The pending mergers of Johnson Controls, Inc. with Tyco International plc and Pfizer Inc. with Allergan plc means the value of inversions in the pipeline ($185B) has nearly reached the total value of all inversions completed between January 1, 2010 and September 24, 2014 ($197B) – the day the Internal Revenue Service (IRS) released its first passel of rules aimed at curbing inversions (Rules Regarding Inversions and Related Transactions, Notice 2014-52, 2014-42 I.R.B. 712 (2014), Anti-Inversion Rules, AIR1). Our fortuitously timed survey comparing inversion activity before and after AIR1 found that while IRS rules appear to have inspired some creative deal-making, they have not slowed the pace of inversions.

Before AIR1, most inversions had a recognizable structure: a U.S. multinational and a smaller, non-U.S. merger partner organized a new holding company in a low-tax foreign jurisdiction. Shares of both merger partners were exchanged for shares of the new holding company and both companies became privately held operating units of a new, publicly held, foreign parent. One benefit of such “classical” inversions was that through post-merger tax maneuvers the U.S. entity’s deferred tax obligations could be made to vanish without coming due. AIR1 addressed some tax-planning techniques (e.g., “hopscotch” loans from foreign subsidiaries to the new foreign parent) that allow access to cash in foreign subsidiaries without repartiation, but inversions remain attractive because other tax minimization tactics (e.g., foreign subsidiary “earnings stripping” through loans to the new foreign parent) remain available.

When is a Redomestication an Inversion?

The term “inversion” is essentially derogatory, and commentators have used it to tar a range of redomestication transactions. In fact, analysis of inversions as a whole requires more precision. To conduct a useful survey of such transactions, we found it necessary to establish a bright-line test to separate inversions from the larger set of cross-border redomestication mergers.

In the Fact Sheet accompanying AIR1, the U.S. Department of the Treasury (Treasury) defined an inversion as a restructuring that replaces a U.S. parent with a foreign parent, “in order to avoid U.S. taxes” (U.S. Department of the Treasury: Fact Sheet: Treasury Actions to Rein in Corporate Tax Inversions (Sept. 22, 2014), Fact Sheet). Treasury’s use of the phrase “avoid” suggests that an inversion, unlike other redomestication transactions, is a scheme to thwart a legitimate tax obligation. President Obama accused inverting companies of not “paying their fair share,” implying that an inverting company’s change of domicile is a ploy to put deferred taxes beyond the reach of the U.S. government (C-Span: Weekly Presidential Address (July 26, 2014)).

Virtually any redomestication by a U.S. entity will lead to lower taxes, because the U.S. has the highest corporate tax rate in the world. Thus, every redomestication merger might actually (or also) be an inversion. And that, of course, is the rub: distinguishing between an inversion and what the Fact Sheet calls a “genuine cross-border merger” requires knowing whether the parties intend to avoid U.S. taxes.

We devised two methods for gauging the relative importance the parties placed on potential tax savings to be reaped by redomestication:

• Some reorganization agreements contained a clause permitting the parties to terminate the agreement if interceding amendments to the tax law would treat the new, non-U.S. parent as a U.S. company. We concluded that such tax conditions were an indication the parties felt the benefits of the merger might be erased by the loss of tax savings derived from redomestication. We thus classified transactions with a tax condition as inversions.
• For deals without a tax condition, we relied on circumstantial evidence, primarily factors demonstrating continuity between the US entity and the new foreign parent. Some commentators have described classical inversions as a mere tax dodge because such deals work a de jure change in tax domicile with scant de facto change in the inverting entity. In a classical inversion, the U.S. entity is, on average, twice the size of its merger partner, and as a result, the new foreign parent looks a lot like the old U.S. parent. The new parent company often has the same management, most of the same shareholders, and occasionally, the same name as the old U.S. parent. We eliminated from our list of inversions redomestication mergers without a tax condition where stockholders and managers of the U.S. entity did not control 51% or more of the new non-U.S. parent.

In November, driven perhaps by fear of the Pfizer-Allergan transaction triggering a second inversion avalanche, the IRS issued a notice clarifying and expanding AIR1 (Additional Rules Regarding Inversions and Related Transactions, Notice 2015-79, 2015-49 I.R.B. 775 (2015), AIR2). But the IRS can only regulate within the bounds set by Congress, and the new rules, like the old, only operate against cross-border mergers meeting the definition of inversion contained in section 7874 of the Internal Revenue Code (IRC § 7874).

Section 7874 defines inversion by reference to the percentage ownership of the new foreign parent by stockholders of the old U.S. parent. If shareholders of the former U.S. parent control 80% or more of the new foreign parent, the new foreign parent is treated as a U.S. company for tax purposes, while redomestication mergers resulting in U.S. shareholders of the former U.S. parent controlling less than 60% of the new foreign entity are not considered inversions at all. Mergers falling between these thresholds are subject to further IRS scrutiny. Thus, since Pfizer shareholders will control only 56% of the new Pfizer-Allergan parent, the Pfizer transaction, like six of the 12 inversions announced since AIR1, remains beyond IRS scrutiny.

Survey Results

We compared inversions announced in the twelve months before AIR1 with inversions announced in the twelve months following AIR1. Our survey found:

• AIR1 did not eliminate inversions. The number of inversions announced in the year before AIR1 is the same as in the year following AIR1 implementation.
• While the number of deals announced after AIR1 is the same as the number announced the year before, the average value of these deals (minus Pfizer-Allergan) is dramatically smaller.

• Recent inversions employed more unusual structures, including “spinversions,” where the merger partner is a foreign subsidiary of a competitor, and inversions to countries with relatively higher corporate tax rates, like Finland (a “Finnversion,” if you will).
• AIR1 appears to have driven inverting companies to seek out different kinds of merger partners, including companies larger than themselves. The number of inversions that led to loss of shareholder or board control increased following AIR1, suggesting that some U.S. managers and investors are willing to cede control in exchange for tax savings.
• There is some evidence of a post-AIR1 democratization of inversions. While pre-AIR1 inversions were overwhelmingly of pharmaceutical companies, the post-AIR1 period saw inversions by companies in a broad range of industries.

Thus, our survey suggests that IRS efforts have failed to slow the rate at which U.S. companies reincorporate abroad. In fact, the increasing variety of companies choosing to invert suggests that redomestication as a tax strategy is becoming less infamous. At the same time, IRS actions have inspired tweaks to the classical inversion model, including novel structures, larger merger partners, and loss of control by U.S. shareholders, making it increasingly difficult to discern which transactions actually deserve this ignominious label.

The preceding post is based on analysis authored by Craig Eastland, Business Law Expert on-Call at Thomson Reuters.   The analysis was published on January, 27 2016 and is available here.