New York unleashes new tax enforcement tool

On April 19 2012, New York State's Attorney General, Eric Schneiderman, announced that his office had filed a $300 million lawsuit against Sprint-Nextel Corporation (Sprint) to recover sales taxes that Sprint had failed to collect from its customers and pay over to New York's state and local governments.

The suit against Sprint was the first time New York State had made use of the tax enforcement provisions of the New York False Claims Act. The suit against Sprint is also the first time New York State intervened in a tax lawsuit that was initiated by a whistleblower under the qui tam provisions of the New York False Claims Act.

The Sprint lawsuit marks the unveiling of a new strategy to help governments enforce their tax laws by using the prospect of substantial monetary rewards to encourage whistleblowers to report instances of possible tax fraud should those tips result in a financial recovery for the state.

Because a company's competitors, suppliers or employees could become a whistleblower in a False Claims Act suit, business owners and managers need to take heed of this new law and take steps to develop and strengthen internal compliance practices to identify possible problems before the company becomes a defendant in a False Claims Act lawsuit, and to avoid retaliation against employees who report possible illegal practices to company management.

New York's lawsuit against Sprint claims that, beginning in 2005, Sprint failed to collect sales taxes that New York State and its local governments assess on the sale of flat rate calling plans Sprint provides to its customers in New York State.

While New York State does not charge sales tax for interstate and international mobile telephone calls, it does charge sales tax when a mobile telecommunications service provider like Sprint charges a customer a flat rate monthly charge for a fixed number of minutes.

According to New York State, the sales tax applies to the entire flat rate charge, even if the customer subsequently uses those minutes for interstate or international calls. Sprint, on the other hand, denies the allegations and contends it is allowed to allocate the minutes of the flat rate plan between intrastate calls and interstate/international calls when calculating the sales tax due on the flat rate plan.

The lawsuit began in March 2011 when a whistleblower, known formally as a relator, filed a complaint under seal in New York State Supreme Court alleging that Sprint had knowingly failed to collect and pay over to the state the proper amount of sales tax due for flat rate plans.

While the case remained under seal pursuant to court order, the New York Attorney General's Taxpayer Protection Unit investigated the relator's allegations. After determining that those claims had merit, the Attorney General joined the relator's lawsuit and filed a superseding complaint that detailed how Sprint allegedly was aware of the New York tax law that assessed taxes on the full amount of the flat rate plan but chose to ignore the law and charge sales tax on only a portion of the flat rate charges.

New York's False Claims Act imposes penalties of up to $12,000 per false claim plus three times the amount of damages caused to the state government by the false claims. In addition, if there is a recovery by the state government in a False Claims Act suit, the losing defendant has to pay the attorney's fees and expenses of the relator's attorney and possibly those of the Attorney General as well.

In addition, the relator may receive up to 25% of the state's recovery as a reward. In the Sprint case, the Attorney General alleged that as of April 2012, Sprint had failed to pay $100 million in sales taxes, and is seeking the recovery of over $300 million from Sprint.

In 1863, during the Civil War, President Abraham Lincoln signed into law the False Claims Act with a qui tam provision that encouraged private citizens to file lawsuits against war profiteers and provided a portion of the federal government's recovery of funds to the private citizen.

Qui tam is the shortened version of a longer Latin phrase, "qui tam pro domino rege quam pro se ipso in hac parte sequitur", that has been translated to "he who brings an action for the king as well as for himself." The idea behind the qui tam provision of the False Claims Act was to create an army of private attorneys general to augment the limited resources of the federal government to root out and combat fraud against the federal government during a time of war. Since then, the False Claims Act has been amended several times to modernise the law.

Since 1986, the updated False Claims Act has been used to recover over $21 billion in monies fraudulently obtained from the US federal government in the context of defence contractors, government funded health insurance programs such as Medicare and Medicaid, mortgage banking, construction, federally sponsored research and federally supported higher education financing.

The False Claims Act permits a private citizen to file a lawsuit in the US federal courts on behalf of the US government and requires the relator to notify the US Department of Justice that a suit has been filed. The law allows the Justice Department at least 60 days to investigate the relator's allegations.

If, after investigation, the Justice Department determines that the relator's allegations have merit, the Justice Department may intervene in, and take the lead in, prosecuting the relator's allegations. If the Justice Department decides not to join the relator's case, the law permits the relator on his or her own to prosecute the case in the place of the Justice Department.

If a suit is successful, the relator receives an award in the amount of 15-25% of the government's recovery if the government intervenes and as much as 30% of the government's recovery if the government declines to join the case. Under this law, over $21 billion has been returned to the US Treasury. In addition, tens of billions of dollars have been saved given the deterrent effects of the whistleblower provisions of the law.

However, the federal False Claims Act does not apply to claims arising under the Internal Revenue Code. The law expressly forbids a private whistleblower to bring a case involving income tax fraud.

Thus, if a person learns that another person or business is engaging in tax fraud and not paying their taxes to the federal government, there is no provision under the federal False Claims Act to permit the whistleblower to file his or her own case in federal court that they can pursue if the government does not wish to proceed with the case.

Until recently, such a person's only recourse has been to file a report with the US Internal Revenue Service (IRS) and pray that if the information led to the recovery of federal tax dollars that the IRS would pay a reward for that information.

In 2006, Congress enacted a law to encourage people to come forward with such information with the promise of rewards if monies were recovered. But, while the IRS Whistleblower Office has received many filings by whistleblowers alleging tax losses and underpayments in the hundreds of millions of dollars, the IRS has yet to pay anyone for that information. One reason that may account for this lack of progress by the IRS is that the whistleblower may only file a report with the IRS – the whistleblower may not file his or her own case in federal court and pursue it on her own if the IRS does not.

In 2005, in an effort to encourage each of the 50 states to enact their own qui tam statutes to help the fight against Medicaid fraud, Congress enacted a law that promised to increase the share of a state's recovery from a Medicaid fraud case if the state enacted its own False Claims Act.

The reason is that Medicaid is jointly funded by the federal and state governments. Under this law, if a state had its own False Claims Act, the state would receive an extra 10% above the amount of that state's share of Medicaid funding.

New York State and the federal government share the cost of Medicaid in New York State on an even basis. Following the enactment of New York's False Claims Act in 2007, New York stood to receive 60% of any recovery in a case involving Medicaid fraud.

In 2010, New York State broke new ground when it added a provision to its False Claims Act that, for the first time, permitted a relator to file a case alleging a violation of the state's tax laws. As amended, the New York law now permits a whistleblower/relator to bring a case to recover taxes if the defendant's annual net income or sales exceeds $1 million and the damages alleged in the action exceed $350,000.

The Attorney General does not have unfettered discretion to use the New York False Claims Act in the tax arena. The amended law requires the New York Attorney General to consult with the state's tax commissioner before filing or intervening in any such case.

In addition, while a relator may proceed with a tax-related case if the Attorney General declines to intervene, the relator must obtain approval from the Attorney General before seeking to compel the state Department of Taxation and Finance to disclose any tax records.

Thus, unlike the case of the federal government's qui tam False Claims Act, a person with knowledge of tax fraud under New York's tax laws can file an action in the state courts and pursue the claim even when the state decides not to intervene in the case. It was under this new provision that the Attorney General's lawsuit to recover unpaid taxes from Sprint began as a qui tam lawsuit filed by a whistleblower in state court.

The financial incentive the New York False Claims Act qui tam law provides for tax whistleblowers provides a challenge for businesses. The vast majority of business owners and managers are honest and fair and comply with the law, but there are no guarantees that everyone in every organisation will do the right thing all the time.

The challenge faced by corporate managers is to create a corporate culture that encourages employees to report wrongdoing to their supervisors when they see it, rather than turn the other way and hide their head in the sand, or file a qui tam suit.

Some critics of whistleblower reward laws have argued that the laws discourage employees from internally reporting fraud as the employee is incentivised to go outside the organisation. But, in the author's experience of handling these types of cases for the last 20 years – both in the US Department of Justice and in private practice – almost all whistleblowers try to the do the right thing by reporting suspected wrongdoing to their supervisors and only after failing to be taken seriously or suffering from retaliation, including getting fired, do loyal and hardworking employees end up going to a lawyer and filing a qui tam suit.

The way to try to avoid becoming a defendant in a qui tam False Claims Act case is to develop and encourage a serious corporate compliance programme.

This entails educating employees about the need to comply with the laws and regulations that govern the particular business and to earn the trust of employees so they will take the risk of reporting possible wrongdoing internally.

This means corporate managers have to take whistleblowers seriously and accord reports of alleged wrongdoing seriously. Moreover, management level employees must be made to understand that it is unacceptable to retaliate against anyone who speaks up against possible wrongdoing.

If employees believe they are taken seriously and will not become the victim of retaliation, unemployed or ostracised from their industry if they report potential wrongdoing, they will be more likely to blow the whistle internally rather than file a qui tam suit.

David Koenigsberg (dkoenigsberg@mbkklaw.com) is a partner at Menz Bonner Komar & Koenigsberg in New York, and he represented the whistleblower in the Sprint lawsuit.