April 26, 2015

Eli Lilly and the Insanity of Foreign Taxes

I’m going through the corporate bond filings of pharmaceutical giant Eli Lilly just out of curiosity.  They have a huge patent cliff coming up, during which time as much as 40% of their revenue base will be exposed to generic competition.  I wondered what it would do to the risk metrics on the senior bonds so I pulled the Moody’s rating and reading over the figures as I listen to an old 1970’s song called Snookeroo.

Side note: The song is interesting.  After the breakup of The Beatles, Ringo Starr wanted the biggest pop giant of the day, Elton John, to write a song for his new solo album.  Starr famously told John to make it, “nice and commercial”, so Bernie Taupin, long-time lyricist responsible for hits like Tiny Dancer, Your Song, and Bennie and the Jets, sat down and wrote out a short biographical poem about Starr’s life.  Elton went to the piano and hammered out a tune, recording this demo:

Then Ringo took it and recorded it his way, with full production values, so that it turned out like this on his album:

The song became the “B Side” of the #3 hit “No No Song” here in the United States.

Anyway, Eli Lilly demonstrates the bizarre taxation policy of the United States.  The firm has billions of dollars in cash in foreign subsidiaries that could be brought back to the United States, to create jobs here, pay dividends here, make acquisitions here, launch new plants here.  Unfortunately, the moment that money touches American shores, it’s subject to full corporate taxation, meaning the government will take more than 1/3rd simply for bringing the money back to the USA and investing it here instead of in, say, China or Germany.  We’re literally incentivizing, by huge sums, building other nations.  Hiring non-American workers.  It’s crazy.

This is a company in Indiana that can’t bring home its profits unless it wants to be punished.  The last time there was a repatriation holiday, waiving the taxes that would due in order to encourage giant corporations to bring money home to the United States, at least 55% of the total money brought back was paid out in the form of increased dividends [PDF].  That’s a lot of extra money sloshing around the U.S. economy instead of sitting in a bank in Switzerland.

  • Anon

    Corporations would have no choice but to repatriate foreign profits if they couldn’t raise funds elsewhere (i.e., borrowing money and paying low, tax-deductible interest to fund business activities and dividend payouts).

    It seems the easy solution would be to just impose corporate tax on foreign profits regardless of whether the profit is repatriated or not.

    • Anon

      Just like with 401(k)s, there should be a limit on how much foreign-earned corporate profits can avoid corporate income tax due to being kept offshore. That’s also another easy solution. Make it like 20% or something. Then 80% gets corporate taxed regardless of whether it’s kept in the US or not.

      Imagine if you could stuff your entire salary, regardless of amount, in 401(k)s! That’s how ridiculous the situation currently is. (Of course, there are arguments on whether there should be a corporate tax and what the rate should be.)

    • MarcKS

      Sounds like a great way to get your businesses to move their head offices outside of America

    • http://www.joshuakennon.com/ Joshua Kennon

      That would make the problem worse because companies would just split into two, spinning off shares of their international divisions, now headquartered overseas, to the stockholders. There wouldn’t be “Coca-Cola”, there would be “Coca-Cola” and “Coca-Cola International”. There wouldn’t be General Electric, there would be “GE USA” and “GE Global”.

    • Jay Bugg

      Corporations do not pay taxes, only people do:

      Stockholders pay in the form of lower stock prices and

      Consumers pay in the form of higher prices.

      Workers pay in the form of lower salaries and benefits.

      And sadly the unemployed pay in the form of fewer job opportunities.

      Once you accept the above facts, it is clear that if issues
      such as better retirements for everyone, lower prices for the poor, “income
      inequality”, and upward mobility matter to you; the only sane corporate tax rate
      policy is a tax rate of zero percent.

      • JustPosting

        Not to be rude or a contrarian, but nothing you listed there is a “fact.” Political rhetoric, perhaps, but nothing that can withstand even a moments scrutiny.

        That said, once you accept the “fact” that false is also true, cheeseburgers are exactly equivalent to orangutans, which is about all I have to say about the conclusion you drew.

        • Jay Bugg

          I encourage you to be as rude as you see fit. Most of my considered opinions are already contrary to popular belief, so by being “contrarian” to me you are defending the status-quo, whole-heatedly it seems. I may have struck a nerve.

          I will happily reconsider my opinion if you can show just 2 facts in my post that are factually wrong. But let us also examine my presumptions.

          Do you think that corporations view taxes as a cost? If it is a cost, and companies are for profit entities would higher taxes cause higher or lower prices? It really is that simple.

          Back to the original post, the US has a complicated tax system, which encourages innovation in the form of accounting and foreign entity creation as a tool for wealth preservation and accumulation. If the US tax rate was 0% would that cause more or less investment here in the US, in capital equipment, and opportunities for Americans all income levels?

          You seem to be taking the position with your cute little “cheeseburgers and orangutans” comment that there is no connection between the US corporate tax rate and the negative effects I mentioned, that opinions is so disconnected from reality that it can only be one generated with political motivation in mind.

          Not to be rude, but often contrarian.

  • J Mack

    i would be interested in your take on the FairTax (if you have read it). It would completely do away with corporate and individual taxes and implement a national sales tax. Key point is that there would be a national “prebate” in which every taxpayer would get a rebate of the projected sales tax paid up to a certain point (say poverty level). It would end this exodus of US companies strictly to avoid taxes. No more shifty shell games to lower taxes. America would become THE most tax friendly place to do business. I can’t imagine the amount of companies that would come here. Think of the vast amounts of money sitting offshore that would be immediately repatriated and put back into the economy through either investment or dividends. I know that it is radical but we can all agree that something radical needs to be done fix our broken tax code.

    • Lord Squidworth

      That would be a disaster for the United States. This isn’t 1870 anymore.

      Our economy requires money to continuously change hands. It’s consumption based. “FairTax” would further allow consolidation of wealth.

      It’d also likely end up benefit the rich more than everyone else.

      Without taking the US off a consumption based economy, a % based tax system is the superior.

      Basically, the rich don’t spend enough for it to equal out in a national sales tax.

      • Jack Scheible

        That’s just silly. If the rich don’t spend their money, what do they do with it? Stuff it in their mattresses? Light their cigars with $100 bills?

        • http://www.joshuakennon.com/ Joshua Kennon

          I can’t speak for Lord Squidworth, but it seems as if he is referencing the economic phenomenon of the marginal utility of money, which decreases as a person experiences higher net worth, resulting in less spending for each additional dollar accumulated, and therefore lower aggregate demand.

          That is, in a given civilization, the evidence is fairly staggering in support of the idea that a sales tax is going to raise more revenue in a society with 100 people each of whom have $100,000 than it will a society with 100 people, in which 10 have $750,000 and the other 90 have $27,778.

          The way to fix this is the modified form of the fair tax that Nobel Prize winning economist Milton Friedman proposed, which involved doing away with government welfare programs and instead providing a negative income tax in the form of a cash rebate check for the first, say, $50,000 in income. It ended up being cheaper than the existing welfare, so the taxpayers save money, and it alleviates some of the problems in a consumption based tax system. It’s a tricky problem, but his was the best solution I’ve ever seen were the country to go this route.

  • segfault

    If you’re ever in Indianapolis, the Lilly mansion and the adjacent Indianapolis Museum of Art are great stops. The art museum has numerous masterpieces that you would only expect to see in Chicago or New York. The mansion isn’t a mega-mansion like the Biltmore Estate, but still worth seeing. Even more impressive: Admission to both is free, you only pay $5 to park your car.

    • http://www.joshuakennon.com/ Joshua Kennon

      Thanks for letting me know; I’ll try to do this if I ever go through town. It’s been a few years since I was there – and I think the last time it was just driving through when we stopped for a cheeseburger at a Steak ‘n Shake on the highway – but I’d love to see this.

  • Shouganai

    Surely, on the macroeconomic level, american companies repatriating profits *wouldn’t* result in any more dollars sloshing around, since the billions of dollars worth of money overseas isn’t actually dollars, but pounds, euros yen etc.
    If the companies repatriated this money, they would simply be exchanging foreign currency for already existing dollars – which, if anything, would push up the price of the dollar and *reduce* domestic demand.

    Maybe that’s why the government doesn’t want companies doing it.

    • http://www.joshuakennon.com/ Joshua Kennon

      Not when you factor in the second and third order effects. If the foreign funds are exchanged for domestic currency so the owners can access it instead of having it frozen out of reach, they can spend it at the grocery store, buy new furniture, upgrade their wardrobe, hire someone to mow their lawn, build a car wash, or even donate to charity. The increase in velocity of money as it goes through the system should more than offset the initial swap.

      • Matt

        I don’t buy the above argument. If a foreign subsidiary earns $1 per share, it shouldn’t matter whether it is paid as a dividend or retained if there are acceptable reinvestment opportunities in that foreign country. The $1 reinvested in the foreign subsidiary should be worth at least $1 of intrinsic value, which should be reflected as $1 of market value for the company’s domestic stockholders. Repatriation doesn’t affect domestic purchasing power on the investment side as domestic stockholders could liquidate their shares and spend that money even if there were no dividend. This is essentially Warren Buffett’s argument against dividends.

        The only rational argument in favor of repatriation is that by encouraging domestic investment as opposed to foreign investment, we create more US jobs which helps our economy. So the argument is more on the job creation side. Repatriation would not increase domestic purchasing power from investments, but it would increase domestic purchasing power from the additional labor income generated.

        • http://www.joshuakennon.com/ Joshua Kennon

          You don’t understand it because you’re miscalculating net profit under GAAP rules, which is leading to your error in intrinsic value assumption that $1 in profit of a foreign subsidiary, reported on the income statement as $1 in after-tax earnings, is actually $1 in after-tax earnings. It’s not. It’s an accounting quirk; the sort of thing that most people don’t understand, like how the “assets” on the balance sheet of a real estate company can really be past interest expense and not represent any real claim on any piece of property.

          It would be best to walk you through a discussion to correct your mistake so we can take it line-by-line to avoid any misunderstandings. You use Warren Buffett as an example, so we’ll go with his valuation model.

          Buffett talks about intrinsic value being the net presented value of all the future cash flows an owner could take out of the business and go spend if he wanted without lowering the unit volume or hurting the competitive position of the firm. For example, $1 in profit from a steel mill, which requires huge reinvestments in factory, plant, and equipment, isn’t the same as $1 in profit from a company like Microsoft, where almost all of the money can be distributed without harming the core enterprise. A big part of those cash flows is determined by how much the government takes from the owner. The higher taxes, the lower the intrinsic value of the firm itself because the utility of ownership is lowered; you have less cash to spend on clothes, vacations, video games, furniture, or sending your kids to college. Which is simply another way of saying to hit a predetermined “fair” hurdle rate, you have to pay a lower price for your equity stake. Along with interest rates, the level of taxation is one of two big levers constantly working to raise or lower the intrinsic value of cash flows across a given economy; e.g., in a low interest-rate, low-tax environment, the intrinsic value of most firms is substantially raised. That is why government policy is so important – a nation that overtaxes its productive enterprises generally experiences less growth and investment, resulting in lower standards of living, while a nation that has taxes that are too low can get some fairly uncomfortable concentrations of financial and political power in the hands of a ruling class.

          For the S&P 500, approximately 49% of pre-tax profits are generated in foreign subsidiaries. Most of these are designated under the tax code as a special type of profit called “permanently retained earnings” in a foreign subsidiary, which allows the parent company to avoid paying a repatriation tax equal to “foreign pre-tax earnings times the difference between the U.S. and foreign tax rates”. With the United States having one of the highest effective corporate tax rates in the world, this is a significant amount of money.

          Profits designated as PRE, which is practically all of them, normally are not required to have an income tax expense estimate for the contingent tax liability owed recorded on the financial statements under GAAP account rules.

          Got that? It’s important. Read it again just in case.

          By now the light bulb should be going off in your head.

          Just in case, in plain English: That means that $1 in profit reported on the income statement of a publicly traded multi-national here in the United States is not equal to $1 in profit reported from a purely domestic enterprise, something that the companies meticulously spell out in the 10K disclosures for those who aren’t aware of the GAAP rules. When the owner went to get his hands on the money, the 100% USA firm could pay out $1 in dividends, while the multinational can only pay out a fraction of $1 depending on how large those PRE are; which, in the case of companies like pharmaceutical giants, is enormous.

          Thus, $1 in foreign earnings does not translate into a proportional increase in intrinsic value (e.g., for a firm with a 15x valuation multiple, a $15 increase in share price) because the markets are mostly rational over long periods of time. This results in many multinationals trading at a price that is less than they would otherwise deserve based on the underlying cash flows alone. The profit is, in the words of Charlie Munger, “good until reached for,” at which point it is taken from you by the government, meaning it’s not really profit since the income statement doesn’t include that final tax grab in the tax expense line.

          By removing the repatriation tax, the intrinsic value formula instantly changes, and all firms with PRE reserves – presently around 89% of companies in the S&P 500 – become more valuable. This results in an increase in stock market price to reflect the upward adjustment to intrinsic value (e.g., see the post-September 11th stock market as a case study) and / or increased dividends being distributed that otherwise would not have been. The data on the “wealth effect” of domestic demand caused by rising stock prices is overwhelming so there’s no need to go into it, but the higher market value does increase GDP.

          In other words, investors aren’t getting the benefit of an increase in market value equal to $1 in profit because that $1 in profit is an illusion caused by an accounting quirk. It gets more complicated when you get into the fact that this can result in some fairly heavy noise on the balance sheet depending on how the foreign earnings are designated and the specifics of the tax timing differences. For a company like Pfizer, you cannot understand the intrinsic value of the business unless you can work through this. Otherwise, you’re throwing darts and making a guess. It’s why Pfizer at 10x earnings can actually be more expensive than Coca-Cola at 15x earnings.

          The $1 in after-tax profits on the income statement is not actually $1 in after-tax profits if the money was generated in foreign subsidiaries because GAAP allows management to avoid recording an income tax expense for money that would be owed if management deems the money permanently reinvested in the foreign country. This often leads to businesses building up enormous, non-productive cash reserves in foreign currencies, where the money sits, unused, to avoid paying tax.

          For a more detailed explanation of the mechanics, this study (PDF) is worth reading.

          TL;DR: The income statement after tax profit figure is not actually the real after tax profit figure for multinationals leading to an overstatement of true earnings, influencing the intrinsic value calculation. This is the sort of thing I avoid talking about because it’s a specialist situation that helps me generate returns like this, but it’s going to scare the heck out of most people who read it, making them think, “stocks are too complicated.”

        • Matt

          Ah that makes sense. I understood that there was no deferred tax liability recorded for foreign earnings, I just forgot to include the impact of tax on the market valuation (even if no dividend is ever paid). Two additional questions:

          1) If you did fly over to Paris to spend your Euro profits, would you still be taxed for the euro dividend even if the profit was not converted to dollars? (For some reason I thought it would not be, but if it is, then yes I do see how it would substantially lower the market value since there would be no workaround for unlocking the money).

          2) Can companies get around this by spinning off their foreign subsidiaries and forming another, say, British corporation? Then the company could pay out dividends in pounds due to the dividend tax treaty between the U.S. and Britain.

        • http://www.joshuakennon.com/ Joshua Kennon

          Can companies get around this by spinning off their foreign subsidiaries and forming another, say, British corporation? Then the company could pay out dividends in pounds due to the dividend tax treaty between the U.S. and Britain.

          It depends, but most of the time: Yes, there are some ways to get around it if you are enormous enough that all of the fees and legal costs would be worth such a move. It may require a lot of steps, and a bunch of intermediary subsidiaries setup to effect the final result, but complicated deals are the bread and butter of Wall Street investment banks. You see this a lot in Europe, where companies will maintain dual listings on multiple exchanges to take advantage of the tax laws of one country versus another. Look at how Royal Dutch Shell or BHP Billiton are structured.

          If the United States suddenly decided to tax all corporate profits at 60% regardless of source, I think you’d see a lot of multi-nationals break themselves up into international and domestic corporations, with the shares distributed to the owners, especially since even equal tax rates are not equal (e.g., the corporate tax rate in Australia is 30%, but the stockholders receive a franking credit on their dividend income so there isn’t a layer of double taxation like there is in the United States).

        • Matt

          I agree on the tax plan mentioned in the article, although another alternative that could work is a national consumption tax with credits for low-income individuals so that it is not regressive. It would be easy to collect and enforce, but in any case, both simplifications seem like reasonable ways to get rid of the distortions generated by the current tax code.

        • http://www.joshuakennon.com/ Joshua Kennon

          You mean something along the lines of what Friedman proposed? That has a high chance of working, too, I’d think. It solves the problem of the tax being regressive on the poor, while not penalizing effort. Concentrations of wealth would be less problematic because any attempt to translate those concentrations into goods and services would trigger a large payback to society in the form of higher tax revenues.

        • Matt

          I believe Friedman had a proposal that could be implemented using either a consumption or an income tax. Both would be feasible. I like the fact that a consumption tax would reward saving and eliminate disincentives to work and earn. Like you said, concentrations of wealth would dissipate when you tried to collect your clothes, video games, cars, etc.

          Concentration of wealth could still be problematic in terms of skewing the representativeness of our democracy, but that effect isn’t so much a fault of Friedman’s system and more of a general problem with the political system.

  • Austin from TX

    We’ve discussed this ad nauseam in b-school with Apple, Dell and Microsoft. It really is interesting how much we spend and how we behave to avoid paying taxes. It’s very rational behavior given the tax code, but fundamentally irrational that there is an entire industry and profession dedicated to charging and avoiding tax. I’m not sure if the data is there to calculate it, but it would be interesting to see the gross production lost by the complexity on both sides of the tax system. Happy V-Day.

  • awake

    Unfortunately some of the leaders of these corporations don’t like those of the past… I doubt the money will find it’s way into the investments that will build up the middle class by providing decent jobs.

    Also when you say pay dividends… Understand the majority of Americans don’t really benefit from that as they are not savvy with the markets as you are. They’ve probably got their money in a 401k being passively invested.

    • Hopeless

      Were I a shareholder and citizen, I’d be delighted to have the cash repatriated. The government could use their share to pay down debt, improve infrastructure, upgrade education or otherwise implement schemes to make the citizens more productive. All of is would benefit the nation.

      Isn’t the problem that the government cannot be relied upon to spend its share wisely?

      • Eric


      • Anon

        There are a lot of short-term benefits to not spending wisely and putting the pedal to the metal.

  • RodgerB

    The tax issue is insane. But We seem trapped by idiots we elect…wondering who are the idiots. That said LLY is a superbly run company and one I follow and hold. And the history at the Headquarters, the Lilly Foundation and the City of Indianapolis as mentioned elsewhere is real interesting.

    • Anon

      When I think of superbly run companies, LLY doesn’t jump to my mind.