Throughout much of 2014, U.S. tax inversions have drawn the renewed scrutiny of the U.S. Congress and the administration of President Obama. To date, none of the anti-inversion measures proposed by members of the U.S. Congress in 2014 have become law. However, the Obama administration has used its authority to create a number of new anti-inversion rules that became effective for inversions completed on or after September 22, 2014. While the new rules and proposed measures will curb some tax inversion structures, we predict that inversion opportunities will continue in 2015.
An inversion refers to a transaction whereby a U.S.-based multinational corporate group seeks to expatriate to another country to reduce its overall effective tax rate and realize significant tax savings. Typically, shareholders of the U.S. company and its foreign partner transfer their shares to the new foreign parent in exchange for parent stock and possibly other consideration. The key to a successful inversion is that former shareholders of the U.S. company must own less than 80 percent of the stock of the new foreign parent. If the former shareholders own 80 percent or more of the new foreign parent, the parent will then be taxable as a U.S. corporation under the U.S. anti-inversion laws.
The Obama administration’s new anti-inversion rules are described in IRS Notice 2014-52. The following is a summary of these new rules and proposed measures, together with our views of the practical impact on future inversion opportunities.
Pre-inversion Rules and Proposals
Limits on a U.S. company’s ability to “skinny down” (IRS Notice 2014-52)
To prevent a U.S. target company from circumventing the 80-percent test by decreasing its value in relation to the foreign partner corporation by spinning off or selling assets, a new rule disregards such transactions occurring within three years before the inversion.
While the new rule requires a careful analysis of all pre-inversion distributions that are not in the ordinary course of business, it should not prevent most inversions with a compelling business purpose from succeeding.
Targeting of “cash box” foreign partner corporations (IRS Notice 2014-52)
For purposes of the 80-percent test, a new rule reduces by formula the number of shares treated as issued to shareholders of the foreign partner corporation, if more than half of the foreign partner group’s assets consists of passive assets such as cash and marketable securities.
This new rule applies to comparatively few transactions and should have a modest effect.
Lower, 50-percent threshold for inversions (proposed legislation)
To reduce the possibility of inverting, proposed legislation would lower the 80-percent threshold to any percentage greater than 50 percent.
Such a rule would thwart some, but not all inversions. Even if enacted, history suggests such a rule would apply only prospectively, not retroactively.
Post-inversion Rules and Proposals
Re-characterization of “hopscotch” loans (IRS Notice 2014-52)
In the past, a loan made by an inverting U.S. company’s foreign subsidiary directly to the new foreign parent generally could avoid attracting U.S. tax. A new rule recharacterizes such “hopscotch” loans as investments in U.S. property subject to tax.
The new rule stymies some but not all current inversions, and it fails to address comparable tax-efficient strategies, such as the “hopscotch” licensing of intellectual property.
Hurdles to corporate restructuring (IRS Notice 2014-52)
As part of its post-inversion planning, a U.S. company may find it tax-efficient to move its foreign subsidiaries outside the U.S. chain, perhaps to release “trapped cash.” New rules are expected to make this much more difficult.
The new rules seem unlikely to prevent all such restructurings. Moreover, the rules should have no effect on future business in new subsidiaries formed outside the U.S. chain. Ultimately, new business grown entirely outside the U.S. chain will escape U.S. tax.
Clampdown on earnings stripping (under consideration)
An inverted U.S. company almost invariably seeks to reduce its U.S. taxes by paying interest to a new foreign parent, a practice known as “earnings stripping.” Both Congress and the Obama administration are considering measures to limit earnings stripping.
As a practical matter, a concerted attack on earnings stripping would face a political and economic backlash from all foreign companies investing in the United States, not merely inverted companies. Accordingly, rules attacking earnings stripping seem likely to be attenuated and to apply in a limited fashion, preserving the opportunity for many U.S. companies to successfully invert.
Reclassification of debt as equity (under consideration)
An alternative means to limit earnings stripping would be to reclassify as equity any debt issued by an inverted U.S. company to its new foreign parent.
Proposals to reclassify debt as equity for this purpose appear to rest on shaky legal ground. A previous attempt by the U.S. government to issue regulations governing the classification of debt and equity, made with great effort in the 1980s, ultimately was withdrawn.
Given the chance to combine with a suitable foreign partner, the prognosis for a U.S. company seeking to invert remains good. The new and proposed rules seem likely to thwart some inverting companies, while preserving opportunities for others. And as is often the case with innovative tax rules, the law of unintended consequences may well work in the taxpayer’s favour.
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