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Gimme Shelters 

After mortgaging our future in an orgy of budget-related borrowing, the Legislature hatches new orgiastic plans: sleazy tax shelters

Wednesday, Aug 13 2003
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Talk about your Wall Street accounting scandals: The new budget passed by the California Legislature is so fraught with financial chicanery that I'd hardly be surprised if state officials next went to work enabling phony offshore shell companies or sham corporate tax-shelter games.

And wouldn't you know it? That's exactly what our state Legislature is doing. Earlier this month the Legislature passed a $99 billion budget that includes massive borrowing, pension fund raiding, state/local tax-swap maneuvers, interdepartmental till-rifling, and $1.5 billion in bonds that suck up future payments from the state's successful lawsuit against tobacco companies.

Now, the Legislature is scheduled to continue its work on a bill that would permanently put California governmental agencies into the business of marketing sham corporate tax shelters that would be based on a projected $1 billion per year in public assets.

The bill, now in committee, would extend a tax break that enables a financial maneuver known as the "lease-leaseback." If the bill is eventually approved, dozens of local and regional agencies would be able to convey to private investors the right to deduct wear and tear, or depreciation, on government-owned equipment from the federal income taxes paid by the investors. These deals are generally conducted through offshore shell companies. They typically involve shuffling millions of dollars around for no other purpose than corporate tax-dodging.

Like the billions of dollars in bond deals floating the new state budget, lease-leasebacks generate not just funding for the California government, but millions of dollars in associated fees for white-shoe lawyers and consultants, money most often scooped up by firms that have Sacramento lobbying arms. In short, SB 760 -- sponsored by two Democrats and supported by every one of the dozens of Republicans who've had a chance to vote on it -- is a perfect poster child for the orgy of financial irresponsibility that's gripped California governance this year. The measure has passed unanimously in committee and in floor votes and is currently in committee for revisions.

For all their theatrical carping about Gray Davis' past financial-management misdeeds, Republicans are joint malefactors in the highly leveraged budget mess that will cripple the state for years to come. A cagily named, $10.7 billion "deficit-reduction bond" package -- through which the state will engage in arcane state-local tax swaps to push this year's budget crisis into the next five years -- was initially nurtured by Senate Republican leader Jim Brulte, says Jean Ross, director of the California Budget Project.

"Brulte proposed rolling forward the deficit. Davis embraced it. The Legislature accepted it," Ross says.

Don't get me wrong: Critics are right when they slam Gray Davis for seeking political benefit by avoiding hard financial choices; his awful handling of the energy crisis may end up costing the state $50 billion.

But Californians are fools to buy the idea that a recall of the governor would purge the state's flaky-financing disease. California public officials of every political stripe have become addicted to Enron-style accounting gimmicks. If voters think a high-drama, right wing­ financed recall will fix this malaise, I've got some offshore tax shelters to sell them.


So, apparently, does the Legislature. SB 760, sponsored by Sens. Jack Scott (D-Los Angeles) and Dede Alpert (D-San Diego), would extend a state tax break, passed last year and scheduled to expire in 2004, that makes it profitable for municipal transit agencies to sell investors the right to use public assets as tax shelters. The state legislative analyst predicts $1 billion of such assets will be used in tax shelters during coming years. With time, a significant part of state infrastructure will be nominally owned by corporate investors, according to this analysis. And every year those investors will claim a loss on their federal income taxes resulting from wear and tear on those assets. In exchange for the right to game the IRS in this way, corporate investors will pay agencies such as Bay Area Rapid Transit a fee that will, by definition, be less than the amount of taxes the investors will be slipping from the federal till.

"To unlock the value in those [government] assets I think is considered by many to be called creative financing," notes BART Controller Treasurer Scott Schroeder, who is currently negotiating with investors on a deal involving $200 million worth of rail cars.

Creative indeed: The BART deal provides a peek into a smoke-and-mirrors financing future.

Complete details of the rail car transaction are secret, and will remain so until Sept. 9, the same day the BART board is scheduled to vote on whether to approve the wildly complex deal. In other words, the board will be voting largely on blind faith that corporate lawyers didn't get the better of the public's negotiators. Because corporate tax shelters take myriad forms, every one of these deals is different. But BART and other transit agencies have already done hundreds of millions of dollars' worth of tax-shelter deals from which a rough outline can be drawn.

Last year, BART leased $130 million of train switching and other electronic gear so investors could use it as a private tax shelter. The same year, the San Francisco Municipal Railway leased $388 million worth of rail cars in connection with a Cayman Islands­based tax dodge.

Under the upcoming BART deal, investors will lease the commuter trains that BART owns from BART. The investors will then lease the trains right back to the transit agency, paying the agency what is almost certain to be a multimillion-dollar fee for the right to deduct the trains' wear and tear from their federal income taxes. The trains will never leave BART's control; it's a purely paper transaction, and both BART and the private investors will make out like bandits -- unless something goes wrong. And there are real and significant risks. Like the Legislature's July borrowing spree, the lease-leaseback legislation now in committee could come back to haunt the public.

Schroeder tells me the deal currently under negotiation assumes BART's rail cars will last another 30 years; if they become worthless before then, BART could be responsible for making investors whole. Such deals assume the IRS will not issue a ruling -- as it has following previous, related deals -- eliminating the tax break that makes the deal profitable. In such cases, investors can sue a government agency such as BART, claiming the flimsy tax shelter was the agency's fault. Another drawback: Deals such as the BART-sponsored federal income tax shelter now under negotiation typically involve massive attorney and financial consultant fees, often equaling as much as 3 percent of the deal's total value. As in the case of the attorney/ lobbyist cottage industry surrounding state bond borrowing, fee-hungry financial consultants lobby and make political contributions to legislators, creating a situation where the incentives all tend in the direction of creating more tax shelters. Tellingly, the financial counsel to Muni in last year's train-car deal was none other than Orrick, Herrington & Sutcliffe LLP, the politically connected law firm that seems to have a lock on California's bond counsel business.

By putting public agencies in the improper business of abetting sham federal tax shelters, our state Legislature invites and encourages greater impropriety across California.


In 2002, corporate accountants at companies such as Enron, WorldCom, and Tyco, among others, violated investor trust by creating pretend profits and hiding real expenses. In 2003, Republicans created the illusion that California's massive financial problems could be solved without tax increases by pushing the state into a position of massive, highly complex, expensive borrowing that will affect public finances for years into the future. Now, legislators from both parties are likely to pass a measure that encourages cash-strapped local governments to jump into the business of helping corporations craft federal tax dodges.

California's burgeoning tradition of shell-game finance has been spurred by a fact that's obvious, despite GOP attempts to dismiss it: Republican governors and Republican-controlled state legislatures across the nation whose states are facing budget shortfalls have turned to tax hikes to solve their problems. In California, Republicans wishing to enliven their effort to recall Gray Davis delayed approval of a budget for three weeks by refusing to accept any new taxes. When it came time to enter into the massive borrowing needed to make good on their no-tax-hike political sloganeering, Republicans were all too happy to go along. Like their compadres on the federal level, California Republicans are comfortable demolishing government finances in the name of tax relief.

If the state is ever going to quit spiraling from financial crisis to financial crisis, California budget voodoo has to stop. The Republican recall drive is not a step in that direction.

About The Author

Matt Smith

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