Mega deals, like the killed $160 billion merger of Pfizer Inc. (NYSE: PFE) and Botox maker Allergan Plc (NYSE: AGN), aren’t the only transactions that will be affected by the U.S. Department of the Treasury’s new rules aimed at curbing tax inversions. There will also be consequences for cross-border M&A in the middle market.

Tax experts warn that the rules, some of which went into effect in April, could have an impact well beyond their intended purpose, which is to hinder mergers in which a U.S. company is acquired by a smaller non-U.S. company so that the combined company's assets will enjoy lower taxes under the foreign domicile. For the middle market, the list of possible negative consequences is long—even for deals not aimed at tax inversions. The consequences include: increased legal and compliance costs for cross-border deals; discouraging foreign investors; and hampering tax-exempt investors.

The proposed rules would even redefine debt and equity in certain situations, making them “the biggest fundamental change in tax law in decades--it’s that big,” says Steven Schneider, a Baker & McKenzie partner in Washington, D.C. “It’s very ambitious what they’re trying to do.”

The Treasury initiative includes rules that make it more likely that the U.S. shareholders in a cross-border merger will end up owning a greater percentage of the combined company. If that percentage is 80 percent or higher, the combined company cannot claim the non-U.S. tax domicile for the U.S. operations. If the percentage of U.S. shareholder ownership is 60 percent to 80 percent, then the foreign domicile is allowed under certain circumstances. If the percentage is less than 60 percent, the non-U.S. domicile is allowed. The new rules make it more difficult for the U.S. company in a cross-border merger to make itself smaller through certain types of distributions to investors in the three-year period before the deal.

Middle-market companies involved in cross-border M&A may be especially vulnerable to tripping up on the rules for that three-year period—even more so than larger companies—because they are more likely to make the unusual distributions targeted by the rule, says Robert Willens, a New York-based M&A and corporate tax expert. “That’s the line you don’t want to cross, because if you do, once the transaction has been completed, you’re pretty much shut out of any tax planning strategies you might have hoped to engage in to lower your effective tax rate,” Willens says. Unwittingly achieving an inversion classification from the IRS means that certain transactions, up to 10 years after the deal, can have income taxable as inversion gains—paying U.S. taxes regardless of whether other losses exist that could offset that income, Willens warns.

Some of the new rules are still in the proposal stage and are subject to a public comment period. The proposed rules target certain types of financing structures that non-U.S. investors use to buy U.S. assets with a mix of equity and internal debt—leverage provided by related company, such as an affiliate or portfolio company. The internal debt receives interest deductions in the U.S., reducing the higher tax rate in the U.S., and interest income in the lower-rate foreign domicile of the parent company.

The proposed rules also target a similar tax reduction strategy, earnings stripping, used after a cross-border deal where the related-party loan is used to make interest payments from the U.S. asset—reducing the U.S. tax basis by stripping out income—and increasing income in the lower-rate non-U.S. country. These proposed rules would block these strategies by giving the IRS unprecedented authority to redefine what had previously been characterized as debt, as equity instead, simply because of the nature of how the financing is used, says Schneider, of Baker & McKenzie.

“It’s the first time I can ever think of where you could have the identical instrument with a third party that’s debt, and then with a related party it’s automatically reclassified as equity. That, some believe, is going above and beyond the IRS’s authority,” Schneider says.

Besides curtailing foreign investment, the proposed rules could create problems for a common investment structure that non-U.S. and tax-exempt institutions in the U.S. use to invest in private equity, Schneider says. These structures, called corporate blockers, prevent taxable income from flowing to the end investor, and commonly use leverage that the proposed rules would target.

Overall, the proposed rules could hamper foreign investment and create compliance issues where previously financing was pretty straightforward. “There’s a lot more paper work and formalities that are easier to mess up on, and just more costly to do, from a transaction standpoint, particularly with the middle market, where they may not have used that many lawyers to do all that stuff,” Schneider says.

Willens says the scope of the proposed rules is “almost without limit. Those rules are much more worrisome and troubling than the acquisition stuff. Those rules are on a totally different level of comprehensiveness. There’s plenty of unintended consequences, as we think more about the rules and learn more about them.”

At the very least, the proposed rules will change the calculations for potential middle-market cross-border deals and reduce the incentive to incorporate complicated tax planning in the deals, says Jeff Goldman, senior counsel for Dykema in Chicago. Middle-market and lower-middle market deals, regardless of size, could be easily tripped up.

Tax attorneys doubt that the proposed rules redefining debt and equity will hold up after a public comment period exposes all of the potential problems the proposal will create. “The fact that they’ve gone so far beyond inversions and created an administrative nightmare, I expect the comments to be strident,” says Jerry Schwartzman, head of M&A tax advisory services at Houlihan Lokey in New York.

Despite doubts held by many tax experts—that the proposed rules won’t survive challenges from public comments, the next presidential administration or potential court challenges, Frank Aquila, partner at Sullivan & Cromwell law firm in New York, says his advice for M&A clients is to take a conservative approach: Assume that the regulations will go into effect as drafted. Says Aquila: “If a deal works from a strategic and financial standpoint, even if those regulations are adopted, then they should certainly go forward with the transaction.”

Financial services industry