Deemed If You Don’t

U.S. multinationals may have a new way to avoid tax on foreign collateral, if a financing arrangement by Huntsman Corp. passes muster.

Those rules reflect a decades-old attempt by the IRS to prevent wealthy industrialist Daniel Ludwig from avoiding tax by using assets outside the country as collateral for loans made to him in the United States. After the U.S. Tax Court ruled in favor of Ludwig in 1977, the IRS carved out a safe harbor limiting such pledges of collateral to no more than 65 percent of the voting rights. While the Huntsman transaction does not exceed that percentage of the voting rights of its foreign subsidiaries’ assets, it also pledges all of those of its domestic subsidiary’s.

Huntsman is by no means the only corporate taxpayer to test the limits of the IRS rules in this area. Enron Corp., for one, came up with a typically complex arrangement involving dual classes of voting rights that allowed the energy-trading company not only to avoid tax on pledges of foreign collateral and deduct the interest on bank loans it backed, but also to deduct interest on a $750 million loan it made to itself. And while that arrangement, which Enron dubbed Apache, was the subject of congressional hearings in 2003 after accounting fraud led to the company’s failure, legislators noted that the arrangement did not expressly violate IRS rules. So the agency tightened those rules to prevent companies from doing the same thing in the future.

All this leads some critics to suggest that Congress should come up with an entirely new system for taxing multinationals. “The deemed dividend approach leads to considerable complexity and planning opportunities,” Reuven S. Avi-Yonah, a law professor at the University of Michigan, noted in a recent paper. “Instead of trying to close these loopholes one by one,” wrote Avi-Yonah, “Congress should substitute direct taxation.”

Somewhat Aggressive

That’s unlikely to happen anytime soon. So companies that want to follow in Huntsman’s footsteps have to hope the IRS will go along on a case-by-case basis, or that they, like Ludwig, can best the agency in tax court. Whether this particular transaction can do that, however, remains to be seen.

“It’s somewhat aggressive,” observes attorney Cummings. He recalls the IRS’s advice to field agents in 2002 to disallow arrangements like one the agency cited, in which the substitution of a domestic subsidiary’s assets for those of a foreign sub’s amounted to an indirect guarantee of the parent’s debt. The Huntsman transaction, says the former IRS official, “is one step away from that. It’s a pledge of notes versus assets, and there’s no authority on that.” If the transaction is not as aggressive as the one disallowed in the 2002 case, “it’s the next best thing,” says Cummings.

Still, Lehman’s Willens notes that the agency’s advice to field agents doesn’t carry as much legal weight as a private letter ruling, let alone a revenue ruling. Willens also says that the tax court chided the IRS for a 1976 revenue ruling that the court claimed amounted to an attempt, as Willens puts it, “to bootstrap their way to a court victory” in the Ludwig case. And even in the 2002 field-service advisory, adds Willens, the IRS acknowledged that its rules stop short of saying that any “facilitation” of a financing is the same thing as an indirect guarantee.

John Deshong, vice president for capital tax at privately held engineering firm Bechtel Corp., contends that such arrangements may pass muster so long as the notes aren’t heavily encumbered at the behest of lenders. “Watch your negative covenants,” he warns, pointing out that he was careful to do that when, as tax vice president of Edison Mission Energy, he arranged a similar transaction in December 2003. That deal has not yet been reviewed by the IRS.

So why did S&P decide to rate Huntsman’s transaction absent a ruling? Essentially, the rating agency is betting that the IRS wouldn’t prevail in tax court. And so, presumably, is Huntsman.

Ronald Fink is a deputy editor of CFO.

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