Wednesday, October 9, 2013

Why Would a 100+ Year-Old Ohio Company Move To Ireland?

Consider the following statements:

  • Eaton Corp acquired Cooper Industries for $13 billion, the largest acquisition in the Cleveland manufacturer's 101-year history.
  • Cooper Industries is based in Houston and incorporated in Ireland.
  • Eaton Corp incorporated a new company in Ireland - Eaton Corp., plc.
  • Eaton Corp will wind up as a subsidiary of Eaton Corp. plc.
  • The new company will have about 100,000 employees in 150 countries. It will have annual sales in excess of $20 billion.

This transaction is called an inversion. Visualize it this way: the top of the ladder (Eaton Corp) now becomes a subsidiary – that is, it moved down the ladder. It inverted.


To a tax planner this is an “outbound” transaction, and it brings onto the pitch one of the most near-incomprehensible areas of the tax code – Section 367. This construct entered the Code in the 1930s in response to the following little trick:

  1. A U.S. taxpayer would transfer appreciated assets to a foreign corporation in a tax haven country. Many times these assets were stocks and bonds, as they were easy to sell. Believe it or not, Canada was a popular destination for this.
  2. The corporation would sell the assets at little or no tax.
  3. The corporation, flush with cash, would merge back into a U.S. company.
  4. The U.S. taxpayer thus had cash and had deftly sidestepped U.S. corporate tax.

OBSERVATION: It sounds like it was much easier to be a tax planner back in the 1930s.

The initial concept of Section 367 was relatively easy to follow: what drove the above transactions was the tax planner’s ability to make most or all the transactions tax-free.  To do this, planners primarily used corporations. This in turn allowed the planner to use incorporations, mergers, reorganizations and divisives to peel assets away from the U.S.  Congress in turn passed this little beauty:

            367(a)(1)General rule.—
If, in connection with any exchange described in section 332, 351, 354, 356, or 361, a United States person transfers property to a foreign corporation, such foreign corporation shall not, for purposes of determining the extent to which gain shall be recognized on such transfer, be considered to be a corporation.

Congress said that – if one wanted to play that appreciated-stock-to-a-Canadian-company game again - it would not permit the Canadian company to be treated as a corporation. As the tax-free status required both parties to be corporations, the game was halted. There were exceptions, of course, otherwise legitimate business transactions would grind to a halt. Then there were exceptions to exceptions, which the planners exploited, to which the IRS responded, and so on to the present day.

By 2004 the planners had gotten very good. Congress passed another law – Section 7874 – to address inversions. It introduced the term “surrogate foreign corporation,” which – as initially drafted – could have pulled a foreign corporation owned by foreign investors with no U.S. operations or U.S. history into the orbit of U.S. taxation. How?

Let’s look at this horror show:

7874(a)(2)(B)Surrogate foreign corporation.—
A foreign corporation shall be treated as a surrogate foreign corporation if, pursuant to a plan (or a series of related transactions)—
the entity completes … the direct or indirect acquisition of substantially all of the properties … held directly or indirectly by a domestic corporation or substantially all of the properties … of a domestic partnership,
after the acquisition at least 60 percent of the stock … is held by former shareholders of the domestic corporation by reason of holding stock in the domestic corporation,
after the acquisition the …entity does not have substantial business activities in the foreign country … when compared to the total business activities of such expanded affiliated group.

How can this blow up? Let me give you an example:
  • Foreign individuals form a domestic U.S. corporation (Hamilton U.S.) under the laws of Delaware.
  • Hamilton U.S. makes a ton of money (not relevant but it makes me happy).
  • All shareholders of Hamilton U.S. are either nonresident aliens or a foreign corporation (Hamilton International) also owned by the same shareholders.
  • The shareholders have never resided nor have any other business interest in the U.S.
  • Hamilton International was formed outside the U.S. and has no other business interest in the U.S.
  • The shareholders decide to make Hamilton U.S. a subsidiary of Hamilton International.
  • The shareholders have a Board meeting in Leeds and transfer their shares in Hamilton U.S. to Hamilton International. They then head to the pub for a pint.

Let’s pace this out:
  • Hamilton U.S. would be subject to U.S. taxation on its operations, as the operations occur exclusively within the U.S. This result is not affected by who owns Hamilton U.S.
  • We will meet the threshold of 7874(a)(2)(B)(i) as a foreign corporation acquired substantially all (heck, it acquired all) the properties of a domestic corporation.
  • We will meet the threshold of 7874(a)(2)(B)(ii) as more than 60% of the shareholders remain the same. In fact, 100% of the shareholders remain the same.
  • We will meet the threshold of 7874(a)(2)(B)(iii) as the business activities are in the U.S., not in the foreign country.
We now have the possibility – and absurdity – that Hamilton International is a “surrogate foreign corporation” and taxable in the U.S. Granted, in our example this doesn’t mean much, as Hamilton International’s only asset is stock in Hamilton U.S., which has to pay U.S. tax anyway. Still, it is an example of the swamp of U.S. tax law.

Let’s get back to Eaton.
Why would Eaton make itself a subsidiary of an Irish parent?
It is not moving to Ireland. Eaton will retain its presence in northern Ohio, and Cooper will remain in Houston. Remember that business activities in the United States will be taxable to the U.S., irrespective of the international parent. What then is the point of the inversion? The point is that more than one-half the new company will be outside the U.S., and the international parent keeps that portion away from the IRS. Remember also that Ireland has a 12.5% tax rate, as opposed to the U.S. 35% rate.

There is another consideration. Placing Eaton in Ireland allows the tax planners to move the treasury function outside the U.S. What is a treasury function? It is lingo for the budgeting, management and investment of cash. Considering that this is a $20 billion company, there is a lot of cash flow. Treasury is a candidate for what has been called “stateless” income.
There is more. Now the development of patents and intellectual property can now be sitused outside the United States. By the way, this is a key reason why virtually all (if not all) pharmaceutical and technology companies have presence outside of the United States. It is very difficult to create intellectual property in the U.S. and then move it offshore. How does a tax advisor plan for that? By never placing the intellectual property in the U.S.
And the point of all this: Eaton has estimated that the combined companies would realize annual tax savings of about $160 million by 2016.

In 2002, Senator Charles Grassley, then the top Republican on the Finance Committee, called inversion transactions “immoral.”  That ironically was also the year that Cooper Industries inverted to Bermuda, and it later moved to Ireland. The Obama administration has proposed disallowing tax deductions for companies moving outside the United States. Nothing has come of that proposal.

The U.S. policy of worldwide taxation goes back to the League of Nations, when the U.S. thought that advanced nations would eventually move to its side. That did not happen, and with time, many nations moved instead to a territorial system. The U.S. is now the outlier. Our tax policy now presumes irrational economics. I am not going to advise a client to pay more tax just because Senator Grassley thinks they should. 

I will take this step further: many tax planners believe that it may be malpractice NOT to consider placing as much activity offshore as reasonably possible. There is more than a snowball’s chance that I could be sued for advising a client as the Senator wants.

I am glad that Eaton kept its jobs in Ohio. It is unfortunate that it had to go through these gymnastics, though.

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