Tax dodging
GEOFF COLVIN: April 15 is just days away, and the pain will be greater than ever. We Americans will pay about $900 billion in income tax this year -- but we won't all pay our fair share. Some of the wealthiest Americans, who have the most to gain by scamming the system, are doing so more aggressively, more creatively, more outrageously than ever. When the IRS recently cracked down on a particularly abusive tax evasion scheme, one taxpayer had to fork over $100 million -- one taxpayer, and no, the IRS did not identify him. It did say it expects to collect $3.5 billion from participants in that one scheme.
What's wrong, how bad is the problem, and can it be fixed? David Cay Johnston is a Pulitzer-prize-winning reporter who covers these issues for The New York Times; he joins us from Rochester, New York.
David, tax scams by the wealthy, both illegal scams and what we might call legal tax scams, seem to be increasing. Why?
DAVID CAY JOHNSTON: Well, because the government has cut back on enforcement on one side steadily, and on the second because the amount of dollars involved is just enormous. I mean there are individuals who say when a salesman comes along, gee, I don't have to pay $20 million, $50 million, $100 million? How do I do that? And like all of us, you know, we can be gullible and believe sometimes that there really is a free lunch.
COLVIN: But has something happened in the past few years? I mean it does seem to be bigger and more aggressive and more creative than it ever was before.
JOHNSTON: Well, I think there are several forces at work. First of all, the rise of computers and spreadsheets that have allowed the creation of exotic financial instruments that the IRS has a hard time figuring out. Remember in the Enron case, the Joint Committee on Taxation concluded the IRS didn’t even understand what was going on. Secondly, the amounts of money that are involved, which are tremendous. Thirdly, there’s been a fundamental breakdown in morality at the big accounting firms, and there’s been a lot of discussion in the technical press and the business and academic press in these areas about the standards of accountants and to some degree tax lawyers in fashioning these deals, many of which are, if not outright shams, they push right up against what is a sham.
COLVIN: And the accounting firms, some of the major accounting firms are working for big corporations auditing their books and simultaneously, I gather, selling some tax advice, including some of these questionable schemes to the executives of these companies?
JOHNSTON: That's right, so that they’re selling them not just to the companies, but in many cases to the CEOs. So the CEO is getting his books audited by you. He is working in a tax device, and guess what? The auditors in these companies, in these accounting firms, astonishingly bless as acceptable these devices that are sold by the other side in the tax shelter business.
COLVIN: Amazing isn't it?
JOHNSTON: And there's no -- for a number of people there's no shame about this.
COLVIN: We're talking about millions and millions and cumulatively many billions of dollars.
JOHNSTON: Well, yes, and we're also doing two other things by doing this. If you're a business that's got competitors and they're not paying taxes legitimately -- not legitimately, but illegitimately not paying taxes, they have an advantage on you. They can underbid you, they can take away your market. The government has an interest in a level playing field and in enforcement of the law. Otherwise everyone is driven down to the lowest denominator and everyone begins to treat the tax law in America the way the Italians do, as a national sport.
Secondly, we're shifting the burden of taxes, and the data all is very clear about this: That over time, what's happening is, those people at the very top, those who have enough money as individuals and companies to engage in these kinds of games, are paying less. And as a result, that means all the rest of us are going to pay more either through higher taxes, through less services, or as we’re seeing at the moment, through a great deal more government debt, which is simply a tax on our future.
COLVIN: You mentioned the effect on corporations and what happens competitively to them if they are paying or not paying taxes. The PBS series Frontline took a look into how corporations began gaming the tax system in a fairly new way in the late '90s. The reporter is Hedrick Smith.
(video package begins)
HEDRICK SMITH: The bull market of the '90s was a spawning ground for a shelter epidemic that swept through corporate America. As profits soared, companies were finding ingenious ways to lose money, or appear to lose money.
JOHN "BUCK" CHAPOTON, Former Asst. Sec. of Treasury: I saw what was called corporate tax shelters grow in the '90s, and I realized -- and other professionals like me realized -- it was not what we used to think of as tax shelters in the days of old.
SMITH: Former Reagan Treasury official Buck Chapoton was troubled by the new tax tricks.
CHAPOTON: These were a different animal. These were close to sham transactions. Some were clearly sham transactions, had nothing to do with investment, they simply were financial mechanisms for creating losses - tax losses, no economic losses.
SMITH: Creating losses, phantom losses, suddenly became pivotal to impressing Wall Street. That alarmed the head of the New York Tax Bar, Harold Handler.
HAROLD HANDLER, Former Chair, New York Tax Bar: What changed in the '90s was that the tax line of the financial statement became a profit center for many corporations.
SMITH: How do you get your tax rate down?
HAROLD HANDLER: Exactly. That was what it was all about. You know, I want to have the lowest tax rate because I can produce the best results for my financial statements for my company. And if the fellow down the street is doing it, I should be able to do it also. And there was a tremendous amount of pressure to do that, and there still is.
SMITH: And the pressure was to manipulate the law. It may come as a surprise, but the law lets corporations keep two sets of books: a bullish book income report to Wall Street and a low-ball tax income report to the IRS.
BOB McINTYRE, Dir., Inst. on Taxation and Economic Policy: Well, a company, let's say it makes $10 billion. That's what it tells the shareholders. But when it gets time to filling out its tax return, it tells the Internal Revenue Service that, “No, we only made $4 billion or $3 billion" because it shelters most of its profits. And the result is, you know, you and I, we've reported our wages, all of it. Nothing we can do about that. But companies say, "Hey, we're not telling the IRS we made all this money because we don't want to pay taxes on it."
SMITH: The corporate hunger to minimize taxes revolutionized the tax trade.
(video package ends)
COLVIN: Corporations use tax shelters as was just described there, but individuals use them too, in that scheme I mentioned earlier, which went by the rather intriguing name "Son of Boss" was one of them. There have been a number of others. Can you explain in a general way and in terms that are even remotely understandable to a non-expert how these things work?
JOHNSTON: Well, the fundamental idea is to create the appearance of a loss, an economic loss when there is no loss. So you do things like this. You put money into an investment, and then you take it back by depreciating the property. In one case that I know about, a company put up $10, and a non-profit organization, I don’t know who it was in either case, $990. So they split things 99 percent to 1 percent, and they went into business. They made $500 million of profits, 99 percent of which were tax free. Then they transferred all the profits back over to the for-profit entity by giving them the assets, and then they wrote off the assets so they didn't have to pay any taxes on it. It was an absolutely brilliant scheme.
COLVIN: Did that one turn out to be legal or illegal?
JOHNSTON: That one is one of several that are being fought in the courts. And it will depend on whether judges take a hypertechnical view of these things, which a number of courts have, or they look at the substance of them.
COLVIN: Meaning it could be, strictly speaking, within the law.
JOHNSTON: That's exactly right. And at the end of the day, if that happens, you're going to see more and more of these deals. And despite the crackdown, you know, Geoff, there’s still plenty of tax sheltering activity going on. We’re seeing more and more corporations move their assets offshore, their intellectual assets offshore. If you buy many medications that are made here in the U.S., the real profit is the royalty on the formula for that drug. Well, that royalty will often be paid to an offshore entity, and therefore it's a business expense in the U.S. that reduces taxes and a tax-free profit taken offshore.
COLVIN: The next question is obviously what can be done about it? And the first line of defense I would think would be IRS audits. How effective are they?
JOHNSTON: Well, the audits rates have been trending down for a long time. Recently the IRS has begun to show an uptick, but I’ve talked to many, many revenue agents, including two of them today, who say that they are under tremendous pressure to shut off audits, to do them quickly. Find something, get out of it and not deal with the substance of the matter. There’s a phrase some agents have for this. They call it audit light. It’s about as good for you if you like beer, light beer.
COLVIN: Why are they under this pressure? To get more audits completed or what?
JOHNSTON: Yes, so that the IRS can say to Congress, "Look at the statistics that we're generating. You see we've reversed this downward trend and we're starting to come up."
But the former commissioner Charles Rossotti in his new book says that the IRS is like a police department that writes lots of traffic tickets and ignores the murderers who are running around in the city.
COLVIN: What other solutions are possible? There’s a lot of talk now about tax reform and maybe junking the whole income tax system in favor of a national sales tax or something like that. Can that work?
JOHNSTON: Well, we can have under the Constitution almost any kind of tax system we want, but all tax systems require enforcement. All tax systems create new problems. And we need to also keep in mind that it will shift what it is we do. You know, right now we have people who furtively slip into buildings to buy drugs. If we go to a national retail sales tax, we may have people furtively slipping into buildings to buy mink coats.
COLVIN: Because the only tax you'll pay is when you buy something, when you buy anything.
JOHNSTON: That's right. Instead of trading in a car every couple of years, you’re going to see people saying, "Oh, hey, I’ve got 820,000 miles on my car." It doesn't mean we can't do it, Geoff, but there's one other important factor to keep in mind: Congress.
We were promised by Newt Gingrich in 1994, "Put us in charge, break the Democrats' hold on the House, and we will bring you real tax reform." Well, it’s 10 years later. Instead of tearing the tax system out by the roots, they've been watering and fertilizing it. It's twice as long as it was back then, and there's no indication that there's a serious effort for real fundamental tax reform.
But even if we get it, as soon as we get it there will be people in there saying, "Please Congress, this little favor for the sunglass industry..."
COLVIN: Right. You can scrape the barnacles off the boat, but they’re going to start building up right away.
JOHNSTON: The very next day.
COLVIN: Now the other supposed solution to this of course was the alternative minimum tax, supposed to insure that no matter how rich you were, you would pay at least some minimum and substantial amount of tax. How well is that succeeding?
JOHNSTON: A disaster. It was adopted in 1969 because 155 families who made the equivalent of $1 million a year paid no tax. Well, we're now up to over 300 families at that income level who pay no tax, and instead...
COLVIN: More than 300.
JOHNSTON: More than 300 who pay no tax, so it's more than doubled. But more importantly, the alternative minimum tax is growing like mad, and so if you are married and have children and make between $50,000 and $500,000 a year, you either are already paying it or will be paying it within a few years. If you make $100,000 to $500,000 a year, it's the de facto tax system for you if you live in any of the states that pay high wages because those are the ones that have high taxes.
COLVIN: As the AMT reaches more and more millions of taxpayers, is there a potential of some kind of revolt here?
JOHNSTON: It's probably going to have to get a lot worse before it gets better. But the way to think about the alternative minimum tax is it's just like credit card debt. Every dollar of alternative minimum tax you pay is a dollar of the tax cuts that you did not get, and it means you can't save that money, you can't invest it in yourself, you don't have it.
COLVIN: It's easy to feel utterly hopeless about this situation ever improving. Is that how you feel?
JOHNSTON: No, no. I mean you know the whole idea of America was, we'll solve our problems. We don't need King George in England to tell us what to do. When problems get bad enough, we address them.
The real challenge is, how bad do they have to get before we begin to say the tax system isn't serving our interests, it's not promoting social stability, it's not promoting investment, especially in the human mind. It's not doing the things we want it to do like grease the wheels of commerce. And we will eventually get to the point where there will be popular broad support. Right now, though, tax is the most vile four-letter word in Washington.
COLVIN: David Cay Johnston, what an appropriate thought to end on as we approach April 15. Thanks for your views.
JOHNSTON: Thank you, Geoff.
Tilson interview
KAREN GIBBS: The last time Whitney Tilson of the Tilson Funds joined us in the Investors Spotlight, he was sitting on the sidelines with a ton of cash, searching for investments which he likes to call 50-cent dollars. Now after quite a dry spell, he's found a number of new opportunities, and he joins us to explain why things look so attractive to him now.
Well, Whitney, it was about nine months ago to the day that you were here, and in that week Martha Stewart was sentenced. Now this week the AIG insurance probe has widened. Have we made any progress in terms of corporate scandals?
WHITNEY TILSON: Well, my feeling is the media's got to report on something and there are a lot of investigators out there looking to make names for themselves, and corporate America is so vast that there will always be pockets of scandal. I actually think overall since the WorldCom and Enron scandals in late 2002, corporate America has made tremendous progress in cleaning up its act, but there’s always going to be some company in the headlines scandalized and with its stock price getting beat up, and as value investors that’s where we tend to look.
GIBBS: Well, you know with the Enron scandal it was new accounting, which turned out to be old fraud. Is it the same problem that we’re seeing with AIG?
TILSON: I don't think so. In AIG's case, we think the stock's a buy and have been buying it recently at these depressed prices, roughly half the levels of about five years ago. And the reason is we think there's a fundamental difference between what happened at Enron and what's going on at AIG, which is the sin of Enron was earnings fabrication. There really were no earnings there. The whole business was an illusion. In the case of AIG, we think the sin, committed by unfortunately many, many companies in corporate America, is earnings smoothing, earnings manipulation, but not earnings fabrication.
GIBBS: The AIG insurance scandal has widened now to even touch Berkshire Hathaway's Warren Buffett. Do you think that this is something that might tarnish the Oracle of Omaha’s reputation?
TILSON: Well, I suppose there's the possibility, but we think not. The product that Berkshire Hathaway sold to AIG, called finite reinsurance, is a widely used, widespread product, bought and sold among large insurance companies and has been for many, many years. It is a product that can be abused. It can be used to manipulate or smooth earnings, and AIG has in fact admitted that this particular $500 million policy that they bought from Berkshire Hathaway was in fact misused. They're restating it on their books. However, we believe that Berkshire Hathaway accounted for it properly and we believe it’s likely that they didn’t know that AIG was planning to use it in the way that they did.
So while Berkshire Hathaway has sort of been brought into the investigation mainly for questioning, they're cooperating fully, and we think it's likely that as this plays out that Berkshire Hathaway ends up coming out quite clean, and the stock which has been down a little bit on the news will bounce back, and we’ve been buying it.
GIBBS: A screaming buy at $80,000.
TILSON: Hard to imagine, but we think it's very attractively priced.
GIBBS: Well, let's step back and take a broader picture of the markets here. You are almost fully invested or so, and this week was pretty good for the markets. The Dow up about 125 points, the Nasdaq better by 20, and the S&P up by 15 or so. But we're still down for the year, thanks in large part to higher interest rates and higher oil prices. What has turned you more bullish on the market?
TILSON: Well, we're not more bullish on the market. The reason we're fully invested today and we weren't six months ago is we found individual stocks that we think are attractively priced, and we try not to have an opinion on the market. Trying to time the market we think is sort of a sucker's game. We know we're not good at it. But we think we, on a handful of occasions each year, we can find a few misvalued, misunderstood individual companies. So we've been finding quite a few companies.
Normally we're rooting around the nooks and crannies of the market, finding little microcaps nobody's ever heard of. That's where you tend to find the 50-cent dollars, where you're trembling with greed, where there's no Wall Street analyst coverage. But every once in a while you find some gem just lying there in plain sight, and we've been finding quite a few of those. They're not as cheap as the sort of lesser quality businesses that can often get really, really cheap, but we're willing to pay more for a better business. So maybe we're not quite trembling with greed, but a little bit of quivering with greed, I'd say.
GIBBS: What are some of those gems that you've uncovered?
TILSON: Well, I talked earlier about AIG and Berkshire Hathaway, I think two of the world's great companies, despite the scandal around AIG. I would put it up there in the top 20 worldwide businesses, and there are a number of others I would cite as well.
One of our favorites is McDonald's, another is Wal-Mart, another is American Express, another is Pfizer. I think those six businesses I've just named, if you were to do a survey of savvy investors to name your top 20 greatest companies in the world, those six businesses would be in the top 20 of a lot of people's lists. And so we're willing to pay a little bit more for those. Instead of 50-cent dollars, maybe we’ll buy them if they’re 75-cent or 80-cent dollars.
So I'm happy to sort of take you through each one individually, why we think it's attractive, but in each case, generally speaking, we think that there’s some short-term noise which is causing people to be pessimistic about the business right now, and we don’t know if that’s going to be fixed in the next six months or even year, but we've got a multi-year time horizon, and we think it's very likely that in each case these businesses, the short-term noise goes away, they resume their nice growth trajectory, and they come back into fashion. And as a group I'd say these businesses are roughly trading at a market multiple today, yet they are insanely great businesses relative to the average business and deserve to trade at a 50 to 100 percent premium on a P/E multiple basis let's say, so that’s an awful nice increase that we think is likely to happen in the next few years on this basket of companies.
Let me give you an example of a company like Wal-Mart, truly one of the world's great businesses. It has more revenues than any company on the planet.
GIBBS: The stock price has been sitting on nothing for...
TILSON: The reason is not because the earnings have gone flat. The company continues to grow its sales at 10 percent a year or so, a combination of new store openings and same store sales growth, and then there's some operating leverage in the business. They've been buying back some stock, so earnings per share has been growing sort of at the low double digit, mid-teens rate let's say. So what's been happening is the stock's been flat for five years or so, the earnings have continued to grow, and that's compressed the P/E multiple to a level today about 20 times trailing earnings, sort of 18 times this year’s estimates. That isn't hugely cheap compared to the overall market. That’s roughly the market average. But for an incredible company like Wal-Mart, which is dramatically superior to the average business, it should not be trading at a multiple equal to the average business.
So the last time Wal-Mart was flat for five years and this happened was in the early '90s. Then about 1996, it got down to a valuation level equivalent to today's. Split adjusted, the stock was under $10 a share. Within two years, the stock was above $70 a share as investors realized, wait a second, this stock's now sort of gotten cheap again. And so we don't think it’s going to be a seven-bagger from here over the next few years, but we think it’s a very, very good bet to roughly double in the next five years.
GIBBS: Last time you were here we talked about Hardee's and the Thickburger. You got your money back. Is it time to sell? What do you do with that stock?
TILSON: Well, having it as a significant position at $3 a share, as it went into the mid-to-high teens, partly for just diversifying our portfolio, it had become a large part of our portfolio, we sold roughly half our position, and that was mostly because there wasn’t the same margin of safety that there was when it was very cheap. But we still think there's a great turnaround story here. The new Thickburger at Hardee's is continuing to drive great numbers there, so we think there's another couple years to run, which is why we still hold half the position anyway.
GIBBS: But you wouldn't buy anymore.
TILSON: Not now.
GIBBS: Okay. How about some other companies that you are buying?
TILSON: I'd toss out American Express, one of Warren Buffett's core holdings at Berkshire Hathaway. He's held it for many, many years. Trading at about 17 times this year's estimates, they're spinning off American Express Financial Advisors, and so pro forma for that spin off which will occur probably in the third quarter of this year. It's trading at about 14 times earnings, again for one of the world's great, great franchises.
GIBBS: What do you think about the pharmaceuticals? A lot of people are looking at it as a demographic play, but I know your friend Bill Miller at Legg Mason says if it's in the headlines, it's in the price. What about that?
TILSON: Right, one of my favorite sayings, actually. The same thing is true of AIG today. Why we're not too, too worried about headline risk is the headlines have been in the paper every single day. In this case certainly two companies that have been getting a lot of press, a lot of headlines, have been Merck and Pfizer over the past couple of months, particularly with the Cox-2 inhibitors. Merck withdrew Vioxx, facing potentially tens of billions of dollars of lawsuits related to that.
We like Pfizer a little bit better. It's a bigger company, more diversified, and their Cox-2 inhibitors, Bextra and Celebrex, have not, they don't quite have the same liability litigation risk that Vioxx does with Merck. Bextra just got pulled from the market this week, but the stock initially was down on that news, but then ended up sort of flat that day, and I think the reason is because investors were realizing that despite some of the prescribing restrictions that will now apply to Celebrex, it's a lot of patients need a Cox-2 inhibitor. That's the best drug for them, and Celebrex is the only one left, so it could ironically end up benefiting Pfizer. And again truly one of the world’s great businesses here, trading at about 12 times earnings. That’s cheap enough for us to be buying it.
GIBBS: All right. Whitney Tilson, it's always great to see you. Thank you for joining us again.
TILSON: Thank you.
NEXT WEEK: Social Security
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