What the tax inversion craze means for investors

By Redwood Investments LLC

Tax benefits from corporations re-domiciling into lower tax rate geographies, known as tax inversions, appear to have accelerated M&A activity.

Pfizer’s (PFE) attempt to purchase AstraZeneca, Omnicom ( OMC) merging with Publicis (PUBGY), and Salix Pharmaceuticals (SLXP) acquiring Cosmo Technologies are all examples where the newly combined entity will be headquartered in the home country of the acquired company, which is intentionally outside of the United States.

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One of the attractions of these acquisitions is to implement a strategic tax inversion, whereby the newly formed company will be subject to the lower tax rate of its foreign constituent.

This results in increased margins and higher corporate earnings while decreasing the U.S. tax collections.

 

The World is Flat

U.S. domiciled corporations pay a 39% tax rate, while the average corporate tax rate for industrialized countries is 25%. In order to remain competitive in the world economy, some U.S. companies are implementing strategies to mitigate the tax rate differential.

Several countries have particularly low corporate tax rates and, not surprisingly, they have been targeted locations for a corporation to move to or merge with another corporation. Bermuda, the United Kingdom, and Ireland are among the most tax efficient locations for American corporations to re-domicile.

 
global-tax-burdens

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Most industrialized countries employ a territorial tax system, which means that corporations only pay taxes on income earned in that specific country. France, Germany, England and Hong Kong utilize the territorial tax system, while the U.S. does not.

U.S. companies are required to pay taxes on the difference between the U.S. tax rate and the international tax rate in order to repatriate profits earned in international markets.

As a consequence of this tax law, U.S. companies keep more than two trillion dollars of corporate profits overseas to avoid the incremental tax burden. This capital can only be used for international investments – acquisitions or capital expenditures – and cannot be returned to the U.S. without incremental tax payments.

Inversion strategies

There are two different inversion strategies most commonly utilized by U.S. companies. First, corporations are moving their headquarters abroad to countries with a lower tax rates.

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