THE ENRON SCANDAL -THE LITTLE- KNOWN STORY HOW IT GOT STARTED AND ITS CONSEQUENCES
By: Dorothy B. Diamond

During the past year news about the offshore world has progressed from a sequestered spot in the business section to sensational frontpage headlines. Scandals about extravagant spending by top executives even inspired a trendy article in a newspaper’s lifestyles section advising how to behave at a dinner party when a prominent guest is under indictment for corporate fraud. Then there’s also the New Yorker cartoon showing a headstone engraved with a list of adjectives describing the deceased tycoon’s praiseworthy qualities ending with the word ‘BUT’ in large capital letters.

Pandemonium in the United States quickly affected the offshore world with the rapid passage of a strict accounting law and either withdrawal or postponement of plans to reestablish headquarters companies in an offshore jurisdiction.

In the future we are going to see a change in U.S. law either removing the inducement to migrate or more punitive action to deter an exit. In addition, the IRS is primed to wage a tougher fight against tax evasion, clamping down on suspicious use of credit cards by individuals, unfair allocation of profits to offshore companies to avoid U.S. taxation, and other ways of reducing or nullifying U.S. profits abroad via sophisticated techniques developed by top accounting firms. As a member of the Big Four told his staff, it is a lot more lucrative to help a client avoid taxes than to go through the labor-intensive process of preparing complex tax returns.

The furor began with Enron

It is not common knowledge that Enron’s downfall started in 1996 when top executives wanted to use offshore partnerships to conceal the energy company’s true financial status but were stymied by the Federal Investment Company Act of 1940 forbidding companies to shift their debts to foreign operations. For a year Enron lobbied to have the Act repealed, but Congress refused to do so after hearing opposing testimony from the Investment Company Institute, a trade organization for the mutual fund industry, and Securities and Exchange Commission regulators. Undaunted, Enron then engaged a former senior SEC staff member to represent it before a special meeting of the agency. What is not known publicly and is a key to the Enron disaster is that in March, 1997 Enron received its own special exemption from the 1940 Act in a five-paragraph order that was not concealed but certainly wasn’t announced at a press conference.

To Enron executives, the exclusive exemption looked like a bonanza. However, preferential treatment turned into disaster when offshore limited partnerships were used to conceal $1 billion in debts, leading to the United States’ largest corporate bankruptcy until Worldcom and the loss of their life savings by many employees who were barred from selling their shares. Andrew Fastow, a top Enron executive, has been indicted on 72 counts.

Following the Enron scandal, more antagonism towards tax havens broke out in the United States when Stanley Works, a 159-year-old tool manufacturer based in New Britain, Connecticut, asked its shareholders to approve moving Stanley’s headquarters (though not its operations) to a tax-free Bermuda shell company and thereby save $30 million annually in tax payments. At first Stanley officials were delighted when 67.2% of shareholders approved the move, slightly more than the two-thirds required vote. However, the company discarded the vote because union officials accused Stanley of rigging the outcome and Connecticut officials filed a lawsuit against the company charging Stanley with employing deception to win the vote. A second election was scheduled for later in 2002, but under pressure from Congress, investors and employees Stanley dropped its plan to relocate and decided instead to focus on legislation to make the tax system fairer.

Stanley is just one of several high-profile United States companies that recently have either reincorporated outside the United States or revealed their plans to do so. The migration is accomplished usually by means of a corporate inversion, defined by the United States Treasury as a ‘ transaction through which the corporate structure of a United States-based multinational group is altered so that a new foreign corporation, typically located in a low or no-tax country, replaces the existing United States parent corporation as the parent of the corporate group.’ As a result, the Treasury points out, the foreign operations of the company go outside the United States taxing jurisdiction and the corporate structure also may provide opportunities to reduce the United States tax on United States operations. Stanley Works would have benefited from an inversion by avoiding tax payments on income earned outside the United States, which the business world decries as unfair double taxation.

Bermuda is a popular site for inversions because of its ‘management friendly’ policy under which a company’s shareholders are unable to enforce United States court judgments against officers and directors. This revelation led shareholders of Nabors Industries, a giant Houston Texas oil-drilling firm planning a move to Bermuda, to bring a federal lawsuit accusing the company of violating its duties to shareholders by weakening their power to hold directors and officers accountable for their actions. The lawsuit, which had strong backing from labor, proved ineffective and Nabors has completed its migration.

Tyco International, which conducts its business from New Hampshire, has informed shareholders that it saves more than $450 million annually in taxes by establishing its headquarters in Bermuda. The company, which received negative publicity after the extravagant spending of its CEO Dennis Kozlowski was revealed, is under pressure to close the Bermuda company and return its headquarters operations to the United States.

Decried as ‘Benedict Arnold’ companies by their opponents, companies that have completed an inversion are said to benefit from easier business relations with foreign entities, better access to international markets, and attracting foreign shareholders. In addition, a firm reincorporating in Bermuda could cut taxes on domestic profits when the Bermuda shell ‘loans’ capital to the United States subsidiary and the interest charge becomes tax deductible.

Gains for Executives, Losses for Stockholders

Since the compensation of chief corporate executives is usually based on profits, after an inversion these executives would reap tremendous financial gains as the company’s balance sheet would improve as a result of lower tax payments. On the other hand, stockholders would suffer losses during the first year because the way the transaction has been structured the Internal Revenue Service views it as a sale of stock and stockholders would be liable for capital gains payments.

Irate Congressmen are backing legislation to deter companies from moving their headquarters offshore. A Massachusetts Democratic Congressman is supporting a Corporate Patriot Enforcement Act prohibiting United States companies that move abroad from being beneficiaries of federal Government contracts. A Connecticut Congresswoman has proposed an immediate moratorium halting reincorporation abroad for tax reasons until detailed legislation is adopted while the influential Chairman of the House Ways and Means Committee would put a three-year moratorium on acquiring a Bermuda address,. And leading Republican and Democratic Senators on the powerful Senate Finance Committee have introduced a bill enabling the Internal Revenue Service to tax a company moving its domicile for tax evasion purposes as if it were still United States-based. When the Committee bowed to pressure from lobbyists and postponed action on legislation hindering or restricting inversions, it claimed that curbing migration could lead to more takeovers by foreign corporations as well as putting some companies at a competitive disadvantage. However, the strong Republican victory last month is likely to revive anti-inversion legislation.

Pressure to discourage companies from moving their headquarters abroad is also being felt at the state level. In California, the state treasurer has banned 19 companies with offshore headquarters from obtaining state contracts under his control as well as from selling their commercial paper to the state’s $45 billion pooled fund for state and local Governments. In addition, pension funds are also being pressured to sell their stock in these 19 targeted companies.

Not content with just settling in a Bermuda tax havens, Stanley had also proposed establishing a corporation in Barbados, one of the few tax haven countries with which the United States has signed a treaty to avoid paying double taxation. Through such an arrangement, a United States company could reduce and eventually eliminate being taxed in the United States by paying interest, royalties and management fees to the Barbados parent until these expenses wipe out all profits earned in the United States. Barbados is entitled to enter into tax treaties because it levies a 2.5% tax on International Business Companies. Under a 1991 protocol appended to the 1986 United States-Barbados income tax treaty, the withholding rate on interest and royalties is 5% as long as the income does not arise from an effectively connected permanent establishment; dividends are taxed a maximum of 15%, reduced to 5% if paid to a company owning at least 10% of the voting power of the paying company.

The O’Neill Solution

A different and more basic solution for the controversy has been suggested by several tax authorities, of whom former Secretary of the Treasury Paul O’Neill was the most influential. He has proposed eliminating the temptation to move to Bermuda by obliterating the United States’ tax on foreign income, which may already be taxed in the country in which it arises, and by making the United States tax code less complex. Mr. O’Neill has stated: ‘If the tax code disadvantages United States companies from competing in the global market place, then we should address the anti-competition provision of the code.’ Contradicting the widespread belief that United States pay higher taxes than companies formed outside the United States, the Organization for International Investment has released a study showing that publicly traded United States companies pay 34.2% of their profits in taxes worldwide vis a vis 39.9% for non-United States companies.

The Treasury Department has warned that simply trying to stop inversions is hazardous because it would probably encourage a shift to other ways of accomplishing reincorporation of a United States corporation in a low or no tax haven. Popular structures include:

a stock transaction, in which stocks are transferred to a holding company and United States shareholders exchange their current stocks for stock in the new foreign parent an asset transaction, which is usually accomplished by merging a United States corporation with a newly-formed foreign corporation and having shareholders own stock of the new foreign parent; and a drop down transaction combining the two previously mentioned procedures.

The Other Side: The Business Point of View

While hiding assets abroad and avoiding payment of taxes on United States income is of course illegal, many businessmen maintain that inversion is not illegal, immoral, or unpatriotic. In fact, they contend it is the job of a corporation’s tax department to take advantage of all legal means to decrease tax liability. The famous statement made by in 1947 by Learned Hand, then a distinguished federal judge, is being revived: ‘Nobody owes any public duty to pay more than the law demands. Taxes are enforced exactions, not voluntary contributions.’

Shipping Patents and Trademarks Abroad

Numerous computer and pharmaceutical companies, which have been deferring tax payments by transferring trademarks, patents and other intellectual property to an offshore holding company, are feeling the displeasure of the Internal Revenue Service. The agency’s tax claims could reach tens of billions of dollars. Bermuda has been the most popular site for this scheme, supplemented by the Cayman Islands, Barbados, Ireland, and Singapore. A multi-tier structure is established by formation of a multi-tier offshore holding company that buys a share of the United States parent company’s intellectual property; the holding company then licenses the property to a third-country subsidiary; this subsidiary collects royalties from other foreign subsidiaries selling the intellectual property products to foreign customers.

Transferring Technology

Transferring technology from a United States company to a foreign subsidiary under a cost-sharing agreement is being used by high tech manufacturers and pharmaceutical companies to lead to lower taxes for the parent company, when the actual research is done in the United States but the foreign subsidiary shares in the costs and became part ownership of an invention or improvement. The Internal Revenue Service has brought a $94 million suit for unpaid taxes in a United States tax court against a California company that has this type of arrangement with an Irish subsidiary.

Credit Card Abuse

The Treasury’s Internal Revenue Service is conducting investigations to end abuse of offshore credit cards by United States residents who break the law by not reporting income received in havens on their income tax forms. The procedure, advertised on some Internet web sites, is for a United States resident to establish a corporation in a tax haven with the help of a local lawyer; open an account in a local bank; obtain a credit card from the bank; deposit funds in the bank without reporting them; and then use the credit card to pay for living expenses and purchases made in the jurisdiction. To halt the practice, said to be defrauding billions of dollars a year in payments to the IRS, the agency has obtained credit card holder records from the three main credit agencies, American Express, Visa, and Master Card.

As the stock market collapsed and corporate scandals including multi-million dollar gifts to executives became public information, the United States Congress acted with haste to pass an anti-fraud bill that was immediately signed by President Bush. The bill’s strict corporate code contains numerous anti-corruption provisions. Three of the most important are:

Accounting firms are banned from providing most consulting services to companies they are auditing; otherwise., accounting may lack candor to avoid offending a client paying more for consulting than accounting.

Every five years the position of accounting partner overseeing the auditing of a specific company must be rotated;

Much to their discomfort, CEO’s are now saddled with the responsibility of having to sign and certify the accuracy of the corporation’s financial reports.

In conclusion, measures to enforce transparency in overseas territories have emanated from London, where the British Government has ordered Anguilla, Bermuda, the British Virgin Islands, Cayman Islands, Montserrat, and the Turks and Caicos to disclose by the end of the year names and accounting information about Europeans holding accounts in these tax havens. Ministers of the six countries immediately held an emergency meeting in the Caymans to prepare their defense against the command. A threat by the Overseas Territories to stage a unanimous withdraw from the British Commonwealth of Nations means that in the end a compromise agreement is likely to be reached.

Having made a determined effort to purge themselves of criminal elements, the outlook for tax havens is that they will enjoy a better reputation as they continue to offer no-low tax inducements, but probably with a sharp decline in applications from United States corporations and individual investors.

By: Dorothy B. Diamond
Co-Author Tax Havens of the World and Global Guide to Investment Incentives and Capital Formation