Endo’s message to the IRS: “F#ck you”

Endo Health Solutions just announced a big acquisition. The company’s rationale is to take advantage of a stunning tax loop hole.

First a little background. Warning: this is a little dry and technical, so if you want, you can skip the background (I indicated below where that ends).

——–background begins———–

The US federal corporate tax rate is 35%. There are a handful of countries around the world where taxes are much lower (most notably Ireland, Singapore, and Switzerland). Ireland, for example, has a tax rate of 12.5%. Who wouldn’t want a lower tax rate? Just pack up and move to Ireland, right?

Well, Congress (which authors the IRS tax code) is smart enough not to allow that. For a variety of reasons, companies can’t simply change their address. The US would continue to identify them as US companies and impose the 35% tax rate. What if, however, a company were to be acquired by an Irish parent. That could result in change of domicile. In order to do this, all one would need to do is set up a shell holding company in Ireland (essentially of no value itself) and issue shares to acquire the US company. Voila, it’s now a new company domiciled in Ireland, right? Well, Congress figured this one out too. Congress passed Section 7874 of the Internal Revenue Codedecreeing that this type of behavior is foul play. If an Irish holding company acquires a US company such that the former shareholders remain the same shareholders, the IRS recognizes this transaction as a sham and continues to treat it as a US corporation for tax purposes (the Irish company will be taxed at 35%, with taxes payable to Uncle Sam). However, the IRS set an 80% threshold, meaning that if the US target is less than 80% of the parent/acquiring Irish company, the IRS accepts the transaction as legitimate.

Here’s where Endo got clever. They identified a way to ‘re-domicile’ and move to Ireland. They just need their newly-conceived Irish parent holding company to make two acquisitions simultaneously. One acquisition is Endo itself (which, by being acquired, effectively moves to Ireland). The other acquisition needs to be a non-US company and also needs to be of sufficient size that it will comprise at least 20% of the newly-formed Irish company. That way, the Irish holding company absorbs Endo, but Endo is less than the critical 80% of the new entity.

It is seriously brilliant.

Endo found a Canadian company, Paladin, to also be acquired by a new Irish holding company. Paladin will be about 22.5% of the new company (which will conveniently be named “Endo”) and existing Endo will be 77.5% of new Irish Endo. Perfect.

Endo paid a premium to induce Paladin to be acquired as part of this transaction. Normally an acquirer-company pays a premium because they can cut costs (ie eliminate some duplicate sales people, accounting people, etc). In such cases, the cost savings exceed the acquisition premium and it makes sense for all parties involved. Endo conceded that there won’t be much in terms of cost synergies from Paladin. However, by moving to Ireland, the tax rate will immediately move down from around 30% to 20% and then will gradually shift toward to the Irish rate of 12.5%. Endo’s tax savings vastly exceed the premium paid.

Financially, here’s the math rationale. If Endo has a pre-tax profit of $100 (purely by way of example) and is taxed at 30%, profit to shareholders = $70:

$100 (pre-tax profit) minus $30 (taxes)  = $70 (final profit)

If the tax rate falls to 15%, profit to shareholders = $85:

$100 (pre-tax profit) minus $15 (taxes)  = $85 (final profit)

Thus, the amount shareholders keep rises from $70 to $85 from this tax-accounting wizardry, a boost of about 20%.

———background ends————

There are a couple of implications to highlight.

  1. Endo’s shareholders are the clear winners. With lower taxes, more profit stays in shareholder pockets.
  2. The USA is the big loser. It’s not just that taxes go down. From the US point of view, taxes go away almost completely. Before this transaction, the US was collecting taxes at a rate of 30%. The tax rate will fall to less than 20%, but even more significantly, it won’t be the US collecting taxes. Endo is becoming an Irish company. Taxes will go to mother Ireland.

In my mind, this begs the question as to whether there are any moral issues raised by Endo’s actions. In answer, I assert that Endo has not breached any ethical boundaries. To the contrary, Endo has a fiduciary responsibility to its shareholders to maximize corporate profits. If the US government offers a legal mechanism by which Endo can lower its tax burden then it is Endo’s obligation to take advantage of this. (If the IRS had opined that transactions like this may be in violation of the spirit of the law, that might be a different story, but it does not seem to be the case.) Ultimately, Endo merely took advantage of a striking loop hole in the flawed US tax system.

Even so, there is an element about this transaction that is unseemly. The culture in the US encourages fairness. Endo operates entirely within the US. It gets to enjoy all the infrastructure and benefits that the federal government pays for with tax dollars. Going forward however, Endo won’t be paying much taxes, and what it will pay mostly won’t go to the US anyway. The absence of Endo’s tax payments (about $265m in 2012) will either be added to the deficit or somehow get made up by increased taxes on the rest of us.

Extrapolating beyond Endo, if one accepts the premise that companies are obligated to use legal means to minimize tax costs, and if one then takes this precedent to the logical conclusion, this transaction could/should be a road map for other companies to follow. While Ireland would delight in its new resultant tax revenue, the implications for the US are less sanguine. Is Congress paying attention?

In closing, I’ll point to a certain irony in all of this. My thoughts turn to the saying, “The only things certain in life are death and taxes.” Endo Health Solutions has focused its efforts on the latter.


sources: Endo to Acquire Specialty Pharmaceutical Company Paladin Labs; Form 8-K: Endo/Paladin Merger Agreement; Section 7874 of the Internal Revenue Code

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