Did Treasury Target Pfizer-Allergan Inversion?

The Obama Administration and the Allergan CEO disagree about whether the government wanted specifically to kill the giant drug merger.
David Katz and Katie Kuehner-HebertApril 6, 2016

Today’s news that Pfizer and Allergan have nixed their $150 billion merger plan followed hard on the heels of Monday’s announcement that the Obama administration was issuing stiff new temporary anti-inversion rules.

U.S. Treasury Secretary Jacob J. Lew

U.S. Treasury Secretary Jacob Lew

Via the merger with Allergan, the Ireland-based maker of Botox, Pfizer could have cut its tax rate as well as as gain control of “the billions of dollars in revenue it was keeping overseas to avoid paying U.S. taxes on top of the taxes it had already paid in foreign countries,” The Wall Street Journal reported today.

In corporate inversions, U.S. multinationals change their tax locales in order to cut or avoid paying U.S. taxes. They do that by acquiring a smaller foreign company and then basing the tax residence of the entire group in a low-tax foreign country. “Typically, the primary purpose of an inversion is not to grow the underlying business, maximize synergies, or pursue other commercial benefits. Rather, the primary purpose of the transaction is to reduce taxes, often substantially,” according to a U.S. Treasury Department fact sheet describing the rules.

“For years, companies have been taking advantage of a system that allows them to move their tax residences overseas to avoid U.S. taxes without making significant changes in their business operations,” Treasury Secretary Jacob Lew said during a conference call with reporters Monday, according to Accounting Today.

An Obama spokesperson denied that the new regs specifically targeted the tax advantages of the Pfizer-Allergan deal, according to the Journal.

For his part, Brent Saunders, the chief executive officer of Allergan,  told CNBC today the U.S. government had targeted his company’s proposed deal with Pfizer. “It really looked like they did a very fine job of constructing a rule here — a temporary rule — to stop this deal, and obviously it was successful,” he said.

Whether Treasury actually intended the rules to kill the deal, part of the regulation fits the situation perfectly. In issuing the provision, the Obama administration said it was looking to curb inversions by ignoring parent company shares gained in inversions or acquisitions “within three years prior to the signing date of the latest acquisition,” according to the fact sheet.

Data curated by FindTheCompany

Under the existing inversion curbs in section 7874 in the U.S. tax code, for a period of ten years, the merged company’s taxable income for any taxable year must not be be less than its “inversion gain” (the income gained via the expatriated U.S. company’s transfer of stock). But some foreign companies have been able to avoid U.S. taxes by acquiring a bunch of American companies over a short period of time before the inversion. In that way, the merged company can make its taxable income far exceed the amount it’s gained by acquiring merely the U.S. company’s stock.

Such inversion schemes are at the heart of M&A deals like Pfizer’s, which focus mainly on cutting taxes, according to the Journal’s account. Investors in the inverting company should own between 50% and 60% of the combined entity for the deal to yield top tax benefits. “Between 60% and 80% also works, but the tax perks are diminished, and above 80%, they are lost entirely. So U.S. companies need inversion partners that are at least one-quarter their size, and ideally more like two-thirds,” the newspaper reported.

Last November, when the Pfizer-Allergan deal was struck, the market caps of Pfizer and Allergan were about $200 billion and $120 billion, respectively, and Pfizer stockholders would own 56% of the merged company, according to the Journal.

The Treasury’s new temporary rules would erase the three prior years’ worth of deals, however. Although Allergan currently has 395 million shares outstanding, it had recently issued about 260 million shares for big acquisitions, the newspaper said.

“Stripping those out leaves about 130 million shares, worth only about $30 billion. Under the current merger ratio, Allergan shareholders’ stake in the combined company would likely drop into the high teens,” according to the story. “In other words, in the eyes of Treasury, Allergan would have been too small to be Pfizer’s inversion partner.”

In Treasury’s view, it’s inconsistent with the tax code’s anti-inversion provision “to permit a foreign company (including a recent inverter) to increase in its size in order to avoid the inversion threshold under current law for a subsequent acquisition of an American company,” according to the fact sheet.

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