After nearly going extinct, corporate inversions have come back strongly in the last few years. In response to the practice, which generally reduces a company’s tax bill, the U.S. Treasury Department issued several pronouncements in 2014 designed to limit the government’s loss of revenue. The measures, however, do not appear to have stemmed the tide.
A corporate inversion is a transaction in which ownership of a company is transferred to a new holding company based in a lower-tax or no-tax jurisdiction. An inversion can be structured as a share-for-share exchange, an asset transfer, or a combination of the two. Economic gains from such transactions are generally taxable.
High tax costs in the United States and the inefficiency of the U.S. tax system hamper many U.S.-based multinationals, particularly with respect to the repatriation of offshore earnings. Unlike most countries, the United States taxes companies on their worldwide income. Income generated by non-U.S. subsidiaries is taxed in the local jurisdiction, and then taxed again when the earnings are repatriated to the United States.
While the U.S. tax on the repatriated earnings is reduced by (or credited with) the amount of taxes paid in the local jurisdiction, the income is generally subject to U.S. tax to the extent the approximately 40% combined federal and state tax rate exceeds the local country tax rate (typically between 20% and 30%).
A U.S. company can generally avoid U.S. taxation on earnings in other countries that are “deemed to be permanently reinvested outside the United States.” However, those earnings are not then available to repay U.S.-based debt, pay cash dividends to shareholders, or fund share buybacks. (Note, though, that earnings of non-U.S. subsidiaries whose ownership has been transferred to the new parent company, or to non-U.S. subsidiaries of the parent, can be used for those purposes.)
While most OECD countries have reduced their corporate tax rates over the past decade, the U.S. effective tax rate has remained stubbornly high and is now the highest among the OECD countries.
When U.S.-based multinationals have used inversions to escape the United States’ high tax costs and inefficient tax system, the move has typically been in connection with a strategic acquisition or merger.
Most recently, in late January, Johnson Controls Inc. announced a merger with Tyco International PLC. The combined company, to be named Johnson Controls PLC, will maintain Tyco’s Irish domicile. The combined company will save at least $150 million on taxes, with an effective tax rate of 18% or 19%, versus Johnson’s 29% historical rate, according to a Wall Street Journal report that used data from Capital IQ.
Once a formerly U.S.-based company is owned by a new, non-U.S. parent, U.S. taxes are reduced through aggressive transfer pricing. Specifically, the strategy involves layering in related-party debt in the United States that reduces U.S. taxable income through interest-expense deductions, while creating taxable income in a related company that is taxed at a much lower rate.
U.S. Tax Limitations
Inversions were popularized in the 1980s and 1990s. By 2004, Congress had became so alarmed at the amount of lost tax revenue that it enacted a law (IRC Section 7874) to discourage the use of inversions. The law achieved the desired effect for a number of years, but less so in the past few years.
The rule does not prohibit inversions. Instead, it provides that an inverted U.S. company remains subject to U.S. taxes as it had previously if its pre-inversion shareholders own at least 80% (by either vote or value) of the new, post-inversion parent company. However, this rule applies only where the new parent is domiciled in a jurisdiction where the combined company does not have material business activities (i.e., at least 25% of employees, assets, and income) after the inversion.
In cases where the U.S. company’s pre-inversion shareholders own between 60% and 80% (by vote or value) of the new parent, the U.S. company is taxed on the “inversion gain.” That means the U.S. company’s net operating losses (NOLs) and tax credits cannot be used to offset any tax on the inversion.
In addition, taxable transfers of non-U.S. subsidiaries from the U.S. company to the new non-U.S. parent are taxed in the United States, and no NOLs or tax credit can be used to offset that gain either. Further, this rule continues to apply to any transfers within the 10-year period after the inversion.
The inversion gain may also include royalty payments between related parties that were created as part of the inversion strategy. This rule applies only where the new parent is in a jurisdiction where the combined company does not have material business activities (at least 25% of employees, compensation, assets (excluding intangibles), and income from unrelated parties) after the inversion.
Finally, if the pre-inversion shareholders of the U.S. company own less than 60% of the new parent, the anti-inversion rule does not apply. As reported in the Wall Street Journal article, Johnson Controls shareholders will own less than 60% of the combined entity after the transaction.
We are not aware of any anti-inversion laws outside the United States (other than general anti-abuse rules, which many countries have). Indeed, the UK saw a number of companies flee the high tax costs there, including advertising giant WPP, United Business Media, and fund manager Henderson Group, all of which left for Ireland in 2008.
Unlike America’s attempt to whittle away at the usefulness of inversions, the UK responded by lowering its corporate tax rate from 32% to 20% and making repatriation of non-UK earnings more tax-efficient. Because of the changes, WPP returned home, the tide of inversions stopped, the UK is a more attractive place to do business, and its corporate sector appears to be on an upswing.
The UK government estimated that over the long term, reducing its corporate tax rate would increase investment by 2.5% to 4.5% and increase GDP by 0.6% to 0.8% (using the “computable general equilibrium” model for gauging the long-term economic effects of policies).
A Deal That’s Hard to Refuse
The recent resurgence of corporate inversions among U.S.-based multinationals, which has occurred despite the presence of IRC Section 7874, may be attributable partly to the fact that many countries have reduced their corporate income tax rates over the past decade. Meanwhile, the United States has clung to its high corporate tax rate and complex, inefficient tax system.
As a result:
- U.S. pharmaceutical company Endo Health merged with Canadian competitor Paladin Labs in February 2014 into a new, Irish parent corporation. Public information indicated anticipated annual tax savings of approximately $75 million.
- Eaton, a diversified U.S. manufacturer, and pharmaceutical company Perrigo merged with Irish competitors in 2012 and 2014, respectively, with expected annual tax savings of more than $150 million each.
- Horizon Pharma acquired Vidara Therapeutics, also in 2014, and is now organized as an Irish company. After the deal closed, Horizon’s CEO indicated that the company’s post-merger tax rate would be in the low 20s and could drop to the mid-teens within three years.
(It’s interesting to note that the Tax Foundation estimates that a reduction in the U.S. corporate tax rate to 20% — equivalent to the current UK rate and 5% lower than the OECD average — would lead to a material reduction in tax revenues of up to $1.8 trillion over 10 years. That would be partly offset by increased GDP, which would effectively lower the reduction in tax revenues to $1.1 trillion.)
The way things stand, from a company’s viewpoint an inversion makes economic sense because of the increased free cash flow that comes from lower taxes. For example, if Endo reduces its annual tax burden by $75 million for 10 years as a result of the inversion, it has increased its net present value by more than $400 million. Looked at another way, the $750 million of cash tax savings over a 10-year period equals almost half of the $1.6 billion price tag for Endo’s acquisition of Paladin.
Also, an inverted company’s increased free cash flow may allow a potential buyer of the company to pay a lower multiple, thus making it a more attractive acquisition target. Further, a recent study indicated that corporate inversions result in significant increases to shareholder value, as share prices tend to spike for both the buyer and the target after an inversion is announced.
Other Factors to Consider
1. Many business advisors recommend to clients that the tax savings from inversions, though substantial, should not be the business purpose for the transaction.
A case in point is the recently proposed Pfizer/Allergan deal. Pfizer’s innovative products business has grown significantly, while its off-patent established products business has declined. With this backdrop, Pfizer’s merger with Allergan — developer of Botox and other branded pharmaceuticals — could add significant value to Pfizer. That likely would be so even if Pfizer eventually decides to split its two business lines, which it is considering. Such business drivers for the merger are significant, despite CEO Ian Read’s outspoken disdain for the high U.S. corporate tax rate.
2. For those considering the opportunity afforded by an inversion as part of an overall strategic merger or acquisition, note that Congress is under great pressure to reduce the corporate income tax rate and also to reform U.S. taxation of U.S. companies’ non-U.S. earnings. Although Congress is well known for its inability to act, companies should keep their eye on any potential changes to the tax regime that may alter the potential tax benefits of an inversion.
3. Ironically, the Obama Administration’s fiscal-year 2015 budget proposal included more stringent anti-inversion rules and taxes on non-U.S. earnings, rather than reducing the corporate tax rate and making the U..S taxation of non-U.S. earnings more efficient. That provision was not passed. Meanwhile, the Treasury Department issued temporary and proposed regulations in January 2014, as well an anti-inversion pronouncement in September 2014 (Notice 2014-52) and another in November 2015 (Notice 2015-79).
The 2014 notice essentially prevented inverted companies from accessing the U.S. company’s foreign earnings either through the use of “hopscotch” loans or by selling foreign subsidiaries to the new foreign parent. This hampered some inversions that were intended to be funded in part through U.S. companies’ foreign earnings.
On the other hand, the notice failed to close down the biggest inversion hole in the U.S. tax system: the ability to reduce U.S. taxes through the use of intercompany debt.
The 2015 notice made it harder for companies to avoid the anti-inversion rules by: (1) artificially increasing the size of the foreign partner; (2) using a new parent in a tax-favorable jurisdiction where the foreign partner is not located; and (3) satisfying the substantial business activities requirement when the foreign parent is not a tax resident in the jurisdiction where it is formed. The notice also tweaks the rules that prevent a U.S. company from selling its foreign subsidiaries to the new foreign parent.
Again, as with the 2014 notice, Treasury failed to close the intercompany debt loophole.
4. A proposal by presidential candidate Hillary Clinton would levy an “exit tax” on companies inverting out of the United States. It would impose current U.S. tax on an inverting company based on the U.S. company’s non-U.S. profits that have not previously been subject to U.S. tax (because they are “permanently reinvested” outside the United States).
5. Because a number of inversion transactions, particularly in the pharmaceutical space, have created a new Irish parent, countries may consider taking OECD action against Ireland.
The WTO and other EU countries have chastised Ireland for its particularly low tax rate (12.5%), which they find anti-competitive. The OECD has suggested that countries should consider adopting treaty provisions that may limit or eliminate any benefit associated with a triangular inversion where the new parent is in a low-tax jurisdiction. This language, while not clear, appears to be aimed at Ireland’s low tax rate and the frequent use of Ireland as the parent of choice for inversions.
6. For companies that have the benefit of happenstance and time, an inversion may make sense in the context of a U.S. company that does not currently have material non-U.S. operations. In that situation, a U.S. company could merge with or acquire another entity and invert with a new non-U.S. parent.
If the U.S. company’s pre-inversion shareholders continue to own between 60% and 80% of the new parent, the U.S. anti-inversion rules would technically apply. However, there should be little or no “inversion gain” if the U.S. company has little or no non-U.S. operations (other than the gain on the inversion itself).
But the inversion would provide the U.S. company the opportunity to grow organically and/or by way of acquisitions outside the United States while avoiding, for the non-U.S. operations, the high tax cost and inefficiency of the U.S tax system. The value of that strategy would be maximized to the extent the company grows outside the United States after the inversion. In doing so, there would be no inversion gain and all non-U.S. subsidiaries could be placed under holding companies that offer low tax cost and efficient repatriation of earnings.
Despite the Treasury Department’s efforts, the inversion structure remains a viable option as a value-add for mergers and acquisitions that have strong business rationales. Although the Treasury pronouncements may make the devil in the details more devilish, the rewards of lower corporate taxes may be worth the added complexity and up-front cost.
Jerome Schwartzman is head of M&A tax services for investment banking firm Houlihan Lokey. Steven Tishman is a managing director of the firm and global head of its mergers and acquisitions group.