09/24/14   Inverting Taxes

Editor’s Corner

Ron Rowland

The rules governing a corporate tax strategy known as inversion changed this week.  An inversion occurs when a U.S. corporation buys or mergers with a foreign rival and moves its official headquarters there in order to achieve more favorable taxation.  Under most circumstances, the foreign office is considerably smaller and the core operations and personnel stay in the U.S.

Two of the main reasons companies undertake this transition are to obtain lower tax rates and escape the worldwide corporate income tax.  When state and local taxes are included, the U.S. corporate tax rate closes in on 40 percent.  That is the highest rate of all the major world economies.  The second reason is that most other countries only tax profits that are earned inside its borders.  The U.S. applies its tax rate to corporate profits no matter where they are earned.  If corporations want to invest overseas profits back home (after taxes were already paid to a foreign government), they have to open their checkbook again to pay even more taxes to the U.S. Treasury.

While the current administration would like to stop the process completely, it would take new laws from Congress.  Since that is not likely to occur, the Treasury department adjusted the way it is interpreting current tax law.  It is taking an aggressive stance with new rules it hopes will make inversions more difficult and less financially appealing.  The objective to make the process more difficult is aimed at an inversion requirement that the former owners of the U.S. company own less than 80% of the new foreign entity.  The new rules target how extraordinary dividends paid prior to the inversion and how assets that are not part of the daily operations affect the value of each entity.  The less financially appealing aspect is aimed at some of the strategies companies use to return profits to the U.S. without having to pay a second round of taxes on them, such as loans and the restructuring of foreign subsidiaries.

Both democrats and republicans agree the reason some companies even consider an inversion is because the corporate tax code is broken, too complex, and in need of broad reform.  Yet some politicians have seized on the issue, attacking the patriotism of inverted companies.  Companies are in business to make profits, not act as an expression of the country’s patriotism.  Their current sin seems to be doing so in a way that is completely legal and possibly even beneficial to the country if some of the returned overseas profits are used to expand domestic operations and create jobs.

Investor Heat Map: 9/24/14

Sectors

Health Care managed to maintain both its momentum and first-place ranking in a volatile week.  Technology, Financials, and Consumer Staples also held on to their positions.  Materials and Telecom were the only two sectors to increase their momentum over the past week, which allowed Materials to climb a notch to fifth and Telecom three places to sixth. Consumer Discretionary fell two spots to seventh, and Utilities slipped to eighth.  Both managed to keep themselves in the green, although they don’t have much of a buffer.  Industrials is barely on the plus side of zero and could be the next to flip over to a negative trend.  Real Estate and Energy are still the only two sectors in the red, and both increased the magnitude of their downside momentum this week.

Styles

The style rankings became even more defensive this past week.  Mega Cap, home of the huge blue chip stocks, solidified its top ranking.  Large Cap Growth, Large Cap Blend, and Large Cap Value all marched upward one notch and sit below Mega Cap, indicating the market’s preference for the relative safety of large capitalization stocks.  Mid Cap Growth, in second place last week and first place two weeks ago, slid all the way to fifth.  This action puts the three Mid Caps together in the middle.  There were no changes in the relative ranking of the six lowest categories.  Small Cap Growth and Small Cap Blend turned red this week, joining Micro Cap and Small Cap Value in negative trends.  It is interesting to note that the magnitude of the negative readings is larger than the positive ones, even though there are more categories in the green.  This further indicates that the strength is being concentrated in fewer and fewer large capitalization stocks while the majority of stocks are now in downtrends.

Global

The U.S. is the last man standing.  In third place last week, the U.S. climbed two steps to grab the top honors in our global rankings.  However, it was not based on strength in the U.S.  Instead, weakness in the rest of the world was the cause.  Five categories flipped over to negative momentum this week, putting ten in the red.  Although the U.S. is still in the green, the discussion above regarding the style rankings reveals that a few big stocks are primarily responsible.  World Equity climbed three spots and Japan climbed four to capture second and third places.  China lost a significant amount of momentum from two weeks ago to last week, and the process was repeated this week with China flipping over to red and dropping from first to fourth place.  Canada moved from green to red and slid a spot to fifth in the process.  The U.K. has been on the bottom for the past two weeks and took a large jump to seventh today.  Like other global categories that improved their relative rankings, this was not the result of strength in the U.K. but weakness in other regions.  Latin America took a dive, plunging from second to eighth place and putting itself in a firm downtrend.  The falloffs in China and Latin America pushed Emerging Markets three steps lower.  Europe held steady in tenth place, and Pacific ex-Japan dropped hard into last place as the Australian dollar continues to get pummeled.

Note:

The charts above depict both the relative strength and absolute strength of various market sectors, styles, and geographic locations on an intermediate-term basis. Each grouping is sorted (top to bottom) by relative strength. The magnitude of the displayed RSM value is a measure of absolute strength, which is our proprietary method of measuring and reporting the intermediate-term strength as an annualized value.

 


“In fact, the administration just assured that deferred income in the once foreign subsidiary will never come back to the U.S. to help create income, jobs, and economic growth here.”

Martin Regalia, Chief Economist at the U.S. Chamber of Commerce, 9/23/14


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