It used to be easier to avoid paying corporate taxes. Back in the 1990s, many corporations used tax shelters that had little economic substance other than to dodge tax liability. Aggressive enforcement actions by the Internal Revenue Service, coupled with changes in accounting and reporting requirements, have combined to make these shelters unattractive to most companies.
Yet the effective rate of tax paid by American corporations has not increased in recent years. Executives and tax directors have found other ways to avoid taxes, combining creative lawyering, aggressive valuation and a high tolerance for complexity.
These tax avoidance mechanisms are mostly legal and hide in plain sight, taking advantage of tax rules written in the days when assets were tangible and difficult to move, properties were sold rather than “monetized†and forms of business organization were fixed and simple.
For multinational corporations, the most common method of tax avoidance relies on moving intellectual property overseas, where profits derived from those assets can be sheltered in low-tax jurisdictions.
Other methods of tax avoidance have received less news media attention but are no less troubling. A recent deal by LIN Media, a media company backed by the private equity firm HM Capital Partners and the investment manager Royal W. Carson III, highlights two techniques. LIN Media owns 43 local television stations around the country, including the CBS affiliate WIVB in Buffalo, the Fox affiliate KHON in Honolulu and the CBS affiliate WISH in Indianapolis, along with other media assets.
In July, it merged with itself. Who knew this was possible? While the merger was trivial from a business standpoint, it generated half a billion dollars in tax losses that the company used to shelter its gain from an earlier deal and eliminate its tax liability.
From a technical standpoint, the former publicly traded parent company, the LIN Corporation, merged with a newly created limited liability company, LIN L.L.C. From a business standpoint, the deal was nonsensical. LIN’s shareholders exchanged their shares in the old company for shares in a new L.L.C., but the business was otherwise unaffected. The deal cost several million dollars in fees paid to bankers and lawyers and countless hours of time and attention from the company’s executives and advisers.
LIN Media did not respond to requests for comment.
Like the shelters of the 1990s, the LIN deal was motivated solely by tax considerations. Unlike those shelters, though, it has enough economic substance to possibly survive an audit.
It is not yet clear whether other companies will try to replicate LIN Media’s tax loss alchemy, but LIN’s advisers on the deal, at Deutsche Bank, promoted the deal in the context of other recent deals that were taxable to stockholders, including DE Master Blenders’ spinoff from Sara Lee, Tim Hortons’ move to Canada, and AON’s move to Britain. And LIN’s legal counsel, Weil, Gotshal & Manges, is known for representing financially troubled companies â€" precisely those companies that often have unrecognized tax losses on the books.
The roots of the deal go back to the late 1990s. LIN TV had monetized some assets through a “leveraged partnership†deal with General Electric and its NBC subsidiary. “Monetized†is banker language for a tax-free sale. Leveraged partnership deals have been popular for some time, often using a technical reading of the relevant tax statute that does not always hold up in court.
In 1998, LIN TV contributed assets to a joint venture with G.E. If LIN had sold the assets outright, it would have created a large taxable gain. Instead, a LIN affiliate guaranteed repayment of a billion-dollar note that the joint venture borrowed from GE Capital, allowing LIN to extract cash from the deal without paying an immediate tax bill. The joint venture was deemed worthless for accounting purposes back in 2008, but LIN stayed in the joint venture while looking for ways to shelter the deferred tax liability from the deal.
Unlike more abusive deals, LIN’s guarantee of the joint venture debt was real, and the liability weighed on the minds of LIN’s managers (and creditors) as the value of the joint venture’s assets continued to decline. Earlier this year, LIN paid $100 million to G.E. to unwind the partnership and get out from under its guarantee of the debt. Unwinding the partnership accelerated the deferred tax liability, which LIN estimated at about $715 million. At a tax rate of about 37 percent, LIN would have had to pay up to $212 million in taxes. For a company without a lot of cash, that created a real problem.
So how can you make more than half a billion dollars in taxable gain disappear?
The heart of the clever scheme lies in the tax attributes of LIN. The LIN Corporation owned 100 percent of its subsidiary, LIN Television, which in turn holds the stock of operating subsidiaries that have declined in value, creating potential tax losses. To free up those tax losses, LIN TV could have liquidated itself and its subsidiaries, distributing the underlying assets to shareholders. But LIN’s public shareholders hardly want to hold direct interests in a bunch of local television stations.
Instead, LIN came up with a plan to merge the parent company with a newly created L.L.C., leaving all the subsidiaries intact. The tax advisers determined that the deal would be treated as a taxable liquidation of the parent company, distributing the assets of the parent company to the shareholders, followed by a contribution of the subsidiary stock to the new L.L.C. The former shareholders of the LIN Corporation now hold the same number of units of LIN L.L.C., which trades on the New York Stock Exchange.
Because the deal was treated as a liquidation for tax purposes, the parent company can recognize its tax losses â€" the difference between the tax basis in its shares of the subsidiary and the fair market value of those shares, which can be determined from the trading price of the parent. Combined with some unrelated net operating losses, this paper loss of about $500 million appears to be sufficient to offset the tax gain from LIN’s unwinding of its partnership with G.E.
At first glance, the tax treatment might seem appropriate. After all, the tax loss was created when LIN’s assets declined in value â€" a real economic loss. But the beauty of the deal, from LIN’s perspective, is that the tax loss is probably preserved in the hands of the subsidiary and can be used to shelter income from tax in future years.
Indeed, the single economic loss is not just duplicated but potentially tripled: some shareholders of LIN may be able to recognize a tax loss on their exchange of shares of the parent company for shares in the new L.L.C., the parent company recognizes the tax loss on its shares in the subsidiary and the subsidiary preserves its tax loss for future use.
The tax result is striking when you consider what happened from an economic perspective: nothing. LIN’s shareholders continue to own 100 percent of the company, just as before. Indeed, for accounting purposes, the transaction is a nonevent.
The I.R.S. may have some options to challenge the deal, should it choose to do so. The merger of LIN into the L.L.C. has no real business purpose. In the context of reorganizations, courts have required parties to demonstrate a nontax business purpose for the deal as a precondition for tax-free benefits. Here, however, the deal is taxable, albeit one that generates tax losses, not gains. Thus, the requirement of a nontax business purpose may not apply.
Like other financial innovations, new tax strategies tend to spread quickly through bankers and lawyers. Congress may have to respond quickly.
Victor Fleischer is a professor of law at the University of San Diego, where he teaches classes on corporate tax, tax policy, and venture capital and serves as the director of research for the Graduate Tax Program. His research focuses on how tax affects the structuring of venture capital, private equity, and corporate transactions. Twitter: @vicfleischer
