JCI Johnson Controls International PLC

By Liz Hoffman 

Treasury's latest shot at stopping corporate inversions could present a real problem for Pfizer Inc.'s pending $150 billion takeover of Allergan PLC -- the largest such deal ever -- but will likely have less of an impact on similar transactions that have yet to close, like Tyco International PLC's tie-up with Johnson Controls Inc.

Inversions are deals that became popular in recent years in which a U.S. company buys a foreign rival and adopts its lower-tax jurisdiction. Such companies frequently proceed to make more acquisitions of U.S. companies to bring them on to their lower-tax platforms.

Inversions have met stiff resistance in Washington, though the government had been unable to do much to stop them. That may have changed with the publication late Monday of a third installment of proposed rule changes, the stringency of which came as a surprise to many.

In an effort to crack down on what Treasury calls "serial inverters" -- companies that have done other tax-lowering deals after inverting -- the regulations unveiled Monday included a three-year look-back. That means Treasury will disregard three years' worth of U.S. acquisitions when determining a foreign company's true size under the tax code.

That complicates the finely tuned math that is crucial for inversions to work. To reap maximum benefits, shareholders of the inverting company should own between 50% and 60% of the combined entity. Between 60% and 80% also works, but the tax perks are diminished, and above 80%, they are lost entirely. So U.S. companies need an inversion partner that is at least one-quarter their size, and ideally more like two-thirds.

When the Allergan deal was struck last year, Pfizer's market capitalization was about $200 billion and Allergan's was about $123 billion. Pfizer's shareholders would own 56% of the combined company.

But if you strip out three years' worth of deals done by Allergan -- which Treasury most certainly would consider a serial inverter -- that math no longer works. Allergan has 395 million shares outstanding. It has issued about 260 million shares for big deals including the $25 billion takeover of Forest Laboratories and the $66 billion combination of Actavis and Allergan last year.

Stripping those out leaves about 130 million shares, worth only about $31 billion. Under the current merger ratio, Allergan shareholders' stake in the combined company would likely drop into the high teens. In other words, in the eyes of Treasury, Allergan is likely too small to be Pfizer's inversion partner.

The two companies said Monday that they are reviewing the regulation and haven't yet commented further.

The move by Treasury has spooked Allergan shareholders who worry it will make the deal uneconomical for Pfizer and cause the drug giant to walk away. Allergan shares are down 16%, erasing more than $16 billion of the company's market value, in a stark signal that many investors are leaving the deal for dead.

Investors in other companies pursuing inversions took a more sanguine approach, perhaps because the three-year rule is unlikely to trip them up. Tyco, the target of Johnson Controls' pending inversion, has made few acquisitions in the past three years. The same goes for Canada's Progressive Waste Solutions Ltd., which is Waste Connections Inc.'s ticket out of the U.S. tax net.

Shares in those companies are falling today, though less dramatically than Allergan's. Progressive Waste is down 6.5%, and Waste Connections has fallen 5.6%. Meanwhile, Tyco has dropped about 2.7%, and Johnson Controls has declined 2.2%. IHS Inc. and its planned inversion partner, Markit Ltd., are each off about 3%.

Waste Connections and Progressive Waste said in a statement Tuesday that they are committed to their deal. They expect the regulations to affect less than 3% of the combined company's expected first-year adjusted free cash flow of $625 million.

A spokesman for Johnson Controls said the companies were reviewing the regulations.

Those deals aren't entirely immune from the new regulations. Treasury also is attacking a practice known as earnings stripping, which is when inverted companies lend money to their American subsidiaries and use the interest payments, which are tax deductible, to lower their U.S. taxes. Treasury will stop treating those loans as debt, negating their benefits.

To the extent Johnson Controls or Waste Connections hinged their deals on earnings stripping, they could see their allure diminished. If the math no longer works -- for example, if the lessened savings can't support the new company's debt -- some transactions could be recut or abandoned.

Write to Liz Hoffman at liz.hoffman@wsj.com

(END) Dow Jones Newswires

April 05, 2016 13:43 ET (17:43 GMT)

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