Tuesday, November 3, 2015

Patriots and Tax Inversions

Governments can be unpatriotic when their self-interest is at stake
This is the second posting that asks the simple question: Are we looking at an issue from the proper perspective?
Is it the patriotic duty of corporations to pay taxes to the US government?  Alternatively, is it the patriotic duty of US government officials to create an environment in which corporations want to operate?  It seems fairly obvious that if the government creates an environment that drives corporations out of the United States it is doing a disservice to its citizens.  It is driving potential revenue sources and jobs out of the country.  The government is supposed to be serving its citizens, including the shareholders and employees of those corporations.  It is not just supposed to be serving its own self-interest at the expense of its citizens.   
By contrast, by law, corporations are supposed to serve their shareholders.  By providing products that consumers want, corporations are supposed to make a profit that justifies the investment. The government of a country can benefit along with its citizens from its unique ability to create an environment that is attractive to corporations.  The US government is failing to create an environment that attracts businesses.  In fact, it is clearly driving them out of the country.
So, how one views the relationship between patriotism and tax inversions depends upon whether one defines patriotism in terms of advancing the well-being of the citizens of the country versus advancing the financial interests of the government.
An Example
For the next couple of days newspapers, editorials and politicians will generate a great deal of chatter about Pfizer's attempt to acquire Allergan.  The WALL STREET JOURNAL broke the story about merger talks between the two companies.  Unfortunately, much of the chatter will focus the tax implications.  The acquisition is large enough to allow the merged company to incorporate under either US or Irish law.
What will be ignored is a fiduciary duty of the Board of Directors of Pfizer to act in the interest of the shareholders and the government's responsibility to enforce that fiduciary duty.   If the merger with Allergan is in the best interests of the shareholders, the US government should fine or remove the Board if they do not execute the merger.  If the merger is not in the best interest of the shareholders, the government has a legitimate role in blocking it.  However, the government has a tremendous profit incentive associated with blocking such a merger and move to Ireland.  Given the government's profit incentive, it is unlikely that the government will enforce the fiduciary responsibilities involved.  So, for the purposes of this blog, let us set aside the issue of an irresponsible government that fails to enforce that fiduciary responsibility.
The back story
Pfizer is not a stranger to controversy surrounding tax inversions.  This is the second attempt to acquire a foreign firm that is large enough to justify moving its headquarters out of the US.  The previous initiative failed.  As an investor, the previous initiative seemed to have no strategic value other than the tax implications.  By contrast, Pfizer's current attempt to acquire Allergan can be justified based upon the difference in the growth profiles of the two companies.  However, like most large mergers, Pfizer will have to overcome the differences in the management cultures and operating practices of the two corporations.  Thus, Pfizer strategy, like all large mergers strategies, is an extremely risky initiative.  The combined tax benefits and business benefits (as perceived by Pfizer's management) require close examination.
One of the benefits of the merger would be that as a foreign company Pfizer will be able to invest in the US on better terms than it can as a US Corporation.  That anomaly arises from Pfizer's desire to use profits from its foreign operations to finance its investments.  Because US companies are taxed on profits earned in foreign countries when those profits are returned to the US, they are given an incentive to reinvest those profits outside US.  No similar disincentive to US investment exists for a foreign corporation.  So, we are left with the question: Is it unpatriotic for Pfizer to try to find the least-cost way to invest in the US, or is it unpatriotic for the government to create a system whereby in order to do that Pfizer has to leave the US?
Pfizer’s Board has a backup plan that responds to its fiduciary responsibility.  Unfortunately, it is less beneficial to the US than the potential merger and inversion.  It is my contention that if this merger fails, Pfizer will break itself up into two or three component corporations.  Each of those corporations will then be small enough to be potential targets for acquisition by foreign firms. Foreign takeovers of U.S. firms, which have the same effect of preventing the government from taxing world-wide earnings, are booming.  Foreign acquisitions of US firms exceed $379 billion so far this year.  That is roughly double the amount of deals in which U.S. companies bought foreign rivals, and it is above any recent year before Treasury acted against inversions.
A misinterpreted, unpatriotic policy folly
There are many politicians who want to double down on a failed policy. The policy will not generate the revenue that self-interested government officials want to collect.  Capital markets are far too global for such a shortsighted policy to work.  Even countries with highly repressive governments like Russia and China have been unable to stop capital flight.  However, such unpatriotic policy failures can, and are, succeeding in moving control of U.S. businesses offshore.  This is neither in the interest of the government nor of the general population, both of which could benefit from having these corporations operating under US laws and generating US jobs and revenue.
It is not just policy wonks and populists that fail to appreciate the issue.  The WALL STREET JOURNAL on October 29 had an article entitled “Taxes Drive Potential Merger of Pfizer, Allergan.”  The article started by stating “Pfizer in early talks to acquire Ireland’s Allergan, thrusting drug maker into rancorous debate over corporate taxes….Pfizer Inc. is pursuing what could be the biggest overseas takeover to lower U.S. corporate tax liability, showing that efforts in Washington to stem such deals have amounted to little.”
The problem with this statement is that Washington's effort to stem the flow of such deals does not amount to little; it is having a major impact.  It is neither the impact that the government wanted nor is it the impact US citizens should desire.  It just makes it more difficult for US corporations to efficiently allocate capital across their global operations.  Further, it does it in a very unpatriotic way by making it more difficult for US firms to figure out how to pursue investments in the US that the company could fund from profits earned overseas.  It thus makes US corporations less competitive globally because of the obstacle it places in the way of their allocating foreign profits to US investments.  Since US corporations do a substantial amount of investing, it also means it is putting the US economy at a disadvantage in terms of accessing the foreign earnings of those corporations.
Ask a different question
At the extreme, one could argue that the US government has forgotten that it governs only as long as it retains the consent of the governed.  The Berlin wall could not contain the East Germans.  Syria cannot retain its citizens.  US citizens residing abroad are renouncing their US citizenship in record numbers, and Mexicans find legal and illegal ways to get into the United States.  Why would the US government be so foolish as to assume that the same does not apply to corporate entities?
If anything, individual citizens are far less mobile than corporations.  Citizens are born in this country, and have family and cultural ties to the country.  By contrast, domestic corporations are just the way to organize capital.  That capital can be easily organized in any country that creates an appropriate operating environment.  Furthermore, those who own the capital can as easily invest in foreign corporations as in US corporations.  If anything, capital is more mobile than people.
Nevertheless, there is benefit to the citizenry of the country and to its government if businesses, including multinational corporations, provide a source of revenue for the government and employment for the citizenry.  Thus, the appropriate question to ask is what steps the government as a patriotic entity should undertake in order to be an attractive place to form a business.  The US government for many decades succeeded in doing that.  However, it currently imposes a fee on multinational corporations that is not justified by the benefits that accrue to a corporation as a result of being a US Corporation.
The rule of law and deep capital markets in the US are definite advantages for corporations.  But, as the rule of law spreads and other capital markets develop, the US will have to rethink how much it can tax corporations for those advantages.  Truly patriotic government officials would realize that tax inversions are a failure on their part.  They are depriving their citizens of employment opportunities and the ability to invest in domestic corporations as well as to feel confident they have made the best use of their capital if they invested in US corporations.
From a policy perspective, the US government should be asking itself what it could do to make corporations want to stay in the US.  It should be asking how I can create an environment that will attract the revenue and employment of major multinational corporations.  Instead it is trying to figure out how to force them to stay in the US.  What could be more unpatriotic than to unnecessarily employ force rather than govern with the consent and in the interest of the governed? 
From the perspective of someone contemplating investing in Pfizer, the question is: will shareholders be better off with the merger with Allergan or should the company be divided so that it can be sold off to foreign investors in pieces?  Given the risks associated with large-scale mergers such as Pfizer is contemplating, it is a legitimate question. 

No comments:

Post a Comment