Complex County Rail Car Venture Turns Sour : Transit: Officials sought a $4-million gain from buying, selling and then leasing coaches. They still expect a profit. But a review of the deal projects a $3.9-million loss, plus a huge potential tax liability.

The deal was supposed to yield a windfall for taxpayers.

Hoping to make a $4-million profit, transit officials turned a purchase of 54 commuter rail cars into a venture stretching from Asia to the Cayman Islands.

Before the trolleys began rolling, the Los Angeles County Transportation Commission sold the cars to a group of anonymous Japanese investors and immediately leased them back.

The complex transaction was designed as a tax shelter for the Japanese, who agreed to share their savings with the transit agency.

To launch the deal, officials hired Wall Street bankers, $370-an-hour lawyers and advisers on three continents. They also paid to establish two companies in the Cayman Islands.

But those costs and others are turning the deal into a loser for the commission. Instead of making money, the agency is projected to lose up to $3.9 million, The Times has found.

In addition, experts said, the deal has exposed the agency to many millions of dollars in potential tax liability.

“The costs are putting the agency in the hole, and the deal is loaded with risks,” said attorney Schuyler M. Moore, a specialist in international finance who examined the transaction at the request of The Times.

The deal raises questions about how much risk public officials should take in pursuing profits and whether the commission properly monitored its consultants.

Transit officials acknowledged that the deal exposes the agency to tax risks but said they believe the transaction will produce a profit of $3.4 million. They now are considering whether to enter into a similar arrangement for 15 more cars.

“There is only one reason we did it: Save taxpayer money,” said Neil Peterson, the commission’s executive director.

Leslie V. Porter, the commission’s top financial executive, said, “You can argue today about whether or not the amount of savings . . . compensated us sufficiently for the amount of risk we took, and you can disagree.”

Commissioner Marvin L. Holen said the lease deal is an example of irresponsible spending. Holen said staff should have alerted the commission to the rising costs and the tax risks. “I’m sure the commissioners would have hesitated, or said, ‘Wait a minute, we’re not willing to accept that risk,’ ” he said.

The commission’s venture into high finance followed its purchase of $81 million worth of rail cars. In 1987, the agency purchased the cars from Japan’s Sumitomo Corp. for the Blue Line, which runs between Long Beach and Los Angeles.

As the cars were coming off the assembly line two years later, the agency started selling them to offshore companies controlled by the Japanese investors.

The agency then would lease back the cars with an option to buy them at the end of 16 years.

The Japanese hoped to realize millions of dollars in tax savings by depreciating the equipment. The investors would indirectly pass on a portion of their tax savings to the commission.

The arrangement was not entirely novel. Other transit agencies over the past decade have successfully tried similar deals.

In Los Angeles, the transit commission was in the black midway through the deal. But the commission’s profit melted away, largely because of costs associated with an unusual bond sale.

Records and interviews show:

* The commission agreed to pay off $26.4 million in bonds issued solely to accommodate the tax needs of the Japanese investors. The commission is projected to lose several million dollars because of the arrangement, The Times has found.

* Expenses for outside consultants and other specialists totaled $1.7 million--almost $150,000 more than staff calculated.

* The Wall Street investment banking firm of Morgan Stanley & Co. received $315,000 in fees after projecting that the commission would make at least $4 million.

* Without commission approval, a New York City law firm, White & Case, was hired for $250,000. Later, the commission nearly tripled the fees, to $740,000.

* An additional $164,000 was paid without proper authorization to seven entities--including a French bank and law firms in the Cayman Islands and Japan, according to a transit accountant. Some of the money was spent on professional services for the Japanese investors.

“The fact that public funds were released to firms which had no contractual relationship with LACTC raises serious questions concerning the effectiveness of LACTC’s internal controls,” the accountant wrote in a memo forwarded to top transit staff.

The transaction has not been audited, although Peterson asked his staff last week to review it.

Peterson said the fees paid to White & Case, Morgan Stanley and the other consultants were appropriate and went for necessary services. “Obviously,” he added, “the (commission’s) paperwork and the documentation of this was not anywhere near to the degree that we would have liked.”

The transit chief acknowledged that he was nervous about using entities in the Cayman Islands, a tax haven known for money laundering. “Obviously, I’d rather have the bank in Tuscaloosa, Ala.,” he said. But Peterson said the anonymity of the investors did not trouble him, because he had no reason to doubt their legitimacy.

He said he decided to press ahead with the deal, relying on advice from his staff and outside experts.

Los Angeles transit officials were among the first to embark on what is known as a “cross-border lease” of rail cars or other heavy equipment.

At least 10 other U.S. public agencies have used similar arrangements over the last decade, teaming with investors in Sweden, Germany, Denmark and Japan.

The Southern California Rapid Transit District has a cross-border lease under way involving about 300 methanol-fueled buses. That agency, too, used a Cayman Islands company and Japanese investors. The RTD hopes to make $2 million.

Such transactions were encouraged by the Reagan Administration as a creative way for transit agencies to raise revenue from private sources.

Los Angeles officials decided in late 1988 to look into a cross-border lease after learning that New York transit officials had generated a $10-million profit.

Within months, transit commissioners in Los Angeles authorized a similar deal.

Staff members enlisted consultants around the world who ultimately billed the agency for about $1.7 million.

The expenses included more than $100,000 to set up and manage two Cayman Islands companies that would serve as conduits for lease payments to the Japanese investors.

Hundreds of thousands of dollars in banking fees were paid to Credit Lyonnais in Paris and Mitsubishi Bank in Singapore.

To help arrange the deal, Peterson traveled to Tokyo in the summer of 1989 to meet with potential investors. A group of unidentified individuals and companies, represented by an affiliate of Mitsubishi Bank, later would be selected.

The weeklong trip, costing $6,500, culminated with a visit to Sumitomo, where Peterson and his finance director dined at the company’s penthouse. In an exchange of gifts, the transit officials distributed Metro Rail pins and other mementos while receiving hand-held televisions.

Sumitomo’s goodwill became vital to the commission. The company had to reschedule its sale of rail cars to Los Angeles to coincide with the lease deal.

In return, the commission granted concessions to Sumitomo that cost the transit agency about $75,000.

By mid-1990, the Blue Line was opening and the lease deal was at a crossroads.

The transit agency, by all accounts, was showing a profit of $2.7 million. The commission had sold and leased back all but 22 of 54 cars.

Then bad news came from Japan: A change in tax law would force the commission to either revamp the final segment of the deal or abandon it.

Officials kept the deal alive through an innovative bond sale that complied with the new tax law. The decision proved to be a costly one.

The commission first had to form a new Cayman Islands company, Dia Railroad Leasing Ltd., and turn it over to the Japanese investors.

Using Dia, the investors then issued bonds to finance their purchase of the rail cars.

The commission, through its lease payments, is repaying the bond debt, plus a related debt in yen. The debt totals $33 million, payable at an annual interest rate of 6.9% over 16 years.

Significantly, that rate is much higher than the agency’s return on its own invested funds. This means the commission is losing money.

“The critical test is to compare what they are earning on their invested funds and what they’re spending on the amount borrowed,” said Moore, a tax attorney at Stroock & Stroock & Lavan who specializes in structuring offshore transactions.

In current dollars, Moore said, the extra cost to the commission is $5.9 million.

Porter said the commission did not use that test in concluding that the lease deal would make $3.4 million. He noted that the commission never calculates the cost of such interest rate disparities when using bond financing.

Richard P. Dominguez, the commission’s former finance director, said the opportunity for profit outweighed the risks. “My perspective was there was money on the table,” he said. “I decided it was a prudent step.”

The Times has calculated that the cost of the bond arrangement, plus consulting expenses, will wipe out the commission’s gain, putting it $3.9 million in the hole.

Attorney Paul A. Sczudlo, chairman of the Los Angeles County Bar Association’s foreign tax committee, said the bonds raise serious questions about the advisability of the deal.

“I have a question about whether a public agency should be experimenting with a bond issue involving a complex foreign tax shelter,” Sczudlo said.

Other tax experts said the bonds have exposed the agency to millions of dollars of potential taxes and penalties.

Moore said the bonds should not have been marketed as tax-exempt municipal securities because they were issued by a Cayman Islands company, not a government entity.

He said the commission could be held liable for any federal and state income taxes due on the interest paid to bond holders. That liability alone, Moore said, amounts to $11.2 million in current dollars. The commission’s own attorneys at White & Case cautioned in an opinion that “there can be no assurance” that the IRS will not challenge the tax status of the bonds. IRS officials in Washington declined to comment.

In an interview, Peterson said agency staff should have “highlighted” the tax opinion for the commission before entering the bond deal.

The deal poses a second potential tax problem that experts say could cost tens of millions of dollars: The agency has paid no withholding tax on its lease payments to the Japanese investors.

The deal was “carefully structured to avoid the imposition of withholding taxes,” Casimir C. Patrick II, a partner at White & Case, wrote the agency.

The law firm advised the agency in 1989 that the withholding issue poses “novel and complex” questions “subject to differing legal interpretations.”

Citing policy, IRS officials declined to comment on this specific case. Agent James Ashley, an accountant who specializes in examining offshore arrangements, said, “Transactions of this type would normally be subject to withholding.”

Meanwhile, cross-border leasing remains attractive to Los Angeles transit executives. They are considering a new deal for acquisition of 15 cars for use on the Green Line, linking Norwalk and El Segundo.

Tracking the Train Deal After purchasing 54 commuter rail cars from Japan’s Sumitomo Corp., transit officials entered into a complex international transaction designed to generate a large tax savings for Japanses investors and at least $4 million for the Los Angeles County Tansportation Commission. But The Times has found that the commission stands to lose up to $3.9 million and that the deal exposes the panel to millions of dollars in tax liability. 1. LACTC buys rail cars from Sumitomo Corp. 2. The cars are shipped to Los Angeles. 3. Cars are sold to a Cayman Islands company owned by Japanses investors. 4. The Cayman Islands company leases cars back to the LACTC. 5. The LACTC pays $1.7 million in consulting fees, mostly to New York City firms. THE PLAYERS Los Angeles County’s deal involved Japanese investors, Wall Street consultants and banks on three continents. These are the major participants: Los Angeles County Transportation Commission-he 11-member board has overseen construction of mass transit projects, which are funded by local sales taxes and government grants. Dia Railroad Leasing Ltd.-The Japanese-owned Cayman Islands company that entered into the arrangement. Documents show that 85% of the sydicate is controlled by Meiko Enterprises, which includes unidentified Japanese investors. The balance is controlled by Diamond Leasing Co. of Japan. Sumitomo Corp.-The Tokyo-based company that built 54 cars for use on the Long Beach-to-Los Angeles Blue Line. Sumitomo later was the focus of a “buy American” controversy over purchase of cars for the Green Line, a planned link between Norwalk and El Segundo.

BACKGROUND

The Los Angeles County Transportation Commission, run by an 11-member board, oversees construction of a regional commuter rail network. This Metro Rail system includes the Long Beach-to-Los Angeles Blue Line, the Red Line subway in downtown Los Angeles and the planned El Segundo-to-Norwalk Green Line. The multibillion-dollar project is funded by local sales taxes, bond proceeds, state gas taxes and federal grants. The commission and the Southern California Rapid Transit District are being merged to form the Metropolitan Transit Authority.