Written on January 22, 2016 by Natalie Boatner
If you’re keeping up with recent events in tax inversion trends, then you’ve likely seen extensive coverage of the Pfizer-Allergan merger. The $160 billion deal would shift Pfizer’s New York headquarters to Ireland and, in the process, substantially reduce Pfizer’s U.S. tax bill. For many, the acquisition highlights flaws in U.S. tax law and the existing corporate tax structure. Understanding the mechanics behind the practice of tax inversion, and the Pfizer-Allergan move in particular, can help us better understand what tax inversion means for companies and for the U.S.
Tax inversion, or corporate inversion as it is sometimes called, is a practice in which a corporation whose legal domicile is within a high-tax nation relocates, often via merger, to a legal domicile with lower tax rates. Despite relocating, the inverted corporation will often maintain its physical headquarters and/or material operations in its higher-tax domicile nation. The U.S. charges higher corporate income tax than most of the world with state and local taxes, it amounts to close to 40% in 2015. This means that there is a higher cost to capital, and that net growth means a corporation must earn the cost of capital or greater to generate actual revenue, whether or not the company is growing.
What’s more, the U.S. is one of only a few developed countries still operating on a global taxation model, as opposed to a territorial model. In the global model, income generated anywhere is taxed at the U.S. rate (which is higher than the corresponding tax in other nations). In the territorial model, the tax rate of income is applied based on the tax rate of the nation in which the income was generated. If this wasn’t enough, there is a clause in the tax code that states that the additional U.S. tax on income generated overseas is only paid when that income is repatriated. This causes a phenomenon known as “trapped” income. In 2015, the amount of “trapped” income was estimated to be $2.6 trillion.
So why is this important, and why are people so upset about Pfizer merging with Allergan? The deal will be the largest instance ever of an American company relocating to reduce its tax burden. The U.S. could miss out on billions of dollars of tax revenue, as well as see a plunge in domestic jobs. Allergan is incorporated in Ireland—a nation that operates on a global tax model. Ireland’s corporate tax rates, at 12.5%, are substantially lower than America’s 40%, eliminating negative effects of relocation. When Pfizer merges with Allergan and shifts its incorporation to Ireland, it untraps a few billion in revenue, and potentially its value and market shares from the revenue saved on corporate taxes. (Although several investors have been disappointed in the projected size of cost reductions.)
While there is no definite reason to believe major reforms will occur after three decades of severe corporate taxation, there has been very loud rhetoric in the political sphere surrounding the Pfizer-Allergan merger. Increasingly, politicians are decrying inversion and addressing the need for reform. But, it’s safe to assume that the flaws in the international corporate tax structure will not be instantly solved by whichever new regime steps into office next year. Pfizer’s CEO claims the new deal will help put the company on equal footing with its competitors. Many eyes are watching to see if his promise holds true in the coming years.