Corporate inversions are the hottest topic in US tax law. In a typical inversion, a US acquiring company combines with a smaller foreign target beneath a new foreign parent. An inversion is generally motivated at least in part by the acquirer's desire to save taxes.
Congress has enacted three Internal Revenue Code provisions to discourage inversions. However, in response to a wave of newly announced deals, Treasury recently released Notice 2014-52, further limiting the ability to do inversions and reducing the tax benefits of inversions.
Benefits of an Inversion
Two aspects of the US tax system are often said to encourage inversions: (1) the corporate tax rate of 35%, one of the highest in the world, and (2) US taxation on the worldwide earnings of a US corporation, including dividends from its foreign subsidiaries (controlled foreign corporations or CFCs). In practice, many companies are able to reduce their effective tax rates below 35%, and to defer US tax on their CFC earnings by keeping the earnings in the CFC indefinitely.
Nevertheless, prior to the Notice, there were three primary benefits to inverting. First, an inverted company could reduce its US taxable income through earnings stripping, that is to say, making deductible interest, rent or royalty payments to related foreign corporations that are not CFCs. Second, the company could access unrepatriated earnings ("trapped cash") held in CFCs without paying immediate US tax by causing the CFCs to make "hopscotch loans" to the foreign parent or by transferring the CFCs "out from under" the US company. Third, future foreign business expansion, and foreign acquisitions, could be made by the new foreign parent outside of the US worldwide tax net, even by using trapped cash removed from CFCs.
Code Provisions Intended to Discourage Inversions
1. If former shareholders of a US acquirer own 80% or more of the stock of the foreign parent after the inversion, Section 7874 generally treats the foreign parent as a US corporation. Triggering this rule would kill a transaction. If the former shareholders own 60% or more of the stock but less than 80%, Section 7874 generally limits the use of tax attributes to offset gains on transfers by the US company of CFC stock or certain other assets for 10 years. This 60% rule has been relatively toothless.
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 US acquirer prior to the inversion.
2. If the inverting US corporation has a greater fair market value than the foreign target, Section 367(a) causes the transaction to be fully taxable to the shareholders of the US corporation. This rule has not been effective in stopping inversions because the corporate tax benefits of inverting often far outweigh the cost of accelerating shareholder taxes.
3. If a transaction fails the 60% test, Section 4985 generally imposes a 15% excise tax on unvested stock compensation of insiders (certain officers, directors and shareholders). Companies generally respond to this rule by accelerating the vesting of such compensation or by paying the excise tax bills.
In order to slow the pace of inversions, Treasury released Notice 2014-52 on September 22 2014. The Notice applies to all transactions closing on or after that date.
For transactions that fail the 60% test, the Notice prevents for 10 years (1) the inverted company's ability to directly access trapped cash in a CFC (for example, through the use of hopscotch loans) without paying immediate US tax, and (2) "out from under" planning under which a CFC could cease to be a CFC.
The Notice also makes the 60% and 80% ownership tests easier to fail. First, if more than 50% of the value of the foreign target consists of cash and similar assets (or operating assets purchased with cash in contemplation of the inversion), a proportionate amount of stock held by shareholders of the foreign target will be disregarded from the denominator of the ownership tests. This rule was designed to prevent the use of foreign targets that have been set up to entice US inverters.
Second, the Notice increases the numerator of the ownership tests by an amount based on "disqualified distributions" (dividends, redemptions, spinoffs, etc.) paid by the US acquirer during the 36 months preceding the inversion. The addback applies regardless of whether the distribution was part of the plan of the inversion. This rule is a trap for the unwary, and requires detailed calculation of the acquirer's payments to shareholders for the prior six years. The Notice also applies the same rule to the fair market value test of Section 367(a).
The Notice does not restrict earnings stripping. However, it states that the Treasury is considering such restrictions, and that any restriction limited to inversions (rather than applying generally) will be effective retroactively to September 22 2014. The Notice also warns that other techniques to avoid the anti-inversion rules might also be stopped retroactively.
The Notice appears to have had some effect in limiting but by no means stopping inversion activity. However, it may cause future transactions to instead be cash acquisitions of US corporations by foreign corporations, or tax-free acquisitions of US corporations by larger foreign corporations. Many if not all of the benefits of inversions can be obtained in that manner, yet the Notice does not apply and there are no other restrictions on such transactions.