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Long-Term Capital's Tax Loss May Help IRS Stem Abuses

Date: Monday, August 30, 2004

Aug. 30 (Bloomberg) -- Long-Term Capital Management LP, whose failure in 1998 forced a bailout by Wall Street's biggest investment banks, has to pay $56 million in tax and penalties after a judge said the hedge fund claimed an improper deduction. The ruling may force other firms to settle tax-abuse cases. U.S. District Judge Janet Arterton decided Friday in New Haven, Connecticut, that the now-defunct fund, founded by former Salomon Brothers Inc. Vice Chairman John Meriwether, improperly took a $106 million deduction linked to a transaction that ``did not have economic substance beyond the creation of a tax benefit.'' ``This is a big step for the IRS,'' said Charles Hurley, a lawyer with Mayer, Brown, Rowe & Maw in Washington, who initially led the government's case against Long-Term Capital, an investment partnership for wealthy individuals and institutions. ``This decision should push people to participate in settlements'' of IRS allegations of tax violations, he said. The IRS has cracked down on abusive tax shelters in the past two years, collecting fines from accounting firms that created them. In 2002, PricewaterhouseCoopers LLP was fined for promoting certain tax shelters, and Ernst & Young paid a $15 million settlement last year. Long-Term Capital of Greenwich, Connecticut, has paid some of its tax bill, which could reach $56 million if the highest amount of penalties, $16 million, is applied. The Government Accountability Office estimates that since 1993, the U.S. has lost about $33 billion in revenue from abusive tax shelters -- transactions set up solely to cut taxes. Possible Deterrence The case against Long-Term Capital, whose partners included Nobel laureates Myron Scholes and Robert Merton, and the fine, may keep other companies and individuals from trying to fight the IRS in court, said Lee Sheppard, a tax lawyer and contributing editor of Tax Notes, an industry journal. ``Penalties scare the hell out of people,'' she said. ``It used to be that if you got a written opinion from an outside lawyer you were OK. This judge said that just because you have a paper, if it is loaded with assumed facts and doesn't apply to your situation, it doesn't protect you from penalties.'' The government's four-week trial in July 2003 against Long- Term Capital featured testimony by 21 witnesses, including hedge fund partners Meriwether and Scholes, as well as experts on tax shelters and equipment leasing and another Nobel laureate, economist Joseph Stiglitz. Legal Advice The legal advice of Mark Kuller, a lawyer with the firm of King & Spalding when he offered the fund tax opinions, was ``unsupported and lacked credibility,'' Arterton wrote in her ruling, which also criticized a bonus paid to Scholes. The Long-Term Capital shelter involved Onslow Trading & Commercial LLC, whose partners were based in London. Onslow Trading engaged in so-called lease-stripping transactions. In one case, it leased computer equipment from General Electric Capital Computer Leasing. Onslow subleased its right to the equipment to U.S. partnerships. Each partnership paid Onslow a lump sum of about $100 million, the amount of rent owed on the leases. That money went into bank accounts set up with the sole purpose of paying GE's computer leasing unit the rent when due. Onslow then approached four U.S. companies, exchanging the subleases and the bank accounts for preferred shares. For every $100 million in tax-deductible rent, Onslow got $1 million in stock. The companies, which included Rhone-Poulenc Rorer Inc. and Advanta Corp., paid the rent on the leases and wrote it off as a business expense. Preferred Shares While the market value of the stock was $4 million, Onslow took the position that the tax basis of the stock was $400 million -- the amount of cash in the bank accounts. In the final stage of the transaction, Onslow went to Long- Term Capital and swapped its preferred shares for a stake in the hedge fund. When Long-Term Capital sold some of the shares in 1997, the hedge fund took a loss equal to the stocks' tax basis, minus the cash it had received from the sale, or about $106 million. Long-Term Capital's lawyer David Curtin argued the fund legally reduced its taxes with the shelter because it brought new investors into the fund, and therefore its transactions had a real economic purpose. The government's lawyer contended the shelter was illegal because its only purpose was to avoid taxes. Long-Term Capital officials said it had obtained opinions from two law firms that stated the transactions were legal and that the government shouldn't impose penalties because the fund was acting on legal advice. No Protection In e-mailed responses to written questions from the New York Times, Scholes said that ``the law firms gave strong opinions.'' ``Without this advice and opinions we would not have gone forward with the transactions,'' he wrote, according to the paper. The government said the firms that offered the opinions weren't independent and that the paid-for letters were ``insurance policies'' to cover audits of the fund by the IRS. ``The court decision confirms that transactions entered into merely to shelter income from taxes will be disregarded for tax purposes and that unreasonable legal opinions will not protect investors from monetary penalties,'' said Eileen O'Connor, assistant attorney general for the Department of Justice Tax Division. Curtin declined to comment. At a congressional hearing last month, an investment bank employee who testified behind a screen to conceal his identity, said Wall Street banks used fraudulent shelters to avoid paying federal taxes on more than $10 billion of income over the last decade. The Bail-Out The IRS said last month that more than 1,500 people who had used a tax shelter called ``Son of Boss'' agreed to settle for back taxes and reduced penalties. The shelter cost the government at least $6 billion, according to the IRS. Meriwether, vice president of Salomon Brothers' domestic fixed- income arbitrage group from 1977-78, formed Long-Term Capital in 1993 after losing his Salomon vice chairman job. He was joined by some of his top proteges from the firm as well as by Merton and Scholes. They initially raised a $2 billion fund and, in some years, generated returns of more than 40 percent. Meriwether's fund lost $4 billion in 1998 after a debt default by Russia prompted investors to shun corporate and mortgage-backed bonds and buy less risky, more-easily traded government securities. Fourteen securities firms and banks, including Goldman Sachs Group Inc., Merrill Lynch & Co., Morgan Stanley and UBS AG, organized a $3.6 billion bailout in September 1998 to avert the turmoil a forced sale of Long-Term Capital's investments would have caused. Meriwether's losses were magnified because the wagers were made using borrowed money -- as much as $50 for each $1 of the firm's cash. Long-Term Capital's investments included bets on Danish mortgage bonds, takeover stocks and junk bonds. The unprecedented rescue of Long-Term Capital showed how concerned regulators and bankers were about the health of financial institutions worldwide. Banks and securities firms had at one point loaned Long-Term Capital more than $100 billion for arbitrage -- trading that takes advantage of price discrepancies between related securities. To contact the reporter on this story: Katherine Burton in New York at kburton@bloomberg.net. To contact the editor responsible for this story: Tim Quinson in London at tquinson@bloomberg.net.