Corporate inversions mean tax hit for shareholders

For an investor who says he just dabbles in stocks, Minnesota doctor James Allen has succeeded far better than most.

By his estimate, Allen has accumulated a more than $1 million stake in Medtronic (MDT), the world's largest medical technology firm, headquartered not far from his home in the Twin Cities area.

He intended to continue holding the stock long-term, for retirement or other special needs. But his plan was unexpectedly upended in June. Medtronic announced it would undergo a corporate inversion by reincorporating its headquarters in Ireland after buying Dublin-based rival Covidien (COV) in a $42.9 billion cash and stock transaction.

The pending deal is expected to help Medtronic avoid billions of dollars of U.S. taxes on future foreign profits if the company opts to invest them in the U.S., such as by building new plants, funding research or buying back stock. The transaction could be complicated by new restrictions on inversions announced Monday night by the Obama administration.

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Treasury to crack down on corporate tax 'inversions'

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For investors like Allen, the deal, if completed, means a more than 33% federal and state tax hit on capital gains — hundreds of thousands of dollars in all. Other shareholders of firms undergoing inversions also face tax bills of varying size.

Why? Because under federal tax laws the IRS considers such deals taxable events, treating them as if long-term shareholders sold their stock and booked gains — even if they opted to exchange their holdings for shares in the newly incorporated company.

"It wasn't in my planning," said Allen. "I think it's reasonable to have taxes in a country as wonderful as this one. But I don't always like paying them."

Allen is among many U.S. shareholders who face unexpected financial consequences from inversion plans being pursued or under consideration roughly a dozen U.S. firms. The companies, which would benefit from lower taxes overseas while maintaining much of their U.S. operations, include such familiar names as banana market giant Chiquita Brands International (CQB) and the Burger King Worldwide (BKW) fast food chain.

As the transactions move forward, shareholders who, like Allen, have seen the value of their shares appreciate or even skyrocket over time, are consulting with financial planners and lawyers and seeking ways to ease the capital gains bite. Separately, Medtronic said it will provide tax-planning services to its shareholders.

"It just goes to show you, you have to plan for all possible contingencies," said Laurie Laner, a Minneapolis-based financial planner advising a client who faces a tax hit on the $54 billion proposed inversion by AbbVie (ABBV) the North Chicago biopharmaceutical firm buying Dublin-based rival Shire (SHPG).

An estimated 47 U.S. firms reincorporated overseas via inversions during the last 10 years, more than in the previous two decades combined, according to an analysis by the Congressional Research Service.

Corporate America cites a market-driven rationale: The top U.S. tax rate on businesses is 35%, the highest among industrialized nations, and domestic firms need lower taxes to keep competitive with international business rivals.

Many of the U.S. firms pursuing inversions also tout projections of long-range growth, lower taxes and higher earnings per share — benefits that could make the transactions good deals for shareholders in the long run. In a recent presentation at a Morgan Stanley healthcare conference, AbbVie CFO Bill Chase said his company's annual dividend is expected to rise more than 15% when the Shire transaction is completed.

The Obama administration, however, says companies that pursue inversions are unpatriotically "gaming the system" and potentially eroding the federal tax base while continuing to take advantage of the U.S. economy and domestic services. Congressional Democrats have joined the attack, introducing several proposed lawsaimed at halting inversions.

Congressional Republicans say the issue should be addressed in a broad revision of the federal tax code that includes a reduction in the top U.S. levy on businesses. However, Utah Sen. Orrin Hatch, the Senate finance committee's ranking Republican, agreed that inversions erode the U.S. tax base and could be addressed by temporary, bipartisan action.

In a Sept. 11 speech for the U.S. Chamber of Commerce, Hatch predicted legislation could be enacted if it served as a bridge to comprehensive tax reform, was not retroactive, was revenue neutral regarding the federal budget and helped shift the U.S. away from taxing companies on worldwide income, rather than what they earn domestically.

Amid continued Capitol Hill gridlock in a congressional election year, Treasury Secretary Jacob Lew Monday night announced new restrictions that are expected to make corporate inversions harder to complete and less profitable.

"Now that it's clear that Congress won't act before the Lame Duck session (after the November elections) we're taking initial steps that we believe will make companies think twice before undertaking an inversion to try to avoid U.S. taxes," said Lew. "Inversion transactions erode our corporate tax base, unfairly placing a larger burden on all other taxpayers, including small businesses and hard-working Americans."

The announcement drew applause from Democrats and criticism from Republicans. Medtronic said it was studying the Treasury action and would "release our perspective on any potential impact on our pending acquisition of Covidien following our complete review."

Permanent restrictions on the transactions would ensure that $19.5 billion in projected corporate tax payments are not lost to the U.S. treasury over the next decade, according to a May estimate by the congressional Joint Committee on Taxation. Some economists and tax experts have questioned that estimate. Allan Sloan, Fortunemagazine's senior editor at large, called it "way, way low" in July testimony to the Senate Committee on Finance.

In contrast to the heavy national focus on the broader inversion issue, somewhat less attention has been devoted to the tax impact on shareholders.

"The market as a whole seems to be less sensitive to shareholder-level tax than one might expect," said Edward Kleinbard, a law professor at the University of Southern California and author of the forthcoming book "We Are Better Than This: How Government Should Spend Our Money."

Some investors who hold shares of inverting companies through mutual funds may not yet realize they could face capital gains taxes. Dan Wiener, CEO of Adviser Investments and editor of the Independent Adviser for Vanguard Investors, said the cumulative capital gains tax payment due could total millions of dollars. The individual hit won't be known until the end of the year, when mutual funds complete annual reports, he said.

"From an investor point of view, nobody's talking about this," said Wiener. "That's ludicrous. It's potentially a lot of money."

Joel Dickson, a senior investment strategist at Vanguard, said Wiener's projections might be inflated. He said any capital gains assessed to mutual fund shareholders of companies that undergo inversions could be offset by losses also carried on the funds' books.

That wouldn't help Allen. The father of three says he's exploring the possibility of donating some of his Medtronic shares to charity, and gifting some of the stock to his children. Those moves would help offset the capital gains hit.

"If you've had any large charitable bequests you'd want to make, this would be the time to do it," said John Gustavson, of CliftonLarsonAllen Wealth Advisors in Minneapolis. But he cautioned "it's not like there's a magic bullet to make it (the capital gains levy) go away."

Still, there is one group of investors for whom some inversion-related taxes won't be an issue. Several companies pursuing the transactions said they plan to pay excise taxes that officers and directors face as a result of the deals. The excise levy was approved by Congress as a way to discourage corporate inversions.

Medtronic estimated its cost at $63 million late last month. The company said the decision was made to ensure that the officials' evaluation of the inversion deal with Shire wouldn't be tainted by the specter of a personal bill for excise taxes. The levies are imposed in addition to the capital gains taxes all shareholders pay in inversion transactions.

"The tax is almost prohibitive in terms of its amount," Medtronic CEO Omar Ishrak said at the company's annual shareholders meeting in August.

Allen said he was angered by the payments, and the explanation.

"How do they get away with easing their own tax burden but not that of the hoi polloi?" he asked. "It's like the federal government declaring that Congress should not be subject to income taxes because it might taint their tax policy."