Potential for limited investment options raises concern

As state Treasurer Phil Angelides urges California’s two giant public-employee pension plans to boycott companies that escape to offshore tax havens, there is doubt that money managers – even those in socially conscious funds – will heed the call.

One firm, Domini Social Investments LLC of New York, already has an informal policy against investing in companies not incorporated in the United States, but it worries that a formal boycott could limit its investment options should more firms head for foreign shores.

There have only been a few firms this year that have tried to move offshore. But “if this turns into a steady stream of reincorporations because Congress doesn’t act, it’s going to be difficult for any investment manager to screen all those companies out,” says Adam Kanzer, Domini’s general counsel and director of shareholder activism. “You are really going to be cutting yourself out of some important aspects of the market.”

Accusing these companies of “shirking their duty as Americans,” Mr. Angelides recently called on his fellow board members on the California Public Employees’ Retirement System and the California State Teachers’ Retirement System to divest their holdings in companies “hiding behind a mailbox in Bermuda.” The two funds, with a combined $250 billion in assets, hold about $752 million in investments in expatriated companies.

His call comes as Congress tries to turn offshore havens such as Bermuda into a paradise lost for companies including Cooper Industries Ltd. of Houston, Ingersoll-Rand Co. of Woodcliff Lake, N.J., and Tyco International Ltd. of Exeter, N.H.

But rallying Calpers – one of the more activist pension funds – to move its money may be a chore. Calpers’ investment committee will consider the matter when it meets Aug. 19.

“Historically, pension funds have not responded to these political issues with a great deal of fervor,” says Chris McNickle, managing director of Greenwich (Conn.) Associates, a market-based research and consulting firm. “Even if [Calpers] were to do so, I would be very surprised if it sparked any kind of a broad-based trend.”

Possible backlash

Would individual investors respond? Elaine Bedel, chairwoman of the Denver-based Certified Financial Planner Board of Standards, thinks they might.

“I think a lot of people are saying, `Is that fair? What are you taking away from our country, from our economic and tax system, by going offshore?”‘ says Ms. Bedel, who is also president of Bedel Financial Consulting Inc., an Indianapolis company with nearly $200 million under management. “I think people are a little bit more concerned and aware of those kinds of things, and there may be more of a backlash because of it.”

Take The Stanley Works, a New Britain, Conn., toolmaker. Although shareholders narrowly approved its reincorporation in Bermuda, the company last week dropped its controversial plan to move.

Officially, Stanley Works said that pending congressional reforms would eliminate the need to move to the offshore tax haven. But observers say extreme public and political pressure forced the company to reconsider.

The debate in Washington on the issue varies widely. House Majority Leader Dick Armey, R-Texas, says that penalizing businesses for moving offshore to reduce their tax burden “is akin to punishing a taxpayer for choosing to itemize” on their 1040. Democrats have branded those offshore companies as “corporate traitors” and are seeking to eliminate the tax benefits for companies that have moved since Sept. 11.

A growing number of U.S. companies have conducted corporate-inversion transactions, taxation experts say. A list from the California treasurer’s office sites 16 major corporations relocating in the past three years, with another two moves pending this year.

“Primarily, the cost of doing it has gone down since the market’s gone down,” says Phil West, a partner and head of the international tax practice at Steptoe & Johnson, a Washington-based law firm. “There is a tax cost to moving to a tax haven, but that tax cost can be less if the gain in the company stock is lower, and since the market has dropped, the built-in gain in the company stock has decreased.

“Also, it seems more acceptable,” Mr. West adds. “As more and more companies do it, others look at it and say, `Why shouldn’t I?”‘

Patriotic terms

Detractors of tax havens paint the issue in patriotic terms. “The trend was gathering steam at a bad time,” says Mr. West, who served as the Department of the Treasury’s top international tax official during the Clinton administration. “What this sounds like is people fleeing the country for tax reasons but still trying to keep the benefits of being in America. In the environment we are now in after Sept. 11, there is political resonance to the argument that this is a bad thing.”

Companies benefit in a number of ways from expatriating to some tropical, white-sand destination. By moving the parent to an island nation, the company no longer has to pay what some call a divided repatriation tax on the earnings of its foreign subsidiaries.

Although companies still pay tax on their U.S. earnings, there are ways to reduce the U.S. tax obligation.

Expatriated parents can reduce their earnings by lending money to what has become a U.S. subsidiary, loading it up with intercompany debt to generate interest deductions, something a U.S.-based company couldn’t do. The cross-border transfer of assets is another way to shift income out of the United States.

The Treasury Department has recommended that Congress tighten some of the earnings-stripping rules. On its own, the department is considering modifying rules for asset transfers as well as checking income tax treaties for loopholes.

They also want stricter reporting requirements by companies to ensure that shareholders are paying the taxes on the gain recognized from a move offshore.

In those deals, the shareholder exchanges stock in the U.S. company for stock in the offshore company, and tighter reporting requirements will remind shareholders that there are tax consequences for those transactions, according to the Treasury Department.

In testimony before the House Ways and Means Committee in June, Pamela Olson, the department’s acting assistant secretary, said the government must evaluate a tax system that led to the flight of some companies.

“Our system of international tax rules should not disadvantage U.S.-based companies competing in the global marketplace,” she said.

Congress has come up with some other ways to halt the exodus. Some legislators propose making offshore companies ineligible to receive government contracts. That would hit them were it hurts, since 10 of the largest companies that are in Bermuda or are considering a move there did about $1 billion worth of business for the government last year, according to published reports.

But it is Mr. Angelides’ call for an investment boycott that may be the biggest threat, says Jerry Cohen, a Washington-based law partner at Sutherland Asbill & Brennan LLP, which also has headquarters in Washington.

“If Calpers and a number of pension funds don’t buy stocks in these companies, they will come home,” says Mr. Cohen, who was the Internal Revenue Service’s chief counsel from 1979 to 1981.

Mr. West, the former Treasury Department official, says he thinks that the number of companies that are going to take advantage of this strategy will decrease on its own.

“You will see a slowing of the trend because of what is going on on the Hill,” he says. That is “unless Congress passes legislation that sets clear lines as to what’s permissible and what’s not. And there is still room for companies – within those congressionally set boundaries – to take advantage of these strategies profitably.”