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Johnson & Johnson's Synthes Deal Revives Foreign Tax Debate

"The innovation seems to be structuring the transaction outside of the IRS guidelines," adds Willens, who credit's J&J for finding an innovative, tax efficient and money saving way to organize the deal.

Willens notes that were there a corporate tax holiday on foreign earnings, J&J wouldn't have to structure such a share swap. "The deal is right in the midst of that whole debate and discussion," he says.

In a sense, J&J's move is front and center on a larger debate on whether the U.S. government should tax or offer a "holiday" to large corporations, who are sitting on over a trillion dollars in corporate cash, which is mostly held abroad, according to a March 13 analysis by Moody's.

A return of foreign earnings from cash rich international giants like J&J, Apple (AAPL - Get Report), Microsoft (MSFT), Cisco (CSCO) and Google (GOOG - Get Report) could be invested to good use at home where economic growth and unemployment hover at just above a mediocre 2% and 8%, respectively. Currently, billions sit overseas as corporations try to keep their tax bill below U.S. rates.

In 2010, Bloomberg reported that as a result of holding significant earnings in foreign subsidiaries and moving money around the world through a "Double Irish" tax strategy, Google minimized its tax bill by $3.1 billion from 2007 to 2009. Earlier this year, The New York Times reported that Apple uses similar moves to sidestep billions in taxes.

J&J's use of its Irish subsidiary to fund an acquisition on a repatriation tax free basis may raise new questions on how U.S. corporations are taxed, notes David Miller, a partner at Cadwalader, Wickersham & Taft who specializes in cross-border M&A and corporate taxation. "I think the overall policy issue is should this be an appropriate time to tax J&J on its foreign cash?" says Miller, who isn't aware of other transactions that used a similar structure.

"What they are doing is entering a forward contract," adds Miller. Through JPMorgan and Goldman Sachs, Janssen Pharmaceuticals based in County Cork, Ireland is using its cash to purchase J&J stock and transfer it to Synthes shareholders, who will get CHF 55.65 a share in cash and 1.7170 shares of J&J common stock in the $19.7 billion deal. Since the swaps are expected to occur in under a quarters' time, the use of J&J stock to fund roughly two-thirds of the deal may not constitute taxable U.S. property, notes Miller.

But it's still unclear why the company now expects the acquisition to be accretive instead of dilutive to earnings, unless the share repurchase structure was decided on after J&J first announced the deal last April. "It appears J&J came up with a clever mechanism to avoid dilution," says Miller.

Previously, J&J had expected some dilution, over a fully tax efficient use of its cash stockpile. "[We'd] love to use all our cash, but we want to do it in a tax-efficient manner," said J&J chief financial officer Dominic Caruso on an April 2011 investor call.

Other questions remain about how aggressive J&J is being in attempting to put its foreign cash to work.

By way of its Irish subsidiary, J&J is merging Synthes with its Britain-based DePuy operations. But according to Synthes' investor relations page, the company appears to be headquartered in West Chester, Pennsylvania, potentially making the deal taxable regardless of whether the Irish subsidiary is involved.

J&J spokesperson Al Wasilewski declined to comment on the share repurchase transaction beyond the company's SEC filings and press release. Nevertheless, in its Tuesday 8-K filing, J&J states that foreign tax avoidance is a key benefit of the swap, but cautions investors that the structure of the deal could be challenged.

"While Johnson & Johnson believes that these transactions will allow it to effectuate the acquisition in a tax efficient manner in accordance with applicable law, it is possible that the Internal Revenue Service could assert one or more contrary positions to challenge the transactions from a tax perspective," J&J said in its SEC filing.

"If challenged, an amount up to the total purchase price for the Synthes shares could be treated as subject to applicable U.S. tax at approximately the statutory rate to Johnson & Johnson, plus interest."

Willens says that the IRS is unlikely to block the swap, but it may try to "clamp down" on the tax loophole that J&J and its financiers have uncovered before other large corporations follow suit. That may have a big impact on J&J and its cash-rich peers, as legislative efforts on "tax holidays" and corporate tax rates stall.

Dianne Besunder, an IRS spokesperson, declined to comment for this article, citing a prohibition to comment on an individual taxpayer's matters.

According to Moody's calculations, roughly $700 billion of the $1.24 trillion in corporate cash held by U.S. companies is sitting abroad, with overseas funds representing roughly 70% of the money in cash rich sectors like technology.

Apple holds 66% of its $100 billion cash stockpile abroad, according to Moodys, while tech giants Microsoft and Cisco hold nearly 90% of cash overseas. With over $35 billion in cash, J&J held the sixth most cash of any U.S. company.
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