US Lawmakers Act Against Tax Inversions: Implications for Corporate Governance

The Tax Cuts and Jobs Act (“TCJA”), which came into effect on 1 January 2018, marks one of the most substantial reforms to the United States tax code in more than 30 years. In response to growing public pressure, US lawmakers have enacted wide-reaching tax reforms to curb the trend of tax inversions. These tax arrangements involve the re-incorporation of US companies abroad, enabling them to avoid US laws and domestic tax rates. This blog will examine how a corporate inversion – the most common type of tax move – erodes the US tax base and increases investment risk.

The investment risk created by tax inversions

Investors are exposed to the fallout from regulatory penalties and reputational damage caused by tax authorities sanctioning companies. European Union tax authorities have been taking a tougher stance against these particularly favorable, and at times unlawful, tax deals offered to multinationals by states to attract employment and capital. In August 2016, the European Commission directed Apple to pay EUR 13 billion for taxes owing to Ireland after finding that the company benefited from unlawful state aid starting in 1991. The company paid 2014 taxes at a rate of only 0.005%, compared to the 12.5% prescribed by Irish tax rules. After this information was made public, Apple’s share price dipped and its market capitalization fell by approximately USD 5 billion. Fortune estimated that in the medium-term the cumulative effect of upward-adjusted tax rates could negatively impact Apple’s market value by tens of billions of dollars. American multinationals quickly took heed of the European Commission’s landmark ruling. In December 2016, in response to the unwanted scrutiny from EU regulators, McDonald’s moved its non-US base from tax-friendly Luxembourg to the UK, by incorporating a new international holding company.

The November 2014 “Lux Leaks” scandal demonstrates the reputational damage tax inversions may cause. More than 300 companies in Luxembourg – including US heavyweights Pepsi and AIG – were found to have slashed their tax bills by diverting profits between group companies. With the January 2018 reversal of former PwC employee and whistleblower Antoine Deltour’s sentence for leaking tax files, future whistleblowers may be emboldened to also act against questionable tax avoidance activities. In 2013, Starbucks learned first-hand about reputational damage when its UK division recorded its first-ever drop in sales, following a year in which the company suffered boycotts and public criticism in the wake of tax investigations. Investors had been advised that the company was profitable, despite the company reporting continuous losses to the tax authorities.

How are tax inversions linked to corporate governance?

For years, the US corporate tax rate of 35% was among the highest in the developed world. Furthermore, corporate tax applied both to US and worldwide profits, meaning that companies were, in effect, taxed twice on their non-US profits. To avoid this double taxation, many US companies have re-incorporated in lower-tax jurisdictions – notably, Ireland, which has a corporate tax rate of 12.5%. Sustainalytics’ research reveals that between 1990 and 2017, nearly 50 large US companies changed their country of legal incorporation. The largest-ever corporate inversion occurred in 2015, when US-based Medtronic Inc. bought Irish company Covidien PLC for USD 49.9 billion. The resulting entity, Medtronic PLC, emerged as one of the world’s largest medical technology development companies. In 2016, Johnson Controls merged with Tyco International under a USD 14 billion deal, and the new entity (Johnson Controls International) was incorporated in Ireland. Johnson Controls forecast that the new firm would realize annual tax savings of USD 150 million. Many US companies that re-incorporate abroad cite competitiveness, not tax benefits, as the reason for the move. When Ingersoll-Rand re-incorporated in Ireland in 2009, Chairman and CEO, Herbert Henkel, specifically referred to Ireland’s common law system and its relationships as an EU member state. Such statements, however, appear incongruent with Sustainalytics’ finding that most of the companies that have inverted since 1990 have retained management and operational control in the US.

Public opposition to tax inversions has typically focused on forfeited tax revenues and the outsourcing of US jobs. Nonetheless, negative impacts may also extend to corporate governance and shareholder rights. Frequently, the countries with favorable tax conditions are also those with lenient corporate governance rules. Re-incorporating to such countries changes the applicable national corporate laws, thus affecting corporate governance. For instance, if we compare corporate laws in the state of Delaware with the laws in the Cayman Islands, we note differences in the interpretations of directors’ fiduciary duties, and in the voting thresholds required to approve corporate actions. Additionally, Cayman Islands shareholders may only bring derivative actions in limited circumstances – and there is legal uncertainty over the recognition and enforcement of US judgments in the Cayman Islands. Tax havens also present jurisdictional issues. For instance, the 2017 New York Court of Appeals case of Davis v. Scottish Re Group Ltd illustrates the procedural challenges in transferring derivative actions out of Bermuda courts.

What makes the 2018 legislative reforms different?

The US has previously passed regulations to combat tax inversions. In 2016, the US Treasury introduced the Multiple Domestic Entity Acquisition Rule, which prescribes that shares accumulated by a foreign company’s US acquisitions in the preceding three years would not be counted towards the value applicable to the inversion threshold. This rule – aimed at preventing “serial inversions” – indirectly targeted companies like Allergan PLC (Ireland), which was in the midst of a USD 160 billion deal with pharmaceutical giant Pfizer Inc. (US), and had previously concluded a USD 66 billion merger with Actavis, and a USD 25 billion acquisition of Forest Laboratories. Had the Pfizer-Allergan deal gone through, it would have been the largest tax inversion ever conducted by a US company, with Pfizer on track to enjoy tax savings of more than USD 1 billion annually.

The 2016 US Treasury Regulations that discouraged the Pfizer-Allergan deal targeted specific, notorious tax loopholes – whereas the TCJA goes further by enacting structural change to the tax code. The TCJA makes the corporate tax system more conducive to retaining profits in the US. By removing the incentive to withhold or move profits abroad, the reliance on tax loopholes may be reduced.

The key features of the TCJA include:

• the lowering of the corporate tax rate from 35% to 21%;
• the adoption of a territorial tax system, whereby repatriated offshore earnings are taxed at reduced rates of up to 15.5%; and
• the introduction of a base erosion and anti-avoidance tax (10% minimum tax).

While the new US corporate tax rate – the lowest in nearly 80 years – falls below the tax rate of competitors including China, Germany and France, it still may not be low enough for some companies, which may continue to eye countries with even lower rates. Additionally, the US has not gone as far as other countries to impose a punitive tax rate. In the UK, companies that artificially deviate profits abroad are subject to a “diverted profits tax” of 25%, instead of the standard 19%.

As an investor, what should you look for?

Prudent investors should be on the lookout for tax avoidance red flags because the country of incorporation not only affects tax rates, it also determines applicable corporate governance laws. Investors face heightened risks when a company’s compliance structure requires fundamental changes to comply with new, unfamiliar laws. Additionally, the examples above demonstrate that tax inversions may increase exposure to regulatory sanctions and public policy incidents involving national tax authorities.

Investors are urged to scrutinize corporate tax policies and specifically to ask: “is the policy approved at the board-level, and does it disclose monitoring procedures?” as there may be a disconnect between the financial reporting units and the board, which is the only body directly accountable to shareholders. Additionally, investors should examine disclosures on the company’s financial arrangements to identify maneuvers aimed at reducing tax liability. Activist investors are in a strong position to put pressure on boards to disclose geographical segment information, including an overview of the tax liability in each country of establishment. Such an approach – which emulates the EU’s Capital Requirements Directive IV – may enable investors to measure the reported tax figures against revenues, assets and employees in the countries of operation, and determine whether tax avoidance is taking place.