Corporate Inversions: New Regulations
Over the last several years, inversion transactions have generated considerable tax and political commentary. Treasury has launched a series of attacks aimed at stopping them, including temporary and proposed regulations with broad-reaching impact.
Benefits of an Inversion
In a typical inversion, a U.S. “acquiring” company combines with a smaller foreign target beneath a new foreign parent. An inversion is generally motivated at least in part by the U.S. acquiror’s desire to save taxes.
Two aspects of the U.S. tax system are often said to encourage inversions: (i) the corporate tax rate of 35%, one of the highest in the world, and (ii) U.S. taxation on the worldwide earnings of a U.S. corporation, including dividends from its foreign subsidiaries (“controlled foreign corporations” or “CFCs”).
Prior to 2014, there were three primary benefits to inverting. First, an inverted company could reduce its U.S. taxable income through earnings stripping, i.e., making deductible interest, rent or royalty payments to related foreign corporations. Second, the new foreign parent could access existing unrepatriated earnings held in CFCs without paying immediate U.S. tax, such as by borrowing the funds from the CFCs. Third, going forward the new foreign parent could expand the group’s foreign businesses (and make acquisitions) through directly owned foreign subsidiaries, thus keeping the resulting earnings outside of the U.S. worldwide tax net.
Existing Law Prior to 2014
Various provisions of the Internal Revenue Code are designed to discourage inversions, the most notable of which is Section 7874. If former shareholders of a U.S. acquiror own 80% or more of the stock of the foreign parent after the inversion, Section 7874 generally treats the foreign parent as a U.S. corporation. If the former shareholders own 60% or more of the stock, Section 7874 generally limits the use of tax attributes of the U.S. acquiror to offset gains on transfers by the U.S. company of CFC stock or certain other assets for 10 years.
Both ownership tests are subject to statutory and regulatory anti-avoidance rules. For example, rules prevent avoiding the 60% or 80% thresholds by either increasing the size of the foreign target or decreasing the size of the U.S. acquiror prior to the inversion.
The new foreign parent can escape application of Section 7874 if, after the transaction, its “expanded affiliated group” has “substantial business activities” in the foreign parent’s country of organization as compared to the group’s global activities.
In response to a wave of inversions, Treasury issued Notice 2014-52 to announce rules intended to prevent taxpayers from meeting the 60% and 80% ownership tests through the use of (i) foreign targets inflated with cash or (ii) U.S. acquirors “slimmed down” from distributions.
In addition, for transactions failing the 60% test, the 2014 Notice prevented for 10 years (i) the ability of the new foreign parent to directly access trapped cash in a CFC without paying immediate U.S. tax, and (ii) “out from under” planning under which a CFC could shed its CFC status, such as by issuing new stock directly to the foreign parent. The Notice reduced inversion activity, but failed to halt it.
Many inverting companies derived substantial benefits by creating a new foreign parent company in a third country selected for its lower tax rate or more extensive treaty network in comparison to the jurisdiction of the foreign target. Treasury announced rules to curb this practice in Notice 2015-79.
The new rules disregard third-country foreign parent stock from the ownership fraction (generally causing the inversion to fail the 80% test), but only if the transaction would fail the 60% test irrespective of the new rule.
The 2015 Notice also made it more difficult to meet the substantial business activities exception under Section 7874 by requiring that the foreign target be tax resident in its jurisdiction of organisation. Treasury was concerned some foreign targets were not subject to tax in their jurisdictions of organisation (i.e., the location of the required substantial activities), either because they were managed and controlled elsewhere or because they were considered fiscally transparent.
In addition, Treasury reduced the benefits of inversions in other ways, including by imposing limits on the use of tax attributes to offset income resulting from certain transfers by CFCs.
2016 Temporary Regulations under Section 7874
In April 2016, Treasury issued temporary regulations under Section 7874 implementing the rules announced in the 2014 and 2015 Notices (with certain modifications), and imposing several new rules.
Most notably, the regulations attempt to prevent serial inversions in which a foreign entity engages in a string of transactions with increasingly larger U.S. companies. In each case, the 60% test is satisfied, but the result is a larger group with a foreign parent that can then become the target of another larger U.S. acquiring corporation. Under the regulations, stock of the foreign parent is disregarded from the ownership fraction to the extent its value is attributable to the acquisition of U.S. companies in the last three years. This rule (like many of the new anti-inversion rules) is a trap for the unwary because it potentially takes into account prior acquisitions of small U.S. targets that would not be considered inversions.
Regulations implementing the 2014 and 2015 Notices generally apply to transactions closing on or after the date of the respective Notice, while rules that had not been announced generally apply to transactions closing on or after 4 April 2016.
2016 Proposed Regulations under Section 385
On the same day that these temporary regulations were issued, Treasury issued proposed regulations under Section 385, which authorises regulations to distinguish debt from equity for tax purposes. Among other things, the proposed regulations would limit or prevent earnings stripping of the U.S. acquiror after an inversion by preventing taxpayers from putting intercompany debt on the U.S. acquiror as part of an inversion. For example, the regulations would treat related-party debt as equity for tax purposes when issued (i) in a distribution, (ii) in exchange for stock of a related entity, (iii) as consideration in an intragroup asset reorganisation or (iv) with a principal purpose of funding a transaction described in (i) through (iii). The proposed regulations also allow the IRS to treat related-party instruments as part debt and part equity, and they impose documentation requirements for certain related-party financial instruments to be respected as debt.
Notably, the proposed Section 385 regulations are not limited in scope to inverted companies. Instead, they would apply to all transactions between U.S. companies and related foreign entities (and in particular to multinational corporate groups). The broad application and extent of the proposed changes have generated substantial commentary from the tax bar and the international community, and it remains to be seen when and in what form the proposals will be enacted.
If finalised, the proposed regulations will in certain circumstances apply to instruments issued on or after 4 April 2016, but before the finalisation date.
Christopher K. Fargo is a partner in Cravath’s Tax Department. His practice focuses on advising clients on the tax aspects of mergers and acquisitions (including transactions involving REITs and MLPs), securities offerings, joint ventures and private equity fund structuring.