U.S. tax inversions and shareholder wealth effects☆
Introduction
International tax avoidance is the corporate scandal of our time. President Trump has spoken against such behavior,1 as have many politicians in the United States (U.S.).2 In 2014, concern surrounding corporate inversions in the U.S. intensified as the combined asset value of the group of corporations that announced their intentions to invert amounted to $319 billion – this amount was larger than the combined assets of all the corporate inversions completed over the past 30 years (CBO, 2017).3 The inversion debate has America and its citizens as losers and corporations as winners. Yet many American citizens are either direct or indirect owners4 of these firms and it may be the case that, as the ultimate beneficiaries of inverting firms, their eventual gains may, in the long-run, benefit America more than the direct losses through firms inverting. With this argument in mind, our main research objective is to examine the relation between inversions and the returns to shareholders.
“A corporate inversion is a transaction in which a U.S.-based multinational group restructures so that the U.S. parent of the group is replaced by a foreign corporation, typically located in a low tax country. Such transactions allow firms to reduce their level of worldwide taxation, but in the aggregate, they function to hollow out the U.S. corporate income tax base” (Lew, 2014: pp. 1).5 The possibility of reducing the effective tax rate for inverting corporations may increase funds available to reward equity holders.6 Conversely, reducing tax and increasing earnings and, or, cash may lead to agency issues associated with free cash flow and, consequentially, adversely affect shareholders wealth.
The evidence presented in this paper suggests that, in the short-run, shareholders benefit from inversions. Our examination of 62 corporate inversions between 1993 and 2015 reveals short-term wealth effects of around 4% (depending on the benchmark used). Surprisingly, given the tax-motivation argument for inversions, when we consider the determinants of abnormal returns in a multivariate setting, the country-pair differences in the effective corporate tax rate relative to the U.S. corporation tax rate is not a significant determinant of inverters abnormal returns. We find, however, that the level of operating income prior to the inversion and the country-pair differences in the governance standards, level of economic development, geographic proximity are determinants of shareholder wealth. Theoretical and empirical literature providing information on why these variables might be significant are discussed at length in Section 3 below.
In the long-run, in contrast to the positive short-run returns, we find that shareholders experience negative returns (depending on which model is used to estimate returns). This finding is consistent with Babkin, Glover, and Levine (2017) who argue that due to agency costs the wealth of many taxable shareholders is reduced when firms invert. Examining the determinants of long-run wealth effects we find a non-linear U-shaped relation between CEO incentives and shareholder returns. The findings suggest that in order to mitigate agency costs an optimal level of CEO equity exists in order to align the interests of the CEO and shareholders leading to greater wealth effects in the long-run.
As it is challenging for market players to precisely determine the ex-ante costs and benefits of corporate inversions, examining the effects ex-post is of importance. Our study provides guidance for regulators, policy-makers and corporate decision makers seeking to discern the short- and long-run effects of inversions. Our findings highlight the effects of the non-tax costs and benefits associated with corporate inversions in determining shareholder wealth. We believe that these findings will be useful for managers considering reincorporation abroad. Furthermore, our results on the effect of section 7874(a) of the American Jobs Creation Act in reducing long-run abnormal returns associated with pure tax optimization are of interest to regulators and policy-makers seeking to inhibit future corporate inversions.
The structure of this paper is as follows. Section 2 discusses international tax avoidance and wealth effects. Section 3 reviews the theoretical and empirical literature and discusses the research hypotheses. Section 4 presents the data and methodology. Section 5 reports the short- and long-term cumulative abnormal returns and multivariate analysis examining the determinants of returns. Section 6 concludes the paper.
Section snippets
International tax avoidance and wealth effects
The United States has a worldwide taxation system and prior to 2018 had one of the highest corporation tax rates in the world, at 35%.7 Under a worldwide taxation system corporations are taxed on their business income regardless of where
Short-run cumulative abnormal returns
Literature examining corporate inversions is still developing in comparison to other areas of corporate finance, with the first tax inversion studies beginning in the early 2000's. The findings examining market responses to inversions are mixed. Desai and Hines Jr (2002) analyze the short-run market responses of corporate inversions for 19 publicly listed U.S. companies between 1993 and 2002. They report mixed evidence of the returns around the inversion announcement date and suggest that
Short- and long-run cumulative abnormal returns
To measure the market reaction to corporate inversions we conduct a short and long-run event study on 62 firms where the event date, t0, is the date on which companies announce their intention to invert.18 Our sample consists of corporate inversions listed in the Bloomberg corporate inversion tracker and Chorvat (2016). We hand-collected the inversion announcement dates from the company filings on SEC's EDGAR
Short- and long-run wealth effects of corporate inversions
Table 4 Panel A, column (3) reports the short-run CARs estimated via the market model. Results suggest that on average firms experience significant positive returns (at the 1% level) surrounding the corporate inversion announcement date of 4%, 2% and 3% for the [−5, +5], [−10, +10] and [−20, +20] daily event windows, respectively. These findings support our hypothesis H1 and are consistent with findings reported in Chorvat (2016). Panel B, presents the long-run CARs for the monthly event
Discussion and conclusion
Corporate inversion is the process by which a firm relocates its legal domicile to a lower-tax foreign country while retaining its material operations in its higher–tax home country. Examining a sample of 62 corporate inversions from 1993 to 2015 covered in the EDGAR data base and identifiable as companies, originating from the U.S. and retaining substantial material presence in the U.S., we find that in the short-run, shareholders benefit from inversions and experience wealth effects of around
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The authors declare that they have no relevant or material financial interests that relate to the research described in this paper.