Tax Inversions on the Rise

Corporate transactions with the purpose – at least in part – to lower U.S. corporate taxes have been on the rise. The latest announcement came on June 15, as Medtronic Inc. announced plans to acquire Covidien, PLC. Under the deal’s terms, the combined company will be domiciled in Ireland, where Covidien is based, rather than in the U.S. The company’s operational base will remain in Minneapolis, which is where Medtronic is based.

These types of transactions are referred to as “tax inversions.” They have become increasingly popular, particularly among health care companies. Health care companies often have significant operations in foreign jurisdictions with low tax rates, such as Ireland. This allows them to generate ample amounts of cash. But, they keep the cash overseas as there is typically a tax cost associated with bringing it back to the U.S.

Recently, Pfizer made a failed bid for UK-based Astra Zeneca. A large portion of that roughly $120 billion deal would have been funded by Pfizer’s overseas cash hoard.

In the case of Medtronic, the transaction also appears to have a dual purpose, as the company has been able to use tax planning strategies to keep its effective tax rate (18.4% in 2013) well below the U.S. statutory rate of 35%. Medtronic management also believes the deal will help it access cash that is currently “trapped” overseas. In other words, the company prefers to keep the cash offshore as it would incur additional taxes to repatriate it to the U.S.

As we discussed a few months ago, many U.S.-based multinationals, earn considerable profits overseas. Because of the tax cost associated with bringing these earnings back to the U.S., they often keep the cash parked outside the U.S. This can cause companies with significant cash balances to borrow in order to return cash to shareholders via either stock buybacks or dividends.

In discussing the deal, Medtronic’s management said the combination is expected to generate meaningful free cash flow, “which it will be able to deploy with greater strategic flexibility,” particularly in the U.S. One related potential benefit is that moving overseas could allow Medtronic to distribute more cash to shareholders because it would no longer keep profits earned outside America offshore, as many U.S. companies do, to avoid taxes.

From BWFA’s perspective, to a certain extent these types of transactions are largely representative of financial engineering.  At the same time, we favor companies that generate strong cash flow; lowering the corporate tax bill increases cash flow. At some point, Congress is likely to change the rules making it harder for companies to benefit from these types of tax-motivated transactions. At the same time, some modifications to the corporate tax system are also needed to allow companies to more easily move cash around without incurring significant additional costs.