Jeff Paravano, Paul Schmidt and John Bates of BakerHostetler LLP provide an in-depth look at corporate inversions and the need for reform in the US.
Broadcom, Burger King, Pfizer, Medtronic, Chiquita, AbbVie, Mylan and Walgreens, among many other companies, have attracted considerable attention over their plans to (or in some cases the mere announcement that they were evaluating whether to) become non-US based. Due to significant business opportunities offshore, inversions have become a popular strategy as merger and acquisition activity increases. The United States’ outdated tax system which includes worldwide taxation of corporate income and a high corporate tax rate puts US-based multinationals at a competitive disadvantage. The hype surrounding inversions could serve as the catalyst to encourage Congress to finally take action toward much-needed tax reform. In the short term, however, election-year politics combined with disagreements as to the appropriate policy response have thwarted any Congressional action. With Congressional action on tax reform before 2017 unlikely, self-help to territorial taxation will continue for some multinational businesses.
An inversion is a transaction that results in an existing US-based company becoming a non-US-based company or a subsidiary of a non-US-based parent. Historically, inversions involved US companies re-domiciling to tax havens. Since the enactment of anti-inversion legislation in 2004, however, inversions have generally involved a merger between a US-based multinational and a non-US-based company, with the parent company post-transaction being headquartered outside of the United States. In certain transactions the US company may become non-US-based, even if all senior-level executives remain in the US.
Why companies invert
An inversion may lead to meaningful tax synergies, driving down the worldwide effective tax rate of the combined group. By creating or combining with a non-US-based parent, the restructured group avoids worldwide taxation by the United States of its income, thereby significantly reducing the group’s tax liabilities.
Some inversions result from a US-based corporation purchasing a foreign company, often paying a premium reflective of the resulting inversion benefits. In other cases, US-based companies are targeted by foreign-based corporations in a position to pay a premium reflective of the tax benefits that result from the US-based target no longer being headquartered in the United States. The primary tax benefit achieved in both cases is territorial, rather than worldwide taxation of corporate earnings.
The US has an outdated tax system that taxes worldwide, rather than only United States, income; it also has the highest effective corporate tax rate in the world. The ability of an inverted company to become taxed by the United States on a territorial (rather than worldwide) basis and also to shift certain types of income outside of the US drives inversions. There are three basic tax benefits of inverting:
Potential tax costs
There are several tax considerations that must be taken into account in connection with an inversion transaction.
How tax benefits manifest themselves
Tax benefits are one of several “synergies” that are quantifiable in a cross-border merger. The value of the anticipated tax synergies frequently becomes part of the acquisition currency for the transaction. Most of the inversion transactions to date have involved premiums to the US-based or foreign-based target shareholders, with the tax synergies contributing substantially to those premiums. Because the worldwide effective tax rate of inverted companies is considerably lower after they are no longer US-based, the inversion provides substantial shareholder value.
Relocation of US-based companies
US-based companies frequently (but not exclusively) relocate to European jurisdictions such as Ireland, the Netherlands and the United Kingdom, due to their territorial tax systems and competitive tax rates. Business drivers such as the location of manufacturing plants, customer bases, and preferred locales for management operations often help narrow the choice of headquarter jurisdiction.
In September 2014, the United States Treasury released Notice 2014-52 to address certain tax benefits of inverting and structuring approaches. That Notice and regulations intending to limit an inverted company’s ability to access trapped cash have slowed but not stopped inversions. The guidance also tightens anti-inversion rules to make it more difficult to avoid “failing” the 60 per cent and 80 per cent thresholds. The new rules apply to inversions completed on or after 22 September 2014.
Notably, neither the Notice nor regulations provide specific rules dealing with earnings stripping, although the Notices states that Treasury is considering future guidance to address earnings stripping. Further, the Notice indicates that any such guidance would apply prospectively, except that the 22 September 2014 effective date would apply to inverted companies. Thus, future guidance may not be limited to inverted companies and may represent generally applicable rules addressing base erosion and profit shifting.
Repatriation and access to trapped cash
Under the US worldwide tax system, a US parent company is not subject to current taxation on the active earnings of its controlled foreign subsidiaries (controlled foreign corporations (CFCs)) but is subject to tax when the CFCs repatriate the earnings – this is referred to as “deferral”. The US tax serves as a disincentive to repatriate foreign earnings.
For inversions completed prior to the effective date of the Notice, after the US group became owned by a new foreign parent, the cash and assets accumulated offshore by the CFCs could be accessed by the foreign parent and foreign sister companies under the foreign parent through loans or equity investments “hopscotching” the US parent, joint venture investments, or certain cross-chain sales. In addition, the new foreign parent could transfer assets to the CFCs in exchange for a sufficient interest to give the foreign parent control of the foreign subsidiary, thereby causing the foreign subsidiary to cease being subject to the “anti-deferral” rules applicable to CFCs, which can tax the US parent currently on certain passive income of the CFCs.
The Notice provides several rules that limit the new foreign parent’s ability to access the cash of the CFCs without incurring US tax or its ability to avoid the application of the anti-deferral rules. The first and second rules would apply to an inverted US company where former shareholders own at least 60 per cent but less than 80 per cent of the new foreign parent. Under the first rule, a debt or stock investment by a CFC in the new foreign parent or a foreign sister company during the 10 years following the inversion would cause the inverted US company to recognise a taxable constructive dividend up to the amount of the loan or equity investment.
Second, the Notice addresses specified “decontrolling” transactions, among others, involving CFCs of the inverted US company. As an example of a decontrolling transaction, after an inversion, the new foreign parent could make a stock investment in a foreign subsidiary of the inverted domestic company, such that the new foreign parent owned 50 per cent or greater of the stock of the foreign subsidiary. Absent the Notice, the foreign subsidiary would cease to constitute a CFC and therefore would cease to be subject to the anti-deferral rules, and the foreign subsidiary’s cash could be accessed without triggering US tax liability. Under the new rules, specified transactions occurring within 10 years following the inversion will be recast so that the foreign subsidiary will remain a CFC and will remain subject to anti-deferral rules.
Finally, the guidance precludes a specific method of accessing CFC cash through an intra-group sale of stock. Absent the new rules, if after an inversion the new foreign parent sold stock of the inverted US company to one of its CFCs, the CFC could be treated as paying a dividend directly to the new foreign parent, and the constructive dividend would not be subject to US tax. Under the new rules, the CFC will not be treated as paying a dividend to the new foreign parent, and the CFC’s earnings will remain at the level of the CFC and will remain subject to US tax.
Recent guidance and inversion structuring techniques
The guidance tightens the existing anti-inversion rules, making it more difficult for the new foreign parent to avoid failing the 80 per cent and 60 per cent thresholds. Generally, under the existing rules, the 80 per cent or 60 per cent thresholds may be avoided if the value of the foreign merger partner exceeds 20 per cent or 40 per cent, respectively, of the value of the new foreign parent after the inversion. Under the new rules, first, if 50 per cent or greater of the assets of the foreign merger partner are “passive” assets, such as cash or marketable securities, the value of the passive assets will not be taken into account in applying the 80 per cent and 60 per cent tests.
Second, extraordinary “skinny-down” distributions by the inverting US company made within the three years preceding the inversion are not taken into account in determining its value for purposes of applying the 80 per cent and 60 per cent tests. Such distributions also are not taken into account for purposes of determining the taxability of any US shareholders of the inverted US company in connection with the inversion. Distributions for these purposes are not limited to distributions that are treated as dividends and includes distributions of subsidiaries in “spin-offs” occurring within the three-year period. Finally, “spin-versions,” in which a part of a US company is spun-off in connection with an inversion, are precluded.
The Notice will have a direct impact on certain aspects of inverting but is not sufficiently comprehensive to prevent inversion transactions from proceeding or to stop the inversions trend. Many of the transactions that have occurred, are pending or are being contemplated reflect a strategic business combination of which the inversion tax synergies are merely one consideration. In addition, not all inversion transactions are done to access trapped cash offshore and even those strongly motivated thereby may have alternative financing or structuring options. The benefits of moving to a territorial tax system and moving certain income-producing activities to lower-rate jurisdictions also remain. An inverted company also benefits from removing its future foreign growth from the US worldwide tax system. In addition, the earnings stripping benefits that allow a reduction in tax on US earnings seemingly remain, although future regulatory action could limit earnings stripping and could apply retroactively.
Public perception is a factor, especially for companies that have direct interaction with consumers or regularly contract with the United States government. The president has branded inverted companies as “corporate deserters” and unpatriotic. Those considerations, however, do not prevent US-based companies from being targeted by larger foreign competitors; nor does it prevent those larger foreign competitors from using escape by the US-based target of the outdated US tax system of worldwide taxation as currency to move US-based worldwide corporate leadership to headquarters outside the United States. If the inversion trend accelerates, worldwide corporate leadership will become more and more non-US-based over time, with US leaders focused on running subsidiaries in the United States for corporate groups controlled and headquartered by non-US leaders. Ultimate decisions about where to locate a plant, where to perform research and development, etc, will more and more often be made by non-US corporate executives.
Corporate tax reform – on the horizon?
The continuing loss of US-based worldwide corporate leadership resulting from self-help relief from worldwide US taxation through inversions should help accelerate United States tax reform.
There is obviously nothing wrong with a global economy, or with ownership of US companies by persons around the world. There is something very wrong, however, with outdated federal tax laws that exert economic pressure on US-based companies not to remain headquartered in the United States and also make US-based companies economically vulnerable to be taken-over by companies headquartered in other jurisdictions. US policymakers should be less focused on maintaining or strengthening walls preventing corporate emigration and instead take steps to make those walls unnecessary and obsolete. In any case, tax reform in the United States remains unlikely in the near term, with the first realistic hope for such reform being sometime in 2017.
Inversions will continue until tax reform is enacted
Under current law, the Treasury Department is limited in its ability to fully address inversions. Congressional action is necessary for that, and long-term solutions are only achievable through comprehensive corporate tax reform. Tax reform takes time, and in the current United States political climate is unlikely to occur before 2017 at the earliest.