New Regulations Will Help the US Treasury Police Inversion Transactions

Jack Lew, Obama’s secretary of the treasury, announced on April 4, 2016, that the US Department of the Treasury and the Internal Revenue Service (IRS) is issuing temporary and proposed regulations to limit the “benefits of and limit the number of corporate tax inversions.” The government bodies also plan to address earnings stripping in these inversions, so it will examine past inversion deals that have already been completed. Some of these may include deals that occurred “within three years prior to the signing date of the latest acquisition,” according to a Treasury fact sheet accompanying the announcement.

Lew said that although the Treasury has already tried to take action (in September 2014 and November 2015) to make tax inversions more difficult and less beneficial for companies, many have still found loopholes and have managed to proceed with these types of deals. In a press release, Lew wrote, “I urge Congress to move forward with anti-inversion legislation this year. Ultimately, the best way to address inversions is to reform our business tax system, which is why Treasury is releasing an updated framework on business tax reform…While that work goes on, Congress should not wait to act as inversions continue to erode our tax base.” He said that as a result of these deals, the tax burden is unfairly transferred to American businesses and families, while companies that inverted reap the benefits of having locations in the United States.

The Treasury will focus on companies that have engaged in a number of acquisitions in series, and it plans to limit a foreign company’s benefits in an inversion. According to the aforementioned Treasury fact sheet, inversion-related tax savings “incentivize foreign-parented firms to load up their US subsidiaries with related-party debt.” In addition, if a transaction does not finance new investment in the US, it will be examined. The measures will make it easier for the IRS to audit for the purposes of conducting a debt-equity tax analysis.

Many past deals in pharma may be scrutinized as a result of this regulatory measure, as many mergers have allowed pharma to benefit from moving its tax domicile to areas where the corporate tax is much lower than in the US. In the short term, the proposed regulations could all but halt the recently proposed Pfizer/Allergan merger. Says Forbes’ Matthew Herper, “the Treasury is proposing that, for the purposes of the Pfizer-Allergan deal, none of the shares that resulted from mergers that have occurred in the past three years count.” In other words, the measures could omit the 2015 merger of Actavis and Allergan, Actavis’ 2014 purchase of Forest Laboratories, and a prior Warner Chilcott deal in the calculation of Allergan’s size. An article in The Wall Street Journal concluded that stripping these deals from calculations could mean that Allergan could then be considered too small a company to serve as Pfizer’s inversion partner, or could limit the economic rewards of the merger. According to the Pfizer-Allergan merger agreement, the termination fee is $400 million if the deal is canceled by either party as a result of changes to federal tax laws that restrict or eliminate the benefits of corporate tax inversion.

The meaning of “temporary” and “proposed” regulations
Because the regulations are not yet law, Terry Haines, the policy analyst at Evercore ISI, wrote in a note to investors that if pharma decides to challenge the new rules, a lengthy litigation may ensue. “What Treasury is trying to do is avoid court scrutiny while discouraging inversions at the same time: if a rule is only ‘proposed’ by a regulator, courts reject lawsuits because the government has not taken a final action that definitely harms someone. This situation, where Treasury is trying to ‘propose’ but yet get specific results against specific transactions, is one where affected companies could try to get federal courts to stay applicability of the proposed regulations.”

Sources: The US Treasury, The Wall Street Journal, Forbes, Evercore ISI

*UPDATE: On April 6, 2016, Pfizer and Allergan formally called off their $160-billion merger due to the new inversion rules. Please see the article Pfizer and Allergan Terminate Merger Agreement for details.