The Hows, Whats, and Whys of the Pfizer-AstraZeneca Corporate Inversion

If Pfizer’s $119 billion offer for Astra Zeneca was truly its last offer, then the current furor over the tax loophole that Pfizer was attempting to take advantage of might die down. For a while. If not, then we can expect Senator Carl Levin of Michigan to continue to attempt to craft legislation to defeat this tax loophole. But what is this tax loophole, how does it operate, and why is it so potent at lowering a company’s US tax liabilities?

What is the Tax Loophole that Pfizer Wants to Use?

The tax loophole that Pfizer wants to use is called a corporate inversion transaction. The most simple way to conceive of this transaction is that the corporation reincorporates in a new country with a lower tax rate. The transaction is structured to be tax-free to the corporation and taxable to the shareholders.

In the most extreme examples prior to passage of the Jobs Creation Act of 2004, American companies reincorporated in bona fide tax havens:

Since the bill was passed, it has become tougher to do a tax free corporate inversion. But it is still possible. In the next section I will discuss the mechanics of a corporate inversion.

How the Corporate Inversion Works

In a typical corporate inversion, US parent company directly merges into a foreign company or it creates a foreign subsidiary which it reverse merges into. The first is a tax-free reorganization under IRC 368(a)(1)(B), and the second is a tax-free reorganization under IRC 368(a)(2)(E). This is a standard corporate transaction in domestic mergers and acquisitions.

However, and this is where the Jobs Creation Act of 2004 amendment in IRC 7874(b) comes into play, the new foreign domicile of the company will be ignored and it will be taxed as if it’s a domestic, US corporation if:

  1. the former shareholders of the US corporation own at least 80% of the new foreign corporation by vote or value; and
  2. the expanded affiliate group of the new company does not have substantial business activities in the country of its incorporation compared to the total business activities of the expanded affiliate group.

In the event that the former shareholders of the US corporation own less than 80% but 60% or more of the new foreign corporation, then the foreign corporation is respected as a foreign corporation, but it loses:

  1. Certain tax credits; and
  2. Net operating losses.

This effectively eliminated the possibility of reincorporating into a typical tax haven which tend to be very small islands in which substantial business activities could not occur. However, there are still tax savings to be found by reincorporating from, for example, the US with a 35% nominal tax rate into the UK with a 21% nominal tax rate.

Generally, the corporate inversion will result in the shareholders recognize gain on the transaction equal to difference between the fair market value of the shares received in the new foreign company and the shareholders’ adjusted basis in the shares. IRC 367(a); Treas. Reg. 1.367(a)-3(a).

In the proposed merger of Pfizer and AstraZeneca, Pfizer proposed the creation of a new holding company in the UK which would acquire both Pfizer and AstraZeneca. Under the May 2, 2014, terms Pfizer shareholders would own 73% of the new UK company and AstraZeneca shareholders would own 27% of the new company, which would allow it to pass the 80% test in IRC 7874.

Corporate Inversions Lower Tax Rates and Eliminate Tax on Repatriating Foreign Income

In the press release linked to in the previous paragraph, Pfizer announced that there would be tax benefits to the merger. The New York Times’s DealBook quantified those tax benefits:

By reincorporating in Britain, Pfizer would most likely save about $200 million a year for each percentage point less it pays in taxes, according to Barclays. Pfizer paid a 27.4 percent rate in the United States; AstraZeneca paid about 21.3 percent in Britain. Those six percentage points could turn into an annual windfall of more than $1 billion.

Additionally, US companies are typically subject to tax on their worldwide income. If US companies plan around Subpart F, then they can defer recognition of income from foreign affiliates until that income is repatriated into the US. Other countries, China being the notable exception, operate on an exemption system under which income is taxed only in the country that is the source of the income. This means that if Pfizer is reincorporated in the UK, then it can use its $57 billion in cash sitting in its overseas entities for investment anywhere in the world without having to pay additional tax to the US government.

This article originally posted at the Global Law & Business Perspective.

photo credit: CarbonNYC cc