1 Critical Question Swirling Around Medtronic's Mega-Merger

Dividend aristocrat Medtronic became the latest U.S. multinational to exploit a quirk in the tax code, called tax inversion, to shift to a lower tax address overseas. The deal will allow Medtronic to repatriate foreign profits to fund dividend hikes without being hit with the 35% U.S. corporate income tax.

After completion of its $43 billion merger with Covidien , the combined company will be based in low-tax Ireland.

In reality however, both companies will keep their operational headquarters in the U.S. Covidien, legally based in Ireland, actually generates 82% of its production in the United States. 

AbbVie, a big drug maker from Chicago, just tried (and failed, at least thus far) to do the same thing, with a $46 billion cash-and-stock offer to Dublin-based Shire. Even household name Pfizer tried to become a British firm last month, with its failed $120 billion takeover bid for AstraZeneca.

Why the health care stampede to go abroad?
Inversions used to be relatively rare. But as health care corporations scramble to cope with health reform, and look for new ways to unlock cash, investment bankers say many more are plotting similar moves. "There is an element of keeping up with the Joneses," said Timothy R. Larson, head of the international tax practice at Marcum, and accounting firm. "It takes one company with enough public recognition to start the domino effect."

Adding to the sense of urgency are rumblings the U.S. Congress could be moving to close the window. "The question is how quickly they are going to shut the loophole down," said Gordon Hamilton, head of health-care mergers and acquisitions at Cavendish Corporate Finance.

In their defense, thanks to a tax loophole, American corporations can make all the money they want overseas, but once they bring the money back home they have to pay U.S. taxes.

"We've created this crazy system where instead of taxing profits when they are earned, we only tax them when they are brought back home," said Martin Sullivan, chief economist at the nonprofit firm Tax Analyst on National Public Radio. "Therefore, there's a tremendous disincentive to bring the money back home."

Much of the money ends up sitting for years outside the United States, in tax havens. Pfizer had $73 billion in overseas non-taxed liquid assets in 2012, according to the International Business Times. That's a big reason why the company attempted to lower its tax rate from the roughly 27% it paid last year to the UK tax rate, which is now 21%, and headed even lower--to 20% next year.

For its part, Medtronic's problem was well-known. The company had $14 billion in cash, most of it outside the U.S. Moving its tax address to Ireland means the company can more easily deliver on its promise to distribute half of its free cash flow to shareholders by buying back shares and paying dividends.

Financial engineering at the expense of real engineering
The Medtronic/Covidien inversion merger is the biggest so far, and it made at least one Congressman furious. "I'm not going to sit idly by," said Senate Finance Committee Chairman Ron Wyden, "while companies employ these armies of tax accountants and lawyers, and figure out how to hot-wire a way to tap into a loophole." Senator Wyden also announced plans to tighten rules about inversions and make them retroactive to May 8, 2014.

Whether such an attempt can gain traction right now is dubious, with the dysfunctional political environment in Congress. Meanwhile, there's a better answer to the problem -- innovation.

A shortage of innovation has led the whole medical-device group to underperform the S&P significantly for the past 5 years. But innovation can be done even in today's climate -- as Tim Mullaney pointed out in a piece for MarketWatch, using the obvious example of Gilead Sciences' wildly successful $84,000 hep-C drug, whose gross margins are more than 90%.

Medtronic raising its dividend is one way the company can make up to its stockholders for its weakening growth prospects. The company announced a 9% increase to its dividend, along with the news of the buyout.

Short term, the market likes these deals, but they present a significant risk. Executives tend to focus mostly in the next few quarters on integrating their organizations -- to the detriment of R&D. Medical device analyst, Tao Levy, from Wedbush Securities, believes that could work to the advantage of Medtronic's competitors, such as Boston Scientific

"While we view the acquisition favorably for Covidien shareholders," Levy wrote in an investor note, "we believe it leaves much to be desired on how Medtronic shareholders will benefit over the next couple of years."

For their part, Medtronic execs are vociferously denying that the merger will hurt innovation. "We have committed to investing $10 billion in the United States -- above and beyond Medtronic and Covidien's existing plans -- on technology innovation over the next decade," said Medtronic's CEO Omar Ishrak in a recent editorial about the merger. Medtronic also promised to add 1,000 jobs in Minnesota in the next five years.

Medical breakthroughs are rare, and extremely difficult in the device field, as evidenced by the huge setback experienced by Medtronic with Symplicity earlier this year. In January, the blood pressure device failed to convey a benefit compared with a placebo procedure in a large clinical study. The failure cast doubt over the future of a technology that was touted as a potentially large source of revenue growth for Medtronic. 

Medtronic badly needs a replacement for Symplicity. If Medtronic's CEO follows through on his promises about investing in innovation, the deal could make sense for investors long-term. But that's a big if.

1 more Medtronic question
The question is, simply: Will Medtronic be one of the best dividend stocks over the next decade? After all, the smartest investors know that dividend stocks simply crush their non-dividend paying counterparts over the long term. That's beyond dispute. They also know that a well-constructed dividend portfolio creates wealth steadily, while still allowing you to sleep like a baby. Knowing how valuable such a portfolio might be, our top analysts put together a report on a group of high-yielding stocks that should be in any income investor's portfolio. To see our free report on these stocks, just click here now.

The article 1 Critical Question Swirling Around Medtronic's Mega-Merger originally appeared on Fool.com.

Cheryl Swanson owns shares of Gilead Sciences. The Motley Fool recommends Covidien and Gilead Sciences. The Motley Fool owns shares of Gilead Sciences and Medtronic. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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