Lehman seeks court approval of $1.8 billion settlement in IRS claims

By Jim Witters

Wilmington, Del., March 1 - Lehman Brothers Holdings Inc. is seeking court approval of the settlement of 26 disputed claims involving the U.S. Internal Revenue Service, according to documents filed Thursday with the U.S. Bankruptcy Court for the Southern District of New York.

The settlement represents more than $1.8 billion of the disputed $2.6 billion.

The IRS proposed 36 adjustments to income, tax credits and penalties after auditing Lehman's 2001 through 2007 consolidated income tax returns and evaluating additional tax positions claimed by the company during the audit that were not included on its originally filed consolidated income tax returns, according to court documents.

Lehman Brothers disputed the adjustments, which could have increased the company's tax liability by $2.6 billion.

"After two years of focused negotiations, LBHI and the IRS have settled, subject to the approval of this court, 26 of the 36 issues that constitute the 2001 to 2007 tax disputes," court documents state.

A hearing on the proposed settlements is scheduled for March 21.

Investment transactions

In dispute are $494.7 million in foreign tax credits and $191.3 million in deductions claimed in connection with the investment transactions from 2002 to 2007. Penalties on the claims amount to $99.44 million.

To resolve the dispute

• Lehman Brothers will be allowed 40% of the claimed foreign tax credits for the 2002 to 2004 tax years, 25% of the claimed foreign tax credits for the 2005 to 2007 tax years, and 100% of the claimed deductions for the 2002 to 2007 tax years;

• Lehman Brothers will reduce its taxable income by $330.2 million, the amount of the disallowed foreign tax credits; and

• No penalties will be imposed against Lehman Brothers with respect to the investment transactions.

Specifically, Lehman will be allowed $109 million of the $272.53 million in foreign tax credits for 2002 to 2004; $55.55 million of the $222.2 million in foreign tax credits for 2005 to 2007; and all of the $191.3 million in deductions for 2002 to 2007.

Bond borrowing transactions

During the 2001 to 2005 tax years, Lehman subsidiaries entered into four financing transactions for which Lehman Brothers Holdings Inc. claimed foreign tax credits and deductions for interest expense, swap payments and other expenses.

The IRS challenged the tax credits and deductions, saying Lehman failed to comply with applicable statutes and common law doctrine, court documents state.

In dispute are $145.8 million in foreign tax credits and $59.5 million in deductions. Penalties on the disputed claims amount to $33.34 million.

To resolve the bond borrowing issues

• Lehman Brothers will be allowed 35% of the claimed foreign tax credits in the 2003 tax year and 100% of the claimed deductions for 2001 to 2005;

• Lehman Brothers will reduce its taxable income for the 2003 tax year by $94.8 million, the amount of the disallowed foreign tax credits; and

• No penalties will be imposed in connection with the bond borrowing transactions.

Specifically, the company will be allowed $51.02 million of the $145.8 million in foreign tax credits and all of the $59.5 million in deductions.

Capital loss issue

During the years in question, Lehman Brothers invested in capital assets that later were sold for less than their acquisition value, according to court documents.

Lehman claimed capital losses on its consolidated income tax returns for the 2002 and 2004 tax years, as well as capital losses identified during the audit that should have been claimed for the 2001 tax year.

The IRS challenged the company's entitlement to the capital losses, saying it failed to substantiate the loss and failed to comply with applicable statutes and common law doctrine.

In dispute are $217.8 million of capital losses for 2002 and 2004 and $8.21 million of capital losses for 2001.

To resolve the capital loss issue

• Lehman Brothers will be allowed none of the capital losses for 2001 or 2004 and about 20% of capital losses for 2003; and

• No penalties will be imposed against Lehman Brothers with respect to the capital loss issue.

Specifically, Lehman Brothers will be allowed $33.91 million of the $167.71 million of capital losses claimed for the 2003 tax year.

Research and development

During the years in question, Lehman Brothers claimed credit for qualified research activities, but the IRS claims the company failed to substantiate the activities.

At issue are $16.23 million of research credits for the 2001 to 2007 tax years.

To resolve the research and development credit issue, the IRS and Lehman Brothers agreed that the company would be allowed $10.2 million in credits.

Dividends received deduction

In dispute are $198.63 million of deductions for dividends received on short positions claimed on Lehman Brothers' 2001 through 2004 consolidated income tax returns and $125.84 million of deductions for dividends received on risk arbitrage positions for the 2003 through 2007 tax years.

To resolve the dividends received deduction issue, the parties agreed that Lehman Brothers would receive 75% of the disputed deductions related to the short positions and none of the deductions related to the risk arbitrage positions.

Specifically, the company will be allowed $150 million of the $198.63 million deductions claimed for 2001 to 2004.

Double reporting of income

Lehman Brothers and several of its subsidiaries indirectly owned interests in partnerships that held real estate investments.

"Due to limitations in LBHI's accounting systems, the income from these partnerships was reported twice on LBHI's consolidated returns, and thus LBHI claimed deductions reversing out one inclusion of the partnership income," according to court documents.

In dispute is $87.8 million of income reversal for 2003 and about $200 million of income reversal for 2004. Also in dispute is $25.7 million of income reversal for the 1997 through 2000 tax returns.

To resolve the double reporting of income issue, the company and the IRS agreed that Lehman Brothers would be allowed $63.6 million of income reversal for 2003, the full amount for 2004 and none for the 1997 through 2000 tax years.

Other issues

Other issues in which the parties reached agreement include the following:

• Dispute: $42.1 million of nonconventional fuel credits claims on the 2007 tax return;

Resolution: Lehman Brothers will be allowed the full amount.

• Dispute: $106.8 million in cost-to-carry interest expense on debt to buy or carry tax-exempt municipal bonds;

Resolution: Lehman Brothers will conform its interest allocation methodology used for the 2001 through 2007 tax returns to the IRS standard. As a result, Lehman Brothers will reduce its interest expense deductions by $93.8 million for the 2001 through 2007 tax period.

• Dispute: $483.3 million in deductions from 2002 through 2004 in connection with real estate mortgage investment conduits for losses when the interests were sold and $89.1 million for similar deductions in 2005 to 2007;

Resolution: Lehman will be allowed all of the 2002 to 2004 deductions and none of the 2005 to 2007 deductions.

• Dispute: $8.2 million in income generated by the sale of Indymac Bank that should have been reported on the 2003 and 2004 income tax returns;

Resolution: Lehman will increase its reported income by $8.2 million for those years.

• Dispute: $17.2 million in partnership income Lehman failed to report in 2005 and 2006;

Resolution: Lehman will increase its reported income by $13.1 million for those years.

• Dispute: Lehman claimed foreign tax credits for foreign taxes paid by foreign affiliates.

Specifically, $358 million paid by Lehman Brothers International (Europe); $270 million paid by Lehman Brothers Japan; $46.8 million paid by PAMI - New Century Finance; $22 million paid by Lehman Brothers (PTG); and $14.1 million paid by Lehman Brothers (Indonesia);

Resolution: Lehman will be entitled to claim $317 million paid by Lehman Brothers International (Europe); $184.5 million paid by Lehman Brothers Japan; $46.8 million paid by New Century Finance; zero paid by Lehman Brothers (PTG); and $7.83 million paid by Lehman Brothers (Indonesia).

• Dispute: $45.05 million for United Kingdom taxes paid by Longmeade Ltd. and $12.7 million not claimed but identified during an audit;

Resolution: Lehman will be allowed none of the claims.

• Dispute: $41 million in losses in connection with Liberty Hampshire's equity-linked notes in 2007;

Resolution: Lehman will be allowed none of the losses claimed.

New York-based Lehman Brothers Holdings was the fourth-largest investment bank in the United States. The company filed for bankruptcy on Sept. 15, 2008. Its Chapter 11 case number is 08-13555.

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