Allergan, Pfizer Inc. Fall Prey to Tax-Inversion Hawks (AGN, PFE)

Looks like the merger of Pfizer Inc. (PFE) and Allergan (AGN) isn’t going to happen after all, thanks to some new rules from the U.S. Treasury Department.

Allergan, Pfizer Inc. Fall Prey to Tax-Inversion Hawks

Announced in November to the cheers of shareholders, but to the jeers of patriots upset that yet-another tax-dodging U.S. company , the impending union of Ireland-based Allergan and New York-based Pfizer is now officially (mostly) not worth the trouble.

While the new rules posted Monday afternoon are anything but an elegant solution to the issue of American companies moving headquarters overseas — where corporate tax rates can be considerably lower — they do work.

The turn of events does beg the question, though: What exactly was the Treasury, of all arms of the government, able to impose to put the clamp-down on tax inversions?

Meet the New Tax Inversion Laws

In retrospect, it was only a matter of time before someone laid down some tougher laws on the, albeit legal, tax-dodging practice of superficially moving a company overseas.

Valeant Pharmaceuticals (VRX) did it in 2010 by acquiring Canadian company Biovail; Medtronic PLC (MDT) bought Covidien in 2014, moving its business address to Ireland in the process; and AbbVie Inc (ABBV) would have hooked up with Irish drugmaker Shire PLC (SHPG) in 2014 had the Treasury Department not wrangled some last-minute rules to kill the deal before it was consummated. (As one may have surmised, Ireland’s corporate tax laws are particularly gentle.)

Monday’s new rules were particularly tough, taking a 16% bite out of AGN when shareholders heard the bad news. The merger of Pfizer and Allergan was deemed a done deal, and Allergan shares had been priced as such. Now they’re not.

The legal/philosophical questions immediately surfaced, of course, not the least of which was whether or not the Treasury even has the authority to impose such rules. The new rules would have been tougher to question had they been approved by Congress as law, and even Treasury Secretary Jack Lew says actual legislation is still merited.

So far, though, Pfizer, Allergan, Congress and the White House haven’t questioned the new standards.

As for what these new rules do, none of them are especially dramatic in and of themselves; some would say they’re nickel-and-dime impositions. In sum, however, they can take a big toll. Among the biggest hurdles:

So-called “serial inverters” can no longer count recent (in the past three years) acquisitions as part of their official corporate size — size that is necessary to qualify those entities as eligible for a tax-inversion merger.

As the laws currently stand, such overseas pairings must be of companies of a certain — and relative — market cap to be approved and eligible for favorable tax treatment.

This new rule is a roundabout means of making existing laws work as intended, although it takes dead aim at Allergan and its recent deals.

Another aspect of Treasury’s new rules address “earnings stripping” by allowing the IRS to re-categorize debt on the balance sheet as equity instead. Debt is often loaded up on the U.S. company before the merger is completed, because higher interest payments lower taxable income afterwards. More equity means greater tax liability.

Yet another aspect of the new rules requires a significant amount of due diligence be completed for a pairing to secure a tax-favored status. This due diligence can be time-consuming, costly, and if nothing else, annoying enough to help deter future tax inversions.

In other words, the U.S. Treasury Department may have just established a means of nagging U.S. corporations into submission.

Bottom Line for Allergan, Pfizer and Tax Inversions

The new rules don’t outright prohibit Allergan and Pfizer from teaming up and officially moving the whole operation to Dublin. It does, however, negate the bulk of the benefit of doing so.

Analysts at Evercore ISI opined that “The deal is trading as if it’s 95 per cent dead,” in reference to the steep drop AGN shares are suffering on Tuesday.

PFE shares weren’t hit as hard. In fact, PFE stock actually gained 2%. The opinions regarding Pfizer’s upside from the pairing were mixed, and some investors may be breathing a sigh of relief the union of the two companies isn’t going to happen after all.

At the very least, Pfizer shareholders can take some solace in the fact that while the tax inversion would have been nice-to-have, it wasn’t a must-have. The status quo has simply been maintained. Allergan shareholders were a little further down the want-to-have part of that continuum, judging from that stock’s response.

As for other potential tax inversion deals, it’s safe to say the Treasury Department has put the kibosh on the bulk of them.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities.

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