By Guy Span

Could you imagine that public agencies would play games with federal tax dollars, so that there would be less federal income, make transit purchases cost twice as much, and allow the local agency to pocket some of the proceeds? There is a supposedly legal way to do this and here’s how it works:

Depreciation is a well-known accounting term that accrues costs as objects deteriorate over time. There are tricky ways to speed this up and slow it down, depending on the effect you wish to achieve. The key thing, in order to have fun and games, is that depreciation represents a cashless cost, as the business operator would theoretically set aside that cash to pay for the replacement of the object.

Then we take an asset rich company, with lots of expensive machines that doesn’t make a lot of money. They can sell some assets to a company that earns a lot (say a bank) for a nominal fee and lease them back. The asset heavy company has in fact sold some of its depreciation to the bank, making the asset heavy company appear more profitable and allowing the bank to shelter more of its profits from the IRS. Everyone wins but the taxpayer.

There are other even less benign forms, where a company sells significant assets to an investor group for market value, leases them back at market rates, dividends the cash to the shareholders, who then sell the stock after pocketing the dividend. Merchant bankers call this type of sale/leaseback “synthetic debt” as it does not appear as debt on the books of the company, but rather as a cash operating expense (which replaces the cashless depreciation). It doesn’t matter what you call it, as the looted company has been stripped of its value and the new stockholders will not find out for years (New Zealand’s Tranzrail is a good example).

Then there’s depreciation in the public sector. Public agencies, particularly transit systems, sort of ignore depreciation, with the blessings of government. For example, the Metropolitan Atlanta Rapid Transit Authority (MARTA) won a prestigious accounting award for their 2003 Annual Report. You can read it cover to cover and depreciation is not even mentioned. It does note that they signed a contract with a supplier for the refurbishment of 238 transit cars at a cost of $266 million. So we know depreciation is a real cost.

Our own Metropolitan Transit Commission (MTC) does not use depreciation when it compares the fare box recovery ratios of the various systems. Thus, asset heavy systems like BART look better with no depreciation compared to asset light systems like ferries. Remember that depreciation was designed to set aside a pot of money so that when the time came, worn out objects could be replaced. Since the cost is ignored and there is no pot of money, transit systems turn to the federal and state governments to replace worn-out stuff. And the competition for these dollars is intense. You see, as a transit manager, the more capital dollars you consume buying new stuff the higher your (ignored) depreciation costs. The flip side is that new BART cars and brand-new buses cost less to maintain, so you have actually improved your apparent efficiency. And according to the MTC’s own reports, it measures each system by this highly artificial yardstick.

There are other ways to play with depreciation and one of them is time. Lengthening the life of a depreciating object will lower the annual depreciation cost. While there are some standards, there is also a lot of leeway. BART depreciates its stations, track structures, and improvements over 80 years (and Washington’s METRO uses 75). Interestingly enough, BART has a $900 million bond before the voters in November to strengthen the tube, stations, and elevated sections that are 34 years old, but being depreciated as if they would last 80 years. Passing the bond will reset the clock. It is not the purpose of this article to pass on the merits of BART’s bond funding, as a tube failure would cripple the Bay Area, but merely to note that the structures being rebuilt are less than halfway through their useful depreciated lives. In short, depreciation costs real money, some $900 million in this case.

Then, some transit systems are engaged in what can only be called an odd behavior, namely sale/leaseback transactions. BART has engaged in at least two of these transactions, which would also lower its effective depreciation charges, by “selling“ the depreciating items. The first was in 1995, when, according to the BART annual report, an unnamed “Swedish company” (Asea Brown Boveri, according to BART representatives) bought 25 railcars for $50.383 million and BART promptly leased them back. BART was paid $2 million in cash, which it recorded as a gain on sale, and no further cash would change hands. To date, ABB has recorded $14.967 million in depreciation costs, which presumably it uses to offset federal taxes.

Let’s say that again. A public agency is paid $2 million in cash to shelter a private company from $14 million in taxes payable to another public agency that helps fund the first one. If ABB shelters the full $50 million in depreciation from the IRS, then the taxpayers will have paid for the transit cars twice: once when they gave BART the money and a second time as ABB avoids new taxes. The Government Accounting Office said that while they were not investigating this issue and were unaware that public agencies were doing this, there was a Bill (HR 4520) that would close the loophole, should it pass the Senate. The IRS said it couldn’t comment on specifics, but did note that they routinely disallow tax benefits for transactions structured wholly to avoid taxes. But the sale/leasebacks still continue.

In March 2002, according to the Annual Report, the District sold (and leased back for 40 years) its new rail traffic control equipment to unnamed “investors” for $206 million (BART later said the investor was CIBC, Canadian Imperial Bank Corporation). In this highly complex transaction, BART pocketed $23 million but is accruing the income (amortizing) over the next 15.75 years (so if they spent all the money that year, no one will notice the smaller lack of income in the future). No mention is made of the annual depreciation saved but it will cost the federal government $200 million in tax savings over the life of the project. These are two examples of what is being played out, world-wide, on a greater stage. Someone might ask why Wachovia Bank “owns” a sewer system in Germany. Even AC Transit is not immune, as they have recorded a $2.5 million gain in a sale/leaseback transaction, although without providing further details.

Since the MTC ignores depreciation for fare box recovery ratios, perhaps we are making transit investment choices without considering all the costs. But some observers note that AC Transit does not pay anything for its road use. The damage to the public right-of-way is paid by others, so that using depreciation unfairly advantages buses over rail. But perhaps it would be fun to have a view of the real cost of each system, if we considered that depreciation that will one day need to be funded. And other observers say that public agencies that play games with private investors to dodge federal taxes should be closely scrutinized.

You can contact Guy Span at info@baycrossings.com.