Medtronic to Pay CEO’s $25 Million Tax Bill on Covidien Deal

Aug 29, 2014 2:59 pm ET

(Updates with comments from compensation consultant in the seventh paragraph.)

Aug. 29 (Bloomberg) -- Medtronic Inc. plans to pick up a $25 million tax bill for Chief Executive Officer Omar Ishrak, the cost of a special penalty imposed by Congress on executives who shift their company’s tax domiciles out of the U.S.

The company is also paying a $38 million tab for the rest of its top officers and directors, Minneapolis-based Medtronic said in a filing with U.S. regulators. The tax penalty arises from Medtronic’s plan to adopt an Irish address as part of its takeover of Covidien Plc.

The requirement stems from a 2004 law meant to discourage CEO’s from lowering their companies’ tax bills by shifting their legal addresses out of the U.S. It imposes an excise tax, currently 15 percent, on the value of any restricted stock or unexercised options the executives hold at the time of the transaction.

“It was clearly designed to be punitive,” said Paul McConnell, managing director at Board Advisory, an executive compensation firm, pointing out that companies regularly cover such costs for their executives. “It’s clearly a tax directed at these executives to prevent this from happening.”

Medtronic’s decision to cover the tax “is a rational response to an irrational law,” he said.

Compared with the value of the Covidien transaction to Medtronic shareholders, “the potential cost of the excise tax payment is relatively insignificant,” the company said in the Aug. 27 filing under the name Medtronic Holdings Ltd. The contents were reported earlier today by the Minneapolis Star- Tribune. Medtronic agreed to buy Covidien, a maker of hospital supplies, for $42.9 billion in June.

Dodging Penalties

The decision also covers Medtronic’s board members, raising the question of whether they would have pursued the deal if they had to bear the tax burden, said Brian Foley, a consultant in White Plains, New York, who helps companies set pay.

“This was initially a deal in which the company can dodge its taxes, and now we’re allowing management to dodge the penalties,” he said. “They are being made whole with other people’s money, the shareholders’ money. They may be legal transactions, but that doesn’t make them right.”

Medtronic’s board made the decision to cover the executive’s costs, called a tax gross up, so they wouldn’t be personally penalized for an acquisition that’s in the company’s best interest, said Fernando Vivanco, a Medtronic spokesman. The decision to move the company’s address to Ireland is allowed under current U.S. law, he said in an e-mail.

‘Best Interest’

“This tax is levied regardless of the strategic rationale of the transaction,” Vivanco said. “The company believes these individuals should not be discouraged from taking action that they believe is in the best interest of Medtronic and its shareholders. The tax gross up allows them to focus on what is in the best interests of the company, and not on their personal finances.”

Ishrak was paid more than $12.1 million in total compensation in fiscal 2014, Medtronic said in a July 11 filing.

Medtronic is one of a series of companies this year to strike tax-lowering address changes known as inversions. The action prompted President Barack Obama to plan a regulatory crackdown and some Democrats in Congress to propose legislation to ban such deals.

Covidien’s Move

Medtronic’s Irish address will allow it to get access to billions of dollars of foreign earnings without paying the U.S. corporate income tax that would otherwise be due. The transfer is possible because Covidien, run from Mansfield, Massachusetts, is incorporated in Ireland thanks to a 1997 inversion. Ishrak and the Medtronic management team plan to remain in Minnesota following the takeover.

Since Congress imposed the penalty on top executives of inverting companies in 2004, most companies have chosen to pay their managers’ tax bills or avoid the tax by allowing the executives to collect their equity awards early.

The officials don’t yet own the shares and may not ever get them, which is one reason Medtronic’s board acted on their behalf, McConnell said.

“If they didn’t do this, the executives would be paying taxes on income they may never realize,” he said. “If the acquisition is a disaster and the CEO is fired, he would have paid taxes on options he never got.”

Tax Escalation

The cost of paying the tax bills can mushroom, because the tax payments, if made by the company, are themselves subject to the excise tax.

Medtronic opted in favor of paying the bills, it said, because to accelerate the equity awards “would undercut Medtronic’s compensation philosophy of insuring that executive officers hold long-term performance-based compensation,” the company said in the filing.

The move makes sense because a company wants its executives to put shareholders’ interests ahead of their own, said Erik Gordon, a professor at University of Michigan’s Ross School of Business.

“Executives, being human, have trouble doing that if it means giving up a personal benefit,” Gordon said. “The move recognizes a reality that is no less real for the fact that the executives make more one way or the other than most people dream of. It’s a realistic response to an unattractive reality.”