Hewlett-Packard Co. on Monday lost a battle with the U.S. Internal Revenue Service for more than $190 million in tax refunds tied to a Dutch tax shelter designed by the derivatives arm of American International Group.
The ruling turns a spotlight on an aggressive tax-cutting strategy created last decade by AIG Financial Products and bankrolled by several European banks.
The strategy involved trading derivatives with the aim of generating capital losses and foreign tax credits for large corporations, like HP, which then used them to try to lower their U.S. tax bills.
Judge Joseph Goeke of United States Tax Court in Washington, D.C., ruled against HP, which had sued the IRS in 2009 seeking the refunds.
The strategy, broadly known as a foreign tax credit generator, involves complex investments by large U.S. companies in foreign entities, typically in low-tax jurisdictions. The companies claim on their U.S. tax returns offsetting, or tax-lowering, credits for payments they make or owe to foreign tax authorities on the investments.
The IRS contends that many foreign tax credit generators lack economic substance and are engineered to create artificial financial benefits that are not valid for IRS deductions. The IRS outlawed many foreign tax credit generators around 2007. An IRS spokeswoman declined to comment on the HP ruling.
HP’S AIG STRATEGY USED ABN-AMRO
The AIG-FP strategy used by HP involved a Dutch entity, called Foppingadreef, that was created by AIG-FP in 1996 and funded by Dutch bank ABN-Amro.
In his 82-page opinion, Judge Goeke wrote that HP’s investments in Foppingadreef in 1996 were not valid for more than $15.5 million in capital-loss deductions claimed by HP in 2003 because the investments were not real economic bets.
Instead, the judge wrote, HP’s stakes in the Dutch entity were carefully structured loans made by HP to and via the entity, which paid back HP.
“HP’s investment is more appropriately characterized as debt, rather than equity, for Federal income tax purposes,” the judge wrote. That legal language echoes rulings of previous years that outlawed retail-investor tax shelters with names like Son of Boss.
Foppingadreef also generated for HP at least $178 million in tax savings in so-called indirect foreign tax credits that are not allowed, according to the ruling.
Indirect foreign tax credits are tax offsets created by interest, dividends and other investment returns. Because Foppingadreef was not an equity investment, and instead was a debt vehicle, the indirect foreign tax credits claimed by HP were not valid for deductions, the ruling said.
DUTCH ENTITY BLESSED BY LAWYERS
Foppingadreef was incorporated in the Dutch Antilles, a Caribbean tax haven, with lawyers from Sullivan & Cromwell and Skadden, Arps blessing the entity. AIG-FP sought legal advice for the entity because, the judge wrote, “AIG-FP understood that in order for the transaction to be marketable, it would need to be reviewed by others to ensure that it had broader appeal.”
Spokesmen for the two law firms could not be reached for immediate comment.
The AIG-FP financial engineer who created the transaction, Robert Findling, wanted to use differences between European and U.S. tax treatments of a certain type of interest payment “to model a foreign investment that would generate a stream of preferred dividends and produce significant foreign tax credits,” the judge wrote.
Foppingadreef generated the losses and credits by trading in various derivatives, including warrants and swaptions. AIG-FP, which is based in London, could not be immediately reached for comment.
One day after the 1996 incorporation, AIG-FP closed a planned deal to sell a major stake in Foppingadreef to ABN-Amro. A spokesman for ABN-Amro could not immediately be reached for comment.
In 1996, AIG-FP began pitching Foppingadreef to clients as an attractive tax-advantaged investment. Over a series of meetings last decade, Foppingadreef was reviewed by HP’s treasury, legal and tax departments in Palo Alto, Calif., at company headquarters, and approved at the highest levels of the company. A spokesman for HP declined to comment on the ruling.
In early 2004, HP transferred its shares in Foppingadreef to ABN-Amro, and claimed a capital loss of more than $15.5 million. The judge wrote that the entire transaction was not an investment because in part it was designed to allow HP to cash out its stake — effectively, a loan — at a pre-determined date.
In a separate lawsuit filed against the IRS in Tax Court in 2009, HP is seeking to recover an additional $248.5 million in taxes and interest it paid in 1994, 1995 and 1998.
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