Survey Finds New Structures, But No Decline in Inversions

January 27, 2016

L-378667_RTR23GK8On Monday, Johnson Controls, Inc. announced it would merge with Tyco International plc. Both companies will become subsidiaries of a new Irish-domiciled, New York Stock Exchange-traded parent named Johnson Controls plc. The Johnson Controls inversion, coupled with the Pfizer-Allergan inversion announced in September, suggest that despite the Internal Revenue Service’s (IRS) best efforts, inversions have returned.

On September 24, 2014 the IRS issued new regulations designed to reduce the number of inversion transactions by limiting the benefits of “post-inversion tax avoidance” (Rules Regarding Inversions and Related Transactions, Notice 2014-52, 2014-42 I.R.B. 712 (2014), Anti-Inversion Rules, AIR). In an accompanying Fact Sheet, the U.S. Department of the Treasury (Treasury) defined an inversion as a restructuring by a U.S. multinational that replaces a U.S. parent with a foreign parent, “in order to avoid U.S. taxes” (U.S. Department of the Treasury: Fact Sheet: Treasury Actions to Rein in Corporate Tax Inversions (Sept. 22, 2014), Fact Sheet).

Treasury’s definition highlights the most contentious objective of inverting: shielding foreign income from U.S. taxes. U.S. tax law treats the foreign profits of U.S. companies differently from profits generated domestically. Income from foreign operations is taxed at the same rate as U.S. income, but U.S. tax on foreign profits doesn’t become due until the money is put on the books of the U.S. parent, or “repatriated.” The tax code refers to potential tax due on un-repatriated income as a “deferred” tax obligation. U.S. multinational corporations often carry a theoretical obligation, due on repatriation, to pay deferred taxes on foreign income, and this regulatory scheme creates an incentive to delay, or if possible forgo, repatriating such income.

Before the Anti-Inversion Rules, most inversions had a recognizable structure: a U.S. multinational and a smaller, non-U.S. merger partner organized a new holding company in a low-tax foreign jurisdiction. Shares of both merger partners were exchanged for shares of the new holding company and both companies became privately held operating units of a new, publicly held, foreign parent. One benefit of such “classical” inversions was that through post-merger tax maneuvers the U.S. entity’s deferred tax obligations could be made to vanish without coming due. The Anti-Inversion Rules addressed some tax-planning techniques (e.g., “hopscotch” loans from foreign subsidiaries to the new foreign parent) that allow access to cash in foreign subsidiaries without repartiation, but inversions remain attractive because other tax minimization tactics, like foreign subsidiary “earnings stripping” through loans to the new foreign parent, remain available.

When is a Redomestication an Inversion?

The term “inversion” is essentially derogatory, and commentators have used it to tar a range of redomestication transactions. Unfortunately, analysis of inversions as a whole requires more precision. To conduct a useful survey of such transactions, we found it necessary to establish a bright-line test to separate inversions from the larger set of cross-border redomestication mergers.

A Scheme to Avoid Taxes

Treasury’s use of the phrase “to avoid taxes” suggests that an inversion, unlike other redomestication transactions, is a scheme to thwart a legitimate tax obligation. President Obama accused inverting companies of not “paying their fair share,” implying that an inverting company’s change of domicile is a ploy to put deferred taxes beyond the reach of the U.S. government (C-Span: Weekly Presidential Address (July 26, 2014)).

Few companies have advertised tax avoidance as their impetus for redomestication. That said, who doesn’t want to avoid paying taxes? In fact, virtually any redomestication merger will lead to lower taxes (the U.S. has the highest corporate tax rate in the world). Effectively, every redomestication merger might actually (or also) be an inversion. And that, of course, is the rub:  distinguishing between an inversion and what the Fact Sheet calls a “genuine cross-border merger” requires knowing whether the parties intend to avoid U.S. taxes.

We devised two methods for gauging the relative importance the parties placed on potential tax savings to be reaped by redomestication:

  • Some reorganization agreements contained a clause permitting the parties to terminate the agreement if interceding amendments to the tax law would treat the new, non-U.S. parent as a U.S. company. We concluded that such tax conditions were an indication the parties felt the benefits of the merger might be erased by the loss of tax savings derived from redomestication. We thus classified transactions with a tax condition as inversions.
  • For deals without a tax condition, we relied on circumstantial evidence, primarily factors tending to suggest continuity between the US entity and the new foreign parent. Some commentators, including the President, have described classical inversions as a mere tax dodge because such deals work a de jure change in tax domicile with scant de facto change in the inverting entity. In a classical inversion, the U.S. entity is, on average, twice the size of its merger partner, and as a result, the new foreign parent looks a lot like the old U.S. parent. The new parent company often has the same management, most of the same shareholders, and occasionally, the same name as the old U.S. parent. We eliminated from our list of inversions redomestication mergers without a tax condition where stockholders and managers of the U.S. entity did not control 51% or more of the new non-U.S. parent.

Survey Results

We compared inversions announced in the twelve months before the Anti-Inversion Rules with inversions announced in the twelve months following the Anti-Inversion Rules. Our survey found:

  • The AIR did not eliminate inversions. The number of inversions announced in the year before the AIR is the same as in the year after the AIR.
  • While the number of deals announced after the AIR is the same as the number announced the year before, the average value of these deals (minus Pfizer-Allergan) is dramatically smaller. Many of the inversions announced before the AIR were never completed, but not all terminations can be ascribed to the Anti-Inversion Rules. Transactions were rejected by shareholders and cancelled by antitrust regulators. As of this writing, a number of deals announced after the AIR are still pending. It remains to be seen if post-AIR deals will have a better closure rate than those announced before.
  • Recent inversions employed more unusual structures, including “spinversions,” where the merger partner is a foreign subsidiary of a competitor, and inversions to countries with relatively higher corporate tax rates, like Finland (a “Finnversion,” if you will).
  • The AIR appear to have driven inverting companies to seek out different kinds of merger partners, including companies larger than themselves. The number of inversions that led to loss of shareholder or board control increased following the Anti-Inversion Rules, suggesting that some U.S. managers and investors are willing to cede control in exchange for tax savings.
  • The Pfizer-Allergan agreement contains a tax condition, but on the whole, the use of tax conditions has declined slightly. This suggests that the AIR have had some success reducing the number of deals driven almost entirely by tax savings.
  • The AIR Expansion prohibits “Third Country” inversions where the new foreign parent is organized in a low-tax jurisdiction that is not one of the jurisdictions where the merger partners are organized. Our survey found these transactions constituted 25% of inversions both before and after the AIR. Of the three announced after September 24th, one has already closed. The other two transactions were amended to conform to the requirements of the AIR Expansion.
  • There is some evidence of a post-AIR democratization of inversions. While pre-AIR inversions were overwhelmingly pharmaceutical companies, the post-AIR period saw inversions by companies in a broad range of industries.

In November, driven perhaps by fear of the Pfizer-Allergan transaction triggering a second inversion avalanche, the IRS issued a notice clarifying and expanding the Anti-Inversion Rules (Additional Rules Regarding Inversions and Related Transactions, Notice 2015-79, 2015-49 I.R.B. 775 (2015) AIR Expansion). But the IRS can only regulate within the bounds set by Congress. The new rules, like the old, only operate against cross-border mergers meeting the definition of inversion contained in section 7874 of the Internal Revenue Code (IRC § 7874). Section 7874 defines inversion by reference to the percentage ownership of the new foreign parent by stockholders of the old U.S. parent. If shareholders of the former U.S. parent control 80% or more of the new foreign parent, the new foreign parent is treated as a U.S. company for tax purposes, while redomestication mergers resulting in U.S. shareholders of the former U.S. parent controlling less than 60% of the new foreign entity are not considered inversions at all. Mergers falling between these thresholds are subject to further IRS scrutiny. Thus, since Pfizer shareholders will control only 56% of the new Pfizer-Allergan parent, the Pfizer transaction, like six of the 12 inversions announced since the AIR, remains beyond IRS scrutiny, thus demonstrating Lawrence Hsieh’s contention (and a reasonably apt subtitle for this post) that  “bright-line government restrictions are no match for private sector legal engineering” (Insurance Mergers Face U.S. Regulatory Uncertainty Despite Inversions Clarification, The Knowledge Effect, Dec. 28, 2015).

Largest Inversion Transactions 2013 – 2015

In the wake of the Anti-Inversion Rules, it appears that large inversions are (mostly) out. Four of the five largest inversions were announced prior to September 24th 2014.

New Structures Table 1

The AIR did not eliminate inversions. The number of inversions announced in the year before the AIR is the same as in the year after the AIR.

New Structures 1

While the number of deals announced after the AIR is the same as the number announced the year before, the average value of these deals (minus Pfizer-Allergan) is dramatically smaller. Many of the inversions announced before the AIR were never completed, but not all terminations can be ascribed to the Anti-Inversion Rules. Transactions were rejected by shareholders and cancelled by antitrust regulators. As of this writing, a number of deals announced after the AIR are still pending. It remains to be seen if post-AIR deals will have a better closure rate than those announced before.

New Structures 2

The AIR appear to have driven inverting companies to seek out different kinds of merger partners, including companies larger than themselves. The number of inversions that led to loss of shareholder or board control increased following the Anti-Inversion Rules, suggesting that some U.S. managers and investors are willing to cede control in exchange for tax savings.

New Structures 3

The Pfizer-Allergan agreement contains a tax condition, but on the whole, the use of tax conditions has declined slightly. This suggests that the AIR have had some success reducing the number of deals that would not be done but for tax savings.

New Structures 4

The AIR Expansion prohibits “Third Country” inversions where the new foreign parent is organized in a low-tax jurisdiction that is not one of the jurisdictions where the merger partners are organized. Our survey found these transactions constituted 25% of inversions both before and after the AIR. Of the three announced after September 24th 2014, one has already closed. The other two transactions were amended to conform to the requirements of the AIR Expansion.

New Structures 5

There is some evidence of a post-AIR democratization of inversions. While pre-AIR inversions were overwhelmingly pharmaceutical companies, the post-AIR period saw inversions by companies in a broad range of industries.

New Structures 6

 

New Structures 7

IRS efforts have failed to slow the rate at which U.S. companies reincorporate abroad. In fact, the increasing variety of companies choosing to invert suggests that redomestication as a tax strategy is becoming less infamous. At the same time, IRS actions have inspired a number of tweaks to the classical inversion model, including novel structures, larger merger partners, and loss of control by U.S. shareholders, making it increasingly difficult to discern which transactions actually deserve this ignominious label.