Tax inversions have been all over the financial news recently. But do they benefit investors?
The process involves a US company buying or merging with a foreign company. The US company then rearranges its income and corporate structure so that it can pay the lower tax rate paid by the foreign company.
Companies are interested in this strategy because it can help them avoid paying the US corporate tax rate, often as high as 35%.
Pharmaceutical firm AbbVie (NYSE: ABBV) recently announced that it intends to complete a tax inversion by merging with Shire (Nasdaq: SHPG), an Irish pharmaceutical company. When the deal is completed later this year the combined companies would pay taxes in the UK at a much lower rate than in the US, possibly as low as 13%.
Cutting the company’s tax burden from 35% to 13% could result in obvious cost savings. But what is the long term impact of such a move?
In theory the tax inversion should help investors. But that’s not always the case. Here are three ways tax inversions can actually hurt investors.
1. Tax inversions create a taxable event
Traditional acquisitions and mergers occasionally create a taxable capital gain for shareholders. However in these cases the shareholders receive a cash payment, which they can use to pay the applicable taxes.
In the case of a tax inversion, investors are stuck with a taxable capital gain but don’t receive any cash with which to pay taxes.
Of course, this doesn’t matter to investors who buy after the deal closed. The tax inversion really only punishes long term investors who hold their shares throughout the inversion process.
2. Tax inversions may hurt the company’s brand
It’s no secret that companies seeking to complete tax inversions are doing so to avoid paying higher taxes in the US. As such, some equate ‘tax inversion’ to ‘tax evasion.’ And where I’m from, tax evasion is regarded as more than a little unpatriotic.
‘Unpatriotic’ and ‘tax evader’ are labels that most companies would prefer to stay away from.
Take Walgreens (NYSE: WAG) as an example.
The company announced this week that it is no longer considering a tax inversion. Among the major reasons cited in the decision was potential harm to its “iconic” American brand.
Nobody wants to be branded as un-American. This is especially true for a company that depends on brand loyalty and repeat business from millions of hardworking Americans.
A tax inversion may save on taxes in the short run. But if the brand suffers irreparable long term damage, investors surely lose.
3. Tax inversions may be punished by the U.S. government
Tax inversions send US tax dollars overseas and the Obama administration has made clear that isn’t going to let this tax money go without a fight.
While the Treasury is urging Congress to take action preventing tax inversions, it isn’t relying on a largely useless Congressional session to solve the problem. The Treasury Department is widely reported to be considering ways it can prevent or punish tax inversions.
Considering the extent to which President Obama has been willing to use executive orders in lieu of legislative action, it seems likely to me that the administration will put forward something to the effect of blocking future inversions. It may go so far as to attempt punishing companies that have already completed tax inversions.
Tenuous is the ground on which the Obama administration would have to stand in order to block tax inversions. However, a long legal process could extend inversion processes by years and add millions to the costs, making such a move much less desirable.
Despite how appealing a tax inversion might look on paper, a long and drawn out legal battle with one of the US government’s most aggressive departments will surely kill some of the inversion’s appeal.
Perhaps the company comes out on top and enjoys lower taxes for the rest of its existence. But perhaps the IRS wins by default when the legal battle costs more than the inversion is intended to save.
Any way you look at it, tax inversions probably aren’t as shareholder friendly as they are portrayed to be.
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