The flag is at half mast for U.S. taxpayers.
In September 2014 and November 2015, the U.S. Treasury announced “guidance” that allegedly made it more difficult for companies to undertake an “inversion” and reduced the economic benefits of doing so. Yesterday, the hapless Treasury took additional steps to address this problem by issuing “temporary regulations” on inversions and proposed regulations to address earnings stripping.
“For years, companies have been taking advantage of a system that allows them to move their tax residences overseas to avoid U.S. taxes without making significant changes in their business operations. After an inversion, many of these companies continue to take advantage of the benefits of being based in the United States – including our rule of law, skilled workforce, infrastructure, and research, and development capabilities – all while shifting a greater tax burden to other businesses and American families,” said Treasury Secretary Jacob J. Lew
This has become an embarrassing presidential election year issue. The proposed regulations generally do not apply to so-called related-party debt that is incurred to fund actual business investment, such as building or equipping a factory.
A corporate inversion is a transaction in which a U.S.-parented multinational group changes its tax residence to reduce or avoid paying U.S. taxes., a U.S.-parented group engages in an inversion when it acquires a smaller foreign company and then locates the tax residence of the merged group outside the United States, always in a low-tax country. The primary purpose of the transaction is to reduce taxes, often substantially.
After a corporate inversion, multinational corporations often use a tactic called earnings stripping to minimize U.S. taxes by paying deductible interest to their new foreign parent or one of its foreign affiliates in a low-tax country. Treasury has previously said it was considering potential guidance in this area.
In September 2014 and November 2015, Treasury announced “guidance” that made it more difficult for companies to undertake an inversion and reduced the economic benefits of doing so. Yesterday Treasury said it was taking additional action – via press release – to address this problem by issuing “temporary regulations” on inversions and proposed regulations to address earnings stripping.
The temporary regulations allegedly make it more difficult for companies to invert by limiting inversions by disregarding foreign parent stock attributable to certain prior inversions or acquisitions of U.S. companies (action under section 7874 of the code).
However, some foreign companies may avoid section 7874 – the tax code’s existing ineffective curbs on inversions – by acquiring multiple American companies over a short window of time or through a corporate inversion.
The value of the foreign company increases to the extent it issues its stock in connection with each successive acquisition, thereby enabling the foreign company to complete another, potentially larger, acquisition of an American company where section 7874 does 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.
Treasury claims that it is not consistent with the purposes of section 7874 to permit a foreign company (including a recent inverter) to increase in its size in order to avoid the inversion threshold under current law for a subsequent acquisition of an American company. For the purposes of computing the ownership percentage when determining if an acquisition is treated as an inversion under current law, Treasury will now exclude stock of the foreign company attributable to assets acquired from an American company within three years prior to the signing date of the latest acquisition.
In addition, the proposed regulations address the issue of earnings stripping by targeting transactions that increase related-party debt that does not finance new investment in the United States (Action under section 385 of the code says Treasury)
Under current law – obviously written by corporate lobbyists – following an inversion or foreign takeover, a U.S. subsidiary can issue its own debt to its foreign parent as a dividend distribution. The foreign parent can then transfer this debt to a low-tax foreign affiliate. The U.S. subsidiary can then deduct the resulting interest expense on its U.S. income tax return at a significantly higher tax rate than is paid on the interest received by the related foreign affiliate.
Treasury admits that the related foreign affiliate may use “various strategies” to avoid paying any tax at all on the associated interest income. “When available, these tax savings incentivize foreign-parented firms to load up their U.S. subsidiaries with related-party debt,” Treasury said.
The temporary restrictions – in theory, government bureaucratic theory – makes it more difficult for foreign-parented groups to quickly load up their U.S. subsidiaries with related-party debt following an inversion or foreign takeover, by treating as stock the instruments issued to a related corporation in a dividend or a limited class of economically similar transactions. For example, the proposed regulations:
- Treat as stock an instrument that might otherwise be considered debt if it is issued by a subsidiary to its foreign parent in a shareholder dividend distribution;
- Address a similar “two-step” version of a dividend distribution of debt in which a U.S. subsidiary (1) borrows cash from a related company and (2) pays a cash dividend distribution to its foreign parent; and
- Treat as stock an instrument that might otherwise be considered debt if it is issued in connection with certain acquisitions of stock or assets from related corporations in transactions that are economically similar to a dividend distribution.
