A while ago, I wrote about the financial or tax, “inversions” that have been sweeping the US pharmaceuticals industry. Basically, a US company that pays a full 35% Federal corporate tax bill can reincorporate in a low-tax foreign jurisdiction–purely on paper–by taking over a foreign firm already set up there. This is financial engineering at its finest/worst. No one has to move; offices and plants remain untouched. Certain conditions do have to be met, however. The US acquirer must fold itself into the foreign acquiree so that the foreign entity is the survivor. And foreigners must own 20% of the shares of the merged company. Otherwise, it’s pure financial gravy.
Consider a US company that has $1,000,000,000 in pre-tax income. After Federal tax, that’s $650,000,000. If the firm can “invert” itself and end up with a 20% tax rate on that income, the after-Federal-tax number becomes $800,000,00. That’s an annual savings of $150,000,000–a 23% jump in the funds that can be used for capital investment or paying dividends.
IHG
It’s no longer just drug companies, though. Last weekend, media reports that Intercontinental Hotels Group, PLC (IHG) had been approached by a US hotelier, speculated to be Starwood (HOT), about a combination of this type. IHG supposedly rejected a $10 billion takeover offer. (IHG’s stock price indicates we may not have heard the last chapter of this story, since the quote rose to just about the reputed offer price after the news came out.
investment implications
1. Back in the Stone Age (the late 1970s), when I entered the investment business, investors were very sensitive to the rate at which a company’s profits were taxed. At that time, the prevailing view has that the higher the tax rate, the better quality the earnings were. The rationale was that in order to be used for dividend payments, cash generated in low-tax jurisdictions would need to be repatriated and local corporate tax paid. Therefore, the apparent profits generated in low tax areas were illusory and not to be trusted.
Now, that view seems very Austin Power-ish. As I see it, for good or ill, over the past decade or more investors have been indifferent to the rate at which profits are tax. It’s solely profit growth that counts. Whether it’s achieved through selling more products or by astute tax planning doesn’t matter.
But the “modern” view has to be changing again, I think, as inversions become more popular. It’s now a distinct investment plus to be a foreign company in a low-tax jurisdiction. This means that, sooner or later, a US firm in the same industry will make a takeover bid.
2. As the US corporate tax base begins to erode through financial inversions, there should be a response from Washington. The rational one, in my view, would be to simplify the tax code and lower the levy on corporations to what’s normal in the rest of the world.
But no. So far the only movement in Congress is to retroactively make inversions illegal. This is the kind of thing that has helped give India its current reputation as a high risk area to do business in.
Still, reform of corporate taxes would potentially create a whole raft of winners and losers. So it’s something to keep an eye out for.