Goldman Warns Of "Tax Inversion" M&A Euphoria
Corporate “inversions” have been around since the 1980s in various forms but have come back into focus recently, but as Goldman's Alec Phillips notes have recent regained popularity as world tax rates grow ever more divergent. On the back of several high profile 'proposed' deals, a certain level of hysteria has taken hold amid potential targets but the issue has drawn enough attention that politicians are once again considering intervening. As Goldman warns, however, companies considering these transactions may now hesitate in light of the possibility that the expected tax benefits will be undone (and expect broad-based tax reform to reduce, if not eliminate, any advantages).
Via Goldman Sachs,
US companies have been looking abroad to lower their US tax bills
Corporate “inversions” have been around since the 1980s in various forms but have come back into focus recently. It started with US-based companies establishing entities in a low-tax jurisdiction—often Bermuda or the Caymans—which would then become the parent company of the existing US-based corporate group. By doing this, income that their foreign subsidiaries earned would be kept uninvolved with the complex US tax code and, in some cases, there were tax benefits for US earnings as well.
As corporate tax policies became more advantageous in many other countries than the US, inversions became more common. The first wave occurred more than a decade ago and ultimately reached a political tipping point in early 2002 after several industrial and energy firms announced deals around the same time. After lawmakers proposed tightening the rules, it took Congress two and a half more years before it enacted changes. Several more companies inverted in the meantime.
Though 2004 rules still govern the treatment of deals today, if the post-merger company does not have either: (1) at least a 20% change in shareholder ownership compared with the prior US company; or (2) “substantial” business activities in the foreign jurisdiction (e.g., 25% of employees, assets, or income), the newly foreign company continues to be treated as a US company for tax purposes.
A driver of cross-border M&A
The rules enacted in 2004 discouraged intra-company inversions but created a new incentive for cross-border M&A. Since realising tax benefits from a transaction now requires at least a 20% change in ownership, US firms have opted to combine with smaller firms in tax-friendly jurisdictions instead. An added tax benefit is that, in some scenarios, these cross-border transactions can create flexibility to use overseas cash that, for tax reasons, has not been repatriated.
Policy changes could threaten deals…or accelerate them The issue has drawn enough attention that politicians are once again considering intervening. The annual budget President Obama submitted to Congress in March 2014 proposed to further tighten the restrictions on deals closed after year-end 2014, by denying any tax benefits from transactions if: (1) less than 50% (rather than 20%) of ownership changes; or (2) if the post-merger firm has substantial business activities and is managed in the US.
More recently, following recently announced cross-border M&A activity, several lawmakers have proposed changes along the same lines as the President’s budget. However, the latest proposals would deny tax benefits to deals closed after May 8, 2014.
Companies considering these transactions may now hesitate in light of the possibility that the expected tax benefits will be undone. However, if the prior political response to inversion transactions is any guide, it could take Congress a couple of years to enact the changes, and even if a retroactive effective date is included, it may be later than originally proposed. Thus firms face a choice: call off deals they are contemplating, or accelerate them to get ahead of any potential cut-off date.
Waiting for tax reform
While passage of standalone legislation to block inversions seems unlikely this year, eventual tax reform legislation is likely to affect inversion transactions in two ways. First, Congress is likely to address the issue directly in broader tax reform legislation if it has not already. Second, any broad tax reform plan that Congress enacts is likely to lower the US corporate rate and might also reduce the incentive to hold cash abroad rather than repatriating it. This would reduce, though probably not eliminate, the incentive to undertake these deals. We expect broad-based tax reform to become more of a focus in 2015, but enactment of major change may take another few years.
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