AGN Allergan plc

By Richard Rubin 

Pfizer Inc.'s quick abandonment of its merger with Allergan PLC this week shows just how tough it is to challenge a Treasury Department determined to clamp down on corporate inversions with increasingly ambitious regulations.

Pfizer's alternative -- plow ahead and challenge the Treasury's new rules in federal court -- would have required a gamble and a long wait. Doing legal battle with the government would have necessitated Pfizer proceeding with the merger so it could challenge any taxes the U.S. tried to impose.

The consequences of trying and losing could have been enormous, because the rules released Monday might have unraveled Pfizer's attempt to put the combined company's tax address in Ireland -- and subjected it to many years of back taxes.

"Presumably this is intended to have a chilling effect," said John Harrington, a former Treasury international tax lawyer who now advises corporate clients in Washington. "A lot of companies wouldn't want to discover three, four years later that they were a U.S. company the whole time."

And it could have taken even longer than that. Just last year, tech companies scored a major victory when the U.S. Tax Court struck down a 2003 regulation on share-based compensation -- and that case is still under appeal.

The government's advantage is the product of a 149-year-old law known as the Tax Anti-Injunction Act, which says taxpayers can't sue to stop tax laws and regulations until the government has tried to assess the tax.

That process gives the government an inherent advantage, because Treasury can explore the boundaries of its legal authority and scare off potential challenges. It would take an unusually determined plaintiff -- or one that doesn't have too much money at stake -- to take on the government. On the other hand, once the government sets rules, companies and their tax lawyers can start planning around them.

The chilling effect from Treasury regulations helped kill AbbVie Inc.'s 2014 attempt to merge with Shire PLC. The collapse of the Pfizer-Allergan deal, which would have been the largest corporate inversion ever, marked an even bigger victory for the Obama administration. White House press secretary Josh Earnest said before the companies scuttled the merger that the administration would be "pleased" if any inversions were halted as a result of the new rules.

Even if Pfizer had challenged Treasury or if another company does so, it is far from clear whether a court would overturn the government's regulations. Companies could attempt to argue that the government didn't follow proper regulatory procedures or exceeded its authority, a case that would be bolstered by the administration's own assertions that it lacks sufficient authority to completely halt inversions, the deals in which U.S. companies take a foreign address.

The Treasury Department released two separate rules Monday, each with its own legal justification. A Treasury spokeswoman said this week's decisions have "strong basis" and that its authority was clear.

The one that hit the Pfizer deal targeted what the government called "serial inverters," or companies that are part of multiple inversion transactions. The rule would have disregarded three years of mergers with U.S. companies that got Allergan to its current size; that could have made Allergan too small to merge with Pfizer and still comply with the law, which treats a merged company as domestic if the former U.S. company's shareholders own at least 80% after the deal.

Michael Graetz, a tax professor at Columbia Law School, said the Treasury is on solid legal ground and that only a company doing an inversion with minimal tax benefits would have a good reason to risk challenging it.

"I think they would be likely to prevail in litigation on that," he said of the Treasury. "It would be very hard for a company that was doing an inversion for tax reasons to push forward on the theory that they were going to win in court."

Treasury's serial inverter regulation is more ambitious than past efforts, said Ed Kleinbard, former chief of staff of the congressional Joint Committee on Taxation.

"That is, to my way of thinking, a bit troubling, because you end up concluding that a series of unrelated transactions, each of which has real economic consequences, nonetheless have to effectively be treated as one," said Mr. Kleinbard. He said he supported Treasury's decision to step into the vacuum left by Congress.

The second set of rules issued Monday applies beyond inversions. Using Section 385 of the tax code, the Treasury Department gave itself more ability to reclassify debt transactions as equity investments. That would make it much harder for companies to engage in earnings stripping, the practice of loading up a U.S. subsidiary with deductible intercompany debt and effectively pushing profits offshore.

That rule making may be easier -- though not much faster -- to get into court, because the penalties of losing the case would be that what a company considers a debt instrument would be taxed as equity. That would be damaging, but far less than the consequences of the government reclassifying a foreign company as domestic.

But Section 385 also contains an extremely broad grant of regulatory authority to the government, letting the Treasury secretary write regulations "as may be necessary or appropriate" to differentiate equity from debt.

"Just the words of 385 make it very clear that the Treasury has this authority," said Samuel Thompson, a tax law professor at Penn State University. "It's really a lay-down hand."

Write to Richard Rubin at richard.rubin@wsj.com

(END) Dow Jones Newswires

April 06, 2016 16:15 ET (20:15 GMT)

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