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In February, Johnson Controls, a Milwaukee-based manufacturing company, announced plans to merge with Ireland-based Tyco International. This was the latest in a string of transactions, commonly called an “inversion,” under which an American company restructures and reincorporates in a foreign country. One of the few areas of agreement in Washington is that inversions are a serious problem requiring urgent attention, but of course opinions are all over the map as how to respond. Here we take a look at the history of these transactions, legislative and regulatory responses, and what really needs to be done.
While frequently cast as a recent phenomenon, these kinds of transactions have been taking place for more than 30 years. The first occurred in 1983 and involved McDermott International, which inverted and became a Panamanian company. While inversion news went silent for almost an entire decade, in 1993, Helen of Troy, a U.S. cosmetics company, inverted to Bermuda. Gaining Helen of Troy extra notoriety, the transaction was entirely tax free to both its shareholders and the company itself.
In response to this second inversion, the Treasury Department in 1996 promulgated regulations under Internal Revenue Code (IRC) Section 367, ensuring that tax would be collected on shareholder-level gains in inversion transactions. However, since the new regulation would not have resulted in tax owed by the former U.S. company, the new regulation had little deterrent effect against undertaking inversions from the entity-level perspective.
In the late 1990s and early 2000s, facing only shareholder-level tax consequences, companies such as Cooper Industries, Foster Wheeler, and Global Crossing continued to reorganize their corporate structures so that the parent of the resulting organization was no longer a U.S. company but rather a foreign company in a lower tax jurisdiction. Under these inversions, the underlying business was not changed and the shareholders of the former U.S. parent became the shareholders of the new foreign parent company. Generally in these transactions, neither capital nor employment shifted abroad, and headquarters remained in the United States. In other words, no business activities were shifted to the foreign country of the new parent company. These inversions appeared to some policymakers to be purely tax motivated.
As these inversion transactions continued into the early 2000s, Congress responded with section 7874 as part of the American Jobs Creation Act of 2004 (AJCA). Pursuant to AJCA, for transactions occurring after March 4, 2003, an inversion would be respected for U.S. tax purposes if the U.S. company has “substantial business activities” in the foreign country.
“Substantial business activities” was not defined under section 7874 but was left to regulatory guidance, which came out in 2006. At present, regulations define “substantial business activities” as the company having 25% of its employees, assets, and income located in, or derived from, the relevant foreign country. While the current threshold is 25%, Treasury has periodically revised the threshold. Further,
- The 2006 regulations provided a safe harbor (automatically preventing certain transactions from being cast as inversions) generally requiring at least 10% of group headcount, assets, and sales in the foreign jurisdiction. In 2009, the safe harbor was dropped.
- The 2006 regulations also created a facts and circumstances test, but in 2012, Treasury abandoned it in lieu of the current bright-line 25% test.
If the U.S. company does not have “substantial business activities” in the foreign country, the tax treatment of the new foreign parent is dependent upon the percentage of the continuing ownership stake.
- If the continuing ownership stake is 80% or more, the new foreign parent is treated as a U.S. corporation, thereby nullifying the corporate inversion for tax purposes (i.e., the company continues to be subjected to U.S. tax on its worldwide income).
- If the continuing ownership stake is at least 60% but less than 80%, the new foreign parent is respected but other adverse tax consequences may follow. Specifically, any U.S. taxes on gains applicable to transfers of assets to the new inverted company (“inversion gain”) cannot be offset with foreign tax credits or net operating losses.
Inversions again were on the upswing in recent years but, this time, not just for tax reasons. While near-term tax benefits remain, American companies striving for global expansion resort to inversions as a self-help mechanism to level the global tax playing field.
In September 2014, reacting to the inversion upswing, Treasury issued Notice 2014-52 (the “2014 Notice”) applicable to transactions completed on or after September 22, 2014. The Notice affirmed Treasury’s intent to issue regulations to both make it more difficult to invert as well as to tap into overseas earnings.
To the first end, the 2014 Notice proposed modifying several techniques used to achieve the 80% or less ownership requirement to be treated as an inverted company. The notice proposed changes to anti-stuffing rules, the treatment of extraordinary dividends, and the treatment of spin-offs undertaken in conjunction with the inversion. To make accessing offshore cash more challenging, the Notice proposed modifications to the hopscotch rules, disregarded certain decontrolling of controlled foreign corporations (CFCs) after inversion, and modified certain related party stock sale rules.
Most recently, in November 2015, Treasury issued Notice 2015-79 proposing rules again making it harder to invert and harder to remove CFCs from under the U.S. company to the new foreign parent. Applicable to transactions on or after November 19, 2015, Notice 2015-79 (the “2015 Notice”) proposed a tax residency requirement and other modifications to the 80% ownership test, including third-country rules and additional anti-stuffing directives. Applicable on or after the issuance of the 2014 Notice, rules are proposed that expand the scope of currently taxable inversion gain and require recognition of all built-in gain (BIG) in CFC stock.
In short, Treasury has sought through ever-tighter rules to slow the pace of inversions. Treasury was at first somewhat successful, until tax professionals came to understand the rules so that they could again proceed with transactions compelled by fundamental economic and tax forces.
Along the way, we’ve also seen some equally misguided congressional proposals. Sens. Schumer (D-NY) and Durbin (D-IL) each proposed to punitively treat inverted companies’ interest deductions differently than other similarly situated taxpayers, thereby discouraging foreign investment and adding complexity to the Code. Reps. Levin (D-MI) and Van Hollen (D-MD) just reintroduced this misguided approach in the House. Senate Finance Committee Ranking Member Wyden (D-OR) is purportedly considering his own legislation. The administration, not one to miss out, also proposed anti-inversion language in its budget proposals.
Even after all these changes and proposals, shifts of U.S. assets and companies abroad continue. Outright purchases of U.S. companies continue at record levels. Hundreds of U.S. companies are acquired or taken over by foreign firms each year, and the administration’s rules and these congressional proposals would only accelerate these trends.
So what has Congress achieved?
- U.S. companies are still being picked off by foreign companies.
- Fewer and fewer of the benefits of these companies’ activities are remaining with the U.S. economy.
Is this really the desire of the administration and Congress?
Instead of focusing on punitive measures that ultimately make our antiquated and anti-competitive tax system more so, let’s address the real issues—the aspects of the U.S. tax system driving these transactions. Fortunately, we know what those are: high tax rates and an anti-competitive international tax system. And we know how to fix them. It’s time for the administration and Congress to get serious about comprehensive tax reform that American businesses so desperately needs.