Tax Inversion: Pfizer, Burger King, Obama, Adam Smith and Chinese Walls

Tuesday, October 6, 2015

By Farrokh Langdana, Director, Executive MBA Program & Professor of Finance and Economics

Faculty Blog:

When US pharmaceutical giant Pfizer made overtures to acquire the British company AstraZeneca in 2014, it brought the phenomenon of “tax inversion” into the global headlights. Driving this proposed move by Pfizer, and later by Burger King and Chiquita Banana (among many others), was the fact that in late 2014, the combined state-federal income tax in the US was 40 percent compared to 21 percent in the UK.

Given that fact that Pfizer had 70 percent of its cash, amounting to over $35 billion, parked overseas, bringing this money back to the US would be subjecting it to this highly punitive rate. The overall US tax rate (40%), barring North Korea, is one of the highest on the planet.  In addition to the percentage rate, the US is one of very few countries—virtually alone, actually—in taxing worldwide profits whenever they are repatriated to the United States.

In 2014, Burger King decided to place its headquarters in Canada by acquiring coffee-and-donut giant, Tim Hortons, to facilitate its inversion by now making it a Canadian company.  This move would result in a savings of $117 million in U.S. taxes by never having to pay corporate income tax on foreign profits if and when it decided to bring the money home to the US. Reuters reported that this could save the company about $275 million from 2015 to 2018, based on a range of Wall Street earnings projections (“Burger King to Save Millions,” Reuters, 12/11/14).

The US government responded by leveling accusations of “unpatriotism” at companies that were attempting to invert. Treasury officials took action by changing five sections of the U.S. tax code to make inversions harder and less profitable, and remove some of the benefits that had made the transactions recently attractive, particularly in the pharmaceutical industry.

By fall 2015, the verdict was in. Regulation did not work. Regulation can never change economic behavior by itself.  In the year following the attempt by the Treasury department’s tightening of laws to lessen the tax benefits of inversion, six US companies had inverted, compared to nine the year before (“Obama’s Inversion Failure,” Wall Street Journal, 9/26/15). 

And foreign takeovers of US firms—ultimately having the same positive effect on tax avoidance—boomed. In the first nine months of 2015 alone, foreign acquisitions of US companies exceeded $379 billion, roughly double the amount of deals in which US companies were buying foreign rivals according to the Wall Street Journal.  So, once again higher US tax rates have left us with lower tax revenues, and encouraged the tax-driven offshoring of US business.

As the Wall Street Journal so elegantly stated, “Corporate opportunities ought to be driven by business opportunities, and not tax arbitrage. And the goal of US tax policy should be to encourage companies to invest in America, not everywhere else (“Pfizer’s Tax Takeover,” Wall Street Journal, 4/29/14).”

But, none of this should come as a surprise, really.  Adam Smith famously taught us in Wealth of Nations (1776), that one cannot ever regulate economic behavior. He pointed out that it is all about the right incentive systems; it must “pay” to respond in a certain manner.  If it makes tax-related sense to invert, the companies will invert and they should invert, charges of “unpatriotism” notwithstanding. 

On the other hand, if the well-designed tax and regulatory climate encourages our companies to stay in the US, and even entices foreign companies to invest in America, they will, and they should because it makes economic sense!  It is all about designing the right incentives that match the goals, and then—ONLY THEN—stepping back and letting the “invisible hand” of Adam Smith perform its economic miracle. 

Ultimately, the Chinese say it best when they point out that you cannot build a 50-foot wall to prevent anyone from entering or leaving.  They warn you that as soon as you do, someone will invent a 51-foot ladder.  Mr. President, tear down the Walls.  51-foot ladders are everywhere.

TAGS: Business Insights Economics Executive MBA Farrokh Langdana Finance MBA Taxation