The Taxonomist

I got a call from MCI the other night. It came just as I was finishing up a paper attacking a multibillion-dollar tax loophole that MCI is trying to create for itself. Having already been surprised at being contacted by AT&T and Verizon on the issue that same day, I wondered how MCI had found out, too. But my paranoia was unjustified. MCI's call was merely an attempt to persuade me to change my long-distance service.

As has been well reported, MCI, aka WorldCom, was driven into bankruptcy due to the largest accounting fraud in American history, which has cost the company's shareholders and creditors hundreds of billions of dollars. Now MCI is trying to milk the public even further, by perverting the purpose of a federal tax law that lets companies coming out of bankruptcy postpone certain taxes. MCI wants to turn that postponement into a permanent tax exemption.

I was tipped off to MCI's attempted tax rip-off a few months ago by my friends at the Communications Workers of America, which lost tens of thousands of jobs at AT&T and elsewhere due to MCI's long-distance price war. MCI's competitors couldn't afford to compete at MCI's low prices and, as it turns out, neither could MCI -- except by cooking its books.

So what's MCI up to now? In its bankruptcy proceeding, MCI will shed tens of billions of dollars in debt -- "upwards of $19 billion or more," according to one of its (redundantly stated) bankruptcy filings, or as much as $27 billion, according to another filing. That's good news for MCI (and bad news for its creditors), but there's a fly in the ointment: Debt cancellation normally generates taxable income for the borrower, meaning a potential federal tax bill for MCI of as much as $9.5 billion at the 35 percent corporate tax rate.

The rule making debt cancellation taxable goes back to the early days of the income tax, and when you think about it, it's not just logical, it's essential. Otherwise, for example, workers could just be paid in loans that are quickly forgiven, tax-free. In fact, it's hard to think of any kind of income -- wages, sales, dividends, interest, capital gains, rents or whatever -- that couldn't easily be converted into a loan. So without a usual tax on debt forgiveness, the income tax would collapse.

The tax code does give a break to companies coming out of bankruptcy. To make it easier for them to get a fresh start, reorganized companies don't have to pay tax immediately on their washed-out debt. Instead, they're taxed on the income from their canceled debt gradually, by losing future deductions.

MCI, however, has come up with an outrageous scheme to try to get around ever paying tax on its forgiven debt. Essentially, it claims that the company should be divided into two parts. One part -- call it "finance" -- borrowed all the money on which the debt is being canceled. The other part -- "operations" -- has all the accumulated tax write-offs. So, says, MCI, finance has cancellation-of-debt income but no future tax deductions to lose, while operations has lots of tax write-offs but no cancellation-of-debt income.

Of course, if a company's borrowing can be treated as unrelated to the operations that it financed, no tax would ever be collected on debt cancellation in bankruptcy. That makes no sense, but apparently several other bankrupt companies besides MCI are currently making the same ridiculous argument. So the monetary stakes for the public go beyond even MCI's potential $10 billion.

Although the purpose and history of the tax law show that MCI's position is indefensible, the language of the statute is not as clear as it could be. Most experts think that the IRS could probably remedy this legislative oversight on its own, but thus far the Bush administration hasn't weighed in. So the anti-MCI forces have persuaded a bipartisan group of senators and representatives to introduce a bill to clarify the statute.

I'm amused to be supporting a bill whose lead Senate sponsor is Rick Santorum, the ultraconservative Republican firebrand from Pennsylvania. It's also rather unusual for me to be on the same side on tax policy as AT&T and Verizon -- which, when they contacted me, were pleased to hear that I was already writing negatively about MCI. In fact, after I published my paper, one of my more cynical tax-lawyer friends called me to ask why I was "intervening in a phone-company dispute."

But in this case, AT&T's and Verizon's self-interested opposition to MCI gaining a competitive advantage coincides with good tax policy. I'm sure I'll be on the other side of the fence from those companies, not to mention Rick Santorum, soon enough.

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