Corporate Inversions: What They Are and Why Do They Matter
Proposed regulations recently released by the Internal Revenue Service (“IRS”) in April of 2016 aim to further reduce the benefits of and limit the number of corporate tax inversions. Large U.S. Corporations save millions of tax dollars each year from corporate inversions.
Corporate Inversions
A corporate inversion occurs when a U.S.-based company merges with a foreign corporation and relocates its commercial domicile to that foreign country, typically in a country with lower tax rates. U.S. corporations are typically taxed on worldwide income so, as a result and in efforts to save tax dollars, many U.S. corporations relocate operations to foreign countries which not only tax at a lower rate, but also only tax on domestic profits, significantly lowering the U.S.-based company’s tax burden. Most corporations do not feel the effects of corporate inversion, as it does not significantly affect business operations. Corporations can still take advantage of reliable rule of law, intellectual property protection, government support for basic research, educated workforce and publicly provided infrastructure.
Earnings Stripping
The most important outcomes of a corporate inversion are earnings stripping and aggressive transfer pricing. This is accomplished when the foreign corporation issues debt to the U.S.-based corporation which then pays interest expense back to the foreign corporation. The U.S. corporation is therefore afforded the deduction for the cost of the interest payments, significantly reducing its U.S. tax base and therefore shifting more profits to the lower-tax foreign jurisdiction. Earnings stripping provides major incentives for U.S.-based taxpayers to domicile in alow-tax country and shift profits outside the U.S.
Proposed Regulations
On April 4, 2016, the U.S. Treasury issued temporary and proposed regulations under IRC §385 with respect to corporate inversions. If adopted, the proposed regulations would significantly reduce the economic benefits of corporate inversions.
The rules have been tightened by targeting transactions that generate large interest deductions by simply increasing related-party debt without financing new investment in the United States. The rules would allow the IRS, in the event of an audit examination; to able to effectively classify related-party financing as part equity/part debt, rather than the current rule that generally treats them as either debt or equity.
If finalized, the proposed regulations would:
- Treat as stock certain related-party interests that otherwise would be treated as indebtedness for federal tax purposes;
- Authorize the Commissioner of the IRS to treat certain related-party interests in a corporation as indebtedness in part and stock in part for federal tax purposes; and
- Establish extensive documentation requirements in order for certain related party interests in a corporation to be treated as indebtedness for federal tax purposes.
The proposed regulations also address “serial inverters” under IRC §7874 in which foreign-owned affiliated groups that have grown larger through inversions or acquisition of U.S. corporations, and earnings stripping, which erodes a U.S. corporation’s U.S. tax base. Under the proposed regulations, serial inverters would be subject to anti-inversion rules and thus a proposed merger or acquisition with a U.S-based company could potentially be halted.
Further, the regulations address facilitating improved due diligence and compliance by requiring certain large corporations to perform up-front due diligence and documentation with respect to the characterization of related-party financial instruments as debt. If requirements are not met, instruments will be characterized and treated as equity for tax purposes.
Expanded and Affiliated Groups
The proposed regulations would be limited in scope as they would apply to the characterization of indebtedness between members of an “expanded group.” The term “expanded group” would be defined by referencing the term “affiliated group,” as described in IRC §1504(a). However, the proposed regulations would also broaden this definition in the following ways:
- Unlike an affiliated group, an expanded group would include foreign and tax-exempt corporations, as well as corporations held indirectly (i.e. through partnerships);
- In determining relatedness, the proposed regulations would adopt the related corporation constructive ownership/attribution rules; and
- The proposed regulations also would modify the definition of affiliated group to treat a corporation as a member of an expanded group if 80% of the vote or value is owned by expanded group members (as opposed to 80% of the vote and value).
Current Corporate Inversions
Most recently, a proposed $160 billion merger between Pfizer and Ireland-based Allergan, PLC was called off due to the release of the proposed regulations. This merger would have saved Pfizer an estimated $1 billion annually by domiciling in Ireland. The failed Pfizer-Allergan merger is a perfect example of corporate inversion, the likes of which are currently under significant scrutiny by the United States Treasury.
Following the Pfizer-Allergan abandoned merger, conversely, Delphi Automotive PLC announced that it had won an appeal with the IRS allowing the company to be treated as a U.K. resident for U.S. federal tax purposes. The IRS initially determined that Delphi should be treated as a U.S. company under Internal Revenue Code (“IRC”) §7874(b) after the company reincorporated in the U.K. Delphi appealed the initial conclusion reached by the IRS on June 24, 2014 wherein the IRS concluded that IRC §7874(b) did apply in Delphi’s case and, as a result, Delphi would have been subject to federal income tax on its worldwide income. Following the appeal, the IRS Office of Appeals, on April 8, 2016, concluded that IRC §7874(b) did not apply in Delphi’s case and, thus, Delphi continued to be recognized as a U.K. resident for tax purposes.
Affect on the Healthcare Industry
Corporate inversion issues have also significantly affected the healthcare industry. On April 28th, there were approximately $40 billion in new healthcare deals announced including, but not limited to, Abbott Laboratories agreement to purchase heart device maker St. Jude Medical, Inc. and the purchase of Stemcentrx, a cancer drug maker, by AbbVie, Inc. Although the proposed regulations put an end to the $160 billion combination between Pfizer and Allergan, PLC outlined above, according to Bloomberg, there have been approximately $144 billion in deals for biotechnology, healthcare and pharmaceutical companies announced this year.
Conclusion
The proposed regulations would apply to (1) any applicable instrument issued or deemed issued on or after the date the proposed regulations are published as final and (2) any debt instrument issued on or after April 4, 2016.The comment period on the proposed regulations is set to expire on July 7th. However, there have been many requests to extend this period for an additional 90 days to October 5, 2016.
Though strides have been made to address the corporate inversion tax loophole, President Obama has stressed that only legislation can close it for good. Republicans and Democrats actually agree that corporate inversions should be addressed; the problem is how. Expect the conversation to continue through the presidential election in November of 2016, as the presidential nominees will certainly discuss how to eliminate corporate inversion, but also how these types of issues will affect tax code in the aggregate beyond 2016. Corporate inversion could be the type of catalyst that brings unprecedented change to the tax code.
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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 for your individual facts and circumstances.
