Corporate tax inversions continue to make news headlines, garnering attention from Main Street, to Wall Street, to Washington. In 2014, numerous U.S. companies have either engaged in or are considering an inversion transaction to move their corporate tax home from the U.S. to a foreign jurisdiction. Corporate level tax savings is one of the leading motivations for many inversion transactions.
Shareholders holding appreciated shares in a company initiating an inversion may recognize taxable gain as a consequence of the inversion, which is often a surprise to those not familiar with the intricacies of these transactions. Stakeholders should confer with their tax advisors to assess the tax consequences of a particular inversion transaction in their individual circumstances.
THE BASIC TRANSACTION
Although there are various types of corporate inversions, the recent trend has been for a U.S. multinational company to acquire a foreign company (a target) with a tax home in a country with a corporate tax rate lower than the marginal 35% U.S. Federal corporate income tax rate. The U.S. company acquires the non-U.S. company, and in the course of the transaction becomes a non-U.S. company by, ultimately, becoming a U.S. subsidiary of the foreign company. Examples of tax favored jurisdictions include Ireland with a 12.5% corporate income tax rate as well as the United Kingdom with a 21% corporate income tax rate and a favorable tax treaty with the U.S.
In short, an inversion typically results in the multinational company (now foreign multinational) being taxed at a lower overall tax rate and limiting the extent of income subject to U.S. income tax to only its U.S. sourced income. There are many details and this is only a high level summary of these highly complex transactions.
THE CURRENT INVERSION ACTIVITY
Corporate inversions are not new. They have been occurring for decades. What is noteworthy is the level of current inversion activity. $260 billion in deals were proposed or completed in the second quarter of 2014, more than five times the deal level in any quarter since 2009. Many reasons can be cited for the heightened level of activity:
THE IMPACT ON SHAREHOLDERS
U.S. shareholders holding appreciated inversion company stock experience gain recognition in a typical stock inversion. The impact of that gain recognition depends on the circumstances of the shareholder — whether an individual shareholder holds shares in a taxable account or a tax deferred retirement account (e.g., an IRA or 401(k)) or contributed inversion shares to an exchange fund to diversify a concentrated stock position; whether shares are held by a charitable remainder trust; or whether shares are held by a tax exempt charitable organization.
In a stock inversion the shareholders of the original U.S. parent corporation are required to tender their shares in exchange for new shares in the resulting inverted foreign corporation. Thus, the shareholders of the original U.S. corporation become shareholders of the new foreign parent. Future dividend payments will be dividends of a foreign corporation, potentially subject to various tax withholdings. For shareholders with significant stock holdings required to be tendered, gain recognition may be significant, which can be an issue if the person does not have sufficient liquidity to pay the resulting tax liability.
For example, the recently announced AbbVie - Shire merger will result in a "New" AbbVie. Pursuant to the merger, AbbVie shareholders will receive one "New" AbbVie Share for each "Old" AbbVie share. Shire shareholders will receive a mix of cash and New AbbVie stock. The New AbbVie will be a subsidiary of U.K. based Shire.
How any gain is taxed and the tax rate for an individual or trust shareholder will depend on the holding period and whether or not the taxpayer is a high-income taxpayer. Long term capital gain tax rates vary depending on the income level of the taxpayer — 0%, 15% and 20%. Additionally, the 3.8% Medicare contribution tax on net investment income may apply to high income individuals and certain private trusts.
Individual shareholder tax planning alternatives in anticipation of a corporate stock inversion are limited, but there are some traditional appreciated marketable security tax planning strategies to consider. If a shareholder desires to hold any stock through the tax recognition, consideration may be given to harvesting tax losses in their securities to offset taxable gain.
For those with a charitable orientation, a timely pre-transaction gift of shares to charity is one option. The maximum income tax benefit is with a gift of long-term appreciated marketable securities to a qualified public charity or to a donor advised fund. An individual donor may deduct the fair market value of the stock up to 30% of adjusted gross income with a 5-year carryover. A timely pre-transaction gift of inversion stock to a charitable remainder trust can defer the individual income tax consequences of an inversion with the added benefit of a current income tax deduction. However, for high income taxpayers, a partial phaseout of itemized deductions will apply to any charitable deduction.
Timely pre-inversion transaction gifts may also be made to non-charitable donees in a lower tax bracket. We presently have three long-term capital gain tax rates, 0%, 15% and 20%. The 20% long term capital gain tax rate applies to taxpayers who are subject to the 39.6% marginal income tax rate.
Pre-inversion gifts, whether to charitable or non-charitable donees, will have the added benefit of "managing" the original owner's modified adjusted gross income for purposes of the 3.8% Medicare contribution net investment income tax. While there is no charitable deduction for the net investment income tax, if a taxpayer's modified adjusted gross income is below the tax threshold ($250,000 for a married couple filing jointly and $200,000 for individuals), the tax will not apply. Therefore, it will be helpful to assess whether an inversion will take an individual holding shares in a taxable account over the modified adjusted gross income tipping point.
For individual shareholders who previously contributed concentrated positions in inversion stock to what is known as an "exchange fund" for diversification, an assessment of the tax consequences to the contributing exchange fund participant may be in order. In very brief summary, for those within the 7-year holding period at the time of the inversion transaction gain recognition event, pre contribution gain will be allocated to the contributing fund participant and post contribution gain will be allocated among all fund participants. For those who are within the 7-year holding period in an exchange fund that permits pre 7-year withdrawals of contributed stock, consideration may be given as to whether withdrawal and gifting is desirable.
For those contributors who have been in an exchange fund for more than 7 years or will have achieved a 7 year holding period in the exchange fund prior to the date the inversion transaction closes, exiting the fund with the customary basket of diversified securities (which typically does not include contributed securities), will leave the inversion gain recognition behind with the fund and its continuing participants. Alternatively, if a post 7-year holding period exchange fund participant remains in the fund, it is likely that he or she will bear the pre-contribution share of any gain and an allocated share of post contribution gain.
TIME IS OF THE ESSENCE
We have made repeated reference to "timely" pre-inversion transaction recognition planning for taxable shareholders. Inversions involve a series of events that culminate in the closing of the transaction including internal analysis, private negotiation, public discussion, corporate action by both the acquirer and the target, shareholder action, and regulatory approvals. If a shareholder is considering a gifting strategy associated with inversion stock it is important to be mindful that gifts are only complete once the donor gives up "dominion and control". This means parting with the rights and privileges of ownership without the power to reverse the gift.
The Internal Revenue Service takes a hard look at gifts of stock nearing an income realization event, including transactions where the shareholder has no direct control over the transaction. If the shareholder fails to make the gift until the transaction becomes final or inevitable, the gain typically will be attributed to the donor for income tax purposes, but the gift likely may continue to be considered complete and final for gift and property ownership purposes. The question to ask is whether there are conditions that may allow the offering party (the acquiring U.S. corporation) to withdraw its bid or whether the transaction has "ripened" to the point where it has a momentum of its own?1 The earlier in the transaction process that a gift is made, the less likely the successful reattribution of gain to the donor by the Internal Revenue Service, but the greater the potential that the transaction will be derailed in the current legislative and regulatory environment.
ON THE HORIZON
Senator Ron Wyden, Chairman of the Senate Finance Committee, has undertaken work to analyze and address the issue of inversions and the broader need for corporate income tax reform. Senator Wyden noted recently that:
"Comprehensive tax reform will entice leading companies to invest further in the U.S. and reduce the ability, as well as the need, to manipulate the system. I'm committed to making this happen and including changes in the inversion rules as part of a tax overhaul. Tax reform is a heavy lift and won't be done overnight, but it has been done before and it can be done again…."
Corporate inversion activity has unquestionably focused a spotlight on what has been characterized as "corporate expatriation". For the taxable shareholder holding appreciated shares, the tax consequences can be significant and consultation with financial and tax advisors is advisable.
1Ferguson v. Comm’r, 108 T.C. 244 (1977), aff’d 174 F.3d 997 (9th Cir. 1999).