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Corporate Tax Inversions & Impact on U.S. Investors

August 22, 2014

(Reprinted from the September 2014 edition of the Bath Country Journal)

Shifting profits abroad is nothing more than business as usual for large American companies and much confusion exists as to the impact on U.S. investors.

So-called tax “inversions” hit the mainstream news media when U.S. medical device manufacturer Medtronic bought rival Covidien, which is domiciled in Ireland and has a much lower corporate tax rate.  Inverted companies will be reincorporated and global headquarters shifted to the lower tax country.  Operations generally will continue as they were before, which may mean that most of the sales and profits are still coming from the U.S. market.

In the case of Medtronic, the merged firm is paying taxes on most of its net income in Ireland, at a 12.5% rate.  This will save the company between $3.5 billion and $4.2 billion in overall taxes.  Overall, nearly 50 U.S. companies have used this tactic over the past decade.  The net effect is to reduce U.S. tax revenues by an estimated $17 billion over the next decade.

Companies may employ different tactics to obtain similar results. For example, by assigning patents to a foreign subsidiary, Apple, Inc. now generates 30% of its total net profits through a firm based in Ireland, saving an estimated $7.7 billion in U.S. taxes in 2011 alone.  When the Wall Street Journal examined the books of 60 big U.S. companies, it found that they had shielded more than 40% of their annual profits from Uncle Sam.

How does this affect you as an U.S. investor?  First, you will bear a slightly higher tax burden as the government seeks to recover lost revenues.  The Journal report found that if just 19 of the 60 companies had to pay U.S. taxes on their earnings like you or me, the $98 billion in additional tax revenues would more than offset the $85 billion in automatic spending cuts that were triggered by the fiscal cliff negotiations.  In addition, companies that are holding assets offshore for tax reasons have effectively made that money unavailable to invest in the U.S., which could lower economic growth and cost jobs for the U.S. economy.

Finally, an inversion could actually trigger higher taxes for shareholders of these corporations if owned in a non-retirement account. When the company inverts, all current shareholders are required to pay capital gains taxes on their holdings in that year, as they are issued new stock in the new company.  Therefore, if you happen to own $100,000 worth of Medtronic, and your shares originally cost you $20,000, you would have $80,000 in realized gains, subject to capital gains taxes. For high-income earners the tax hit could push the capital gains tax as high as 23.8% and phase-out deductions and exemptions, making the effective tax rate even higher.

For most investors who own stocks through mutual funds, they can ignore the inversion talk. Tax considerations of these will generally be most applicable to those who accumulated significant, low-basis stock through employer-provided equity compensation plans over years of working for a company.

Yet, there is a bigger question of fairness. Opponents of inversions would note that corporate income taxes as a percent of GDP has fallen by more than 50% from the 1960s and before. However, these same critics often leave out the fact that corporations pay nearly double into Social Security and Medicare today compared to the same time. Total business taxes paid vary but consistently average about 5% of GDP. Inversions may decrease this over time.

Regardless of political beliefs, it is difficult to see how inversions are good for the U.S. and U.S. investors. These companies want access to our human capital and consumer markets, and the U.S. should have fair and effective tax policies in place to incent these companies to stay and pay their fair share.

Kevin Kroskey, CFP®, MBA is President of True Wealth Design, an independent investment advisory and financial planning firm that assists individuals and businesses with their overall wealth management, including retirement planning, tax planning and investment management needs.

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