Covidien (COV) surged to a 52-week high of $86.75 per share on June 16, after rival medical device manufacturer Medtronic (MDT) announced it would buy the Irish company for $42.9 billion in a cash-and-stock deal. The combined company would have its executive offices in Dublin, but it would continue to stage most of its operations in Minneapolis, where Medtronic employs more than 8,000 people. Similarly, although Covidien is run from Mansfield, Massachusetts, it’s been incorporated in Ireland since 2009.
Why? It most likely comes down to the fact that the U.S. government has the highest corporate tax rate among developed nations at 35 percent. That’s what has many health care companies moving to Ireland. Or, at least, moving just enough of their operations there to avoid paying taxes in the United States.
Medtronic Not Alone
On top of Medtronic, there are more than 40 American companies that currently reincorporate in foreign countries or have plans to do so. In a recent wave of big moves, many health care companies have considered moving enough of their operations overseas to benefit from Ireland’s attractive 12.5% corporate tax rate.
Pfizer (PFE) , the largest U.S. drug maker, tried to acquire AstraZeneca (AZN) with a $117 billion bid in May 2014. The N.Y.-based company was seeking to lower its tax rate through the deal by moving its official headquarters to London, where AstraZeneca is based. While Pfizer was also planning to gain from AstraZeneca’s experimental immune therapy cancer drugs, a new class treatment that would have filled a hole in Pfizer’s product portfolio, it also seems certain the tax benefits were a major motivator.
The Pfizer deal failed when AstraZeneca shareholders balked at what they considered a low price for the company despite the deal having had the potential to be the largest inversion to date, but there have been plenty of other successful inversions involving multi-billion dollar valuations.
The pharmaceutical company Actavis (ACT) moved from New Jersey to Ireland by taking over Irish company Warner Chilcott in 2013, and then acquired Forest Labs of New York for $25 billion earlier this year. In December 2013, The Perrigo Company (PRGO) , the largest maker of private label over-the-counter medicines in the U.S., completed the acquisition of Elan Corporation for approximately $8.6 billion. The new combination will, undoubtedly, locate in Ireland, a move that would reduce its effective tax rate from 23.2 percent to 17percent and chalk up $150 million in annual savings. And Jazz Pharmaceuticals Inc. (JAZZ) moved from Palo Alto to Ireland after purchasing an Irish specialty drug maker Azur Pharma in 2011.
Taxes Motivating Overseas Moves
The “death and taxes” adage is appears to be applicable here. But while these companies can’t completely avoid paying taxes, they will certainly do whatever they can to avoid paying any more than they have to.
In the cases above, the companies all claimed that they would have more opportunities to further their international platform in a low-tax environment, especially via an Irish legal domicile (a territorial tax system) that would serve as an international hub. These transitions are made in the name of “protecting shareholders’ interests.” But is it true?
Takeovers by U.S. companies in low-tax environments have doubled in proportion to all overseas deals according to data compiled by Goldman Sachs Group Inc. analysts. The desire for such an arrangement, know as a tax inversion, is the main factor.
One big advantage of a tax inversion deal, except a lower statutory tax rate, is that deals can become more affordable. Once inverted, companies can more-easily use overseas cash to pay for a deal, and the earnings from any acquired company will also be taxed at the new lower rate.
As for Medtronic and Covidien, both companies have struggled to grow as hospitals and insurers push to control costs. In the U.S., the Affordable Care Act has put even more pressure on medical centers to work more efficiently and reduce repeat hospital admissions. Medtronic has struggled since 2010 with declining sales in its two major segments, including heart rhythm devices and spinal products for emerging questions about their safety and overuse.
“While the Covidien deal revolves around the tax advantages, Medtronic will gain by changing its legal residence to Dublin, that’s a part of a bigger strategy aimed at breaking loose from its historic dependence on heart pacemakers and defibrillators,” said Medtronic’s CEO Omar Ishrak in a conference.
Why Pharmaceutical Companies are on the Crest of this Wave
Similar transitions do happen in other industries. Global offshore contract driller Rowan Companies (RDC) moved its legal domicile to the United Kingdom in 2012, partially because the ability to remain competitive with the global effective tax rates of its peers. Insurance broker and consulting firm Aon Corp. (AON) moved from Chicago to London to be closer to the world’s largest insurance market and to benefit from a tax system where worldwide income is not taxed.
But why do so many of these deals involve pharma companies? These companies have seen years of consolidation among their customers, including hospitals and physician groups, and there has been a wave of mergers between hospital systems, as well as between hospitals and the practices of independent surgeons, over the past several years. As a result, hospitals have gained greater negotiating power with suppliers.
Pharma companies, in particular, prefer Ireland as their new home because the Green Isle boasts an encouraging tax regime for pharmaceutical manufacturers.
Another reason is that the Irish government provides a forum for good manufacturing practice-compliant sites with comparatively modest fees, a priority for most pharma companies looking to ensure cost-savings amid expiring patents.
Governments Unlikely to Stand Idle
The Irish government has begun to worry about the popularity of tax inversions. The country’s pillar of development policy may be used for purposes for which it was not intended, thus undermining Ireland’s insistence that it is not a tax haven and making it more difficult to defend its economic system in an international environment that is in the process of turning seriously against tax avoidance. The Irish authorities believe that the inversion trend is “push rather than pull”, implying that the high rate of U.S. tax rather than the low rate of Irish tax is driving the shift.
For the U.S., the trend threatens billions of dollars of tax revenues and raises “significant policy concerns,” in the words of the U.S. Treasury. Since 2010, U.S. purchases into the low-tax environments accounted for 15 percent of all overseas transactions with a value of $250 million or more, according to Goldman Sachs’ data. Without any changes in law, future deals will cost the U.S. an estimated $19.5 billion in tax revenue over the next 10 years.
As such, the federal government isn’t likely going to ignore these mergers forever. President Barack Obama has already made a proposal that would make inversion deals tougher. A U.S. company currently must buy a foreign company whose market value is at least 20 percent of the combined company, but President Obama’s proposal would raise that limit to 50 percent. In addition, Sen. Carl Levin (D-Mich.) and Senate Finance Chairman Ron Wyden (D-Ore.) both claimed in May that they plan to propose legislation that might curtail such deals.
Change in the Near Term Seems Unlikely
However, there’re little chances for doing any tax reform advancing in the near future. Any reform would likely have to include changing the rates paid by individuals and small businesses as well, and any changes to the tax system represent a political challenge that currently seems impossible to overcome.
In other words, companies like Medtronic and Covidien still have time to consider their escape from the U.S. tax system carefully.