Economic Downturn?
The Federal Reserve’s Open Market Committee announced last week that it would raise the Fed’s baseline interest rate by 0.75 percentage points, the largest such increase since 1994.
The Fed’s move came in the wake of the Labor Department’s earlier announcement that the consumer price index (a measure of inflation) rose by 1 percent last month, and by 8.6 percent for the past 12 months, the highest rate of inflation since 1981. Following the release of the inflation figures, all the major domestic stock indices plummeted.
As a result of the foregoing, combined with the geopolitical uncertainty arising from the war in Ukraine, the continued supply chain issues (exacerbated by China’s ongoing difficulty with Covid), and other related factors, many economists and business owners are anticipating a recession.[i]
Whistleblowing Activity
If a recession does materialize, we will experience a significant decline in economic activity across most of the economy that will continue for several months; Economics 101, right?
In theory, one outcome of a recession will be a reduction in consumer confidence, which will be accompanied by decreased consumer spending. The drop in consumer demand, in turn, may reduce a business’s need for labor and materials, which leads to a reduction in business-to-business spending, more unemployment, etc. You get the picture.
Another impact of this “domino effect” may be the tightening of credit as lenders become more cautious about assessing the creditworthiness of potential borrowers.
In order to survive in such an environment, the owners of some businesses that are desperate enough may be tempted to resort to various “schemes” to save money; some of these schemes may involve questionable or aggressive tax-saving strategies taxes.[ii]
At the same time, struggling employees, employees who feel underappreciated, disgruntled former employees, or others that are somehow connected to such businesses[iii] may decide to inform the taxing authorities of such schemes in the hope of receiving a monetary award.[iv]
Indeed, the government will encourage them to come forward. For example, the New York Attorney General’s whistleblower portal “welcomes and encourages whistleblowers, tips, and complaints. Whistleblowers are essential to fulfilling our mission – protecting the citizens of New York. Whistleblowing insiders are particularly critical in opaque industries, where transparency is limited. We take special care to protect whistleblowers.”[v]
Similarly, the State’s Taxpayer Protection Bureau explains that a “critical tool” at its disposal is the New York False Claims Act: “a powerful law that empowers the Attorney General, local governments and private citizen ‘whistleblowers’ to bring actions against people, businesses, and other entities that defraud New York State or local governments.”[vi] The Bureau explains that:
“Using this law, and often working with whistleblowers, the Taxpayer Protection Bureau conducts civil investigations and prosecutes civil enforcement actions against individuals who knowingly make or use false or fraudulent claims, records, or statements to obtain or withhold money or property that belongs to the government.
“Whistleblowers are private citizens who have evidence of fraud committed by persons or companies against New York State or local governments. The New York False Claims Act encourages whistleblowers to come forward by protecting them from retaliation, authorizing them to bring actions on behalf of the state or local governments, and rewarding their courage by making them eligible for a share of the sums recovered as a result of the actions they file.”
That is not to say that the interests of the government and the whistleblower will always be aligned with one another. Query, for example, whether the whistleblower is motivated primarily by a sense of civic duty or, rather, by a desire for revenge[vii] or monetary reward.
In fact, in a noteworthy disagreement between the New York Attorney General and a whistleblower that recently came to light, the whistleblower questioned whether a settlement announced by the government was appropriate.
“Agreement In Principle”
In a filing last week with the U.S. District Court for the Southern District of New York, the Attorney General for the State of New York indicated that the State had “reached an agreement in principle” to settle the New York False Claims Act cause of action brought against Egon Zehnder International Inc. (“EZI USA,” a domestic corporation) and its Swiss parent Egon Zehnder International AG (“EZI AG”; together with EZI USA, the “Defendants”).[viii]
The Attorney General’s filing also indicated that New York would soon be moving to intervene in the “qui tam” action[ix] – which was brought by a whistleblower (the so-called “Relator”) on behalf of the State – in order to settle the claims asserted by the Relator “in the State’s name and on the State’s behalf.”
The Complaint
The Relator initially filed this qui tam action in Manhattan Supreme Court in January 2017. After the Attorney General declined to prosecute or intervene in the action,[x] the Relator filed an amended complaint in 2021 (the “Complaint”) in which it alleged that the Defendants violated the New York False Claims Act by knowingly reporting “artificially reduced taxable income” to New York City and New York State, thereby depriving these jurisdictions of millions of dollars of taxes.
Removal to Federal Court
The Defendants subsequently removed the action to the U.S. District Court, asserting that the federal court had jurisdiction over the case because the claims arose under the Code and related regulations and, thus, implicated “significant federal issues.” Specifically, the Defendants argued that, because New York income taxes are calculated based on the net income reported on a taxpayer’s federal tax return, any liability EZI USA had under New York tax law “necessarily turn[ed] on a determination of the Company’s compliance with federal tax law.”[xi]
Two Sets of Books
According to the Complaint filed by the Relator with the Manhattan Supreme Court, EZI USA and EZI AG “knowingly filed false tax returns, and made and used other false records and statements, that were material to its obligations to pay New York State and NYC taxes on EZI USA’s business income” during the ten-year period ending in 2013.
The Complaint asserted that, in furtherance of its tax evasion schemes, EZI USA kept two sets of books. One set included EZI USA’s “real” revenues and costs and was used internally to conduct the company’s business and evaluate its actual performance; the other set undercounted EZI USA’s revenues and overstated its deductible costs and was used to prepare EZI USA’s tax returns.
The tax evasion schemes allegedly took two forms. One was for EZI USA to “off-shore” revenues so that EZI USA could illegally avoid counting as taxable income about $86 million of its approximately $128 million in U.S. revenues from client assignments where it worked jointly with foreign EZI AG offices.[xii]
Off-Shoring Income
The Complaint contended that EZI USA recorded its real revenues from the joint assignments in one set of books that it called its “performance” books. It recorded only a fraction of those revenues in a second set of books that it called its “legal” books. EZI USA used only the so-called “legal” books to prepare its tax returns, which resulted in its understating its taxable income and underpaying its U.S. federal taxes.
The Complaint alleged further that EZI AG required EZI USA to maintain these two sets of books and to use only the so-called “legal” books to prepare its tax returns. EZI AG directed its offices around the world to shift taxable profits and deductible losses among offices to lower its worldwide tax liabilities.[xiii]
On-Shoring Expenses
EZI USA’s other alleged scheme to illegally lower its domestic tax liabilities was to take tax deductions for about $7 million in costs that did not “belong” to it. Rather, the costs belonged to foreign EZI offices and, according to the Complaint, were not properly deductible by EZI USA. This scheme to “on-shore” affiliates’ costs was also claimed to have been directed by EZI AG.
Indeed, it was asserted that EZI USA’s and EZI AG’s off-shoring and on-shoring tax schemes were accomplished with clear and actual knowledge by EZI USA and EZI AG.
Ignoring the Warnings
According to the Complaint, the companies were repeatedly warned by insiders that their conduct was improper, illegal, and even fraudulent. Moreover, the Relator asserted that these warnings went up to the highest executives of the companies. Several of these warnings were said to have been made in writing or in recorded conversations.[xiv]
Rather than heed these warnings, the Complaint continued, EZI USA and EZI AG dismissed them and affirmatively continued the schemes for years. They also acted to conceal their schemes to avoid detection. One way they allegedly did that was by lying to EZI USA’s outside tax preparer, “who would not have gone along had he known of the schemes.” The companies never informed the tax preparer that there were books describing EZI USA’s “real” revenues and costs, nor that the records they provided to the tax preparer did not include all of the revenues or the correct costs.
The Complaint also alleged that EZI USA and EZI AG misled IRS auditors in order to conceal the schemes.[xv] When the auditors asked how EZI USA recognized income on the joint assignments with its foreign affiliates, EZI USA, acting at the direction of EZI AG, is said to have described the so-called “legal” books, while concealing the “performance” books. The Complaint states that in contemporaneous internal communications, EZI USA and EZI AG personnel discussed how EZI USA should “deflect attention” from the under-reported income, and that they expected that the auditors, as outsiders, would not find EZI USA’s real practices.[xvi]
Prayer for Relief
The Complaint concluded that, by engaging in this misconduct, EZI USA and EZI AG damaged New York State and New York City by avoiding the payment of approximately $13.25 million in taxes, and repeatedly violated the New York False Claims Act. Under that Act, the Complaint continued, EZI USA and EZI AG were jointly and severally liable for three times the damages, plus penalties and interest.
In bringing the action, the Relator[xvii] sought to redress for New York’s benefit EZI USA’s and EZI AG’s violations of the State’s False Claims Act.
Interestingly, the Defendants were reported as having stated that the allegations in the Complaint were “made by a disgruntled former employee who was dismissed for poor performance in 2012.”[xviii]
The Act
The New York False Claims Act permits and encourages whistleblowers to file actions and pursue claims on behalf of the government when they know of information concerning knowingly false or fraudulent conduct that victimizes the government through, among other things, the failure to pay taxes.
According to the Act, any person who “knowingly”[xix] makes, uses, or causes to be made or used, a false record or statement material to an obligation to pay or transmit taxes (for example income taxes and withholding taxes, respectively) to the State,[xx] or who conceals, or knowingly and “improperly” avoids or reduces their statutory obligation[xxi] to pay or transmit taxes to the State, shall be liable to the State for a civil penalty plus an amount equal to three times the amount of all damages which the State sustains because of that person’s acts.[xxii]
The foregoing rule applies to claims, records, or statements made under the tax law only if (i) the net income or sales of the person against whom the action is brought equals or exceeds $1 million for any taxable year subject to any action brought pursuant the Act,[xxiii] and (ii) the damages (i.e., the tax deficiency) pleaded in such action exceed $350,000.[xxiv]
Qui Tam
The Act provides that any person may bring a qui tam civil action for a violation of the tax laws on behalf of the State.[xxv]
The State may choose to supersede or intervene and proceed with this action. The Attorney General is required to consult with the Department of Taxation and Finance prior to intervening in any qui tam action that is based on the filing of false claims, records or statements made under the tax law. If the State declines to participate in such an action, the qui tam plaintiff must obtain approval from the Attorney General before making any motion to compel the Department of Taxation and Finance to disclose tax records.[xxvi]
Award
If the Attorney General elects to convert the qui tam civil action into an enforcement action, or if the Attorney General elects to intervene in the qui tam action, then the person who initiated the qui tam action may be entitled to receive between 15 and 25 percent of the proceeds recovered in the action or in settlement of the action. It is up to the court to determine the percentage of the proceeds to which a person commencing a qui tam action is entitled, by considering the extent to which the plaintiff substantially contributed to the prosecution of the action. If the Attorney General does not elect to intervene or convert the action, and the action is successful, then the person who initiated the qui tam action may be entitled to receive between 25 and 30 percent of the proceeds recovered in the action or settlement of the action.[xxvii]
The Settlement
In the above-referenced filing with the District Court, the Attorney General explained that it was negotiating the language of a proposed settlement agreement with the Defendants but did not disclose any details thereof.
However, the Attorney General also stated its understanding that the Relator intends to object to the proposed settlement as “not fair, reasonable, and adequate.” The Attorney General explained that, although the Relator is the named plaintiff in the action, the State is the real party in interest, and the State may settle the New York False Claims Act causes of action brought on its behalf.
In anticipation of the Relator’s objection, the State indicated that it plans to file a motion seeking a determination by the District Court, pursuant to the New York Finance Law,[xxviii] that notwithstanding any objection by the Relator, the proposed settlement “is fair, adequate, and reasonable with respect to all parties under all the circumstances.”
What’s Next?
Stay tuned, especially for the explanation of the Relator’s position. It should be interesting.
That said, if there is a recession (let’s hope not), and if businesses begin to experience some serious economic pain, the best tax strategy would be to avoid doing anything stupid.
If a business is hurting, it is almost certain that its employees, vendors, and customers will also be struggling. Why give them something they may want to report to the government?
If the business does implement a tax-saving strategy, it will be imperative that the business be in a position to demonstrate through contemporaneously prepared documentation that there was also a bona fide non-tax reason underlying the strategy and that it consulted with reputable tax advisers before making its decision.
The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.
[i] Of course, Mr. Biden disagrees with this assessment. He also challenges the assertion that the 2021 infusion of stimulus funds into the economy had anything to do with the current inflationary trend, notwithstanding that 40% of the U.S. dollars now in circulation were printed in the last 12 months. Then again, a man who shuffles when he walks should not be riding a bike.
[ii] After all, it is not unusual, even in a healthy economy, to find a struggling business that will fail to remit employment and/or sales taxes to the taxing authorities so as to divert these funds to the payment of its own expenses and to thereby stay afloat.
[iii] Including vendors and customers who become aware of some ill-advised practices.
[iv] For a great discussion of the correlation between economic downturns and increased whistleblower activity, see the article by Clemens Mayr, Julie-Martine Loranger, and Dominique Paiement from McCarthy Tetrault LLP at https://www.lexology.com/library/detail.aspx?g=076dc66f-05b1-4467-802d-9fc91a38579a.
“History,” they write, “has taught us that economic recessions not only unfortunately encourage fraud but also cause existing unethical conduct to come to light.”
[v] https://ag.ny.gov/whistleblower.
[vi] https://ag.ny.gov/bureau/taxpayer-protection-bureau.
[vii] Karma is a bitch, though. Or is it a boomerang? I’ve heard both.
[viii] State of New York ex rel. Am. Advisory Servs., LLC, v. Egon Zehnder Int’l, Inc., et al. No. 21 Civ. 6883.
[ix] Short for “qui tam pro domino rege quam pro se ipso in hac parte sequitur,” which according to Black’s Law Dictionary means “who brings the action for the king as well as for himself.”
Under the provisions of the False Claims Act, a whistleblower with firsthand knowledge of the defendant’s violations of the tax law is authorized to bring such an action against the defendant. The real party in interest is the State.
[x] Query why.
[xi] https://casetext.com/case/states-ex-rel-am-advisory-servs-v-egon-zehnder-intl.
For a very tangentially related post, see https://www.taxslaw.com/2022/05/will-new-york-be-looking-at-your-federal-tax-return-probably/.
[xii] In response, the Defendants explained that they did not view themselves as separate corporate entities; instead, they viewed and apparently conducted themselves as part of a single global firm with offices and thousands of employees all over the world.
The U.S. was their largest market and their largest office was in New York City.
[xiii] As EZI USA’s Co-Managing Partner summed it up, the practice was about “our shifting of billings to the appropriate geography for tax reasons,” which was so “we don’t have to pay taxes on [the billings].”
[xiv] EZI USA’s top financial employee was said to have warned an EZI USA Co-Managing Partner that “You know, it’s fraud when it comes right down to it. . ..”
[xv] The IRS audited EZI USA three times during the ten-year period ending in 2013, and disallowed certain deductions claimed by the taxpayer.
[xvi] The Complaint alleged that EZI USA’s Co-Managing Partner summarized the situation by saying “This was a conscious effort. This is just a risk we’ve been taking for years and they’ve [the IRS] just never figured it out.” He even suggested that if the IRS auditors did discover the issue, the company could pretend to be surprised and tell the auditors that “we didn’t realize that this is not OK.”
[xvii] Identified as American Advisory Services LLC, a shell company utilized to hide the identity of the whistleblower.
[xviii] https://www.cnbc.com/2021/07/29/headhunter-firm-egon-zehnder-accused-of-new-york-tax-fraud-by-whistleblower.html.
[xix] Meaning that a person: (i) has actual knowledge of the information; (ii) acts in deliberate ignorance of the truth or falsity of the information; or (iii) acts in reckless disregard of the truth or falsity of the information; it does not require proof of specific intent to defraud; however, acts occurring by mistake, or as a result of mere negligence, are not covered. Act Sec. 188.3.
[xx] Or to a local government.
[xxi] Act Sec. 188.4.
[xxii] Act Sec. 189.1(g) and (h). Treble damages.
[xxiii] These threshold figures should cover most businesses and wealthy individuals.
[xxiv] Act Sec. 189.4.
[xxv] Act Sec. 190.2. However, if the allegations in the complaint involve damages only to a city with a population of one million or more (i.e., New York City), then the attorney general may not supersede or intervene in such action without the consent of the corporation counsel of such city.
[xxvi] If the State declines to participate in the action, the qui tam action may proceed subject to judicial review, the civil practice law and rules, and other applicable law.
As to the specificity of the pleadings and the burden of proof, see Act Sec. 192. https://www.nysenate.gov/legislation/laws/STF/192 .
[xxvii] Act Sec. 190.6.
[xxviii] Sec. 190(5)(b)(ii). “The state or a local government may settle the action with the defendant notwithstanding the objections of the person initiating the action if the court determines, after an opportunity to be heard, that the proposed settlement is fair, adequate, and reasonable with respect to all parties under all the circumstances.”
