Last time we discussed the taxation of an inverting corporation (see Let's Talk Tax Inversions - Part One).
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.
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.
About the author
Steven D. Hamilton is a career CPA, with extensive experience involving all aspects of tax practice, including sophisticated income tax planning and handling of tax controversy matters for closely-held businesses and high-income individuals.