The US federal government may be threatened to lose billions of
dollars in revenue. A joint congressional committee on taxation
estimates the U.S. Treasury may lose $19.5 billion over the next
decade. On the other hand, the corporate houses, which may include
some of your favorite stocks, are strategically well placed to save
those billion bucks. The common reason for these is tax inversion.
Simply put, this latest trend is US corporate houses acquiring
offshore companies in nations that offer lower tax rates. By
acquiring the foreign companies, these US firms are shifting their
legal homes and thereby chopping the tax bills.
The global merger & acquisition (M&A) activity clocked a
seven-year high. Recurrent foreign acquisitions by U.S. companies
indicate that tax inversion is one of the major reasons behind the
spike. The US corporate income tax rate is the highest in the
industrialized world and thus it is logical for the US firms to
find alternative sources whereby they can limit their tax burden.
No matter what it costs to the treasury, trimming the tax burden
will eventually help US firms have more cash in their pocket. This
additional cash along with advantages like boosting a product
portfolio or adding skilled workforce through acquisitions should
help these firms do better. Eventually, this should get reflected
in their stock prices as well.
Mutual funds holding these stocks in their portfolio should thus
experience solid uplift in the near term.
However before we pick the likely gainers, let us dig a little
deeper into the subject.
What Is Tax-Inversion?
Medtronic, Inc.'s (MDT) $42.9 billion acquisition of its Irish
competitor in surgical technologies and global healthcare major
Covidien plc (COV) is a good example of the tax inversion process.
The deal was an effort to offset the impact of the high U.S.
corporate tax rate by shifting Medtronic's tax base overseas.
A tax inversion involves the acquisition of a foreign company and
subsequently adopting its home country's domicile. Alternatively,
the combined entity can create a holding company in a country where
the tax rate is lower.
Healthcare Sector Taps Most of the Opportunity
We note that the trend of tax inversion has been mostly prevalent
in the healthcare sector. Medical devices and pharma companies are
rapidly buying foreign competitors. It is usually easier for a
large corporation to purchase small companies than to develop new
drugs indigenously. Also, the market for drugs is truly global.
Thus the advantages are huge in addition to offloading the tax
Many large US pharma companies already have considerable
international revenue base. Tax inversion will further increase
their international presence. A strong European pharma sector also
makes for several potential targets.
Apart from Medtronic, Mylan, Inc. (MYL), Actavis plc (ACT), Salix
Pharmaceuticals Ltd. (SLXP) and Jazz Pharmaceuticals (JAZZ) are
among the other players in the pharma space reaping the benefits.
Pharma, Biotech M&As Heat Up: Tax Inversion in
U.S. Charges Highest Tax, UK a Favored Spot
One cannot completely blame the U.S. firms for looking for
opportunities to evade taxes in U.S. According to Organization for
Economic Cooperation and Development, the combined tax rate
(including federal corporate income tax and estimates for state and
local rates) in U.S. is 39.1%. That is the highest among the OECD
On the other side of the pool, U.K. offers a 21% tax rate. Ireland
is the lowest with a tax rate of 12.5% while Slovenia, Poland and
Hungary follows with rates of 17%, 19% and 19%, respectively.
The 21% tax rate in UK is attractive to many of the U.S. firms.
Moreover, the location, language and lifestyle in Britain is also
drawing the interest of American firms. Robert Willens, corporate
tax adviser, told The Wall Street Journal that "Right now, it's
safe to say that the U.K. is the preferred country of destination
for inverted companies, given the favorable tax regime and the
non-tax attractions of the U.K.".
The best example here is AbbVie Inc.'s (ABBV) move to shift its
legal home to U.K.
AbbVie-Shire Acquisition: The Biggest on the
Fueling debate on the tax inversion, AbbVie and Shire (SHPG)
reached an agreement last week for the proposed acquisition of the
latter. Valued at approximately $54.5 billion, the AbbVie-Shire
deal features among the top 50 inversions to take place in the last
10 years. (Read:
AbbVie Set to Acquire UK-Based Shire in Q4
Chicago-based AbbVie is expected to trim its overall effective tax
rate to 13% in 2016 from 22.6% last year by reincorporating in
British island of Jersey. The popular tax-haven Jersey has a 0%
standard corporate tax rate.
Not only the tax exemption, but a boost to the product portfolio is
seen as one of the advantages of the deal. Richard Gonzalez ,
AbbVie Chief Executive, said: "The proposed transaction would
create a well-positioned and focused biopharmaceutical company,
giving us the opportunity to expand and augment our product
portfolio, advance our pipeline, accelerate our growth, and create
long-term value for our shareholders".
Mylan, Walgreens Join the Strategy
The same week, Mylan's $5.3 billion all stock deal with Abbott
Laboratories (ABT) emphasized an increasingly important driver of
M&A activity this year. Mylan will become part of the new
company, organized in Netherlands. The deal will help Mylan cut its
tax rate to 20-21% in the first full year and thereafter to high
teens. The deal is expected to result in over $200 million in
pre-tax operational efficiencies by the end of third year.
Walgreens Co. (WAG) too is being made a part of the strategy.
Walgreens had bought 45% equity interest in Alliance Boots GmbH for
$6.7 billion. Starting Feb 2, 2015, it may purchase the remaining
55% over a six-month period. Reportedly, Walgreens investors have
been demanding the drug retailer to shift base to Europe; again to
cut the corporate tax burden. (Read:
Will Walgreens Relocate to Europe?
Obama: Unpatriotic Tax Loophole
Given the flurry of such deals that may cost the government
billions of greenbacks, US President Barack Obama has now stepped
in and termed the inversions as "unpatriotic tax loophole". The
President is believed to have urged Congress to pass a legislation
that would restrict domestic companies from saving taxes by
shifting legal bases to other nations.
The Obama administration's proposed legislation carries the
effective date as Jan 1, 2015. However, Jack Lew, the US Treasury
Secretary wants it to be made retroactive to May 2014.
In fact, in a journal for accountants and tax lawyers,
, former Treasury official Stephen Shay noted that Obama may invoke
a 1969 tax law. The White House may fix the loophole without
Jacob Lew: Reform the Business Tax Code
Treasury Secretary Jacob Lew is also focused on the tax inversion
trend and believes that Congress needs to emphasize banning the
inversions and then look into reforms. He said: "It is so important
that we reform our business tax code to make the U.S. economy more
competitive and to accelerate economic growth and job creation… But
one particular tax loophole has become increasingly urgent to
address: the fact that the law rewards U.S. corporations with
substantial tax benefits when they buy foreign companies and
declare that they are based overseas".
The White House is said to be not against mergers, but they need to
be for economic efficiency rather than being an escape route from
paying higher taxes.
Jacob Lew believes tax reforms will still have opportunities for
U.S. firms to find countries 'with near-zero rates'. "By moving
their tax homes overseas, these companies are making the decision
to reduce their taxes, forcing a greater share of the
responsibility of maintaining core public functions on small
businesses and hardworking Americans," he said.
"Our tax system should not reward U.S. companies for giving up
their U.S. citizenship, and unless we tackle this problem, these
transactions will continue," said Jacob Lew.
Nobel laureate economist Paul Krugman too has been critical of tax
inversion. He said that US firms are "shirking their civic duty"
through inversion deals.
A Boost for the Stock Prices
Mergers themselves boost investors' returns. Stock prices usually
go up on acquisition news. Through this year we have seen even the
broader indices moving up on several instances following
Moreover, when one adds the inversion deals, the advantages are
definitely more for investors. As mentioned earlier, more cash in
the pocket and higher profits for corporate houses should be
reflected in the stock prices as well.
How Can Investors Earn More?
Nonetheless, it is also risky to play the M&A rush and more so
the inversion trend. Investors should learn a few tricks before
betting their bucks.
The primary rule should be identifying or focusing on a particular
sector. Looking at the inversion trend, the healthcare sector has
been the dominant player, for reasons which we already discussed
earlier. Thus, it might be prudent to focus on this sector. ICON
Healthcare Fund's portfolio manager Scott Snyder notes that "Tax
inversions have poured gasoline on the fire".
Here, Morningstar analyst David Krempa notes that investors should
be avoiding broad healthcare funds and instead focus on the ones
that allocate assets to biotechs and specialty pharmaceutical
firms. SPDR S&P Pharmaceuticals ETF (XPH) for instance is
equal-weighted and has larger exposure to smaller firms. These
firms are more prone to be acquired.
Investors can also take advantage by employing merger arbitrage
strategy in their portfolio. This strategy looks to tap the price
differential (or spread) between the stock price of the target
company after the public announcement of its proposed acquisition
and the price offered by the acquirer to pay for the stocks of the
target company. Investors should go long on the target or acquired
company and short on the acquiring company. When the deal is
completed, shares of the target company will increase to the full
deal price (in some cases slightly below the deal price), giving
investors a decent profit. (Read:
Merger Arbitrage ETFs in Focus on Rising Deal
Healthcare Funds to Buy
Let's take a look here at some healthcare mutual funds that are
worth betting on. These funds sport a
Zacks Mutual Fund Rank #1 (Strong Buy)
. Remember, the goal of the Zacks Mutual Fund Rank is to guide
investors to identify potential winners and losers. Unlike most of
the fund-rating systems, the Zacks Mutual Fund Rank is not just
focused on past performance, but the likely future success of the
ICON Healthcare Fund Class A
(ICHAX) invests most of its assets in equities from the healthcare
industry. These equities may include common stocks and preferred
stocks and can range from small to large market capital firms.
AbbVie Inc is among the top 10 holdings and ranks sixth. The top 3
holdings are Johnson & Johnson (JNJ), McKesson Corporation
(MCK) and Celgene Corporation (CELG).
The fund has returned 13.4% year to date and currently carries a
Zacks Mutual Fund Rank #1(Strong Buy)
ProFunds Pharmaceuticals UltraSector
(PHPSX) seeks daily returns which are 150% of the daily return of
the Dow Jones U.S. Pharmaceuticals Index. To achieve the desired
results, it invests in a mix of securities and derivatives. The
balance of the fund's assets is utilized to purchase money market
Companies such as Pfizer, Merck, Allergan, Actavis, Forest
Laboratories and Mylan feature among the top 10 holdings.
The fund has returned 16.4% year to date and currently carries a
Zacks Mutual Fund Rank #1(Strong Buy)
Fidelity Select Health Care
(FSPHX) invests the majority of its assets in companies whose
principal operations include production, design and sales of health
care or medicine products and services. The fund focuses on
acquiring common stocks and purchases both domestic and foreign
Actavis, Covidien and Shire feature among the top 10 holdings.
The fund has returned 16.8% year to date and currently carries a
Zacks Mutual Fund Rank #1(Strong Buy)
To view the Zacks Rank and past performance of all healthcare
mutual funds, investors can
click here to see the complete list of funds
About Zacks Mutual Fund Rank
By applying the Zacks Rank to mutual funds, investors can find
funds that not only outpaced the market in the past but are also
expected to outperform going forward. Learn more about the Zacks
Mutual Fund Rank in our
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View All Zacks #1 Ranked Mutual Funds
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MEDTRONIC (MDT): Free Stock Analysis Report
COVIDIEN PLC (COV): Free Stock Analysis Report
MYLAN INC (MYL): Free Stock Analysis Report
ACTAVIS PLC (ACT): Free Stock Analysis Report
SALIX PHARM-LTD (SLXP): Free Stock Analysis
JAZZ PHARMACEUT (JAZZ): Free Stock Analysis
ABBVIE INC (ABBV): Free Stock Analysis Report
ABBOTT LABS (ABT): Free Stock Analysis Report
WALGREEN CO (WAG): Free Stock Analysis Report
SPDR-SP PHARMA (XPH): ETF Research Reports
JOHNSON & JOHNS (JNJ): Free Stock Analysis
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