As pointed out in an article on the Accounting Today website, The Attraction of Inversions, by Roger Russell, since 1982 about 51 U.S. corporations have “restructured” their corporate offices from the U.S. to Ireland, or some other lower-tax jurisdiction, presumably to reduce their tax obligations.
Such a move reduces corporate taxes because the company will no longer have to pay income taxes in the U.S. on foreign-sourced earnings. Of course, after such an “inversion,” they will continue paying U.S. income taxes for U.S.-based earnings.
Certainly, one would anticipate that such an action would have a net benefit for a restructuring company’s shareholders. However, academic research suggests that, contrary to expectations, as a result of a corporate inversion, the restructuring company’s long-term U.S. shareholders might actually experience a net wealth loss, particularly at the inception of the inversion.
A working paper by Anton Babkin, Brent Glover, and Oliver Levine (SSRN 2015) finds some evidence that the main beneficiaries of corporate inversions are: corporate chief executive officers (“CEOs”), and non-U.S. investors, presumably living in low income tax jurisdictions.
However, the authors conclude that, for longer-term U.S. shareholders, the net benefits of a corporate inversion would be much lower than for the beneficiaries mentioned above. In fact, some of these long-term U.S. investors might actually experience a net loss rather than a net gain.
According to Babkin et al.’s paper, when a company enacts a corporate inversion, its U.S. shareholders must pay U.S. capital gains taxes on their stock holdings, even if they continue to hold onto their shares. Additionally, some long-term investors might incur a capital gains tax bill that exceeds any wealth gain from the stock price increase associated with the inversion.
As compared with non-executive shareholders, corporate CEOs could experience a significant financial gain as a result of the inversion.
Under U.S. income tax laws, an individual’s investment in unexercised stock options, which often is a significant component of a corporate CEO’s compensation, are exempt from capital gains tax until such options are exercised. So, as explained by Babkin et. al:
“…an increase in the share price resulting from the inversion will increase both the value of the CEO’s stock and options, but only the stock portion will incur the capital gain[s] tax penalty. Using data on the option and stock holdings of each CEO in our sample of inverting ﬁrms, we show that the model-implied wealth eﬀect is signiﬁcantly positive for the CEO. The increase in the value of the CEO’s options exceeds the capital gains tax bill imposed by the inversion. In addition, we ﬁnd the tax basis for the CEO’s stock holdings is signiﬁcantly higher than for long-term shareholders, making the capital gains tax less costly than for many investors. (page 2: Emphasis added)”
Of course, in subsequent periods, the non-executive shareholder will have an opportunity to benefit from reduced taxes paid by the corporation, which can be used to make successful strategic investments and to reduce outstanding debt obligations. And, I’m sure in some instances, the favorable wealth effect accruing to the shareholder post-inversion will exceed any initial net loss associated with the inversion.
However, Babkin et al.’s conclusions should give shareholders and their associated corporate boards of directors “food for thought,” particularly when a corporate CEO proposes a “tax savings plan” featuring initiating a corporate inversion.