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Introduction to Teaching “Taxes and Business Strategy”

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1 Introduction to Teaching “Taxes and Business Strategy”
February 26, 2015 Introduction to Teaching “Taxes and Business Strategy” ATA Doctoral Consortium Merle Erickson Booth School of Business

2 Overview of Today’s Presentation
Example Course Syllabus Course Materials “Taxes & Business Strategy,” 5th edition Scholes, Wolfson, Erickson, Hanlon, Maydew, and Shevlin “Cases in Tax Strategy” Basic Course Methodology Some Examples of Topics and Transactions/Cases Extensive use of articles from the financial press Use of real transactions that illustrate concepts and tax benefits

3 Topics Class Time Final Exam Determines Grade Background on the Course
Course Syllabus Topics Class Time Final Exam Determines Grade Background on the Course

4 Topics Scholes/Wolfson Framework Taxes Influence Behavior Investments
Organizational Form and Income Shifting Financing and Corporate Distributions M&A (multiple weeks) Tax Arbitrage and Tax Shelters

5 Class Time 65% lecture, 35% cases
Basic institutional setting (e.g., taxation of employee stock options) Fundamental Strategy Concept (e.g., multilateral perspective)

6 Final Exam Determines Grade
“Merle, Just wanted to let you know that your final was the hardest test I have taken in my life. But the class was well worth it. Just wanted to shoot you a note, saying thanks and that the first deal I was assigned to this summer was a foreign income trust that was formed as a partnership with a C corp. The stuff you teach is what we need.” Spring 2010 Student Associate Bank of America Merrill Lynch

7 Background on the Course
“Scholes put his money where his mouth was in Taxes and Business Strategy, a business school textbook he wrote with four other business school professors who have taught tax courses. This book, which is in wide use in business schools, is credited, or blamed, depending on your point of view, for the cavalier attitude that modern managers take toward their companies' civic obligations. (Scholes, Wolfson, Erickson, Maydew, and Shevlin, Taxes and Business Strategy (Prentice Hall 2002).) Taxes, in this book's view, are a nuisance, which is to be minimized or avoided. "The taxing authority is an uninvited party to all contracts," the authors state. - Lee Sheppard “HEDGE FUNDS, HOGS, AND PORC.” Tax Notes, November 4, 2002

8 Background on the Course
“Anyone may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one's taxes.” - HELVERING v. GREGORY, Circuit Court of Appeals, Second Circuit, (1934)

9 Background on the Course
“Let me begin by stating that if Intel were to be founded today, I would strongly advise that the parent company be incorporated outside the United States.” - Robert H. Perlman, Tax Director, Intel Corporation [Hearing before the Committee on Finance, U.S. Senate, March 11, 1999]

10 Examples of Topical Coverage
Taxes Influence Behavior How does Tax Law Develop and Unintended Consequences of Tax Policies Income Shifting Strategies Corporate Distributions and Corporate Financing Mergers & Acquisitions Tax Arbitrage/Tax Shelters

11 Taxes Influence Behavior
Estate Taxes and Timing of Death Location of Earnings

12 Estate Taxes and Timing of Death
“This paper examines data from U.S. federal tax returns to shed light on whether the timing of death is responsive to its tax consequences. We investigate the temporal pattern of deaths around the time of changes in the estate-tax system periods when living longer, or dying sooner, could significantly affect estate-tax liability. We find some evidence that there is a small death elasticity, although we cannot rule out that what we have uncovered is ex post doctoring of the reported date of death.” – Dying to Save Taxes: Evidence from Estate-Tax Returns on the Death Elasticity, Kopczuk and Slemrod, The Review of Economics and Statistics (May 2003)

13 Estate Taxes and Timing of Death
“The situation is causing at least one person to add the prospect of euthanasia to his estate-planning mix, according to Mr. Katzenstein of Proskauer Rose. An elderly, infirm client of his recently asked whether undergoing euthanasia next year in Holland, where it's legal, might allow his estate to dodge the tax. His answer: Yes.” - LAURA SAUNDERS, “Rich Cling to Life to Beat Tax Man,” The Wall Street Journal, December 30, 2009

14 Location of Earnings “So if in a given year, Mr. (Usain) Bolt ran in six races, one of which was in Britain, Her Majesty’s government could collect income tax on one-sixth of his total income from sponsorships. Given that Mr. Bolt’s contract with Puma alone is worth $9 million annually, the final U.K. tax bill for a single London race could dwarf his appearance fee, which has been in the range of $150,000 to $250,000.” -Usain Bolt’s Tax Lesson, The Wall Street Journal, August 15, 2012

15 Location of Earnings “Other Dutch shelters that Promogroup has arranged for the three have already paid off handsomely; over the last 20 years, according to Dutch documents, the three musicians [The Rolling Stones] have paid just $7.2 million in taxes on earnings of $450 million that they have channeled through Amsterdam — a tax rate of about 1.5 percent, well below the British rate of 40 percent.” - Lynnley Browning “ The Netherlands, the New Tax Shelter Hot Spot,” The New York Times, February 4, 2007

16 How does Tax Law Develop and Unintended Consequences of Tax Policy
“But this bubble was different. … -- at the end of the capital-gains rainbow was the right to take up to $500,000 of profit, tax free. Thank you President Bill Clinton for your 1997 action, … thank you for fueling the mother of all housing bubbles; …” - Vernon L. Smith, The Clinton Housing Bubble, The Wall Street Journal, December 18, 2007

17 Income Shifting Strategies
UPS Spin-off of its insurance subsidiary to Bermuda

18 UPS’s Income Shifting Strategy
Before Tax Planning UPS (Company in U.S.) (Division– Insurance “business”– very profitable)

19 UPS’s Income Shifting Strategy
Spin-off of Insurance Business UPS’s shareholders own both– UPS and Insurance Business UPS Insurance “business” Bermuda Spins off Insurance Business into Bermuda domiciled entity

20 UPS’s Income Shifting Strategy
Re-Insurance Contract UPS’s shareholders own BOTH – UPS and Insurance Business UPS Insurance “business” [Bermuda] $100 Insurance Fee National Union Insurance (PA) $99 Reinsurance Fee Shift insurance profits to low tax jurisdiction

21 “The U. S. Court of Appeals for the Eleventh Circuit reversed
“The U.S. Court of Appeals for the Eleventh Circuit reversed. It concluded that because there was a real insurance policy between UPS and National Union, and because National Union assumed liability for the losses of UPS's excess value shippers, the overall transaction had real economic effects and a business purpose. The court noted that a business purpose does not mean a reason for a transaction that is free of tax considerations. Rather, a transaction has a business purpose when, regarding a going concern like UPS, it figures in a bona fide profit-seeking business, a concept of business purpose that is "a necessary corollary to the venerable axiom that tax- planning is permissible.” - Sandra Favelukes O'Neill, Viewpoints - Let's Try Again: Reformulating the Economic Substance Doctrine, Tax Notes, Dec. 1, 2008,

22 Other Examples WorldCom State Income Taxes Wal-Mart State Income Taxes
Google Income Shifting Starbucks Income Shifting Closely held C Corporation Income Shifting Merger Based Inversions

23 WorldCom’s State Income Tax Strategy


25 Merger Based Inversion
Some of this material is based on a summary of inversions by McDermott, Will & Emery available at:

26 Corporate Distributions and Financing
Seagram - Du Pont Stock Repurchase Debt/Equity Hybrid Securities

27 Corporate Distributions (Seagram’s Case)
$1.8 Billion

28 Debt-Equity Hybrids


30 Corporate Financing (Enron’s Debt/Equity Hybrid Securities)
“Tiered preferred share transactions such as MIPS and TOPrS have their genesis in the fundamental principle that leverage generally is favored for tax purposes (because of the deductibility of interest and the non-deductibility of dividends) but disfavored for financial accounting purposes (because reported debt tends to depress marginal share price and credit ratings relative to outstanding equity). Thus, companies generally prefer to obtain equity financing for financial accounting purposes, but prefer to obtain debt financing for tax purposes. Because the financial accounting rules for characterizing financing as either debt or equity do not correspond with the tax rules for determining such characterization, companies have taken advantage of opportunities to arbitrage the financial accounting and tax rules in order to achieve an ideal objective--financing that can be reported on financial statements as equity and on tax returns as indebtedness. Tiered preferred shares are the financial instruments with which many companies have accomplished this result.” - REPORT OF INVESTIGATION OF ENRON CORPORATION AND RELATED ENTITIES REGARDING FEDERAL TAX AND COMPENSATION ISSUES, AND POLICY RECOMMENDATIONS VOLUME I: REPORT Prepared by the Staff of the JOINT COMMITTEE ON TAXATION (February 2003)

31 Corporate Financing (Enron’s Debt/Equity Hybrid Securities)
“The IRS also concluded that the LLC’s issuance of the preferred securities and the subsequent loans to the corporation had economic substance because the transaction served nontax business purposes, including: (1) the provision of funds for working capital and general corporate purposes, including the repayment of outstanding indebtedness; (2) a reduction in the corporation's overall cost of capital; and (3) a reduction in the corporation's debt/equity ratio.” - REPORT OF INVESTIGATION OF ENRON CORPORATION AND RELATED ENTITIES REGARDING FEDERAL TAX AND COMPENSATION ISSUES, AND POLICY RECOMMENDATIONS VOLUME I: REPORT Prepared by the Staff of the JOINT COMMITTEE ON TAXATION (February 2003)

32 M&A- Tax Structuring/ Planning Creates Value
Taxable Stock Acquisition (with Sec. 338 (h)(10) Election)

33 Clairol and Proctor & Gamble Transaction:

34 Clairol/P&G cont’d “Willens breaks down P&G's savings on a tax basis: Assume that the Clairol purchase created some $4 billion of goodwill. To calculate the "tax benefit," multiply this figure by the corporate tax rate of roughly 40 percent. The resulting tax savings: $1.6 billion, Willens notes. "If you then 'present value' that result (to reflect the fact that it will be realized over 15 years) you arrive at about the $1 billion 'savings' they (P&G) are touting," he adds.” – - Craig Schneider, “P&G's Clairol Purchase Gets a Double Dose of Savings,”, May 24,

35 Snapple Teaching Cases
The economic effects of 338(h)(10) election in a subsidiary sale 1997 Quaker Oats Sale of Snapple to Triarc for $300M Snapple Stock Basis ~= $1.7B Snapple Asset Basis ~= $200M No 338(h)(10) Structure =$250M Tax Refund [As the Deal was Actually Structured] With 338(h)(10) Election = $35M Tax Liability

36 Snapple Cases Cont’d: 2000 Sale of Snapple to Cadberry Schweppes for $1.2 Billion with 338(h)(10) Election: “4. PAYMENT TO T PARENT. On the date on which the IRS Form 8023 is to be filed, simultaneously, immediately prior to such filing, (a) the parties shall cause four originals of each of the Forms to be duly executed, and T Parent shall take two executed originals of each Form and SBGH shall take two executed originals of each Form, and (b) CS and SBGH shall jointly and severally pay to T Parent an aggregate of $200 million (the "Election Amount"). - Triarc September 20, K, Exhibit 10. Material Contracts

37 Mergers & Acquisitions Continued
Valuation of a target’s NOLs I.R.C. Section 382

38 Southwest/Airtran Merger - Value of Airtran NOLs
“Equity transaction Each share of AirTran Holdings common stock was exchanged for $3.75 in cash and shares of common stock of the Company. The common stock consideration was based on the average of the Company’s closing common stock price for the 20 trading days ending April 27, 2011, which was $ The transaction valued AirTran Holdings common stock at approximately $7.57 per share, or $1.0 billion.[…] As of the acquisition date, AirTran had NOLs of $542 million, which expire between 2017 and 2029” - Southwest Airlines Co. 12/31/2001, 10-K

39 Southwest/Airtran Merger- Value of Airtran NOLs
“Discounted Cash Flow Analysis Morgan Stanley performed a discounted cash flow analysis, which is designed to estimate a value of a company by calculating the present value of estimated future cash flows of the company. … Morgan Stanley adjusted the resulting value for the present value of the federal net operating loss benefit, calculated to be $125 million to $129 million.” - Southwest Proxy Statement

40 Tax Arbitrage/Tax Shelters
Various Strategies Short Against the Box (Estee Lauder) Step Down Preferred Stock Basics of Economic Substance/Business Purpose Jade Trading Case (below) Numerous other Tax Cases Jade Trading Teaching Case (“Son of BOSS”) Purchase and Sale of Call Options on Euros Narrow Spread Maximum Profit Potential of Approximately $140,000 Taxpayer Paid $900,000 in Transaction Fees Judge Ruled that Transaction Lacked Economic Substance and Business Purpose


42 “Plaintiffs’ and Defendant’s experts, Mr. Shoji and Dr
“Plaintiffs’ and Defendant’s experts, Mr. Shoji and Dr. DeRosa, agreed the maximum profit potential on the spread at expiration, on its face, was roughly $140,000, no matter how high the Euro climbed. The fact that the Ervins had to spend over $934,000 to obtain an investment return of $140,000, establishes that no reasonable investor would engage in such a transaction to earn a profit.” – Jade Trading, LLC v. U.S.

43 Long Term Capital Management v. U.S.
“The two men who faced off in federal court here this morning seemed ill matched for a game of intellectual chess, one a career trial lawyer for the Justice Department, the other a Nobel laureate in economics. They met because the Internal Revenue Service disallowed a tax shelter that the economist, Myron S. Scholes, acquired for Long-Term Capital Management, the hedge fund with such complex investing strategies that its collapse five years ago required government intervention to avert a worldwide financial panic. For nearly three hours, he parried questions from Charles P. Hurley, the government lawyer, … Then, after he answered a question showing that the shelter could not have turned a profit, and with no question pending, Dr. Scholes revealed what was on his mind. "I'm being trapped here," he blurted out.

44 Long Term Capital Management v. U.S. (Cont’d)
The questioning that led to that moment had begun more than two hours earlier when Mr. Hurley, … opened an aggressive line of questioning aimed at impeaching Dr. Scholes's testimony the day before, in which he minimized his expertise about taxes. "I said I was not an expert with regard to taxes," Dr. Scholes said. Mr. Hurley held up a copy of "Taxes and Business Strategy," a $130 text used at Stanford's graduate school of business; the primary author is Dr. Scholes. And finally there was the big question, though it was asked so subtly that the first time Dr. Scholes answered without much argument. Yes, he testified, he had asked for and received a multimillion-dollar bonus from the other partners in Long-Term Capital for finding the tax shelter and strengthening it. Between the opinion letter fees and the bonus for the one executive, the tax shelter could only, barely, show a profit. Add in the millions paid as a bonus to Dr. Scholes and the shelter could not show a profit apart from the tax benefits.” - DAVID CAY JOHNSTON, Economist Questioned on Tax Shelter Role, The New York Times, July 10, 2003

45 Questions?

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