Corporate Tax Inversions, Down but Not Out?
By Timothy Larson - Partner-in-Charge -Tax & Business Services - New York
At the end of 2013, the number of U.S. individual citizens revoking their U.S. citizenship for another home country hit an all-time high. In the corporate world, there has been a similar trend. One of the “hottest” and more controversial tax topics “inside the Beltway” in 2014 has been the resurgence of corporate tax inversions (“inversions”). With 47 inversions completed in the last decade, of which approximately 25% occurring in the last couple of years, what is fueling the up-tick in 2014? Just follow the cash. It’s no secret that U.S. multinationals have stockpiled offshore over U.S.$2.1 trillion in foreign profits since 2005 because the U.S. taxes worldwide income – either currently or at some future date (combined federal and state rate can exceed 40%). This de-incentivizes many U.S. multinationals from repatriating foreign earnings, in order to defer this incremental U.S. taxation.
During earlier weaker economic periods, U.S. companies often took a “wait and see” approach to first determine what corporate tax reform (such as a shift to a territorial taxation system) might happen and/or whether another “one-time” tax-favored repatriation holiday would be introduced (similar to a decade ago) to encourage repatriation. Also, companies focused intensely on delivering incremental shareholder value by implementing cost-cutting initiatives have likely capped out and exhausted those measures. As the global economy has strengthened and there has been a surge in strategic transactions, U.S. multinationals tapped into corporate tax inversions to deliver significant shareholder value a different way – a reduced U.S. tax bill.
What exactly is an inversion? Simply put, a tax inversion is the process whereby a U.S. multinational group essentially re-domiciles outside the United States. In short, the U.S. parent company of the group is either replaced with a non-U.S. parent or, perhaps, becomes a subsidiary of a foreign parent corporation, even if all the executives remain in the United States. In light of anti-inversion legislation enacted in 2004, a strategic transaction (e.g., merger) with a foreign company provides the only palatable opportunity to accomplish a tax inversion. A U.S. multinational group that is no longer domiciled in the U.S. is typically and consequently no longer subject to U.S. taxes on its foreign income (i.e., territorial taxation – taxation only in the jurisdiction where the income is earned). Furthermore, the existing U.S. operations including workforce generally remain intact – that is, there is not a significant exporting of U.S. jobs offshore. The gravy in some inversion transactions beyond the “self-help” territorial taxation can be the use of intercompany debt to leverage up the U.S. operations which, subject to existing so-called “earnings stripping” limitations, reduces the U.S. cash tax burden while achieving a favorable tax rate arbitrage on the interest.
Thus, the upshot of a tax inversion is simple, global access to the foreign “trapped” cash while potentially by-passing the U.S. tax net. Just how powerful is this? With the prospect of having an effective tax rate that could be reduced by 35% – 50%, for example, U.S. multinationals are willing and/or able to pay a considerable premium for a foreign target corporation that in some (not all) cases make it too difficult for the foreign target shareholders to refuse. Of course, the proverbial “tax tail” does not (and should not) wag the “business dog” and thus any strategic transaction would primarily be executed, to create and drive value to the shareholders, typically through post-transaction operational synergies. Naturally, due consideration must also be given to a whole host of other factors (such as change in control issues, public policy and political issues, access to capital, SEC requirements, financial reporting requirements, national security regulatory considerations, etc.) when analyzing the cost-benefit analysis of undertaking an inversion.
So what does it really take to execute an inversion? For starters, the previously enacted anti-inversion legislation generally applies (to prevent an inversion) when:
- Substantially all of the assets of the U.S. corporation are acquired directly or indirectly by the foreign acquiring corporation;
- At least 60% of the foreign corporation’s stock (by vote or value) is held by the former shareholders of the U.S. corporation; and
- At least 25% of the operations of the new expanded group are not in the foreign corporation’s jurisdiction (the so- called “Substantial Business Activities” test).
If the percentage of ownership by the former shareholders of the U.S. corporation is at least 60% but less than 80% and the other two tests are satisfied, certain adverse tax consequences (e.g., 10-year limitation of net operating losses and/or foreign tax credits) can occur.
In summary, a full takeover does not work, but a merger might. The ideal foreign target corporation should be big enough to constitute at least 25% of the merged group, but smaller than the U.S. corporation such that the foreign target shareholder proportion in the merged group falls within the 20% – 40% range. The foreign target corporation could be public or private.
What has been the Congressional response to the increased incidences of companies announcing their intentions to invert? After several legislative and administrative proposals and Congressional debate over what type of legislative action would be appropriate to tighten the rules on inversions and thus halt (or at least significantly slow down) the rising number of companies looking to invert with strategic thirdparty transactions, the Treasury Department took a shot across the bow and issued Notice 2014-52 on September 22, 2014, which, not only tightened the applicable rules, but also aimed to complicate any post-inversion planning.
In respect of the tightening anti inversion legislation, the Notice focused on the following three areas in an effort to treat the foreign corporation as a U.S. corporation, thus negating the anticipated benefits of the inversion:
- “Cash Box” transactions whereby if 50% or more of the assets of the foreign corporation are “passive” assets, the value of such passive assets will not be taken into account in applying 80% and 60% tests described above.
- “Skinny Down” distributions whereby certain distributions by the U.S. corporation within three years preceding the inversion will not be taken into account in applying the 80% and 60% tests described above.
- “Spin-versions” whereby the use of a spin-off of part of the U.S. corporation to effect an inversion is precluded.
The Notice also targeted the following three areas with the intention of preventing access to the U.S. corporation’s existing offshore profits without subjecting such offshore profits to incremental U.S. tax:
- “Anti-Hopscotch” loans from the U.S. corporation’s foreign subsidiaries (i.e., controlled foreign corporations – CFCs) to the new foreign parent corporation (that “hopscotch” the U.S. corporation) would be subject to U.S. taxation (e.g., a deemed dividend) under Section 956;
- “Decontrolling” transactions whereby the new foreign parent corporation buys enough CFC stock to “de-CFC,” it would, in fact, still treat the new foreign parent corporation as owning under Section 7701(l) such stock in the U.S. corporation, not the CFC itself, such that the CFCs are still subject to the anti-deferral regime of Subpart F; and
- Sales (for cash) of the U.S. corporation stock by the new foreign parent corporation to the CFCs will essentially be sourced as a dividend to the U.S. corporation solely out of the CFC eliminating the possibility to export untaxed CFC earnings to foreign parent corporation without U.S. tax.
Notice 2014-52 did have some “quick-hit” impact and resulted in a few large inversions being called-off within weeks of its issuance. In other cases, it may not have halted an inversion but certainly increased the anticipated cost of the transaction by causing the U.S. corporation to have to seek more expensive external financing to complete the transaction (because it would not be able to access the foreign trapped cash to essentially fund the transaction).
Will the inversions continue? Yes. Why? Under current law, the Treasury Department, despite the potential short-term impact of Notice 2014-52, is limited in its ability to fully address inversions, and there really is no guarantee that the provisions described above would even hold up in Court if tested. Congressional action is the key to fully addressing inversions, but the optimal long-term solution would be best derived through comprehensive tax reform (e.g., territorial taxation with perhaps a U.S. corporate tax rate reduction), which takes time. In all likelihood, 2017 is looking like the earliest this could occur.
- Prevent inverted companies from accessing a foreign subsidiary’s earnings while deferring U.S. tax through the use of “hopscotch” loans.
- Under current law, U.S. multinational taxpayers owe U.S. income tax on profits of their Controlled Foreign Corporations (CFC’s), but are not required to pay the tax until those profits are paid to the U.S. parent as a dividend. The profits are known as deferred earnings.
- If a CFC tries to avoid paying the tax on the deferred earnings by making a loan or investing in the U.S. parent or one of its subsidiaries, the U.S. parent is treated as receiving a taxable dividend.
- Inverted companies are dodging this rule by having the CFC make the loan instead to the new foreign parent. This gives rise to the “hopscotch loan” and is not considered U.S. property, which is not taxed as a dividend in the U.S.
- The new regulations will disallow these loans by reclassifying them as U.S. property.
- Prevent inverted companies from restructuring a foreign subsidiary in order to access the subsidiary’s earnings tax-free.
- After an inversion transaction has taken place, some U.S. multinationals avoid U.S. tax on the deferred earnings of the CFC by having the new foreign parent corporation purchase a controlling interest in the stock of the CFC, thereby taking away control from the U.S. parent. This allows the new foreign parent to access the earnings of the CFC and avoid having to pay U.S. tax on them.
- The new Regulations will treat the new foreign parent as owning stock in the former U.S. parent instead of the CFC. The CFC’s ownership recognition would remain the same and would be subject to U.S. tax on its profits and deferred earnings.
- Prevent inverted companies from transferring cash or property from a CFC to the new foreign parent to avoid U.S. tax.
- This is where the new foreign parent sells its stock in the former US parent to the CFC with deferred earnings, in exchange for cash or property of the CFC, which results in a tax-free repatriation of the CFC’s deferred earnings. The new regulations will prohibit this strategy.
- Make it more difficult for U.S. entities to invert by strengthening the requirement that the former owners of the U.S. entity own less than 80% of the expanded affiliated group (EAG).
- Limit the ability of companies to count passive assets that are not part of the entity’s daily business functions in order to inflate the new foreign parent’s size, thereby avoiding the 80% threshold.
- Prevent U.S. companies from reducing their size pre-inversion by making extraordinary dividends.
- Disallow U.S. companies from inverting a portion of their operations by transferring assets to a newly formed foreign corporation that it spins off to its shareholders.