Treasury Implements New Rules Aimed at Inversions, Other Tax Strategies, Scuttling Pfizer-Allergan Deal and Evoking Howls from Pharma

Surprisingly, the Treasury Department took aggressive action to make it much more difficult to do corporate inversions, a recently-popular strategy by which a US company was acquired by a smaller firm in a lower-tax foreign jurisdiction. Voila! The new home country is where the taxes are filed, lowering the tax rate. The merged companies would engage in additional strategies to further lower the tax bill. Within hours of the announcement, Pfizer executives had decided to scupper their $150 billion merger with Allergan, which would have moved Pfizer’s headquarters to Ireland.

It seems out of character for a business-friendly Administration to take this tack. Last year, the Treasury announced some measures intended to curb inversions, which had recently become both visible and controversial. Yet almost immediately after the rule change, the widely-discussed Hortons-Burger King merger took place, which arguably was not driven mainly by tax considerations. That may have been seen as an embarrassment. Moreover, as the planned Pfizer-Allergan deal illustrates, many of the inversions were being done by pharmaceutical companies, which are deservedly unpopular right now. Drug companies overall have been pushing through price increases at rates well in excess of the inflation rate, and the proceeds have gone for stock buybacks, dividends, executive pay, and marketing over R&D. And to add insult to injury, US pharmaceutical companies get considerable subsidies in the form of large amounts of government-funded research. And companies like Valeant represent the McKinsey vision for what the industry should look like: patent trolls who maximize the value of their intellectual property, rather than having any real interest in combatting disease.

So the open question is whether Treasury intended its rule changes last year to be a warning shot, and the parties that should have gotten the message decided to ignore it, or that the Administration was particularly offended or embarrassed by the Pfizer-Allergan merger and decided to rouse itself.

One reason the Administration could act is that countries in advanced economies are coming to the point of view that corporate tax minimization has gone to far. Admittedly, the austerian policies of the Eurozone are no doubt a big driver: countries that are budget-starved and squeezing their own citizens can’t afford to let big corporations be the equivalent of tax scofflaws, even if their moves are kosher under the current tax codes. From a European Commission press release this January:

Why has the Commission made the fight against corporate tax avoidance a priority?

Corporate tax avoidance deprives public budgets of billions of euros a year[1], creates a heavier tax burden for citizens and causes competitive distortions for businesses that pay their share. It also undermines the EU goals of growth, competitiveness and a stronger Single Market. The cross-border nature of corporate tax avoidance means that action only at the national level cannot tackle the problem and can even lead to further problems. Unilateral efforts by Member States to protect their tax bases create administrative burdens for businesses, legal uncertainty for investors and new loopholes for tax avoiders to exploit.

Therefore, the Commission is pursuing an ambitious campaign for a coordinated EU approach against tax avoidance, following the global standards developed by the OECD last autumn, to boost Member States’ collective stance against this problem, restore fairness in corporate taxation and ensure stability for businesses and investors in the EU.

Even though any multi-country initiative takes time, my tax mavens tell me the Europeans are serious. And the unusually firm tone of the official statement seems consistent. For instance, “Member States adopted the Commission’s proposal for transparency on tax rulings in record time and other important corporate tax reforms have been launched.”

The Wall Street Journal gave a high-level summary of the main effects of the changes. Mind you, it’s 300 pages of new rules, so I sincerely doubt anyone has analyzed this in depth:

How do they do that?

First, they go after what they call “serial inverters,” companies that have engaged in multiple inversion transactions. The rules would disregard three years of past mergers with U.S. corporations in determining the size of the foreign company. By subtracting the value of U.S. assets a foreign company had acquired, the foreign company would become smaller in relation to the U.S. company.

Why does that size matter?

After a merger, if the shareholders of the former U.S. company own at least 80% of the combined firm, the government treats the new combined business as subject to U.S. taxes, basically negating the inversion, even if its address is abroad. If they own at least 60%, some restrictions apply but the company is still considered foreign. That’s led companies to keep their inversions below 60%—and prompted the government to propose rules halting various techniques for doing so…

What else is Treasury doing?

The government issued regulations against what’s known as earnings stripping, a kind of transaction that typically occurs after an inversion. Companies can lend money from their foreign headquarters to what is now the U.S. subsidiary in a transaction that has no effect on the consolidated company’s books. But it matters for tax purposes, because the U.S. subsidiary gets interest deductions against the world-high 35% U.S. corporate tax rate, effectively pushing income to a country with a lower tax rate. The rules would give the government more authority to treat those debt transactions as equity movements under the tax code.

A top international tax expert added by e-mail:

The new stuff concerns interest deductions. It is not limited to inversions. Foreign-parented companies have been able to strip out their US income with intragroup interest deductions forever. No one bothered them about it because they hire people for US auto plants.

Now under the new rules, interest payments would not be deductible, and would be treated as dividends, meaning they might incur withholding tax at the border. Taxpayers also have to show that intercompany debt would be repaid.

The rules say which intercompany debt they hit. They think they can differentiate debt that represents real capitalization of a US affiliate from phony debt that involved no new capital coming into US. If it isn’t new capital, the intragroup debt is preferred stock.

You don’t have to have done an inversion to be affected by this rule. You merely need to be paying interest to a foreign parent.

The Financial Times reports that US tax crackdown provokes foreign fury. From the story:

The angry rhetoric came a day after the Treasury department released new proposals which threatened the biggest planned inversion to date — Pfizer’s takeover of Irish-domiciled Allergan — and triggered big losses for some hedge funds, such as Paulson & Co and Third Point.

“It came as a total surprise. Everyone thought the Treasury had used all their firepower,” said one hedge fund manager…

Ms [Nancy] McLernon [president of the Organisation for International Investment, a trade group for foreign companies in the US] said the proposal would penalise foreign companies with long histories in the US that use legitimate intra-company loans to pay for investments in facilities and equipment.

Her group’s members include Nestlé, Royal Dutch Shell, BASF, Airbus, Nissan, Unilever, Deutsche Telekom, Tate & Lyle and other multinationals.

The entertaining part was that the generally business friendly FT comments section for the most part wasn’t buying it. Some reactions:

Nestle tax executive: jog on. Your cost of capital is lower than a snails belly and the US market is too big – you need it more than it needs you. Go play your games somewhere else.

Judging by the shrill response, The President has hit the target, and how! Excellent Mr President! Carry on!

US subsidiaries of foreign multi-nationals can always borrow from US banks or issue their own bonds instead of relying on intra-company loans.

All of those American politicians that businesses have bought over the years, did not stay bought. Who knew?

It’s important to note that Treasury took these moves took the form of new administrative guidance, which is roughly equivalent to a new reading of existing laws. The Treasury position on stepped transactions and its use of a 50 year old but largely dormant rule allowing Treasury to decide what is debt versus equity for tax purposes is defensible but might be challenged successfully in court. The Economic Policy Institute praised Treasury for doing the best it could within its constraints:

The Treasury’s regulatory actions continue to provide temporary fixes, which will help reduce the short-term erosion of the U.S. corporate tax base. They deserve credit for using the limited tools available to them in the most robust way to slow this erosion. But regulatory authority can only go so far, and legislative action is necessary to fully stop this type of corporate tax evasion.

Good luck with that. But this is still a surprisingly positive development, and perhaps as sign of a shift in the zeitgeist, that the idea that corporations must ever and always be catered to is finally being questioned.

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  1. Thoughtful person

    Obama trying to show there is a difference between Rs and Ds?
    -influence and popularity of Sanders on discourse
    -Obama’s final year
    -Rs in congress hopelessly obstructionist
    -similar to Argentina, Cuba, Brazil policy at the moment
    Whatever the reason, not complaining…

  2. MikeNY

    Good news. Maybe Valeant was ‘peak pharma’. It’s nice to see these companies increasingly in the political cross-hairs.

  3. Nick

    Very interesting, indeed.

    “It’s important to note that Treasury took these moves took the form of new administrative guidance, which is roughly equivalent to a new reading of existing laws.”

    So essentially, Obama, who is in the final stretch of his tenure, decided to improve those public-opinion ratings and burn some bridges with the business community by interpreting the law a bit differently. Well, those very same bridges are sure to be reconstructed on inauguration day by Clinton, Trump or Cruz.

    Hopefully that Wisconsin momentum will grow even stronger for Sanders.

  4. divadab

    This policy will, if uniformly implemented, end a lot of sketchy tax-avoidance schemes that use international debt to move taxable profits to low-tax jurisdictions.

    I was a footsoldier in an Arthur Andersen scheme involving a Nova Scotia partnership and european banks to offshore US profits to Ireland, which then had a 10% corporate tax rate. The company was able to double-dip – effectively deduct the same interest twice in the US using this structure.

    It’s for this kind of thing that AA bit the dust – I should think that a good place for the IRS to start looking for abusive tax structures is to audit every single AA-devised scheme. Admittedly, a bit late now, but there is no statute of limitations on tax fraud.

  5. Northeaster

    Pssst…Don’t look at Merck KGaA. While only a top 25 in Pharma, the rest chemical, they have simply gobbled up everything in The United States. The most recent being buying up Sigma-Aldrich for a cool $17 billion, whose major hubs outside of St. Louis are in Canada and Mexico.

  6. Adrian H

    Pharma isn’t howling. The rest of ’em are snickering at Pfizer. Most of the big pharma companies are run by clueless bullies who resented that Pfizer seemed to have found a trick to goose profitability without actually producing new drugs.

    1. Yves Smith Post author

      Huh? Please tell me who is “producing new drugs”. Well over 85% of “new drug applications” are for minor reformulations of existing drugs to extend patent life. And of what the public would consider to be a new drug, alot of those were developed by biotech cos that are acquired when their work pans out.

      I suggest you talk to some tax people. Your view is not at all well informed. The tax strategies that Treasury has gone after are important to Big Pharma as well as many other multinationals. And some of the tax bennies of past pharma inversions are also going to be undone under the new rules.

  7. zapster

    Too bad it took a monumental leak of financial chicanery to alarm the president enough to take an action that could have been taken long ago.

  8. crittermom

    Good news, indeed.
    I received word of it in an email yesterday, thanking me for signing a petition asking for this very thing.
    I’d like to think the over 200,000 of us who signed the petition sent to Obama & the Treasury Dept had an influence.
    Were our voices actually heard? Couldn’t have hurt!

    I also signed a thank you letter provided with the announcement email, thanking Obama for doing so.

    Now if only there were a petition to the Dem super-delegates requesting they listen to us……

    1. crittermom

      Update: I was just presented another petition, this one going to the DNC, saying that super-delegates should be eliminated. I signed it.

  9. RUKidding

    Nice to hear some good news these days. Wish ObamaCo had taken such steps earlier and not only with BigPharma.

    Geez with these greedy parasites there is never enough. Someone somewhere has to draw a line in the sand.

    Said not snarkily: Thanks, Obama!

  10. Foppe

    Hillary trying to claim it/call it a parade (courtesy of the guardian, who felt a burning need to point this out to readers):

    Glad to hear Pfizer is calling off the merger. We need to close the loopholes that let corporations escape paying their taxes

  11. crittermom

    Flip-flop Hillary. Has she ever come down on big pharma before trying to ride these coattails?

  12. RBHoughton

    Many thanks and well done NC – Is anybody else carrying this exchange? Not Bloomberg.

  13. MikeW

    Big pharma = a primary beneficiary/abuser of US patent laws, that they claim are crucial, yet don’t want to pay US taxes. The irony!!

  14. MelK

    Should have read yesterday’s Wall Street Journal. They reacted like it was a combination of the stamp act and the quartering of British soldiers. So incredibly over the top that it was hilarious. Which means of course means this act by the Administration really struck a nerve.

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