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Business Day

Fair Game

Revisiting a $400 Million Tax Break

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IF you saw $20 on the ground, would you stop to pick it up? Silly question.

O.K., try this one: Would you stop to pick up $400 million?

That not-so-silly question is for our friends who run the Whistleblower Office at the Internal Revenue Service.

The $400 million matter involves Fairfax Financial Holdings of Toronto, an insurance company that has battled some big-name adversaries on Wall Street.

The brains behind Fairfax is V. Prem Watsa, sometimes called the Warren Buffett of Canada. Mr. Watsa recently joined the board of Research in Motion, the struggling Canadian maker of BlackBerrys.

Long before that, however, Mr. Watsa’s team at Fairfax was busy doing something else: reducing its American tax bill. Thanks to a complex stock deal that ran from 2003 to 2006, the company received a $400 million tax benefit.

How? Mr. Watsa’s company offset income from a profitable reinsurer subsidiary, the Odyssey Re Holdings Corporation, against losses at Fairfax. Under I.R.S. rules, companies can file so-called consolidated returns only if they belong to the same parent corporation and if one owns at least 80 percent of the other.

Trouble was, Fairfax didn’t own 80 percent of Odyssey back in 2003. To reach that threshold, it needed to buy 4.3 million Odyssey Re shares, then trading on the New York Stock Exchange.

Fairfax could have paid cash for the stock — $78 million at the time. But that’s not what it did. Instead, it wrote a $78 million i.o.u. maturing in 2010 to an affiliate of Bank of America in the Cayman Islands. Bank of America then borrowed $78 million of Odyssey Re shares in the open market and transferred them to Fairfax, which reimbursed the bank for its costs. Over the next three years, Fairfax got its tax benefit.

The question that has dogged this transaction is whether Fairfax really owned those Odyssey Re shares when it claimed its tax benefit. If it did, that $400 million savings was fine. If it didn’t, the I.R.S. could come calling.

Fairfax, not Bank of America, put together the deal in the first place, and the insurer has repeatedly said the transaction met all the rules. Fairfax received a clean tax opinion from Ernst & Young on the deal, but Bank of America has done no other deals of this kind. The bank declined to comment.

According to Fairfax, the I.R.S. has not disputed the consolidation for the company’s tax years of 2003 through 2006. The I.R.S., as is its custom, declined to comment.

Michael J. Bowe, a lawyer who represents Fairfax, said: “When all the evidence is considered, it is clear that, as the I.R.S. twice found, Fairfax owned these shares and was properly consolidated.”

But interesting evidence has come to light — in an unrelated lawsuit filed by Fairfax against a group of hedge funds — that again raises questions about the deal. Several documents written by deal participants suggest that it failed to meet the most basic test: that Fairfax actually owned the Odyssey Re shares, which traded under the ticker ORH.

Meanwhile, the expert witness hired by one hedge fund in the case, Edward D. Kleinbard, a professor at the University of Southern California Gould School of Law and a rock star in the world of tax law, testified in 2011 that the transaction was a sham.

Fairfax sued the hedge funds in 2006, accusing them of trying to manipulate its share price. The case was full of Wall Street intrigue: Fairfax contended that several prominent money managers had conspired to drive down its stock. It demanded $6 billion in damages.

The hedge funds denied the allegations, and the judge overseeing the case agreed with most of them, whom he has dismissed from the case.

While the Odyssey Re deal has apparently not met I.R.S. opposition, it is the subject of a complaint by one of the hedge funds sued by Fairfax to the I.R.S. Whistleblower Office. It is not clear if the office has seen the evidence produced in the hedge fund lawsuit.

Mr. Kleinbard, who served as chief of staff of Congress’s Joint Committee on Taxation, outlined in a 60-page opinion why he had concluded that the Odyssey Re transaction failed from a tax standpoint. Based on his reading of the confidential court documents, he said Fairfax executed what he called a “borrow to hold” deal instead of actually owning the Odyssey shares. Ownership, he said, would have allowed a proper consolidation of the two companies’ tax returns. “Fairfax borrowed shares to no economic effect simply to create the impression that it owned them,” he wrote. “Fairfax did not accomplish any business objective through this transaction, but rather simply paid a fee to BofA to acquire a false claim to file a consolidated federal income tax return with Odyssey Re.”

Ernst & Young’s clean tax opinion, Mr. Kleinbard wrote, was based solely on representations made by Fairfax. The auditor did not independently analyze whether the insurer obtained share ownership. He cited confidential deposition testimony from an Ernst & Young executive who had worked on the opinion. Ernst & Young declined comment.

Mr. Bowe, who represents Fairfax, said that “only defendants and their paid experts, like Mr. Kleinbard, argue Fairfax did not have an economic interest in these shares.”

One of the more interesting documents in the public domain, though, is an internal April 2003 e-mail from Robert Giammarco, then a Bank of America executive who managed the bank’s relationship with Fairfax. The e-mail outlined the pros and cons of the deal; one disadvantage, the e-mail warned, was that the deal “Does not provide true economic ownership of the ORH shares to Fairfax.” Marketing materials used by Bank of America to pitch a similar deal to another insurer, the St. Paul Companies, noted the same problem. (St. Paul did not do the deal.)

Fairfax said that Mr. Giammarco was mistaken and that he subsequently changed his mind. Its lawyers produced several pages of a 2011 deposition in which he backed away from his initial view on the ownership issue. “I think I just got it wrong,” he said.

Notable, however, is the fact that Mr. Giammarco’s shifting perspective came after he had worked at Odyssey from March 2005 to October 2006 as executive vice president and, for much of that time, as chief financial officer. When he left Odyssey, he got $2 million in severance and other pay. He is now a Merrill Lynch banker. Mr. Giammarco declined to comment.

Given these developments, it will be interesting to see if the I.R.S.’s Whistleblower Office questions the tax benefit reaped by Fairfax. It’s not that simple, of course, but $400 million lying on the ground is pretty enticing. Officials at that office didn’t respond to e-mail and phone messages seeking comment.

Inside NYTimes.com

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