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.

The Estate of Marilyn Monroe

There is a saying among tax pros: “do not let the tax tail wag the dog.” The point is to not let taxes so influence the decision that the final decision is not in your best interest. An example is failing to sell a profitable stock position for the sake of not paying taxes. Seems a good idea until the stock market – and your stock – takes a dive.

This past week I was reading about the estate of Marilyn Monroe. Did you know that her estate was the third highest-earning estate in 2011?  Her estate earned $27 million and came in behind the estates of Michael Jackson and Elvis Presley. What is driving this earning power?

What is driving it is “rights of publicity.” For example, the website Squidoo.com reports that Marilyn Monroe posters remain one of the top-sellers for students decorating their dorm rooms. A “right of publicity” exists at the whim of state statute. There is no federal law equivalent. Indiana is considered to have one of the most far-reaching statutes, recognizing rights to publicity for 100 years after death.

Marilyn Monroe divorced Joe DiMaggio in October, 1954. She then left California for New York. In 1956 she married Arthur Miller, and the couple lived In Manhattan’s Sutton Place. Marilyn still considered this her home when she died in Brentwood, California in August, 1962.

The executors of her estate had a tax decision to make: was her estate taxable to California (where she died) or New York (where she maintained the apartment and staff). They decided it would be New York, primarily because California’s estate taxes would have been expensive. By treating her as a New York resident, they were able to limit California to less than $800 in taxes.

Let’s go forward three or four decades, and states like California and Indiana now permit celebrities’ estates to earn large revenues, in large part by liberalizing property interests such as publicity rights. Some states have not been so liberal - states such as New York.

You can see this coming, can’t you?

Let’s continue. In 2001 The New York County Surrogate’s Court permitted the estate to close, transferring the assets to a Delaware corporation known as Marilyn Monroe LLC (MMLLC). The licensing agent for MMLLC is CMG Worldwide, an Indiana company that also manages the estate of James Dean. Is the selection of Indiana coincidental? I doubt it, given what we discussed above.

Marilyn is an iconoclastic image, and her photographs – and the rights to those photographs – are worth a mint. Enter Sam Shaw, who took many photographs of Marilyn, including the famous photo of her standing over a subway grate with her skirt billowing. The Shaw Family Archives (SFA) got into it with MMLLC, with MMLLC arguing that it exclusively owned the Monroe publicity rights.  SFA sued MMLLC in New York, and the court granted SFA summary judgment. The court noted that Marilyn Monroe was not a domiciliary of Indiana at her time of death, so her estate could not transfer assets to Indiana and obtain legal rights that did not exist when she died. She was either a resident of New York or California, and neither state recognized a posthumous right of publicity at her time of death.

MMLLC had no intention of rolling over. It called a few people who knew a few people.

In 2007 Governor Schwarzenegger signed into law a bill creating a posthumous right of publicity, so long as the decedent was a resident of California at the time of death. Even better, the law was made retroactive. The law could reach back to the estate of Marilyn Monroe. Wow! How is that for tax planning!

Now the estate of Marilyn Monroe started singing a different tune: of course Marilyn was a resident of California at her time of death. That entire issue of making her a New York resident was a misunderstanding. She had been living in California. She loved California and had every intention of making it her home, especially now that California retroactively changed its law 45 years after her death.

You know this had to go to court. MMLLC did not help by aggressively suing left and right to protect the publicity rights.

Last week the Ninth Circuit Court of Appeals (that is, California’s circuit) ruled that The Milton Greene Archives can continue selling photographs of Marilyn Monroe without paying MMLLC for publicity rights. The court noted that the estate claimed Monroe was a New York resident to avoid paying California taxes. The estate (through MMLLC) cannot now claim Monroe was a California resident to take advantage of a state law it desires.

NOTE: This is called “judicial estoppel,” and it bars a party from asserting a position different from one asserted in the past.

The appeals judge was not impressed with MMLLC and wrote the following:

"This is a textbook case for applying judicial estoppel. Monroe’s representatives took one position on Monroe’s domicile at death for forty years, and then changed their position when it was to their great financial advantage; an advantage they secured years after Monroe’s death by convincing the California legislature to create rights that did not exist when Monroe died. Marilyn Monroe is often quoted as saying, 'If you’re going to be two-faced, at least make one of them pretty.'”

What becomes now of MMLLC’s rights to publicity? Frankly, I do not know. It is hard to believe they will pick up their tent and leave the campground, however.

I am somewhat sympathetic to the estate and MMLLC’s situation. It was not as though the estate made its decision knowing that property rights were at stake.  At the time there were no property rights. It made what should have been a straightforward tax decision. Who could anticipate how this would turn out?

On a related note, guess whose case will also soon come before the Ninth Circuit on the issue of post-mortem publicity rights?  Here is a clue: he was from Seattle, had a four-year career and died a music legend. Give up?

It’s the estate of Jimi Hendrix.