Inversions And The Growing Scrutiny Of Corporate Tax Avoidance by Walter Colsman, ColumbiaManagement
- While inversions are not new, the pace of inversions has rapidly increased in the last few years.
- We believe the debate over tax policy and perceived corporate tax avoidance will only grow from here.
- Investors should be cautious about companies that have taken aggressive tax stances.
U.S. corporate tax rates are among the world’s highest (Exhibit 1) and current tax code calls for the taxation of all profits earned by U.S. companies, including those earned overseas. U.S. multinationals earning significant sums in foreign subsidiaries can either keep those funds trapped offshore to avoid an incremental U.S. tax or they can repatriate the cash, incurring the tax. Many companies in this situation have executed an inversion to gain full portability of funds without tax consequences. While inversions are not new, the pace of inversions has rapidly increased in the last few years. This is due to the maturation and consolidation of relevant industries such as pharmaceuticals; increasing hoards of trapped overseas cash with waning prospects of a tax holiday for repatriation; a rising M&A wave driven in part by low interest rates; increasing demands from shareholders in a lower-growth environment where capital efficiency gains in importance; and finally a sense of urgency to level the playing field with foreign competitors before Washington blocks the ability to invert.
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Given the savings available from inversions, investor (and investment banker) advocacy for such strategies has risen, but so has political rhetoric that inverting is unpatriotic and must be confronted. While many believe that comprehensive tax reform is the solution, Congress and the White House are deadlocked. The White House believes that action needs to be taken quickly to avoid a cascade of inversions, the sense of urgency only heightened by the upcoming elections. After months of speculation, Treasury Secretary Jack Lew just issued four rules changes in an attempt to thwart inversions. As Treasury has legal limits to what action it can take, these rules attempt to close off some of the levers companies use to execute inversions. For instance, the trapped cash many companies were using to help pay for the foreign target may now not be used, removing an attractive feature of many deals and making them more costly.
While Treasury’s rules could be challenged in court or circumvented, there has most likely been some chilling effect in board rooms. Treasury could take further action, but their objective arguably has been achieved, with political points scored. Treasury’s press release also puts the ball in Congress’s court for next steps. For the near term and current wave of deals, the inversion landscape has probably been set, but we have seen the threat of future changes. Future action could include targeting earnings stripping, a trickier issue to address because 1) the tactic goes beyond inversions and 2) there are legal issues. Equity ownership thresholds could also be increased, but this would require congressional action. For Congress to act, both of these topics would likely be addressed in the broader context of U.S. jobs and investment (with over $2 trillion of overseas cash) and a more competitive corporate tax rate.
The inversion debate extends beyond the U.S. to Europe as well. For example, Pfizer Inc. (NYSE:PFE)’s recent attempt to acquire AstraZeneca plc (ADR) (NYSE:AZN) (LON:AZN) caused an uproar around jobs in the UK. There is increasing debate within the European Union about varying tax rates within the Union itself as well as the need for global tax reform.
Inversions will continue to happen, but authorities are increasingly aware of the many tactics being deployed to reduce or avoid taxes. Overall, we believe the debate over tax policy and perceived corporate tax avoidance will only grow from here. While there is clearly a wide political divide on key elements of comprehensive tax reform, there does seem to be some common ground. Republicans want to lower tax rates, but may be open to closing loopholes. Democrats want to raise tax revenues while eliminating perceived inequities. This would seem to leave the closing of loopholes as common ground for compromise. Therefore, while comprehensive tax reform is unlikely to pass ahead of the 2016 elections, we suggest caution around companies that have taken particularly aggressive tax stances. Debate around these issues is likely to draw market attention to the risks to earnings in advance of legislation actually being passed.