The tax bar is a repository of the greatest ingenuity in America, and give them the opportunity, they will do you in. --Martin D. Ginsburg, a member of the tax bar, in testimony to the House Ways and Means Committee.
A number of corporations involved in mergers and takeovers are using new forms of high-stakes tax avoidance, capitalizing on arcane provisions of the code to escape hundreds of millions of dollars in federal taxes.
These tactics, under critical examination by experts in Congress and the Treasury, cost the government $500 million to $1 billion a year, according to congressional estimates. Specialists contend the losses could balloon to far higher levels as more companies catch on.
Most of the mergers and acquisitions in which taxes have been avoided have involved oil and natural gas properties, the value of which has risen sharply in recent years.
The tax avoidance tactics are classic examples of corporations' taking advantage of regulations designed to govern other transactions, particularly dealings involving small family businesses, and sections of the tax code enacted by Congress without either debate or public knowledge of the purpose.
The firms using the regulations and code provisions to advantage include U.S. Steel, which acquired Marathon Oil in one of the most controversial mergers in recent years; Conoco; Esmark, and IU International.
In the case of U.S. Steel, estimates of the potential tax avoidance in the first year are about $400 million, according to the publication Tax Notes. "I haven't heard that figure disputed," a U.S. Steel spokesman said. "It could be a big-ticket item," the spokesman said. "We want to take advantage of the law as it exists." He added that U.S. Steel has asked the Internal Revenue Service for a ruling on the permissibility of the tax break.
Legislation to prevent the practices has been introduced by Rep. Fortney H. (Pete) Stark Jr. (D-Calif.), chairman of the Ways and Means subcommittee on select revenue measures, which held hearings last week. A similar measure has been introduced in the Senate by Howard M. Metzenbaum (D-Ohio).
Their contention that the tax provisions are incentives for mergers that might not otherwise be economically justifiable is shared, in large part, by the Treasury. There is not, however, full agreement between members of Congress and Treasury officials over the best way to remedy the situation.
At the same time, a host of tax lawyers and accountants is lining up to argue that while there may be abuses, the Stark bill goes too far.
The two tax mechanisms under fire are:
A method whereby companies can take full depreciation deductions on assets purchased in a merger while avoiding most, or all, of the normal requirement that previous tax savings from depreciating the same assets be paid back to the federal government.
For example: Company A buys Company B. B owned an oil field but had already taken most of the depreciation deductions on it. Company A, however, wants to collect the depreciation benefits from the field which, with the increase in the cost of oil, have grown enormously. This is permissible but, in most parallel situations, the earlier tax breaks taken by B would be taken back by the federal government in a process called "recapture."
Complex rules governing what are called partial liquidations under consolidated corporate tax reporting, however, permit Company A to avoid almost all of the "recapture" requirements. Congressional aides describe this as "double depreciation."
The second tactic involves avoidance of corporate capital gains taxation when a firm sells an asset that has increased significantly in value. Instead of a sale, which would mean that the company selling the asset would have to pay capital gains taxes on the increased value, the transaction is completed using a stock "redemption."
In this situation, Company A wants to acquire, for example, an oil field from Company B for $500 million. Company A buys $500 million worth of the stock in Company B. Company B then "redeems" the stock by buying it from Company A in exchange for the oil field.
Although far more subject to challenge by IRS than the first method of avoiding tax, companies using this kind of scheme contend that, under the law, a tax-free stock redemption occurred, not a taxable sale of property.
U.S. Steel is seeking IRS approval to use the first of these two mechanisms, the "partial liquidation," to gain the full tax advantages from acquiring Marathon's most valuable asset: a 50 percent interest in the Yates oil field in Texas.
As written, the regulations apparently permit U.S. Steel to get full tax benefits from the oil field despite the fact that the same tax breaks were claimed previously by Marathon.
The number of firms using the technique is unknown, but IRS has been issuing private rulings allowing similar practices at the rate of over one a week, according to one tax lawyer.
Mobil Oil Corp. used the stock redemption tactic in buying TransOcean Oil Inc. from Esmark for $740 million. Instead of paying cash, which would have required Esmark to pay a capital gains tax of about $100 million, Mobil bought Esmark stock. Esmark then redeemed the stock and paid Mobil with the stock controlling TransOcean.
Among tax lawyers, whose main function is to find ways for clients to avoid taxes, the tactic has been dubbed "the Mobil-Esmark technique." In fact, however, credit for developing the tax avoidance mechanism belongs to IU International.
IU International in 1980 received $275 million when it sold 58 percent interest in a Canadian subsidiary, Canadian Utilities, to ATCO Ltd. In a "share swap," ATCO bought common stock in IU International. IU then redeemed the stock by paying ATCO with its holding in Canadian Utilities.
"It was a tax free exchange," Robert Calman, vice chairman and chief financial officer for IU International, said. "We never thought of it as a sale. It was an exchange. We were pleased with the transaction."
The taxes that would have had to be paid if the transaction had been a sale are not clear. But they are estimated at well over $10 million.
A much larger tax savings was achieved, about $250 million, when Conoco used a stock swap to transfer 53 percent interest in Hudson Bay Oil and Gas Co. to Dome Petroleum Ltd.
The Dome-Conoco transaction "came on the heels of our deal," Calman said. "They never talked to us, but we think they read our papers."
In testimony at the Ways and Means hearing, David G. Glickman, deputy assistant treasury secretary, agreed with much of the criticism of the two practices under review, although he indicated that the Treasury wants to explore other ways of controlling them.