Merger and acquisition activity has been strong, especially cross-border deals. This type of activity is typically a confirmation of good economic trends. The transaction value of some of these deals is of numbers we haven’t seen in a long time. Cost savings, operational synergies and strategic factors are all given as reasons the deals are considered. Tax benefits are sometimes cited as one of the cost savings in the transactions, especially the large cross-border transactions.
Some recent news reports have indicated the U.S. Treasury will be impacted by some of the transactions. The U.S. may be impacted positively and negatively. There may be tax revenue if the transaction is structured as a taxable acquisition to U.S. shareholders. On the corporate side, the U.S. Treasury is impacted as a result of the transactions being structured to take advantage of the lower tax rate jurisdictions. In 2004, Congress enacted legislation intended to change the taxation of some cross-border transactions. The intent of these efforts was focused on ending corporate migrations to tax haven jurisdictions. This was often an island in the Caribbean. In 2014, it is often a country in Western Europe.
At the end of the day, should anyone be surprised U.S. companies are taking taxes into account in these merger transactions? We have discussed U.S. corporate tax rates in the past in this column and how the U.S. compares against the rest of the world in tax competiveness. The U.S. certainly isn’t in any medal contention for competitive tax rates. How times have changed. In 1986, the U.S. led the drop in corporate tax rates and has long since been passed by all of our major trading partners. The U.S. has also lagged our trading partners in the taxation of foreign earnings. Most of our trading partners exempt all or a significant part of dividends from foreign subsidiaries from corporate taxation. Many others have other incentives dealing with research activities.
The last overhaul of the U.S. Tax Code was in 1986. There have been many proposals recently to make significant changes to the Tax Code, including several by Michigan’s David Camp. Many of the proposals are in recognition of the uncompetitive features of the U.S. Tax Code and the need to have comprehensive tax reform. Unfortunately, given the current political environment in Washington, it is unlikely any major tax reform is to happen in the short term.
We have also seen the hype around Senate investigations on the tax structures of many large U.S. companies and the legal tax strategies used by those companies to reduce worldwide taxes. Many of the companies point out the company has a fiduciary duty to shareholders to take all reasonable and legal steps to maximize shareholder value. The questioning by the senators has not been pleasant for affected companies and their advisers.
The recently announced and rumored deals may serve as a wake-up call to Washington on the need for serious and comprehensive tax reform. In one of the recent deals, it was reported (based on comments attributed from company officials) that the acquisition of a U.S. company by a foreign acquirer will result in a post-transaction effective tax rate in the single digits. This low tax rate is possible, in part, to the deal structuring, and the post-transaction structuring of how and where the company conducts its business operations. Comments by U.S. Treasury officials and members of Congress in the wake of the recent deals have resulted in recognition by some of the urgent need for corporate tax reform.
A potential deal that has received significant press coverage may result in a major U.S. company being a subsidiary of a U.K. holding company when all the dust settles. Specific transaction details are not known, but many speculate the U.K. aspects of the transaction will allow tax planning to reduce U.S. corporate taxes. This may include structuring that results in significant amounts of debt being placed into the U.S. company with the resulting interest expense reducing post-transaction U.S. taxable income. Given the high U.S. marginal corporate tax rate, that savings can be significant. The interest income is taxed in the U.K. at 21 percent (nearly half the U.S. combined federal and state tax rate). Under the U.S.-U.K. Tax Treaty, interest paid by a U.S. corporation to a qualified resident of the U.K. is not subject to any U.S. withholding tax. If additional planning is implemented, that effective rate on the interest income may be reduced further.
The U.K. also offers other tax advantages over the U.S. This includes the taxation of any foreign earnings. The U.K. participation exemption regime allows foreign earnings to be repatriated free of any U.K. tax on those earnings. This differs from the U.S. where its worldwide income tax regime taxes the earnings upon repatriation to the U.S. This tax cost on repatriated earnings is why we often hear about all the offshore cash that has been accumulated and has not been repatriated back to the U.S.
Many companies with large cash tranches overseas are actually borrowing in the U.S. and getting benefit of the interest deduction against its U.S. earnings and using the borrowed funds for stock buy backs or operational needs while the overseas cash is not being repatriated to the U.S. If repatriated to the U.S., it would be taxed at the 35 percent federal tax rate (less any foreign tax credits for any underlying foreign tax paid on such earnings).
In addition, the U.K. also has an exemption from U.K. tax on the gains from the sales of subsidiaries (including foreign subsidiaries) as well as a patent box where patent income from U.K. developed intellectual property is taxed at 10 percent. Meanwhile, in the U.S., the research tax credit expired at the end of 2013 and is up for renewal. The U.K. research and patent tax incentives are considered by many to be more generous than the U.S. incentives.
The recent flurry of cross-border mergers and acquisitions may be the spark that gets the flame for tax reform moving to revamp the U.S. tax system into one that can compete going forward. The current situation offers a great opportunity for comprehensive tax reform. If nothing happens, more transactions with tax savings will likely be highlighted in the financial and main street press.
Bill Roth is a tax partner with the local office of BDO USA LLP. The views expressed are those of the author and not necessarily of BDO. The comments are general in nature and not to be considered specific tax or accounting advice and cannot be relied upon for the purposes of avoiding penalties. Readers are advised to consult with their professional advisers before acting on any items discussed herein.