M&A activity has recently exploded in the pharma space, catching the eye of many advisors with long-term holdings in the sector.
Allergan, a maker of ophthalmic and dermatological remedies, is up 50% year-to-date. Meanwhile, AstraZeneca, the world’s seventh-largest pharma company, has risen more than 30%. Both stocks are at all-time highs, thanks to takeover offers from respective suitors Valeant and Pfizer.
In addition to the usual merger synergies, many of the touted benefits of the deals stem from growing interest in transactions known as tax inversions. This is when a U.S.-based company moves its headquarters to a lower-tax jurisdiction. The company in the higher-tax country can act as the acquirer or the acquiree.
Pfizer is headquartered in New York, and offered to buy AstraZeneca, which has its legal address in London, U.K. (The deal is now dead, after AstraZeneca rejected multiple offers.) Valeant is headquartered in Quebec, and has made a hostile bid for Allergan, which calls California home.
The benefits are not restricted to pharma stocks either, with several U.S. companies looking to lower their tax bills through inversions. In March, Chiquita Brands announced a merger with Fyffes, a Dublin, Ireland-based food distributor. The two are combing forces to become the largest banana distributor in the world.
Despite claims the merger was done to generate $40 million in pretax synergies, and the immediate post-deal tax benefit would be minimal, the company is still choosing Ireland as its new tax residence.
The increased pace of tax inversions is reminiscent of the income trust conversion craze in Canada, which peaked in 2006. Many companies undertook the financial manoeuvre to boost their share prices, and the government was concerned about potential tax leakage.
It was only when some of the largest companies in Canada, including BCE and Telus, starting contemplating the change that the federal government altered the tax rules.
With that lesson fresh in the minds of many investors, advisors are somewhat torn between looking at potential merger candidates as investments and counseling their clients against possible government intervention.
It wouldn’t be the first time the U.S. government stepped in to stem the tide of tax inversions. In 2001, industrial conglomerate Ingersoll-Rand jumped ship for Bermuda, which, among other defections, prompted the government to impose a moratorium of sorts. New legislation banned companies from moving tax addresses if it meant that more than 80% of the merged entity was still owned by shareholders of the former U.S. company.
Proposals like the $100-billion Pfizer-AZN deal raised eyebrows in Washington. Under existing rules, U.S. companies need only acquire a company that’s 25% of its own market value to complete a conversion.
President Obama’s budget plan for fiscal 2015 proposes to raise the hurdle, requiring the U.S. company to swallow an entity larger in market value in order to qualify. Both the Pfizer and Chi-quita deals would fail such a test.
The proposal has received little support in Congress, despite promising to bolster the federal treasury by $17 billion over the next decade. That figure seems grossly underestimated, given the current trend. Pfizer alone might generate annual tax savings of almost $1.4 billion.
Still, the numbers are large enough to spark serious debate among U.S. lawmakers, with many wishing to solve the inversion problem through broad-based tax reforms, including reducing effective tax rates.
The U.S. is regarded as having the highest effective rates in the developed world—in the mid-30% range. The U.K. is closer to the low-20% range, Ireland’s standard rate is 12.5%, and Bermuda
and the Cayman Islands levy no corporate tax.
How Canada stacks up
Valeant is headquartered in Laval, Que., but holds significant intellectual property in several low-tax jurisdictions, including Switzerland, Ireland, Barbados and Bermuda. The manoeuvres allow the company to keep its cash tax rate in the low single digits.
Canadian tax laws differ from the U.S., and act as a competitive advantage for Valeant when vying for target companies. Canadian firms are allowed to repatriate dividends from subsidiaries in low-tax jurisdictions that have tax treaties with Canada, such as Barbados and Bermuda.
U.S. rules may change over time, but there is a distinct gap in the interim that is exploitable by advisors focused on the Canadian side of the equation. Indeed, they might set their sights on acquirers like Valeant, as well as potential takeover targets.
U.S.-based firm Endo Health acquired Canadian company Paladin Labs in March 2014, in part for the tax inversion benefit, handing investors a 120% return on the transaction. Paladin’s founder has started a new venture, Knight Therapeutics, shares of which were distributed to former Paladin investors. Knight’s management has stated it will follow the Paladin strategy, which might eventually include using an offshore address for tax purposes.
While Paladin used an Irish address to reduce taxes, and transferred those benefits to Endo, Knight currently lists a Barbadian subsidiary in its disclosures.
Other mid-cap Canadian pharmas are garnering increased attention following the successful runs of Valeant and Paladin. A former Valeant executive now heads Concordia Healthcare, which is often billed as the next Valeant. It has an office in Barbados, and a goal of making continued acquisitions.
While the writing might be on the wall for some tax inversion deals, the glacial pace of reform in Washington means nothing is imminent. While the Paladin deal just squeezed by under the current rules, Valeant’s stalking of Allergan would come close to meeting the tighter requirements proposed.
In short, lawmakers won’t be able to shut down the practice completely, so advisors haven’t seen the last tax inversion deal come down the pipe.