This post was originally published on Forbes Oct 20, 2015
Staples has a sophisticated cash management system. Cash is stripped from subsidiaries and all bills are paid from a central account. I could see that there must be all sorts of operational advantages to that sort of system, but some bright bulbs in the Staples tax department or perhaps a consultant dreamed up another advantage of the cash management system (CMS). Instead of looking at it as the parent taking the money from the subsidiaries, let's look at it as the subsidiaries loaning to the parent. The interest income and expense going back and forth will wash out for federal income tax and GAAP financial statement purposes, but if it breaks right it will save state income tax - unless state revenue departments catch on.
Massachusetts Catches On
Last month Staples was in front of the Massachusetts Appellate Tax Board (You have to scroll down a bit to get to decision) to defend its practice of treating intercompany transfers as interest bearing loans. There was a bit over $10,000,000 in tax at stake. Massachusetts corporate excise has both an income and net worth component. Both were affected by the question of whether the intercompany balances between parent and subsidiary were valid debt. According to its 10-K, Staples had over $22 billion in sales last year and finished the year with assets over $10 billion, so $10 million might not seem like that much, but compared to a worldwide tax provision of $133 million, $10 million is as we say "a number".
Given the not insignificant stakes I was surprised at how poorly Staples had executed the scheme and the apparent weakness of the defense they put on.
Why Don't You Have Somebody Who Knows What Happened?
Dina Courchesne testified for Staples. Ms. Courchesne has certainly had an impressive career. A 1995 Bentley graduate, she joined Staples after 7 years with Deloitte. She served as manager of external reporting, manager of international accounting and at the time of the hearing was the director of corporate accounting making her responsible, among other things, for the financial statements filed with the SEC. There was a problem with her testimony. Essentially she didn't know a thing about the incestuous transactions between the parent and the subsidiaries. This is perfectly understandable, given that these transactions get eliminated in the consolidated financial statements, but her testimony probably reinforced the notion that the loans were not real.
Ms. Courchesne testified that Staples held cash on behalf of the CMS subsidiaries and credited interest as a bookkeeping entry owed to those subsidiaries that had cash on deposit. Ms. Courchesne did not know the rate of interest credited to the subsidiaries and whether the rate was competitive with what a bank would have paid on deposit.
Ms. Courchene's lack of knowledge of the nature of the arrangements was really emphasized in the decision with some of her testimony highlighted.
Q: Here in the CMS system was there a ceiling on the amount that any of the subsidiaries put into the system?
A: I'm not aware — I'm not certain. Our treasury and legal department would have coordinated that. We're just doing the accounting behind the underlying transactions.
Q: Was there a ceiling with respect to the amount of money that the subsidiaries could take out of the cash management system?A: Again, that would be something that our treasury and legal department would handle.
[BOARD'S PRESIDING COMMISSIONER]: Is your answer to both those questions, “I don't know”?
A: I do not know.
I'm wondering what the Staples lawyers were thinking. Being lawyers and all, I can understand them being clueless about who is likely to know about particular aspects of a transaction, but you would think that they would have prepped her better. On the other hand, it may be that testimony from the people who did know what was going on would have doomed them.
Reilly's Fourth Law
This case is a beautiful illustration of my fourth law of tax planning - Execution isn't everything, but it is a lot . There actually were promissory notes, which is good. The problem is that nobody seems to have paid any attention to them.
However, despite these provisions, the appellants offered no evidence of any payments on these Promissory Notes. The evidence offered — standalone balance sheets — showed bookkeeping entries of amounts generally characterized as due to or due from Staples pursuant to the CMS. If interest accrued to a subsidiary, it was merely credited as a bookkeeping entry.
As long as Staples was profitable overall, you would expect that the amount that the parent "owed" the subsidiaries would just grow. That is what happened. At 1/31/2005, the balance had ballooned to over $2.4 billion. At the end of its most recent fiscal year Staples consolidated book value was $5.3 billion.
The Board's analysis of why the arrangement was not a bonafide loan goes to some length, but it is probably summed up here.
...there were no repayment schedules, no history of repayments, and no other evidence indicating that there was any actual repayment or intent to repay the excess cash retained by Staples. This perpetual and unlimited stream of cash flowing up to Staples led to the net accounts-payable balances growing well beyond the original Promissory Note amounts.
The cause might have been hopeless, but some attention to detail might have helped. This case makes me wonder how solid many other corporate tax schemes would turn out to be if subject to much in the way of scrutiny. Accountants tend to think that journal entries are deeply meaningful, but it seems that whenever they are tested in court, judges are dismissive of "mere bookkeeping entries".
Taxpayers should take care that their debt instruments satisfy state requirements for bona fide debt.