Burger King Worldwide, which has a whopper ($11.53 billion) of a merger pending with Canadian coffee house chain Tim Hortons Inc., is the most prominent target of new U.S. Treasury rules designed to curb tax-avoidance inversions via foreign merger. (For more coverage on tax inversion deals, see Tax Inversion Deals Increase Despite Criticims.)
But it’s the healthcare and pharmaceutical industries that could feel the brunt of new rules designed to curb the benefits of acquiring and merging with offshore firms in an effort to flee domestic tax rates that can be as high as 39% when accounting for both state and federal taxes.
The rules have already prompted the cancellation of Salix Pharmaceutical’s $2.7 billion proposed acquisition of Cosmo Technologies, and according to Moody’s Investors Service, several other pending M&A agreements in the medical industry could come under renewed scrutiny by the ratings agency due to the Treasury’s actions, which “will likely reduce some of the credit-positive financial benefits of several pending mergers among U.S. healthcare and pharmaceutical companies.”
Two of those inversion-driven deals included in Moody’s report involve two non-investment grade firms: Chesterbrook, Pa.-based biopharmaceutical firm Auxilium Pharmaceuticals (B3’ by Moody’s, CCC+’ by Standard & Poor’s) and Salix (B1’/’B+’), which is a Raleigh, N.C., producer of drugs and medical devices in the gastroenterology area. Moody’s report was published prior to Thursday’s cancellation of the Salix-Cosmo merger.
Salix in June proposed a takeover of Cosmo in Europe that would allow Salix to move its corporate headquarters to Ireland and reduce its tax rate from the high-30% range to the low-20% range, according to Moody’s. Auxilium is could see the same benefit if it proceeds with a $400 million purchase of Canadian biotech firm QLT, which researches treatments for retinal diseases.
Salix cited the new Treasury rules as the reason for dropped its plans, noting a “changed political environment has created more uncertainty" for what it expected to gain from the merger.
Corporate tax inversions have become a “small but growing fraction” of 2014 M&A deals, according to S&P.
When a public and legislative outcry erupted in August over the tax-diversion incentives contained in Burger King’s deal for Tim Hortons, the Obama administration rushed into place new rules on Sept. 22 designed to remove inversion incentives. Among those were restrictions on inter-company loan tactics designed to tap foreign profits without paying dividend taxes, and the tightening of U.S. ownership levels that inverted firms have used to gain foreign-tax treatment from the Internal Revenue Service.
The healthcare-related M&A agreements cited by Moody’s in its report prompted a credit-positive outlook for the acquirers because of the tax-inverted outcome. But if the Treasury rules force those firms to punt or renegotiate the originals deals, the deals could suddenly flip into credit-negative events for the acquiring firms (although not likely downgrades).
One scenario could be the pricey cancellation fees from a called-off merger; another could be a renegotiation of terms that would be “less advantageous to creditors, including funding sources, which in many cases was expected to include existing off-shore cash, equity or intercompany loans,” according to Moody’s.
Lead report researcher and Moody’s senior vice president Michael Levesque sees two specific rules that could upturn the value of an inversion deal in these healthcare/pharmaceutical hookups. “One is whether existing offshore cash can be used to fund the deal itself. And second is after the deal closes, how effectively a company can move offshore cash up to the parent holding company.”
Establishing taxation on intercompany loans, or “hop-scotch” loans, led to Friday’s decision by Minneapolis-based medical equipment firm Medtronic (A2’/AA-) to revise its planned $42.9 billion merger with low-tech medical device maker Covidien. Medtronic says it will now seek $16 billion in U.S.-based debt financing rather than $13.5 billion in cash borrowed from foreign subsidiaries to help fund the deal, which the company affirmed it would continue to pursue.
In a report this summer, Moody’s held that the merger’s main benefit for Medtronic was as a tax benefit, since the deal otherwise seemed to provide little in the way of synergies, geographic expansion or high-end technology. The company said on Friday that the terms of the original deal remain unchanged, meaning that Medtronic still plans to reincorporate in Ireland. Moody’s placed Medtronic on review for a downgrade, but expects the loss of tax benefits and the additional debt to lower Medtronic’s rating no lower than one or two notches, so the company would maintain its investment-grade status.
Moody’s on Friday also noted that Salix’s withdrawal from the Cosmo merger removed a credit-positive event from its outlook.
Another deal up in the air may be the $54.8 billion behemoth deal struck in June by AbbVie Inc. (Baa1’ by Moody’s, A’ by S&P) for UK-domiciled Shire plc. While the deal was rated a credit-negative by Moody’s due to the substantial leverage involvedit boosts debt-to-Ebitda to the 3.5x-3.7x range from 2.2xMoody’s revised AbbVie’s outlook to positive from stable because of the corporate inversion structure of the transaction.
There is also the pending $5.3 billion proposal by Chicago-based Mylan Group (Baa3’/BBB-’) to obtain the generic drugs business of Abbott Laboratories and move that business to the Netherlands, while carving out a U.S.-based subsidiary in Pittsburgh for current Mylan management. Mylan intends to match the move of its generic drug rival, Activis, which purchased Warner Chilcott in 2013 for $5 billion in order to obtain home status in Ireland.
The new Treasury rules are not retroactive, so will not impact completed deals like drug maker Endo International’s $1.6 billion acquisition of Paladin Labs in 2013 that allowed the Malvern, Pa.-based Endo (BB-’ by S&P) to set up shop in Canada.
But Levesque believes there are concerns the new Treasury rules could stymie future merger and acquisition activity, “because inversions have been one of the drivers.”
In a September report on corporate tax inversions, S&P agreed the tactic has been a motivation for some firms. But S&P also believes that many resulting inversion deals have not delivered the desired benefit. In several cases, particularly in healthcare inversions, the resulting deterioration in a credit profile often outweighed the accrued tax benefits.
S&P noted the focus on tax reduction often outweighed business strategy as companies took on extra leverage for unnecessary or duplicative products or operations. And even with the hope of repatriating profits down the road, most firms likely would only re-purpose the funds for shareholder dividends, “which would also increase credit risk.”