Tax Inversions and Investors

The financial transaction known as an “inversion” is designed to take advantage of lower corporate tax rates outside the United States.  While the practice has been subject to an increasing level of political criticism, there does not appear to be any credible evidence that it is a violation of current tax law.

Despite the political rhetoric, corporations, individuals and their advisors, generally seek to understand the ramifications of the tax code and legitimately seek to minimize their tax liability.  Remember, the tax code is written by the same political class that enjoys criticizing selected organizations and individuals who, while in compliance, are not paying as much as the critics suggest is their “fair share”.

Inversions have been near the top of the criticism list for some time.  In that regard, it should be noted that the U.S. corporate tax rate is 35%, the highest in the developed world.  In addition, the U.S. is one of the few countries that makes its companies pay that rate on all their worldwide income, although they can defer the tax on profits attributed to overseas earnings until they bring the money home.

Many nations, including Canada and the U. K., tax only domestic profits.  One of the perverse results is that an independent U.S. company can end up paying more taxes than the same company, if owned by a foreign parent.   Another problem relates to reinvestment of net income.  If a U.S. company brings overseas earning home, it pays a second tax.  If an overseas owned company brings retained earnings into the U.S., no new tax is involved.  This places domestic companies at a material disadvantage when using overseas earnings to fund U.S. expansion.

Tax codes are complex, changes are controversial and generally take a long time to enact.  Investors should remember that corporations view taxes as a cost of doing business. They pay taxes, just as they buy raw materials and pay employees. Thus, they are merely a conduit, as the customer actually pays the tax, through the price of the product or service.  Consequently, corporations that are subject to higher tax rates may be put at a competitive disadvantage in that they require a higher selling price in order to cover their total costs.

All comments and suggestions are welcome.

Walter Kirchberger, CFA®