Robert Browning, the 18{+t}{+h} century poet, spoke of how the best laid plans of men and mice ‘gang aft a-gley’ — a Scottish rendition of the phrase, ‘often go awry’. He was consoling a mouse, whose little nest burrowed deep in the field had been upturned by a plough. If the mouse thought it had found a safe and secure place, only to be accidentally caught under the sharp edge of a plough, men too often find themselves at the receiving end of the slings and arrows of misfortune.
But while mice continue to trust their luck, nesting under farmlands, men — or at least the chieftains of commerce and business — secure themselves against fate by drawing on the expertise of tax accountants and corporate lawyers. Even so, they come up short from time to time when fate, in the form of taxmen, wills otherwise.
Vodafone’s travails with the Indian tax authorities, which continue even to this day, is still fresh in our minds. We would never really know if Vodafone factored in its potential tax liability and adjusted its acquisition price accordingly when it acquired Hutchison’s mobile telephony business in India. If it didn’t, it is fair to say that it was acting no different from the mouse in Robert Brown’s poem in trusting chance.
The case of American pharmaceutical giant, Pfizer, however, is different. Recently, it said that it was calling off its proposal to merge with Allergan plc, an Irish company in the same business. It was conscious of the fact that the deal could run into some rough weather due to changes in American tax laws, which could strip the proposed merger of all commercial and business logic. At the same time, it didn’t want Allergan to bind it to the terms of merger, on the failure of which it could impose on Pfizer huge liquidated damages.
Escape clause
As the company (Pfizer) said in its filing with the stock exchange, its decision ‘was driven by the actions announced by the US Department of Treasury on April 4, 2016’ which prompted the company to conclude that such changes constituted an “Adverse Tax Law Change”, a circumstance under which the merger could be called off with minimal financial consequence to Pfizer. The company was required to pay only $150 million in compensation to Allergan for a deal that was worth $160 billion had it fructified.
Pfizer’s act in calling off the merger proposal is emblematic of a salutary principle that strategic decisions, no matter how well thought out, can come up against the unexpected. While managers would be well advised to prepare for all contingencies, it wouldn’t hurt to arm oneself with an ‘escape’ clause so that it is possible to walk away from a commitment even at the last possible moment.
What exactly did the US Treasury Department do? To comprehend that, it would be necessary to first understand how the deal was structured. The merger proposal actually involved Pfizer merging itself with Allergan, and the shareholders of Pfizer receiving shares in an Irish company, thus making a true-blue American company reinvent itself as an Irish company in the eyes of the American tax law.
Tax inversion
When a large company and a relatively smaller one come together under a transaction of merger, it is customary for the larger entity to retain its identity while the smaller one’s identity gets subsumed.
Since what was sought to be proposed is the opposite, the transaction is described as an ‘inversion’, to denote a deviation from the normal. Since this being done to leverage the advantage of variation in tax rates in different jurisdictions, the merger is described as ‘tax inversion’ transaction. It is such transactions that have drawn the attention of the US Treasury Department.
The latter made two changes, one of which made the prospect of the post-merger entity being treated as a foreign company under US tax law, more onerous. Prior to the change in the rule, it was possible for such an entity to claim that it should be treated as a foreign company if existing shareholders of a US company ended up owning less than 80 per cent of the equity stake in the post-merger entity. The amended rule changed this requirement to 60 per cent. In other words, the new rule raised the prospect of more companies post-merger being regarded as American for tax purposes.
While Pfizer still cleared the amended rule, as existing shareholders in the post-merger entity would fall to 56 per cent, a further complication was introduced to the local ownership rule with the added stipulation that merger transactions going as far back as three years would also be taken into account while computing the percentage of local ownership in the post-merger entity.
Deal-breaker
This would have been a deal-breaker as Allergan started out as an American company and, through a series of mergers during the relevant three-year period, had taken over a few American companies before being eventually absorbed into the Irish incorporated Allergan.
In the event, if some of the existing shareholders of Allergan are to be counted as American stakeholders in the new company, there was every possibility of Allergen, post absorption of Pfizer’s global business, to be treated as an American company for tax purposes even though legally, it is an Irish incorporated company with an American operation. If the whole idea behind the merger was to reduce the tax burden and improve the per-share earnings for existing shareholders of Pfizer, the merger lacked a strategic rationale under the amended tax rule.
Not content with that, the US Treasury Department also introduced another rule change, which made stripping American income of its tax liability just that much more difficult for corporates. Under this rule, loans in excess of $50 million extended by a foreign parent or any of its affiliates (related parties) to an American subsidiary can be regarded as equity and, consequently, interest payments on such loans would be disallowed as legitimate business expenditure.
Thus ended, at minimal cost to Pfizer, the termination of what was to have become the biggest merger in international corporate history.