On April 4, US Treasury announced new temporary and proposed regulations governing
inversions. Two days later, pharmaceutical giant Pfizer abandoned
its attempt to buy Irish-based company Allergan, leaving counsel to sift through
the rubble of the deal for clues as to the future of inversions.
Inversions allow companies to shift their
headquarters for tax purposes. Pfizer was to purchase Allergan for $160 billion, with the aim of
moving the headquarters of the resultant new firm, for tax purposes, to Ireland.
Instead, Pfizer now owes Allergan a $400 million break fee.
The current US administration has long
frowned on the practice of inversions – without resounding success. The Treasury
has twice attempted to tackle the practice, to little effect. As a result,
nobody saw the April 4 move coming.
“I think it is safe to say that people were
very surprised at the regulation package that the US Treasury issued,” said
Bernie Pistillo, partner at Morrison & Foerster.
The surprise was twofold. One source of
bewilderment was the contents of the package. Counsel simply didn’t anticipate
it. But a second more potent shock stemmed from how there was absolutely no
inkling in advance that a package was coming. Taken together, it’s clear that both
bombshells were intended.
- Counsel were surprised by
Treasury’s move to block the Pfizer-Allergan deal;
- Under the new regulations, much
of any combined group would have been subject to US tax;
- The new regulations will likely
make it much more difficult for a US company to invert, and reduce the number
of potential foreign targets;
- Nonetheless, the demand for
inversions is likely to continue until the US looks to modernise its tax regime.
“It was a true stealth effort. I think it
is pretty clear that the government wanted there to be no advance warning of
this, so as to minimise the risk of any particular transaction being
accelerated,” said Pistillo.
“The timing was a surprise,” said Sara
Luder, head of Slaughter & May’s tax practice in
London.Perhaps that surprise is understandable.
The US Treasury first announced it was looking at earnings stripping rules in
2014. According to Luder, the fact it didn’t take steps earlier was thought, by
some, to indicate the Treasury was struggling to find a way of tackling the
issue without primary tax legislation. And because that primary tax legislation
was something the US is unable to produce as a result of an obstructive Congress,
any effective tackling of inversions seemed dead in the water.
“We know companies will continue to seek
new and creative ways to relocate their tax residence to avoid paying taxes
here at home,” said Treasury secretary Jacob Lew at the announcement.
“Today, we are announcing additional
actions to further rein in inversions and reduce the ability of companies to
avoid taxes through earnings stripping,” Lew said, who also stressed the need
for Congressional action, indicating the limits to Treasury’s ability to act
Counsel have identified two rules that
First, the new serial inverter rule, under
which the stock of a foreign merger partner that was issued in connection with
the acquisition of a US entity within the last 36 months will be disregarded
for purposes of determining whether the relevant 60% inversion threshold has
“The three-year add-back change was also a
surprise - it is surprising to see a government take a step that was so clearly
targeting a particular transaction,” said Luder.
“In the Pfizer deal, the serial inverter
rule was directly applicable because Allergan had previously been the party to
three different inversion transactions within the past three years,” said
Second, lawyers have noted the
earnings-stripping or debt-equity rules, which will operate to reclassify
certain related-party debt instruments as equity and disallow an interest
deduction. This strategy has been key to reducing the US tax burden of the
former US group parent in many expatriation transactions.
Under the new regulations, a significant
percentage of the Allergan shareholding would have been disregarded, resulting
in much of the combined group being held by former shareholders of Pfizer. And
therein lies the rub.
“The likely result would be that the
combined group would be treated as a US corporation for all US tax purposes,”
Even had this rule not applied, according
to Pistillo, the new limitations on earnings stripping resulting from the new
debt-equity regulations would have made the transaction much less attractive to
All of the above begs an important
question: is the US Treasury acting within its rights? Some commentators suspect
the regulations are in fact outside its, and the IRS’, authority.
“There are strong arguments to be made in
favour of this conclusion, even with respect to a number of the inversion
regulations that were issued prior to April 2016,” said Pistillo.
But even if the current round of guidance does
stretch the Treasury’s mandate a little thin, nobody would want to take so large
a risk as to test that theory with an actual merger.
“In the context of a major public
transaction such as the Pfizer deal, executives would never want to proceed
with a transaction and rely on the ability to challenge these regulations in
court,” said Pistillo.
In other words, likely giving activist
shareholders angst, the mere issuance of these regulations was enough to tank
The new regulations will make it much more
difficult for a US company to invert with a repeat offender. They will also greatly
reduce the attractiveness, and availability, of standard earnings stripping
transactions post-inversion. But even these rules are unlikely to stop every
“For many companies looking to expatriate,
the driver is the ability to remove its foreign affiliates from the US-controlled
foreign corporation regime, and to access trapped cash that has not been
subject to US taxation,” said Pistillo.
According to Pistillo, the US is moving towards
international tax reform, and looking at the taxation of un-repatriated
offshore earnings as a means of paying for those reform efforts.
"It was a true stealth effort"
As such, many US multinationals may be
increasingly tempted to exit the national tax net before their offshore
earnings are repatriated and taxed, even at a preferential rate. The demand for
inversions won’t necessarily drop as their prospective ease falls.
“The demand for inversions is likely to
continue until the US looks to modernise its tax regime,” said Luder. He takes
a global view, seeing the rest of the world as moving towards a territorial
regime in which profits are taxed only where they are earned. The US, in contrast,
continues to claim taxing rights over a US group's worldwide profits.
“While this remains the case US groups will
continue to find inversions attractive - even with the earnings stripping
changes,” said Luder. That said, it takes two to tango and the Treasury rules
will have an impact overseas as well as at home. “The three year lookback rule
will mean that there are fewer potential foreign targets,” Luder said.
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