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TALES from the KPMG SKUNK WORKS: the BASIS-SHIFT OR DEFECTIVE-REDEMPTION SHELTER by Calvin H

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TALES from the KPMG SKUNK WORKS: the BASIS-SHIFT OR DEFECTIVE-REDEMPTION SHELTER by Calvin H (C) Tax Analysts 2005. All rights reserved. does not claim copyright in any public domain or third party content. TALES FROM THE KPMG SKUNK WORKS: THE BASIS-SHIFT OR DEFECTIVE-REDEMPTION SHELTER By Calvin H. Johnson Table of Contents Calvin H. Johnson is professor of law at the Uni- versity of Texas at Austin. This report arises out of his I. Was FLIP/OPIS Fair Game? ............433 testimony before the U.S. Senate Permanent Subcom- A. Description of the FLIP/OPIS Basis-Shift mittee on Investigation hearings on the role of profes- Shelter ........................ 433 sionals in the U.S. tax shelter industry. Prof. Johnson has agreed to serve as an expert for plaintiffs who B. The Heart of the Shelter ............ 435 bought KPMG shelters and seek recovery of costs. He C. The Paramount Substance-Over-Form thanks James Martens and Samuel Buell for comments Doctrines ....................... 438 on an earlier draft, but acknowledges responsibility II. FLIP/OPIS and Professional Standards ... 440 for errors. A. The One-in-Three Chance Test ........ 440 In this report, Johnson argues that the basis-shift or B. One-in-Three Applied to Outcomes .... 441 defective-redemption shelter, called FLIP or OPIS by III. Concluding Remarks ................ 442 KPMG, was an early product of KPMG’s endeavor to develop complete tax packages that could be sold for KPMG, the fourth largest accounting firm, is negoti- multimillion-dollar fees to many customers. The ating with the Justice Department over the terms by which it might avoid criminal indictment for its conduct FLIP/OPIS shelter gives a rare opportunity, he says, to 1 see both KPMG internal deliberations and also the arising out of its tax shelters. From about 1996 through profession’s many independent evaluations. KPMG 2003, KPMG had an extensive operation to invent and said the shelter was likely to prevail, Johnson writes, sell packaged tax shelters. According to the bipartisan but the tax profession has reached a consensus that the report of the Senate Permanent Subcommittee on Inves- shelter did not meet professional standards, shown by tigations: its acceptance of the IRS’s generous settlement offer. KPMG devoted substantial resources and main- In the FLIP/OPIS shelter, Johnson says, a Cayman tained an extensive infrastructure to produce a Islands straw entity borrowed from a foreign bank, continuing supply of generic tax products to sell to bought the bank’s stock, and was redeemed out of the clients, using a process which pressured its tax stock a few weeks later. The technical claim was that professionals to generate new ideas, move them the basis of the Cayman Islands straw could not be quickly through the development process, and ap- used in the redemption, but was shifted to stock held prove, at times, illegal or potentially abusive tax 2 by a related U.S. taxpayer to produce a large artificial shelters. tax loss for that taxpayer. Johnson argues that the basis did not shift, in part because the Cayman Islands entity did not recapture any significant fraction of the 1 redeemed shares, so that the redemption was not Lynnley Browning, ‘‘KPMG Says Tax Shelters Involved Wrongdoing,’’ The New York Times, June 17, 2005, at C1. ‘‘essentially equivalent to a dividend.’’ Johnson also 2 argues that various substance-over-form doctrines ‘‘Report of the Permanent Subcommittee on Investigations of the U.S. Senate Homeland Security and Governmental Affairs prevent the loss: Non-bona-fide losses are not allowed; Committee, on the Role of Professional Firms in the U.S. Tax transactions without expectation of pretax profit are Shelter Industry’’ at 6 (Feb. 8, 2005) (hereinafter PSI Report). The not respected; accounting that does not clearly reflect chair of the Permanent Subcommittee on Investigations is Sen. income can be defeated by the IRS; and the step Norm Coleman, R-Minn., and the report represents his endorse- transaction doctrine applies. Prof. Johnson is unwill- ment of the work originated when Sen. Carl Levin, D-Mich., ing to speculate as to how broadly the lessons learned was chair of the subcommittee. The subcommittee held hearings from FLIP/OPIS describe the current professional from which its report derives. ‘‘U.S. Tax Shelter Industry: The culture. Role of Accountants, Lawyers, and Financial Advisers,’’ Hear- ings Before the Permanent Subcommittee on Investigations, (Footnote continued on next page.) TAX NOTES, July 25, 2005 431 COMMENTARY / SPECIAL REPORT The KPMG operation was looking for polished ‘‘turn- enue from their sales to offset the risks of litigation. Philip key’’ tax products that could be sold easily to multiple Weisner, the chief of the KPMG National Tax Office, was (C) Tax Analysts 2005. All rights reserved. does not claim copyright in any public domain or third party content. clients.3 ‘‘The business model,’’ KPMG said internally, ‘‘is responsible for supervising the 100 lawyers and at some based upon the simple concept of investing in the devel- point he cut off further discussion of the merits of one opment of a portfolio of elegant, high-value tax products shelter. Weisner concluded that ‘‘our reputation will be and then maximizing the return on this investment used to market the transaction’’13 and that though [KPMG’s] distribution network.’’4 For a partici- pant who purchased a shelter, KPMG offered a package I do believe the time has come to s**t and get off the of completed documents and ‘‘basically cookie cutter pot. The business decisions to me are primarily opinions’’ following a prototype.5 A ‘‘skunk works’’ two: (1) Have we drafted the opinion with the operation was once a secret research lab for developing appropriate limiting bells and whistles...and(2) planes to defeat the Nazis and the Communists.6 The Are we being paid enough to offset the risks of KPMG tax skunk works dreamed up transactions against potential litigation resulting from the transaction? our United States. My own recommendation is that we should be paid a lot of money here for our opinion since the KPMG aggressively promoted its products, pressuring transaction is clearly one that the IRS would view its agents to ‘‘sell, sell, sell.’’7 As one KPMG e-mail put it, as falling squarely within the tax shelter orbit.’’14 ‘‘We are dealing with ruthless execution, hand-to-hand Weisner identified the shelter as a high-risk operation, combat, blocking and tackling. Whatever the mixed trading on KPMG’s reputation, justified by fees reaching metaphor, let’s just do it.’’8 The KPMG customers for the almost $100 million for the shelter at issue and covered shelters were big-gain taxpayers — identified through by ‘‘bells and whistles’’ limitations on their opinions. KPMG’s nationwide network as having gains larger than Jeffery Stein, No. 2 man at KPMG,15 responded: $20 million to shelter.9 As late as 2003, KPMG listed in its inventory 500 active tax products offered to multiple I think [the expression is] s**t OR get off the pot. I clients for a fee.10 Overall, KPMG collected at least $124 vote for s**t.16 million in fees for its skunk works shelters, which would And so KPMG offered its shelters to its customers. To have eliminated $10 billion of gain from the tax base had 11 avoid indictment, KPMG itself is willing to admit wrong- the shelters been successful. doing, calling the operations ‘‘unlawful conduct’’17 and Within KPMG, there was a lot of professional dissent an embarassment that should ‘‘never happen again.’’18 as to whether KPMG shelters worked, which was picked up in the e-mail traffic the Senate subcommittee repro- KPMG was not alone in marketing packaged shelters. duced.12 KPMG decided to go ahead with the marketing Ernst & Young, Pricewaterhouse Coopers (PwC), and of its shelters, however, despite the internal dissent, on BDO Seidman are being sued for damages by taxpayers the assumption that KPMG would receive enough rev- who purchased shelters they sold that the IRS has since gone after.19 PwC is now describing its shelters as an ‘‘institutional failure.’’20 Arthur Andersen also sold multimillion-dollar tax schemes, and it too suffered ‘‘in- stitutional failure.’’ 108th Cong., 1st Sess. (Nov. 18 and 20, 2003) (four vols.) (hereinafter PSI Hearings), which included a minority staff report, id. at 45 (hereinafter Minority Staff Report). 3PSI Report at 132. 4Memo of Randy Bickham, Aug. 30, 1998, in 1 PSI Hearings 13E-mail from Philip Weisner to multiple KPMG National at 858. See also id. at 861, calling for a product research and Tax Office professionals (May 10, 1999), Plaintiff’s Exhibit #172. development function with Deutsche Bank and UBS to develop 14Id. new products. 15Minority Staff Report 1 PSI Hearings at 166. 51 PSI Hearings at 86. 16E-mail from Jeffrey Stein to Philip Weisner, (May 10, 1999), 6For a description of skunk works operations against the 1 PSI Hearings at 181. former two targets, see Benn R. Rich and Leo Janos, Skunk Works 17‘‘KPMG Statement Regarding Department of Justice Mat- (1994) (describing Lockheed’s skunk works shop that began in ter,’’ The Wall Street Journal, June 16, 2005. 1943 and developed the first American jet, the U-2 spy plane, 18Eugene O’Kelly, KPMG chair and CEO (May 12, 2004), PSI and stealth fighters). report at 81. See also Richard Smith, vice chair of tax services for 7Minority Staff Report, 1 PSI Hearings at 191-194. KPMG, in id. at 57. (Stating that because of the risk to its 8Id. at 194. reputation and its credibility, ‘‘[w]e no longer offer or imple- 9See, e.g., PSI Report at 125, 1 PSI Hearings at 222 ($20 million ment aggressive look-alike tax strategies. In particular, we no ‘‘minimum’’).
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