Citigroup and Morgan Stanley embrace Taxman's loophole

--The global investors who plugged the leaks in the balance sheets of Wall Street may have got good deals. One party that looks like a loser: the U.S. Treasury. --Both Citigroup Inc. and Morgan Stanley used a financing structure that satisfies bank regulators concerned about their capital while also convincing federal-tax authorities that the interest payments they make to investors are actually tax-deductible interest on debt. Citigroup, which used this method to raise $7.5 billion from the Abu Dhabi Investment Authority in November, likely will save about $500 million on its U.S. taxes over nearly three years. Morgan Stanley could save roughly $300 million in taxes over 2½ years, thanks to the way it structured its mid-December deal to raise $5.5 billion from China Investment Corp. --The banks aren't doing anything improper, but merely taking advantage of a controversial 2003 Internal Revenue Service ruling that blessed the tax benefits of such deals. In recent years, numerous companies have raised money using these so-called hybrid structures, with nicknames like "Feline Prides," "Peps," and "Upper DECS." Generally, interest payments on debt are tax-deductible for companies, but dividends on common and preferred stock are not. --The hybrid structure used by both Citigroup and Morgan Stanley allows them to get the best of both worlds. The money raised is counted by the Fed and the SEC as Tier 1 capital to a point, but a portion of the payments on the new funding are tax-deductible. Bond-ratings agencies, which also are concerned about the banks' capital ratios, similarly view the new financing as equity. --The financing arrangements used by the two banks are complex, but generally are similar. --Until then, Citigroup will pay Abu Dhabi more than 6% annually on the outstanding sum -- initially about $495 million a year. The IRS considers those payments to be interest on the debt issued to Abu Dhabi and therefore tax deductible. Citigroup is paying the Abu Dhabi fund a separate fee, which is not tax-deductible, for taking part in the transaction, which, when added to the interest, totals an 11% annual return. --Then comes the second part of the transaction. Before Abu Dhabi buys the Citigroup shares, the emirate will try to begin selling the Citigroup debt to another investor. Theoretically, even after Abu Dhabi purchases the shares, the Citigroup debt still exists.