Corporate Inversions Explained
The Wall Street Journal last week featured a front-page article by Gerald Seib about how ISIS has upended President Obama’s second-term agenda. He writes, “Obama has become only the latest American president to learn that history doesn’t afford the occupant of the Oval Office the luxury of choosing what kind of presidency he gets to conduct. A president has many powers, but the power to control the tides of history as they form around him isn’t one of them.”
What a great reminder that presidents don’t always get to govern by proactively pushing their agenda, whenever they want. Sometimes they must govern reactively. There is one issue, however, where Washington has been given many opportunities to legislate proactively and failed, and now they are being forced to react. That issue is corporate taxes. The U.S. has the highest corporate tax rate, at 35% (plus state taxes), in the entire developed world. While almost every country has lowered corporate tax rates in the last 15 years, the U.S. has not. American companies have pleaded with Washington for tax reform. At the same time, their earnings and cash overseas have continued to grow. In the absence of tax reform, they have pleaded for a tax cut on repatriating earnings from overseas back to the U.S. They have gotten neither. Thanks to pressure from investors to do something productive with that cash (and near-zero interest rates), this has become fertile ground for the now much-maligned corporate inversions. What exactly is a corporate inversion? In short, a U.S. company acquires a foreign company and relocates its headquarters into the foreign company’s domicile, which happens to have a lower corporate tax rate.
A little history is in order
Companies have relocated from the U.S. to other countries for as long as there have been countries like Bermuda which offer low tax rates. Congress has debated the issue numerous times, but rather than use it as a catalyst for broader tax reform, it has passed only legislation punishing companies who move overseas, most recently in 2004. Our politicians don’t like the idea of “fat cat” companies paying less taxes. After 2004, companies couldn’t simply move their headquarters overseas anymore without basically dismantling and reassembling themselves, and paying a huge tax bill. Furthermore, Congress made it financially unworkable for companies to acquire overseas “shell companies” to act as holding companies. So, companies stopped moving overseas for awhile after 2004.
But then, country after country started dropping their corporate tax rates in order to become more globally competitive, so the number of inversion deals increased again. How can they pull it off? By acquiring a foreign company which is big enough to claim at least 20% of the ownership of the combined company.
So, this has long been a thorn in the side of lawmakers, particularly Democrats, but it didn’t become a burning issue in Washington until this year. Why? Probably because the number of deal announcements has increased, and (more importantly) really big U.S. companies are doing it. Whereas Eaton, Ensco, and Applied Materials, which did inversion deals in the past few years, are fairly large companies, Pfizer, Medtronic, and Abbvie seem to have kicked the proverbial hornet’s nest simply by being really large. And now there are consumer companies like Burger King and Walgreen (who considered it, but ended up staying domiciled in the U.S.), which has enabled politicians to rile up voters even more. Now, Congress and the White House are proposing new rules to punish inversions even more.
You might be wondering, “Are inversions legal?” Yes, companies can move their headquarters wherever they want. The world is a marketplace for companies, just like states and cities in the U.S. compete for companies. Countries compete via tax rates, tax incentives, intellectual property protection, regulatory burden, access to raw materials, trained work forces, and customer bases. Are inversions unpatriotic? We’ll leave that to the beholder.
So how does it work? Take a typical American multinational company, selling its products around the world. In the old days, this American company might have had all its manufacturing in the U.S., and exported its products to, say, England, and paid the U.S. tax rate of 35% (plus state taxes) on all profits. Eventually, this company’s European sales grew to the point that it made sense to make their products there. Then, the UK decided to lower corporate tax rates. So, the company set up an operating company in London. The profits it earns in that business are taxed at the UK tax rate of 21% (20% next year). That’s much better than 35%+! The U.S. gets no share of these UK profits, UNLESS they are “repatriated” out of the UK and into the U.S. company.
But there’s an even better idea—let’s reduce the profits the company’s U.S. operations generate, because they’re taxed at the highest rate. How do we do that? Move the corporate HQ to the UK! We’ll still keep all our American employees and executives in the U.S., so the only real change will be our address.
There’s a bunch of benefits to doing this which are not really available to companies who remain headquartered in the U.S. We can have the U.S. subsidiary borrow a billion dollars from the UK headquarters; then the U.S. subsidiary pays interest back to the headquarters. Interest expense lowers the U.S. subsidiary profits, and interest income raises the foreign profits. Another method is moving intellectual property (like patents) overseas, which enables companies to actually move some sales out of the U.S., even if those sales are to U.S. customers.
Yet another trick is repatriating cash which is “stranded” overseas back to U.S. investors. Right now, when a U.S. company earns profits in a land with lower taxes, generally they keep the cash from those profits in that land. If they transfer that cash to the U.S., they would face Uncle Sam for the difference in profits (in the UK case, it would be 14% of the cash repatriated: 35% – 21% = 14%, plus state taxes). But if the headquarters moves to London, the company has no such restrictions on moving that cash around, because the U.S. is the only country in the world with this onerous restriction. So, after an inversion, the company is free to use the cash, on acquisitions, dividends, share buybacks and capital spending, regardless of where that cash ends up.
When you listen to the executives of companies who are proposing inversion deals talk about their deals, you probably won’t hear “lower taxes” as a reason for the deal, let alone as the reason. You’ll hear such benign pleasantries as access to faster growing markets, diversifying product pipelines, combining intellectual property, operating synergies, cash flow synergies. They hide the tax deal simply for PR reasons—they would much rather have a confused public than an enraged public.
The Core Stocks!
We’re not sure what to think about the fact that our core stocks seem to be Ground Zero for the wave of inversions. In addition to Pfizer (which scrapped its deal for AstraZeneca), Medtronic, and Abbvie, Walgreen strongly considered moving to Switzerland in the midst of its acquisition of Alliance Boots, but decided against it, mainly for PR reasons. Meanwhile, Abbott Labs is selling its “Established Pharmaceuticals” developed markets business, which sells generic drugs mostly in Europe, to Mylan. Mylan then plans to re-domicile in the Netherlands. We’ll take a look at all these deals in our next quarterly newsletter, in the broader context of all the large M&A suddenly taking place, and assess how companies make decisions on how to use their cash flow.
Tax Ramifications to the Investor
There is one unfortunate side effect among the highly-touted tax savings that will be enjoyed by the inverting corporations. Their shareholders will be taxed on the transactions. Yes, even though you own the stock of the company who is the acquirer, and you will continue to own your stock after the deal is completed, you will incur capital gains on any profits you have in the stock. If this seems unfair, call your Congressman and tell him to write some legislation making it easier for companies to do inversion deals! Of course, if you own the stock in a tax-deferred account (like an IRA) or a non-taxable account (like charitable trusts or certain foundations), you should owe no taxes. To be sure, you should talk to your accountant.
The bottom line is that these deals will probably all get completed, as Congress is too inept and absorbed with re-election to pass any legislation, and Obama is limited in what he can do from his perch. If they do, and you have sizable profits in Medtronic or Abbvie in a taxable account, you’ll be paying some taxes either in 2014 or 2015.
HOWEVER, one way to get around capital gains taxes is to donate the stock to a qualified charitable organization or foundation. The beneficiary of your stock can typically sell it for no taxes. If you have been considering making a charitable contribution this year, you might want to consider gifting stock in lieu of cash. Most not-for-profits have brokerage accounts that enable them to receive stock gifts. If you’d like to talk further about this right now, don’t hesitate to call or email us.