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In the Nation's Interest

M&A Inversion and Tax Repatriation: A $100 Billion Poker Game?

By Jeff Hooke


Global M&A activity climbed 32 percent in 2014’s first quarter.  The U.S. market led the way with a 55 percent gain.  The growth shows continued confidence in the United States and global economy, as M&A buyers committed to sizable new investments.

Pfizer Proposed M&A Inversion Deal with Astra Zeneca

Never highly thought of in the public mind set, large M&A deals often attract negative attention.  Pfizer’s proposed $119 billion takeover of British-based Astra Zeneca (another drug maker) is one lightning rod.  Pfizer is the largest U.S. drug company, and number 48 on the Fortune 500.  By acquiring Astra Zeneca, the combined firm will have enough foreign ownership (29 percent) to become a British corporation.  Assuming the deal closes, Pfizer’s  foreign profits escape tax rates that are higher in the United States than in England.

A handful of large U.S. firms (e.g., Eaton, Applied Materials, Ingersoll Rand) completed  M&A inversions, and the rumor mill indicates that drugstore retailer Walgreens (number 38 on the Fortune 500) is mulling a similar $10 billion deal for European retailer Boots.  The pool of prospective inversions remains small because of the limited number of acquisition prospects, which should be sizable businesses in low-tax developed countries.  Nonetheless, when a corporate leader like Pfizer suggests that it can domicile itself outside of the United States without a financial penalty, potentially depriving the U.S. Treasury of future tax revenue, others will take notice.

Having worked in international investment banking, I had thought that many U.S. multinationals would be reluctant to give up their American citizenship.  Why incur the political risk and lose the “halo” of U.S. affiliation and the legal protections afforded by the federal government? But, my discussions with two credit rating agencies indicated that a generic U.S. business reincorporating in England, for example, endures little or no negative effect on its  bond rating – so the cost of capital, a critical variable in determining its stock price, would be unchanged.

Legislative Reactions to the Inversion Deal

Several elected officials want to use the Pfizer proposal to revisit the inversion regulations.  Others say the deal is symptomatic of the relatively high U.S. corporate tax rates on foreign earnings; and, thus, the rate differential encourages investment allocation based on taxes, when U.S. companies should instead emphasize operational motivations – like inventing new products or entering new markets.  The need for tax reform becomes evident.

Overseas Cash and U.S. Tax Repatriation

Tax inversion revitalizes the discussion on a closely related topic: tax repatriation.  U.S.-owned foreign businesses pay income taxes to the nations in which they operate.  When the foreign subsidiary remits profits to the U.S. parent (as a cash dividend), the federal government here charges another income tax, roughly the difference between the 35 percent U.S. rate and the lower foreign rate, depending on a number of factors.  If the average local rate is 20 percent, for example, the cost of bringing home $3 billion in foreign profits might be $600 million (15 percent times $3 billion equals $600 million).  U.S corporations have sent profits home in recent years, but they leave a large residual.  Hence,  $1.9 trillion in cash now sits overseas for the S&P 500.

Truthfully, most of the money doesn’t reside in a foreign country:

  • The foreign subsidiary deposits the money in a U.S. bank (so the U.S. bank might ‘on lend’ the money to customers or buy U.S. Treasury bonds), or
  • The foreign subsidiary invests the cash in U.S. commercial paper or other short-term corporate instruments.

And, much of the money is not the result of pure foreign profit.  Rather a portion is connected with domestic activity.  Therefore, the U.S. parent company:

  • Pays royalties on intellectual property used in the United States but housed in an overseas subsidiary;
  • Buys parts made by a foreign subsidiary for use in final U.S. products;
  • Pays interest on debt issued to a foreign subsidiary.

It’s likely that many companies promote these transactions in order to shift U.S. profits to low tax jurisdictions.  Legitimate transfer pricing is hard to define at times, and the Internal Revenue Service is hard pressed to audit every business.  The distortions caused by the system cry out for reform, a cause CED has echoed in the past to promote global competitiveness.

Tax Holidays, Fairness  and the U.S. Congress

In 2004, the Congress approved a one-time tax holiday, enabling multinational U.S. firms to pay just 5 percent to send the foreign cash home – a substantial savings.  Over 800 companies took up the offer, remitting $312 billion.  The suggestion of another tax holiday arises from time to time, but it raises the question of fairness.  How do we reward the legitimate international operators, without benefiting the tax avoiders?  The latter group could be gaming the system, hoping for 5 percent when the next tax holiday is enacted, when they should have been paying 35 percent.  Most domestic businesses lack that ability to move income between countries.

From a financial perspective, bringing the money back is a positive for U.S. multinationals.  No one is sure how long the Congress can hold off on large-scale repatriation.  If there is another tax holiday, the multinational “bid” is likely to be a 5 percent repeat, and the government “ask” could easily be much higher, like a 15 percent tax.  The negotiation gap could be a hundred billion dollars or more.