How U.S. Tax Inversions Affect Shareholder Wealth

The United States had one of the world’s highest tax rates – around 35 percent – prior to the Tax Cuts and Jobs Act of 2017 (TCJA 2017, and especially the Global Intangible Low-Taxed Income (GILTI) rules in new tax code Section 951A). It also uses the country-of-residency basis for corporate taxation that subjects, at least in theory, all worldwide income earned by a corporation to U.S. tax. Corporations that receive a significant proportion of foreign income can employ corporate inversions, which lead to the U.S. parent company being treated as a foreign entity.  Those firms relocate their legal domicile to a lower-tax foreign country while continuing to operate in the U.S. thus achieving significant tax savings and generating abnormal returns (Hanlon and Heitzman, 2010; Schmidt et al., 2015).

In a recent paper, we present evidence that, in the short-term, shares of inverting companies increase in value.  In the long-run, however, their value declines.  We argue that this decline is, in part, influenced by agency costs. Our work also highlights the importance of the effective design of executive contracts, as well as the changing nature of policies for reducing, although not eliminating, the use of tax inversions to benefit companies but not necessarily their shareholders.

We conduct our analysis by utilizing an event study to examine unexpected changes in shareholder wealth, captured by cumulative abnormal returns (CARs), around corporate events (in our case, the announcement that a corporation intends to invert).  We use multivariate regression analysis to examine the determinants of changes in shareholder wealth (that is, the determinants of the CARs).

We follow previous papers in obtaining our initial sample of 62 corporate inversions between 1993 and 2015.  We examine short-run CARs over time frames ranging from five days before and after the announcement to twenty days before and after the announcement and find wealth effects of from 2.32 percent to 4.92 percent (estimates differ with the time frame studied and the benchmark utilized to calculate the CARs).  When we examine the determinants of changes in shareholder wealth, we find evidence that the tax haven status of the host country relative to the home country has a positive effect on wealth, but we do not find any statistically significant effects from  differences in the tax rates per se between the home and host country (consistent with Slangen et al., 2017).  Further, we see evidence that shareholders are rewarded when firms conduct inversions in countries with lower-quality corporate governance.

In all instances where we find statistically significant long-run CARs, we find the wealth effect is negative but the range of our statistically significant estimates is large, between          -6.03 percent to -20.96 percent.  While we report that inverting to a regime where governance is worse increases short-run shareholder wealth, we do not see this in the long-run.  We examine this issue further by considering the impact of CEO remuneration. In the long-run, we find a negative relationship between the CEO’s returns and shareholder returns consistent with agency conflict theory (Babkin et al., 2017).  The relationship is not linear.  As CEOs’ remuneration increases, the agency conflict is reduced.

It is difficult, if not impossible, for managers and policy makers to determine, ex ante, the costs and benefits of many corporate decisions. Our study contributes to the debate   on corporate inversion in particular, and international tax avoidance in general.  Using ex post data, our methodology can establish the presence of market regularities and the factors that influence outcomes. Our short-run results suggest that inversions increase shareholder wealth. Our long-run results suggest that inversions damage shareholder wealth and that this is associated with higher agency costs.  Recent policy efforts, including the U.S. TCJA 2017, the proposed Stop Corporate Inversions Act of July 2017, and aggressive approaches to tax-enforcement with respect to multinational corporations by the European Union, and the OECD-led Base Erosion and Profit Shifting (BEPS) reforms have targeted the incentives for corporate tax inversions. Despite these efforts, however, the latest data from the Bureau of Economic Analysis shows that multinational corporations continue to shift core activities out of the United States. , Intellectual Property off-shoring has, however, replaced the more traditional full inversions as the dominant method of tax optimization.

REFERENCES

Babkin, A., Glover, B., & Levine, O., 2017. Are Corporate Inversions Good for Shareholders? Journal of Financial Economics 126, 227–251.

Hanlon, M., Heitzman, S., 2010. A Review of Tax Research.  Journal of Accounting and Economics 50, 127–178.

Laing, E., Gurdgiev, C., Durand, R.B., Boermans, B., 2019.  U.S. Tax Inversions and Shareholder Wealth Effects.  International Review of Financial Analysis 62, 35-52.

Schmidt, P. M., Bates, J. D., Paravano, J. H., 2015. Why Tax Inversions Continue to be an Effective Global Tax Planning Strategy. Journal of Taxation of Investments, 32, 3–9.

Seida, J., Wempe, W., 2003. Investors’ and Managers’ Reactions to Corporate Inversion Transactions.  Available at SSRN: https://ssrn.com/abstract=359820.

Slangen, A. H. L., Baaij, M., Valboni, R., 2017. Disaggregating the Corporate Headquarters:  Investor Reactions to Inversion Announcements by US Firms. Journal of Management Studies 54, 1241–1270.

This post comes to us from professors Elaine Laing at Trinity Business School, Trinity College, Dublin; Constantin Gurdgiev at Middlebury Institute of International Studies at Monterey and Trinity Business School, Trinity College, Dublin; Robert B. Durand at School of Economics, Finance and Property, Curtin University, Perth, Australia; and Boris Boermans at Baird Investment and Wealth Management Firm, London and Trinity Business School, Trinity College, Dublin. It is based on their recent paper, “U.S. Tax Inversions and Shareholder Wealth Effects,” available here.

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