June 26 (Bloomberg) -- In June 2008, U.S. Virgin Islands Governor John deJongh Jr. agreed to give London-based Diageo Plc billions of dollars in tax incentives to move its production of Captain Morgan rum
Click to view image: 'fdb2bd28033c-6a00d83451586c69e200e553e4df948833800wi.jpg'from one U.S. island -- Puerto Rico -- to another, namely St. Croix.
DeJongh says he had no idea his deal would help make the world’s largest liquor distiller the most unlikely beneficiary of the emergency Troubled Asset Relief Program approved by Congress just four months later.
Today, as two 56-foot-high (17-meter-high) tanks for holding fermenting molasses will soon rise from the ground on the Caribbean island of St. Croix, the extent to which dozens of nonbank companies benefited from last October’s emergency financial rescue plan is just beginning to come to light.
The hurried legislation adopted by a Congress voting under the threat of sudden global economic collapse led to hidden tax breaks for firms in dozens of industries. They included builders of Nascar auto-racing tracks, restaurant chains such as Burger King Holdings Inc., movie and television producers -- and London’s Diageo.
“It’s kind of like the magician’s sleight of hand,” says former House Ways and Means Committee Chairman William Thomas, a California Republican who ran the committee from 2001 to 2007 and oversaw all tax legislation. “They snuck these things in a bill that was focused on other things.”
Congress inserted the tax benefits for companies other than banks in a fog of confusion and panic after the House of Representatives rejected the first attempt to fund the bank support effort urged by then President George W. Bush and Treasury Secretary Henry Paulson.
Lawmakers rubber-stamped the package of arcane, if innocuous-sounding, tax items with one eye on the calendar. An election was only a few weeks away, and legislators were desperate to return home to campaign for their own re-election.
A year later, lawmakers and the public are just now discovering some of the curious subsidies tucked into TARP and the government’s other massive intervention programs. Four months after TARP took effect, President Barack Obama pushed through a $787 billion bill intended to pump up the nation’s economy.
That legislation included $20 billion in tax breaks for companies that produce energy from wind and other alternative sources as well as $1.6 billion in relief related to the tax treatment of canceled debt for Sprint Nextel Corp., the third- largest U.S. mobile-phone-service company, and other firms.
Like TARP, the stimulus bill was passed quickly, with little scrutiny.
“You had this remarkable brief period with no transparency, filled with backroom deals being made and an absolute blackout of information,” says Jim Lucier, a senior political analyst at Capital Alpha Partners LLC, a Washington firm that tracks legislation for hedge funds and institutional investors.
Referring to TARP tax breaks, he says, “It’s ridiculous and it’s a product of the legislative sausage-making machine.”
Max Baucus, the Montana Democrat who chairs the Senate Finance Committee, spent much of 2008 searching for a way to enact the tax provisions, says Russ Sullivan, the committee’s staff director. Baucus recommended to Majority Leader Harry Reid of Nevada that the tax breaks be included in the October bailout bill, Sullivan says.
Baucus made the pitch after Paulson’s first push to get the bailout bill approved was defeated by the House on Sept. 28. That action precipitated a 778-point fall in the Dow Jones Industrial Average that afternoon.
No Controversy Expected
The tax breaks, Baucus told senators at the time, wouldn’t be controversial because most renewed current law and would bring Senate support for the bill, Sullivan says.
The largest added measure would spare more than 25 million U.S. households from a scheduled increase in the alternative minimum tax -- a special levy that eliminates many deductions when they become too high relative to income -- for one year by temporarily indexing the tax for inflation.
Baucus didn’t know until months later, Sullivan says, that one of those added provisions would steer about $2.7 billion to Diageo over the next three decades. That’s because Diageo wasn’t even mentioned in the bill and lawmakers didn’t realize they were ratifying deJongh’s deal by extending the underlying tax policy that made the agreement possible in the first place.
$150 Billion Added
Paulson requested $700 billion for TARP. Congress added $150 billion in tax breaks and other spending when it crafted and passed the legislation in October.
While many U.S. lawmakers didn’t know about the Diageo benefit when they voted for the bill, Puerto Rican officials did -- and they didn’t like it.
DeJongh’s compact with the British liquor company meant his territory would get a much larger share of federal tax dollars from rum exports -- and Puerto Rico would lose that money.
“We learned about it in March when Puerto Rico complained,” Sullivan says of the Diageo deal. The committee is reviewing the arrangement. Its only concern is whether the U.S.V.I., and thus the U.S. government, is contractually obligated to give tax revenue to the company.
Under the terms of the deal, the U.S. gives the money to the U.S.V.I., not the company.
‘Do What They Want’
“The Virgin Islands can do what they want to with their source of revenue,” Sullivan says.
The legislation, which includes dozens of narrowly written provisions, created a new class of bailout beneficiaries.
One, championed by Michigan Representative Dave Camp, the top Republican on the tax-writing House Ways and Means Committee, and supported by Baucus, is saving Nascar track builders $109 million in taxes this year by allowing more generous write-offs.
Other tax breaks backed by Baucus help restaurant franchises make renovations by shortening depreciation schedules. Another shaves $478 million during the next decade from tax bills to movie and television producers as a better way of encouraging them to shoot in the U.S.
Rose City Archery Inc. of Myrtle Point, Oregon, which makes wooden arrows designed for children, also benefits. The legislation saves the company up to $200,000 a year because it repeals a 39-cent-per-arrow excise tax on Rose City’s products.
The company, which makes arrows used by the Boy Scouts of America and other youth organizations, says it costs 30 cents to produce an arrow and so it was being taxed at a rate of more than 100 percent.
The added tax breaks prevented the TARP legislation from being rejected a second time, says Michael Steel, a spokesman for House Minority Leader John Boehner. Twenty-six Republicans, including Tim Murphy of Pennsylvania, John Shadegg of Arizona and Zach Wamp of Tennessee, reversed their earlier no votes.
Each of the tax provisions has a story -- and plenty of defenders.
Congress first passed the tax benefit for Nascar in 2004. It was intended to shield stock-car racetrack companies such as International Speedway Corp. from Internal Revenue Service audits over its use of seven-year depreciation schedules. That time period was originally set for use by amusement parks.
The IRS wanted the Daytona Beach, Florida-based owner of the Daytona International Speedway and Talladega Superspeedway and its competitors to deduct construction costs over a longer period.
$100 Million for Racetracks
The change in the racecar-track tax law will cost the U.S. $100 million during the next decade, according to estimates by the congressional Joint Committee on Taxation (JCT).
“The IRS should not be able to whimsically reclassify anyone’s tax liability after two decades, which is what they tried to do with regard to motor-sports facilities,” says Sage Eastman, a senior adviser on the Ways and Means Committee. “Congress originally acted to provide clarity and certainty in the tax law.”
Restaurant chains say that they, like racetracks, needed help with construction accounting. Fred Rosenthal, president of Beltsville, Maryland-based Jasper’s Restaurants, says his industry needed shorter cost-recovery periods for renovations to restaurants.
The October bill changed that time to 15 years from 39 and 1/2 years. That will cost the IRS $8.7 billion over the next decade, according to the JCT.
‘Rum Cover Over’
At issue in the Diageo case is a federal tax policy known as the rum cover over. That’s the share of a $13.50 federal excise tax on every so-called proof gallon of rum sold in the U.S.
The money is collected by the U.S. Treasury Department, which then rebates it to the governments of Puerto Rico and the U.S.V.I. to help them pay for social services such as Medicaid. As territories, Puerto Rico and the U.S.V.I. get few direct appropriations from the federal government.
The tax has two parts: a permanent $10.50 federal tax dating to 1917 that Washington turns over in full to the territorial governments and a $3 additional tax added in two phases in 1984 and 1993, of which $2.75 is rebated.
That second, additional tax expires every two years. That’s the portion that was renewed by Congress as part of the October bailout.
Iowa Senator Charles Grassley, who has served in Congress since 1975 and is now the top Republican on the tax-writing Senate Finance Committee, says he didn’t know about the Diageo agreement. He also says the rum provision always takes him by surprise when it’s due to be renewed in what Congress calls ’’tax extender bills.’’
“Every time this comes up, I think it’s a new issue and I take it to my staff, and they say, ‘Oh, no, we’ve been doing this for 20 years,’” Grassley says.
Ed Kleinbard, who resigned as chief of staff of the nonpartisan JCT in May to become a professor at the University of Southern California’s Gould School of Law, says Congress routinely deals with the tax extenders the same way it dealt with the bailout legislation itself: It doesn’t study the details.
“The fact is that temporary tax subsidies are not reviewed for substance when they are renewed,” Kleinbard said in a May 7 speech to the American Bar Association.
“Instead, the entire herd of ‘extenders’ is paraded through the legislative process as a unit,” he says. “And just as good cowboys do not lose many yearlings, it is virtually unheard of for an ‘extender’ to get separated from the rest of the herd and not get renewed.”
$33 Million for Tuna Canning
That means provisions such as a $5,000 tax credit for first-time buyers of houses in the District of Columbia have become a de facto part of the tax law since first becoming a temporary benefit in 1997.
It also effectively cements a $33 million break for companies that invest in American Samoa. That benefit had been targeted at tuna canners such as Del Monte Foods Co., which owned the StarKist tuna brand until Seoul, South Korea-based Dongwon Group bought it in June 2008. Del Monte is based in House Speaker Nancy Pelosi’s San Francisco district.
The $2.7 billion Diageo tax break in the October bailout bill gives the most financial aid to a non-U.S. company.
“I don’t think that the taxpayers knew they were investing in Captain Morgan when the Congress was considering the first bailout bill,” says Steve Ellis, vice president of Taxpayers for Common Sense, a Washington-based government watchdog group.
Taxpayers Fund Distillery
“What happened is we sent taxpayer money to effectively build a distillery in the Virgin Islands that will benefit Diageo, one of the world’s largest conglomerates,” Ellis says,
The Diageo deal started shortly after deJongh took office in 2007. The governor says the company contacted him to say it planned to leave Puerto Rico after having decided the U.S.V.I. might be a better location to produce Captain Morgan.
He negotiated with the company for 18 months before cementing the arrangement in June 2008.
Diageo bought Captain Morgan from Seagram Co. in 2001 and was making plans to move from Puerto Rico in any circumstance, says Diageo executive Dan Kirby, who’s in charge of what the company has dubbed “Project Island.”
It wanted a long-term supply of rum and direct control of production. So it decided not to renew its contract with the current maker of its base rum, family-owned Destileria Serralles Inc. in Ponce, Puerto Rico.
In the deal, the U.S.V.I. agreed to build a distillery for Diageo, using $250 million in public bonds that will be repaid with federal excise taxes from the U.S.
Subsidies to Diageo
The U.S.V.I. will give subsidies representing as much as 44.5 percent of that revenue to Diageo to promote Captain Morgan and provide a form of funding for molasses from sugar-growing countries.
Fitch Ratings on June 19 rated the bonds BBB-, one notch above junk, and cited, “a potential change in the USVI’s use of matching funds to incentivize distillers.” It gave the debt a so-called stable outlook based on “the expected continuation of the matching fund payments by the U.S. government.”
Fitch noted that one risk was the introduction of legislation proposed by Puerto Rico resident commissioner Pedro Pierluisis to deny Diageo any tax benefits. “Passage of such legislation in Fitch’s view is remote,” the agency said.
Diageo also qualifies for additional tax incentives, reducing its U.S.V.I. tax liabilities to as low as 3.5 percent, from 35 percent.
In exchange, Diageo agreed to stay in St. Croix for at least 30 years and hire 40 or more local workers.
In March, deJongh, 51, describes the history of the agreement in his office in the Government House, a mustard- colored stucco building that blends in with the colonial Danish architecture of Christiansted, St. Croix’s largest town.
He says he traveled to Washington in June 2008 to brief federal officials. He met with Representative Charles Rangel of New York, who’s chairman of the Ways and Means Committee; Senate Energy and Natural Resources Committee Chairman Jeff Bingaman of New Mexico; West Virginia Senator Jay Rockefeller; and then Interior Secretary Dirk Kempthorne.
“We wanted to be very upfront with everybody about what we were doing,” says deJongh, a former commercial banker for what’s now JPMorgan Chase & Co. As part of the transparency, he says, all of the information was posted on the territorial government’s Web site.
“I don’t view it as federal money. I view this primarily as dollars that the federal government has said to the territories, ‘They’re means by which you can grow,’” deJongh says.
For Diageo, the deal was a coup that will give the company more control over production. It will also cut costs and expand the market for Captain Morgan rum, which is already the fastest- growing major rum brand in the world, according to London-based Euromonitor International Plc, which tracks such information.
“It’s outrageous that someone said, ‘I’ll give you 50 cents on the dollar to move your location’ to a foreign-based company where nothing new was being created,” former Representative Thomas says.
Diageo, which had a stock market value of 21 billion pounds ($35 billion) as of June 8, reported net sales of 5.07 billion British pounds in 2008. Revenue from selling rum accounted for 5 percent of Diageo’s income. Still, Captain Morgan, named for Henry Morgan, the 17th-century Jamaican privateer, is a major driver of earnings for Diageo, spokeswoman Zsoka McDonald says.
Guinness, Johnnie Walker
The company’s other premium brands include Guinness beer, Jose Cuervo tequila and Johnnie Walker whisky. Captain Morgan has about 25 percent of the global rum market, according to Euromonitor.
Diageo’s share price declined 12.8 percent in 2009 as of June 8, trading at 842.5 pence ($13.73). In February, the company cut its earnings forecast for the year to a projected profit of 4 percent to 6 percent, less than its previous estimate of as much as 9 percent, because of the weak global economy.
Diageo executive Kirby and Michael Bertman, the company’s Washington lobbyist, walk the property line where the distillery will be built on St. Croix. Kirby, 52, says an estate once owned by Alexander Hamilton had rum shipped from St. Croix to George Washington’s soldiers to keep them warm at Valley Forge during the American Revolution.
“Is it better for Captain Morgan to come here with the inducements? Yes,” Bertman, 42, says. “It’s better than we have now, without a doubt, to create a better price for our rum. We’re a lot bigger, and we’re going to get a lot bigger.”
Bertman says the tax revenue generated by Captain Morgan will help the U.S.V.I. more than it served Puerto Rico -- even after Diageo pockets its share -- because Puerto Rico’s $74 billion economy dwarfs that of the U.S.V.I., with a $1.6 billion economy.
“It’s a much different place than Puerto Rico,” he says. “The impact of this money on this territory compared to that economy, it’s very, very different.”
In Puerto Rico, however, deJongh’s deal is seen as nothing short of theft.
“Being creative as a governor is one of the things that you get elected to do, but I’m not sure that you can call this creative; it’s acting like a pirate,” says Roberto Serralles, a vice president at Destileria Serralles.
The company has made Captain Morgan for a quarter century and may have to lay off 330 workers when production moves to St. Croix, Serralles, 42, says.
The territory’s lobbyists and allies have introduced legislation seeking to undo deJongh’s deal.
Puerto Rico -- home to Bacardi Corp., which has the world’s best-selling rum brand according to Euromonitor -- has for years produced more of that liquor than any other location in the world. As a result, the island received the lion’s share of the U.S. tax rebate, or about $400 million a year.
The Diageo move will cut that take by about half. It uses the money to fund public service programs for its 4 million residents, who are U.S. citizens. Puerto Rico receives $4,260 per person in federal spending compared with an average of $8,339 in the 50 U.S. states, according to Census Bureau data.
“This has been, you know, a buffer, it’s been a shock absorber,” says Puerto Rican Secretary of State Kenneth McClintock, who says the revenue amounts to about 10 percent of the commonwealth’s operating budget.
“Puerto Rico does need that money -- and right now. As a result of the Diageo thing, we’re going to lose out on a lot,” McClintock says.
Bacardi Chairman Joaquin Bacardi says his company will benefit from Diageo’s move to St. Croix.
“I feel that we will only be strengthened by the decision of the competition to leave, because we will be the sole, 99 percent basically, Puerto Rican rum brand,” he says. He likens the brand’s appeal to that of Florida oranges or wine from California’s Napa Valley.
McClintock, Serralles and Puerto Rican officials say that if Congress repeals the Diageo deal, the entire tax rebate program could fall into jeopardy.
Thomas says the Diageo deal should be stopped.
“No one should allow it to continue,” Thomas says. “To steal business from one island to another -- that’s not value added; that’s just crazy.”
A looming $5.5 trillion federal deficit by the end of 2013 may force Congress to challenge tax laws benefiting restaurant chains, racecar track builders and a London-based liquor company. But if history is any guide, taxpayers may find more hidden expenses in financial rescue legislation yet to come.
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