OCEAN CITY — With rising confidence in the economy, corporations are once again turning to mergers and acquisitions (M&A) to grow their earnings. In the U.S. alone, the value of the deals announced so far this year is around $1.4 trillion, up almost 70% from last
year, according to Bloomberg.
Along with growing cross-border M&A, this year has brought a slew of corporate inversions, with the merger
between Burger King and Canada’s Tim Horton’s raising the discussion of them to a fever pitch in political and investment circles.
Inversion deals start with a strategic justification, but then involve locating the new parent company’s headquarters abroad, typically with the objective of lowering tax rates. This is accomplished by acquiring or merging with a foreign company.
Corporate inversions have spiked in the last decade, with 47 U.S. companies reincorporating overseas, according to the Congressional Research Service.
According to the Organisation for Economic Co-operation and Development, the U.S. corporate income tax rate is among the highest in the developed world, at 39%, including the average state tax rate. While it is true that most large U.S. corporations pay a lower effective rate, the U.S. is also the only major country to tax worldwide income, and it assesses U.S. taxes on foreign-earned profits when they are repatriated to the U.S. For the S&P 500 companies, which generate more than half of pre-tax earnings outside the U.S., the lure of corporate inversions is obvious.
It is interesting to note that many of the recently announced inversions have occurred in Ireland, where the tax rate is only a third that of the U.S. Pharmaceutical companies account for the vast majority of them, the biggest being Abbvie Inc.’s recent takeover of Shire PLC.
Inversions have generated significant attention in Washington this year. The Congressional Joint Committee on Taxation has estimated that changing the law to make inversions less attractive could raise roughly $20 billion for the federal government over the next decade.
With lawmakers set to leave the Capitol by the end of the month and return after the midterm elections on Nov. 4, passage of any tax legislation before mid-2015 is highly unlikely, according to BofAML Global Research.
Despite bipartisan support on the need for tax reform, political polarization has prevented legislation from gaining traction. Rather than a quick fix, some politicians insist that any bill should be part of a comprehensive package of corporate tax reform that addresses the root cause of inversions. The issue is likely to gain attention in the upcoming Congressional term, with implications for corporate America and the economy.
A lower effective tax rate typically translates to greater free cash flow and higher margins for companies, generating shareholder value. There are additional implications to consider, however. U.S. shareholders may be subject to capital gains taxes when U.S. shares are replaced by the foreign company’s shares. For combined companies that pay dividends, U.S. investors may be subject to withholding tax on them. Foreign regulatory oversight could also mean less transparency for shareholders.
All these factors must be reviewed on a case-by-case basis, and investors should consult a tax advisor regarding such concerns.
(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)