US drugmaker Pfizer announced on Monday (Nov 23) that it will buy Ireland-based Allergan for US$160 billion in the biggest deal ever in the health sector.
But the mega-deal is facing a political backlash in the United States as it involves Pfizer "inverting" into the smaller Allergan, shifting its global headquarters and taxable profits to tax-light Ireland.
It would be the largest so-called tax inversion move to date, and will bring huge savings to Pfizer, which says the deal will slash its tax rate from 25 per cent in 2014 to as low as 17 per cent in the first year of the deal.
What is a tax inversion?
It is a piece of financial engineering that multinational companies, particularly from the US, have turned to in order to reduce their tax bill.
In a tax inversion, one company buys a rival based in a different country with lower tax rates. It then "reincorporates" by shifting the address of its headquarters to the country with the lighter tax burden.
In many cases the operational HQ - the main business - might remain in the original country, but the firm simply holds some of its board meetings in the new jurisdiction.
Why do US firms do it?
The main reason is that the corporate tax regime in the US is the most demanding among developed economies. American firms are taxed on their domestic earnings at up to 39 per cent, and also on income repatriated from foreign subsidiaries.
Most other countries impose a much lower rate than the US on repatriated earnings. If a company can shift its country of incorporation, the US taxman loses the right to take a slice of income from foreign subsidiaries.
How much profits have US firms shifted overseas
To date, American firms have stashed an estimated US$2 trillion (S$2.83 trillion) overseas, rather than repatriate the money.
What's wrong with tax inversions?
US President Obama has called companies that do them "corporate deserters" who are being "unpatriotic" by seeking to reduce their contribution to US coffers.
He and other US politicians say they are happy for companies to buy foreign firms when the deal makes obvious sense, even if the end result is a lower tax bill. What they object to is an artificial takeover designed purely to avoid tax.
How old is this tactic?
The first major inversion took place in 1982, when US construction firm McDermott moved to Panama, switching its corporate headquarters to the Central American country and slashing the tax rate on its earnings.
After a wave of similar deals, the US cracked down in 2004 with an anti-inversion law targeted at firms relocating to tax havens.
However, it still permitted the company to change address, as long as its merger partner was a quarter of its size or larger.
That ruled out moves to tiny tax havens where subsidiaries were unlikely to be big enough to satisfy this criterion. However, it also made a more attractive destination of Europe, where there are many firms large enough to bypass anti-inversion laws.
Has Pfizer tried the tax inversion tactic before?
Pfizer tried a tax inversion last year by buying British pharmaceuticals rival AstraZeneca in a deal that would have cut its tax rate from 27 per cent to 21 per cent. But the deal eventually collapsed amid uncertainty about White House plans to crack down on tax inversions.
So, aren't there more recent rules against tax inversions?
There are but they won't stop Pfizer from going ahead.
Mr Obama's Treasury department last week introduced new measures designed to clamp down on tax inversions. These put tighter restrictions on inversions where the US company ends up with a combined stake of between 60 per cent and 80 per cent of the foreign takeover target.
This was intended to stop firms buying much smaller foreign rivals simply to switch addresses to a country with a lower tax rate.
But the terms of the Pfizer-Allergan means the US firm will own 56 per cent of the new company. That puts it just below the threshold at which the tax inversion could be blocked.
Some US Democratics have proposed a 50 per cent foreign ownership test and other new limits, but legislation was widely seen as unlikely before 2017 - after the US general elections. The US Treasury could tighten its rules in the meantime, though it can only go so far on inversions without congressional action.
Source: The Guardian, Reuters