Pfizer’s massive tax play for AstraZeneca

April 29, 2014, 8:05 PM UTC

Pfizer’s $100 billion takeover bid for rival drug maker AstraZeneca could be too big a tax dodge for the U.S. government to ignore.

In what would be one of the largest and most brazen “tax inversion” mergers ever attempted by a U.S. company, the Pfizer (PFE) deal seems to be testing the patience and resolve of lawmakers and bureaucrats. In a tax inversion, the headquarters of a U.S. company is technically moved abroad to a lower tax jurisdiction in order to save on paying taxes to Uncle Sam. In this case, Pfizer would reincorporate itself in Britain.

While comprehensive corporate tax reform still seems like a long shot, the Pfizer deal, if consummated, might push lawmakers to move ahead with plans to seal up the tax loophole for good, putting an abrupt end to the recent wave of tax-induced mergers.

Tax advantages are rarely the primary motivation for pursuing a merger, but they can sweeten the synergies just enough to seal one up. But in the last few months, it seems that taxes are playing a larger role in deals than had previously been the case. For example, it seems that nearly every big deal that has been announced recently has claimed a tax inversion as one of the few concrete benefits of the deal. For some, it seems like it was the only reason.

Tax inversions are not new, but the U.S. government apparently assumed it had erected enough barriers to prevent companies from indulging in them. For example, the government requires around 20% of the company’s stockholders in the new entity to be foreign in order for it to be considered a legal move. That has made it difficult for companies to simply change their status, as was the case in the late 1990s when companies like Tyco inverted to tax free jurisdictions.

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Despite the government’s best efforts, tax inversions have exploded again, taking more U.S. companies out of the taxman’s reach. To meet the ownership rules, companies are being encouraged to acquire smaller foreign companies. The new entity is incorporated either in the jurisdiction of the smaller, foreign target or in another jurisdiction where the tax rate is seen as even more favorable for the newly combined entity.

Pfizer’s bid for AstraZeneca (AZN) is just the latest in a string of tax inversion deals. For example, pharmaceutical company Endo recently merged with Paladin Labs and reincorporated in Ireland, where the corporate tax rate is 12.5%. The deal is estimated to have saved New Jersey-based Endo some $50 million a year in taxes. Advertising giants Omnicom (OMC) and Publicis announced a proposed merger in July 2013, along with plans to incorporate the combined company in the Netherlands, saving an estimated $80 million a year in taxes. And when Eaton Corp acquired Cooper industries of Ireland, it lowered its net effective tax bill from an already low 12.5% to 2.5%.

But the Pfizer deal takes the cake. Pfizer’s effective U.S. tax rate last year was 27.4%. By domiciling in the U.K., that rate would fall to 21.3%. That translates to an annual tax savings of some $1.2 billion for the drug company. But that seems like just an added bonus when you factor in Pfizer’s cash held overseas. By becoming a U.K. company, Pfizer would no longer be responsible for paying the U.S. a repatriation tax of 35% on its foreign cash earnings. With 70% of the company’s $49 billion in cash held overseas, that translates into a possible one-off tax savings of some $12 billion. The fact that Pfizer made that money while it was a U.S. company doesn’t seem to matter.

When seen in that light, it is understandable why Pfizer would be so keen on linking up with U.K.-based AstraZeneca. At the very least, it probably wouldn’t be offering such a staggering premium for the company if it were based, say, in Texas.

So is Pfizer wrong to be denying Uncle Sam his cash? Morally, one might say the company is crossing the line, but legally they have every right to engage in this sort of behavior. The sheer size of the tax bill Pfizer would be tearing up here seems way too big to go unnoticed in Washington, though. In the past 20 years, the U.S. government has made it progressively harder for companies to engage in tax inversion. The latest explosion of deals seems to have come to a head with the Pfizer deal and could finally force Congress to act.

To be sure, Democrats and Republicans seem united in their opposition of tax inversions, even though both sides are loath to admit it. President Obama actually put forth a proposal in his administration’s budget that would make it much harder for companies to engage in tax inversions by raising the foreign ownership level threshold from 20% to 50%. Republican tax hawks, led by Rep. Dave Camp, the current chairman of the powerful House Ways and Means Committee, want to cut the tax inversion loop hole as well by pushing through major corporate tax reform that would wipe away incentives companies currently receive to domicile abroad.

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“It is a real problem when the tax code provides an incentive for U.S.-based companies to move overseas, often times taking good jobs with them,” Camp told Fortune. “The tax reform draft I released was designed to put an end to those incentives, and actually make America a more attractive place to invest and do business.”

Passing total corporate tax reform before the November midterm elections seems like a long shot, but sealing the tax inversion loophole could be in the cards if Pfizer pushes ahead.

The government has a history of throwing down the gauntlet when big companies like Pfizer cross the line. When engineering giant Ingersoll-Rand reincorporated in Bermuda in 2001 to escape U.S. taxation, the government cracked down hard on inversions, stating that companies wishing to invert must have “substantial” business activity in the country they reincorporate in. That pretty much ended inversions for island tax havens for good.

Pfizer executives are hoping they can slip this merger past government tax hawks without attracting too much attention. While they may be successful, it will not go down quietly.

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