Pfizer and Allergan have called off their proposed $160 billion merger citing the US Department of Treasury's issuance of temporary and proposed regulations to further reduce the benefits of and limit the number of corporate inversions, a move that the companies said created an adverse tax law change. So what has the Treasury Department done thus far, and what is next for Pfizer and Allergan?

Part of the rationale for the proposed mega-merger between Pfizer and Allergan was the ability of Pfizer to achieve an improved corporate tax rate through the location of its global headquarters in Dublin, Ireland, the current location of Allergan's headquarters. Although Pfizer had said it would have remained operationally based in the US, Pfizer would have achieved a preferred corporate tax position by acquiring the Dublin-headquartered Allergan. With uncertainty cast with the US Treasury's action earlier this week, the preferred tax position that was part of Pfizer's financial rationale for the megamerger was also put into doubt. DCAT Value Chain Insights (VCI) examines the implications.

Gaining perspectives  
Pfizer's proposed $160 billion merger with Allergan, which the companies announced in November 2015 would have been the largest merger in the history of the pharmaceutical industry. Pfizer's decision to pursue Allergan followed its interest in acquiring AstraZeneca in 2014, another mega merger for Pfizer that did not come to fruition. Pfizer announced in late May 2014 that it would not make a formal offer to acquire AstraZeneca following AstraZeneca's decision to reject Pfizer's non-binding $119-billion proposal. Pfizer's interest in acquiring AstraZeneca was to build its pipeline and commercial portfolio, but it also had a financial component in establishing a new UK-incorporated holding company of the proposed combined company. The proposal for the deal brought to the fore the issue of corporate inversion, a practice by which a US-based multinational company restructures so that the US parent is replaced by a foreign corporation as a means to achieve a lower tax rate.

Pfizer's pursuit of AstraZeneca, along with other deals involving corporate inversion, notably AbbVie's proposed $55 billion acquisition of Dublin-headquartered Shire in 2014, led the US Treasury Department to issue new rules on corporate inversion in September 2014 and November 2015 and ultimately led AbbVie to terminated its proposal to acquire Shire. That deal also involved a tax inversion structure for AbbVie under which AbbVie would have formed a new company, New AbbVie, which was to be incorporated in Jersey, the UK, Shire’s current place of incorporation. Following the completion of the deal, New AbbVie would have become the holding company of the Shire Group and the AbbVie Group. Through its incorporation in the UK, the AbbVie board expected the transaction to reduce New AbbVie’s effective tax rate to approximately 13% by 2016. The new company planned to retain operational headquarters in Chicago with a presence in both the US and UK. Following the termination of the proposed merger, both companies later pursued other large-scale acquisitions. AbbVie acquired Pharmacyclics, biopharmaceutical company specializing in hematological oncology drugs, for approximately $21 billion in May 2015. In August 2015, Shire made a $30 billion non-binding proposal to acquire Baxalta, the specialty biopharmaceutical company spun off from Baxter in July 2015; Baxalta later upped the price in a formal $32 billion offer in January 2016, in a deal that is expected to close in mid-2016.

Treasury action spurs decision  
Now the US government's action on curbing corporate inversion has struck again, this time in the form of the proposed Pfizer and Allergan deal. In a statement, Pfizer said that the decision to terminate the merger was mutual among the companies and spurred the US Treasury Department’s recent actions. “The decision was driven by the actions announced by the US Department of Treasury on April 4, 2016, which the companies concluded qualified as an ‘Adverse Tax Law Change' under the merger agreement,” said Pfizer in a company statement. In connection with the termination of the merger agreement, Pfizer has agreed to pay Allergan $150 million for reimbursement of expenses associated with the transaction. Pfizer also said it plans to make a decision about whether to pursue a potential separation of its innovative and established businesses by no later than the end of 2016, consistent with its original time frame for the decision prior to the announcement of the potential Allergan transaction.

Corporate inversions have drawn the attention of the US government as such cross-border transactions have recently increased. The Congressional Research Service identified 23 inversions since 2012, compared to only three in total in 2010 and 2011, which led the US Treasury Department to take action. US Treasury Secretary Jacob J. Lew outlined the prior actions taken by the Department in September 2014 and November 2015, and further action announced on April 4, 2016, to address corporate inversion. “Treasury has taken action twice to make it harder for companies to invert. These actions took away some of the economic benefits of inverting and helped slow the pace of these transactions, but we know companies will continue to seek new and creative ways to relocate their tax residence to avoid paying taxes here at home,” said Lew, in a statement “Today [April 4, 2016], we are announcing additional actions to further rein in inversions and reduce the ability of companies to avoid taxes through earnings stripping. This will have an important effect, but we cannot stop these transactions without new legislation. I urge Congress to move forward with anti-inversion legislation this year. Ultimately, the best way to address inversions is to reform our business tax system, which is why Treasury is releasing an updated framework on business tax reform, outlining the administration's proposals to date as a guide for future reform. While that work goes on, Congress should not wait to act as inversions continue to erode our tax base.”

Specifically, the Treasury announced it was taking action to limit inversions by disregarding foreign parent stock attributable to recent inversions or acquisitions of US companies. This will prevent a foreign company (including a recent inverter) that acquires multiple American companies in stock-based transactions from using the resulting increase in size to avoid the current inversion thresholds for a subsequent US acquisition.

The Department also addressed so-called “earnings stripping,” a practice used in corporate inversions by multinational corporations to reduce high domestic taxation by using interest deductions to their foreign headquarters in a friendly tax regime to lower their corporate taxes. The Treasury Department announced three key items to address earnings stripping by: (1) targeting transactions that generate large interest deductions by simply increasing related-party debt without financing new investment in the United States; (2) allowing the Internal Revenue Service on audit to divide debt instruments into part debt and part equity, rather than the current system that generally treats them as wholly one or the other; and (3) facilitating improved due diligence and compliance by requiring certain large corporations to do up-front due diligence and documentation with respect to the characterization of related-party financial instruments as debt. If these requirements are not met, instruments will be treated as equity for tax purposes.

Treasury said will continue to explore additional ways to address inversions. It also released an updated framework for business tax reform, which revises the framework released in 2012. This lays out the key elements of the President's approach to reform and details the specific proposals the administration has put forward, including a comprehensive approach to reforming the international tax system.

What is next for Pfizer and Allergan
Pfizer's termination of its deal for Allergan raises questions on what Pfizer may seek to do, in the form of another deal, and on a more immediate basis later in 2016 whether to separate its innovator and established drug businesses. Pfizer’s interest in acquiring Allergan was to add to its Innovator Products business. Pfizer manages its commercial operations through two distinct businesses: an Innovative Products business and an Established Products business. The Innovative Products business is composed of two operating segments: the Global Innovative Pharmaceutical segment (GIP) and the Global Vaccines, Oncology and Consumer Healthcare segment (VOC). The Established Products business consists of the Global Established Pharmaceutical segment (GEP), which includes all legacy Hospira commercial operations, following Pfizer’s $17 billion acquisition of the specialty pharmaceutical company, Hospira in 2015. For 2015, Pfizer reported total revenues of $48.85 billion, a 2% decline year over year. Revenues of its Innovative Products business increased 11% to $26.76 billion, and revenues from its Established Products business (including the legacy Hospira business) decreased 14% to $21.59 billion.

For its part, Allergan is proceeding with a large deal announced prior to its proposed merger with Pfizer, namely the $40.5 billion divestment of its generics business to Teva Pharmaceutical Industries, a deal that is on track to close later this year in June and which positions Allergan as a pure-play specialty pharmaceutical companies. Up to this, the transformational deal for Allergan was Actavis’ $70.5 billion acquisition of Allergan, which closed in March 2015. The move followed Actavis' $28 billion acquisition of Forest Laboratories in 2014. That deal was followed by another mega deal, the announcement by Allergan of its decision to sell its generics business to Teva for $40.5 billion, a move Teva made following its terminated efforts to acquire Mylan. In July 2015, Teva agreed to acquire Allergan Generics, the generics business of Allergan (formerly the generics business of Actavis) for $40.5 billion ($33.75 billion in cash and $6.75 billion in shares of Teva), which would give Allergan an approximate 10% stake in Teva. The move positions Allergan as innovator-based specialty pharmaceutical company with 2015 pro forma sales of approximately $15.5 billion with a focus in seven therapeutic areas, including eye care, gastroenterology, aesthetics, women’s health, central nervous system, urology, and anti-infectives. Following the close of the deal, Allergan will have a manufacturing network of 12 plants globally and a mid-to-late-stage R&D pipeline with 70 projects and a 2015 pro forma investment in R&D of approximately $1.4 billion. The transaction would result in after-tax net cash and equity proceeds for Allergan of approximately $36 billion.

“While we are disappointed that the Pfizer transaction will no longer move forward, Allergan is poised to deliver strong, sustainable growth built on a set of powerful attributes. Leading therapeutic franchises with strong brands across seven therapeutic areas provide the foundation for continued strong growth in 2016 and beyond. Our pipeline is one of the strongest in the industry, loaded with 70 mid-to-late stage programs including 14 expected approvals and 16 regulatory submissions in 2016 alone,” said Brent Saunders, CEO and president of Allergan,” in a company statement