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IPE special report May 2018

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Special Report, Outlook 2015: Taxing times for investors

With the benefit of hindsight it now seems clear that one probably unintended consequence of AstraZeneca’s successful defence against Pfizer’s recent hostile bid is the way it gingered up the US Treasury and Congress against tax inversion deals. 

Reports suggest that AstraZeneca lobbied Treasury long and hard over what it saw as the unfair advantage tax inversion – acquiring a company to establish a new parent company in a lower-tax jurisdiction – gave to Pfizer. Pfizer stood to be able to release up to 80% of the funds held as deferred tax if the merger went through, which could be seen as helping it to pay an ‘unfair’ premium for AstraZeneca stock. 

The Treasury was growing alarmed, in any case, at the scale both of the tax inversion deals already done and the massive potential pipeline. Treasury secretary Jacob Lew is reported to have said that actions by his agency alone would have only a marginal effect without comprehensive legislation by Congress – although that seems unlikely. Heather Self, tax partner at the law firm Pinsent Masons, argues that there does not appear to be any majority in Congress for anti-inversion legislation this side of an election. 

The attraction of a successful tax inversion is that it allows a company to release funds it has been setting aside to cover deferred tax provision, while at the same time improving its accounts by eliminating a major liability. The scale of the issue was signalled when Apple chose to issue a bond this year rather than repatriate some of the mountain of cash it had accumulated overseas.

“Pfizer is carrying a $19bn (€15bn) deferred tax provision, which could be released if its offshore earnings are no longer expected to be repatriated to the US. That would give a significant boost to earnings,” Self comments. “US companies have to pay tax on their global profits, but only when they repatriate them. Until then, accounting standards force them to show a deferred taxation provision which can be very substantial as it builds up over time. They have been using inversion deals for at least the last 15 years. There was a clampdown around 2001 to stop Stanley Tools doing an inversion, then it all went quiet for a while.” 

Curb

The US furore over tax inversion is only one of three significant campaigns currently being run against multinational tax avoidance. The EU is pursuing what it argues is “probably” illegal state funding: it accuses states such as Ireland and Luxembourg of setting up “unfair” low-tax deals to get companies to base subsidiaries in their territories. Amazon, Starbucks, Apple and Fiat are all caught up in the EU’s probe. It argues that the revenues and costs being allocated to some of these subsidiaries bear no resemblance to the scale of the economic activity being carried out. If it proves its case, the EU has the power to order all the gains from the low tax deal to be clawed back. 

The OECD has also launched a major campaign, with the support of the G20, to curb what it calls ‘base erosion and profit shifting’ (BEPS) by multinationals. Unfair transfer pricing and opaque, revenue-sapping deals with politicians in developing countries are among the OECD’s concerns, against which it has published a series of papers advising G20 governments on possible actions to rein in BEPS and create a level playing field for international taxation. 

The outcomes of these campaigns matter to investors since they directly affect the amount of free cash that corporates have at their disposal to invest with, buy back stock, distribute to shareholders or finance acquisitions.

On the subject of tax inversion, David Wood, managing director at Standard & Poor’s’ Corporate Ratings, points out that a massive pile of cash has built up outside the US that would be taxed if it were repatriated. Companies must recognise and provide for growing debt obligations to the US Revenue Service in the shape of this deferred tax. 

“The total amount outside the US for all US companies is estimated at around $2trn, with a concentration among the bigger hi-tech and pharmaceutical companies,” Wood says. 

Wood expects the campaign against tax inversion to cast a chill over a number of potential and pending deals in the healthcare sector in particular. “There are a number of pharmaceuticals with thinning drug pipelines who are on the acquisition trail,” he says. “Tax inversion would have helped those deals but now they will need to be done for more economic reasons. That might make some of those deals more marginal. Time will tell.”

There are already one or two spectacular instances of potential acquirers pulling away as a result of the US Treasury’s hardened stance on inversions. Most recently in the pharma industry, Abbvie announced its intention to use the cash earmarked to acquire Shire in a tax-inversion deal for a major share buyback, instead. 

Mayer Cherem, managing director and head of the portfolio solutions group at PAAMCO, the fund of hedge funds, thinks the impending tax inversion legislation is a new variable that has to be considered as part of special situations M&A strategies. 

“Hedge fund managers used to allocate a maximum of 10-15% to inversion plays,” he says. “Many of them got maxed-out and we saw still more inversion deals coming to the market, so the spread between the market price and the deal price started widening to attract funding. Right now, the entire space is feeling a degree of fear because no one knows how legislation will finally play out, so that is attractive for us. It is impacting deals and driving down pricing, which means some M&A deals are now trading at very attractive levels.”

But he also adds that, if inversion is the only reason for a deal, investors should take care: “We like sound strategic reasons for a deal and if there is some inversion to be had, well and good, but it has to be simply the icing on the cake.”

Furore

Corporate credit investors may be even more wary. Wood points out that the new Treasury regulations limit a company’s ability to access deferred tax cash to fund acquisitions. 

“That means that they may need to borrow even more if they are going to do the deal, so that is credit negative for us,” he says. 

Also, the tendency for them to hand large amounts of freed-up tax money back to shareholders can cause cash-flow stresses that can impact credit ratings. 

“With the OECD and the EU, we will be looking at the tax moves going on to try to figure out what the implications for credit ratings will be,” he adds. “Liquidity and cash play an important role in assessing a company’s credit profile and we will be looking at tax initiatives around the world within the context of corporate cash flow, cash build up and liquidity. Everything is still in play here and we have to see what emerges.”

The initiatives being run by the EU and more importantly – because it is more wide-ranging in scope – the OECD’s anti avoidance campaign, have a long way to run. 

“The OECD, and behind it, the G20, is serious about stopping untaxed structures from playing fast and loose with tax revenues,” as Self puts it. “If the US does not change its tax rules, it is very likely that the EU will move to impose tax costs on US multinationals anyway. This is going to create a furore and trying to see where it is all going to end is like playing 29-dimensional chess.”

 The outcome of a 29-dimensional chess tussle is hard to predict, of course. But it will clearly raise the level of the ‘political risk’ that investors and fund managers will need to consider as part of the due diligence process.

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