You asked (1) how Stanley Works' proposal to reincorporate outside the United States can legally reduce its U. S. taxes, (2) if any efforts are underway to limit such transactions, and (3) what the federal and state revenue impact of the Stanley Works plan would be.

STANLEY WORKS PROPOSAL

When a company reincorporates outside the United States mainly for tax purposes, it is called a "corporate inversion transaction. " The Treasury Department defines an inversion as a transaction that alters the corporate structure of a U. S. -based multinational company so that a new foreign corporation, typically located in a low- or no-tax country, replaces the existing U. S. parent corporation as the parent of the corporate group. The inversion is usually a paper transaction that does not change the company's headquarters, management, or operations.

According to its July 10, 2002 revised proxy statement filed with the Securities and Exchange Commission, Stanley Works, Inc. ("Stanley Connecticut") plans to form a Bermuda corporation (Stanley Works Ltd. or "Stanley Bermuda"), which will in turn form a Connecticut merger subsidiary called Stanley Mergerco. Stanley Mergerco will merge with Stanley Connecticut and the surviving company will become a wholly owned indirect subsidiary of Stanley Bermuda, a foreign corporation.

Outstanding shares in Stanley Connecticut will be automatically exchanged for the same number of shares in Stanley Bermuda. After the inversion, though Stanley's nominal headquarters will be Bermuda, the company's basic operations will be unaffected.

The complexity of the Stanley inversion transaction and the federal tax laws and regulations involved makes it impossible to say if every aspect of the proposal will go unchallenged by the Internal Revenue Service. But the proposal appears to use the same methods as several other corporations have also used to lower their federal tax liability. In addition, the Stanley transaction, in several major respects, seems to match a general description of legal corporate inversion transactions outlined in a recent report on corporate inversions from U. S. Treasury Department's Office of Tax Policy (Corporate Inversion Transactions: Tax Policy Implications, May 2002). The Treasury report describes several federal tax provisions that Stanley and other corporations can take advantage of through inversions to reduce their federal taxes.

The United States generally taxes U. S. multinational corporations on their worldwide income. By turning a company into a foreign corporation, an inversion removes its income from foreign operations from U. S. taxing jurisdiction. By law, foreign income earned by offshore companies is subject to U. S. taxes only when repatriated to the U. S. in the form of dividends.

Furthermore, even though an inverted company's U. S. operations remain subject to U. S. taxes, the Treasury report states that an inverted company can restructure its operations to increase payments from the U. S. subsidiary to the foreign parent in a way that will reduce its overall tax liability. This appears to be what Stanley has in mind when it says in its proxy: "Management believes the proposed reorganization will provide opportunities for Stanley Bermuda to realize additional effective tax rate savings in future years through the reduction of U. S. taxes on foreign earnings. " (Stanley proxy, p. 6).

For example, a U. S. subsidiary may borrow money from its foreign parent and repay it with interest. Federal tax law generally allows companies to deduct such interest payments from taxable corporate income, thus lowering the taxes of the U. S. subsidiary. Meanwhile, the foreign parent receiving the interest payments is deliberately located in a jurisdiction (such as Bermuda) that either does not tax corporate income or subjects it to very low taxation. Stanley's proxy statement lists one of the benefits of its proposed inversion as the "reduction in U. S. tax [that] results from the payment of interest expense by Stanley U. S. Holdings, Inc. " and notes than a Bermuda company pays no taxes in Bermuda on corporate income or capital gains (Stanley proxy, p. 6).

The Treasury report notes that U. S. law imposes 30% withholding tax on interest payments to a related party as well as on earnings distributions from a U. S. company to its foreign parent. But the withholding tax can be substantially reduced (often to 5% or less) under an applicable U. S. income tax treaty with a foreign jurisdiction. Barbados is such a treaty country. The Stanley proxy statement explains that although, Stanley Bermuda will be incorporated under Bermuda law, it will be centrally managed and controlled in Barbados. "As a tax resident of Barbados, Stanley Bermuda will be entitled to the benefits under the income tax treaty entered into between the United States and Barbados" (Stanley proxy, p. 6).

The way U. S. multinational corporations can use Bermuda and Barbados to make taxes disappear has led this type of corporate arrangement to be nicknamed the "Bermuda Triangle" tax loophole.

PROPOSED FEDERAL ANTI-INVERSION LEGISLATION

Several bills and amendments proposed in Congress seek to deny corporations some or all of the tax benefits they currently receive from so-called "mailbox inversions" and the Bermuda Triangle loophole. Among them are proposals to:

1. change the rules governing deduction of interest payments from U. S. subsidiaries to foreign parents;

2. ensure that companies pay a tax when they transfer assets offshore;

3. require top executives to pay a 20% excise tax on the value of stock options and other stock-based compensation at the time of an inversion transaction, just as stockholders already pay on capital gains from stock in a U. S. company that is exchanged for foreign company stock in an inversion;

4. for tax purposes, treat a foreign company created solely to buy an American company for purposes of an inversion as if it were a U. S. company;

5. place a moratorium on mailbox inversions; and

6. prohibit federal government agencies from contracting with inverted corporations.

The enclosed fiscal policy memo from the nonpartisan Tax Foundation includes a side-by-side comparison of three major anti-inversion bills (S. 2119, H. R. 3884, and H. R. 3857) as well as other basic information about corporate inversions. We also enclose a summary of the anti-inversion provisions of legislation introduced by Rep. Bill Thomas, Chairman of the House Ways and Means Committee, on July 10, 2002 (H. R. 5095).

FEDERAL AND STATE REVENUE IMPACT

Stanley estimates it would save $ 30 million per year in corporate taxes as a result of its inversion and reduce its effective tax rate on worldwide operations from 32% to between 23% and 25%. The company also estimates the one-time gain to the U. S. Treasury from capital gains taxes payable by shareholders on the exchange of the U. S. company's stock for shares in the new Bermuda-based company at approximately $ 150 million. The Tax Foundation estimates the net loss to the U. S. Treasury from the Stanley inversion at roughly $ 4. 7 million per year over the next decade (see enclosed fiscal policy memo).

According to Michael Galliher of the Department of Revenue Services (DRS), state corporation tax revenues would suffer from Stanley's corporate inversion. The Connecticut corporation tax uses federal corporate taxable income as the starting point for figuring a company's Connecticut tax. Thus, if a company's federal taxable income is reduced, the state would also suffer a revenue loss. Galliher says DRS has no estimate of the state revenue impact of the Stanley inversion. The department believes it would not be possible to quantify the impact because state corporation tax returns do not provide enough information to make such an estimate.

JL: eh