If the Treasury Department was trying to scare investors away from corporate inversions by saying the U.S. would examine ways to stop the deals, it worked.
Stock markets yesterday punished companies pursuing inversions and investors have genuine reason for concern about the prospects for cross-border mergers that limit U.S. corporate taxes.
The policy landscape on inversions has shifted significantly since last week, when lawmakers -- deadlocked on tax policy -- left Washington for a five-week break. The lack of congressional action and the Obama administration’s reluctance to move on its own had given companies and investors confidence that pending deals wouldn’t be affected by government action.
President Barack Obama said yesterday he wants the U.S. to act “as quickly as possible” to discourage inversions using whatever authority the government already has.
“We don’t want to see this trend grow,” he said. “We don’t want companies who have up until now been playing by the rules suddenly looking over their shoulder and saying, you know what, some of our competitors are gaming the system and we need to do it, too.”
As Congress bickered, Obama began speaking about inversions in late July, turning a corporate tax proposal buried in his budget into the centerpiece of a speech on the economy.
A former Treasury official outlined steps the government could take without Congress. And Democrats this month began pressing Obama and Treasury Secretary Jacob J. Lew for action.
With one statement this week, Treasury changed the market assumption that the government wouldn’t act without Congress to stem inversion transactions.
On Aug. 5, Treasury said that it was examining regulatory changes that would amount to a “partial fix” while the administration keeps pushing Congress to curb inversions. Obama said yesterday that the administration was reviewing how it interprets existing laws and that he wouldn’t announce details “in dribs and drabs.”
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Even without clarity on what powers the Treasury might invoke, investors indicated yesterday that the U.S. possesses regulatory tools that could unwind the mergers or make them less attractive.
Walgreen Co. (WAG:US) shares plunged yesterday after the drugstore chain opted against an inversion, citing opposition in Washington and potential Internal Revenue Service enforcement among its reasons.
The Treasury statement was a reversal for Lew, who had said July 16 that the government had scoured “obscure” tax code provisions and would be doing more if it could.
Tax lawyers say the Treasury has constrained powers to make inversions less attractive. Its tools include limiting companies’ access to foreign cash to finance the deals and making it harder for them to engage in earnings-stripping transactions that reduce their U.S. taxable income after the inversion is completed.
“If people don’t think they have authority, they’re wrong,” said John Buckley, former chief tax counsel for Democrats on the House Ways and Means Committee. “Whether they’ll exercise it or not, that’s a different question.”
Ed Kleinbard, former chief of staff of the Joint Committee on Taxation, said the “artificial” transactions should be curbed immediately by lawmakers.
“When Congress seems hopelessly paralyzed, even in respect of narrowly targeted rules to protect that tax base, people start casting about for any possible regulatory fix, no matter how improbable or ill-suited,” he said. “That’s really the wrong approach -- the right one is to keep pressure on Congress to man up and do the right thing.”
Any rules from Treasury could affect at least eight pending inversions along with other companies considering similar deals. Depending on how the rules about earnings stripping are written, they could also affect companies such as Ingersoll-Rand Plc (IR:US) that inverted before the current wave.
Politically, the administration’s statements maintain pressure on companies to consider the consequences of inversions even as it somewhat relieves Congress from taking quick action. For investors, the Treasury statement caused them to question whether the pending deals would face unforeseen hurdles.
The stock of companies involved in planned inversions -- including AbbVie Inc. (ABBV:US), Medtronic Inc. (MDT:US), Mylan Inc. (MYL:US) and Shire Plc (SHP) -- fell yesterday as broader U.S. markets were little changed. The market reaction to Treasury’s announcement came even though Treasury hasn’t committed to doing anything and though the U.S. government has said its tools are limited without legislation.
“The prospect of action by the executive branch got everyone’s attention,” said Peter Sorrentino, a Cincinnati-based money manager who helps oversee $1.8 billion at Huntington Asset Advisors Inc. “Given the prospect that the White House is talking about implementing a change retroactive to May, I would be surprised if these inversions continue.”
Medtronic fell 1.1 percent to close at $61.30 in New York yesterday and was down 0.2 percent at 11:05 a.m. today. AbbVie fell 1.4 percent yesterday before gaining 0.8 percent today. Mylan was down 1.1 percent yesterday and another 2 percent today.
For investors, the only thing worse than the risk of a canceled inversion is a deal that’s actually canceled.
Walgreen said yesterday that it would buy the portion of Alliance Boots GmbH that it doesn’t already own without changing its address for tax purposes.
The decision drew plaudits from Democratic senators and the Change to Win coalition of unions. Investors sent Walgreen shares down $9.91 (WAG:US), or 14 percent, yesterday in New York, the biggest one-day decline since 2007, reducing the company’s market value by more than $9 billion. Shares fell today by 0.16 percent to $59.12.
Walgreen, based in Deerfield, Illinois, said a decision to shift its legal address out of the U.S. might have backfired because it could have been challenged under IRS tax-abuse rules. The largest U.S. drugstore chain warned of “almost certain, intense, protracted IRS scrutiny” that might have taken a decade to resolve.
Obama said inversions should bother average Americans because the companies still take advantage of being in the U.S.
“It’s not right,” he said yesterday. “The lost revenue to Treasury means it has got to be made up somewhere, and that typically is going to be a bunch of hard-working Americans who either pay through higher taxes themselves or through reduced services.”
The administration and Democrats propose to make it effectively impossible for companies to invert by buying a smaller foreign business. They want to make the change retroactive to May, which would affect the Medtronic and AbbVie deals, among others.
Such legislation hasn’t advanced, in part because Republicans want to address the issue through a broader revamp of the tax code and because they are concerned about retroactive changes.
That stalemate prompted Democratic senators such as Richard Durbin of Illinois and Elizabeth Warren of Massachusetts to ask Treasury to act.
In its statement this week, the department said it was looking at a “broad range of authorities” that would limit inversions or “meaningfully reduce the tax benefits after inversions take place.”
Henrietta Treyz, an analyst at Height Securities LLC, wrote in a note to clients yesterday, “This is a sharp change in tone from the Treasury, which has to date been quite clear that it believed the power of its agency as well as the IRS to stem inversions has been exhausted.”
The latter portion of the Treasury statement may refer to a practice known as earnings stripping, in which companies with legal addresses outside the U.S. load up their U.S. subsidiaries with debt and other deductions. Although they are still subject to U.S. income taxes on their domestic profits, the companies are able to push those profits outside the U.S.
A 2007 Treasury Department study found evidence that inverted companies engage in earnings stripping.
Stephen Shay, the former top international tax lawyer at Treasury, suggested two possibilities for addressing inversions, both of which he said could be accomplished by regulation.
One would characterize some debt of inverted companies as equity. That would prevent companies from engaging in earnings stripping because they wouldn’t be able to get the same deductions for interest expenses in the U.S.
The other approach Shay recommended in a Tax Notes article last month would stop companies from financing inversions with offshore earnings that haven’t been taxed by the U.S. Currently, Treasury allows companies to lend their offshore stockpiles to their new foreign parents.
The Organization for International Investment, which represents companies based overseas with U.S. operations, said some ideas under discussion could affect more than just inverted companies.
“Punitive measures that apply broadly to foreign-based companies would have a chilling effect on the U.S. investment climate to the detriment of American workers,” Nancy McLernon, the group’s president and chief executive officer, wrote in a letter to lawmakers dated Aug. 5.
Buckley, the former House Democratic staff member, said that if the Treasury Department wants to stop the transactions, it would issue a statement saying it will issue regulations later that would be retroactive to the date of the initial statement. Such a statement could come quickly, even if the actual rules take time to write.
Buckley said Treasury officials could use section 482 of the tax code. That gives the government wide authority to reallocate deductions and income among a company’s subsidiaries to prevent tax evasion or to more clearly reflect where income is earned.
Any company attempting to challenge the subsequent regulations would probably have to go forward with the transaction and then take the government to court, Buckley said.
“You don’t need more than a colorable argument that you could do this,” he said. “The deal craters if the IRS announced this action.”
Treyz, of Height Securities, said the government could also limit government contracts for inverted companies.
Without legislation, the Treasury can really just operate “at the margins,” said John Harrington, a former international tax counsel at Treasury who is now a lawyer at Dentons in Washington.
Harrington said the regulatory process can take time as officials try to make sure they aren’t creating gaps that companies can exploit.
“The likelihood that something will influence behavior will depend on how specific the proposal is,” he said.
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