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.

Why Is The IRS Looking At Restaurant Tips (Again)?

I recently visited one of our clients. He owns a restaurant/bar. That is a tough business under the best of circumstances.  It is a business where almost all your profit comes from paying attention to the nickels and dimes.

Is there anything new out there, he asked?

We talked about the IRS’ recent interest in employee tips and gratuities. What is the difference?

• A tip is an amount determined by the patron

• A service charge is an amount agreed upon by the restaurant and patron

The IRS has long defined a tip as:

1. Paid free from compulsion
2. Determinable by the customer
3. Not dictated by the restaurant/employer
4. The recipient of which is identified by the customer

You may know that restaurant employees are paid a lower minimum wage, as a substantial part of their income is expected to come from tips. The employees are supposed to report their tips to the restaurant, which in turn withholds the employee’s share of the taxes. The restaurant also pays employer FICA on the base wages and tips.

The IRS has long believed that there exists substantial noncompliance with tip reporting by restaurant employees, and it has rolled out a number of “programs” over the years with the intent of increasing compliance. I have been through several of these, and my conclusion is that the IRS just wants money, even if it takes a work of fiction to get there. For example, if the IRS feels that the cash tip rate is too low, they will simply propose a higher rate, and call upon the restaurant (which then means me) to prove otherwise. Failure to do so means the restaurant is writing a tidy check for those actual taxes on proposed tips.

It is unfortunately too common that a server will be under-tipped if he/she is serving a large party. As a defense mechanism, many restaurants have imposed a service charge policy (also known as an auto gratuity or “auto-grat”) on that table or tables. The policy has worked fine for years.

But not for the IRS. They have recently clarified that they don’t believe auto-grats count as a tips, as the customer does not have the option of changing the amount or directing who is to receive it. I have to admit, the IRS has a point. However, are they making things worse by pressing the point? Let’s go through a few issues:

• The auto-grat will be on the server’s paycheck, rather than cashed out at the end of the shift. This is not a big deal in the scheme of things – except perhaps to the server.

• Restaurants are allowed to claim a tax credit for employer FICA paid on tips in excess of the amount necessary to get a server to minimum wage.

a.     Reduce the amount considered to be tips and you reduce the credit available to the restaurant.

b.     Meaning more tax to the restaurant.

• An auto-grat is considered revenue to the restaurant. Tips are not. States with a gross revenue tax – such as Ohio with its CAT – will now tax those auto-grats.

a.     Meaning more tax to the restaurant.

• Following on the same vein as (3), the customer will pay more sales tax, as the auto-grat is included in sales.

a.     Meaning more tax to the customer.

• How does one (I don’t know: say my accounting firm) figure out what rate of pay to use if the employee works overtime?

a.     Remember, service charges are resetting the base rate of pay.

b.     What if they server works tips and auto-grat tables over the course of one shift? Do they have one rate of pay or two? How would you even calculate this?

• Let’s throw a little SALT (State And Local Tax) into the mix: some states do not follow the federal definitions. For example, New York will consider auto-grats to be considered tips if they are separately stated on the receipt or invoice. New Jersey and Connecticut follow this line also.

a.     The good thing is that auto-grats will not be subject to New York sales tax.

b.     The bad thing is the accounting required to figure this out.

How long do you think it will be before the attorneys eviscerate some restaurant chain for violations of FLSA and overtime regulations? Remember, a service charge can change a server’s base pay, something a tip cannot do. On the other hand, the odds of overtime under the current economy are pretty low.

What about discrimination? How long before someone sues for being scheduled insufficient/excessive service -charge/non-service-charge shifts?

You know what I would do? I would do away with service charges altogether. I am not bringing that tiger to the party. Tips only at my restaurant.

Is it good for the servers? Since when does any of this care whether it is good for the employee?

It is about one thing: more money to the IRS. There may have been a time when I would have been sympathetic to the government’s position, but in this day of credit and debit cards, I am cynical about how much “unreported” income there is left to squeeze out of this turnip. I am also concerned that some restaurants may impose a service charge and then keep a portion of it for themselves rather than pass it along in full to the servers and others.  I am unhumored by the IRS, but I would be beyond unhumored by a restaurant that did that to its employees. 

Civil War Horses, Con Men and Lois Lerner

I think I have been insulted.

I am reading this morning that the Court of Appeals for the D.C. Circuit is hearing the IRS appeal of the Loving decision.  That decision concerned the recent effort by the IRS to regulate tax preparers, and the IRS lost the case. There were three parts to the IRS effort:

• a unique preparer identification number, called a PTIN (“pea tin”). The PTIN would allow – in theory - the IRS to track which individuals prepared which returns. I say “in theory” because it is not uncommon for larger returns to have two or more preparers and one or more reviewers. Traditionally the highest-ranking last person in the chain is considered the official preparer, but the IRS did not write its regulations that way.

• a competency test. CPAs, enrolled actuaries, attorneys and enrolled agents were exempt, as their credentialing already includes a competency test.

• a continuing education requirement. Tax laws change frequently, so the IRS thought that continuing education would be a good idea. It is.

Here is the rub: where does the IRS get the authority to make these proclamations? I know it sounds a bit quaint to talk about “government of laws rather than of men” in the current political environment, but there are a few sticklers out there who still believe in the concept. One of them was Judge Boasberg in the Loving decision.

Yesterday the IRS trotted out its attorneys, arguing that they have the right to regulate whatever they want under the “Horse Act of 1884.” Folks, that is “18” 84. 

Do you remember the following words?

The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.”

This is the 16^th amendment, creating the income tax and ratified in February 1913. That is “19”13. Which comes after “18”84, for most people. Let’s be blunt here: how can a law from the 1800’s give the IRS any authority over income tax preparers when the income tax was not even created until 1913?

I have to admit, I had to look up the Horse Act of 1884. We must have missed that bright shiny in high school American History. After the Civil War, people brought claims against the U.S. for dead or missing horses. Makes sense, as horses were required to work the farm or for transportation, and their loss would have been keenly felt. Always seeking a vacuum, fraudsters soon appeared to help people press horse claims against the government. Soon all horses were thoroughbreds, and the government was facing more actions than there were horses lost in the Civil War. The government realized they were being scammed by con men and, in defense, starting regulating those people. The government even used the term “enrolled agent,” a term still used today for a class of preparer who has passed a competency examination given by the IRS itself.

So the IRS attorneys are arguing that tax CPAs like me are akin to fraudsters who inflated the value of dead or missing horses in action against the government following the Civil War?

As I said, I think I have been insulted.

I am also reading that Lois Lerner, the former head of the IRS Exempt Organizations Division, is retiring. You may remember that she invoked the Fifth Amendment when appearing before Congress on May 22, 2013. She was the political hack from the Federal Elections Commission who somehow wound up at the IRS reviewing and delaying applications from conservative groups, especially Tea Party organizations, seeking 504(c)(4) status in time for the 2012 presidential election. Good thing she was there too or the election may have gone a different way. She was quite happy to initially throw a few Cincinnati IRS employees under the bus, saying they had gone “rogue.” Later investigation, including e-mails, put a rest to that lie. Congress could have instead spoken with a few practicing tax CPAs, and we could have told them the same thing.  

She has been on “administrative” leave since then, drawing an approximate $170,000 salary. Now she gets to retire. It’s a nice retirement too, as she able to look for another government position and still collect her retirement pay, estimated over $50,000 annually. 

I would love a deal like that. Unfortunately, the IRS thinks of me as a con man.

State Tax Absurdities: California's Time Travel Laugh-In

I do enjoy following tax developments out of California, as they are so … so…. How to be diplomatic? Think Rowan & Martin Laugh-In reruns – entertaining, but in a time-travel sense. Hearing “groovy” seems a bit imbecilic after all these years, and surely, McGovern is not still running for President, is he? Why then does California continue to give the same answer to every problem - “tax them more?”

Here are a couple of tax grenades that California has thrown out there recently:

1. There is an Iowa corporation (Swart) that owns farms in Kansas and Nebraska. It also has a few investments, one of which is a 0.02% interest in a California LLC (“Cypress”) that bought and sold capital equipment across several states.  Mind you, Swart did not exercise any management or control over its investment. This would be the equivalent of you investing in a California REIT (a REIT is an investment that owns real estate, such as apartment buildings). The California Franchise Tax Board nonetheless contacted Swart and told them that their investment in Cypress was “enough” to require them to file a California LLC tax return.

So what, you are thinking. Here is what: California imposes a minimum $800 annual fee on an LLC tax return.

Think about the numbers for a moment. Let’s say that Cypress made a tidy profit. We need a number. How about $4 million? Swart’s 0.02% share would be $800, which coincidentally is the same as California’s minimum fee. Not to mention the fee for an accountant to wade through this.

Swart filed suit on July 9, 2013, so we do not yet know the outcome.

California’s interest is obvious, duplicitous and mercenary: it wants money. Your money, if you stand on that street corner long enough. Cypress alone has 384 other members who are California nonresidents. 

It is also self-defeating. Tax Analysts summarized it well:

While states are always on the lookout for each and every dollar of tax revenue, taxing investments in California serves as a big disincentive for out-of-state companies to invest in the state.”

2. Do you know what a Section 1031 exchange is? This is where you exchange one property for another, and the government gets no taxes. More accurately, the tax effect is “deferred.” An easy example would be swapping one office building for another.

Don’t get me wrong here: a 1031 has all kinds of rules and sub-rules which, if you get them wrong, will transmute your tax-deferred exchange into a fully taxable event. I wanted only to introduce the concept.

Let’s say that you own an office building in Burbank. You swap it for another in San Antonio, Texas. The IRS doesn’t care that you moved states. California does care, though. The Laugh-In time travelers in Sacramento have passed a new tax law. Beginning in 2014, you will have to file an annual report if you exchange California property for non-California property in a Section 1031 exchange. The forms do not exist yet, but they will … and soon. You will have to acknowledge that you still own the replacement property. If you do not, California will assess you a tax.

Think about that for a moment. Let’s say that Steve Hamilton, a tax CPA in the Napa Valley swaps California for Florida real estate. Years go by, and as part of his estate planning, and preparatory to retiring to Ireland, he places the Florida real estate in a family limited partnership.  Is California REALLY going to send him a tax bill? And why would he pay it? What are they going to do: stop him at the airport?

In graduate school (many years ago), we discussed an efficient tax system as having the least drag on economic decision-making and the fewest reductio ad absurdum conclusions.  Sacramento needs to get back to the future with its tax policy, as they are stuck in a time warp.

Groovy.