On July 11, 2018, the Treasury Department and the IRS published final Treasury regulations on inversion transactions (the “Final Regulations”). The Final Regulations substantially adopt the temporary Treasury regulations issued in April 2016 (the “Temporary Regulations”). Inversion activity has slowed in recent years as a result of anti-inversion measures contained in IRS Notices and prior Treasury regulations, including the Temporary Regulations, which measures made it more difficult to effect an inversion transaction and also reduced tax benefits that made inversion transactions attractive (e.g., tax-efficient access to offshore cash). In addition, as discussed below, certain provisions in the Tax Cuts and Jobs Act of 2017 (the “TCJA”) are intended to discourage inversions, including by making the U.S. more attractive from a tax perspective. Inversion transactions, however, may continue to occur in certain instances and the Treasury Department and the IRS continue to focus on inversion transactions. The summary below is limited to certain noteworthy aspects of the Final Regulations.
An inversion transaction generally is a transaction in which a U.S.-parented group changes the jurisdiction of its parent corporation to a foreign jurisdiction. In most instances, a U.S.-parented group effects an inversion transaction by being acquired by a smaller foreign corporation.
Generally, an inversion transaction is subject to Section 7874 (and the limitations set forth therein and in other relevant Code sections) when (i) a foreign corporation acquires a U.S. corporation (or substantially all of its assets), (ii) the shareholders of the U.S. corporation receive 60% or more of the stock of the foreign corporation and (iii) following the acquisition the foreign corporation does not have 25% or more of its worldwide operations in its country of organization. Under Section 7874(b), if the shareholders of the U.S. corporation receive 80% or more of the stock of the foreign corporation, the foreign corporation will be taxable as a U.S. corporation. If the shareholders of the U.S. corporation receive 60–79% of the stock of the foreign corporation then, under Section 7874(a)(1), the U.S. corporation cannot use pre-acquisition losses to offset certain gain and income recognized from certain restructurings and other related party transactions during an “applicable period” of 10 years following the inversion. In addition, several other Code sections generally provide that (i) restructuring transactions pursuant to which foreign subsidiaries of the U.S. corporation are transferred “out from under” the U.S. corporation will be taxable transactions and (ii) such foreign subsidiaries cannot make loans to the foreign corporation without a U.S. income inclusion.
Previously issued Section 7874 regulations treated multiple acquisitions of U.S. companies as a single acquisition generally only if such acquisitions were pursuant to the same preconceived plan. The Temporary Regulations abandoned the plan concept and instead provided that for purposes of determining whether the acquisition of a U.S. corporation is an inversion transaction, stock issued by the foreign corporation in connection with acquisitions of other U.S. corporations within the 36-month period will be disregarded. Thus, the 36-month rule does not apply based on whether prior transactions are related to the current U.S. corporation acquisition and, by disregarded foreign corporation stock previously issued, make it more likely that Section 7874 will apply to the current U.S. corporation acquisition. The Final Regulations generally adopt the Temporary Regulations.
The validity of the Temporary Regulations was challenged in Chamber of Commerce of the United States v. Internal Revenue Service, 2017 WL 4682049 (W.D. Tex. 2017). The court held that the Treasury Regulations were invalid from a procedural perspective because there was not a proper notice and comment period for the public. The court, however, held that the 36-month rule did not exceed the statutory authority for Treasury U.C. regulations contained in Section 7874. The IRS has appealed the decision and the case is now before the Court of Appeals in the Fifth Circuit.
Third Country Rule
The Temporary Regulations contained a rule that prevented a U.S. corporation and a foreign corporation from moving to a third jurisdiction in connection with an inversion transaction. This rule generally applied if (i) the new foreign parent company is a tax resident of a different jurisdiction than the acquired foreign corporation, (ii) the shareholders of the U.S. corporation receive at least 60% of the stock of the new foreign parent company and (iii) the gross value of the acquired foreign corporation exceeds 60% of the gross value of the new foreign parent company (including the acquired foreign corporation but excluding the U.S. corporation). If the rule applied, for purposes of Section 7874, the stock of the new foreign parent company received by shareholders of the acquired foreign corporation would be disregarded in determining the percentage of foreign parent company stock received by the shareholders of the U.S. corporation. Thus, this rule could apply where (i) a U.S. corporation and a foreign corporation combine under a new foreign parent company, or (ii) an existing foreign parent company acquires both a larger foreign corporation and a larger U.S. corporation. In addition, if a foreign parent company changes its tax residence prior to but in connection with its acquisition of a U.S. corporation, the rule would apply to disregard the stock of the foreign parent company held by its existing shareholders.
The Final Regulations adopt the Temporary Regulations with two modifications. First, the third country rule does not apply if (i) both the foreign acquiring corporation and the acquired foreign corporation are created or organized in, or under the law of, a foreign jurisdiction that does not impose corporate income tax and (ii) neither the foreign acquiring corporation nor the acquired foreign corporation is a tax resident of any other foreign jurisdiction. Second, the third country rule does not apply if the foreign acquiring corporation’s group has substantial business activities (based on the 25% test for employees, assets and income in the relevant foreign jurisdiction contained in Treasury Regulation Section 1.7874-3) in the jurisdiction in which the foreign acquiring corporation is a tax resident. For purposes of determining whether there are substantial business activities, the acquired U.S. corporation and its subsidiaries are not taken into account.
In addition, the Final Regulations contain a new rule providing that if the acquired foreign corporation changes its tax residency in a manner that does not result in a new foreign corporation (e.g., changing the place of management and control), the acquired foreign corporation is treated as both the acquired foreign corporation and the foreign acquiring corporation.
The Treasury Department and IRS noted that they declined to include a tax treaty exception based on a comparison of treaty benefits available to the foreign acquiring corporation in the third country as compared to the benefits that would otherwise be available in the jurisdiction in which the acquiring foreign corporation is a tax resident. Although the third country rule is based on preventing a move to a third jurisdiction for tax planning purposes, the Treasury Department and the IRS believe that even if such a move would not result in incremental treaty benefits, there is other tax planning that may be available.
Impact of Tax Reform on Inversion Transactions
The TCJA contains several provisions that are intended to discourage inversions, including by making the U.S. more attractive from a tax perspective. Although, in the right circumstances, inversion transactions could continue, the Final Regulations together with the TCJA may continue to significantly curtail inversion transaction activity. Set forth below is a summary discussion of relevant provisions of the TCJA.
- The TCJA reduces the U.S. corporate tax rate from 35% to 21%. One of the goals of this reduction in the corporate tax rate was to make doing business as a U.S. corporation more competitive with other jurisdictions. Thus, the 21% rate may discourage U.S. corporations from engaging in inversion transactions because the jurisdiction of the new foreign parent company may have a similar corporate tax rate (e.g., the U.K.).
- After a corporate inversion, multinational corporate groups typically sought to reduce their taxable U.S. base through intercompany debt and other transactions that resulted in deductible payments by U.S. operations.
- Treasury regulations under Section 385 made it more difficult to create intercompany debt in connection with an inversion transaction (although it is unclear whether these Treasury regulations will be repealed). In addition, new Section 163(j) replaces the old Section 163(j) “earnings stripping” rules and limitations interest deductions to 30% of adjusted taxable income. For taxable years beginning before January 1, 2022, adjusted taxable income is computed without regard to depreciation, amortization and depletion (i.e., similar to EBITDA). Beginning on January 1, 2022, adjusted taxable income will take into account depreciation, amortization and depletion (i.e., similar to EBIT).
- In addition, the TCJA imposes a new minimum tax called the Base Erosion and Anti-Abuse Tax or “BEAT.” This provision can apply if a U.S. corporation has reduced its taxable income by a little more than 50% through payments to related parties that are deductible such as interest and certain royalties and management fees.
- Under new Section 245A, a U.S. corporation that owns 10% or more of a foreign corporation generally will receive a 100% dividends-received deduction on dividends paid by the foreign corporation out of its foreign-source earnings. As a result, a U.S. corporation can repatriate its offshore earnings in a tax-free manner. Note that under the new global intangible low-taxed income rules or “GILTI,” U.S. corporations may nevertheless be subject to current tax on earnings of their foreign operations.
- In addition, the TCJA contains specific penalty rules for U.S. corporations that engage in inversion transactions. Specifically, if during the 10-year period following the enactment of the TCJA, a U.S. corporation undertakes an inversion transaction: (i) the U.S. corporation is retroactively subject to a 35% tax rate on the full one-time deemed repatriation amount determined under Section 965 and the use of foreign tax credits is prohibited, (ii) the excise tax on stock compensation of insiders is increased from 15% to 20%, (iii) dividends paid by the foreign acquiring corporation are taxable to U.S. noncorporate shareholders at a 37% tax rate (rather than the 20% qualified dividend income tax rate) and (iv) for purposes of the BEAT, base erosion payments will include payments for costs of goods sold.
In sum, the Final Regulations generally adopt the Temporary Regulations. The Temporary Regulations were set to expire in 2019. The issuance of the Final Regulations demonstrates the continuing concern of the Treasury Department and the IRS over inversion transactions. In addition, the TCJA reflects an attempt by Congress to level the playing field from a tax perspective and make the U.S. a more tax-friendly jurisdiction while also specifically penalizing any inversion transactions that occur in the near term. It remains to be seen, however, whether U.S. corporations will engage in inversion transactions.