New rules unlikely to stop Medtronic deal

Newly announced tax rules will make it more complex and expensive for U.S. companies to pursue maneuvers like Medtronic's proposal to acquire Irish health care firm Covidien and move the combined company's legal headquarters overseas.

But the fresh regulations are unlikely to stop such deals from happening.

The Treasury Department announced the legal tweaks late Monday amid an escalating debate over so-called inversion deals such the one envisioned by Fridley-based Medtronic, one of the world's largest medical device companies. On Tuesday, analysts said the changes could drive up the cost of the $42.9 billion deal but would be unlikely to lead the companies to drop it.

Debbie Wang, an analyst with Morningstar in Chicago, said the deal would likely go through based on its "strong strategic value." Medtronic has said from the beginning that tax advantages are not the deal's principal attraction.

At least seven other U.S. companies including Burger King Worldwide are pursuing inversions, which would enable them to avoid some U.S. taxes. But the increasing popularity of the deals has stirred a political backlash, with President Obama calling companies that pursue them unpatriotic.

The Obama administration has urged Congress to pass a tax-reform bill to outlaw the deals. Defenders of the maneuver argue that inversions are rational and legal responses to the United States' high corporate tax rate and its unusual policy of taxing some business that takes place in other countries.

With little progress seen on several pending anti-inversion bills, Treasury Secretary Jacob Lew announced five new rules Monday night that would remove some of the economic incentives the deals offer.

Analysts said the new rules didn't go as far as they could have, although they still complicate matters for inversion-bound companies. The new rules apply to deals that close after Monday, even if they were announced previously, but they don't apply retroactively to deals that already closed.

Among other provisions, Treasury is taking aim at a central feature of the Medtronic-Covidien tie-up, which is the ability to loan billions of dollars between foreign subsidiaries of the same company without technically bringing the money into the United States and triggering a 35 percent "repatriation" tax on the money.

Medtronic executives had been planning to transfer $14 billion in overseas cash to a new foreign subsidiary through one of these "hopscotch" loans to cover nearly all of the cash required in the deal. The remainder of the $42.9 billion would be paid for through borrowing.

But the rules announced by Lew on Monday tighten up the accounting so that hopscotch loans would be recognized on U.S. soil for tax purposes, even if made between foreign subsidiaries.

That would create a choice for Medtronic executives: either use traditional bank-backed debt to fund the deal instead of the cash, or pay the repatriation tax on the cash loans.

If Medtronic executives urge their shareholders to vote against the merger, they will face an $850 million termination fee. But that penalty is waived if changes in the U.S. tax code end up treating the new company, Medtronic PLC, as a U.S.-based company despite its Irish mailing address.

"These new rules will not result in Medtronic PLC being treated as a U.S. corporation which, as we understand it, is the only condition in the merger agreement that permits the 'no fault' abrogation of the deal," corporate tax adviser Robert Willens wrote in a note to clients Monday night. "These rules do not strike anything like a mortal blow."

Another potential option available to Medtronic would be to file a lawsuit to challenge Treasury's legal authority to issue the rules. But the deliberate pace of the legal system means the final outcome of such a challenge would remain uncertain long after the deal's expected closing date. And it's not clear such a case stands a good chance of prevailing in court anyway.

"Although there likely will be challenges to this guidance, it is always difficult for taxpayers to overturn Treasury guidance that has gone through appropriate notice and comment," said J. Richard Harvey Jr., a professor with the Villanova School of Law in Pennsylvania, in an e-mail. "Thus, as long as Treasury follows the proper procedures, they should have the upper hand in any litigation."

Lew did raise the prospect of a second round of rules from Treasury that would attack another inversion tactic called "earnings stripping," in which deductions on interest from intracompany loans are used to offset the taxes due on U.S. earnings. But a note to investors from Morgan Stanley Research late Monday said Medtronic is not as exposed to that risk, so future rules on that front would not pose a significant challenge to the deal.

Ultimately, many observers contend that Treasury's rules can't make up for deeper shortcomings in the tax code. Those observers include Lew himself, who said Monday that passing new legislation is the only way to "close the door" on all inversions. But whether Treasury's stopgap measures will make much difference remains a matter of debate.

"This is all crazy. It's like building a higher fence in East Germany to keep the people in, rather than asking what it is that makes people want to leave," University of Minnesota economics professor Christopher Phelan said. "We have close to the highest tax rate in the world. We are the only country that taxes foreign income. And it's just nuts."

Joe Carlson • 612-673-4779

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