July 13, 2007

No "Good Will" for Blackstone's Tax Hijinks

As public anger over the tax avoidance techniques used by private equity companies continues to grow, David Cay Johnston is (justly) stoking the fires even more, with an outstanding piece in today's New York Times describing a clever, outlandish and completely legal tax maneuver by one of the most high-profile of these companies, the Blackstone Group.

The headline: Blackstone "has devised a way for its partners to effectively avoid paying taxes on $3.7 billion, the bulk of what it raised last month from selling shares to the public."

At the heart of the story is the concept of "good will" and how its tax treatment has changed in the past two decades.

A little background: when one corporation buys another, it pays not only for the acquired company's buildings, machines and so forth, but also for its so-called "intangibles" or "goodwill." These intangibles include such things as the purchased company's trademarks, trained workers, customer lists, and the expectation that its customers will continue their habit of buying its products. In a word, goodwill can be thought of as a company's reputation.

For many companies, this intangible "goodwill" is a pretty big chunk of the company's value. A company like Blackstone doesn't have any factories or valuable machinery, for example; most of what makes them valuable is their expertise, experience and reputation.

In general, a company can write off the value of its assets over time. A company's factories and machinery gradually depreciates in value, and companies get to write off the annual loss in its value as a cost of doing business. But companies can't write off their goodwill. This makes a fair amount of sense: take a company like Coca-Cola. Its factories and bottling machinery will deteriorate over time. But its reputation for making tasty soda pop will remain undiminished (unless they start making insane marketing decisions). So you shouldn't be able to write off the value of something that isn't losing its value.

But, as a result of a poorly-thought-out tax change enacted in 1993, there is one condition under which companies are allowed to write off goodwill: when they inherit the goodwill as the result of purchasing another company. And legally, that is exactly what has happened with the Blackstone IPO: when the private company Blackstone went public, it basically created a whole new company. The new (public) Blackstone basically bought the assets of the old (private) Blackstone for $4.75 billion. Of that, it's estimated that about $3.7 billion was goodwill.

(Goodwill can be calculated as a residual: if Blackstone is worth $4.75 billion, and you can only identifying tangible assets (buildings, machinery, etc.) worth $1.05 billion, then the remainder of the sales price must be goodwill.)

So the newly-public Blackstone gets to write off their goodwill, all $3.7 billion of it. There are rules, of course: the deductions have to be spread out over a 15-year period, in the same general way that tangible assets are depreciated over time. But eventually, they'll write it all off.

Of course, the underlying assumption (that Blackstone's existing goodwill will all be frittered away 15 years from now, leaving a worthless husk behind) is absurd. Unless the new leadership at Blackstone drives the company into the ground, the value of its goodwill will likely not diminish at all. But for tax purposes, they get to pretend it will.

Johnston has done a terrific service by publicizing this arcane and hard-to-understand loophole. (I've read the article a few times and I'm still not 100% sure I get it.) But the real story isn't that one much-vilified company-- Blackstone, the Wal-Mart of 2007-- has found yet another seedy tax dodge. It's that Congress actually approved this absurd tax break back in 1993.

When Congress was considering enacting this tax break in 1992, CTJ's Robert McIntyre identified one of the most disturbing implications of such a move in a Washington Post op-ed, asking "Does it really make sense to give Wall Street new incentives to bring back the merger mania of the 1980s?"

And he was right. It helps that the company most visibly taking advantage of this unfair tax break is already public enemy #1. But Congress should be asking itself why a tax incentive for mergers makes sense in general, rather than focusing solely on the malfeasance of Blackstone. And this is the one shortcoming of Johnston's article-- he's so intent on (correctly) skewering Blackstone that he doesn't discuss the question of where this tax break came from and whether it should be repealed. But that's a minor quibble in the context of an article that will hopefully do a lot to raise the visibility of this arcane, but important, tax issue.


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