Merger With Covidien Provides Address in Ireland, but Tax Implications Are Complex
Reaping the benefits of tax inversion isn’t as straightforward as many think.
Through its $42.9 billion merger with Covidien COV +1.13% PLC, Medtronic Inc.MDT +0.86% will gain an Irish address, a lower overall tax rate and more overseas cash to spend in America without paying U.S. taxes. But at least initially, the new cash flow will come only from surgical-tools and hospital-supplies maker Covidien, whose overseas profits have always rested outside the U.S. tax net, Medtronic said.
To free Medtronic’s future international earnings from the U.S. tax net is complicated, and would require additional maneuvering, tax experts said. Medtronic is one of the largest global makers of heart and spine implants.
It is a common misconception that a tax inversion—in which a U.S. company reincorporates abroad—automatically removes that company’s future earnings from the reach of U.S. tax authorities.
In fact, an inversion is typically just the first step in a series. Tax experts say inversions are a long-term play aimed at gaining access to profits from still-in-development product lines and new acquisitions, not a quick fix to get access to overseas cash from existing revenue sources.
“These companies are betting on future success,” Kent Wisner, a corporate tax adviser at Alvarez & Marsal Taxand LLC, said. “Some are merely setting the stage for future businesses not yet started or barely started that will be under the new foreign entity.”
Multinational companies typically create local subsidiaries in each country where they operate that are subject to their host country’s tax laws as well as the tax laws of their home country. American companies’ foreign subsidiaries are subject to U.S. taxes—typically the difference between the tax rate of the foreign country and the U.S. statutory rate of 35%—and that doesn’t change in the eyes of the Internal Revenue Service just because a company moves its tax domicile overseas, experts say.
If the new, foreign-based company—to be called Medtronic PLC—wants to transfer, say, French assets and future cash flows out from under the U.S. tax net and over to the new Ireland-based parent company, it will likely face a tax bill from the U.S. on the fair market value of those assets, Mr. Wisner said.
A company can also arrange an asset sale at fair market value between its subsidiaries without incurring U.S. taxes, said Robert Willens, a tax consultant. However, the proceeds of the sale would accrue to the U.S. foreign subsidiary, possibly defeating the purpose of inverting to escape U.S. taxes, some tax experts said.
“If we were to transfer assets from a Medtronic foreign subsidiary to Medtronic PLC or a Covidien subsidiary, it would trigger a repatriation tax on the value of the assets,” Cindy Resman, a Medtronic spokeswoman, said in an email.
That is probably not the most palatable option for a company that through April of last year hadn’t paid U.S. taxes on more than $20.5 billion of accumulated overseas earnings in foreign subsidiaries.
There are old-fashioned tax maneuvers such as transfer pricing and intercompany debt that allow companies to relocate their profits between countries to take advantage of the best tax rates, but those methods are complex and expensive and typically already available to U.S.-based companies, Adam H. Rosenzweig, professor of law at Washington University School of Law in St. Louis, said.
What a company can do to escape U.S. taxes on overseas profit after an inversion is to create new subsidiaries for new products or sources of revenue—or put them under the acquired company’s foreign subsidiaries. Profits from these new lines of business can be used to pay out dividends and other corporate purposes without being subject to U.S. taxes.
At the same time, the company would keep mature product lines and other sources of profit under the U.S.-taxable subsidiary, while continuing to maintain the resulting cash overseas in non-U.S.-taxable subsidiaries.
The company can move early-stage product lines into new U.S.-tax-exempt subsidiaries because they don’t yet generate significant overseas sales or profits, said Mr. Rosenzweig, emphasizing that he was speaking generally and not specifically about Medtronic.
The company still has to pay U.S. taxes on the fair-market value of the assets, but since the products aren’t generating much revenue, the company can argue the assets have little to no value and avoid a significant tax hit, Mr. Rosenzweig said. If the company expands into new businesses through foreign acquisitions, the overseas profits that result would also be exempt.
In this way, the new foreign-based company can “freeze” its legacy subsidiaries in time while setting the stage to avoid U.S. taxes on its next generation of products.
Eventually, the company’s old foreign subsidiaries will close up shop, he said. “To the extent these assets are mature and low-growth, they will eventually shrink as a percentage of world-wide revenue without the need to pay the ‘exit tax’ as the new foreign business.”
Medtronic, for its part, said its acquisition of Covidien was motivated primarily by strategic considerations, not taxes. Meanwhile, the new Medtronic will have access to Covidien’s $1.18 billion in cash and cash-equivalents.
“We cannot comment on any hypothetical transactions to reduce Medtronic’s tax on its offshore operations after closing, and the transaction was not premised on any such transactions,” Medtronic’s Ms. Resman said. “Going forward, we will of course evaluate the options available to us and our overall business strategy as we have always done, so as to best manage our business and growth opportunities.”
Write to Joseph Walker at joseph.walker@wsj.com
