Corporate Social Responsibility / Finance / International Business / Organizational Strategy

The Competitive Advantage of Tax Inversions

aon

Tax inversions are a strategy used by corporations to relocate their headquarters in another country for the purpose of taxing their foreign earnings based on the income tax rate of the country in which revenue is earned. Previously, multinational companies suffered from a double taxation, meaning that revenue earned domestically and internationally was taxed using the U.S. corporate tax rate of up to 35 percent when brought back to the States. In recent months mergers and acquisitions have gone through the roof. Companies in competing industries have been racing to find the next oversees company to merge with and consequentially adopt their tax rate. When a company realizes an opportunity to merge, they often act quickly. One drawback is quick decision making by managers can lead to a poor merger that could diminish firm value. The main motif for tax inversions however, is rooted in competition. If one of your competitors can reduce their tax expense through international acquisitions, you are going to race to get a piece of that pie.

Policy makers in the United States have been getting increasingly worried about corporate tax inversions. One view is that through inversions, the United States is getting cheated out of billions of dollars in tax revenue. Corporations have an obligation to pay corporate taxes in the country in which they do business. When companies invert, they often don’t change much at all except the location of their headquarters, which could be as simple as a name change. So with the use of a loophole in the tax code and the hiring of strategic M&A engineers, these firm are “cheating” the tax code.  The opposing view proposes that it is not a form of “cheating”; inversions are the natural consequence of a high corporate tax rate and it is completely ethical for corporations to seek out ways to pay the least amount of taxes as allowable by law.

The main problem I have with tax inversions is that they threaten the natural competition of corporations in the United States. Aon PLC, an insurance brokerage firm, is an example of a company that gained a competitive advantage by reincorporating to London in 2012. As reported by The Wall Street Journal’s Daniel Haung, “In 2011, before moving, Aon had an effective tax rate of 27.3%. The company’s tax rate dropped to 25.4% by the end of 2013, and shrunk further to 17.5% by the second quarter of 2014. Aon’s annual 10-K filing lists two U.S.-based companies among its competitors, Towers Watson and Marsh & McLennan. Their 2013 effective tax rates are 31.9% and 30.1%, respectively.” Thus, tax inversions are a tactic of unfair competition directed at domestic companies that do not have the recourses to invest in overseas mergers and acquisitions.

The decision of managers to reincorporate overseas is not an unethical one. It is a corporation’s right to pay the least amount of taxes as permitted by law. Instead, I believe the problem lies within the United States tax code. On September 22, 2014, the United States Treasury launched a series of tax tweaks seeking to address the loophole in our tax code that makes these inversion deals appealing. The Treasury’s new tax tweaks will make it harder for companies to complete the inversion deals as well as limit the availability of cash earned oversees. Have these new tax rules solved the problem of unfair corporate competition? I would argue no. The companies that have completed their acquisition deals prior to the Treasury’s new tax rules are grandfathered in. These firms are still thriving with lower foreign taxes and their competitors are now stopped short of any potential mergers or acquisitions that would help them compete. Deals that previously were deemed a good investment are now a lot less attractive. Companies that have decided to opt out have lost dollars previously invested and have had to pay substantial opt out fees. It can be challenged as being an unfair tax reform for the underlying reason that those companies that are grandfathered into their M&A deals were left nearly unaffected.

One ultimate solution could be to amend the U.S. tax code. Lowering the corporate tax rate might level the playing field between companies that have been grandfathered into their tax inversions and companies that have been blocked by the Treasury’s new tax rules. A lower corporate tax rate could attract more business volume to the United States. This growth in domestic business could compensate for the lowered corporate tax rate. Managers, limited by the Treasury’s new tax laws and encouraged by a lower corporate tax rate will be less inclined to force M&A deals. Consequentially, when firms invest in M&A, they can focus more on value maximization versus tax avoidance.  From a competition perspective inverted firms will no longer have a substantial advantage over domestic firms in terms of the amount of taxes paid.

William Podrasky


Sources:

http://blogs.wsj.com/moneybeat/2014/10/21/winners-and-losers-emerge-in-wake-of-treasurys-new-tax-rules/?KEYWORDS=corporate+tax+inversions

http://fortune.com/2014/09/22/obama-administration-releases-new-rules-to-fight-tax-inversions/

http://online.wsj.com/articles/treasury-to-unveil-measures-to-combat-tax-inversions-1411421056

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