Johnson Controls Tax Inversion Merger With Tyco

One of the anachronistic components of the current United States tax law is the treatment of foreign profits generated by a firm that is domiciled in America. If Coca-Cola, based in Atlanta, generates profit selling Cherry Coke in Brazil, it faces the prospect of a 35% tax on profits when it tries to take those Brazilian Cherry Coke profits back to Atlanta to allocate the freshly available capital. This rule was a product of the Marshall Plan that helped rebuild Europe after the war, as the United States facilitated the ability of its corporations to become multinationals in exchange for a tax bite of those repatriated profits.

As the rest of the world caught up to the United States, and technology advances made it easier for corporations to communicate internationally, the bargaining power between U.S. corporations and its own government shifted. The tax on foreign earnings as part of a permission to enter those markets was no longer viewed by corporate actors as a bestowal from the government but rather as an entitlement–Manifest Destiny for the 21st century. And furthermore, the loss of certainty from leaving the U.S. regulatory framework wasn’t all that bad–the difference between the confidence in corporate laws between America and Ireland is not what it was in 1945.

As such, corporate actors, well aware of their responsibility to maximize profits on behalf of the shareholders whom they serve, have searched for ways to eliminate this form of foreign taxation. Enter corporate inversions. If an American company mergers with a company located abroad, it may switch domiciles to that foreign country and avoid taxation on the repatriation of earnings.

A company undergoing an inversion may suffer significant tax penalties associated with the transaction if: (1) less than 25% of the business activity occurs in the home country of the new foreign parent, and (2) the shareholders of the former U.S. parent own 60% or more of the combined entity. If the continuing ownership is over 80%, it is treated as if it is still a U.S. corporation–the taxation remains the same and the merger is only regarded as a cosmetic but insubstantial change. If the ownership is more 60% of the original U.S. corporation but less than 80%, then there are special tax penalties that apply.

The key, then, to a successful corporate tax inversion is finding a foreign country that is responsible for at least 25% of the combined entity’s business, and then drawing up the merger terms in such a way that the initial U.S. corporation represents less than 60% of the shareholders in the new combined corporation in a foreign country.

It should come as no surprise that analysts are projecting that Ireland will account for between 25% and 30% of Tyco and Johnson Controls’ business activity under the combined entity, though the Johnson Controls website has not yet released details about how this merger will affect its overall business activity. The only word from Johnson Controls is that it will conduct a spinoff of its automotive seating and interiors business into an independent company called Adient. This will reduce the amount of earnings from Johnson Controls that are being generated in the United States, and make it easier for Ireland to be responsible for 25% of overall business activity so that the merger transaction can avoid additional taxation.

The sub-60% threshold will be met. As part of the announcement, Johnson Controls indicated that it will own 56% of the combined company and Tyco shareholders will own the remaining 44%. Johnson Controls shareholders will be collecting a $3.9 billion cash payment, or about $6.02 per share, as part of the deal (and this is not considered a sham transaction as corporations are free to negotiate to a cash-component of a merger deal without the second-guessing of motives per operation of the business judgment rule, permitted by the Wisconsin legislature in Chapter 180 of its statutory code. Johnson Controls is incorporated in Wisconsin.)

The structure of the deal indicates that the second element of a successful tax inversion regarding sub-60% ownership will be met, and early signals and predictions anticipate that the first element regarding business activity will also be met (though this has yet to be confirmed by Johnson Controls).

Regarding the specific companies, Tyco has gotten its affairs in order in the aftermath of former CEO Dennis Kozlowski’s self-dealing early last decade. Tyco has $1.4 billion in cash against $3.1 billion in debt, and has 9% annual returns since beginning an extended series of spinoffs in 2007. The last spinoff came in 2012, and Tyco has grown profits from $1.35 to $2.24 over that same time frame.

Johnson Controls is a gem of a firm with 13% annual returns since 1985. Its shareholder returns haven’t been great in the short term, but I view this as a case of the stock price getting way ahead of fundamentals. Coming out of the recession, Johnson Controls stock flew from $8 in 2009 to $40 in 2010. Johnson Controls has grown earnings at 11% annually since then, but the stock regressed to the $35-$40 range even as profits grew from under $2 in 2010 to $3.42 in 2015. The stock’s valuation shifted from 22x earnings to 14x earnings over the past five years–the issue is that the stock price got way too high in 2010 and took some years for the earnings to catch up. It’s not that the business itself was performing inadequately.

The market hasn’t responded too kindly to the news of the Tyco merger, sending the stock down 4%. This may due to an expectation that the U.S. Congress will do something to block the tax inversion aspect of the merger or the merger altogether, or it may be the result of lingering prejudice towards Tyco for its poor internal controls a decade ago.

Regarding the desire to stop inversions in general, U.S. Senate Finance Committee Chairman Orrin Hatch put it best: “Absent comprehensive tax reform that includes shifting to a territorial tax system with base erosion protections, Congress ought to examine viable bipartisan solutions that will effectively target and combat inversions and not tip the balance to tax-driven foreign acquisitions of U.S. firms.” Regarding how this will work out for shareholders of Johnson Controls, the current low valuation, immediate tax savings of $1.5 billion through 2018 and then $150 million annually thereafter, and the 2017 expected spinoff indicates a bright future for shareholders ahead. In fact, the valuation at Johnson Controls is so low that shareholders ought to wonder whether they are giving away too much by issuing their depressed shares as a currency to make this acquisition of Tyco at a 30%+ premium. There will be some turbulence, but Johnson Controls ought to continue to do well consistent with past history.

Notice: This article, which I believe may be of interest to readers, is for general information only. It only reflects my best understanding of the topic at hand and should not be relied upon as legal or investment advice.

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