When Applied Power Inc. (APW) spun off its communications and electrical infrastructure services division last year, it did so in a way that will increase its earnings for years. The company decided to reincorporate in Bermuda, and thereby exclude all future foreign earnings from U.S. tax. After paying a one-time corporate-level tax on the move, APW then spun off the division last July in a tax-free reorganization to its shareholders. Expatriation in this fashion--also known as a flip transaction--should add between 5 percent and 10 percent to what APW's bottom line would have been after taxes as a U.S. company.
APW, still headquartered in Waukesha, Wisconsin, contends that taxes weren't its sole motivation. "A large part of our revenues and a significant part of our future strategic opportunities are outside of the U.S., so this move made a great deal of sense to us," says Joe Lower, leader of finance and corporate development. "The tax picture is important, but this should also help us to create more flexibility in financing arrangements, transaction structuring, and accessing sources of global capital."
APW is by no means the first U.S. company to merge tax-free with an offshore subsidiary. In response to earlier deals, the U.S. Treasury Department in 1994 erected regulatory obstacles to expatriation. And while those haven't prevented companies from moving offshore to minimize taxes, the hurdles are complicating cross-border deals. That includes those between independent companies whose primary objectives have little or nothing to do with tax savings. Of course, the tax benefits of going offshore might be diminished if the incoming Bush Administration gets Congress to enact its proposal to slash tax rates across the board. But for the time being at least, the benefits are substantial enough to draw interest from a growing number of companies. Among the latest is Foster Wheeler Corp., a Clinton, New Jersey based construction and engineering firm that has announced plans to move to Bermuda.
The case that inspired the Treasury Department involved a company called Helen of Troy Inc. (now Ltd.), which initiated a flip transaction to take itself to the Cayman Islands. After issuing an emergency cease-and-desist notice making any future regulations retroactive to the date of issue, the department has since written regulations on the new rules, embodied in Section 367 of the Internal Revenue Code. These, in fact, make it very difficult for companies to go offshore without incurring a tax known as a toll charge. In APW's case, the charge came to $40 million.
Nevertheless, a handful of companies besides APW have done flip transactions anyway, taking advantage of offshore status in such tax-free nations as Bermuda and the Cayman Islands. "There was a lot of talk when Helen of Troy did its transaction that everyone would go out and do this, so the IRS took action," says Robert Willens, senior managing director and tax adviser at Lehman Brothers in New York. "But for some companies, the tax savings still outweigh the toll charge. The regs just aren't a deterrent in some cases."
Another company that has paid the toll is Tyco International Ltd., based domestically in Exeter, New Hampshire. When Tyco sought a way to build on its fire-safety business a few years ago, one likely acquisition candidate was ADT Ltd., a Bermuda based company with an extensive security systems business in the United States and abroad. The deal also opened up a tax-saving opportunity. And after doing the math, Tyco evidently concluded that the long-term benefit of lower taxes would more than offset the up- front toll charge.
Tyco declined to comment on the transaction, but the company's CEO and chairman, L. Dennis Kozlowski, said in published reports that as a result of the merger, he himself owed about $10 million in capital-gains taxes on his personal holdings in 1998.
Today, Tyco's total tax rate is about 30 percent, including all taxes and nondeductible items, compared with 43 percent in 1995. Its rate would drop even lower if Tyco expands more rapidly outside the United States than within, since there is no corporate tax in Bermuda, compared with a 35 percent corporate tax rate in the States.
This tax treatment of foreign income is especially attractive to companies that have most of their business overseas, particularly in low- or no-tax jurisdictions. And expatriation is especially tax-efficient when the company is growing through acquisitions, as Tyco is, since the deals themselves produce more income beyond the reach of the Internal Revenue Service.
That has also been the scenario for Transocean Sedco Forex Inc., an offshore and deepwater oil drilling and services firm. First, Transocean ASA, a Norwegian company that reincorporated in the Cayman Islands, merged with Sonat Offshore Drilling Inc., a U.S. drilling firm, in 1996. Then, in 1999, Transocean merged with Sedco Forex Holdings Ltd., an oil- drilling unit of Schlumberger Ltd., which is itself domiciled in the Netherlands Antilles but is run from New York and Houston. The combined company reincorporated in the Caymans, but still has principal offices in Houston. In announcing the move, CEO J. Michael Talbert said the company was hoping to shave 10 to 20 percentage points off its 1998 tax rate of 29.5 percent over the long term. And now Transocean is acquiring another U.S.-based firm, R&B Falcon Inc., in another tax-free merger.
As APW's Lower suggests, getting foreign income out of the hands of Uncle Sam is just one of the draws of going offshore. Another lies in the flexibility companies gain in managing subsidiary debt and shifting funds to where they are most needed. All that can be done without having to keep track of U.S. credits on income subject to tax elsewhere.
"Foreign tax credits can be very difficult for U.S. companies to manage, especially if [they] have lots of debt on the books and are making acquisitions overseas," says Howard Lederman, tax leader at APW. "Going offshore, you put yourself in a different ballgame. Instead of worrying about limits on credits and interest allocation, you can focus on the right operating structure and can move cash around more easily to fund that structure."
BARRIERS TO HAVENS
One reason companies might agree to pay the toll charge is that meeting the criteria to avoid it can be a challenge. For one thing, the tax regulations stipulate that, for the deal to be tax-free at the shareholder level, not more than 50 percent of the voting rights or value of the combined company can remain in the hands of the U.S.-based sellers. In effect, this means that smaller foreign companies can't acquire larger U.S. companies without triggering U.S. capital-gains tax. In addition, offshore companies must be able to show that they are engaged in an "active" trade or business, which rules out the move for holding companies and other passive acquirers. What's more, the target's officers, directors, and large shareholders cannot end up with a majority of the acquiring firm after the transaction.
Finally, there is the biggest barrier of all, that of "substantiality." This rule says that the acquiring firm must be substantially the same or greater in value than the selling firm. That test might not be so difficult to meet if the standard were simple market value. But the Treasury Department's method for calculating value reflects myriad exclusions, known as "anti-stuffing rules." These exclusions include all passive assets, many financial assets, any acquisition done with an eye to meeting the substantiality test, and a host of others.
"It can be virtually impossible to identify all the assets of foreign companies that may fall under these rules, so many cross-border deals now go to the IRS for a private-letter ruling," says Louis Feldman, an investment banking director at Credit Suisse First Boston and a tax-structuring specialist for mergers and acquisitions. "A number of deals have not met the guidelines and received waivers; others came close to not getting the needed approvals at all. No one knows when the IRS may refuse to grant a waiver or change its standards, so companies going into cross-border deals can never be sure they will get tax-free status when they start."
STILL MORE HURDLES?
This uncertainty has plagued some of the biggest international mergers of the last few years, including the Daimler- Chrysler, Vodafone-Airtouch, and Excel- Teleglobe deals. In each case, the IRS either found that the acquirer met the regulations or granted a waiver for substantial compliance, which it is allowed to do under the regulations. Getting a private ruling on these questions typically takes three to nine months, depending on the complexity of the deal.
What's more, the Treasury Department has left the door open to further regulations in this area to make sure the IRS collects what is due. Although fully aware of the hurdles the regulations create, the department indicates that extra hurdles and approvals may be needed to keep a grip on its interests--the taxable income of corporations here, and the right to grant tax-free status to deals that would otherwise be taxable events. The department contends that the private-letter mechanism in the regs works in favor of taxpayers. One official notes that the mechanism's use is now routine, and that the outcome is often tax-free status.
Perhaps the biggest issue preventing more corporations from taking themselves offshore for tax purposes is the court of public opinion. Most of the companies mentioned in this story would not comment on their current tax status, or even cooperate in confirming relevant facts about their transactions. Simply put, there's a definite stigma attached to companies that make aggressive moves to avoid taxes. "No one wants to be the poster child for corporate tax avoidance, and that keeps many companies from ever considering the advantages that may lie in offshore status for them," says Feldman.
Then there are concerns about the potential impact on one's shareholder base. For one thing, when a company moves offshore, many mutual funds and pension funds are forced to sell their shares. That's because of restrictions on owning what are now, technically, foreign shares, even though the company is still listed on a domestic exchange and thus required to reconcile its accounts to U.S. accounting standards.
Even without such ownership restrictions, investors may shy away from such securities because of concerns over corporate governance and shareholder rights. Such combinations as Daimler-Chrysler and Vodafone-Airtouch have suffered from this "flowback," as the phenomenon is known, of U.S. shareholders selling their shares and reinvesting in domestic-based firms.
How has APW managed to avoid these problems? Joe Lower attributes positive shareholder reaction to the fact that the procedure has become more commonplace and, therefore, better understood. But he concedes that the economic and practical costs will still be unacceptable to most companies. "At first glance, this looks very attractive to a lot of people," he says. "But on a company-by-company basis, looking carefully at the tax cost and other costs, and carefully modeling the potential benefits, most decide that this is not a good option for them." Concludes Lower: "I don't think there will ever be a rush of companies doing this."
Ian Springsteel is a freelance writer based in Boston.
Out of Sight, Out of Mind
Perhaps the most brazen move offshore was that of Fruit of the Loom Inc. (now Ltd.) in 1999, when the company reincorporated in the Cayman Islands following the relocation abroad of most of its manufacturing operations. Expatriation came at a low point in the company's share performance, which gave most shareholders very little in the way of a toll charge to shoulder. Despite the benefits of a lower tax rate, Fruit of the Loom ended up in Chapter 11 a year later, under a new CEO, and was delisted from the New York Stock Exchange. Today, the company is considering a repatriation move to simplify its corporate structure. --I.S