“Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes. Over and over again the Courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands.”
Judge Learned Hand, U.S. Court of Appeals, Gregory v. Helvering (1934)
Just about anyone who reads the newspaper, watches the news on TV, surfs the Internet, or is exposed to a politician, pundit, or business program commentator has likely heard at least something about “inversions,” otherwise referred to as “tax inversions” or “corporate inversions.” In simple terms, an inversion describes any situation wherein a U.S. company re-incorporates overseas, inevitably to a country where the corporate tax rate is lower than in the United States. Such a change tends to have little or no effect on business functions, as the company typically continues to be managed as before from the same location. It also does not change the taxes owed on earnings generated inside the U.S. All that really changes is the official tax domicile, in which non-U.S. income will henceforth be taxed. However, as we will describe below, owing to the fact that the U.S. has a much higher corporate tax rate than most of the world, this adjustment can result in major savings for the inverted company.
Brief History of Inversions and Legislative Responses
The first inversion of the modern era occurred in 1982 when McDermott International, an engineering and construction company, decided to re-incorporate in Panama. McDermott was followed about a decade later by Helen of Troy, a manufacturer of brand name consumer products, which decided to re-incorporate in Bermuda. Not surprisingly, Panama’s corporate tax rate was much lower than ours, while Bermuda imposes no corporate tax. Both inversions got the attention of the Internal Revenue Service, which enacted rules intended to stem the outflow of corporate tax dollars from the U.S.
Those rules proved ineffective at preventing a sharp uptick in inversions near the turn of the millennium. Between 1996 and 2002, almost two dozen companies completed inversions, including such prominent and diverse names as Tyco, Fruit of the Loom, Ingersoll-Rand, Cooper Industries, Foster-Wheeler, Accenture, and Noble Drilling. In this round of inversions the new tax domicile of choice was overwhelmingly Bermuda or the Cayman Islands, which also has no corporate income tax. The common theme was that most of these companies had substantial earnings outside the U.S.
This first real wave of inversions caused Congress to take notice, eventually resulting in The American Jobs Creation Act of 2004, which sought to limit and/or penalize future inversions through a combination of taxes and minimum foreign ownership requirements. Simultaneously, the IRS enacted Section 7874 of the Internal Revenue Code, which paralleled many provisions of the 2004 Jobs Act. Separately, at that time Congress declared a Tax Holiday, which allowed U.S. corporations to repatriate overseas cash at a tax rate of roughly 5%.
While these steps had the desired effect of slowing the pace of inversions (only six occurred between 2005 and 2011), another factor in play was the Great Recession of 2008-2009, which reduced taxable income for many U.S. corporations and resulted in net losses for some, both of which temporarily lessened the burden of high U.S. corporate tax rates. The slower pace was short-lived, however. The earnings recovery beginning in late 2009, combined with gaps in the legislation passed in 2003-2004 and growing corporate impatience with Congress’s failure to enact corporate tax reform, led to a re-emergence of inversions as an attractive legal way in which to lower the overall tax burden. Between the beginning of 2012 and today, more than two dozen additional corporations — Eaton, Applied Materials, Medtronic, Abbvie, Chiquita Brands, and Mylan among them — have announced or completed inversions to lower tax jurisdictions. Several others, including Pfizer, Walgreen, and Omnicom, proposed inversions but, for various reasons, decided not to follow through. This latest wave of inversions has seen a shift in the new tax domicile of choice from the Caribbean to Europe, particularly Ireland and the Netherlands.
As might be expected, all of the headlines have resulted in a variety of legislative proposals to stanch the flow, including in the President’s 2015 Budget, several bills submitted to the Senate by Democrat Carl Levin, and a draft Tax Reform Act of 2014 from Republican Dave Camp, Chairman of the House Ways and Means Committee. While there appears to be agreement on both sides of the aisle that something ought to be done about inversions, there is little or no consensus on how to address the issue. As a result, the Obama Administration is looking at possible ways to act on its own without requiring Congressional approval.
Why Inversions Are So Attractive
The reason U.S. corporations are motivated to consider inversions is rooted in the current U.S. corporate tax system, which puts U.S. companies at a disadvantage relative to most of their global competitors. The key issues are the rate at which corporate income is taxed and the portion of global income that is taxed.
On the question of corporate tax rates, these of course vary significantly throughout the world, both with respect to rates at the national level as well as whether additional regional taxes are imposed (i.e. at the state or local level). Notwithstanding such variation, the fact is that our top marginal corporate tax rate of 35% is the highest among the 34 members of the Organization for Economic Cooperation and Development (OECD), with the rest averaging 23%. Furthermore, on an “all in” basis, after factoring in any additional regional taxes, the U.S. rate reaches 39%, compared with an average of 24% for the other 33 OECD countries and 21% for the European Union. According to accounting firm KPMG only 17 of 135 countries had an “all in” corporate tax rate above 30%, with the U.S. rate the second highest in the world. Only that of the United Arab Emirates was higher.
On the question of what income is subject to tax, most countries have implemented a system known as territorial taxation, in which they tax only income earned within their borders. A handful of countries, including the U.S., tax worldwide income, regardless of where it is earned. In the case of the U.S., income earned outside the country is only taxed if and when the resulting cash is repatriated back to the U.S. Although the corporation receives a tax credit for any taxes already paid in the country where the income was earned, repatriation almost always results in additional taxes owed due to the higher U.S. tax rate. Under such circumstances, it is little wonder that U.S. corporations are now estimated to be holding as much as $2 trillion of cash outside the U.S. Ironically, this hoard both encourages and facilitates inversions via the acquisition of foreign companies with that cash.
Another factor contributing to the surge in inversions is the fact that many countries have been engaged in a “race to the bottom” in recent years by repeatedly cutting their corporate tax rates. Referring again to KPMG data, almost half the tabulated countries have cut their rates one or more times since 2006 including Canada, Germany, Israel, Italy, the Netherlands, Switzerland, and the United Kingdom (which is reducing it yet again in 2015). The last time the U.S. lowered its corporate tax rate was in 1986, when it went from 40% to 34%.
Fiscal Impact of Inversions
Given that inversions are legal under today’s laws and something that corporate managements and boards of directors must at least consider given their fiduciary obligation to act “in the best interests of their shareholders,” the question is: How much do inversions matter?
Interestingly, corporate taxes today represent a small portion of total federal tax revenues. Whereas in the 1950s corporate taxes covered anywhere from a quarter to a third of total federal spending, that percentage has declined steadily to less than 25% in the 1960s, 15% in the 1970s, and 10% today.
Furthermore, it has been estimated that the total tax revenue that could be lost via future inversions over the next decade ranges from $17 billion to $20 billion. Assuming $2 billion per year, which compares with a current federal budget of $3.9 trillion, it represents a mere 5/100ths of 1%. For all the wailing and gnashing of teeth in Washington (not to mention the waste) this is a veritable drop in the bucket.
Corporate tax policies in the U.S. are not in sync with the rest of the world and serve to hurt the competitive position of U.S. corporations. Not only are U.S. corporate tax rates high relative to those of almost all other countries, but the taxation of foreign-earned income is not a common practice elsewhere. These measures have led both to the increase in inversions and to the huge amounts of corporate cash held overseas. Companies are not out of line to pursue inversion strategies. In fact, our belief is that management teams owe it to their shareholders (owners) to follow strategies that lower the amount of their profits paid in taxes regardless of the country that receives them. It is a question not of patriotism, but of fiduciary responsibility.
We do not know when, or in what manner, these issues will be addressed by our legislative authorities. Our fervent hope is that they will be dealt with soon, lest we continue to watch iconic American corporations relocate their legal headquarters to other countries and continue to hold their cash overseas rather than repatriating it and reinvesting it back in the U.S. That being said, from an investment standpoint, our willingness to invest in companies is not primarily a function of their ability to reduce their tax burdens. Rather, we focus on companies that can produce a quality stream of growing earnings driven by their basic business endeavors.
Stock Market Comment – Was That It?
Stock market corrections — typically considered declines of at least 5% to 10% — are normal periodic occurrences. While always uncomfortable, corrections are in fact beneficial – pauses that refresh, if you will.
Over recent months we have been expecting an interim pullback. With the lack of attractive stock market alternatives, one of our primary concerns has been that investor enthusiasm might build to an excessive level. In that environment, stocks could move too far above their fundamental underpinnings, and thereby be subject to a bigger setback later.
Does the recent period of stock market weakness, approximately 4%, qualify as a correction? Hardly, but it might not yet be over in either depth or time. The fact is that nobody will know if there is more weakness to come until after the fact, so we will just have to wait to find out. If, indeed, there is more to the corrective process, we will look to adjust our clients’ portfolios opportunistically. On a longer-term basis, corporate earnings are growing and stocks are still reasonably priced, so we remain primarily invested.