Finance driving economic growth
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The U.S. is mired in a growth slowdown. Between 1960 and 2007 – right before the Great Recession – the economy adjusted for inflation grew more than 3% annually. Recessions inevitably happened and growth slowed, but the declines were temporary, and the economy always recovered the lost ground. Things changed following the 2007-09 housing meltdown. Since that time, real GDP growth has slowed to barely 2%.
The growth slowdown is not preordained; it is a policy driven outcome that can be reversed by implementing the right reforms. Toward this goal, a ruling by the U.S. Tax Court this past summer made small but significant progress.
Undoubtedly, U.S. tax law is gobsmackingly boring but getting the structure right is critical. And part of that structure is ensuring that the IRS consistently enforces the code without imposing arbitrary changes on certain taxpayers.
Simplifying the case, back in 2014 AbbVie abandoned an agreed upon merger with Shire PLC and consequently paid the Irish company the $1.6 billion breakup fee that AbbVie had agreed to pay should the deal fall through. Such fees are standard features of merger and acquisition (M&A) deals and provide important protection should the transaction fall apart, which happens.
Corporate M&A activity plays an essential role in driving economic growth. In the case of the pharmaceutical industry, robust M&A activity helps maintain a vibrant research landscape and allows both large and small pharmaceuticals to focus on their comparative advantages.
Smaller biopharmaceutical companies are nimbler and more entrepreneurial. They consequently have a comparative advantage in conducting novel drug development. This research is costly, inherently risky, but, when successful, drives innovation. Small biopharmaceutical companies can attract the necessary financial resources to fund their R&D because, should the novel treatment be a success, the investors have the opportunity to earn an above market rate of return – without such a potential, it makes little sense for investors to bear these risks.
Success is only achieved when the drug has passed extensive, and expensive, clinical trials and has received FDA approval – and even then, commercial success is not guaranteed. But getting the new treatment through the clinical trials and FDA approval process requires a skill set that typically differs from the competencies of the smaller firm. This is why a vibrant M&A market is so important.
A vibrant M&A market transfers ownership of the potential drug to the larger company, which can then leverage its comparative advantage to usher the new potential treatment through the rest of the drug development process much more efficiently. It also rewards the original entrepreneurs for their insights and risks, by letting them cash out. The returns these original investors realize will then incentivize future innovations.
The benefits from M&A do not just apply to the pharmaceutical industry. M&A activity improves operational efficiency and enhances productivity across the broader macroeconomy. Of course, not all mergers and acquisitions are successful. But a well-functioning M&A market is a tremendous advantage for the U.S. economy that helps drive overall economic growth.
And this brings us back to the AbbVie case.
After the deal with Shire PLC fell through, AbbVie treated the $1.6 billion as an expense, which is the typical tax treatment for the M&A cost. The IRS claimed otherwise, and under its novel and inappropriate treatment, the expense would have been categorized as a capital loss and would have increased the company’s tax liability by $572 million.
If allowed to stand, the tax treatment would increase the expected cost and risks from potential mergers or acquisitions. With higher costs and greater risks, the amount of M&A activity would be less. Fewer deals would mean diminished productivity growth with a resulting impact on economic prosperity and slower overall income growth.
In a summary judgment opinion, Tax Court Judge Emin Toro backed AbbVie’s decision to treat the $1.6 billion so-called break fee it paid to Shire PLC in 2014 as an ordinary deduction. This decision is consistent with the IRS’ previously long held position that break-up fees are deductible business expenses under U.S. tax law and is supported by numerous prior IRS rulings and court decisions. The Tax Court’s decision brings the IRS back in line with these precedents.
A stable regulatory environment is essential for incentivizing robust economic growth – and that goes for the tax code as well. The June court decision confirming that the tax treatment on breakup fees will not be arbitrarily changed provides this stability with respect to the tax code. It is a positive sign that, if broadly expanded, will help regain some of our lost economic mojo.
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