The U.S. Treasury Department has apparently killed the $130 billion merger of Allergan (AGN) - Get Report and Pfizer (PFE) - Get Report with its new directive regarding inversions.

The federal agency on Monday amended its view on the corporate combinations that move domiciles to non-U.S. jurisdictions for tax advantages in a way that would restrict the tax benefits of the Pfizer- Allergan deal.

The merger, announced last October following a prior adjustment by the Treasury department regarding inversions, was structured so Pfizer, the technical target in the deal, would not account for more than 60% of the equity in the combination. The deal was structured to avoid the "inversion" definition but still have a decidedly positive effect on the effective tax rate for the combined companies compared to the weighted average of the two companies pre-merger tax rates.

So long as existing Pfizer shareholders would not own 60% of the new company, the merged entity fell outside the Treasury Department notice of September 2014 allowing the company to avoid accrual of deferred taxes regarding certain foreign earnings and access to those earnings without a U.S. tax expense.

The Treasury Department's latest action regarding inversions observes that "foreign companies may avoid section 7874 -- the tax code's existing curbs on inversions -- by acquiring multiple American companies over a short window of time...so the value of the foreign company increases...thereby enabling the foreign company to complete another, potentially larger, acquisition of an American company to which section 7874 will not apply.  Over a relatively short period of time, a significant portion of a foreign acquirer's size may be attributable to the assets of these recently acquired American companies."

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So Treasury determined for the purposes of  computing the ownership percentage when determining if an acquisition is treated as an inversion under current law, it would exclude assets attributable to the foreign company that were acquired within three years of the deal seeking to avoid section 7874.

This means Allergan, which as the former Actavis has been involved in several significant mergers in recent years, would not be able to include a significant portion of its assets in computing the ownership split in the Pfizer merger and Pfizer is not going to remain under the 60% ownership cut-off. So the merger with Pfizer will have much less in the way of tax advantages as contemplated.

The merger agreement includes a termination out if there is any change in law with respect to Section 7874 or the issuance of an official interpretation of applicable Law, as set forth in published guidance by the IRS. The new treasury notice seems to trigger that termination right, which would require Pfizer to pay up to $400 million in fee reimbursement to Allergan.

The companies in a joint statement they are reviewing the Treasury action.

Pfizer would still retain some tax benefits in the transaction, and could challenge the validity of the Treasury notice over the transaction, arbs said. Since Treasury cannot establish tax law, Pfizer should be in a strong position with a legal challenge, but that would take several years and walking from the deal is a more likely outcome, arbs said.

The market agreed. Allergan shares dropped 15%, or $42, to $236 Tuesday.