interactive.wsj.com/archive/retrieve.cgi?id=SB1011049746340475960.djm
January 15, 2002
Politics & Policy
Enron Tax Strategy Opposed by Clinton
Draws Attention of Government Officials
By JOHN D. MCKINNON
Staff Reporter of THE WALL STREET JOURNAL


WASHINGTON -- Government officials are examining whether Enron Corp.'s extensive use of a controversial tax strategy, once opposed by the Clinton administration, contributed to its financial problems.

The tax strategy drew fire in 1996 and 1997 as a potentially improper way to reduce taxes while masking company debt. Initially, it promised a kind of accounting alchemy. It allowed a company to borrow money from a subsidiary and treat the transaction as debt that generates interest deductions for tax purposes -- but as equity for its shareholders.

But the Clinton administration failed to get Congress to block it, and the Internal Revenue Service dropped a legal challenge to Enron's use of the strategy, known generically as "trust-preferred securities." The strategy has been widely marketed and used: Goldman Sachs Group Inc. pioneered the product with an investment known as MIPS, or Monthly Income Preferred Shares or Securities. Other firms quickly followed with similar products, with different names and slightly different forms.

A spokeswoman for Goldman said the company underwrote an early Enron MIPS deal but, in general, has had little involvement with the company. As the strategy was initially marketed during the 1990s, a corporation typically formed a subsidiary that issued preferred shares paying a fixed, regular amount to investors. The subsidiary then lent the proceeds to the corporation.

See full coverage of Enron's downfall.

For tax purposes, the corporation could deduct interest paid on the debt, arguing that the preferred shareholders owned the subsidiary. But for financial-accounting purposes, the corporation could argue that it controlled the subsidiary; hence, it could treat the loan more like an asset.

Defenders of the strategy said that in recent years, tighter accounting rules have required clearer disclosure of the debt on a company's books, although certain aspects of the strategy still carry advantages over conventional loans for purposes of ratings agencies.

The Houston energy-trading firm didn't respond to requests for comment on its use of the strategy, which became hugely popular with banks, insurance companies and utilities, among others. One advantage is that such arrangements often allow interest payments to be deferred for five years.

But the deals initially raised red flags among regulators. The Clinton administration asked Congress in 1996 and again in 1997 to limit the strategy's use in many situations. Securities firms and businesses lobbied intensely to defeat the proposal. The Internal Revenue Service challenged Enron's use of it with two subsidiaries: Enron Capital LLC, a Turks and Caicos entity, and Enron Capital Resources LP, a Delaware limited partnership. In both cases, the IRS didn't allow Enron to take the interest deductions.

Enron responded in April 1998, filing a petition in the U.S. Tax Court to overturn the IRS's decision. The litigation became the test case for the investments and briefly roiled the financial and accounting industries.

"The case will be closely watched because the MIPS structure has been used by taxpayers to raise billions of dollars in capital that is meant to be treated as debt for tax purposes but not entirely as debt by ratings agencies such as Moody's and Standard & Poors," accounting firm Ernst & Young LLP wrote to its clients in June 1998. A number of observers predicted the IRS would fail in its challenge. The IRS eventually conceded the key issues in the Enron case and issued technical advice to taxpayers allowing use of trust-preferred transactions to justify deductions in many circumstances. The ruling was "likely an outgrowth of the favorable settlement in Enron v. Commissioner," Ernst & Young wrote.

Energy price swings and the company's use of off-balance-sheet partnerships appear to have contributed substantially to Enron's problems. But government officials also are interested in Enron's use of trust-preferred products. They said that at least $900 million or so shows up in the company's latest annual report. Ed Kleinbard, a lawyer in New York who assisted the Securities Industry Association in responding to IRS audits of companies that used the trust-preferred vehicle, said that in the current regulatory environment, use of the trust-preferred strategies is legitimate. "I don't think of this as an example of the system gone awry," he said.

-- Michael Schroeder contributed to this article.

Write to John D. McKinnon at john.mckinnon@wsj.com