Threats to the overall economic outlook still loom (see: renewed Grexit fears), but 2014 marked a strong, double-digit return for most U.S. indices. As the new year begins, markets are full of speculation regarding the effects of Janet Yellen’s conclusion of quantitative easing and the recently-announced European stimulus plan. Will 2015 provide a sixth straight year of U.S. growth?
It is important to note areas that drove last year’s results. Among the most notable growth stories of 2014 was the significant uptick in Merger and Acquisition (M&A) volume providing significant company expansion, synergies, and capital. As we have already seen in the initial days of 2015, M&A activity is surging ahead. The question must be asked: is this resurgence an economic boon or a sign of bad public policy?
One of the main drivers of 2014 mergers was the attractiveness of reincorporating overseas to mitigate the substantial U.S. corporate tax burden, a practice known as an inversion. Corporate domestic rates are close to 40 percent, a rate widely regarded as woefully uncompetitive. Corporations have found a solution through acquiring an overseas firm and restructuring their businesses accordingly. Put simply, by relocating to a ‘corporate haven’ businesses are able to reduce massive tax expenses without having to move material operations centralized in a higher-tax country.
The prevalence and magnitude of inversions is most clearly highlighted in Actavis’ $66 billion acquisition of Allergan last year. Leading up to the deal, Allergan was fleeing a hostile takeover by the pharmaceutical giant Valeant. Valeant had sought to slash Allergan’s R&D budget in order to inorganically prop up their balance sheet with capital. Allergan, advised by Goldman Sachs’ strategy and defense team, developed an “anyone but Valeant” approach, and went about the business of acquiring suitors.
The Dublin-based Actavis was an attractive buyer for Allergan for many reasons. But one incentive looms large: Ireland’s 15 percent corporate tax rate. This lowered tax burden will allow Allergen to slash costs over 20 percent annually. Quite simply, it’s a rational choice for a profit-maximizing firm. By finding a buyer possessed of similar corporate values and a much lower tax burden, Allergan has given analysts confidence to estimate a market cap of $128 billion for Actavis. In addition, synergies from the deal, an idea that approximates the combined benefits of two companies joining rather than remaining separate entities is estimated around $1.8 billion.
Another reason for the increased volume of inversions is attributed to historically low interest rates. In the case of Actavis’ buyout of Allergan, Actavis issued $27.5 billion of new debt in order to finance the deal. With low interest rates driving down cost of capital, the incentive has never been higher to issue debt. With the 10-year Treasury note down almost 35 percent over the last year alone, interest rates have continued to foster expansion and promote inversions.
It seems apparent that inversion can be a successful business strategy. After all, government policy in the U.S. doubly incentivizes it, through high tax rates and low interest rates. Recently however, President Obama and others have proposed to crack down on the practice. Already stricken with over $18 trillion in national debt, the government is losing tax revenue to inversions. The Wall Street Journal estimates lost tax revenue at close to $20 billion over a decade. To actually cut down on inversions and reap the resulting tax receipts, policymakers should consider the driving cause of the practice: rational incentives, not nefarious profiteering.
As 2015 progresses, keep the Allergan-Actavis deal in mind. Inversions are setting up as a corporate policy battleground. Time will tell whether inversions, and the response to inversions, will bolster or hamper economic recovery.
—Austin Summers is a sophomore studying finance
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