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Aversion to Inversions

Corporate inversions are all the rage, but some are against it

27Aug

The tax rate Medtronic would pay in the United States after its merger with Covidien would be the same as it was before it, Medtronic CFO Gary Ellis insisted.

Coming as it did in mid-June, as the controversy over corporate inversions was heating up, the argument that Ellis made was significant. A little over a month later, President Obama, in an interview, excoriated U.S. companies that wanted to “move [their] technical address just to avoid taxes.” Singling out firms that, like Medtronic, were looking to change their domiciles to Ireland as part of an inversion, the president said that such moves amounted to “gaming the system.”

Earlier in July, in a letter to House Ways and Means Committee chairman Dave Camp (R-Mich.), Treasury Secretary Jacob Lew called on Congress “to shut down this abuse of our tax system” by enacting a bill similar to one that would severely curtail inversions, retroactive to May 8, 2014. Designed to sunset two years later, the bill, introduced by Sen. Carl Levin (D-Mich.) and others, would insist that U.S. shareholders would have to hold less than 50% of the shares of the merged company—a substantial drop from the 80% maximum required by current law.

That retroactive date would include two huge inversions announced in June for which the proportion of foreign ownership the Levin bill would require would be way too high: the $55 billion melding of AbbVie and Ireland-based Shire and the $42.9 billion Medtronic-Covidien merger.

With anti-inversion rhetoric building, it made sense for Ellis to point out certain details that might change the emerging narrative that companies like Medtronic were cheating U.S. citizens of tax revenue and jobs. In an interview transcribed by Seeking Alpha at a Wells Fargo analysts conference, the finance chief acknowledged that the merger faced a “political risk [that the company would] just have to manage through.”

One way Ellis did that was to note that the medical device maker would pay “the same exact tax” rate in the United States after the deal as before it. The company would still pay a 35% federal income tax rate on all money earned here; up to 12% in state-specific taxes, depending on the state’s corporate tax rate; and up to 9.25% in local taxes.

True, the inversion would spawn huge amounts of low-taxed capital in Ireland, and Medtronic would not be “double-taxed” on the money it might want to invest in U.S. businesses. Perhaps trying to counteract the impression of tax flight, Medtronic noted when it announced the deal that “we will go from having the ability to use 33% of our overall cash flow to the ability to use 60% of the combined company’s cash flow.” That added cash “will be used to invest in innovation,” said the company, including “$10 billion of additional investment in U.S. technology innovation over the next 10 years.”

If the federal government isn’t convinced and it does end up barring inversions—in August, the Obama administration was looking for ways to stop the transactions that wouldn’t require the participation of Congress—both Medtronic and Covidien still have an out. As a condition of the deal, if the government takes any action that would strip the deal of its tax advantages before June 15, 2015, the inversion would become void. Given the upcoming congressional elections in November and corporate support for inversions, it’s a good bet that at least current deals will be allowed to stand.

Thus, for a growing number of U.S. based-multinationals, the tax benefits of doing an inversion stack up nicely against the political risk. Nevertheless, once a deal is done, the complex task of shifting assets around to make the deal work financially—as well as pass muster with the Internal Revenue Service—looms ahead. Inversions may end up being a longer-term game than many people think.

The Replacements

In an inversion, a U.S.-based multinational typically merges with an offshore partner and replaces its U.S.-based parent company with a new foreign holding company domiciled in a low-tax country. More than 45 U.S. corporations have reincorporated overseas via inversions in the last 10 years, according to new data compiled by the Congressional Research Service. Overall, more than 70 U.S. companies have inverted since 1994, with one other inversion occurring in 1983.

Why the recent rush to invert? At its most philosophical level, the justification stems from what critics see as the growing divide between the burdensome U.S. tax system and those of the United Kingdom, Ireland, and Europe—a schism that, they contend, puts U.S. companies with large foreign operations at a competitive disadvantage to their overseas counterparts.

Under the U.S. tax system, the IRS assumes that income that a corporation earns outside the country ultimately comes back onshore to be taxed here, in addition to being taxed in the country where it was earned. To avoid placing the full brunt of such double taxation on U.S. corporations, the federal government provides them with the ability to take a foreign tax credit on repatriated income earned abroad, according to Kevin Johnson, a tax attorney with Pepper Hamilton. But that foreign-sourced income is still subject to U.S. tax on the difference that results between the application of U.S. and foreign tax rates. When you consider that the typical corporate tax rate in the United States is 35% compared with 12.5% in Ireland, you can see that the difference can yield huge tax bills for a U.S. multinational with extensive overseas operations.

By contrast, in many countries, income earned in another country isn’t subject to tax in the home country when it’s brought back there. For example, when a U.K. company’s operating subsidiary in France pays a dividend back to the U.K. company, the dividend isn’t included in the U.K. parent’s tax base, according to Joan Arnold, another Pepper Hamilton lawyer, noting that “it’s only taxed once in the jurisdiction where it is.”

The need to establish such a territorial, or “water’s edge,” tax system in the United States has been a rallying cry of business advocates who see it as part of a comprehensive overhaul that would drastically cut corporate tax rates. But even the likes of powerful Republicans such as Camp have not been able to advance broad-gauge tax reform legislation very far in the current Congress.

In the face of inaction on comprehensive reform, and fearing that the Obama administration might crack down on inversions, corporations may be rushing to complete them as a form of “‘self-help’ territorial taxation,” according to Philip Cohen, a tax professor at Pace University’s Lubin School of Business. “Companies are witnessing other companies engaging in transactions that get around [Section 7874 of the Internal Revenue Code of 1986], often by merging with a smaller foreign target, and asking, ‘Why not consider it, given the upside?’” he says.

Where There’s a Will

Under Section 7874, which was itself constructed to curb inversions, U.S. multinationals have found considerable upside: a way to reincorporate offshore in lower-tax jurisdictions to avoid being taxed in the United States on their future overseas earnings.

To enjoy that status, a U.S.-based company typically buys a company, or a unit or a spin-off of one, in a lower-taxed country. The U.S. company also forms a new foreign holding company that owns the merged U.S.-offshore company.

Whether the foreign target company and the new holding company are placed in the same jurisdiction can vary. AbbVie has agreed, for example, to acquire Dublin-based Shire and situate the new parent company in the English Channel Island of Jersey. On the other hand, Eaton, a power transmission giant then based in Cleveland, bought Dublin-based Cooper Industries in 2012 and formed its new holding company there.

Much more important, from a tax-planning perspective, at least, is that the new company’s shareholders or operations have a significantly non-U.S. presence. An inverted company can only avoid taxes on U.S.-based earnings in one of two ways. One is to arrange things so that more than 20% of the shares of the new company are owned by nonshareholders of the original U.S. company, a requirement often fulfilled when the U.S. company pays for the foreign company with at least 20% of the domestic company’s shares.

The second way for a merger to qualify as an inversion is to structure the deal so that at least 25% of the U.S. company’s employees, sales, and assets reside in the new corporate domicile.

A Shrinking Universe

If it’s ever enacted, the Levin bill, “The Stop Corporate Inversions Act of 2014,” would indeed stop most inversions as they’re now conceived by increasing the needed percentage of non-U.S. stock ownership from 20% to 50%. Since many of the U.S. companies currently interested in inversions are behemoths to begin with, such a change would mean that they would have to seek much bigger inversion partners overseas to make that percentage work. Indeed, the increased popularity of such deals may already be starting to shrink the universe of overseas targets, tax attorneys say.

The most prominent current exception, however, is in the pharmaceutical and health-care sector, where practically all of the recent action has taken place. “There are a lot of non-U.S. pharmaceutical companies that are big [enough] … to make inversions work,” says Charles Kolstad, an international tax attorney at Venable, a law firm. For U.S.-based pharmacos, inversions also represent an opportunity to shift research offshore, where the new holding company or foreign-based sister companies can invest untaxed income in R&D.

(In August, however, drugstore giant Walgreen ended speculation that it would structure its merger with Alliance Boots, a European drugstore chain, as an inversion. The Deerfield, Ill.-based company announced that it intended to complete its combination with Alliance by forming a new holding company based in the Chicago area. Walgreen had come under intense pressure from politicians and petitioners to remain domiciled in the United States.)

Kolstad says he’s seen a lot of inversion activity in the oil and gas business, spurred by the abundance of large energy-services businesses outside the United States. By contrast, “if you look at the high-tech world,” he says, “if you’re a Google, an Amazon, or an Apple, there aren’t a whole lot of non-U.S. companies that are big enough to make the inversion work.”

Shifting Assets

Following the location of a partner and the structuring and negotiation of an inversion, there’s a lot more work to do. So much, in fact, that before CFOs sign off on such deals, they should think hard about whether the merged companies can generate a high enough proportion of foreign earning for the arrangement to make sense, especially considering the cost and effort likely to be involved.

Shortly after the merger, the U.S. company is likely to find itself ensnared in complex intracompany transactions aimed at shifting existing revenue-generating assets out of the United States. “Once an inversion has happened, there’s got to be a sale of those assets in some fashion to a foreign-based subsidiary of the new company in order to get access to some of that cash without paying U.S. income tax on it,” says Dean Sonderegger, executive director of product management in the software segment of Bloomberg BNA.

To illustrate the difficulty of such asset transfers, Sonderegger provides the example of a U.S. company that has gone through an inversion and has thus become a subsidiary of a new foreign parent company. The U.S. company wants to invest income generated by the assets of its French subsidiary into the company’s U.S. operations without paying a repatriation tax here.

“The only way the [the U.S. company] can do that is to sell those assets to another subsidiary, one that’s owned by the parents and not owned by the U.S. subsidiary,” he says.

Even so, Sonderegger notes that the U.S. company is likely to be taxed on the proceeds from the sale of those assets. “It’s ironic that to reap some of the benefits of the foreign inversion, you might have to go through a number of taxable events that were the same type of taxable events that you were looking to avoid,” he says.

In the long term, however, companies stand to gain much more from the future growth of the merged entity than they do from asset shifting—provided, of course, that the merger has solid nontax business reasons for being. “If you’re talking about giving up 20% of your stock to do a potential acquisition, then the only way is that the acquisition itself makes sense,” says Don J. Lonczak, an attorney with Baker Botts who has worked on a few completed inversions.

In short, while the tax benefits may offer a strong incentive for the companies to come to terms, M&A fundamentals like the need for complementary workforces and product lines—and, especially, an agreeable price tag—are still the biggest determinants of a successful deal. That was one apparent lesson of the failure of the inversion proposed by U.S. drug giant Pfizer to AstraZeneca, a U.K. pharmaceutical firm. In May, Pfizer walked away from the deal after AstraZeneca rejected a number of its offers.

Attempting to explain what happened at a Goldman Sachs health care conference a few weeks after the deal failed, Pfizer CFO Frank D’Amelio said that in terms of the two companies’ product portfolios, “one plus one could be more than two.” The operations of the two companies also seemed to fit together nicely, and the tax inversion stood to provide a big benefit.

Yet “when all was said and done,” the finance chief said, “the reason the deal didn’t get done was…price.”

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