Yesterday, Moody’s dropped Merck’s debt ratings by one notch. Yawn. Merck is still firmly at the higher end of investment grade. [My backgrounder here, on all of that to and ‘fro.] Moody’s took special note of the fact that MSD — Merck’s primary non-US subsidiary — would not be on the hook for Merck’s upcoming debt issuances.
Today, Merck priced a $6.5 billion series of six debt traunches. None of the traunches is guaranteed by MSD. Why?
Because Merck intends to use the $6.5 billion borrowed — ultimately — to acheive a repatriation of MSD’s foreign net cash earnings, free from United States federal income taxation (on deemed dividends), that’s why.
By preventing (disallowing, actually) Merck’s “controlled foreign corporation” (MSD) from acting as a backstop on today’s debt issuances, Merck created a “US shareholder-only” obligation, in the language of applicable federal income tax regulations.
Merck will now ultimately fund the first large chunks of its stock buyback from the debt issued today, then use the MSD permanently-parked foreign net cash earnings to repay the non-guaranteed debt. Under several convoluted IRS memos, if Merck stirs its stock-buyback/debt issuances/debt repayment soup “just absolutely perfectly” [in Martha Stewart’s affected New England clenched teeth accent, no less!] — it will not have to pay federal income taxes on any part of these transactions. And it will have reduced the foreign net cash earnings it is presently holding through MSD second-tier subs (in Europe and Japan, primarily).
[To immensely over-simplfy a long series of intervening steps, here — if MSD (with its own cash) pays off parent US Merck’s debt — when it is not contractually “on the hook” for it, IRS memos declare it is not a dividend ordered by the parent, US Merck — and thus it is not taxable as part of Merck’s repatriated earnings. If on the other hand, US Merck were to nakedly order MSD to send the cash home to pay an obligation MSD had backstopped anyway, that is plainly a “deemed dividend“, in IRS speak.]
So — again — we see that Moody’s knee-jerk reaction was simply ill-advised, and ultimately will mean nothing. The other debt rating agencies have put Merck on watch, but havn’t downgraded it — presumably because their analysts understand that bringing home foreign net cash earnings, tax free, is a good thing for both the Merck debt-holders, and the Merck common stockholders. Here’s a bit from Merck’s “Red Herring” 424(b) debt prospectus, filed this morning, with the SEC (at pages S-3 and S-5)
. . . .The notes are obligations exclusively of Merck and not of our subsidiaries, and payment to holders of the notes will be structurally subordinated to the liabilities of our subsidiaries.
The notes are not guaranteed by any of our subsidiaries and therefore the notes will be structurally subordinated to all existing and future secured and unsecured indebtedness and other liabilities of our subsidiaries. The indebtedness of our subsidiaries totaled $6.7 billion as of March 31, 2013. In addition, as of March 31, 2013, certain of our subsidiaries also guaranteed $6.3 billion aggregate principal amount of our existing indebtedness. Our obligations under the notes will be structurally subordinated to guarantees by our subsidiaries of our indebtedness. We also guarantee indebtedness of our subsidiary Merck Sharp & Dohme Corp. (“Old Merck”), including $6.2 billion aggregate principal amount of its outstanding debt securities (which is part of the $6.7 billion of indebtedness of our subsidiaries referred to above). Therefore the notes will be structurally subordinated to Old Merck’s obligations with respect to those debt securities, and our guarantee of those debt securities will rank pari passu with the notes. The terms of the notes and the indenture do not preclude our subsidiaries from incurring debt or other liabilities or providing guarantees that will be structurally senior to the notes. . . .
We intend to use a substantial portion of the net proceeds of the offering to repurchase our common stock. . . .
Apple is doing it — Merck is doing it. And Moody’s doesn’t get it (at least as to Merck). But that’s all okay. The world will soon move on. Something new tomorrow, here.