Pfizer/Allergan: What’s next for mega-mergers?

While 2015 was the year of the mega-merger, 2016 could well be the year of the never-merger, as the value of abandoned deals reaches its highest since the eve of the financial crisis.

Last week saw the collapse of Pfizer’s $160bn merger with Allergan, after the US Treasury and Internal Revenue Service (IRS) issued proposed regulations to reduce the benefits of corporate tax inversions. And with the transaction set to have been the largest tax inversion deal in history, the actions of the US Treasury could not have been more strategically timed.

“There is a lot to unpack,” says King & Spalding partner John Clay Taylor. “The regulations issued last week really put things into legal formats that were already issued and lawyers have been trying to get their heads round them.”

The US Treasury made no reference to the Pfizer and Allergan deal in its announcement last week, but it is widely suspected to have issued the proposals to stop the pair in their tracks. Sources say the rules “shot that deal down” and “hurt the pride of Pfizer and Allergan”, while market commentators claim Congress only knew about the rules just an hour before they were released.

“No-one expected these rules to be snuck in and it was a bit of a bombshell,” says one corporate partner. “Clients are asking whether they’re going to be caught by this and it’s going to have a big impact on anyone connected to the US.”

Rewriting the rules 

Pfizer’s deal with Allergan was announced last November, but the pair said last week they had been “driven” to terminate the deal as a result of the actions of the US Treasury and IRS. One corporate partner even says the parties “recognised there might be government intervention” by arranging a comparatively low break-up fee of $150m.

The proposed regulations issued by the US Treasury cover various points of contention, importantly excluding foreign acquirers of US businesses in the last three years. The rules aim to stop foreign acquirers from using their enlarged size to avoid inversion thresholds for subsequent US acquisitions, thereby specifically affecting Allergan which had grown through M&A transactions.

Allergan’s size had been one of the main drawing points for Pfizer, as it needed a large enough merger partner with which to combine. Yet despite the rules making organically-grown companies more attractive to US buyers, they may actually limit the amount of multi-billion tie-ups that can take place.

“In future inversions, it will be the organically grown companies that will be attractive merger partners for US companies,” one corporate partner says. “Pfizer is so big that it needed a merger partner that was equally as large, but it’s hard to grow so large organically and there are a smaller number of companies out there.”

Historic inversions

Pfizer’s intended merger partner Allergan was already significantly smaller in terms of revenue size, with Pfizer reporting revenues of $49.6bn compared to Allergan’s turnover of $4.2bn. This contrasts to Pfizer’s preferred merger partner of two years ago, when the pharmaceutical giant famously had its eye on UK rival AstraZeneca, whose revenue reached approximately $24.7bn.

However, that inversion also fell through in 2014, in a move almost mirroring the most recent collapse of Pfizer and Allergan. It came as the Obama administration said it was looking to reduce the benefits of inversions, putting scrutiny on companies that were planning to move their tax domicile to regions such as the Republic of Ireland.

Tax inversions have therefore been a particular bugbear of the US Government in recent years, with the Republic of Ireland’s 12.5 per cent corporation tax rate on trading income continuing to appeal to companies wishing to escape the US rate of nearer 35 per cent.

“There’s such a disparity in rates that it makes the US quite unattractive,” says one Republic of Ireland partner. “The US changes are a knee-jerk reaction and it puts up a trade barrier making it a bit uncompetitive.”

William Fry partner Martin Phelan agrees, saying that the way to stop inversions would be to instead make the US more attractive for US corporates and have the dollar going in at a cheaper tax rate.

“These actions have been taken to gain short-term political praise, but they will actually damage the US economy in the long-term,” he says. “It’s the US tax law that needs to be changed.”

The challenges 

However, the fact that the US Treasury issued such drastic rules at such a pivotal time implies that the administration thought it had no other option.

“The [US] government wants to discourage inversions and will use whatever means necessary,” one corporate partner says. “The rules are pretty draconian and they’re pushing the boundaries of their authority, but it’s the only available avenue for the administration.”

As well as issuing rules to prevent the inversion itself, the US Treasury is also targeting transactions that generate large interest deductions by increasing related-party debt without financing new investment in the US. These rules have been described by King & Spalding tax partner John Clay Taylor as “relatively benign but amazing in impact”, as these are ones that will have the wide-reaching implications.

“This is quite a sea change and shift in major tax rules,” Clay adds. “Up until now, debt deals have been given more favourable treatment than equity deals. But these rules say that if the lender is related to you, then debt will be treated as equity and you won’t get the tax treatment you were hoping for.”

Clay believes the rules concerning the interest deduction could lead to a “huge re-ordering of the system” that will prompt lawyers to rethink about how they conduct existing financings, guarantees and third party lenders.

“The concern for non-US clients is what the impact will be on existing financings and deals in place,” adds King & Spalding European tax partner Daniel Friel. “The rules affect new deals, but there will be questions over refinancing and guarantees.”

European connections 

While some lawyers are focused on what this means for their non-US clients going forward, others see a potential change in strategic direction over in Ireland. Companies may start looking for other ways to structure their business, with spin-outs serving as a viable option for companies that would otherwise have inverted.

“We remain attractive in Ireland and I predict more spin-outs in Ireland as a result,” says another partner in the Republic of Ireland. “If you wish to spin out your group into different sectors, then you may have the possibility of doing that and Irish holdings would be able to come into their own.”

This could be done by identifying the target business to be spun-out, before deciding which holding business to put it under. Sources believe IP-heavy industries would be most likely to be spun-out due to the manner in which profits are relocated, with the method potentially providing companies with an alternative way to structure business under the new rules.

As it stands therefore, all lawyers can do is predict the next stage of the tax inversion saga. Some invisage that there will not be much of an impact on the M&A side until the US Presidential Election is over, while others predict an increase in Asian interest as companies shy away from US deals.

However, the majority agree that the US’ actions were a bold, but potentially, rushed move, claiming “it’s never a good thing when a merger of that size falls through”. As the value of abandoned deals reaches its highest since the eve of the financial crisis, the corporate world will be tentatively hoping the market picks up.