Capital pains tax: Medtronic inversion ires investors

That'll be $63 million for us—and a very, very big capital gains tax bill for the rest of you.

Long-time Medtronic shareholders—including at least two ex-directors—are sharply criticizing the medical technology company for a "tax inversion" acquisition of Dublin-based Covidien that will leave many of those shareholders on the hook for millions in capital gains taxes.

Their anger is compounded by the fact that Medtronic will reimburse its top executives and board members to the tune of about $63 million to offset some special, personal tax obligations resulting from the deal, which are distinct from capital gains taxes they will owe.

Even the head of Franklin Mutual Series, a leading institutional shareholder in Medtronic, said the move "doesn't, at first blush, feel good"—although he still plans to vote for the acquisition.

Medtronic Chairman and Chief Executive Omar Ishrak.
Reuters
Medtronic Chairman and Chief Executive Omar Ishrak.

In the inversion deal, announced in June, Minnesota-based Medtronic will be converted into an Irish-domiciled entity for tax purposes. A 2004 federal law designed to discourage deals that seek better tax rates abroad imposed a special 15 percent excise tax on stock-based compensation to company insiders—a tax that is separate from capital gains taxes.

But Medtronic's move to cover such costs for its insiders' excise tax effectively eliminates the taxes as a disincentive.

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Around 20 Medtronic executives and directors will have their excise tax bills and related costs picked up by the company—including an estimated $24.75 million for CEO Omar Ishrak.

Separately, many long-term shareholders will feel the pinch of often hefty capital gains taxes because Medtronic's shares will be liquidated and replaced by new shares in the cash-and-stock-based deal.

The fact that current directors will have their tax burden eased, while former directors and other long-time shareholders have to pay up is what is being questioned, along with incurring any tax hit for anyone in the first place.

"I don't think that's in the best interests of shareholders," said David Schall, a Minneapolis executive search firm owner and stock proxy for his 84-year-old father, Richard. "I'm quite sure they still could have done this deal and remained a U.S. corporation."

Richard Schall, a former General Mills executive, sat on Medtronic's board for 30 years, and over that time acquired thousands of shares in Medtronic.

"He never sold a share, ever," said David Schall. As a result, he said, his father will have "a seven-figure liability" from capital gains taxes that result from the planned $42.9 billion deal

"How many deals have you ever heard of where the acquiring company creates a taxable event for shareholders?" David Schall asked in frustration. He said Ishrak is "doing what he was hired to do, but it feels like he's doing it on the backs of the shareholders, which is weird."

Schall was one of several speakers at Medtronic's shareholder meeting in August who asked Ishrak pointed questions about the deal. Ishrak's three-year tenure as CEO has been marked by a nearly 70 percent rise in the company's stock price.

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"This is the least shareholder-friendly proposal I have ever seen," 79-year-old stockholder Arthur Binger said at the meeting, drawing loud applause.

Another former long-time Medtronic board member, who requested anonymity, told CNBC last week he will be out millions of dollars from the deal, which will include not only a 20 percent hit from federal capital gains taxes, but also Minnesota state taxes that treat capital gains as regular income.

"I think it's grossly unfair," he said. "I had no idea that somebody could come along and put a gun to my head and demand 34 percent of my Medtronic's assets, which is pretty much what happened."

He said many Medtronic retirees, some current employees and many long-term shareholders will be adversely affected.

The Medtronic headquarters building in Minneapolis, Minnesota.
Ariana Lindquist | Bloomberg | Getty Images
The Medtronic headquarters building in Minneapolis, Minnesota.

For long-term shareholders, he said, "a significant part of their net worth is in Medtronic, and a significant part of their retirement income is in Medtronic, and they're going to have to sell a third of their stock, which means in their case, it's going to really affect their standard of living."

Before the acquisition, many of those investors had planned to deal with capital-gains tax exposure by leaving Medtronic stock to their heirs, he noted. The tax basis for those heirs would be the price of the stock when they inherited it, not the original purchase price.

The former director has put his objections to the deal in writing to a current board member whom he knows.

David Schall said he has spoken to one other former director who opposes the deal as structured because of the capital gains tax effect.

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The dispute over the excise tax reimbursements and the capital gains taxes adds fuel to an uproar over inversions, whose critics complain weaken the corporate tax base of the U.S.

Earlier inversion deals include Burger King's announced plan to buy Canada-based doughnut Tim Hortons. U.S. Treasury Secretary Jack Lew has threatened to take action to thwart inversions.

Medtronic said buying Covidien will give it only a slightly better tax rate on its global annual revenue. More importantly, the company said, the deal will allow it to bring in cash from overseas without subjecting that money to a much-bigger tax bite. The company said it is committed to bringing back $10 billion over the next decade and investing it in its U.S. operations.

"There is a clear benefit that we couldn't just walk away from," Ishrak said at the board meeting, referring to $14 billion of Medtronic cash overseas and the chance to tap Covidien's cash for future use in the U.S.

At the meeting, Ishrak told shareholders he considered another way to do the deal that wouldn't have triggered the capital gains taxes, but he said, "We didn't feel that the structure would lead to the maximum financial performance of the company going forward."

Read MoreU.S. Senate Democrats propose exit tax for inverting companies

"There is a pain here, which I understand, and I don't deny, cannot deny," Ishrak said after shareholders repeatedly noted the taxes they would have to pay from the deal, and how much their remaining stock would have to go up to cover their costs. "I can say, for the long-term value of the company, this is a good thing."

Medtronic spokesman Fernando Vivanco told CNBC the company is picking up the cost of the excise tax for executives and directors to avoid a situation where they are faced with a personal financial liability if they approve a deal involving the company.

"The company believes they should not be discouraged from action that they believe is in the best interests of Medtronic and the shareholders," Vivanco said. "It allows individuals to consider the financials of the company rather than their person financials." Medtronic has noted that it is not picking up the cost of the capital gains taxes owed by executives or directors who are subject to the excise tax.

David Toung, a senior analyst with Argus Research, said he thinks "the reaction of these shareholders is a bit of a surprise to management."

"I'm not sure if Medtronic management really understood all the ramifications of this," Toung said. "There's a bifurcation of interests here. You've got the long-term shareholders who are going to get hit with capital gains taxes. It's a forced sale ... and they didn't expect it."

"I also think that Medtronic really needs to do this deal, because they really need additional avenues of growth that Covidien brings," said Toung, who noted that an inversion-based deal has financial advantages for the company that a normal purchase of Covidien wouldn't bring.

The deal has yet to be voted on by shareholders, but the company said it expects it to close by early 2015.

Even the long-term individual shareholders who object to the deal expect it to easily win approval, because more than 85 percent of Medtronic shares are owned by institutional investors.

"My strong-held opinion is that the institutions will vote for this deal," David Schall said.

CNBC reached out to a number of large institutional shareholders in Medtronic for comment. In most cases, the institutions either did not reply or declined to comment.

Asked about the plan to reimburse executives' and directors' personal excise tax liability, the CEO of Franklin Mutual Series, which owns about 23 million shares, said: "I can't say we feel good about it. ... But, I think we understand it."

"This is a case where, number one, Medtronic has, as does Covidien, substantial amounts of capital [overseas] that are not accessible at this point, which will become accessible," Franklin CEO Peter Langerman,said. "I think on balance, we are convinced this transaction was better for shareholders than not."

"I don't know if there was a way of getting around this problem," he said of Medtronic's agreement to reimburse the excise taxes. While calling criticism of that move "justified," Langerman asked, "Is it a show-stopper? Not if you think as we do."