The United States tax code is fueling Pfizer, Inc.’s $98.7 billion bid to take over the London-based pharmaceutical company AstraZeneca. If the deal goes through as proposed, a new parent company in Britain would own the combined entity, making it easier for the new firm to strip income out of its American tax base. The deal is one of several recent transactions known as “inversions,†where a multinational company like Pfizer, based in New York, becomes an expatriate by acquiring a smaller foreign target.
Inversions are especially popular these days for pharmaceutical and biotechnology companies, where most of the value of the company is found in tax-mobile intangible assets. Recent examples include Valeant Pharmaceutical’s acquisition of Biovail, a Canadian company, and Endo Health Solutions’ acquisition of Paladin Labs, another Canadian company. Ireland is another popular haven: the pharmaceutical company Actavis moved to Ireland by way of merger with Warner Chilcott, setting up the expatriation of Forest Laboratories through a merger with the now-Irish Actavis. While the tax treatment of shareholders in the United States in inversions varies â€" they are sometimes taxed on built-in gains at the time of inversion â€" the underlying tax motivations for these deals are consistent.
The United States tax code creates two reasons for these sorts of deals: OK? (1) American corporations must pay tax on worldwide income, not just income in the United States, and (2) American corporations may defer tax on most income from foreign sources until the income is repatriated to the United States.
The first factor â€" worldwide taxation â€" means that American multinationals have an incentive to give up their United States citizenship. Most countries have adopted a territorial system, giving up any tax claim on income from foreign sources. After an inversion, therefore, the new entity pays tax to the United States only on income from the United States. According to the Pfizer news release, the inversion “would not subject AstraZeneca’s non-U.S. profits to U.S. tax,†something the company said would be in the best interests of the combined company’s shareholders.
Left unsaid is that the merger means that Pfizer, like AstraZeneca, will avoid American taxes on foreign profits. Also left unsaid is that for most American multinationals, a lot of income from foreign sources is really American income in disguise. Most large multinationals use aggressive transfer pricing and other techniques to strip income out of the United States. Martin A. Sullivan of Tax Analysts wrote last year that “although Pfizer’s shares of worldwide profits and sales have both been growing, the company’s profits are disproportionately concentrated outside the United States relative to sales.†From 2008 to 2012, he found, 124 percent of Pfizer’s pretax profits came from foreign sources, while only 57 percent of its sales were overseas. Those figures suggest that Pfizer is already artificially shifting profits overseas.
Joan Campion, a spokeswoman for Pfizer said in an email that because “there is no specific offer or consummated transaction at this point, we would not speculate on the potential effects of a possible transaction.†She added that the potential transaction has a number of financially attractive elements, including operating under a more efficient tax structure.
The second factor â€" deferral â€" means that companies like Pfizer have a lot of overseas cash available. Multinationals keep foreign profits overseas to avoid the repatriation tax, and the cash needs somewhere to go. In its most recent annual report, Pfizer reported $69 billion in foreign profits indefinitely reinvested overseas, and each year’s profits generate more cash. Acquiring a foreign company is a tax-efficient use of cash.
From a policy perspective, the problem goes beyond lost tax revenue. In his seminal article, “The Nature of the Firm,†the economist Ronald Coase argued that the boundaries of the firm depend on what is known as the make vs. buy decision. If the costs of making a product inside the firm are less than the costs of contracting out, the company will make the product, not buy it. The advantage of contracting outside the firm is the access to the invisible hand of the marketplace, which helps the firm allocate resources more efficiently. The disadvantage is that it introduces search costs, raises information costs, creates costs for negotiating and enforcing contracts and other transaction costs. The boundaries of the firm are set at the point where the benefits of the market are outweighed by these transaction costs. In this way, according to Mr. Coase and most economists, firms make the most of the invisible hand of the market and allocate economic resources to their highest and best use.
But taxes distort this Coasean view of the boundaries of the firm. We don’t know if Pfizer is targeting AstraZeneca because the combined firm will be more efficient or because of the tax savings.
It’s tempting to look at the Pfizer deal simply as a loss for taxpayers in the United States. But it’s worse than that. A Coasean perspective is useful because it focuses attention on how taxes distort “real†(nonfinancial) management decisions, like how to organize a firm, whether to buy or make major aspects of production, where to locate assets and production functions inside the firm, and how and where to reinvest profits. Because reinvested profits are taxed more lightly than distributed profits, taxes may often have the effect of causing firms to grow larger than is economically efficient.
But the clearest distortion is not size, but location. For multinational corporations based in the United States, taxes create an incentive to expand overseas operations by opening foreign subsidiaries, expanding foreign operations and acquiring foreign companies. Unlike a pure tax shelter, which generates paper losses to avoid taxes, the effects of tax expatriations are real. Taxes distort the organization of corporate activities and shift operations outside our borders.
The silver lining here is that the Pfizer deal, which would be the largest expatriation in United States history, may jolt Congress into action.
