Halt! You May Owe The Irs $500 Million

Why Laidlaw's tax flap has other multinationals worried

To become North America's No.1 ambulance and school-bus contractor, Canada's Laidlaw Inc. has ridden an outsourcing trend among hospitals and school districts. Tired of the costly hassle of owning and operating their own vehicle fleets, many have hired Laidlaw to transport patients and schoolchildren. The strategy has helped send revenues soaring five-fold, to $3 billion today.And to fund the rapid growth, Laidlaw hit on a clever tax arrangement. To buy out competitors in the U.S., where the carrier does 90% of its business, the Burlington (Ont.)-based company used low-cost financing provided through a subsidiary in a European tax haven.

But Laidlaw just hit a major speed bump. The Internal Revenue Service is charging that the company pushed a legitimate offshore financial maneuver over the line and took unjustified tax breaks. If the charges hold up in court, Laidlaw admits it will owe as much as $500million in back taxes and interest--one of the highest tax awards in history. That would swallow almost all of its 1997 operating income of $617 million.

Bad enough, but the case also has big implications for other foreign multinationals. The allegations have sent a chill through these companies doing business in the U.S. Many of them use similar financing for their American units, and they fear the IRS could hit them next. Says accountant Charles Taylor of DeLoitte & Touche: "No one wants to be in a Laidlaw situation." He and other tax accountants are scrambling to see if their clients are vulnerable to IRS scrutiny.

Accountants say the agency has questioned several Laidlaw-like arrangements during routine audits in recent years, but so far it appears Laidlaw is a special case. "What these guys tried to do with the tax code is off the charts," says Robert Willens, Lehman Brothers Inc.'s tax expert. Nevertheless, they're not alone. Europeans are fond of the setup, Canadians more so. KPMG Peat Marwick partner Bill R. Lawlor estimates that half the Canadian outfits with U.S. subs use it.

YELLOW FLEET. The Laidlaw dispute stems from the mid-1980s, when it kicked off its growth plan after starting out as a small trucking outfit owned by Michael DeGroote, a gruff entrepreneur who made a fortune in construction. He got the company into school buses and garbage hauling before leaving in 1990. Current CEO James R. Bullock joined in 1993 and quickly sold the waste division. Today, the Laidlaw name is on the sides of 37,000 school buses.

Rather than fund the acquisition-led growth at its two main U.S. subsidiaries directly from its own coffers, Laidlaw used intra-company loans. That way, the American subsidiaries could deduct interest payments on their U.S. tax returns. The main source of the borrowings was a wholly owned financing unit, Laidlaw International Investments, set up in the Netherlands to benefit from low tax rates on foreign finance facilities.

Eventually, the borrowings by Laidlaw's U.S. subsidiaries--Laidlaw Transportation Inc. and Laidlaw Industries Inc.--swelled to hundreds of millions of dollars a year. Those sums attracted the attention of the IRS. In a claim filed four years ago, the agency said the loans to the U.S. units weren't real loans, since they didn't pay back the principal on the maturity date. The IRS also says the subsidiaries got their interest payments refunded almost immediately, labeled as fresh loans. Further, the IRS says the U.S. units lacked the financial means to handle the debt, due to weak cash flows. Its conclusion: If the loans were really just capital infusions from parent Laidlaw, they weren't eligible for tax deductions.

Laidlaw filed suit last September to block the IRS claim. Neither the company nor the IRS will comment on the tax imbroglio. DeGroote did not return calls. In legal filings, the company argues that the Dutch loans are bona fide debt.

Laidlaw, in the court papers, says the IRS is looking at its offshore financing the wrong way. The loans weren't repaid at their 1989 maturity, the company says, because this was a routine rollover. And a tripling of cash flow from 1986 to 1988 proves that the U.S. units were in better financial shape in the 1980s than the IRS makes out, Laidlaw contends.

On June 30, though, U.S. Tax Court Judge John O. Colvin rejected that reasoning on the grounds that the maturity date was mere "window dressing" to make the investments look like debt. Plus, real loans don't involve the instant return of interest payments to the borrowers, he wrote--a point Laidlaw doesn't contest. Colvin also argued that all the cash flow was needed for expansion, leaving nothing for debt service.

BIG KITTY. Laidlaw lost that opening round when Colvin disallowed the deduction on $975 million in loans made from 1986 through 1988. His decision, which the company intends to appeal, hit Laidlaw with a $141 million judgment. Next, both sides will duke it out over similar IRS claims for 1989-1991, then 1992-94. Those claims could run the tax tab up to $500 million, CEO Bullock has stated in a news release. He also said the IRS may go after post-1994 deductions. If so, the liability may soar.

How will Laidlaw cope? Nervous investors have knocked the stock down 28%, to around 9. Nevertheless, the U.S. divisions are now solidly profitable and the company has amassed a $200 million kitty to pay off the IRS. But depending on the outcome in tax court, that could be merely a downpayment--and there may be more cases to come.