A corporate transaction that has received considerable publicity in recent months is the so-called “inversion” where a public U.S. company migrates to a foreign country, typically by merging with a smaller foreign company and thereby becoming a subsidiary of a new public foreign company (“Foreign Parent”). Not surprisingly, the potential for income tax savings usually is among the key objectives of an inversion transaction. The United States has one of the highest corporate tax rates in the world, and a complicated set of rules designed to tax the earnings of foreign subsidiaries of a U.S. company, while a number of foreign jurisdictions, including the United Kingdom, have become attractive alternatives for a public company to organize by offering lower corporate tax rates and tax exemptions for earnings derived from operations conducted outside their borders.
Congress acted many years ago to protect its tax revenues and limit opportunities for a U.S. public company to undertake an inversion transaction by enacting section 7874 of the Internal Revenue Code. Very generally, in order to have a “successful” inversion transaction under section 7874, either the shareholders of the formerly public U.S. company must own less than 80% of the stock of the Foreign Parent after the merger (i.e., the smaller foreign company cannot be too small), or the Foreign Parent must have substantial business assets and operations in its home jurisdiction. If an inversion transaction fails to satisfy the requirements of section 7874, Foreign Parent would continue to be treated as if incorporated in the United States for income tax purposes; that is, Foreign Parent would remain a full U.S. taxpayer despite the migration.
A flurry of recently completed or announced inversion transactions, including deals contemplated by U.S. pharmaceutical companies such as Pfizer, Allergan and AbbVie, has led Congress to conclude that the “anti-inversion” limitations imposed by the current provisions of section 7874 are not sufficient. Legislative proposals have surfaced, for example, to reduce the stock ownership threshold of section 7874 from 80% to 50% (i.e., the smaller foreign company no longer could be small), but thus far, these proposals have not gained any traction. In the absence of Congressional action, the Department of Treasury (“Treasury”) and Internal Revenue Service (“IRS”) announced their intention in Notice 2014-52 (the “Notice”) to issue future Treasury regulations aimed at slowing the pace of inversion transactions.
According to the Notice, any subsequent Treasury regulations would apply on a retroactive basis to inversion transactions occurring on or after the date of the Notice, September 22, 2014. Among the major proposals in the Notice are rules designed (i) to tighten the application of the stock ownership test of section 7874, (ii) to prevent the repatriation to Foreign Parent of earnings from foreign subsidiaries of the inverted U.S. company without U.S. income taxation and (iii) to limit the availability of post-inversion restructuring with respect to those foreign subsidiaries. The mere issuance of the Notice, and the corresponding threat of retroactive application of future Treasury regulations, is reported to have scuttled at least a few potential inversion transactions, including AbbVie’s proposed merger with Shire.
Stock Ownership under Section 7874
As explained earlier, section 7874 will treat the Foreign Parent emerging from an inversion transaction as a U.S. corporation for income tax purposes if the shareholders of the formerly public U.S. company own 80% or more of the stock of the Foreign Parent. Treasury and the IRS apparently are concerned that U.S. companies can be too creative in finding ways to accomplish inversion transactions without violating the 80% stock ownership threshold. To that end, the Notice targets two methods of skirting the ownership limitations: “skinny-down” distributions and “cash box” mergers.
In a skinny-down distribution, the U.S. company makes an extraordinary distribution of cash or other property to its shareholders in advance of an inversion transaction so as reduce its equity value and, thus, lower the percentage of Foreign Parent stock that shareholders of the U.S. company will need to receive in a merger with a smaller foreign company. The Notice now will require the U.S. company to count the amount of the extraordinary distribution as part of its equity value, and then determine whether its shareholders should have received 80% or more of Foreign Parent stock had the extraordinary distribution not occurred. If the answer is yes, then the inversion transaction will fail under the stock ownership threshold of section 7874, and the Foreign Parent will find itself a full U.S. taxpayer.
The Notice also addresses situations where an inversion transaction involves a smaller foreign company that may be nothing more than a holding company for cash and investment assets (i.e., a cash box). Here, the Notice provides that cash and various investment assets owned by the smaller foreign company will be ignored in calculating its equity value for purposes of the stock ownership threshold of section 7874 if the value of those assets exceeds 50% of the value of the total assets of the foreign company. Thus, where the smaller foreign company in an inversion transaction proves to be a cash box under this 50% test, the determination of the percentage of Foreign Parent stock that should be received by shareholders of the U.S. company under section 7874 will be based on a smaller foreign company that is treated as being even smaller.
Repatriation of Earnings of Foreign Subsidiaries
As publicized with frequency, U.S. companies may be hesitant to receive dividends out of the earnings of their foreign subsidiaries, and may instead choose to leave those earnings accumulated outside the United States, due to the U.S. income tax that would be payable on the dividends. For this reason, special U.S. tax rules seek to prevent U.S. companies from gaining access to the earnings of their foreign subsidiaries without paying a dividend and the related U.S. tax that would be due on the dividend. For example, a loan from a foreign subsidiary to a parent U.S. company, or an investment by the foreign subsidiary in stock of the U.S. company, generally can be taxable in the same manner as the receipt by the U.S. company of a dividend for income tax purposes to the extent of the accumulated earnings of the foreign subsidiary.
After an inversion transaction, a U.S. company potentially can avoid the application of these special U.S. tax rules, such as by permitting its foreign subsidiary to “by-pass” the U.S. company and make a loan directly to the new Foreign Parent, or acquire stock in the new Foreign Parent. The Notice proposes to fix this perceived loophole. Essentially, such a loan or stock investment would be re-characterized with U.S. company rather than the Foreign Parent, with the result that the U.S. company could be taxable on a deemed dividend to the extent of the accumulated earnings of the foreign subsidiary that are associated with the loan or stock investment.
Restructuring of Foreign Subsidiaries
As another way to access the earnings of a foreign subsidiary of a U.S. company following an inversion transaction, the stock ownership of the foreign subsidiary might be restructured to shift sufficient stock ownership to the new Foreign Parent so that the foreign subsidiary would not longer be subject to the special U.S. tax rules described above. The Notice announced that Treasury regulations would be issued, perhaps in controversial fashion, to re-characterize such restructurings in appropriate circumstances. For example, a direct investment by Foreign Parent in a foreign subsidiary of the U.S. company could be treated instead as an investment by Foreign Parent in the U.S. company, followed by an investment by the U.S. company in the foreign subsidiary, so as to prelude a stock ownership shift.
Future Action: Earnings Stripping
While the Notice may have impacted planning for inversion transactions as intended, Treasury and the IRS have stated that their work is not done, and that more guidance limiting the benefits of inversion transactions could be forthcoming. In this regard, future Treasury regulations targeting so-called “earnings stripping” appear high on the agenda. In short, earnings stripping can occur when the Foreign Parent lends money to the U.S. company as part of an inversion transaction, giving rise to interest deductions against the taxable income of the U.S. company (and hopefully without tax imposed on the interest income of the Foreign Parent, depending on the laws of its home jurisdiction and the terms of any tax treaty with the United States).
The Internal Revenue Code already imposes limitations on the ability of U.S. companies to engage in earnings stripping. Some members of Congress and the Administration have expressed the view that those limitations should be even more limiting in the case of inverted U.S. companies, but again Congressional action has not progressed. While the manner in which Treasury and the IRS might provide their own response on earnings stripping is uncertain, Treasury has indicated that any future Treasury regulations aimed at earnings-stripping could apply on a retroactive basis to the date of the Notice.