Is There Any Point To Middle Class Entitlements?

I was reading a Bloomberg article last week titled “Those Pointless Upper-Middle-Class Entitlements.” It is - to be fair - an opinion piece, so let’s take it with a grain of salt.

The article begins:

Let’s talk about upper-middle-class entitlements, the subsidies that flow almost entirely to those in the upper fifth or even tenth of the income distribution. You know, the home mortgage interest deduction and the tax subsidies for 401(k)s, IRAs and other retirement plans.

Then we have a spiffy graph: 

I am confused with what is considered a “tax break.”

The true “tax break” here is the earned income credit. We know that this began as encouragement to transition one from nonworking to working status, and we also know that it is the font of massive tax fraud every year. The government just sends you a check, kind of like the tooth fairy. An entire tax-storefront industry has existed for decades just to churn-out EIC returns. Too often, their owners and practitioners are not as … uhh, scrupulous … as we would want.

And this is a surprise how? Give away free money to every red-headed Zoroastrian Pacific Islander and wait to be surprised by how many red-headed Zoroastrian Pacific Islanders line up at your door. Even those who are not red-headed, Zoroastrian or Pacific Islander in any way. 

Here is more:

Of course, we wouldn’t want to take away all of those tax expenditures, would we? The earned income tax credit and the Social Security exclusion, for example, are targeted at people with pretty low incomes.

Doesn’t one need to have income before receiving an INCOME TAX expenditure?

Then we have these bright shiny categories:

·       Defined contribution retirement plans

·       Defined benefit retirement plans

·       Traditional IRAs

·       Roth IRAs

Interesting. One would think that saving for retirement would be a social good, if only to lessen the stress on social security.

We read:

Wealthy people who would save for retirement in any case respond to subsidies by shifting assets into tax-sheltered accounts; the less wealthy don’t respond much at all.

It makes some sense, but don’t you feel like you are being conned? Step right up, folks; make enough money to save for retirement and you do not need a tax break to save for retirement.

When did we all become wealthy? Did someone send out letters to inform us?

Did you know that the majority of income tax breaks are claimed by people with the majority of the income?  

Think about that one for a second, folks.

This following is a pet peeve of mine:

·       Deferral of active income of controlled foreign corporations

We have discussed this issue before. Years ago, when the U.S. was predominant, it decided that U.S. corporations would pay tax on all their earnings, whether earned in the U.S. or not.

There is a problem with that: the U.S. is almost a solo act in taxing companies on their worldwide income. Almost everyone else taxes only the profit earned in their country (the nerd term is “territoriality”).

Let’s be frank: if you were the CEO of an international company, what would you do in response to this tax policy?

You would move the company – at least the headquarters - out of the U.S., that’s what you would do. And companies have been moving: that is what "inversions" are.

So, the U.S. had no choice but to carve-out exceptions, which is how we get to “deferral of active income of controlled foreign corporations.” This is not a tax break. It is a fundamental flaw in U.S. international taxation and the reason Congress is currently considering a territorial system.

By the way, how did these tax breaks come to be, Dudley?

Why do these subsidies continue nonetheless? Mainly, it seems, because they’ve been granted to a sizable, influential population who, it is feared, will fight any effort to take them away. 

Politicians giving away money. Gasp.

But mainly it’s the millions of upper-middle-class Americans who, like me and my family, are beneficiaries of tax subsidies for home mortgages, retirement accounts and/or college savings.

To state another way: It is unfair that people with more money can do more things with money than people with less money.

Profound.

What offends about this bella siracha is:

You train for a career.

You set an alarm clock daily, dress, fight traffic and do your job.

You get paid money.

You take some of this money and save for nefarious causes such as your kids’ college and your eventual retirement.

Yet you keeping your own money is the equivalent of receiving a welfare check euphemistically described as an “earned income credit.”

No, no it is not.

And the false equivalence is offensive.

I get the issue. I really do. The theory begins with all income being taxable. When it is not, or when a deduction is allowed against income, there is – arguably - a “tax break.” The criticism I have is equating one-keeping-one’s-money (for example, a 401(k)) with flat-out welfare (the earned income credit). Another example would be equating a deeply-flawed statutory tax scheme (multinational corporations) with the state income tax deduction (where approximately 30% of this tax break goes to two states: California and New York). 

And somebody please tell me what “wealthy” means anymore. It has become one of the most abused words in the English language.

Bloomberg

Let's Talk Tax Inversions - Part Two

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.

Let's Talk Tax Inversions - Part One

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. 

Pfizer Wants To Decrease Its Taxes By Moving To Britain

I am reading the following headline at Bloomberg Businessweek: “Pfizer’s $99 Billion Bid for AstraZeneca Is a Tax Shelter.”

No, it is not. This is a tax shelter the same way I am Floyd Mayweather Jr.’s next opponent.

It is sign of a problem, though.

Pfizer is based in New York City. AstraZeneca is based in London. Pfizer has proposed the deal, but AstraZeneca has not yet accepted. The deal may fall yet fall through. There are any number of reasons why a drug company would buy another drug company, but this one would move one of the largest U.S. multinationals to London. The term for this is “inversion.”

Mind you: the Pfizer executives are not moving. They will remain in New York, and Pfizer research facilities will remain in Connecticut. Pfizer will however go from being a U.S.-based multinational to a U.K.-based one. How? There will be a new parent company, and that parent will be based in London. Voila!

Inversions are more complicated than they used to be. In 2004 Congress passed IRC Section 7874, which denies tax benefits to an inversion unless certain thresholds are met. For example,

·       If the former shareholders of the former U.S. parent own 80% or more of the foreign corporation after the inversion, then the inverted company will continue to be considered – and taxed – as a U.S. company.

You can quickly assume that new – and non-U.S. shareholders – will own more than 20% of the new Pfizer parent.

What if you own Pfizer stock? In addition to owning less than 80% of the new parent, code Section 367 is going to tax you when Pfizer inverts. This is considered an “outbound” transaction, and there is a “toll” tax on the outbound. What does that tell you? It tells you that there has to be cash in the deal, otherwise you are voting against it. There has to be at least enough cash for the U.S. shareholders to pay the toll.

Let’s say the deal happens. Then what?

I cannot speak about the drug pipeline and clinical trials and so forth. I can speak about the tax part of the deal, however.

As a U.S. multinational, Pfizer has to pay taxes on its worldwide income. This means that that it pays U.S. taxes on profits earned in Kansas City, as well as in Bonn, Cairo, Mumbai and Sydney. To the extent that a competitor in Germany, Egypt, India or Australia has lower tax rates, Pfizer is at an immediate disadvantage. In the short term, Pfizer would be less profitable than its overseas competitor. In the long term, Pfizer would move overseas. Congress realized this and allowed tax breaks on these overseas profits. Pfizer doesn’t have to pay taxes until it brings the profits back to the United States, for example. Clever tax planners learned quickly how to bend, pull and stretch that requirement, so Congress passed additional rules saying that certain types of income (referred to as “Subpart F” income) would be immediately taxed, irrespective of whether the income was ever returned to the United States. The planners responded to that, and the IRS to them, and we now have an almost incomprehensible area of tax Code.

Take a moment, though, and consider what Congress did. If you made your bones overseas, you could delay paying taxes until you brought the money back to the U.S. Then you would have to pay tax – but at a higher rate than your competitor in Germany, Egypt, India or Australia. You delayed the pain, but you did not avert it. In the end, your competitor is still better off than you, as he/she got to keep more of his/her profit.

What do you do? Well, one thing you cannot do is ever return the profit to the United States. You will expand your overseas location, establish new markets, perhaps buy another – and foreign – company. What you will not do is ship the money home.

How much money has Pfizer stashed overseas? I have read different amounts, but $70 billion seems to be a common estimate.

When Pfizer inverts, it may be able to repatriate that money to the U.S. without paying the inbound toll. That is a lot of money to free up. I could use it.

The U.S. also has one of the highest – in truth, maybe the highest – corporate tax rate in the world. The U.K. taxes corporate profits at 20%, compared to the U.S. 35%. The U.K. also taxes profits on U.K. patents at 10%, an even lower rate. This is a pharmaceutical company, folks. They have more patents than Reese’s has pieces. And the U.K. taxes only the profits generated in the U.K., which is a 180 degree turn from Washington’s insistence that it can tax profits of an American company anywhere on the planet.

Now, Pfizer does not get to avoid U.S. taxes altogether. It will still pay U.S. tax on profits from its U.S. sales and activities. The difference is that it will not pay U.S. taxes on sales and activities occurring outside the United States.

Since 2012 approximately 15 large U.S. companies have moved or announced plans to move offshore. Granted, there are numerous reasons why, but a significant – and common – reason has to be the benighted policy of U.S. multinational taxation. What has the White House proposed to stem the tide? Increase the ownership threshold from 20% to 50% before the company will be deemed based outside the U.S.

Brilliant.  To think that Washington at one time pulled off the Manhattan Project, Hoover Dam and landing a man on the moon. How far the apple has fallen.

The issue of corporate inversion has been swept up as part of the larger discussion on tax reform. That discussion is all but dead, unfortunately, although perhaps it may resurrect after the Congressional elections. The Camp tax proposal wants to move the U.S. to a territorial tax system rather than the existing worldwide system, which is an acknowledgement of the problem and a very good first step. It will not stop Pfizer, but we may able to stop the next company to follow.