The U.S. Treasury Department issued temporary regulations on April 4, 2016 that change the landscape for U.S. companies interested in “inverting” so that a foreign company becomes the group’s parent. These regulations are effective today, and while they have significant implications on the inversion analysis from a tax perspective, they are not expected to impact U.S. government procurement law – another area in which there are very substantial penalties for inversion.
In addition, as promised in prior inversion guidance, Treasury’s new measures also contain proposed regulations to address “earnings stripping” that target the U.S. tax benefits of transactions that increase related-party debt. Although the press has widely reported on the inversion aspect of the new guidance, the earnings stripping rules may in fact have greater impact, as they will affect both corporate groups that have undertaken an inversion transaction and those that have not.
The significance of inversion
Corporate inversion is the general term for a number of transactions, including a merger that has the effect of relocating a U.S. corporation’s legal domicile to a country with a lower tax rate. To discourage corporate inversions and preserve U.S. tax revenue, Congress has passed laws that impose penalties in the Internal Revenue Code (IRC) (that can operate to nullify some or all of the tax benefits of an inversion) and in the body of government contract law (that render inverted companies ineligible to obtain government contracts and funding).
Although the definition of “inverted domestic corporation” (IDC) is the same under tax and government contract statutes, Treasury’s rules governing the analysis under the definition are not identical to those in the Federal Acquisition Regulation (FAR). Thus, it is possible for a company to be subject to a tax penalty but to escape any government contracts penalty.
Tax impact of temporary inversion regulations
The temporary regulations target inversion deals by applying a new (and stricter) methodology for determining whether a company meets the statutory control/stock ownership thresholds that apply in considering whether a corporation is inverted. See U.S. Department of Treasury, Fact Sheet: Treasury Issues Inversion Regulations and Proposed Earnings Stripping Regulations (April 4, 2016), https://www.treasury.gov/press-center/press-releases/Pages/jl0404.aspx. In short, under the new rules, post-merger ownership percentages are to be calculated in a way that disregards any inversion transactions involving acquisitions of U.S. companies made during the prior three years. These regulations are effective immediately.
More specifically, if a transaction is classified as an inversion in which the shareholders of the U.S. company continue to own 80 percent or more of the stock of the foreign parent, the foreign parent is treated as “tax resident” in the U.S. in the same manner as a domestic company – in effect, the transaction is not respected for U.S. tax purposes. If the shareholders of the U.S. company own between 60 and 80 percent, certain tax benefits of the inversion are disallowed, including the ability to use net operating losses or other tax attributes to reduce U.S. tax on the “offshoring” of U.S. assets and the ability to access “trapped cash” in controlled foreign subsidiaries without paying U.S. tax. The new rules provide that in determining whether the 60 and 80 percent ownership tests are met, stock of the foreign company attributable to assets acquired from a U.S. corporation during the past three years is disregarded. In essence, the new rules “slim down” foreign companies that have “fattened up” through multiple inversion transactions in the three-year period before an inversion and make it harder for the shareholders of the domestic corporation to stay below the 60 and 80 percent ownership thresholds.
Tax impact of proposed earnings-stripping regulations
According to Treasury, after a corporate inversion, multinational corporations often use a tactic called “earnings stripping” to minimize U.S. taxes by paying deductible interest to their new foreign parent or one of its foreign affiliates in a low-tax country. Treasury’s proposed regulations (issued pursuant to a pre-existing regulatory grant under IRC Section 385) target transactions that increase related-party debt in a manner that, in Treasury’s view, does not finance new investment in the U.S., whether or not an inversion transaction is involved. If finalized as drafted, the proposed regulations would apply to debt issued on or after April 4, 2016.
The regulations make it more difficult for foreign-parented groups to capitalize their U.S. subsidiaries with related-party debt following an inversion or foreign takeover by treating as stock the instruments issued to a related corporation in a dividend or a limited class of economically similar transactions. This has the effect of “preserving” the U.S. corporate tax base by disallowing interest expense deductions. In a significant change to current tax law, the regulations also allow the Internal Revenue Service on audit to divide a purported debt instrument into part debt and part stock. Finally, the new rules impose substantial documentation requirements that require inclusion of information necessary for debt-equity tax analysis, including contemporary written evidence of a binding obligation for the issuer to repay the principal amount borrowed, among other things. These rules apply whether or not a corporate group has been involved in an inversion transaction.
The proposed regulations generally apply only to debt in excess of $50 million issued between related corporations, subject to a general anti-abuse rule for structured transactions involving unrelated persons, and do not apply to consolidated U.S. groups. Nevertheless, the new rules are expansive and are expected to have a significant impact on corporate tax planning techniques that have been utilized for decades.
Government contract impact of temporary inversion regulations
Inverted domestic corporations (IDC) per the FAR are penalized greatly in that the government may not enter into or fund any contract with any such corporation. The FAR provides that a company can avoid being considered an IDC if it can show that the shareholders of the legacy domestic company own less than 80 percent of the former domestic company’s stock by vote or value or if it can show that it has “substantial business activities” in its new country of domicile.
The government contracts inversion test does not venture beyond this 80 percent ceiling to apply the stricter 60 percent ceiling (and thus does not create the 60- to 80-percentage span as does the IRC). While the test for determining whether a company is an inverted domestic corporation under the FAR mirrors the 80 percent threshold test used by the IRC, the FAR does not cross-reference the IRC or its regulations. In fact, in its 2011 rulemaking involving the inversion regulations, the FAR Council expressly stated that the FAR does not rely on the IRC when determining whether a company is an IDC. Accordingly, Treasury regulations – such as the temporary ones issued earlier this week – addressing computation of ownership in the context of the inversion thresholds – do not apply in the government contracts context, unless and until they are adopted into the FAR. Nevertheless, it is conceivable that a procuring agency could take the position that, where the FAR is silent on a particular issue, there is a reasonable basis for adopting Treasury’s interpretation.
It is also worth noting, that Treasury’s temporary regulation could affect state government contracts in states with statutes that specifically rely on the IRC to ascertain whether a company is inverted. For example, proposed New Jersey legislation would define an “inverted domestic corporation” as “a company that has been determined to be an inverted [company by the U.S. Department of the Treasury or] corporation by the Internal Revenue Service pursuant to subsection (b) of section 7874 of the federal Internal Revenue Code (26 U.S.C. s.7874).” In this context, where a procurement statute hinges on the IRC specifically, the new Treasury regulation likely would apply in the analysis of whether a company would be considered to be inverted.
Certainly, Treasury’s new measures introduce significant changes that impact corporate groups, whether inverted or not. Given Treasury’s desire to act rapidly to curb corporate tax inversions and to prevent erosion of the tax base, it is unclear how much consideration – if any – will be afforded to public comment. What is clear, however, is that Congress has not passed new legislation dealing with these issues. Given this fact, Treasury’s regulations could well be subject to challenge in the future.