The US federal government may be threatened to lose billions of dollars in revenue. A joint congressional committee on taxation estimates the U.S. Treasury may lose $19.5 billion over the next decade. On the other hand, the corporate houses, which may include some of your favorite stocks, are strategically well placed to save those billion bucks. The common reason for these is tax inversion.
Simply put, this latest trend is US corporate houses acquiring offshore companies in nations that offer lower tax rates. By acquiring the foreign companies, these US firms are shifting their legal homes and thereby chopping the tax bills.
The global merger & acquisition (M&A) activity clocked a seven-year high. Recurrent foreign acquisitions by U.S. companies indicate that tax inversion is one of the major reasons behind the spike. The US corporate income tax rate is the highest in the industrialized world and thus it is logical for the US firms to find alternative sources whereby they can limit their tax burden.
No matter what it costs to the treasury, trimming the tax burden will eventually help US firms have more cash in their pocket. This additional cash along with advantages like boosting a product portfolio or adding skilled workforce through acquisitions should help these firms do better. Eventually, this should get reflected in their stock prices as well.
Mutual funds holding these stocks in their portfolio should thus experience solid uplift in the near term.
However before we pick the likely gainers, let us dig a little deeper into the subject.
What Is Tax-Inversion?
Medtronic, Inc.’s (MDT - Free Report) $42.9 billion acquisition of its Irish competitor in surgical technologies and global healthcare major Covidien plc is a good example of the tax inversion process. The deal was an effort to offset the impact of the high U.S. corporate tax rate by shifting Medtronic’s tax base overseas.
A tax inversion involves the acquisition of a foreign company and subsequently adopting its home country’s domicile. Alternatively, the combined entity can create a holding company in a country where the tax rate is lower.
Healthcare Sector Taps Most of the Opportunity
We note that the trend of tax inversion has been mostly prevalent in the healthcare sector. Medical devices and pharma companies are rapidly buying foreign competitors. It is usually easier for a large corporation to purchase small companies than to develop new drugs indigenously. Also, the market for drugs is truly global. Thus the advantages are huge in addition to offloading the tax burden.
Many large US pharma companies already have considerable international revenue base. Tax inversion will further increase their international presence. A strong European pharma sector also makes for several potential targets.
Apart from Medtronic, Mylan, Inc. (MYL - Free Report) , Actavis plc , Salix Pharmaceuticals Ltd. and Jazz Pharmaceuticals (JAZZ - Free Report) are among the other players in the pharma space reaping the benefits. (Read: Pharma, Biotech M&As Heat Up: Tax Inversion in Focus)
U.S. Charges Highest Tax, UK a Favored Spot
One cannot completely blame the U.S. firms for looking for opportunities to evade taxes in U.S. According to Organization for Economic Cooperation and Development, the combined tax rate (including federal corporate income tax and estimates for state and local rates) in U.S. is 39.1%. That is the highest among the OECD nations.
On the other side of the pool, U.K. offers a 21% tax rate. Ireland is the lowest with a tax rate of 12.5% while Slovenia, Poland and Hungary follows with rates of 17%, 19% and 19%, respectively.
The 21% tax rate in UK is attractive to many of the U.S. firms. Moreover, the location, language and lifestyle in Britain is also drawing the interest of American firms. Robert Willens, corporate tax adviser, told The Wall Street Journal that “Right now, it's safe to say that the U.K. is the preferred country of destination for inverted companies, given the favorable tax regime and the non-tax attractions of the U.K.”.
The best example here is AbbVie Inc.’s (ABBV - Free Report) move to shift its legal home to U.K.
AbbVie-Shire Acquisition: The Biggest on the Block?
Fueling debate on the tax inversion, AbbVie and Shire (SHPG) reached an agreement last week for the proposed acquisition of the latter. Valued at approximately $54.5 billion, the AbbVie-Shire deal features among the top 50 inversions to take place in the last 10 years. (Read: AbbVie Set to Acquire UK-Based Shire in Q4)
Chicago-based AbbVie is expected to trim its overall effective tax rate to 13% in 2016 from 22.6% last year by reincorporating in British island of Jersey. The popular tax-haven Jersey has a 0% standard corporate tax rate.
Not only the tax exemption, but a boost to the product portfolio is seen as one of the advantages of the deal. Richard Gonzalez , AbbVie Chief Executive, said: “The proposed transaction would create a well-positioned and focused biopharmaceutical company, giving us the opportunity to expand and augment our product portfolio, advance our pipeline, accelerate our growth, and create long-term value for our shareholders”.
Mylan, Walgreens Join the Strategy
The same week, Mylan’s $5.3 billion all stock deal with Abbott Laboratories (ABT - Free Report) emphasized an increasingly important driver of M&A activity this year. Mylan will become part of the new company, organized in Netherlands. The deal will help Mylan cut its tax rate to 20-21% in the first full year and thereafter to high teens. The deal is expected to result in over $200 million in pre-tax operational efficiencies by the end of third year.
Walgreens Co. too is being made a part of the strategy. Walgreens had bought 45% equity interest in Alliance Boots GmbH for $6.7 billion. Starting Feb 2, 2015, it may purchase the remaining 55% over a six-month period. Reportedly, Walgreens investors have been demanding the drug retailer to shift base to Europe; again to cut the corporate tax burden. (Read: Will Walgreens Relocate to Europe?)
Obama: Unpatriotic Tax Loophole
Given the flurry of such deals that may cost the government billions of greenbacks, US President Barack Obama has now stepped in and termed the inversions as “unpatriotic tax loophole”. The President is believed to have urged Congress to pass a legislation that would restrict domestic companies from saving taxes by shifting legal bases to other nations.
The Obama administration’s proposed legislation carries the effective date as Jan 1, 2015. However, Jack Lew, the US Treasury Secretary wants it to be made retroactive to May 2014.
In fact, in a journal for accountants and tax lawyers, Tax Notes, former Treasury official Stephen Shay noted that Obama may invoke a 1969 tax law. The White House may fix the loophole without congressional approval.
Jacob Lew: Reform the Business Tax Code
Treasury Secretary Jacob Lew is also focused on the tax inversion trend and believes that Congress needs to emphasize banning the inversions and then look into reforms. He said: “It is so important that we reform our business tax code to make the U.S. economy more competitive and to accelerate economic growth and job creation… But one particular tax loophole has become increasingly urgent to address: the fact that the law rewards U.S. corporations with substantial tax benefits when they buy foreign companies and declare that they are based overseas”.
The White House is said to be not against mergers, but they need to be for economic efficiency rather than being an escape route from paying higher taxes.
Jacob Lew believes tax reforms will still have opportunities for U.S. firms to find countries ‘with near-zero rates’. “By moving their tax homes overseas, these companies are making the decision to reduce their taxes, forcing a greater share of the responsibility of maintaining core public functions on small businesses and hardworking Americans," he said.
“Our tax system should not reward U.S. companies for giving up their U.S. citizenship, and unless we tackle this problem, these transactions will continue,” said Jacob Lew.
Nobel laureate economist Paul Krugman too has been critical of tax inversion. He said that US firms are “shirking their civic duty” through inversion deals.
A Boost for the Stock Prices
Mergers themselves boost investors’ returns. Stock prices usually go up on acquisition news. Through this year we have seen even the broader indices moving up on several instances following acquisition news.
Moreover, when one adds the inversion deals, the advantages are definitely more for investors. As mentioned earlier, more cash in the pocket and higher profits for corporate houses should be reflected in the stock prices as well.
How Can Investors Earn More?
Nonetheless, it is also risky to play the M&A rush and more so the inversion trend. Investors should learn a few tricks before betting their bucks.
The primary rule should be identifying or focusing on a particular sector. Looking at the inversion trend, the healthcare sector has been the dominant player, for reasons which we already discussed earlier. Thus, it might be prudent to focus on this sector. ICON Healthcare Fund’s portfolio manager Scott Snyder notes that “Tax inversions have poured gasoline on the fire”.
Here, Morningstar analyst David Krempa notes that investors should be avoiding broad healthcare funds and instead focus on the ones that allocate assets to biotechs and specialty pharmaceutical firms. SPDR S&P Pharmaceuticals ETF (XPH) for instance is equal-weighted and has larger exposure to smaller firms. These firms are more prone to be acquired.
Investors can also take advantage by employing merger arbitrage strategy in their portfolio. This strategy looks to tap the price differential (or spread) between the stock price of the target company after the public announcement of its proposed acquisition and the price offered by the acquirer to pay for the stocks of the target company. Investors should go long on the target or acquired company and short on the acquiring company. When the deal is completed, shares of the target company will increase to the full deal price (in some cases slightly below the deal price), giving investors a decent profit. (Read: Merger Arbitrage ETFs in Focus on Rising Deal Volume)
Healthcare Funds to Buy
Let’s take a look here at some healthcare mutual funds that are worth betting on. These funds sport a Zacks Mutual Fund Rank #1 (Strong Buy). Remember, the goal of the Zacks Mutual Fund Rank is to guide investors to identify potential winners and losers. Unlike most of the fund-rating systems, the Zacks Mutual Fund Rank is not just focused on past performance, but the likely future success of the fund.
ICON Healthcare Fund Class A (ICHAX - Free Report) invests most of its assets in equities from the healthcare industry. These equities may include common stocks and preferred stocks and can range from small to large market capital firms.
AbbVie Inc is among the top 10 holdings and ranks sixth. The top 3 holdings are Johnson & Johnson (JNJ), McKesson Corporation (MCK) and Celgene Corporation (CELG).
The fund has returned 13.4% year to date and currently carries a Zacks Mutual Fund Rank #1(Strong Buy).
ProFunds Pharmaceuticals UltraSector (PHPSX - Free Report) seeks daily returns which are 150% of the daily return of the Dow Jones U.S. Pharmaceuticals Index. To achieve the desired results, it invests in a mix of securities and derivatives. The balance of the fund’s assets is utilized to purchase money market securities.
Companies such as Pfizer, Merck, Allergan, Actavis, Forest Laboratories and Mylan feature among the top 10 holdings.
The fund has returned 16.4% year to date and currently carries a Zacks Mutual Fund Rank #1(Strong Buy).
Fidelity Select Health Care (FSPHX - Free Report) invests the majority of its assets in companies whose principal operations include production, design and sales of health care or medicine products and services. The fund focuses on acquiring common stocks and purchases both domestic and foreign securities.
Actavis, Covidien and Shire feature among the top 10 holdings.
The fund has returned 16.8% year to date and currently carries a Zacks Mutual Fund Rank #1(Strong Buy).
To view the Zacks Rank and past performance of all healthcare mutual funds, investors can click here to see the complete list of funds.
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