Will New Treasury Rules Contain Tax Inversions?

Late on Monday, the U.S. Treasury Department outlined new rules to deter domestic companies from moving abroad in an attempt to reduce tax payments. Some experts were of the opinion that the changes to the laws will discourage deal making of this nature for a while. Others believe that this may only reduce the speed of such agreements, that too for a limited period of time. However, stocks of companies involved in such deals slumped after the announcement of new rules.

The Basis for Tax Inversion

At 35%, the U.S. corporate tax rate is one of the highest rates in the world. A tax inversion involves the acquisition of a foreign company and subsequently adopting its home country’s domicile. Alternatively, the combined entity can create a holding company in a country whose tax rate is lower.

This could help U.S. companies reduce their tax rates to single digits. The conditions attached to such a move specify that 20% of the stock of the resultant entity must be transferred to the shareholders of the company which has been acquired.

Treasury Outlines New Rules

The U.S. Treasury has made changes to five sections of the tax code which are intended to make it tougher for companies to enter into tax inversion deals.

The major changes to the tax code include putting a stop to “hopscotch” loans. This involves U.S. companies issuing loans to a newly created overseas parent company born out of a deal involving tax inversion. The idea is to avoid paying U.S. taxes on foreign earnings which have been repatriated.

A separate change made would prevent companies entering into inversion deals from executing a tax-free transfer of tax or foreign property to the new parent company located abroad from a “controlled foreign corporation.” This is intended to prevent companies from undertaking restructuring of foreign subsidiaries to gain access to deferred earnings while avoiding the payment of taxes.

Another loophole which has been plugged involves an existing requirement regarding inversion. This requirement stipulates that a U.S. company can enter into an inversion agreement only if more than 20% of ownership of the new company created as a result of the deal is owned by the foreign “acquirer.” Now, U.S. companies will not be able to cut down their size before closing such a deal. This is normally done by issuing large dividends. Additionally, they will be unable to increase the size of the new foreign parent by taking into account passive assets.

Further, new rules stipulate that U.S. companies can no longer move assets to a foreign subsidiary by undertaking inversions of portions of the domestic companies. After such assets are shifted they are “spun off” to shareholders.

Stocks Which Felt the Pinch

The inversion wave has affected the healthcare sector the most. Medical devices and pharma companies are rapidly acquiring smaller foreign competitors. Following the announcement, Medtronic, Inc. (MDT) slumped 2.9% yesterday. Irish medical supplies firm Covidien plc (COV), which Medtronic is attempting to acquire, lost 2.5%.

Similarly, Abbott Laboratories (ABT) lost 2.1%. The company’s generic drug business in mature markets is slated to be purchased by Mylan, Inc. (MYL). A new company will then be created which will be based out of Netherlands to reduce the tax burden. However, Mylan gained 0.2%.

On the other hand, AbbVie Inc. (ABBV), which announced in July that it was acquiring Irish firm Shire plc (SHPG), declined 2%. This deal also aims to move its legal address out of the U.S. to reduce tax payments.

Burger King Worldwide, Inc. (BKW) lost 2.7%. Near the end of August, the company had agreed to acquire Canadian company Tim Hortons. However, the company said that it will continue with the deal despite the steps taken by the Treasury to reduce tax inversions.

A spokesman from the company said the deal is “moving forward as planned.”  He also claimed the deal was not aimed at reducing taxes but was instead propelled by long-term growth plans.

Are Changes an Effective Deterrent?

The largest benefit of tax inversion remains untouched. This provides U.S.-based companies with the option of moving domestic profits out of the country to a new foreign parent via interest payments not subject to taxes. Officials said they are still evaluating this option. On the other hand, this means that another regulatory measure is still to be played out.

Legal experts believe that clauses in merger agreements which provide buyers with an exit option would continue to be applicable. Some of them are of the opinion that some pullouts may occur, since inversions may become less lucrative. At the same time, it would not end tax inversion deals altogether.

Other experts are of the opinion that the effect of the new rules may continue only for a short duration. They believe that companies may find new methods of conducting such agreements despite the changes. Deal making could resume soon, some opined. Another group believes that these changes could be circumvented or challenged.

In Conclusion

Many Republicans in Congress are optimistic that the spate of inversions would encourage the Obama administration to reach an agreement on far reaching tax reforms. They believe this would make the U.S. a better place to conduct business. However, the new changes may mean that pressure for the administration to act on this front may have reduced.

At the same time in a statement on Monday, President Obama said he believed that more should be done in order to make tax rules more equitable and increase opportunities in the U.S.
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MEDTRONIC (MDT): Free Stock Analysis Report

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