Using Offshore Tax Havens Tax Inversion Mergers Under Fire

Taxes charged by governments are a lot like consumer prices charged by retailers. The more you raise the price, the less money you actually bring in as shoppers learn to find better deals elsewhere.

This is precisely what many American corporations are doing, shopping around for better tax rates in other countries. Where corporate income tax in the U.S. averages some 39% (a combination of the 35% federal rate plus a 4% weighted average state rate), other English-speaking jurisdictions are charging considerably less – such as the United Kingdom at 21%, Ireland at 12.5%, and a number of tax havens including the Isle of Man, Cayman Islands and Bahamas that charge 0%. That’s right, zero percent. Just a few fixed annual fees regardless of income and you’re done with taxes.

It does not come as a surprise, then, that dozens of U.S. corporations are moving to those other locales. They don’t want to completely uproot their operations all together, though, as operating within the U.S. – the largest consumer marketplace in the world – has distinct economic and legal advantages. So they are doing the next best thing (for them anyway), merging with a foreign company in a jurisdiction with low tax rates, and moving their official address there.

While most mergers are pursued for strategic purposes, such as increasing market share, increasing reserves, gaining a few patents, and synergizing overlapping operations to cut costs, there are some mergers that are little more than simple tax-dodging, with minimal changes to the buying company’s leadership and ownership. It’s kind of a marriage of convenience.

Well, the U.S. government is about to play home-wrecker to a good many of these convenient arrangements when it introduces a new bill it is working on. Yet not everyone in Washington is against U.S. companies re-domiciling themselves to save on tax. Supporters of the practice are in fact denouncing the proposed amendments, hoping the corporate exodus will serve as a wake-up call for the government to lower its rates and bring corporations back to America.

The Impact of the Corporate Exodus

Over the past several months, some pretty high profile mergers have taken place between American companies and foreign companies, with a few even higher profile near escapes.

The failure of U.S.-based Pfizer (NYSE: PFE) to purchase the U.K.’s AstraZeneca (NYSE: AZN) would have resulted in Pfizer cutting its tax burden almost in half. In just the last three years, Pfizer paid a total of $10.148 billion in income tax expenses. The merger would have saved the company some $1.6 billion a year in income tax, while costing the U.S. some $3.3 billion a year in income.

But there are plenty of smaller deals redirecting tax revenue to other countries. The $85.8 billion large cap AbbVie Inc. (NYSE: ABBV), maker of the arthritis drug Humira, recently announced its upcoming $55 billion purchase of the $28.8 billion large cap U.K.-based Shire Plc. (LSE: SHP), offering to pay almost twice the company’s worth. Why so much? While there are some synergy cost savings, there is also a tremendous tax savings amounting to some $8 billion over the next 15 years. AbbVie reported over $1.2 billion in income tax expenses over the past year alone, which the merger would cut nearly in half.

This comes just one month after another pharma giant, the $62 billion large cap Medtronic Inc (NYSE: MDT), a Minneapolis-based medical device manufacturer, agreed to spend $42.9 billion buying medical-device maker Covidien PLC (NYSE: COV). Although Covidien is headquarters in Massachusetts, it is legally domiciled in Ireland, whose 12.5% tax rate is one third that charged by the U.S. Having paid more than $2.15 billion in income tax expenses over the past three years, Medtronic stands to save some $473 million a year – half a billion – in income tax by marrying Covidien.

The tax savings are so enormous that it has even enticed arch rivals to burry their hatchets and shake hands.

“Almost 25 years ago, banana giants Chiquita and Fyffes were embroiled in a turf war in the fields of Honduras,” reported the Wall Street Journal in March. “Now though, the companies are merging in a billion dollar deal that would create the biggest banana company in the world.” While strategy and synergy are clearly involved, you can bet a tax savings averaging some $50 million a year sweetened the deal.

While such “tax inversion” mergers have been taking place since the early 1980’s, they have picked up their pace dramatically recently, with more than half of the 60 inversions over the past 30 years having taken place during the last six years, Reuters tabulated.

At least eight new tax inversion mergers have been announced this year so far.

The problem is already costing the federal and state governments an estimated $2 billion a year in lost tax income, prompting U.S. Treasury Secretary Jacob Lew to warn Congress last week to take steps quickly to discourage the practice.

“In a letter to members of Congress, [Lew] said corporations that do inversions want to keep U.S. advantages – such as intellectual property protection, research support, financial security and reliable infrastructure – without paying for them,” Reuters reported.

President Obama’s administration is working on a bill that would make it much more difficult for U.S. corporations to have their cake and eat it at the expense of U.S. taxpayers.

Shutting the Escape Hatch

Senate Finance Chairman Ron Wyden will today be chairing a hearing on inversions and international taxes.

Several Senators and other Democrats will be pushing for changes to current tax inversion rules allowing “U.S. companies [to] change their tax home through a merger if the [existing] shareholders of the foreign company own at least 20 percent of the combined company,” explains Bloomberg. They will be recommending raising the minimum ownership requirement to 50%, discouraging almost all tax-saving-based mergers. What good is it to give up half the company just to save some tax?

While the proposed change would not affect mergers that have already been completed, it would be made retroactive to May of this year, and would affect a number of mergers in process. Some recent merger deals have already included clauses on how to deal with any changes to merger rules that are made retroactive.

Some politicians question whether a retroactive start date is even legal, given the disruptions it would cause to mergers already in progress. Yet as noted in a 2012 Congressional Research Service report, “It would be rare for a tax provision to be characterized as a ‘wholly new tax’ so long as taxpayers were on some kind of notice that a tax might be imposed.”

As long as there was some prior warning, changes to tax rules could be made retroactive without requiring legislative approval, since it would not be considered creating a whole new tax. This explains Senate Finance Chairman Ron Wyden’s May 8th article in the Wall Street Journal in which he expressed the administration’s intent to make the rule changes, which was “intended to mark that day as the effective date for anti-inversion legislation that he wants to pass”, Bloomberg concludes.

A senior administration official reiterated that “Lew’s mention of the May 2014 effective date in a July 15 letter to lawmakers was designed to put companies on notice about the administration’s intentions”, Bloomberg informs.

A Perfectly Timed Debate

Yet the proposed changes are far from good and done, as Democrats are finding very little support from the

Republican-lead House of Representatives. Several Republicans have already expressed their resistance, labeling such proposals “punitive” and “porous”. They want to see changes to the tax code itself, measures that would address the root cause of the exodus, rather than simply making it harder for corporations to escape.

“Our politicians want to lock the doors,” Steve Miller, chairman of American International Group Inc., analogized on Bloomberg Television. “The real answer would be, let’s put out the fire, which means to make our U.S. tax system competitive on a global scale.”

The timing of the proposal to change merger rules making it harder for companies to move to other countries for the sake of saving tax is definitely no mistake. With mid-term elections coming up fast, we can expect the subject to become a hot topic on the campaign trail.

Democrats are counting on driving the point home in specific areas that have been economically harder hit. “It might find a receptive audience in areas with significant job losses,” anticipates John Pitney, a professor of politics at Claremont McKenna College in Claremont, California. There is no better campaign topic than saving American jobs and reigning-in tax evasion.

The Republican camp may thus find battling against the amendments quite distasteful to American voters, and the party may be forced to ease up on its opposition to improve its chances at securing more seats in the Senate.

Yet the Republican team has some higher value cards in its hand that it can play during the mid-terms, as they expect the corporate tax code to have limited appeal to only a select few regions of the country. Other popular Republican pursuits like fracking and coal regulations should help them score big in states such as Colorado and Kentucky.

So don’t look for Republicans to back down early, at least until they get a feel for how the mid-term campaigning progresses.

Ah, the wheeling-and-dealing that go on in Washington. It makes the intrigues of the corporate world look like child’s play.