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.
Yipes!
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.
