"Are Corporate Inversions Good for Shareholders?" by Anton Babkin, Brent Glover, and Oliver Levine. December 2015. SSRN #2700987.
Among industrialized countries, the United States has the highest corporate tax rate, at 35 percent. To take advantage of lower rates in other countries, some U.S. firms elect to sell themselves to smaller foreign firms, a process called "inversion." These sales have drawn considerable ire from U.S. politicians and activists, and the Obama administration has vowed to "do something" about it.
In April, the U.S. Treasury Department issued regulations to throw sand in the gears of inversions. The commentary on these regulations--both pro and con--was the usual food fight about growth, taxes, and investment in the United States. Underlying all of that talk was the assumption that inversion reduces taxes for shareholders. But that assumption is incorrect in many instances.
The tax consequences of inversions are complicated because they are taxable events. That is, individual shareholders are taxed on the increased value of their shares. This can result in different tax outcomes from inversions for shareholders who have held the stock for a long time prior to the inversion and short-term shareholders (including corporate officers exercising company stock options).
For an inversion to be advantageous, the present value of the corporate tax reduction must be larger than the capital gains tax payments. When the reduction in the effective corporate tax rate is modest, those shareholders who purchased the stock near the current market price and thus have little individual capital gain to be taxed are net winners while longer-term shareholders who purchased the stock at a price much lower than the current market price, and thus have large capital gains, are net losers.
The authors study 73 inversions that occurred from 1983 to 2014 for which equity price data are available. Using historical price and turnover data for the 73 inversions, the authors estimate returns for the average, median, 10th percentile and worst-off shareholder. For those investors who had owned stock for five years or more and whose firms had 35 percent foreign earnings, the average return (in the worst 10 percent of the distribution of inversions) was -2.21%.
So if many long-term shareholders lose from inversions, why do they occur? The authors focus on the difference in returns to CEOs and long-term shareholders. The return earned by CEOs of inverted companies is different than the return of average shareholders because the CEOs have options rather than stock and the difference between the option strike price and market price is not a capital-gain taxable event. In their data, the average CEO had capital gains of $1.3 million and paid a capital gains tax of $538,000, but they also had increased value of options of $530,000.
In many circumstances, the CEO has incentives to invest that are not well-aligned with long-term shareholders. The authors show that the higher the option compensation of a CEO, the greater the likelihood of an inversion, controlling for industry and year fixed effects, normal firm characteristics, as well as the foreign share of taxes.
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|Title Annotation:||Working Papers|
|Author:||Van Doren, Peter|
|Date:||Jun 22, 2016|
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