Earlier today I came across this interesting article from NY Times author Gretchen Morgenson explaining how the federal government can increase tax revenue by targeting one specific type of tax avoidance. Check out the text below.
Financial engineering — funky mortgages, off-balance-sheet vehicles and complex derivatives — contributed mightily to our current crisis. And the meltdown’s resolution, by no means complete, has already required hundreds of billions in taxpayer commitments.
If the Treasury is ever to replenish its coffers, increased tax receipts will be sorely needed. But these inflows could be reduced if an unusual tax-avoidance transaction — set up to allow losses at one company to offset profits at another — gains acceptance throughout corporate America.
Given the potential tax benefits associated with the strategy (and given the enormous losses that have been generated across industries in recent years), the popularity of the maneuver is almost certain. At least that’s the view of Robert Willens, an authority on taxes and accounting, who spent decades at Lehman Brothers and now runs his own shop in New York.
In an article that was published last week in Tax Notes, a well-regarded publication devoted to tax policy and analysis, Mr. Willens examined a deal that Bank of America completed for a unit of Fairfax Financial Holdings, a Canadian insurance company, and the Odyssey Re Holdings Corporation, a writer of property and casualty reinsurance that had been spun out of Fairfax in 2001.
The complex structure allowed Odyssey to avoid paying taxes on some of its profits by shifting those earnings onto Fairfax’s books. Fairfax had weathered nearly $1 billion in losses accumulated during a previous downturn in the insurance market. So it had losses it could use to offset the Odyssey profits coming onto its books. And the shift saved Odyssey an estimated $400 million in taxes.
The debate over the tax structure is contentious. Fairfax says that the Internal Revenue Service signed off on it and that the company has done nothing untoward. It also disputes Mr. Willens’s impartiality in questioning the transaction, citing his work as a paid consultant for a hedge fund that has targeted Fairfax.
Under tax rules, offsetting losses against gains can occur only among companies operating within the same parent corporation and filing a consolidated income tax return. Therefore, a company hoping to shelter another’s earnings with its own losses must acquire at least 80 percent of the shares in that profitable enterprise. From a tax standpoint, a stake below 80 percent would mean the companies wouldn’t be affiliates.
THE particulars of the Fairfax deal are as follows: Before the Fairfax-Odyssey transaction, which was created in March 2003 and unwound in August 2006, Fairfax held 73.8 percent of Odyssey’s shares. To meet the consolidation threshold, Fairfax had to buy 4.3 million additional Odyssey shares. At the time, that required an investment by Fairfax of around $78 million.
But instead of paying cash for the shares, Fairfax struck a deal with Bank of America, its longtime banker, and issued debt to the bank in exchange for the stock. Fairfax issued two notes to an offshore affiliate of the bank in the amount of $78 million. The notes matured in 2010 and carried an interest rate of 3.15 percent, well below the rate Fairfax would have had to pay if it had issued debt publicly.
Through the affiliate, Bank of America agreed to borrow Odyssey shares from other investors and transfer them to Fairfax. Even though the Bank of America affiliate was short the shares it transferred to Fairfax, it retained several significant attributes of ownership in those shares, Mr. Willens says.
The Internal Revenue Service did not dispute the Fairfax-Odyssey consolidation for 2003 and 2004. Since the I.R.S. declines to discuss specific cases, it is unclear why it has not yet closed the books on 2005 and 2006 when the earlier consolidation was already in place and approved.
