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Posts Tagged ‘irs’

In order to understand Robert Mercer’s brilliant financial engineering,  let’s begin our analysis using three outstanding local Portland beers.  They are Rogue Brewery’s Shakespeare Stout, Widmer’s Hefeweizen and Deschutes Breweries Fresh Squeezed IPA.  All are distributed by Portland based Columbia Distributing, one of the nations largest beer distributors, which was purchased by the Jim Simons controlled investment fund Meritage in 2012.  Simons along with Robert Mercer are Co-CEO of the $100 billion Rentec hedge fund.

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This analysis will unravel the relationship between Rentec’s Medallion fund, its company retirement plan,  the Meritage private equity fund, which purchased Columbia Distributing in 2012, and numerous tax exempt foundations including those of Jim Simons, Nat Simons and Robert Mercer.

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Doris is 85 and suffers from moisture build up in her eye, what some call wet eye.   She is on Medicare and gets treated with Eylea, a Regeneron product, every 4-5 weeks.  Each treatment costing $6,200.   That is more than $70,000 per year even though Doris never made more than $40,000 while working.   Her total out of pocket cost is $10.29 per treatment.

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Trump Mercer Simons Koskinen Bharara

See Latest Post on Nov 27 For Significant Updates After Release of the “Paradise Papers” – Access Via Blog Search for   Trump Patron

President Trump’s most significant backer, Robert Mercer (CEO of the giant hedge fund Renaissance Technologies), is Deutsche Bank’s largest customer.   Deutsche Bank is indeed also President Trump’s and Jared Kushner’s largest lender.  One phone call from Mercer and either should be able to refinance or gain a new loan, as both did in 2016.

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In 2012 I reviewed Mitt Romney’s IRA for Mark Maremont of the Wall St. Journal, explaining the mechanics regarding how he amassed $100 million in this tax deferred account.  This and related follow up stories in other publications after Maremont broke the story prompted the Senate Finance Committee to commission the Government Accounting Office (GAO) to analyze how IRA balances could exceed $100 million when the annual contribution limits are so modest.

Parish & Company later provided extensive analysis, commentary and guidance to the GAO and must say that I was thoroughly impressed with the organization’s professionalism. competence and independence.  The following September 9, 2014 Bloomberg story by Margaret Collins and Rich Rubin is based upon the GAO report findings released in early September.

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Disclosure:  Intel is currently the largest single individual equity holding in both my personal and most of my clients’ portfolios.   No shares will be recommended for sale based upon this original research.

intelceobrian

Intel CEO Brian Krzanich

The purpose of this post, which will be accompanied with an email directly to top management, is to effect positive change and help Intel avoid an inevitable class action lawsuit by employees over mismanagement of its retirement plan.   Already Fidelity Investments itself and Massachusetts Mutual are subject to such lawsuits in which employees are claiming excessive fees and poor choices.  In both cases, employees are absolutely correct.

To be clear, it should be stated that the employee directed portion of the Intel pension plan is superb, in large part due to its open nature in which employees can invest in virtually anything via a brokerage equivalent account.  The problem is specific to the profit sharing and “Target Funds” portion, both of which have been infiltrated by hedge funds.

What Intel and many other firms still do not seem to fully realize is that these are essentially employee assets, not company assets.  And even though the company is managing the profit sharing component of the plan on behalf of employees, these are still “employee assets.”  Put more directly, within this plan lies the average employee’s life savings and allowing someone to speculate with them is an absolute breach of the ERISA prudent fiduciary requirement, Section 404C.

The problem is simple and involves Intel’s decision in 2011 to allocate 25 percent of its profit sharing and target related retirement options to a basket of approximately 25 hedge funds, affecting billions in employee retirement assets.   “Target funds” are popular with many investors today. The hedge funds that have infiltrated the pension plan include buyout funds, funds speculating on commodities, etc.

Not only do the hedge funds charge annual management fees 10 times higher than standard wholesale level fees for such plans, 1.5 percent versus .15 percent,  they also take 20 percent of all future profits on top of the management fees.   If Intel executives want to make such investments in their personal portfolios, that is one thing yet this level of institutional gambling with employees assets makes no sense.

Returns on these hedge funds greatly lagged the market in 2013 and while some advocates, including Mark Gardiner of Intel Capital, who until recently chaired the Oregon Investment Council’s $70 billion PERS portfolio, claim hedge funds are designed to outperform in more difficult markets,  there is no escaping that this is an absolute mess.  Oregon PERS is similarly aggressively increasing investments in speculative hedge funds.

Further complicating this issue is that Intel labels the hedge funds A thru V, not even having the courage to state exactly who they are in disclosures to employees, thus eliminating an opportunity for participant oversight.  For example, Fund C is a “Directional Fund” that invests in forwards and future commodity markets” while fund F is a “Technology based long/short fund.  Performance metrics include “sharpe” and “sorption” ratios, an explanation of which is not worth your nor my time.

Government Filings Reveal Specific Hedge Funds in Intel Plan

Government filings, not provided to Intel employees, reveal that these hedge funds include  the following (see complete listing at the end of this post):

**  HBK Investment OFF FD LTD Limited Partnership

HBK, whose office is listed as being in Dallas, Texas,  does do the required SEC ADV filing yet in its disclosure it claims it does not manage assets for pensions.  In addition, in the required ADV Part 2 filing it does not directly disclose its fee structure.   This is a clear breach of the SEC requirement, apparently no one at the SEC has looked at the disclosure.

Another complication for Intel is that it has not filed the required 990-T tax form to disclose what it owes in UBIT or unrelated business income tax from these pension based partnership investments.  This is a special tax on tax exempt entities, like pensions, who invest directly in operating businesses via private equity and hedge fund partnerships.  The way to avoid UBIT complications is to invest in publicly traded equities.

This 990-T filing is also designed to prevent tax exempts from trading valuable unusable tax deductions they are allocated in the partnerships to taxable partners who can fully use them.  The IRS rule that specifically prevents this trading of deductions is the “fractions rule.”  Today 95 percent of the investments dollars made into partnerships managed by the largest private equity and hedge funds is composed of tax exempt investors including pensions and endowments.    It is not hard to see the potential for abuse when such a large percentage of these valuable tax deductions being allocated remain unusable because they belong to tax exempts like the Intel pension plan.

Hedge funds may argue that they allocate tax deductions based upon the “economics of the deal,” what they call target allocations, which is simply a euphemism for allocating based upon cash flow, that is, who gets the cash.    It is as if they have invented a separate tax system for themselves, one playing by a different set of rules.   I might say, well, that is fine but there is this thing called the tax code and it does not define profitability based upon who gets the most cash.  Hedge funds primary source of cash is often issuing debt under its portfolio companies name and paying themselves rather than reinvesting in the business.  A leading company like Intel should have no role in enabling such a scheme.

The UBIT’s overall purpose is to maintain a level playing field in commerce and prevent pensions from running active businesses via a partnership structure within the tax exempt structure and allow the business to avoid all tax.  While Intel might claim that there was no UBIT tax generated in any of its 25 hedge fund partnerships,  that is extremely unlikely, some might say ridiculous.

Why Fixing the Pension is More Important Than Quarterly Earnings

Intel is a great company, perhaps the most critical industrial firm based in the U.S.   Often forgotten is the scale of manufacturing Intel does at home and the remarkable peripheral benefits that occur, both in seeding new companies and supporting government services at all levels.

In contrast Google and Facebook are wholly structured based upon a desire to sell personal privacy, using ridiculous tax schemes to avoid tax and accumulate cash for acquiring companies and stifling both innovation and competition.  Some would argue these tax schemes should be considered criminal.  Apple engages in similar tax schemes and metes out punishment to any publication that dare disclose how it conducts its business, particularly in China.

In contrast to Google, Facebook and Apple,  Intel stands as a beacon of integrity and opportunity.

While most analysts will focus intently on Intel’s earnings, to be announced later today, of much greater interest to long term oriented investors like myself should be how the company responds to these observations and more specifically how long it takes to remove hedge funds from its employee owned pension plans.

List of Hedge Funds in Intel Pension Plans

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The following letter was sent to SEC Chair Mary Schapiro and IRS Commissioner Doug Shulman on “tax day” with the hope they will jointly work at restoring the integrity of cash flow statements, without question the most important analytical tool for investment advisors like myself.  It is simply astonishing, given their material nature, that listed companies are not fully disclosing purchased and accumulated net operating losses nor the impact of complying with the “fractions rule” in the case of private equity partnerships.

 

Parish & Company
10260 S.W. Greenburg Rd., Suite 400
Portland, OR 97223
Tel:(503)643-6999 Fax:(503)293-3507
Email: bill@billparish.com

April 15, 2011

Mary Schapiro
Office of the Chairman
Securities and Exchange Commission
Mail Stop 1070
100 F Street NE
Washington, D.C. 20549

cc: Elise B. Walter – SEC Commissioner
Troy A. Parades – SEC Commissioner
Robert Khuzami – SEC Director
Doug Shulman – IRS Commissioner
Heather Maloy – IRS Commissioner Large Business Division
Walter Harris – IRS Director Financial Services
Elise Bean – Congressional Oversight Committee

Dear Chair Schapiro,

In 15 years as an investment advisor I have always done my best to support the SEC’s work, having led many key corporate governance related initiatives. Past Chairs Levitt, Pitt and Donaldson are all familiar with my work, which has also been reported in front page stories in leading publications including Bloomberg, the New York Times, Barrons and USA Today.

The purpose of this letter today is to alert you directly to an alarming trend with respect to the rapidly eroding integrity of cash flow statements filed with the commission. The culprit is non-disclosure of important tax related transactions involving material net operating losses, in addition to compensation and related expense allocations subject to the “fractions rule”and NOL loss limitation rules that are material to past, present and future cash flows involving publicly traded partnerships, such as Blackstone, in which tax exempt investors participate. The NOL related limitation issues are also a significant issue in mergers and buyouts of public companies.

Back in late 1999 when I provided original research to Gretchen Morgenson, David Cay Johnston and Floyd Norris of the NY Times regarding how Microsoft paid no federal income tax I was told that this was ridiculous. You discredit your excellent work by saying such a thing, Morgenson added. Six months later she did a front page story outlining the scheme involving the issuance of NQ stock options. Similarly Bob Herdman, Chief Operating Officer at the Commission, thought the idea ridiculous at first.

While everyone was focused on the future dilution of options, my focus was instead on the historic tax based cash flow impact of options. What made this original research possible was a cash flow statement that analyzed cash flow and, in conjunction with footnotes, provided a good general idea of tax related impacts.

More recently, since last summer, I have tried to get the NY Times to do a story on how major private equity and hedge funds may indeed be escaping taxation completely via gaming carried interest deductions in violation of two key IRS reforms established by former President Reagan, the “fractions rule”and limitations on purchased NOLs.

The Times chose to focus on publicly traded GE and in their story never fully highlighted how GE is using NOLs. How could the Times put their reputation on the line based upon my work without adequate SEC disclosure? Also interesting to note is that at one time over the last two years, one private equity firm, Harbinger, owned more than 10 percent of the NY Times. Similarly, per Yahoo finance, JP Morgan owns almost 10 percent of Gannett, parent to USA today.

Media consolidation and outright ownership of media by major financial institutions, including private equity and hedge funds that have bitterly fought to undermine both the SEC’s and IRS efforts, has complicated this task. Perhaps now is a good time for the SEC and IRS to be more vigilant and oriented at making news aimed at solving fundamental problems before they accumulate and lead to major market problems. While leading attorneys at major law firms representing the private equity crowd enjoy great access with top officials via conferences and other venues, independent advisors like myself with a distinguished record can barely get a phone call returned.

GE was low hanging “media fruit” so to speak. Clearly the much bigger issue is that involving the takeover of public companies by private equity and hedge funds, effectively converting these formerly tax paying entities to the equivalent of tax exempts using NQ option and carried interest schemes resulting in an NOL pyramid scheme. Again, the bulk of these NOLs were never cash expenses but simply NQ options and carried interest.

If these private equity and hedge funds were indeed catering only to affluent investors that would be fine yet today many of these organizations receive most of their funding from public pensions. I have written about this extensively over the last 5-7 years and pushed hard to get the concept behind carry fees fully understood and disclosed. Again, numerous examples of this work appear in major publications.

One of the big lessons of the dot.com era was the need for the SEC to collaborate more with the Federal Reserve and see the economic impact of accounting irregularities. Most notable of course back then were merger and stock option accounting related issues. Former San Francisco Fed President Robert Parry told me, look Bill, “accounting issues were not in the fed’s purview” in late 1999. This was when the market was more focused upon whether Alan Greenspan took a bath before a meeting of the Federal Reserve.

The key lesson in the recent crisis involving mortgage financing and related derivatives was of course that conflicts of interest with key regulators and rating agencies can lead to similarly disastrous results. If Moody’s had done their job, we would have had no crisis. Also germane was the impact of top government officials such as Robert Rubin moving to industry and aggressively attacking important safeguards, Glass-Steagall in his case.

The reason I have copied your former colleague at FINRA, current IRS Commissioner Doug Shulman, is that to date there has been almost no discussion regarding how tax policy played a major role in both crises and in my opinion, with the proposed repeal of the fractions rule, could ignite the next. My work in this area goes back to 1999.

My hope is that you will work together to restore integrity in what is clearly the most important disclosure of all for any public company, the cash flow statement and related footnotes. Doing so will also greatly enhance overall tax equity, in my judgement. The notion that major tax related impacts not be disclosed is a significant fraud upon all statement users and puts the whole system at risk.

More specifically, someone at the Treasury has proposed repealing the fractions rule in the 2012 revenue guidelines. To that, I only have the following thoughts: Robert Rubin/Glass-Steagall; Wendy Graham/Derivatives Deregulation. It is absolutely ridiculous when it was such an important reform and there has been almost no enforcement of it for years, perhaps not unlike mortgage underwriting standards. The industry failed in Congress and failed to get an American Bar Association sponsored revenue ruling ,yet now it the Treasury itself advocating the repeal of the fractions rule.

While some companies will argue rightfully that tax returns are private and not required to be disclosed, such material NOL and “fractions rule” related information must be disclosed when public firms are taken private or in the event of significant sales or mergers. This is fundamental accounting 101. Some would add that failure to do so is the very essence of fraud because it fuels the notion that investing is an insider’s game. What it also does is allow problems to accumulate and ultimately exacerbate major problems in the market.

These cash flow based disclosures are vital information to an SEC Registered advisor like myself, and other investors. And for the last couple of years I have found increasing frustration in dealing with leading journalists because they are simply not getting the mandatory public disclosure required to corroborate my research findings and forward key corporate governance initiatives.

A good recent example is the General Electric sale of NBC to Comcast. So why do these two completely independent firms get to “game the system” with respect to the allocation of net operating losses belonging to GE via a special allocation partnership, subsequent to a sale of the business? One might ask, is this a fraud upon taxpayers, investors, both or simply much ado about nothing? When I make such an observation to a leading journalist, they need to be able to see a footnote that confirms or refutes my claim. This is as basic as corroborating total revenues per the income statement.

It is understandable that many journalists have expressed no interest in covering the proposed repeal of the “fractions rule,”simply because they don’t understand it. The reason of course is that these public partnership firms are not providing adequate disclosure to the SEC. In addition, something appears very amiss at the Treasury department. Who is behind this repeal, really? If you do a search of Blackstone’s 10K you will find no references to the fractions rule, nor related financial adjustments made to confirm to it. Similarly, no one at the Internal Revenue Service is willing to discuss this. (See attached letter to Curt Wilson, Associate General Counsel Passthroughs at the IRS).

At https://billparish.wordpress.com you can also see a blogpost that features a brief audio, taken from an American Bar Association Conference in which one of the nations leading attorneys, Sanford Presant, explains how investors received $7 in tax deductions for each $1 invested prior to the fractions rule. Also included is a brief audio clip from a top IRS official, Curt Wilson, who volunteered to sit on a panel, noting he sees no enforcement issues with the “fractions rule.”

How can we transfer our angst over the fractions rule to you,”a King and Spaulding attorney asked the IRS’s Wilson? Wilson later told me that the fractions rule was not being considered for repeal yet it is now in the 2012 Revenue Guidelines for repeal. Wilson will not confirm who is involved in the repeal nor its specifics. Again, in my mind this will be the genesis of a crisis if not prevented, similar to the repeal of Glass-Steagall or the rules regarding derivatives trading.

Per my analysis, firms with inadequate cash flow disclosure to the commission with respect to NOL and fractions rule related considerations include, but are not limited to Bank of America, Goldman Sachs, JP Morgan Chase, Morgan Stanley, Citigroup, General Electric, Comcast, Blackstone, KKR, TPG (via acquisitions including J Crew since TPG is not publicly traded), Apollo and Fortress.

For example, if Blackstone is going to purchase a publicly traded company and thereby assumes significant accumulated NOLs, those valuable NOLs must be disclosed fully to existing shareholders prior to a sale. In addition, the same partnership must disclose the impact of the fractions rule, specifically, how much of the deductions cannot be taken due to having tax exempt investors in the purchasing partnership. Such investors often represent more than 80 percent of all funds in major private equity partnerships.

Also relevant are the limitations on the deductibility of purchased NOLs, and whether they are being fully deducted using a reverse scheme, in which an entity with significant NOLs purchases a firm paying significant taxes, thereby escaping the required amortization reform put forth by Reagen. My original research identified this scheme in 2001 subsequent to the takeover of Time Warner by AOL.

It is not enough to say, we need not disclose such information since it is an item on our tax return. Full disclosure and materiality mandate such disclosure of material tax driven cash flow items directly on the cash flow statement or in the footnotes.

In another example, if TPG purchases J Crew and by doing so receives $1 billion in net operating losses, a large part of which are tax deductions created from stock options, how are these valuable net operating losses treated. These expenses never resulted in a cash outlay, and if the partnership at TPG buying J Crew has 80 percent tax exempt investors, are these NOLs being stripped away in violation of the fractions rule prior to being put in the partnership? And, if so, is this not a violation of the fractions rule resulting in a LILO like leasing doubling up of tax deductions for taxable general partners, etc?

One could argue such non-disclosure to the SEC is manufacturing a tax deduction pyramid or flipping scheme in which private equity firms take companies private, public, private again and then public. Each time creating staggering NOLs in the form of stock option or carried interest deductions, not resulting from an outlay of cash for equipment or wages, but rather a paper tax deduction pyramid scheme.

Regarding Blackstone, another potential issue includes the valuation of partnership interests that create valuable tax deductions? Are these straight up or are they the equivalent of a stock option back dating scheme being used that is aimed to increase tax deductions by awarding such units at artificially low strike prices, achieving the same impact as backdating? Of course tax exempt partners may not care, yet what of the future cash flow impact for public unit holders? In reviewing the history and Blackstone’s limited public disclosure, something just does not look right, in my opinion.

Furthermore, if Blackstone executives exchange unvested NQ options with Blackstone partnership units based upon carried interest, the strike price value difference between each should be fully disclosed to shareholders, not simply in aggregate.

In my original research on stock options back in 1999 I often noted this backdating impact and was simply amazed that at the time there was no concern. It was sad to see how this developed into a legal feed bucket for law firms that never acknowledged the most damaging part of the scheme, that being the creation of a tax deduction pyramid scheme.

In 2000, I arranged a related story on this for Gretchen Morgenson of the NY Times involving two employees at Microsoft who expressed an interest in becoming clients. I tentatively agreed to accept them as clients only if they were willing to discuss their situation with Morgenson given the important tax governance related involving their situation. Similarly, Morgenson agreed that, if she did the story, she would mention my simple idea regarding a pivotal tax reform.

The couple had exercised options but failed to sell shares to pay the tax until they filed their return several months later. The subsequent drop in Microsoft’s stock price left them with a large tax bill and insufficient assets to pay the tax. I had expected that the story, which appeared on the front page, would include my comment that the IRS provide a one-time adjustment in such situations, provided the total options were less than x in value. Unfortunately the comment did not appear yet it was however recognized as a key story with Morgenson being awarded the Pulitzer Prize.

My guess is that the Times advertisers, including Microsoft and Cisco Systems, did not want the story done because if employees were allowed to “look back” on a one time basis, this would clearly eliminate the tax deduction the companies were taking. More centrally, it would challenge the stability of this innovative tax deduction pyramid scheme that began with NQ options and has now morphed into carried interest.

Of course this is particularly germane if a CEO orchestrates the sale of a public company and stays on with the private equity firm as a shareholder. Perhaps Tony James, Blackstone’s president, put it best by saying,“Now we can just exchange the unvested portion of an executive’s NQ options with our partnerships units and not expend valuable cash in order to bring them on board and get the deal done.” You can see this summarized at https://billparish.wordpress.com in two blog posts. One is dated August 2010 and the second March 31, 2011. Both provide important background for this letter.

I spoke with Mark Zehner in your office about this issue last fall, specific to the fractions rule, and frankly must reflect significant disappointment at the lack of follow up, especially given the stellar work he did in the municipal finance area. This is not a UBTI driven issue unique to tax exempt investors in public partnerships but rather an assault on the basic integrity of“the key financial statement” used by advisors like myself to analyze the merits of a particular investment opportunity, the cash flow statement.

We all want the economy to turn around, yet in my opinion, that will only happen when integrity and confidence are restored to the cash flow statement. Doing so will allow numerous peripheral areas to self correct ranging from capital flows to overall tax equity.

Thank you for considering these thoughts and of course I will make myself available for follow up commentary. The opportunity to develop some level of dialogue with the commission would be much appreciated. This could include someone at the commission suggesting I be invited to speak at a major conference, etc.

Sincerely,

Bill Parish

** Blog posts and related audio clips at https://billparish.wordpress.com

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Prior to the fractions rule, investors were investing $1 in order to get $5 to $7 in tax deductions.

President Reagan was so incensed that he signed into law new legislation, the “fractions rule,” specifically designed to end this scheme.  During this period no firm was more abusive with respect to tax avoidance than General Electric. Today Reagan’s reform is being challenged in an assault on taxpayer fairness led by the private equity firm Blackstone and its CEO Steve Schwarzman (pictured below left), in conjunction with the American Bar Association (ABA).  See my August 2010 blogpost “Blackstone: Private Equity or Public Theft,” for expanded background.

Before you consider the proposition of gaining $5 of deductions with a $1 investment preposterous, listen to the brief clip below of Sanford Presant of Greenberg Traurig, one of the nation’s leading real estate attorneys.  It is actually two short clips, the first is his introduction at a major tax conference and the second an explanation of what led to the fractions rule in his own words.

Presant is a national authority in this area and has had major roles with the ABA, in addition to heading up Ernst and Young’s real estate practice. The complete audio recordings for Presant’s remarks, in addition to those of Internal Revenue Service Associate Chief Counsel Curt Wilson, can be purchased at http://www.dcprovidersonline.com.

Also featured in the recording is Wayne Pressgrove of King & Spaulding, who makes a case to IRS Counsel Wilson for a revenue ruling to disable the fractions rule.   It is ironic that Reagan relied on the same law firm, King & Spaulding, to craft the fractions rule in the 1980’s, and these lawyers did brilliant work.

Audio Clip 1 (0:25)
Hear Sanford Presant Introduction and Background

mp3 file (for iPad users)

Audio Clip 2 (1:26)
Hear Presant Enthusiastically Explain How Investors Received $5 of Tax Deductions for Each Dollar Invested

mp3 file (for iPad users)

At a 2010 ABA conference, Internal Revenue Service Associate Chief Counsel Curt Wilson volunteered to sit on a panel and explained where the IRS stands on fractions rule enforcement. Wilson is introduced by Wayne Pressgrove of King & Spaulding.

Audio Clip 3 (3:32)
Hear IRS Associate Chief Counsel Curt Wilson Discuss the Fractions Rule

mp3 file (for iPad users)

Wilson notes there always seems to be “considerable angst” in the audience regarding compliance with this rule.  He added that one of the American Bar Association’s key initiatives was to amend the fractions rule. Remarkably, Wilson adds that he has seen almost no activity in this area at the IRS for years, either centrally or in the branches.  One might ask if this is just but another GE-like inspired scheme.

Earlier this year Wilson responded directly to me via email that the IRS was not planning to repeal the fractions rule.  However, the Treasury department’s February 2011 General Explanations of the Administration’s Fiscal Year 2012 Revenue Proposals were released and they include a repeal of the fractions rule (see page 90). Wilson now notes that someone else in his office is responsible for the fractions rule, yet he will not disclose who this is.

Why is this important for all investors?

This month NY Times reporter David Kocieniewski wrote a remarkable piece on General Electric, noting the company earned significant profits, yet paid no federal income tax in 2010.  The article also noted that GE maintains a “970” employee tax department headed by John Samuels, a former United States Treasury department official.

Such situations are important for all investors to consider because long-term cash flow is a primary determinant of  investor success.  Next to labor costs, taxes are often the most significant cash outflow for most businesses.  Clearly, tax avoidance alone is not sustainable long term and such a risk should be considered.   Other firms with significant such risk include Google and Cisco Systems.  The overall point again is simply, cash flow matters.

Given the opaque nature of these tax schemes at firms such as GE and Blackstone, it is often helpful to analyze them from the bottom up.   For example, Catalent Pharma Solutions is a Blackstone-owned company that files its own 10K with the SEC.   This provides valuable information including executive non-qualified (NQ) option agreements at Catalent and footnotes explaining how entities roll up to the Blackstone parent.   Much of this information is simply not available in Blackstone’s own 10K filing with the SEC.

The following list of entities shows exactly how Catalent eventually connects to Blackstone, its parent.  The Top Level partnership, Blackstone Holdings III L.P., appears in Blackstone’s SEC filings and org chart. It is mostly owned by tax-exempt public pensions. The carried interest fees these tax-exempt pensions pay is indeed Blackstone’s primary source of income, an expense to the tax-exempt pensions and revenue to Blackstone.

If Blackstone is manufacturing non-qualified (NQ) tax deductions at the Catalent wholly-owned subsidiary level, which are actually a pass-through of the carry fees (internal carry plan) paid from tax-exempt limited partners to company executives, then this could be a significant violation of the fractions rule.  Sound bizarre?   Perhaps that is the beauty of laundering activity through so many layers of entities, combined with transfer pricing algorithms managed by leading accounting firms. Keep in mind that Blackstone has hundreds of individual companies in its various partnerships.

Please note that given the opaque nature of these issues and related complexity, my hope is that a leading journalist will confirm the facts directly with Blackstone.  This material is not copyrighted and has been provided to both Gretchen Morgenson and Floyd Norris of the NY Times for review.  It was Morgenson who reported on my findings regarding the Microsoft Corporation in 2000, similarly noting a scheme which allowed them to pay zero federal income tax.  From an investment point, again, the key observation of this analysis is that “cash flow matters.”

One could argue that the only real company in this whole structure is Catalent.  Imagine how frustrated their competitors who pay significant taxes feel.  Perhaps this is the real nexus of the national debate over taxes.  Rates should be able to come down in all categories, yet this is simply not possible until the basic tax equity issues are addressed.   What we need is enforcement of the fractions rule, specifically with respect to compensation allocations, in my opinion.

Repealing the fractions rule is now the “Holy Grail” for many private equity firms, in particular with respect to the allocation of compensation deductions.  The 2012 Treasury Department revenue proposal refers to using a less restrictive rule that does not deal with the key issue involving tax exempt entities, perhaps returning us to the days when certain insiders can invest $1 and get $5 in tax deductions.

Despite all the controversy surrounding Reagan’s Presidency, one can be certain that he would have dealt with this nonsense swiftly.  We will soon see how the current Administration does.

These private equity firms failed to get the fractions rule repealed in Congress.  They then failed again in their request to obtain a revenue ruling, sponsored by the ABA, from IRS Commissioner Doug Shulman.  The ruling was designed to exempt compensation (carry fees) from fractions rule considerations. They now have remarkably gotten the United States Treasury Department itself advocating their cause per the 2012 Treasury Revenue Proposals which effectively repeal the fractions rule.

Somewhere out there is an underpaid lobbyist and about the only thing standing between their success in repealing the fractions rule is a good journalist.

The following letter was sent to Warren Buffett and his heir apparent, David Sokol, on March 24, 2011 because he like all investors will see diminished opportunities as companies are taken private by private equity firms such as Blackstone in order to implement what might be called a tax deduction pyramid scheme.

Interestingly,  Sokol resigned shortly thereafter on March 30, 2011.  By the way, does anyone really believe Warren Buffet would invest $9 billion in Lubrizol so Sokol could earn a profit of $3 million, perhaps the equivalent of a rounding error for his personal portfolio?  Similarly, does anyone really believe Sokol resigned solely based upon this investment?

In any event, here is the letter to Buffett, whom some argue is a leader in key corporate governance issues, including tax equity.


March 24, 2011

Warren Buffett

Berkshire Hathaway Inc.

3555 Farnam St.

Suite 1440

Omaha, NE 68131

cc: David Sokol

Dear Warren,

I hope you are well and enjoying things. The last correspondence we had resulted in that most memorable letter from David Sokol regarding the purchase of PacifiCcorp here in the Northwest.

The reason I am writing today is that I would like to reveal, similar to the work I did regarding Microsoft in 1999 that ultimately resulted in two reporters earning Pulitzer prizes and a veritable cottage industry of media tag alongs, a most astonishing taxation story. One that, if you do not address, will clearly hobble many of your portfolio companies.

On this issue, we should be on the same page. The challenge is that we will need to briefly visit what leading tax attorneys call the Mariana Trench of the Internal Revenue Code, that is the fractions rule, scheduled to be repealed per Obama’s 2012 revenue proposals. See link to blogpost titled “Blackstone, Private Equity or Public Theft,”at http://www.billparish.com

Recommendation: Have your top analyst take a look and confirm you will not only be priced out of many acquisitions but also see your portfolio companies hobbled if this is repealed. No matter how well run and efficient you are, and no matter how great the sloth at these PE firms, this will greatly impact you in my opinion.

There are many specific facets to this scheme yet they all revolve around ultimately allocating unusable tax deductions belonging to tax exempt partners to taxable partners. Most remarkable is that these are not real expenses such as depreciation but rather mostly compensation in the form of carried interest fees.

Substantive Facts:

1) Private equity funds now receive most of their funding from tax exempt sources, in particular public pensions. George Roberts and others now spend most of their time gathering such tax exempt investors.

2) The fractions rule was put in place to prevent GP’s like Blackstone and KKR from trading additional partnership benefits with tax exempts LP’s who had vast amounts of deductions that could not use, since they are tax exempt. As one leading attorney put it, investors were trading on tax benefits, at times getting 5-7 dollars of deductions for every dollar invested, and that is what brought us the fractions rule.”

3) Here is how the current scheme works and how it will cumulatively hobble you over time:

PE firms portfolio acquire companies and create vast stock option programs, what some call internal “carry plans,” and by doing so take NQ option deductions at the individual portfolio company level. In reality, this is nothing but a push down of the carry fees paid from mostly from tax exempts, which is non-deductible. These carry fees are an economic expense belonging to tax exempt, often booked as a balance sheet transfer, never hitting the P&L statement.

4) The reason this impacts Berkshire is that everything else equal, you cant compete on a long term cash flow basis with firms that pay no taxes at all In addition, as Roberts states, their strategy is to aggressively price competitors out of the various markets and then later raise prices.

While you may say, this won’t effect us Bill, do have one of your best analysts take a good took. Quite remarkable. I’ve also provided this information to the Internal Revenue Service yet they will not comment.

My basic point is that if the fractions rule is eliminated and compensation deductions, in particular carry fees, can be allocated without restriction by only needing to conform to more lenient rules, it will be one big mess. See http://www.billparish.com for link to blog post titled “Blackstone, Private Equity or Public Theft.”

5) IRS Perspective to Date: Curt Wilson in the office of passthroughs and special industries has noted in national ABA conferences that “although their is considerable angst regarding the fractions rule,”it has been off the IRS radar screen. He also responded to me via email earlier this year when I expressed concern over the ABA aggressively pushing for repeal, specifically lobbying him hard at national conferences, that the IRS did not support that. Remarkably, however, in February the Treasury issued guidelines for 2012 which include its repeal. When asked for additional information, Wilson replied that someone else is handling this in his office but I can’t get a response from him who this is, much less any specifics.

Please do take a look. and naturally I will make myself available if someone there would like to discuss in more detail. By the way, as you likely know, all four of the major CPA firms are making very significant revenues servicing private equity and hedge funds who aggressively use carry fees. I began my career at Arthur Anderson when it was a great firm in 1980’s. Perhaps helping prevent this repeal will also help prevent an Anderson like moment in the future for one of these firms. It is indeed possible that this is a bigger situation than LILO leasing.

Best regards.

Bill Parish

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