Why Walgreen is Staying American and Paying Its Taxes

Source: Walgreens

Walgreen (WBA 0.57%) announced this week that it plans to buy the 55% of Switzerland-based Alliance Boots that it doesn't already own, but the American pharmacy isn't going to move overseas to lower its taxes as Wall Street had expected.

Investors are none too happy, sending shares down 14% on Wednesday.

Walgreen blamed the decision on an inability to structure a transaction with Alliance Boots that would allow it to move overseas. To undergo these so-called tax inversions, companies have to follow strict rules such as a certain percentage of the shareholders of the new company have to come from the foreign company. Management was clearly concerned with a protracted fight with the IRS.

But Walgreen hinted that the decision to stay in the U.S. was influenced by the potential for its business to suffer if it moved overseas.

"The company also was mindful of the ongoing public reaction to a potential inversion and Walgreen's unique role as an iconic American consumer retail company with a major portion of its revenues derived from government-funded reimbursement programs."

While you could certainly see a bit of an uproar if Walgreen moved overseas, I have a hard time seeing customers leaving for the long-term.

How many people avoid drinking Budweiser because it's no longer American? How about eating a Good Humor ice cream bar? Shopping at 7-Eleven? Feeding your baby Gerber-brand pureed carrots?

They're all owned by companies headquartered outside the U.S. Even John Hancock Life Insurance -- named after the guy who first signed the U.S. Declaration of Independence -- isn't even owned by a U.S. company .

Admittedly there's a difference between brands being bought by a foreign company and purposely moving overseas to avoid taxes. Maybe the bad press would have put a dent in business, especially when competitors, such as CVS Caremark (NYSE: CVS) are getting good press with its decision to stop selling cigarettes and tobacco products in its stores.

Government strikes back
While tax inversions are perfectly legal if all the rules are followed, President Obama isn't pleased that companies are moving overseas. Last month, Treasury Secretary Jacob J. Lew sent a letter to members of Congress urging them to "support legislative initiatives to reverse the trend toward corporate inversions."

With a divided congress and midterm elections approaching, passing that kind of legislation doesn't seem particularly likely.

Rather than push to stop tax inversions, the government could just discourage companies from moving overseas by not doing business with them. As Walgreen points out, "government-funded reimbursement programs" -- Medicare and Medicaid, for instance -- are a major portion of its business. If it wasn't allowed to participate in those programs the company would be sunk.

But it's hard to see how that type of legislation might be enacted given that there are plenty of foreign companies that provide useful services to Medicare and Medicaid. The largest generic-drug makers, Teva Pharmaceuticals (TEVA 4.23%), Novartis' (NVS -1.64%) Sandoz, and soon-to-be Mylan (MYL), are all headquartered overseas. It's hard to see how the government could avoid doing business with them.

Perhaps the law could be structured to only include companies that have moved after a certain date. But even that runs into ethical issues. Imagine if a drug company with the only treatment available for a certain disease does a tax inversion. Is the government going to deny citizens the drug because it's not paying U.S. tax?

Chickened out
In the end, it seems Walgreen just decided the risks -- legality of the transaction, potential IRS troubles, damage to reputation, and political backlash -- didn't justify the reward of lower taxes. Management arguably chickened out, but being conservative isn't necessarily the worst trait to have in management.

Walgreen looks like a decent investment at this knocked down price, with a solid 1.7% dividend yield and some global growth prospects as it integrates Alliance Boots.

Even if it'll be paying a little more taxes than it could have.