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Love It and Leave It?

The hue-and-cry over inversions may change the way overseas income is taxed.
Tim Reason, CFO Magazine
July 1, 2002

Employees of Ingersoll-Rand Co.'s Bobcat division were deeply moved by a photograph of firefighters gathered around a Bobcat skid-steer loader to pay tribute to a victim of the World Trade Center collapse. Just six days after the terrorist attacks, the firm began manufacturing a special-edition "Spirit of America" loader, painted in patriotic red, white, and blue.

At the same time, CEO Herbert Henkel was putting the finishing touches on a plan to reincorporate the New Jersey manufacturer in Bermuda--a proposal that was put to shareholders six weeks later. "We urge you to join [the board] in supporting this important opportunity," wrote Henkel. "The reorganization should help enhance our business growth and cash flow and reduce our worldwide effective tax rate."

Ever since, congressional Republicans and Democrats alike have blasted Ingersoll-Rand and other companies that pursue such so-called inversions as being un-American. Says Iowa's Chuck Grassley, the ranking Republican on the Senate Finance Committee and co-author of a bill aimed at stemming the practice, "It's outrageous that some companies are willing to leave their country during a war and a recession just to save some taxes."

Yet the outcry--and the inversions themselves--are merely a skirmish in a larger international tax battle involving Congress, the World Trade Organization (WTO), and companies worldwide. At stake is whether the United States will continue to tax income earned overseas--an issue of enormous consequence. "There is hardly a U.S.-based company of any significant size that is not faced with applying the international tax rules to some aspect of its business," notes a May U.S. Treasury report, called "Corporate Inversion Transactions: Tax Policy Implications," that urges a broader policy response to the inversion issue.

Without a broader response, finance executives will remain in the precarious position of having to defend any international tax policies aimed at maximizing shareholder value against their patriotic duty. Current tax rules create "a major disparity between what is right for the country and what is right for your company," says Thomas M. Jones, in the Chicago office of McDermott, Will & Emery. "We should strive to achieve a tax system that aligns patriotism with good business sense. That is the [real] challenge that Congress needs to take on."

Island Hopping
Ingersoll-Rand's expatriation is not unique. At this year's round of annual meetings, shareholders of Cooper Industries, Leucadia National, Noble Drilling, and The Stanley Works all voted to move overseas--on paper, at least.

Inversion is largely a paper transaction, in which a U.S. corporation creates an offshore subsidiary--typically little more than a mailbox in a foreign tax haven--and then "inverts" the ownership, transforming the subsidiary into the legal parent of the U.S. corporation that created it. That instantly eliminates U.S. taxes on income earned abroad. Once established, the offshore parent can also issue intercompany debt and charge licensing fees on intangible assets, which provides deductions and reduces the remaining taxable profits of the U.S. firm.

Otherwise, there is little change besides an exchange of U.S. stock for stock of the new foreign company, which typically carries the same symbol it had before. Indeed, so nominal is the change that Ingersoll-Rand, Tyco International, and Cooper Industries--all now Bermuda firms--continue to be listed on the S&P 500, which excludes non-U.S. companies.

The recent rush to invert has been driven by the fact that the recession and lower stock values have weakened the tax code's existing deterrent to such corporate emigration. Following the February 1994 inversion of Helen of Troy, the IRS limited inversions by levying a capital gains tax on most exchanges of U.S. stock for foreign company stock. That move, until recently, made inversions relatively rare. "Over the last eight years, just a few companies would expatriate per year," explains John M. Peterson, chair of the global tax practice of Chicago-based Baker & McKenzie, which claims to have pioneered inversion by advising Helen of Troy. "But more recently, with the stock market down, there has been a flurry of activity."

It's that timing that has fueled much of the anger in Congress, where the expatriations are seen as capitalizing on the economic effect of the September 11 terrorist attacks. "Here's a company pulling up stakes when the cleanup at Ground Zero is barely done," charged Grassley on news that The Stanley Works shareholders had approved reincorporation in Bermuda.

Yet most companies with inversions in the works seem largely undaunted. The Stanley Works, for example, says it plans to proceed with its inversion, despite a warning from Grassley that it was "setting up a showdown with Congress," as well as charges of irregularities in its shareholder vote by the Connecticut attorney general that have since forced the company to schedule a revote.

Cooper Industries actually turned the September 11 argument around, noting that it had explored "every reasonable alternative that could maximize value for Cooper's shareholders, including a sale of Cooper in whole or in parts," but found no takers after the terrorist attacks. The company predicts reincorporation will reduce its effective tax rate from 32 percent to as low as 20 percent, generating $55 million annually in additional cash flow.


Shareholders of New York-based Leucadia National Corp. approved a Bermuda inversion in May, although the firm plans to wait until the one-time tax hit can be reduced from an estimated $315 million to $100 million. CFO Joseph A. Orlando refuses to explain how the company plans to do so--"I think it's clear enough from [our proxy statement] what we are doing," he says--but Leucadia has not been shy about its motives. The benefit of avoiding U.S. corporate tax on overseas investments, declared chairman Ian M. Cumming and president Joseph S. Steinberg in their annual report letter, "is at the heart of what we are paid to do--increase shareholder value."

American Exceptionalism
At the heart of the arguments for inversion is the claim that the United States stands essentially alone in taxing income earned overseas. That's not entirely true--there are other countries that tax overseas income, and U.S. firms do get credit for income taxes paid to other countries with which the United States has tax treaties. But most other countries have simpler territorial systems that tax only income earned within their borders, or use value-added taxes that are refunded for exports. "No country has rules for the immediate taxation of foreign-source income that are comparable to the U.S. rules in terms of breadth and complexity," says the May Treasury report. Inversion, it adds, is often referred to as "self-help territoriality."

If firms are helping themselves align their taxes with what they see as international norms, it is primarily because U.S. efforts to do the same have largely failed, argues attorney Jones. Take the controversy over the foreign sales corporation (FSC) law, which gave companies an exemption from U.S. tax for a portion of the income earned from export transactions conducted through foreign subsidiaries. In February 2000, the WTO, which oversees trade between nations, declared the exemptions to be illegal subsidies. The United States responded by repealing the FSC and passing the Extraterritorial Income Exclusion Act of 2000 (ETI), which the WTO also declared illegal.

Essentially, says Jones, the WTO "told us we had made our bed--a worldwide taxation system--and we have to lie in it." Ironically, those export incentives were intended to bring the tax burden of U.S. companies in line with that of their European competitors. "ETI tried to mimic territoriality with a little carveout in our system, but unfortunately, the WTO said that's a sham," says Jones. The European Union, angered by the Bush Administration's decision to raise steel tariffs, has since used the decision to threaten the United States with retaliatory excise duties amounting to more than $4 billion.

The WTO's action, coupled with the inversion trend, has forced Congress to once again tackle international tax rules. "The WTO's most recent decision and the resulting sanctions facing our businesses are another wake-up call for reform," noted Rep. Jim Ramstad (R-Minn.) in February.

Band-aid Solution?
Republicans are already voicing plans for dramatic change, from moving to a territorial system to pie-in-the-sky rhapsodies about eliminating corporate taxes. But any major international tax reform will take years, notes Jones. In the meantime, some immediate action on inversions seems likely. "Whether it's a Band-Aid or not," he says, "it's high priority."

Grassley, for example, along with Finance Committee chairman Max Baucus (D-Mont.), is author of the Reversing the Expatriation of Profits Offshore (REPO) Act, introduced in April, which would tax inverted U.S. companies as if they were still incorporated in the States. Between March and May, five similar bills were introduced in Congress, with such names as the Corporate Patriot Enforcement Act and the Uncle Sam Wants You Act (which would impose a moratorium on expatriations dating retroactively to September 11).

While none of these bills constitute a major tax overhaul, whatever is passed will affect more than those businesses that have inverted. "It is clear there will be a bright red line drawn against using inversion to reduce U.S. tax on U.S. income," says Jones. That is likely to have an impact on all companies with foreign parents. It could also have a chilling effect on future cross-border mergers or acquisitions of U.S. companies. Combinations such as DaimlerChrysler do not carry the same upfront tax penalties as inversion, and their potential to reduce U.S. tax revenues appears to worry the U.S. Treasury more than inversions.

Could any new legislation force inverted companies to repatriate? Experts doubt it, but they point out that the legislation and the recent publicity may deter others. "The political heat is not to be underestimated," says Jones. "[Inversion] is a very hot potato right now. That is probably the biggest disadvantage--the perception that it is unpatriotic."

As for the larger international tax issues, Congress is between a rock and a hard place. To mollify the EU, it must repeal ETI--without trying to squeeze yet another version past the WTO. That's bound to anger U.S. firms. But if Congress does nothing, the EU will likely start levying punitive duties against U.S. exports. And the EU is not likely to wait around for years of congressional fighting over a complete overhaul of the U.S. taxation system. No wonder Congress is so angry at the companies that caused all this fuss.


Tim Reason (timreason@cfo.com) is a staff writer at CFO.

Follow The Sun: Who's Inverting Where?*

CompanyCountry of IncorporationYear Inverted
Helen of TroyBermuda1994
Electric Mutual Liability InsuranceBermuda1995
Triton Energy**Cayman Islands1996
Tyco International***Bermuda1996
Everest Reinsurance HoldingsBermuda1999
Fruit of the LoomCayman Islands1999
PX ReBermuda1999
TransOcean Sedco ForexCayman Islands1999
White Mountain Insurance GroupBermuda1999
XomaBermuda1999
Applied PowerBermuda2000
AccentureBermuda2001
Foster WheelerBermuda2001
GlobalSantaFe***Cayman Islands2001
Ingersoll-RandBermuda2001
Cooper IndustriesBermuda2002
Nabors IndustriesBermuda2002Y'
NobleCayman Islands2002Y'
The Stanley WorksBermuda2002Y'
Weatherford InternationalBermuda2002Y'

*A partial list
**Purchased in 2001 by Amerada Hess
***Inverted through merger with existing offshore company
Y'Planned
Sources: Company News Releases, Press Reports

No Getaways Here

Both the May Treasury report on inversions and the REPO legislation propose a tightening of Section 163(j) of the U.S. Tax Code, which currently caps the deduction for interest expenses paid to related parties. "The prevalent use of foreign related-party debt in inversion transactions is evidence that these rules should be revisited," notes the report, adding that any changes should not be limited to inverted companies, but should also be applied to those businesses that had foreign parents from the outset, or to foreign corporations that acquire U.S. operating groups.

The REPO Act also tightens the 163(j) rules for interest paid to U.S. lenders when the guarantor is a related tax-exempt or foreign person. And, notes Lehman Brothers's Robert Willens, "for this purpose, the concept of guarantee goes well beyond the ordinary understanding of the term." In other words, any company with a foreign parent may now have a harder time deducting interest payments.

Also likely to be affected are captive insurance companies--another form of inversion. As the report states: "Consideration should be given to whether the use of related-party reinsurance permits inappropriate shifting of income from the U.S. members of a corporate group to a new foreign parent and its foreign affiliates." -- T.R.




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