Normally a merger of that size would make a splash in the business pages, while eluding broader public scrutiny. But this was different. If the acquisition had gone through, Pfizer would have been able to relocate to the United Kingdom and avoid being taxed at the high American rate on $69 billion of cash it held overseas.
It would have been a sweetheart deal for Pfizer — without moving any of its employees or facilities, the company would have been able to pocket billions of dollars that otherwise would have been earmarked for the Internal Revenue Service.
The deal eventually fell through after AstraZeneca rebuffed multiple offers from Pfizer, but by that point, Americans had
become familiar with the corporate maneuver known as an inversion — and they didn’t like what they saw.
At its most basic, an inversion is when a company re-incorporates abroad for tax purposes through a merger or acquisition. While inversions aren’t a new phenomenon — according to the Congressional Research Service, 47 companies have inverted in one form or another since the 1980s — around half of those deals by dollar value were done in 2014.
The backlash against inversions began to heat up throughout the summer as more potential deals from companies like AbbVie, Walgreen, Mylan, and Chiquita were announced. A group of U.S. Senators introduced a bill aimed at shutting down inversions for two years. Fortune ran a blistering cover story calling inverting companies “positively un-American.”
The rhetoric reached a fever pitch in July when President Barack Obama said in his weekly radio address that inverting
companies were taking advantage of an “unpatriotic tax loophole.”
August brought the news that Burger King would be moving its throne to Canada by acquiring Tim Hortons in order to create the world’s third-largest fast food enterprise.
But at a time when the United States is growing faster than almost any other developed economy, why are corporations lining up to renounce the red, white, and blue and pledge allegiance to a foreign flag?
America prides itself on being an exceptional country and nowhere is that more clear than when it comes to its tax system. While almost all other nations tax solely domestic earnings, the United States taxes its corporations and their foreign subsidiaries on all of their income, no matter where it is earned.
That means American companies operating abroad will often be taxed twice — once by the country where they’re doing business and again by the IRS.
Companies can however defer paying those taxes until that money is brought back into the U.S., leading many major corporations to hoard cash abroad. The total amount of money stashed outside of the U.S. has doubled from 2008 to $2.1 trillion, with some companies letting tens of billions of dollars sit idly outside of American borders.
Inversions are one way these companies can put that money back to use without it being subject to the U.S.’s high corporate tax rate.
Roy Berg, an American tax specialist at Moodys Gartner Tax Law LLP, says that U.S. authorities haven’t been sitting idly by. “Treasury knows that’s the name of the game,” says Berg. “They’re not stupid and they don’t like it when you can step around rules like that.”
Since the 1990s, both Congress and the U.S. Treasury have been issuing new laws and regulations to try and put a brake on inversions. But companies have continued to find creative ways to keep the deals going.
“Tax policy is always a game of whack-a-mole,” says Berg.
Take the rules set out in 2004, when Congress decreed that any inverted company that still had 80 per cent of the same shareholders as the previous American corporation would be treated as a domestic entity and be subject to the appropriate taxes.
“A U.S. company would acquire a foreign company and just make sure that the foreign shareholders get at least 20 per cent or more of the shares,” says Jeffrey Rubinger, an international tax lawyer at Bilzin Sumberg Baena Price & Axelrod LLP in Miami.
In 2009, the U.S. Treasury told companies they could only invert to countries where they had “substantial business activities,” eliminating previously popular destinations like Panama and Bermuda. And so companies started to invert to
developed countries like Ireland, the Netherlands, the U.K., and Canada.
While American lawmakers and commentators have been loudly denouncing inversions, recipient countries like Canada have been reveling in the trend.
Valeant, Canada’s largest pharmaceutical company, arrived here via inversion in 2010. Even Tim Hortons repatriated to Canada via inversion in 2009 after being spun off by Wendy’s.
Prime Minister Stephen Harper, during a rare question-and-answer session in New York, was practically gloating about the new corporate immigrants. “Business activity moving to where tax rates and where economic environments are more competitive is just the law of economics,” he told the crowd at Goldman Sachs.
While relatively low corporate tax rates have certainly been a factor, Canada also has a tax treaty network that’s often very generous to companies operating abroad.
“Most of the time you hear about using Switzerland or Ireland or the U.K. for these inversions, but Canada really offers the same benefits as those European countries in that they also exempt dividential corporate income tax,” says Rubinger.
Another benefit the Canadian tax system provides is the ability to get foreign tax credits for taxes that have been spared by foreign countries. “So they’ll give you a credit on taxes that you never paid,” says Rubinger.
And some benefits have nothing to do with taxes.
Canada is a more defendant-friendly jurisdiction with better liability protection than the United States.
“You’ve got these big pharmaceutical companies with earnings based on patents, but if they’ve got a bad drug, that can bring down the whole ship,” says Berg.
Even the Canadian court system can be an incentive to move. Unlike the United States, most civil matters are heard before a judge not a jury.
Berg points to the lengthy and complex patent litigation between Apple and Samsung, which was heard in front of a jury, as an example of why American companies might prefer to take their chance with a judge. “If we’re going to be sued for patent infringement, I don’t want 12 Texans trying to understand my 2,000 page patent
application,” he says.
Paul Gilman, a partner with Aronberg Goldgehn Davis & Garmisa in Illinois, says inverting companies like to stay within
the developed world even though some developing countries may offer more attractive tax rates.
“Once you move, you’re governed by the corporate law of that country,” he says. “You have to be very careful that you’re not going to a jurisdiction that has a not very well developed body of corporate law.”
But Canadians shouldn’t get too comfortable with the idea of American companies moving north en masse. A combination of political pressure and new Treasury rules has already put a number of deals on ice.
In August, Walgreens kyboshed a potential inversion to Switzerland after some politicians began to call for only U.S.-based pharmacies to have access to government-funded programs like Medicare and Medicaid.
Then in September, the U.S. Treasury released new rules making inversions more difficult and less profitable.
These primarily targeted the creative maneuvers companies have developed over the past few years to facilitate inversion deals.
“Hopscotch” loans, where a foreign subsidiary of an inverting company lends money to a newly formed foreign parent, skipping over the U.S. company and avoiding taxes, will now be treated as dividends, and thus subject to U.S. taxation.
“That will have some negative impacts for companies that are inverting because it’s more difficult to use the offshore money,” says Rubinger.
The “skinny down” distribution, where a U.S. company would artificially lower its value by issuing an extraordinary dividend or selling off assets to comply with the 80 per cent threshold, has also been axed.
While other widely used and controversial techniques like “earnings stripping” weren’t affected by the new regulations, they’re already having an impact.
A number of companies that were planning on inverting, including AbbVie, Salix Pharmaceuticals, and Chiquita Brands International, cancelled their deals.
And according to Rubinger, some companies will be wary of inverting for fear of anti-inversion legislation from Congress in the future. “I think overall inversions are going to slow down because people aren’t sure what the U.S. Congress is going to do and if they do enact rules, if they’re going to be retroactive,” he says.
So is this the end of the inversion? Not likely.
“It’s going to slow them down a bit but it’s not going to stop them,” says Gilman.
While the new rules did kill some of the proposed inversions, the majority of the deals are still going through. Some of the survivors, like Tim Hortons and Burger King, were motivated by more than just tax considerations, says Gilman.
But even some of the deals that were heavily influenced by tax avoidance are still moving forward.
“As long as you can qualify for the inversion under the 80 per cent test and deal with not having a hopscotch loan, you can still do it,” says Gilman.
According to Gilman, inversions are merely a symptom — the U.S. tax system is the disease.
“The U.S. Treasury needs to deal with this from an economic perspective and try to get the U.S. tax code in line with the global tax scheme,” he says.
But it’s unlikely that will happen anytime soon.
“The President can’t get anything done and Congress is unwilling to compromise. It’s a shame,” says Gilman. “You need tax reform, you need to find a way to get the trillions of dollars that is sitting overseas back to invest in the United States.”
And it’s not just the American tax system that needs fixing.
“On a global basis, corporate tax structures grew up in the early 20th century, where you were more of a global manufacturing economy,” says Berg. “Whereas now so much of the core of productivity is based on intellectual property.”
Inversions have been especially enticing for companies that depend on intellectual property for their profits, like pharmaceuticals and medical device manufacturers.
“It’s hard to move manufacturing plants around the world, but it’s easy to move intellectual property,” says Berg.
Many of the European jurisdictions that are popular with inverting companies have extremely generous tax treaties when it comes to patent rights.
Berg does see some hopeful signs. “There is a very strong shift towards transparency and towards eliminating these creative ways to structure international business through existing treaty networks and through preferential tax treatment,” he says.
Ireland recently announced it would no longer allow the so-called “double Irish” arrangement, which allowed many companies to effectively pay no tax on income from intellectual property and royalties.
The Organisation for Economic Co-operation and Development, the European Commission, and the U.S. government have all begun to apply pressure on tax havens like Switzerland and Luxembourg.
And public outrage is forcing companies like Apple, Starbucks, and Google to openly defend their tax positions.
“The people who are playing really aggressive are going to have to do so in the light of day where public pressure is always going to be greater,” says Berg. “We are in the midst of a paradigm shift where a lot of our legal and tax infrastructure has at least one foot, if not two, in the 20th century.”
But unless there is a major overhaul of the American and global tax systems, foreign earnings will remain stashed abroad, inversions will likely continue, and U.S. authorities and multinational corporations will keep playing their game of international hide-and-seek.