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September 10, 2014
News Analysis: Grossing Up an Inversion Tax
by Ajay Gupta

Full Text Published by Tax Analysts®

This article first appeared in Worldwide Tax Daily on September 4, 2014.

Medtronic Inc. will pay $63 million to insulate its executive officers and directors from the consequences of an excise tax that will be triggered on completion of a transaction announced June 15 in which the company will merge with Covidien PLC and concurrently invert to Ireland.

If Medtronic's officers and directors were to discharge their own tax liability, instead of falling back on the company's largesse, the total excise tax payments would amount to no more than $23.25 million. The difference, of about $39.75 million, represents the cost charged to Medtronic for the privilege of picking up the tab for its officers and directors -- a cost that will be borne in part by the company's shareholders. That result is a function of how Congress chose to design the excise tax -- a design that can be easily amended to ensure that no director or officer of an inverting corporation can slough off his excise tax liability.

Section 4985 of the code imposes an excise tax on the officers and directors of an inverting corporation who are subject to the reporting requirements of section 16(a) of the Securities Exchange Act of 1934. That tax amounts to 15 percent of a covered officer's or director's stock-based compensation, including stock options, held during the period beginning six months before and ending six months after the close of the inversion transaction.

In a statement filed August 26 with the Securities and Exchange Commission, Medtronic disclosed that it will gross up this excise tax by making additional payments to the company's covered officers and directors, "so that, on a net after-tax basis, they will be in the same position as if no such excise tax had been applied." According to the SEC filing, grossing up the excise tax on CEO and Chair Omar Ishrak alone will account for approximately $24.75 million of the $63 million in additional payments. The remainder is made up of $32.78 million for nine other executive officers and $5.5 million for 10 non-employee directors.

Par for the Course

Medtronic's decision to make these gross-up payments is by no means unusual. To the contrary, grossing up the section 4985 excise tax appears to be the norm in inversion transactions. For example, AbbVie Inc. announced July 18 that it was merging with Shire PLC and reincorporating in Jersey and simultaneously signaled its intent to make similar gross-up payments to its covered officers and directors. In an SEC filing of the same date, AbbVie disclosed that it "has agreed to indemnify such persons for any such excise tax obligation," though it failed to quantify the gross-up payments.

Reuven S. Avi-Yonah, Irwin I. Cohn professor of law and director of the International Tax LLM Program at the University of Michigan Law School, who advocates enacting robust anti-inversion legislation while also reducing the corporate tax rate to 25 percent, argues that by grossing up the section 4985 excise tax, corporations are effectively negating the policy objective of that tax.

Parity Between Shareholders and Management

What is that policy objective, and how does section 4985 seek to further it? Section 4985 was enacted by the American Jobs Creation Act of 2004, the same legislation that added to the code section 7874, Congress's first and thus far only direct attack on inversions. The accompanying report by the House Ways and Means Committee (H.R. Rep. No. 548, 108th Cong., 2d Sess. 246 (2004)) sets out the committee's motivation in imposing the section 4985 excise tax:

    The Committee is concerned that, while shareholders are generally required to recognize gain upon stock inversion transactions, executives holding stock options and certain stock-based compensation are not taxed upon such transactions. Since such executives are often instrumental in deciding whether to engage in inversion transactions, the Committee believes that, upon certain inversion transactions, it is appropriate to impose an excise tax on certain executives holding stock options and stock-based compensation. Because shareholders are taxed at the capital gains rate upon inversion transactions, the Committee believes that it is appropriate to impose the excise tax at an equivalent rate.

In other words, Congress was mindful that in a stock inversion transaction, tax consequences often fall unevenly on the inverting corporation's shareholders and its management. Even if the transaction is structured as an otherwise nontaxable exchange, the section 367(a) toll charge could apply to U.S. shareholders of the inverting corporation. Under reg. section 1.367(a)-3, if, in the aggregate, all U.S. shareholders own half or more, by vote or value, of the outstanding stock of the foreign parent immediately after the exchange, they have to recognize gain (but may not recognize loss) on the transaction to the extent that the fair market value of their shares exceeds their adjusted bases in those shares. By comparison, the corporation's officers -- the very individuals who solicit, negotiate, and finalize the stock inversion -- as well as the corporation's directors -- the individuals who approve that transaction -- can immunize themselves from the toll charge by holding stock-based compensation, such as stock options, instead of actual shares of stock.

Congress believed that this disproportionate tax burden could result in misaligned incentives in pursuing a stock inversion transaction. The section 4985 excise tax was intended to restore parity in treatment. This is evident from two features of the tax. First, under section 4985(c), the tax applies "only if gain (if any) on any stock in such corporation is recognized in whole or part by any shareholder"; that is, only in a stock inversion transaction that is either structured as a taxable exchange or one in which the section 367(a) toll charge applies. And second, under section 4985(a), the tax applies at "the rate of tax specified in section 1(h)(1)(C)"; that is, the maximum capital gains rate at the time of enactment and, thus, the highest rate of capital gains tax or section 367(a) toll charge payable by shareholders in a stock inversion transaction at that time.

The Mechanics of Section 4985

The excise tax is imposed on each "disqualified individual" of the inverting corporation. Section 4985(e)(1) defines the term to include all individuals "subject to the requirements of section 16(a) of the Securities Exchange Act of 1934 with respect to such corporation or any member of the expanded affiliated group which includes such corporation" -- in short, officers, directors, and 10 percent shareholders.

The base of the tax is the value of the covered individual's "specified stock compensation." Section 4985(e)(3) defines the term expansively to include "payment (or right to payment) granted by the expatriated corporation (or by any member of the expanded affiliated group which includes such corporation) to any person in connection with the performance of services by a disqualified individual for such corporation or member if the value of such payment or right is based on (or determined by reference to) the value (or change in value) of stock in such corporation (or any such member)" -- in short, all stock-based compensation. For stock options and other similar rights, including stock appreciation rights, section 4985(b)(1)(A) defines value as the "fair value" -- presumably, one derived by an option valuation model such as the Black-Scholes model. For all other stock-based compensation, section 4985(b)(1)(B)defines value as the "fair market value."

The Consequences of Grossing-Up

The conference report (H.R. Rep. No. 108-755, 108th Cong., 2d Sess. 579 (Conf. Rep. 2004)) makes it clear that the excise tax will have no effect on the income tax treatment of specified stock compensation. Thus, for the tax burden of the stock inversion to be borne equally by the shareholders and management, each disqualified individual must pay his own section 4985 excise tax. What happens if, instead, the inverting corporation pays the tax on behalf of a disqualified individual? Under Old Colony Trust Co. v. Commissioner, 279 U.S. 716, 720 (1929), any third-party payment of the excise tax would be included in the disqualified individual's taxable income. Moreover, section 4985(f)(2)(A) provides that this payment "shall be treated as specified stock compensation," and consequently, also be subject to a 15 percent excise tax. As a result, the payment of the disqualified individual's section 4985 tax liability by the inverting corporation will be "inefficient" -- each dollar paid by the corporation will reduce the disqualified individual's tax liability by a lot less than a dollar.

To see the extent of the inefficiency, we have to make some assumptions about the disqualified individual's marginal income tax rates. According to its SEC filing, Medtronic's estimate of $63 million in total gross-up payments assumes a federal tax rate of 39.6 percent and a state tax rate of 8.5 percent, for a total marginal income tax rate of 48.1 percent (disregarding the federal deductibility of state taxes). Using the same numbers, ignoring employment taxes, and adding the 15 percent section 4985 excise tax, means that 63.1 percent of any payment will be applied toward satisfying the additional tax liability created by that payment. Only the remaining 36.9 percent will be available to satisfy the original section 4985 excise tax liability. Thus, each dollar paid by the inverting corporation will reduce the disqualified individual's tax liability by no more than 36.9 cents. Conversely, to satisfy one dollar of the disqualified individual's tax liability, the inverting corporation will have to make a payment of $2.71 (2.71 being the reciprocal of 0.369). In sum, in choosing to gross up a disqualified individual's section 4985 tax, an inverting corporation will end up paying over 2-1/2 times what the disqualified individual would have paid.

Using the 2.71 multiple, we may conclude that the $63 million in Medtronic's estimated total gross-up payments for all its disqualified individuals reveals a combined original section 4985 excise tax liability of about $23.25 million. In addition to that amount, Medtronic will be out $39.75 million for the privilege of paying the section 4985 excise tax liability on behalf of its disqualified individuals. To add insult to injury, under section 4985(f)(2)(B), not a single cent of the $63 million paid by Medtronic shall "be allowed as a deduction under any provision of chapter 1."

Professor Adam Rosenzweig of the Washington University School of Law points out that grossing-up the section 4985 excise tax raises the question of who bears the incidence of that tax. Though it is difficult to make an exact determination, he observes that we can safely surmise that as with many taxes paid by a corporation, the incidence falls on the corporation's shareholders, consumers, or workers, or some combination of them.

It follows that Medtronic's shareholders bear some portion of the original section 4985 excise tax liability of $23.25 million, as well as of the additional deadweight burden of $39.75 million. Further, the nondeductibility of its payments increases the cost to Medtronic and therefore adds to the tax burden of its shareholders, who will also pay taxes on all built-in gains in their Medtronic's shares because the merger and inversion entails a taxable exchange. That result seems to turn on its head Congress's proclaimed goal of equalizing the tax burden of a stock inversion between the inverting corporation's shareholders and management.

Unsurprising Outcome

Congress could not have been surprised by the practice of grossing up the section 4985 excise tax. For one, the conference report (H.R. Rep. No. 108-755, 108th Cong., 2d Sess. 578 (Conf. Rep. 2004)), in discussing the need for Treasury guidance on valuing stock-based compensation, refers to similar guidance provided under the golden parachute payment limitations of section 280G. Surely, Congress was aware that the 20 percent excise tax imposed on "an officer, shareholder, or highly-compensated individual" for excess parachute payments has been routinely grossed up by corporations ever since 1984 when that tax was first codified in section 4999. Moreover, as noted above, section 4985 itself addresses the proper tax treatment of third-party payments of the excise tax; it requires that these payments themselves be subject to the tax and be nondeductible.

Thus, not only was Congress on notice about the possibility of gross-up payments, but it also provided specific instructions on how they should be treated. Those instructions increase the tax burden on the inverting corporation and, as a result, on its shareholders. That seems to make a mockery of feigned congressional concern "that, while shareholders are generally required to recognize gain upon stock inversion transactions, executives holding stock options and certain stock-based compensation are not taxed upon such transactions." It is difficult to avoid the conclusion that section 4985, the legislative antidote to that professed concern, is a disingenuous, or worse, cynical, response to the "inversion crisis."


If Congress had been serious about ensuring that disqualified individuals actually pay out of pocket the excise tax nominally imposed on them, it could have engineered that outcome. As noted above, section 4985(f)(2)(A) treats as "specified stock compensation" and, as a result, subjects to the 15 percent excise tax, "any payment of the tax imposed by this section directly or indirectly by the expatriated corporation or by any member of the expanded affiliated group which includes such corporation." Congress could have, instead, subjected all those payments to a much higher tax rate. A rate of 70 percent, for example, would have meant that along with federal and state income taxes, over 100 percent of any payment seeking to reimburse a disqualified individual would have to be paid over to some taxing authority. Not a single cent of the payment, no matter how large, would then have ended up with the disqualified individual it sought to reimburse. Faced with that confiscatory tax, no inverting corporation would have attempted reimbursement -- not because it cost too much, but because it would have been futile.

There would certainly have been enforcement challenges in tracking down a payment, labeling it as reimbursement, and, consequently, classifying it as one covered by the confiscatory tax. But all of those challenges exist under the current regime, which imposes the much lower 15 percent tax on these payments. Moreover, disgorgement by means of high taxes is not a foreign concept to the code -- the section 6672 trust fund penalty is an example that springs to mind.

Indeed, if Congress truly believes that striking a greater balance in the tax burdens of shareholders and management will influence a corporation's decision to invert, it can still make the changes outlined above. All that is required is a simple amendment to section 4985(f)(2)(A). And while Congress is at it, it can repeal section 4985(f)(5), which affords disqualified individuals the protection of deficiency procedures. Let them pay first before they get to challenge their assessment in court. Medtronic's SEC filing proves, as if proof were needed, that these individuals are not exactly wanting for resources.

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