Tax inversions 101

You’ve likely seen all the negative headlines regarding the topic of tax inversions, but what you may not know is why these inversions are so politically divisive and harmful to shareholders.

Tax inversions are a tax strategy for American corporations to lower their tax bill by buying a foreign company and then moving their corporate headquarters to the home country of the acquired company. Some critics argue that this action is simply a game of smoke and mirrors, because the corporations still operate for the most part in the United States, but from a corporate tax standpoint are considered foreign companies.

Congress and President Obama have vilified such well-known American corporations as Walgreens, Medtronic, and most recently Burger King, because they are buying or attempting to buy foreign companies just to reduce their corporate tax bill. In fact, the Obama administration recently announced plans to curtail tax inversions by eliminating financial incentives that lead to inversions and closing loopholes that would prevent inversions from happening in the first place. President Obama said he would act through executive order because he does not expect Congress to address the issue.

To many Americans, this tax inversion move is unpatriotic because it is perceived as a tax dodge. However, if CEOs are charged with looking for ways to increase the bottom line, particularly when revenue growth is getting harder to find, then reducing corporate taxes is an easy way to boost profits and potentially increase the underlying stock price of their companies.

The biggest losers in these inversion transactions are the current shareholders. The Internal Revenue Service deems inversions a taxable event regardless of whether shareholders sell their shares or keep them. Usually, when takeovers happen, shareholders receive some cash to pay any tax liabilities that may occur; however, with inversions, this is just not case. Instead, shareholders will have to either come up with new cash to pay taxes or sell more shares.

For example, if a shareholder buys a stock for $20 dollar a share and the inversion transaction price takes place at $40 a share, then the shareholder will be taxed on the difference between the two prices. In  this case, that would translate into capital gains of $20 per share. From a tax perspective, this means a 20 percent Federal capital gains tax and if the shareholder is in the highest bracket, there would be an additional 3.8 percent Medicare surtax. This doesn’t even include any state taxes, so a California resident might owe a total of 33 percent in capital gains taxes.

From an estate planning perspective, long-term investors who now own low-cost basis stock, will be forced to pay capital gains taxes whether they like it or not, and if they hold the shares until their deaths, their heirs would get a step-up in cost basis. One way around paying these capital gains taxes would be to gift these tax inversion shares to family members or charity. Shareholders can give an unlimited amount of shares to charity or up to $ 14,000 in stock tax free to family members. Investors should check with their tax advisor if they have any plans to gift shares because of these types of transactions.

Adding insult to injury, there will be some shareholders who won’t be paying any taxes. Officers, directors and highly-compensated executives at these companies don’t incur any personal taxes on their own shares because their companies are picking up the tax liability for them – hence another reason CEOs really like these deals!

Tax inversions also beg the question of why U.S. corporate tax rates are so high in the first place? The United States currently has a 39.1  percent corporate tax rate, which is the second-highest corporate tax rate in the world. Economic powerhouse Guyana is first at 40 percent. If corporate CEOs are supposed to maximize shareholder stock value by increasing corporate earnings, why wouldn’t they feel compelled to move their corporate headquarters to Canada with a 15 percent tax rate or Ireland, which offers a 25 percent rate? Sadly, it is more tax efficient for U.S. corporations to do business in bankrupt Argentina with a 35 percent corporate tax rate than the United States.

Until Congress and the White House can agree on lowering corporate tax rates in this country, more and more American companies will continue to consider acquiring companies in other countries with lower corporate tax rates, regardless of the political fallout.

Interestingly, Walgreens management decided not to move forward with a tax inversion when the company announced it was buying the rest of Switzerland’s Alliance Boots that it didn’t already own.  Walgreens was severely punished by the stock market for its decision, with shares dropping 14 percent in just one day.

What does that tell us? The stock market likes inversions because they lead to increased earnings. Even Warren Buffet got into the inversion act by agreeing to help finance the Burger King takeover of Canadian coffee and donut company Tim Hortons. If Warren supports inversions they must be good for the market. If only that were the case for shareholders too.

Categories: Finance