US medical device maker Medtronic is likely to try to renegotiate the terms of its $42.9bn deal to buy Dublin-based Covidien in response to new US tax rules, according to people familiar with the situation.
The US Treasury this week reduced the ease and benefits of US companies buying foreign rivals so they can move their tax domicile abroad, a practice known as inversion.
Concerns that US companies were using the strategy to avoid paying taxes spurred the action.
The new rules make it more expensive for Medtronic to buy Covidien, by potentially requiring it to take out a loan instead of using cash held abroad, according to the people familiar with the matter and a Reuters analysis of the contract.
Covidien, which originally approached Medtronic, could be asked to consider a lower price, and to take more stock and less cash, these people said.
Increasing the stock component of the deal would be needed to meet the new government threshold for an inversion and resulting dip in US taxes.
It remains unclear how receptive Covidien will be to that possibility, and it has some leverage, since Medtronic faces an $850m breakup fee if it abandons the deal.
While Covidien allowed Medtronic to freely walk away from a deal in the event of a US tax law change, the new Treasury guidelines fall short of a US law change. If shareholders of either company vote down the deal, there is no breakup fee.
Medtronic did not respond to requests for comment, but it said earlier this week that it was studying Treasury's actions and would release its position following a review. Covidien could not be immediately reached for comment.
The allure of smaller tax bills in countries such as Ireland and Britain has prompted at least ten US companies to attempt inversions this year, a record.
Medtronic and AbbVie, which has agreed to buy Dublin drugmaker Shire for $54.7bn, are both subject to the new restrictions, raising questions about this year's two largest announced inversions.
Lawyers and bankers say Medtronic appears to be the biggest victim of the rules, not only for the size and structure of its deal, but also given the fact that a key target of Treasury's actions is foreign profits held offshore by US multinationals.
Medtronic has roughly $14bn of cash held overseas, the most among the nine companies with pending inversion deals. AbbVie, meanwhile, has a significant portion of its $10bn cash held in foreign subsidiaries.
A big draw of the Covidien takeover was the potential to access substantially all of Covidien's cash without subjecting it to US tax.
Under US tax law, Medtronic has to pay a US corporate tax of 35% if it brings home foreign earnings, for purposes such as distributions to shareholders.
Many inversions are driven by the promise of lower tax rates, but Medtronic already has an effective tax rate of 18%, similar to that of Covidien. It has said the combined company's tax rate would decline by one or two percentage point.
One new tax rule prevents inverted companies from using "hopscotch" loans that allow them to avoid dividend taxes when tapping such tax-deterred foreign profits.
Another rule bars inverters from gaining access to the same kinds of profits by using "decontrolling" strategies that restructure foreign units so they are no longer US controlled.
Those guidelines mean Medtronic may now have to rely on a roughly $13.5bn bridge loan to finance the cash portion of its Covidien deal.
Medtronic had planned to lend some of its foreign money to its new Irish parent to help pay for the deal, according to the merger document, but that plan is now potentially exposed to the anti-hopscotch rule.
While the cash would have been a zero cost, drawing on the loan would incur Medtronic an initial interest expense of around 1.15%, which would rise further depending on the duration of the loan, according to calculations by Thomson Reuters Loan Pricing.
Morgan Stanley analyst David Lewis this week estimated that raising debt would cut earnings-per-share accretion from the deal by 3-4%, or 14-18 cents per share, and would nearly double a key debt load ratio, pro forma total debt to earnings before interest, taxes, depreciation and amortisation.
Further, in order to make the merged company an Irish-domiciled entity under the new US tax rules, Medtronic will have to increase the stock component of the cash-and-stock offer such that Covidien shareholders end up with more than 40% of the combined company.
Currently, Covidien shareholders are set to own 30% of the merged company.
The merger, if successful, would create a close competitor in size to the medical device business of industry leader Johnson & Johnson.
It broadens Medtronic's scope beyond its array of heart devices, spinal implants and insulin pumps into devices used in surgical procedures.
The companies said the expansion should allow them to provide one-stop service to hospitals, thus better competing for business, particularly in the United States where healthcare reform and shrinking government reimbursement for medical procedures has kept pressure on device pricing.
They forecast the combination would bring at least $850m of annual pre-tax cost synergies by the end of fiscal 2018.