Among the landmarks of 1980s popular culture was a wildly successful arcade game: Pac-Man. The goal? To steer Pac-Man through a series of mazes, devouring Pac-Dots and enemies as quickly as possible.
The changing obstacles posed by the U.S. tax “inversion” regime bear more than a passing resemblance to Pac-Man. In an inversion, a U.S.-based multinational corporate group seeks to expatriate to another country to reduce its overall effective tax rate and realize significant tax savings. But the inversion rules also apply to multinationals based outside the United States.
Foreign multinationals soon discovered they could side-step the 80 percent rule, as long as they acquired U.S. targets that were not too “big.”
In a typical real-world scenario, a foreign (non-U.S.) multinational expands into the United States by acquiring a series of U.S. target companies. The foreign parent might, for example, acquire a U.S. target by issuing additional foreign parent shares in exchange for target shares.
Since at least 2003, such foreign parents have risked being treated as taxable U.S. corporations under the U.S. anti-inversion rules. Under these rules, if the former U.S. target shareholders own 80 per cent or more of the new foreign parent, then the parent will be taxable as a U.S. corporation.
Foreign multinationals soon discovered they could side-step the 80 per cent rule, as long as they acquired U.S. targets that were not too “big.”
For example, suppose an Irish parent worth $600 million seeks to acquire a U.S. target worth $400 million in an all-share transaction. Following the acquisition, former shareholders of the U.S. target would own Irish parent shares worth $400 million—that is, 40 per cent of an Irish company now worth $1 billion. Because 40 per cent is less than the 80 per cent threshold, the inversion rule would not be triggered.
On the other hand, suppose the Irish parent were, instead, to acquire a U.S. target worth $3 billion in an all-share deal. Former target shareholders would now own Irish parent shares worth $3 billion. That is, they would own 80 per cent of an Irish parent now worth $3.6 billion. This would trigger the inversion rule, causing the Irish parent to be taxed as a U.S. corporation.
Could the Irish parent have avoided U.S. taxation under the inversion rule by exercising patience? Indeed it could have.
Suppose the Irish parent had, instead, acquired the two U.S. target companies in succession, Pac-Man style. After first acquiring the $600 million U.S. target, the Irish parent would be worth $1 billion. The subsequent acquisition of the $3 billion U.S. target would result in its former shareholders owning only 75 per cent of the Irish parent ($3 billion divided by $4 billion). Certain adverse U.S. tax consequences could apply, but the Irish parent would not be taxable as a U.S. corporation.
In other words, acquiring successively larger U.S. companies, Pac-Man style, allowed a foreign multinational to stay under the 80 per cent threshold. In theory, the foreign acquirer could grow large enough to acquire almost any U.S. target without running afoul of the inversion rules.
Under the Pac-Man Rule, U.S. acquisitions for the three years preceding a given U.S. acquisition are essentially disregarded.
This well describes the history of an Irish pharmaceutical company, Allergan plc. By undertaking a series of small acquisitions, Allergan (including predecessors) was poised in 2016 to acquire an American pharmaceutical giant, Pfizer Inc.
Allergan did not, in fact, acquire Pfizer. Alarmed by the ability of foreign acquirers to side-step the inversion rules by engaging in a series of U.S. acquisitions, the outgoing Obama administration promulgated a tax regulation that may be described as the “Pac-Man Rule.”1
Under the Pac-Man Rule, U.S. acquisitions for the three years preceding a given U.S. acquisition are essentially disregarded. In the above scenario, the acquisition of the $600 million U.S. target would be disregarded in analyzing a subsequent acquisition of the $3 billion U.S. target. As a result, former shareholders of the $3 billion target would be treated as owning 80 per cent—not 75 per cent—of the Irish parent. Under the Pac-Man Rule, the Irish parent would therefore be taxable as a U.S. corporation.
In its zeal to halt Allergan from acquiring Pfizer, the U.S. government made the Pac-Man Rule effective almost immediately upon issuance in April 2016. This turned out to be the Achilles’ heel of the rule.
In September 2017, a Texas federal court set aside and held unlawful the Pac-Man Rule, concluding that the government failed to provide taxpayers with adequate notice and the opportunity to comment on the new rule.2
Thus, as of the date of writing, the Pac-Man Rule is not good law. Although the scope of relief from the Pac-Man Rule is not entirely clear, at least in theory, it should not prevent Allergan from acquiring Pfizer.
What next? Certainly the U.S. government could appeal the Texas federal court’s judgment. Or it could simply re-propose the Pac-Man Rule with adequate notice and provision for comment.
The government might also delay any action on the Pac-Man Rule until the outlines of corporate U.S. tax reform are clearer. Sweeping U.S. corporate tax reform could render the rule obsolete.
As the short and tumultuous life of the Pac-Man Rule demonstrates, the volatility in the U.S. taxation of cross-border transactions shows no sign of abating. Buyer beware.
1 U.S. Treasury Regulations Section 1.7874-8T. The Pac-Man Rule is also known as the multiple acquisition rule or the serial inverter rule.
2 Chamber of Commerce of U.S. v. IRS, No. 1:16-CV-944-LY, 2017 BL 358853 (W.D. Tex. Sept. 29, 2017).