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TCJA-Altered Landscape Keeping Firms From Relocating

Posted on July 15, 2019

Drug makers AbbVie and Allergan generated a bit of nostalgia June 25 when they announced that they will merge in a $63 billion deal. Back in the summer of 2014 the news was rife with rumblings of potential mergers and acquisitions deals between U.S. companies like AbbVie and foreign companies like Ireland-based Allergan, and speculation as to whether or not those deals would result in inversions.

Five years and several anti-inversion regulations later, that activity has slowed, but it’s not dead. However, this time for AbbVie and Allergan — which is a product of an inversion itself — that type of transaction wasn’t in the cards. The new company won’t relocate, as AbbVie will continue to be incorporated in Delaware and maintain its principal executive offices in North Chicago.

We know the ways in which the Obama administration’s rules and regulations weakened inversion activity from 2014 onward, but the 2017 Tax Cuts and Jobs Act has also altered the corporate landscape with a slew of positive and punitive changes that have made it more worthwhile for companies to remain in the United States following a cross-border M&A. Despite those changes, the question of whether it is worth migrating intellectual property and other foreign assets back to the United States is a toss-up and an issue that may arise more frequently, especially in the pharmaceutical industry, as commentators expect more megamergers in the future.

A Rocky M&A History

The road to the AbbVie-Allergan merger is littered with broken pharma M&As. In the latter half of 2014, potential mergers between AbbVie and Shire and Valeant and Allergan fell through, along with a notoriously huge deal between Pfizer and AstraZeneca. Pfizer, not to be deterred, tried to acquire Allergan the following year, but there too the deal collapsed months after it was announced.

Anti-inversion publicity sank some of those deals, but the reality is that M&A and inversions have never been particularly easy in the pharmaceutical industry despite their lucrative tax benefits. On average, U.S. corporations that inverted between 2004 and 2014 experienced a $33 million reduction in their overall tax expense, according to a 2017 analysis from the Congressional Budget Office. Per the CBO, according to data from 1994 through 2014, inverting companies’ drop in U.S.-specific tax expenses was, on average, 46 percent larger than their drop in worldwide tax expenses. But that incentive is no longer as potent because of the TCJA’s corporate rate reduction to 21 percent.

Deal Details

In the case of AbbVie and Allergan, negative press is stemming from concerns that the resulting company will have trouble keeping up with competitors, not from suspicions of tax arbitrage. The $63 billion cash and stock transaction is expected to close by early 2020, pending regulatory and shareholder approval. Once it closes, AbbVie shareholders will own 83 percent of the company and the remaining 17 percent will be held by Allergan shareholders. AbbVie, which will lose patent exclusivity to its blockbuster Humira drug in 2023, is betting big that Allergan’s portfolios will present several much-needed avenues for growth, especially since Allergan holds a lock on the medical aesthetics industry. Popular brand-name products like Botox, Juvederm, and CoolSculpting all belong to Allergan. AbbVie is hoping that Allergan’s other verticals — in Botox therapeutics, neuroscience, women’s health, eye care, and gastrointestinal care — will profit handsomely for the new company.

Research and Development

Research and development is also playing an important role in the pending deal. AbbVie is overly dependent on Humira for sales and R&D. The drug is responsible for about 60 percent of the company’s sales and props up AbbVie’s $14 billion growth platform, particularly regarding the company’s infrastructure and R&D investment. The Allergan acquisition would immediately double the company’s growth platform and Humira would take a considerable back seat, according to AbbVie’s investor presentation. The new growth platform, worth at least $29 billion, would fund the new company’s R&D engine and support its business development. AbbVie maintains eight R&D centers, and only two are located outside the United States, in Germany and Japan. In 2018 the company spent $5.1 billion in adjusted R&D, so there’s a lot at stake. Allergan’s R&D network is much more spread out globally, but the company also maintains several U.S. centers including San Francisco; Madison, New Jersey; and Cambridge, Massachusetts.

As a baseline, the corporate rate drop to 21 percent automatically made the U.S. R&D tax credit under IRC section 41 more potent. The net benefit used to be 65 percent (100 percent minus 35 percent) but it is now 79 percent (100 percent minus 21 percent). But recent changes to the R&D amortization and expensing rules under IRC section 174 are not as positive. Pre-TCJA, companies could fully deduct their R&D expenses in the same year they arose. As of 2022, those that choose to conduct R&D domestically will have a five-year amortization period. The amortization period for foreign research has also been extended under the TCJA to 15 years, so the domestic change is comparatively better but not a benefit per se, according to critics.

Corporate Tax Impacts

The corporate rate drop, which brings the United States below the OECD’s 23 percent average, has likely blunted corporations’ need to seek better rates elsewhere. “If you look at the U.K. for example, it changed its rate from 21 percent to 20 percent to 19 percent and it may go a little bit lower. When you look at the administrative hassle and costs of moving out of the United States to a viable European country, you may think twice and stay here if you know you will get a 21 percent corporate income tax rate or better, without having to do anything,” Adnan Islam, partner and co-practice leader of Friedman LLP’s International Tax group, told Tax Notes. Beyond that, a suite of domestic tax incentives and provisions has helped several pharmaceutical companies slash their U.S. effective rate lower.

The TCJA has been especially generous to AbbVie, which reported that its 2018 adjusted tax rate was 9 percent and is expected to gradually increase to 13 percent over the next five years. In AbbVie’s case, most of its R&D activity is in the United States, but many of its Humira patents are parked in Bermuda, according to a 2018 Reuters report. Over the past few years, AbbVie needed to access that offshore cash and consequently had to repatriate the money at the previous 35 percent corporate rate, keeping the company’s effective tax rate hovering around 22 percent, Reuters said. Under the TCJA AbbVie will be able to repatriate foreign cash more effectively, CEO Richard Gonzalez said during a 2018 investor call. Meanwhile, the law’s anti-deferral mechanism — the global intangible low-taxed income provision — slaps a minimum 10.5 percent tax on foreign-derived patents, copyrights, and other intangibles.

“What do CEOs care about, when they do deals or are looking at financial statements? They’re looking at effective tax rates, and when you have cash flows that are subject to tax at around 10, 11, 12 percent, most people find that very acceptable,” according to Ramon Camacho, international tax principal in the Washington National Tax practice for RSM US LLP.

Treasury Response to Inversions

Inversion activity has been hot and cold since the 1990s, but 2014 gained some notoriety from a sharp uptick in proposed deals. In the first nine months of 2014, 10 corporations with about $300 billion in collective assets announced that they were thinking about moving overseas. Several major names were involved, including Burger King, Pfizer, Chiquita, and Medtronic. Before that, the highest activity year, 2012, had witnessed seven inversions with about $60 billion in collective assets, according to the CBO. Yet six of the 10 deals announced in 2014 ultimately failed to launch, perhaps partially attributable to the Treasury Department, which issued guidance in September 2014 that made it noticeably harder for U.S. corporations to complete inversions.

Treasury Notice 2014-52 undermined inversion activity by targeting inverted companies’ ability to access their subsidiaries’ overseas earnings tax free. It also made it more difficult for U.S. companies to meet the ownership thresholds required to complete an inversion. Before Treasury stepped in, some inverting corporations would avoid paying U.S. taxes on the earnings of their controlled foreign corporations by having the CFC loan money to the new, foreign parent instead of the U.S. entity because that loan was not considered to be U.S. property. The notice removed the benefit of those so-called hopscotch loans by treating them as taxable U.S. property and subject to U.S. dividend tax rules.

Treasury also blocked U.S. corporations from using a popular “de-controlling” strategy in which the new foreign parent would purchase just enough stock in the U.S. CFC to take control of the entity and therefore avoid U.S. tax. Under the new rules, the foreign parent is considered to own stock in the former U.S. parent rather than the CFC, and so the CFC remains subject to U.S. tax. The rules also closed a popular loophole in which the new foreign parent would sell its stock in the former U.S. company to the U.S. company’s CFC and receive cash or property in exchange, tax free.

U.S. law places strict ownership limits on inverted companies. U.S. shareholders must own less than 80 percent of the new company for the inversion to be recognized and to receive full tax benefits, although the government prefers a lower ownership threshold. Because of this, the government reserves the right to apply tax penalties to companies whose U.S. ownership threshold is 60 percent or higher. U.S. companies were skirting the 80 percent rule by using passive assets to inflate the size of the new combined company and by making extraordinary dividends to reduce their size pre-inversion. They were also engaging in so-called spinversions: spinning off part of their assets into a new foreign corporation and then spinning that off to their U.S. shareholders, a move that avoided U.S. tax. Notice 2014-52 put an end to these tactics, and all of these measures were largely cemented in final rules in 2018.

The government followed up in 2016 with final regulations that made it more difficult for inverted corporations to engage in earnings stripping and move their U.S. profits to lower-tax jurisdictions.

The TCJA’s response to inversions has considerably heightened the negative tax repercussions for these deals and presents huge deterrents in even thinking about an inversion, Islam said. Importantly, there’s a new recapture rule, which substantially increases the amount of tax due on deemed repatriations from companies that invert during a 10-year period that started December 22, 2017. Normally, the deemed repatriation rate under section 965 is 15.5 percent for offshore cash and cash equivalents and 8 percent for earnings reinvested in noncash assets. In the case of newly inverted companies, however, the rate rises to 35 percent and applies to any type of offshore, untaxed earnings. Newly inverted companies must also pay the tax much sooner than others — within the first tax year of expatriation, while other companies can spread their tax obligation over eight years. Their dividends are also treated as normal income, instead of receiving the reduced qualified dividend income rate. Firms that inverted after November 9, 2017, are also ineligible for a special exclusion from the base erosion and antiabuse tax. Under the TCJA, companies may exclude payments for the cost of goods sold from their BEAT calculations, but firms that invert after the November cutoff date must include any cost of goods sold payments to related foreign parties.

“You also don’t get much of an advantage anymore through intercompany leverage because of the real serious tightening on the rules governing the interest deduction for intercompany loans under section 163(j),” according to Camacho.

Camacho also pointed to the TCJA’s amendments to the dividends received deduction (DRD) as a potential incentive to stay. “The statute gave us a DRD for what I would call plain vanilla non-subpart F operating earnings from foreign operations. All of a sudden now, corporations in the U.S., when they receive dividends, they’re just not taxable on those dividends most of the time,” he said.

Still Parked Offshore

The hope, post-TCJA, had been that companies would return their offshore IP to the United States or at least keep new IP here. The reality within the TCJA landscape is that it may be harder for corporations to repatriate their IP than originally envisioned. On the other hand, political pressures and uncertainties in other jurisdictions combined with the reduced corporate tax rate may also make the United States a more attractive home.

“We have a lot of clients asking us to model what it would look like to bring IP back so they don’t have to deal with foreign governments and cost structures. And remember the environment that we’re in — it’s not just that the U.S. is more attractive, the European tax landscape is becoming less attractive at the same time. So people are already thinking about this because of [base erosion and profit shifting] and other things that are going on in other countries,” Camacho said.

GILTI may provide an incentive to keep those assets and actitivies abroad and enjoy a lower effective tax rate, within certain parameters. “You can only get to the beneficial rate on GILTI to the extent that you don’t have subpart F income, because subpart F has to be analyzed before GILTI. And if you have subpart F income, it’s all ordinary income taxed within the current year, i.e., no deferral, with the existing subpart F rules in effect,” Islam told Tax Notes.

Then there’s the foreign-derived intangible income deduction, which works with GILTI by giving U.S. corporations a separate deduction on income derived from selling property and services to foreign customers for foreign use. Sales under FDII include leases, licenses, and other dispositions. Eligible taxpayers can receive a 37.5 percent corporate income tax deduction, decreasing to 21.875 percent after 2025, lowering their effective tax rate on that income to 13.125 percent. “The effective tax rate from FDII is more relevant when looking at potential and direct comparisons,” Islam said. “For example, Ireland has a 12.5 percent corporate income tax rate for active operations and has a much lower base tax rate than the U.K. and many other European jurisdictions,” Islam said.

But FDII may also motivate taxpayers to place their assets outside the United States because domestic assets reduce the amount of income that is eligible for the FDII deduction, as noted by Reed College economics professor Kimberly Clausing in an October research paper.

GILTI and FDII issues aside, Islam pointed out that shifting IP out of the United States remains a challenge because of the expanded statutory definitions of intangible property and the section 367 toll charge on outbound transfers of IP located in the United States. Similar measures exist in other jurisdictions like the United Kingdom, which imposes an exit tax on multinationals if they try to migrate IP or appreciated assets out of the U.K. Ireland is also now hitting multinationals with a 12.5 percent exit tax when they migrate IP out of the country.

“Is it worth it to move? Modeling should be done to compare the resulting effective tax rates for different scenarios. Do I think that people are going to bring their foreign (non-U.S.) IP and assets back into the U.S.? Likely not or not yet,” Islam said, citing recent experiences with his clients.

Allergan, on its end, has said it remains “committed” to Ireland, although the exact terms of that commitment have not yet been disclosed, according to several Irish news reports. Nonetheless, some companies are shifting IP abroad and doubling down on foreign R&D undeterred. In June, U.S. call center software company Genesys announced that it would move €1.4 billion worth of its global IP to Ireland after acquiring Irish artificial intelligence company Altocloud last year, according to The Irish Times. U.S. pharmaceutical development company Biohaven also announced in June that it will move its IP to Ireland and run its operations out of the country. Last year, the U.S. medical diagnostics firm Biosensia acquired an Irish diagnostics company, Kypha, and chose to expand the Irish unit’s facilities.

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