Closing the tax inversion loophole
October 2014 | FEATURE | CORPORATE TAX
Financier Worldwide Magazine
Increasingly, American corporations have begun to take advantage of a merger and acquisition loophole which provides them with considerable tax benefits. The practice, known as inversion, allows US firms to purchase foreign companies and re-domicile abroad. By engaging in inversions, firms can save hundreds of millions of dollars in tax revenue.
Under existing law, US companies are permitted to re-domicile in a foreign jurisdiction on the condition that foreign shareholders own at least 20 percent of the newly combined company. By re-domiciling abroad, the company is no longer legally based in the US and is therefore not liable to pay taxes on profits earned abroad.
While tax savings of this nature are undoubtedly popular with shareholders, there is mounting pressure on regulators to close the loophole. President Obama’s administration has suggested a scheme which would see the loophole closed. Mr Obama himself has referred to firm’s completing inversion deals as “corporate deserters”. There is also mounting Congressional pressure from Democrats and Republicans alike. Democrat Senator Ron Wyden has likened inversion deals to a “plague”. Although bilateral agreement regarding the banning of inversions seems unlikely for the time being, Congress has proposed raising the threshold of foreign ownership to 50 percent at the end of 2014. However, this proposal seems only to have caused acceleration in the number of firms pursuing inversions.
Closing the loophole, although popular among some lawmakers, would present firms and regulators with a number of challenges – not least, whether to apply any closure retroactively and subject corporates to mammoth unpaid tax bills in the process. Senator Wyden is one influential voice championing the enforcement of retroactive legislation. According to Mr Wyden, inversion transactions are an “underlying sickness” which “continues to gnaw away at the American economy with increasing intensity”.
Should the loophole be closed, it would represent a significant departure for the US. Indeed, despite some attempts to address tax loopholes in the early 2000s, the US’ approach to corporate tax has remained at a standstill for nearly 30 years. The last time the country successfully overhauled its federal tax code was in 1986, and while many of the world’s major economies have lowered their tax rates in recent years, taxation law in the US has not moved. As a consequence, the US has been left with the highest corporate tax rate in the developed world – 39.1 percent compared with a global average of 25 percent. Arguably, the US’ excessive tax rate has forced American firms to re-incorporate elsewhere in order to remain competitive in an increasingly global economy.
The pharmaceutical industry in particular has been forced to pursue a number of inversion deals in recent months. There has been a considerable amount of consolidation within the industry as firms have looked to significantly reduce costs. Poor product pipelines in particular have been responsible for a number of pharma groups looking to strengthen their bottom line by escaping high US corporate income taxes. In July, Mylan Pharmaceuticals Inc agreed to acquire Abbott Laboratories in a $5.3bn deal which will see the assets of Abbott transferred to a new company set up in the Netherlands. The deal will allow Mylan to shift its tax base there and save millions of dollars in the process. The Mylan deal, however, pales into insignificance compared with the $54bn acquisition of UK drug manufacturer Shire by American pharmaceutical company AbbVie Inc. The deal for Shire will see Abbvie, which is based in Chicago, Illinois, re-incorporate itself in Jersey in the Channel Islands, and tax-domiciled in Britain. As a result, from 2016 AbbVie will be required to pay an effective tax rate of about 13 percent per annum, a significant reduction from the firm’s current liability. The AbbVie/Shire deal is one of the largest tax inversion transactions announced to date.
Although companies in the pharma industry have been the most high profile exponents of inversion deals to date, other sectors too have been pursuing similar deals. Critics of the scheme note that firms which have re-domiciled abroad are expected to save approximately $1bn in tax revenue per annum, which otherwise would have been payable in the US. Despite this criticism, it is important to note that the inversion process is entirely legal and, crucially, a favourable move from a shareholder perspective. Deciding not to re-domicile can have negative consequences, as a recent deal showed. In August, US pharmacy giant The Walgreen Company agreed to acquire the 55 percent of British high street chemist Alliance Boots GmbH that it didn’t already own for approximately $15bn. However, when the firm opted against an inversion, Walgreen’s shares dropped by 4 percent in trading immediately after the deal was announced, and a further 15 percent in the following morning’s trading.
Wallgreen’s decision was a landmark in many regards. In the months leading up to its takeover of Boots, Wallgreen’s stance on inversion deals was the source of speculation, particularly given that the majority of inversions to date had come from the pharma sector. Whether its decision to bow to growing political and public pressure and remain domiciled in the US will have a bearing on future inversions remains to be seen, however the decision has been poorly received on Wall Street. For companies like Walgreen’s that see significant value wiped off their share prices for choosing to remain in the US, the threat of potential shareholder activism may eventually push them to reconsider their position.
Proponents of the loophole have suggested that the process has become necessary due to the anti-competitive and anti-business nature of the US tax system. Arguably, the US tax code has put American firms at a considerable disadvantage compared with their counterparts throughout Europe and the rest of the world. Supporters of inversions have suggested that in the long run the reduced competitiveness of US firms with manufacturers worldwide could potentially have an impact on living standards, job creation and long-term economic growth across the country. Going forward, the fact that the US has the highest corporate tax rate in the developed world could act as a major deterrent to firms looking to expand into the market. By re-domiciling in countries such as Ireland, the Netherlands and the UK, all of which have significantly lower corporate tax rates, firms are fulfilling a fiduciary duty to their shareholders – a duty to maximise their returns wherever possible. The UK, with its tax rate of 21 percent, has emerged as a popular destination for inversion. Not only does the UK have a significantly lower tax rate than the US, it also shares a number of cultural similarities with the US which ease the re-domiciling process. A shared language and business culture has made the UK a natural choice. Of the 20 inversion deals announced over the last 18 months or so, eight firms have chosen to re-domicile in the UK.
Unsurprisingly, support for inversion deals has been forthcoming from activist shareholders, who themselves have been become increasingly influential in recent years. Notable activists groups such as Marcato Capital Management LP and Jana Partners LLC have been championing inversion. The latter group in particular was a strong supporter of Wallgreen pursuing an inversion transaction. Activist shareholder groups have often agitated for the pursuit of lower taxes; one tactic saw them urge restaurant chains to put real-estate holdings into tax-efficient vehicles such as real-estate investment trusts. However, many groups have now switched their attention to tax inversions.
Many political and economic commentators have spoken out against inversion deals, decrying the perceived negative impact that they have on the national economy. Jacob Lew, the US Treasury Secretary, has joined Mr Obama in urging American firms to develop a “new sense of economic patriotism” and remain domiciled in their home nation. Some critics of the scheme believe that those companies pursuing inversions are not just shirking their tax responsibilities but are failing the US in general. Inversion companies, according to some analysts, are refusing to share the burden of supporting the very government that provides the services, legal system and workforce which enables those companies to generate enormous profits for their shareholders.
Discussions are ongoing about the best way to tackle the rise of inversions, although it may take some time for true legislative change to occur. Quick fix options are also being considered. ‘Earnings stripping’ is just one of the possible tactics which could be used as a deterrent, however critics of the tactic have noted that some versions of the earnings stripping restrictions which have been proposed by both the Senate and the White House are too broad and would have a negative impact on American subsidiaries of foreign firms already established in the US.
In the meantime, the legal position of inversion transactions is clear: firms which choose to re-domicile abroad are within their rights to do so, and this is unlikely to change in the immediate future. But the morality of relocating to a country with a lower tax rate is more nebulous. No matter which side of the argument one falls on, the tax system in the US is in desperate need of review. The combination of a prohibitively high tax rate, and ambitious and aggressive countries such as Ireland continuing to cut their tax rates, mean that the US will continue to miss out on billions of dollars of tax revenue going forward. Congress’s Joint Committee on Taxation projects that failing to limit inversions will cost the Treasury an additional $19.5bn over the next 10 years.
Although there are obvious revenue benefits to be derived from closing the inversion loophole, doing so could have a different detrimental effect on the US economy. The Organisation for International Investment, an advocacy group for foreign companies operating in the US, has noted that by closing off tax inversion deals the American economy could be starved of billions of dollars of foreign direct investment from companies such as Sony, Siemens AG and GlaxoSmithKlein. In a letter to a number of senators, Nancy McLernon, the group’s chief executive, echoed calls for a wide ranging reform of the country’s tax system, bringing it further in line with tax rates in other developed nations.
Although opinions on inversion deals remain divided, there seems to be a consensus forming around the future of the American tax code. It is becoming clear that steps must be taken to lower the country’s tax rate as quickly as possible. The US needs a tax rate which will promote competition and attract investment into the country. On the surface, inversion deals can be considered unpatriotic and exploitative of the American system; however, from a shareholder perspective, an inversion deal can generate a great deal of value.
Until definitive and well considered action is taken to address the issue of the US’ high tax rate, inversion transactions will continue to gather pace, and popularity, irrespective of political hand wringing.
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