Thursday, August 23, 2012

The Bain document drop

While press and blogosphere attention is rapidly focusing on Gawker's very interesting (but massive) Bain document drop, I am not sure how much time I will have to join in the fun.  There are a lot of documents there, and while I am confident they contain some very interesting nuggets, these are likely to require a broader context (e.g., comparing them to other public information).  Plus, I am just back from vacation, I'm trying to finish a chapter of my international tax book, my first fall class meets 8 days from now, various other things that take my time are coming up over the next few weeks, etcetera, etcetera.  I know, cue the violins - it's not so terrible, but it may indeed keep me from digging in very much.  Hopefully others will make up for my shirking.  (I won't name names, but certain people at Tax Notes and at particular West Coast law schools come to mind.)

In any event, Gawker is off to a nice start, by noting such details as the Bain entities' use of total return equity swaps, apparently or at least possibly to support owning dividend-paying U.S. stocks as an economic matter while claiming not to own them for U.S. federal income tax purposes.  An example of such a swap would be as follows.  Suppose I think GE stock would be a good investment, but I don't want to own it for tax purposes because the Caymans entity through which I am investing would owe withholding tax on any dividends that GE paid.  So I arrange a swap with a bank that has the following terms.  One year from today, it will pay me the interest that I would have owed it on a $100 million loan.  It will pay me an amount equal to the dividends that I would have derived during the same year had I owned $100 million of GE stock.  In addition, it will pay me the amount by which $100 million of GE stock appreciated during the year (or I will pay it a similarly determined amount if GE's stock price goes down).  The bottom line is that, counter-party credit risk aside, this is economically equivalent to borrowing $100 million at the specified interest rate in order to hold $100 million of GE stock for a year.

This use of total return equity swaps, such as to avoid the U.S. dividend withholding tax, was very widespread for more than a decade, and may not be dead yet, although the IRS issued a shot-across-the-bow Notice concerning the practice in 2010.  But taxpayers who engaged in it to avoid the dividend withholding tax were coming perilously close to committing tax fraud, in cases where the economic equivalence to direct ownership was too great.  (For example, in a lot of these deals even the exact timing of dividend payments had to be replicated in the swap.)  Given that considerations of economic substance are relevant to ownership determinations for U.S. federal income tax purposes (i.e., "tax ownership"), the only leg that taxpayers had to stand on in some of these cases was common practice and the apparent lack of IRS enforcement (not a very strong leg if the correct application of the law was clear).

How far out on the limb were Bain-affiliated foreign entities that were making money through total return equity swaps, and claiming not to owe U.S. withholding tax?  And what should we make of this, for purposes of the presidential campaign, if what they were doing, while legally dubious, was common practice?  Fair questions for discussion, I'd say, and good examples of why Gawker is performing a valuable public service here.

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