Dow Jones Makes It Clear That Inversion Deals Are Unwanted Trend

Dow Jones Industrial Average officials just made membership requirements for its elite index even more stringent, prompted by a surge in inversion deals made to avoid the high U.S. corporate tax rate.

Inversion deals not welcome in Dow

The committee overseeing the storied blue-chip benchmark just updated the definition for index inclusion. The classification now states that companies that conduct business in the United States but are incorporated abroad are not eligible for admission in the 30-stock index.

The Dow tweaked the language used in its process of accepting components into the coveted index to officially read that member companies must be incorporated and headquartered in the United States. Additionally, the United States must be a company's largest revenue-generating country.

That means the new eligibility requirements clearly exclude companies that have moved overseas via inversion deals.

The index, launched on May 26, 1896, has always consisted of only U.S.-headquartered companies. The new criteria, while perhaps always understood, are now practically written in stone.

"Considering this is one of the oldest indices, and always considered to be a purely U.S. index, we wanted to maintain that legacy," David Carlson, director of U.S. and Canadian equity indexes at S&P Dow Jones Indexes, which oversees the Dow Index, told The Wall Street Journal.

The S&P 500 Index, the Nasdaq Composite, and the Nasdaq 100 all permit foreign-based entities to be included in their indexes.

While the S&P 500 is limited to U.S. companies, it doesn't eliminate companies that move their legal headquarters overseas if they continue to meet other criteria. Currently, 24 companies in the broad-based benchmark are headquartered outside the United States. Four more are incorporated overseas, yet still maintain offices in the United States, according to S&P Capital IQ.

The Nasdaq 100 presently includes 10 foreign companies in its tech-heavy index.

The new wording from the Dow comes amid a burst of tax inversion deals completed over the last five years, and the flurry of such transactions announced year to date.

It also follows new rules implemented this week from the U.S. Treasury Department.

In an inversion, an American-based company reincorporates for tax purposes in a country that boasts a much friendlier tax rate, while still maintaining the bulk of its operations in the United States. Favored destinations include Ireland, the U.K., Canada, the Bahamas, and Bermuda.

Inversions are lucrative in that they allow companies to trim their overall tax burden by avoiding America's hefty 35% corporate tax rate - 40% on average, including state levies - on income earned overseas. The combined U.S. tax rate is double the average in Europe and more than triple the 12.5% rate in Ireland.

According to S&P Capital IQ, at least 35 companies have relocated overseas for tax purposes since 2009. Meanwhile, just 25 did so in the preceding eight years. Officials anticipate as many as 30 new tax inversions by year's end.

But, pending deals have just hit a roadblock...

Monday, the Treasury tightened tax rules to deter American companies from transferring their headquarters to overseas countries with lower tax rates.

Under the new Treasury rules, which went into effect immediately but are not retroactive, it's now much more difficult for companies to complete an inversion.

A 2004 law allowed inversions through a merger as long as the old U.S. firm's shareholders own less than 80% of the combined firm. Via creative accounting, some companies have gotten around that stipulation by artificially inflating the size of the foreign firm's share or shrinking the size of the U.S. firm's share. The new rules prohibit such techniques.

In addition, the Treasury has made it harder for companies that invert abroad to use cash accumulated overseas - a major draw among recent deals.

Presently, companies are only required to pay U.S. tax on their foreign earnings when they bring them back to the United States. Inverted companies have skirted this rule in the past by having a foreign subsidiary it controls make a "hopscotch" loan to the new foreign parent instead of the U.S. company.

Under the new rules, the Treasury will now deem such loans as "U.S. property," and the money will be subjected to U.S. dividend tax rules. Exempt from this rule are banks and financial services companies.

"These first, targeted steps make substantial progress in constraining the creative techniques used to avoid U.S. taxes," said Treasury Secretary Jack Lew.

The Dow's move to clearly dismiss non-U.S.-based companies could have some firms rethinking doing an inversion, as their share prices could be adversely affected. That's because index funds that replicate the Dow index could be forced to sell their stocks.

One Dow component that's been mulling an inversion is pharmaceutical giant Pfizer Inc. (NYSE: PFE). The New York City-headquartered drug maker attempted to buy U.K.-based AstraZeneca Plc. (NYSE ADR: AZN) earlier this year, but its overtures were rejected. In addition, Pfizer explored a takeover of Ireland-based Actavis Plc. (NYSE: ACT).

While a Pfizer/AstraZeneca deal definitely had strategic merit, and the tax benefit was icing on the cake, a Pfizer/Actavis transaction was clearly tax motivated.

More on tax inversion deals: It appears that the move by Warren Buffett-backed Burger King to buy iconic Canadian fast food chain Tim Hortons 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... Full Story

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