What the failed Pfizer-Allergan deal means for the future of tax inversions

Tax inversions are still legal, but are they still on the way out? Here's what the failed Pfizer-Allergan deal showed us. 

It’s April, and one thing is on everybody’s minds – taxes. It’s somewhat fitting, then, that one of the biggest tax-related deals ever, the $160 billion Pfizer-Allergan mega-deal, got nixed. This comes on the heels of promised new rules from the US Treasury regarding tax-inversions that are retro-actively enforced.

The premise of a tax inversion is fairly simple. Let’s imagine two made up companies, called Feezer and Ullergan. Ullergan is situated in a country with low corporate taxes, while Feezer is in a higher tax regime. Feezer proceeds to either buy or merge with Ullergan, with the new entity reincorporating in Ullergan’s home country, enjoying the lower taxation rate it provides. Such moves have been quite popular as of late, since a 2009 law was enacted, creating a loophole once again making tax inversions viable – they were popular in the 90s, as well, before being legislated essentially out of existence – as the US has the highest corporate taxation rate in the developed world.

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Corporate Tax Rates Around the Globe. Source: KPMG. Note, this includes regional (state/provincial) taxes, as well as federal.

The reason companies do this is pretty obvious – a massive windfall to their bottom lines. However, they are wildly unpopular among the US public and the government, largely because most inversion deals are essentially in name only, meaning material operations and key personnel remain in the United States. In response, the US Treasury enacted new rules to prevent so-called “serial inverters” from continually tax-regime hopping to the country of greatest convenience.

What does this all mean for the M&A market today, though? First and foremost, the Pfizer-Allergan deal fell through because of Allergan’s new status as a serial inverter. It will likely also have a chilling effect on future tax inversions, but only to a point – deals without either party violating the serial inverter requirements will still be able to go through. This means that those like Tyco/Johnson Controls and Progressive Waste Solutions/Waste Connections will probably close without much of an issue. However, Allergan is hardly alone in its tax avoidance ways, so fewer deals in the pipelines can be expected. Since it tends to be larger companies that attempt tax inversions, as they have the most to gain from them, this could mean that last year’s record high M&A transaction value may stand for quite some time. Dealmakers will likely return their focus to more so-called “real” deals in lieu of mega-sized tax inversions. The traditional mergers between two companies with many synergistic benefits or strategic corporate acquisitions for bolt-on purposes could rise in terms of numbers, if not value.

On the bright side, this could also signal some positive developments for US companies looking to avoid their high taxation rates. A profit repatriation tax holiday could be done, similar to what Congress enacted in 2004 where profits could be brought back to the US at a discounted tax rate of 5.25%. This could be advantageous for a number of reasons; an influx of cash bring jobs and drive business investment spending, something that has been woefully lagging as a contributor to GDP as of late. It could also help allay fears of a credit bubble, as companies have been issuing bonds in lieu of repatriating overseas profits, taking advantage of extremely low interest rates at home. When these bonds mature and have to be repaid, a nice cushion of cash would protect a company’s balance sheet and prevent it from having to refinance at potentially much higher rates of interest. There is, however, some partisan disagreement regarding a tax holiday, and such an effort was defeated by the Senate in 2009. Another possibility is that continued tax inversion deals could prompt an overhaul of the tax code, an action which does have bipartisan support, in a broad context, though the exact mechanisms which should be changed are disputed across aisle lines and ideologies.

Tax inversions are here to stay for the time being. While controversial, they are perfectly legal and until that changes, corporations will always be looking for a way to reduce their bill to the taxman. But if rules continue to tighten, as with the “serial inverter” designation, this may have major implications for M&A in the coming years.

Kevan Hartford

Kevan Hartford is a Toronto-based finance professional working in asset management.