The Treasury no doubt felt that it could chalk one up in the win column early in April 2016 when, following its release1 of a veritable carpet bombing of new regulations designed to blow-up inversion transactions, the primary target, Pfizer Inc., chose to wave the white flag and cancel—at least for the time being—its efforts to merge with Allergan PLC.
One can easily imagine, deep in the bowels of the IRS headquarters at 1111 Constitution Avenue in Washington, D.C., giddiness reigning supreme, with elated tax policy wonks exchanging awkward "high fives." Let's not go there.
Unfortunately, a more sober assessment is that the Treasury's "victory" was Pyrrhic at best and catastrophic at worst, as the Treasury "doubled down" on a U.S. corporate income tax policy that is in a shambles. Pfizer was trying to leave the U.S. for precisely the same reason that so many corporations have already left, and many others would be delighted to follow. The U.S. has one of the highest corporate tax rates in the world, and, moreover, asserts (almost uniquely among major countries) the right to tax the world-wide income of every U.S. corporation, including every multinational corporate group with a U.S. parent corporation, regardless of how minimal or tangential the U.S. relationship may otherwise be to that income.
Put it this way: Having a multinational corporate group with substantial worldwide operations owned beneath a U.S. corporation is not merely a "questionable" strategy, or even a "poor" idea; it is provably, mathematically the wrong structure if your goal is to operate the corporation in the best interests of its owners, employees, and other stakeholders.
Distilled to its basics, the current Treasury policy is both bullying and wrong-headed. Treasury has signaled, through three aggressive announcements over the past 18 months,2 that it will do all it can to stop U.S. corporations from leaving—even when the law is not necessarily on the Treasury's side.
Some people think current U.S. policy is accurately described using a "Hotel California" metaphor—you can check-out anytime you like, but you can never leave—but the better analogy, precisely because it so clearly illustrates the melding of bad policy and all-but-certain failure, is the Berlin Wall. Khrushchev built the Berlin Wall in 1961 because growing hordes of East Germans were fleeing, and it grew increasingly awkward to try and defend the workers' paradise of the Eastern Bloc when large swatches of workers were intent on bailing out. So too with U.S. tax policy: Treasury thinks the natural answer to the fact that many U.S. corporations want to escape the U.S. is to make them stay unwillingly, by building the corporate tax equivalent of the Berlin Wall.
Ironically, the current U.S. tax mess is easily fixable, and indeed the United Kingdom, which itself was hemorrhaging corporations to Ireland just a few years ago, has provided an exact blueprint: Bring the corporate tax rate down, and stop trying to tax the repatriation of foreign earnings.3 But accepting this simple, obvious solution and the related consequences seems oddly anathema in Washington D.C. these days.4
So, in the meantime, we are where we are, which is more or less on the wrong side of 1961 Berlin. How this will all shake out in the short- and medium-term is far from clear—politics hangs like a heavy fog—but one thing seems self-evident: In the long term, current U.S. tax policy seems likely to work out every bit as well for the U.S. as building the Berlin Wall did for Khrushchev. It will, eventually, need to come down.
The Unspoken Target of the New Regulations
The desperation of Treasury to find some solution, any solution, to the current U.S. inversion stampede is perhaps best measured by the sheer length of its most recently issued regulations— some 200 pages of new regulations under Section 7874,5 adding a dense layer of picayune provisions governing inversion transactions (but, le t i t be clearly stated, coming nowhere close to actually stopping inversions if the parties are determined and willing to stare down the Treasury's ire), plus, for good measure, another 135 pages under Sect ion 385,6 dealing with rules to distinguish debt from equity, with a special emphasis on preventing so-called "earnings stripping."
Of course, nowhere in the new regulations and the accompanying announcements did Treasury explicitly state that this was all part of an orchestrated "Stop Pfizer" movement, but on the other hand no one in the financial markets was the least bit deceived.
More than 50 former U.S. companies have incorporated outside the United States since 1982, and in recent years the exodus has picked up at an alarming pace, with more than 20 major corporations heading out the door to more congenial tax climes just since 2012.7 The list of the newly departed is both demoralizingly long and peppered with the names of top-notch, even iconic, companies, including Burger King, Medtronic, Liberty Media, Eaton Corporation, Stanley Works, Ingersoll-Rand, Seagate Technology, Fruit of the Loom, and Tyco International.
The latest corporation to announce its fond farewells—and the biggest to date—was supposed to be Pfizer, the huge and highly regarded drug company (ranked #2 in the world)8 heretofore headquartered in New York but soon to be owned via merger by Allergan PLC, a corporation formed under the laws of Ireland but also with a strikingly large managerial presence in New Jersey.
More than a few observers believe that Treasury specifically tailored some of the newly issued regulations specifically to stop the Pfizer-Allergan merger.9 For example, the new regulations contain a three-year look-back period10 that seems suspiciously tailored to Allergan— a composite of an original smallish Irish corporation and several already-inverted U.S. corporations—and raised the question whether Allergan was really "Irish enough" to qualify as an inversion partner.
Admittedly, the only thing more embarrassing than having a corporate heavyweight like Pfizer leave the U.S. was the fact that it was merging into Allergan, a Frankenstein creation of several other previously inverted U.S. drug companies. In fact, previously inverted U.S. companies often seem to become a natural "foreign" partner for subsequent inverting U.S. companies.11 The Treasury calls companies like Allergan "serial inverters," and the three-year look-back rule is designed to prevent serial inversions—but, the problem is, it only applies for a period of three years. Even under the Treasury's new-and-improved rules, Pfizer and Allergan can take a mulligan and redo their inversion transaction all over again—possibly as soon as next year, and in all events by 2018.
Footnotes
1. "Treasury Announces Additional Action to Curb Inversions, Address Earnings Stripping," 4/4/2016, found at https://www.treasury.gov/press-center/press-releases/Pages/jl0405.aspx.
2. The first Treasury announcement, announced by press release on 9/22/2014, and followed up by the more formal guidance of Notice 2014-52, 2014-42 IRB 712, contained a variety of interesting and important proposals, and was reviewed in detail in the article by Darby, "Inverted Priorities: Why the Proposed Treasury Rules are Unlikely to Stop Inversion Transactions," 18 Practical International Tax Strategies 2 (2014). As the article title suggests, the first round of Treasury proposals addressed perceived abuses and tightened the rules, but did not prevent inversion transactions. The second announcement, 'Fact Sheet: Additional Treasury Actions to Rein in Corporate Tax Inversions," 11/19/2015, found at https://www.treasury.gov/press-center/press-releases/Pages/jl0281.aspx , contained further tweaks that expanded and embellished the rules proposed in the first announcement but suggested, by the exceptional length and relatively modest additions of substantive content, that Treasury was already running dry on further ideas. As will be discussed below, the third announcement seems to offer even less substance – except where is it taking steps that at least some commentators believe go beyond the boundaries of the Treasury's rulemaking authority.
3. The Congressional Research Service, in a report "Corporate Expatriation, Inversions, and Mergers: Tax Issues" issued 5/27/2014, stated: "Two features made a country an attractive destination: a low corporate tax rate and a territorial tax system that did not tax foreign source income. Recently, the UK joined countries such as Ireland, Switzerland, and Canada as targets for inverting when it adopted a territorial tax. At the same time the UK also lowered its rate (from 25 percent to 20 percent by 2015)."
4. Congressional Research Service, in its 5/27/2014 report, stated (almost too candidly) as follows: "Some have suggested that lowering the corporate tax rate as part of broader tax reform would slow the rate of inversions. Although a lower rate would reduce the incentives to invert, it would be difficult to reduce the rate to the level needed to stop inversions, especially given revenue concerns." A revised report, issued 10/3/2014, was much less candid on this issue.
5. FR Doc. 2016-07300, filed 4/4/2016, 5:00 pm, publication date 4/8/2016, is a terse, economical 204 pages.
6. FR Doc. 2016-07425, filed 4/4/2016 5:00 pm, publication date 4/8/2016, is 136 pages.
7. Bloomberg has maintained a running list of expatriated U.S. companies since 5/27/2014, which can be found at http://www.bloombergview.com/quicktake/tax-inversion. The list identifies the year, the destination, and, where applicable, the merger partner. Prior to about 2012 (when Treasury first began aggressively jiggering the rules under Section 7874) it was often possible to do a "naked inversion" into a wholly owned foreign subsidiary. Today, the most promising mechanism under Section 7874 is to merge into a foreign corporation in the desired jurisdiction that is at least 25% the size of the U.S. corporation. See Darby, "Inverted Priorities: Why the Proposed Treasury Rules are Unlikely to Stop Inversion Transactions," note 2, supra.
8. A Forbes magazine article dated 6/4/2015 ranked Johnson & Johnson #1, Pfizer #2 and Swiss-based Novartis #3 in size in the pharmaceutical industry. See http://www.forbes.com/sites/liyanchen/2015/06/04/2015-global-2000-the-worlds-largest-drug-and-biotech-companies/#7b9203285768.
9. Among those who think so is Allergan CEO Brent Saunders, who stated so publicly immediately after the merger was called off. See "Allergan CEO: Merger with Pfizer was targeted by U.S. government," published at http://www.cnbc.com/2016/04/05/ AbbVie, Inc. had a similar complaint in 2014 when its proposed $52 billion merger with Shire Plc was terminated following the first round of Treasury announcements attacking inversion transactions. The 2014 tax proposals "reinterpreted longstanding tax principles in a uniquely selective manner designed specifically to destroy the financial benefits of these types of transactions," AbbVie said in a statement at the time. See article at http://www.bloomberg.com/news/articles/2016-04-06/pfizer-allergan-plan-to-mutually-end-merger-cnbc-reports.
10. The new look-back period is described in the Third Announcement as follows: Limiting inversions by disregarding foreign parent stock attributable to certain prior inversions or acquisitions of U.S. companies (Action under section 7874 of the code). Some foreign companies may avoid section 7874 – the tax code's existing curbs on inversions - by acquiring multiple American companies over a short window of time or through a corporate inversion. The value of the foreign company increases to the extent it issues its stock in connection with each successive acquisition, thereby enabling the foreign company to complete another, potentially larger, acquisition of an American company to which section 7874 will not apply. Over a relatively short period of time, a significant portion of a foreign acquirer's size may be attributable to the assets of these recently acquired American companies.
It is not consistent with the purposes of section 7874 to permit a foreign company (including a recent inverter) to increase in its size in order to avoid the inversion threshold under current law for a subsequent acquisition of an American company. For the purposes of computing the ownership percentage when determining if an acquisition is treated as an inversion under current law, today's action excludes stock of the foreign company attributable to assets acquired from an American company within three years prior to the signing date of the latest acquisition.
11. In addition to Allergan, examples include Eaton Corporation, a major manufacturer of valves formerly headquartered in Cleveland, which merged in 2012 into Cooper Industries, a former U.S. corporation that moved to Ireland in 2009. Similarly, Tim Hortons expatriated to Canada in 2007, and then became the foreign merger partner for Burger King, which moved to Canada in 2015.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
