Nội dung

University of Arkansas, Fayetteville ScholarWorks@UARK Accounting Undergraduate Honors Theses Accounting 5-2015 Does Corporate Inversion Lead to Tax Savings? Nathan P. Downs University of Arkansas, Fayetteville Follow this and additional works at: http://scholarworks.uark.edu/acctuht Part of the Accounting Commons Recommended Citation Downs, Nathan P., "Does Corporate Inversion Lead to Tax Savings?" (2015). Accounting Undergraduate Honors Theses. 17. http://scholarworks.uark.edu/acctuht/17 This Thesis is brought to you for free and open access by the Accounting at ScholarWorks@UARK. It has been accepted for inclusion in Accounting Undergraduate Honors Theses by an authorized administrator of ScholarWorks@UARK. For more information, please contact scholar@uark.edu, ccmiddle@uark.edu. Does Corporate Inversion Lead to Tax Savings? By Nathan Downs Advisor: Dr. Karen Pincus An Honors Thesis in partial fulfillment of the requirements for the degree of Bachelor of Science in Business Administration in Accounting Sam M. Walton College of Business University of Arkansas Fayetteville, Arkansas May 8, 2014 1 Introduction In August 2014, the unexpected announcement of Burger King’s plan to move its corporate headquarters to Canada through their merger with Tim Horton’s drew ire from not only members of Congress, but also the president himself. In a direct response to Burger King and other U.S. corporations who might be contemplating similar corporate inversions, the White House vowed to issue an executive order to curb companies from escaping taxes by taking up residence in a foreign nation. While the inversion controversy has been reported upon intermittently for many years, the recent activities of high-profile companies like Burger King and Pfizer has led to more press on this subject. So what is corporate inversion and why has it caused so much dissension? A corporate inversion occurs when an American corporation acquires or merges with a foreign-domiciled company. As a result, the corporate structure of the American company becomes “inverted” by legally altering its place of incorporation. The foreign company becomes the legal parent company through the transaction, and shares of the former U.S. company are typically converted to shares of the newly formed entity. However, significant changes in operations rarely accompany corporate inversions (Seida & Wempe, 2004). The newly formed entity continues to function as it did pre-inversion, specifically the physical locations of its U.S. facilities, employees, and operations. In addition to the official change of address, there can be legal and regulatory ramifications. For example, an inverted U.S. firm listed on the New York Stock Exchange could choose to adhere to “International Financial Reporting Standards” (IFRS) instead of U.S. “Generally Accepted Accounting Principles” (GAAP). In many instances, the foreign entity was incorporated in a nation that levies a corporate income tax at a low or nil rate, otherwise known as a tax haven. Furthermore, as noted in the 2 inversions of Weatherford International, Aon Corporation, and Cooper Industries the foreign company was initially registered and established as a subsidiary of the American company itself. This form of inversion is known as a “naked inversion” since it does not demand any major changes in control due to the prior associations of the two companies.1 The primary motivation behind a corporate inversion is simple, to reduce a corporation’s tax burden. It is believed that corporate inversions lead to lower effective tax rates, improved cash flows, and overall higher earnings that gives American companies the competitive advantage to thrive in a globalized economy. On July 18, 2014, chief executive officer of Abbott Laboratories, Miles White, defended corporate inversions in an op-ed piece in the Wall Street Journal. He is quoted as saying, “In terms of global competitiveness, the U.S. and U.S. companies are at a substantial disadvantage to foreign companies. Taxes are a business cost. Our disproportionately higher tax rate puts foreign companies at a huge advantage competitively.” This rationale is shared among executives of American companies who have chosen to invert. The supposed improvement in financial performance through the result of inversions is congruent with the beliefs of profit-motivated organizations. Another reality of corporate inversions is the relocation to nations who abide by a territorial tax system. This type of tax system only taxes income that is derived from the nation in which it is earned. However, the U.S. subjects its corporate residents to residential taxation. In this less common system, a corporation owes taxes on all worldwide income regardless of where the income is sourced. In theory, an American company is liable for U.S. tax on profits it claims were made offshore if it wants to repatriate the money back domestically. However, once a 1 There has been legislation passed to prohibit this form of inversion, and is further discussed on page 4. 3 corporation reincorporates as foreign, the profits it claims were earned for tax purposes outside the U.S. become fully exempt from U.S. tax. Even though a foreign corporation still owes U.S. tax on profits it reports were earned in the U.S., corporate inversions are often followed by the practice of “earnings-stripping”. The corporation makes its remaining U.S. profits appear to be earned in other countries in order to avoid paying U.S. taxes on them. For example, a corporation can do this by encumbering the American part of the company with debt owed to the foreign part of the company. The “interest payments” on the debt are tax deductible, officially reducing American profits, which are effectively shifted to the foreign part of the company. This method was popular for many years before the “Revenue Reconciliation Act” was passed in 1989. This bill led to the addition of Section 163(J) to the IRS Code in an effort to curb abusive earnings-stripping strategies. This section disallows the deduction of interest expense if the ratio of debt to equity of the corporation exceeds 1.5:1 (26 USC §163j). Recently, a common method being used to employ earnings-stripping are royalty payments. Let’s say that the foreign segment of a corporation owns the rights to intellectual property such as a patent for a product. They will then grant the American part of the company the right to sell this patented product. In return, they will have pay an agreed upon amount for this right, otherwise known as a royalty. Royalty payments are an effective mechanism to reduce American taxable income since they’re classified as an expense. The foreign part of the company continues to receive all of the profits from this exploitation, meanwhile they shift their tax burden to lower taxed jurisdictions. In 2004, Congress passed the “American Jobs Creation Act” which included legislation to crack down on inversions. Moreover, this bill annexed Section 7874 to the IRS Code. Section 4 7874 contains certain requirements in order for a U.S. corporation to reincorporate to a foreign tax jurisdiction. If the company fails to meet any of these requirements, it will be treated and deemed as a U.S. corporation for tax purposes. First, the foreign corporation must “substantially” acquire all of the properties of the U.S. corporation (26 USC §7874a). Second, after the acquisition, the former U.S. company’s shareholders cannot hold more than 80% of the new company (26 USC §7874a). However, if the former U.S. company’s shareholders own at least 60% but still less than 80% of the new company the inversion is subject to a certain stipulation. The government will recognize the legitimacy of the inversion, but the corporation is subject to a ten year penalty that taxes the entity on all “inversion gains”. Lastly, the U.S. company must have “substantial business activities” in the jurisdiction where it wishes to relocate (26 USC §7874a). In 2006, an addendum was added to Section 7874 defining substantial business activities. The newly formed company must have at least 10% of its employees, property, and income in the country where it relocates its corporate residence. This requirement was seen as the biggest obstacle for corporations who desired to invert. Especially, if the inversion destination was somewhere like the Cayman Islands or Bermuda. Nevertheless, many corporate inversions still were able to pass this business activity test. Consequently, this resulted in an amendment to the statue. In 2012, the activity requirement was increased to 25% in an effort to further curb inversions. The number of corporate inversions has grown exponentially over the last decade mainly due to an antiquated tax code and partisanship in Congress. Since 1983, seventy-six corporate inversions have taken place, with 47 of those occurring in the last decade. Countries such as the Cayman Islands and Bermuda that do not tax corporate income were attractive destinations for inverting firms prior to anti-inversion legislation. In recent years, nations like the United 5 Kingdom have become popular due to the combination of favorable tax rates and the ability to meet the business activity test. The Joint Committee on Taxation estimates that corporate inversions could cause $34 billion in lost tax revenue over the next ten years (Barthold, 2014). Politicians and economists alike have scrutinized this practice stating that many of these U.S. corporations who have inverted or plan to invert are heavily dependent upon America’s infrastructure and property laws. Therefore it becomes easier to understand why this controversial practice has drawn condemnation, with President Obama even going as far as calling corporate inversions an “unpatriotic tax loophole” (Obama, 2014). Corporations that choose to invert, argue that this action allows them to remain competitive due to the nature of U.S. corporate tax rates. The U.S. corporate income tax rate which is 35%, is considered one of the highest nominal tax rates in the developed world. However, a study done by the Citizens of Tax Justice (non-partisan research group) found that between 2008 and 2012 the average effective tax rate for U.S. corporations was 19.4% (McIntyre, 2014). With certain industries such as utilities paying an average effective tax rate of 2.9% (McIntyre, 2014). This is a far cry from the 35% tax rate listed in the corporate tax schedules. This raises the question; do U.S. companies really realize tax savings when they perform an inversion? This thesis investigates the tax implications of U.S. companies that employ the practice of corporate inversion. I have selected eleven companies that have utilized this strategy, and have conducted research to determine if corporate inversion results in a tax savings when compared to a matched set of non-inversion companies. For my research, I will compare the tax liabilities of the selected companies both before and after the inversion has occurred. Methodology 6 I investigated the financial ramifications of corporate inversions using a sample of eleven inversion firms and nine matched control firms (two matched firms were used more than once) as seen in Table 1 and 2 below. The matched control firms were chosen by three sets of criteria. First, the matched firm had to operate within the same industry of the inverted firm. To ensure this, both firms had to have identical four digit SIC codes. The “Standard Industrial Classification” (SIC) is a code used by U.S. government agencies to classify companies by industry and common characteristics. However, all three matched firms for Cooper Industries, Pentair Incorporated, and Eaton Corporation did not possess the same SIC code. These three firms operate in a myriad of segments within Diversified Industrials, making it difficult to locate a matched firm using the criteria described above. Therefore, I used Hoovers.com to select a matched firm that operates as a direct competitor and offers similar product lines. Second, the matched firm had to be within 20% of total revenue during the year of inversion, in comparison to the inverted firm. Third, the matched firm had to be incorporated and legally domiciled in the United States. In addition, the matched firms are aligned in time with the business of the respective inverted firm. Table 1: Sample of Inverted Firms New Corporate Name of Firm Year of Inversion SIC Code Industry Residence Transocean 1999 Cayman Islands 1381 Oil & Gas Drilling 2001 Cayman Islands 1381 Oil & Gas Drilling Incorporated Global Marine Incorporated 7 Oil & Gas Weatherford 2002 Bermuda 3533 Machinery and International Equipment Noble Corporation 2002 Cayman Islands 1381 Oil & Gas Drilling Nabors Industries 2002 Bermuda 1381 Oil & Gas Drilling Ensco International 2009 United Kingdom 1381 Oil & Gas Drilling 1999 Bermuda 6331 White Mountains Fire, Marine, and Insurance Casualty Insurance Insurance Aon Corporation 2012 United Kingdom 6411 Brokerage & Services Electronic Cooper Industries 2002 Bermuda 3670 Components & Accessories Special Industry Pentair Incorporated 2012 Switzerland 3550 Machinery Miscellaneous Industrial Eaton Corporation 2012 Ireland 3590 Machinery & Equipment Table 2: Sample of Matched Control Firms Name of Firm Name of Matched Firm SIC Code Industry 1381 Oil & Gas Drilling Helmerich & Payne Transocean Incorporated Incorporated 8 Global Marine Pride International 1381 FMC Technologies 3533 Oil & Gas Drilling Incorporated Oil & Gas Machinery and Weatherford International Equipment Noble Corporation Diamond Offshore Drilling 1381 Oil & Gas Drilling Nabors Industries Pride International 1381 Oil & Gas Drilling 1381 Oil & Gas Drilling Helmerich & Payne Ensco International Incorporated White Mountains Fire, Marine, and HCC Insurance Holdings 6331 Insurance Casualty Insurance Marsh & McLennan Insurance Brokerage & Aon Corporation 6411 Companies Services Industrial Instruments for Cooper Industries Danaher Corporation 3823 Measurement & Display Pumps & Pumping Pentair Incorporated Flowserve Corporation 3561 Equipment Industrial Machinery & Eaton Corporation Illinois Tool Works 3560 Equipment This thesis examines whether a corporate inversion results in a reduction of the effective tax rate. To test this, I took into consideration the firm’s pretax income, income tax provision, and effective tax rate over a five year period. Furthermore, I sorted total revenue and pretax income for each sample firm by domestic and foreign to see if there was any evidence of earnings stripping post-inversion. The “inversion period” is defined as two years prior to the inversion (Years 1 & 2), the year of inversion (Year 3), and two years following the inversion (Years 4 & 5). The firm’s pretax income and income tax provision are both listed in the 9