Tax Evasion or Inversion: A Short History & Case Study

Previously, we offered you as succinct an account as we could of how U.S. corporate “Tax Inversion” became a headline issue in our country. Just to provide some review, between 1997 and 2002, the following U.S. corporations utilized a completely legal strategy to move their tax domicile to a lower-tax foreign country: 

By 2002, members of the U.S. Congress were expressing their utter outrage and vowing to ensure that no more U.S. companies would be allowed to use that strategy. Therefore, Congress embarked on its standard string of public hearings, debate, deal making, and “pork project” (add-in) amendments. Combine that with the inevitable lobbying by special interest groups, and Congress did produce completed legislation; however, this process (despite all that outrage) took until 2004. The result was IRC Section 7874 — regulatory amendments to the U.S. corporate tax code.

That effort did temporarily stem the flow of U.S. corporations overseas.[1]  In the earliest years of the newly amended regulations, one of the most helpful contributions toward ensuring corporate compliance were the detailed “case study” explanations offered by the U.S. Treasury within the published regulations.  In addition, the “safe harbor” provisions included within the regulations enabled CFOs to more confidently discern what constitutes “substantial business presence” overseas!

However (mysteriously) in the 2009 version of those same regulations, both the detailed “case study” explanations and those “safe harbor” provisions were nowhere to be found. That only served to make those regulations more opaque and befuddling – never a constructive action by government!

Combine the above with the fact that Section 7874 had enough gaps (loopholes) to drive most “Tax Inversion” efforts right on through them; and then add (for good measure) the fact that U.S. corporate tax rates and policy are (currently) among the world’s least competitive, the only surprise should be that there have not been more U.S. corporations initiating a “Tax Inversion”!!

What has been the result of the above? Here is a list (compiled by Bloomberg) of U.S. firms who have initiated a “Tax Inversion” since the year after Section 7874 first appeared (Note– there have been “Inversions” since MDT’s!):

Tax experts whose opinions I have read agree that “Inversion” is not a “quick fix”! That (very unfortunately) is not the impression suggested by articles in the mainline press, which (in my opinion) are far too quick to describe “Inversion” as a “tax evasion” strategy rather than a legal and effective way to maximize shareholder value.

Let me illustrate how a fictional U.S. corporation can maximize shareholder value (over time) through a Tax Inversion. I need to emphasize two key points:

1) The case study and the company (Mango International Limited (MILI)) are completely, and entirely a product of my fertile imagination [Check out the “MILI” ticker; there is no such ticker on any U.S. exchange!]

2) The primary point of the case study is that “Tax Inversion” does not result in an immediate “tax fix”. Instead, Inversion requires much analysis, discernment, and longer-term strategizing. As you read it, you’ll discover what I am driving at!

A TAX INVERSION CASE STUDY[2]

The subject of this (fictional) educational case study is Mango International Limited (abbreviation (not a stock symbol) MILI), a U.S. based corporation founded by T.R. Petty in 2001, with two primary divisions:

A MOBILE TECHNOLOGY DIVISION: focused upon the optimization of mobile data hardware, software, and cloud augmentation…. with the goal of transforming worldwide medical care by democratizing it through the implementation of continuously improving mobile medical monitoring and the facilitation of virtual “face to face” interaction between patients and medical providers!

A PHARMACEUTICAL DIVISION: focused upon transforming world-class research into therapeutically effective drugs that will help to improve the quality of life for persons from Atherton, California (average home price of $6.7 million)

to the Republic of Burundi (located in the African Great Lakes region of South East Africa and one of the world’s five poorest nations). 

The vision of MILI is to restore energy and renew hope for people around the world by developing, championing, and delivering “human-focused solutions” that emerge within the nexus between mobile technology and medical need.[3] 

As members of the MILI management team evolved into some of the most widely admired corporate leaders in the world, a vision took shape that convinced them that no goal was too big or too bold to be achieved if the team worked together with a single minded purpose and the will to succeed. 

As the years passed, both divisions became steadily more profitable. However, the Mobile Technology Division captured the imagination of people around the world and garnered nearly unlimited support from the hallways and byways of Wall Street, Canary Wharf (London), Dame Street (Dublin), and so forth!

The key to MILI’s success within the mobile market has been the synergy between its focus upon the unlimited potential of the “Mobile/Medical Care” space and its “best in the industry” integration of Mobile Technology and the Cloud (Cloud-based Mobile Augmentation (CMA))[4]

MILI is making progress toward rolling out its next generation CMA solution: SAMI (Service-based Arbitrated Multi-tier Infrastructure) – a multi-tier IaaS to execute resource-intensive computations and store heavy data on behalf of smart phones that are (by nature) resource-constrained.

The success of the Pharmaceutical Division has been accelerated and enhanced by strategic partnerships with the Mayo Clinic, Abbott Labs (ABT)[5], and Shire PLC (SHPG).  MILI’s research scientists are among the world’s best, and as a result, MILI is regularly approached to engage in joint ventures with other firms overseas. (MILI is currently in talks with two overseas firms).

SUMMARY OF MILI EVOLUTION:

Here is a very brief list of the development and growth of MILI:

2001: Founded in Chicago, IL (USA)

(Golden Coridor, near O’Hare Airport) Operated out of a combination office/research plant;

2002: Added a research office in San Diego, CA (Tech Coast) and a production plant in Chicago;

2003: Added a liaison office in Rochester, MN when the Mayo Clinic came on board as a strategic partner;

2004: Entered into joint venture with Abbot Laboratories.

2005: Added a research/production location in Berlin, Germany (Silicon Allee);

2006: Signed a joint venture agreement with Shire plc to focus on rare disease therapies;

2007: Added a production location in Toyko, Japan;

2009: Added a research/production center in Dublin, Ireland (the Irish Silicon Valley);

2011: Added a research/production location in Tel Aviv, Israel.

As MILI’s sales grew organically, domestic (US) sales naturally predominated.

     Ave. % of                  Ave. % of

Total Ann. Sales        Total Ann. Sales

  USA SALES          FOREIGN SALES

Between 2001 and 2007                         91%                        09% 

Between 2008 and 2012                         74%                        26% 

Between 2012 and 2013                         59%                        41%

Projected thru 2016                               52%                        48%

However, as you can see, MILI’s non-USA sales have grown steadily, accounting for an ever-growing percentage of total sales.  As we learned in our prior article, MILI owed/paid tax (through its foreign-based subsidiaries) on its foreign-sourced income[6]. If MILI ever brought any of its overseas income back into the U.S., MILI would also owe income tax to the IRS (on income already taxed overseas)[7].

However (attention: learning point!) if MILI keeps that foreign-sourced income overseas, any tax owed to the IRS is postponed![8]  So guess what MILI does?  It maintains those funds overseas – with the total amount accruing through the years to an amount of $1.7 billion by the start of 2014. MILI knows that if they ever decide to repatriate those funds, it would owe approximately $340 million in income to the IRS – a significant incentive to avoid repatriation!

So the accumulated overseas income (already taxed once) is a significant issue for the CEO and Board of MILI as they make funding decisions moving ahead!

Let’s turn now to the escalating portion of MILI’s total income that is sourced overseas. Foreign income will soon nearly equal (or exceed) Domestic income, and MILI leaders do not relish the prospect of an increasing amount of accumulated unspent income being “trapped” overseas in order to avoid double taxation!  Therefore, MILI strategized with its key personnel overseas (as well as strategic partners) to uncover a solid, complementary foreign corporation to acquire!

A very promising London-based candidate emerged, so MILI sent its founder/CEO over to London to negotiate directly with that firm’s CEO and board. They managed to keep those negotiations out of the press and thereby arrived at a mutually appealing agreement with little controversy or fanfare!

As an integral part of that agreement, the new combined corporation (Mango Berries International Ltd.) will be domiciled in Ireland (via the Channel Islands) and the stock will trade on the NYSE (MBILI) and LSE (MBILIY).

This is (of course) a “Tax Inversion”… but as I hinted in the earlier article, securing the full range of benefits from “Inversion” is neither easy nor immediate. Instead, it is a process that is initiated as a forward-looking strategy! Here is an overly condensed look at what MILI (soon to be MBILI) will need to do to move through that process:

1) Identify all “mature” products and business units based within the U.S.;

a) Identify them as such and place them within the “U.S. Division” upon the reorganization that leads to MBILI;

b) Earnings from these units will continue to be subject to U.S. tax;

c) As the “Mobile Tech” within these units becomes outdated and replaced by evolving technology and products, sales within these units will diminish and fade away.

d) As “Drug Therapies” within this division lose patent protection and/or are replaced by improved therapies, sales in these units will diminish and fade as well.

2) Identify all start-up and developing products or units within the U.S. and prepare to transfer them to one or more of MBILI’s units within the soon-to-be “Overseas Division”;

        a) Report the estimated “Taxable Value” of these products/units to the IRS

b) Since actual sales from these operations are currently (relatively) negligible, it is reasonable to project that the actual “Tax Due” will be minimal

c) Once all related taxable income is reported and the requisite tax is paid, transfer all of these products and units to the “Overseas Division” as described above.

d) As a consequence, future income streams from all such units/products will be free from U.S. tax and be subject to only one layer of income tax! 

3) Ensure that a thorough “valuation” is done on all active products and units within MILI at the time of merger, as well as a complete accounting of all overseas cash not yet taxed by the IRS (dated as of the legal day and year of merger).

a) That accounting record will inevitably be referred to at a number of points in the future. For example:

         i) Whenever a unit or product that existed within a foreign unit of MILI prior to the merger is transferred or sold, income tax will be owed to the U.S.;

         ii) Whenever cash from said unit(s) that had accumulated prior to the merger is repatriated, tax will be owed to the IRS.

4) Because of 3) above, MILI will perform the same analysis as outlined in 1) and 2) above on all MILI products/units located overseas at the time of merger.

         a) As shown in 1) and 2), the objective is to split all units/products within MILI (prior to merger) into either a “Legacy” subsidiary (ie. upon which U.S. tax will be owed as dictated by appropriate regulations) or a “Growth” subsidiary (upon which U.S. taxes will not be owed).

         b) As seen earlier, over the course of time, all of the income and assets within the “Legacy” components of MILI will “peter out” while the income and assets of the “Growth” components will grow and prosper… free of the 35% U.S. corporate tax rate.

5) But we aren’t done yet!! We must take into account both “Patents”

and (all other) “Intellectual Property” (IP)[9]

         a) During the evolution and growth of MILI, it moved from generating 2-4 Patents/IP each year to churning out 14 in 2009, 12 in 2010, 10 each in 2011 and 2012, and 11 in 2013!

         b) For tax purposes, each Patent/IP has a “value”.

         c) Therefore, MILI must complete a thorough assessment of the “maturity” of each existing Patent/IP at the time of the merger and discern whether to assign said Patent/IP to the “Legacy” portion of the new company or the “Growth” portion.

         d) The same logic as detailed above will be used in that assessment

         e) The result will be a division between:

1) Patents/IP upon which a one-time tax is paid to the IRS because it is being transferred to the Overseas Division;

2) Patents/IP that will remain subject to U.S. tax law because they are assigned to the US Division!

The bottom line regarding this strategy of “Tax Inversion” is, in no way, a “Quick Fix”. However, it does provide a completely legal (as of today, at least) strategy to maximize shareholder value by:

1) Reducing the amount of corporate earnings subject to “double taxation” (caused by the requirement under U.S. tax law that a corporation’s “worldwide income” be subject to the 35% U.S. corporate tax rate)!

2) Because of the impact of 1) above, the accumulation of overseas cash from foreign-sourced income (already taxed once) will slow down, thereby reducing the drag on corporate growth that results from any “frozen asset”.

3) All products/units/divisions within the new corporation (MBILI) will be aligned for maximum future earnings potential and minimum double taxation. In addition, as the “Legacy” operations run out their effective economic life, the new corporation will approach the goal of 100% of all operations reaching peak efficiency with regard to tax-compliant earnings growth!

DISCLOSURE: Besides applying his vivid imagination to the creation of this entirely fictional company … the author is deeply indebted to the fascinating online article entitled “Cloud Based Augmentation For Mobile Devices”  (6/20/13); see: http://arxiv.org/pdf/1306.4956.pdf.

[CONTINUATION OF “MORE CASH THAN YOU CAN IMAGINE… OVERSEAS!”] 

As detailed in our “Case Study” narrative, “Inversion” is primarily a “future-oriented” strategy designed to secure access to profits from product lines that are still in the developmental stage.

Kent Wisner recently confirmed the above observation (Wisner is a tax adviser for corporations at Alvarez & Marsal). Wisner recently commented about companies which have “Inverted” saying: “Some are merely setting the stage for future businesses not yet started or barely started that will be under the new foreign entity…. These companies are betting on future success.”

In composing the related “Case Study”, I relied upon expert commentary related to the recent $42.9 billion acquisition by Medtronic (MDT) of (Ireland-based) Covidien (COV). From the details of that acquisition story, I learned that if MDT decided to transfer any assets (and related cash flows) from a current MDT foreign subsidiary to a current COV unit: “It would trigger a repatriation tax on the value of the [transferred] assets.”[10]

With regard to MDT’s specific circumstances, above and beyond any existing (pre-merger) assets it might desire to transfer to either COV subsidiaries or a unit within the new (merged) corporation (on which it would owe U.S. income tax), it held over $20.5 billion in accumulated overseas earnings (already taxed once) in foreign subsidiaries … on which it will owe U.S. income tax when/if it is repatriated into the U.S.![11]

Professor Adam Rosenzweig (Washington University School of Law) is the expert from whom I borrowed the strategy of dividing pre-merger products/assets (and Patents/IP) into two categories[12]

To neatly summarize this strategy, Rosenzweig points out that a corporation carrying out an “Inversion” can thereby “freeze” its legacy subsidiaries in time and simultaneously “free up” its next generation(s) of products/services to escape the snare of double taxation!  Through this strategy, the corporation’s older (lower growth) products/assets will, in due time, shrink as a percentage of total company revenue (and eventually be discontinued) – thereby enabling the corporation to avoid paying any “exit tax” on mature products held overseas at the time of merger.

Let me offer another pertinent example of a real world U.S. corporation that is forced to deal with the challenge of existing U.S. corporate tax policy on a weekly basis: MasterCard Incorporated (MA), based in Purchase, New York.[13]

There is no question that MA is on of the United States’ most “global” companies! It processes transactions from over 210 countries each year, and it (most recently) reported earning just 39% of its revenue within the United States!!

Given these facts, it is no surprise that a considerable amount of the CFO’s time (she is Martina Hund-Mejean) is consumed by the task of leading regular meetings focused upon managing the approximately $3.5 billion of accumulated foreign-sourced earnings that MA still holds in overseas accounts in order to avoid the “second tax” that would be imposed by the U.S. if those funds were “repatriated”!  Hund-Mejean and her colleagues refer to those funds as “trapped cash”, and it is a growing challenge for them (last year it totaled only $2.6 billion!).

One real world consequence for Hund-Mejean of “trapped cash” and U.S. corporate tax policy is this:

Whenever MA considers any investment opportunity, she and her colleagues must perform carefully constructed “stress tests” in order to determine a “worst case scenario” through which tax might be owed to the United States as a result of repatriated profits!

As Hund-Mejean points out, this is just one example of how the globally non-competitive corporate tax policy of the U.S. places even our best and strongest U.S. global competitors under a significant handicap: “That [repatriation tax] is a direct cost to us… That’s a huge disadvantage being a U.S. based company!” (Separately, she amplified that MA competitors do not face a headwind like that.)

So just how big is the “trapped cash” for U.S. corporations in general?

BIG!

According to Bloomberg, the amount was nearly $2 trillion in March[14] (surely over $2 trillion by now!).  And no surprise, the majority of this humungous cash pile belongs to a handful of our nation’s biggest global companies! Twenty-two of our global “giants” hold over half of that $2 trillion “trapped cash”!

To present these figures in a slightly different graphic format, here is an image that contrasts the overseas cash held by those 22 “U.S. global giants” with the cash held by all other U.S. firms:

As of March of 2014, the overseas cash held by the “U.S. Global Giant” grew by about $206 billion vis-a-vis one year earlier (with (evidently) every intention to keep that cash overseas until Congress offers an “amnesty” program or otherwise motivates them to actually repatriate those funds).  And as you might conjecture, three of the biggest contributors to this recent growth in overseas cash are technology companies!!

Why do these firms keep those funds overseas?  Here are two well-known  examples: 

1) If Microsoft (MSFT) brings all of its overseas cash back into to U.S., it would owe the IRS approximately $24.4 billion in income tax!!

2) Qualcomm (QCOM) has some $21.6 billion sitting overseas. Distinguished CEO, Dr. Paul Jacobs, as he passed the reins of “Chief Executive” to his successor, passed out a homework assignment to QCOM shareholders:

“Send your Congress people your opinion that you’d like American companies to be able to bring offshore money back to the United States to either reinvest [or return to shareholders]”.

None of this will change until U.S. corporate CEOs and board members no longer see stark examples of U.S. owned companies paying more income tax than an almost identical competing company owned by a foreign corporation!   

Professor Jennifer Blouin from theWharton School offers an eloquent summary of how U.S. global firms feel about U.S. corporate tax policy: 

“Until they change the tax law, there’s not much other than extreme distress in the United States that would precipitate a repatriation.  I’m stumped as to why we can’t change the U.S. system.”

INVESTOR TAKEAWAY:

By now, despite all the misleading articles, opinions, implications, inferences, innuendos, and outright poppycock that has appeared within the supposed “business” and general media, you have a much more complete and accurate accounting of the details surrounding the so-called “Tax Inversion” issue!

I hope you will no longer take at face value the sound bites that emanate from Washington, D.C. And I hope that, since you have put yourself into the seat of corporate CEO, obligated to fulfill your fiduciary duty to maximize shareholder value within the bounds of all applicable laws and regulations, you have developed much greater empathy regarding the challenges faced by U.S. global corporations within the current economic and tax environment. 

Allow me to draw your attention to the “real world” example of Walgreens Co. (WAG). This very week it was revealed that. contrary to widespread analyst and shareholder expectations, the completion of WAG‘s acquisition of Alliance-Boots will not result in a Tax Inversion.  Complicating matters, and confirming that there were significant issues within the management of WAG (as I suggested in my earlier article about WAG: https://www.markettamer.com/blog/abbott-is-miles-ahead-of-this-stock-in-the-news) it was announced that the CFO of WAG had been replaced the very week that WAG was announcing the long-awaited news on Alliance-Boots!  No, it is never easy to fulfill the responsibilities of a CEO!!

Finally, I hope you (in particular) recognize that “Inversion” does not offer any corporation a “quick fix”.[15]  “Inversion” does not immediately release a company employing that strategy from the 35% U.S. corporate tax rate!! Instead, “Inversion” is a time-consuming, involved, complicated process that only bears it promised “fruits” over time!   And it is a strategy whose rationale is driven completely and solely by the globally non-competitive corporate tax policy of the U.S.[16] Who is responsible for that policy, as well as for the failure of the supposed “solution” that was created in Washington between 2002 and 2004?  It is the U.S. Congress and the U.S. Treasury Department! 

So the next time you think someone needs to be “blamed” for the current “Inversion” trend, blame them… not U.S. corporations trying their best to compete within the ever more global economy around them!  When Congress, the White House, or Secretary Jack Lew feel compelled to point fingers about “Tax Inversion”, I suggest they either look in the mirror, or frame and hang this timeless (and well-known) cartoon:  

DISCLOSURE: No one can purchase MILI or MBILI because it is a company created from the author’s imagination.  The author does not currently own the stock of any company mentioned (but does own some options on ABBV). Nothing in this article is intended as a recommendation to buy or sell anything. Always consult with your financial advisor regarding changes in your portfolio – either subtractions or additions.

FOOTNOTES:

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