Editor’s note: In a Baton Rouge federal courtroom this spring, Chief District Judge Brian Jackson issued a 74-page opinion with more than $1 billion in ramifications for Dow Chemical Company. Siding with the IRS, the judge concluded that the specialty chemical company with 54,000 employees worldwide and $56.8 billion in sales in 2012 took part in two sham partnerships designed to exploit perceived weakness in the tax code to avoid paying taxes. According to a judgment finalized in mid-June that closed the case, the decision will cost the company $1 billion in phony tax deductions and 20% in penalties. Dow has said it is exploring the possibility of appeal. This is the story of those partnerships and their ties to the Capital Region.
As with so many business deals, it all started with a slideshow.
In April 1992, the New York City-based global investment banking firm Goldman Sachs approached executives at Dow Chemical Company, touting a product called Special Limited Investment Partnerships, or SLIPS.
In short, these were complex transactions pairing multinational companies with offshore banks to strip away taxable income from a transaction and allocate it to an entity not required to pay taxes in the United States. The result: lower taxes.
Over the next several months, there would be two more presentations—each of them more closely catered to Dow’s interests. Goldman Sachs kept mention of tax benefits to a minimum—stressing instead the advantage of off-balance-sheet financing to lower debt-to-equity and leverage ratios—and a confidentiality agreement prohibited Dow from disclosing information about SLIPs to “any outside legal, tax or accounting advisors without permission.”
Even in those early days, court documents show, Dow executives had questions for lawyers working with Goldman Sachs about the legality of such an arrangement: namely, whether it would be regarded by the IRS as a sham.
But in April 1993, Dow’s board of directors took a vote, and Chemtech I was born.
This partnership’s first incarnation was essentially a patent management firm, a common practice in the chemical industry to maximize the profitability of patents.
To this partnership, Dow contributed 73 of its patents. These were not patents that might be sought by other firms seeking to license them, thus making a profit for Chemtech, Dow and its partners, according to an expert witness in the case. In most instances, they were just pieces and parts of Dow technology. But these patents were appraised at $867 million, with a total tax basis of $54,000.
Then came the task of securing partners. Chemtech’s general and managing partner was Dow Europe S.A., which transferred roughly $10 million in cash to the company and ultimately owned 1% of Chemtech. Diamond Technology Partnership Company, a Dow subsidiary, transferred the U.S. patents to Chemtech as its contribution, securing it 88% ownership in the partnership. Ifco, a subsidiary of Diamond Technology, acquired a limited partnership interest by contributing $100 million in capital.
Later, five foreign banks dumped another $200 million into Chemtech, drawn by the promise of better premiums and less credit risk than corporate bonds, and by the escape from U.S. tax liability. At the urging of Goldman Sachs advisers, Dow took the unusual step of indemnifying the foreign banks against any potential tax exposure.
In a nutshell, court papers show this is how Chemtech worked: Dow paid royalty fees to Chemtech for the use of its own patents. Chemtech paid the foreign banks a fixed fee of about 7% interest on their $200 million investments. The company then moved the remaining cash to its own subsidiary corporation, Chemtech Portfolio, which then loaned the money back to Dow. No one but Dow ever licensed any of those patents.
For tax purposes, Dow claimed a royalty expense deduction on its corporate income tax returns. But the cash was returned to Dow without triggering any significant income tax, because the bulk of it was allocated to the foreign banks. And those foreign banks weren’t required to pay taxes.
In 1997—four years after the founding of Chemtech I—the U.S. Treasury cracked down on what it termed “hybrid entities” that claimed to be partnerships under U.S. law for the purposes of the domestic partners, but not under foreign law for the purposes of the foreign banks. The problem: an unintended result of tax exemptions in both countries. In Treasury Decision No. 8722, the agency concluded such arrangements were contrary to the intent of tax treaties between the countries, which “contemplate that income relieved from taxation in the source country will be subject to tax in the treaty country.”
It was at that point that Dow began planning Chemtech II.
To this partnership, Dow contributed a portion of its chemical plant in Plaquemine, Louisiana. Today, the 1,500-acre integrated manufacturing facility known as its Louisiana Operations is home to most of Dow’s global businesses. The site has 23 production units manufacturing more than 50 intermediate and specialty chemical products, such as chlorine and polyethylene, which are used to produce cosmetics, detergents, solvents, pharmaceuticals, adhesives, plastics, automotive parts, electronics components and more.
Internal memorandums from Dow presented during the trial described Chemtech II as “an offshoot from the Chemtech I transaction,” with potential tax benefits estimated at a “conservative” $100 million. Internal communications between corporate officers exchanged in February 1998 that were presented as evidence in the case documented Dow’s intention that the plant “remain under Dow’s control,” and that the company’s intent was to “not affect in any manner the operation of these [plant assets].”
In June 1998, Dow contributed the Louisiana plant assets—valued at $715 million—to Dow Chemical Delaware Corp., which, in turn, handed them over to Chemtech II. Dow then agreed to lease back the chemical plant.
It was similar to Chemtech I in its circular cash flow: Dow paid Chemtech II millions to rent the Louisiana chemical plant, and after Chemtech paid its partners and management fees, the excess cash went to Chemtech Portfolio, which loaned the bulk of the money back to Dow Chemical International.
Chemtech II claimed “artificially large depreciation deductions” on its tax return, court documents indicate, while Dow claimed a rental deduction for the chemical plant, the majority of which was returned to it in cash via loans.
Meanwhile, Dow executives went to work on plans for Chemtech III.
In April 2005, the IRS notified Dow Chemical that it wasn’t going to allow the Chemtech-related deductions. Chemtech Royalty Associates sued in court, seeking to overturn the agency’s decision. More notifications from the IRS would come, as would three more lawsuits from Dow.
Throughout its battle with the IRS, Dow has maintained the Chemtech transactions were designed simply so the company could keep its credit ratings during a period of “difficult business conditions and reduced earnings” and raise low-cost capital.
“The Chemtech transaction was part of Dow’s overall financial strategy,” Baton Rouge attorneys David Bienvenu Jr. and Jason DeCuir wrote in the initial lawsuit challenging the IRS rulings. “[It] allowed Dow to maintain the financial flexibility by avoiding a ratings downgrade and to raise working capital as well as capital to cover long-term projects that Dow might need to fund in the future.”
It would be six years before the matters would finally go to a bench trial before Chief District Judge Brian Jackson, lasting three days in June 2011. Four months ago, Jackson handed down his 74-page ruling, concluding that Chemtech I and Chemtech II were “shams.” The judgment was made final last month, and all four cases were closed. Dow disputes his findings and is contemplating an appeal.
Central to the judge’s decision was the apparent lack of evidence that either incarnation of Chemtech resulted in any economic advantage to Dow other than to avoid paying taxes.
Jackson noted, for example, that the original Chemtech failed to license a single patent to any party other than Dow. And when a dispute with the foreign banks arose over whether the patents were undervalued, Dow vigorously fought the assertion and dubbed its partners “greedy”—even though it owned majority interest in Chemtech and stood to benefit the most financially from any gains in value. Additionally, the judge observed, there were cheaper and less complicated alternatives to SLIPs to achieve the goal of off-balance-sheet financing.
Jackson wrote in his ruling that taxpayers aren’t prohibited from considering tax consequences in business dealings, unless the transaction is a façade. But where Dow with its numerous lawyers and tax professionals at its disposal went wrong, the judge lamented, was in viewing its tax department as a profit center.
