Pilgrim's Pride, A Senator And Tax Complexity

The Democratic staff of the Senate Finance Committee published a report last month titled “How Tax Pros Make the Code Less Fair and Efficient: Several New Strategies and Solutions.”

I set it aside, because it was March, I am a tax CPA and I was, you know, working. I apparently did not have the time liberties of Congressional staffers. You know the type: those who do not have to go in when it snows. When I was younger I wanted one of those jobs. Heck, I still do.

There was a statement from Senator Wyden, the ranking Democrat senator from Oregon:

Those without access to fancy tax planning tools shouldn’t feel like the system is rigged against them. 

Sophisticated taxpayers are able to hire lawyers and accountants to take advantage of … dodges, but hearing about these loopholes make middle-class taxpayers want to pull their hair out.”

There is some interesting stuff in here, albeit it is quite out of my day-to-day practice. The inclusion of derivatives caught my eye, as that of course was the technique by which the presumptive Democratic presidential nominee transmuted $1,000 into $100,000 over the span of ten months once her husband became governor of Arkansas. It must have taken courage for the staffers to have included that one.

Problem is, of course, that tax advisors do not write the law.  

There are complex business transactions taking place all the time, with any number of moving parts. Sometimes those parts raise tax issues, and many times those issues are unresolved. A stable body of tax law allows both the IRS and the courts to fill in the blanks, allowing practitioners to know what the law intended, what certain words mean, whether those words retain their same meaning as one travels throughout the Code and whether the monster comes to life after one stitches together a tax transaction incorporating dozens if not hundreds of Code sections. And that is “IF” the tax Code remains stable, which is of course a joke.

Let’s take an example.

Pilgrim’s Pride is one of the largest chicken producers in the world. In the late 1990s it acquired almost $100 million in preferred stock from Southern States Cooperative. The deal went bad.  Southern gave Pilgrim an out: it would redeem the stock for approximately $20 million.

I would leap at a $20 million, but then again I am not a multinational corporation. There was a tax consideration … and it was gigantic.

You see, if Pilgrim sold then stock, it would have an $80 million capital loss. Realistically, current tax law would never allow it to use up that much loss. What did it do instead? Pilgrim abandoned the stock, meaning that it put it outside on the curb for big trash pick-up day.

Sound insane?

Well, the tax Code considered a redemption to be a “sale or exchange,” meaning that any loss would be capital loss. Abandoning the stock meant that there was no sale or exchange and thus no mandatory capital loss.

Pilgrim took its ordinary loss and the IRS took Pilgrim to Court.

Tax law was on Pilgrim’s side, however. Presaging the present era of law being whatever Oz says for the day, the IRS conscripted an unusual Code section – Section 1234A – to argue its position.

Section 1234A came into existence to address options and futures, more specifically a combination of options and futures called a straddle. . What options and futures have in common is that one is not buying an underlying asset but rather is buying a right to said underlying asset. A straddle involves both a sale and a purchase of that underlying asset, and you can be certain that the tax planners wanted one side to be capital (probably the gain) and the other side to be ordinary (probably the loss). Congress wanted both sides to be capital transactions (hence capital gains and losses) even though the underlying capital asset was never bought or sold – only the right to it was bought or sold.

This is not one of the easiest Code sections to work with, truthfully, but you get an idea of what Congress was after.

Reflect for a moment. Did Pilgrim have (A) a capital asset or (B) a right to a capital asset?

Pilgrim owned stock – the textbook example of a capital asset.

Still, what is stock but the right to participate in the profits and management of a company? The IRS argued that – when Pilgrim gave up its stock – it also gave up its rights to participate in the profits and management of Southern. Its relinquishment of these rights pulled the transaction into the ambit of Section 1234A.

You have to admit, there are some creative minds at the IRS. Still, it feels … wrong, doesn’t it? It is like saying that a sandwich and a right to a sandwich are the same thing. One you can eat and the other you cannot, and we instead are being wound in a string ball of legal verbiage.

The Tax Court agreed with the IRS.  Pilgrim appealed, of course. It had to; this was a $80 million issue. The Appeals Court has now overturned the Tax Court.

The Appeal Court’s reasoning?

A “right” is a claim to something one does not presently have. Pilgrim already owned all the rights it was ever going to have, which means that it could not have had a right as envisioned under Section 1234A.

The tax law changed after Pilgrim went into this transaction, by the way.

Do I blame the attorneys and accountants for arguing the issue? No, of course not. The fact that an Appeals Court agreed with Pilgrim means the tax advisors were right. The fact that the law was later changed means the IRS also had a point.

And none of the parties involved  – Pilgrim and its attorneys and accountants, the IRS , the Tax Court and the Appeals Court wrote the law, did they?

Although the way Congress works nowadays, they may have been the first ones to actually read the bill-become-law. There perhaps is the real disgrace.

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. 

President’s “Plan For Economic Growth and Deficit Reduction”

I was reviewing the tax provisions of the President’s “Plan for Economic Growth and Deficit Reduction.” It is possible that the “Super Committee” may adopt some of the tax provisions, so perhaps it is worthwhile to review the proposals.

(1)  Extend through 2012 the 100% bonus first-year depreciation.

(2)  Reduce the employer portion of the social security tax from 6.2% to 3.1%.

a.       This would cap-out at $5 million in payroll.

b.      Therefore the maximum cut would be $155,000 ($5,000,000 times 3.1%).

(3)  Create a tax credit for hiring employees who have been out-of-work for more than 6 months.

(4)  Create a tax credit to offset the increase in social security tax attributable to payroll increases over the corresponding period of the preceding year.

a.       So if your payroll was $1 million last year and $1.5 million this year, you would receive a credit for the social security taxes on the $0.5 million increase.

b.      There is a cap of $50 million.

c.       The credit would be good for the last quarter of this year and all of 2012.

(5)  The pre-EGTRAA tax rates would return for those making over $200,000 and $250,000.

OBSERVATION: Senator Schumer thinks these limits should be higher for New Yorkers. He is the senator from … New York.

(6)  Limit the tax rate at which high-incomes can reduce their tax to 28% for itemized deductions, excluded foreign income, health insurance and other selected deductions.

OBSERVATION: Right… make the calculation so complicated that even tax software won’t be able to get it right. Perhaps Congress and the WH should start with eliminating the phase-outs for personal exemptions, itemized deductions, student loan interest, education credits, child credit, AMT exemption and etc that would make this a circular calculation to stress even a mathematics graduate student.

(7)  Reduce the employee social security tax from 6.2% to 3.1%.

OBSERVATION:  Read this in conjunction with (2) above.

(8)  Repeal last-in first-out accounting (LIFO).

OBSERVATION: There is no accounting reason for this, as LIFO is considered to be a generally accepted accounting principle. It forms the tax accounting backbone of virtually every vehicle dealership in the nation.

(9)  Repeal the use of lower-of-cost –or-market inventory accounting.

OBSERVATION: Again, there is no accounting reason for this.

(10)  Increase the net FUTA tax from 0.6% to 0.8%.

OBSERVATION:  FUTA was increased on a “temporary” basis from 0.6% to 0.8% in 1976, although it went back to 0.6% this year. Does that sound “temporary” to you?

(11)  Eliminate the percentage depletion and intangible drilling cost provisions for oil and gas companies.

(12)  Eliminate coal activity expensing of exploration and development costs, as well as percentage depletion for hard mineral deposits and capital gains for royalties.

(13)  Modify the transfer-for-value exception on life insurance contracts.

OBSERVATION: Seems the viatical industry has drawn attention to itself.

(14)  Require business jets to be depreciated over 7 years rather than 5.

(15)  Revise the rules on transfers of intangibles to controlled foreign corporations.

OBSERVATION:  Think Google.

(16)  Revise the rules on the deductibility of interest paid to foreign persons.

I leave it to you to deem how serious you consider these proposals.