Bogus Tax Reaps Easy Money

How would you feel if you found out that the grocery store where you shop had been charging you a non-existent sales tax for the last 10 years? The fictitious sales tax was pure profit for the store and wasn't remitted to any taxing authority. The store's profit margins exceeded those of similar stores operating honestly and probably earned nice bonuses for the managers involved in the fraud.

That's what happened in this case although on a much larger scale. A confidential source told U.S. Secret Service agents that International Catering Services (ICS), an airline catering company, was charging airline companies at the Elmville International Airport, a 4.55 percent port fee and 6 percent state sales tax on those fees. The problem was that the port fee had been eliminated at the Elmville airport 10 years ago. It appeared that ICS was pocketing all of the port fees.

The airlines believed that the port fee at Elmville, like the port fees at many other airports, was a legitimate tax imposed by the airport authority. According to catering and airline industry officials, business negotiations historically had been conducted in a spirit of trust and confidence in the honesty and integrity of all parties. To err is human; to intentionally err for financial gain is fraud.

Federal prosecutors focused on alleged violations of mail fraud, wire fraud, and money laundering statutes during the 10 years under investigation. Investigators initially found that ICS illegally collected approximately $8 million in bogus Elmville port fees during that period.

Port Fees Defined
Port fees are imposed on vendors in the form of a tax administered by an airport authority. The fees aren't negotiated items; the airport authority levies them. Charges for port fees and sales taxes imposed on vendors operating at the airport, such as caterers, are passed on to the customers of the vendors, such as airlines, dollar-for-dollar. This is the same way that any sales tax operates; the grocery store charges you the sales tax that's been properly levied and remits it to the appropriate governing authority.

Airlines expect to pay port fees at most major airports as a necessary cost of doing business with catering companies. All parties assume that the vendors will give the port fees to the airport taxing authority. Vendors at the facility, such as caterers, are required to remit port fees to the taxing authority. Vendors don't collect port fees for their benefit just as employers don't withhold Social Security taxes from employees' salaries for the employers' benefit. Levied taxes are not a source of net income.

Financials Foretell Fraud
ICS's own internal operating statements told even a casual reader that strange things were happening with the port fees in Elmville. Because port fees are merely to be collected and remitted, there should be offsetting figures on the ICS's statements in the income and expense categories. These statements showed an income item labeled Access Fee Income (Port Fees) and an expense item labeled Access Fee Expense (Port Fees). For any given year, these two figures should be approximately the same amount.
Selected figures below illustrate what was reported at Elmville with what was reported by ICS at several other airports in one year. Note that the access (port) fee income and access (port) fee expense are approximately the same, as it should be for a pass-through tax, at the other airports:

An alternative to recording pass-through items such as payroll taxes or port fees is to never categorize them as either revenue or expense but to set up a payable such as Federal Income Taxes Payable or Port Fees Payable. Port fees would be credited (increased) to the payable account when billed to the airline and debited (decreased) when remitted to the taxing authority. The port fees account should have a zero balance when both transactions have been recorded.
For the same year as shown above, the net income percentages (net income/total income) of these locations also highlight the higher net income percentage of a facility collecting but not remitting port fees:

(As shown in these charts, small schedules or flow charts can make a point more effectively than detailed presentations. It may take weeks or months to assemble the evidence and backup materials used to arrive at a final schedule, but it should take only a few minutes to explain it to a prosecutor, judge, or jury. If necessary, you can still present layers of schedules that become more detailed at each level while retaining the integrity of the facts and always tying them back to the summary schedule.)

ICS claimed innocence. But investigators discovered an incriminating overhead projector transparency prepared for a meeting of ICS senior executives. The transparency, listing Elmville's reasons for outstanding performance, contained a quote from an ICS manager: "The other impact, as we all know, is port fee ... (which has a) 100 percent effect on gross margin." A 100-percent effect on gross margin means the whole dollar of revenue is flowing through to gross margins as would happen with an unremitted port fee.

ICS's Unsuccessful Defense
Key managers at ICS's corporate headquarters received substantial bonuses because of the fraudulent Elmville port fee charges. When the government confronted ICS with the evidence, company officials tried but couldn't explain away the alleged fraudulent practices. Understandably, the company didn't want to return the millions it had charged the airlines.

The government gave ICS a chance to answer the charges at a meeting early in the investigation. Attending were representatives from ICS, its legal team, and an accountant from a large national accounting firm retained by the company. The government team at the meeting consisted of representatives from the U.S. Secret Service, the Postal Service Inspector's Office, and consultants to the Secret Service from Nossen & Associates, a forensic accounting firm. ICS's detailed data presentation didn't support its argument that it had given the airlines in Elmville a "credit" to compensate them for charging port fees, which ICS had retained for its own use. In fact, the purported credit was simply an after-the-fact calculation designed to justify the improper port fee. During the presentation the government team realized that some of the schedules ICS used weren't historical documents at all but schedules that had been prepared expressly for the meeting. ICS's managers referred to them as "reconstructions."

ICS's presentation didn't counteract the government's charges but actually supported them. Prior to another meeting requested by ICS, a newly hired vice president said he would bring "contemporaneous" documentary evidence to support the claim that "credits" had been given to Airline A. However, the documents he presented at the meeting were basically the same as those presented at the previous meeting. When asked about this, the vice president said he relied on "inductive reasoning" to come to his conclusions. He knew less about the details of the case than the other people at the meeting. Because he had been with ICS for only a few months, he frequently answered questions by saying, "I wish I could tell you but I wasn't there."

Investigative Actions and Outcomes
The government executed search warrants and seized ICS's records. Nossen & Associates staff members Dick Nossen, Joan Norvelle, Wendy Spaulding, and Russ Barefield examined the records to determine if ICS had imposed, collected, and retained port fees and, if so, to what extent.

The financial team reached these conclusions:
1. The Elmville airport authority hadn't imposed a port fee for a 10-year period.
2. ICS collected approximately $8 million based on charges for fictitious port fees during that time.
3. Airline A was a major customer of ICS's services at the Elmville airport and therefore became the largest victim of ICS's fraudulent activities. ICS also defrauded Airline B and Airline C.
4. None of the fictitious port fees collected by ICS in Elmville were remitted to the Elmville airport authority.

A year later, after further meetings and negotiations, ICS provided $6.9 million to the U.S. government; all parties agreed to the Stipulation and Settlement Agreement in Lieu of Forfeiture filed in the U.S. District Court. The following wording is taken directly from the Order of the Court:
The parties have filed with the Court a Stipulation and Settlement Agreement in Lieu of Forfeiture, which resolves all outstanding matters in this case. The Court accepts the settlement of the parties and finds that (International Catering Services), and the claimants Airline A and Airline C have consented to the Magistrate Judge conducting all proceedings in this matter, and that the actions of the United States in the investigation and seizure resulting in this settlement were reasonable and proper.

Based upon the above findings, and deeming it proper to do so, it is HEREBY, ORDERED, ADJUDGED AND DECREED that:
1. The United States shall distribute the sum of $5,700,000 to Airline A;
2. The United States shall distribute the sum of $86,485.47 to Airline C;
3. The United States shall distribute the sum of $1,113,514.53 to the United States in lieu of forfeiture of the defendant property; and
4. The United States is directed to notify the Court once the checks have been distributed.

According to the settlement, ICS also agreed to repay Airline B $325,000 for the total amount of fraudulent port fees taken from that company billed during the 10 years under investigation. Additionally, after the initiation of this investigation, ICS made payments of more than $4.5 million to compensate for false port fee charges at other airports in the United States.

ICS officials, even at the time of the settlement, contended that there was no intentional over-collection of airport fees or wrongdoing. From the government's perspective, however, the United States Attorney for that jurisdiction announced that this settlement allows the government to make the victim airlines whole and at the same time takes away from (ICS) the benefit, which it obtained through its improper conduct.

Joan Norvelle, Ph.D., CFE, and Wendy Spaulding, CPA, provide forensic accounting services, including expert witness testimony, to federal law enforcement agencies. Norvelle is a Regent Emeritus. Her e-mail address is: .