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August 21st, 2014

Mergers: The In Version

Inversion denotes a yoga position, but now connotes corporate finance.

Using an inversion transaction structure, several U.S. corporations have recently announced mergers with foreign corporations where income tax reduction is one of the motivations for the business combination. In typical “the sky is falling” fashion, both the popular press and the unpopular elected officials have expressed their outrage over this legal maneuver as unpatriotic and evil. Ironically, the ownership of these news organizations and many of the largest financial supporters of the same politicians are tax avoiders at the Olympic level. Perhaps a brief review of some of the longstanding tax dodges and dodgers that annually cost the IRS billions might be useful.

Warren Buffet, whose public relations continue to position him as a Jimmy Stewart-like character, has rarely seen a tax for which he could not find a trap door. Warren is widely quoted as an advocate for a rich man’s tax, yet his recent disposition of a long term holding in The Washington Post is perhaps a better mirror of his soul. His sale of Berkshire Hathaway’s interest in the Post, via Graham Holdings, a paper with many articles expressing shock about corporate inversions, earned Berkshire Hathaway 100x their investment. Total tax owed and paid by Berkshire, on a gain of one hundred times their money, was zero. This was accomplished by use of the “like-kind” exchange tax rules. Instead of giving cash to Berkshire for their stock, Graham gave Berkshire a TV station and Berkshire stock Graham owned to avoid the tax. This also lets Graham avoid tax on disposition of the TV station they have owned since 1969. In Berkshire’s case, they avoided the tax on a $1.1 billion stock disposition.

Apple Computer, whose many executives are active political donors, avoided paying any U.S. tax on $9 billion in earnings in 2012 by keeping the income offshore. Apple uses a tax device known as “a double Irish with a Dutch sandwich” to keep their income stateless. Merck, whose pretax income rose to $1.9 Billion last quarter actually had a negative tax rate. The government owed Merck money due to the system’s vagaries. General Motors earned $5.6 Billion in 2012, but paid no taxes as the U.S. waived bankruptcy law, in 2009, to permit GM to carry forward losses that no other bankrupt company legally could. Ironically, the U.S. is letting bankruptcy law shield GM from victims’ claims over faulty ignition causing deaths. Charles Darwin is rolling over in his grave.

A substantial subset of the massive legal tax escapes is available to certain legal entities, or to certain industries, both of which have filled political coffers with everything from booze to Bitcoin. The Master Limited Partnership (MLP) is a structure that permits corporate earnings to be passed untaxed at the business level through to the owners. If a MLP acquires a tax paying corporation, the tax paying corporation ceases to pay any future taxes. Kinder Morgan was a corporate savant in using the structure to avoid taxes and as an acquirer to remove corporations from the tax rolls. Real estate, an industry that long ago developed an allergy to taxes, was successful in gaining approval for Real Estate Investment Trusts (REIT) to pass through its untaxed income to owners. Beyond traditional real estate being granted this tax treatment, it is now being sought by others who are seeking to be classified as real estate. Windstream, an owner of a copper and fiber network, otherwise known as wires, recently gained REIT status for its network from the IRS and will not have to pay hundreds of millions in taxes. Another tax device that has received recent attention is the use of basket options by hedge funds to convert ordinary income into long term gains. Hedge funds have large amounts of short term trades, many that are often positions held for seconds. Basket options are sold by banks to hedge funds on accounts normally held by banks, but controlled by hedge funds, to accomplish the conversion of holding periods. These transaction highlight the opposite concern surrounding the private equity carried interest issue where critics wish to tax long term gains at short term rates. Hedge fund short term income is being converted into long term gains by clever option strategies permitted by the law. In short, inversions represent only the latest variant of corporate tax reduction efforts that result from a tax code created by a series of uncoordinated laws rarely drafted incorporating notions of either fairness or of federal spending requirements. Laughably, many of the voices loudly proclaiming their support for a “fairer” tax burden are the voices of the tax avoiders.

The largest ever bankruptcy of a leveraged buyout, TXU, recently occurred. TXU, now known as Energy Futures Holding Corporation, was purchased in a $45 billion buyout in 2007. All of the press coverage has been devoted to the size of the failure and to the absence of prudence in leveraging a bet on natural gas price movement. An associated public policy question is raised by the bankruptcy. Dodd-Frank was ostensibly created to combat systemic risk and several congressional hearings have echoed the supposed “systemic risk” posed by private equity investments. A quick look at the facts of the TXU failure sheds light on that myth. TXU filed for bankruptcy: What happened next? 1) The debt traded up in price. 2) No workers lost their jobs. 3) The equity investors had a realized loss. 4) Debt holders were positioned to take control of the company. 5) The system yawned. If a $45 billion loss, the largest in private equity history, does not cause the system to palpitate, against what risk is Dodd-Frank protecting us? Inclusion of PE in Dodd-Frank has now diverted substantial finite SEC resources from hunting for the next Madoff and, instead, looking for a non-existent threat. Time to end the charade.

A typical public company annual meeting lasts a few hours. The State of the Union address is a touch more than an hour. It is a challenge to believe it requires two days to summarize a firm’s activities. Presentations are often reminiscent of Beowulf, where the same story is retold several times for fear the audience missed a point. Dodd-Frank will no doubt reduce both the continued presence of guests whose presence is being paid for by the PE Fund and the delivery of attendee gifts or free sports activities. As technology progresses, the entire process might move to an app available on an investor’s smart phone.

I’m Rob Morris and I approved this blog.

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