By renouncing its American corporate citizenship, Pfizer Inc. has entered into a $155 billion merger agreement with Allergan PLC, thus creating the world’s biggest drug maker.[1] After making headlines globally on November 23rd 2015, one might assume that the deal was surely one of a kind. By creating the largest drug company in the world and combining their scientific resources, this merger deal will have an enormous positive impact on society. However, the underlying motive of the Pfizer-Allergan merger deal was a corporate inversion and not the advancement of the drug industry. Corporate inversion for evading taxes has become a “normal” trend in the U.S. business world. The motive behind such a deal is to take advantage of lower taxes in the foreign country where the corporation resettles. Shortly after that announcement, Johnson Controls Inc. and Tyco International PLC also agreed to merge.
What is Corporate Inversion?
In contrast with the worldwide system, the current American tax system requires that the federal government tax an American corporation as long as it resides in the United States. Residency for tax purposes is defined as the place of incorporation. On the other hand, the worldwide system employs the territorial system, where the government will tax only the corporate income of the domestic corporation that is earned within the given jurisdiction.[2]
Therefore, a corporate inversion is a transaction in which a U.S. company merges with a foreign one, dissolves its U.S. corporate status and reincorporates in the foreign county, in order to avoid United States taxes. A U.S. corporation can invert if one of the following conditions are met: 1) if the owners of the U.S. corporation retain less than 80% of the outstanding stock of the new merged company after the merger, or (2) if the new merged company has substantial business activities in the foreign country equaling at least 25% of the operations after the merger. [3]
In a study published by the Organization for Economic Co-operation and Development, the U.S. corporate income tax was ranked as the highest in the developed world to reach 35 percent, following France and Belgium.
A Brief History of Tax Inversion
In 1983 McDermott Inc., a Delaware corporation, established McDermott International, a Panamanian company, and shifted shareholders to Panama by exchanging shares in the former American McDermott, for shares of the new Panamanian parent. Since then, nearly 51 U.S. companies have reincorporated in low-tax countries since 1982, including 20 since 2012.[4] Companies from almost all industries are following the footsteps of McDermott and abdicating their U.S. citizenship for tax purposes. One industry has played a more relevant role in this matter. On July 14, 2014, following the AbbVie offer of merger, the New York Times published an article entitled “Drug Firms Make Haste to Elude Taxes” discussing the fact that “nothing about the industry makes it more suitable for inversions than, say, food or technology, a number of factors have combined to make health care the focus of the inversion wave that is sweeping corporate America”. One of the most notable attempts to invert was the AbbVie-Shire decision to merge. AbbVie, a Chicago based corporation, attempted to merge with Shire, which would have allowed it to lower its taxes by reincorporating in Britain. However, the merge was not successful because the United States Department of the Treasury issued new guidelines that affected that transaction.
Over the years both the executive and legislative branches have made several attempts to make corporate inversions more difficult, if not impossible. Nonetheless, these attempts have failed. According to Bloomberg “a wave of inversions stopped abruptly in 2002, when U.S. legislators pledged action to prevent them. Not long after the anti-inversion bill passed Congress in 2004, a new wave of inversions began, making use of exceptions to the law”.[5]
In a press release by the United States Department of the Treasury on November 19, 2015, the Department emphasized old measures and announced new ones to prevent corporate inversions, such as actions under Section 7874 of the U.S. tax code. One aspect of the rules, which limits companies’ ability to transfer foreign operations to a new foreign parent company, will apply to future transactions by all companies that completed inversions since Sept. 22, 2014. [6]
Today’s Corporate Inversions
Kimberly Clausing, Professor of economics at Reed College analyzed the reasons behind the sudden growing number of corporate inversions in the past couple of years. Given that the main features of the US tax system have been in place for decades, why is this spate of inversions happening now? Two possible factors are likely at play. First, these strategies might simply become more acceptable ways for multinational corporations to achieve lower global tax burdens. Second, the stockpile of unrepatriated foreign cash is growing to towering levels, nearing $1 trillion. [7]
Under the Pfizer-Allergan merger, Pfizer’s tax base would shift to Allergan’s home base in Ireland in a so-called inversion. As a result of the move, Pfizer expects to cut its tax rate to 17% or 18%, from its roughly 25% rate currently.[8] Johnson Controls, a Wisconsin based corporation, and Tyco International, an Irish Corporation, announced entering into a $14 billion merger deal. Tyco paid 12% of its profit in taxes over the past three years, versus an average 29% by Johnson Controls, according to S&P Capital IQ. Johnson Controls said its effective tax rate before certain items was around 19% over the past two years ended Sept. 30.[9]
The common element between these two recent deals is their new home country. When reincorporating in a new country, U.S. corporations look for the lowest tax rate country. In these cases it was Ireland, which has a tax rate of nearly 12.5%.
The Future of Corporate Inversion
In its long-term budget forecast, the Congressional Budget Office is projecting that corporation inversions will remain a trend impacting corporate income tax base.[10] Income shifting will erode corporate tax revenues by 5 percent, or about 0.1 percent of Gross Domestic Product, from 2016 to 2026.[11]
From a business perspective, one might argue that the board of directors of any corporation is abiding by their fiduciary responsibilities to the corporation and its shareholders when deciding to relinquish the U.S. citizenship and the high tax rates that come with it and to move to a lower tax country. Even though it is frowned upon by both political parties, the Democrats characterizing it as corporate abuse and Republicans are arguing that it is a consequence of unreasonably high U.S. corporate tax rates, it remains a legal transaction.
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[1] http://www.wsj.com/articles/pfizer-allergan-on-cusp-of-merger-deal-1448217490
[2] http://ir.lawnet.fordham.edu/cgi/viewcontent.cgi?article=1413&context=jcfl
[3]http://democrats.waysandmeans.house.gov/sites/democrats.waysandmeans.house.gov/files/CRS%20report%20on%20inversions.pdf
[4] http://www.bloombergview.com/quicktake/tax-inversion
[5] http://www.bloomberg.com/infographics/2014-09-18/tax-runaways-tracking-inversions.html
[6] http://www.wsj.com/articles/u-s-unveils-rules-to-make-corporate-inversions-more-difficult-1447970935
[7] http://taxpolicycenter.org/UploadedPDF/413207-corporate-inversions.pdf
[8] http://www.wsj.com/articles/pfizer-and-allergan-to-merge-in-huge-inversion-deal-1448280652
[9] http://www.wsj.com/articles/johnson-controls-tyco-deal-adds-to-u-s-tax-exodus-1453769049
[10] https://www.cbo.gov/sites/default/files/114th-congress-2015-2016/reports/51129-2016Outlook.pdf
[11] http://www.forbes.com/sites/beltway/2016/01/26/tyco-tax-inversions-income-shifting-and-lost-revenue/2/#2ca9b559b89f
