Tax Analysts Blog

How Not to Stop an Inversion

Posted on Sep 5, 2014

So far, Congress has acted once to curb inversions. The American Jobs Creation Act of 2004 codified section 7874, the so-called anti-inversion legislation. The same bill also added code section 4985, which addresses stock inversions, such as those recently announced by Medtronic, AbbVie, and others.

Section 4985 imposes a 15 percent excise tax on the stock-based compensation of an inverting corporation’s executive officers and directors. In enacting that excise tax, Congress professed to address an imbalance in the relative tax burdens of a stock inversion on the inverting corporation’s shareholders and management.

Clearly, in a stock inversion structured as a taxable exchange, shareholders face capital gains taxes. But even in an otherwise nontaxable exchange, shareholders could be subject to the section 367(a) toll charge. By comparison, management can escape the tax net by holding stock-based compensation, including stock options, instead of actual shares of stock. Contending that this asymmetry in taxation misaligned managerial incentives in pursuing an inversion, Congress decided to subject the stock-based compensation of officers and directors to tax at a rate equal to the then-highest rate faced by shareholders—15 percent.

Though Congress was arguably correct in identifying the problem, it was unquestionably disingenuous in offering a solution. As it drafted the new 15 percent excise tax of section 4985 on stock-based compensation, Congress could not have been ignorant of the experience with the 20 percent excise tax of section 4999 on excess parachute payments. Ever since that section’s enactment in 1984, corporations have routinely “grossed up” the excess parachute payments tax—paying the tax on behalf of their executives on whom it was imposed, and being forced to incur considerable additional expenditures as a result. Concluding that the gross-up experience with section 4999 would be replicated with section 4985 could not have been a stretch.

In fact, not only was Congress on notice about gross-ups, it actually anticipated them. Section 4985 provides that all payments to reimburse the excise tax will themselves be subject to the tax, and that no part of a reimbursement payment can be deducted. Those provisions have not remained empty words. Far from it -- stock inversions have been regularly accompanied by announcements of gross-ups that acknowledge the ensuing consequences of cascading taxation and nondeductibility.

A case in point is Medtronic, which announced last week that it will pay $63 million to insulate 20 officers and directors from the section 4985 excise tax triggered by its merger with Covidien and concurrent inversion to Ireland. Back-of-the-envelope calculations suggest that if the individuals had paid their own taxes, the bill would have amounted to about $23.25 million.

By picking up the tab, Medtronic inflates that bill. Payments made by Medtronic on behalf of its officers and directors comprise the latter’s income and, as a result, are subject to federal and state income taxes, and as noted above, to the section 4985 excise tax. Medtronic, of course, will reimburse these charges as well. That, in turn, will generate additional taxes. On and on it goes until the series converges. In Medtronic’s case, convergence occurs at $63 million, over two and a half times the original tax liability. And not a single cent of that will be deductible.

That cost, like the cost of any corporate outlay, deductible or otherwise, will fall on Medtronic’s shareholders, consumers, and workers. But the officers and directors, the individuals who solicited, negotiated, finalized, and approved the inversion -- the very individuals that Congress worried wouldn’t face properly aligned incentives -- will be spared all taxes. How do you like them apples!

This seemingly paradoxical result, in which an excise tax motivated by a desire to equalize the tax burden between shareholders and management further aggravates the inequality, is far from inevitable. There is no reason why reimbursement payments should be subject to the same rate of tax as the excise tax itself. Indeed, if reimbursement payments are taxed at a high enough rate, iterative taxation would preclude successively higher payments from converging to a finite amount. Attempts at corporate reimbursement would then be frustrated, forcing officers and directors to pay their own liability.

For example, a tax rate of 70 percent on reimbursement payments, when coupled with a combined federal and state income tax rate of 30 percent, would tax away 100 percent or more of every reimbursement dollar, rendering any attempt at reimbursement futile. The real incidence of the section 4985 excise tax would then fall on those on whom the tax was nominally imposed in the first place—an inverting corporation’s officers and directors who were instrumental in the decision to undertake the inversion.

That outcome would represent a dramatic departure from the manner in which the section 4985 excise tax story has typically played out in stock inversions over the decade that the tax has been in place. More importantly, achieving that result would entail minimal legislative effort. Changing half a dozen words of one subsection of section 4985, the one dealing with the tax treatment of reimbursement payments, will do the trick. The remaining provisions of section 4985 need not be touched. No such amendment to section 4985 has, however, even been hinted at amid the flurry of legislative and administrative initiatives sparked by the many recently announced inversion deals.

All those proposals focus on the inverting corporate entity—a wonderfully inanimate piñata-like container that can be repeatedly hit for enjoyment and will occasionally yield the candy of additional revenue. None targets the individuals at the helm of the corporation, the men and women who stand to make vast amounts of money from their collective decision to execute an inversion.

Politicians, from the president on down, have been crying themselves hoarse about the need to instill “economic patriotism” in corporate America. It seems that their idea of patriotism is an extremely impersonal one.

A related article will appear in next week’s Tax Notes International.

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