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New York ad firm Omnicom estimates that a merger and reincorporation in the Netherlands will save $80 million a year.

Law to limit moves overseas backfires

Instead of CEOs paying penalty, they get benefits earlier

– Ten years ago, Congress passed a law intended to penalize chief executive officers whose companies shift their legal addresses to tax havens.

It hasn’t worked out as planned. In the past two years, a fresh wave of companies has fled the U.S. system to avoid hundreds of millions of dollars in taxes.

For example, in October, New Jersey drugmaker Actavis changed its incorporation to Ireland. It helped CEO Paul Bisaro avoid the law’s bite by handing him more than $40 million of stock as much as three years ahead of its schedule, then promising him an additional $5 million to remain with the company.

The 2004 law aimed at reducing the tax benefits of reincorporating overseas has “clearly been a failure,” said Edward Kleinbard, a professor at University of Southern California’s Gould School of Law. “And it now has the perverse result of putting money into executives’ pockets sooner.”

The law imposes a special tax of 15 percent on restricted stock and options held by the most senior executives when a company reincorporates outside the U.S.

Since the measure took effect, at least seven large companies have disclosed in securities filings that they risked triggering the tax. All took steps to shield their executives from having to pay.

Three of the companies’ boards simply picked up the tax bill for their executives, maintaining that the managers shouldn’t suffer for a decision that benefits shareholders.

Boards at three other companies, including Actavis, helped them avoid the tax altogether by allowing restricted stock to vest early and for options to be exercised. Awarding the equity early raises the risk that the executives might quit or sell their shares, or get paid for meeting goals they never attain.

Since 2012, at least 13 large U.S. companies have announced or completed shifts of legal address, which tax experts call “inversions,” to lower-tax nations such as Ireland and Switzerland.

New York advertising firm Omnicom estimates that a planned incorporation in the Netherlands this year, part of a merger with a French rival, will save the combined company $80 million a year.

The cost of the recent wave of address changes in lost U.S. federal tax revenue may be $500 million a year, estimates Robert Willens, a tax and accounting consultant in New York.

The statutory U.S. corporate income tax rate of 35 percent is the highest among developed countries, although many companies end up paying less. Lawmakers in both parties and President Obama have endorsed tax code changes that would lower the rate below 30 percent, reducing the incentive to reincorporate overseas.

Some Democratic lawmakers have introduced legislation that would treat companies managed from the U.S. as domestic even if they’re incorporated elsewhere. Sen. Carl Levin, D-Mich., said last year the change would raise tax revenue by $6.6 billion over 10 years. None of those bills have attracted much Republican support.

Tax-haven flight

The 2004 law was triggered by an earlier flurry of corporate flights to tax havens. Tyco International of Exeter, N.H.; Fruit of the Loom of Chicago; and Ingersoll-Rand, in Woodcliff Lake, N.J., incorporated in Bermuda or the Cayman Islands in the late 1990s and early 2000s.

Lawmakers took notice by 2002, when 159-year-old Connecticut toolmaker Stanley Works announced plans to use a Bermuda address. They denounced the company’s CEO and proposed more than 30 different bills to curtail the practice. Connecticut’s attorney general sued, and union officials organized protests in the company’s hometown of New Britain.

“These expatriations aren’t illegal. But they’re sure immoral,” said Charles Grassley of Iowa, then the top Republican on the Senate Finance Committee. Stanley Works eventually dropped the Bermuda plan.

Grassley helped shepherd a series of anti-inversion measures into law in the American Jobs Creation Act of 2004. Some provisions made it harder for companies to get tax savings from incorporating abroad. Acquiring a mailbox in Bermuda was no longer enough.

One route that remains available involves a foreign merger, as long as the partner is at least one-fourth the size of the U.S. firm. Most of the reincorporations since 2004 have been achieved through acquisitions abroad. They include Liberty Global, the Englewood, Colo., cable operator, and Tower Group, the New York insurer.

So many pharmaceutical companies are switching addresses that bankers are pitching takeovers of Irish drugmakers based on the tax benefits. Gregg Gilbert, a Bank of America drug analyst, dubbed it a “tax rate land grab.”

Another provision in the 2004 law imposed the penalty on CEOs.

Since the mid-1990s, the IRS has required stockholders of some companies reincorporating abroad to recognize capital gains on the shares and pay income tax. But that rule doesn’t apply to the restricted stock or unexercised options of executives, who technically don’t own the shares. Some lawmakers saw that as an unjustified boon for the CEOs.

“It is only fair for these executives, who are picking the pockets of the American taxpayer to the tune of $4 billion, to feel some of the pinch,” Rep. Richard Neal, D-Mass., said in 2002.

Overhaul needed

The law is a classic example of how Congress’s attempts to tweak corporate behavior through the tax code usually backfire, said Kevin Murphy, a professor at USC’s Marshall School of Business who studies executive compensation.

“One thing we can always count on is that there will be lots of unintended consequences – usually costly – for shareholders and for taxpayers.”

The accelerated payments may also upend companies’ compensation plans, said Brian Foley, a consultant in White Plains, N.Y., who helps companies set pay. Restricted shares are designed to be earned over time. If officers can cash out their shares immediately, they may no longer have as much reason to stay at the company or contribute to its long-term success, he said.

“I want him or her to have skin in the game,” Foley said. Without restrictions on equity awards, “they can pick up their sticks and leave, and they get to take all that vested stuff with them.”

Congress should overhaul the whole corporate tax system rather than targeting address shifts, said Bret Wells, a professor at the University of Houston Law Center. U.S. rules allow foreign companies to dodge taxes on their American profits, a process called “earnings stripping,” more easily than domestic companies can.

“Inversion transactions should be a wakeup call,” Wells said. “They should tell us there’s something wrong with our tax system when it’s more valuable to be foreign-owned than U.S.-owned.”