Understanding the Term “Tax Inversion”
Pfizer and Allergan are merging to become the behemoth of the pharmaceutical industry. A big reason for this merger is taxation: Allergan, the lower taxed Irish company, will absorb Pfizer, the more heavily taxed US company. This type of transaction is called a tax inversion, and I am writing this article to help explain what this, and the related concepts of corporate governance and corporate taxation, means.
First, let’s talk about a corporation. A corporation is a legal entity that can own assets and enter into contracts with other parties for the purpose of an enterprise owned by many individuals. The corporation is the legal representation of ownership by several parties. How much each party owns of the enterprise is determined by the number of shares they own in the company.
For example, if the company has 1.000.000 shares of ownership outstanding, and I own 300.000 of those shares, then I own 30% of the company. All of these shareholders, despite being owners, can’t be involved in every operational decision of the company (that’d be havoc). So these shareholders vote on a group of people called the board of directors, whose job it is to find people to run the enterprise to the liking of the shareholders. And if not, the shareholders will vote them out.
The board will appoint people to positions such as the “chief executive officer” and the “chief financial officer”, and set compensation for them. If shareholders feel the person is not worth the salary, they can vote out the board as recourse.
In assessing the performance of a corporation, there are three main financial statements:
Balance sheet: a snapshot of the company’s assets and liabilities. This is where you find the company’s net worth.
Income statement: shows the revenues and expenses of a company over a period of time. The money left over is called earnings/net income/profits.
Statement of cash flow: cash going in and out of the company in its operating, financing, and investment activities. Public companies create these statements for the public in quarterly report (10q) and its annual audited report (10k).
The Income Statement
The financial statement that is important for understanding a tax inversion, is the income statement. This is what one would look like:
Revenue/sales from the reporting period
– minus cost of goods sold (unit costs)
= gross profit
– operating costs (payroll/utilities/rents)
= operating profit
– interest expense (for the debts of the company)
= earnings before taxes (this is the portion of a company’s profit that is taxed)
– tax expense
= net income/earnings
Net income is what people refer to as the “bottom line” when they say “it’s all about the bottom line.” Net income is the money that can be paid to shareholders and/or reinvested into the company in order to grow the company.
So if you’re the CEO of the company you are sensitive to earnings, because angry shareholders mean changes in management.
How do you increase earnings by increasing revenues or making any of those subtractions a smaller number:
– Reducing the costs in producing your good or service;
– Reducing the cost to operate by cheaper rents, less payroll, cheaper vendor costs;
– Reducing the debt-reducing interest on that debt;
– Reducing the amount of taxes the company pays.
A corporation gets taxed based on where the corporation is incorporated, not necessarily where its operations occur. So a company in Ireland can have US offices and US-based employees, but still pay the Irish tax rate. When one corporation merges with another it gets taxed at the rate of the remaining corporation (Allergan in this case, thus paying Irish taxes).
Does this mean jobs move? Not necessarily. It depends on how much they merge the companies operationally. If they are merged legally they may still operate independently as they do now.
The top rate for use taxes is 39%.
It’s completely rational for companies to seek a lower tax burden, although of course it’ll always raise the ire of the political elite, feeling sore over the loss of tax revenue.
Do politicians have a right to be cross? I don’t think so. These companies are generally providing goods and services, and companies have a responsibility to their customers and to their shareholders. They don’t have a responsibility to governments who want to sneak extra tax income beyond the sales tax from the commerce they bring in and income tax their workers pay.
If countries want more companies to be domiciled within their jurisdictions, they should lower their tax rates.
If they aren’t bringing in enough tax income they should take a good hard look to see if every social or military contract is as necessary as their contractors and lobbyists will argue they are. Is every dollar of corporate subsidies and foreign aid truly well spent?
Government won’t ask these questions unless it has to, and the more inversions there are, the closer we get some level of introspection from policymakers.
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