The Secret To Making A Killing From The World’s Highest Corporate Taxes

The United States has a corporate tax rate of 35% — the highest in the developed world, and not exactly a competitive advantage for companies trying to return profits and value to stockholders.

It may seem unlikely, but there is actually a way for smart investors to profit from this high tax burden.

#-ad_banner-#It involves following the logic of billionaire hedge funder Bill Ackman in his bruising takeover battle for Allergan (NYSE: AGN). (It is so promising that fellow hedge fund rival John Paulson is joining forces with Ackman on this deal.)

The secret to Ackman’s strategy is that he is using a Quebec pharmaceutical firm as the takeover vehicle. The name of this company is Valeant Pharmaceuticals (NYSE: VRX), but that’s only incidental to this story.

The real story is that Canada’s corporate tax rate is 15% — less than half of the U.S. rate mentioned above – and other developed countries share a similar tax advantage. Presuming Ackman’s hostile takeover happens, it means that when Allergan’s tax domicile moves from the U.S. to Canada, Allergan’s corporate tax burden — the company paid $519 million in 2013 — will go way, way down in future years. The resulting gain in profit helps justify Ackman’s acquisition price.

It is too late for stock investors to jump on the Allergan trade — the so-called tax inversion premium is already built into the takeover share price — but there are other pending and proposed corporate headquarters moves in the works, as U.S. companies flee American shores for Europe and elsewhere to escape some of the highest business taxes in the world.

As The Economist succinctly put it: “America is a land of immigrants, but some of its biggest companies are keen to emigrate.” Bloomberg identified over 40 public companies that have switched their U.S. tax citizenship elsewhere in recent years, and noted the pipeline is starting to flow faster.

One of the best bets for investment on this theme is AbbVie (NYSE: ABBV), a U.S. biopharmaceutical headquartered in Chicago that has a long-term deferred tax liability of $570 million and an effective tax rate of 22.6%, thanks to various breaks and loopholes.

AbbVie has been trying to combine with Shire (Nasdaq: SHPG), an Irish drug concern, and move the combined company to the British island of Jersey, which has a 13% tax rate – a huge discount on even AbbVie’s relatively low effective rate.

The bottom-line impact of a lower rate tax for American corporate exiles can be profound. For instance, The Economist reported that another U.S. company, medical device maker Medtronic (NYSE: MDT), which is combining with Ireland’s Covidien and moving its headquarters there, will add $60 million to its bottom line with each percentage-point drop in its tax rate in Ireland, which has a rate of about 15%.

But there are other reasons to like AbbVie besides tax rates.

American companies that change their tax domicile also move their overseas earnings and cash out of the reach of the IRS. According to The Wall Street Journal, AbbVie has $10 billion in cash stashed in foreign accounts now. Being able to repatriate that money into its corporate coffers would be a big benefit.

Even if AbbVie fails in its Shire takeover, or decides to go elsewhere, there are other potential pharmaceutical targets for it to pursue outside of the U.S. It seems unlikely the company would put together a mulit-billion-dollar war chest and then abandon the hunt for a foreign merger partner.

On July 1, AbbVie hiked its own profit forecast. And Barclays last week raised its rating on the stock, with a $69 price target.

AbbVie’s blockbuster drug is the rheumatoid arthritis treatment Humira, from which it receives as much as 60% of its revenue. However, AbbVie recently announced it has entered a pivotal Phase III clinical trial with Veliparib, a promising potential treatment for breast cancer.

AbbVie has a profit margin of 22%, better than many of its peers, on revenues of $19 billion. Its trailing price-to-earnings (P/E) ratio is 22.5, again lower than the industry average. Both points indicate there is still room for upward valuation in the shares.

AbbVie says it intends to keep its primary operations and most of its employees in the U.S. regardless of whether it seeks tax protection elsewhere. The company could be a big beneficiary if Washington ever manages much-needed tax reform to stop companies from feeling like they are being forced to move elsewhere.

Risks To Consider: Congress could try to eliminate the tax advantage that occurs when U.S. companies move their headquarters to Europe, the Caribbean or just about anywhere else, but the chances of success for that in an election year may be dim. There could be currency and foreign political risks to consider as well depending where AbbVie moves, and Humira goes off patent protection in 2016.

Actions To Take –> AbbVie is a buy at current levels, but it may not be wise to buy a complete stake all at once. If AbbVie walks away from its Shire offer, ABBV will likely fall, which means more shares can be accumulated at a discounted price. Either way, in the medium term, AbbVie is likely to find a foreign merger partner, and its operating margins are bound to move considerably higher.

Last but not least, AbbVie pays a 3.2% dividend yield — and high-yielding stocks that have plenty of cash for dividend growth are the foundation for my colleague Amy Calistri’s “Daily Paycheck” investing strategy. To see how she’s used this strategy to earn more than $60,000 in dividend checks since 2010, click here.