WorldCom Tax Strategy
May Have Saved Millions
By CARRICK MOLLENKAMP and GLENN R. SIMPSON
Staff Reporters of THE WALL STREET JOURNAL
WorldCom Inc. may have avoided hundreds of millions of dollars in state taxes in the three years after its 1998 acquisition of MCI Communications Corp. through an elaborate tax strategy created by accounting firm KPMG LLP.
In an effort to minimize its state taxes, WorldCom, the telecommunications company now known as MCI, moved as much as $19 billion in revenue between 1999 and 2001 through a Delaware-based subsidiary of the company, according to an accounting analysis filed in the U.S. Bankruptcy Court in New York.
Because Delaware doesn't tax the income of out-of-state corporations, the move substantially reduced WorldCom's nonfederal income-tax obligations, according to filings in the bankruptcy proceedings. However, the documents don't indicate how much WorldCom's taxes were reduced by the arrangement. WorldCom filed for bankruptcy protection in July 2002 and is based in Ashburn, Va.
The key to the tax shelter was KPMG's advice that WorldCom declare much of its regular income as being returns on intellectual property -- rather than receipts from sales of phone services, according to a confidential 128-page KPMG planning document reviewed by The Wall Street Journal.
According to that document and a court filing, KPMG rationalized what it called a "Total Tax Minimization" strategy partly by contending that a large portion of WorldCom's postmerger income stream was "excess profits" partly attributable to the shrewdness of the company's top corporate managers.
To maximize its tax savings under Delaware law, WorldCom, then based in Clinton, Miss., assigned the rights to all of its trademarks and other intellectual property to the Delaware-based unit, MCI WorldCom Brands LLC, which then collected steep royalty payments from nearly 150 other WorldCom subsidiaries around the country. Under most state laws, royalty payments made by subsidiaries to affiliates for the use of intellectual property are 100% tax deductible. In this manner, WorldCom subsidiaries could deduct billions of dollars in profits earned at the regional level as an expense, while the WorldCom Brands unit accounted for the income as tax-exempt under Delaware law.
"It definitely appears to be more aggressive than what other companies have done," said Michael Mazerov, a state tax analyst for the Washington-based Center on Budget and Policy Priorities and an expert on how companies use Delaware holding companies to reduce state taxes.
Tax-planning firms aggressively marketed the use of intellectual-property holding companies in Delaware as state-tax shelters during the 1990s. Some state revenue officials now contend the practice is illegal and that it is partly to blame for the decline in corporate-tax receipts that states have seen during the past decade. It isn't clear whether any states have initiated action to recoup taxes from MCI.
At the time WorldCom implemented the KPMG tax strategy, Arthur Andersen was the company's auditor. KPMG since has taken over as the company's auditor.
Timothy Connolly, a spokesman for KPMG, said: "The intangible holding-company structure in Delaware was a common tax-planning strategy that was fully supported under Delaware law." He added, "At a time of widespread state budget deficits and in the midst of a difficult economic environment, 20/20 hindsight is driving views regarding the appropriateness of sound business and tax planning."
The intellectual-property management program KPMG set up for WorldCom appears more ambitious than many other similar efforts. Depositions, legal briefs and internal company documents describing the strategy were filed as part of the MCI bankruptcy proceedings. Next month, the U.S. Bankruptcy Court begins hearing debate on whether the telecommunications company, which was forced to seek bankruptcy protection after a corporate accounting scandal erupted last year, can emerge from bankruptcy protection. In April, the company said it had won strong creditor backing for a bankruptcy-reorganization plan.
MCI spokeswoman Claire Hassett said, "We have generally addressed tax and related issues in our plan of reorganization and look forward to discussing them more fully as appropriate during our confirmation hearing beginning on Sept. 8."
The tax shelter came to light in a court filing by investors who own $358 million in MCI bonds and securities. Lawyers representing the MCI investors say the Delaware structure was nothing but an attempt to avoid paying taxes.
"It's a transaction that appears to have been entered into solely for tax purposes," said Gordon Dobie, a lawyer for the bond investors. "Our view is that it is a sham transaction and should be unwound." Those investors, who bought the MCI securities before WorldCom acquired the company in 1998, contend that the company now is diverting their investment to pay other WorldCom debts instead of theirs.
MCI says that WorldCom and MCI finances are consolidated, and that even if it could untangle the combined companies, MCI owes WorldCom the $19 billion that was sent to the Delaware division.
According to the documents filed in court, WorldCom, which completed its merger with MCI in September 1998 paid $1.9 billion in intellectual-property royalties that year. In 1999, KPMG began advising the company on the tax strategy, and royalties began to increase sharply.
The 128-page confidential document, dated June 1999 and titled "Intercompany Pricing Analysis: MCI WorldCom," also detail the structure. According to that document, MCI WorldCom "asked the Economic Consulting Services practice of KPMG LLP to help estimate royalty payments for the use of certain intangibles by other members of the MCI WorldCom group of companies."
By 1999, according to a WorldCom document, there were some 280 related companies or subsidiaries under the corporate umbrella. Approximately half of those qualified to pay royalty fees to MCI WorldCom Brands, the Delaware intellectual-property unit. That unit could charge for "intangibles" such as the use of its trademark in ad campaigns.
But much of the payments were for services such as smart management of the company. "Because of these enhanced revenue-generating opportunities and significant cost reductions made possible by the foresight and investments made by MCI WorldCom's top management, MCI WorldCom Group is expected to earn profits in excess of normal operating returns," the KPMG memo states. "MCI WorldCom will receive royalty payments from any affiliates earning excess profits for the use of intangibles created by top corporate management."
Mr. Mazerov, the tax expert, said the payments for skilled management were atypical. "To the extent that the licensing agreement and the royalty payments are for management know-how or synergy created by an acquisition, that is quite unusual," he said.
KPMG in its 1999 analysis projected that the total royalty payment from all subsidiaries that year would be $2.8 billion.
According to the postbankruptcy analysis performed by FTI Consulting Inc., an Annapolis, Md., forensic-accounting firm hired by WorldCom creditors, the royalty fees in 1999 totaled $5.9 billion.
In 2000, the royalty fee increased to $7 billion. A year later, the fee totaled $6.5 billion.
According to one court document, KPMG originally suggested that two groups of WorldCom businesses would pay the royalty fee to MCI WorldCom Brands.
Instead, MCI calculated royalties for 144 separate subsidiaries.
Write to Carrick Mollenkamp at carrick.mollenkamp@wsj.com3 and Glenn R. Simpson at glenn.simpson@wsj.com4
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