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Summary

  • Drug stocks got hit over the last several trading days due to political noises about tax inversions.
  • I agree with Mylan's CEO (Democrat Senator's daughter) that this is just noise and tax inversions cannot be stopped because of the existence of foreign companies with US operations.
  • Mitigating this would require bringing US tax rates and US tax laws in parity with the rest of the world. Such a solution seems far away (e.g. a different galaxy).
  • To see why tax arbitrage is here to stay, just look at Ireland. Ireland has a lower rate than Continental Europe.
  • Ireland bailed out foreign (European) banks and incurred huge debt. Continental Europe then blackmailed Ireland to lower its tax rate. Ireland didn't buckle and its economy came roaring back.

Tax inversion frenzy

Tax inversion is the method of lowering a US company's tax rate by acquiring a foreign company. As long as the shareholders of the foreign company being acquired own at least 20% of the shares of the combined company, the acquirer can take on the tax rate of the acquiree. The US federal corporate tax rate of 35% is one of the highest in the world. In addition, the US is one of only six countries in the world that taxes the profits made in foreign countries at the tax rate of the home country.

Examples of recent drug company inversions and attempted inversions are (many of these deals were announced this year):

  • Actavis (NYSE:ACT) acquiring Warner Chilcott of Ireland
  • Perrigo (NYSE:PRGO) acquiring Elan Pharmaceuticals of Ireland
  • Mylan Laboratories (NASDAQ:MYL) acquiring an Abbott Laboratories (NYSE:ABT) subsidiary to move to the Netherlands
  • Mylan getting rejected by Meda (MEDAA) of Sweden
  • Medtronic (NYSE:MDT) acquiring Covidien (NYSE:COV) to move to Ireland
  • Abbvie (NYSE:ABBV) acquiring Shire (NASDAQ:SHPG) to move to the UK
  • Pfizer (NYSE:PFE) getting rejected by Astrazeneca (NYSE:AZN) of the UK
  • Salix Pharmaceuticals (NASDAQ:SLXP) acquiring a subsidiary of Cosmo Pharmaceuticals (COPN) to move to Ireland
  • Auxilium Pharmaceuticals (NASDAQ:AUXL) acquiring QLT (NASDAQ:QLTI) to move to Canada
  • Valeant Pharmaceuticals (NYSE:VRX) acquiring Biovail of Canada

Unlike other companies mentioned above, I believe Valeant Pharmaceuticals has fallen more due to its terribly broken business model and the scary insider trading lawsuit.

Almost all the above stocks have fallen after the Treasury Department said it was examining executive orders to prevent inversions. I believe this was just political noise to gear up for the mid-term elections because it is impossible to do this without nasty consequences. Therefore this could be a buying opportunity.

How will the US prevent tax inversion?

To start with, how does one define a "US-based" company versus a foreign company? All the following possibilities have problems:

Should the majority of employees be US citizens?

If this is used as the definition, it would discourage the hiring of US citizens leading to higher unemployment. Less qualified foreign citizens would have an advantage.

Should the majority of shareholders be US citizens?

If this is used as the definition, it would tell companies to set a limit to the number of shares that can be owned by US citizens. US investors would be at a disadvantage.

Should the majority of company management be US citizens?

Encourages company management to change their citizenship while retaining permanent residency. If company management is banned from living in the US, they could hop over to Canada or the UK.

Should the majority of revenue come from the US?

Not only would this terrorize existing foreign companies, it also reminds us of countries such as Venezuela or Cuba.

Leveling the playing field with already inverted companies

The political noise is being made about preventing any more inversions. But that leaves already inverted companies such as Valeant Pharmaceuticals with an advantage over non-inverted companies. Such inverted companies or foreign companies can acquire US-based companies like locusts until there are no "US-based" companies left.

Noise from the Treasury Department ("Don't let the facts get into the way of a good story or a good campaign.")

I agree with Heather Bresch, CEO of Mylan. She is the daughter of the Democrat Senator from West Virginia (Joe Manchin). This is what she said in the Q2 earnings call:

As far as inversions, I guess, here's my two cents worth on it. I think there is a lot of noise, in the sense that the facts have really been sheltered. I know I've joked before, "Don't let the facts get into the way of a good story or a good campaign." And I truly believe there's such an uneducated dialogue going on around inversions right now that is going to be very, I believe, difficult for an Executive Order at the Treasury Department to do something that doesn't just truly jeopardize foreign entities, including the companies who have inverted and just companies that are foreign that do a significant amount of business in the United States, which contributes to huge jobs. There's treaty aspects. So I think as much as the Senate may want to vote on something to take it back into the field and be able to say to their constituencies they're trying to do something, I just continue to think the odds of anything getting done and looking at one little snapshot of our tax code, which needs to be significantly reformed, is unlikely.

Just look at Ireland

Ireland is a tiny country with a population of just 6 million. It has no natural resource advantages of any kind. Despite this, it is an economic powerhouse. During the financial crisis, it bailed out foreign banks who had invested in Irish real estate. (I think some countries in Continental Europe wouldn't have bailed out foreign banks if they were in Ireland's shoes.)

After these mammoth bailouts, this tiny country of 6 million people was in dire straits. Continental Europe offered financial help in return for Ireland increasing its corporate tax rate. In public statements, several European politicians badgered Ireland's corporate tax rate while the prospect of bankruptcy hung over Ireland. But Ireland didn't buckle to this pressure and proudly refused the kind of bailouts that Greece, Spain and Portugal received.

Ireland's exports then boomed and its financial position recovered. This should be a lesson to everyone that tax rate differences will remain a competitive advantage and will not go away. The UK recently copied Ireland and lowered its tax rate to 20% starting in 2015. This has motivated Abbvie and Pfizer to try to relocate to the UK.

Political deadlock

Fixing the US corporate tax system is years away. Just look at the standoff between the trillion dollars in cash held by companies abroad and lawmakers. Getting this cash to the US would incur a big tax - for example, if the cash is from an Irish subsidiary taxed at 12.5%, repatriating it to the US parent would incur a tax of 35% - 12.5% = 22.5%). A tax holiday would have allowed this cash to be invested in the US. But political ideology means this cash has sat and is going to sit abroad for a long time. One of the reasons companies do inversions is to get access to this cash. By changing their tax country, they can escape the US tax on profits earned in foreign countries.

I think the president will not make any politically expedient short-term move that damages the country despite political rhetoric. Therefore in my opinion, nothing more than noise is going to come out of the Treasury Department.

One of the main obstacles to corporate tax reform has been opposition to the reform being revenue neutral. That is, if the US collects an average tax rate of 25% from corporate income, revenue neutrality means that after tax reform the US would continue to get a tax rate of 25% from corporate income. Some companies pay 0% and some pay close to 40% (when you include state taxes). But the average works out to the twenties. As one can imagine, agreeing on such issues will take a very long time. Meanwhile it makes for great political theater.

Foreign countries are not going to take it lightly if the US penalizes foreign companies. The last thing you want is a trade war.

Source: Why Tax Inversions Won't Go Away