Offshore investment deals led to appearance of profitability - until IRS intervened
Metropolitan Mortgage & Securities Inc. made an offshore investment six years ago that the Internal Revenue Service determined was designed to deprive the U.S. government of millions of tax dollars.
The plan worked wonderfully at first — Metropolitan was able to turn a $3.2 million investment into a $28 million income-tax credit, according to the company.
The transaction was a way to help brighten the company’s financial books during a critical time. But the investment eventually would unravel and was one of the key factors in sending the venerable Spokane company into a tailspin.
Metropolitan got into the deal on the advice of its outside accounting firm, PricewaterhouseCoopers LLP, and Seattle financial advisor Quellos Group Ltd.
Metropolitan needed to be profitable — or at least appear profitable — in order to begin marketing tens of millions of dollars of unsecured bonds, called debentures, on the Pacific Stock Exchange. Doing so would help the company escape vigorous regulation by the state, the state securities division has said.
The buyers of those debentures would be thousands of Northwest residents, many senior citizens and apparently unsophisticated investors who were attracted to Metropolitan’s advertised appeal as a rising local company with a solid reputation.
Using the offshore investment strategy advised by its accountants, Metropolitan cut its 1999 income taxes by $17.9 million. That helped it post a $16.3 million profit that year.
Such strategies are called tax shelters, and they’re carefully constructed to help corporations and wealthy individuals avoid income taxes.
Critics call them shams and claim tax shelters used during the 1990s robbed the U.S. Treasury of $85 billion.
“The current tax system lets tax evaders beat the system by closely following detailed rules set up for legitimate transactions even though they are being used for no genuine economic purpose except to avoid paying taxes,” Sen. Joe Lieberman, D-Conn., charged last year during a Senate investigation into tax shelters such as the one undertaken by Metropolitan.
When the IRS spied Metropolitan’s tax shelter, it moved to disallow the tax credits. Metropolitan maintains that its investment was legitimate and had three tax opinions written to press its point and fought the IRS decision. It lost. That set in motion a chain of events that sent the company’s insurance subsidiary, Western United Life Assurance Co., into receivership and threatened Metropolitan’s very existence.
Metropolitan had moved a large piece of the tax credit created by the offshore investment into Western in violation of state rules, said James Odiorne, deputy insurance commissioner overseeing receiverships.
Western was not allowed to invest in foreign securities where it was not registered to do business. Also, Odiorne was concerned that the insurance company was involved in an investment that lost huge amounts of money on paper while not disclosing all the details. “Once we finally had a look at this thing, it baffled us,” Odiorne said.
The IRS’s negative ruling forced Western to take an $18.4 million write-down earlier this year.
Odiorne said one unpleasant surprise after another regarding Western and Metropolitan finally triggered the receivership. One of those surprises included the resignation of its outside auditor, Ernst & Young LLP, which disavowed three years of Metropolitan’s financial reports after determining that executives couldn’t be trusted. Metropolitan’s current executives, who were hired long after the tax shelter was used, declined to be interviewed for this story.
In a written statement, Metropolitan Chief Financial Officer William Smith acknowledged the company has been negotiating with the IRS and other parties and remains hopeful of reaching a settlement on taxes due.
A complex arrangement
The deal that helped Metropolitan post phantom losses during 1998 and 1999 — which the company turned into tax credits — was extraordinarily complex.
According to public records recently released by the insurance commissioner’s office, it worked like this:
On Oct. 15, 1998, Metropolitan paid $3.2 million to a company on the Isle of Man called Thoresby Ltd. The money bought what’s called a subscription warrant, which guaranteed that Metropolitan would buy within five years 85 percent of a Thoresby subsidiary located in the Cayman Islands called Madrona Capital Inc.
With this apparatus is place, Madrona began investing.
First, on Nov. 4, 1998, Madrona agreed to buy $79.6 million worth of stock in Union Bank of Switzerland (UBS). It didn’t put up that money though; instead, Madrona entered into a deal to pay UBS in 50 days and said it would pay about $625,000 in interest to the Swiss bank during that time. At the same time, UBS said it would take back those shares on the 50th day under certain circumstances.
On Dec. 28, 1998, UBS exercised that option to take back its shares with the $79.6 million never actually changing hands. Madrona’s paper investment in the bank was wiped out. That same day, Metropolitan paid UBS $796,000 for the right to buy the same number of shares that Madrona had earlier agreed to buy for $79.6 million.
The next day, on Dec. 29, 1998, Metropolitan sold the right to buy those shares, which are referred to as call options, for $363,210 — less than half the price it had bought them for just one day earlier.
It wasn’t until about three months later, on March 23, 1999, that Metropolitan made good on its guarantee to take over Madrona, but it paid $0 because the Cayman Islands company was by then worthless.
The circuitous transactions enabled Madrona to generate a paper loss of more than $79 million in the span of 74 days.
Metropolitan, now the owner of Madrona, absorbed the loss and wrote off 35 percent of it. That created a $28 million income-tax credit the company could — and did — record on its financial books as an asset.
At the same time all this was going on, Metropolitan also bought and sold shares of UBS on its own in the week prior to its first dealings with Madrona.
Metropolitan sold most of its UBS shares in November that year to its Western United subsidiary for about $5.1 million. The inter-company deal netted Metropolitan a $1.5 million profit in less than two months.
Western sold its shares of UBS on Dec. 29 for about $5.2 million, earning an approximately $100,000 gain.
The entire deal has been maligned by the U.S. government as a FLIP transaction, an acronym for tax shelters called Foreign Leveraged Investment Programs.
Of the tax opinions backing Metropolitan’s claim that the shelter was a legitimate investment strategy, one was put together by PricewaterhouseCoopers.
Although the document bore no individual author’s name, the opinion described the dual purpose of the investment, which it had helped to set up. The deal had “the dual purpose of achieving a significant tax benefit and the possibility of making a profit on the transaction,” the accounting firm said, noting “the tax benefit is the more significant purpose.”
Another opinion was put together by a University of Kentucky tax law professor.
A third opinion was put together by a Seattle law firm.
While evading federal incomes taxes is nothing new, the sophistication and use of tax shelters reached record levels during the late 1990s. The frenzy was driven by the late-1990s economic boom that created big profits and high investor expectations.
Prestigious accounting firms — KPMG LLP, Ernst & Young LLP, and PricewaterhouseCoopers among them — sold these tax shelters to hundreds of clients.
The abuse led to a crackdown. The IRS launched a short-lived campaign that gave taxpayers a 120-day grace period to voluntarily disclose questionable tax shelters without fear of stiff penalties. Few companies jumped at the chance, and Metropolitan was one that didn’t.
Then last year the state insurance commissioner’s office became very interested in Metropolitan’s Madrona tax shelter because of the $18.4 million liability riding on Western’s books.
Odiorne also worried that Western executives were masking details.
“They tried dancing around the issues,” Odiorne said of former Western executives. “These dancers are now out, with (the insurance commissioner’s office) at the helm.”
Scott Cordell, a Western vice president, said the insurance company will restate its books minus the income-tax credit.
Of the $18.4 million disallowed by the IRS, the company will take an approximately $6 million loss on its books and foist $11.2 million back to Metropolitan through an indemnification agreement.
The insurance company will likely have to cut a check to the IRS for between $600,000 and $1 million and try to move on, Cordell said.
Metropolitan, which filed for bankruptcy protection on Feb. 4, is still negotiating a settlement with the IRS.
PricewaterhouseCoopers, the architect of Metropolitan’s tax shelter, now disavows the practice.
“This had not been a traditional part of our tax practice, but regrettably our firm became involved in three types of these transactions between 1997 and 1999,” PricewaterhouseCoopers senior tax partner Richard Berry testified last fall before the U.S. Senate’s Permanent Subcommittee on Investigations.
In all, the accounting firm participated in 50 of the so-called FLIP transactions.
PricewaterhouseCoopers reportedly paid $1 million to settle allegations it erected tax shelters. It has refunded some of the fees charged to tax-shelter clients, although New York-based spokesman David Nestor said he couldn’t disclose if the company would return money to Metropolitan and Western.
As for Quellos Group, the Seattle firm identified, analyzed and implemented the specific stock and option transactions that were required to execute FLIP transactions, CEO Jeff Greenstein said in testimony before the Senate subcommittee in November 2003.
Greenstein’s firm describes itself as a “global financial boutique” that is a leader in “alternative investment strategies.”
Unlike PricewaterhouseCoopers, Greenstein’s testimony offered no regret for advising companies about what he called tax strategies.
Quellos declined to answer questions for this story, including whether the firm would refund advisory fees, such as the $2.4 million paid by Metropolitan, to companies who have had their shelters exposed as tax-evading schemes.
Greenstein, who serves on the committee overseeing the University of Washington’s endowment portfolio, testified that Quellos no longer provides advice on the sorts of tax strategies looked into by the Senate. Not once did he call them tax shelters.
Madrona Capital, which had operated out of a law firm’s office in the Cayman Islands, no longer exists.
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