The Tax Games Tyco Played

It made an art form of avoidance, but a climate shift has opened the door to harsher scrutiny

The criminal indictment of L. Dennis Kozlowski paints a stunning portrait of complex schemes the former chief of Tyco International Ltd. (TYC ) allegedly used to evade New York State and City sales taxes on $13.2 million worth of personal artwork. To beat the 8.25% tax, the June 4 indictment charges, Kozlowski and his co-conspirators used such tactics as preparing false invoices and shipping empty boxes to the conglomerate's executive offices in New Hampshire.

That scheme was child's play compared with the apparently legal methods Tyco has used to avoid corporate income taxes. Under Kozlowski, tax avoidance became a way of life and a key corporate strategy. It's not just that Tyco five years ago moved to the now-famous tax haven of Bermuda. Since then, it has gone to extraordinary lengths to amass subsidiaries in such tax-friendly locales as Barbados, the Cayman Islands, and Jersey. From 2000 to 2001 alone, the number doubled to more than 150.

The payoff: Tyco has cut its effective tax rate from 36% in 1996, just before the Bermuda move, to 23% in 2001. In an interview last year, Tyco Chief Financial Officer Mark H. Swartz said tax stratagems would slash Tyco's 2001 tax bill by some $600 million. "It has been a huge strategic advantage," he bragged.

Yet Tyco didn't actually pay anything near even that 23% rate, according to Bob McIntyre of Citizens for Tax Justice, a Washington advocacy group. Why? That rate was based on Tyco's "provision" of almost $1.5 billion for income taxes. But in its 2001 10-K, Tyco admits only $754 million was considered due in that year. Of that, $629 million was said to be for non-U.S. income taxes. The company doesn't spell out exactly how much of the remainder covers U.S. taxes, but the amount would be reduced further by a deduction for millions of executive stock options that were exercised. McIntyre says Tyco may have wound up paying nothing: "Was [the U.S. tax bill] positive? Probably not."

Suddenly, though, Tyco's powerful advantage is coming under scrutiny. And it couldn't happen at a worse time for the $36 billion company, which is scrambling to avoid a liquidity squeeze. In Congress, which for years showed little interest in this issue, Tyco has become the No. 1 example for those seeking to rein in a tax strategy many consider unpatriotic. "Tyco has raised tax avoidance to an art," grouses Rep. Richard E. Neal (D-Mass.), who has introduced legislation that would force Tyco to pay taxes as a U.S. corporation beginning in 2004.

That perception, along with Kozlowski's indictment, makes it more likely that tax authorities in the U.S. and other high-tax industrialized countries will put Tyco's tax schemes under a microscope. The basic strategies "are very consistent with the tax code and regulations," says one Wall Street tax expert. However, because a number of Tyco's subsidiaries appear to exist mostly to deal with related units, that could be challenged by the Internal Revenue Service. "Tyco is an obvious audit target," argues Leslie B. Samuels, a New York tax attorney and former U.S. assistant Treasury secretary for tax policy.

Tyco first began to focus on tax avoidance in 1997, when Kozlowski bought ADT Ltd., a security-services firm. ADT--headed by the controversial Lord Michael A. Ashcroft, now a member of Tyco's board--already was based in Bermuda. Through a reverse merger, in which the smaller ADT effectively acquired Tyco, Tyco no longer had to pay U.S. taxes on its non-U.S. income.

The biggest savings, though, came in succeeding years. Many of the tax-haven subsidiaries Tyco owns--with such names as Silver Avenue Holdings, Driftwood, and Bunga Bebaru--have little apparent connection to its operating businesses. But they are perfect vehicles "for shielding interest, dividends, royalties, and other forms of passive income from tax," says Samuel C. Thompson Jr., a professor at the University of Miami School of Law. In fiscal 2001, Tyco reported that while 65% of its revenues came from the U.S., just 29% of its income did. In other words, 71% was no longer subject to the 35% U.S. corporate income tax. A Tyco spokesman declined to discuss the company's overall tax policy. He said many of the subsidiaries "are dormant" and some are being dissolved.

Tyco's 10-K provides no information about the operations of most of these mysterious subsidiaries. But tax experts point out that the units could be used to engage in transfer pricing. Goods produced in a high-tax country might be sold to a tax-haven subsidiary for a low price, and then legally resold at a higher price--with most of the profit tax-free. Clearly, one of the most important overseas units is Luxembourg-based

Tyco International Group. TIG borrows much of the billions Tyco needs to finance its $27 billion of debt, and then reloans it to Tyco units in the U.S. and other high-tax countries. In its 10-K, Tyco reported that TIG had $16.7 billion in such intercompany loans outstanding. The beauty of this is that the interest Tyco's U.S. subsidiaries pay on these intercompany loans is tax-deductible in the U.S. Moreover, Samuels says TIG could be charging Tyco's other subsidiaries a higher interest rate than it is paying--further increasing the tax benefit. But the interest payments Tyco's U.S. units ship back to TIG are not taxed in Luxembourg, says Robert Willens, a Lehman Brothers Inc. tax analyst.

At least one of Tyco's overseas units has come under official scrutiny. Earth Tech Venezuela was formed in 1999 to handle a $200 million contract a Tyco unit had won to build and operate an industrial water-treatment complex in that country. In a deposition taken last December as part of a labor dispute lawsuit involving a disgruntled former executive, Charles S. Alpert, general counsel of U.S.-based Tyco subsidiary Earth Tech, testified that "on the advice of the Tyco tax department," Earth Tech Venezuela was set up so it was owned by Luxembourg-based Tyco Group. Such a move would shield the Venezuelan project from U.S. taxes.

Now, BusinessWeek has learned that the Securities & Exchange Commission is investigating whether Earth Tech may have used means to win the contract--such as paying bribes--that would violate the Foreign Corrupt Practices Act. Miguel Delgado Bello, a vice-president for Earth Tech Venezuela at the time of the bid, says that in mid-May he met with SEC investigators to discuss bribes he alleged were paid by the Tyco unit to seal the deal. But Tyco points out that Delgado, fired later in 1999, was thoroughly discredited in a May 15, 2002, U.S. District Court ruling that found he "has given false testimony [and] fabricated an effort to perpetuate a fraud on the court." Nonetheless, sources say the SEC is still probing the bribe allegations.

Some tax experts suspect if the IRS fully probed Tyco's bag of tax tricks, the company could be hit with huge penalties, because it could argue Tyco's tax situation doesn't reflect economic reality. Since Kozlowski's resignation, Tyco has strived to argue that his personal conduct will have no material impact on the company. But Kozlowski's legacy also included an increasingly aggressive strategy of avoiding taxes by any means possible. That may prove to be an even bigger problem for Tyco.

By William C. Symonds in Boston, with Geri Smith in Caracas, Venezuela

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