The Winner is....Pfizer; or, Tax Planning Definitely Does Pay - Big Time!

Pfizer definitely wins the 2015 award for tax planning - maybe even a lifetime award over a 30/40 year period.

In the 1980's Pfizer created an offshore bank so that the earnings on its deferred offshore cash could be reinvested and avoid current US tax. For decades, Pfizer has carried out R&D in the US and then moved it offshore, so that earnings via royalties could be deferred in Ireland.  

Pfizer has now reached the high water mark of tax planning.  Through its recently announced inversion transaction (merging with Dublin-based Allergan where the surviving entity will be Allergan - though renamed Pfizer plc), and in particular the form it chose, all its offshore earnings will now enjoy permanent deferral - they will never be subject to US tax.   How is this possible?

The current inversion rules state that if former Pfizer Inc. shareholders own 80% of Pfizer plc, then Pfizer plc is treated as a US domestic company, so the inversion attempt totally fails.  

If the former shareholders own between 60% and 80% of Pfizer plc, then there are various tax consequences and limitations.  The most important limitation is that earnings of Pfizer's non-US subsidiaries ("CFCs") cannot be lent to Pfizer plc and avoid US tax.  

Some background: under current US tax rules, if CFCs earn "active" income, then such income is not subject to US tax until the CFC distributes such income as a dividend back to its US parent or another US affiliate.  To avoid abuse of this rule, a loan by a CFC back to its US Parent or US Affiliate is treated as a deemed dividend and is subject to US tax.

However, until recently, after an inversion, a loan by a CFC to the foreign NewCo (for example, to make acquisitions or repurchase shares) bypassed the former US parent and was not subject to the deemed dividend rules.   Recently, the IRS issued rules that extend the deemed dividend rules to include a loan by a CFC to the foreign NewCo.

The new, extended deemed dividend rules only apply to an inversion in the 60% to 80% category. If, after the inversion, the former US shareholders own less than 60% of the new foreign parent, then none of the inversion rules apply. 

This is what Pfizer has done.   Former Pfizer Inc. shareholders will own only 56% of Pfizer plc and there is no limitation on its ability to have its CFCs make loans directly to Pfizer plc.

How valuable is this to Pfizer?   Pfizer has two pockets of deferred offshore earnings.  One amount is reported in its financials.  This amount is $74 billion and is referred to as earnings permanently reinvested overseas on which no US tax is provided.  The deferred tax on those earnings would be approximately $29 billion (40% effective federal and state tax rate).    

The other amount is not directly reported on Pfizer's financials (or the financials of any other US company that employs this technique), and can only be inferred from the amount of the deferred tax liability ("DTL") reported on its financials.  In the case of Pfizer, this amount appears to be another $70 billion of earnings (see article "A Tax-Cutting Move That Pfizer Can Hardly Resist" New York Times 11/14/15).  While Pfizer has provided for tax on these earnings, they are still overseas and no US cash tax is due until they are actually repatriated. 

As a result of the inversion, Pfizer will never repatriate the earnings on which, while US tax has been provided for, no cash tax has been paid. Accordingly, it should enjoy an immediate $28 billion GAAP earnings benefit by removing the $28 billion DTL associated with those earnings.  It will be interesting to see if Pfizer will continue to report, the other $74 billion of offshore earnings as permanently reinvested.   

In summary, over many decades, Pfizer has managed to defer US tax on $144 billion of earnings.  As a result of the inversion, Pfizer will avoid a potential cash tax cost of $57 billion (nearly 37% of the combined Pfizer-Allergan enterprise value) and will ultimately increase its GAAP earnings by $28 billion!

Congratulations to Pfizer - nice management of its tax line!