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Mylan’s (MYL - Analyst Report) recent $5.3 billion all stock deal with Abbott Laboratories (ABT - Analyst Report) has once again emphasized an increasingly important driver of M&A activity this year. Several factors have contributed to the seven-year high in M&A deal value. But recurrent foreign acquisitions by U.S. companies indicate that tax inversion is one of the major reasons.

Increase in M&A Activity

The lack of organic means of growth for many U.S. companies meant that mergers and acquisitions were the next best route to get bigger. The presence of large amounts of cash on corporate balance sheets, favorable credit markets, low interest rates and strength in the stock market provided a conducive environment for M&A activity to gather speed.

Some of the most notable deals include Facebook, Inc’s (FB - Analyst Report) $19.0 billion buyout of WhatsApp and Actavis plc’s (ACT - Analyst Report) acquisition of Forest Laboratories for $25.0 billion. Further, Medtronic, Inc. (MDT - Analyst Report), the world’s largest medical devices maker, acquired its Irish rival Covidien Public Limited Company for $42.9 billion.

What Is Tax-Inversion?

Medtronic’s $42.9B acquisition of its Irish competitor in surgical technologies and global healthcare major Covidien plc is a good example of the tax inversion process. The deal was an effort to offset the impact of high U.S. corporate tax rate by shifting Medtronic’s tax base overseas.

At 35%, the U.S. corporate tax rate is one of the highest rates in the world. A tax inversion involves the acquisition of a foreign company and subsequently adopting its home country’s domicile. Alternatively, the combined entity can create a holding company in a country whose tax rate is lower.

This could help U.S. companies reduce their tax rates to single digits. The conditions attached to such a move specify that 20% of the stock of the resultant entity must be transferred to the shareholders of the company which has been acquired.

Popularity in the Healthcare Sector

The inversion wave has affected the healthcare sector the most. Medical devices and pharma companies are rapidly acquiring smaller foreign competitors for two major reasons. Firstly, the industry has been a natural leader in the M&A space. This is because it is usually easier for a large corporation to purchase small companies than to develop new drugs indigenously. Secondly, the market for drugs is truly international.

Additionally, several large pharma companies already have considerably large international profits. Tax inversion removes the necessity of repatriating such profits, making them subject to a higher tax rate. A strong European pharma sector also makes for several potential targets.

Major Deals This Week

Ultimately, as several healthcare companies conclude inversion deals, others are pressured to follow suit. This week alone markets received news of two such massive deals. Mylan will acquire Abbott Labs’ branded specialty and generics business in developed ex-U.S. markets for $5.3 billion.  The new company, organized in the Netherlands, will be headed by Mylan’s present leadership group.

Mylan stated in its press release that in the first full year following closure, its tax rate will be in the range of 20% to 21% and decline further (high teens) going forward. The formation of the combined entity is expected to result in more than $200 million in pre-tax operational efficiencies by the end of the third year.

Meanwhile, a fifth offer of $53 billion from Chicago-based AbbVie (ABBV - Analyst Report) has received tentative approval from Irish drug company Shire (SHPG - Analyst Report). This would be the biggest deal of the year upon completion.

Senate Roadblocks Ahead?

Earlier this week, Treasury Secretary Jack Lew said Congress should pass legislation to end tax inversions. In his letter to Congressional leaders Lew said:  “We should not be providing support for corporations that seek to shift their profits overseas to avoid paying their fair share of taxes.”

However, the legislation, similar to a provision in the latest federal budget proposal, is unlikely to find favor with Congress as a whole. There is broad agreement in principle among a large section of Congress about the need to amend the tax code. This would entail lowering the corporate tax rate of 35% and firming up international tax rules. However, Republicans and Democrats have not been able to agree on the details as well as on changes in individual taxation.

In Conclusion

Given the current regulatory environment, it is unlikely that deals involving tax inversion will face regulatory roadblocks in the short term. The benefits to the companies involved are more than apparent. This is particularly true for the healthcare sector. Clearly, more M&A activity involving tax-inversion can be expected in the days ahead.

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