Tax inversion clampdown hits US M&A
Pfizer/Allergen merger abandoned; cross-border deals set for slowdown.
Pharmaceutical giants Pfizer and Allergan were forced to abandon their $160 billion merger in April following the US Treasury’s clampdown on tax inversion deals. This would have been the largest pharmaceutical company merger in history and would have enabled Pfizer to redomicile from its headquarters in New York to the lower tax jurisdiction of Ireland. Allergan had moved its head office to Dublin after a reverse merger with Irish pharmaceutical company Activis last year.
Inversion deals allow corporations to relocate their headquarters to countries with lower tax rates. Since the beginning of 2011, there have been 23 inversion deals completed by US companies, according to Dealogic. Six more are pending. President Barack Obama called on Congress to close “one of the most insidious tax loopholes out there”, saying it shortchanges the country. The president said less tax revenue meant less spending on schools, transportation networks and other investments. He said the practice also hurts middle-class Americans because “that lost revenue has to be made up somewhere”.
“It was very hasty of the Treasury and should have been discussed a little longer,” says one lawyer in New York. “It was clearly rushed out to prevent Pfizer and Allergan merging.”
Indeed market participants say this was the catalyst – that while the IRS and the Treasury had been hinting for two years that they were going to change the rules, the speed at which it happened was solely to stop this merger.
“It’s Monday evening and a 300 to 400 page rule book comes out – that is not typically how the process goes,” says the lawyer. “We knew, however, that the Treasury was crafting a structure to shut down that deal.” It’s not the first time Pfizer has tried an inversion deal – in 2014 it attempted an inversion with UK firm AstraZeneca.
Rob Holo, Simpson Thatcher & Bartlett
Two sets of proposed regulations have been issued as part of the clampdown. The first prevents foreign companies from including the value associated with domestic acquisitions made in the previous three years in their aggregate value calculation for tax inversion purposes. This makes it more difficult for foreign companies to engage in serial inversion transactions with US firms. Allergan had been making acquisitions, for example with Actavis, to make itself more attractive to Pfizer as a tax inversion partner. The government also proposed anti-stripping rules that limit the ability of a corporate group to undertake interest-stripping transactions.
“In a classic transaction where, for example, a UK or Irish parent was created to acquire a US company through an inversion deal, the US subsidiary would dividend out a note to the foreign parent,” explains Rob Holo, partner at law firm Simpson Thacher & Bartlett in New York. “If planned correctly, that note dividend itself would not be subject to US tax, and then interest payments thereafter paid by the US subsidiary would create a deduction in the US, a high tax jurisdiction, while creating interest income in a lower tax jurisdiction. It’s a rate arbitrage game, but the new regulations limit the ability to interest strip,” he says.
John Barrie, a tax lawyer at Bryan Cave, says that the entire cross-border structure now needs to be rethought and that the new regulation was not considered deeply enough. “When you think about how corporations move offshore to pay less tax it really is not different to the way corporations sometimes move income around to reduce their state taxes. In theory if tax rates were the same, there would instead be offsetting tax credits to encourage firms to domicile in certain places. There needs to be a bigger discussion about international tax rules if we want to embrace a global economy but ensure taxes are paid fairly.”
Holo says bankers will be looking at new structures to help US firms seeking a foreign parent to mitigate taxes. The largest five banks in US M&A declined to speak to Euromoney on this topic.
Says Holo: “Firms can still enter royalty arrangements to avoid running into the issue of interest stripping where intellectual property is developed offshore and deductible royalties are paid to a non-US country which taxes them at a lower rate. The new regulations only apply to issuances of debt – potentially converting that debt into equity. Bankers will now be adapting their M&A models to see if pending deals are still worth it.”
“These transactions are never tax-only deals. There is always a corporate business purpose to doing them” - Rob Holo, Simpson Thacher & Bartlett
Holo feels there will still be an appetite for foreign deals.
“These transactions are never tax-only deals. There is always a corporate business purpose to doing them,” he says. “They create business benefits, cost-savings opportunities and the opportunities for international growth. Those benefits still exist. There will still be plenty of deals done.”
At press time the inversion deal between US car battery maker Johnson Controls and its Ireland-based peer Tycol was still going ahead.
Barrie however believes investment-banking fees may be dented as firms hit ‘pause’ and let the regulation and revised inversion rules digest, and rethink their growth strategies. Above all he says that private equity firms are likely to be affect by the regulation as debt structuring may become a less attractive means of offsetting revenues.