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From Securities Regulation Daily, September 23, 2014

Treasury acts to curb corporate merger inversions

By Jim Hamilton, J.D., LL.M.

Against the backdrop of pending Congressional legislation, Treasury and the IRS acted to reduce the tax benefits of, and when possible, stop corporate merger tax inversions. This is an administrative effort to significantly diminish the ability of inverted companies to escape U.S. taxation. For some companies considering mergers, yesterday’s action will mean that inversions no longer make economic sense.

Specifically, guidance and rules eliminate techniques that inverted companies currently use to access the overseas earnings of foreign subsidiaries of the U.S. company that inverts without paying U.S. tax. The administrative action applies to deals closed yesterday or after. It is not retroactive.

Treasury said that it would continue to examine ways to reduce the tax benefits of inversions, including through additional regulatory guidance as well as by reviewing tax treaties and other international commitments.

In a statement, Senate Finance Committee Chair Ron Wyden (D-Or.) said that, while Treasury’s action underscores the urgency of dealing with corporate inversions, only Congress has the full range of tools to address the immediate problem of inversions and ensure that U.S. companies can be globally competitive. Chairman Wyden intends to move bi-partisan legislation in the lame duck session of Congress to immediately address corporate inversions.

Corporate inversion. A corporate inversion is a transaction in which a U.S. based multinational restructures so that the U.S. parent is replaced by a foreign parent, in order to avoid U.S. taxes. Current law subjects inversions that appear to be based primarily on tax considerations to certain potentially adverse tax consequences, but it has become clear by the growing pace of these transactions that for many corporations, these consequences are acceptable in light of the potential benefits.

Hopscotch loan. Taking action under Section 956(e) of the Internal Revenue Code, the regulators will now prevent inverted companies from accessing a foreign subsidiary’s earnings while deferring U.S. tax through the use of creative loans, which are known as “hopscotch” loans. Under current law, U.S. multinationals owe U.S. tax on the profits of their controlled foreign corporations (CFCs) although they don’t usually have to pay this tax until those profits are repatriated (that is, paid to the U.S. parent firm as a dividend). Profits that have not yet been repatriated are known as deferred earnings.

Currently, if a CFC tries to avoid this dividend tax by investing in certain U.S. property, such as by making a loan to, or investing in stock of its U.S. parent or one of its domestic affiliates, the U.S. parent is treated as if it received a taxable dividend from the CFC. However, some inverted companies get around this rule by having the CFC make the loan to the new foreign parent, instead of its U.S. parent. This “hopscotch” loan is not currently considered U.S. property and is therefore not taxed as a dividend. The new rules will remove the benefits of these “hopscotch” loans by providing that such loans are considered U.S. property for purposes of applying the anti-avoidance rule. The same dividend rules will now apply as if the CFC had made a loan to the U.S. parent prior to the inversion.

De-controlling strategy. After an inversion, some U.S. multinationals avoid ever paying U.S. tax on the deferred earnings of their CFC by having the new foreign parent buy enough stock to take control of the CFC away from the former U.S. parent. This “de-controlling” strategy is used to allow the new foreign parent to access the deferred earnings of the CFC without ever paying U.S. tax on them.

Acting under Section 7701(l) of the tax Code, Treasury will prevent inverted companies from restructuring a foreign subsidiary in order to access the subsidiary’s earnings tax-free. The new rules would treat the new foreign parent as owning stock in the former U.S. parent, rather than the CFC, to remove the benefits of the “de-controlling” strategy. The CFC would remain a CFC and would continue to be subject to U.S. tax on its profits and deferred earnings.

Treasury also closed a loophole in the federal tax code to prevent inverted companies from transferring cash or property from a CFC to the new parent to completely avoid U.S. tax. This action Section 304(b)(5)(B) would impact transactions involving the new foreign parent selling its stock in the former U.S. parent to a CFC with deferred earnings in exchange for cash or property of the CFC, thereby effectively resulting in a tax-free repatriation of cash or property bypassing the U.S. parent.

Cash boxes. Finally, the Obama Administration’s actions would make it more difficult for U.S. entities to invert by strengthening the requirement that the former owners of the U.S. entity own less than 80 percent of the new combined entity. Action under Code Section 7874 would limit a firm’s ability to count passive assets that are not part of its daily business functions in order to inflate the new foreign parent’s size and thereby evade the 80 percent rule, known as using a cash box.

Companies can successfully invert when the U.S. entity has, for example, a value of 79 percent, and the foreign acquirer has a value of 21 percent of the combined entity. However, in some inversion transactions, the foreign acquirer’s size is inflated by passive assets, also known as “cash boxes,” such as cash or marketable securities. These assets are not used by the entity for daily business functions. Yesterday’s notice would disregard stock of the foreign parent that is attributable to passive assets in the context of this 80 percent requirement. This would apply if at least 50 percent of the foreign corporation’s assets are passive. Banks and other financial services companies would be exempted.

In some instances, a U.S. entity may pay out large dividends pre-inversion to reduce its size and meet the 80 percent threshold, also known as “skinny-down” dividends. Treasury will, under Section 7874, now disregard these pre-inversion extraordinary dividends for purposes of the ownership requirement, thereby raising the U.S. entity’s ownership, possibly above the 80 percent threshold.

In some cases a U.S. entity may invert a portion of its operations by transferring a portion of its assets to a newly formed foreign corporation and then spinning-off that corporation to its public shareholders. This transaction takes advantage of a rule that was intended to permit purely internal restructurings by multinationals. Under yesterday’s action under Section 7874, the spun-off foreign corporation would not benefit from these internal restructuring rules with the result that the spun off company would be treated as a domestic corporation, eliminating the use of this technique for these transactions.

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