Why has the $160bn Pfizer-Allergan deal been abandoned?
The US Treasury Department announced on Monday changes to rules under which deals could be classified as “tax inversions”, which meant it was no longer as economically attractive for the deal to take place.
What is a tax inversion?
It is a piece of financial engineering that multinational companies use to reduce their tax bill. One company buys a rival based in a different country with a less onerous tax policy. It then “reincorporates” by shifting the address of its headquarters to the country with the lighter tax burden.
In many cases the the main business might remain in the original country but the firm simply holds some of its board meetings in the new jurisdiction.
What are the rules aimed at preventing tax inversions?
The US has made a number of attempts to crack down on so-called “serial inverters” by reducing the tax benefits available to them.
Even before this week’s move, The Obama administration had put tighter restrictions on inversions where the US company ends up with a combined stake of between 60% and 80% of its foreign takeover target. The intention was to stop firms buying much smaller foreign rivals simply to switch addresses to a country with a lower tax rate.
Now the US Treasury wants to change how it calculates the size of the two companies involved in a deal by ignoring any assets bought by the takeover target from a US company in the past three years.
In some cases, that would take the predator company over the 60% threshold by notionally reducing the size of its takeover target. This particularly impacts Pfizer because Allergan has been built through a series of deals.
Another new measure targets so-called “earnings stripping”, by classifying loans between related companies as equity during a tax audit. This would also affect the determination of the size of a company.
Why do US firms do it?
The corporation tax regime in the US is the most onerous among developed economies. American firms are taxed on their domestic earnings at 35% – although the rate can be higher – and also on income repatriated from foreign subsidiaries.
Most other countries impose a much lower rate than the US on repatriated earnings. If a company can shift its country of incorporation, US tax authorities lose the right to take a slice of income from foreign subsidiaries.
This system has led American firms to stash an estimated $2tn (£1.3tn) overseas, rather than repatriate the money. It is also seen as a key motivation behind most tax inversions.
Why are they unpopular?
Some US firms have been accused of buying smaller European rivals simply to reduce their tax bill, rather than because of any long-term strategic rationale.
On Tuesday, President Barack Obama said: “When companies exploit loopholes like this it makes it harder to invest in the things that are going to keep America’s economy going strong for future generations.”
How old are inversions?
The first high-profile inversion took place in 1982, when New Orleans construction firm McDermott moved to Panama, switching its corporate headquarters to the Central American country and slashing the tax rate on its earnings.
After a wave of similar deals, the US cracked down in 2004 with an anti-inversion law targeted at firms relocating to tax havens. However, it permitted the company to change address, as long as its merger partner was a quarter of its size or larger.
That ruled out moves to tiny tax havens where subsidiaries were unlikely to be big enough to satisfy this criterion. It also made a more attractive destination of Europe, where there are many firms large enough to bypass anti-inversion laws.
