A Head Fake From the Taxman

New guidelines on inversions shouldn't mean much for the pharma mega-deal, or stop others.
At Closing, June 18th
36.16 USD

Allergan shareholders got all riled up for nothing.

Shares of the Botox maker sank 2.8 percent on Thursday as fears that the U.S. Treasury Department was about to get tougher on inversions outweighed the news that Pfizer was preparing a nearly $200 billion bid for the company. The department's new guidelines -- announced after the market close -- turned out not to be such a body blow after all.

For the most part, the proposed changes just fine tune the steps already taken by the Treasury last year to make it harder and less appealing for companies to use acquisitions that move their legal address abroad for tax benefits. There was nothing groundbreaking -- and most importantly, nothing that should significantly derail a Pfizer inversion.

Cue Allergan shares making up their losses and then some on Friday.

Bouncing Back

Allergan shares pop after Treasury guidelines fall short

Source: Bloomberg

The latest guidelines do make it incrementally harder to structure inversions and remove some economic benefits, but the handicaps only apply to transactions in which the U.S. company's investors wind up with between 60 percent and 80 percent of the combined entity. Pfizer already knew that was dangerous territory; those were the types of inversions targeted by the Treasury last year. By structuring its Allergan purchase as an all-stock deal with a high premium, Pfizer could be able to skirt the tougher rules.

Deal Boom

Drugmakers have announced half a trillion in deals in the last three years, driven in part by inversions

Source: Bloomberg

For other inversions, the proposed limits on companies' ability to transfer foreign subsidiaries to a new overseas parent without incurring U.S. taxes do remove some potential economic advantages. That benefit isn't the main driver of inversions, though, and curbing it shouldn't be a big deterrent. 

Things could have been a lot worse. Many had speculated -- and the Treasury itself had signaled -- that a practice known as earnings stripping could be the next target of the agency's inversion crusade. The maneuver is used by inverted companies to effectively shift profit to lower-tax countries and reduce the amount of income taxed at the U.S. rate of 35 percent, the highest in the industrialized world. It's hard to know just how much Pfizer is relying on earnings stripping to eke out value from an Allergan combination, but the deal is probably measurably less attractive without that perk. 

While Treasury Secretary Jacob Lew said additional guidance on earnings stripping could be coming, the fact that the latest announcement didn't address the tactic is evidence of just how hard it is for the agency to do much about it. Earnings stripping is hardwired into the U.S. tax code, so congressional action is likely needed for any meaningful changes. Restrictions could also have far-reaching consequences because many multi-national companies are fond of the practice.

The new changes outlined by the Treasury aren't totally meaningless. For one thing, so-called spinversions -- in which one entity contributes just a chunk of their business to a new foreign company based in a more favorable tax jurisdiction -- are probably dead. That's because of beefed-up regulation around firms' ability to meet ownership thresholds by artificially ``stuffing'' a new company with assets, said tax expert Robert Willens.

Mylan did a spinversion of sorts when it acquired Abbott's generic-drug business in established markets and created a new company based in the Netherlands. Fertilizer maker CF Industries has been in the process of trying something similar by acquiring Netherlands-based OCI's European and North American assets and relocating to the U.K. That deal -- which could potentially also fall prey to rules aimed at preventing companies from cherry-picking third-party tax residences -- looks like it could be in trouble.

Other companies considering an inversion may rethink things. Susquehanna says a tax-driven takeover of Shire or Valeant is probably less likely -- although frankly, acquirers have probably got bigger reasons to stay away from Valeant.  

But it's going to take a lot more than what the Treasury just put forth to kill off inversions for good. For now, looks like Pfizer-Allergan -- the biggest inversion of all time -- is still a go.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

    To contact the author of this story:
    Brooke Sutherland in New York at bsutherland7@bloomberg.net

    To contact the editor responsible for this story:
    Beth Williams at bewilliams@bloomberg.net

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