Prem Watsa’s Fairfax Financial Holdings (TSE:FFH) may be in trouble with the IRS concerning a tax break it received by offsetting the income it received from Odyssey Re Holdings Corporation against losses at Fairfax. The possible infringement occurred from 2003 to 2006 and involved a tax break of $400 million USD. The new complaint received by the IRS’s Whistleblower Office by a Hedge Fund was reported by the New York Times yesterday. The IRS has so far declined to comment on its willingness to investigate the allegation. If they do find any supporting evidence however they would certainly be interested in trying to retake that money from Fairfax.

The controversy concerns a tax break given to Fairfax after consolidating its tax years between 2003 and 2006 and the question at the centre of the problem is whether or not Fairfax owned enough of Odyssey in 2003 in order to be able to legitimately claim the tax breaks it received. The company would have needed to own 80% of the shares in order to do so. Evidence of problems with the claim were brought to light in a suit Fairfax filed against several hedge funds it accused of manipulating its share price. The case has been running for five years and has brought to light practices from both sides which have been deemed questionable.

The mechanism Fairfax used in order to obtain the shares was a complicated one. They gave an i.o.u to a Cayman Islands Bank of America subsidiary. That company then borrowed $78 million worth of Odyssey Re shares and transferred them to Fairfax. $78 million was the exact amount needed to reach an 80% ownership in the company and so legally consolidate its earnings. One opinion, espoused by Edward D. Kleinbard, a tax law expert, in the case brought against the funds is that Fairfax obtained the shares for no business reason but only to avoid the taxes it would have had to pay otherwise. Kleinbard was an expert witness called by the defense and this was used to undermine the credibility of his opinion by the representative of Fairfax Michael Bowe.

The deal was organised by Bank of America rather than Fairfax. It also received a clean tax opinion from Ernst & Young. Their involvement in the transaction was also brought into question. An executive from Bank of America named Robert Giammarco had expressed his doubts over the transaction in an email sent in 2003. He had said that the deal did not give Fairfax full economic ownership of the shares. Apparently he changed his mind afterward, working as an executive in Odyssey between 2005 and 2006. Much of that time was spent as the company’s CFO.

This is not the first piece of damaging evidence to come out of the case. The suit involves Dan Loeb, Chairman of Third Point Ventures LLC, as a defendant and it has revealed an extremely adversarial relationship between between Fairfax and Loeb. In emails which leaked last year and were sent in 2006 Loeb had written “die Prem die” among other things. The other defendants include Adam Sender, James Chanos and Steven Cohen, some of the biggest fund operators out there. The suit claims that the Fund managers had teamed up to lower Fairfax’s share price. That particular quote was taken from an email sent by Loeb to Sender in June 2006.

The questions surrounding the Odyssey Re deal and the tax credits resulting from it is one that may well be investigated by the IRS. Depending on how they value the credibility of the claim, and if Kleinbard’s testimony is studied and used as support it very well might be, they would be hard pressed for an excuse for not hunting a $400 million debt. If the IRS does indeed go after the cash it would mean trouble for Prem and Fairfax. The company has had many of the funds dismissed from its suit including Loeb’s and Cohen’s after a Judge said they could not be tried in New Jersey or declared the allegations baseless. Meanwhile the court is still hearing damaging evidence against Prem’s Fairfax which may lead to further action against the group.