Tax inversions are back in the spotlight again, with Burger King's recent pitch to take over Canadian doughnut chain Tim Hortons.
Business professor Elizabeth Chorvat studies public finance and the effect of tax rules on both corporate behavior and household savings and investment behavior. She spoke with News Bureau business and law editor Phil Ciciora about the growing trend of companies domiciling themselves abroad for tax purposes.
What makes it attractive for domestic corporations to reincorporate themselves abroad? Is it tax relief, or are there other factors at play?
We cannot assume that tax relief is the exclusive motivation for these transactions. In announcing such a move, multinational corporations often cite the efficiencies of the proposed structure. For example, when the managers of Chicago-based Aon proposed an inversion in 2012, the press release emphasized the increased efficiencies associated with moving their headquarters to the United Kingdom. As was the case with Aon, these hypothetical efficiencies are typically not detailed for public consumption. Shareholders are often provided more details in advance of the shareholder meeting that is required to approve the transaction, but even those disclosures don't provide real cost-benefit analyses or income projections that would give the investor some notion of precisely how these efficiencies might arise.
How big of a role does efficiency play in the decision-making process for a business weighing whether to domicile itself abroad? Are these so-called efficiencies tax-driven?
One of the efficiencies inherent in corporate expatriations results from the differences between the basic structure of the U.S. tax system and those of nearly every other industrialized country. In particular, almost every other country in the world bases its system on what is known as territorial or source-based taxation. Under a source-based tax regime, each taxing authority taxes only the income earned within that country.
By contrast, the U.S. tax system is a worldwide or residence-based regime. Under this regime, the U.S. imposes a tax on income earned abroad that is brought back to the U.S. by a parent corporation or - perhaps more important - income that has been deemed to have been brought back to the U.S.-based parent corporation.
So, for example, if a company moves capital in the form of a loan from one subsidiary to another, it is likely to trigger a U.S. tax on the transfer. If the parent company of the group were not a U.S. company, this tax would generally not be imposed. These rules effectively create a toll charge on a U.S.-based company that would not exist if the parent company were headquartered outside of the U.S.
While we might think of territorial or source-based taxation as offering a form of tax relief - in that it reduces the amount of tax imposed, and inversion then as a form of what we might call "self-help territorialism" - we can also think of it as increasing the flexibility available to the group in carrying out its day-to-day capital management activities.
Of course, most of the transactions in the current wave of inversions are not pure inversions, but rather mergers between two companies, where one of the companies is incorporated in the U.S. and the other incorporated abroad. In these transactions, there are always non-tax reasons why the corporate boards of each company believe that the merger will be advantageous to the shareholders of their respective companies. Because one of the companies is already a foreign company, we might reasonably presume that there would have to be an expectation of increased profits to that non-U.S. company resulting from the merger of the two companies.
This is to say, since the foreign company will not receive any tax benefits from the merger, there must be some non-tax benefits that the management of that company expects to flow from the merger transaction. The recently approved merger of Chicago- based AbbVie and Shire PLC is an example of this, where the two pharmaceutical companies each expect to benefit from shared drug technologies.
How much did bad publicity play into the decision by Walgreens to back off its threats of domiciling itself abroad?
Only the management of Walgreens knows the answer to that question. But if I am correct that the chief advantage of inverting - or, more accurately, of engaging in an outbound reorganization - is the ability to move capital more easily, then it may be that the advantage of an inversion was insufficient at this particular time for Walgreens. The management of Walgreens may have decided that the capital allocation problem was not a big enough issue for the company to overcome the tax cost of an inversion transaction.
The decision to forego the inversion can be traced to the earnings profile of the company, which doesn't currently fit the typical profile of an inverting U.S. company.
In its income statement for 2013, Walgreens reported that only a little over 1 percent of the company's earnings were from outside of the U.S. In other words, before the acquisition of Alliance Boots, foreign-source income constituted a relatively small portion of the overall income of the corporate group. This suggests that there was only a very limited potential benefit from expatriating, since the group's U.S.-source income, which at present constitutes almost all of the income of the group, would continue to be taxed in the U.S.
Remember that inversion doesn't alter the fact that U.S.-sourced income will always be taxed in the U.S.
You've studied the corporate tax inversions, and a recent paper of yours is the first to study the link between corporate expatriation behavior and "intangibles." What can your research tell us about the phenomenon?
My long-term event study of corporate inversions suggests that corporate managers believe that the benefits of inversions outweigh the cost when two factors are present.
First, because the immediate tax cost of inversion is based upon the market value of the company, corporate managers must believe that the stock of the company is undervalued in the market.
Second, these corporate managers must have the expectation of sufficient future excess profits - and specifically foreign-source excess profits - that, when removed from the reach of U.S. taxation, will generate tax savings sufficient to justify the cost of the inversion.
If the thesis of my research is correct, the structure of Walgreens' business was such that it could not generate sufficient tax savings from this self-help territorialism, since its profits are almost all earned in the U.S. and thus would continue to be taxed in the U.S. Therefore, it was not a great surprise to me that Walgreens did not choose to invert.
Note that because Walgreens will now own Alliance Boots, it could decide to invert at any time in the future. If the Boots chain grows significantly in the future, Walgreens may revisit the decision not to invert.
The pattern of industries in which these inverting companies earn most of their profits is consistent with the thesis of my working paper. A disproportionate number of companies that have inverted are pharmaceutical companies, whose entire profits stream comes from intangibles and, more specifically, from patents.
As I argue in the paper, we would expect that the corporate managers of inverting companies believe that the market is undervaluing the assets of the company, with the result that the tax cost of the inversion is depressed. Moreover, when there has been sufficient time to develop a measurable trend, the long-terms excess returns to corporate inversions continue to outpace the market.
Too little time has transpired in this second phase of inversions to determine if the corporate managers of these companies are correct.