The Future of Tax Inversion

The term tax inversion is coined a “tax burden” in finance for a valid reason.  Companies generating earnings would like to either pay shareholders or reinvest in further growth – not pay royalties to the government.  In the US, that royalty is a hefty 35% corporate tax.  Not surprisingly, many companies have already found ways to sidestep the tax.

One common method is to move earnings overseas, taking advantage of the lower corporate tax rates in foreign countries.  To understand this strategy, let’s look at a familiar example.  Apple Inc. generates earnings from selling products in iTunes.  As consumers, we click “buy” and pay for a product.  We may think our payment is sent to Apple in one sum, but in reality it is split and distributed across different Apple subsidiaries around the world.  One such subsidiary is iTunes S.à.r.l., situated in Luxembourg with only a few dozen Apple employees.  In 2011, this subsidiary collected $1 billion in revenue, approximately 20% of the total revenue from iTunes sales worldwide.  What is its purpose?  This $1 billion of revenue is taxed at Luxembourg’s corporate tax rate, which is consistently lower than the rate in the US.  Luxembourg’s rate currently stands at 29.22%, compared to 35% in the US.  This process is known as tax inversion. Exploiting this loophole in international corporate tax rates saves companies billions of dollars each year.  As a result, the Obama administration has been pressing for new legislation that would charge companies fees for engaging in tax inversion practices.  This past September, the US treasury declared new rules on corporate tax inversions, rendering many large deals (that had been agreed upon) useless. The healthcare market took two large hits.  In the first, an Illinois-based pharmaceutical company named AbbVie proposed a $54 billion acquisition of an Irish-based pharmaceutical company named Shire.  The proposed tax inversion would allow AbbVie to reincorporate in Britain and avoid large US corporate taxes.  Instead, AbbVie will now have to pay Shire $1.635 billion in a breakup fee for terminating the biggest agreed deal of the year and biggest EVER inversion deal. The second healthcare company to be affected was Medtronic, a medical device provider seeking to acquire Covidien.  Medtronic specializes in pacemakers and spinal treatments, Covidien in surgical equipment.  Together, the two companies would become one of the largest providers of medical equipment.  Unfortunately, this agreement was written as a tax inversion that was now under scrutiny.  Yet, Medtronic’s Chairman and Chief Executive Omar Ishrak described the merger saying, “It’s not about lowering tax rates.  The difference is that through this combination, Medtronic can get access to the free cash flow that Covidien generates and deploy it in the U.S. There are larger technology acquisitions, innovations and R.&D. that we have not been able to do.”  True to this philosophy, Medtronic continued with the merger.  However, it had to borrow $16 billion to fund the $43 billion agreement.  Had Medtronic followed the original tax inversion agreement, it would have paid with cash situated overseas, but would have been subject to $3.5 billion losses in new tax inversion fees. Although the new rules by the US Treasury placed difficulty on tax inversion deals, the new system is still meeting opposition.  Surprisingly, the opposition includes other international countries in addition to the tax-burdened companies.  Specifically, policy makers in the US have been strict against Ireland and Luxembourg, which have historically been prime targets for companies participating in tax inversion.  In Ireland, the corporate tax rate is currently at 12.5%, compared to the US’s 35%! There are two sides to each coin.  As the US government declares tax inversion economically unpatriotic, Ireland and Luxembourg refuse to give up their tax revenue streams from companies looking to avoid US taxes.  In Ireland’s October 14th annual budget statement, lawmakers added several changes to Ireland’s tax rules regarding intellectual properties and employee salaries that offered technology giants multiple ways to maintain their low existing tax rates.  Ireland’s Prime Minister told reporters, that the country was not afraid of the US Treasury’s new policies – Ireland’s own tax changes make the country even more attractive than before for growing companies. Understandably, Ireland is interested in maintaining these tech giants’ presence.  Its recovering economy is expected to grow 4.6% this year, a great portion of which comes from attracting almost 1,100 new international companies.  When a country’s successful economic growth is dependent on attracting international companies, which in turn is dependent on maintaining low tax rates, it’s hard for policymakers to let the tax rewards (and revenues) go.  It’s clearly a risky and controversial strategy – but each country is going to do its best to attract company operations and tax revenue.  US policymakers have made their move, and Ireland has responded.  The future of tax inversion in business is still unclear.

  • Richard

    I agree. A wise businessman in the Caribbean named Sir Kyffin Simpson always said that the key to success is progression and humility, and clearly he’s done very well for himself as a self made man!

  • John Andrews

    The Airgain IPO launches this week, and they’re a one-brand company.

    Some investors don’t think it’s a good stock though:

  • Cincinnati World Cinema

    Well said, Joe, and worth rereading on a regular basis! Another advantage of small-to-midsize city living is pace and competition. Living in NYC, LA and SF entailed a hectic pace, hallmarked by capital S striving, as one realized there were a ton of others doing what I do. Spending so much time in one’s car in SoCal meant much less time for quality pursuits and pleasures. A smaller pond with relaxed pace allows one to savor life and special moments.

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