US Treasury tax reforms force Pfizer to rethink mega merger

JONATHAN WATSON

On 6 April 2016, US pharmaceutical giant Pfizer announced it was abandoning its planned merger with drug developer Allergan. Had the deal gone through, it would have been the biggest acquisition ever in the global pharmaceutical sector. According to the company, new rules unveiled two days previously by the US Treasury amounted to an ‘adverse tax law change’ under the terms of the merger agreement. Allergan is to be paid $150m for ‘reimbursement of expenses associated with the transaction’.

The Treasury reforms are the latest attempt by US authorities to crack down on so-called ‘tax inversions’. These are deals where one company buys another based in a different country with a less onerous corporate tax regime. It then ‘reincorporates’ by shifting the address of its headquarters to the country with the lighter tax burden. Under its planned deal, Pfizer was expected to move its head office from New York to Ireland, where Allergan is based.

Ireland is a popular destination for US firms seeking to pay less tax. ‘If you look at the top 10 Irish companies in terms of revenue, for those over €750m, eight of them are inversions,’ says James Henry, a senior fellow at the Columbia Center on Sustainable Investment and member of the New York Bar.

Frank Clemente, executive director of Americans for Tax Fairness, says preventing the deal is ‘great news for all American taxpayers: individuals, small businesses and large domestic corporations’. If the acquisition had been completed, Pfizer could have avoided ‘as much as $35bn it already owes in US taxes on its offshore profits,’ he suggests.

The new rules are intended to target ‘serial inverters’ by imposing a three-year limit on foreign companies adding US assets to avoid ownership requirements for a later inversion deal. They also invoke Section 385 of the US tax code to strengthen the Treasury’s ability to reclassify debt transactions as equity investments. The aim here is to put a stop to earnings stripping after inversions, whereby US subsidiaries of multinational companies reduce their tax bills by issuing debt to their foreign parents.

‘You can’t help thinking [the US lawmakers] have gone for something where there is an immediate public impact,’ comments Alex Cobham, director of research at the Tax Justice Network. ‘Pfizer happened to be the one in the firing line. It wasn’t doing anything its competitors hadn’t already done.’

According to David Shapiro, an international tax attorney based in the Philadelphia office of Saul Ewing, and Young Lawyers Programme Officer on the IBA Taxes Committee, acquiring US companies was also key to Allergan’s growth strategy. ‘It inverted originally and then set about growing by acquiring US companies by reason of their strategic position as a foreign company.’

Some have questioned the US Treasury’s authority to introduce the reforms. Shapiro says it is ‘relying on very broad anti-abuse authority under the regulations – which it does have’. The question is how broad. ‘This is purported to be to avoid possible abuse of the public offering rule, but in the view of many people, that rule has already been stretched to breaking point.’

An analysis previously prepared by Professor Reuven Avi-Yonah, director of the international tax LLM program at the University of Michigan Law School, argued that the Treasury could modify a rule it issued in 2014 (Notice 2014-52) to block the Pfizer/Allergan deal. ‘The Treasury has the authority to apply the 2014 Notice to transactions like Pfizer/Allergan… by executive action,’ wrote Avi-Yonah. ‘It does not need Congress to act... that would probably stop these inversions in their tracks.’

Avi-Yonah welcomes the Treasury’s new move ‘because it highlights that the Pfizer/Allergan inversion, like quite a few others, was really a merger of two US companies with no real connection to Ireland’. He says this is also the case for another pending inversion transaction, Johnson Controls’ $14bn merger with Tyco International – although that deal is still considered likely to go ahead.

However, Avi-Yonah is less sure about the debt equity rules. ‘These go way beyond inversions,’ he says, ‘[although] I do think the Treasury has ample authority for them under Section 385’.

Shapiro is similarly concerned that the debt equity rules ‘include some real traps that could cause problems for companies that aren’t even involved in an inversion. The standard used is so broad that most debt instruments could be subject to challenge’.

Ultimately, the best answer in the long term is for the US to be looking at an overall system that is more in keeping with the rest of the world. The US has no national value added tax, for example, which reduces its ability to drive down its corporate tax base in the way that other jurisdictions have.

‘While the Treasury actions will make it more difficult, and less lucrative, for companies to exploit this particular corporate inversions loophole, only the Congress can close it for good,’ stated US President Barack Obama. ‘The best way to end this kind of irresponsible behaviour is with tax reform that lowers the corporate tax rate, closes wasteful loopholes and simplifies the tax code for everybody.’

Until then, companies will still be able to carry out planned inversions but, says Shapiro, ‘it’s much more likely that if they are not paying attention, or are unaware of the rules, they will stumble into a really bad tax situation’.

‘Rules that are easy to stumble into should not exist without a truly compelling reason,’ he adds. ‘My worry is that, with the frequency of cross-border transactions today, this is going to become a much larger issue.’