Shifting the Tax Burden

Corporations engage in mergers and acquisitions for a multitude of reasons, including synergy, product line expansion and greater geographic reach. Recently, tax-motivated deals related to freeing up trapped cash and/or corporate inversions have become more newsworthy.

Corporate Tax Rates

The top US corporate tax rate is currently 35%, the world’s highest. Adding state taxes increases this rate to 39.2%. However, this is not the true rate most companies pay. Companies can take advantage of a multitude of credits, deductions and exemptions to meaningfully reduce their corporate tax rate. In fact, a 2010 Government Accounting Office study of profitable corporations with assets of $10 million or more found that the effective tax rate for such corporations was only 12.6%. The 12.6% was derived using actual taxes paid on corporate tax returns.

There can be wide variations in the amount of tax corporations pay. For example, based on SEC filings Chevron’s (CVX) effective tax rate over the last 12 months was 40.7%, General Electric’s (GE) was 3.6% and Pfizer’s (PFE) was 22.8%.(i)

One of the primary means by which multinational corporations can reduce their tax bills is using overseas subsidiaries to shuffle money, intellectual property and assets into lower-taxed jurisdictions such as the Netherlands, Bermuda and Ireland. Where possible, companies are also using existing loopholes or creating new ones to lower taxes. Companies are also able to reduce their tax bills by forming other legal entities such as master limited partnerships(ii). As a general rule, MLPs do not pay taxes.

Government’s Tax Revenues

As a result, the federal government’s corporate tax revenues are decreasing sharply. According to the Congressional Research Service (CRS), less than half of the government’s business revenue comes from corporations. This figure was about 80% in 1980.

A good question to ask is “Is the government truly losing tax revenues, or is at least a portion of the tax burden being shifted to others, such as individual investors?” For example, in most mergers between US companies, shareholders receive shares of stock in the acquiring company for shares of stock in the acquired company. Such transactions are typically not taxable. However, in a corporate inversion, shares of a US-based company are exchanged for shares of a foreign-based company. Under the tax rules, any gains realized prior to the transaction are taxable. Similarly, if assets of an MLP are acquired by the corporate partner, taxes are also paid by the owners of the partnership interests. At the same time, the corporate partner’s tax bill is lowered. In essence, these activities are enabling corporations to shift a portion of their tax liability to shareholders.

From BWFA’s perspective, to a certain extent, these transactions represent financial engineering. At the same time, our investment approach favors companies that generate strong cash flow; lowering the corporate tax bill benefits cash flow. Since such transactions can also have direct implications on individuals, it is important that we are aware of such dealings by companies held or potentially held in client portfolios. Given all the negative publicity the activities described above have generated, it is likely that Congress will ultimately change the rules and make it more difficult for companies to benefit from these types of tax-motivated transactions.

i. At the time of publication, CVX, GE and PFE were not on BWFA’s Buy, Sell or Hold list.

ii. (Note: A master limited partnership (MLP) is a publicly traded limited partnershipShares of ownership are referred to as units. MLPs generally operate in the natural resource, financial services, and real estate industries. Unlike a corporation, a master limited partnership is considered to be the aggregate of its partners rather than a separate entity.)