Nortel US overpayment of $2B to Nortel Canada from 2001 to 2005

Story by James Bagnall in the Ottawa Citizen.

Court documents filed this week suggest that Nortel's U.S. subsidiary overpaid by $2 billion for R&D and other services provided by the Canadian subsidiary from 2001 to 2005. A court filing said this was "despite the best efforts of the Nortel companies to accurately calculate payments" under a cross-border transfer pricing agreement. Like other multinationals, Nortel uses a system of accounting that allocates costs and profits among its divisions according to a formula negotiated with the various tax authorities.

The overpayment by Nortel's U.S. unit vastly increased its costs and reduced the taxes owing. This was the basis, in part, for a massive claim submitted in August by the Internal Revenue Service, which sought $1.8 billion in taxes owing from 1998 to 2008 and $1.2 billion in penalties.

However, earlier this week, the IRS settled this claim in exchange for a cash payment of $37.5 million and an understanding that Nortel's Canadian and U.S. subsidiaries will negotiate unresolved transfer pricing issues with their respective tax authorities. It's not clear what amounts would be involved in such a settlement. The court documents note merely that taxes owed by the U.S. subsidiary would rise while those owed by the Canadian unit would drop.

Of great concern to Nortel's Canadian creditors – suppliers, retirees and employees on long-term disability -- is a separate condition attached to the deal with the IRS. Nortel's Canadian subsidiary will recognize a $2.1 billion claim against its assets by the company's U.S. unit, in recognition of the overpayments for R&D and other services over the years.

If such a claim succeeded, it would substantially dilute the amount of money available for the other Canadian creditors. However, it's still not known what percentage of the $3 billion in proceeds from the sale of Nortel assets will be allocated to Canada. The money for the moment is held in escrow, to be distributed when all the company's assets have been sold, probably by mid-2010.