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What Do Corporate Inversions Mean for Clients?

Recently, there has been an acceleration of U.S. multi-national companies merging with smaller offshore firms as a way to move their headquarters overseas and save 35 percent in corporate taxes. Burger King, for example, just merged with Tim Hortons in Canada. Medtronic is buying Covidien in Ireland. But these inversions may not be a good investment if a company is doing it solely for tax reasons, or if a client has been a long-time shareholder, said Andy Friedman, principal of The Washington Update, during the Financial Services Institute’s FA Summit in Washington, D.C. this morning.

When an inversion occurs, the company still must pay taxes on all products sold in the U.S. Normally, any foreign subsidiary of a U.S.-based company will not be taxed on its profits, as long as the money remains in the subsidiaries overseas, Friedman added.

“When those profits are repatriated back to the parent company here in the United States, they’re subject to a 35 percent corporate tax,” Friedman said. The U.S. is the only developed country in the world that does that. “What Burger King and other companies do is they avoid taxes on their foreign earnings by inverting.”

When they invert, the company is able to get those profits up to the parent company, where the cash can be used to pay dividends, buy back stock or redeploy elsewhere in the corporate group.

President Barack Obama has said that these inversions are unpatriotic, and some companies are avoiding doing it because they don’t want to upset the government. The Treasury came out with rules to make them less profitable, but the rules don’t stop inversions. Congress would have to change the tax law to stop them, but there is little agreement on how to do so, Friedman said.

These inversions can be good for investors, Friedman said.

“When you have an inverted company, it’s lowering its taxes,” Friedman said. “Lower taxes mean higher after-tax earnings; that typically is good for stock values.

“Perhaps even more important, inverted companies now have access to a much larger pool of cash to increase dividends or buy back stock and that too suggests maybe investing in an inverted company makes a lot of sense.”

But a recent study that looked at all inverted companies for the past 30 years found that half outperformed the market and half underperformed, Friedman said. That suggests that many companies undertook these mergers for tax reasons, not because it was a good merger.

“So deciding whether your clients should invest in an inverted company, the first question I would ask is: Is this a good merger? Does it make sense for these companies to come together? Are there cost savings? Are there synergies? If the answer is ‘yes,’ then the taxes are an icing on the cake; that’s a good investment. But if the answer is ‘no, this is a bad merger,’ then taxes aren’t going to save a company that isn’t making any money.”

Also, for clients who are long-term shareholders of these companies, they will be required to recognize gains on any appreciation in their stock holdings if a company inverts.

“So the Burger King shareholder who exchanges his Burger King share for a share of the Canadian Burger King Tim Hortons recognizes gains,” Friedman said. 

TAGS: Equities
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