On April 4, 2016, the Treasury Department announced the release of new temporary and proposed regulations aimed at curtailing the use of “corporate inversion transactions” by domestic companies seeking to migrate to comparatively low-tax foreign jurisdictions by way of a combinations with smaller foreign acquiring companies. The temporary regulations largely formalize a number of anti-inversion rules that were previously announced in IRS Notices 2014-52 and 2015-79, including restrictions on the extent to which newly inverted companies can restructure their foreign subsidiaries so as to reduce U.S. taxation on their post-inversion operations. The proposed regulations, which purport to have a wider reach than inverted companies, represent an initial attempt by the Treasury Department to tighten the so-called “earnings stripping” limitations on the ability of taxpayers to use inter-company financing arrangements to reduce their U.S. taxable income through interest deductions.
A notable addition to the Treasury Department’s anti-inversion measures in the temporary regulations is a provision aimed at “serial inverters;” that is, foreign companies that grow over time through the acquisition of U.S. companies seeking to invert. Very generally, in order to have a “successful” inversion transaction under U.S. tax law, the shareholders of the inverting U.S. company must own less than 80% of the stock of the acquiring foreign company after the combination. Under the new rule for serial inverters, stock issued by a foreign company in connection with acquisitions of other U.S. companies over the preceding three years would not be taken into account in the 80% determination (whether or not the previous acquisitions were part of a plan), thereby increasing the percentage of stock of the foreign company treated as received by the inverting U.S. company and making a successful inversion transaction more difficult to achieve.
Shortly after promulgation of the temporary regulations and its new rule for serial inverters, the planned merger between Pfizer Inc. and Allergan plc was terminated.
The proposed regulations relating to earnings stripping were issued under a statutory provision (IRC section 385) that gives the Treasury Department broad authority to issue regulations addressing whether an interest in a corporation is classified as debt or equity (or as part-debt, and part-equity). Consistent with such statutory authority, the proposed regulations indicate that the Internal Revenue Service would be permitted to treat instruments in a corporation as part-debt, part-equity, so as to reduce the amount of deductible interest on indebtedness, if the facts and circumstances indicate that such treatment is warranted under general U.S. tax principles. Additionally, the proposed regulations, if finalized, would conclusively treat corporate instruments as equity for U.S. tax purposes when issued in certain related-party situations (such as where a subsidiary distributes an intercompany note as a dividend or uses an intercompany note to purchase stock of an affiliate), or are held by certain related parties and not supported by specifically required documentation, even if general U.S. tax principles would support debt characterization.
The rules in the temporary regulations that implement the prior IRS Notices generally apply on a retroactive basis to transactions occurring on or after the issue date of such IRS Notices. The new additions in the temporary regulations, including the serial inverter rule, generally apply to transactions occurring on or after April 4, 2016. The proposed regulations generally would apply to debt instruments issued on or after April 4, 2016, with the potential re-classification of an instrument as stock delayed until 90 days after the date final regulations are published so as to give taxpayers an opportunity to repay or otherwise eliminate related-party instruments that could be affected by the regulations.