POSTED BY Marion Goodsell
Tax inversions predominated media coverage throughout the summer giving voice to those opposed to the 35 percent U.S. corporate tax rate, and to those decrying the dearth of economic patriotism. From the later group, there were calls for congressional action; however, in July, Harvard Law Professor Steven Shay pointed out that regulation rather than legislation offered ready solutions to curb inversion activity. In September, the Treasury Department responded substantively with IRS Notice 2014-52, to prevent all but those transactions promising true combination value.
The Treasury Department seeks to curtail inversion transactions that fall within certain criteria, by reducing the deal’s economic benefits. The transactions restructure a U.S. based multinational corporation resulting in a foreign parent and the U.S. company, that was the effective acquirer, as a subsidiary. The form of these deals has been shaped by legislative action under the Jobs Act of 2004 that requires companies to have “substantial business activity” in the foreign country of reincorporation and by Treasury rules that increasingly tighten the meaning of substantial business activities. The U.S. company, unless it met certain conditions, was required to have 25 percent of income, assets, and employees in the country that would become its new tax domicile. Later rules set a series of thresholds for stock ownership, leaving the current form of inversion thorough mergers and acquisitions as the only viable option for moving abroad. Foreign stock ownership must be greater than 20 percent and shareholders of the former U.S. parent must own at least 60 percent of the share of the new foreign parent. However, if the shareholders of the former U.S. parent have a continuing ownership stake above 80, the new foreign parent is treated as a U.S. corporation for tax purposes. The transactions garnering headlines all summer have the ideal continuing ownership fall between 60 and 80 percent, where the foreign status of the new parent will be recognized.
The Treasury Department’s most recent guidance, characterized as an initial step, eliminates techniques in inversions used to access foreign income without paying U.S. tax. The Notice, acting under § 956(e), first targets “hopscotch” loans. The loans use deferred earnings, profits that have not been repatriated to the U.S. company in the form of dividends, to fund the new foreign parent, thus avoiding taxation. The hopscotch loans were not taxed as dividends because they creatively avoided being U.S. property; in applying the anti-avoidance rule these loans are now considered U.S. property. This eliminates their economic benefit as the dividend rule applies as if controlled foreign corporation (CFC) had loaned the deferred earnings to the U.S. parent before the inversion transaction.
The next action under § 7701(l) applies to the “de-controlling” strategy, which has the new foreign parent purchase enough stock to transfer control of the CFC from the former U.S. parent in order to access deferred earnings of the CFC without paying tax. The notice eliminates the benefit of this strategy by treating the new foreign parent’s ownership as stock in the former U.S. parent, not in the CFC, while the CFC would continue to be subject to tax on its profits and deferred earnings.
Under § 304(b)(5)(B), the Notice also closes a loophole so that a new foreign parent can no longer bypass the U.S. parent for a tax-free repatriation of cash or property by selling its stock in the former U.S. parent to a CFC with deferred earnings in exchange for cash or property of the CFC.
Finally, the Notice takes three actions under § 7874. The first reinforces the 80 percent ownership maximum by preventing the use of a “cash box.” The transactions can no longer inflate the new foreign parent’s size to exceed 20 percent of the combined entity by counting passive assets, such as marketable securities or cash that are not used for daily business functions. Although exempting banks and financial services companies, if at least 50 percent of the foreign company’s assets are passive, the assets will be disregarded in the context of the 80 percent requirement. In a second action related to this maneuver, U.S. companies can no longer “skinny down,” reducing their size pre-inversion by making extraordinary dividends. These dividends will be disregarded, raising the U.S. entity’s ownership toward or above the 80 percent threshold. The third and final action prevents “spinversions,” in which a U.S. corporation inverts some of its operations, transferring assets to a newly formed foreign entity, which it spins off to shareholders, all to avoid U.S. taxation. Spinversions opportunistically used a rule that permitted multinationals to conduct internal restructuring. The Notice eliminates benefits for spun-off foreign corporations, by treating them as domestic corporations.
The September guidance responds not only to the creative forms of inversion, but also to popular perception of these transactions, as U.S. firms hold an estimate $1 trillion stockpile abroad, and as the number of transactions seemed to rise. Some argue that inversions threaten the U.S. domestic tax base, while detracting from meaningful discussion over the headline U.S. 35 percent corporate tax rate, that exceeds those of other OECD countries. While the Notice severely reduces economic benefits of deals primarily motivated by tax avoidance, Jack Lew and the Treasury Department underscored that suitable mergers evincing real synergies and genuine combination motivations. The Burger King and Tim Hortons merger is a ready example of a combination that, while providing tax benefits, could also yield conventional benefits for two complementary businesses.
BIO: Marion is the Associate Content Editor for the Journal of High Technology Law. She is a third year law student at Suffolk University Law School with a concentration in Business Law and Financial Services.
