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Johnson & Johnson's Synthes Deal Revives Foreign Tax Debate

NEW YORK (TheStreet) -- To make the largest deal in its 126-year history an earnings boost, Johnson & Johnson (JNJ) is keeping its acquisition of Synthes as far as from the U.S. taxman as possible.

After receiving regulatory clearance for its $19.7 billion acquisition of Swiss medical device maker Synthes, Johnson & Johnson says the mega-deal will add to earnings per share after previously forecasting dilution: All with the help of bankers JPMorgan Chase (JPM) and Goldman Sachs (GS).

Johnson & Johnson, the world's largest health care products company, is using a "brilliant" $12.9 billion stock swap between its Irish subsidiary, Janssen Pharmaceuticals, and its bankers JPMorgan and Goldman Sachs to minimize its U.S. tax bill.

The move is sparking a change of opinion from analysts about the benefits of the acquisition and Johnson & Johnson's shares, which have underperformed the Dow Jones Industrial Average in the past year. It also reignites a heated debate about taxation on hundreds of billions in foreign earnings at many of the largest companies in the U.S.

According to an 8-K filing with the Securities and Exchange Commission, Johnson & Johnson said that it will use foreign earnings held at its Irish subsidiary to buy $12.9 billion in its own shares from Goldman and JPMorgan. Those shares, along with some cash, will then be handed over to Synthes to fund the buyout.

To make the deal work, JPMorgan and Goldman will borrow and buy 203.7 million Johnson & Johnson shares in the open market over the next year. J&J will then use cash held at its Irish subsidiary to repay the bankers' J&J stock, the company said in a June 12 filing.

The whole point of the financial acrobatics is to make the company's Irish subsidiary purchase J&J shares and Synthes, thus avoiding a U.S. tax hit.

The share swap with two of Wall Street's biggest banks will replace any stock issuance to fund the cash and stock deal for Synthes, which could have diluted shareholders and led to a hefty tax bill.

That move is expected to "finance the transaction in an efficient manner to enhance shareholder value," said J&J in a Tuesday press release that announced the Federal Trade Commission's approval of its Synthes acquisition. As a result, the company said that merger dance will add up to five cents to its 2012 earnings per share and 15 cents in 2013, after previously forecasting EPS dilution of up to 22 cents.

"Instead of a dilutive stock issuance followed by a share buyback program, the company has borrowed stock through an accelerated share repurchase agreement, which transforms the transaction into an accretive deal," wrote Jefferies analyst Jeffrey Holford, who upgraded J&J's shares to buy from hold, boosting his price target for the company by nearly 6% to $72.

Holford calculates that the move increases J&J's earnings per share by roughly 3% in 2012 and up to 5% a year between 2013 and 2017.

Although regulatory approvals and a string of analyst upgrades on Wednesday are key developments for J&J, which has underperformed the Dow in the last 12 months, the real story may center on the financial engineering of the stock repurchase arrangement.

"It looks like they found a way to avoid the tax on repatriation of foreign earnings," says Robert Willens, a tax expert who describes the stock swap arranged between J&J's Irish subsidiary and its bankers as "kind of brilliant."

Instead of repatriating its foreign earnings held in Ireland through a taxable dividend, as the Internal Revenue Service established in 2011, Willens notes that J&J is using the acquisition and stock swap to utilize its non-U.S. earnings without incurring the tax charges of a repatriation. The move, he says, is not likely to be seen as a dividend paid from J&J's foreign operations to its core U.S. business, headquartered in New Brunswick, N.J.

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