IRS Makes Move Against Corporate Inversions
posted Nov 21, 2014 by Paul Oliveira, CPA
The Obama administration plans a series of measures to discourage U.S. companies from using international mergers to cut the amount of taxes they owe to the IRS.
In announcing new IRS rules, Treasury Secretary Jack Lew noted that the transactions in the agencies’ crosshairs are “transactions in which a U.S. based multinational restructures so that the U.S. parent establishes a foreign tax domicile, in large part to avoid U.S. taxes.” The agencies are not going after international mergers, he said, adding: “This shifting of a firm’s tax address is not the same as a merger driven by business reasons, such as efficiency or expansion…. Genuine cross-border mergers make the U.S. economy stronger by enabling U.S. companies to invest overseas and encouraging foreign investment to flow into the United States.”
Simply put, a corporate inversion is a process by which an existing U.S. corporation simply changes its country of residence, generally by becoming a subsidiary of a foreign parent corporation, typically with the sole reason of facing a lower tax rate in its new country of residence and paying no U.S. tax on its foreign-source income.
In response to the increased use of an exemption related to substantial business activity in a foreign country, the IRS issued regulations that increased the safe harbor for the substantial business activities test to 25% from 10%. This action can be accomplished through regulations rather than legislation, because the relevant statute does not specify how the substantial business activity test is to be implemented.
Over the years, Congress has passed legislation to tighten the rules related to corporate inversions, but U.S. firms could still shift their headquarters abroad and retain control either by having significant economic operations in the foreign country (and thus be exempt from anti-inversion provisions) or by merging with a foreign firm at least 25% the size of the U.S. company.
Curbing two basic aspects
In an effort to further rein in corporate inversions, the IRS issued Notice 2014-52, describing regulations that will generally apply to transactions completed on or after Sept. 22, 2014. These regulations address two basic aspects of inversions:
- They limit the ability to access the accumulated deferred earnings of foreign subsidiaries of U.S. firms.
- They tighten ownership requirements. Inversions are now allowed as long as the old U.S. firm’s shareholders own less than 80% of the merged company. The new regulations limit the ability of companies to count passive assets that are not part of the entity’s daily business functions in order to inflate the new foreign parent’s size and evade the 80% rule. Banks and other financial services companies would be exempt from this requirement.
The new regulations do not prohibit cross-border mergers or address earnings stripping by shifting debt to the U.S. firm. The Treasury Department has said that only legislative action could fully restrict inversions.
Limiting access to earnings
Because a firm has inverted and the U.S. firm is a subsidiary of a foreign parent, there are methods of accessing the earnings of overseas subsidiaries. The regulations include three ways to block this:
- Prevent hopscotch loans. The regulations would prevent access to funds by what are known as hopscotch loans. In this process, the U.S. company’s foreign subsidiary lends money to the new foreign parent. Under the new regulations, these types of loans would be treated as an investment in U.S. property subject to dividend tax.
- Prevent decontrolling. After inverting, some U.S. multinationals have the new foreign parent buy enough stock to take control of the controlled foreign corporation (CFC) from the U.S. parent. This decontrolling tactic lets the foreign parent access the deferred earnings of the CFC without ever paying U.S. tax on them. Under the new regulation, the new foreign parent would be treated as owning stock in the former U.S. parent, rather than the CFC. The CFC would remain a CFC and remain subject to U.S. tax on its profits and deferred earnings.
- Prevent tax-free repatriations. Following some inversions, the new foreign parent sells its stock in the former U.S. parent to a CFC with deferred earnings in exchange for cash or property of the CFC, effectively resulting in a tax-free repatriation of cash or property bypassing the U.S. parent. The new regulations eliminate the ability to use this strategy.
What the future may hold
In a report on the new regulations, the Congressional Research Service (CRS) noted that the current debate in Congress on inversions is fluid: Some prefer a targeted approach, while others believe that inversions should be addressed only in the context of comprehensive tax reform.
The CRS, which provides policy and legal analysis to committees and members of the U.S. Congress, says the administrative remedies recently promulgated and under consideration may contribute to policymaking but they are limited in their scope, and so legislative measures continue to be under consideration.
Following the announcement of the new regulations, Senate Finance Committee Chairman Ron Wyden, D-Ore., and the committee’s top Republican, Orrin Hatch of Utah, said they were committed to putting together a stopgap measure to reduce the benefits of tax inversions that could win support from both parties.
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