Mylan's Inversion Passes Taxes On To Shareholders - Here's What You Should Know

Aug. 6.14 | About: Mylan Inc (MYL)

Summary

Mylan is undergoing an "inversion" to reduce their corporate tax liability.

The effective rate of taxes Mylan was paying in the United States is not even close to 35%.

Shareholders should start planning for tax season.

Mylan (NASDAQ:MYL) has gathered a few headlines lately for their inversion with Abbott Laboratories (NYSE:ABT). Unfortunately, many investors don't understand the consequences of an inversion. The basic concept of an inversion is that the company passes on capital gains tax to the shareholders now in exchange for lower taxes on company profits in the future. Shareholders in Mylan, or other companies undergoing an inversion, need to know how those changes are going to impact them. The primary focus of the article will be explaining the inversion and the way to plan for it. Mylan is the example we will use, but the lessons are applicable to other companies as well.

What happens when a company undergoes an inversion?

Inversion is frequently compared to marriage with a person that is not a citizen. In order to have an inversion, it takes two corporations. If a corporation decides to engage in merger with a foreign company, they can decide how they want to present that merger. If an American citizen marries a foreign person, they can help that person come to America. If an American corporation merges with a foreign corporation, the foreign corporation can help them leave the U.S. tax code. In short, the merger is like a marriage for corporations, but they are trying to exit the US instead of enter it.

What does the company get from it?

The company that is undergoing the merger will be able to protect a significant portion of their income from U.S. taxes. The amount their taxes are reduced depends substantially on the circumstances and would be difficult to project without inside information. Officially, the U.S. corporate tax rate caps out at 35%, but there are several loop holes carved into the law that dramatically reduce the effective tax rate that corporations pay. In this case, MYL knows which tax breaks it will qualify for and has determined it is in their best interest to find a foreign partner that is willing to merge.

Mylan isn't exactly paying absurd levels of taxes in America. The following table breaks it down:

What do you (or shareholders) get from it?

The shareholder gets to pay taxes on capital gains. The way these transactions are structured they frequently create capital gains taxes for shareholders as the company sells itself. The WSJ published a piece on inversions that includes this great chart:

Because these capital gains taxes are passed onto shareholders, the impact depends on who owns the shares and how they own them. Retirement accounts are not included in the chart, but we believe the normal rules would apply and exempt those accounts from taxation on capital gains.

How do you plan for it now?

If you're holding Mylan in a tax advantaged account, such as an IRA or 401-K, you're in good shape. The tax advantages should remove the capital gains tax, and the reduction in taxes due by the company at the corporate level may allow your investment to compound faster. In that sense, shareholders using retirement accounts or otherwise exempted from capital gains taxes are likely to find themselves getting something (faster growth potential) for nothing. On the other hand, investors holding Mylan in a taxable account should engage in some additional tax planning to ensure the capital gains do not cause them to land in an unfavorable position.

How do you plan for it long term?

When allocating your investments between tax advantaged accounts and regular accounts the potential for inversions gives investors an incentive to place inversion candidates into the tax advantaged accounts. It is a little late to allocate those trades now, but for the following years investors may want to be wary of where they hold each account.

What will it do to share price?

From a simple net present value analysis, the value of cash flows including the capital gains tax should be higher if the company achieves a significant reduction in taxes. Looking at tax arbitrage on a more personal level, if investors plan ahead by using tax advantaged accounts, the cost should be nothing. In that case, any decrease in future taxes would increase net present values. However, it should be noted that this assumes the merger transaction is a fair deal and not create a net cost to the company.

How do investors feel about it?

Fortune magazine has referred to the inversions as "Positively un-American". They aren't exactly a communist newspaper, so their bashing of corporations for fleeing taxes deserves some merit. If you haven't read their piece on it, you can find it here. Meanwhile, Mark Cuban has declared that he will sell the stock of any company performing an inversion. His raw intellect deserves respect from anyone. He raised the issue that a company reducing their tax burden does not cause the costs to go away. The taxes are a means for collecting resources to cover the costs the country incurs; the taxes themselves are not the cost. They are merely a way of allocating the costs.

We agree with Mark Cuban on the ethics of the inversion. The deal is bad for America, and legislation should be put in place to prevent it. Until that happens, investors need to prepare for the ramifications of the inversion through tax planning. It may seem contradictory to decry the evils of inversion while helping clients plan for it, but our goal is to help the clients first and fix the world second.

What else should I know about Mylan's inversion?

Jack Lew, U.S. treasury secretary has been a vocal opponent of inversions. He is pushing congress for retroactive legislation. There are ample precedents of retroactive legislation being passed, so investors should consider it to be a very real risk.

Conclusion

If markets are relatively efficient and Mylan's price was indicative of its value prior to the deal, an inversion should raise the value. In short, if you were bullish on the stock before, you should be more bullish afterwards. Regardless of your level of bullishness, you should be taking steps to plan for capital gains now if you are holding the stock in a taxable account. If you have a moral opposition to holding stocks in companies that seek to dodge taxes through inversions, you may want to sell Mylan. Either way, the change in classification of Mylan could result in it being dropped from some portfolios. The stock might be more volatile, especially in the short term, if large sell orders are required from some investment firms. We expect volume and volatility to be elevated, but are indeterminate on the change in price, because reduced taxes may be offset by changes in discount rates.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision.