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New Tax Inversions Rules: Threats to Healthcare ETFs?

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The going has been tough for the healthcare space has this year following the slide in biotechnology stocks. The pain seems to have aggravated since the U.S. Treasury Department and Internal Revenue Service imposed tougher rules to curb ‘tax inversion’ deals. This is especially true as the Treasury levied a three-year limit on foreign companies bulking up U.S. assets to avoid ownership limits for a later inversion deal.

This means that the new rules would restrict the U.S. companies to participate in inversion transactions if they have already done so within the past three years. Additionally, the Treasury also proposed rules against the practice known as earnings stripping often undertaken following an inversion. In this regard, the new rules would curb related-party debt for U.S. subsidiaries in transactions that do not finance new investments in the United States (read: Trump Healthcare Reforms: Will ETFs Gain Health or Suffer?).

A Near-Term Blow?

Tax inversion deals have been extremely popular among the drug companies and medical device makers, and were one of the major drivers of the healthcare space in the past few years. In tax inversion, U.S. companies acquire foreign companies to relocate their headquarters offshore in order to reduce or avoid tax bills. Notably, the U.S. has a higher corporate tax rate of 35% while other countries like the U.K. and Ireland have lower rates of 20% and 12%, respectively.

The new rules dealt a huge blow to the proposed $160 billion Allergan (AGN - Free Report) takeover deal by the largest U.S. drug maker Pfizer (PFE - Free Report) announced last November. This is because Allergan has been involved in several mergers within the past 36 months. As a result, the planned merger, expected to close in the second half of this year, has been terminated and Pfizer will pay Allergan $150 million as reimbursement of expenses associated with the transaction. The proposed $16.5 billion merger of Johnson Controls (JCI - Free Report) with Ireland-based Tyco International Plc could also take a backseat due to the move.
However, this is not the first time that inversion rules have unraveled the mergers and acquisitions in the space. Though the new rules will slow down the pace of inversion transactions, the companies will continue to seek new and creative ways to relocate their tax residence to avoid paying taxes at home, as per the Treasury Secretary Jacob J. Lew (read: Merger & Acquisition ETFs: Will 2016 Replicate 2015?).

As such, the move is likely to have a near-term impact on the healthcare ETFs but the long term still looks bright given encouraging industry trends including promising new drugs, growing demand in emerging markets, an aging population, ever-increasing healthcare spending and Obamacare. Investors could take advantage of the beaten down prices and load up healthcare ETFs in their portfolio for the coming months.

These funds provide substantial exposure to pharmaceutical stocks and have a solid Zacks ETF Rank of 1 or 'Strong Buy' rating:
Health Care Select Sector SPDR Fund (XLV - Free Report)
The most popular healthcare ETF follows the Health Care Select Sector Index. This large cap centric fund manages about $12 billion in its asset base and trades in heavy volume of around 14.2 million shares. Expense ratio came in at 0.14%. In total, the fund holds 60 securities in its basket with Johnson & Johnson (JNJ) taking the top spot at 11.3% while the other firms hold no more than 7.04% of assets. Pharma accounts for 38.1% share from a sector look while biotech, healthcare providers and services, and equipment and supplies make up for a double-digit exposure each.
iShares U.S. Healthcare ETF (IYH - Free Report)
This fund provides exposure to 122 securities by tracking the Dow Jones U.S. Health Care Index. This is a large cap fund with JNJ dominating the fund’s return at 10.8% of total assets. Pharma takes the top spot from a sector look at 36.9%, closely followed by biotech (24.8%), medical equipment (15.9%) and managed health care (10.3%). The product has amassed nearly $1.8 billion in its asset base while charges 44 bps in annual fees. It trades in solid volume of around 201,000 shares a day (see: all the Healthcare ETFs here).
Vanguard Health Care ETF (VHT - Free Report)
This ETF tracks the MSCI US Investable Market Health Care 25/50 Index and holds 345 stocks in its basket with Johnson & Johnson as the top holding with 10% allocation. Other firms hold less than 6.5% share in the basket. Pharma takes the largest share at 34.8% while biotech and healthcare equipment round off the top three spots. VHT is also one of the popular and liquid ETFs with AUM of $5.3 billion and average daily volume of over 273,000 shares. It charges 9 bps in annual fees and expenses.
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