Coke Bottler's Merger Might Lose Tax Gain to Inversion Rules

  • Private-equity funds seen as regulation's possible losers
  • `Companies are in a bit of a state of shock' at proposed rules

When Coca-Cola Enterprises Inc. announced a merger with two overseas counterparts last August, the Atlanta-based bottler of Coke drinks in Western Europe said the deal had nothing to do with cutting its corporate tax bills.

Now, after the U.S. Treasury Department proposed tougher-than-expected regulations designed to prevent firms’ shifting profits offshore last month, the company has a different message.

In an April 11 securities filing, Coca-Cola Enterprises warned that one Treasury proposal, unveiled seven days earlier, could reduce the merger’s anticipated annual savings of as much as $375 million -- though it didn’t specify a new amount. Since the rule targets a tax-cutting technique known as “earnings stripping,” the company’s disclosure shows that tax savings were an important benefit of the merger all along, said Robert Willens, a tax and accounting consultant in New York.

“For them to even mention it, you can safely infer that earnings stripping was at least a pretty decent part of the savings,” Willens said.

The disclosure, one of the first instances in which a large, multinational company has cited the rule as a potential crimp on tax benefits, shows the Treasury proposal’s reach. Though it was released in the narrow context of corporate inversions, it’s poised to affect the daily financial operations of a far larger number of companies, tax lawyers say. Treasury officials will accept public comment on the rule until July.

“Companies are in a bit of a state of shock because of how sweeping the regulation is," said Sam Kaywood Jr., co-chairman of the Federal Income & International Tax Group at law firm Alston & Bird LLP in Atlanta. David Hariton, a corporate tax lawyer at Sullivan & Cromwell LLP, said the proposal could mean unexpected tax bills for firms ranging from private equity funds, which use internal debt transactions to pay investors, to large foreign banks that are now restructuring their U.S. units into holding companies, as required under the Dodd-Frank Act.

Fred Roselli, a Coca-Cola Enterprises spokesman, declined to detail the proposed rule’s effect on the planned merger, but said it “would not impact our ability to close the deal by the end of the second quarter.” The company has said it anticipates $350 million to $375 million in annual savings over the new company’s first three years. Shareholders are scheduled to vote on the merger at a May 24 special meeting.

Politicians’ Target

In a typical inversion, a U.S. company combines with a smaller foreign company, then moves its tax address overseas to a lower-tax jurisdiction. Since the first inversion in the 1980s, about 50 companies have undertaken the strategy. 

The maneuver has become a target for politicians and regulators amid a spate of recent deals, including Minneapolis-based Medtronic Inc.’s move to Ireland last year through a $53 billion merger with Covidien Plc. New York-based Pfizer Inc.’s $160 billion plan to invert with Allergan Plc of Ireland was canceled last month because of another Treasury proposal that would limit a company’s ability to participate in inversion transactions if it has already done them within the past 36 months.

One way that inverted companies get tax benefits is through earnings stripping, a strategy that shifts taxable earnings out of the U.S. by means of loans between subsidiaries. Companies load U.S. subsidiaries with debt -- and lucrative deductions on interest payments -- while the interest income goes to foreign affiliates in low-tax countries. Treasury’s proposed rule would treat part or all of certain intra-company loans as equity, rather than debt -- canceling interest deductions for U.S. units and creating taxable dividends.

Operational Address

Although the merger of Coca-Cola Enterprises and Coke bottlers in Germany and Spain will result in a new company domiciled in the U.K., the deal doesn’t meet one standard definition of an inversion: Shareholders of Coca-Cola Enterprises would wind up with just 48 percent of the new company. (Treasury regulations that limit tax benefits for inversions apply when U.S. shareholders own 60 percent or more.) Also, the new company, which would be named Coca-Cola European Partners Plc, wouldn’t just have an empty U.K. tax address; its operational headquarters will be in the U.K. as well, according to corporate disclosures.

Still, Coca-Cola Enterprises cautioned investors that the Internal Revenue Service might deem its merger an inversion anyway -- under another new rule that limits the tax impact of certain asset transfers before a merger. Willens said that rule, which went into effect last month, might have the effect of boosting U.S. shareholders’ stake in the new company. And he said the IRS might also question whether the new company’s tax address should rightly be in the U.K., given that the two European bottlers involved in the deal are in Spain and Germany.

Meanwhile, the Treasury Department is accepting public comments on its proposed earnings-stripping rule, which is meeting resistance from tax lawyers and corporations who say it would bar routine financial tools, such as “cash pooling,” in which companies sweep daily excess cash from various subsidiaries into a single account.

Coca-Cola Enterprises, which was spun off from Coca-Cola Co. in 1986, has most of its business in Spain, Germany and other European countries, but has been paying taxes at U.S. rates. While the top U.S. corporate income tax rate is set at 35 percent by statute, the company’s effective rate was 20 percent last year, due to offsets from foreign tax credits. In the U.K., the top statutory corporate income tax rate is 20 percent.

Overseas Earnings

U.S. law allows companies to defer taxes on foreign earnings that the company keeps offshore, and Coca-Cola Enterprises has been keeping about $1.8 billion overseas. A new U.K. address would allow it to tap that profit without triggering U.S. taxes.

Coca-Cola Enterprises insists that tax benefits weren’t driving the merger. “This is not even remotely a tax-driven transaction,” John Brock, its chief executive officer, told reporters and investors last August when the deal was announced. “It’s a strategic and operational transaction.”

Still, the company’s April 11 filing said the merger “will result in significantly enhanced cash management flexibility, including access to non-U.S. cash flow with associated financial benefits, as compared to incorporation in the United States.”

Bret Wells, an associate law professor at the University of Houston Law Center, said that’s jargon for gaining access to offshore cash and for the intra-company loans targeted in the Treasury proposal. “The fact is that it is cheaper and less tax costly to run U.S. businesses from non-U.S. platforms,” he said.

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