Last week, the Internal Revenue Service and Treasury
Department announced a number of new regulations
intended to make it more difficult to qualify for tax
advantages associated with inversion transactions and
reduce certain of those benefits. Nonetheless, the
regulations, which are not retroactive and therefore
only affect future deals or pending transactions that have
not yet closed, appear unlikely to strip so much of the tax
advantages associated with inversions as to stem the inversion
trend. In announcing the regulations, however,
Treasury Secretary Lew suggested that additional
rule-making was likely, thereby holding open the
possibility that future regulations may further reduce
the tax benefits to be secured from inversions. We
discuss below the new regulations, what they mean for companies
that have signed agreements to merge but not yet consummated
the transactions and the potential scope of future
rulemaking by Treasury.
A corporate inversion is a transaction whereby a domestic company
merges with a foreign entity (usually one that is
domiciled in a more "tax friendly" country), achieves
more than 20% new ownership, and is then able to claim
non-U.S. residence and adopt the foreign country's lower
corporate tax structure.[2] Over the last few months, there have
been a number of high profile U.S. companies seeking to
invert, including Burger King (Canada), Medtronic
(Ireland), AbbVie (Ireland) and Mylan
(Netherlands).
The response to these transactions from those in the political
sphere has been unsurprising: President Obama has called
inversions "wrong" and "unpatriotic," while Treasury
Secretary Lew wrote a letter to Congress requesting
legislation stopping U.S. corporations "from effectively
renouncing their citizenship to get out of paying
taxes."[3]
Senators Schumer and Durbin quickly introduced legislation to
combat inversions by restricting the deductibility of
interest expenses and requiring IRS approval for foreign
related-party transactions, although there seems little
chance of Congressional action before mid-term
elections.
There are, of course, existing laws that were enacted to make
inversion transactions more difficult. As noted
previously by the authors,[4] section 7874 of the Internal
Revenue Code (the "Code") seeks to prevent (by negating
the tax benefits) U.S. entities from transferring stock or
assets to foreign corporations, unless there is a significant
change in ownership (i.e., no more than 60% of
the stock of the newly constituted foreign corporation
is held by former shareholders of the domestic
entity). If the 60% threshold is crossed, the new
foreign corporation is treated as a "foreign surrogate
corporation," meaning that while it is generally respected as a
foreign corporation for tax purposes, it is not permitted to
use deductions to offset gain or income from the
inversion transaction. If, however, 80% or more of
the newly constituted foreign corporation is still owned
by the former domestic shareholders, the entity will be
treated as a domestic corporation for U.S. federal
income tax purposes. An older Code provision,
section 367, denies tax free status to certain transfers of stock of
U.S. corporations to foreign corporations. Unlike
section 7874, section 367 does not cause the foreign
corporation's status as a foreign corporation to be
recast. Instead, the transaction in question is
subject to taxation.
Following the political uproar over inversions, on September 22,
2014, the IRS and Treasury Department issued Notice
2014-52 (the "Notice") indicating their intent to
publish regulations that are intended both to make
inversion transactions more difficult to accomplish and
reduce their benefits. The new rules take a
two-prong approach.
First, the regulations will seek to address transactions that are
structured to avoid the application of sections 7874 and
section 367. In particular, the new regulations
will: (i) in calculating ownership of the merged entity
for purposes of section 7874's 80% threshold, forbid
inflating the size of the foreign acquirer by including
"passive assets" (such as cash or marketable securities)
that are not part of the foreign entity's daily business
function;[5] and (ii)
disregard large, pre-inversion dividend payments or
distributions (including spin-offs) by the domestic
entity designed to reduce its size in order not to
exceed the 80% threshold.[6] Both of these provisions will
make it harder for a domestic entity to effect an inversion, either
because it will be more difficult to stay under the 80%
threshold or because the transfer itself will be taxable
under section 367.[7] The Notice also addresses
post-acquisition transfers of stock of the foreign
acquiring corporation. Prior to the Notice, because the
present regulations disregard post-acquisition transfers, one
could claim exclusion from inversion treatment merely
because an intermediate step in an acquisition involved
a transfer to a member of the expanded affiliated group
("EAG"), a chain of corporations connected through stock
ownership by a common parent where the parent owns more
than 50% of the each corporation's stock. To
eliminate this possibility, the Notice includes a provision that
prevents the application of this rule if the foreign
acquiring corporation's stock is later transferred in a
transaction related to the acquisition to a person or
entity that is not an EAG member.[8]
Second, taking aim at post-inversion restructuring, the Notice
targets transactions involving controlled foreign
corporations ("CFC") of the domestic entity.[9] For example, to prevent
companies from accessing CFC earnings tax free, the
regulations will count as taxable U.S. property any
loans made by the CFC to the new foreign parent
(i.e., "hopscotch" loans). Additionally, the new
rules will prevent the domestic entity from "de-controlling"
its CFCs, i.e., having the new foreign parent
purchase stock in the CFC in order to protect the CFC's
deferred earnings from U.S. taxes. To accomplish
this, the regulations will consider the new foreign
corporation as owning stock in the former domestic
entity, not the CFC, thus subjecting the CFC to U.S. taxation.[10]
Finally, the new rules will seek to limit
the ability of the new foreign parent to avoid
repatriation of cash or property by selling the stock of
the former domestic corporation to CFCs in so-called
"section 304 transactions." Under
section 304, sales of stock to related entities are normally
treated as dividends, rather than sales.[11] Prior to the Notice, it was
possible to take the position that no dividend was
created by reason of the transfer. This will no longer
be possible. Each of these provisions will be generally
effective for acquisitions or transfers completed on or
after September 22, 2014.
The impact of the Notice remains to be seen. The Treasury
Department expressed measured optimism that the
regulations would "significantly diminish the ability of
inverted companies to escape U.S. taxation."
Indeed, Treasury Secretary Lew said that "for some
companies considering deals, [the new regulations] will mean
that inversions no longer make economic sense." Secretary
Lew also both called on Congress to enact additional
reforms and suggested that further regulatory reform was
forthcoming, noting that the new regulations were only
the "first, targeted steps" designed to make
"substantial progress in constraining the creative
techniques used to avoid U.S. taxes."
The Notice itself stated that Treasury and the IRS "expect to
issue additional guidance to further limit inversion
transactions," including with respect to corporate
strategies that "avoid U.S. tax on U.S. operations by
shifting or 'stripping' U.S.-source earnings to lower
tax jurisdictions." The Notice adds that the Treasury
Department is also "reviewing its tax treaty policy regarding
inverted groups and the extent to which taxpayers
inappropriately obtain tax treaty benefits that reduce
U.S. withholding taxes on U.S. source income."
So far, few of the companies involved in pending but
unconsummated inversion transactions have commented,[12] although it appears
unlikely that the new regulations would permit a merging party to
exit the deal even where the relevant merger agreements
contain a provision that conditions the inverting
company's obligation to close on there being no change
in the applicable tax law. For example, the merger
agreement between Medtronic and the Irish company
Covidien contains a clause that the acquisition is subject
to the condition that:
there shall have been no change in applicable Law . . . with
respect to Section 7874 . . . or official interpretation
thereof as set forth in published guidance by the IRS .
. . [that] would cause [the new foreign corporation] to
be treated as a United States domestic corporation for
United States federal income tax purposes.[13]
At this point, it seems unlikely the new rules would permit
Medtronic (or the various other domestic entities with largely
identical provisions in their inversion agreements) from
backing out of the deal (at least without paying a
sizeable break-up fee) because the regulations do not
actually change section 7874 to prevent a
corporate inversion, but instead raise the bar to
inverting and/or eliminate some of the benefits to such a
transaction. Nonetheless, the regulations contemplated by the
Notice, as well as the potential for additional rule
making, very well may change the terms or scuttle
pending or contemplated deals. As just one
example, recent media reports suggest that Medtronic may
attempt to restructure portions of its deal with
Covidien, including by lowering its purchase price or asking
Covidien to accept more stock and less cash.[14]
[1] Jason Halper is
a partner in Orrick, Herrington & Sutcliffe LLP's
securities litigation and regulatory enforcement
practice group and serves as co-head of the firm's
financial institutions litigation practice, Peter
Connors is a partner in Orrick's tax group, and William Foley
is a managing associate in the firm's securities litigation and
regulatory enforcement group.
[2] For more on
corporate inversion transactions, see Jason Halper,
Peter Connors et al., The Legal and Practical
Implications of Retroactive Legislation Targeting
Inversions, The Harvard Law School Forum on
Corporate Governance and Financial Regulation,
Sept. 16, 2014, available at: http://blogs.law.harvard.edu/corpgov/2014/09/16/the-legal-and-practical-implications-of-retroactive-legislation-targeting-inversions/.
[3] Interestingly,
former President Bill Clinton recently refused to call
corporate inversions unpatriotic, noting that companies
"answer[] to shareholders" and thus "feel duty-bound to
pay the lowest taxes they can pay." Clinton
continued that the U.S. has the "highest overall
corporate tax rates in the world" and that "the best
discouragement [of corporate inversions] is to reform taxes."
Kevin Cirilli, Bill Clinton Shies Away from
'Unpatriotic' Label, The Hill, Sept. 23,
2014.
[4] See
supra, note 2.
[5] Notice,
§2.02(b). If more than 50% of the assets of the foreign
entity are "passive," a proportionate amount of that
entity's stock will not be counted for the purposes of
section 7874's 80%-20% test.
[6] Notice 2014-52,
§2.02(b). These pre-inversion distributions, which
are often called "skinny-down" dividends, reduce the
value of the domestic corporation, which, in turn,
reduces the number of shares its former shareholders
receive in the inversion transaction so that they will
hold no more than 79% of the new entity. The new regulations
will disregard any extraordinary dividends made within 36
months of the closing of the transaction.
[7] Section 367
imposes a tax on shareholders of a domestic company acquired
by a foreign acquirer unless the value of the transferee
foreign corporation is at least equal to the fair market
value of the U.S. target company. In addition to
disregarding large distributions designed to get under
section 7874's 80% threshold, the new regulations will
disregard transfers intended to avoid taxation under
section 367.
[8] Notice 2014-52,
§2.03(b)
[9] Notice 2014-52,
§3.01(b). A CFC is a foreign corporation in which
more than 50% of the stock is owned by certain classes
of U.S. voting shareholders.
[10] Notice
2014-52, §3.02(e).
[11] Notice
2014-52, §3.02(b),
[12] A spokesman
for Tim Horton's Inc., the Canadian company involved in
the Burger King inversion transaction, said that the
deal "is moving forward as planned," and noted that the
merger was driven by long-term growth rather than tax
benefits. Additionally, the CEO of AbbVie recently
stated that he is "more confident than ever about the
potential of [the] combined organizations."
[13] For a list
of all inversion transactions since February 2014 and
the substance of any no-change-in-law provisions in the
relevant merger agreements, see supra, note
2.
[14] Katharine
Grayson, Medtronic and Covidien are likely to
renegotiate purchase terms: report, Minneapolis/St.
Paul Business Journal, Sept. 29, 2014.
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