Friday, September 19, 2014
Last time we discussed the taxation of an inverting corporation.
There are three levels of tax severity to the corporation itself:
(1) The IRS ignores the inversion completely and continues to tax the foreign company as if it were a U.S. company
(2) The IRS will respect the foreign company as foreign, but woe to whoever tries to move certain assets out of the U.S. or otherwise use certain U.S. – based tax attributes for a period of 10 years.
(3) The IRS will respect the transaction without reservation.
Then there is the toll-charge on the shareholders. If they own more than 50% of the new foreign company, the shareholders will pay tax on their shares AS IF they had sold them rather than exchanged them for stock in the new foreign parent. The practical effect is that any inversion has to include cash to the U.S. shareholders, otherwise such shareholders would be reaching into their wallet to pay tax (and would likely vote to scuttle any inversion deal).
It was this toll charge that caught the attention of Congress. If you think about it, someone owning actual shares would be taxed, but someone having a future right to shares would not. Who would such a person be? How about corporate insiders: management and directors? Executives frequently receive stock options and other stock-based compensation. Congress felt that management and directors should also have “skin in the game,” thus the origin of Section 4985.
One quickly realizes the parity Congress wanted:
(1) First, Section 4985 applies only if gain is realized by any shareholder. If there is no toll charge on the shareholders, then there will be no toll charge on management and directors.
(2) The Section 4985 tax will be the highest tax rate payable by the shareholders, which is the capital gains rate (15%)
There is some technical lingo in here. The tax Code dragnets all individuals “subject to the requirements of Section 16(a) of the Securities Exchange Act of 1934” – in short, the officers, directors and 10% shareholders. It also includes their families.
So Congress wanted insiders to also pay tax. That’s great. I wanted to play in the NFL.
Let’s take a look at another Congressional attempt to “rope in” executive pay: the golden parachute limitations of Section 280G. This tax applies to “excess” compensation payments upon a change in corporate control. The insider is allowed a base amount (defined as average annual compensation for the five years preceding the year of change in control). The excess is subject to an additional 20% excise tax – in addition to the payroll and income taxes already paid.
How does it work away from the fever swamp of Washington?
It doesn’t. Corporations routinely “gross-up” the executive compensation until the tax is shifted back to the corporation.
I suspect that every tax accountant has run into a compensation “gross up” exercise. I have done enough over the years to make my eyes cross.
Let’s return to our inversion discussion. What do you think companies are doing when their executives are subjected to the 15% Section 4985 excise tax?
Yep, the gross-up.
The mathematics of a gross-up are terrible. Let’s take the example of someone who is subject to the maximum federal tax rate (39.6%), add in the ObamaCare Medicare tax (0.9%), the Section 4985 tax itself (15%) and a state tax (say 6%), and 61.5% of every dollar is going to tax (I am leaving out the deductibility of the state tax). If I am to gross-up a payroll, I am saying that only 38.5 cents of every dollar will be available to satisfy the original Section 4985 tax liability. This means that the gross-up will have to be $2.60 (that is, 1 divided by 38.5%) for every dollar of the original Section 4985 tax.
But Congress, never willing to leave a bigger mess undone, added yet another twist to Section 4985: the corporation is not allowed to deduct the gross-up. Let’s say that the excise tax was $1 million. The gross-up would be $2.6 million, none of which is deductible by the company.
Medtronic is a medical device maker based in Minneapolis. It operates in more than 120 countries and employs approximately 50,000 people worldwide. It has agreed to acquire Covidien, an Irish medical device company. Since we are talking about inversions, you can surmise that the new parent will be based in Ireland. For its part, Medtronic says it will be leaving its Minneapolis-based employees in Minneapolis, which makes sense when you consider that they have employees located throughout the planet.
Medtronic will of course continue to pay U.S. tax on its U.S. income. What it won’t do is pay U.S. tax on income earned outside the U.S. This is not an unreasonable position. Think about your response if California tried to tax you because you drank Napa Valley wine.
Medtronic triggered the Section 4985 excise tax on its executive officers and directors. This tax is estimated to be approximately $24 million.
Remember the loop-the-loop involved with a gross-up. How much will it cost Medtronic to gross-up its insiders for the $24 million?
Around $63 million.
None of which Medtronic can deduct on its tax return.
Can you explain to me how this can possibly be good for the shareholders of Medtronic? It isn’t, of course.
Way to play masters of the universe, Congress.
Friday, September 12, 2014
You may have read recently that Burger King is acquiring Tim Hortons Inc, a Canadian coffee and donut chain. What has attracted attention is the deal is structured as an inversion, which means that the American company (Burger King) will be moving its tax residency to Canada. I suppose it was hypothetically possible that the deal could have moved Tim Hortons Inc to the U.S. (think of it as a reverse inversion), but that would not have drawn the attention of the politicians.
The combined company will be the world’s third-largest fast-food company, right behind McDonalds and Yum! Brands (think KFC and Taco Bell). While the U.S. will have by far the largest number of locations, the majority of the revenue – again by far – will be from Canada.
An issue at play is that U.S. companies face a very harsh tax system, one in which they are to pay U.S. tax on all profits, even if those profits originated overseas and may never be returned to the U.S. Combine that with the world’s highest corporate tax rate, and it becomes fairly easy to understand why companies pursue inversions. In certain industries (such as pharmaceuticals), it is virtually imperative that the some part of the company be organized overseas, as the default tax consequences would be so prohibitive as to likely render the company uncompetitive.
Let’s talk a bit about inversions.
Inversions first received significant Congressional scrutiny in the 1980s, when McDermott Inc did the following:
· McDermott organized a foreign subsidiary, treated as a controlled foreign corporation for U.S. tax;
· The subsidiary issued stock in exchange for all the outstanding stock of McDermott itself; and
· Thus McDermott and its subsidiary traded places, with the subsidiary becoming the parent.
In response Congress passed IRC Sec 1248(i), requiring any future McDermott to report dividend income – and pay tax – on all of its subsidiary’s earnings and profits (that is, its undistributed profits).
In the 1990s, Helen of Troy Corp had its shareholders exchange their stock for stock of a new foreign parent company.
In response the IRS issued Reg 1.367(a)-3(c), requiring the U.S. shareholders to be taxable on the exchange because they owned more than 50% of the foreign company after the deal was done.
In the aughts, Valeant Pharmaceuticals paid a special dividend to its shareholders immediately before being acquired by Biovail, a Canadian corporation. Valeant paid out so much money - thereby reducing its own value - that the Valeant shareholders owned less than 50% of the foreign company.
Interesting enough, this did not (to the best of my knowledge) draw a government response. There is a “stuffing” rule, which prohibits making the foreign corporation larger. There is no “thinning” rule, however, prohibiting making the U.S. company thinner.
Then there was a new breed of inversions. Cooper Industries, Nabors Industries, Weatherford International and Seagate Technologies did what are called “naked” inversions. The new foreign parent incorporated in the Cayman Islands or Bermuda, and there was no effort to pretend that the parent was going to conduct significant business there. The tax reason for the transaction was stripped for all to see – that is, “naked.”
That was a bridge too far.
Congress passed IRC Sec 7874, truly one of the most misbegotten sections in the tax Code. Individually the words make sense, but combine them and one is speaking gibberish.
Let’s break down Section 7874 into something workable. We will split it into three pieces:
(1) The foreign company has to acquire substantially all the assets of a domestic company. We can understand that requirement.
(2) The U.S. shareholders (referred to “legacy” shareholders) own 60% or more of the foreign parent. There are three sub-tiers:
a. If the legacy shareholders own at least 80%, the IRS will simply declare that nothing occurred and will tax the foreign company as if it were a U.S. company;
b. If the legacy shareholders own at least 60% but less than 80%, the IRS would continue to tax the foreign company on its “inversion gain” for 10 years.
i. What is an “inversion gain?” It involves using assets (think licenses, for example) to allow pre-inversion U.S. tax attributes to reduce post-inversion U.S. tax. The classic tax attribute is a net operating loss carryover.
c. If the legacy shareholders own less than 60%, then Section 7874 does not apply. The new foreign parent will generally be respected for U.S. tax purposes.
But wait! There is a trump card.
(3) The IRS will back off altogether if the foreign company has “substantial business presence” in the new parent’s country of incorporation.
There is something about a trump card, whether one is playing bridge or euchre or structuring a business transaction. The tax planners wanted a definition. Initially the IRS said that “substantial business presence” meant 10% of assets, sales and employees. It later changed its mind and said that 10% was not enough. It did not say what would be enough, however. It said it would decide such issues on “facts and circumstances.” This sounds acceptable, but to a tax planner it is not. It is the equivalent of saying that one need not stop at a stop sign, as long as one is not “interfering” with traffic. What does that mean, especially when one has family in the car and is wondering if the other driver has any intention of stopping?
After three years the IRS said that it thought 25% was just about right. Oh, and forget about any “facts and circumstances,” as the IRS did not want to hear about it.
The 25% test was a cynical threshold, figuring that no one country – other than the U.S. – could possibly reach 25% by itself. Even the E.U. market – which could rival the U.S. – is comprised of many individual countries, making it unlikely (barring Germany, I suppose) that any one country could reach 25%.
Until Pfizer attempted to acquire AstraZeneca, a U.K. based company. The White House then proposed reducing the 80% test to a greater-than-50% test and eliminating the 60% test altogether. It also wanted to eliminate any threshold test if the foreign corporation is primarily managed from the United States.
The Pfizer deal fell through, however, and there no expectation that this White House proposal will find any traction in Congress.
And there is our short walk through the minefield of tax inversions.
There is one more thing, though. You may be wondering if the corporate officers and directors are impacted by the tax Code. Surely you jest- of course they are! There is a 15% excise tax on their stock-based compensation. How does this work out in the real world? We will talk about this in our next blog, when we will discuss the Medtronic – Covidien merger.
Saturday, September 6, 2014
Have you heard of Windstream Holdings?
They are a telecommunications company – that is, a phone company – out of Little Rock, Arkansas. They made the tax literature recently by getting IRS approval to put some of its assets in a real estate investment trust, abbreviated “REIT” and pronounced “reet.”
So what is a REIT?
REITs entered the tax Code in 1960. For decades they have been rather prosaic tax vehicles, generally housing office buildings, apartment complexes and warehouses.
Yep, they invest in real estate.
REITS have several tax peculiarities, one of which has attracted planners in recent years. To qualify as a REIT, an entity must be organized as a corporation, have at least 100 shareholders, invest at least 75% of its assets in real estate and derive at least 75% of its income from the rental, use or sale of said real estate. Loans secured primarily by interests in real property will also qualify.
REITS must also distribute at least 90% of their taxable income in the form of shareholder dividends.
Think about this for a second. If a REIT did this, it would not have enough money left over to pay Uncle Sam its tax at the 35% corporate tax rate. What gives?
A REIT is allowed to deduct shareholder distributions from its taxable income.
The REIT can do away with its tax by distributing money. This is not quite as good as a partnership, which also a non tax-paying vehicle. A partnership divides its income and deductions into partner-sized slices. It reports these slices on a Schedule K-1, which amounts the partners in turn include on their personal tax returns. An advantage to a partner is that partnership income keeps its “flavor” when it passes to the partner. If a partnership passes capital gains income, then the partner reports capital gains income – and pays the capital gains rather than the ordinary tax rate.
This is not how a REIT works. Generally speaking, REIT distributions are taxed at ordinary tax rates. They do not qualify for the lower “qualified dividend” tax rate.
Why would you invest in one, then? If you invested in Proctor & Gamble you would at least get the lower tax rate, right?
Well, yes, but REITs pay larger dividends than Proctor & Gamble. At the end of the day you have more money left in your pocket, even after paying that higher tax rate.
So what has changed in the world of REIT taxation?
The definition of “real estate.”
REITs have for a long time been the lazy river of taxation. The IRS has not updated its regulations for decades, during which time technological advances have proceeded apace. For example, American Tower Corp, a cellphone tower operator, converted to a REIT in 2012. Cell phones – and their towers – did not exist when these Regulations were issued. Tax planners thought those cell towers were “real estate” for purposes of REIT taxation, and the IRS agreed.
Now we have Windstream, which has obtained approval to place its copper and fiber optic lines into a REIT. The new Regulations provide that inherently permanent structures will qualify as REIT real estate. It turns out that that copper and fiber optic lines are considered “permanent” enough. The IRS reasoned, for example, that the lines (1) are not designed to be moved, (2) serve a utility-like function, (3) serve a passive function, (4) produce income as consideration for the use of space, and (5) are owned by the owner of the real property.
I admit it bends my mind to understand how something without footers in soil (or the soil itself) can be defined as real estate. The technical issue here is that certain definitions in the REIT area of the tax Code migrated there years ago from the investment tax credit area of the tax Code. There is tension, however. The investment tax credit applied to personal property but not to real property. The IRS consequently had an interest in considering something to be real property rather than personal property. That was unfortunate if one wanted the investment tax credit, of course. However, let years go by … let technology advance… let a different tax environment develop … and – bam! - the same wording gets you a favorable tax ruling in the REIT area of the Code.
Is this good or bad?
Consider that Windstream’s taxable income did not magically “disappear.” There is still taxable income, and someone is going to pay tax on it. Tax will be paid, not by Windstream, but by the shareholders in the Windstream REIT. I am quite skeptical about articles decrying this development as bad. Why - because a corporate tax has been replaced by an individual tax? What is inherently superior about a corporate tax? Remember, REIT dividends do not qualify for the lower dividends tax rate. That means that the REIT income can be taxed as high as 39.6%. In fact, it can be taxed as high as 43.4%, if one is also subject to the ObamaCare 3.8% tax on unearned income. Consider that the maximum corporate tax is 35%, and the net effect of the Windstream REIT spinoff could be to increase tax revenues to the Treasury.
This IRS decision has caught a number of tax planners by surprise. To the best of my knowledge, this is the first REIT comprised of this asset class. I doubt it will be the last.
Friday, August 29, 2014
Let’s travel to the Bay State for a taxpayer requesting reasonable cause against the imposition of penalties.
The amount in dispute is $100.
Yes, you read that correctly.
Our protagonist is Jonathan Haar, and he lives in Massachusetts. On April 15, 2011 he had the audacity to file a paper extension and include a $19,517 check for his tax year 2010 state return. The paper extension and payment
“… did not comply with the requirements set forth in Technical Information Release (“TIR”) 04-30 (“TIR 04-30”), which states that if a payment accompanying an extension application equals $5,000 or more, such extension application and payment must be submitted electronically.”
Got it. The state says that it is less expensive to process electronic than paper tax filings and payments. Seems reasonable. How do we get people to follow along, however? One way is to make whatever the state wants mandatory.
Our protagonist unfortunately had travelled this path before, and he had been warned for tax year 2005 and penalized for year 2006. Massachusetts had a tax recidivist! They assessed the above-mentioned $100 penalty on our ne-er-do-well.
If you were my client, I would have told you to pay the $100 and move on. Mr. Haar is not my client, and he refused to pay. He instead filed an appeal, which appeal went to the Massachusetts Appellate Tax Board.
“Mr. Haar maintained that the Commissioner’s electronic payment mandate is a ‘serious invasion of both [his] privacy and [his] personal business practices,’ as it exposes his finances to risk of cyber attack.”
“I intentionally do no electronic banking nor direct bill paying, I have none of my credit cards linked to my bank accounts directly and I think anyone who does any of the above is exposing themselves to multiple risks of cybercrime and identity theft.”
Mr. Haar further expressed doubts as to the security of the computer systems used by the Department of Revenue (“DOR”), noting that "if the Pentagon can be hacked," he had little confidence that DOR could protect his – or anyone’s – personal data from theft.
Massachusetts argued that it had the authority to mandate electronic filing and payment, as well as assess penalties if a taxpayer failed to comply with their filing and payment mandates. Massachusetts does recognize exceptions for reasonable cause, but its own Administrative Procedure 633 (“AP 633”) provides that
… the fact that a taxpayer does not own a computer or is uncomfortable with electronic data or funds transfer will not support a claim for reasonable cause.”
COMMENT: Call me quaint, but I would say that someone not having a computer is prima facie reasonable cause for not being able to file an electronic return or transfer funds electronically. The issue I see with AP 633 is its absolutism: the language “will not support” leaves no room. Why not say instead “generally will not support,” if only to allow space for unexpected fact patterns?
In support of its position, the DOR trotted out two officials: the first was Robert Allard, a tax auditor. He pointed out that Mr. Haar filed an electronic return, presumably through a professional preparer. I suppose that Mr. Allard felt that if one could electronically file then one should be able to electronically pay.
The second was Theresa O’Brien-Horan, a 26-year employee and Deputy Commissioner, who testified that
… the mandate at issue in this appeal – requiring individual taxpayers who apply for an extension with an accompanying payment of $5,000 or more to file and pay electronically – is helpful to DOR because it maximized up-front revenue intake.”
… the $5,000 threshold was chosen because it would ‘impact 17% of the taxpayers, but … get the money banked for 84% of the revenue.”
You can virtually feel the customer service vapor emanating from Ms O’Brien- Horan.
When asked whether reasonable cause was the Massachusetts equivalent of an ”opt out,” Ms. O’Brien-Horan answered “yes.”
OBSERVATION: The IRS, for example, prefers that one file an electronic return. The IRS however did not put the burden on the taxpayer; rather it put the burden on the preparer. If a preparer prepares more than a minimal number of returns annually, the preparer is required to file the returns electronically. This is awkward, as the return belongs to the taxpayer and not to the preparer. The preparer is not allowed to release any return – even to the IRS – without the taxpayer’s approval. What does the preparer do if the taxpayer does not grant approval? The preparer includes yet-another-form with the return indicating that the taxpayer has “opted out.” This prevents the IRS from penalizing the preparer for not filing electronically.
If Mr. Haar’s position was reasonable, then Mr. Haar could “opt out,” irrespective of any self-serving Massachusetts Administrative Procedure.
Ms. O’Brien-Horan just didn’t think that Mr. Haar was being reasonable.
But the Board did.
“Given his reference to the hacking of the Pentagon’s computer system, and in light of the many well-publicized instances of large-scale thefts of financial information following computer breaches at businesses and other institutions, and the appellant’s consistent practice of avoiding electronic payment of all his bills, including his tax obligations, the Board found that the appellant’s failure to utilize the Commissioner’s mandated electronic tax payment to be reasonable.”
Two things strike me immediately.
The first is the cause for concern comprising Mr. Haar’s argument. It had not occurred to me to off-grid all of one’s banking transactions, but he gives one pause. I recently read the following on www.marketwatch.com, for example:
A Russian gang has stolen 1.2 billion user names and their passwords as well as more than 500 million email addresses, the New York Times reports.
The information came from more than 400,000 websites, according to the Times, which says researchers at Milwaukee-based Hold Security discovered the cyber heist.
Mr. Haar is highly cautious. His position is somewhat eccentric but not unfounded. A reasonable tax collection agency would have granted him this one and moved on.
The second is the inanity of Massachusetts DOR. Rather than abate a $100 penalty, it preferred to pursue the matter, at who knows what cost to state and citizens. We know that cost would include Mr. Allard and Ms O’Brien-Horan’s payroll, not to mention that of their superiors, legal counsel and who-knows-what else. I can understand not wanting to set a precedent, but … really? My take is that the DOR is too well-funded if they have the time and money to pursue nonsense like this. Perhaps DOR budgets cutbacks are in order for Massachusetts.