CRS Unclear If Enron Situation Raises Tax Policy Questions

[1] The recent bankruptcy of the Enron Corporation has raised a number of public policy issues related to corporate finance. In general, these issues relate to the oversight of financial activities by corporate managers -- broadly, are reforms needed to ensure that corporate managers act in the interest of investors and employees? Does the quality of information available about public corporations need to be improved? In addition, however, some have suggested that the Enron collapse may raise tax policy questions. First, did Enron actually pay federal taxes? Published analyses of Enron's financial reports differ in concluding whether Enron did or did not pay federal income tax while simultaneously reporting profits to its stockholders.

[2] A second question is the tax-saving devices the company may have used. The company's financial reports suggest that the firm's principal tax-saving mechanisms were the use of foreign subsidiaries and the deduction of costs associated with employee stock options. Of these mechanisms, however, the deduction of stock option costs is generally not a tax "benefit" or "loophole." And while the channeling of earnings through foreign subsidiaries is generally considered a tax benefit, the basic benefit such subsidiaries deliver -- a tax benefit known as deferral -- is a long- standing component of U.S. tax policy that is widely used by U.S. multinational corporations. In short, absent further information it is not clear that Enron's financial situation raises general federal tax policy questions. This report will be updated when and if definitive information about Enron's taxes becomes available.

[4] Enron's collapse has raised several public policy issues -- issues that generally relate to the financial activities of corporate managers and their oversight. For example, is the current U.S. system of auditing public corporations and the standards and methods of accounting sufficient to convey accurate information to the public? Are employee stakes in company pension plans sufficiently protected? Are sufficient mechanisms in place to protect corporate shareholders from inappropriate financial activities by corporate management?¹

[5] But whether Enron raises significant tax policy questions is uncertain, absent additional information. First, the basic fact of the company's bankruptcy does not necessarily raise questions for federal tax policy. As part of the free market system, companies frequently fall; taxes usually do not play a role in those failures. Also, if Enron's true profits were indeed overstated, a tax policy issue is not necessarily raised. The tax code's definition of profits -- taxable income -- can differ dramatically from profits as defined according to financial accounting or economic principles. Further, reporting mechanisms for taxes and accounting profits are separate -- profits for tax purposes are reported to the Internal Revenue Service; accounting profits of public corporations are reported to the U.S. Securities and Exchange Commission. Thus, even if reporting or information issues arise with respect to a firm's accounting profits, they do not necessarily present tax issues.

[6] One analysis, however, has concluded that there is a tax dimension to Enron's financial record. On January 17, 2002, Citizens for Tax Justice (CTJ) -- a research and advocacy organization -- published an analysis that concluded that Enron paid no federal tax on its U.S. profits in four of the five years spanning the period 1996 - 2000, and actually received tax refunds in most of the years. ² The analysis was based on a reading of the firm's form 10-K filings with the SEC; while the forms are not directly related to taxes, they necessarily present tax information in the process of reporting the firm's overall financial situation. The CTJ analysis stated that Enron was able to reduce its taxes because of tax savings generated by employee stock options and by creating more than 800 subsidiary firms in foreign "tax havens." CTJ linked its Enron analysis with another report in which it concludes that the number of large, profitable U.S. corporations that pay no tax is growing.

[7] An Enron spokesperson stated that the company did, in fact, pay $112 million in federal tax in 2000, and also paid tax in 1998 and 1999 -- a position that reiterates information presented in tables contained in the firm's 2000 10-K (the CTJ conclusions are based, in part, on information in the report's footnotes. And an article published in the Washington Post on February 3, 2002, also suggested that Enron did pay federal tax.³ The Post's conclusion was based, in part, on Enron's reporting of an increase in its Alternative Minimum Tax (AMT) credits during 2000 -- a company only accrues such credits if it pays the minimum tax. Thus, if Enron's report of increased AMT credits is accurate, it necessarily paid some federal tax in 2000.

[8] Whether Enron did or did not pay federal tax, what of the tax-saving devices it is reported to have used -- the foreign subsidiaries and deductions for stock options? Here, too, it is uncertain whether tax policy issues are raised. The CTJ analysis stated that Enron used stock options to reduce its taxes by $597 million over 1996 - 2000. A stock option gives an employee the right to purchase his employer's stock at a fixed price, regardless of what happens to the stock's price in the future. If the stock's price rises and the employee exercises his option to buy the stock, the company incurs a cost equal to the difference between the price the employee paid and the stock's market value. Thus, permitting a firm to deduct the value of a stock option is not a tax "benefit," and simply permits the firm to deduct the cost of employee compensation paid in the form of stock options.

[9] The use of foreign subsidiaries does confer a tax benefit, albeit one that is a long-established part of U.S. tax policy that is widely used by U.S. multinationals. The benefit -- known as deferral -- works like this: U.S. corporations are subject to U.S. tax on their worldwide income. Foreign-chartered corporations, however, are subject to U.S. tax only on their U.S. income. Thus, if a U.S. firm arranges to earn its foreign income through foreign subsidiaries, the income is free of U.S. tax until it is remitted to the U.S. parent corporation. Policy debates over deferral have gone on for decades: its critics contend it reduces U.S. economic welfare by diverting U.S. capital resources to locations abroad; its defenders argue that it promotes U.S. competitiveness.

[10] Enron's annual report 2000 indicates the firm did use deferral to reduce its taxes; the firm states that its foreign subsidiaries possess $1.2 billion of undistributed earnings for which no U.S. tax has been provided.⁴ But it is not clear whether Enron's use of deferral presents a new or different policy issue. For example, despite the large number of subsidiaries, there are indications that the tax savings they generated were not enormous. Note 5 of the firm's annual report ("Income Taxes") suggests that the firm's savings from deferral may have been in the neighborhood of $34 million in 2000 -- not a huge sum given the firm's reported total before-tax profits of $1.4 billion and foreign profits of $773 million.⁵

[11] One high-profile set of offshore transactions Enron conducted in recent years apparently did not rely on deferral to generate tax savings but on the deduction of interest payments on particular financial instruments that blurred the distinction between debt and equity. The instruments are securities known as Monthly Income Preferred Securities (MIPS), which possess characteristics of both debt and equity. Using MIPS, Enron issued debt to offshore subsidiaries, who, in turn, issued securities considered equity on the firm's balance sheet. After initially objecting to the treatment of the securities as debt, the Internal Revenue Service (IRS) in November, 1998, issued a Technical Advice Memorandum classifying Enron's MIPS as debt and payments on the MIPS as tax deductible interest.⁶ For Enron, the advantage of the MIPS was their classification as debt for tax purposes, on the one hand, and their classification as equity by bond-rating agencies.⁷ Enron's subsequent financial difficulties have led some commentators to suggest that the IRS ruling was the more accurate of the classifications.⁸

[12] Among the remaining issues raised by Enron is that of pensions: are there sufficient safeguards in place to protect employees' stakes in their company pension plans? A crucial tool under current law for federal regulation of pensions is the tax systems: firms that do not meet certain pension standards can be denied favorable tax treatment. However, given the ancillary role of taxes in that issue, a discussion of pensions is beyond the scope of this report.

²A summary of the analysis is posted at the CTJ website, at [ http://www.ctj.org/html/enron.htm ].

³Glenn Kessler, "Enron Appears to Have Paid Taxes," The Washington Post, Feb. 3, 2002, p. A10.

⁴Enron Corporation, Annual Report 2000 (Houston, TX: 2001), p. 51.

⁵ In their 10-K filings, firms are required by law to reconcile the percentage of their pre-tax earnings actually paid in federal tax (their effective tax rate) with the amount of tax they would pay if they were to pay federal tax at the statutory tax rate (generally 35%). Enron's Note 5 contains a table that attributes a 2.4 percentage-point reduction in its effective tax rate to a "foreign tax rate differential": apparently a tax saving from paying tax at (lower) foreign tax rates rather than the U.S. tax rate, and a reference to deferral.

⁶The description of MIPS here is based on: Lee A. Sheppard, "IRS Attacks Enron MIPS," Tax Notes, June 1, 1998, p. 1089; and Kessler, "Enron Appears to Have Paid Taxes," The Washington Post. The IRS ruling is contained in TAM 19910046 (November 16,1998).

⁷Sheppard, "IRS Attacks Enron MIPS."

⁸Sheryl Stratton, "Enron May Revive Financial Products Proposals," Tax Notes, Jan. 28, 2002, p. 411.