fbpx

page 1Click on image at left for a more printer-friendly version…

By David R. Hines, CFA Daniel M. Lay and Thomas M. Pierce

Tax inversion mergers have been prominent in the financial headlines this year. A tax inversion occurs when a U.S. company uses a cross border merger to re-incorporate in a more tax-friendly country.  These mergers create unique tax consequences in portfolios, most notably; shareholders of both the target company and the acquiring company will potentially realize capital gains.  In this note, we explain the benefits of these mergers, why these mergers create taxable events, and discuss how charitable giving may reduce or eliminate negative tax consequences for the taxable investor.

While there may be several incentives for U.S. companies to initiate tax inversions, the primary motivator tends to be a reduction in a company’s tax bill. The United States has one of the highest stated corporate tax rates in the world. By re-incorporating in a country with a lower tax rate, companies create shareholder value through increased net income and cash flows. This is in addition to the increased earnings and cash generated from possible synergies and cost-cutting.

Also, many large domestic companies have billions of dollars in cash (profits) held outside the United States because repatriating this cash triggers a U.S. tax to the company. Reorganizing in a more tax-friendly country allows the U.S. company to repatriate foreign profits without paying the top 35% corporate tax rate. The company can then use the cash to reduce debt, pay dividends, and/or reinvest the capital.

In most of the tax inversion deals recently announced, the share price has risen for both the target company and the acquiring company. Unless Congress changes corporate tax law, more U.S. companies will likely consider a tax inversion strategy as a means to boost share price, reduce long term tax obligations and repatriate foreign profits.

There are offsets to the benefits of this type of merger. For example, taxable investors may have to pay a capital gain upon the completion of the transaction of the tax inversion. In a typical domestic merger, target company owners exchange their shares for shares of the acquiring company.  There is no realized capital gain for the shareholders of the acquired company and shareholders’ cost bases simply carry forward to shares of the acquiring entity.  Further, shareholders of the acquiring company do not realize a capital gain under the “typical” merger scenario. In a tax inversion, however, U.S. tax authorities treat the merger as the formation of a new entity.  Shareholders on both sides of the merger exchange shares for a new entity, thereby creating a taxable event. Under these circumstances, taxable investors may realize a capital gain even though there is no sale of shares.

Investors have limited opportunities to avoid capital gain consequences once a tax inversion deal is set into motion. For charitably minded shareholders there is an opportunity to gift appreciated shares to avoid capital gains. When donating shares to a qualified charity, taxable investors transfer the gain to an entity that does not have to pay a tax. This scenario may create a “win-win” for both the donor and the charity. If the investor decides to donate the shares, he/she must also take care to make the gift before both the shareholder approval vote and certain regulatory consents are obtained by the company in order to avoid realizing any capital gain.

Since January, 2012, at least 20 U.S. headquartered companies have announced or attempted acquisitions designed to change their country of domicile. The list includes several companies held in H.M. Payson client portfolios; shares in Medtronic (MDT), Abbvie (ABBV), Covidien (COV) and Pfizer (PFE), to name a few. Congress has taken notice and the Obama Administration has proposed changes in the law that would make it very difficult for U.S. based companies to purchase smaller non-U.S. entities; the chief purpose of which is changing the larger company’s domicile in order to reduce or eliminate its U.S. tax liabilities. Political rhetoric aside, current law, provided certain conditions are met, allows mergers principally driven by tax inversion considerations. However, the situation is obviously fluid and dynamic and we will continue to monitor developments and the potential impact it represents to our clients’ portfolios.

Market Log- July 29, 2014

S&P 500: 1,969.95

10 year T-Note: 2.46%

Crude Oil: $100.93

Gold: $1,319.40

 

This information is for educational purposes only and is not intended as tax advice. Please consult your tax advisor for information that is more detailed or for advice regarding your individual situation.

This commentary is prepared by H.M. Payson for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any security. The information contained herein is neither investment advice nor a legal opinion. The views expressed are those of H.M. Payson as of the date of publication of this report, and are subject to change at any time due to changes in market or economic conditions. The comments should not be construed as a recommendation of individual holdings or market sectors, but as an illustration of broader themes. H.M. Payson cannot assure that the type of investments discussed herein will outperform any other investment strategy in the future, nor can it guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. Although information has been obtained from and is based upon sources H.M. Payson believes to be reliable, we do not guarantee its accuracy. There are no assurances that any predicted results will actually occur. Past performance is no guarantee of future results. Registration with the SEC or with any state securities authority does not imply a certain level of skill or training.  All Content © 2014 HM Payson 

Related Articles

Putting a Recession into Context

In the face of elevated stock market volatility, rising US-China trade tensions,…

For Claire: A Maine Huts & Trails Story

Maine Huts & Trails provides outdoor excursions in beautiful Western Maine, boasting…