Swift and merciless. That was the apparent effect the U.S. Treasury’s April 4 regulatory package had on what was poised to be the largest inversion in history. But several pending inversions have emerged relatively unscathed, and experts are predicting continued corporate exodus, raising questions about what exactly Treasury has accomplished.
On April 6 Pfizer Inc. announced the termination of its agreement to merge with Allergan PLC, making the failed tie-up the largest withdrawn mergers and acquisitions deal on record, according to financial markets platform Dealogic Ltd. (Prior coverage: Tax Notes Int’l, Apr. 11, 2016, p. 145.) Had it closed, the deal would have been the second largest on record, after Vodafone Airtouch’s $172 billion acquisition of Mannesmann in 2000.
Treasury had bagged its trophy, it would seem. Friedemann Thomma of Venable LLP captured the sentiments of many observers over recent weeks when he told Tax Analysts he thought Treasury’s latest round of anti-inversion rules were issued specifically to address the Pfizer deal (T.D. 9761, REG-135734-14, REG-108060-15). Thomma said he finds it disconcerting that the IRS and Treasury have effectively built rules around specific fact patterns. ‘‘I’m not a fan of that,’’ he said. ‘‘Conceptually, we want to achieve certain goals, and the latest round of regulations was very much targeted.’’
But Andrew Eisenberg of Jones Day, a former attorney-adviser in the IRS Office of Associate Chief Counsel (Corporate), pointed out that IRS and Treasury are most effective at writing rules when they have real facts in front of them. ‘‘It’s really hard to write rules in a vacuum,’’ he said. ‘‘When certain transactions are announced, the government does utilize those transactions in crafting its rules.’’
Arguably as striking as the quick collapse of Pfizer’s deal following the issuance of the new rules is the number of companies that remain undeterred.
During Johnson Controls’ second-quarter earnings call April 21, CEO Alex Molinaroli said the company is proceeding with its merger with Tyco International PLC and expects $650 million in operational and tax synergies over the three years following the merger — just as it did before Treasury released the reg package. (Prior coverage: Tax Notes Int’l, Apr. 25, 2016, p. 356.) The new rules did cause the company to revisit its tax planning, Molinaroli said. It was also said during the call that the company is confident that tax synergies from the deal will be in the range anticipated before the new rules were released.
IHS Inc. and U.K.-based Markit Ltd. said April 5 that after reviewing the new rules, they don’t expect their $13 billion merger-of-equals to be subject to IRC section 7874. When the companies announced their agreement in March, they projected a tax rate in the low to mid-twenties for the combined company. ‘‘Treasury rule changes will not impact the combined company’s adjusted effective tax rate guidance,’’ the companies said after their review. (Prior coverage: Tax Notes Int’l, Mar. 28, 2016, p. 1104.)
Waste Connections Inc., which is planning to invert to Canada through its merger with Progressive Waste Solutions Ltd., said April 5 that Treasury’s proposed regulations could have an impact of less than 3 percent of the combined company’s expected year 1 adjusted free cash flow, ‘‘excluding any additional structuring benefits that could offset such impact.’’ The companies said in a release that they remain committed to the merger and expect the deal to close in the second quarter of 2016. (Prior coverage: Tax Notes Int’l, Jan. 25, 2016, p. 314.)
U.S.-incorporated fertilizer company CF Industries Holdings Inc. announced last August that it planned to combine with Netherlands-based OCI NV using a new holding company domiciled in the U.K. Shortly after the release of Notice 2015-79, 2015-49 IRB 775, which included the third-country rule, the company said the tax residency of the new holding company would be in the Netherlands, rather than the U.K. A CF Industries spokesperson told Tax Analysts that the company has no comment on the rules released April 4.
Without mentioning Treasury’s new rules, Coca- Cola Enterprises announced April 11 that its combination with Coca-Cola Iberian Partners SAU and Coca- Cola Erfrischungsgetränke GmbH to form new U.K. corporation Coca-Cola European Partners Ltd. is on track to close by the end of the second quarter of 2016. (Prior analysis: Tax Notes Int’l, Aug. 17, 2015, p. 559.) The company did not respond to a request for comment by press time.
Connecticut-based industrial equipment maker Terex Corp. and Finnish competitor Konecranes PLC announced April 27 that they will proceed with their agreement to form new Finnish company Konecranes Terex PLC even though the Treasury regulations eliminated substantially all the tax synergies expected from the deal.
Other companies have chimed in about the non- effect Treasury’s rules will have on their cross-border transactions. Shire PLC announced April 6 that it ex- pects its $32 billion acquisition of Baxalta Inc. to pro- ceed as announced in January. (Prior coverage: Tax Notes Int’l, Jan. 18, 2016, p. 234.) Medtronic PLC sought to reassure investors April 6 that the temporary and proposed regulations ‘‘do not have a material financial impact on any transaction undertaken by the company.’’ Medtronic Inc.’s acquisition of Ireland’s Covidien closed in January 2015.
What Happened to Pfallergan?
Treasury’s perceived attack on Pfizer might be fairly described as targeted, but it wasn’t unexpected. Some observers were surprised by the company’s April 6 termination announcement, given its presumed awareness that Notice 2015-79 wasn’t Treasury’s final word on inversions, the deal’s compelling business rationales, and Pfizer’s continued projections of confidence leading up to the release of the new rules.
‘‘I would have expected Pfizer knew and believed the government would pull out all the stops,’’ said Ira Gorsky, a strategist at Elevation LLC. The importance of the Allergan deal to Pfizer was clear, Pfizer CEO Ian Read had long pitched the deal as a priority, and Allergan is considered a well-run company, Gorsky said, adding, ‘‘People had the perception that Pfizer was prepared to have a long, drawn-out fight against government overreach if it came to that.’’
Gorsky and others agreed that regardless of whether Treasury is on firm legal footing, the practical barriers to challenging the regulations — for example, having to close a transformative transaction and wait for audit — are prohibitive. ‘‘There’s a big difference between saying something is unlawful or is government overreach and actually trying to roll it back,’’ Gorsky said. He added that if Pfizer had proceeded with the deal with an intent to challenge the regulations, the resulting uncertainty in its books would have been significant.
Not many taxpayers will enter a transaction expecting specific tax results knowing that to realize those results they will have to go to court and win on the point that a regulation is invalid, Eisenberg said. ‘‘It’s likely that the only time somebody will challenge these rules is if they inadvertently fall into them,’’ he said.
Still, companies were on notice that Treasury would take further action against inversions. When coupled with the uncertain fate of regulatory proposals in an election year and the improbability of a legislative response in the current administration, Gorsky said he thought Pfizer ‘‘would have taken the chance that the next administration wouldn’t have the same view as the current Treasury or that a different deal could be worked out. I thought it was their window to do something.’’
Notably, the cost to Pfizer for walking away from the Allergan deal was relatively modest. While the companies had agreed to potential termination fees of up to $3.5 billion, Pfizer ended up owing only $150 million for reimbursement of Allergan’s expenses, with the reason for the termination characterized as an ‘‘adverse tax law change’’ as defined in the merger agreement. The parties had planned for an inexpensive unwinding of the deal in the event of a change in law regarding section 7874. ‘‘They had the contractual out, so they took it,’’ Gorsky said.
Pfizer’s Next Move
Now that Pfizer has abandoned the Allergan deal, it really doesn’t have anything else, Gorsky said. ‘‘I think the window is closed for Pfizer and that the shutdown was important for the government to secure as a signal that it will do everything fair and unfair to stop companies from doing this,’’ he added. ‘‘Pfizer isn’t going to try again unless it gets a friendlier administration,’’ he said.
While the company has said its decision to terminate the deal was driven by recent Treasury actions, Gorsky pointed out that the U.S. government is a customer of Pfizer’s. ‘‘You never know what kind of private pushback Pfizer could have gotten,’’ he said. Recent statements indicated that the company was prepared for a Treasury challenge, so it either didn’t want to deal with the uncertainty created by the new rules, ‘‘or it was fearful of some other form of retribution,’’ according to Gorsky. A Pfizer spokesperson told Tax Analysts the company has no comment.
Another complication for Pfizer is the ‘‘post-Martin Shkreli environment where pharmaceutical companies have been tarred as bloodthirsty opportunists willing to raise prices so as to harm patients,’’ so adding tax dodger to that image is too much for Pfizer to absorb from a reputational standpoint, Gorsky said.
Bret Wells, a tax law professor at the University of Houston Law Center, thinks Pfizer will probably be back, either with Allergan or another partner. ‘‘If Pfizer agreed to pay a stock premium based on its expectation of a large, upfront interest-stripping benefit, then the current valuation and exchange ratios may not make sense now,’’ Wells said. ‘‘It doesn’t mean the deal isn’t a good deal at some stock price.’’
Meanwhile, Allergan can take its $40 billion war chest from the sale of its Actavis Generics business to Teva Pharmaceutical Industries Ltd. and start buying up U.S. companies, said Gorsky. The sale to Teva is expected to close in June, according to an April 6 Allergan release.
Plus, under the 36-month lookback in the multiple domestic entity acquisition rule of Treasury’s temporary regulations, Allergan will become a desirable large merger partner — even for potential inverters — not long from now, according to Edward D. Kleinbard of the University of Southern California Gould School of Law.
Some practitioners have speculated that with the lookback, Treasury has effectively instituted a cooling- off period and may have been signaling Congress that it has a few more years to act.
Future Trends
The cat-and-mouse nature of the new rules has cre- ated a sense of déjà vu in the tax community. With each new inversion Band-Aid comes renewed convic- tion that inversions and corporate flight won’t be stopped by surgical administrative action. ‘‘If you sic enough smart tax lawyers on a complicated set of rules, they’re going to find a way to arbitrage them,’’ said Eric Talley of Columbia Law School, summing up popular sentiment among those who spoke with Tax Analysts.
Several observers commented that Treasury’s actions could lead to an environment in which global com- panies are generally not U.S.-parented. Some specu- lated that in the absence of U.S. tax reform, companies will continue to be drawn offshore to more competitive jurisdictions regardless of how hard Treasury makes it to do so without tripping the IRC section 7874 owner- ship thresholds.
‘‘All that these new rules will do is create a perma- nent competitive advantage for foreign acquirers,’’ Read wrote in an April 6 Wall Street Journal op-ed. ‘‘There will be more foreign acquisitions of U.S. companies resulting in fewer jobs for American workers.’’ He ac- knowledged that his company benefits from world-class academic institutions, a highly skilled labor force, and other U.S. advantages, but noted that Pfizer’s foreign competitors do too — and ‘‘pay significantly less for the privilege.’’
The U.S. tax system disadvantages U.S. companies relative to their foreign competitors, and inversions eliminate that disadvantage, Wayne Winegarden of the Pacific Research Institute told Tax Analysts. ‘‘It’s not the best solution,’’ which would be corporate tax reform, he said.
The answer isn’t as simple as lowering the U.S. tax rate, Eisenberg said. ‘‘Even if corporate tax rates go to 25 percent, there will always be a lower corporate tax rate available in an alternative country, which means there will always be incentive for U.S. companies to outbound their income-producing assets,’’ he said.
It’s possible that the wave of the future is a sharp decrease in the number of U.S. parents because U.S. corporate rates will always be greater than those of many other countries, Eisenberg said. Whatever the U.S. tax rate is, there will always be pressure to get earnings outside the United States, he said. ‘‘Companies fight for their shareholders by doing what they can to increase company value — and tax is an expense that reduces that value.’’
Talley said the proposed IRC section 385 rules might inspire companies that weren’t even thinking of inverting to move offshore. ‘‘One could make the argument that the section 385 rules are actually more injurious to companies that had no plans to invert,’’ he said. Regulatory developments in other areas — securities law, for example — have already paved the way for companies to leave the United States, and the tax package could have a similar effect, Talley said. (Prior analysis: Tax Notes Int’l, June 15, 2015, p. 978.)
Thomma said he thought the proposed section 385 regulations were potentially more damaging to the cross-border M&A world than the serial acquisitions rule. Those rules ‘‘will add another layer of complexity to debt-financed M&A transactions and could thus slow down or impede common structures like those placing debt financing on operating subsidiaries of a target,’’ he said. Making an intercompany loan now requires running ‘‘through the gauntlet of section 385, making sure there’s no possibility of potential recharacterization, and complying with all documentation requirements,’’ which are somewhat consistent with, but more onerous than, transfer pricing documentation rules, he said.
Thomma said the compliance burden is a real concern for clients. He said he won’t be surprised if companies that have the opportunity to move their parent companies offshore and operate under a more efficient structure get nudged further in that direction by the new rules. ‘‘Any related-party financing is an issue, any cash pooling will be affected, typical treasury manage- ment practices will be affected,’’ he said, adding that emerging growth companies are the most likely to move offshore.
Proposed U.S. Treas. reg. section 1.385-2 (REG- 108060-15), regarding documentation of related-party indebtedness, is intended to apply only to large tax- payer groups. Companies with up to $100 million in assets or up to $50 million in revenue ‘‘will think quickly and seriously about getting out of the U.S. tax system,’’ Thomma said. ‘‘I think it’s going to be harder for the more established companies to get out of these rules,’’ he added.
Inversions will continue because there are still huge benefits to doing them, Wells said. ‘‘The government has tinkered with the [section] 7874 rules consistently since 2004 and still hasn’t stopped the problem because the financial savings are so compelling,’’ he said. Left undiscussed are ‘‘all the tools left in the earnings stripping toolbox that can be done post-inversion or by foreign-based multinationals,’’ he added.
Wells predicted that intellectual property migration and the ability to do royalty stripping will become a larger benefit over time. ‘‘The IRS can’t deal with that under section 385 but it could under section 482 — and it should,’’ he added.
Non-interest earnings stripping is difficult, Kleinbard said. But what Treasury has done with traditional interest stripping ‘‘is both very complicated and more limited in scope than what Congress could have done in straightforward legislation,’’ he said.
Investment bankers and lawyers will find the most efficient corporate structure for running combined businesses, and as long as there’s an inversion benefit to be had, companies will continue to invert, Wells said. ‘‘I don’t want to say people will do tax-motivated deals; they won’t,’’ he said. ‘‘They’ll do deals that make economic sense.’’ But inverting clearly brings synergies that are unrelated to nontax business combination efficiencies, and foreign acquirers have the ability to pay larger premiums than would be justified without the tax savings, Wells added. Mihir Desai, a professor at Harvard’s law and business schools, said he doesn’t think about the effects of the regulatory package as concerning inversions, per se. ‘‘I think of this as a broad pattern of M&A that shifts the balance of power toward larger foreign firms — which are now the preferred buyers of U.S. corporate assets — in merger negotiations,’’ he said. Allergan, for example, has a preferential tax status and can pay higher prices for targets than U.S. com- petitors, Gorsky said. ‘‘Treasury knows there’s nothing it can do at the moment to prevent foreigners from buying U.S. companies, so everything it’s trying to prevent is still going to occur,’’ he said. ‘‘It’s just going to show up in a different form.’’
The competitive disadvantage the U.S. tax system creates for domestic companies will lead either to foreign companies buying out U.S. companies or U.S. companies losing the ability to compete, said Winegarden. ‘‘Either way, you’re moving capital from the higher-tax, less-tax-efficient country to the more preferable tax country,’’ he said. Inversions tend to result in keeping employees and facilities in the United States, which, from a U.S. economics perspective, is a better outcome than a foreign takeover that dismantles the U.S. headquarters and moves jobs offshore, he said.
Another consequence could be that U.S. companies downsize, said Desai. He cited Pfizer’s announcement that it will decide whether to pursue a separation of its business by the end of the year, consistent with the time frame it contemplated for the decision before the announcement of the Allergan transaction. ‘‘Either foreign firms win or U.S. firms get smaller so they can undertake the same transactions they were going to without running afoul of the regulations,’’ Desai said, adding that neither result is in the interest of the United States.
Wells said Treasury should be more focused on the fundamental financial tax savings generated from inverting than its satisfaction with arbitrary strata of combined entity ownership percentages. The new section 385 regulations are just a first step, he said. ‘‘It shouldn’t matter whether the inbound investor is an inverted company or a foreign-based company, if they’re stripping the U.S. tax base, that is an unfair competitive advantage,’’ he added.
Macro-Level Effects
Treasury thinks it must address inversions, which are just one subset of the M&A market, ‘‘but the alternative view is that you don’t have to do something, and in fact you can make things worse by doing something,’’ Desai said.
Several observers labeled Treasury’s willingness to pursue pending deals a disturbing trend. One economist said that with merger arbitrage funds taking positions on the outcomes of deals, subjecting signed transactions to new regulations creates an unfortunate set of lobbying incentives. ‘‘Now even when a deal is done, it’s not done,’’ which creates incentives for funds, competitors, or even estranged former partners from failed deals to lobby to change the rules, said Winegarden. Treasury’s signal that the rules of the game might not be constant com- promises one of the fundamentals of a solid economy, he said. He agreed with the premise that in the absence of tax reform, no action is preferable to the action taken.
For every horror story showing that retroactivity is unfair, there’s a corresponding cautionary tale about why having only prospective rules is a bad idea, Talley said. He added that 2014 and 2015 were ‘‘great years to be an M&A attorney, but they would have been even better if Treasury wasn’t allowed to touch signed deals.’’
Talley said he’s ‘‘not insensitive to the idea that people relied to their detriment on existing legal rules, but no one could have fairly expected that for the first time in human history we were living in a static regulatory environment.’’ The way to strike the right balance between the costs posed by prospective-only rules and costs posed by retrospective-only rules might be for Treasury ‘‘to avoid being utterly predictable, as if Secretary [Jacob] Lew were flipping a coin,’’ he said.
Eisenberg agreed that the new rules create some business-related inefficiencies. ‘‘There were combin tions that could have taken place that were probably good from a nontax business perspective that can’t happen now,’’ he said. He added that U.S. companies will now have to combine with foreign or domestic companies that might not give them as favorable business synergies.
But maximizing synergies in M&A doesn’t always equate to optimal economic efficiency, Talley said.
When Pfizer walked away from Allergan, people who stood to gain from the synergies missed that opportunity, ‘‘so that looks like a prima facie economic cost,’’ he said. Despite an inefficiency at the company level, however, a deal breakup is not necessarily a social inefficiency ‘‘when one takes into account that tax authorities around the world get shortchanged on some of these deals,’’ Talley said. If the tax benefits of some types of transactions, such as inversions, are too large, ‘‘companies will decide to merge in ways that reinvent each other’s wheels, which is inefficient’’ said Talley. The companies don’t get much in the way of operating or other synergies by combining, but the tax savings are significant enough that despite an efficiency loss to their productive capacities, they still gain overall. ‘‘If that’s the kind of thing being deterred by the regs, then Treasury just forestalled a decision that would have visited a social inefficiency on society,’’ Talley said.
Further, because the name of the game in executing inversions is to be European and big — or become big by acquiring European, rather than U.S., entities — the industries represented are going to get more and more concentrated to the point where deals may be blocked by antitrust authorities — not to mention what would happen to drug prices if a global pharmaceutical com- pany were to amass 60 percent of the market, Talley said. ‘‘That would also be a social loss, so even though a merger might appear to be full of strategic synergies, it may essentially be leveraging anti-competitive market power,’’ he added.
