Much of the focus of proposals for reform to combat the recent — and apparently growing — spate of inversions, the practice of reincorporating abroad to take advantage of lower tax regimes, has centered on reducing the U.S. statutory corporate tax rate, which at 35 percent is the highest in the developed world.
But for Stanley Druckenmiller, the founder of hedge fund firm Duquesne Capital Management, inversion-focused tax reform won’t work “unless tax cuts at the corporate level go hand in hand with tax hikes at the shareholder level,” he said at the Delivering Alpha conference, co-hosted by Institutional Investor and CNBC on July 16. This, he added, would involve raising taxes on capital gains and dividend income as overall corporate rates were brought down, thereby protecting the U.S. Treasury’s tax revenue base from erosion.
It’s a novel suggestion that bears scrutiny, particularly given that a number of U.S. companies seeking shelter in lower-tax jurisdictions have delivered robust returns for shareholders.
Last Friday pharmaceutical giant AbbVie announced that it will buy Dublin-headquartered Shire for $54 billion, thus allowing the suburban Chicago–based company to reduce its tax bill by reincorporating in Jersey, a U.K. Crown dependency in the Channel Islands that is a popular corporate offshore destination.
The merger was an exclamation point to a week in which concerns over the wave of inversions reached a new height. Two bills have already been introduced in Congress this year in the wake of moves by several U.S.-domiciled companies, many of them in health care, to use M&A to reincorporate in more hospitable corporate tax jurisdictions. Early last week Treasury Secretary Jack Lew sent letters to lawmakers urging them to speed passage of these proposals through Congress; he also used an appearance at Delivering Alpha to reiterate the call to action. Alone, the executive branch “does not have the ability to address this inversion question,” he said. “There are limits to what we can do without legislative action.”
Much of the hand-wringing over inversions is based on fears that the U.S. corporate tax base will erode. The Joint Committee on Taxation, a nonpartisan congressional research body, said in a recent note that the U.S. would receive an additional $20 billion in revenue over the next decade if most inversions were halted. Lost, however, amid the hoopla over Lew’s intervention in the debate and the prospect of lost corporate tax revenue, is the realization that the stocks of companies undertaking inversions have generally performed well following their reincorporation abroad.
Druckenmiller pointed this out at Delivering Alpha. “I’m not for corporations paying zero percent,” he told the conference, noting, however, that although the nominal federal corporate tax rate in the U.S. is 35 percent, once state and local taxes are factored in, the average corporate rate rises to 39.1 percent. True, many companies end up with a much lower rate, with some paying zero or getting refunds. But, he added, “shareholders are the ultimate beneficiaries here.”
Consider the way inversions have been playing out. Last November, Endo Health Solutions, a Pennsylvania-based pharmaceuticals company, paid $1.6 billion for Canadian drugmaker Paladin Labs and announced it was reincorporating in Ireland for annual tax savings of around $50 million. Since then the company, which is listed on the New York Stock Exchange, has seen its stock rise more than 50 percent, compared with 11 percent for the Standard & Poor’s 500 index and 17 percent for the health care sector. The story is similar for other recent inversion deals. In September last year, Silicon Valley’s Applied Materials reported it was buying Tokyo Electron with the plan of reincorporating in the Netherlands for potential annual tax savings of $100 million. Since the inversion, Applied’s stock has risen 45 percent, versus 16 percent for the overall market and 19 percent for the tech sector. Cleveland-headquartered industrial manufacturer Eaton gained 72 percent in the year following its acquisition of electrical-equipment supplier Cooper in May 2012; the market gained 36 percent. And so on.
Inversions are seemingly bad for the U.S. Treasury but good for U.S. shareholders. There are both winners and losers. Druckenmiller wants to reform the tax system to better reflect that reality.
As the law presently stands, U.S.-domiciled firms are denied the benefits of a tax inversion if the original U.S. shareholders own 80 percent or more of the new firm. Both bills before Congress propose to lower that threshold to 50 percent, which would significantly shrink the pool of U.S. companies eligible to reincorporate in lower-tax environments. Companies may now be rushing into deals in order to get ahead of Congress. At first, “it was like a fad,” with companies pursuing inversion deals simply to keep up with one another, says Juliane Keppler, managing director of the global tax and regulatory team at Nasdaq OMX Corporate Solutions Group in New York. But the potential introduction of inversion-limiting legislation may have altered the deal-making dynamic, she adds. “How much of this is now being driven by the tax advisers? Is it a vicious cycle? Possibly.”
Druckenmiller’s call at Delivering Alpha was essentially for the inversion debate to be placed within the conversation of broad-based U.S. tax reform. To be fair, many voices in Washington are advocating for inversions to provide a catalyst for more sweeping tax reform — but most of the suggestions focus on the need for lower tax rates and ignore the benefits to shareholders.
A Congressional Research Service report published in May pointed out that “reducing the corporate tax rate without the corresponding base-broadening would likely reduce corporate tax revenue, adding to chronic budget deficits.” Druckenmiller’s idea to raise capital gains and dividend rates to better align with income tax rates, even as corporate rates are lowered, he argued, would “grow the economy and raise revenue.”
Of course, it’s not clear whether the revenue raised through hikes at the shareholder level would be sufficient to offset losses sustained by lowering the corporate rate. But as the Obama administration scrambles to fashion a response to the intensifying surge of inversions, Druckenmiller’s proposal, placed within the context of healthy stock performance by inverting companies, offers a more nuanced picture of the gains and losses.
Follow Aaron Timms on Twitter at @aarontimms.