A common assumption is that tax planning by corporate managers benefits shareholders. Since corporate income is subject to “double taxation” at both the corporate and shareholder levels, tax-reduction strategies by corporate managers can reduce the entity-level tax, thereby increasing the after-tax corporate earnings available to the shareholders.
Omri Marian’s new article challenges this conventional assumption by presenting a more nuanced understanding of the dynamic between corporate and shareholder-level tax effects. The work demonstrates how corporate tax planning may in fact disadvantage shareholders in many cases, and why certain shareholders may be unable to prevent it.
There are two key elements to Marian’s argument. The first is what Marian terms “Shareholder Taxable Corporate Transactions (STCTs)”—corporate transactions that can reduce corporate tax liabilities but may have adverse shareholder-level tax consequences, such as capital gains realized by shareholders upon an inversion transaction or forced distributions following a REIT spinoff or conversion. The second element is the heterogeneity of shareholder tax circumstances, and in particular the significant share of corporate stock held by tax-exempt investors. These shareholders may be entirely indifferent to any shareholder-level tax consequences of STCTs (and are solely interested in reducing corporate-level taxes), while other taxable shareholders may be significantly more exposed.
From this starting point the work makes the following arguments. First, because STCTs may have tax consequences at both the corporate and shareholder levels, some shareholders can end up worse off as a result of the transaction. Furthermore, the net cost to these shareholders may outweigh the net benefit to the corporation and the other tax-exempt shareholders, resulting in inefficient transactions that increase, rather than decrease, the parties’ net tax liabilities. Finally, the work identifies an underappreciated agency problem, whereby corporate managers may successfully extract wealth from the corporation in cooperation with tax-exempt shareholders, and against the interests of other shareholders. This effect occurs when tax-exempt shareholders accede to corporate “gross ups” to compensate corporate managers for their individual tax costs of engaging in STCTs, in order to structure transactions that benefit the tax-exempt shareholders (by reducing corporate-level taxes) but that generate additional individual-level tax costs to other shareholders.
The work concludes by evaluating possible solutions to protect shareholders from adverse corporate tax planning, and to realign managerial and shareholder interests. Marian argues one possible tax solution could be implementation of a “mark-to-market” regime whereby shareholders are immediately taxed on changes in the value of their corporate interests, which would render moot many shareholder-level consequences of STCTs. A more promising avenue, in Marian’s view, is to allow taxable shareholders (even if they hold a minority of the corporate shares) to prevent STCTs that are adverse to their own interests.
The work is important because it provides a more nuanced—and undoubtedly more accurate—view of the dynamic between corporate-level tax planning and shareholder-level tax consequences. It also highlights a significant agency concern that challenges the assumption that corporate managers act in the shareholder’s best interest when engaging in corporate tax planning.
One intriguing aspect of the work is the role of “gross ups” that compensate corporate managers for their own individual tax consequences from STCTs. Marian argues that these provisions can align the interests of corporate managers and the tax-exempt shareholders, to their mutual benefit but to the detriment of the other taxable shareholders. The work gives the examples of the Medtronic-Covidien inversion, which included a gross-up to cover the managers’ excise taxes under § 4985 of the Code, and the Johnson Controls-Tyco inversion, which was structured to avoid the tax altogether, at the cost of diluting shareholders’ equity interests. It would be interesting, however, to know if there are any cases where a corporation grossed-up managers for all of their individual-level tax consequences, including in their role as shareholders. If not, the existence of a gross-up may help to insulate the managers from some (but not all) of their personal tax consequences arising from STCTs, but still may not perfectly align the interests of the managers and the tax-exempt shareholders.
The work is generally skeptical that we should look for solutions in the tax law. For example, Marian writes that it would be “extreme” to adopt a mark-to-market system “system just to solve the governance issues of STCTs.” Commentators have argued, of course, that there are other strong policy reasons for adopting a mark-to-market system, in order to improve the fairness and efficiency of the tax system. In this case, resolving the agency problems that Marian identifies could be viewed as an additional justification for a tax reform that may be desirable on other grounds.
Marian argues, in contrast, that corporate law provides a more promising avenue for possible solutions. It may be, however, that corporate law is already at least partially equipped to handle these problems. As Marian notes, the Medtronic shareholders who were hit with large capital gains taxes in the inversion filed a class-action lawsuit claiming a breach of fiduciary duty. In this respect, Marian’s analysis and arguments should bolster the shareholder’s claim, and their ability to seek remedy under current law.