General Electric's (NYSE:GE) relationship with U.S. tax collectors is complicated at best and contentious at worst. Recent developments with the industrial giant and the IRS point to the latter.
Last Friday, GE sued the IRS to try to recoup a $658 million federal tax refund the company believes the agency inappropriately disallowed. At first glance, shareholders might frown upon GE's pursuit of a relatively small sum in light of the company's less-than-sterling tax reputation. But, as the two entities sift through the muddy waters of corporate tax law, it could also serve as a redeeming case for GE if handled correctly.
The nuts and bolts
The crux of GE's latest tax issue dates back to 2003, when the industrial company spun off a relatively small reinsurance business to Scottish Holdings, a subsidiary of Scottish Re Group Limited. The reinsurance business, known as ERC Life, fetched a paltry sum of $151 million for 95% of the outstanding stock. As a result, GE's books took a hit to the tune of $2.2 billion, and even for GE, that's a hefty sum.
Because of the transaction, which was also part of a simultaneous internal restructuring, GE claims that it should have been allowed to carry the loss back to 2000, the last year GE had taxable gains. This would have entitled GE to a related tax refund for that year. Instead, the IRS disallowed the capital loss of $2.2 billion and sent GE an invoice for payment in 2010. GE wound up paying $439 million in taxes and $219 million in interest. Not too thrilled with this outcome, GE's lawyers filed a complaint on Friday, Feb. 14, claiming the IRS "erroneously and illegally denied GE's claim for a refund."
To be sure, the nature of ownership and the transaction itself are quite convoluted. All of the nuances, for those interested, can be found in a 12-page filing (link requires registration) with the U.S. District Court in Connecticut. GE, after all, was a sprawling enterprise with its fingers in one too many pies near the turn of the century.
Still, the heart of the issue is whether GE's spinoff was a maneuver designed with an eye toward tax avoidance or one with a legitimate business purpose. To this end, GE states that the restructuring was done to counter "financial and regulatory issues confronting the business" at the time. Obviously, an IRS agent somewhere has doubts.
So far, a representative of the IRS has not commented on the lawsuit, but GE spokesperson Seth Martin provided the following statement: "The dispute involves a good-faith difference of opinion over the tax consequences of a restructuring done more than a decade ago. While we have paid the taxes in question, we believe it is in all parties' interests to resolve this through a court decision."
The lawsuit, then, is the first step toward that outcome, and this could be a sideshow for GE for quite some time. As Forbes contributor Janet Novack points out, GE has persevered in other tax-related contests as illustrated by a decade-long case involving GE Capital Corp.'s connections to an airplane leasing business. The verdict in that case was unfavorable for General Electric.
The most concerning aspect for GE investors is the attention and scrutiny even a relatively small case like this could bring to the company. GE has struggled to shed its reputation as a single-minded entity determined to "exploit opportunities to reduce tax," as pointed out in a New York Times story in 2011.
But GE, like any corporation, aims to minimize the amount of taxes paid. The broader issue is whether a company like GE, given all the loopholes and advantages available to an international operation is paying its "fair share" on a regular basis. To this end, GE engaged an advisory panel last year to discuss relevant issues like whether "their tax planning reflects the economic substance of where value is really created." This idea in particular strikes at the heart of the current case.
If GE can prove the facts support a legitimate business purpose involving the reinsurance unit and associated restructuring, this lawsuit could cast GE in a favorable light. If not, it's back to the drawing board for a company that desperately needs to restore its image as a fair-minded American taxpayer.
Isaac Pino, CPA, and The Motley Fool own shares of General Electric. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.