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ANNOUNCER: It's a shell game, corporate America's hidden profit center.
CHARLES ROSSOTTI, IRS Commissioner 1997-2002: The tax shelter business has become basically stealing from the treasury.
ANNOUNCER: Hide and seek against the IRS.
JOHN "BUCK" CHAPOTON, Former Asst. Sec. of Treasury: These were close to sham transactions. Some were clearly sham transactions.
ANNOUNCER: When they didn't pay, the burden fell on us.
BOB McINTYRE, Dir., Inst. on Taxation and Economic Policy: These guys are just complete freeloaders on the rest of us. They're paying a whole lot less than they used to us, and the rest of us are picking up the tab for them.
CHARLES ROSSOTTI: You could double everybody's refund if you just collected all the taxes that were due.
ANNOUNCER: Tonight on FRONTLINE, correspondent Hedrick Smith follows the tax shelter trail to surprising places.
HEDRICK SMITH, FRONTLINE Correspondent: So this is human waste, chemical waste?
ANNOUNCER: Uncovering the companies behind the tax schemes.
MANFRED JOSTES, Dortmund City Council: First Union, North Carolina.
ANNOUNCER: Discovering how the schemes were sold.
JOE JACOBONI, Entrepreneur: And their response was, "No, this is a clean deal. We're using the IRS laws against them."
ANNOUNCER: And unveiling what's really going on inside America's biggest tax firms.
MIKE HAMERSLEY, Former KPMG Tax Attorney: The elements of hiding the facts were really just blatant. At that point, I really realized some of the stuff that these guys are doing may very well be criminal.
ANNOUNCER: Tonight on FRONTLINE, the great American tax dodge.
HEDRICK SMITH, FRONTLINE Correspondent: [voice-over] Tax season, and the returns are starting to roll in at IRS centers all across the country. But there's a problem. Not everyone is honestly paying what they owe. Some big-time taxpayers are gaming the system with illegitimate tax shelters and sticking the rest of us with the bill.
CHARLES ROSSOTTI, IRS Commissioner 1997-2002: Well, my reaction is, you know, more people are buying into this stuff than I thought, you know? And of course, the magnitude of it was- was very- very substantial.
HEDRICK SMITH: Republican businessman Charles Rossotti recently spent five years as commissioner of internal revenue. While running his own technology company, Rossotti had seen some dubious tax schemes.
CHARLES ROSSOTTI: Well, of course, having been in business, I mean, I had- had had people, you know, come in and try to sell me various things. I always believed in business, if it's too good to be true, it probably is too good to be true.
HEDRICK SMITH: But inside the IRS, Rossotti was shocked to see how severely epidemic of bogus tax shelters had infected the tax system.
CHARLES ROSSOTTI: I think it's a huge danger to the tax system. What we learned from our agents, what we learned from the tax experts, what we've learned from the honest practitioner is it was true. There were a heck of a lot of promoters marketing a heck of a lot of devices to a heck of a lot of corporations to shelter income so they wouldn't pay corporate taxes.
HEDRICK SMITH: It's a far cry from what you and I do. We struggle to hold down our taxes with legitimate deductions- IRAs, mortgage interest on our homes. But major corporations and boom-time millionaires zero out their taxes with tax tricks. And who cooks up the tricks? Highly respected accounting and law firms, the very people we trust to keep the system honest. So you and I wind up paying the difference- not just for shelters but for the entire tax gap.
CHARLES ROSSOTTI: The whole problem is anything that's not being paid that should be paid. I mean, that's basically what the honest taxpayer's making up. That's- that's, you know, somewhere in the range of $250 billion to $350 billion a year, which basically means that everybody is paying 15 percent more, if you want to look at it that way.
HEDRICK SMITH: [on camera] Fifteen percent is a big chunk.
CHARLES ROSSOTTI: Yeah. You could give everybody twice as big a refund as they average get if you just collected all the taxes that are due.
HEDRICK SMITH: And how big a part of this is the tax shelter problem?
CHARLES ROSSOTTI: That is certainly the biggest single source of the gap.
HEDRICK SMITH: [voice-over] They don't exactly hand you a road map to help you find these well-concealed tax shelters, which turn up in the most unexpected places. Our search begins in the industrial heartland of Germany, the city of Dortmund, where in late 1997 city officials were offered a deal they couldn't refuse.
MANFRED JOSTES, Dortmund City Council: [through interpreter] It's absolutely unbelievable. I still to this day can't believe that something like this works.
HEDRICK SMITH: Dortmund would get $10 million cash, like manna from heaven, for agreeing to lease its old streetcars to an American company.
MANFRED JOSTES: [through interpreter] We give the streetcars to the USA, and then you lease them back so we can still use them here.
HEDRICK SMITH: Dortmund leased 65 streetcars to a U.S. investor and instantly leased them back. So Dortmund still owned and operated the streetcars. Nothing really happened. It's called a LILO- lease in, lease out.
MANFRED JOSTES: [voice-over] It is the same as before. Yes, it is very hard to understand if you are not in the banking business.
HEDRICK SMITH: Why would an American investor pay $150 million to lease 25-year-old streetcars that stayed in Dortmund? I found an expert, a German lawyer who works with U.S. investors on cross-border leasing deals, Dr. Markus Wenserski.
[on camera] What is a cross-border leasing deal? What does it involve?
MARKUS WENSERSKI, Leasing Lawyer: Well, the basic idea is to create a tax benefit for a profitable U.S.-domiciled company- for example, banks, financial institutions or whatever.
HEDRICK SMITH: [voice-over] It's a huge business, more than $100 billion in Germany alone over the past five years. Wenserski helped me understand how a deal works.
[on camera] If I understand you correctly, the lease of the German asset, the streetcar system, goes to America, but the lease goes back to Germany so the Germans continue to run the subway system-
MARKUS WENSERSKI: Exactly.
HEDRICK SMITH: -or the streetcar system.
MARKUS WENSERSKI: That's the basic idea.
HEDRICK SMITH: And the money goes from America to Germany, maybe it goes back to a Swiss bank, but then it goes back to America. Is that right?
MARKUS WENSERSKI: Exactly.
HEDRICK SMITH: So the- so the asset goes away and comes home, and the money goes away and it comes home.
MARKUS WENSERSKI: Well, it's a very simple description, but essentially, it's right.
HEDRICK SMITH: So is it a good deal financially?
MARKUS WENSERSKI: Well, the focus is on the tax benefit of the whole transaction and not on the exchange of payments or services.
HEDRICK SMITH: The whole point of it is the tax benefit. Is that right? It doesn't work without the tax benefit.
MARKUS WENSERSKI: Well, it wouldn't work without the tax benefit, and that's the driver for the transaction.
HEDRICK SMITH: [voice-over] The tax benefit came from a fast write-off for the American investor's big up-front lease payment. But who was the American investor? That was a well-kept secret. In fact, the lease contract required secrecy. Even Dortmund city officials seemed unsure who was behind the deal.
[on camera] You don't know who the investor was?
MANFRED JOSTES: Nein. Nein.
HEDRICK SMITH: Did you know who the investor was?
MANFRED JOSTES: [through interpreter] I suspect it was being done through Deutsche Bank or subsidiaries, but I'm not sure.
HEDRICK SMITH: [voice-over] Deutsche Bank, it turned out, was just the German middleman.
[on camera] Mr. Jostes, I wonder if you recognize this document.
MANFRED JOSTES: [through interpreter] These are the official documents from this very meeting.
HEDRICK SMITH: Tell us the heading.
MANFRED JOSTES: "Der U.S.-investor."
HEDRICK SMITH: And then what does it say after that?
MANFRED JOSTES: [through interpreter] In our case, it is a big, renowned American bank, First Union, with headquarters in North Carolina.
TELEVISION COMMERCIAL: In the financial world, banking as we have known it has become a thing of the past. Brokerages-
HEDRICK SMITH: [voice-over] First Union Bank. In two decades, this upstart Carolina bank gobbled up a hundred regional competitors. Its aggressive acquisition strategy was led by former CEO Ed Crutchfield.
ED CRUTCHFIELD, Former CEO First Union Bank: You simply have to reinvent yourself or change yourself so that you have the ability to compete with that New York crowd who had up `til 19-about-90 been eating our lunch. That's the main thing it took, was nerve. [laughs] I don't know. I mean, again, it took vision. You had to be able to think outside the box a bit.
TELEVISION COMMERCIAL: All of our financial institutions are in transition-
HEDRICK SMITH: So First Union rode the Wall Street wave of the `90s, moved beyond standard banking into investment banking, brokerage and using sophisticated financial tools like leasing.
TELEVISION COMMERCIAL: -has helped investors seeking diversity-
ED CRUTCHFIELD: Leasing is really just another way of financing. You know, it's just another arrow in the quiver. It's another financing tool that we- that we offer. And as to why we would want to do that for a city in Germany, I don't know the specifics of that, but perhaps-
HEDRICK SMITH: I read First Union had gotten about a billion dollars in fast tax write-offs from a bunch of leasing deals, including that deal in Dortmund.
[on camera] But as a CEO, you were certainly aware it was-
[voice-over] So I started to ask about the tax write-offs.
ED CRUTCHFIELD: I don't know that I could have told you what it meant to our bottom line.
HEDRICK SMITH: You make a $4 billion profit a year, and something's delivering you a billion dollars-
ED CRUTCHFIELD: Well, Rick, if you're going to do an investigative report, let's- let's change the subject and-
HEDRICK SMITH: [voice-over] Crutchfield said he was unprepared, had not been forewarned about discussing taxes.
ED CRUTCHFIELD: -same subject, the interview's over.
HEDRICK SMITH: And cut off the interview. I wrote Crutchfield, asking him to take time to prepare and do another interview, but Crutchfield would not talk to us. Neither would the bank.
So I went to see a watchdog on tax issues, Robert McIntyre, director of the Institute on Taxation and Economic Policy. He said First Union's tax benefits from leasing were huge.
BOB McINTYRE, Dir., Inst. on Taxation and Economic Policy: Leasing was central to their tax-sheltering strategy, as far as their annual report reveals. From 1997 to 1998, First Union reports that it saved close to a billion-and-a-half dollars in taxes from leasing. They were pretty aggressive at sheltering. That was enough to cut its tax rate in 1998 to only about 6 percent. It was almost, you know, down to nothing.
HEDRICK SMITH: First Union had plenty of company. The bull market of the `90s was a spawning ground for a shelter epidemic that swept through corporate America. As profits soared, companies were finding ingenious ways to lose money- or appear to lose money.
JOHN "BUCK" CHAPOTON, Former Asst. Sec. of Treasury: I saw what was called corporate tax shelters grow in the `90s, and I realized - and other professionals like me realized - it was not what we used to think of as tax shelters in the days of old.
HEDRICK SMITH: Former Reagan Treasury official Buck Chapoton was troubled by the new tax tricks.
JOHN "BUCK" CHAPOTON: These were a different animal. These were close to sham transactions. Some were clearly sham transactions, had nothing to do with investment, they simply were financial mechanisms for creating losses - tax losses, no economic losses.
HEDRICK SMITH: Creating losses, phantom losses, suddenly became pivotal to impressing Wall Street. That alarmed the head of the New York Tax Bar, Harold Handler.
HAROLD HANDLER, Former Chair, New York Tax Bar: What changed in the `90s was that the tax line of the financial statement became a profit center for many corporations.
HEDRICK SMITH: [on camera] How do you get your tax rate down?
HAROLD HANDLER: Exactly. If that's the- that was what it was all about. You know, I want to have the lowest tax rate because I can produce the best results for my financial statements for my company. And if the fellow down the street is doing it, I should be able to do it also. And there was a tremendous amount of pressure to do that, and there still is.
HEDRICK SMITH: [voice-over] And the pressure was to manipulate the law. It may come as a surprise, the law lets corporations keep two sets of books: a bullish book income report to Wall Street and a low-ball tax income report to the IRS.
BOB McINTYRE, Dir., Inst. on Taxation and Economic Policy: Well, a company- let's say it makes $10 billion. That's what it tells the shareholders. But when it gets time to filling out its tax return, it tells the Internal Revenue Service that, "No, we only made $4 billion or $3 billion" because it shelters most of its profits. And the result is, you know, you and I, we've reported our wages, all of it. Nothing we can do about that. But companies say, "Hey, we're not telling the IRS we made all this money because we don't want to pay taxes on it."
HEDRICK SMITH: The corporate hunger to minimize taxes revolutionized the tax trade.
HAROLD HANDLER: A client would call with a transaction that was being promoted for purposes only to reduce taxes, having no business reality. That's bothersome because it changes the dynamic of what you're doing. You're now no longer doing real things but you're doing artificial transactions for the purpose of reducing tax owed.
HEDRICK SMITH: Artificial transactions, an all-important dividing line between bogus tax sheltering and legitimate tax planning.
HAROLD HANDLER: The difference is that when you're tax-planning a business transaction for a corporation, there's a real transaction. There's something that really is being accomplished.
HEDRICK SMITH: In the new game of fabricated shelters, moving money from box to box, the key players are the firms which created and sold tax tricks.
JOHN "BUCK" CHAPOTON: The tax professionals were the culprits. The accounting firms, some law firms, both good accounting firms and good law firms, were in- were promoters of these transactions.
LARRY LANGDON, Former IRS Division Head: They would go and sell a product to a particular company and reap a million-dollar fee. And it became addictive. It was like opium.
HEDRICK SMITH: As Hewlett-Packard's tax vice president for 22 years, Larry Langdon was pitched plenty of shady tax schemes.
LARRY LANGDON: And there were a number of CFOs, CEOs and others who realized it was going on and it was wrong. But frankly, I would say a fair number, almost half of the major companies, were succumbing to that sort of pressure.
HEDRICK SMITH: The increase in abuse of shelters and use of legitimate deductions was fueling an even bigger trend, a sharp decline in corporate tax rates, according to public records.
BOB McINTYRE, Dir., Inst. on Taxation and Economic Policy: Well, on paper, the corporate tax rate is 35 percent, but because there's so many loopholes, so many shelters- well, we did a study, looking at companies through 1998, 250 of the biggest, and their average rate by 1998 was 20 percent, not 35. And lately, we think the rate is down to about 15. In other words, companies are paying less than half of what they're supposed to.
HEDRICK SMITH: Some companies paid zero taxes. Others even got tax rebates. And as the corporate tax payments plummeted, so did the corporate share of the total tax take.
BOB McINTYRE: From 1950 to 2000, corporations averaged about 17 percent of the federal taxes. And all of a sudden, now, down to 7 percent- 7 percent of the government paid for by corporate taxes. So yeah, they're paying a whole lot less than they used to, and the rest of us are picking up the tab for it.
HEDRICK SMITH: And what was the IRS doing about all this? In the late `90s, the IRS that Charles Rossotti found was in a state of crisis, deeply on the defensive. Just as the shelter epidemic was taking off, Congress attacked the IRS and cut its budget.
CHARLES ROSSOTTI, IRS Commissioner 1997-2002: It was in a situation where people were a little bit hunkered down. They were- they were like people that were in a foxhole with a lot of incoming artillery shells coming in.
HEDRICK SMITH: The IRS pulled in its horns. It was so hopelessly understaffed and outgunned that Rossotti said it couldn't even keep up with tax cheats.
CHARLES ROSSOTTI: The IRS, you know, simply does not have enough resources, broadly, to cover even the most serious compliance cases, which means that, you know, people are robbing banks on all four corners, we're only able to stop one robber.
HEDRICK SMITH: To try to combat tax shelters, Rossotti enlisted one of the tax trade veterans, Hewlett-Packard's Larry Langdon.
LARRY LANGDON: I wanted to tackle the tax shelter problem, and I found that the IRS was way behind the times with regard to what I knew was going on in the corporate sector.
CHARLES ROSSOTTI: We were playing, you know, like, man-to-man defense. I mean, the IRS was, like, taking a knife into a gunfight. I mean, you know, we had one- you know, a couple of agents, you know, here fighting against, you know, major, well-staffed, well-organized corporations and tax advisers.
HEDRICK SMITH: Worse, it was so overwhelmed by paper that it couldn't even spot the phony shelters. Tax lawyer and analyst for the journal Tax Notes Lee Sheppard.
LEE SHEPPARD, Contributing Editor, Tax Notes: Finding the transactions is a problem. I mean, if you're talking a Fortune 100 company, the return would be floor to ceiling paper. Even if you're under continuous audit, it's not like the corporate tax manager is going to say, "Oh, look over here. Here's the tax shelter." It's not what they get paid to do. I mean, I don't want to imply that everybody's always hiding the ball, but sometimes, hiding the ball is what you're trying to do.
HEDRICK SMITH: Hiding the ball. Remember that streetcar deal in Dortmund? They hid the investor. They buried the shelter in tax returns. That's why the IRS had so much trouble tracking the leasing business. IRS agents just stumbled into the first hints of trouble while screening returns.
CARY ALLEN, IRS Technical Advisor, Leasing: You could see the leasing activity changed. We didn't know what kind of change it was. We just knew taxpayers were getting more heavily involved in leasing.
HEDRICK SMITH: Cary Allen a senior tax auditor at the IRS center in Charlotte, North Carolina, was like Sherlock Holmes trying to unravel the leasing deals.
CARY ALLEN: And we saw a change in the trend for description of leasing. It was going along at a certain rate per year, and then we saw kind of like a graph that goes up. So-
HEDRICK SMITH: [on camera] Big jump in activity.
CARY ALLEN: Well, it started slowly and then started rising. So you knew there was a change in business practice.
HEDRICK SMITH: [voice-over] A change that involved big tax breaks.
CARY ALLEN: They'd get up to $100 million a transaction, then $500 million. Then some of them ended up being billion-dollar transactions.
LARRY LANGDON: There are a number of heroes in this whole exercise, and Cary Allen is one of them. He discovered, on the part of the IRS, the first lease-in, lease-out transaction. And frankly, he was tenacious enough to pursue it, understand all of the documentation and put the jigsaw puzzle together.
CARY ALLEN: We said, "We got to get an answer to this. This is a problem" because it appears to us, as agents, nothing is really happening here, that this is not really a lease like we've ever seen before.
So this is all going in circles, so this draws our attention.
HEDRICK SMITH: Allen is forbidden to talk about specific companies or tax audits, but he sketched out a typical LILO deal.
[on camera] Not going to count it for tax purposes.
CARY ALLEN: Right.
HEDRICK SMITH: [voice-over] It's complicated, but he showed me why he believed it was a sham financial transaction.
CARY ALLEN: We don't think anything's going to happen or nothing's really happening because-
HEDRICK SMITH: Paper shuffling without genuine business purpose- not a legitimate shelter.
CARY ALLEN: They really don't have to move any money, then it's making journal entries.
It's the circle of flows of money, basically remove the risk out of the transaction. The money was not used like you normally see in a leasing arrangement.
KEN KIES, Leasing Lobbyist: Well, and that- that's just plain wrong.
LARRY LANGDON: Ken Kies is a Capitol Hill veteran, now a spokesman and Washington lobbyist for the leasing industry, working hard to protect their leasing deals.
KEN KIES: They're very complicated transactions. They're heavily negotiated. They- in each case, they have legal opinions from very reputable law firms. Those transactions very comfortably fit within 30 years of leasing law.
HEDRICK SMITH: [on camera] Weren't the American investors getting their major gain out of the tax reduction benefit of these cross-border leasing deals?
KEN KIES: Well, the answer is that's certainly a significant part of it, and that's true in every lease, I mean, and it has been for 30 years.
HEDRICK SMITH: [voice-over] But the IRS did not buy that argument. On audit, it challenged 300 LILOs by more than 30 banks and corporations. In May, 1999, it issued a regulation specifically barring LILOs.
LARRY LANGDON: In effect, what that did was create a major chill with regard to selling any of those transactions in the future. So we killed it for the future.
HEDRICK SMITH: In all, the IRS banned more than two dozen types of tax shelters. It even won a few court cases against big corporations. But it was like cat-and-mouse, always a jump or two behind.
[on camera] So hasn't the IRS banned about 28 transactions, put them out on a public list and said, "These won't work"?
HAROLD HANDLER: Yes. But as fast as the IRS can publish that list, the promoters can come up with transactions that are different- sufficiently different that they don't fit within that- those- those guidelines.
HEDRICK SMITH: So they change a little thing here and change a little thing there and-
HAROLD HANDLER: That's right. That's exactly right. And it's a constant game. It just keeps going on and on.
HEDRICK SMITH: So Joe, tell me, where are we?
JOE JACOBONI, Entrepreneur: We're at Marina Bay-
HEDRICK SMITH: Yeah?
JOE JACOBONI: -in Fort Lauderdale, Florida.
HEDRICK SMITH: [voice-over] The promoters had found a new market, a new niche for their tax tricks, individuals who struck it rich, like entrepreneur Joe Jacoboni.
[on camera] And what kind of crew does this have? You got a captain-
JOE JACOBONI: A captain, an engineer, a first mate, two stewardesses and a chef.
HEDRICK SMITH: So you got the whole works.
JOE JACOBONI: Yes. It's a five-star hotel on the water. And this is the- this is the sun deck.
HEDRICK SMITH: Oh, great. So you must have done well in business to wind up with a boat like this. Tell me about your business.
JOE JACOBONI: Well, in 1991, I pretty much leveraged everything I owned, borrowed money from everybody I knew and started the company on about $50,000.
HEDRICK SMITH: [voice-over] His company, which provided tech support for the skyrocketing computer industry, took off. And six years later, Jacoboni cashed in.
[on camera] How much did Cincinnati Bell pay?
JOE JACOBONI: The end- the final price was $32 million- $28 million of it was mine, and I put the money in the bank.
HEDRICK SMITH: And who was your banker?
JOE JACOBONI: First Union.
HEDRICK SMITH: First Union was your banker?
JOE JACOBONI: Yes, sir.
TELEVISION COMMERCIAL: Who are we? We're First Union, helping our neighbors in every way we can.
JOE JACOBONI: So it was amazing how many people came out of the woodwork that had great ideas what to do with the money. They had been a trusted bank for many, many years with me, and so I pretty much kept the money with them.
HEDRICK SMITH: [voice-over] First Union steered Jacoboni into a tax scheme devised by the bank's own auditor, one of the country's top accounting firms and one of the most aggressive in marketing tax shelters, KPMG.
JOE JACOBONI: I got a phone call from the senior tax person at KPMG, Carolyn Branan [sp?], and they just told me that this was an investment strategy and that it was going to cost me X millions of dollars.
HEDRICK SMITH: What KPMG called an "investment strategy" would cost Jacoboni $2.4 million, but it would eliminate all of the capital gains tax he owed on the sale of his company, more than $7 million.
JOE JACOBONI: I asked them questions like, "Has this ever been audited?" And their response was, "No, this is a clean deal. We've done- we've done numerous deals like this with people that are in exactly your situation. It's never been audited."
HEDRICK SMITH: [on camera] So they're saying this is perfectly in compliance with IRS rules and regulations.
JOE JACOBONI: Absolutely. Absolutely. The word "bulletproof" was used at one point in time.
HEDRICK SMITH: [voice-over] To seal the deal, KPMG promised the blessing of a top-shelf law firm.
JOE JACOBONI: The terminology they used, Rick, was there was a more-likely-than-not chance I would win an audit. But off the record, their attitude was, "Joe, you have no problems. We're KPMG. We would never do anything to put you in a position to where you would be in trouble with the IRS."
HEDRICK SMITH: All the same, KPMG wasn't taking chances of the IRS finding out. It told Jacoboni to keep it all confidential. He says he couldn't even show the deal to his own accountant.
JOE JACOBONI: Because they said it was proprietary, that they had created it and that they just were not- they were not going to share it with anybody.
HEDRICK SMITH: In September, 1997, Jacoboni took the leap. He ponied up his $2.4 million.
[on camera] Where are you sending this money?
JOE JACOBONI: To various and sundry situations, sending it to a company called Jacaranda Corporation-
HEDRICK SMITH: Which is?
JOE JACOBONI: I have no idea.
HEDRICK SMITH: And where is it?
JOE JACOBONI: Cayman Islands.
HEDRICK SMITH: And what do you think it's doing?
JOE JACOBONI: Quite honestly, Rick, I didn't know what the transaction was doing. All I knew was KPMG was managing the transaction and telling me, "You need to put this money here, put that money there."
[www.pbs.org: Inside Cayman's tax havens]
HEDRICK SMITH: [voice-over] To check out Jacaranda, I flew to Grand Cayman Island, an international tax haven where you can set up and disband a company in a New York minute. Once a sleepy British colony, Cayman today claims to be the world's fifth largest financial center, with $1 trillion a year in bank turnover. Jacaranda had been created as a conduit for the KPMG tax scheme sold to Jacoboni. In the hunt for Jacoboni's Cayman company, my first stop was the government registry of companies.
[on camera] I'm looking for information about Jacaranda Capital.
CLERK: A company?
HEDRICK SMITH: It's a company, yeah. Jacaranda Capital. It's a company that was set up in 1997.
CLERK: Well, let me see if one of the assistants is available because-
HEDRICK SMITH: [voice-over] Typical Wall Street information about company operations and owners was not available. But there was a listing of Jacaranda's registered office, the local law firm of Maples and Calder. So I went to see its managing partner, Anthony Travers.
[on camera] How many lawyers do you have working here?
ANTHONY TRAVERS, Managing Partner, Maples & Calder: In this office, we have about 250, yeah.
HEDRICK SMITH: Oh?
ANTHONY TRAVERS: We have 10 lawyers in London. We have 10 lawyers in Hong Kong.
HEDRICK SMITH: So you have about 250 in this area?
ANTHONY TRAVERS: Yeah. Exactly. Including-
HEDRICK SMITH: I'm interested in a company. It's called Jacaranda. Maples and Calder was listed as its registered office. Can you help me find out about that company? Can you tell me anything about that company?
ANTHONY TRAVERS: I really can't because of the legitimate right to privacy.
HEDRICK SMITH: Can you tell me anything about who its directors are? Can you tell me- can you tell me about what its purpose of business is?
ANTHONY TRAVERS: No.
HEDRICK SMITH: Why can't you tell me?
ANTHONY TRAVERS: It so happens that that is what the confidentiality law says. It endeavors to establish a right to privacy, and actually, I commit a criminal offense if I breach that law.
HEDRICK SMITH: [voice-over] That was a dead end, so I asked Travers to take a look at some documents we had turned up.
ANTHONY TRAVERS: I'm not going to ask you how you got these.
HEDRICK SMITH: They were minutes of Jacaranda's first board meeting. Two attorneys from Travers's law firm had incorporated the company. I asked about its two listed directors.
ANTHONY TRAVERS: They are directors of an institution in the Cayman Islands which is in the business of providing directors. This one listed here-
HEDRICK SMITH: [on camera] Which one?
ANTHONY TRAVERS: -Queensgate [sp?] Bank and Trust Company.
HEDRICK SMITH: Queensgate Bank and Trust Company? What is- they provide directors?
ANTHONY TRAVERS: Yes. They do.
HEDRICK SMITH: So if you're in America and you want to set up a company and you don't want to have to come here and you want to have directors, you go to Queensgate?
ANTHONY TRAVERS: It provides independent directors who-
HEDRICK SMITH: [voice-over] So Jacaranda was not just a ready-made company, it had ready-made directors.
ANTHONY TRAVERS: This looks like a fairly standard corporate transaction, having flipped through these papers.
HEDRICK SMITH: [on camera] So this happens dozens of times, hundreds of times.
ANTHONY TRAVERS: May well be, yes.
HEDRICK SMITH: And Travers's law firm had cozy ties to Jacaranda's directors.
[on camera] What's interesting to me is the address of the meeting of the board of directors is the same as the address of your law firm.
ANTHONY TRAVERS: I think if you look out of the window, you'll probably see them in the building next door. [laughter]
HEDRICK SMITH: But I mean, at the time this was happening, they were on another-
ANTHONY TRAVERS: We're actually- we're actually tenants of theirs.
HEDRICK SMITH: [voice-over] What's more, Travers said, his firm had little reason to look too closely at Jacaranda and its business dealings because KPMG vouched for it.
[on camera] You mean, it wasn't your responsibility-
ANTHONY TRAVERS: It wasn't- it wasn't our primary obligation or responsibility to redo the engineering in relation to matters of U.S. taxation.
HEDRICK SMITH: Or to look that closely at a Jacaranda, if it came to you from KPMG.
ANTHONY TRAVERS: I think if it came from KPMG, we would make certain assumptions about the propriety of the transaction, yes.
HEDRICK SMITH: [voice-over] Back home, Jacoboni made similar assumptions about KPMG. But around the time he bought into KPMG's tax scheme, IRS lawyers were starting to take a dim view of such shelters. Called "basis shifting," the scheme involved a quick in-and-out stock deal by the Cayman company that supposedly generated phantom paper losses for Jacoboni to offset his real capital gains.
LARRY LANGDON: It turns on a legal construct that creates a loss. You go through two legal entities and have a liquidation and generate an artificial loss. That's the substance of a basis shift.
LEE SHEPPARD, Contributing Editor, Tax Notes: However you want to characterize it, you are talking about a transaction that, but for the tax, you would not do.
HEDRICK SMITH: [on camera] Well, is this thing a sham? Is this a distortion of the law? Is this turning the rules upside down and twisting them?
LEE SHEPPARD: Twisting the rules, yes. It is- it is twisting the rules.
HEDRICK SMITH: [voice-over] For three years, the government's probe into basis-shifting schemes went unknown to Joe Jacoboni. Then the bombshell, a notice from the IRS. Jacoboni frantically called his KPMG adviser, Carolyn Branan.
JOE JACOBONI: We started the conversation out with, you know, "I can't believe this is happening." You know, "Carolyn, tell me, why- what went wrong? Do they have a case?" And Carolyn's response was, "Joe, they're so stupid. They can't even figure out this deal. They've been trying to figure it out for two-and-a-half years." I said, "Carolyn, two-and-a-half years?" I said, "This is August of 2001. Are you telling me that you knew the IRS was questioning this transaction in the beginning of 1998?" There was silence on the phone. "Well, they've been aware- we've been aware that they knew about this transaction, and they have not been able to figure it out since then."
HEDRICK SMITH: [on camera] Did she say anything how you would do in an audit?
JOE JACOBONI: That was my next question, is, like, well, you know, "Am I going to lose the audit?" She says, "Most definitely, you'll lose the audit."
HEDRICK SMITH: She said you were going to lose the audit?
JOE JACOBONI: Oh, yeah. Absolutely. So now I am absolutely going ballistic. I'm, like- I'm seeing $7.2 million. God knows what the interest rate was going to be, 40 percent penalties. And I'm, like, "Carolyn," you know, "I'm going to fight it."
HEDRICK SMITH: [on camera] Carolyn Branan referred FRONTLINE's questions to KPMG. KPMG declined an interview. In a court document, it denied Jacoboni's version of events. But Jacoboni says KPMG recommended that he pay the taxes he owed, then sue the IRS.
JOE JACOBONI: "You guys are going to defend the audit for me?" "Of course, Joe. We'll defend the audit." I'm, like, "Are you- you guys are going to pay for this, right?" "Of course not, Joe."
HEDRICK SMITH: [on camera] They're not going to pay.
JOE JACOBONI: No. She said, "Joe, you are responsible for an audit. You're going to have to pay us for it."
HEDRICK SMITH: [voice-over] That was too much for Jacoboni. He decided to sue- not the IRS but KPMG. That's when he learned from internal KPMG memos that KPMG quality control had long held grave doubts about the tax scheme sold to Jacoboni, a basis-shifting scheme called FLIP.
JOE JACOBONI: But, quote, "Larry Delap [sp?] determined that KPMG should discontinue marketing the existing product."
HEDRICK SMITH: [on camera] The existing product was the deal they sold you.
JOE JACOBONI: FLIP.
HEDRICK SMITH: It's called FLIP.
JOE JACOBONI: Right.
HEDRICK SMITH: So he's saying that in the fall of `97, their quality guy is saying to the rest of the outfit in KPMG, "Stop selling this thing."
JOE JACOBONI: Right. And I believe it was sometime in September before they even sold me the program that they were told to stop selling it.
HEDRICK SMITH: So they're selling you stuff that they're saying internally they know doesn't work.
JOE JACOBONI: Right. Their fees were more important than their integrity and honesty to their client and protecting their clients. So "Let's keep on selling it. If the IRS doesn't audit it, we're fine."
HEDRICK SMITH: [voice-over] And KPMG did just that. It sold more than 160 wealthy individuals the same deal as Jacoboni, including the late race car driver Dale Earnhardt and William Simon, former Republican candidate for governor of California.
[on camera] So a lot of folks are going to look at this who haven't been as fortunate or as successful as you are and say, "Hey, Joe, you made $28 million and you were just trying to get out of your taxes."
JOE JACOBONI: Rick, I did what every American does every year. We go to tax accountants because the code's so complex that they have to interpret it. So I trusted the quality and reputation of one of the largest accounting firms in the world. I guess you can't even do that anymore. I don't know who you trust.
TELEVISION COMMERCIAL: All the same, completely identical. First it was sheep, now it's tax advice.
HEDRICK SMITH: [voice-over] Everybody was in the game. At KPMG, tax shelters were top priority, the firm's hottest profit center.
MIKE HAMERSLEY, Former KPMG Tax Attorney: Their whole culture was driven by sales. This sounded like a great idea for super-charging the tax practice. "Stop waiting for people to call you and give them an answer. Let's go out and sell a lot more product. Let's get out there and sell it proactively."
HEDRICK SMITH: Tax lawyer Mike Hamersley witnessed the KPMG tax shelter machine from the inside. In 1998, he was wooed away from Ernst & Young.
MIKE HAMERSLEY: I thought it was a good opportunity. I had friends at KPMG. I was excited to- to come over and work with them and work in this field. They were well-respected people.
HEDRICK SMITH: Hamersley joined the brain trust of the KPMG tax practice, the Washington national tax office. And right from the start, what he saw bothered him.
MIKE HAMERSLEY: Actually, the very first project that I was given was a tax shelter, a very aggressive tax shelter. What I was shocked about was the willingness to accept facts and representations that they knew to be false.
HEDRICK SMITH: Hamersley recalled having told KPMG colleagues that their shelter schemes wouldn't work legally.
MIKE HAMERSLEY: One of the ways in which you can identify as a tax shelter is ask yourself would anyone in their right mind do one of these transactions but for the tax benefits, or if those losses were real losses? Would anyone do that? Would you be able to sell that? And the answer almost always is no.
HEDRICK SMITH: Hamersley said KPMG's hottest shelters were hush-hush even to insiders.
MIKE HAMERSLEY: Their most abusive tax shelters were fairly clandestine.
HEDRICK SMITH: [on camera] Clandestine because?
MIKE HAMERSLEY: Because the really ugly stuff they would- there were restrictions on access.
HEDRICK SMITH: They didn't want their own people to know?
MIKE HAMERSLEY: They did not want their own people to know.
HEDRICK SMITH: What's going on here? What's the practice here? And why is this happening?
MIKE HAMERSLEY: One of the things that's going on is not wanting the strategy to leak out to another promoter. The other thing is not wanting it to leak out to the IRS.
HEDRICK SMITH: [voice-over] Keeping the IRS in the dark was critical to KPMG's sales strategy. The firm calculated that it would be better off financially to ignore IRS requirements to register its tax shelters.
MIKE HAMERSLEY: The penalties associated with not registering paled in comparison to the revenues that would be generated by these tax shelters that had to be registered. And if they were registered, KPMG decided they couldn't sell them. So they made a business decision not to register them.
HEDRICK SMITH: In internal memos, KPMG made the cold calculation that penalties would be less than 10 percent of its fees. Business flourished. Revenues at the tax practice climbed to more than $1.2 billion, a 45 percent jump in just three years. And the more money KPMG made, the less money Uncle Sam collected.
MIKE HAMERSLEY: The fees that KPMG got was determined specifically and exclusively on the amount of tax savings that they generated for the tax shelter purchase.
[www.pbs.org: Read KPMG's internal memos]
Sen. CARL LEVIN (D), Michigan: This to me was the nail in their coffin. The phony, deceptive device that they created was profitable to them, to the extent to which there was a loss. The greater the loss, the greater the money that KPMG made.
SUBCOMMITTEE CHAIRMAN: [November 18, 2003] This hearing of the permanent Subcommittee on Investigations is called to order.
HEDRICK SMITH: Senator Carl Levin of Michigan spearheaded a probe of tax shelter abuses by the Senate permanent Subcommittee on Investigations.
Sen. CARL LEVIN: The testimony today will also show the lengths to which KPMG went to hide its tax products and its sales efforts from the IRS.
HEDRICK SMITH: Last fall, the committee called major accounting firms on the carpet- KPMG, Ernst & Young, PricewaterhouseCoopers. The others apologized.
ACCOUNTING FIRM REPRESENTATIVE: -and we have learned from our mistakes.
HEDRICK SMITH: KPMG insisted it had done nothing illegal.
JEFFREY EISCHEID, Chief, Personal Finances, KPMG: It's true that these strategies were complicated and that the tax consequences turned on careful and detailed analyses of highly technical tax laws, regulations, rulings and court opinions. But all of these tax strategies were consistent with the laws in place at the time.
HEDRICK SMITH: But after a year of probing thousands of company documents, Levin was unconvinced.
Sen. CARL LEVIN: We found a very pervasive use of tax avoidance schemes that were designed and cooked up and concocted by otherwise supposedly legitimate accounting firms and investing firms.
HEDRICK SMITH: [on camera] Now, you focused in your investigation heavily on KPMG. Why KPMG?
Sen. CARL LEVIN: We had subpoenaed a lot of materials from a lot of firms, and we decided that this was one of the worst perpetrators.
HEDRICK SMITH: [voice-over] Perhaps the biggest shock was KPMG's crass marketing. Instead of letting clients ask for tax advice, KPMG set up a telemarketing center to cold call new prospects.
Sen. CARL LEVIN: I mean, it's pretty obscene to me that you got a firm like KPMG that goes through telemarketing to persuade taxpayers who've made a big capital gain or made some big income that they can reduce their tax bill if they'll follow a scheme which KPMG has devised.
HEDRICK SMITH: And Hamersley reported that the KPMG high command was calling the shots on shelter promotion.
MIKE HAMERSLEY: It was driven from the top. It was coming from the top guy in the tax practice, Jeff Stein. They would have conference calls where he would demand an explanation of why you were not adequately selling the tax shelters.
HEDRICK SMITH: Stein did so well with the tax practice that in 2000, he was promoted to number two in KPMG's entire U.S. operation.
MIKE HAMERSLEY: Jeff Stein's objective was to change the mindframe of a tax professional from finding problems with transactions and trying to address them objectively to going out and proactively selling tax shelters and trying to close sales.
HEDRICK SMITH: Stein and top KPMG partners declined to be interviewed by FRONTLINE. But Mike Hamersley, by now a senior manager in KPMG's Los Angeles office, said things went from bad to worse.
MIKE HAMERSLEY: The activities got more and more aggressive, and the elements with a particular promoter in the Los Angeles office, the elements of hiding the facts were really just blatant. And we- that- that's when it really finally hit home, "Wow," you know, "some of the stuff that these guys are doing may very well be criminal."
HEDRICK SMITH: [on camera] And you went home-
MIKE HAMERSLEY: Went home thinking, you know, "How did I get here?" This was an industry that survived in the past, prior generations, on its ethics and integrity. How did the- how did the industry get her? And how did I get here? This was just not what I bargained for.
HEDRICK SMITH: [voice-over] The defining moment, Hamersley says in court documents, came when KPMG superiors demanded that he sign off on tax matters that he considered illegal, a charge KPMG disputed.
MIKE HAMERSLEY: I had no choice. I had to blow the whistle, and you know, the consequences that resulted were expected.
HEDRICK SMITH: In October, 2002, KPMG put Hamersley on paid leave. Hamersley sued KPMG, charging the firm had ruined his reputation. A settlement was reached. Last fall, KPMG, which is facing federal investigation, told Congress that it had stopped mass-marketing aggressive tax shelters.
RICHARD SMITH, Vice Chair, Tax Services, KPMG: We no longer offer or implement aggressive lookalike tax strategies-
HEDRICK SMITH: In a corporation shakeup, it removed several key tax partners. As for Mike Hamersley, KPMG said he wasn't qualified to discuss tax shelters because he hadn't been involved.
MIKE HAMERSLEY: Although I wasn't directly involved in the marketing of the tax shelters, I got a close look at many of the strategies, and I was surrounded by the people who were directly involved in the shelters. That's the basis of my information. You don't have to be a bank robber to understand and observe a bank robbery.
HEDRICK SMITH: Remember the bogus leasing deals the IRS thought it had shut down in 1999? Well, the industry adapted. And in Paris last fall, I found leasing industry insiders gathering at a five-star hotel for a conference on cross-border leasing. Leasing lobbyist Ken Kies flew in from Washington.
KEN KIES: The people primarily represented here are people that help structure the transactions. They're from all over the world. There's people here from Australia, the United States, Europe.
HEDRICK SMITH: Many were eager to hear Kies tell them how changes in American tax law would affect their future deals. Kies assured them that the leasing industry had the ear of powerful U.S. lawmakers.
KEN KIES: -one time. We were very aggressive at going and meeting with every member of the House leadership, from Speaker Hastert through Tom DeLay, who's second in charge, Roy Blunt, who's the third in charge-
HEDRICK SMITH: I was surprised by how many new opportunities the leasing industry had found.
[on camera] So it looks like the leasing business is doing real well in Europe right now.
KEN KIES: It's in the many billions of dollars- I would guess $20 billion, $30 billion, maybe bigger.
HEDRICK SMITH: [voice-over] So there was still plenty of assets to lease in Europe. And how was the industry planning to stay out of trouble with the IRS? Getting an answer took a while. Back in Germany, I found one in the city of Bochum, just 20 miles down the road from Dortmund. Like many cities, Bochum found itself in a financial pinch in 2002.
HEINZ DIETER FLESKES, Bochum City Council: We didn't have enough money to do all the things we had to do as our duties as a community to the people in Bochum. So we were looking for ways out of that dilemma, and one of them was the idea of trying to go get into a financial deal on the way of cross-border leasing.
HEDRICK SMITH: The idea of cross-border leasing wasn't unusual. What was unusual was the city asset that U.S. investors wanted to lease.
[on camera] Mr. Ahlbach, where are we right now?
Mr. AHLBACH: [through interpreter] We are standing in the Bochum sewer system, which is about 1,200 kilometers long and close to downtown Bochum.
HEDRICK SMITH: [voice-over] The Bochum lease wasn't about streetcars.
[on camera] And tell me, Herr Ahlbach, what did the Americans lease?
Mr. AHLBACH: [through interpreter] They have leased the pipes. There are different tubes, different parts of the system.
HEDRICK SMITH: So what is in this water? This is human waste, chemical waste?
Mr. AHLBACH: [through interpreter] This is not industrial waste, it is only from people.
[www.pbs.org: Germany's backlash against leasing]
HEDRICK SMITH: [voice-over] By leasing its sewer pipes for half a billion dollars, Bochum got a $20 million fee. But Vice Mayor Gabriele Reidl opposed the deal.
[on camera] Why do you object to the cross-border leasing deal?
GABRIELE REIDL, Vice Mayor, Bochum: Well, one thing, that is only a deal for tax shelter in United States. And I say it is a bad example to the people in Bochum because I want them to pay their taxes honestly.
HEDRICK SMITH: So you think the main reason for this deal is a tax shelter in America.
GABRIELE REIDL: Yes. I'm sure. This is also what was told to us.
HEDRICK SMITH: Who are the American investors? Do you know?
GABRIELE REIDL: No, I don't know. We were not told who they are. They told they don't want to be named.
HEDRICK SMITH: And so the city accepted that? The city council accepted that.
GABRIELE REIDL: Yes. We were told if we want to make the deal, we have to accept this.
HEDRICK SMITH: [voice-over] But FRONTLINE has learned that the U.S. investor in Bochum sewers was-
TELEVISION COMMERCIAL: First Union is now Wachovia. Wachovia, an uncommon approach to banking.
BOB McINTYRE, Dir., Inst. on Taxation and Economic Policy: Well, Wachovia, amazingly, in 2002, even though it reported $4 billion in profits, reported that it didn't pay any taxes, and in fact, got a tax rebate from the government of about $160 million.
HEDRICK SMITH: [on camera] How much were they actually writing off from leases at Wachovia?
BOB McINTYRE: Well, they said they saved $3 billion in taxes over the last three years from leasing, so huge write-offs.
HEDRICK SMITH: [voice-over] But if LILO leasing deals had been banned by the IRS, how could banks like Wachovia still be working that angle to cut their taxes? Wachovia declined to talk to FRONTLINE, so I asked that German lawyer.
MARKUS WENSERSKI, Leasing Lawyer: The reason is we started with the LILO deals, the lease-in, lease-out structures. Then certain changes in the American tax law happened which made our colleagues in the United States from the tax side saying that we better should move to a service contract structure.
CARY ALLEN, IRS Technical Advisor, Leasing: Well, they've changed the structure. Instead of what we called a lease-in, lease-out, they've changed the structure a little bit. From what we can tell at this point, they're still doing something very similar that they were doing with the LILOs.
HEDRICK SMITH: But leasing lobbyist Ken Kies disagrees.
KEN KIES: These are different transactions. They have different terms. The economics are different. And a different set of rules apply.
HEDRICK SMITH: [on camera] So the industry moved to something that-
KEN KIES: It evolved. The industry evolved, is a way to put it. They are doing a different economic transaction which is governed by a different set of tax rules.
LEE SHEPPARD, Contributing Editor, Tax Notes: Well, the guts of it is pretty much the same as it was before. You've still got- you've still got nothing going on and your American corporate customer basically buying itself some deductions. They happen to be depreciation deductions rather than rent deductions, but you're still just buying deductions.
HEDRICK SMITH: [on camera] Is it correct that the basic structure of the deal is essentially the same, even though on the surface, one looks like a lease-in, lease-out, and the other's called a service contract?
MARKUS WENSERSKI: Yeah. I would say so. It's a basic- the basic structure is a lease structure, and there are certain amendments which have to be made just to make it possible to enjoy the tax benefits.
HEDRICK SMITH: [voice-over] Same structure, same problem. Something didn't smell right. It was hard to see the economic substance and business purpose down there in the Bochum sewer.
Cleaning up the mess of illegitimate tax shelters is still unfinished business in Washington. And Charles Rossotti is worried.
CHARLES ROSSOTTI, IRS Commissioner, 1997-2002: I think this thing is going to rebound, especially as the economy improves. The fundamental drivers of this are still there. I mean, it's still a very profitable business for the promoters. There's still a tremendous amount of tax that could be saved. The law is still way too weak and too murky.
[www.pbs.org: Prospects for tax shelter reform]
HEDRICK SMITH: Rossotti says Congress must take strong action: pass legislation banning tax shelters with no clear business purpose and economic substance.
CHARLES ROSSOTTI: Congress has to say it plain and simple. You know, plain and simple, that, you know, if you're just doing a transaction that's structured for tax benefits, that you wouldn't do in the absence of the tax benefits, then it's- then it's a tax shelter and it's not legitimate.
Sen. CHARLES GRASSLEY (R-IO), Chair, Finance Cmte: I say to the hucksters, it's time to find an honest living.
HEDRICK SMITH: Republican Charles Grassley of Iowa led the GOP-dominated Senate to pass a bill that includes an economic substance rule and stiffer penalties for shelter promoters. But industry is fighting that bill.
Sen. CHARLES GRASSLEY: You're talking about powerful accounting firms, powerful legal firms, powerful investment bankers in a conspiracy to promote these tax shelters. They also have a fourth arm. They hire some of the most powerful lobbyists in town to work against this legislation.
HEDRICK SMITH: So broad tax shelter reform remains bottled up in the House Ways and Means Committee. The Bush administration proposes closing some loopholes and stiffer penalties, but some say that's just not enough.
CHARLES ROSSOTTI: Congress needs to act. They need to outlaw tax shelters, period.
Sen. CARL LEVIN: You need also the administration, whoever's in power, to go after these guys, to call in these guys, to call in the heads of the accounting firm, the heads of the accounting practice and the law practice. They ought to be called into the White House and say, "This is shameful stuff, folks. This has got to stop."
TAX ME IF YOU CAN
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ANNOUNCER: Visit FRONTLINE's Web site for more on this report, including frequently asked questions about the abuse of tax shelters and what the U.S. government is doing to attack the problem, experts' views on how best to deter bogus tax shelters, piecemeal measures or sweeping reforms, and a two-part report on tax shelters on PRI's Marketplace, plus extended interviews and streaming video of the full program. Then join the discussion at pbs.org.
Next time on FRONTLINE:
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