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Apr 05, 2016

New Treasury rules scuttle Pfizer-Allergan merger

Guidance targets post-inversion earnings stripping and acquisition rampages designed to avoid inversion threshold

The latest round of guidance from the US Treasury Department intended to put the kibosh on tax inversions has done just that. On Wednesday, Pfizer and Allergan announced they were terminating their $150 billion merger agreement, which would have been the biggest tax inversion yet if it had come off.

The Treasury Department had twice previously issued formal temporary rules designed to curb the financial incentives for US firms to move their tax residence offshore, in September 2014 and November 2015. But the fact sheet it released on April 4 ramps up the clampdown by targeting earnings stripping, a tactic multinational corporations often use, Treasury says, ‘to minimize US taxes by paying deductible interest to their new foreign parent or one of [their] foreign affiliates in a low-tax country.’ Treasury says new legislation is also required for these rules to be enforced. 

Earnings stripping allows a US subsidiary to issue its own debt to its foreign parent as a dividend distribution after an inversion or foreign takeover. The foreign parent can then transfer this debt to a low-tax foreign affiliate while the US subsidiary gets to deduct the resulting interest expense on its US income tax return at a meaningfully higher tax rate than that at which the foreign affiliate is being taxed. The Treasury Department’s latest rules makes it harder for foreign-parented companies to do this by treating any instrument issued to a related company in a dividend transaction as stock. The proposed regulations generally don’t apply to related-party debt incurred to finance actual business investment such as building or outfitting a factory, according to the fact sheet.

The new rules also target the practice of foreign companies acquiring multiple US firms in quick succession or through an inversion in order to increase their value. This could enable them to acquire even larger American companies and avoid the inversion threshold as set under the the US tax code, as the US firm being acquired accounts for less than 80 percent of the combined entity’s total stock value.

This is precisely the tactic Allergan has used in recent years to grow to its current size. The string of acquisitions that Dublin, Ireland-based Allergan made starting in 2013 fueled the growth in its market cap to $100 billion, ‘making it a more-fitting counterpart for Pfizer, under the rules from 2015’, as reported by the New York Times’ Dealbook blog on Tuesday.

Adam Kanzer, managing director of Domini Social Investments, sees tax inversions as just the ‘tip of the iceberg’ when it comes to the much broader problem of international tax avoidance. Kanzer has been working on it for a few years and has found it a steep learning curve to tackle, but says for most socially responsible investment firms, it’s a fairly new issue. ‘One of the complexities is that the vast majority of this is perfectly legal so the question is: if it’s legal, why shouldn’t companies take advantage of it?’ he asks.

Some of it comes down to interpretation, which clouds the question of how legal these practices are, Kanzer adds. ‘Much of it, the way I see it, is a form of arbitrage between different countries’ tax regimes because multinationals are able to skirt through the gap,’ he says. ‘They think they can play one set of rules off another. And it may not be illegal, [but] that may be merely because nobody ever thought to do exactly what [these companies are] doing.’

While the OECD is currently in the throes of rethinking its tax rules, Kanzer says he’s been trying to get companies to think about developing ethical policies that would guide their tax practices, and help them pay closer attention to the impact those policies have on society. ‘The argument I’m trying to make is that tax is not just an expense ‒ it’s also an investment,’ he explains. ‘You’re making a long-term investment in society and there’s a lot of payback for that. You get a well-educated workforce, well-paved roads, school systems and research, which many companies have capitalized on. It’s not a one-way street.’

In addition to sharing in the quotidian social benefits that taxes support, some US companies have also been aided more explicitly by taxes, such as the auto manufacturers the federal government bailed out in 2009 during the recession sparked by the financial crisis. Because the auto bailout also saved the auto companies’ suppliers, Johnson Controls drew criticism when it announced in late January plans to merge with Ireland-based Tyco International and said it expected to save roughly $150 million a year in taxes by moving its tax residence offshore.

The pace of tax inversions has sped up in recent years, as reported by Corporate Secretary in February. The Dealbook story notes that about 40 companies have undertaken inversions in the past five years, citing data from Dealogic. The intention of corporate governance extends beyond ensuring companies are complying with the law to encouraging ethical cultures that can help motivate employees and protect companies from reputational damage for questionable decisions.  

It’s helpful to be reminded that the federal government adopted the idea of deferring payment of taxes on income earned overseas decades ago as a means of incentivizing US firms ‘to become multinationals so they can grow internationally [and] have access to cash internationally to grow their operations,’ Kanzer says. ‘This was supposed to be a benefit to help companies grow, and it’s turned into a tax dodge because now they’re not actually investing [the cash]. It’s sitting in a bank account, or in an investment account. The only obstacle is the tax rate.’ 

David Bogoslaw

Associate Editor and Online features producer for Corporate Secretary