Bordering on Tax Evasion

Should corporations concern themselves with the fate of a few liquor smugglers? A recent Supreme Court decision could have consequences for businesses as well as bootleggers.

In 1996, David and Carl Pasquantino began periodically telephoning a discount liquor store in Hagerstown, Maryland, to buy large quantities of cheap liquor. With help from an associate, Arthur Hilts, the Pasquantino brothers transported the liquor from Hagerstown to their hometown of Niagara Falls, New York, where they stored it until Hilt and other drivers smuggled the liquor into Canada in the trunks of cars.

For four years, until they were apprehended by U.S. authorities in May 2000, the trio paid all applicable Maryland and federal taxes, but they avoided paying Canadian taxes and duties worth $3.6 million (in U.S. dollars).

Apprehending them was one thing; charging them was another. Because of a common-law doctrine known as the “revenue rule,” U.S. prosecutors were barred from indicting the smugglers on charges of foreign tax evasion. Instead, the prosecutors charged them with domestic wire fraud, claiming that the defendants used a U.S. telephone system to defraud the Canadian government.

The case of Pasquantino et al. v United States eventually reached the U.S. Supreme Court; on April 26, a 5-to-4 decision for the prosecution sent the Pasquantino brothers to prison for 57 months each and Hilts for 21 months.

Lawyers familiar with the Pasquantino case observe that prosecutors used a technicality — a Canadian tax-evasion charge — to help shut down widespread liquor and cigarette smuggling between the United States and Canada. In practice, according to corporate tax experts, Pasquantino could expand the application of the wire-fraud statute to cover foreign tax evasion — an expansion that could have consequences for businesses as well as bootleggers.

Until now, recovery of foreign tax revenue, as well as prosecution of the underlying tax evasion, was understood to be the responsibility of the defrauded nation. But in his opinion for the Supreme Court majority, Justice Clarence Thomas wrote that the revenue rule, which at its core bars one country from collecting for another, doesn’t fully apply to Pasquantino. Since the U.S. government did not seek to recover the lost Canadian revenue, Thomas asserted, the revenue rule has only an “attenuated” link to the wire fraud.

In addition, noted Thomas, the Pasquantino convictions punish the defendants for using the U.S. telephone system to commit a federal crime, not for evading foreign taxes. “Their offense was complete the moment they executed the scheme inside the United States,” Thomas wrote; the wire fraud statute “punishes the scheme, not the success.”

For U.S.-based corporate tax managers who break foreign laws, sometimes in the name of “aggressive tax planning,” Pasquantino could lead to federal investigations — possibly even convictions. And for managers who exploit legal loopholes but still adhere to the letter of the law regarding tax shelters, transfer pricing, or the characterization of foreign revenue, the ruling might bring uncertainty to areas once considered settled.

Some tax experts wonder if the Supreme Court did enough to clear up ambiguities in the case law. In broad terms, the court failed to “adequately appreciate the gray area…or complexity of [foreign] tax laws,” comments Philip West, former international tax counsel for the Department of the Treasury, the government’s highest-ranking international tax lawyer. West, now a tax partner at law firm Steptoe & Johnson in Washington, D.C., adds that the “threat of Pasquantino” will make itself felt when U.S. courts trying domestic wire-fraud cases attempt to interpret the subtleties of overseas tax laws.

West and other experts stress that despite the Supreme Court decision, legitimate tax-planning efforts are endangered only by worst-case scenarios. But “although unlikely,” West contends, under the Pasquantino decision those scenarios “become possibilities.”

Thomas Carlucci, a partner in the San Francisco office of law firm Foley & Lardner, has a special warning for companies already under investigation by the Securities and Exchange Commission or the Department of Justice. If their financial conduct (or misconduct) has already attracted the attention of regulators, then their tax shelters and transfer-pricing procedures may invite extra scrutiny. “It’s not likely a wire-fraud charge would be the sole violation being investigated,” notes Carlucci, “but it introduces a new risk exposure.”

Philip Marcovici, an international tax partner in the Zurich office of law firm Baker & McKenzie, reckons that cross-border mergers and acquisitions may be another potential problem area. Marcovici, who advises high-wealth individuals, explains that outside the United States, many companies — public or private, large or small — are still controlled by families. U.S. corporations that acquire such businesses are usually required to buy out the target’s family-controlled interests, which can represent between 30 percent and 50 percent of total corporate ownership.

Thorny tax issues can arise when a family, as a condition of the deal, insists that the American acquirer transfer part of the buyout proceeds to a tax haven such as an offshore trust, for example. According to Marcovici, such tax sheltering is routine; it might be used to hoard wealth or even to mask income to protect the family from kidnap-and-ransom situations, he says.

The sheltering might be ignored by a country with a lenient tax code or lax law enforcement, but U.S. prosecutors — armed with the Pasquantino precedent — could charge the acquiring company and its tax managers with wire fraud if a U.S. phone system was used to arrange some part of the deal. The Supreme Court decision is unclear about whether wire-fraud indictments could extend to the company’s tax or banking advisors.

Quentin Riegal, vice president of litigation for the National Association of Manufacturers — which represents 14,000 industrial members, including 10,000 small and mid-sized companies — also worries that Pasquantino will make it more difficult for U.S. companies to compete in the global marketplace.

Riegal posits that if foreign courts follow the example set by the Supreme Court’s decision, they might begin to interpret U.S. tax law using their own countries’ standards. As a result, U.S. companies could be subject to criminal charges abroad, based on what courts there deemed to be tax evasion in the United States. “One man’s reasonable interpretation of tax law is another’s interpretation of fraud,” asserts Riegal.

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