As the US took tougher steps Monday to limit the tax-cutting power of corporate inversions, analysts said the new rules may put a planned $160bn merger between Pfizer and Allergan in jeopardy.
By yesterday, Allergan shares were trading at $224.78 at 8:30am in New York, below their price of $271.57 on October 26, before reports that the two drug-makers were in talks about a deal.
“The deal is trading as if it’s 95% dead,” Michael Craig, an analyst with Evercore ISI, said in a note to clients late on Monday.
The Treasury Department said on Monday the rules would limit companies’ ability to participate in inversion transactions if they’ve already done them within the past 36 months. Allergan has been involved in several mergers in that time frame. In a corporate inversion, a US company merges with a smaller foreign firm and then transfers the new company’s tax address offshore.
Pfizer and Allergan were reviewing the Treasury Department’s announcement on Monday night, according to a joint statement from the companies. “Prior to completing the review, we won’t speculate on any potential impact,” the statement said. Allergan’s $2.5bn of 4.75% notes maturing in 2045 dropped 4.6¢ to 102.4¢ on the dollar at 8:45am in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
“The real question is whether Pfizer reads today’s regs as reason enough to not continue to pursue the deal,” wrote Umer Raffat, a senior analyst with Evercore ISI.
At issue is the Treasury’s plan to change how it calculates whether a cross-border merger is subject to anti-inversion penalties, which would limit much of an inversion’s tax benefits in cases where US shareholders wind up with 60% or more of the new, merged firm.
As announced, the Pfizer-Allergan merger doesn’t meet that standard; Pfizer shareholders would wind up with 56%, which puts the deal beyond the reach of the Treasury rules. However, if the rule means that some of Allergan’s merger-driven growth since 2012 wasn’t allowable, the ownership ratio would swing more toward Pfizer in the Treasury’s analysis and the planned transaction would be rendered less beneficial, for tax purposes.
It’s unclear whether the Treasury has the authority to enforce that change, though Raffat wrote that he thinks the agency can change the way it interprets ownership percentages.
Also on Monday, the Treasury announced new rules that would make it more difficult to engage in a tax strategy known as “earnings stripping,” which enables US subsidiaries of multinational companies to reduce their tax bills by issuing debt to their foreign parents.
Under those rules, which would apply to related-party transactions after April 4, certain securities of at least $50mn that were previously considered debt will be at least partially treated as stock. That would make it more difficult for foreign companies to load their US units with related- party debt, according to a Treasury news release.
“For years, companies have been taking advantage of a system that allows them to move their tax residences overseas to avoid US taxes without making significant changes in their business operations,” Treasury Secretary Jacob J. Lew said in a conference call with reporters. “We will continue to explore additional ways to limit inversions.”
Lew called on Congress to adopt legislation aimed at inversions, as did White House Press Secretary Josh Earnest, in a statement.
Analysts were scouring the Treasury’s proposals on Monday evening for clues as to whether they’d affect Pfizer-Allergan, which is scheduled to close later this year.
Allergan, which has a legal address in Dublin, began as Watson Pharmaceuticals, a small, New Jersey-based maker of generic drugs. In 2012, it bought Iceland’s Actavis and took that company’s name. The next year, it bought Warner Chilcott, and used the transaction to move its tax address abroad, while keeping its operating headquarters in the US. More deals followed, for Forest Laboratories and Allergan. The resulting company took Allergan’s name last year.
Lew told reporters on Monday: “Some companies are serial inverters.” He didn’t name names.
Under existing rules, when a US company merges with a foreign firm, US shareholders must own less than 80% of the new firm for it to be considered a foreign company for tax purposes. If the Treasury disregarded the portion of Allergan’s growth attributable to prior inversions, its merger with Pfizer might not qualify, said Henrietta Treyz, an analyst at Height Securities.
“So the question for Pfizer is, can you still get over that threshold and do you still want to do it?” Treyz said.
Mark Schoenebaum, an analyst at Evercore ISI in New York, said the effect of the new rules won’t be fully clear until Pfizer comments on the rule changes.
Another new rule aims to curb deals that take place when a smaller foreign company issues shares to bulk up for the sole purpose of an inversion with a larger, US-based company. That will allow the Treasury to disregard the foreign parent’s new stock when evaluating whether the proposed deal puts the US company at the 60% threshold.
The rules on earnings stripping focus on inverted companies’ use of related-party debt that has characteristics of equity, according to a senior Treasury official, who spoke on condition of anonymity. Under prior rules, a foreign parent company has an incentive to load up its US subsidiary with such debt so it can take interest-payment deductions as if the entire security were debt.
Going forward, the Treasury said the Internal Revenue Service will be allowed to determine how much of such debt instruments should be regarded as equity for tax purposes. The rule will apply to related-party debt of more than $50mn and does not apply to related-party debt that is used for investment in the US, the official said. That will have the effect of forcing sophisticated, large companies to prove upfront to IRS officials that their transactions involve actual debt, he said.
Inversions have become a political flash point, with presidential candidates including Democrat Hillary Clinton and Republican Donald Trump promising to discourage the practice. Democrats in Congress, including New York Senator Charles E Schumer and Michigan Representative Sander Levin, welcomed the Treasury’s announcement on Monday. Republicans have called for addressing inversions in the larger context of international tax reform, which would include lowering the 35% corporate income tax in the US, which is among the world’s highest.