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Rationale for the Allergan-Pfizer Merger

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This merger is an inversion driven by tax considerations

The Allergan-Pfizer merger is the latest in inversion trades driven by US tax policy. In an inversion, a smaller foreign corporation “buys” a larger US domestic corporation, which then adopts the foreign domicile for tax purposes. In reality, the much larger US corporation (Pfizer, in this case) is buying the smaller foreign corporation (Allergan). However, the merger agreement specifies Allergan (AGN) as the buyer, or “Parent”, and Pfizer (PFE) as the target, or “Company.”

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Inversions are driven by the US corporate tax rate, which is the highest in the world at 35%. Most countries have territorial tax systems, in which a corporation is taxed on the income it generates in its own country. For example, a British company pays UK taxes on its UK income and foreign taxes on its foreign income.

In the United States, however, a company owes US taxes on income earned in the United States and income earned overseas, which has been taxed already by other countries. This amounts to double taxation on foreign income and explains why many large US corporations have massive cash hoards abroad. They don’t want to pay double taxes, so the income just sits in overseas bank accounts.

Needless to say, this has caused much consternation among politicians (especially on the left) who believe US corporations are not paying their fair share. The US government has taken steps to tighten the US tax code to restrict inversions, but there really isn’t much it can do to prevent them without rewriting the tax code or banning foreign corporations from buying US corporations. The companies are making a controversial move in the middle of an election season. There will be political heat.

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Synergies and earnings effects

The companies anticipate the merger will generate peak synergies of $2 billion per year, which will take about three years to realize. They anticipate the merger will be neutral to 2017 earnings per share and accretive thereafter. The combined company’s tax rate is expected to fall to 17%–18% in the first year after closing.

Other merger arbitrage resources

Other important merger spreads include the Cigna (CI)-Anthem (ANTM) deal, which is slated to close in 2H16. For a primer on risk arbitrage investing, read Merger Arbitrage Must-Knows: A Key Guide for Investors.

Investors who are interested in trading in the healthcare sector can look at the Health Care Select Sector SPDR Fund (XLV).

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