It Looks Like A Stock But Deducts Like A BondPhillip L. Zweig
Two big U.S. energy producers think they may have struck a tax-saving gusher of sorts in the Turks and Caicos Islands--yes, the Turks and Caicos Islands. But some Wall Streeters believe the Internal Revenue Service might eventually cap their tropical tax loophole.
For years, this spine-shaped island cluster 90 miles due north of Haiti was best known for its Club Med and scuba diving. Lately, however, the islands have gained prominence on Wall Street as the wellspring of two preferred stock offerings that appear to give the issuers, Texaco Inc. and Enron Corp., the best of two worlds. Normally, companies can deduct the interest costs of bond offerings but not the dividends paid on stock. Called MIPS (monthly income preferred shares), the new $25-a-share offerings--priced on Oct. 27 by Texaco and on Nov. 4 by Enron--appear to enable the issuers to deduct the "dividends" on the preferred shares as if they were interest. Rating agencies are treating the shares much like equity. A comparable debt sale might endanger the issuers' credit standing.
LONG ARM. Although similar transactions have been done for European companies and financial institutions, Texaco's $600 million MIPS and Enron's $200 million issue represent the first such offerings by U.S. corporations, according to Goldman, Sachs & Co. Vice-President Christopher Hogg. Although Goldman, which sells mostly to institutions and rich individuals, led the deals, they target mainly retail investors.
Sound too good to be true? Maybe it is. A few Wall Streeters privately wonder whether Turks and Caicos are far enough away to enable the deals to escape the long arm of the IRS. Asked for comment, the IRS maintained its usual silence on specific tax situations. An IRS spokesman says the agency has not provided "general guidance" on tax treatment of such offerings. But a Big Six accounting firm tax partner says that the IRS, under pressure to produce revenue, has lately been "very aggressive" in scrutinizing large offshore tax-driven transactions.
At the moment, a number of other companies are "waiting in the wings," as a Goldman source put it, to get their issues to market. Barring an unfavorable IRS ruling, investment bankers figure that some $10 billion worth of the new instrument could hit the market over the next 12 months.
These transactions take advantage of a recently enacted provision in the corporate statutes in Turks and Caicos. According to the Goldman source, the move was engineered by Sullivan & Cromwell, Goldman's outside law firm, which also issued a tax opinion supporting the transaction.
Under the Turks and Caicos law, Texaco and Enron established subsidiaries that sold preferred shares to investors and lent the proceeds to the parent companies. In the Texaco transaction, the terms of the loan were 50 years (renewable for an additional 50 years) at 67/8%, the same rate of interest paid to preferred shareholders. Since Texaco "borrowed" the money from Texaco Capital LLC, its offshore subsidiary, it intends to deduct the interest expense just as it would on an ordinary bank loan. By organizing these subsidiaries as partnerships, the parents avoid U.S. withholding taxes on the interest payments. Assuming that Texaco's 26% first-half-'93 effective tax rate remains constant for the life of the loan, the company's aftertax interest cost would be only about 5.1%.
"ALCHEMY." Thanks to the long maturity, coupon-suspension rights, and other features, rating agencies regard the exotic new offerings as having "equity characteristics" that therefore pose no threat to the issuers' ratings. Accordingly, Standard & Poor's Corp. and Moody's Investors Service reaffirmed their existing single-A ratings on Texaco's senior and preferred debt and their triple-B ratings on Enron's senior and preferred.
Regarding the tax play, Moody's Senior Vice-President Harold Goldberg quips: "It's a form of alchemy--one of the world's oldest professions," adding: "If it's tax-effective, it's an attractive way of building capital." S&P's Managing Director Solomon B. Samson says: "Our presumption is that [the deals are] going to work," adding that the underwriters feel they "will meet the criteria of the IRS."
Texaco and Enron seem quite pleased with their apparent coup. Enron Executive Vice-President Edmund P. Segner says that because the Houston-based company expects its earnings to grow faster than the 8% coupon on the issue, the deal is a winner regardless of the tax benefits. A Texaco financial officer says the company wanted to sell preferred stock, and "when this structure was introduced to us, it looked like something we should analyze." As for the IRS, he says: "Suffice it to say, we're comfortable with the structure and don't consider it aggressive at all." The revenuers may look at it differently.
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