Tax Inversions: Tail Wags Dog?
The uproar over Pfizer’s failed bid for AstraZeneca has faded, but the tax inversion debate is just heating up. This week, Medtronic’s offer for Covidien has again raised questions about why companies are so eager to move their tax homes abroad—and what it means for investors.
In a tax inversion, a US company effectively renounces its domestic tax status to become a foreign entity for tax purposes. Pfizer’s acquisition attempt was aimed at reincorporating in the UK. And US-based retail chain Walgreens is facing pressure from shareholders to move its tax base overseas for similar reasons, as they have an opportunity to take full ownership of UK-based Alliance Boots in 2015.
Now Medtronic is stepping into the firing line. The Minneapolis-based medical device company has made a bid worth $42.9 billion for Covidien, headquartered in Dublin. While we see the strategic rationale, Ireland’s ongoing tax rate of 12.5% is certainly mouthwatering for a company with $14 billion of trapped overseas cash.
Much of the debate is political. Washington is abuzz with talk about closing tax loopholes, maintaining jobs and safeguarding federal revenue. Pfizer’s CEO Ian Read faced tough questions from parliament in London about his intentions. For investors, it may seem like the tax inversion tail is wagging the corporate dog. Yet it’s clear that the impact on deal prices, potential earnings growth and future stock returns cannot be ignored.
US Tax Rates in the Spotlight
The US has one of the world’s highest corporate tax rates—35%. With earnings increasingly coming from international sources, American companies have a choice. They can leave those earnings overseas, taxed at local rates but untaxed from a US perspective. Or they can bring the profits back home, paying an incremental tax, which is the difference between what they paid abroad and the US rate.
For most companies, it’s a no-brainer—the earnings are usually left overseas. However, the downside is that the capital is largely unproductive, as it outstrips local investment needs and can’t be used for dividends or share repurchase. That’s why a company like Apple borrows to execute its share buyback program—even though it has $110 billion of cash “trapped” overseas.
Companies try to change this dynamic through a merger with, or acquisition of, a company in a lower tax jurisdiction. A firm can only migrate its tax home to the lower tax jurisdiction if 20% of the new company’s shares are overseas. That’s not easy to accomplish, but promises significant savings for the US company if achieved.
Regulatory change could take different routes. For example, the 20% hurdle to qualify for an inversion could be raised to 50% or more, making it much harder to accomplish. Congress may be tempted to do this, but such short-term thinking would only maintain the uncompetitive structure of the US corporate tax system without solving the underlying problem.
Which Companies Will Seek Inversions?
Without a regulatory solution, which firms will be drawn to consider a tax inversion? We think the most likely candidates are companies with a significant part of their business outside the US, real intellectual property assets, a meaningful “trapped” overseas cash position and, realistically, a medium-sized market cap. Larger-cap companies would find it harder to identify targets that are big enough to clear the 20% hurdle, as these would be huge acquisitions for the largest multinationals.
Sectors such as healthcare and technology are especially prone to tax inversion attempts. That’s because of their ability to shift intellectual property around geographically, which leads to the greatest tax-planning savings. Given the scarcity of appropriate acquisition targets, prices for these types of deals may be inflated. When tax inversion is motivating a takeover, we think investors should weigh the cost and risks of such deals against the potential of an inversion to cut a company’s tax bill dramatically and unlock substantial earnings growth.
Unfortunately, a reworking of the tax code, which would be most beneficial to companies with the greatest domestic earnings exposure, is a non-starter until after the US mid-term elections in November. In the meantime, we expect the interest in tax inversions to build—especially if there is concern that the window will close.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
James T. Tierney, Jr., is Head of Concentrated US Growth at AllianceBernstein (NYSE:AB).