Transfer Pricing Questions Arising in Bankruptcy, Whistleblower Cases
August, 13th 2014
As a rule, the U.S. Tax Court is the venue for transfer pricing litigation in the U.S. But recently, transfer pricing analyses have come up in both a bankruptcy case involving Nortel Networks and a whistleblower case involving Vanguard Group Inc. In the Nortel case, the company's defunct Canadian parent and its U.S. and European subsidiaries are deeply divided over how or whether a transfer pricing agreement that governed research and development among the companies should dictate the allocation of $7.3 billion in liquidated assets. And U.K. pensioners argue that the fairest way to proceed is not to allocate the assets at all, but to divide the funds on a pro rata basis—an argument one bankruptcy expert says faces very long odds.
Meanwhile, a former employee of the management company for Vanguard has filed a petition in New York Supreme Court charging that the mutual fund giant has operated as an “illegal tax shelter” for nearly 40 years. David Danon worked as an in-house tax attorney for Vanguard Group Inc. until he was discharged in 2013, and claims that VGI violated Section 482 by providing administrative and management services “at cost” to its affiliated funds. This pricing strategy, he says, has not only sheltered millions in state and U.S. taxes, but given Vanguard a competitive edge in the mutual fund industry.
Excerpts from both stories, written by Transfer Pricing Report staff writer Dolores W. Gregory, follow.
Nortel The transfer pricing arrangements of defunct telecommunications giant Nortel Networks may dictate how the proceeds from the multinational's liquidation are divided, according to documents filed in the U.S. Bankruptcy Court for the District of Delaware.
In a proceeding being tried simultaneously in Delaware and Canada, Nortel Networks Inc. (NNI), its Canadian parent and its European affiliates are battling each other and some 56,000 pensioners in the U.K. and Canada over the division of $7.3 billion in proceeds from the multinational's liquidation. Of those funds, $2.9 billion was generated by the sale of individual lines of business, while $4.5 billion resulted from the sale of some 7,000 patents to a consortium of high-technology giants that included Microsoft Corp., Apple Inc. and Sony Corp.
On June 24, the U.S. Bankruptcy Court in Wilmington, Del., and the Ontario Superior Court of Justice in Toronto concluded six weeks of testimony from various parties who advanced radically different notions of how those funds should be allocated.
While the three debtor groups involved appear to agree that the allocation should be based on the value of the property transferred or surrendered by the debtors, they are deeply divided about the basis for the valuation.
The most extreme position, taken by the Canadian debtors, is that the bulk of the estate—including the entire patent portfolio—should be allocated to Canada because Nortel Networks Ltd. (NNL), the operating parent, held legal title to the property before the asset sale. The Canadian debtors argue that the appropriate allocation of assets would be 82.2 percent to Canada, 13.7 percent to the United States, and 4.1 percent to the European debtors.
'One of the Greatest Heists of Value'
Such an allocation scheme would put NNL's creditors at a significant advantage over the creditors of other debtor estates, including 36,000 pensioners in the United Kingdom, and it is bitterly opposed by the other parties. According to the Ad Hoc Group of Bondholders, in a brief filed May 12, “the Canadian Debtors' position, if adopted, would represent one of the greatest heists of value in history” and is a theory “concocted solely for this litigation.”
The appropriate allocation, the bondholder group says, is the one proposed by the U.S. interests, which is based on the fair market value of the affiliates' licenses to the intellectual property.
The U.S. interests group represents NNI and related affiliates, along with the Official Committee of Unsecured Creditors. It argues that its valuation approach is consistent with the terms of the master R&D agreement that granted various Nortel subsidiaries exclusive licenses to exploit the company's intellectual property within their territories.
According to the U.S. interests, nearly 74.3 percent of the patent portfolio and 70 percent of the business lines proceeds should be allocated to the U.S., while 9.7 percent of the patent portfolio and 11.9 percent of the business lines proceeds should go to Canada. The remainder of the portfolios—16 percent and 18 percent, respectively—should be allocated to the European debtors.
Positions of the Estates
The positions of the other debtor estates and creditor groups are laid out in court filings. Among them:
Two economist reports indicate that while operating subsidiaries in Europe, the Middle East and Asia (the EMEA debtors) agree that allocation should be based on the transfer pricing arrangement, the allocation should reflect the “R&D spend”—the amount each entity invested in developing the IP under the terms of the master R&D agreement. Thus, under this approach, 31.9 percent of the assets would be allocated to Canada, 49.9 percent to the U.S., and 18.2 percent to the EMEA debtors, based on the ratios of funds invested by the debtors between 1991 and 2006. An expert report by economist Paul Huffard on behalf of the EMEA debtors also states that an alternative allocation approach would look at fair market value of the licenses. One calculation under this scenario would grant EMEA debtors 30.9 percent of the assets, while the U.S. would receive 57.7 percent and Canada, 11.5 percent. Attorneys representing some 36,000 members of Nortel's U.K. pension plan argue that allocation should be skipped altogether. Rather, the funds should be distributed to unsecured creditors on a pro rata basis—an approach that would grant each creditor some 71 cents on the dollar. The Canadian creditors committee, representing 20,000 pensioners, pension interests, and current and former employees, favors the allocation scheme of the Canadian debtors, but notes that, in the alternative, a pro rata approach would be fair. Inappropriate Transfer Pricing
In their pre-trial brief filed May 11, U.K. pension claimants—the U.K. Pension Trust Ltd. and the Board of the U.K.'s Pension Protection Fund—say they face a $3 billion shortfall in Nortel Networks U.K.'s (NNUK's) pension plan. They are bringing a claim against the entire group—not just NNUK—because they maintain that Nortel's transfer pricing was designed to shift funds away from the U.K. subsidiary to its Canadian parent, to the ultimate detriment of the pensioners.
According to an expert report by Steven Felgran, economist for the U.K. pension claimants, NNUK should have received transfer pricing adjustments of $2.1 billion between 2001 and 2008, while Canada was due $4.2 billion and the U.S. should have paid out $6.3 billion. NNUK did not receive any payments between 2003 and 2007, resulting in what were effectively interest-free loans from NNUK to NNL, Felgran said.
He noted that the Internal Revenue Service and the Canadian tax authorities reached a settlement in July 2010 over Nortel's 2001-05 advance pricing agreement application, leading to a $2 billion adjustment to NNL's taxable income. The IRS and the Canada Revenue Agency are no longer party to the bankruptcy proceedings.
However, Felgran stressed, “that settlement between the taxing authorities does not mean that the reallocation of taxable income between NNI and NNL achieved arm's-length results.”
Further, he noted, Nortel's restructuring costs should have been shared across the group. Instead, the transfer pricing of those costs prejudiced NNUK in the amount of $500 million to $600 million between 2001 and 2008, substantially to the benefit of the Canadian parent.
Since the bankruptcy petition was filed in 2009, the U.K. pension claimants noted, legal wrangling has run up $1.3 billion in fees. That sum will come out of the bankruptcy proceeds, reducing funds available to pay claims. However, they noted that the U.K. pension claimants are the only party whose legal expenses will not be paid out of the bankruptcy proceedings; the pensioners are bearing their costs directly.
A ruling in favor of the U.K. claimants would establish a more equitable procedure for international insolvencies going forward, they argue.
“The Courts have an opportunity to set a precedent that will avoid the moral hazard that has plagued the Nortel proceedings for more than five years and has cost $1.3 billion in professional fees to date from occurring again in the future,” the U.K. pension claimants said. “Territorial wrangling significantly diminishes value for stakeholders in a global insolvency involving a highly integrated multinational enterprise whose assets are entangled, and ought not to be condoned or rewarded.”
A former employee's lawsuit claiming Vanguard Group Inc. improperly priced related-party services—allowing it to shelter nearly $1 billion in U.S. taxes over 10 years—could shake up the mutual fund giant, according to several observers.
“I don't see any exemptions from Section 482 that this complex of funds and its management would be entitled to,” said Robert Willens, a New York tax attorney specializing in financial matters and capital markets.
“It would come down to the normal facts and circumstances determination that 482 cases tend to come down to,” Willens said.
The petition was filed in New York Supreme Court by David Danon, a former tax counsel for Vanguard Group Inc. (VGI). VGI is a management company that services the Vanguard family of funds. Together they comprise the Vanguard Group, a $2 trillion mutual fund complex that Danon charges has operated as “an illegal tax shelter” since 1975 by virtue of VGI's “at cost” pricing of its services to affiliated funds.
By pricing its administrative and management services at cost, VGI has enabled Vanguard Group to gain a competitive pricing advantage against other mutual fund companies—an advantage gained primarily through avoiding federal and state income tax, the petition said.
The petition was filed under seal in May 2013 and made public in late July after the New York attorney general declined to investigate.
Daniel Wiener, editor of a newsletter for Vanguard investors, told Bloomberg BNA that the lawsuit might have a serious impact on the way Vanguard does business.
“If this guy's claims are correct that the only difference between Vanguard and their competitors is the way they treat their taxes, it's a big deal,” Wiener said.
“It would be a huge blow to Vanguard if they have to start paying more taxes, because it would cut into their raison d'etre—which is to be the low-cost provider.”
The lawsuit also might damage the company's reputation, he said, though right now Wiener does not see much fallout. Most shareholders, he said, probably are not aware of the lawsuit.
False Claims Act
Danon, who was an in-house tax attorney for Vanguard from 2008 to 2013, filed a qui tam action under New York's False Claims Act. Danon also filed whistleblower complaints with the Securities and Exchange Commission and the Internal Revenue Service.
The petition claims that VGI's pricing practices violate Internal Revenue Code Section 482 and N.Y. Tax Law Section 211(5) and allowed it to evade more than $1 billion in U.S. taxes and more than $20 million in New York taxes over a 10-year period.
The petition also charges that VGI failed to file New York income tax returns even though it had significant contacts and business in the state and handled billions in investments by New York residents and businesses. When the company finally did file New York returns in 2011 and 2012, the petition charges, it filed false returns that distorted its income.
Further, the petition charges that VGI mishandled a $1.5 billion contingency reserve that was established to cover unanticipated losses. The reserve is funded out of a special fee charged to the investment funds, but VGI does not report the fees as income, the petition said. Rather, VGI defers receipt of the fees or transfers them back to the funds until a payment is made, thus rendering the reserve a “fraudulent Vanguard effort to retain an excess of revenues over costs and still maintain that it is providing at cost services,” the petition said.
Linda Wolohan, a spokeswoman for Vanguard, told Bloomberg BNA that Vanguard believes the case is without merit and intends to vigorously defend itself in court. “The issues presented in the complaint are far too complex to get a full and proper hearing in the news media,” she said in an e-mail, adding that “Vanguard has operated under its unique structure for nearly 40 years and has always considered it a highest priority to satisfy our obligations under the law and the rules set forth by the SEC, the IRS, and the DOL, among other regulators and agencies.”