"It potentially changes in a meaningful way the financial calculus that merger partners are going to undergo as they look at inversion," Neil Barr, co-head of the tax department at Davis, Polk & Wardwell in New York, said in an interview on Tuesday. "The needle appears to have moved pretty meaningfully."
Reconsidering deals
Lew's goal was to have companies reconsider inversion deals they're already working on. He also left open the prospect of future action aimed at earnings stripping, the post-inversion transactions that companies use to reduce taxes on US income.
"This action will significantly diminish the ability of inverted companies to escape US taxation," Lew told reporters on a conference call on Monday. "For some companies considering deals, today's action will mean that inversions no longer make economic sense."
Pfizer, Walgreen
The Treasury announcement heightened the tension between the government and companies considering obtaining a foreign address to lower their tax bills. Lew and President Barack Obama made clear that they were prepared to use rulemaking authority to try stop some deals, even at the risk of a backlash from the companies and from Republicans, who complained that Lew's moves went too far.
A wave of inversions caught lawmakers' attention this year when large US companies including Pfizer and Walgreen explored transactions and Medtronic, AbbVie and Burger King moved forward with deals.
The new rules, which will apply to transactions that close starting on Monday, include a prohibition on "hopscotch" loans that let companies access foreign cash without paying US taxes. They also curb actions that companies can use to make such transactions qualify for favourable tax treatment.
Pending deals
The changes will have the biggest effect on the eight US companies with pending inversions, including Medtronic and AbbVie, which plan the two largest such deals in US history.
In its purchase of Covidien, Medtronic plans to loan some of its untaxed profits outside the United States to its new Irish parent company. That transaction may be penalised by the hopscotch rule.
Treasury's actions may raise Medtronic's cost of financing without imperiling its deal or AbbVie's, Willens said.
Treasury stopped short of making the rules retroactive to deals that have been completed. Companies already reaping the benefits of a foreign tax address will face minimal changes except for the risk of a second round of Treasury rules affecting manoeuvres known as earnings stripping.
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Big leap
"Taking a regulatory step was a big leap by the Treasury Department, yet they've only addressed part of the tax juice from US companies inverting," said Steve Rosenthal, a senior fellow at the Urban Institute in Washington and a former corporate tax lawyer. "The earnings stripping remains a large problem."
Writing regulations aimed at earnings stripping, which analysts had expected could be part of the first wave of Treasury action, can be a difficult exercise. The government will be trying to curb abusive transactions without hurting all foreign-based companies operating in the US.
Henrietta Treyz, an analyst at Height Securities, said Treasury is leaving open the possibility of future action to maintain pressure on companies.
"As we have long forecast, a steady stream of 'updates' and further 'announcements' should be expected to come from Treasury throughout September and October and almost regardless of the outcome of the mid-term election, through the remainder of 2014 as senators and the administration try to keep the business community on their toes and apprehensive of future action that may render inversions less attractive," she wrote in a note to clients on Tuesday.
Congressional inaction
Obama and Lew have urged Congress to pass a bill that would curtail inversions. When Congress left Washington for campaign season without acting, the administration did.
"While the administration's actions are an important step, only Congress can fully close the tax inversion loophole," Senator Carl Levin, a Michigan Democrat, said in a statement. "Congress should act promptly when we return to eliminate this tax dodge."
Treasury will release the formal regulations later. In keeping with past practice, the announcement served as a detailed notice of the government's plans.
The changes may cause complications for companies including Medtronic that are counting on the benefits of tax-free access to foreign cash. Another deal involving Horizon Pharma closed on September 19.
Medtronic said in a statement on Monday, "We are studying Treasury's actions. We will release our perspective on any potential impact on our pending acquisition of Covidien following our complete review."
Kenric Tyghe, a Toronto-based analyst with Raymond James, said it's unlikely the changes proposed in the US would affect the Burger King-Tim Hortons deal.
Strategic rationale
David Woollcombe, a Toronto-based partner at McCarthy Tetrault, said he doesn't see the regulations having much effect on deals or potential deals that are driven by a strong strategic rationale, as opposed to tax arbitrage.
The changes proposed will apply to pending and future deals and will likely diminish the tax advantage that US companies have sought from an inversion, he added.
"They are trying hard to plug a leaky boat with a series of stopgap measures, as the prospect of meaningful US tax reform in the short term is very low," Woollcombe said in an email. "The Democrats need to be able to point to some action having been taken in advance of the mid-term elections as inversions have become a political lightning rod."
Under current law, US companies that invert through a merger are still treated as domestic for tax purposes if the former US company's shareholders own more than 80 per cent of the combined company. The administration wants to reduce that 80 per cent to 50 per cent; that requires legislation.
80 pc limit
In the absence of legislation, the Treasury Department looked for ways to make it harder for companies to get around the 80 per cent limit.
The new rules seek to limit so-called spin-versions, in which US companies spin off units into a foreign company.
They also would restrict use of a technique known as skinnying down, in which companies make special dividends to reduce their size before a merger to meet the current law's requirements.
US companies wouldn't be as able to seek out so-called old and cold foreign companies with cash and other passive assets as merger partners to meet the rules.
Foreign subsidiaries
Other changes announced in the rules would make it harder for inverted companies to relinquish control of their foreign subsidiaries to get them out of the US tax code's orbit. US companies must pay taxes when they repatriate foreign profits.
The changes to those control provisions and the hopscotch rules would apply to inversion deals where the former US company's shareholders own 60 per cent to 80 per cent of the combined business.
Emails and calls to spokesmen at Mylan, AbbVie late on Monday weren't immediately returned. Mylan and AbbVie have inversion deals pending. Pfizer's bid for London-based AstraZeneca Plc failed in May though CEO Ian Read has said he is still looking for an inversion opportunity.
Lawmakers, who left Washington last week to campaign for the November 4 election, haven't shown much interest in writing bipartisan legislation to curtail inversions. Most Republicans say the issue should be addressed as part of a broader revamp of the US tax code.
"We've been down this rabbit hole before, and until the White House gets serious about tax reform, we are going to keep losing good companies and jobs to countries that have or are actively reforming their tax laws," Representative Dave Camp of Michigan, the Republican chairman of the House Ways and Means Committee, said in a statement.
"I fear this administration is only interested in doing the bare minimum - just enough to say they care," Camp said.
- Bloomberg
