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)—

7874(a)(2)(B)(i) 

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,

7874(a)(2)(B)(ii) 

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,

7874(a)(2)(B)(iii) 

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.

Changes In Ohio Taxes Beginning In 2013

Ohio Governor John Kasich on June 30, 2013 signed Ohio House Bill 59, which made significant changes to Ohio taxes.  

Individual Income Tax Decrease

 Individual income tax rates will be cut 10% over three years.

The $20 personal exemption credit will be available only to taxpayers with Ohio taxable income under $30,000.

Sales Tax Increase

Effective September 1, 2013 Ohio’s sales and use tax rate will increase to 5.75% (from 5.5%)

Minimum Commercial Activities Tax (CAT) Increase

The Commercial Activity Tax (CAT) was previously $150 on the first $1 million in annual gross receipts, regardless of total annual gross receipts. The CAT tax on the first $1 million will now vary depending on the taxpayer’s total annual gross receipts. The new minimums are as follows:

• $1 million or less in annual gross receipts – $150
• From  $1 million to $2 million in annual gross receipts – $800
• From $2 million to $4 million in annual gross receipts – $2,100
• More than $4 million in annual gross receipts – $2,600

Please note that the above apply only to first $1 million in annual gross receipts. Receipts over $1 million will continue to be taxed at a 0.26 percent rate.

 Small Business Income Deduction

There is a new tax deduction for small business income starting in 2013. The deduction will be the lesser of $125,000 ($62,500 per spouse if filing separately) or 50% of the small business income includable in federal adjusted gross income.

 The deduction will apply to sole proprietors as well as to investors in passthrough entities.

The deduction will not be available to trusts and restates.

 New Ohio Earned Income Tax Credit

New for 2013, the new credit will be equal to 5% of the federal tax credit.

New Sales Tax on Downloads

Beginning in 2014, sales tax will apply on downloads of music, books and videos.

Ohio Offers Two Tax Amnesties

As part of the 2012/2013 budget bill, Ohio has authorized a general amnesty for selected state taxes, including personal income, school district, sales and commercial activity taxes.

This is an attractive amnesty program, although it does have one significant drawback. Under the program Ohio will abate all penalties and one-half the interest. Taxes eligible for the amnesty must have been due and payable as of May 1, 2011. This means that a 2010 individual income tax will be eligible (as it was due April 15, 2011), but a May 2011 sales tax return would not (as it was due June 23, 2011). In addition, you cannot have been previously contacted by Ohio.

Ohio expects full payment when you file these tax returns. Remember – this is a revenue raiser for the state.

The significant drawback? The general amnesty window is very brief: from May 1 to June 15, 2012.

There is a separate use tax amnesty that runs from October 1, 2011 to May 1, 2013.

Note: Use tax applies to purchases of taxable products or taxable services where the seller did not collect the Ohio sales tax. The use tax applies both to individuals and businesses. The use tax is the cousin to the Ohio sales tax. It serves to prohibit one from avoiding Ohio sales tax by purchasing items from another state (free of sales tax) and then bringing them into Ohio.

If one pays all use tax due on or after January 1, 2009, Ohio will waive or abate use tax owed for prior periods. There is also a non-interest payment program available for businesses not previously registered for use tax, although this option requires an officer to personally guarantee the tax debt. On the plus side, Ohio will allow the business up to seven years to pay the back taxes. Once again, you cannot have been previously contacted by Ohio.

The New InvestOhio State Tax Credit

The recent Ohio biennial budget bill included an income tax credit for investments in qualifying small businesses.  This was a late addition, and it was made in response to some rather depressing statistics about Ohio business over the last decade:

·         Ohio has lost more jobs than any state other than California and Michigan

·         Ohio has ranked in  the bottom 10 states for population growth

·         Ohio’s economy has ranked in the bottom 5 states

The new tax credit is referred to as “Invest Ohio.” The credit will run for two years (Ohio has biennial budgets), and the state estimates that the program will cost $100 million. The state hopes to stimulate at least 30,000 jobs, at which number the state anticipates to breakeven.

The credit is nonrefundable. You need to have an Ohio income tax to make this worthwhile.

Let’s go through the steps:

(1)    This is an income tax credit. More specifically, only taxpayers with income taxes will be able to use it. You may recall that Ohio C corporations pay a Commercial Activity Tax (or “CAT”) in lieu of income taxes, so this credit is not for C corporations. Rather it is for individuals, passthroughs, trusts and estates.

(2)    You have to be an eligible small business.

a.       Your total assets are $50 million or less OR your total sales are $10 million or less

                                                               i.      Because of the “or,” you must meet one of the two tests to qualify.

b.      You must have enough presence in Ohio to qualify. There are two alternative tests:

                                                               i.       More than half your employees are in Ohio.

1.       It doesn’t matter how many employees you have. Just one (yourself) is enough.

                                                             ii.      You have more than 50 full-time equivalent employees in Ohio.

1.       This does not need to be more than half.

NOTE: Let’s go over this, as it may not be clear. If you have 2 employees and both are in Ohio, you qualify. If you have 274 employees, of which more than 50 are in Ohio, you qualify. Technically, this second test is done by full-time equivalents rather than employees, but you get the idea.

(3)    Fresh money is going into the business as equity.

a.       This fresh money is going to acquire, increase or maintain an equity interest.

                                                               i.      You are not playing banker here. This is not a “Loan from Owner.”

                                                             ii.      You are receiving shares, units – something- that indicate ownership.

                                                            iii.      An easy example is someone who becomes a new shareholder in an S corporation by investing $25,000. This is fresh money and he/she has acquired an ownership interest.

1.       What is you already own 100%? You cannot go over 100%.

a.       Answer:  this will count.

(4)    You have to spend the money in an approved way.

a.       You have to buy tangible personal property.

                                                               i.      Desks, a copier, computer monitors or a business van will qualify.

b.      You can buy real property, as long as it is in Ohio. Ohio will not subsidize that Florida condo.

c.       You can buy intangibles, such as patents, copyrights or trademarks.

                                                               i.      The one that occurred to me was enterprise software or a website.

d.      Compensation for new or retrained employees for whom the business is required to withhold Ohio income tax.

                                                               i.      I am not sure my firm has clients that would incur employee “retraining.”

                                                             ii.      A new employee will count.

1.       There is a big EXCEPT here: the employee cannot be an owner, manager or officer.

                                                            iii.      The Ohio tax withholding becomes an issue for the border residents. For example, I live in northern Kentucky but work in Cincinnati. I do not have Ohio withholding because of the reciprocal tax agreement.  As I read this, I would not qualify.

(5)    You have to spend this new money within six months.

(6)    The credit is 10 percent.

a.       There is a maximum however.

                                                               i.      The maximum credit is $1,000,000 per taxpayer.

1.       If you are married, this becomes $2 million.

b.      My understanding is that this $1 million limit is for the first credit period, which is two years. If the credit is renewed, my understanding is that you will get a brand new $1 million limit.

(7)    Tax credit period

a.       The first period of the program runs from 7/1/2011 to 6/30/2013 (remember: biennial budget).

b.      The timing of this credit is odd.

                                                               i.      You have to wait until the period is up (6/30/13) before you can claim the credit.

1.       So an investment in 2011 gets no payoff until 2013.

2.       At least you can use it in the same year the period expires.

c.       You then get 7 years to use up the credit. More specifically, an investment in 2011 would get to use its credit in tax years 2013 to 2019.

d.      IF THE PROGRAM IS CONTINUED IN 2013 …

                                                               i.      Then the waiting period becomes five years rather than two. That is a long time to it for a credit to kick-in. An investment in 2014 would have to wait until 2019 before using the credit.

(8)    You have to keep the money invested for the credit qualifying period.

a.       That is, you cannot put money in and take it right back out.

b.      But, then again, the first period is only two years. This is not a long time.

(9)    Paperwork

a.       There is paperwork for …

                                                               i.      The application and qualification,

                                                             ii.      The certification, and

                                                            iii.      A pledge not to dispose of the investment before the end of the holding period

b.      In short, the business and its owner will have paperwork. This makes sense, as Ohio wants (at a minimum) to keep track of how many people are using the program.

c.       The program is being administered by the Ohio Department of Development. They are your contact, not the Department of Taxation.

(10) Owners of passthrough entities will claim the credit based on their distributive or proportionate share of the entity.

Rick Kruse and I agree that the key point to this credit is the fresh cash. Perhaps the cash is funded by savings, by borrowings, or perhaps by a circular transaction, but somehow new money has to enter the picture. The problem may be getting the fresh cash in the owner’s name.

Think about the following examples:

(1)               The S corporation buys a truck. There is a down payment and a term note for the balance. Even if the shareholders sign on the note, there has been no fresh cash into the business, so there would be no tax credit.

(2)               The LLC wants to buy shop equipment. There are three members. Only one of the members is willing (or able) to start the required “fresh cash” sequence.  Perhaps he/she is the only one with enough savings, enough credit or enough collateral to borrow.  Therefore, only one of the members can initiate the “fresh cash” cycle. This situation may be more about member dynamics than tax planning.

(3)               The partnership constructs a building. The construction loan is signed by the partners. Under this loan, the draws are disbursed directly by the bank to the contractors and suppliers.  Whereas one can argue “fresh cash,” there has been no increase in equity. There has been only an increase in debt.  

Here is one that intrigues me:

(4)               A key employee is awarded 50 shares under a stock bonus program. The stock vests, so the employee recognizes taxable income on his/her personal return. The business in turn purchases equipment within the requisite six month period. Do we have a "fresh cash” cycle?

BTW, the instructions and directions for this credit are virtually nonexistent as I write this. For the time being there are questions with no answers. For example, can one set up a new company in order to qualify as an “eligible small business” or will the new company being aggregated with an existing company?  This is a basic technique – and therefore a basic question - for any tax practitioner.

If your business qualifies as an Ohio eligible small business, you simply must consider this credit in your tax planning. If you will be buying equipment, or trucks, or software, or hiring ANYWAY, why not plan for the credit? If you can’t make it work then you can’t, but at least consider it.