A Goldman Sachs research note explains the stakes in the current spate of tax-inversion deals by U.S. firms taking over foreign targets. Most of the listed firms in the pharma, bio, and medical-device industries have over half their sales outside the U.S. Because of our horrific corporate tax code, they end up with incredible chunks of cash overseas. Eli Lilly, for example, has 89 percent of its cash overseas. Edwards Lifesciences, Amgen, Merck, Varian, Covance, Baxter, and Abbot all have at least 80 percent of their cash offshore.
Because they cannot bring the cash back home without greedy politicians getting their hands on it, these firms’ ability to invest in the U.S. is limited. The solution, many appear to be discovering, is “tax inversion,” whereby the U.S. firm consolidates with a foreign company, and establishes its head office abroad. Despite the assertion that the U.S. corporate-tax code is so riddled with loopholes that none pay the 35 percent rate, the Goldman Sachs note shows that firms in the healthcare industry suffer quite high effective tax rates. Pfizer, for example, is estimated to have a 27 percent tax rate in 2014. Varian Medical Systems’ is estimated at 28 percent; and Cubist Pharmaceuticals’ at 36 percent.
Having a headquarters overseas might not look like that big a deal if most of the capital invested and workers remain in the U.S. Covidien, for example, has 14,000 employees stateside and only 1,400 in Ireland. Shire Pharmaceuticals has 1,500 workers in the U.S. and only 100 in Ireland. However, the problem is that there is a limited capacity for tax inversions.
As explained by the Goldman Sachs team, the newly consolidated company has to have a minimum 20 percent foreign ownership to qualify for tax inversion. That means that that target has to have a market cap at least 25 percent that of the U.S. bidder – and that is only if the deal is fully financed by equity. For example, a U.S. company with a market cap of $300 billion (e.g. Johnson and Johnson), needs a target with at least a market cap of $75 billion to meet the threshold. If it wanted to pay for the deal half with equity and half with cash, the size of target would have to be at least $200 billion to make the grade. (And, the short-term point of the tax inversion is to get rid of excess cash. A deal fully financed with new equity would likely entail yet more transactions, e.g. special dividends or share buybacks.)
Given the required size of the target, large U.S. companies have a limited number of candidates. Pfizer, with a market cap of around $200 billion, gave up its pursuit of AstraZeneca in May. Notwithstanding implications for corporate strategy, Pfizer needs a target with a market cap of at least $50 billion to execute the tax inversion. Well, according to the Goldman Sachs note, once foreign companies with significant family ownership or other barriers to acquisition are screened out, there are only three candidates: AstraZeneca, GlaxoSmithKline, and Sanofi! (Even a bid premium of 30 percent would only add two or three companies to the list.)
In short, the tax-inversion strategy has a limited lifespan. Without U.S. corporate tax reform, U.S. based pharmaceutical, biotech, and medical-device companies will find it increasingly impossible to grow their U.S. operations using this tool. All that cash stored overseas will be put to work overseas, and not due to comparative or competitive advantage of other nations, but our anti-competitive tax code.
The time for corporate tax reform is now.