The word “ironic” may be used too much, but how else do you describe Medtronic moving its headquarters to Ireland so that it will have more capital to invest in the U.S.?
Buying Covidien PLC for $42.9 billion turned out to be Medtronic’s solution to one of its most vexing problems: How does the global medical device maker use its “trapped cash,” the more than $20 billion in earnings from its non-U.S. subsidiaries, without paying a higher U.S. tax rate?
It’s actually trapped by choice, of course, as leaving capital offshore is one of the ways that big companies manage to pay far less in income taxes than the statutory federal rate. Companies would argue that the U.S. tax bite leaves them no real choice.
Medtronic has this trapped-cash problem because it has been quite skilled at keeping down its tax bill. Only a handful of companies in its industry have a lower effective tax rate than Medtronic’s, about 17.3 percent of pretax income.
The average tax expense for a group of about two dozen big medical-device companies is about 25 percent, according to a May study by the investment firm Morgan Stanley.
One of the ways big U.S. medical device companies pay taxes well below the 35 percent statutory rate is to find ways to incur more of their costs (and thus lower profit) in their home country, where the tax rate is higher. Medtronic is fairly typical in that it gets about 45 percent of its sales from abroad but about 55 percent of pretax profits.
U.S. companies are generally taxed in the U.S. on the money they make anywhere, but if the money made abroad isn’t brought home in the form of dividends or distributions from offshore subsidiaries, it’s not taxed.
More importantly, those earnings don’t necessarily create a tax liability assuming taxes will get paid someday, even though it seems obvious that those profits eventually have to be brought home to pay as dividends to the shareholders who own the company.
So shouldn’t the accounting department be booking a tax expense anyway, even if no taxes get paid right away?
That isn’t the way it works, because these earnings are, as the accounting term goes, to be “indefinitely reinvested” outside the U.S.
The offshore profits piling up are in the form of cash and short-term investments. Morgan Stanley found that on average, the big medical-device companies had about 60 percent of their cash held offshore. The company with the highest percentage of cash held offshore of any on the list, at 95 percent, was Medtronic.
The global companies have used all sorts of ways to try to get some of that capital back home cheaply. They have used intercompany loans. They have brought some profits back when they had tax credits or other “deferred tax assets” to offset some tax liability.
Too clever by half
Johnson & Johnson got very clever in finding a way to use non-U.S. profits to pay for its 2012 acquisition of a company called Synthes, using earnings held in a foreign subsidiary to buy J&J shares from investment banks: Those shares along with cash were used to buy Synthes.
It was so clever that the IRS promptly said no more of those would be allowed.
The most popular strategy appears to be simply waiting. The last time there was a special tax holiday on repatriated earnings from offshore subsidiaries was 10 years ago, and companies seem to be hoping another tax holiday comes along.
Meanwhile, the American companies borrow money to buy back stock, fund acquisitions or pay dividends, even as cash flow swells the balances in their Irish or Dutch accounts — looking indefinitely for that great investment opportunity.
Why not just pay the taxes? Well, if a company found a good deal in Ireland, it could invest a dollar. If it found a good investment in the United States, it could invest 65 cents after-tax.