On Monday 23rd November, the US based pharmaceutical business Pfizer (producer of Viagra) announced that it had reached a $160 billion deal to acquire the Irish based pharmaceutical business Allergan (producer of Botox). If it is successful it will be the third largest deal in takeover history.
In a previous blog on this website a number of reasons were discussed to explain why businesses may engage in mergers and acquisitions (M&As) Are large mergers and acquisitions in the interests of the consumer . These include market power, access to growing markets, economies of scale and reducing x-inefficiency. One of the interesting things about the Pfizer and Allegan deal is the importance of another factor that was not discussed in the article – tax avoidance.
Rates of corporation tax vary considerably between countries and may deter some businesses from operating in the US where it is at the relatively high level of 35%. This compares with a rate of 20% in the UK, 12.5% in Ireland and 0% in Bermuda. The global average rate is 23.7% whereas the average across EU countries is 22.2%.
However, a far bigger incentive for a US firm to merge with or acquire businesses in other countries is the unusual way the US authorities tax profits. Most countries use a territorial system. This means that tax is only paid on the profit earned in that country. For example if a UK multinational business has subsidiaries in other countries it only pays corporation tax in the UK on profits earned in the UK. The profits earned by its subsidiary businesses would be taxed at the rate set by the government in the country where they were located.
The US authorities use a worldwide system. This means that profits earned by a subsidiary in another country are also taxed in the US. This is best explained with the help of a simple numerical example.
Assume a US multinational earns $100,000 in profits from a subsidiary based in Ireland. These profits will be taxed in Ireland at the rate of 12.5% and the company would have to pay $12,500 to the Irish government. If that profit was returned to the US it would be taxed again at a rate of 22.5%: i.e. 35% – 12.5%. The company would have to pay the US authorities $22,500.The worldwide system means that the total rate of tax paid by the firm is 35% but it is split between two different countries. If the territorial system was used, the firm would only pay the $12,500 to the Irish government.
So how could M&As change things? If an M&A enables a US multinational business to change its country of incorporation (i.e. move the address of its headquarters) from the US to another country that operates a territorial system its payments will fall. This is sometimes referred to as tax inversion. As the Bloomberg columnist Matt Levine stated:
If we’re incorporated in the U.S., we’ll pay 35 percent taxes on our income in the U.S. and Canada and Mexico and Ireland and Bermuda and the Cayman Islands, but if we’re incorporated in Canada, we’ll pay 35 percent on our income in the U.S. but 15 percent in Canada and 30 percent in Mexico and 12.5 percent in Ireland and zero percent in Bermuda and zero percent in the Cayman Islands.
As a result of the merger with Allergan, Pfizer will move the address of its headquarters to Ireland even though its global operations and executives will still be based in New York. It has been estimated that this will generate a one off tax saving of $21 billion as Pfizer would avoid having to pay US taxes on $128 billion of profits generated by its non US subsidiaries.
A number of US politicians have condemned the proposed deal. For example Hilary Clinton stated:
This proposed merger, and so called inversions by other companies, will leave US taxpayers holding the bag.
Twenty US companies have moved their headquarters to countries that operate a territorial system of taxation since 2012. These include Burger King’s move to Canada and Medtronic’s move to Ireland.
The US government has tried to tighten the rules but the two major parties disagree about how to deal with the problem.
Articles
Pfizer Seals $160bn Allergan deal to create drugs giant BBC News,(23/11/15)
Pfizer’s $160bn Allergan deal under pressure in the US BBC News,(24/11/15)
Pfizer set to buy Allergan in $150bn historic deal The Telegraph,(23/11/15)
Pfizer and Allergan poised to announce history’s biggest healthcare merger-corporate-tax The Guardian,(22/11/15)
Pfizer takeover: what is a tax inversion deal and why are they so controversial? The Guardian,(23/11/15)
Questions
- The newly merged business would jump above Johnson and Johnson to become the world’s largest biotech and pharmaceutical company in the world. Who are the other biggest eight Biotech and pharmaceutical businesses in the world?
- What exactly is a subsidiary? Give some real-world examples.
- How have the US authorities changed the rules in an attempt to deter tax inversions?
- Assume that a US multinational makes $1 million profit in the US and $1 million profit from its subsidiary in Ireland. Explain how changing its country of incorporation from the US to Ireland will alter the amount of corporation tax that it has to pay.
Global merger and acquisition deals with a combined value of £2.7 trillion ($4.06 trillion) have taken place so far this year (1 Jan to 3 Nov). This is a 38% increase on the same period in 2014 ($2.94 trillion) and even surpasses the previous record high for the same period in 2007 ($3.93 trillion) (see the chart from the Dealogic article linked below).
Measured by dollar value, October was the fifth biggest month in Mergers and Acquisitions (M&As) history with the announcement of $514bn of actual or proposed deals. These included:
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the proposed £71 billion deal to acquire SABMiller (the world’s second largest brewer) by AB InBev (the world’s largest brewer); |
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the $67bn takeover of network storage provider EMC by Dell (the world’s third largest computer supplier); |
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the proposed deal to acquire Allergan (producer of Botox) by Pfizer (the producer of Viagra). |
Although the dollar value of M&As was extremely large in October the actual number of deals, 2177, was significantly lower than the average of 3521 over the previous 9 months.
Are these large M&As in the interests of the consumer? One advantage is that the newly combined firms may have lower average costs. Reports in the press, following the announcement of most M&As, often discuss the potential for reductions in duplicate resources and rationalisation. After the successful completion of a takeover two previously separate departments, such as finance, law or HRM, may be combined into one office. If the newly integrated department is (i) smaller than the previous two departments added together and (ii) can operate just as effectively, then average costs will fall. This is simply an example of an economy of scale.
Average costs will also decrease if x-inefficiency within the acquired business can be reduced or eliminated. X-inefficiency exists when an organisation incurs higher costs than are necessary to produce any given output. In other words it is not producing in the cheapest possible way. In a number of takeovers in the brewing industry, AB InBev has gained a fearsome reputation for minimising costs and removing any waste or slack in acquired organisations. In an interview with the Financial Times, its chief executive, Carlos Brito, stated that:
“In any company, there’s 20 per cent that lead, 70 per cent that follow and 10 per cent that do nothing. So the 10 per cent, of course, you need to get rid of.”
If any reduction in costs results in lower prices without any lessening in the quality of the good or service, then of course the customer will benefit. However, when two relatively large organisations combine, it may result in a newly merged business with considerable market power. With a fall in the price elasticity of demand for its goods and services, this bigger company may be able to increase its prices and make greater revenues.
An important responsibility of a taxpayer-funded competition authority is to make judgements about whether or not large M&As are in the public interest. For example, the Competition and Markets Authority in the UK investigates deals if the target company has a UK turnover that exceeds £70 million, or if the newly combined business has a market share that is equal to or exceeds 25 per cent. If the CMA concludes that an M&A would lead to a substantial lessening of competition in the market, then it could prohibit the deal from taking place. This has only happened on 9 occasions in the last 12 years. If competition concerns are identified, it is far more likely that CMA will allow the deal to go ahead but with certain conditions attached. This has happened 29 times in the last 12 years and the conditions are referred to as remedies.
The CMA has recently published a report (Understanding past merger remedies) that attempts to evaluate the relative success of the various remedies it has used in 13 M&A cases.
Articles
Are big mergers bad for consumers? BBC News, Daniel Thomas (30/10/15)
Mergers and acquisitions madness may be about to stop The Guardian (11/10/15)
M&A deal activity on pace for record year The Wall Street Journal, Dana Mattioli and Dan Strumpf (10/08/15) [Note: if you can’t see the full article, try clearing cookies (Ctrl+Shift+Delete)]
Global M&A Volume Surpasses $4tr in 2015 YTD Dealogic, Anthony Read (04/11/15)
M&A Volumes Weaken in October despite Megadeals Financial Times, James Fontanella-Khan and Arash Massoudi (01/11/15)
The merger of Dell and EMC is further proof that the IT industry is remaking itself The Economist (12/10/15)
Questions
- Using a cost curve diagram, explain the difference between economies of scale and x-efficiency.
- Explain why a takeover or merger might reduce the price elasticity of demand for the goods or services produced by the newly combined firm.
- Explain how the CMA determines the size of the appropriate market when calculating a firm’s market share.
- Draw a diagram to illustrate the simultaneous impact of greater market power and lower average costs that might result from a horizontal merger. Consider the impact on consumer, producer and total surplus.
- What is the difference between a structural and a behavioural remedy?
The proposed $100 billion takeover of SABMiller by AB InBev is the third largest in history. It provides a good example of how the UK Panel on Takeovers and Mergers operates.
Economics textbooks often discuss competition authorities such as the Competition and Markets Authority but they rarely mention the UK Panel on Takeovers and Mergers (The Panel).The Panel is an independent body that was established in 1968. It has up to 35 members who all have professional expertise on the subject of takeovers i.e. they are usually employees of or have been seconded from (i) law and accountancy firms (ii) corporate brokers (iii) investment banks.
The Panel’s main responsibility is to implement the City Code on Takeovers and Mergers. This code sets out a number of ground-rules that companies must follow if they are involved in a merger or takeover. These rules became statutory in 2006 following the Companies Act of that year. The following objectives underpin the code:
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To ensure that the shareholders of the target company in a proposed takeover are treated fairly and are given the opportunity to make an informed decision about the relative merits of the takeover. |
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To ensure that the whole takeover/merger process operates in a structured and systematic manner. |
The Panel does not make any judgements on the commercial case for the takeover or merger. This is left to the management and shareholders of the companies involved. It also does not get involved with competition issues such as whether the newly established firm would have significant market power. These decisions in the UK are left to the Competition and Markets Authority. If the merger has a European element/dimension to it then it is investigated by the European Commission.
The rules that made up the code remained largely unchanged from 1968 until some important changes were made in September 2011. This followed the controversial takeover of Cadbury by the US food company Kraft. Kraft had first announced its intention to make an offer to acquire Cadbury in September 2009 but a deal was not agreed by the management of Cadbury until January 2010. Concerns were expressed at the time that this long and protracted takeover had made it very difficult for Cadbury to run its business effectively because of the uncertainty it created. It was also argued that the rules gave the acquiring company a significant tactical advantage in the takeover process and made it too easy for them to succeed.
One important change is that a targeted company must publicly announce the name of any companies that have made an approach about a possible deal. This announcement then activates a 28 day bid deadline period known as ‘pusu’ which stands for ‘put up’ (the money: i.e. make a formal bid) or ‘shut up’ (and walk away). This means that if the potential acquirer has not made a formal bid by the end of this 28-day period it is prohibited from making a bid for another 6 months. A request can be made to the Takeover Panel for an extension to this initial 28-day period, but this can only be done with the agreement of the target company.
Therefore SABMiller was obliged to announce on 15th September 2015 that
“Anheuser-Busch InBev SA/NV (AB InBev) has informed SABMiller that it intends to make a proposal to acquire SABMiller. No proposal has yet been received and the Board of SABMiller has no further details about the terms of any such proposal.”
The timing of this announcement made 14th October the official deadline by which AB InBev had to make a formal offer. After rejecting five bids, an offer of £44 a share by AB InBev was agreed in principle by the SABMiller management team on 13th October. 
Given the size and complexity of the deal (i.e. AB InBev is financing the deal by borrowing over $70 billion from 21 different banks), an initial two-week extension until 28th October was granted by the Takeover Panel. This could only have been granted with the agreement of SABMiller. Another one-week extension was agreed and then, on 4th November, SABMiller management made the following announcement.
“In order to allow SABMiller and AB InBev to finalise their discussions and satisfy the pre-conditions to the announcement of a formal transaction, the board of SABMiller has requested that the Panel on Takeovers and Mergers further extends the relevant deadline until 5pm November 11, 2015.”
One major issue has been the potential impact of the takeover on the level of competition in the US market. AB InBev and SABMiller already have market shares of 46% and 27% respectively. SABMiller’s strong presence in this market is a result of its joint venture, MillerCoors, with Molson Coors. One reason behind the last request for an extension is to grant enough time for a deal to be finalised for the sale of SABMiller’s 58% stake in MillerCoors to Molson Coors. Without this sale the US competition authorities would not approve the takeover.
Most observers believe that it will take a year for the deal to be completed and it will be interesting to chart its progress over the next 12 months.
Postscript: AB InBev announced on 11th November that it had made a formal offer of £71 billion to acquire SABMiller and SABMiller’s share in MillerCoors had been sold to Molson Coors for $12 billion.
SABMiller to seek another Takeover Panel extension for AB InBev takeover The Telegraph, Ben Martin (04/11/15)
AB InBev and SABMiller allay concerns about 68bn MegaBrew deal The Telegraph, Ben Martin (28/10/15)
AB InBev, SABMiller extend takeover deadline to Nov.4 Reuters, Philip Blenkinsop (28/10/15)
SABMiller agrees AB Inbev takeover deal of £68bn The Guardian, Sean Farrell (13/10/15)
SABMiller is AB Inbev’s toughest takeover yet. It may not be its last The Economist (14/10/15)
Brewery Battle: AB Inbev and the Craft Beer Challenge BBC News, Peter Shadbolt (13/10/15)
Beer Giants AB Inbev and SABMiller Agree Takeover Terms BBC News (13/10/15)
Questions
- The proposed takeover of SABMiller by AB InBev would be the third largest in history. What are the two biggest deals?
- The European Commission investigates ‘large’ mergers that have an ‘EU dimension’. On what basis does the European Commission judge if a merger is large or has an EU dimension?
- On what basis are mergers judged by the Competition and Markets Authority in the UK?
- What is a ‘virtual bid’ period? How did the ‘pusu’ bid deadline operate before the changes were introduced in 2011?
- Pfizer’s bid for Astrazeneca did not succeed in May 2014. Some people blamed the collapse of the deal on the 28-day ‘pusu’ deadline and rule 2.5 (i) of the code. What is rule 2.5 (i) and how did it contribute towards the failure of this deal?
Oil prices will remain below $60 per barrel for the foreseeable future. At least this is what is being assumed by most oil producing companies. In the more distant future, prices may rise as investment in fracking, tar sands and new wells dries up. In meantime, however, marginal costs are sufficiently low as to make it economically viable to continue extracting oil from most sources at current prices.
The low prices are partly the result of increases in supply from large-scale investment in new sources of oil over the past few years and increased output by OPEC. They are also partly the result of falling demand from China.
But are low prices all bad news for the oil industry? It depends on the sector of the industry. Extraction and exploration may be having a hard time; but downstream, the refining, petrochemicals, distribution and retail sectors are benefiting from the lower costs of crude oil. For the big integrated oil companies, such as BP, the overall effect may not be as detrimental as the profits from oil production suggest.
Articles
BP – low oil price isn’t all bad new BBC News, Kamal Ahmed (27/10/15)
Want to See Who’s Happy About Low Oil Prices? Look at Refiners Bloomberg, Dan Murtaugh (31/10/15)
Low prices are crushing Canada’s oil sands industry. Shell’s the latest casualty. Vox, Brad Plumer (28/10/15)
Data
Brent spot crude oil prices US Energy Information Administration
BP Quarterly results and webcast BP
Questions
- Why have oil prices fallen?
- What is likely to happen to the supply of oil (a) over the next three years; (b) in the longer term?
- Draw a diagram with average and marginal costs and revenue to show why it may be profitable to continue producing oil in the short run at $50 per barrel. Why may it not be profitable to invest in new sources of supply if the price remains at current levels?
- Find out in what downstream sectors BP is involved and what has happened to its profits in these sectors.
- Draw a diagram with average and marginal costs and revenue to show why profits may be increasing from the wholesaling of petrol and diesel to filling stations.
- How is price elasticity of demand relevant to the profitablity of downstream sectors in the context of falling costs?
The UK’s balance on trade continues to be sharply in deficit. At the same time, both manufacturing and overall production are still well below their pre-crisis levels. What is more, with a sterling exchange rate that has appreciated substantially over recent months, UK exports are at an increasing price disadvantage. The hoped-for re-balancing of the economy from debt-financed consumption to investment and exports has not occurred. Investment in the UK remains low relative to that in other major economies (see).
But other developments in the global economy are working in the UK’s favour.
Manufacturing globally is becoming more capital intensive, which reduces the comparative advantage of developing countries with low labour costs.
At the same time, the dividing line between manufacturing and services is becoming more blurred. Manufacturers in developing countries may still produce parts, such as chips or engines, but the design, marketing and sales of the products may take place in developed countries, such as the UK. Indeed, as products become more sophisticated, an increasing amount of value added may occur in developed countries.
The UK may be particularly well-placed in this regard. It can provide many high-end services in IT, business support and financial services to international manufacturers. It may have a comparative advantage in idea-intensive production.
Finally with a higher exchange rate, the UK’s terms of trade have been improving. The downside is that it makes UK exports more expensive in foreign currency terms, but it also makes commodity prices cheaper, which have already fallen in dollar terms, and also the prices of imported component parts. This helps offset the effect of the appreciation of the exchange rate on exports.
The following article by Jeremy Warner considers whether, despite its poor performance in traditional manufacturing, the UK might have hit an economic ‘sweet spot’ in its trade position.
Article
Unbalanced but lucky, Britain hits an economic sweet spot The Telegraph, Jeremy Warner (8/9/15)
Data
UK Trade (Excel file) ONS (9/9/15)
(See, for example, Worksheet 1. You can search for longer series using Google advanced search, putting www.ons.gov.uk in the ‘site or domaine’ box and searching for a particular series, using the series identifier found at the top of each column in the Excel file, such as BOKI for balance on trade in goods.)
Exchange rate data Bank of England Statistical Interactive Database
Questions
- Explain the difference between the balance on trade, the balance on trade in goods and the balance of payments on current account.
- Why has the UK not experienced a re-balancing of the economy as hope for by the Chancellor of the Exchequer, amongst others?
- What is meant by the ‘terms of trade’?
- What would cause an ‘improvement’ in the terms of trade?
- Are the UK’s terms of trade likely to move in the UK’s favour in the coming months? Explain.
- What current factors are mitigating against a recovery of UK manufacturing exports?
- Is de-industrialisation necessarily a ‘bad thing’?
- Does the development of new capital-intensive technologies in manufacturing mean that the UK could become a net exporter of manufactures? Explain why or why not.
On Monday 23rd November, the US based pharmaceutical business Pfizer (producer of Viagra) announced that it had reached a $160 billion deal to acquire the Irish based pharmaceutical business Allergan (producer of Botox). If it is successful it will be the third largest deal in takeover history. 
