Term Paper (Financial Management Class )

Running head: Corporate Inversions and Valuation Impacts 1

Corporate Inversions and Valuation Impacts

Great Student

Lawrence Technological University

Corporate Inversions and Valuation Impacts 2

Abstract

Corporate inversions have become popular with U.S. corporations seeking a reduction in

statuary tax rates. They continue to impact the global marketplace even as the Internal Revenue

Service seeks to discourage their continued use by firms seeking tax shelters. The promise of

lower taxes and improved global efficiencies drive corporations to pursue these deals. Effects of

these mergers can be directly measured or have indirect impacts which companies must consider

prior to the deal. Inversion transactions can be complex and often have mixed results for the

shareholders and the companies who seek them. Corporate inversions will continue as the global

market place continues to change and countries seek out new investments while companies

pursue reduced taxes, operation efficiencies, and improved overall value for their shareholders.

Corporate Inversions and Valuation Impacts 3

Rise of the corporate inversion

“A corporate inversion is the migration of a U.S. corporation to a foreign jurisdiction

through a merger and acquisition transaction.” (Jason M. Muraco, 2014, p. 1) These migrations

grew in prominence during the late 1990’s and early 2000s. According to Muraco, the main

reasons for their rise was the high corporate income tax rates in the United States, U.S. policy of

taxing multi-national company’s worldwide income, and corporate inversion’s ease of

implementation.

The expansion of free trade and increased global competition has continued to fuel the

interest in inversions. Competition across multinational industries due to reduced trade barriers

and tariffs has led to companies to globally seek reduced costs and improve productivity of their

operations. Countries looking to have increased investment in their economies by such

companies, have responded by reducing corporate tax rates to a significantly lower level than the

United States. (Michael Cragg, 2015) This disparity between tax rates has, according to Cragg,

led to around fifty U.S. corporate inversions between 1996 and 2014. See Table 1 for a

comparison of statutory tax rates.

Perceived benefits of inversions

Companies completing an inversion realize key benefits which include a lower effective

tax rate on future earnings, the ability to access its non-U.S. cash reserves more tax-efficiently

and a more favorable profile for future acquisition activity. (Jason M. Muraco, 2014) The

substantial impact on a company’s annual tax liability is one of the observed benefits of the

inversion. An increase in inversion transactions since 2008 is the result of U.S. corporate tax

rates being one of the highest among developed countries and lack of broader tax reform

legislation. This disparity in tax rates can be seen when sampling twelve companies’ statutory

Corporate Inversions and Valuation Impacts 4

tax rates and comparing the 3-year average pre-inversion rates to the resulting average rates after

the transaction (See Table 2). According to Muraco, the three-year average statutory tax rates of

these companies was 35% prior to their inversion and approximately 19% post-inversion, a 45%

reduction in the median statutory tax rate. This reduced tax burden is a big draw for companies

looking to increase their net income and improve their cash flow, and therefore the overall asset

value.

Trying to reduce or stop inversions

Initial responses to corporate inversion led the Internal Revenue Service (IRS) to issue a

notice in which U.S. shareholders of a U.S. corporation would be subject to taxation in specific

transactions. Section 367(a) of the Internal Revenue Code (IRC), the first set of anti-inversion

guidance, followed in 1996. This reaction only impacted the shareholders of the inverted

corporation and therefore was not effective in deterring publically traded corporations from

inversion transactions. Stricter sections of the IRC were enacted after a series of high profile

corporate inversions during the late 1990’s and early 2000’s (Jason M. Muraco, 2014). Section

7874 was more effective in reducing inversions by implementing key criteria for the transaction;

1) Ownership Test, 2) Asset Test, and 3) Business Activities Test. These ‘tests’ put more burden

on the U.S. corporations wanting to conduct an inversion. However, as the restrictions have

increased on corporate inversions, companies still look to them as a response to the increase in

U.S. corporate tax rates and their taxation of foreign earnings brought back into the United

States. Even with the existing tax codes, companies still meeting the three ‘tests’ are more likely

to benefit from lower statutory tax rates outside of the U.S.. This coupled with other benefits

have not deterred corporations from inversions. The number of U.S. corporate inversions have,

according to Cragg, risen from 2011 to 2015 (See Figure 1).

Corporate Inversions and Valuation Impacts 5

Valuation impacts

Primary drivers

The primary drivers of an inversion which can affect the valuation of the company are the

corporate tax rate and realized operational benefits of conducting business in a lower cost

country. Reducing and maintain a low tax rate can improve the net income of a corporation. Net

income post-inversion will increase if all things remain constant due to the lower tax rate. This

increase will improve overall cash flow on assets and the overall company valuation. In addition

to lower tax rates, some companies also see an operational advantage to moving a greater

percentage of their operations out of the United States. Lower labor and operating costs can be

leveraged on a global scale to optimize overall operations and improve earnings before interest

and taxes (EBIT). These reduced costs support increased net income and overall valuation.

Indirect drivers

Publicly traded equity values for the parents of the inversion can be easily

calculated using discounted cash flow or comparable methods. This is typically used to

determine the successful completion of an inversion (Michael Cragg, 2015). However, other

indirect factors resulting from a corporate inversion may affect the valuation. These may include

the perception of the company as a result of moving out of the United States and potential for

lost or reduced U.S. workforce. Poor public opinion and bad press can lead to possible reduction

in market value. This can impact the book value if the company is not able to break free of the

negative image and ensure current and future shareholders of the benefits of the new company’s

position after the inversion transaction. Some inversions result in additional debt or require

additional investments to reduce or eliminate poor performing assets. These long term

investments can also reduce the positive impacts to the valuation by increasing the require capital

Corporate Inversions and Valuation Impacts 6

expenditures to move operations to the new country. The merger structure may also create a

complicated valuation scenario. In cases where some subsidiaries, rather than the whole U.S.

company, are part of an inversion, separate subsidiary valuations would be required to determine

the resultant’s new parent ownership share (Michael Cragg, 2015). Other factors such as

synergies and the idiosyncratic nature of the transaction can also affect the valuation according to

Cragg.

Initial changes

A valuation analysis published in Journal of the American Taxation Association using

Monte Carlo sampling procedures assessed the statistical significance of abnormal returns

around the inversion announcement date. This study showed 5 of the 20 inversions had

significant negative announcement period returns, only 2 showed significant positive returns, and

the remaining 13 showed no significant market reaction (C. Bryan Cloyd, 2003). Overall the

average return of these 20 firms during the announcement period was slightly negative, but not

significantly different from zero according to Cloyd. Statistically no real change in value is

initially derived from the announcement of the inversion.

Longer term effects

Some of the inversions studied by Cloyd and his colleagues had estimated nontax costs of

inversion greater than the annual tax savings estimate. This may have a long term impact on the

valuation. Corporations who have these higher nontax costs of an inversion may not be able to

leverage operational efficiencies to make up the difference. All things being equal, leveraging

these efficiencies after an inversion is key to long term value and improving the overall effects of

the transaction by increasing earnings before interest and taxes (EBIT) and thus operating cash

flow (OCF). Higher leveraged companies may not see the full benefit of the lower tax rate due

Corporate Inversions and Valuation Impacts 7

to lower income before taxes. Companies with low debt would see a bigger positive impact on

their OCF due to the lower tax rate after the inversion. (OCF = EBIT – Tax + Depreciation).

Continued operational improvements along with the right mix of debt and equity will support the

long term effects of the inversion transaction.

Results of an inversion

Corporate inversions have had mixed results. A review of 52 completed transactions

over a thirty year period showed 19 companies outperforming the Standard & Poor’s 500 index,

19 underperforming, 10 bought by rivals, 3 have gone out of business and 1 has moved back to

the United States (Drawbaugh, 2014). This demonstrates the perceived benefits of an inversion

are not a guarantee of long term success. However, the firms which leverage the global markets

through these transactions and see improved operational efficiencies will not only take advantage

of the lower tax rate, but also improve their net income.

Countries in which the newly inverted corporations are domiciled also can benefit from

the transaction. Increases in Gross Domestic Product (GDP), jobs, and consumer spending can

result from inversion transactions. Ireland is home to a number of inversions. This has resulted

in a revised 2015 economic growth rate of 26.3 percent from the preliminary estimate of 7.8

percent (Jolly, 2016). These deals may seem to artificially inflate the GDP, but additional

investment in the country as a result can help bolster the overall country’s economy.

Shareholders often go along for the ride on inversion deals. Even though early U.S. tax

codes made little impact to the companies, it scrutinized shareholder transactions. The benefit

and risk of the inversion transaction, like other mergers and acquisitions, are ultimately

transferred to the shareholders. If successful, inversions can increase net income, cash flows and

ultimately the valuation and share price.

Corporate Inversions and Valuation Impacts 8

Future of the inversion

The global economy continues to become more dynamic as companies continue to seek

lower costs and improved operational efficiencies. Countries seeking economic growth make

themselves attractive to companies through lower taxes, trade deals, and other strategic values.

Stopping inversions has not been successful with the current tax legislation. Another way to

fight companies moving to different countries might be to embrace the trend and focus on

making the U.S. more attractive to new and existing businesses. Unless the United States can

structure its tax laws to support companies staying within the U.S. and reduce trade concerns

with other regions, corporate inversions will continue and perhaps grow in frequency providing

possible benefits to its shareholders.

Corporate Inversions and Valuation Impacts 9

References

C. Bryan Cloyd, L. F. (2003). Firm Valuation Effects of the Expatriation of U.S. Corporations to

Tax-Haven Conuntries. The Journal of the American Taxation Association, 25, 87-109.

Drawbaugh, K. (2014, August 18). When companies flee U.S. tax system, investors often don't

reap big returns. Retrieved from Politics Special Reports - Reuters.com:

http://www.reuters.com/article/us-usa-tax-inversion-insight-idUSKBN0GI0AY20140818

Jason M. Muraco, J. A. (2014). Corporate Inversions: The End...Again? Retrieved from srr.com:

srr.com

Jolly, D. (2016, July 12). Ireland, Home to U.S. ‘Inversions,’ Sees Huge Growth in G.D.P.

Retrieved from nytimes.com:

http://www.nytimes.com/2016/07/13/business/dealbook/ireland-us-tax-inversion.html

Michael Cragg, J. d. (2015, July 20). Corporate Inversion Transactions: Valuation

Considerations. Tax Notes International, 261-269.

Corporate Inversions and Valuation Impacts 10

Tables and Figures

Table 1 - Statutory Tax Rate Comparison (Michael Cragg, 2015)

Corporate Inversions and Valuation Impacts 11

Table 2 - Pre and Post Inversion Tax Rate Comparison (Jason M. Muraco, 2014)

Corporate Inversions and Valuation Impacts 12

Figure 1 - (Michael Cragg, 2015)