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Qui Tam Troubles, Part IV: Does New York Have the Answer?

Posted on July 7, 2014 by Amy Hamilton

This is the final article in a series on qui tam suits. The first two discussed suits in Illinois that have generated national discussion regarding potential abuses of state false claims acts that extend to taxes. The third article shared a practitioner's thoughts on qui tam and whistleblower statutes generally. This article discusses New York's approach to tax fraud suits, which is being heralded as a possible model for both state and federal regimes.

Randall Fox is the former bureau chief of the New York attorney general's Taxpayer Protection Bureau, which enforces the state's expanded False Claims Act and works with whistleblowers filing qui tam cases. Before he moved into private practice at Kirby McInerney LLP in April, Fox's responsibilities included handling New York's nearly $400 million sales tax case against Sprint Nextel Corp.

But Fox is no stranger to big-ticket False Claims Act cases. Before the creation of the Taxpayer Protection Bureau in 2011, Fox worked in the AG's Medicaid fraud unit, where he represented New York in its False Claims Act case against pharmaceutical giant Merck & Co. The government argued that it was defrauded when it paid Merck for prescriptions for the pain medication Vioxx after the company allegedly misrepresented the dangers the drug posed to users; the case settled nationwide for $980 million.

Fox says states should follow New York's example and apply their false claims acts to alleged tax fraud. While a series of qui tam tax suits in Illinois is dominating national discussion regarding potential abuses of state false claims acts that extend to taxes, whistleblowers and their advocates have praised New York's approach as a possible model for both state and federal lawmakers. Fox said the qui tam process is important because it enables the government to leverage the assistance of insiders with knowledge about tax fraud perpetrated at the highest levels.

"Financial incentives are essential to encouraging whistleblowers to disclose corporate fraud that otherwise might go undetected by the government," Fox said. It's not easy to be a whistleblower, "so there has to be a reward to encourage people to take that step," he said. In addition to treble damages for those found guilty of fraud in a False Claims Act case, whistleblowers in New York suits can receive up to 25 percent of any revenue collected by the state as a result of the information they provide. "It's basic capitalism, really, to use a whistleblower's profit motive to fight against a tax cheat's profit motive," Fox said.


Keys to Qui Tams

Then a state senator, New York AG Eric Schneiderman (D) four years ago spearheaded the expansion of the state's False Claims Act to tax matters. According to a source at the AG's office, officials consider three components of the state's approach to qui tam actions critical to its success in addressing large-scale tax fraud:
  • The New York False Claims Act is structured to exclude small cases by imposing dollar thresholds that must be met before the act can apply. The thresholds require that any business subject to a tax qui tam action net more than $1 million annually and knowingly defraud the government of more than $350,000 in taxes. One point sometimes missed about New York's $350,000 damages threshold is that it is a pleading threshold.
  • The act provides for the office to have stewardship of the tax cases.
  • The office established the Taxpayer Protection Bureau to aggressively attract good whistleblower cases and handle them.

As that source sees it, New York's thresholds have worked either because it's clear when cases do not meet the act's statutory requirements or because of the AG's stewardship of the cases.

One trade-off of the threshold is that New York loses out on the recovery of taxes in smaller cases that fall below the false claims statute's thresholds. But according to Fox, Schneiderman's thinking behind the proposed expansion of the False Claims Act was to focus the state's resources on big-ticket issues. "The idea was to focus on millionaires who commit tax fraud," he said.

Fox did not refer to the Illinois qui tam cases as nuisance suits, saying he doesn't know whether the claims have legal merit. However, the New York AG's office has asked would-be whistleblowers not to bring repetitive, small-value suits so that it can focus on the most egregious cases.

The AG is investigating income and sales tax qui tam actions under seal and has announced the recovery of more than $10 million in taxes as a result of information provided by tax whistleblowers, including a $6.2 million settlement with Lantheus Medical Imaging Inc. and its former parent company, Bristol-Myers Squibb Co., announced in March.

Schneiderman's investigation into alleged tax fraud by some of Wall Street's largest private equity firms made national news in 2012 when the Taxpayer Protection Bureau subpoenaed documents from more than a dozen companies, including Bain Capital, founded by then-Republican presidential nominee Mitt Romney. Fox said he's not at liberty to discuss the status of those investigations, adding, "All I can say is I was impressed by how much in-depth coverage there was about what I think a lot of people found to be a very interesting issue."

The pending case against Sprint was the first tax enforcement action Schneiderman unsealed under the enhanced False Claims Act. After the government conducted its own investigation into the whistleblower's allegations, Schneiderman intervened and filed a superseding complaint alleging that Sprint knowingly filed false tax returns and undercollected $130 million in sales taxes on flat-rate access charges for wireless calling plans to gain an advantage over competitors. The treble damages provision of the False Claims Act would put Sprint on the hook for almost $400 million.

Sprint denies the allegations, saying Schneiderman is ignoring the state's exemption of interstate voice services from sales taxes and the federal Mobile Telecommunications Sourcing Act provisions allowing companies to unbundle wireless services to separate taxable and nontaxable charges. The New York Court of Appeals will hear Sprint's arguments for dismissing the case, with oral argument possible by the end of this year. (Prior coverage: State Tax Notes, June 23, 2014, p. 686.)

If the state's highest court doesn't dismiss Sprint's case, it would proceed back to district court where, barring settlement, there would be more discovery and a trial. Should the state prevail, many in the AG's office believe the case would prove to the rest of the nation that a qui tam statute with thresholds and responsible enforcement can help a state quickly uncover and litigate complicated tax fraud, leading to recovery.

Fox believes New York's approach already is a success and that the False Claims Act litigation model is invaluable to states as an enforcement tool because of how it can encourage whistleblowers to assist government in detecting and reducing tax fraud.


A Q&A With Fox

Tax Analysts: I heard you got an earful from members of the tax sections of the New York City and New York State bar associations at one of your earliest public appearances as bureau chief. What were some of their concerns then, and did they differ from issues raised today?

Randall Fox: The tax provision was brand new, and the attorney general's office had recently stressed its intention to be aggressive in going after tax frauds. The practitioners primarily raised policy issues about whether the False Claims Act should apply to tax violations at all.

The Legislature had already passed the law, so the policy debate was a bit late. It was time to see how the tax qui tams functioned in practice. The experience since then has proven that allowing tax qui tams was a wise policy choice. The cases that have progressed to the point of being public have been real and substantial, and they have been about facts that the defendants had hidden from the government in their tax filings and audits or had hidden by not making filings at all. No enforcement action would have happened had it not been for the whistleblowers coming forward.

The main argument that I heard at that early public appearance -- and since then -- is that there should not be tax qui tams because tax issues are complex and can involve unsettled issues. But those factors do not lead to the conclusion that we should discard the incentive to whistleblowers to come forward and benefit tax enforcement. Lots of tax issues are not complex and are easily addressed once they are brought to light. There is no real complexity, for example, when a retailer collects sales taxes and pockets the money rather than passing it along to the government.

Even when the tax rules are complex, there can still be a knowing tax law violation. Indeed, some taxpayers purposefully use complex devices for the very purpose of shielding tax evasion from scrutiny. Complex evasion, in particular, benefits from having whistleblowers because they can report on misconduct that might otherwise be hidden, and sometimes they can cut through the complexity.

The argument that tax qui tams should be eliminated because tax law sometimes involves unsettled issues also goes too far. There are lots of settled issues in tax, and they can make for easy cases of violation. If a case involves a truly unsettled, unclear issue so that the taxpayer could not know he was violating the tax law, then it likely will not make for a very good False Claims Act case. Unfortunately, some people are inclined to argue that clear issues are really unclear. That some people can mischaracterize the rules is no reason to trash a useful enforcement tool.

TA: There also are concerns that New York qui tam actions can lead to politicized tax proceedings. The argument is that an elected official -- the attorney general -- can take over a case and be in complete control of the litigation.

Fox: I've heard people complain that the IRS and state revenue departments are overly politicized, too -- they report up to politicians, too. So the argument seems easy to make, but it's not well justified. Anyway, in New York, the attorney general's office has traditionally been involved in tax disputes, pursuing criminal cases of tax fraud and representing the tax department in litigation with taxpayers. In the context of False Claims Act tax cases, it is unlikely you can completely separate the tax department from the enforcement efforts. The act provides that the AG has to consult with the tax department before intervening in a case. In addition, the tax department may have relevant materials, and you may need to have the tax department as a witness.

TA: What about taxpayer confidentiality issues? Practitioners point out that the AG can issue press releases accusing a corporation of tax fraud before fraud has been shown, creating significant reputational risk for a company.

Fox: In any fraud case, whether it's tax fraud, procurement fraud, or anything else, a defendant can face reputational risk. Responsible government officials will raise claims after an investigation and building a solid basis for [those claims]. The defendants are free to tell their side of the story. If the argument is that the attorney general should not publicize good-faith claims because that might hurt the reputation of a defendant, that would be a blow to government transparency. Citizens have a right to know what their public servants are doing. Publicizing solid claims is also important because it proves that enforcement efforts work and encourages other people to comply with the law.

TA: How do you respond to the push right now from practitioners for states to eliminate tax qui tams entirely?

Fox: The idea of repealing the application of a state's false claims act to taxes, or creating a tax carveout or bar, seems to be throwing the baby out with the bath water. The New York experience shows that rewarding whistleblowers for shining the light on tax fraud is an effective way to catch purposeful tax evasion that likely would not otherwise have been discovered. Rooting out tax fraud promotes an important fairness principle for everyone who pays their fair share of taxes and is not cheating. If someone does not like the small-scale cases that we have seen in Illinois, then the solution is to move the focus of the law to the bigger cases, not to throw [the concept] away. It would seem that this extreme argument to eliminate tax qui tams is aimed more at protecting fraudsters than at fixing the problem.

TA: So how might a state guard against abuse of its False Claims Act like what Illinois is experiencing?

Fox: I think having dollar thresholds would eliminate the concerns that some people have about the large number of repetitive small cases filed in Illinois. Of course there is a lot of small, repetitive tax fraud committed in our nation, and that needs to be addressed somehow. But if you think in terms of a cost benefit analysis for an attorney general's limited resources, you are better off focusing on the more sizable cases. That's why the New York False Claims Act set a threshold that draws the line at millionaires. The IRS does the same thing with its whistleblower program, requiring a $2 million recovery before it pays an award to a whistleblower.

I never like to see a litigation process abused, but when you ask how to avoid abuse of the False Claims Act, I first want to know what you consider to be abuse. Some people seem to think that using the act against them is by definition abuse of the statute, without reference to whether there was actually a violation. The main point of the False Claims Act is to protect the government and the taxpayers who fund it. If the act is being used for contrary purposes, that is a concern for all of us. There are already numerous ways to police against any litigation abuses, such as sanctions for frivolous actions. Those same mechanisms can be used in False Claims Act cases. In fact, because the government has such a high level of interest in False Claims Act cases, the Justice Department or state attorneys general are probably more likely than in other contexts to make their voice heard if they perceive that the statute is being misused.

TA: What about arguments that a plaintiff's lawyer is basically an extortionist or is legally extorting money?

Fox: That's a kind of childish name-calling. It distracts from any real debate. I would rather think about whether there is a violation that deserves to be addressed and, if so, ask what tools best address it and whether existing tools need to be adjusted in light of our experience with them. As of this August, the New York tax qui tam provision will be four years old, and it has been a very effective tool to catch tax frauds, while keeping the AG's resources focused on the bigger-ticket cases.

The antitax qui tam argument wants to leave all tax enforcement to the IRS and state revenue departments, but that ignores the fact that the budgets of those agencies are under attack, meaning less enforcement and more opportunities for the unscrupulous to get away with tax evasion. For example, the Government Accountability Office just released a report that found the IRS has not been doing enough to review the taxes of partnerships and S corporations. So businesses in those forms, like private equity firms and hedge funds, can more easily evade taxes and are less likely to get caught. That's not fair to the rest of us. With such tight resources, we should be looking for more effective ways to identify tax cheats and enforce tax laws, not for more ways to tie our hands.

The arguments for eliminating tax qui tams also ignore the expertise that some whistleblowers can bring to the table. Tax is often a sophisticated and sometimes rapidly developing world. It is never easy for a government agency to keep up with all the permutations of issues that clever people and businesses might use so it can spot the illegal ones. Whistleblowers can be sophisticated, too, and can help the government sort through complex illegal strategies.

TA: You call New York's False Claims Act approach to tax whistleblowers a litigation model, whereas you describe the IRS's stand-alone whistleblower program as an audit model. Could you elaborate?

Fox: Both the False Claims Act approach and the IRS whistleblower program's approach send the message that illegal conduct will be caught, so would-be fraudsters should think twice before they act. But they are structured differently. Under the False Claims Act's litigation model, a whistleblower files a lawsuit, serves it on the government, and the government gets to investigate and decide whether to take over the case or not. Under the IRS's audit model, the whistleblower files a form with the agency, and the matter goes into a traditional IRS audit.

The IRS is looking for tax underpayments and will apply any interest and penalties. The whistleblower can report anything from outright fraud to simple mistakes. If the recovery is more than $2 million, the whistleblower gets awarded with a percentage of the recovery. Under the False Claims Act, you won't have a good case if you simply rest on the fact of an underpayment or an innocent mistake -- you also have to be able to allege that the defendant acted knowingly. Mere negligence is not enough.

TA: How closely does the AG's office work with the New York State Department of Taxation and Finance on the tax whistleblower cases?

Fox: Sometimes the cases are very straightforward, even the tax cases. Sometimes the cases are more complicated, and it helps to have subject matter expertise from the tax department. How the bureau and tax department work together will vary from case to case.

The New York False Claims Act requires that the attorney general's office consult with the tax department before taking over a whistleblower case. In practice, there has been a much more intense relationship, so the attorney general's office is going to be talking with the tax department from early on in a tax whistleblower case. The AG's office might, for example, ask the tax department about a defendant's tax returns or the department's understanding of the laws or regulations at issue.

TA: Are there administrative advantages to having a whistleblower tax case come in through the False Claims Act model?

Fox: In some ways, being the government lawyer in these whistleblower cases is a plaintiffs' lawyer's dream because the cases come to you pre-vetted, and the whistleblower's counsel usually lays out the important points for you. When a well-developed case comes in, it gives the government a leg up in the investigative process. Then, the office will examine the matter, often with the help of the New York Department of Tax and Finance.

The focus is going to be on whether there is a good case that the government should pursue. It doesn't want to pursue bad claims, but it definitely wants to pursue good claims. If money has been ripped off from the government, they want to recover it.

TA: Whenever the Sprint case is in the news, someone points out that the company was under audit when the whistleblower came forward. In the complaint, the AG is basically alleging that the company misled the tax department's auditor -- but there seems to be a question, generally, whether someone can be a whistleblower on an issue the government is already examining.

Fox: There is nothing in the legislative record to support an argument that the New York False Claims Act was not intended to apply when there was a tax department audit. Case law under the False Claims Act is clear that it is no defense that the government had an opportunity to spot fraud and missed it.

That makes sense. Assume that a taxpayer hid important facts from a tax auditor to limit its tax liability. We should not excuse the taxpayer from False Claims Act liability because it was so cunning. A whistleblower might be particularly helpful in bringing out those important facts. On the other hand, if the taxpayer gave full and honest disclosure of its positions and the tax department explicitly approved of them, then [the taxpayer] likely won't have False Claims Act liability because it hasn't done anything knowingly false.