Tax reform is the hot topic these days — but changing corporate tax law is usually so complicated that everybody gives up in frustration and disgust. So let me offer a simple thing that Congress can do to close one loophole that was small and obscure for years but is threatening to go mainstream and suck billions of dollars out of our collective pockets.
The loophole involves household names such as Duracell, Procter & Gamble and Warren Buffett. And it may soon involve Yahoo and one of China’s biggest household names: Alibaba, the successful Web company.
The loophole is something called a “cash-rich split-off” that allows companies to dispose of assets on which they have big gains and to emerge with cash without technically selling anything. Company A puts cash or other “investment assets” plus an operating business into a subsidiary that it swaps tax-free to Company B in return for B’s holding of A’s stock. The loophole is that the business has to be only a third of the value of the total transaction. So you can have what amounts to a sale masquerading as an asset swap.
Take the pending transaction for Buffett’s Berkshire Hathaway to trade its stock in P&G for P&G’s Duracell business and $1.8 billion to $1.9 billion of cash.
Berkshire’s P&G holding, worth $4.7 billion when the deal was announced, cost it only $336 million. A cash-rich split-off would let Berkshire avoid tax on a $4.36 billion gain. At a 38 percent combined federal and state corporate income tax rate, Berkshire saves $1.66 billion, compared with selling the stock for cash. It’s not clear how much P&G saves, but it could be as much as $1 billion, compared with a straight-up sale of Duracell (which P&G has said it has no intention of doing). Neither company would comment on my numbers, which are based on public filings.
The tax avoided by Berkshire and P&G total serious money — but Yahoo and Alibaba might do a deal that makes this look like small change.
Yahoo, which owns $39 billion of Alibaba stock for which it paid little, is under pressure from hedge funds to do something tax-efficient with its big BABA holding, which is worth far more than Yahoo’s businesses.
If Yahoo did a $15 billion cash-rich split-off with Alibaba, it would save $5.7 billion of tax, compared with a straight-up sale. Yahoo would emerge with Alibaba businesses worth $5 billion or so and about $10 billion of cash, which would provide it with a hefty war chest. Yahoo could then distribute the balance of its Alibaba shares to its shareholders tax-free. Everyone would be happy — except for those of us who care about drains on the Treasury. (I don’t know how much gains tax Alibaba might save on businesses it might swap to Yahoo, but I’m sure it would be substantial).
I’ve been writing about cash-rich split-offs since the first one emerged in 2003. Until now, I’ve treated them as an amusement. After all, these deals are specifically allowed by the tax code, they involve interesting convolutions and aren’t remotely like the games that the likes of Apple or General Electric play.
But the Berkshire-P&G deal and the prospect of a huge Yahoo-Alibaba deal made me sit up and pay serious attention. It’s the same kind of reaction I had last year when drug giant Pfizer tried to turn itself into a British company by acquiring AstraZeneca, which would have reduced Pfizer’s taxes sharply. That woke me up to the dangers of corporations deserting our country for tax purposes and led to the essays I wrote last year about so-called tax inversions.
Dealing with inversions is complicated and has serious societal and business implications. That’s why nothing has been done to stop them other than some useful but limited technical changes the Treasury put in place.
But it’s easy to close the cash-rich split-off loophole, which is nothing but a tax game. How? Require that more than 90 percent of the deal’s value (rather than the current one-third) consists of operating businesses. Tax expert Robert Willens says you can do this by tweaking Section 355(g)(2)(A) of the tax code to define a “disqualified investment corporation” as one whose investment assets are 10 percent or more of its total assets.
Before we proceed, some disclosures. Berkshire has done three of these split-offs, including one last year with Graham Holdings, the former owner of The Washington Post. I own stock in both Berkshire and Graham, and I am a Graham pensioner. I’ve posted details on all of Berkshire’s split-offs here.
It’s probably too late for the tax-code change I suggested to stop the Berkshire-P&G transaction, because it has been announced. But it’s not too late to stop a possible Yahoo-Alibaba deal or others that might emerge now that cash-rich split-offs are getting high profiles and Buffett’s imprimatur.
Sure, closing one loophole isn’t as good as fixing the whole corporate tax code. But picking low-hanging fruit is better than picking no fruit at all.