The Dow Jones Industrials (DJINDICES:^DJI) today built on their record close last Friday, gaining 103 points as of 12:30 p.m. EDT. As the first-quarter earnings season draws to a close, investors appear to have returned their focus to macroeconomic issues that point toward an expanding economy. Yet the number of mergers and acquisitions has been on the rise as well, and controversy about pharma giant Pfizer's (NYSE:PFE) attempt to buy out British drugmaker AstraZeneca has raised speculation about whether tax-motivated mergers could eventually get stomped out by tax-law changes. Still, with Wells Fargo (NYSE:WFC) and countless other companies having benefited from the tax advantages of mergers in the past, it seems shortsighted to single out Pfizer among a long line of actions from thousands of corporate taxpayers designed to reduce taxes.
The pros and cons of tax inversions
Pfizer's buyout offer has attracted so much attention for several reasons. Although many companies have taken steps to move their headquarters outside the U.S. for tax reasons, Pfizer's status as a member of the Dow Jones Industrials and as the largest pharmaceutical-focused company in the nation makes it an extraordinary case.
Moreover, Pfizer has made no attempt to hide the huge potential benefits from having an international tax home. The 35% corporate tax rate in the U.S. is far higher than the 21% rate that applies in the U.K. On top of the business advantages of incorporating complementary drug pipelines and enjoying cost synergies from economies of scale, saving on taxes is a key driver of earnings gains for Pfizer if it can get the merger approved.
The fact that even high-profile companies in the Dow Jones Industrials are looking at the tax-inversion framework makes it even more critical for lawmakers to consider the corporate tax code as a vehicle for enhancing competitiveness and drawing new businesses to the U.S. rather than driving them away. Between the availability of the tax-inversion strategy and the fact that corporations are keeping trillions of dollars locked abroad rather than paying taxes to repatriate their assets, the U.S. Treasury isn't benefiting from high tax rates. Therefore, even though lower tax rates would intuitively reduce tax revenue, the net impact might not be as bad as it looks at first glance.
Perhaps more important, no matter how simple or complex the tax laws get, companies will work to take advantage of opportunities to reap tax benefits. In 2008, for instance, Wells Fargo took advantage of a change in tax law that allowed it to claim loan losses from failing acquisition Wachovia against its own net income. As those losses became available, Wells Fargo was able to use them against its own recovering bottom line, producing far less tax liability than it would have owed without the deal. Many at the time argued that the deal would cost the U.S. government more than a rival proposal that would have involved the FDIC stepping in to handle the bad loans, but in the end, the deal went through and Wells Fargo reaped the rewards.
Taxes are a key part of corporate profitability, and smart companies do whatever they can to reduce their tax bills. Regardless of whether Pfizer is successful in its merger pursuits, you can expect plenty of other companies -- including those in the Dow Jones Industrials -- to follow similar strategies in the future.
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Dan Caplinger owns warrants on Wells Fargo. The Motley Fool recommends Wells Fargo. The Motley Fool owns shares of Wells Fargo and has the following options: short June 2014 $50 calls on Wells Fargo and short June 2014 $48 puts on Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.