New tax inversion rules put merger arbitrage ETFs in focus

Tax inversion has become so common a U.S. business practice that the U.S. Treasury Department needs to chalk out a set of rules to discourage domestic companies from shifting their headquarters. The companies often resort to this practice to evade higher tax payments, seeking to make their bases in nations with lower tax burdens.

The U.S. corporate tax rate is as high as 39.1% (per OECD), the highest among the OECD nations. Also, the U.S. is among the few OECD nations without a territorial tax scheme which provides overseas earnings of domestic companies a relief from domestic taxation, as indicated by Forbes.

Thanks to this stringent policy, a scurry of merger-acquisition deals was noticed in the recent past. Through such deals, the U.S. domiciled companies joined foreign companies and shifted their headquarters to foreign lands where tax rates are lower in order to see a cut in tax bills.

Prompted by this trend, we have seen some high profile merge deals taking place between Medtronic, Inc. (MDT) and Irish medical supplies firm Covidien plc (COV), between AbbVie Inc. (ABBV) and another Irish firm Shire plc (SHPG) and between the famous fast food chain Burger King Worldwide, Inc. (BKW) and Canada-based Tim Hortons Inc. (THI).

To stop the flow of these deals, and the resultant loss in tax revenues, the U.S. Treasury altered some sections of the tax code that make it harder for companies to enter into tax inversion deals. One change includes the end of ‘hopsctoch’.  This requires U.S. companies to pay U.S. tax on when their overseas profits are returned to the nation.

The other change is that a U.S. company can reach an inversion deal subject to less than 80% of ownership of the new company is owned by the U.S. partner. Thanks to this rule, U.S. companies cannot regulate their sizes now onward through corporate practices. Further, new rules lay down that U.S. companies can no longer shift ‘passive assets’ to a foreign subsidiary.

How to Play?

Thanks to this recent surge in merge acquisition activities, IQ Merger Arbitrage ETF (MNA) and ProShares Merger ETF (MRGR) have gained investor attention. In any case, easy borrowings and a huge cash balance with corporate have been the basic tailwinds for the space. The flair for tax inversion was an added advantage.

Now, the recent inversion clampdown and potential rise in interest rates next year might take a bite out of these ETFs. However, several market participants still believe that these new regulations will not completely end the overseas deal making spree; and that these will just slow down the trend. We still believe merger and acquisition ETFs could be in focus in the coming days given the rising talks about tax inversion.

 In fact, Tim Horton confirmed its progress with the Burger King deal despite inversion restrictions. Some experts expect the Medtronic and Abbvie deal to be sealed too. In such a backdrop, it might be worth it to take a closer look at the M&A ETFs. Below we have highlighted the ETFs and the strategy followed by these in detail.

Merger Arbitrage in ETFs

Merger arbitrage strategy looks to tap the price differential (or spread) between the stock price of the target company after the public announcement of its proposed acquisition and the price offered by the acquirer to pay for the stock of the target company.

Basically, this differential takes into account the uncertainty factor that the deal might not materialize. If it does, however, investors generally enjoy some quick gains and if it doesn’t, they face the risk of some losses.

A simple merger arbitrage strategy would be to take opposite positions (long/short) in the stocks of the target and acquiring company. However, what position to take in which company would depend entirely on an investor’s perception of the deal.

MNA in Focus

This fund offers exposure in global companies for which there have been public announcements of a takeover while at the same time providing short exposure to global equities as a partial equity market hedge. The strategy is accomplished by tracking the IQ Merger Arbitrage Index.

The fund invests about $61.7 million in 38 holdings putting the largest allocation to Morgan Stanley ILF/TREAS/INST, Intermune, Family Dollars, and Kinder Morgan Energy and Tim Hortons on the long side. Costs come in at 76 basis points a year. The ETF has added about 3.2% so far this year (as of September 24).

MRGR in Focus

This product follows the S&P Merger Arbitrage Index, which is a benchmark that holds up to 56 publicly announced deals within developed market countries, having 113.6% long positions, 53.5% short positions and holding 39.9% of assets in the form of cash.

From a sector perspective, consumer discretionary, technology and communications take the top three positions on long side. The ETF has been able to manage assets worth $1.8 million. The fund charges 75 bps in fees. MRGR has lost about 1.6% in the year-to-date frame (as of September 24).
MEDTRONIC (MDT): Free Stock Analysis Report
BURGER KING WWD (BKW): Free Stock Analysis Report
TIM HORTONS INC (THI): Free Stock Analysis Report
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Zacks Investment Research is characterized by a team of experts who are passionate about your investing success and is focused on sharing the same reliable investment research they would want for themselves.

Zacks Investment Research

Zacks Investment Research

Zacks Investment Research is characterized by a team of experts who are passionate about your investing success and is focused on sharing the same reliable investment research they would want for themselves.

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