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Wednesday September 17, 2014

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Shareholder Strategies to Avoid Inversion Gain

Recent tax policy discussions in Washington, D.C. have focused on the subject of corporate inversions. This article will discuss the topic of corporate inversions generally, explain the specifics of how corporate inversions impact corporate shareholders and offer some strategies on how a shareholder could use planned giving as a way to avoid or defer capital gains tax consequences from an inversion.

What is a corporate inversion?

In a corporate inversion, a U.S.-based, often publicly traded company (the "target"), is acquired by a foreign company (the "parent"). The acquisition is typically structured so that the target becomes a wholly-owned subsidiary of the foreign-parent following the acquisition. In some cases, prior to the inversion, the parent is a wholly-owned subsidiary of the target and the inversion reverses the target-parent relationship, enabling the former subsidiary to become the parent. In other cases, the parties are unrelated prior to the acquisition. At the shareholder level, an inversion typically results in a stock swap. The shareholders surrender their shares in the target and receive shares in the parent.

Corporate inversions are often driven by tax issues. Inversions can reduce the effective tax rate on U.S.-based domestic income and, in some cases, foreign income earned by the parent and the target. While not supportive of the inversion strategy, the U.S. Department of Treasury has written that inversions have the ability to "achieve a substantial reduction in taxes" for the businesses that engage in an inversion.

U.S. Corporate Tax Law Considerations

Federal and State Taxation on Earnings

Nearly all U.S.-based, publicly traded companies are taxed as Subchapter C corporations. These "C-corps" are taxed separately from the company's shareholders. The corporation pays corporate income taxes on its net earnings and any distribution to shareholders is also taxable at the shareholder level.

Currently, the top federal corporate income tax rate is 35%, which is exclusive of any state corporate income taxes. The top combined federal-state statutory corporate income tax rate for U.S. based companies was 39.1% last year, with an average effective tax rate of 30.9% based on 2012 data.

The top federal dividend tax rate paid by shareholders is 23.8%, which affects individual taxpayers with an adjusted gross income of $200,000 or a couple that is married and filing jointly with income above $250,000. The combined federal-state dividend tax rate can range from approximately 25% up to 33% in California and averages 28.6% on an effective basis.1

As a result, corporate earnings will be taxed, on average, at 30.9% on the corporate side and, any distributions made to shareholders from the company's after-tax profits, could be taxed up to 28.6%. Let's look at how this works in practice:

Example 1. A U.S.-based C-corp, Go America, Inc., produces uniforms for the U.S. Navy. In 2013, the company had pre-tax earnings of $20 million, an effective tax rate of 30.9% and paid $6.18 million in federal corporate income taxes.2 If the company distributed the balance of its after-tax earnings ($13.82 million) to shareholders, each of whom were paying an effective dividend tax rate of 28.6%, the shareholders would pay additional federal and state taxes on the dividends of $3.95 million. On a combined basis, Go America, Inc. and its shareholders would be paying more than $10.13 million, or nearly 51% of the company's pre-tax earnings in federal and state taxes.

The tax consequences for Go America and its shareholders could also be expressed as follows:

Combined Corporate/Shareholder Tax Burden on Distributed Profits
Corporate Impact  
  Corporate Profits $20.0M
  Effective Corporate Tax Rate30.9%
  Corporate Taxes Paid $6.18M
  After Tax Earnings (Profit) $13.82M
Individual Impact  
  Dividends $13.82M
  Effective Dividend Tax Rate 28.6%
  Individual Dividend Taxes Paid $3.95M
Combined Taxes $10.13M
Combined Tax Rate 50.7%

Worldwide vs. Territorial Tax Regime

Another aspect of the United States' tax code that affects corporations and their shareholders relates to the method in which the earnings of U.S.-based, multi-national corporations are determined and taxed. Most countries have adopted what is known as a "territorial" approach to corporate taxation. The countries that have adopted this approach only collect corporate taxes on the income earned within that country's borders and exempt from taxation foreign earnings of a subsidiary that are earned abroad and paid to the parent in the form of dividends.

The U.S., by contrast, has adopted a "worldwide" approach to corporate taxation. This means that a U.S.-based company must pay U.S. corporate income taxes on all of its income, including the income that is earned overseas by foreign subsidiaries, even if the foreign income has already been taxed by another country. This system does, however, allow for income deferral which means the U.S. company only needs to pay the income tax when the foreign earnings are "repatriated" by bringing the income back to the U.S. When the income is repatriated, the U.S. company is allowed a credit to offset the previously paid foreign taxes on these earnings.

Economists suggest that the impact of the United States' worldwide corporate tax regime is hindering foreign investment in the United States and that it also encourages domestic corporations to invest foreign earnings overseas rather than repatriating those earnings where they would then be subjected to U.S. taxation. The U.S. worldwide tax regime is a significant reason why many officers and directors of publicly traded, U.S.-based companies have explored the idea of corporate inversions. An inversion would allow the company to effectively relocate to a jurisdiction with far more favorable tax laws, allowing the corporation to maximize the return on investment for shareholders in the long term.

To illustrate this point, let's compare the tax picture of a U.S. company with a foreign subsidiary to show how that company's tax picture would change if the company engaged in a corporate inversion:

Pre-Inversion Tax Picture Post-Inversion Tax Picture
MacroFirm, a U.S. company, has an Ireland based subsidiary, MacroIE, that earned $100 million this year. Assume MacroIE and MacroFirm engaged in a corporate inversion so that MacroFirm was now a wholly-owned subsidiary of MacroIE. Let's see what would happen if MacroIE returned $100 million in post-tax earnings to the U.S.
MacroIE would pay $12.5 million in tax to Ireland. MacroIE would pay $12.5 million in corporate taxes to Ireland.
MacroIE transfers its post-tax earnings of $87.5 million to MacroFirm. MacroFirm must count all of MacroIE's earnings as income. MacroIE could transfer the post-tax balance of $87.5 million to MacroFirm for investment in the U.S.
MacroFirm would pay U.S. taxes on its subsidiary's earnings at a rate of 22.5% (the federal rate of 35%, less the tax already paid in Ireland). No U.S. corporate income tax would be due with this transfer.
Net Post-Tax Earnings Returned to U.S.: $65 million Net Post-Tax Earnings Returned to U.S.: $87.5 Million

This example demonstrates that an inversion can reduce a corporation's federal tax liability significantly. It also explains why many business leaders have criticized the U.S. system as too complex, harmful to competitiveness, out of sync with America's trading partners and why the tax code may actually be encouraging inversions as corporations look for ways to reduce expenses to stay competitive in a global economy.

Shareholder Recognition of Capital Gain

An inversion is not without potential tax consequences for the target company's shareholders. Under Section 367 of the U.S. tax code and related regulations, the exchange of target company stock by a shareholder for parent stock can be a taxable event that requires the shareholder to recognize capital gain on the stock swap.

The Internal Revenue Code treats the exchange of stock as if the shareholders of the target company sold their stock when the target shareholders end up holding more than 50% of the parent's stock following the inversion. In such case, the target shareholders will pay capital gains tax on the difference between the fair market value of the parent company stock received from the inversion and the cost basis in the target company stock that was surrendered.

An example will illustrate the impact of the exchange from a shareholder's perspective:

Example 2. Moe Napoli, a California resident, owns 1,000 shares of Electric Company, Inc. stock with a value of $225 per share. Moe's cost basis in the stock is $25 per share. Electric Company is a U.S.-based company that recently agreed to be acquired by Baltic Avenue Investments AG, a German company. Electric Company and Baltic have signed the acquisition agreement and the transaction has been approved by the board of directors and shareholders for both Electric Company and Baltic. Under the agreement, Baltic has agreed to a 2 for 1 stock swap for Electric Company's stock. Baltic will give two shares of Baltic stock for each share of Electric Company stock surrendered by Electric Company's shareholders. Baltic stock is currently trading at $150 per share.

Moe was very pleased with the deal negotiated by Electric Company's board of directors. He was happy to learn that he would be trading stock worth $225,000 for stock worth $300,000. Moe's joy, however, was short-lived after he met with Darrell Toppat, his CPA. Darrell advised Moe that under Section 367, Moe would have to pay capital gains tax on the difference between the fair market value of the Baltic stock he received ($300,000) and his cost basis in the Electric Company stock he surrendered ($25,000). Accordingly, Moe would have gain of $275,000 and would owe $90,750 in federal and state capital gains taxes based on his blended capital gains tax rate of 33%.

Prearranged Sales & Bypassing Capital Gains

Shareholders facing post-inversion capital gains should consider a strategy to avoid or defer the consequences of the inversion. A shareholder who contributes his or her stock in the target company to fund a planned gift, such as a charitable remainder unitrust ("CRT"), can avoid, or "bypass," the capital gains from the inversion as long as the contribution of stock is not regarded as a "prearranged sale."

Basics of Prearranged Sale

A transaction is treated as a “prearranged sale” when the owner of property, such as stock, has a legally binding obligation, or contract, to sell the stock prior to any transfer, including a transfer to fund a CRT. A prearranged sale exists when there is: (1) an established buyer; (2) an established price; and (3) a legally enforceable agreement to sell. If a transaction is categorized as a prearranged sale, the shareholder cannot bypass capital gains and must pay tax on the gain personally even if the donor subsequently transfers the stock to another party including to fund a CRT, CGA or other charitable vehicle. Rev. Rul. 78-197 explicitly states that the gain must be recognized by a shareholder when "the donee is legally bound, or can be compelled by the corporation, to surrender the shares for redemption."

In order to preserve the tax benefit to bypass gain, it is very important that a shareholder and his professional advisors understand when a contemplated sale or inversion becomes a prearranged sale. In cases where the owner of real estate or a shareholder has signed a purchase agreement and accepted an earnest money deposit, it is easy to conclude a prearranged sale exists. Some transactions, however, involve facts that make it more difficult to determine if there is a prearranged sale. Many stock transactions, including inversions, utilize a purchase agreement but the transaction is also subject to a condition precedent that must first be met, such as a majority of a company's shareholders voting to approve the merger, before the shareholders have a binding obligation to sell.

Caselaw Concerning Conditions Precedent and Prearranged Sales

There are two tax cases, Ferguson v. Commissioner, 108 T.C. 14 (1997) and Gerald A. Rauenhorst, et. aux. v. Commissioner, 119 T.C. No. 9; No. 1982-00 (7 Oct. 2002) that are very instructive in determining at what point a prearranged sale exists when a stock sale is subject to the condition precedent of shareholder approval. These cases demonstrate that a charitable transfer must occur before shareholder approval. Once shareholders have ratified the sale, whether by vote or tender, the shareholders' gain has "ripened" and each shareholder must recognize any gain from the sale.

Ferguson involved a tender offer by DC Acquisition Corp. ("DCA") to purchase American Health Companies, Inc. ("AHC"). Following the merger, DCA would merge into AHC and AHC would become a wholly-owned subsidiary of DCA's parent ("CDI"). The Ferguson family founded AHC and, at the time of the tender offer, owned 18.8% of the outstanding shares of AHC. DCA's tender offer allowed members of the Ferguson family to convert their shares in AHC to shares of CDI of equivalent value. AHC's board of directors, excluding the Fergusons who abstained, voted to approve the merger and to recommend to AHC's shareholders that they accept the tender offer.

The merger was subject to an approval vote by a majority of AHC's shareholders or, alternatively, subject to the requirement that DCA acquire control of a majority of the outstanding shares of AHC through the tender, obviating the need for a formal vote by AHC's shareholders. The Ferguson family advised CDI that they would opt to convert their AHC shares to shares of CDI on August 22, 1988. By August 31, 1988, AHC shareholders controlling a majority of the outstanding shares of AHC had accepted DCA's tender offer. Subsequently, on September 9, 1988, several members of the Ferguson family transferred approximately 10% of their AHC shares to charity and various charitable trusts. The Ferguson's did not pay capital gains tax on the gain associated with the charitable transfers.

The Internal Revenue Service ("Service") concluded that the Fergusons could not avoid capital gains tax on the gifts of stock because, at the time of the charitable transfers, the Fergusons were parties to a prearranged sale by virtue of the fact that a majority of AHC's shareholders had approved the sale by August 31, 1988 by accepting the tender offer. The Service assessed the Fergusons for deficiency, penalties and interest. The Ferguson's argued that the tender offer was not finalized until October 12, 1988 when DCA's board concluded the terms of the merger had been satisfied.

The Tax Court agreed with the Service, concluding that the condition precedent for AHC shareholder approval had been met and a prearranged sale existed when more than 50% of the outstanding shares of AHC had been tendered in favor of the merger. Accordingly, the court concluded that the Fergusons could not avoid the capital gains associated with the AHC shares contributed to charity.

The lesson from the Ferguson case is clear. If a shareholder intends to transfer stock into a CRT, and thus avoid the gain associated with a sale of the shares, the transfer must occur before 51% of the shareholders have accepted the terms of the transaction, whether by way of formal vote or by tender.

Using Planned Gifts to Avoid Inversion Gains

Having discussed the shareholder consequences of a corporate inversion and the issue of prearranged sales, we move next to discuss the specific tax and income benefits shareholders can achieve using planned giving.

Charitable Remainder Unitrust

A CRT pays a fixed percentage of the trust's assets for a life, lives, a term of up to 20 years, or a combination of a life or lives and a term up to 20 years, after which the balance of the trust assets are transferred to one or more qualified charities. A donor can contribute appreciated stock to a CRT, receive income from the CRT for life and take a charitable deduction equal to the present value of the charitable remainder in the year of the contribution to fund the CRT.

Example 3. Let's return to the case of Moe Napoli from Example 2. Recall that Moe had 1,000 shares of Electric Company, Inc. stock worth $225 per share at a cost basis of $25 per share. Baltic Avenue Investments AG made a tender offer for Electric Company's stock that would allow Moe to transfer $225,000 in Electric Company stock in exchange for $300,000 in Baltic stock. Following the merger, Electric Company would merge into Baltic, completing a corporate inversion. Recall that Moe would be required to pay capital gains on $275,000, the difference between the $300,000 value of the Baltic stock Moe would receive and Moe's $25,000 cost basis in his Electric Company stock.

Assume, however, that Electric Company's board of directors signed a merger agreement subject to approval from a majority of Electric Company's shareholders and that Moe met with Darrell Toppat, his CPA, a month before the Electric Company's shareholder vote. Under these facts, there is not yet a prearranged sale binding Moe to sell his Electric Company stock. Moe now has sufficient time to engage in strategic tax planning. Moe's "tax education day," the day he learned about the gain from the inversion, occurred before, not after, the shareholder vote on whether to accept Baltic's offer.

Assume that Darrell helps Moe, age 75, establish a one-life CRT that will provide Moe with an annual payout of 5.5% of the trust value. Moe is subject to a blended federal-state income tax rate of 47.03% and capital gains rate of 30%. If Moe transfers 1,000 shares of his Electric Company stock to the CRT before the Electric Company shareholder meeting, Moe can expect the following benefits:

Bypass of Capital Gains: Moe would bypass $200,000 in capital gains, saving $60,000 in federal and state capital gains tax based on the current value of Moe's Electric Company stock prior to shareholder approval of the inversion. Post-approval, Moe would have an additional $50,000 in gain, and would owe an additional $22,500 in taxes.

Income Tax Deduction: Moe would be able to take a charitable income tax deduction of $129,704, equal to the present value of the charitable remainder of the CRT. The deduction would save Moe $61,000 on his state and federal income tax returns.

CRT Income: Moe would receive $12,375 in annual CRT income.

Once the stock is transferred to the CRT, if the CRT holds the stock on the day of the Electric Company vote, the trustee of the CRT can vote for Baltic's tender offer and can exchange the Electric Company stock for Baltic stock. This stock swap from the inversion will not be subject to capital gains taxes related to the shares owned by the CRT.

Retirement Unitrust

A second CRT application to assist shareholders impacted by corporate inversions is a retirement unitrust. A retirement unitrust is a CRT that is established as a "flip trust," where the trust pays out the lesser of a standard trust percentage and the trust income until a "retirement date" or the "flip" event (after which the trust converts to a standard payout trust). With a retirement unitrust, trust assets are invested for growth instead of income. This reduces income payments to the income beneficiary prior to retirement, which allows the trust to retain earnings and maximize growth so that the income beneficiary receives greater income once they reach retirement.

Example 4. Assume the same facts as in Example 3 but that Moe is 50 years old. If Moe transfers his Electric Company stock to a charitable remainder trust with a flip or retirement date of January 1, 2030, Moe would still bypass the same amount of capital gain as in Example 3, but his income tax deduction would be reduced to $53,268, which would save him $25,099. However, the retirement unitrust would pay Moe substantially more in retirement, $19,927 per year beginning in 2030.

Sale and Unitrust

Another CRT application that can help a shareholder avoid capital gains tax triggered by a corporate inversion would be a "sale and unitrust." With a sale and unitrust, a shareholder makes a partial gift of stock to a CRT and sells the remaining shares on her own. The sale and unitrust can be set up with a "zero tax" option so that the charitable deduction from the contribution of stock to the CRT completely offsets the taxable gain from the stock sale.

Example 5. Assume Moe age is 75 and he wants to engage in a sale and unitrust. With this kind of arrangement, Moe could sell $113,429 of his Electric Company stock and contribute $111,571 of his stock to a CRT. The deduction from the transfer to the CRT would completely offset Moe's capital gains from the stock sale. A word of caution: the deduction rules for appreciated property limit Moe's deduction to 30% of his contribution base (typically his adjusted gross income). Accordingly, depending on Moe's income and other deductions, Moe may have to pay some tax on the gain up front but he can carry forward any unused deduction for up to five years to achieve the zero tax benefits of the sale and unitrust over the long term.

Charitable Gift Annuity Application

Another planned gift that can help shareholders that will be affected by corporate inversions is a charitable gift annuity ("CGA"). With a CGA, the donor contributes the appreciated stock directly to a charity to fund a CGA. The CGA is a contract that obligates the charity to make fixed annuity payments to the donor for life. The annuity payment is based on an annuity rate that is determined by the donor's age. This rate is multiplied by the value of the stock at the time of the charitable gift to determine how much the annuity will pay out each year. When the donor passes away, the charity that issued the CGA keeps the balance of the donor's gift. A CGA provides the donor with a tax deduction, partial bypass of capital gains and fixed payments.

Example 6. Prior to the Electric Company shareholder meeting, Moe, age 75, decides to contribute all of his Electric Company shares to Community Chest, a local charity, in exchange for which Community Chest will issue a gift annuity to Moe. Based on Moe's age, Community Chest is willing to provide Moe with a CGA that pays out 5.8% annually. Moe can expect the following benefits from the CGA:

Bypass of Capital Gains: Moe would partially bypass $200,000 in capital gains, saving $27,017 in tax.

Income Tax Deduction: Moe is entitled to a charitable income tax deduction of $101,313, saving him $47,648 in state and federal income tax.

CGA Income: Moe would receive $13,050 in annual annuity income from Community Chest. Based on Moe's life expectancy when the annuity was established, $3,079.80 of the annual annuity income would be treated as ordinary income, $8,866.42 as capital gain (taxed at a lower rate than Moe's income) and $1,103.78 would be tax-free.


As the above illustrations demonstrate, planned giving vehicles, such as a charitable remainder trust or charitable gift annuity, can play an important role in helping to shelter a shareholder from the tax consequences of a corporate inversion.


1 Tax Foundation, "The United States' High Tax Burden on Personal Dividend Income," March 5, 2014.
2 Tax Foundation, "Another Study Confirms: U.S. Has One of the Highest Effective Corporate Tax Rates in the World," May 31, 2013

Published September 1, 2014
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