, as a 69-year-old head of a

start-up, I have an immense amount of work to do to do all the

other stuff that we are responsible for.

I think we will try to help all we can in this tax shelter area,

because I find it morally, immensely repugnant. But I think that

the lead will have to come from our brethren at the table here.

Senator BUNNING. All right. This will be my last question. I want

Ms. O’Connor, Mr. Williams, and Ms. Olson to get into this. This

question is for Ms. O’Connor, but I would appreciate all others providing input.

Ms. O’Connor, the committee has heard concerns that Justice

will at times disregard tax policy and tax administration in making

arguments before a court. My understanding is that this will go as

far as Justice stating that they are not bound by public’s positions

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of the IRS. This is very troubling and I would appreciate hearing

from you.

Ms. O’CONNOR. Thank you for your question, Senator. It is one

I am hearing for the first time, right now, though, so it is coming

as a surprise to me that you hear complaints like that.

The Tax Division does not make tax policy. We are, however,

part of the Justice Department and in that capacity we are able to

see how tax law is a part of law. When we are arguing cases before

courts we must make sure that the government, not just in the tax

law area, is making consistent arguments.

Having said that, though, while the Attorney General does have

the authority for all litigation in all U.S. courts except for the Tax

Court, it is our firm belief that the Internal Revenue Service and

the Treasury are our clients, that Treasury is responsible for tax

policy.

Unless there is some really pressing reason not to, and this

would be resolved at the highest levels, our litigating position

would be consistent with what the IRS hopes that it would be.

Now, there are times when we are already litigating a certain

case and the IRS might wish that it had taken a different litigating

posture earlier. Having already made representations before the

courts, we cannot then go in the next day and make a different one.

But I would be happy, if you would be interested in giving me

any particulars at a time when I am able to reflect on them, to give

you a more thoughtful response.

Senator BUNNING. Ms. Olson?

Ms. OLSON. I guess one of the things that has become very clear

to me over the course of the last two and a half years, is that relying on the courts to make policy or decide tough issues is a very

hazardous way to go.

That is one of the reasons why we have been very aggressive,

over the course of the last two and a half years in our published

guidance process, to do everything that we can to resolve issues

through the published guidance process.

One area where that has proven particularly true, is an effort to

determine what expenses in the creation of intangible assets

should be capitalized. The IRS, instead of publishing guidance,

began litigating some cases and won the first few cases in the Tax

Court. Ultimately, many of those decisions were reversed by the

appellate court.

In the process, we have a mass of inconsistent rules depending

on particular factual situations, particular circuits, and very little

clarity for either taxpayers or IRS agents in determining what the

rules are.

So what we have determined to do, is to try to identify what

those kinds of issues are that really are in need of published guidance where we can provide a consistent answer for taxpayers

across the board.

We really think that is the right way to go, and we have worked

with the Justice Department on some of those issues where there

have been issues that have already been in litigation to make sure

that we have the opportunity to do published guidance so that we

do get consistent responses for taxpayers and we do have clear

guidance for agents about what the rules are.

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Senator BUNNING. Mr. Williams?

Mr. WILLIAMS. Senator, I think one of the things I always tried

to articulate when I was Chief Counsel, was that litigation does not

drive tax policy, tax policy drives litigation. That is to say, litigation must yield to a determination of what the proper rules should

be administratively.

The reason for that, is because in administering the tax system

we have a nationwide responsibility. We want to make sure that

taxpayers all across the country are subject to the same rules.

To the extent that you take positions in cases that differ from

that, even if it may win a particular case, it will lead ultimately

to a wrinkle at best in administering the system, because if you

win the case but it is on the basis of a rule or an articulation of

a rule that is different than tax policy promulgated in regulations

or rulings, then you will have some taxpayers living under different

rules and that is not healthy for the system.

So, I think, to the extent that the Justice Department can reflect

the positions of the Treasury Department in moving forward,

whether it is in shelter or more general tax litigation, I think the

system is better off.

Senator BUNNING. It has come to my attention though that there

are certain individuals and certain corporations that would choose

a specific place to have a court hear their case rather than another

court because the rulings out of a tax court in Cincinnati, or Cleveland, or Los Angeles might be different and be more favorable to

the taxpayer than they would in some other areas. I say that only

because of experience with the courts.

Mr. WILLIAMS. There is no question, Senator, that that happens.

That is a function of two things. One, is the statutes, which provide

different routes of appeal depending on whether you litigate it in

the Tax Court, the District Court, or the Court of Federal Claims.

There are just two separate appellate courts that review those decisions. That is one part of the issue.

The other part is, you have got judges that have different views

of the law or of particular cases, which is one of the reasons that

litigation should not drive tax policy, tax policy should drive litigation.

Senator BUNNING. Well, even the interpretation of the tax policy

by the judges, whether it be in a tax court or an appellate court,

differ.

Mr. WILLIAMS. Yes, that is right, Senator. If you are advising a

client and you realize that there is a more favorable precedent in

one circuit than another, you would be malpracticing as an attorney if you did not advise them of the difference.

Senator BUNNING. To use the right court.

Mr. WILLIAMS. Exactly.

Senator BUNNING. All right. I want to thank you all for your testimony. If there is anybody else that would like to add something,

this is the time to do it.

[No response]

Senator BUNNING. If not, we will be adjourned.

[Whereupon, at 12:48 p.m. the hearing was concluded.]

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PREPARED STATEMENT OF HON. JIM BUNNING

Thank you, Mr. Chairman.

We have before us today an interesting array of witnesses as this committee continues to examine the issue of abusive tax shelters.

In recent years, the U.S. Congress and the U.S. Government have paid a lot of

attention to the issue of tax shelters and many changes have been made in this area

through both legislation and regulation. Many of those changes and many current

proposals focus on requiring more taxpayer disclosure with a goal to make such

transactions more transparent.

I understand that more aggressive enforcement action has been seen coming from

the Department of Justice and the I.R.S. recently. In particular, I have read of the

‘‘John Doe’’ summonses that have been issued in recent weeks and months.

I look forward to hearing the testimony of our witnesses today. In particular, I

will be listening for insights and opinions from our panels regarding the various

proposals in this area that this committee is still considering.

PREPARED STATEMENT OF HENRY CAMFERDAM

1. Good Morning. My name is Henry Camferdam. I live in Carmel, Indiana. I appreciate the opportunity to talk to you today. I have been looking forward to this

opportunity for quite awhile.

2. I want to talk to you about two areas:

a. My involvement in what I was told was a legal tax savings strategy known

as ‘‘COBRA;’’ and

b. what action I would like to see taken against the people who designed, promoted and sold me this tax strategy.

3. In the early 1990s, I started a company called Support Net, Inc. (‘‘Support

Net’’). Over time, this company became a tremendous success. In 1995, Support Net

hired Ernst & Young (‘‘E&Y’’) to work on various state sales tax issues.

4. In early 1996, Jeff Adams and I, on behalf of Support Net, hired E&Y to do

Support Net’s audit & tax work. E & Y designated Jay Heck as the lead audit partner and Wayne Hoeing as the senior tax manager.

5. On or about February 26, 1996, Carol Bockelman Trigilio was hired as Support

Net’s CFO on the suggestion and /or reference of Jay Heck at E&Y, where she formerly worked in their Entrepreneurial Audit Services Group.

6. In the summer of 1996, Support Net, because of its capital needs due to its

rapid growth, began discussions with E&Y about E&Y assisting Support Net with

finding potential investors or a buyer.

7. This culminated on or about August 26, 1996, with Support Net signing an engagement letter agreement for E&Y to prepare a Senior Offering Memorandum.

8. In October 1996, E&Y began soliciting potential buyers/investors with the Senior Offering Memorandum it had prepared. Support Net initially went to market to

raise capital to grow the business, because it was, at that time, one of Indiana’s

fastest growing companies. Support Net went from $50 million to $500 million in

sales in 3 years.

9. The process, however, culminated not just in raising capital but rather in a sale

of the business to Gates/Arrow Distributing, Inc., a division of Arrow Electronics,

Inc (‘‘Arrow’’). On or about June 9, 1997, Support Net received a Letter of Intent

from Arrow.

10. On or about October 16, 1997, a definitive Agreement between Arrow and

Support Net was announced on Wall Street, followed by a sale in December of that

year of 50.12% of Support Net to Arrow. E&Y received a commission for this sale

of approximately $900,000.00.

11. E&Y was also the audit/tax professionals for Arrow. The local E&Y office in

Indianapolis (Jay Heck and Wayne Hoeing) continued to perform the audit and tax

work for Support Net, in conjunction with their peers in New York assigned to

Arrow.

12. All amounts from the sale of Support Net received by Jay Michener, Jeff

Adams, Carol Trigilio and me (collectively, the ‘‘ Partners’’) in 1997 and 1998 (and

these amounts were in the millions) were duly reported on both federal and state

tax returns, and tax was paid. E&Y prepared the tax returns for me, Jeff Adams,

Support Net, and BAMC, LLC (which held the Partners’ interests in Support Net).

Prior to the COBRA tax strategy sold to us by E&Y, none of us had ever been involved in a tax shelter of any sort, and we had always reported and paid the taxes

we owed.

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13. Unfortunately, a business dispute arose between Arrow and BAMC, LLC. In

March 1999, BAMC, LLC and the Partners filed a lawsuit in federal Court in New

York against Arrow and others for, among other things, breach of contract and

fraud.

14. In the late summer of 1999, we at Support Net worked with Wayne Hoeing

of E&Y and tax professionals at Arthur Anderson to evaluate the tax and business

impact of settlement offers we received from Arrow.

15. In August 1999, we received and accepted a settlement offer from Arrow for in excess of $70 million cash, in exchange for a sale to Arrow of the remainder of

Support Net not previously sold. E&Y was aware of this settlement, as we had been

staying in touch with them frequently to consider the tax impact of any settlement

offer.

16. In addition, all four of the Partners had consulted with Wayne Hoeing of E&Y

during this same time frame as to what tax payments should be made (and when).

Wayne advised us that Federal estimated taxes were to be paid by January 15,

2000, and state estimated taxes were to be paid prior to December 31, 1999, so they

could be itemized on our 1999 Federal returns. Also, in September 1999, we consulted with Wayne and worked through Third Quarter estimated taxes and again

confirmed tax payments for the Support Net sale. The four of us fully intended to

report and pay the taxes owed, as we had always done in the past. We had actually

set aside the money we needed to pay the taxes and the rest was invested.

17. In late October 1999, Wayne contacted Carol about a potential tax saving

strategy to benefit me due to my large capital gain on the sale of Support Net. Carol

informed me that Wayne briefly presented the idea to her: for gains over $50 million

in 1999, worked whether the gains were ordinary or capital, involved foreign currency options, and took advantage of a ‘‘tax loophole’’ that he did not specifically

describe. According to Wayne, the strategy would eliminate all capital gains taxes,

thus saving me millions. Carol suggested that he call me directly. After I spoke with

Carol about her conversation with Wayne, I told Jay Michener and Jeff Adams generally about my conversation with Carol.

18. As suggested by Carol, Wayne called me about the potential tax saving strategy. During our discussion, I suggested to Wayne that all four of the Partners meet

with E&Y to see their presentation of the idea, since all of us had gains on the sale.

Wayne told me then of the urgency: that we needed to start the transaction within

the next week to ten days because the transaction took about 6–8 weeks to complete

and that it needed to be completed prior to the end of 1999. As a result, we agreed

to meet with E&Y on or about November 5, 1999, to hear the details of the strategy.

19. On or about November 5, 1999, the Partners met with Wayne Hoeing, Brian

Upchurch, and Carl Rhodes of E&Y at E&Y’s Indianapolis office. There was no one

else present (i.e., no one from Jenkens & Gilchrist or Brown & Wood). With the exception of having to sign a short confidentiality agreement as soon as we arrived

(before anything else took place), it was a typical casual meeting for us with Wayne,

with whom we had a long-standing relationship. Carl was there at the suggestion

of our broker, Dave Knall. Dave had known Carl for years and felt his judgment

was conservative and could be trusted. Wayne and Carl brought Brian to the meeting: Brian actually conducted the meeting and seemed to be the most knowledgeable

about what was being discussed; it appeared that Wayne and Carl were really

present more for client relations, than for any substantive knowledge they might

have.

20. The meeting on or about November 5,1999, lasted one to two hours. Primarily,

it was a PowerPoint presentation presented by Brian Upchurch. Brian appeared to

be the lead contact in Indianapolis for the COBRA transaction; according to the

Power Point, COBRA stood for ‘‘Currency Options Bring Reward Alternatives.’’

Wayne and Carl, to a lesser extent, assisted with answering our questions and in

giving their take on the strategy. We asked many types of questions, because none

of us understood the deal. In response, Wayne and Brian stated, ‘‘That’s why you

have us.’’ I depended on Wayne to tell us if this transaction was valid and appropriate for us. Wayne advised us that they could make this transaction work for us.

Wayne told us this was a valid tax shelter; that the tax shelter would be upheld

if we were audited; and that Ernst & Young would defend us up to Court. They also

showed us an opinion letter from Jenkens & Gilchrist during the presentation,

which we were told was ‘‘insurance’’ in the event of an audit. They also suggested

we obtain a second legal opinion just to make sure. They informed us they had another law firm, Brown & Wood, which could provide us with a second legal opinion.

We weren’t allowed to keep any of the materials discussed in this meeting.

21. During the November 5, 1999, meeting, we contacted Steve Humke, our attorney at the Ice Miller firm in Indianapolis and requested he join us in the meeting.

He could not join us at that time. Carl and Brian later visited Steve’s office. I spoke

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with Steve after their meeting. Steve told me that the meeting lasted almost one

hour. Steve also told me that Carl and Brian would not permit him to bring in an

Ice Miller tax expert or any other attorney. Steve had to sign the same confidentiality agreement we did. They let him briefly look at the Jenkens opinion. According to Steve, the meeting was ‘‘rushed.’’ Steve told me that he could not render an

opinion on the transaction, as Carl and Brian wouldn’t even let him keep the opinion to review. Steve advised me that Jenkens & Gilchrist was a large, reputable

firm and that we would have to rely on our relationship with E&Y for direction.

22. Following the meeting on or about November 5, 1999, Wayne picked the ‘‘loss’’

I needed to generate. The loss was almost in alignment with the prior ownership

of BAMC, LLC (which had held the shares of Support Net and was owned by the

Individual Plaintiffs).

23. Wayne told me they were in a hurry to get the deal done. As a result, a few

days later, I believe on or about November 9, 1999, the four of us met Wayne Hoeing and several other individuals at Twin Lakes Golf Course before Jeff, Jay, and

I were to play golf. Because of the urgency, Wayne wanted to squeeze the meeting

in before our tee time. The purpose of the meeting was to sign all the paperwork

to start the implementation of the tax strategy, including transactional documents

and a two page engagement agreement (the ‘‘Engagement Agreement’’) between

each of us and E&Y. The meeting only lasted 30 minutes or so. No copies of the

documents were given to us at that time—Wayne said they would be mailed to us

later. Although the transactional documents were later sent to us in a binder, the

Engagement Agreement and the promotional materials used during the meeting

were never sent to us. I did not understand the transaction. During this meeting,

Jay asked Wayne, ‘‘What is this strategy?’’ Wayne responded by saying, ‘‘It is already done, don’t worry about it.’’

24. No time was spent at this meeting on or about November 9, 1999, discussing

the documents, as Wayne continued to tell us that we needed to go forward with

the strategy immediately to have it completed by the end of the year. He appeared

to be in a hurry to get the deal done, and, in fact, acted as though the deal was

done. Trusting Wayne, I quickly signed the voluminous documents, which included

documents for the formation of limited liability companies for each of the four of

us, a partnership known as Carmel Partners, and an S-corp called BAMC, Inc. I

viewed it as like closing a mortgage loan, where it was sign the documents or go

to another lender, except that in this case E&Y was the only party we knew of who

could eliminate our taxes, in their words, ‘‘legally and conservatively.’’ I also knew

that I didn’t have the time to show the Engagement Agreement to Steve Humke

or another lawyer, and was led to believe that because of all the confidentiality surrounding the strategy that wasn’t really an option anyway.

25. Through the rest of November and December of 1999, we did as instructed

by E&Y to implement the tax strategy known as ‘‘COBRA.’’ I also had a brief conversation with David Parse at Deutsche Bank at which time David Parse picked the

options for us (the ‘‘Euro’’ for me, the ‘‘Yen’’ for the others) because I had no idea

what to do. We also signed and sent Deutsche Bank accounts forms on which they

had already filled in information about our supposed investment experience before

sending them to us.

26. In early December 1999, the four of us received engagement letters from Jenkens and Gilchrist. I signed and returned mine. I never talked to anyone at Jenkens

and Gilchrist, and this is the only agreement we had with them about the work they

were doing for us.

27. On or about December 22, 1999, we sent, as directed, a wire to E&Y from Carmel Partners’ account for $1,056,000. On December 29, 1999, we sent, as directed,

a wire to Jenkens & Gilchrist from BAMC, Inc.’s account at Duetsche Bank for

$2,012,000.

28. On or about June 20, 2000, we received a letter from Brian Upchurch of E&Y

transmitting to us a package containing the Brown & Wood opinion (dated March

9, 2000), a request for each of us to sign an engagement letter with Brown & Wood,

other materials, and a request for us to send payment to Brown & Wood. I never

talked to anyone at Brown & Wood. In fact, all of their documents were sent to us

via E&Y—not directly to us. I never intended, expected, or contracted to arbitrate

with Brown and Wood regarding the COBRA transaction. We initially didn’t want

to pay Brown & Wood because their opinion letter was received so late; however,

Brian Upchurch with E&Y told us if we didn’t pay Brown & Wood they would probably ‘‘turn us in’’ to the IRS. On October 2, 2000, we mailed a payment of $75,000

to Brown & Wood.

29. In March 2002, E&Y sent me a letter informing me about a ‘‘Tax Amnesty

Program’’ offered by the IRS. This letter was followed-up by a telephone call with

E&Y wherein E&Y advised me not to participate in the ‘‘Tax Amnesty Program.’’

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During the discussions where E&Y told me not to participate in the Tax Amnesty

Program, E&Y did not inform me about the existence and implications of IRS Notice

2000–44, which I later came to understand was directed at COBRA and similar

transactions that indicated the IRS did not believe those transactions were lawful.

Following the advice of my accountants, I did not enter the Tax Amnesty Program.

30. On approximately June 6, 2002, Wayne Hoeing of E&Y informed me by letter

that the IRS was investigating E&Y and was demanding the production of broad

categories of documents and other information with regard to the COBRA transaction I did.

31. E&Y informed me that E&Y had received administrative summons from the

IRS and that in the opinion of E&Y, documents and information in their files pertaining to the professional services they had rendered to me in connection with the

COBRA transaction were responsive to the summons.

32. In a letter dated June 6, 2002, signed by Wayne Hoeing of E&Y, I was informed that E&Y would produce documents and information regarding the transaction I had done if no objection was received. I informed E&Y the same day that

I objected to the disclosure of any information about me, including my name and

any documents related to the transaction I had done.

33. In September 2002, E&Y informed me that, on the advice of their outside

counsel, they planned on disclosing my name to the IRS but promised that no documents would be produced and that E&Y would notify me if the IRS required production of my documents.

34. On approximately September 5, 2002, a suit was filed in the Northern District

of Illinois seeking to prevent E&Y from disclosing to the IRS the identify of individuals that had completed the COBRA transaction. There were several hearings in

connection with this lawsuit. E&Y at no time informed me that they believed the

Court had permitted them to disclose my name to the IRS or that they intended

to do so immediately. Unfortunately, on approximately September 24, 2002, E&Y

voluntarily disclosed my name to the IRS. E&Y’s disclosure of my name to the IRS

was done in express violation of the instructions I had given to E&Y not to disclose

my identity, documents, information, or any communications to the IRS without my

consent, which was never given. No Court ever ordered E&Y to disclose my identity

to the IRS. The bottom line is that E&Y was more worried about protecting themselves and currying favor with the IRS than protecting the rights of their clients.

35. I want to emphasize the following points to the Committee:

a. E&Y and Jenkens & Gilchrist took advantage of a long-term relationship

I had with E&Y. E&Y and Jenkens & Gilchrist took advantage of the trust and

confidence I had for E&Y. E&Y and Jenkens & Gilchrist took advantage of

E&Y’s knowledge of my financial condition. I did not approach E&Y for this tax

strategy; rather, they approached me. I fully intended to pay the taxes I owed

on the gain from the sale of my company.

b. I was never made aware of the actual relationships and roles of E&Y, Jenkens & Gilchrist, and Deutsche Bank with respect to COBRA. For instance,

E&Y informed me that COBRA was an E&Y tax strategy. I now know that

COBRA was a Jenkens & Gilchrist tax strategy. E&Y informed me that Jenkens & Gilchrist was an ‘‘independent’’ law firm that would review the tax

strategy and write an opinion letter supporting the strategy, which would protect me from penalties in the event of an audit. This was untrue. I now know

that Jenkens & Gilchrist was not an ‘‘independent’’ law firm since Jenkens &

Gilchrist designed, created and promoted this tax strategy. Finally, I was not

aware that E&Y, Jenkens & Gilchrist, and Deutsche Bank met before marketing COBRA to determine how to split the fees up among them.

c. E&Y told me not to enter the IRS Amnesty Program. However, a short time

later E&Y turned my name over to the IRS without my permission.

d. Neither E&Y nor Jenkens & Gilchrist explained to me that existence and

significance of various IRS Notices, which indicated that the IRS would disallow

COBRA. If I had been informed of the existence and significance of this information, I would not have done the tax strategy to begin with and certainly

would have entered the Amnesty Program when it was offered by the IRS.

e. E&Y and Jenkens & Gilchrist used high pressure sales tactics to sell me

the COBRA. E&Y also emphasized the need for me to ‘‘trust them.’’ My trust

in E&Y resulted in this ordeal I am now in.

f. I have always paid my taxes. In fact, I paid the taxes I owed from the initial sale of part of Support Net. I would have paid the taxes I owed on the gain

from the sale of the rest of Support Net; however, my trusted legal and tax advisors placed me in a tax savings strategy that they represented was completely

legal. Since I had never entered into a tax shelter and had never been audited,

I relied on the advice and recommendations of E&Y and Jenkens & Gilchrist.

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36. In closing, I have several questions for the Committee:

a. While I and other taxpayers in this situation have been subjected to tough

talk about penalties and interest, E&Y, Jenkens & Gilchrist, and Deutsche

Bank have not come under scrutiny for their conduct. Why have you not

brought action against E&Y, Jenkens & Gilchrist, Deutsche Bank, and others

that marketed these tax shelter products to trusting individuals like myself?

b. Why are E&Y, Jenkens & Gilchrist, and Deutsche Bank allowed to keep

hundreds of millions of dollars in fees that were paid for these transactions,

while the participating tax payers are currently undergoing extensive and expensive audits?

c. What is being done to make E&Y, Jenkens & Gilchrist, and Deutsche Bank

accept responsibility for their conduct?

d. What can be done to protect future taxpayers from being in the position

I and many others are in: having to pay one group of lawyers to defend me from

the IRS, and another group of lawyers to assert my civil claims against the promoters who talked me into this strategy?

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PREPARED STATEMENT OF PHILIP C. COOK

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(233)

COMMUICATIONS

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