Corporate inversions – a review of the US Treasury’s announcements

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Please note that this article may contain technical language. For this reason, it is not recommended to readers without professional investment experience.

The US Treasury Department has taken new steps to further curtail a popular type of corporate transaction in which a US company merges with a foreign counterpart, then moves abroad to lower its tax bill. The strategy known as corporate inversions technically involves having the foreign company, based in a country with lower tax rates, buy the US company’s assets. Ireland, with its highly competitive 12.5% corporate tax rate, has been a popular place to incorporate.

The new rules, announced in conjunction with the Internal Revenue Service, take particular aim at foreign companies that have completed multiple deals with US companies in a short period, what the regulator calls “serial inverters.

Corporate inversions – look-back period and anti-earnings stripping measures

The two major issues here are the implementation of a three-year look-back period for US-based mergers and acquisitions (M&A) and earnings stripping:

1 – Three-year look-back period. This relates to how the Treasury is going to enforce ownership fractions for inversions. If the shareholders of a foreign acquirer own more than 20%, but less than 40% of the combined entity, and the foreign acquirer conducts substantial business activities in the foreign jurisdiction, the inversion technically works. If the shareholders of the foreign acquirer own more than 40% of the combined entity, the inversion works and most of the negative consequences are avoided. The new rules go further, effectively counting domestic acquisitions by an inverted acquirer in the last three years as impermissible. If the value of those previous acquisitions is disregarded, the foreign acquirer becomes smaller and subject to more stringent inversion rules.

2 A tactic known as ‘earnings stripping’ involves the US subsidiary borrowing from the parent company and using the interest payments on the loans to offset earnings — a cost that is not reflected on financial statements, but which lowers the tax bill. The new rules classify this intra-company transaction as if it were stock-based instead of debt, eliminating the interest deduction for the US subsidiary. This change applies not just to inversions, but to any foreign company that has acquired a US entity and used this technique to lower taxes.

Exhibit 1: Federal government tax reciepts have not kept pace with company profits

 corporate profits

Implications of the new steps to curb corporate inversions

We thought the Treasury had deployed the full extent of its regulatory power in two previous inversion updates. The rules recently announced by the Treasury, however, were seen as much more aggressive and expansive and sent shock waves up and down Wall Street. The most immediate reaction was the news that Pfizer plans to abandon its USD 152 billion merger with Allergan – the largest deal yet aimed at helping a US company shed its US corporate citizenship for a lower tax bill. Pfizer executives have made no secret of their belief that renouncing its corporate citizenship and lowering its overall tax bill was their duty as stewards to shareholders.

Yet even by the Treasury’s own admission, the latest rules will not be enough to completely halt the flow of companies seeking to renounce their US citizenship. There is even a question as to whether the Treasury has overstepped its authority. Such a move would be possible only with an overhaul of the tax rules by Congress, which few believe will happen soon. The current political climate also complicates the matter. Corporate tax policy may be a key issue in the fall presidential elections as Democrats have moved to toughen legislation, while Republicans look to lower corporate tax rates.

Investment conclusions

It remains to be seen what effect the new rules have on the broader equity market. While inversions have not played a dominating role in the mergers and acquisitions, (40 companies have struck inversion deals over the past five years, according to data from Dealogic), this does put additional pressure on investment banks. Meanwhile, in filing a lawsuit to block the Halliburton-Baker Hughes merger, the Obama administration has demonstrated its increasing willingness to challenge giant takeovers, reflecting a belief that the corporate world goes too far in its pursuit of megamergers.

Finally, the tax rate risk facing certain companies just got pulled forward. The good news is that the anti-earnings stripping rules grandfather all instruments prior to April 4 and appear limited to foreign parents. The bad news is that we expect tax rate creep for US companies headquartered abroad and that these companies have lost their tax advantaged acquirer status. It also makes us wonder if this is the first step towards tighter tax regulatory frameworks globally.

Eric McLaughlin

CFA, Senior Investment Specialist, US Equities

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