Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.
Zappers: Technology-Assisted Tax Fraud, SSUTA, and the Encryption Solutions
Richard Thompson Ainsworth*
“Zappers,” or automated sales suppression devices, have brought unheard of efficiencies and economies of scale to a very simple tax fraud—skimming the cash sales that pass through point of sale (POS) systems and network connected electronic cash registers (ECRs). Until recently, “the largest criminal tax case in the history of Connecticut,” which also was the “largest computer-driven tax-evasion case in the nation,” was a Zapper case. Stew Leonard’s Dairy, a local grocery chain associated at one time with a dairy farm in Norwalk, Connecticut, skimmed an estimated $17 million in receipts over a ten-year period. Stewart J. Leonard took the skimmed cash out of the country in large denomination bills by suitcase to St. Martin in the Caribbean.
More recently, Talal Chahine and his wife, Elfat El Aouar, owners of the 13-store La Shish restaurant chain in Detroit, Michigan, acquired the dubious distinction of replacing Stew Leonard’s Dairy as the leading U.S. Zapper case. Although Elfat was sentenced on May 16, 2007, to 18 months’ imprisonment for income tax evasion, Talal is believed to be in Lebanon and remains a fugitive from U.S. authorities who have issued a warrant for his arrest. Talal and Elfat zapped more than $20 million in cash sales over a five-year period and sent the funds in small denomination cashiers checks to Lebanon, allegedly to fund Hezbollah terrorism.
Zappers have also led to state sales tax evasion audits. For example, the state of Connecticut commenced its audit of Stew Leonard’s Dairy “as a result of IRS actions, in February, 1992.” In 1993, when Stewart J. Leonard pleaded guilty in the federal income tax evasion audit, the Connecticut sales tax audit was nowhere near completion. In February 1996, the Connecticut Department of Revenue Services (Connecticut Tax Department) auditor “issued a final tax determination report, proposing” a little over $500,000 of sales tax liability, which was fixed in a notice of assessment issued in March 1996, in the amount of $1,402,514.24 (tax reported above, plus interest and penalties). Ultimately, the Connecticut Supreme Court determined (for the open periods) “that there was no credible evidence” that Stewart J. Leonard and the Stew Leonard Dairy had underreported sales tax. It upheld the trial court’s decision, since proof that the taxpayer committed federal income tax fraud was not proof that the taxpayer committed sales tax fraud. Relying on testimony in the record by Service agents that the taxpayer’s fraudulent income tax evasion scheme (conducted through a Zapper called the “Equity Program”) had no effect on the reporting of state sales tax, the Connecticut Supreme Court refused to “conclude that the trial court abused its discretion by failing to draw the adverse inference.”
There is no public record of any state sales tax evasion actions by the state of Michigan against Talal, Elfat, and the La Shish restaurants. However, it seems likely that along with skimmed gross receipts are skimmed sales taxes. The Michigan Department of Revenue was unable to confirm or deny the existence of any actions based on the state’s privacy laws.
Zapper fraud is not confined to the United States. Zappers are a significant problem in the European Union (EU), where they are under the intense scrutiny of a nine-country research group, the Fiscalis Committee’s Cash Register Project Group. Zappers have been detected in Canada, Brazil, Australia, Sweden, Norway, Belgium, Portugal, Germany, the Netherlands, and France. A German Working Group on Cash Registers, comprised of the highest-tier central and regional tax authorities, is examining Zappers and has issued an interim report. Work on a technological solution to Zapper fraud is underway at the German National Metrology Institute (PTB: Physikalisch-Technische Bundesanstalt) where the INSIKA project (Integrierte Sicherheitslösung für Kassensysteme—Integrated Security Solutions for Cash Registers) began in 2008. A Canadian pilot project that will test a similar solution in volunteer restaurants in Montreal and Quebec City is expected to begin in November 2009.
When one compares the U.S. Zapper experience with other countries, it is not the similarity in the fraud mechanism (the Zapper) that is the most striking; it is the difference in the way Zappers are uncovered that catches one’s attention. Outside the United States, authorities identify Zappers primarily through consumption tax audits (such as value added tax (VAT) or goods and services tax (GST) audit). Conversely, within the United States, authorities uncover Zappers primarily through federal income tax investigations.
Not surprisingly, the investigative results also differ. Consumption tax investigations tend to focus on the Zapper itself, whereas income tax investigations tend to focus on the specific fraudster and the Zapper is simply the means selected to commit the fraud. As a result, consumption tax investigations frequently result in multiple enforcement actions against many unrelated but competing businesses, all of whom are using the same or similar Zappers. In contrast, income tax investigations frequently result in isolated single taxpayer enforcement actions. Thus, where consumption tax enforcement may uncover tens or even hundreds of Zappers within a marketplace (many of whom may be engaged in relatively low levels of fraud), income tax enforcement actions focus on specific taxpayers whose fraudulent activity either has a very significant revenue impact or has other serious consequences, such as the alleged terrorism funding in the La Shish matter.
In Part II, this Article reviews U.S. and foreign experiences with Zappers. Part III discusses the difficulties in measuring the scope of Zapper tax fraud on a national and international level, as well as highlights several of the findings and solutions of governmental working groups analyzing technology-assisted tax fraud. Part IV focuses on U.S. Zapper enforcement actions and explains how income tax enforcement alone misses the full enforcement mark. This part also details recent technological solutions developed at the state and local tax level in the United States through the Streamlined Sales and Use Tax Agreement (SSUTA) to ensure tax collection from vendors. Part V sets forth several proposals to address Zapper tax fraud. The primary recommendation is for creative use of certified tax software solutions under the SSUTA. Specifically, a certified service provider under the SSUTA could be employed in conjunction with the cryptographic cash register security process under development through the German Working Group on Cash Registers Project to ensure that the correct amount of sales tax is being collected and remitted and income tax paid to the states and federal government, respectively. In addition, this Article advocates technology-intensive federal and state cooperative enforcement actions against Zappers and concludes that only a joint effort will be successful in uncovering and shutting down technology-assisted tax fraud.
*Director of International Government Affairs at ADP Taxware, Inc. in Wakefield, Massachusetts; Adjunct Professor at Boston University School of Law