Wednesday, July 23, 2014

Surprise: The real cost of inversions are paid by shareholders

There are several companies I own, which are trying to do a corporate inversion, in an effort to renounce their US corporate citizenship. This inversion is achieved when a US based company buys a foreign corporation, and as a result moves its legal domicile in the foreign country. As a result, the new combined company would be treated as a non-US company in the eyes of the US tax authorities. This is appealing to companies, because they would only owe US income taxes on income derived solely from US operations.

Under current laws and regulations, US companies that earn money abroad have to pay steep tax bills if they were to repatriate those funds to the homeland, in order to pay dividends, buy back stock or invest in the business. Once an inversion is complete however, these companies would not owe any taxes on income that is earned from foreign operations. As I discussed earlier, most of the companies that dividend investor tend to buy earn a very high percentage of revenues from abroad. This is the nice thing about owning a solid blue chip, which sells branded products and services around the globe, and earns more money to pay higher dividends to you over time.

There are some details that need to be met in order to do this inversion, such as the fact that at least 20% of shareholders of the new company need to be foreign, but this is not the point of this article. The important thing to remember is that inversions generally help reduce the tax rates of companies. From a tax perspective, if you are a US company and your top income tax rate is 35%, it does make sense to relocate to Ireland and pay a tax rate of 12.50%, if you can get away with it. This is essentially what an inversion does.

As a shareholder, less expenses translates into more earnings per share. In addition, cash that is locked abroad for so many US companies that do business internationally will now be easier to access for dividends, share buybacks, investment in the business. Furthermore, if the company relocated to a place like UK for example, dividend income is not subject to any withholding taxes to the US investor. Hence, those shares could still be held in tax-deferred accounts such as IRA’s. So at first glance, it seems like inversions are a good thing to shareholders of the acquirer, since they will result in higher earnings per share, and the possibility for higher dividends and share prices as a result.

As I dug deeper however, I learned that there is a tax that ordinary shareholders like you and me have to pay on inversions. When the tax inversion occurs, shareholders of the acquirer will be treated as if they sold their stock and then purchased the stock in the new, “inverted” company. This creates a taxable event, which means that investors would have to pay a tax on their gains. If the price at which investors acquired their shares was higher, then they might end up deducting losses. In the cases of Medtronic (MDT) and Abbvie (ABBV) however, I believe that most long-term investors are sitting at nice unrealized gains. The only consolation is that stock basis would be stepped up after this exercise. However, the forced tax leakage would be costly for long-term investors like me.

My cost basis in companies like Abbvie (ABBV), Medtronic (MDT) and Walgreens (WAG) is around 2 times lower than current prices ( I have been acquiring shares in each of the companies and their predecessors between 2008 and 2013). Only a small portion of my positions in each company is in tax-deferred accounts. For example, my basis in Abbvie is $29.43/share, while my basis in Medtronic is around $35/share.

I try to seldom sell, because I have to pay taxes. This reduces amount of money I have working for me. By not selling, I have a deferred tax liability to the IRS, which I hope to never pay. This is money I owe, but I don’t pay interest on. This is essentially float, that further helps me achieve financial freedom. It also means I have more money compounding for me. If I sell, I pay tax, and have less money to invest. The opportunity cost of a dollar paid in taxes, that grows by 10%/year for 50 years is $117. At a 3% yield, this is almost $3.50 in income in 50 years, for each dollar I put to work today. That is $1 less working for my descendants or my charitable causes.

These are not good news for any long-term holders like me, who have low tax bases. This is another reason I am trying to max out any tax-deferred accounts, in an effort to shield as much of my money from the crippling effect of annual taxes on my capital gains and dividends. Those friction costs do cost money, that means less money available for my dividend machine to use for its compounding purposes. Either way, over time, expansion of a business is good, since synergies are achieved, taxes are lowered, and this improves the earnings capability of the business. This increases the worth of the business, and the ability to pay higher dividends over time. The ability to pay dividends is further increased by the ability to access cash stored abroad at ease. So the net effect could be positive of course for the patient long-term holder. The effects would be really positive for the patient long-term holder, who placed their shares in a tax-deferred vehicle such as a Roth IRA.

I guess I am learning something new every day. Today is no exception. I thought this was a good deal for shareholders, since corporate taxes will decrease, which increases EPS, and allows companies to be able to access cash abroad for purposes of higher dividends and buybacks. However, this has to be weighed against the tax hit which many long-term investors are facing. What is really bad is the fact that most stock is owned through mutual funds, which do not care about many things such as corporate governance, taxes etc. For those who believe index funds are the way to go, you are one of the reasons why corporate managements think they can do what they want to do. When you have passive owners, who do not believe “active management” produces alpha, you are setting up really perverse incentives for management on executive compensation, corporate strategy, short-term thinking etc.

Hat tip to a reader in France, for alerting me to this topic.

Full Disclosure: Long ABBV, MDT, WAG

Relevant Articles:

My Retirement Strategy for Tax-Free Income
Dividends Provide a Tax-Efficient Form of Income
Roth IRA’s for Dividend Investors
Why should companies pay out dividends?
Dividends versus Share Buybacks/Stock repurchases

17 comments:

  1. Dear DGI,

    This is a problem the world over. Perhaps countries should reduce their tax take. The US companies can perhaps relocate to Delaware, which I understand is the smallest state and has the highest number of company registrations and has tax advantages, so I am given to understand.

    ReplyDelete
    Replies
    1. Hi Louis,

      Even if a corporation goes to Delaware, they would still be subject to US Federal Income taxes. We live in interesting times, where companies can easily move HQ to the places that offer them the lowest taxes. It is a race to the bottom. As a shareholder, that is great for me. As a person, this could be bad for services in this country, and affect people like me and you.

      Delete
  2. As you say, live and learn, but this is something I have not seen mentioned before. Should we expect to receive a similar explanation from these companies if the inversion goes through? I own all three in both varities of accounts. Who is responsible for maintaining the records of this event, and do you think there will be a notation on the 1099 from your broker? I hope there is more discussion of this in the future.
    DGM - Texas

    ReplyDelete
    Replies
    1. I believe an investor should receive a 1099 from their broker once the inversions occur, similar to situations where you would have sold stock, The only difference is that in ABBV case for example, when deal closes, investors will pay tax on gains on stock they are still holding

      Delete
  3. So, what steps are you planning to make to resolve this with regards to your affected holdings? Will this tax hit occur as soon as HQ are moved to a foreign country or do you have to keep this in mind and account for it when (and if) you sell many years in the future?
    Interesting reprimand to the Idx fund investors...Could you expand it? How do idx investors encourage corporate America to misbehave? I'm an idx investor in addition to DGI. I not for idx funds in 401k, I'd need to forego my tax strategy to lower my current tax rate and refuse the matchin 'free money' from my employer. You should weigh the whole thing (including risks, time shortage and inclination and understanding to do active management, etc.) before foolishly accusing that it's idx invetors' fault. I'd say it's more tax code fault together with $$ bribing the US gov't (lobbyism is a 'demogratic' method of bribing in my eyes) to keep it that way.

    ReplyDelete
    Replies
    1. The problem is that most stock in the US in held in mutual funds. A large part of shareholders in those funds don't really check investments, and don't want to bother learning about those. Mutual funds are not going to care and vote on certain aspects, like taxes, because their performance fees are not calculated net of tax. Index funds are set up in a way that it doesn't pay to do any research on companies, just buy a basket and you will be ok. Well, if everyone starts indexing, and not caring about what is in those indexes, and blindly follows them without caring about companies there, their fundamentals and valuation, don't you think the end result will be terrible? This might not be a problem now, but could be the next crisis we see.

      If you have massive ownership in companies, where shareholders are index funds who don't believe in doing much more than own shares and are told that any research is bad and thus don't vote or evaluate company managements, don't you think this is going to create perverse systems in those same company managements? If I am a CEO, and I have the board by my side, I can do whatever I want, and get paid whatever I want to get. Since the shareholders don't care, who is there to do anything about it and keep me accountable? This is how activist investors earn their money.

      I do not believe indexing to be panacea for investor pains. If you don't know what you are doing, indexing can be bad, because you will be buying shares for a while, and then hear stocks are down, will panic, and cash out of those index funds. The most important thing is to do the work, understand stock market history, learn about investments. Most people I talk to are pretty clueless about investments. In fact, 90%+ of those I talk to have to idea what's going on.

      I share your opinion on tax reduction with 401k and matching. Luckily, I have been able to rollover past 401k and invest directly in what I find to be best for my money. I always talk about what I believe to be best for my money. I am not an investment advisor, and nothing I say here should be viewed as something that you or anyone else should act on. Do your research before you put money to work,

      By the way, you should be able to accept opinions that go counter to what you think, in order to expand your horizons. Also, if someone disagrees with you, that doesn't mean they are "foolish". When someone tells you something that you don't understand, politely ask for more explanation. Don't call them names

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  4. DGI,

    I found this out when reading up on some material regarding the MDT inversion. I'm not real happy with this, but don't really have a choice. I could sell out of MDT before the transaction takes place and I'll still have to pay capital gains. Or I can let the transaction complete, pay the taxes, and own a piece of the new company. I'll likely go with the latter choice, kicking and screaming all the way along.

    Best wishes!

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    1. Well, hopefully the increase in intrinsic value will compensate for the taxes we have to pay. Lucky for you, you might be in a lower bracket in 2015, so your dividends and capital gains might be taxed at 0%.

      Delete
  5. DGI,
    Nice write-up. About 90% of what I know about inversions is what I just learned from reading your article.
    Thanks,
    KeithX

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    Replies
    1. Thanks Keith..I learned about this after reading a few articles that a very smart reader sent my way. You can check it here:

      http://www.washingtonpost.com/business/economy/corporate-tax-dodgers-leave-the-rest-of-us-to-foot-the-bill/2014/07/11/de311d1a-06c2-11e4-a0dd-f2b22a257353_story.html

      and

      http://taxfoundation.org/article/corporate-inversions-introduction-issue-and-faq

      Best Regards,

      DGI

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  6. So basically there is no way around this ,no matter what you do you will have to pay the capital gains tax if you own 1 or more of these stocks correct? I am heavily weighted in Walgreens and am up 100% on the shares I own. So I stand to take a big hit.

    I remember reading about Walgreens doing the inversion but do not think it is suppose to take place anytime soon..

    Thanks
    Chad

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    1. I think WAG is just considering it, based on what I read. They obviously haven't decided, nor posted anything more specific.

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  7. Recent articles in Rueters (6/25/14) suggest far more active mutual fund participation in tax inversions. In this case, T R Price is mentioned as part of the alliance attempting a hostile takeover of Allergan (AGN). In this case, there will be far more negative effects on the employees, the shareholders, and the company's other stakeholders in America then simply forcing through a massive capital gain for investors such as myself.

    ReplyDelete
    Replies
    1. You are correct that there are other constituencies that are affected by mergers and acquisitions. As an investor, you are affected. If you work at an acquired company, your job might be on the line. But how do I use this knowledge to make money?

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  8. DGI-

    Another good article. I'm curious if this would be a good opportunity to rebalance your portfolio. I have owned WAG for about 2 years now, so I have over a 100% gain. I normally do not try to time the market resist selling much like you do. Currently WAG is quite expensive around a 24 PE with a sub-par 1.6% yield. Since you are being force to "sell" anyways, have you considered selling outright and reinvesting in something that looks more valuable? If you are going to be forced to realized a capital gain, you might as well pick up something yielding 3% instead of 1.6%. I guess I am just suggesting that you treat it as a force out merger where WAG sent you cash and you have to decide if you want to invest in a company like WAG with the new money you have.

    -Z

    ReplyDelete
    Replies
    1. Hi Zach,

      I think you might like this article:

      http://www.dividendgrowthinvestor.com/2014/01/should-you-sell-after-yield-drops-below.html

      Best Regards,

      DGI

      Delete
  9. Thank you for the information. Never heard of this until now. If a certain percentage of shareholders must be foreign wouldn't that prove hard to move your corporation? Especially if the majority of the companies stock is held by U.S. EFT or mutual funds.

    ReplyDelete

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