Apple, Cash Kings Poised to Follow J&J's Tax-Dodging Mega Deal

NEW YORK ( TheStreet) - After Johnson & Johnson ( JNJ) surprised investors and analysts in June by finding a way to structure its $19.7 billion acquisition of Swiss medical device maker Synthes as a tax coup, other corporations with cash stockpiled abroad may repeat the model.

A wide range of cash-rich companies across the tech, drug and energy sectors, and most notably Apple ( AAPL), are poised to follow Johnson & Johnson's strategy of parlaying foreign cash into domestic stock purchases to fund tax-avoiding deals for foreign companies.

"We continue to believe that there is a 'window of opportunity' for large, multinational companies to pursue similar transactions," wrote RBC Capital Markets analyst Glenn Novarro in a Thursday note assessing the impact of Johnson & Johnson's Synthes acquisition. Companies in the e-commerce, software, and semiconductor sectors with high foreign cash stockpiles, intellectual property and profit margins may be among the best positioned to follow J&J, notes Novarro.

With the help of bankers JPMorgan Chase ( JPM) and Goldman Sachs ( GS), Johnson & Johnson used a $12.9 billion stock swap between its Irish subsidiary, Janssen Pharmaceuticals, and JPMorgan and Goldman Sachs to minimize its U.S. tax bill on the deal, which is the largest acquisition in its 126-year history.

Instead of repatriating foreign earnings held in Ireland through a taxable dividend, as the Internal Revenue Service established in 2011, J&J structured the stock swap to utilize its non-U.S. earnings.

In addition, the share swap involving the foreign affiliate allowed the world's largest drug company to avoid issuing new shares to finance its Synthes deal, allowing the merger to add to earnings per share as opposed to an initial forecast of share dilution. J&J has raised its 2012 earnings per share forecast by five cents and by 15 cents for 2013 earnings, after previously forecasting EPS dilution of up to 22 cents.

The key is that J&J's move, which tax expert Robert Willens called "brilliant," 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.

The move sparked a change of opinion from analysts about the benefits of the acquisition and Johnson & Johnson's shares, which had underperformed the Dow Jones Industrial Average in the 12 months prior to the acquisition's June close. Shares have rallied almost 10% since and are hovering near 12-month highs.

Novarro's cash-rich likely acquirer list includes Apple, Dell ( DELL), Abbott Laboratories ( ABT), IBM ( IBM), Microsoft ( MSFT), Oracle ( ORCL), Cisco ( CSCO), Celgene ( CELG) and energy players Devon Energy ( DVN) and National-Oilwell Varco ( NOV).

How the Johnson & Johnson deal works:
  • JPMorgan and Goldman will borrow and buy 203.7 million Johnson & Johnson shares in the open market over the next year.
  • Johnson & Johnson uses 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, the acquired company, to fund its buyout, according to an 8-K filing J&J made with the Securities and Exchange Commission on June 12.
  • "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," said Jefferies analyst Jeffrey Holford, who upgraded J&J's shares to buy from hold, and boosted his price target for the company by nearly 6% to $72 in a June note to clients.

    With the risk that investors react negatively to any strategic acquisitions amid global economic worries, corporations looking to use M&A to buy new growth or products can use the J&J model as savvy means of deflecting concerns. And the clock is ticking.

    "Our tax experts further believe that the IRS is unlikely to respond with a new notice to close the tax loophole exposed by the JNJ/Synthes deal until the beginning of 2013, at the earliest," Novarro wrote.

    The deal has reignited a debate about taxation of foreign earnings at many of the largest companies in the U.S. If other corporations follow J&J's move, it may further provoke 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 to minimize U.S. tax bills.

    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.

    A return of foreign earnings from cash-rich international giants like J&J, Apple, Microsoft, Cisco ( CSCO) and Google ( GOOG) could be invested domestically during a period of weak economic growth (2%) and high unemployment (8.2%).

    Apple holds roughly 70% of its $100 billion cash stockpile abroad, according to Moody's, while tech giants Microsoft and Cisco hold nearly 90% of their cash overseas. With over $35 billion in cash, J&J held the sixth-most cash of any U.S. company, according to Moody's.

    Novarro notes that Apple would be likely to use its $74 billion-plus in foreign cash to make small deals and dividend payments, while the likes of Dell and EMC ( EMC) could use their foreign cash to make larger acquisitions. Those with a high percentage of overall cash sitting abroad and operations headquartered in the U.S. are most likely to use the loophole, the analyst notes.

    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.

    Still, there is risk that the IRS decides to take swift action to shut the loophole, starting with J&J, even if analysts like Novarro handicap such a move at just 20% to 30%. Willens says that a similarly structured deal may put tax authorities in motion.

    "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 June SEC filing, announcing the Synthes acquisition structure.

    "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."

    For more on Johnson & Johnson, see TheStreet's portfolio of the highest-yielding drug stocks.

    -- Written by Antoine Gara in New York

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