Behind the Rules Regarding Corporate Inversions and Related Transactions
The U.S. Department of the Treasury (the “Treasury”) issued Notice 2014-54 (the “Notice”) to announce that it is taking administrative action to substantially reduce the economic benefits companies gain from inverting, and to make inversions more difficult to accomplish. The ability of inverted companies to escape U.S. taxation will significantly diminish.
The Notice eliminates certain techniques inverted companies currently use to access the overseas earnings of foreign subsidiaries of the U.S. company that inverts without paying U.S. tax. The Treasury guidance applies to corporate inversions that close on or after September 22, 2014.
NOTICE 2014-52 ADDRESSES THE FOLLOWING ISSUES
- “Hopscotch” loans, which are creative loans that allow inverted companies to access a foreign subsidiaries earnings while deferring U.S. tax
U.S. multinational companies owe U.S. tax on the profits of their controlled foreign corporations when those profits are paid to the U.S. parent as a dividend. Profits that have not yet been repatriated are known as deferred earnings. Currently, the U.S. parent is treated as if it received a taxable dividend if the controlled foreign corporation made a loan to or invested in the stock of the U.S. parent or an affiliate. Inverted companies have had controlled foreign corporations make “hopscotch” loans to the new foreign parent instead of its U.S. parent to get around this dividend rule. These loans were not considered U.S. property and not subject to tax as a dividend. Under the Notice, the same dividend rules will now apply as if the loan had been made to the U.S. parent.
- Restructuring a foreign subsidiary in order to access the subsidiary’s earnings tax-free
Corporations used a restructuring strategy after an inversion allowing the new foreign parent to access deferred earnings of a controlled foreign corporation without paying U.S. tax. This strategy involved the new foreign parent buying enough stock to take control of the controlled foreign corporation away from the former U.S. parent.
Under the new rules, the new foreign parent would be treated as owning stock in the former U.S. parent rather than the controlled foreign corporation. The later would remain subject to U.S. tax on its profits and deferred earnings.
- Close a loophole to prevent inverted companies from transferring cash or property from a controlled foreign corporation to the new parent to completely avoid U.S. tax
A new foreign parent would sell its stock in the former U.S. parent to a controlled foreign corporation with deferred earnings in exchange for cash or property. That is, the tax deferred earnings would bypass the U.S. parent and reach the new foreign parent entity with zero U.S. tax paid on such earnings. The result would be a tax-free repatriation of cash or property. This notice would eliminate the ability to use this strategy.
- Make it more difficult for U.S. entities to invert by strengthening the requirement that former owners of the U.S. entity own less than 80 percent of the new combined entity
In the past, companies have been able 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 and, therefore, evade the 80 percent rule. This notice would disregard stock of the foreign parent that is attributable to passive assets in the context of this 80 percent requirement. This applies if at least 50 percent of the foreign corporation’s assets are passive. Banks and other financial services companies would be exempted.
Prior to inversion, U.S. companies would reduce their size by making extraordinary dividends in order to meet the 80% threshold. The new rules would disregard these pre-inversion extraordinary dividends for purposes of the ownership requirement, thereby raising the U.S. entity’s ownership, possibly above the 80 percent threshold.
Prior to the Notice, U.S. entities were able to invert a portion of their operations by transferring a portion of its assets to a newly formed foreign corporation and then spinning-off that corporation to its public shareholders. This technique had allowed the newly formed foreign corporation to avoid U.S. tax liabilities. Now, under the Notice, the spun-off foreign company would be treated as a domestic corporation, eliminating the use of this technique for these transactions.
This is just a brief summary of the issues Treasury and the Internal Revenue Service have addressed regarding corporate tax inversions. Expect to see additional guidance on this issue in the near future. According to the Notice, the Treasury is considering guidance to address strategies that avoid U.S. tax on U.S. operations by shifting or “stripping” U.S.-source earnings to lower tax jurisdictions, including through inter-company debt. Treasury officials have warned in oral comments that any such rules will be effective as of the date of the Notice, September 22, 2014. Practitioners question whether Treasury has the authority to issue regulations with a retroactive effective date in these circumstances. Stay tuned on this issue.
NEED MORE INFORMATION?
If you would like more information about the Notice or other international tax issues, please contact your WS+B advisor.
Frank Boutillette, CPA, Partner
Co-practice Leader , Financial Services
212.751.9100
[email protected]
Anthony Tuths, JD, LLM Partner
Co-practice Leader, Financial Services
212.751.9100
[email protected]
The information contained herein is not necessarily all inclusive, does not constitute legal or any other advice, and should not be relied upon without first consulting with appropriate qualified professionals.
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