Are Corporate Inversions Good for Shareholders?∗

Anton Babkin Brent Glover Oliver Levine University of Wisconsin Carnegie Mellon University University of Wisconsin

March 10, 2016

ABSTRACT

In 2014 alone, U.S. firms worth over half a trillion dollars announced their intention to expatriate to a foreign country—a corporate inversion—in order to reduce corporate income taxes. To discourage expatriation, U.S. law requires shareholders of inverting firms to realize a personal capital gains tax liability at the completion of the transaction. Thus, while reduced corporate taxes benefit all shareholders equally, a corporate inversion results in a personal tax cost that depends on the individual investor’s tax basis and standing. We develop a model to value the net benefits of inversion and we show that the private returns to investors varies widely across individuals. We find that the benefits of inversion disproportionately accrue to the CEO, foreign shareholders, and short-term investors, while many long-term investors suffer a net loss.

Keywords: Corporate inversions; Shareholder conﬂicts; Taxes; Mergers and acquisitions

∗We thank Andrew Bird and participants at the Tepper Finance seminar and Tepper Accounting Sym- posium for helpful comments. Babkin: Department of Economics, University of Wisconsin-Madison, 1180 Observatory Drive, Madison, WI 53706, [email protected]. Glover: Tepper School of Business, Carnegie Mellon University, 5000 Forbes Avenue, Pittsburgh, PA 15213, [email protected]. Levine: Patrick Thiele Fellow in Finance, Finance Department, Wisconsin School of Business, University of Wisconsin-Madison, 975 University Ave, Madison, WI 53706, [email protected] 1 Introduction

Corporate inversion, the process by which a company reincorporates overseas for tax purposes, has become increasingly popular in recent years as a way to avoid the worldwide reach of the U.S. tax system.1 In 2014 alone, U.S. public companies valued at over half a trillion dollars announced their intention to invert as part of a merger deal. Not surprisingly, this wave of expatriation by prominent U.S. corporations has generated significant attention from the media and scrutiny from lawmakers. Yet, despite this public attention, the costs and benefits of a corporate inversion are not well understood. In this paper, we construct a novel dataset consisting of all inversions by U.S. companies, both proposed and completed, going back to 1983. One important feature of inversion is that the event is taxable to shareholders at the time of completion. Thus, while the reduction in corporate income taxes benefits all shareholders equally, a corporate inversion results in a personal tax cost that depends on the individual investor’s cost basis and tax standing. We develop a model of inversions that incorporates both the personal tax costs to shareholders and the corporate tax savings to the firm. Because the inversion is a taxable event to shareholders, the investor loses the option to defer capital gains tax on her shares. We use our model to value the shareholder’s personal cost of forfeiting their tax-timing option, and quantify each investor’s private return to inversion as a function of their tax basis. We find that, for the average shareholder, inversion has a positive net benefit as the reduction in the corporate income tax exceeds the average shareholder’s personal tax cost. However, we find that an investor’s private return varies widely across shareholders, and is significantly negative for many medium- and long-term taxable investors, as well as for older investors and those investors with high marginal tax rates. This negative private return results from the capital gains tax event triggered by inversion: the loss of the tax-timing option outweighs the reduced future corporate tax rate. Given the differential, and often negative, private returns for investors, shareholders do not have unanimity in the decision to invert.

1The United States is among a small minority of countries with a worldwide tax system: U.S. corporations incur a U.S. corporate income tax liability on earnings derived anywhere in the world. Therefore, U.S. corporations operating in other countries are at a tax disadvantage relative to foreign competitors. As earnings become increasingly global, there is a strong incentive for U.S. ﬁrms to ﬁnd ways to avoid these taxes on foreign income.

1 Given that not all shareholders benefit from corporate inversion, we next explore the incentives of the CEO to initiate an inversion. For the CEO, an inversion’s effect on personal wealth differ from that of a typical shareholder. While executives do incur a capital gains tax at the time of inversion alongside other shareholders, CEOs generally also hold unexercised options which are treated differently for tax purposes. Only directly held shares are subject to tax upon completion of an inversion, making options exempt from this taxation. Therefore, an increase in the share price resulting from the inversion will increase the value of both the CEO’s stock and options, but only the stock portion will incur the capital gain tax penalty. Using data on the option and stock holdings of each CEO in our sample of inverting firms, we show that the model-implied wealth effect is significantly positive for the CEO. The increase in the value of the CEO’s options exceeds the capital gains tax bill imposed by the inversion. In addition, we find the tax basis for the CEO’s stock holdings is significantly higher than for long-term shareholders, making the capital gains tax less costly than for many investors. Given the CEO’s tax preference for option holdings in inversion, we test whether the mix of stock and options holdings help to predict inversion. We find that CEO’s with a larger fraction of shares in their total equity-based holdings are less likely to invert. In addition, the CEO’s personal tax basis becomes increasing predictive of the decision to invert when the CEO holds more shares. At the same time, we do not find evidence that the average shareholder’s basis, and thus tax liability, affects the decision to invert. An additional channel through which CEOs may benefit from inversion is by increased compensation following the transaction. Using data on various components of compensation, we find that option awards, other compensation, and total compensation increase significantly in the year following inversion. The average CEO of an inverting firm receives an increase of $4.9 million in total compensation above her average pay in the post-2006 period. This sizable increase more than compensates for any capital gains tax consequences. We use data on holdings by foreign institutions as a proxy for the fraction of shares that are held by persons not subject to U.S. capital gains tax. We find that, along with size and foreign share of taxes paid, foreign institutional ownership is a strong predictor of inversion. This positive association is true even after controlling for the average shareholder basis, which we find to be mostly uncorrelated with inversion. In addition, firms held heavily by U.S. institutions are less

2 likely to invert. Given that foreign shareholders are not subject to U.S. tax and therefore have higher net benefits to inversion, this result provides evidence that personal tax considerations may affect the decision to invert. This paper contributes to a small but growing literature studying corporate inversions. A few papers investigate the announcement returns and effects on firm value of inversion, for example Desai and Hines (2002), Cloyd, Mills, and Weaver (2003), and Seida and Wempe (2003). Our paper also explores market price reaction, but includes the post-2004 sample in which the legal requirements for inversion were tightened. Our paper also relates to the relationship between CEO incentives, monitoring, and the implementation of tax strategies. For instance, Bird and Karolyi (2015) find that increased institutional ownership leads to lower effective tax rates, and more sophisticated tax strategy. This is consistent with our findings that firms which have a higher level of institutional ownership are more likely to invert. Desai and Dharmapala (2006) explore the relationship between high-powered incentives for managers and how this effects their incentive to engage in tax avoidance. In terms of the model framework, our paper is closest to Morellec and Schürhoff(2010). They study the effect of personal capital gains taxes on a firm’s investment and financing decisions. Green and Hollifield (2003) study the effect of personal taxes on a firm’s cost of equity financing and optimal capital structure decisions. In contrast, we abstract from a firm’s investment and financing decisions, instead focusing on the effects of an inversion. More generally, our model framework belongs to the broad class of contingent claims models used in corporate finance.2 Finally, our paper belongs to a large literature on how taxes affect corporate decision making. Graham (2003) provides a review of this literature. Foley, Hartzell, Titman, and Twite (2007) provide evidence that there has been a significant increase in cash holdings by multinational firms related to the tax costs of repatriation. Finally, our paper relates to a literature that studies the effect of personal taxes on an investor’s optimal consumption and portfolio decisions.3 The paper proceeds as follows. In Section 2 we describe our hand-collected data on corporate inversions, provide descriptive statistics, and quantify announcement returns. Section 3 discusses the tax consequences of inversion and develops a model to value the tax benefits and costs of

2See Strebulaev and Whited (2011) for a survey. 3See, for example, Constantinides (1983), Constantinides (1984), Dammon, Dunn, and Spatt (1989), and Dammon, Spatt, and Zhang (2001).

3 inversion. After exploring the model framework and comparative statics, we use the model to measure the investor’s private return based on their individual holding period and tax basis. Section 4 uses our data and model to quantify the private beneﬁts to the CEO of inversion, and whether the CEO’s personal incentives, and institutional ownership, aﬀect the decision to invert. We conclude in Section 5.

2 Data

In this section we describe the construction of our population of inversion transactions by U.S. public companies. We examine the historical volume of inversion activity and present descriptive statistics comparing inverting ﬁrms to the broader population of U.S. public companies in Compustat.

2.1 Inversion population description

We construct a novel dataset of all inversion transactions by U.S. public companies over the period 1982–2015, consisting of a total of 60 transactions. We hand collect the sample of inverting companies using a variety of sources. We used the CRSP/Compustat Merged dataset to identify years in which U.S. firms changed their country of incorporation. These observations were cross-referenced with SEC filings and press releases from the company to determine the details of the transaction, such as announcement date and tax treatment, and whether it should be classified as an inversion. For cases that involved a merger, these inversion data were supplemented with data from SDC Platinum. For the purposes of this paper, we define two types of inversion transactions. The first, which we refer to as a “naked inversion,” occurs when a foreign subsidiary of a U.S.-incorporated multinational becomes the parent and new location of the company’s incorporation. This foreign subsidiary may or may not have substantial business activities. The second type of transaction, a “merger inversion,” occurs when a U.S. company merges with or acquires a foreign company and the combined company incorporates in a foreign jurisdiction.4 Note that we do not classify U.S. firms acquired by

4Prior to 2004, a U.S. corporation could invert without any foreign assets or activities. Following the passage of the American Jobs Creation Act of 2004, Congress added section 7874 to the IRS code that required the inverting ﬁrm to have substantial foreign activities in order to be considered a foreign entity for tax purposes after the inversion. See VanderWolk (2010) for details of section 7874. The legislation introduced signiﬁcant uncertainty as to the potential tax treatment of these transactions, and the IRS interpretation of the legislation has changed somewhat over time. Today, following guidance from the IRS

4 foreign companies to be an inversion. Of the 60 announced transactions over the period 1982–2015, 25 and 35 inversions are of the naked and merger types, respectively. The first recorded inversion was undertaken by McDermott International in 1982, a construction company that reincorporated in Panama. Thus, while inversions have recently received significant attention in the popular press, these transactions are not a new phenomenon. Nonetheless, the expanded global presence of many U.S. corporations, combined with major legislative changes in the tax code, have resulted in substantial changes in the relative benefits and costs of corporate inversions over the last thirty years.

2.2 Inversion volume and summary statistics

In Figure 1, we plot the historical volume of inversion activity. In each panel of the figure, we report the number of announced inversions represented with bars (left axis), as well as the dollar volume of announced inversions represented by the solid black line (right axis). We compute the dollar value of an inversion transaction as the sum of the market value of equity and book value of debt immediately prior to the announcement. Panel A plots the total inversion activity, and Panels B and C show the activity disaggregated into naked and merger inversions, respectively. As shown in Panel A of the figure, in recent years the magnitude of inversion activity has grown to a substantial size, and nearly half of all inversions have occurred in the last five years of our sample. In 2014, there was over $500 billion in proposed inversion activity. In Table I we present summary statistics for a number of firm characteristics for the set of inverting firms in our sample. Detailed variable definitions that are used throughout the paper are given in Appendix B. The first three columns report statistics for the full set of inversions, naked inversions, and merger inversions, respectively. The final column reports statistics for the entire in 2012, the firm is generally able to satisfy the substantial business activities exception by having “at least 25 percent of each of the group employees, group assets, and group income to be located or derived in the relevant foreign country” (Herzfeld (2014)). We include in our sample only those inversions in which the U.S. firm successfully redomiciles for tax purposes. The introduction of section 7874 made naked inversions more difficult, leading many U.S. firms to execute inversion transactions as a two-step process: acquire a foreign firm, thereby establishing significant business activities in the foreign country required by section 7874, and then simultaneously reincorporate the combined firm in the relevant foreign country. The legislation led to a decline in naked and an increase in merger inversions in the post-2004 period. Interestingly, section 7874, which was designed to discourage corporations from leaving the U.S., creates an incentive for U.S. companies to move or increase operations outside the U.S. in order to fulfill the substantial business activities exception.

5 sample of CRSP/Compustat firms for comparison for the period 1994–2014.5 The table shows that inverting firms tend to be larger, and have a higher share of foreign taxes, than the average Compustat firm. However, along many other dimensions, inverting firms look very similar to the broader population of U.S. public firms. Surprisingly, the foreign share of earnings for inverting firms is not substantially higher than for the average firm that reports these variables.6 Also, despite a potential motive for inversion being access to unrepatriated cash, we do not find that total cash holdings are higher for inverting firms. In Figure 2 we display the inversion volume within each of the Fama-French 48 industries. The figure shows all proposed inversions by public U.S. companies by the date of announcement. The black circles denote a naked inversion and the red correspond to a merger inversion. The size of the circles correspond to the market value of the transaction which is computed as the sum of the market value of equity and the book value of debt for the inverting firm. Industries with no recorded inversions are not shown. As indicated by the figure, there is significant heterogeneity in the concentration of inversions across industries. In particular, inversion activity over the last few years has been concentrated within the “Chemical” industry, most of which are in the areas of pharmaceuticals and biotechnol- ogy.

3 Quantifying the Costs and Beneﬁts to Shareholders

The U.S., unlike most other countries in the world, taxes corporate earnings that are derived anywhere in the world, not just within its borders. For this reason, a foreign corporation has a significant tax advantage when doing business outside the U.S. compared to a U.S.-incorporated firm. While the details of the corporate tax code are complicated, one of the main benefits of corporate inversion is to avoid paying U.S. taxes on foreign earnings.7 This reduced corporate income tax liability benefits all shareholders.

5We choose this sample period for comparison as only one inversion occurs prior to 1994. We restrict the sample to firms with at least $1 million in book assets, and Winsorize at the one percent level. 6Note that only about a quarter of firms report earnings divided into foreign and domestic sources. 7Firms are able to defer paying taxes on this foreign income indefinitely by electing not to repatriate foreign earnings. Foley, Hartzell, Titman, and Twite (2007) show that firms hold substantial cash overseas in large part to avoid this cost of repatriation. The ability to defer this corporate income tax indefinitely substantially lowers the effective tax benefit of inversion.

6 Prior to 1996, any U.S. corporation could renounce its U.S. tax status by creating a non-U.S. subsidiary, often in Bermuda or the Cayman Islands which impose no corporate income tax, and having the U.S. parent “invert” its corporate structure with that subsidiary. However, following a highly publicized inversion of the cosmetics company Helen of Troy, the Internal Revenue Service modified Section 367(a) to make inversion trigger a capital gains taxable event for U.S. shareholders. Thus naked inversions, and inversions through acquisition, are taxable events for U.S. shareholders.8 This capital gains tax, created by the IRS in order to deter expatriation, imposes a cost on individual shareholders as a result of actions taken by the corporation they own. As the tax is only imposed on the amount in excess of the shareholder’s individual tax basis, this tax penalty will impact each shareholder differentially depending on the tax status of her account and the original price paid for her shares. For short-term investors and tax-free investors, this cost is minimal. For long-term investors with large capital gains, this cost can be significant. This cost is especially large for investors planning to bequest their shares upon death as the capital gains tax basis on inherited shares is reset to the current market price at the time of death.9 In this way, even long-term shareholders can significantly reduce or avoid entirely capital gains tax on their estate. Even for investors who do not plan to bequeath their holdings, the cost of being forced to realize a capital gain early can be large. Realizing capital gains tax early is costly in that the investor receives returns on the deferred tax liability embedded in her holdings for as long as the shares are held. Once the shares are sold, that deferred tax liability becomes an immediate one, and that option to defer is lost. Therefore, the ability to choose the optimal time to sell shares is a valuable option, and this value depends on the shareholder’s personal cost basis. In order to quantify the costs and benefits of corporate inversion to individual shareholders, we develop a model that accounts for the tax-timing option implicit in the individual investor’s position, as well

8This applies to transactions where U.S. shareholders own more than 50 percent of the shares, by value or voting power, after the combination with the non-U.S. firm. These shareholder-taxed inversions are called “flip” transactions. Under certain circumstances, the firm may be able to structure the inversion as an “outbound F” reorganization, which imposes taxes at the corporate level rather than on the shareholder. However, due to the strict requirements necessary to perform the latter reorganization, the vast majority of deals are shareholder-taxed. In addition, outbound F deals are generally only permitted when the embedded capital gains for shareholders is small, making the distinction negligible for these types of deals. In the case that the inverting U.S. firm is acquired by a larger foreign corporation, the tax treatment of the transaction is the same as for U.S. domestic mergers. We exclude from our sample those inversions that are not shareholder taxable. 9For a spousal bequest, the basis is set to the midpoint between the current market price and original basis, a “half step up.”

7 as the reduced corporate income tax rate following inversion.

3.1 Model

Our model framework follows Constantinides (1983) and Morellec and Schürhoff(2010). Time is continuous and all agents are risk-neutral with a constant after-tax discount rate of r. The firm is assumed to be entirely equity-financed with earnings before interest and taxes (EBIT), Xt, evolving as

dXt = µXtdt + σXtdWt (1) where X0 > 0 and Wt is a standard Brownian motion. Corporate earnings are taxed at a rate τc.

Equity holders face a personal tax rate on distributions of τd and pay a capital gains tax upon 10 realization at rate τg. Given that capital gains are taxed upon realization, each investor’s share embeds a tax timing option. This can be thought of as a put option with a strike price equal to the investor’s basis. Fundamentally, this implies that shareholders with a different basis will differ in their value of the shares they hold, even with identical beliefs and expectations for firm cash flows. Additionally, we assume that investors die according to a Poisson arrival, with intensity ξ, at which point their shares are bequeathed. For an investor with a basis of B and a market price 11 at death of p(x), the bequest results in a capital gains tax liability ofτ ˜g(p(x) − B)). We define v(x; B) as the private valuation of a shareholder with basis B when the firm’s current cash flow level is x. The market stock price is denoted by p(x). Additionally, let xB denote the optimal threshold for the firm’s cash flow that triggers the sale of a share for an investor with basis B. It can be shown that investors’ optimal strategy is to defer capital gains and immediately realize 12 capital losses. This implies that the optimal tax-loss selling threshold, xB, is given by

p(xB) = B. (2)

The equilibrium market price of the equity claim is set by new investors, who enter with a tax basis equal to the current market price. Thus, the market price encompasses an at-the-money

10For tractability, we do not distinguish between dividends and repurchases. Green and Hollifield (2003) consider this distinction in evaluating the magnitude of the personal tax benefits to equity financing. 11 In the current U.S. tax code,τ ˜g = 0, meaning an investor’s shares get a tax-free step up in the basis at death. In our calibration, we will be consistent with the tax code and setτ ˜g = 0. 12See Constantinides (1983) or Morellec and Schürhoff(2010) for a proof.

8 capital gains tax timing option. The relation between private valuations and the market price is characterized by the ﬁxed-point p(x) = v(x; p(x)). (3)

3.1.1 Inversion

The firm may undergo an inversion, which changes the firm’s effective corporate tax rate from I I τc to τc , where τc ≤ τc. We assume no other parameters of the firm change as a result of the inversion. That is, the change in a firm’s effective corporate tax rate captures all of the benefits to inverting. The opportunity to undergo an inversion is assumed to follow a Poisson arrival with intensity λ. Thus, over the time interval dt, there is a probability λdt that the firm inverts. In what follows, we will use v(x; B) and p(x) to denote pre-inversion values and vI (x; B) and pI (x) to denote post-inversion values. Following the current personal tax treatment for investors in an inversion transaction, we assume that taxable investors are required to realize their capital gains tax liability at the time the inversion occurs.13 Consequently, when an inversion occurs, a taxable shareholder with basis B has a net payoff of I I p (x) − τg(p (x) − B) − v(x; B). (4)

The first term of equation (4) is the market price of the share of the inverted firm, given the cash flow level x. The second term is the capital gains tax that the shareholder is required to pay as a result of the inversion: a tax at rate τg on the difference in the market price at inversion and their personal basis, B. The third term captures the fact that the shareholder gives up their private valuation of the share at cash flow level of x with a basis of B. As we will later show, the expression in Equation (4) can take positive or negative values, depending on the model parameters and shareholder’s basis. Intuitively, for the inversion to be attractive to the investor, the present value of a decreased corporate earnings tax needs to be sufficiently large to offset the cost of losing the tax timing option. The former is a benefit common

13The investor’s capital gains tax is actually realized at the completion of the inversion transaction, which will be after the inversion announcement date. For simplicity, we model the inversion announcement and completion as occurring simultaneously. Given that this period is typically relatively short—the median number of months between announcement and completion is 4.3—this simplification should have little effect on our results. Put differently, the investor in reality has a tax timing option between the announcement and completion dates, though for short intervals the value of this option will be negligible.

9 to all shareholders, however the cost of the lost tax timing option will be speciﬁc to the investor as it depends on their eﬀective capital gains tax rate as well as their basis.

3.1.2 Valuation

We now proceed to derive the investor’s private valuation and market price of equity for the firm. We begin by deriving the values for the post-inversion firm and then proceed to the pre-inversion firm. For an individual investor with basis B, her private valuation of a share in the post-inversion firm satisfies the following ordinary differential equation:

σ2 x2vI (x; B)+µxvI (x; B)+ξ[(1−τ˜ )pI (x)+τ ˜ B −vI (x; B)]+(1−τ )(1−τ I )x = rvI (x; B). (5) 2 xx x g g d c

At any time, an investor with basis B could sell her share of the post-inversion ﬁrm at price pI (x) and receive after tax proceeds of I (1 − τg)p (x) + τgB. (6)

This implies that the ODE in Equation (5) is subject to the following boundary conditions:

I I v (x; B) =(1 − τg)p (x) + τgB for x = xB (7)

I I vx(x; B) =(1 − τg)px(x) for x = xB, (8) where equations (7) and (8) are the value matching the smooth pasting conditions, respectively. I Expressions for the investor’s private valuation v (x; B), the optimal selling threshold xB, and the market price pI (x) for the post-inversion ﬁrm can be solved for analytically and are presented in the following proposition.

Proposition 1. Given current cash ﬂow level x, an investor with basis B has a private valuation of the post-inversion ﬁrm’s equity given by

−γ1 I x I v (x; B) = p (xB) − h(xB; B) + h(x; B), (9) xB where the function h is deﬁned as

(1 − τ )(1 − τ I )x ξ(1 − τ˜ )pI (x) ξτ˜ B h(x; B) ≡ d c + g + g (10) r + ξ − µ r + ξ − µ r + ξ

10 and γ1 is given by s 1 µ µ 12 2(r + ξ) γ = − + − + . (11) 1 2 σ2 σ2 2 σ2 The market price of the post-inversion ﬁrm, given current cash ﬂow level of x, is

! (1 + γ )ηI pI (x) = 1 x (12) I γ1ξτ˜g (1 + γ1)(1 − ω ) − τg − r+ξ where (1 − τ )(1 − τ I ) ξ(1 − τ˜ ) ηI ≡ d c and ωI ≡ g . (13) r + ξ − µ r + ξ − µ For an investor with basis B, the optimal post-inversion selling threshold is given by

I γ1ξτ˜g ! (1 + γ1)(1 − ω ) − τg − r+ξ xB = I B. (14) (1 + γ1)η

Proof. See Appendix A.

We now proceed to characterize the investor private valuation and market price for a firm that has not yet undergone an inversion. For an investor with basis B, their private valuation of the pre-inversion firm, v(x; B), is satisfies the following ODE:

2 σ 2 x vxx(x; B) + µxvx(x; B) + ξ[(1 − τ˜g)p(x) +τ ˜gB − v(x; B)] 2 (15) I + λ[(1 − τg)p (x) + τgB − v(x; B)] + (1 − τd)(1 − τc)x = rv(x; B).

As with the post-inversion ﬁrm, at any time, an investor with basis B could sell her share at the current pre-inversion market price, p(x), and receive after tax proceeds of

(1 − τg)p(x) + τgB. (16)

Thus, the ODE in Equation (15) is subject to value-matching and smooth pasting conditions analogous to those in Equations (7) and (8) for the post-inversion valuation. The private valuationa and market price of the pre-inversion ﬁrm are given in the following proposition.

Proposition 2. Given current cash ﬂow level x, an investor with basis B has a private valuation of the pre-inversion ﬁrm’s equity given by

x −β1 v(x; B) = p(xB) − g(xB; B) + g(x; B) (17) xB

11 where the function g(x; B) is deﬁned as

(1 − τ )(1 − τ )x + ξ(1 − τ˜ )p(x) + λ(1 − τ )pI (x) (ξτ˜ + λτ )B g(x; B) ≡ d c g g + g g , (18) r + ξ + λ − µ r + ξ + λ and β1 is given by s 1 µ µ 12 2(r + ξ + λ) β = − + − + . (19) 1 2 σ2 σ2 2 σ2 Let

(1 − τ )(1 − τ ) ξ(1 − τ˜ ) η = d c , ω = g , r + ξ + λ − µ r + ξ + λ − µ λ(1 − τ ) ξτ˜ + λτ Λ = g , Θ = g g , r + ξ + λ − µ r + ξ + λ (1 + γ )ηI AI = 1 , I γ1ξτ˜g (1 + γ1)(1 − ω ) − τg − r+ξ The market price of the pre-inversion ﬁrm is given by

(1 + β )(AI Λ + η) p(x) = 1 x. (20) (1 + β1)(1 − ω) − β1Θ − τg

For an investor with basis B, the optimal pre-inversion selling threshold is given by (1 + β1)(1 − ω) − β1Θ − τg xB = I B. (21) (1 + β1)(A Λ + η)

Proof. See Appendix A.

3.2 Calibration

Before exploring comparative statics of the model, we discuss calibrating the parameters. We choose parameters to match common values used in the prior literature, as well as those to match the specific data moments of interest in this exercise. The benchmark parameters are chosen to represent an average firm; we will later explore how deviations from these representative parameters affect our estimates. The benchmark parameters are given in Table II. For the basic preference and technology parameters—the risk-free rate r, cash flow growth rate µ, and cash flow volatility σ—we select parameters consistent with values commonly used in related contingent claims models, for example Leland (1994), Morellec and Schürhoff(2010), and Strebulaev and Whited (2011).

12 The ξ parameter captures the life expectancy of an investor. To calibrate this parameter for the marginal investor, we compute the asset-weighted average life expectancy of a US investor holding corporate equity securities and set 1/ξ to match this life expectancy. To estimate the stock ownership-weighted average age of a U.S. investor, we use the U.S. Census Bureau’s 2011 Survey of Income and Program Participation. Table 5 of the wealth tables reports the average stock and mutual fund holdings by age group of the head of household. For each age group, we compute an average life expectancy using the estimated life expectancy for the average age in the group, taken from the Social Security Administration’s 2011 actuarial period life table. Our calibrated value of ξ for the marginal investor is set to match the stock holdings-weighted average life expectancy of U.S. investors. This gives a value of ξ = 0.052 for the marginal investor, which implies a life expectancy of approximately 19 years. In turn, this corresponds to a 63 year-old male or 66 year-old female in the U.S. population. Similar to investor age, there is significant heterogeneity in the capital gains tax rates faced by investors. To calibrate the marginal investor’s capital gains tax rate, τg, we compute an asset- weighted average across rates. The Federal Reserve’s Flow of Funds Table L.223 provides a break- down of the market value ownership of U.S. corporate equities by various entity categories. For each category, we assign a marginal capital gains tax rate and weight these rates by the market value of the holdings for each group as reported for Q3 of 2015 in Table L.223. For a U.S. taxable investor, we use a capital gains tax rate of 28.6%, which is the average top marginal rate in the U.S.14 For tax-exempt and tax-deferred holdings, we apply a capital gains tax rate of zero. Finally, for foreign ownership, we use a rate of 23.2%, which is the OECD weighted average marginal capital gains tax rate.15 We obtain an asset-weighted average marginal capital gains tax rate of 19.1%. Thus, in the model, we set τg = 0.191 for the marginal investor. We assume the marginal investor’s dividend tax rate is equal to their capital gains rate and set τd = 0.191. Finally, upon death, we assume that the shares are bequeathed to a surviving heir and the capital gains tax basis is “stepped up.” Thus we set the capital gains tax rate at death,τ ˜g, to zero. In our model, all gains from inversion are captured by a reduction in the corporate income tax rate faced by the firm. In reality, this reduced tax rate may come in many different forms,

14This rate includes both federal and state capital gains taxes as reported by Pomerleau (2015). 15Again, this rate is taken from Pomerleau (2015).

13 for example by avoiding repatriation taxes on past or future foreign earnings, or by engaging in “earnings stripping.”16 The model structure encapsulates all of these benefits into two parameters: I the pre- and post-inversion effective corporate income tax rates τc and τc . We calibrate these parameters using the tax rates reported by multinational corporations. Using Compustat data on U.S. firm which report both foreign and domestic earnings and taxes, we estimate the effective rate to be 35.9%, which we use for τc. This is estimated by measuring within each industry the ratio of U.S. taxes paid to U.S. earnings, where each quantity is the sum across all firms over the years 1994–2014.17 We then take an average across these industry rates weighted by the frequency of observed inversion. This weighting accounts for differences in tax rates across industries that may affect the propensity to invert. F We use a symmetric approach to calculate the corporate tax rate on foreign income, τc , using the ratio of foreign taxes paid to foreign earnings. We estimate the foreign tax rate, again weighted by inversion frequency, to be 29.6%, which is 18%, or 6.3 percentage points, lower than the U.S. rate. I The post-inversion average effective rate τc is the sum of the U.S. and foreign tax rates weighted by the share of earnings. Using the industry-specific foreign share of earnings, we estimate the I 18 post-inversion rate τc to be 32.3%. Finally, we set the inversion arrival intensity parameter, λ, to 0.01. This is consistent with the 0.9% inversion frequency seen on multinational pharmaceutical companies. In addition, the post- inversion corporate tax rate and the inversion arrival intensity jointly determine the gains from inversion. We can therefore use the announcement returns observed around inversion announcement as an additional check on our choice of these parameters. The average three-day return, in excess of the market, around announcement is 3.8%, which is roughly consistent with the model estimated return of 5.7%. This suggests that we are not understating the corporate income tax benefit of inversion, and that the model adequately captures the gains from inversion.19

16Earnings stripping is the process by which firms shift their U.S. earnings to foreign subsidiaries through the use of parent-subsidiary loans or leases, or through other technical means. 17Using aggregates addresses the problem of negative earnings and taxes at the firm level. This approach essentially provides a size-weighted average tax rate for the industry. We ignore the Mining and Textile industries as they have negative aggregate taxes or earnings over this period. 18Thus, on average, about 57% of total earnings come from foreign sources for the sample of multinational firms. 19One potential concern is that the reduced tax rate we measure in the data does not capture the benefit of reduced taxes on past earnings, i.e. on unrepatriated cash holdings. We find that inverting firms have, on average (median) cash to equity value ratio of 14% (8%). Assuming that half of this cash is unrepatriated,

14 3.3 Comparative Statics

In Figure 3, we present comparative statics for the eﬀect of an investor’s basis on her private valuation. In both panels, we plot the investor’s private valuation relative to the market price, as a function of their basis (normalized by the market price). In each case, as an investor’s basis reaches the market price (B/p(x) = 1), the private valuation converges to the current market price (v(x; B)/p(x) = 1). In Panel A of Figure 3, we plot this ratio for three diﬀerent values of the capital gains tax rate,

τg, holding all other parameters fixed at their benchmark values calibrated in the previous section and given in Table II. For the case of zero capital gains taxes, an investor’s private valuation is independent of their basis and is equal to the market valuation. The figure indicates that the wedge between an investor’s private valuation and the market price is decreasing in the basis-to-price ratio and increasing in the capital gains tax rate. Panel B of Figure 3 displays analogous results for different investor ages, corresponding to different values of ξ. An older investor, one with a higher value of ξ, has a relatively higher private valuation. This results from the fact that this investor has a greater likelihood of getting a free step up in basis at death and avoiding capital gains tax. Consequently, they have a relatively higher private valuation for a given basis-to-price ratio. Figure 4 plots a shareholder’s personal rate of return from an inversion as a function of her basis-to-price ratio. For an investor with basis B, the return from an inversion is computed in the model as (1 − τ )pI (x) + τ B g g − 1, (22) v(x; B) where pI (x) denotes the market price immediately after the inversion and v(x; B) is the private valuation immediately prior to the inversion announcement for an investor with basis B. As before, the two panels displays the private return for different values of an investor’s capital gains tax rate (Panel A) and age (Panel B). For each case, we see that a shareholder’s return to an inversion is increasing in her basis-to- price ratio. Moreover, for many values of the basis-to-price ratio, an investor’s private return to the and that inversion avoids a 25% repatriation tax on this cash, this means inversion would increase firm value on average (median) by about 1.8% (1.0%). While our approach to calibration may not capture this potential gain, we do not expect this gain to be first-order. In addition, as a robustness, we explore lower post-inversion tax rates to capture more dramatic gains than indicated by our calibration.

15 inversion is negative. Panel A shows, as expected, that investors with lower capital gains tax rates experience a higher personal return to inverting. Panel B illustrates that the investor’s personal return is lower for older investors, which correspond to those with a higher value of ξ. Intuitively, the inversion is relatively more costly for an older investor as the have a higher probability of getting a free step up in basis at death. In total, Figure 4 shows that the private returns to an inversion vary substantially across investors according to their relative basis, capital gains tax rate, and age. Furthermore, for many investors, an inversion is a wealth-destroying transaction.

3.4 Model-Implied Beneﬁts to Inversion

The model provides a framework to quantify the benefits of reducing the corporate income tax rate and the shareholder cost of triggering a capital gains tax event. In this section we use the model to estimate the private returns for taxable shareholders as a function of their personal tax basis for the sample of firms which have undergone inversion. For each firm, there exists an entire distribution of shareholder tax bases based on when they purchased the shares and their individual tax statuses. While we can’t directly observe this distribution, we can estimate the basis for various shareholders using several approaches. First, we use an approach similar to that of Grinblatt and Han (2005) to estimate the expected basis for the average shareholder using historical price and average turnover. We estimate the average basis as

∞ X n−1 Bt = ω(1 − ω) Pt−n (23) n=1 where Pt is the stock price and ω is the portfolio turnover rate for the median investor. We operationalize this estimate by using up to the past 7 years of weekly data, and the weights in parentheses are scaled to sum to 1.20 Using individual brokerage data, Barber and Odean (2000) estimate a monthly turnover of 2.58% for the median investor. We use this value for the turnover volume ω. Table III shows the distributional properties of the price-to-basis ratio for diﬀerent subsets of

ﬁrms. In addition to the average basis measure Bt, we also report the 3-, 7-, and 15-year low

20We require at least two years of available price data.

16 price as estimates of the shareholder bases.21 All estimates are shown as the market price divided by the basis measure. As we would expect, the table shows that the price-to-basis ratio depends signiﬁcantly on the purchase date of the shares. As a result, the capital gains tax liability also varies considerably across shareholders.

Shareholder’s private return to inversion

Using the various measures of shareholder basis from the data, and baseline parameter values from Table II, we use the model to compute the shareholder’s private return to an inversion as defined in (22). The shareholder private return differs from the market return because the shareholder loses her tax timing option embedded in shares that have gained in value over the holding period. We calculate the shareholders private return for each inversion in the data, and for each of the various measures of the basis. Panel A of Table IV reports the mean, median, and tenth percentile return across the sample of inversions. The first three rows of Panel A report the shareholder private return statistics across the sample of inversions given the baseline reduction in the average corporate income tax rate following inver- I sion, τc . Column (1) reports the model-implied market return from the inversion announcement which does not depend on a basis. Each subsequent column reports the private return statistics for taxable shareholders with various bases. While the capital gains tax rate for the marginal investor is 19.1%, we assume a capital gains tax rate for the individual investor of 28.6%, the average rate across the 50 U.S. states. We vary this assumption in columns (6) and (7). While the market return from inversion is 5.74%, column (2) shows that the return for an average taxable investor has a private return that is significantly lower at 2.16%. At the tenth percentile of inversions, the private return to the taxable shareholder is negative (−1.54%). For longer term investors, shown in columns (3)–(5) using the 3-, 7-, and 15-year low prices as the basis, the private returns are considerably worse and are on average negative. For example, the private return to a shareholder with a 7-year holding period is on average −6.59%. At the 10th percentile of inversions, these shareholders lose over 13% of their share value. Columns (6) and (7) report the private return statistics by varying the investor’s individual

21As shown in the model, the optimal trading strategy is for shareholders to harvest tax losses and defer gains, resulting in a shareholder having a basis equal to the low price over their holding period. Of course, wash sale rules complicate this strategy, but we approximate the basis using the N-year low price.

17 capital gains tax rate, using the 7-year low price as the basis. The capital gains tax rate for the marginal investor is kept at 19.1%, and all other parameters are kept the same. We see that the capital gains tax rate for the individual investor has a large impact on the private returns to shareholders. Investors which pay a 19.1% effective rate—the estimated marginal rate across all shareholders—have a mean return of −0.70% from inversion, while a high earner in California— who has a combined federal and state capital gains tax rate of 33%—has, on average, a return of −9.35%. At the tenth percentile of inversions, these California residents lose over 17%. The final column of Panel A reports the private return statistics for a particularly tax-disadvantaged investor: a 78 year old California resident in the top marginal tax bracket (33%) who has a basis at the 15-year low price. This investor, in all but one of the inversions in our sample, are hurt by the decision to invert, and on average loses 15.60% percent of the value of their holdings. For this set of long-term and older investors, inversions are highly undesirable and can destroy significant wealth. The bottom three rows of Panel A reports the same private return statistics when we assume much larger savings in corporate income taxes following inversion. Here we assume that the drop in the tax rate is twice that found in the calibration, assuming a 36% drop in the tax rate on foreign I earnings (from 35.9% to 23.6%), resulting in a post-inversion average tax rate, τc , of 28.7%. While this implies a counter-factually large market announcement return of 9.26%, it is illustrative to see that even if the tax savings are extremely large, many shareholders are still hurt by the inversion. Notably, shareholders with only a 3-year holding period have negative returns on average.

Minimum holding period resulting in a negative private return

The private return to shareholders depend signiﬁcantly on their bases. Generally, longer holding periods result in a higher price-to-basis ratio and lower private return. Figure 5 plots the mean private return for the shareholder as a function of the holding period and personal capital gains tax rate. The basis is assumed to be the low price over the holding period, as would be the result of an optimal tax loss harvesting strategy. The dotted line reports the model-implied market return from the inversion. We see that for investors residing in California at the top tax rate of 33% the private returns are on average negative for even relatively short holding periods. Even at lower tax rates the returns

18 become negative after only moderate holding periods. This reflects the fact that inverting firms often experience significant price appreciation prior to inversion, resulting in a higher capital gains tax burden for investors. In Panel B of Table IV we quantify the minimum holding period that would result in a negative private return for the investor. Specifically, for each inversion in our sample we find the minimum number of years for which a basis of the low price over that period would result in a negative private return for the shareholder. We report the quartiles for these holding periods in years for various types of investors and for different post-inversion tax rates.22 Roughly, these values can be thought of the “breakeven” holding period. We use up to 15 years of price data prior to the inversion announcement and require at least 7 years of data. Column (1) reports the holding period for the benchmark parameters given in Table II for an investor with a individual capital gains tax rate of 28.6%, the U.S. average. We find that an investor who held shares for only 1.83 years prior to the announcement of the inversion would have negative returns in half of the sample. At a 1.00 year horizon, 25% of inversions resulted in a negative return. This reveals the holding period does not need to long in order to result in negative returns. Columns (2) and (3) report the holding periods that imply a negative return for tax rates equal to the marginal investor (19.1%) and for the California investor (33%). Even at the lower tax rate, half of the inversions result in a negative return when the investor has a basis of the low price over the last 6.67 years. Column (4) changes the age of the individual investor to 78 years (ξ = 0.1); we see that raising the age of the investor has a similar effect to imposing the higher 33% tax rate. Finally, column (5) reports the minimum holding period for a 78 year old California resident in the top marginal tax bracket (33%). For this investor, even holding shares for under one year results in a negative return in half of the observed inversions. The last three rows of Panel B report the minimum holding periods for a much larger drop in the post-inversion tax rate. Even in this case, the benchmark taxable shareholder would have a negative private return in half of all inversions if the shares were held for 2.92 years. Overall, the table shows that even some short and medium-term investors are personally hurt by inversion.

22Note we do not report the mean because for some inversions the return is positive at all horizons, i.e. these values are undeﬁned. These cases are treated as +∞ for quartile calculations.

19 4 The Incentive to Invert

In the previous section, we saw that the benefits of inversion vary substantially across shareholders depending on their holding period and tax status. Notably, the private benefit to the CEO may differ from that of other shareholders depending on her specific equity and option holdings. In this section, we quantify the CEO’s personal wealth change that results from inversion. We then ask whether the CEO’s private benefits corresponds with the decision to invert. In addition, we ask whether firms held more heavily by foreign institutional investors, who are generally tax-exempt, are more likely to invert.

4.1 Changes in CEO wealth

In order to understand the private incentives of the CEO to effect a corporate inversion, we must understand how the CEO’s private wealth is affected by the transaction. For most CEOs, a significant portion of their wealth comes from equity-based compensation, specifically stock and options. The stock portion of holdings will increase in value due to the corporate tax savings from the inversion, but this benefit will be offset by the triggering of a capital gains tax event that eliminates the CEO’s tax timing option. Thus, the private value of the CEO’s stock holdings are similar to that of any other shareholder, and the net benefit will depend on her personal tax basis. In contrast, distinct features of option compensation cause the private value of the CEO’s option holdings to respond to inversion differently from stock. First, an increase in the share price will increase the value of these options, a basic delta effect. Second, unlike stock holdings, inversion does not trigger a capital gains tax event on unexercised option holdings. Given that option holdings capture the increased value of the post-inversion firm without incurring any tax-timing cost, option holdings have a personal tax advantage relative to stock. Table V reports the change in the CEO’s wealth resulting from an inversion. The sample includes CEO’s of firms which announced an inversion. The wealth change is disagreggated into three components: 1) the change in the value of unexercised option holdings, 2) the change in the value of the stock holdings, and 3) the capital gains tax generated by the stock holdings. As detailed information on CEO compensation is available from SEC filings and the Execucomp dataset, we are able to construct the capital gains tax basis for each individual CEO; the details of this construction are given in Appendix B.2. As age is an important for private valuation, we set

20 the individual’s death arrival parameter ξ for each CEO based on his/her age. The table shows the personal wealth changes implied by the model for two different post-inversion tax rates, as in Table IV. The CEO’s private return on share holdings is computed from the model as (pI (x)/v(x; B) − 1) where pI (x) denotes the market price immediately after the inversion and v(x; B) was the private valuation immediately before inversion for an investor with basis B. The estimated capital gains I tax is reported as a percent of the share’s market value: τg(B − p (x))/v(x; B). The return on options is estimated as the delta on option holdings (δ) times the model-implied market return: δ(pI (x)/p(x) − 1). The total after-tax return on holdings is calculated as the total change in the private value of holdings following inversion over the private value of stock and option holdings just prior to inversion. We assume a capital gains tax rate of 28.6% for the CEO, the average federal and state combined top marginal rate in the U.S. The last four columns of the table report the shareholder’s private returns, as in Table IV, for reference.23 I Focusing on the first three rows with the baseline post-inversion corporate tax rate τc , the results show that CEOs have a significant increase in the value of their share holdings, up 8.52% on average. Triggering the capital gains tax also generates a significant cost of 5.83% in a lost tax-timing option. However, unlike the standard shareholder, the CEO also has option holdings which increase in value but are not subject to tax triggered by inversion. Overall, we see a significant increase in the value of the CEO’s equity holdings of 4.14% and in only one case do we estimate that the CEO is worse off from the inversion. Compared to the private returns of many shareholders, given in the last four columns of the table, the CEO fairs well, with private returns nearly twice as large as for the average shareholder. There is one additional tax consideration for CEOs completing an inversion. As part of the American Jobs Creation Act of 2004, Congress added section 4985 to the tax code which imposes a 15% excise tax on unvested stock and unexercised option compensation for officers and directors that occur within the 12 month window surrounding an inversion. However, given that it is commonplace for the firm to reimburse officers for the excise tax imposed on these awards, we do not include these costs in the above analysis.24

23Note that these values differ slightly from Table IV because we restrict the sample to firms with sufficient CEO compensation data. 24While Gupt (2014) states that “grossing up the section 4985 excise tax appears to be the norm in inversion transactions,” the cost of reimbursement can be quite large. In the highly publicized example of Medtronic in 2014, payouts totalled $63 million to cover an excise tax bill of $23.25 million for its covered officers and directors, as gross ups are themselves taxable income.

21 Overall, the significant increases in the private wealth of the CEO resulting from inversion suggest that the personal incentives of the CEO to invert are strong. The tax advantage of option compensation makes the net benefits to the CEO greater than for a shareholder with the same cost basis. Given the average CEO has significant option holdings, this creates an incentive to invert which may not be well-aligned with the interests of long-term shareholders.

4.2 CEO Incentives and Predicting Inversions

Given that the tax treatment of options is preferential to stock in an inversion, we next ask whether CEOs with a high fraction of their equity-based pay in stock, rather than options, are less likely to invert. Table VI presents a logistic regression of a firm’s decision to invert on its characteristics and its CEO’s incentive measures. The dependent variable takes a value of 1 in the last fiscal year end prior to the announcement of an inversion, and 0 otherwise. All regressions include year and industry fixed effects. Basic firm characteristics—log of book assets, market to book ratio, cash to assets, profitability, institutional ownership—are included. In addition, the foreign share of tax, defined as foreign taxes paid over total taxes paid, is included as a proxy for the extent to which income is derived from foreign sources.25 Measures of the CEO’s incentives include CEO Equity Holdings, which is the estimated market value of the CEO’s stock holdings divided by the sum of the market value of option and stock holdings; and CEO Price-to-Basis, which is the ratio of the market price to the capital gains tax basis for the vested shares owned by the CEO. We also consider a measure of the personal tax costs for shareholders in the inversion decision: Avg. S.H. Price-to-Basis is the current share price divided by the capital gains tax basis for the average shareholder, estimated using the approach described in Section 3.4.26 The benchmark logit estimate is shown in Column (1) of Table VI. Both log of assets and the foreign share of taxes are positive and significant, while the other variables do not show significance. Interestingly, we find no evidence that firms with large cash holdings are more likely to invert, as the coefficient on the cash-to-asset ratio is negative and insignificant. Column (2) introduces a variable which measures the value of the CEO stock holdings as a fraction of total equity-based

25Foreign share of earnings is not used because this value is much less frequently reported than foreign taxes paid. 26We do not include industry or year ﬁxed eﬀects in our logistic regressions because this would exclude observations from the many industries and years in which no inversions occur.

22 holdings. We find a negative and significant coefficient on this stock holdings variable, indicating that CEO’s with a higher level of tax-advantaged option holdings are more likely to invert. Just as for regular shareholders, the CEO’s stock holdings are subject to capital gains tax at the time of inversion. Therefore, we may expect CEOs with a low basis to be less likely to invert. We test this in Column (3) by including the personal tax basis for the CEO’s share holdings, expressed as a price-to-basis ratio. The coefficient estimate is negative but not significant. However, we would only expect the capital gains consideration to large for CEO’s with a high level of stock holdings, not for those with mostly options. Therefore, we should expect the coefficient on the CEO’s price-to-basis ratio to be increasingly negative as the fraction of stock holdings increases. We test this in Column (4) by including the interaction of the fraction of stock holdings with the price-to-basis ratio. The coefficient is highly negative and significant, suggesting that when stock holdings are high, CEO’s with high price-to-basis are less likely to invert. This demonstrates that the CEOs personal tax incentives help to predict inversion. Finally, in Column (5) we include the average shareholder price-to-basis to test whether the tax liabilities of the shareholder base independently predicts inversion. The coefficient estimate in small and not significant. Column (6) includes the average shareholder price-to-basis ratio with the CEO incentive measures. Interestingly, even after including the average shareholder basis— which is by construction positively correlated with the CEO’s price-to-basis ratio—the importance of the CEO’s incentives are unchanged. Overall, we find that the CEO’s personal incentives are a significant driver of the inversion decision, and we find no evidence that the costs to the average taxable shareholder guide this policy choice.

4.3 Post-inversion CEO Compensation

In addition to the direct effect of inversion on the CEO’s stock and option holdings, the CEO generally remains in her position following an inversion. Does compensation look significantly different in the year following acquisition? This post-inversion compensation could be an important channel through which the CEO receives a private benefit of inversion, effecting the CEO’s incentive to undertake expatriation. Table VII estimates the deviation of compensation in the year following an acquisition or inversion from the CEO’s average compensation. Each column regresses a measure of compensation on

23 two indicator variables: one for making a public acquisition, and one for inverting, in the previous year. Each regression includes year and CEO fixed effects. Therefore, the coefficient estimates measure the deviation of that component of compensation from the average value for that CEO in the year following an acquisition or inversion, in thousands of dollars. Note that both indicator variables are equal to one when inversions that were effected through an acquisition. Panel A shows the deviation estimates for the full sample, 1992–2014. Consistent with Harford and Li (2007) we find that stock and option grants, in addition to salary and bonus, increase significantly following acquisitions generally.27 For inversions, there is a $570 thousand decline in bonus compensation and a larger and significant increase in other compensation by $1.45 million. Overall compensation increases by $1.18 million on average, but this is not statistically significant. One potential reason for this increase in other compensation is that executives and directors are generally reimbursed for their personal excise tax liability on certain unvested shares and unexercised options provided under section 4985, as discussed in Section 4.1. This excise tax was not imposed until 2005, along with requirements making inversion more difficult provided under section 7874 (see Section 2.1 for discussion), which lead to inversion occurring almost exclusively through acquisition. In addition, starting in fiscal year 2006 firms were required to self-report the fair value of option grants. This improves the accuracy of the option award value data during this period. For these reasons, we explore separately the post-legislation period 2006–2014 in Panel B. As in Panel A, we see a significant, although smaller, increase in total compensation for firms which make acquisition. For inverting firms during this period we see a significant increase in salary, options awards, and other compensation. On average, the CEO receives $2.28 million more in option awards following inversion than in a normal year.28 We also find strong evidence that CEO’s are being “grossed up” for their personal tax liability, with other compensation increasing by a highly significant $4.28 million. Overall, total compensation increases an average of $6.12 million in the year following inversion.

27Grinstein and Hribar (2004) find that CEOs receive larger bonuses after completing M&A deals and that the bonus is not related to deal performance. 28This may be evidence that the board is adjusting the timing or magnitude of option compensation in order to reduce the CEO’s excise tax liability. Therefore, this tax regulation, by influencing compensation policy, may have the indirect consequence of changing the CEO’s incentives relative to the diversified shareholder; see Panousi and Papanikolaou (2012), Glover and Levine (2014), and Glover and Levine (2015).

24 4.4 Institutional Ownership

In the previous sections, we have shown the CEOs personal incentives help predict the inversion decision while the personal tax costs of average shareholders do not. However, one limitation of the previous analysis is that we do not have data on the extent to which shares are being held in tax-advantaged accounts, such as retirement accounts or by pension funds, or by tax-exempt individuals, such as non-U.S. persons. In all of these cases, there are no personal tax costs of inversion and these shareholders receive on the benefits. In this section, we examine whether the capital gains tax penalty affects the inversion decision using institutional holdings data. FactSet provides disaggregated data on ownership by U.S. and foreign institutions, constructed by Ferreira and Matos (2008) and covering the period 2000–2013. While U.S. institutions hold shares on behalf of both taxable and non-taxable entities, nearly all ownership by foreign institutions represent non-U.S. clients who are not subject to U.S. capital gains taxes. Thus the net benefits of an inversion are higher for shares held by foreign institutions than for those held by U.S. institutions. Consistent with the differential benefits to foreign and domestic holders, we find that the foreign institutional ownership is very large for firms which announce their intention to invert, with a mean (median) holdings of 38.0% (13.0%), compared to 4.3% (0.9%) for non-inverting firms. While we cannot determine if foreign ownership drives the inversion decision, the existence of this ownership structure does result in a lower total tax cost of inversion to shareholders. In addition, we find that U.S. institutional ownership is lower for inverting firms at 38.9% (39.1%) compared to 34.4% (24.1%) for non-inverting firms. Table VIII presents a logistic regression of a firm’s inversion decision on institutional ownership and controls. U.S. and foreign institutional ownership is the fraction of market capitalization held by U.S. and foreign institutions, respectively. Total institutional ownership is the sum of U.S. and foreign institutional ownership. The dependent variable takes a value of 1 in the last fiscal year end prior to the announcement of an inversion, and 0 otherwise. The controls follow those in Section 4.2. Column (1) shows a strong positive relationship between the inversion decision and total institutional ownership. Columns (2) and (3) replace total institutional ownership with the fraction of the firm held by U.S. institutions, which represent clients that are more likely to be taxable U.S.

25 persons, and foreign institutions, which represent mostly persons not taxable in the U.S. Strikingly, the coefficient estimates are negative and positive for U.S. and non-U.S. institutions, as well as highly significant. Column (4) includes both foreign and total institutional ownership. We find that after controlling for foreign institutional ownership, the marginal effect of total institutional ownership is much smaller and marginally insignificant. Finally, Column (5) adds the shareholder price-to-basis ratio for the average investor in addition to the institutional ownership variables. The coefficient is slightly negative, consistent with a concern for the personal tax costs of shareholders in the inversion decision, but is not statistically significant. These results for U.S. and foreign institutional ownership are consistent with the hypothesis that the capital gains tax effect is an important consideration in the inversion decision. While we cannot demonstrate causality, the data show that the negative capital gains tax effects are significantly lower for firms that choose to invert, as their ownership by non-U.S. persons is significantly higher. The differential tax status of shareholders, just as we showed for differential shareholder basis, leads to a potential conflict of incentives across equityholders. Indeed, the U.S. legislation designed to reduce expatriation increases the costs of inversion only for U.S. taxpayers while foreign investors exclusively benefit from the inversion.

5 Conclusion

We show that corporate inversions have widely different private returns to individual shareholders given the personal tax consequences of these transactions. While the benefits of reduced corporate income taxes benefit all shareholders, U.S. shareholders must realize a capital gain at the time of inversion, forfeiting their tax timing option. This cost is often high for long-term investors who purchased their shares at a low price, while the penalty for short-term investors is small. The differential effect on shareholders brings into question the efficacy and fairness of this tax penalty imposed by the executive branch designed to discourage expatriation of U.S. companies. Counterintuitively, this tax policy punishes U.S. shareholders while allowing the benefits to accrue to foreign shareholders, in addition to punishing passive, long-term investors. Our findings shed new light on the net loss of U.S. tax revenue, and the gain to expatriating shareholders, of corporate inversion.

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29 Appendices

A Model Solution

In this appendix we derive the investor’s private valuation and market price for pre-inversion ﬁrm, providing a proof to Propositions 1 and 2.

A.1 Post-inversion valuation

We start by deriving an investor’s private valuation and the market price of the post-inversion ﬁrm. In the next section, we derive the pre-inversion valuations, which depend on these post-inversion values.

A.1.1 Post-inversion private valuation: vI (x; B)

For an investor with basis B, their private valuation of the post-inversion firm, vI (x; B), satisfies the following ordinary differential equation:

σ2 x2vI (x; B)+µxvI (x; B)+ξ[(1−τ˜ )pI (x)+τ ˜ B −vI (x; B)]+(1−τ )(1−τ I )x = rvI (x; B). (24) 2 xx x g g d c

At any time, an investor with basis B could sell her share at the current market price, pI (x), and receive after tax proceeds of I (1 − τg)p (x) + τgB. (25)

This implies that the ODE in Equation (24) is subject to the following boundary conditions:

I I v (x) =(1 − τg)p (x) + τgB for x = xB (26)

I I vx(x) =(1 − τg)px(x) for x = xB. (27)

Equations (26) and (27) are the value-matching and smooth-pasting conditions, respectively, and xB denotes the cash ﬂow threshold at which an investor with basis B optimally sells her shares. It is well known that the solution to this ODE will take the general form29:

I −γ1 v (x) = A0 + A1x + A2x (28)

29See, for example, Dixit and Pindyck (1994).

30 where γ1, the positive root of the fundamental quadratic, is given by s 1 µ µ 12 2(r + ξ) γ = − + − + . (29) 1 2 σ2 σ2 2 σ2

Solving for the A coeﬃcients, we get an explicit expression for the investor’s private valuation of a post-inversion ﬁrm,

−γ1 I x I v (x; B) = p (xB) − h(xB; B) + h(x; B), (30) xB where the function h(x; B) is deﬁned as

(1 − τ )(1 − τ I )x ξ(1 − τ˜ )pI (x) ξτ˜ B h(x; B) ≡ d c + g + g . (31) r + ξ − µ r + ξ − µ r + ξ

A.1.2 Post-inversion market price: pI (x)

Next, we derive the market price. Implicitly, the market price is characterized by the ﬁxed point:

pI (x) = vI (x; pI (x)). (32)

Start with the smooth pasting condition that characterizes an investor’s optimal selling threshold, given by equation (27). This gives

∂pI (x) 1 ∂vI (x; B) = . (33) ∂x 1 − τg ∂x

This must hold for any B, including B = pI (x). Thus, we can write

I I ∂p (x) 1 ∂v (x; B) = . (34) ∂x 1 − τg ∂x B=pI (x) Taking the partial derivative of the expression we have for the investor’s private valuation, given in I Equation (30), evaluating this at B = p (x) (which implies xB = x), plugging this into the equation above, and rearranging, we have the following ODE characterizing the post-inversion market price:

∂pI (x) γ ξ(1 − τ˜ ) ξτ˜ (1 − τ )(1 − τ I )x x + 1 pI (x) 1 − g − g − d c ∂x 1 − τ r + ξ − µ r + ξ r + ξ − µ g (35) x (1 − τ )(1 − τ I ) ξ(1 − τ˜ ) ∂pI (x) − d c + g · = 0 1 − τg r + ξ − µ r + ξ − µ ∂x Deﬁne (1 − τ )(1 − τ I ) ξ(1 − τ˜ ) ηI ≡ d c and ωI ≡ g . (36) r + ξ − µ r + ξ − µ

31 Rearranging the above ODE, we have

ωI ∂pI (x) γ ξτ˜ (1 + γ )ηI 1 − x + 1 1 − ωI − g pI (x) − 1 x = 0. (37) 1 − τg ∂x 1 − τg r + ξ 1 − τg The solution to this ODE has the general form pI (x) = AI (x). Solving explicitly for pI (x), we have ! (1 + γ )ηI pI (x) = 1 x. (38) I γ1ξτ˜g (1 + γ1)(1 − ω ) − τg − r+ξ

Finally, we explicitly characterize the investor’s selling threshold, xB, in terms of their basis B. As noted earlier, for an investor with basis B, the optimal selling threshold for the cash ﬂow level, xB is implicitly deﬁned by I p (xB) = B. (39)

Given the expression for the market price provided in Equation (54), we have

I γ1ξτ˜g ! (1 + γ1)(1 − ω ) − τg − r+ξ xB = I B. (40) (1 + γ1)η

A.2 Pre-inversion valuation and market price

We now derive the private valuation and market price for a ﬁrm that has not yet inverted. The approach to solving for these valuations is the same as in the case of the post-inversion ﬁrm of the previous section.

A.2.1 Private valuation of the pre-inversion ﬁrm: v(x; B)

For an individual investor with basis B, their private valuation of the pre-inversion firm, v(x; B), satisfies the following ordinary differential equation:

2 σ 2 x vxx(x; B) + µxvx(x; B) + ξ[(1 − τ˜g)p(x) +τ ˜gB − v(x; B)] 2 (41) I + λ[(1 − τg)p (x) + τgB − v] + (1 − τd)(1 − τc)x = rv(x; B), where pI (x) denotes the market price of the post-inversion firm with cash flow level x. As with the post-inversion firm, at any time, an investor with basis B could sell her share at the current pre-inversion market price, p(x), and receive after tax proceeds of

(1 − τg)p(x) + τgB. (42)

32 This implies that the ODE in Equation (41) is subject to the following boundary conditions:

v(x) =(1 − τg)p(x) + τgB for x = xB (43)

vx(x) =(1 − τg)px(x) for x = xB. (44)

As before, Equations (43) and (44) are the value-matching and smooth-pasting conditions, respectively, and xB denotes the cash ﬂow threshold at which an investor with basis B optimally sells her shares. As before, the solution to this ODE will take the general form:

−β1 v(x) = A0 + A1x + A2x (45) where β1, the positive root of the fundamental quadratic, is given by s 1 µ µ 12 2(r + ξ + λ) β = − + − + . (46) 1 2 σ2 σ2 2 σ2

Solving for the A coeﬃcients, we obtain an explicit expression for the private valuation of an investor with basis B, given current cash ﬂow level of x:

x −β1 v(x; B) = p(xB) − g(xB; B) + g(x; B), (47) xB where the function g(x; B) is deﬁned as

(1 − τ )(1 − τ )x + ξ(1 − τ˜ )p(x) + λ(1 − τ )pI (x) (ξτ˜ + λτ )B g(x; B) ≡ d c g g + g g . (48) r + ξ + λ − µ r + ξ + λ

A.2.2 Pre-inversion market price: p(x)

We now proceed to derive an explicit expression for the market price of the pre-inversion firm. The approach follows the derivation of the price for the post-inversion firm. Recall that the pre-inversion market price is characterized by the fixed point:

p(x) = v(x; p(x)). (49)

We follow the same approach as before, starting with the smooth pasting condition that characterizes an investor’s optimal selling threshold, given by equation (15). This says

∂p(x) 1 ∂v(x; B) = . (50) ∂x 1 − τg ∂x

33 This must hold for any B, including B = p(x). Thus, the following must hold: ∂p(x) 1 ∂v(x; B) = . (51) ∂x 1 − τg ∂x B=p(x)

Taking the partial derivative of the expression we have for the investor’s private valuation, given in equation (47), evaluating this at B = p(x) (which implies xB = x), plugging this into the equation above, and rearranging, we have the following ODE:

1 ξ(1 − τ˜ ) ∂p(x) β ξ(1 − τ˜ ) ξτ˜ + λτ 1 − g x + 1 1 − g − g g p(x) 1 − τg r + ξ + λ − µ x 1 − τg r + ξ + λ − µ r + ξ + λ (52) 1 λ(1 − τg) I 1 + β1 (1 − τd)(1 − τc) − (1 + β1) p (x) − x = 0 1 − τg r + ξ + λ − µ 1 − τg r + ξ + λ − µ Deﬁne

(1 − τ )(1 − τ ) ξ(1 − τ˜ ) η = d c , ω = g , r + ξ + λ − µ r + ξ + λ − µ λ(1 − τ ) ξτ˜ + λτ Λ = g , Θ = g g r + ξ + λ − µ r + ξ + λ (1 + γ )ηI AI = 1 . I γ1ξτ˜g (1 + γ1)(1 − ω ) − τg − r+ξ Then we can rewrite the above as

ω ∂p(x) β (1 − ω − Θ) (1 + β )Λ (1 + β )η 1 − x + 1 p(x) − 1 pI (x) − 1 x = 0 (53) 1 − τg x 1 − τg 1 − τg 1 − τg

Solving this ODE, we have an expression for the market price of the pre-inversion ﬁrm:

(1 + β )(AI Λ + η) p(x) = 1 x. (54) (1 + β1)(1 − ω) − β1Θ − τg

Finally, analogous to the case of the post-inversion ﬁrm, the optimal selling threshold, xB, is given by (1 + β1)(1 − ω) − β1Θ − τg xB = I B. (55) (1 + β1)(A Λ + η)

34 B Data B.1 Variable deﬁnitions

We use the CRSP and Compustat databases to construct the following ﬁrm variables:

Firm value = market value of common equity (prc * shrout) + short- term debt (dlc) + long-term debt (dltt). Book leverage = (short-term debt (dlc) + long-term debt (dltt)) / book assets (at). Net leverage = (short-term debt (dlc) and long-term debt (dltt) - cash and short-term investments (che)) / book assets (at). Cash to assets = cash and short-term investments (che) / book assets (at). EBITDA to assets = earnings before interest (ebitda) / book assets (at). Asset tangibility = new PPE (ppent) / book assets (at). M/B = (market value of common equity (prc * shrout) + short- term debt (dlc) + long-term debt (dltt) + preferred stock liquidating value (pstkl) - deferred taxes and investment tax credits (txditc)) / book assets (at). Share of foreign earnings (≥ 0) = foreign pretax income (pifo) / pretax income (pi). Only calculated when domestic and foreign incomes are non- negative. Share of foreign taxes (≥ 0) = foreign income taxes (txfo) / current income taxes (txc). Only calculated when domestic and foreign taxes are non- negative. Share of foreign taxes (normal- = |foreign income taxes (txfo)| /(|domestic income taxes ized) (txdom)| + |foreign income taxes (txfo)|). Absolute value allows inclusion of negative observations, while still measuring the relative magnitude of foreign operations. CEO options holdings = market value of options divided by the sum of the market value of options and shares. CEO stock tax basis = ratio of current share price to the CEO’s average cost basis, constructed as deﬁned in Appendix B.2. Average shareholder basis = current share price divided by the capital gains tax basis for the average shareholder, estimated using the approach described in Section 3.4. Institutional ownership (total) = fraction of shares outstanding held by institutions. Institutional ownership (U.S.) = fraction of shares outstanding held by U.S. institutions. Institutional ownership (foreign) = fraction of shares outstanding held by foreign institutions.

B.2 CEO Cost Basis

Data for CEO cost basis computation is taken from Execucomp. Missing data for inverters’ CEO compensation are hand collected from SEC ﬁlings of either ﬁnancial reports or proxy statements—

35 the ﬁrm’s annual 10-K report or a Form DEF 14A. To calculate cost basis, ideally one would need data on prices and volumes for every event of shares being sold, purchased or acquired through opion exercise or restricted stock vesting. Information on options exercised is available in Execucomp for all years, and on vesting shares only since 2006 as required under FAS 123R. Data on all purchases and sales of shares are not readily available, and we therefore approximate these transactions using net purchases, calculated as a change in the number of held shares adjusted for shares obtained through option exercise and vesting. We assume that CEOs do not hold company shares before being appointed to oﬃce. Using the average cost method, cost basis in year t can be calculated recursively as:

 s b +o po+r pr+spp  t−1 t−1 t t t t t t if sp ≥ 0  st t bt = o r st−1bt−1+otpt +rtpt p  p if st < 0 st−st where

st = number shares held at the end of period t. pt = average share price during year t. All share sales and purchases are assumed to be made at this price. ot = number of options exercised during period t. o pt = share price at the time of option ot exercise, assumed equal to pt. rt = number of (restricted) shares vesting during period t. Assumed to be 0 before 2006. r pt = price of restricted shares, rt, at the time of vesting. p st ≡ st − st−1 − ot − rt; net purchase of shares during period t.

36 Table I: Summary Statistics

This table reports summary statistics for the last fiscal year end prior to the announcement of an inversion. This is shown for all inversions as well as split into inversions involving an existing foreign subsidiary (naked) and those effected through a merger. For comparison, the final column reports summary statistics for the CRSP/Compustat universe of U.S. public firms for the period 1994–2015. For each characteristic, we report the mean, the median in brackets, and the standard deviation in parentheses. Variable definitions are provided in Appendix B.

All inversions Naked Merger All Compustat

log(Market size) 8.367 7.688 8.852 6.107 [8.466] [8.167] [8.749] [5.990] (1.683) (1.482) (1.668) (2.055) log(Sales) 7.504 6.998 7.852 5.401 [7.498] [7.219] [8.035] [5.360] (1.738) (1.529) (1.807) (2.250) Gross book leverage 0.269 0.258 0.276 0.217 [0.259] [0.240] [0.271] [0.162] (0.163) (0.145) (0.177) (0.216) Net book leverage 0.128 0.136 0.123 0.038 [0.147] [0.184] [0.144] [0.068] (0.237) (0.226) (0.247) (0.366) Cash/Assets 0.140 0.123 0.153 0.180 [0.085] [0.067] [0.129] [0.077] (0.151) (0.175) (0.133) (0.226) EBITDA/Assets 0.123 0.102 0.137 0.040 [0.128] [0.125] [0.129] [0.082] (0.113) (0.114) (0.112) (0.221) PPE/Assets 0.268 0.406 0.184 0.224 [0.179] [0.383] [0.109] [0.136] (0.256) (0.279) (0.203) (0.235) M/B 1.658 1.229 1.928 1.815 [1.193] [0.923] [1.356] [1.171] (1.298) (1.023) (1.391) (1.925) Foreign / Total earnings (>= 0) 0.311 0.362 0.274 0.314 [0.247] [0.211] [0.280] [0.243] (0.282) (0.318) (0.254) (0.273) Foreign / Total taxes (>= 0) 0.389 0.398 0.385 0.204 [0.311] [0.303] [0.318] [0.008] (0.348) (0.344) (0.355) (0.313) Sample size 60 25 35 112,370

37 Table II: Benchmark Parameters

This table presents the benchmark parameters used in the model. Where applicable, values are at an annual frequency.

Panel A: Parameters Description Parameter Value Risk-free rate r 0.05 Cash flow growth µ 0.03 Cash flow volatility σ 0.25 Dividend tax rate τd 0.191 Capital gains tax rate τg 0.191 Capital gains tax rate at deathτ ˜g 0.00 Investor death arrival intensity ξ 0.052 Pre-inversion effective corporate tax rate τc 0.359 F Foreign effective corporate tax rate τc 0.296 I Post-inversion effective corporate tax rate τc 0.323 Inversion arrival intensity λ 0.01

38 Table III: Shareholder Basis Summary Statistics

This table presents summary statistics for shareholder’s price to basis ratio using various measures. The mean, median in brackets, and standard deviation deviation in parentheses are reported based on the type of deal and the measure used for calculating the basis. All values are expressed as the market share price divided by the estimated capital gains tax basis. The capital gains tax basis for the average shareholder (Avg. S.H.) is estimated using the approach described in Section 3.4. The middle three columns deﬁne the basis as the low market price over the last 3, 7, and 15 years, respectively. The last column reports the price to basis ratio for the CEO’s personal share holdings; see Appendix B.2 for details on construction.

Holding period (low price) Avg. S.H. 3-year 7-year 15-year CEO All ﬁrms 1.044 2.106 3.326 5.567 1.200 [1.022] [1.547] [2.000] [2.516] [1.023] (0.498) (1.720) (3.904) (8.736) (0.647)

Merger inversions 1.324 2.452 4.692 9.547 1.311 [1.304] [1.985] [2.673] [4.753] [1.258] (0.354) (1.894) (5.804) (12.774) (0.445)

Naked inversions 0.980 1.964 4.013 9.771 0.976 [1.017] [1.497] [2.713] [4.090] [0.992] (0.339) (0.940) (4.261) (14.317) (0.325)

All inverting 1.176 2.245 4.404 9.642 1.176 [1.122] [1.845] [2.713] [4.744] [1.086] (0.385) (1.570) (5.176) (13.329) (0.431)

39 Table IV: Model-Implied Private Return from Inversion

This table presents statistics on the investor’s private return (Panel A) and breakeven holding period in years (Panel B) for the sample of observed inversions based on various types of investors, estimates for the I shareholder’s price-to-basis ratio, and post-inversion tax rates (τc ). The investor’s private return to the inversion is computed from the model as:

(1 − τ )pI (x) + τ B g g − 1 v(x; B) where pI (x) denotes the market price immediately after the inversion and v(x; B) is the private valuation immediately before inversion for an investor with basis B. For each inversion in the data, the model-implied private return is calculated. In all cases, the baseline parameters given in Table II are used. Panel A reports the mean, median, and tenth percentile of the percent returns. The capital gains tax rate for the individual investor is assumed to be 28.6% except in columns (6) and (7). The model-implied market return from inversion announcement is reported in column (1) and does not vary across ﬁrms. Column (2) uses the basis for the average shareholder which is estimated using the approach described in Section 3.4. The 3-, 7-, and 15-year holding period measures, shown in columns (3)–(5), use the low price over that period as the basis. Columns (6) and (7) varies the individual investor’s capital gains tax rate and assumes a basis equal to the 7-year low price. Finally, column (8) reports return statistics for an 80 year old California resident in the top marginal tax bracket (33%) who has a basis at the 15-year low price. Panel B reports the quartiles of the holding period, in years, for which an investor with the given characteristics would receive a negative private return from inversion. For example, an investor with a 33% capital gains tax rate who has held the shares for 1.42 years would receive a negative private return in half of the inversion deals. Column (1) corresponds to the benchmark taxable investor with a capital gains tax rate of 28.6%. Columns (2) and (3) vary this tax rate. Column (4) reports for an investor of age 78 (ξ = 0.1), and column (5) for an 80 year old California resident in the top marginal tax bracket (33%) who has a basis at the 15-year low price.

Panel A: Shareholder private returns (1) (2) (3) (4) (5) (6) (7) (8) Market Holding period (low price) Tax rate (τg) Wealthy I τc Return Avg. S.H. 3-year 7-year 15-year 19.1% 33% CA res. 32.3% Mean 5.74 2.16 -3.02 -6.59 -9.57 -0.70 -9.35 -15.60 Median 3.29 -2.68 -6.80 -11.02 -0.67 -9.68 -17.61 10 pctl. -1.54 -9.44 -13.52 -16.09 -4.96 -17.56 -23.51

28.7% Mean 9.26 4.76 -0.32 -3.84 -6.81 2.34 -6.75 -13.08 Median 5.87 0.04 -4.04 -8.24 2.38 -7.06 -15.08 10 pctl. 1.16 -6.66 -10.73 -13.29 -1.88 -14.90 -20.97

Panel B: Minimum holding period resulting in a negative private return (1) (2) (3) (4) (5) Tax rate (τg) Age Wealthy I τc Benchmark 19.1% 33% 78 CA res. 32.3% 1Q 1.00 3.08 0.67 0.67 0.50 Median 1.83 6.67 1.42 1.17 0.92 3Q 3.25 10.00 2.75 2.75 1.83

28.7% 1Q 1.75 6.92 1.08 1.08 0.83 Median 2.92 14.08 2.25 2.08 1.50 3Q 6.67 15+ 3.75 3.75 2.83 Table V: Model-Estimated Private Return to the CEO from Inversion

This table presents statistics on the CEO’s private return for the sample of observed inversions. The first four columns present the model-estimated change in the value of the CEO’s stock and option holdings using the CEO’s personal tax basis and age, for two different levels of the post-inversion corporate income tax I rate, τc . The final four columns present the model-implied private return to taxable shareholders using four different measures of the cost basis; see Table IV for details. For each inversion in the data, the model-implied percentage change in the private value of holdings is calculated. The mean, median, and tenth percentile percent changes are reported. The CEO’s private return on share holdings is computed from the model as (pI (x)/v(x; B) − 1) where pI (x) denotes the market price immediately after the inversion and v(x; B) is the private valuation immediately before inversion for an investor with basis B. The estimated capital I gains cost (C.G. Tax) is reported as a percent of the share’s market value: τg(B − p (x))/v(x; B). The return on options is estimated as the delta on option holdings (δ) times the model-implied market return: δ(pI (x)/p(x)−1). The total after-tax return on holdings is calculated as the total change in the private value of holdings following inversion over the private value of stock and option holdings just prior to inversion. Details of the construction of the CEO basis are given in Appendix B.2.

CEO’s private return Shareholder’s private return I τc Options + Stock − C.G. Tax = Wealth Avg. S.H. 3-year 7-year 15-year 32.3% Mean 5.62 8.52 -5.83 4.14 2.39 -2.71 -6.28 -9.36 Median 5.60 7.42 -3.71 3.75 3.34 -2.09 -6.29 -10.74 10 pctl. 0.43 5.74 -12.47 2.40 -0.46 -8.53 -13.36 -15.92

28.7% Mean 9.07 12.15 -6.87 7.18 4.97 -0.02 -3.54 -6.60 Median 9.03 11.00 -4.73 6.43 5.90 0.63 -3.53 -7.96 10 pctl. 0.69 9.26 -13.54 4.62 2.23 -5.76 -10.57 -13.12

41 Table VI: Inversion Decision: CEO Incentives

This table presents results from a logit regressions of a firm’s inversion decision on firm characteristics and CEO incentive measures. The dependent variable takes a value of 1 in the last fiscal year end prior to the announcement of an inversion, and 0 otherwise. M/B is the market to book value of assets. Foreign Share Taxes is the ratio of foreign taxes paid over total taxes paid. CEO Equity Holdings is the estimated market value of the CEO’s equity holdings divided by the sum of the estimated market value of option and stock holdings. CEO Price-to-Basis is the ratio of the share price to the capital gains tax basis for the vested shares owned by the CEO; this ratio is set to 1 when the basis exceeds the price. Avg. S.H. Price-to-Basis is the current share price divided by the capital gains tax basis for the average shareholder estimated using the approach described in Section 3.4. Reports coefficient estimates with t-statistics in parentheses. Significance at the 1, 5, and 10 percent levels are indicated by ***, **, and *.

(1) (2) (3) (4) (5) (6) Invert Invert Invert Invert Invert Invert log(Assets) 0.268** 0.247** 0.271** 0.263** 0.268** 0.263** (2.18) (1.98) (2.21) (2.11) (2.17) (2.11) M/B 0.113 0.090 0.135 0.112 0.108 0.101 (1.03) (0.71) (1.26) (0.81) (0.93) (0.68) Cash/Assets -2.205 -2.391 -2.224 -2.653 -2.192 -2.604 (-1.24) (-1.34) (-1.25) (-1.45) (-1.23) (-1.42) Earnings/Assets 1.338 0.983 1.499 1.412 1.259 1.278 (0.65) (0.46) (0.74) (0.66) (0.59) (0.58) Foreign Share Taxes 1.509*** 1.491*** 1.492*** 1.477** 1.512*** 1.486*** (2.65) (2.61) (2.62) (2.57) (2.66) (2.59) Inst. Ownership 2.097 1.711 2.070 1.931 2.064 1.870 (1.48) (1.21) (1.47) (1.36) (1.44) (1.30) (a) CEO Equity Holdings -1.455** 5.231* 5.495* (-2.24) (1.91) (1.90) (b) CEO Price-to-Basis -0.408 -3.057* -3.246* (-0.78) (-1.83) (-1.80) (a) ∗ (b) -5.892** -6.080** (-2.35) (-2.33) Avg. S.H. Price-to-Basis 0.078 0.216 (0.14) (0.32) Constant -11.054*** -10.724*** -10.601*** -7.701*** -11.092*** -7.633*** (-6.05) (-5.82) (-5.56) (-3.18) (-6.00) (-3.11) Observations 16781 16781 16781 16781 16781 16781 Pseudo R2 0.050 0.064 0.052 0.084 0.050 0.084

42 Table VII: Post-inversion CEO compensation

This table estimates the deviation in compensation in the year following an acquisition or inversion from the CEO’s average compensation. Each column reports the coefficient estimates from a regression of the compensation variable of interest on two indicator variables: one for making a public acquisition, and one for inverting, in the previous year. Both the acquisition and inversion indicators are set to one for inversions effected through acquisition. All specifications include CEO and year fixed effects. Reports coefficient estimates with t-statistics in parentheses. Significance at the 1, 5, and 10 percent levels are indicated by ***, **, and *.

Panel A: 1992–2014 (1) (2) (3) (4) (5) (6) Salary Bonus Stock Awards Option Awards Other Comp. Total Comp. Acquisition 6.920** 91.021*** 201.926** 508.899*** -24.018 794.824*** (2.57) (3.93) (2.33) (3.88) (-0.99) (4.93) Inversion 11.338 -570.051** -1360.730 1965.117 1454.714*** 1184.085 (0.38) (-2.20) (-1.34) (1.22) (5.37) (0.66) Obs. 38664 38664 38647 38412 38664 38664

Panel B: 2006–2014 (1) (2) (3) (4) (5) (6) Salary Bonus Stock Awards Option Awards Other Comp. Total Comp. Acquisition 4.617 7.865 110.188 87.275 15.006 224.950** (1.19) (0.28) (1.57) (1.64) (0.65) (2.23) Inversion 80.549** -150.005 -581.190 2279.492*** 3261.621*** 4890.466*** (2.04) (-0.53) (-0.81) (4.18) (13.75) (4.76) Obs. 16760 16760 16760 16760 16760 16760

43 Table VIII: Inversion Decision: U.S.-Taxable Institutional Ownership

This table presents results from a logit regressions of a firm’s inversion decision on firm characteristics, institutional ownership, and average shareholder basis. U.S. and foreign institutional ownership is the fraction of market capitalization held by U.S. and foreign institutions, respectively, and is used to proxy for holdings by U.S.-taxable and non-U.S.-taxable persons. Total institutional ownership is the sum of U.S. and foreign institutional ownership. The dependent variable takes a value of 1 in the last fiscal year end prior to the announcement of an inversion, and 0 otherwise. M/B is the market to book value of assets. Foreign Share Taxes is the ratio of foreign taxes paid over total taxes paid. Avg. S.H. Price/Basis is the current share price divided by the capital gains tax basis for the average shareholder estimated using the approach described in Section 3.4. Reports coefficient estimates with t-statistics in parentheses. Significance at the 1, 5, and 10 percent levels are indicated by ***, **, and *.

(1) (2) (3) (4) (5) Invert Invert Invert Invert Invert log(Assets) 0.379*** 0.427*** 0.327*** 0.296** 0.297** (3.29) (4.94) (2.85) (2.33) (2.34) M/B 0.131 0.119* 0.126 0.132 0.138 (1.33) (1.68) (1.48) (1.39) (1.50) Cash/Assets -2.118 -1.922 -2.420 -2.462 -2.471 (-1.21) (-1.13) (-1.36) (-1.37) (-1.38) Earnings/Assets 1.727 2.237 2.097 1.916 2.072 (0.90) (1.46) (1.21) (1.04) (1.09) Foreign Share Taxes 1.378** 1.132** 0.334 0.369 0.370 (2.48) (2.08) (0.54) (0.59) (0.60) Total Inst. Ownership 3.481*** 1.931 1.965 (2.78) (1.57) (1.59) U.S. Inst. Ownership -2.092*** (-3.15) Foreign Inst. Ownership 4.497*** 4.087*** 4.090*** (8.07) (6.94) (6.95) Avg. S.H. Price-to-Basis -0.142 (-0.28) Constant -13.462*** -10.003*** -10.721*** -11.862*** -11.769*** (-8.40) (-11.61) (-9.87) (-8.04) (-7.81) Observations 35582 35582 35582 35582 35582 Pseudo R2 0.107 0.103 0.195 0.202 0.202

44 A. Total Inversion Volume 15 600 10 400 5 200 Number of inversions Value of inverting firms, 2014 $ bln 0 0 1990 1995 2000 2005 2010 2015 Year

B. Naked Inversion Volume 15 600 10 400 5 200 Number of inversions Value of inverting firms, 2014 $ bln 0 0 1990 1995 2000 2005 2010 2015 Year

C. Merger Inversion Volume 15 600 10 400 5 200 Number of inversions Value of inverting firms, 2014 $ bln 0 0 1990 1995 2000 2005 2010 2015 Year Figure 1: Inversion Volume. The ﬁgure displays the historical volume of inversion activity by U.S. public companies for the period 1992–2014. The vertical bars represent the number of inversions (left axis) and the line represents dollar volume (in 2014 dollars) of inversion transactions (right axis). Counts and dollar volume include both completed as well as pending or withdrawn deals. For details on the construction of these measures, see Section 2.1. 45 Services FIRE Retail Radio & TV Instruments Electrical Machinery Chemical Furniture Textile Food Construction Nonmetal Minerals Oil and Gas Mining Agriculture 1990 1995 2000 2005 2010 2015 Announcement date

Figure 2: Inversion Activity by Industry. This figure displays the historical inversion activity (completed, pending, and withdrawn), by industry. Dates refer to the announcement date of the inversion. Black circles denote a naked inversion and red correspond to a merger inversion. The size of the circles corresponds to their total market value, measured as the sum of the market equity and face value of debt of the inverting firm. Industries are defined according to the Fama and French 38 industry classification.

46 A. Capital Gains Tax Rate (τg)

0.95 ) x ( /p

) 0.9 B ; x ( v 0.85

τ = 0 g τ = 0.191 0.8 g τ = 0.33 g

0 0.2 0.4 0.6 0.8 1 B/p(x)

B. Investor Age (ξ)

0.95 ) x (

/p 0.9 ) B ; x ( v 0.85

= 0.02 0.8 ξ ξ = 0.052 ξ = 0.1 0 0.2 0.4 0.6 0.8 1 B/p(x)

Figure 3: Comparative statics for private value to price ratio as a function of the investor’s basis. The figure shows an investor’s private value, normalized by the market price, as a function of their basis-to-price ratio. In Panel A, this ratio is plotted for three different values of the investor’s capital gains tax. Panel B shows the ratio for three different values of an investor’s age. In each case, all other parameters are set to their benchmark values listed in Table II.

47 A. Investor Capital Gains Tax Rate (τg) 0.05

-0.05

-0.1

-0.15

τ = 0.191 Shareholder Inversion Return -0.2 g τ = 0.286 g τ = 0.33 g -0.25 0 0.2 0.4 0.6 0.8 1 B/p(x)

B. Investor Age (ξ) 0.06

0.04

0.02

-0.02

-0.04

-0.06

-0.08 Shareholder Inversion Return ξ = 0.052 -0.1 ξ = 0.08 ξ = 0.1 -0.12 0 0.2 0.4 0.6 0.8 1 B/p(x) Figure 4: Shareholder private return as a function of the investor’s basis. The figure plots an investor’s private return to an inversion as a function of their basis-to-price ratio. Panel A shows the private returns for different values of an investor’s capital gains tax rate, τg. Panel B shows returns for different investor ages, corresponding to the parameter ξ. All other parameters are set to their benchmark values listed in Table II. The investor’s private return to the inversion is computed from the model as: (1 − τ )pI (x) + τ B g g − 1 v(x; B) where pI (x) denotes the market price immediately after the inversion and v(x; B) was the private valuation immediately before inversion for an investor with basis B. 48 0.1

0.05

-0.05

Shareholder inversion return -0.1 = 0.191 g τ = 0.286 g τ = 0.33 g -0.15 0 2 4 6 8 10 12 14 Holding period (years)

Figure 5: Shareholder private return as a function of holding period. The ﬁgure plots the mean private return of an inversion for an investor as a function of their holding period. The low price over that period is used as the shareholder’s basis. Three diﬀerent values of the capital gains tax rate are shown, corresponding to 19.1% (solid blue line), 28.6% (red dashed line), and 33% (green dot-dashed line). The dotted line corresponds to the model-implied market return from the inversion.