Originally published on Forbes.com June 12th, 2014
Here in Massachusetts, we dealt rather harshly with the British taxing our tea. Now Massachusetts is getting some taxes from a UK company (National Grid) that has been transmitting our electrons. Kind of ironic. In the recent decision of the Massachusetts Appellate Tax Board in the case of National Grid Holdings, Inc (You can get a download here), the irony is compounded by the fact that they even gave their dodgy scheme a historic code name – Project Mayflower. Actually dodging Massachusetts taxation was probably incidental to Project Mayflower. Apparently, the plan was to dodge taxation in any jurisdiction at all on the return on $2.68 Billion in capital.
According to Wikipedia, National Grid is not exactly national in the United States. It operates 9,000 miles of transmission in Massachusetts, New Hampshire, Rhode Island, New York and Vermont. In the interest of full disclosure I should probably mention that the very electrons that are powering the creation of this post in North Oxford, Massachusetts (birthplace of Clara Barton) are transmitted by National Grid.
When I read a case, I find it is more entertaining if I root for somebody. Generally, I root for the taxpayer, but in this case, I decided to go with the home team. God save the Commonwealth. Early in, I was pretty sure that I had picked the winner, when I read this part of a sentence – “Between December 2001, and February 2002, National Grid completed two purported financing transaction..” Over my years of following tax decisions, I have concluded that any form of the word “purport” is judgespeak for “Liar, liar, pants on fire”.
The purported financing transactions had 47 steps in the US and 44 in the UK . There were numerous entities many of which were newly-created disregarded entities. The dealings revolved around “deferred subscription agreements” (Nothing to do with magazines) that had the US entities paying out deductible interest that was not taxable to the UK entities receiving it.
It brings to mind one of the observations in Thomas Piketty’s Capital in the Twenty-first Century that when you try to balance worldwide assets and liabilities, there are more credits than debits. Of course, that means when you are measuring income you end up with more debits than credits. It is as if Earth is indebted to some other planet. All that interest sent by the US entities to the former mother country somehow dissolves in the Atlantic Ocean like the tea dumped in Boston Harbor in 1773.
Project Mayflower had been based on the concept of a “domestic reverse hybrid”, whatever that is. When the IRS ruled that that type of structure was inappropriate, Project Spam was initiated to achieve a similar result. Three documents were the key to Project Spam – the articles of association of a newly created entity called NG8, an offer of subscription and an agreement for purchase and sale of shares. “Taken together, these documents purported to reflect NGHI’s $2.68 billion of outstanding debt for U.S. and Massachusetts tax purposes.” (Emphasis added)
“Operation Spam” was followed by “Operation Spa”. It seems that “Operation Spa” was designed to deal with UK issues.
As you might expect there is a rather complicated discussion that it takes a hardcore tax geek to love. Here are a couple of high points.
The present appeals involve complex transactions through which National Grid sought to achieve a successful international tax arbitrage, a transaction entered into by a multi-national taxpayer to take advantage of differences in the laws of two different sovereign countries to derive tax benefits in both. The sole motivation for the form of the transactions at issue, as evidenced by the record, was the regulatory changes under I.R.C. § 894 that imperiled the utility of a domestic reverse hybrid entity, which had been used to effect a tax arbitrage, the legality of which is not in dispute.
Mass DOR was pretty harsh in its judgment of the whole scheme.
The Commissioner argued that in seeking to achieve their desired tax results, the appellants created documents that clearly did not constitute debt in the U.S. or the U.K. and acted in a duplicitous manner , telling two fundamentally different factual stories to the two jurisdictions. In support of this argument, the Commissioner asserted that the facts necessary to receive interest deductions in the U.S. contradicted those required to avoid creating a debenture within the meaning of § 765 in the U.K.
The Appellate Tax Board was a bit gentler. The Board probably stopped short of “pants on fire“.
As a threshold matter, the Board did not find that the appellants intentionally told two different stories to the U.S. and the U.K. The record reflects that the appellants did indeed treat the DSAs differently in the U.S. and the U.K. for tax and financial reporting purposes, but it did not establish that National Grid told two different stories. In fact, the only story told was of stock subscription and sale agreements, the implications of which the appellants claimed were different under the laws of the two jurisdictions.
Ultimately though, the interest was disallowed.
For the foregoing reasons, the Board found and ruled that the DSA arrangements did not qualify as bona-fide debt for Massachusetts tax purposes. Moreover, the Board found it particularly troubling that the appellants’ numerous contemporaneously created documents were drafted with meticulous care to avoid any terminology or provision that could possibly be construed as debt by the U.K. authorities, but which were argued by the appellants to typify debt for U.S. and Massachusetts purposes. Moreover, both Project Mayflower and Projects Spam and Spa were in form tax-driven transactions and no evidence was presented that demonstrated some purpose underlying the transactions’ form other than tax avoidance.
Why Is Massachusetts Having To Do This?
There was not an enormous amount of tax money at stake in the audit year in question – around $1.5 million. The federal tax involved would have been a significant multiple of that, but I can’t tell from this decision whether that will still be open. National Grid fought pretty hard though. The introduction indicates that the appeal was spread over 15 days. Still, it is really the IRS that should have been fighting this with the states just picking up the adjustments.
I have been reading about all this off-shore money and the proposals to squelch the way companies have been managing their tax liabilities, but a case like this makes me think that a lot of those arrangements might fall apart if the IRS had more resources to chase them. There is a brain drain from the IRS to the Big Four. Something tells me that if we were serious about the deficit the Government would reverse that brain drain and hire some of the best and the brightest from public accounting and industry tax departments. They would know where the bodies are likely buried.
Thanks For All Those Electrons National Grid
I poked at National Grid’s financial statements to see if I could find anything about these transactions. I suspect that this might be related.
The aggregate amount of temporary differences associated with the unremitted earnings of overseas subsidiaries and joint ventures for which deferred tax liabilities have not been recognized at the reporting date is approximately 2,118m. No liability is recognised in respect of the differences because the Company and its subsidiaries are in a position to control the timing of the reversal of the temporary differences and it is probably that such differences will not reverse in the forseeable future.
That 2,118m is pounds, which as I write this are worth $1.68 each. Translated from GAAP speak there is about $3.5 billion that they have robbed from Peter that they might have to pay Paul someday, but it is remote enough that they don’t have to book a liability.
National Grid also claims in its financial statements that
National Grid] manages its tax affairs in a proactive and responsible way in order to comply with all relevant legislation and minimise reputational risk. We have a good working relationship with all relevant tax authorities and actively engage with them in order to ensure that they are fully aware of our view of the tax implications of our business initiatives.
Well, NG, I appreciate all those electrons you have been sending me, pretty reliably, but if you are making money on it, you really should be helping to support the Commonwealth’s infrastructure, so you slipped up a bit on the reputational risk at least here in the birthplace of Clara Barton.
You can follow me on twitter @peterreillycpa.