Tax Inversions 101: Why the Pfizer Tax Inversion Matters

Tax Inversions 101: Why the Pfizer Tax Inversion Matters

New treasury regulations enacted by the Obama administration are aimed towards making tax inversions more complicated to perform for businesses looking for a tax haven. But what exactly are these tax inversions and why do they matter?

A tax inversion is an effort by a business to reduce its taxes by moving its operations overseas, through the process of a calculated merger. In the case of Pfizer, a merger with the Dublin-based Allergan was designed to move the company away from its New York headquarters, saving the business billions in taxes.

The Basics of a Tax Inversion

During a tax inversion, an American-based company generally relocates its headquarters to a country that has a lower tax rate. Ireland, Switzerland, and Bermuda are all common options. Naturally, a company can't simply choose to move its operations without significant financial ramifications -- it needs a reason to do so. This reason is usually manufactured by merging with a smaller but still established company in one of these locations. The smaller company then becomes the new "headquarters" of the business, and the business transitions its operations (and taxes) to the other country. 

The Pros and Cons of a Tax Inversion

Though a tax inversion may seem relatively complicated (and expensive), it usually saves a company a significant amount in taxes. The United States has one of the highest tax rates for corporations in the globe, and the United States further taxes international transactions. Many countries not only have a lower tax rate but also only tax transactions within the country itself. For companies that deal internationally, the United States is logistically the worst company to be based in. During a tax inversion, operations can still remain in the United States, as long as the company itself is still headquartered elsewhere. 

For shareholders, the story is a little more complicated. Shareholders can actually end up paying more taxes on their proceeds through a tax inversion, but ideally they will still feel the benefits of a growing business. Shareholders may end up on the hook for additional taxes, especially with new laws and regulations targeted towards reducing the benefits of a tax inversion. For the country as a whole, tax inversion is negative: it vastly reduces the amount of taxes that companies should be paying.

New Regulations Against Tax Inversion

The treasury department has been seeking to make the idea of tax inversion less attractive and less feasible. In a tax inversion, the American-based company would generally have to meet an 80 percent ownership limit in the United States and a 20 percent ownership threshold within the other country. This would usually be accomplished by moving around capital and assets directly before the merger. The treasury has now put limitations on this strategy: U.S. companies can no longer purge dividends directly prior to the sale and foreign companies will no longer be able to artificially boost their assets. The treasury is also attempting to make it harder to move international profits into other foreign subsidiaries.

The Pfizer Inversion With Allergan

The Pfizer inversion will likely save the company billions of dollars. For Allergan, the story is a little more complicated: the company, post-merger, has been largely stripped down, and the company's stock has suffered as a consequence. Though Allergan investors may benefit from the merger long-term, the smaller purchasing company usually suffers throughout the process. In the mean time, Pfizer will be able to continue its operations largely as it did before, following the $160 billion merger.

Tax inversions have been used by tax-conscious businesses since the early 1980s, and have remained appealing throughout the decades as a way to reduce a company's tax burden without significantly changing its infrastructure. However, the U.S. Treasury Department is working hard to make it more difficult to perform this type of tax manipulation. A tax inversion generally does not represent a legitimate shifting to overseas operation, but instead an attempt at avoiding taxes through the use of a figurehead office in another country. New regulations have made tax inversion more difficult, but still possible, for companies willing to arrange such a merger.

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