Corporate Inversions: Stanley Works and the Lure of Tax Havens

1. Corporate Inversions: Stanley Works and the Lure of Tax Havens

2. Income Tax Systems Worldwide System • The US has a worldwide tax system • The country taxes income earned by the corporation NO MATTER where they earned that income - domestically or abroad • General rule: the income of a foreign subsidiary of a U.S. company is not taxed until it is transferred to the U.S. parent company by payment of dividends or a liquidation distribution (Deferral) Territorial System • Most countries use a territorial system • Under a territorial tax system, a country ONLY taxes the income earned within their borders

3. Corporate Inversion How does an inversion work? • A corporate inversion occurs when a U.S. company merges with or acquires a foreign-based company, then re-characterize itself as a foreign corporation. During this process, the company changes its country of residence (TAX PURPOSES). • The U.S. company becomes a subsidiary of the foreign one, but the foreign firm is controlled by the original U.S. firm. HOWEVER, companies that ‘invert’ are still liable and do pay taxes on all revenue earned in the US, but are no longer required to pay taxes on the income earned internationally. • An inversion does not change the operational structure or functional location of the company

4. Corporate Inversion What are the tax advantages of an inversion? • The U.S. corporate income tax rate is 35% + Worldwide Income System • Once inverted, a company no longer pays U.S. taxes on its global income. Instead, it is only responsible for paying taxes on income generated in the U.S. Why do some consider inversions to be unfair? • The company will continue to enjoy the benefits of being a U.S. company, including access to U.S. markets, rule of law, patent and intellectual property enforcement, support for R&D

5. Corporate Inversion in the US Source: Bloomberg

6. Tax Credits and Tax Deduction  • To mitigate the potential of double taxation • Tax deductions The taxes paid to foreign government are treated as if they were any other type of business expenses. This reduces taxable income, lowering the amount of taxes. • Tax credits A tax credit allows the corporation to subtract the amount of the credit from the total that they would otherwise owe in taxes • Difference between tax credits and tax deductions: A tax credit directly reduces tax bills, while tax deductions indirectly reduce tax bills by reducing the size of the taxable income from which the tax bill is calculated.

7. Taxable income in W Tax paid to F T Taxes paid to W Tax Deduction • $100*40%=$40 • $160*30%=$48 • $200-$40=$160 E.g. Company A is headquartered in country W $100 pre-tax profits in country W, and $100 pre-tax profit in country F W: 30% tax rate, F: 40% tax rate. Note this is $88 tax on $200 income (44%)

8. Full Credit Tax paid to F Tax supposed to pay to W Tax credit for taxes paid to F Taxes paid to W $60-$40=$20 $200*30%=$60 $100*40%=$40 $40 Full Credit company A can claim the entire amount of tax paid to country F as foreign tax credit. E.g. Company A is headquartered in country W • $100 pre-tax profits in country W, and $100 pre-tax profit in country F • W: 30% tax rate, F: 40% tax rate Note total tax is $60 on $200 income (30%) but W only gets 20% of income generated in W.

9. Partial Credit (US applies this) Tax paid to F Tax supposed to pay to W Tax deductible allowed to be claimed Taxes paid to W $60-$30=$30 $200*30%=$60 $100*30%=$30 $100*40%=$40 Partial Credit company A can claim foreign tax credit up to the amount it is supposed to pay at W’s rate (but not the amount company A actually paid to F) to reduce its tax. E.g. Company A is headquartered in country W • $100 pre-tax profits in country W, and $100 pre-tax profit in country FW: 30% tax rate, F: 40% tax rate. Note W gets 30% of income generated in W, but company pays $70 on $200 income (35%)

10. Comparison of the Three

11. Deficit Credit (DC) Deficit credit : foreign tax rate is less than US statutory rate, a DC firm lacks sufficient foreign tax credit to avoid all US taxes on its foreign income E.g. Foreign Income= $100, Tf=15%, Tw=35%, Tax paid to F=$15 Total tax paid = Tw*$100=$35 Tax paid to W=(Tw-Tf)*$100=$20 • Note that the $20 paid to W is only paid at repatriation • By delaying repatriation, it defers US tax liability

12. Excess Credit (EC) Excess credit: when foreign tax rate exceeds US statutory rate, the firm does not pay US taxes on its foreign income because it has already paid the full US tax rate (and more) in taxes to the foreign country. The “excess” tax it paid to the foreign country becomes EC E.g. Foreign Income= $100, Tf=45%, Tw=35%, Tax paid to F=$45 > $35, enough to shield the company from US tax obligation Unused excess credit can be carried back (1yr) or forward (10yrs) at time of case

13. U.S. Tax System - Expense Allocations U.S. Firm with Foreign Operations General overhead expenses in the U.S. R&D expenses in the U.S. Interest payments on debts in the U.S. Benefits foreign operations

14. U.S. Tax System - Expense Allocations • U.S. has a worldwide taxation system and must distinguish between foreign and domestic revenue and expenses • Permitting full deduction of expenses may understate “true” taxable income • System allows for the allocation of some expenses based on measure of worldwide activity Examples: Percent of total assets abroad Percent of total sales generated abroad

15. U.S. Tax System - Expense Allocations • U.S. Firm’s Expenses: General Overhead: $250 R&D: $600 Interest Expense: $150 Total: $1,000 • U.S. Assets: $4,000 (80%) • Foreign Assets: $1,000 (20%) $1,000 $800 $200 U.S. Expense Foreign Expense

16. U.S. Tax System - Foreign Tax Credits U.S. Firm: Foreign Profit: $200 U.S. Tax Rate: 35% Foreign Tax Credit Limit = $200 x 35% = $70 Firm pays foreign tax < $70 Foreign Tax Credit = Foreign Taxes Paid Firm pays foreign tax > $70 Foreign Tax Credit = $70

17. U.S. Tax System - Foreign Tax Credits • Foreign Tax < Tax Credit Limit Foreign Profit: $200 Foreign Taxes Paid: $50 U.S. Tax Rate: 35% U.S. Gross Tax: $70 Tax Credit: ($50) U.S. Taxes Paid: $20 • Foreign Tax > Tax Credit Limit Foreign Profit: $200 Foreign Taxes Paid: $80 U.S. Tax Rate: 35% U.S. Gross Tax: $70 Tax Credit: ($70) U.S. Taxes Paid: $0

18. U.S. Corporate Tax Rate

19. U.S. Corporate Tax Rate

20. and the Case of • Stanley proposed moving company residence to Bermuda • New entity domiciled in Bermuda • One time domicile change • Pfizer proposed a takeover of Allergan • Pfizer would adopt Allergan’s domicile of Dublin, Ireland • Allergan repeatedly moved company domicile from country to country

21. and the Case of • Stanley inversion voted on by shareholders in 2002 • Pfizer announced intention to purchase in 2015 • Stanley stockholder reacted positively to news of deal and negatively to possible end of deal • Pfizer stockholders reacted negatively to news of deal and positively to end of deal

22. Why Pfizer Walked Away From Allergan Deal

23. How New Rules Affected the Pfizer Deal

24. How New Rules Affected the Pfizer Deal _ Part I

25. The Example of Apple • Reduction of corporate income tax rate 1.- Separating profits it reports and the taxes it pays from the business activity that generates those profits. 2.-Allocating profits on European Union sales to an internal “head office” in Ireland RESULT Ireland’s effective tax rate on Apple’s European profits was 0.005%, far below the official 12.5% corporate tax rate

26. Unremitted foreign income -Deferral provisions in the American tax code = Apple doesn’t have to pay taxes while the money remains overseas. -Reported as deferred tax liabilities (30 billions in 2016): Apple has no incentive under current tax law to repatriate its foreign cash.

27. Apple’s US Shareholders -In general, US citizens benefit from government expenditure which relies on corporations paying more taxes • Social programs • Public education • Environmental protection • Infrastructure (e.g. roads, power supplies) -However, a US shareholder would prefer Apple continue its current tax practices: • Dividends • Investment appreciation

28. How Income Outside the U.S. Is Taxed (History) Stage1: from 1994 to 2003 • There was not much regulation against corporate inversion • U.S. firms targeted Bermuda and Cayman Stage 1 (1st wave) Source: Bloomberg

29. How Income Outside the U.S. Is Taxed (History) Stage2: The American Jobs Creation Act of 2004 • New law made U.S. companies more difficult to acquire tax advantages • In fact, the number of inversions decreased Stage 2 (New Act) Source: Bloomberg

30. How Income Outside the U.S. Is Taxed (the American Jobs Creation Act of 2004) New definition as a U.S. incorporated company • After the inversions, if a company stock ownership remains at least 80% the same in new countries, it is treated as a U.S. company 2. If new corporated firm does not do substantial business activity in new countries, it is treated as a U.S company • “Employees, assets, and income in incorporated area are more than 25% of all of the group.” In a worldwide tax system, foreign income of U.S. company is taxed

31. How Income Outside the U.S. Is Taxed (History) Stage3: After 2010 • Acquisition is the common method • England and Ireland are the new target due to lower corporate tax • Companies now aiming for below 80% range to avoid 80% rule Stage 3 (2nd wave) Source: Bloomberg

32. How Income Outside the U.S. Is Taxed? (What is happening now?) Source: Bloomberg