Luke Watson

Are corporate inversions worth it?

The U.S. Treasury Department recently issued guidelines aimed at curbing the practice of corporate inversions—where American companies shift their “tax mailboxes” overseas to pay a lower tax rate.

While inversions yield a sizable and long-term tax benefit, this method rarely leads to long-term financial success, according to new research from University of Florida professor Luke Watson.

The Treasury Department has enacted restrictions on inversions twice before since September 2014, but those new rules did little to limit the practice. The Treasury’s latest actions on April 4, however, are much more stringent. These new restrictions have already nixed a $160 billion agreement for Pfizer to acquire Allergan, and could endanger other multi-billion dollar mergers.

The Treasury’s most recent actions have had two major effects. First, is limiting “serial inverters,” foreign firms that have repeatedly engaged in inversions. The second is to close the loophole on “earnings stripping.” In earnings stripping, a foreign company—now the parent company of its American subsidiary after inversion—makes a sizable loan to the U.S. subsidiary. For tax purposes, the interest the U.S. subsidiary pays on that intracompany loan is deducted from its U.S. profits and becomes taxable income to the parent company in a lower-tax foreign country, reducing that company’s overall tax burden. The same tactic can be applied to shift income out of foreign countries with high tax rates.

Watson, an assistant professor in the Warrington College of Business’s Fisher School of Accounting, said earnings stripping is the major tool companies use to achieve tax savings on inversions.

“When companies invert, they give lip service to the fact that the U.S. taxes foreign earnings, and that inverting will get them to a system where only the jurisdiction where they’re earning income taxes that income,” Watson said. “So they tout that as the real benefit. But what our research shows is that the real benefit isn’t coming from avoiding U.S. taxation of foreign earnings at all. We find no evidence of that.

“What we find the real benefit is in earnings stripping—the ability to find means to reduce the U.S. tax on U.S. earnings and reduce the foreign tax on foreign earnings.”

Watson, along with professors Stephen Lusch (University of Kansas) and Jim Seida (Notre Dame University), compared the tax savings and company performance of 10 firms that engaged in single-company inversions between 1994 and 2002 to 34 similar, non-inverted firms based on the companies’ similar sizes and industries.

They found that inverted companies reduced their effective tax rates by approximately 12 percentage points compared to non-inverted companies, and the benefit from that tax reduction continues for at least a decade. However, because of associated costs with inversions that Watson said still aren’t clear, the long-term performance of inverted firms decreased relative to their competitors.

“We find that 12-percentage point reduction is occurring every year on average. That’s big money for these companies,” Watson said. “But what’s even more interesting is these firms are experiencing inferior performance on a pre-tax basis. So there’s some kind of cost that these firms are incurring that is actually greater than the tax savings they’re getting from inverting. We are trying to identify those costs in this study, but it’s difficult. We don’t find a lot of consistent evidence for one particular cost mechanism that’s causing this deficient pre-tax earnings performance.”

Watson hopes this research will be utilized as the conversation surrounding corporate inversions heightens. While this study focuses on single-company inversions, Watson believes the effects would be similar for merger inversions.

“I think this has big implications, particularly this finding that there’s not a huge benefit in U.S. tax savings on foreign earnings,” Watson said. “That’s widely touted as the primary benefit of inversion, but we think that maybe cheap talk aimed at deflecting the real benefit which is earnings stripping. So I think policy makers could be influenced by that—that earnings stripping and the U.S. corporate tax rate should be the focus of tax reform.”

“And, for firms, this is sort of a cautionary tale. You can invert and achieve these great tax savings, but if that’s your plan, are you focusing on the right thing? Maybe these firms took their eye off the ball a little bit, and instead of making strategic decisions, they made only financial decisions.”