Citing a feared negative public reaction, Walgreens announced it would remain a U.S. company with headquarters in Chicago after its $5.29 billion merger with the British pharmacy chain, Alliance Boots. Walgreens' announcement stands out among recent transactions sending U.S. corporations overseas, particularly in the health care and pharmaceutical industries. So far this year, there have been more than a dozen tax-motivated foreign mergers announced including drug companies Pfizer, AbbVie and Mylan.
Two structural features of the U.S. tax code encourage corporations to discard their U.S. "citizenship" and become foreign corporations. The U.S. corporate tax rate, at 35 percent, is high compared to the average Organization for Economic Cooperation and Development (OECD) rate of 25 percent, the average European Union rate of 21 percent and the zero tax rate available in select locations like the Cayman Islands and Bermuda. Many corporations effectively pay much less than 35 percent, after factoring in loopholes and deductions, policies that cost approximately $150 billion in untaxed revenue last year. But the reported tax rate is high compared to other jurisdictions and the complexity required to reduce that rate in practice also is a deterrent.
Second, other countries like the United Kingdom become attractive foreign tax locations because they operate under a territorial system that does not tax profits earned outside of the home country. Under the U.S. system, however, returning foreign-earned corporate profits home is a taxable event at high corporate tax rates. As a result, it is estimated that $2 trillion in foreign-earned profits of U.S. corporations sit in foreign bank accounts unavailable for use absent paying taxes.
For a corporation to move overseas, it may be less disruptive and difficult than it sounds. To begin, a corporate home is a legal concept, and it may or may not coincide with the physical presence of that company. There are two main ways to achieve an overseas move. A transaction called an inversion where a U.S. company reincorporates overseas becoming, say, a Bermuda corporation was popular in the 2000s. Inversions also can happen when a U.S. company forms an overseas affiliate and the original company becomes a subsidiary of the foreign affiliate.
The 2004 American Jobs Creation Act prevented companies pursuing inversions from reaping tax benefits of the transactions if the original stockholders retained 80 percent or more of the new company or if there was not substantial business operation in the new location. Treasury regulations have defined "substantial business operations" as meaning 25 percent of corporate activity thus effectively stopping inversions as a means to transfer corporate profits overseas.
Another vehicle to move a U.S. company overseas is through a merger with a foreign company, and this is where the recent uptick has occurred. If a larger foreign company buys the U.S. one then both profits and control effectively move overseas in the newly combined company. If, however, a larger U.S. company buys a smaller overseas one, then control may stay effectively in the U.S., with only the profits moved overseas.
For example, in 2012 Cleveland-based Eaton purchased Cooper Industries PLC in an $11.8 billion merger. After the merger, the new company Eaton Corporation PLC, incorporated in Ireland and headquartered in Cleveland, projected savings of $160 million a year as a result of not being subject to U.S. corporate taxes. This potential to save money from avoided taxes fueled the relocation motivation. For months, Walgreen investors, including hedge funds, pressured the company to relocate to the United Kingdom. After news broke that the U.S drugstore would retain its stars and stripes, its stock fell 14 percent.
Recently President Obama and Treasury Secretary Jacob J. Lew called for tax reform to deter corporate defectors, calling the overseas moves legal, but immoral and calling on companies to engage in economic patriotism. Proposals by congressional Democrats have not gained bi-partisan support. Not to be deterred, however, President Obama included proposals in his 2015 budget to decrease the corporate tax rate, decrease the ownership threshold for inversions and close some corporate tax loopholes. Congressional action before the end of the year is unlikely, but the strong rhetoric of economic patriotism and corporate defectors will likely have a place in the 2014 election debates.
Tax policy alone isn't the solution, or only factor to consider. Two other important pieces of the puzzle are public reaction and market pressure -- both of which were at play in the Walgreens/Boots negotiations. Feared negative public reaction tipped the scales in favor of remaining a U.S. company for Walgreens, with market pressure nearly causing the opposite result. Public pressure for economic patriotism and corporate stewardship must be a part of any permanent solution. It will mitigate market-based profit maximization pressures. Brand identity and consumer loyalty are not subject to the kind of loopholes that riddle the tax code or the partisan gridlock in Washington, D.C.
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