February 02, 2005

By David Henry One way Warren E. Buffett became the world’s most successful investor was by understanding how putting off tax payments can build wealth. Every year in the owner’s manual he includes with Berkshire Hathaway (BRK-A) annual reports, he spells out the advantages of deferred tax liabilities over ordinary debt. His essays show how Berkshire boosts returns by keeping cash invested as long as practical until sending it to the U.S. Treasury.

Now, with his Jan. 28 backing of Procter & Gamble’s (PG) novel two-step, tax-free deal for Gillette (G), Buffett is again seizing an opportunity to exit a position without triggering a giant tax bill. Berkshire’s gain on the 96 million Gillette shares it has held since 1989: $4.3 billion. Yet because it is plowing all of that gain into shares of the new company, Uncle Sam will have to wait for his piece of the profits.

MODEL APPROACH. Exactly who suggested the deal structure is not clear. Neither Buffett, Gillette’s largest shareholder, nor the investment bankers involved would comment. Given Buffett’s well-known aversion to taxes, though, bankers most likely devised the structure to satisfy him while also preventing an all-stock deal from drastically watering down P&G’s earnings.

Just as important, the ingenious structure could become a Wall Street model for future mergers and acquisitions. At the same time it comes with a lesson about what investors can and can’t learn from watching Buffett.

Think of the deal as a two-step jig: The first movement makes Buffett happy, while the unusual second step pleases P&G. First, P&G will pay for Gillette with nothing but stock, issuing 0.975 shares of its common stock for each Gillette share. Gillette investors will owe no tax since they’re exchanging one stock for another. If, instead, P&G had paid for Gillette with cash, Berkshire alone would have faced a whopping $1.5 billion tax bill thanks to the 35% corporate rate it pays.

TWO-STEP MANEUVER. Problem is, all that new stock will dilute the value of the shares P&G’s current investors hold and slash its earnings per share. So as part of the deal P&G announced that it will spend $18 billion to $22 billion over the next 12 months to 18 months buying back some of the stock it just issued for Gillette. The result, says P&G, is the same as if it had paid for Gillette with a package of 60% stock and 40% cash.

Why not just structure a 60-40 deal in the first place? Because that could leave many Gillette shareholders with an unwanted tax bill, as happened to Buffett in 1996. Then, Capital Cities/ABC Inc. in which Buffett held a $2.2 billion unrealized profit, sold out to Walt Disney (DIS). Disney agreed to pay partially in stock, but when the Disney shares were divided among all Cap Cities shareholders who wanted them, Buffett ended up with half his money in cash — and a tax bill of some $400 million.

P&G’s two-step gets around that. Gillette shareholders can keep as much stock as they want, controlling when their taxes come due. Tax-exempt pension funds or others who want to cash out can sell in the open market whenever they choose. And because P&G will be spending billions on the buyback, there’s less risk that a wave of investors selling out will send the shares tumbling. It is very democratic, says Lawrence A. Cunningham, professor of law and business at Boston College and the editor of a book of Buffett’s essays.

LESS RISK. Of course, tax concerns are not all that drives Buffett’s decisions. He has proven that by selling winning positions for cash, such as stakes in Disney and Freddie Mac (FRE). Still, given the huge capital gains — and deferred taxes — Berkshire has racked up on key holdings such as American Express (AXP) and Coca-Cola (KO), they are clearly important. And taxes should be a bigger concern to Buffett than to many others: Berkshire’s 35% corporate rate is more than twice the 15% individuals pay on capital gains.

Therein lies a lesson for investors trying to piggyback on Buffett’s picks. Many assume that if he owns a stock, it’s worth buying. But because Berkshire’s tax rate is so high, Buffett bears less risk holding overpriced stocks. After tax, he would give up only 65% of profits foregone by not selling at a high, while an individual would forfeit 85%.

By the same token, on those occasions when he does sell and offer Uncle Sam his 35% cut, he’s sending a loud signal that the outlook is bleak. But since Buffett never reveals what he’s selling until he’s done, it’s hard to play copycat. Investors are better off trying to learn how Buffett thinks. Henry is a senior writer for BusinessWeek in New York