Inversion Deals Aren’t Dead; They Are Just On A Smaller Scale Now

Last September, the US Treasury Department announced new tax rules designed to crack down on the rising trend of “tax-inversion” deals in the pharmaceutical industry, as an increasing number of US firms had begun to pursue overseas acquisitions in attempts to relocate their legal addresses to non-US based headquarters to avail tax benefits.

The new rules made it harder for the large drug-makers to consider acquiring a foreign company, while also putting an end to some of the already finalized deals. One of these included the $54 billion deal under which AbbVie Inc (NYSE:ABBV) had agreed to acquire Shire PLC (ADR) (NASDAQ:SHPG). AbbVie then had to pay a hefty sum of $1.64 billion to Shire as a breakup fee after the deal fell apart.

However, the US government was not completely successful in curbing these so-called tax-inversion deals.

Last week, a deal overshadowed by the bigger merger and acquisition news in the industry was the $2.1 billion acquisition of British-based Pace Plc by US telecommunications equipment maker Arris Group, Inc. (NASDAQ:ARRS), under which Arris would be shifting its headquarters to the UK. Although the new rules made it a difficult deal to ink, the deal carries highly accretive prospects and will serve to reduce tax rates for Arris. Arris shares went up 22% following the news of the deal.

Talking about how the deal was disguised such that it went unnoticed, Robert Willens, a New York-based independent consultant on corporate taxes, said during a telephonic call that Arris designed the deal such that it “will signal to people that, ‘Hey, the Treasury notice didn’t really end the game here and it’s still a worthwhile thing to do.’”

“It’s not going to be an isolated event,” he further added.

It can be expected that majority of the tax-inversion deals in the future will continue to be as small-scale in nature as the deal between Arris and Pace, i.e. relatively smaller in size and value, and between companies that are not huge names. Such deals have higher chances of getting done as smaller values and names can go without attracting much attention and setting off political alarms, which are usually the reason why deals between larger firms mostly end up falling apart, such as Pfizer Inc.’s (NYSE:PFE) failed attempts to acquire AstraZeneca plc (ADR) (NYSE:AZN) last year for over $100 billion.

Tax-inversion deals have not died down; rather, they have just become smaller. According to the data compiled by Bloomberg, the value of inversion deals has been less than $2 billion on average since the time AbbVie walked away from the Shire deal. Some of these small-scale deals include the merger between STERIS Corp (NYSE:STE) and Synergy Health Plc, and between Tornier NV (NASDAQ:TRNX) and Wright Medical Group Inc (NASDAQ:WMGI). However, both of these deals are still pending.

Consequences Of Crackdown On Inversion Deals

One of the major consequences of the Treasury crackdown is the limitation on the hopscotch loans, which enabled the companies to have access to foreign cash without paying US taxes, which is one of the main highlights that AbbVie was looking for when it struck the Shire deal.

One of the advantages of the inversion deals which the Treasury rules could not counter is the earnings stripping, a move which allows the inverted companies to transfer their earnings to the countries with lower tax rates, effectively lowering the amount of taxable income, which would have been taxed at the US rate of 35% if the company had not inverted. The US is known to have the highest tax rates among the industrialized world.

According to Mr. Willens, earnings stripping is of greater significance to most companies than having access to foreign cash.

The Treasury had said the practice of earnings stripping may be countered with a second round of guidance; however, no restrictions have been announced yet. William Dantzler, a tax partner at White & Case LLP, said the Treasury might have to face a difficult time while countering the practice and would require help from the Congress, as the technique for earnings stripping is hardwired into the US tax codes. He said the technique is used by the foreign firms that have large-scale operations in the US.

“Inversions made sense last year for multiple reasons and the Treasury only killed one of those reasons, which was accessing trapped cash,” Mr. Dantzler said during a telephonic interview. “All the other reasons still exist.”

Are Large Deals Possible After New Rules?

Many analysts and executives still believe that despite the new rules announced to curb inversion deals, mega-sized deals are still possible. According to Mr. Willens, the large-sized inversion deals are still doable. Ian Read, chief executive officer at Pfizer, mentioned in October 2014, after the new rules had been announced, that he saw “no reason why we wouldn’t be able to do an inversion” if an attractive acquisition target is available.

Pfizer announced in February 2015 that it had agreed to acquire Hospira, Inc. (NYSE:HSP) in a deal worth $17 billion. Analysts saw the deal as a door opener for other large-sized deals, including the acquisition of Allergan, Inc. (NYSE:AGN) by Actavis plc (NYSE:ACT) in a deal worth over $70 billion.

Ed Outslay, an accounting professor at Michigan State University, said that despite the fact the inversion deals might not be financially attractive for giant drug-makers such as Pfizer, now that they cannot move their foreign subsidiaries from the US-based parent company and have access to the overseas cash tax-free, he believes the “inversions will still be in play under the right circumstances.”