Is Voluntary Compliance Becoming Less Voluntary? A Whistleblower Case Study and Other Tax Compliance Topics Presented by Megan L. Brackney, Kostelanetz & Fink, LLP Brian W. Kittle, Mayer Brown LLP* John P. Steines, New York University School of Law Mario J. Verdolini, Davis Polk & Wardwell LLP January 23, 2018 *Providing no comments on case study
Agenda A Whistleblower Case Study: Caterpillar Internal Investigations in Tax Cases Should We Let Sleeping Dogs Lie? Mistakes in Prior Returns 1
A Whistleblower Case Study: Caterpillar 2
2017 Raid March 2, 2017: Federal agents from the IRS, the Department of Justice, the Department of Commerce and the FDIC conduct a raid on Caterpillar s headquarters 3
2014 Senate Hearing April 1, 2014: Senator Carl Levin (D-Mich.), Chairman of Permanent Subcommittee on Investigations, at hearing on Caterpillar s Offshore Tax Strategy 4
Whistleblower Claim and IRS Proposed Adjustment In 2008, Daniel Schlicksup (Global Tax Strategy Manager) sends claim to IRS In June 2009, Schlicksup files retaliation lawsuit against company, bringing Caterpillar tax strategy to attention of Senate Permanent Subcommittee on Investigations In December 2013, IRS asserts $2.4B in adjustments against Caterpillar for years 2007 to 2009 relating to non-u.s. Caterpillar subsidiary, CSARL 5
Whistleblower Statute Tax whistleblowers entitled to awards of 15% and 30% of collected proceeds, comparable to amounts under False Claims Act for non-tax issues But less favorable for tax whistleblowers than under other whistleblower statutes Tax whistleblower claims must be made directly to the IRS No private right of action (unlike claims under False Claims Act) No express protection against retaliation unlike False Claims Act and Sarbanes-Oxley IRS Whistleblowers Improvements Act of 2017 Provides express retaliation protection Additional communication between IRS and whistleblowers about status of claims Introduced by Senators Chuck Grassley (R-IA) and Ron Wyden (D-OR) Commentators have called for private right of action but none currently proposed 6
How Aggressive Was Caterpillar s Planning? From 1960 to 1999, Caterpillar purchased Caterpillar-designed replacement parts from third party manufacturers and sold them to COSA COSA: oversaw distribution of replacement parts outside United States acted as lead marketing company for Europe, Africa and Middle East developed and maintained Caterpillar s non-u.s. dealer network Caterpillar recognized income from parts sales to COSA COSA s income from parts sales was Subpart F income Third Party Suppliers Caterpillar (U.S.) COSA (Switzerland) Pre-1999 Supply Chain Non-U.S. Dealers 7
How Aggressive Was Caterpillar s Planning? (cont.) In 1999, Caterpillar restructures its non- U.S. parts business CSARL (Swiss successor to COSA) takes over Caterpillar s role as global parts purchaser from third-party manufacturers CSARL and Caterpillar enter into licensing and servicing agreements relating to non- U.S. parts sales According to Caterpillar, restructuring has enabled it to defer U.S. taxes of at least $2.4B Third Party Suppliers CSARL (Switzerland) Non-U.S. Dealers Post-1999 Supply Chain Licensing and servicing agreements Caterpillar (U.S.) 8
How Aggressive Was Caterpillar s Planning? (cont.) John Steines: Caterpillar s restructuring is of an entirely different realm [from transactions that most impartial tax professionals would concede are tax shelters] a sensible business decision to remove a redundant middleman between supplier and customer, fully within the text and spirit of subpart F, notwithstanding that it deferred some U.S. tax. Reuven Avi-Yonah: Caterpillar did not remove the middleman; it remained in the middle in every physical way, so that the substance of the business (managed entirely from the U.S. with 70% of the parts shipped overseas from the U.S.) remained entirely discrete from its form (ownership of all parts by CSARL). 9
Mitigation Opportunities? 2004. CEO and tax department receive letter from anonymous source Early 2008. Schlicksup continues to raise concerns to tax director and asks to see memos prepared by PwC and McDermott Will & Emery August 2008. Schlicksup transferred to IT division with small raise. June 2009. Schlicksup files retaliation suit in federal court. 2007. Schlicksup raises concerns in e-mails to tax director in January, legal department in July and August, and ethics officer in September. Schlicksup receives negative comments in performance review. May 2008. Schlicksup e-mails detailed memo to executive office. Late 2008. Schlicksup files whistleblower claim with IRS. 10
Inside the Mind of a Whistleblower Whistleblowers are generally not motivated by bounties They want results and they want their concerns to be taken seriously likelihood of external report increases dramatically if employee feels initial report was ignored Perception that management behaves ethically and pays attention to internal reporting decreases likelihood of external reporting Employees generally prefer reporting internally, first to direct supervisors (notwithstanding the loss of anonymity), then to more senior managers Typically report externally only when either ignored internally or no internal option Source: Ethics Resource Center, Inside the Mind of a Whistleblower: A Supplemental Report of the 2011 National Business Ethics Survey (2012). 11
Inside the Mind of the Agency In the IRS Whistleblower Program, Fiscal Year 2016, Annual Report to Congress, the Director of the IRS Whistleblower Office, Mr. Martin, penned [S]ince 2007... the IRS has approved more than $465 million in monetary awards to whistleblowers. 12
Whistleblower Mitigation Strategies General strategies Communicate culture of compliance Foster transparency and internal reporting of issues Publicize whistleblower policy, including non-retaliation policy Define retaliation to educate employees Have an anonymous reporting system Train management in handling whistleblower claims Show that claims are taken seriously Conduct performance reviews based on objective criteria Tax-specific whistleblower mitigation Train employees with access to sensitive information on uncertain tax positions and their justification Implement internal controls for tax-related information Coordinate with, and leverage, non-tax policies 13
Internal Investigations in Tax Cases 14
Execution of the Internal Investigation Identify client Set scope Fix timeline Pick team: In-house counsel or other personnel (legal, accounting, compliance, HR, etc.) Outside counsel Forensic investigators and experts Obtain documents Document retention policy/document hold Emails and other electronic data Board minutes and notes Look for privileged documents 15
Execution of the Internal Investigation (Cont d) Interview witnesses Consider who should be present and who should take the lead Consider sequence of interview Consider former as well as current employees Consider whether Upjohn disclosures are appropriate Consider need for separate counsel and joint defense agreements Consider indemnification and advancement of fees Document results of investigation How to report and summarize the investigation? How to disclosure results? How to monitor reaction to results and remedial action? How to address public relations issues? Privilege issues Work product doctrine Fact v. opinion work product Attorney client privilege Focus on who is the client Section 7525 16
Yates Memo on Individual Accountability for Corporate Wrongdoing Keep in mind that internal investigation may lead to civil or criminal investigation Premise of Yates Memo that effective way to combat fraud is to hold individuals who perpetrated wrongdoing accountable Puts pressure on individual witnesses in corporation investigations and highlights stakes involved in witness interviews Yates Memo applies to civil and criminal cases 17
Ethical Issues in Internal Investigations Importance of identifying who client is Duties of loyalty and confidentiality to client Attorney/client and other privileges Model Rule of Professional Conduct 1.13: Organization as Client Lawyer retained by organization represents organization In dealing with organization s directors, officers, employees or other constituents, lawyer shall explain identity of lawyer's client Lawyer may represent organization s directors, officers, employees, or other constituents as well as the organization provided that parties consent to dual representation as required by model Rule 1.7 Model Rule 1.7: Conflicts of Interest: Current Clients Lawyer shall not represent client if representation involves concurrent conflict of interest unless: Lawyer reasonably believes that lawyer can provide competent and diligent representation to each affected client; Representation is not prohibited by law; Representation does not involve assertion of a claim by one client against another client represented by lawyer in same litigation or proceeding; and Affected clients each gives her informed consent, confirmed in writing. 18
Should We Let Sleeping Dogs Lie? Mistakes in Prior Tax Returns 19
An Enduring Issue: Mistakes in Prior Returns: An Example Example: Parent distributes subsidiary in tax-free spin-off transaction Later discovers that its spin-off year tax return failed to report deferred intercompany items triggered by spin 20
Context of Refund Claim Amended Return to the best of my knowledge and belief, this amended return is true, correct, and complete. Informal Claim During Audit Declaration signed under penalties of perjury that the facts contained therein are true. 21
Gating Considerations, In Sum Is it an error? Is there a defense? Is there an offset? Are there reserve and UTP effects? Is correction barred by statute of limitations? Duty of consistency Does special rule apply, e.g., Form W-2? Does it establish accounting method or otherwise affect current return? Does it implicate contractual indemnities or insurance claims? Mitigation, notice Are you otherwise amending return containing error? 22
Should vs. Shall Correct Errors Treasury regulations provide that amended return should be filed to correct failure to report gross income, deduction or loss in proper year Treas. Reg. Section 1.451-1(a) Treas. Reg. Section 1.461-1(a)(3) Under limited circumstances, taxpayers may be required to file amended returns 23
No Legal Requirement to Amend No legal requirement to file amended return; no separate penalty for failure to amend Broadhead v. Comm r, T.C. Memo 1955-328 Badaracco v. Comm r, 464 U.S. 386 (1984) Amending return or voluntary disclosure in audit reduces likelihood that IRS will assert penalties Professional organizations and IRS require adviser to inform his/her client of error and its consequences IRS Circular 230, Section 10.21 AICPA SSTS No. 6 ABA Formal Opinion 85-352 24
What Is Your Ethical Duty Regarding Advice to Amend? Circular 230 10.21 A practitioner who... knows that the client has not complied with the revenue laws of the United States or has made an error in or omission from any return... must advise the client promptly of the fact of such noncompliance, error, or omission. The practitioner must advise the client of the consequences as provided under the Code and regulations of such noncompliance, error, or omission. 25
Note that CPAs Have a Greater Ethical Duty. AICPA Statements on Standards for Tax Services, No. 6 (4) A member should inform the taxpayer promptly upon becoming aware of an error in a previously filed return, an error in a return that is the subject of an administrative proceeding, or a taxpayer s failure to file a required return. A member also should advise the taxpayer of the potential consequences of the error and recommend the corrective measures to be taken.... (5) If a member is requested to prepare the current year s return and the taxpayer has not taken appropriate action to correct an error in a prior year s return, the member should consider whether to withdraw from preparing the return and whether to continue a professional or employment relationship with the taxpayer. 26
Other Practical and Ethical Considerations Decision to correct error should be informed by practical and ethical considerations, including: Taxpayer s policies/reputation Moral/philosophical considerations Whistleblower risk 27
What about Failure to File? Can You Advise a Client Not to File a Tax Return that Is Legally Required? Failure to file is a misdemeanor (26 U.S.C. 7203) Failure to file with affirmative acts of evasion is a felony (26 U.S.C. 7201) Adviser could be accused of aiding, abetting, counseling or commanding a criminal violation under 18 U.S.C. 2 28
Manner of Correction Amended return Superseding return On audit 29
Manner of Correction (Cont d) Voluntary Disclosure 30
IRS Voluntary Disclosure Practice Internal Revenue Manual 9.5.11.9 It is currently the practice of the IRS that a voluntary disclosure will be considered along with all other factors in the investigation in determining whether criminal prosecution will be recommended. This voluntary disclosure practice creates no substantive or procedural rights for taxpayers as it is simply a matter of internal IRS practice, provided solely for guidance to IRS personnel. Taxpayers cannot rely on the fact that other similarly situated taxpayers may not have been recommended for criminal prosecution. Requirements: Truthful, timely, and complete; Legal Source Income; Pay or make good faith arrangements to pay. 31