July 2014 – Inverted Tax Logic

Corporate “tax inversions” have generated a blizzard of controversy of late. But this tax-avoidance device born of the byzantine U.S. corporate tax code is not new, and, until recently has been a topic that rarely aroused excitement beyond CFOs, tax lawyers and the IRS.

Suddenly, however, inversions are headline news and self-proclaimed pundits have emerged in the media and among politicians. Investors would do well to avoid sensational claims and instead consider the issue through the lens of economic reasoning.

The following definition, from Investopedia is a useful starting point:

Corporate Inversion: Re-incorporating a company overseas in order to reduce the tax burden on income earned abroad. Corporate inversion as a strategy is used by companies that receive a significant portion of their income from foreign sources, since that income is taxed both abroad and in the country of incorporation. Companies undertaking this strategy are likely to select a country that has lower tax rates and less stringent corporate governance requirements.

It also helps to keep clearly in mind the duties and resulting incentives of corporate decision makers: managers are paid to maximize shareholder value and therefore strive to maximize the after-tax returns of shareholders. As the global economy has become increasingly integrated over the past few decades, shareholders — that is, you — have seen their stake in foreign earnings grow. Inversions have grown increasingly attractive to managers as a means of protecting shareholder income because corporate taxes levied against foreign income are far greater for firms incorporated in the U.S. compared with those incorporated abroad.

The maximum marginal corporate income tax rate in the U.S. is 39 percent. This exceeds the 25 percent average maximum marginal tax rate among nations in the Organization for Economic Cooperation and Development (OECD). The U.S. also taxes foreign earnings of multinational firms twice, first in the country where they do business, and again in the U.S. when those earnings are repatriated, with a credit that can be applied against foreign taxes paid. Governments in the rest of the developed world on the other hand exempt foreign earned income from taxation (France, for example exempts 95 percent of foreign source income).

These international disparities invite tax inversions and also provide incentive for management to retain overseas those earnings that are generated abroad, which in turn encourages reinvestment in opportunities (factories, R&D, etc.) located outside the U.S.

Also in This Issue:

Quarterly Review of Capital Markets
Connecting the Dots
The High-Yield Dow Investment Strategy
Recent Market Statistics
The Dow-Jones Industrials Ranked by Yield
Asset Class Investment Vehicles