The Best Hope for Reducing Taxes... Isn't What You Think

It appears that the move by Warren Buffett-backed Burger King Worldwide Inc. (NYSE: BKW) to buy iconic Canadian fast food chain Tim Hortons Inc. (USA) (NYSE: THI) and relocate to Canada to lower its corporate tax rate was the straw that broke the camel's back when it comes to tax inversion deals.

One has to wonder whether the wily Mr. Buffett was not only trying to make money but doing his best to accelerate much-needed tax reform when he agreed to finance BKW's expansion into the northland...

Why Mergers Are on the Rise... and the Government's Attempt to Slow Them

Year to date, M&A volume has reached $2.4 trillion, the highest year-to-date level since $3.3 trillion in 2007 according to Dealogic. One of the factors that has contributed to this boom in mergers has been a flood of tax inversion deals.

Indeed the inversion pipeline is still strong. To counter the problem, the U.S. Treasury acted to make it much more difficult for U.S. companies to move their legal headquarters to lower-tax countries.

Whether the actual target of the new rules is inversions or tax reform, what happens next will impact us in an unexpected way.

Here is what we need to know to take maximum advantage...

To execute a tax inversion deal, a U.S. company must purchase a foreign company and the shareholders of the non-U.S. company must comprise at least 20% of the combined shareholders of the combined company. U.S. companies engaging in such transactions have been trying to avoid the developed world's highest corporate tax rate.

Recently these deals have been focused on the pharmaceutical and healthcare industries, and stocks in those industries took a dive after the Treasury released its new regulations on Monday. British pharmaceutical giant AstraZeneca Plc. (NYSE ADR: AZN), which had been the target of a failed inversion bid by U.S. drug maker Pfizer Inc. (NYSE: PFE), dropped 3.6%. AbbVie Inc. (NYSE: ABBV), which is involved in a $54 billion deal to buy Irish pharmaceutical giant Shire Plc. (Nasdaq ADR: SHPG), was down 1.9%. Covidien Plc. (NYSE: COV), an Irish company being bought by American medical device maker Medtronic Inc. (NYSE: MDT) was down 3%.

The Obama administration came out harder and faster than many expected. Realizing that it would be unable to get any action through a paralyzed Congress two months before mid-term elections, Treasury Secretary Jacob Lew called on his tax writers to draft regulations that will make tax inversion much harder and less profitable. The rules make several changes to current rules that are effective immediately for any deals that have not yet closed, which includes the Burger King deal.

First, Treasury closed a loophole that allowed a tax-free transfer of cash or property from a foreign subsidiary to the new foreign parent and moved to prevent companies from restructuring foreign units to access deferred earnings without paying taxes.

Second, Treasury banned so-called "hopscotch" loans that allow companies to avoid taxes on repatriated foreign earnings by making loans to a new foreign parent company created in a tax inversion deal.

Third, it attacked techniques that allowed companies to meet the condition that a U.S. business can invert only if the new company has foreign ownership above a 20% threshold. Previously, companies were able to finesse this requirement by reducing their size prior to completing the merger but the new rules prohibit them from doing so.

Fourth, the new rules prevent companies from engaging in "spinversions" whereby they invert themselves and effectively relocate to a lower cost jurisdiction by shifting assets to a foreign entity and then spinning it off to shareholders. Such a spin-off will now be counted as a U.S. company subject to U.S. corporate tax rates.

The new rules are of course meant to temper enthusiasm for tax inversion, but the "tax" problem is more complex. What's needed to stem the inversion flow is a more focused look at our overall corporate tax policies. It's all on the table, but here's what we're missing...

Taking Charge

Five years after the financial crisis, as the U.S. and global economy struggle to grow, it is a sad specter to see investment bankers running around convincing companies to engage in inversion deals to generate big fees and hedge funds betting on these deals in order to try to profit from them. This type of gaming the system is not what capitalism is supposed to be about.

That is why it is incumbent on Congress to take away the temptation for some of the most highly educated and motivated among us to spend their energies in such unproductive activities. The only way for that to happen is for Congress to pass comprehensive corporate tax reform that would lower the corporate tax rate to make it more competitive with those in other developed countries.

While they are at it, our lawmakers need to make it possible for U.S. companies to repatriate the trillions of dollars of cash they are holding offshore in order to be able to put it to work in the U.S. economy. There is now bipartisan agreement that this needs to happen; all that is missing is the leadership to make it happen.

The Obama Administration should be commended for acting quickly to stop the U.S. tax base from being hollowed out. Now it needs to move further and take a leadership role in restructuring the U.S. corporate tax system to help it promote growth and productive investment.

Mr. Buffett may have had more up his sleeve than donuts and burgers when he agreed to finance Burger King's tax inversion deal. Rather than being a hypocrite as some have charged, he was more likely being a patriot.


About the Author

Prominent money manager. Has built  top-ranked credit and hedge funds, managed billions for institutional and high-net-worth clients. 29-year career.

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