Rating firms ponder Medtronic downgrades over new tax rules

New U.S. tax rules applicable to Covidien acquisition make deal less attractive, Moody’s said.

Two Wall Street rating firms expect to downgrade Medtronic Inc.’s debt because the company will have to borrow $13.5 billion more than it expected to buy health care supplier Covidien and move the combined company to Ireland.

The changes in the deal’s structure follow new tax rules that increase borrowing costs to as much as $700 million, though Medtronic told investors Friday that the new costs will be offset by interest it will earn on overseas cash that it had originally planned to spend in the deal.

Taken together, the extra costs are still expected to be much lower than $850 million in annual cost savings projected for the combined company following the deal, a fact sheet sent to investors Friday said.

Nonetheless, both Moody’s Investors Service and Standard & Poor’s Ratings Services announced earlier this month that they planned to downgrade Medtronic’s credit rating based on the new tax rules.

“In light of the newly proposed Treasury rules, Medtronic’s acquisition of Covidien is no longer as attractive because the company will significantly increase leverage and likely lose certain tax benefits,” wrote Diana Lee, senior credit officer with Moody’s.

Moody’s may ultimately drop Medtronic’s long-term A2 credit rating by two notches, Lee’s analysis said. Standard & Poor’s said it would also drop Medtronic’s corporate-tax rating by two notches. Both downgrade warnings were announced Oct. 3.

In June Medtronic announced the biggest deal in its history, a $42.9 billion proposal to acquire Covidien and place the two health care giants under a new parent company in Ireland, where corporate income taxes are a third of the 35 percent U.S. rate. The original proposal included a provision to spend about $13.5 billion in cash that Medtronic has accumulated in offshore accounts.

Inversion trend accelerated

Medtronic was not alone. About a dozen large U.S.-based multinational companies have proposed moving overseas via acquisition — a type of deal known as a corporate inversion. Although inversions are not new, experts say the trend accelerated this year after hopes dimmed that Congress would pass a corporate-tax holiday to make it more attractive for companies to repatriate earnings from overseas sales.

Inversions can offer a way to spend overseas cash without incurring U.S. taxes if the money is moved through offshore intra-company loans.

On Sept. 22, Treasury Secretary Jacob Lew made good on threats from President Obama by proposing rules that would apply U.S. taxes to so-called “hopscotch” loans like ones that Medtronic was contemplating. The announcement derailed the nation’s biggest pending inversion, Chicago-based AbbVie’s proposal to buy Dublin-based Shire for $54 billion and move to Ireland.

But Medtronic officials stayed the course. They potentially face an $850 million termination fee if they cancel the deal.

According to a 1,000-page filing to Medtronic shareholders on Oct. 21, company directors held two meetings after Lew’s announcement and decided that the deal still offered enough synergies to justify borrowing $16.3 billion to fund it, instead of the $2.8 billion in debt initially planned.

The debt will carry an average interest rate of 4.25 percent. Medtronic will also be earning about 2.5 percent interest income on the $13.5 billion in overseas cash that it will retain after the deal.

Deal synergy unchanged

Meanwhile, the $850 million in annual cost savings set to begin in fiscal 2018 remained unchanged, as did the assumption that the percentage of the companies’ cash flow not taxed in the U.S. would grow to 60 percent after the deal closes, from 40 percent today.

Medtronic officials have said since the beginning that it was the potential synergies and expanded sales and innovation pipeline that justified the deal, not the tax savings.

“The products and services portfolio of the combined company will allow it to address the major disease states impacting patients and health care costs around the world,” Friday’s statement to investors said. The deal “will position Medtronic to better meet the demands of the current health care marketplace, and ultimately, to reach more patients, in more ways and in more places around the world.”