John R. Graham , Contributor
A Goldman Sachs research note explains the stakes in the current spate of tax-inversion deals by U.S. firms taking over foreign targets. Most of the listed firms in the pharma, bio, and medical-device industries have over half their sales outside the U.S. Because of our horrific corporate tax code, they end up with incredible chunks of cash overseas. Eli Lilly, for example, has 89 percent of its cash overseas. Edwards Lifesciences EW +0.17%, Amgen AMGN -1.39%, Merck , Varian, Covance, Baxter, and Abbot all have at least 80 percent of their cash offshore.
Because they cannot bring the cash back home without greedy politicians getting their hands on it, these firms’ ability to invest in the U.S. is limited. The solution, many appear to be discovering, is “tax inversion,” whereby the U.S. firm consolidates with a foreign company, and establishes its head office abroad. Despite the assertion that the U.S. corporate-tax code is so riddled with loopholes that none pay the 35 percent rate, the Goldman Sachs note shows that firms in the healthcare industry suffer quite high effective tax rates. Pfizer PFE +0.73%, for example, is estimated to have a 27 percent tax rate in 2014. Varian Medical Systems’ is estimated at 28 percent; and Cubist Pharmaceuticals’ CBST -4.84% at 36 percent.
Having a headquarters overseas might not look like that big a deal if most of the capital invested and workers remain in the U.S. Covidien, for example, has 14,000 employees stateside and only 1,400 in Ireland. Shire Pharmaceuticals has 1,500 workers in the U.S. and only 100 in Ireland. However, the problem is that there is a limited capacity for tax inversions.
As explained by the Goldman Sachs team, the newly consolidated company has to have a minimum 20 percent foreign ownership to qualify for tax inversion. That means that that target has to have a market cap at least 25 percent that of the U.S. bidder – and that is only if the deal is fully financed by equity. For example, a U.S. company with a market cap of $300 billion (e.g. Johnson and Johnson), needs a target with at least a market cap of $75 billion to meet the threshold. If it wanted to pay for the deal half with equity and half with cash, the size of target would have to be at least $200 billion to make the grade. (And, the short-term point of the tax inversion is to get rid of excess cash. A deal fully financed with new equity would likely entail yet more transactions, e.g. special dividends or share buybacks.)