The Attorney General’s Report of July 20, 2003 (hereafter referred to as the “AG’s Report” or “Report”) either exonerates Chevron and Texaco from charges of filing fraudulent income tax returns or determines that the amounts involved are too small for the State to pursue (State of Hawaii 2003). We examine the AG’s Report and compare the Report with fully-cited facts. This Reply can be viewed as an Adobe Acrobat PDF document at http://www.usm.maine.edu/~gramlich/caltex/reply.pdf or as an html web page at http://www.usm.maine.edu/~gramlich/caltex/reply.htm, including direct links to images of the AG’s Report and each of the non-copyrighted references. (Unfortunately, the AG’s Report discloses no related documentation.) In summary, we find no reason to exonerate Chevron and Texaco and, further, we determine that the amounts involved are not small.
 

Specifically, we argue that:
 

1.    Winston & Strawn failed to disclose its conflict of interest with the State of Hawaii and its advice should therefore be dismissed as prejudiced;
 

2.    The undisclosed “sworn testimony” documents tax fraud and appropriate penalties should be assessed;
 

3.    The AG’s Report inexplicably ignores federal Chief Magistrate Judge Langford’s opinion that Chevron’s internal documents provide evidence of crimes or frauds;
 

4.    The arrangement existed outside of the 1983-1986 period referred to in the AG’s Report;
 

5.    The $4.55 price overstatement is Chevron’s number, not ours;
 

6.    The Report relies upon faulty indicators and evaluators of fair market value;
 

7.    The AG should carefully examine Chevron and Texaco’s audit cushions;
 

8.    The State of Hawaii is not required to allow Chevron the use of the three-factor apportionment formula; and
 

9.    The State’s settlements with Chevron and Texaco were too low.
 

This Reply next summarizes how the alleged fraud was identified, the events that have since transpired, and our purpose for the investigation. Third, we address each of the major points listed above. A brief summary concludes this Reply.
 

The first hint of possible income tax fraud by Chevron and Texaco was discovered by two students fulfilling a class assignment for Professor Wheeler’s accounting course at The University of Michigan. The students discovered the Special Dividend part of the arrangement by comparing the differing amounts of dividends received by Chevron and by Texaco from their 50/50 joint venture, Caltex. The Special Dividend information was expanded to cover a larger number of years and then presented to the San Francisco office of the IRS. The Special Dividends paid by Caltex to either Chevron or Texaco led to the discovery of overstated transfer prices and the existence of the Western Hemisphere Allowance (WHA or kickback). In combination, the arrangement resulted in overstated foreign tax credits and cost of sales deductions for Chevron and Texaco. During the IRS audit of overstated transfer prices, Chevron, citing attorney-client privilege, refused to supply documents requested by the IRS (Chevron 1994). The IRS sued Chevron in Federal District Court and obtained access to 129 documents (U.S. District Court 1996a). On appeal by both parties this decision was overturned and 648 disputed but redacted documents were made available to the IRS (U.S. District Court 1996b, 1996c).

Many of the Chevron documents referred to in this Reply and in our research paper were made available to the public through the sworn testimony of Mr. Brian Hom (the principal IRS examiner) in Chevron’s attorney-client privilege case. After the privilege case was decided but before the IRS filed a tax fraud case against Chevron, Chevron and the IRS settled all issues other than the applicability of the foreign tax credit, with Chevron paying $675 million in 1994 for the years 1979 through 1987 (Chevron 1995, FS-10). Presumably, some of the 129 documents filed with the District Court were among the 648 disputed documents. Most of the 648 documents, however, remain under court seal and thus are not available for public inspection.

In early 1998 the National Office of the IRS issued a Technical Advice Memorandum that settled the remaining tax issue by allowing the taxpayer, Chevron, to benefit from the foreign tax credits it claimed for Indonesian taxes on overstated transfer prices (IRS 1998). Shortly after that event, we began preparing an article that further analyzes publicly-available information and brings that knowledge to the attention of educators, students, and federal and state tax authorities. We are still in this process.

The AG’s Report unfortunately refers to a draft of our research paper that was released in September 2002 instead of the recent article published in the June 2003 issue of Accounting Horizons (Gramlich and Wheeler 2003) that was reprinted with permission in the August 18, 2003, issue of Tax Notes. This academic journal applies a double-blind review process in which two referees are chosen by the editor; the authors are not privy to the names of the referees nor are the referees given the names of the authors. Neither the editor nor the referees received financial benefit from publishing the article and the paper underwent four rounds of reviews prior to its acceptance for publication.[1] We wish that the AG’s Report had been subjected to the same degree of independent scrutiny as our article. Images of each of the source documents for the article can be viewed online at http://www.usm.maine.edu/~gramlich/caltex, unlike the AG’s Report for which no documentation is provided.
 

1.    Winston & Strawn failed to disclose its conflict of interest with the State of Hawaii and its advice should therefore be dismissed as prejudiced. 

Winston & Strawn represented Texaco in at least three cases that were tried during the IRS’ $675 million settlement period of 1979 through 1987 (Murphy, Leo, and Waszak v. Texaco, USDC 1983, 567 F. Supp. 910, Texaco v. Cottage Hill Operating Company, CA-7 1983, 709 F.2d. 452, and Kapco Mfg. Co. v. C & O Enterprises…and Texaco, USDC 1985, 605 F. Supp. 253).[2]These cases are among those that were tried in major courts of law. Unfortunately, there is no way of knowing the number of times that Winston & Strawn represented either Texaco or Chevron in cases settled prior to trial, cases tried in foreign jurisdictions, or cases tried in minor courts. The fact that Winston & Strawn had these clear conflicts of interest was omitted from the AG’s Report. We assume that Winston & Strawn did not disclose this conflict to the State in its efforts to become the law firm selected to represent the State against ChevronTexaco.[3]
 

2.    The undisclosed “sworn testimony” documents tax fraud and appropriate penalties should be assessed.

Clearly, receiving kickbacks (e.g., “WHA” oil) but not disclosing or properly recording the receipt and sale of the oil, for the purpose of evading tax, constitutes income tax fraud.[4]The AG’s Report (p. 5) states:

“The sworn testimony of ChevronTexaco executives show (sic) that ChevronTexacoreceived the WHA only during the period April 1, 1983 to January 31, 1986 and did not receive the allowance for any other year—contrary to the professors’ assumption. TheChevronTexaco affidavits are fully supported by ChevronTexaco internal documents.”(emphasis added)

This statement is an admission of fraudulent tax return filings by both Chevron and Texaco for years 1983, 1984, 1985 and 1986.[5]Such an admission is the logical result of incriminating evidence such as the algebraic derivation of the WHA or “Special Allowance” that is contained in a “confidential” Chevron document known as The Economics of Lifting Sumatran Crude (Chevron 1984, p. 23):

Let:

GSP=Government selling price - $/bbl

MP=Market price for crude in market where crude is overpriced = $/bbl

Eg=CPI gross earnings at GSP - $

Em=CPI gross earnings at MP - $

T=Tax rate in market where crude is overpriced – expressed as a decimal

SA =Market oriented A/T Special Allowance - $/bbl

B=Production – bbls

SA = ((1-T) – {(Eg – Em)/[(B)(GSP – MP)]}) (GSP-MP)

The existence and substantial intricacy of this equation demonstrates that management carefully contemplated the “Special Allowance” (e.g., WHA), and that the amount of the Allowance depended mathematically on the extent of overpricing and the tax rate paid to the Indonesian Government. Further, Chevron and Texaco performed monthly reconciliations of the effects of overpricing and kickbacks in determining the amount of the Special Dividend (IRS 1998). IRS examiner Hom declared under oath that Chevron had not disclosed nor properly accounted for the WHA (Hom 1994, paragraphs 69 and 70). Because the WHA is a kickback that was not disclosed to the IRS, the taxpayer’s sworn testimony that it received the WHA for four years (but failed to disclose it to the IRS) documents tax fraud.[6]Further, if the corporate officers who signed the tax returns were aware of the arrangement, they should face criminal tax evasion charges since they signed the tax return beneath the following statement:

I declare, under the penalties set forth in section 231-36, HRS, that this return (including any accompanying schedules or statements) has been examined by me and, to the best of my knowledge and belief, is true, correct, and complete.[7]

In summary, if the AG’s Report is accurate, it documents tax fraud. As a result, the AG should impose criminal and civil penalties based on this evidence, both on pertinent individual executives and on the entire Chevron and Texaco firms (now known as ChevronTexaco) and on complicit officers of the offtakersand Caltex.[8]

The State of Hawaii apparently chose not to assess a penalty on Chevron or Texaco for the filing of false initial tax returns that clearly were based upon false transfer prices, undisclosed kickbacks, and Special Dividends. As the AG’s Report indicates, Chevron paid $675 million covering years 1979 through 1987 in a settlement with the IRS rather than going to court (Chevron 1995, FS-4 and FS-9). Texaco also settled with the IRS for an undisclosed amount (Texaco 1998, Exhibit 13, p. 28). If the amount that Texaco paid was only one-half of the amount paid by Chevron, the now-combined company would have paid over $1 billion for the tax scheme just for the years covered. Given the sworn statement by ChevronTexaco executives that is referred to in the AG’s Report (but not disclosed), penalties should have been assessed.
 

3.    The AG’s Report inexplicably ignores federal Chief Magistrate Judge Langford’s opinion that Chevron’s internal documents provide evidence of crimes or frauds. 

Most of the publicly available information about this situation is contained in Chevron documents that were attached to IRS examiner Brian Hom’s sworn declarations.Mr. Hom was International Group Manager for the Examination Division of the San Francisco IRS office when the case began in 1994 (Hom1994, 1996).The few Chevron documents that Mr. Hom provided, and the many others examined by federal Chief Magistrate Judge F. Steele Langford, became the basis for Judge Langford’s opinion which reads in part:

The court concludes [1] that the proffer, along with the documents themselves, adequately supports a finding of probable cause to believe that one or more crimes or frauds have been committed or attempted and [2] that the attorney-client communications at issue were created in furtherance of those crimes or frauds, [3] including a showing of the client’s intent. [Chevron was the client] (U.S. District Court 1996a, p. 22).

Judge Langford’s words contain three significant points: [1] the Judge reviewed documents that support the finding of fraud; [2] Chevron had created the attorney-client issue to further those crimes or frauds; and [3] the combination of this evidence demonstrates Chevron’s intent to commit fraud.

Following this conclusion, Judge Langford listed the 129 documents that contain evidence of crimes or frauds and therefore were not protected by attorney-client privilege (U.S. District Court 1996a, pp. 23-25). Upon appeal, however, District Appeals Court Judge Saundra Armstrong determined that 648 documents, not only the 129 that Langford identified, should be produced for the IRS because they were not protected by attorney-client privilege (U.S. District Court 1996b, 1996c).

The AG’s Report implies that Winston and Strawn examined these 648 documents and that their conclusion is that they do not indicate tax evasion, in direct contrast with Chief Magistrate Judge Langford. Since this finding directly questions Judge Langford’s wisdom, ChevronTexaco should be required to make the documents available to the public in conjunction with any agreement by the State not to prosecute. 
 

4.    The arrangement existed outside of the 1983-1986 time period referred to in the AG’s Report.

The AG’s Report claims that Chevron and Texaco’s overpricing/kickback/Special-Dividend arrangement represented a minor transgression between 1983 and 1986 for which the companies have already paid their debt to the State of Hawaii. We assert that this is not true. Specifically, this section documents that: (A) Special Dividends, a key element of the arrangement, existed both before and after the 1983-1986 period, (B) the kickback existed prior to 1983 under a different name than “WHA,” (C) Chevron executives contemplated several different (probably illegal) ways of replacing the WHA arrangement in January 1986, including the creation of a “Downstream Processing Allowance,” and (D) ChevronTexaco’s fourth quarter earnings press release indicates that the false prices and kickbacks continue.

    A.    Special Dividend payments were made both before and after the 1983-1986 period.

The following table shows the dividends paid (in $ millions) by Caltex to each of its 50% shareholders for the years indicated, as reported in Chevron and Texaco annual reports:
 

The AG’s Report cites sworn testimony that the receipt of the WHA ended on January 31, 1986 (see #2 above regarding undisclosed “sworn testimony”). Unfortunately, the AG’s Report does not present a copy of the testimony. A Caltex letter to Chevron and Texaco executives on January 28, 1986 (Hom 1996, Exhibit L), just 3 days before the January 31, 1986, “ending” date states in part:

As we have discussed the past few days, the drastic decline in crude oil prices has resulted in the calculated WHA approaching a level so high that there is not enough SL [Sumatran Light crude oil] production available for CandT [Chevron and Texaco] to lift to fully cover the WHA. And even if there were enough crude available, it is far more than the shareholders can utilize in their refining systems.

The letter offers four alternative means of dealing with the problem:

    1.    One solution would be for PN [Pertamina] to pay CPI [Caltex] (in kind) on an after-tax basis.[Elaboration follows in the original text.]

    2.    PN could pay CPI in cash for the WHA.[Elaboration follows in the original text.]

    3.    Establish an unofficial Reference Price (RP) that would be used to calculate taxes, cost oil, weighted average price, investment credit and WHA.[Elaboration follows in the original text.]

    4.    Another possible alternative to the WHA is a Downstream Processing Allowance (DPA). As we visualize this, it would be a booked charge by CPI to costs, based upon a calculated downstream loss per barrel, which currently must be absorbed by shareholders’ refining and marketing organizations. As we see it, this allowance would be passed to the offtake companies by CPI, and through them to the actual recipients of the crude oil, so that their purchase price per barrel would have a processing credit to offset the “inflated” GSP. [Elaboration follows in the original text.] (emphasis added)

We do not know whether a new method of achieving the same results that the WHA provided was achieved. We do know, however, that the executives explored renaming the kickback the “Downstream Processing Allowance (DPA)” as one of four alternatives.  Although not stated in the AG’s Report, we hope that the AG investigated whether the WHA was replaced with a similar kickback scheme under a different name.  The four alternatives were designed as possibilities for replacing the WHA but none of the alternatives simply corrected the accounting for the existing structure.

    D.    ChevronTexaco’s fourth quarter earnings press release shows that false prices and kickbacks continue.

    Outside of our research paper, we have stated that the overpricing/kickback continued into the fourth quarter of 2002, based on evidence in ChevronTexaco’s own press report (Chevron 2003, p. 4).  Specifically, we asserted that the reduction in barrels pursuant to the production sharing agreement wit