Tax Collector Reaches Out and Touches Telebras Investors

When the Brazilian government announced in May that it was selling its controlling interest in Telecomunicacoes Brasileiras S.A., a.k.a. Telebras, U.S. shareholders probably didn't give a passing thought to the tax consequences.

They were, no doubt, much more interested in tracking their shares in a dozen new companies created by the breakup of the national phone carrier.

Besides, spinoffs happen all the time in the U.S., and they generally are not taxable. The American antecedent of the Telebras breakup -- the spinoff of seven Baby Bells from AT&T (T) in 1984 -- was a tax-free event to shareholders.

But as tax time in the U.S. draws near, so does a rude awakening. The breakup of Telebras was a taxable event, and U.S. shareholders of the company could be liable for capital-gains taxes, even if they never sold their original Telebras ADRs or shares of the 12 Baby Bras.

The splitting-up of a company can be tax-free under U.S. tax law if a few requirements are met. But these requirements probably weren't foremost in the minds of officials of the Brazilian firm, even though its American depositary shares, or ADRs, were, by far, the most heavily traded on any U.S. stock exchange. Even post-breakup, Telebras HOLDRs (TBH), instruments representing shares of all the Baby Bras, are the second-most heavily traded ADRs year to date (after Sweden's LM Ericsson Telephone (ERICY)).

"It's very unusual to see a taxable split-up. It's almost unprecedented," says Robert Willens, a managing director of Lehman Brothers in New York.

Breakup Fails U.S. Tax Test

According to Section 355 of the U.S. tax code, the breakup of a company can be tax-free if it passes certain tests. All the parent firm's assets must consist of stock in the subsidiaries, and each of the subsidiaries must be engaged in trade or business for a minimum of five years, says Willens. And the latter is exactly the test that Telebras failed: The company's cellular subsidiaries were not in business for the required five years at the time of the reorganization.

Because the transaction was taxable, "U.S. shareholders will be treated as having constructively exchanged their Telebras shares on the approval date for interests in the 12 new holding companies plus any cash or other property to be distributed by Telebras in the course of its liquidation," according to an information statement released by the company in June.

Translation: You now may owe capital-gains tax on your original shares in Telebras.

Shareholders may have been under the impression that all they did was swap shares, but the transaction is viewed as a surrendering of the parent for the 12 new companies, says Willens. The date shareholders approved the distribution, May 22, 1998, is the date shareholders are considered to have sold their Telebras ADRs and purchased the 12 Baby Bras, according to the U.S. tax code.

Shareholders didn't actually get the new Baby Bras shares until Nov. 17, almost six months later. And "under general principles of tax law, you're technically not taxable until the day you get the shares," says Willens, but not in this case. Because the taxable event occurred on May 22, that's the date that must be used when calculating capital gains or losses on this transaction, he says.

The closing price of Telebras ADRs on May 22 was $110.31, so the difference between that amount and an investor's original basis in the shares equals the capital gains or losses, says Martin Nissenbaum, national director of personal income tax planning at Ernst & Young. May 22 also is the date taxpayers should use to determine whether gains or losses are short-term or long-term, notes Nissenbaum.

Shareholders who received cash for fractional shares should reduce the $110.31-per-share basis by the amount of cash received.

HOLDRs Exchange Not Taxable

Telebras shareholders were given the option of exchanging their shares for an NYSE-listed ADR that represents a basket of all the successor companies. These Telebras HOLDRs were issued by Bank of New York and began trading on the NYSE July 28. Converting shares into HOLDRs did not trigger a taxable event. But even investors who converted their shares to HOLDRs still are liable for taxes triggered by the breakup of Telebras.

The HOLDRs seem to be the only logical thing that came out of this deal, at least as far as the tax implications go. For investors who held onto shares of the Baby Bras, calculating the cost bases in each will be a nightmare, says Nissenbaum, who offers an easy solution: Just give the shares, which in dollar terms have been sinking lately along with the Brazilian economy, to charity and be done with them.

>To order reprints of this article, click here: Reprints