On September 22, 2014, the Department of Treasury took action against corporate inversions in Notice 2014-52. Generally speaking, an inversion occurs when a U.S. company changes its legal place of residence by restructuring and replacing the U.S. parent with a foreign parent. To accomplish an inversion, a U.S. company merges with a foreign company and the foreign shareholders must own more than 20% of the merged entity. The change in legal residence often benefits companies from a tax perspective. Under U.S. tax law, domestic taxpayers must pay tax on all income, whether earned domestically or abroad. Under most other countries’ tax systems, taxpayers only pay tax on income earned in that country. For example, assume a U.S. company earns $100 in foreign country A. It pays country A’s tax rate of 25% on the $100 ($25). When the U.S. company repatriates the income to the U.S., it pays tax based on the difference between the U.S. rate of 35% and the foreign rate of 25% ($10). The company ultimately pays $35 in tax between the two countries. However, if the company relocates to foreign country A, it will only owe tax to foreign country A and will avoid the additional 10% U.S. tax.
Despite the calls of many to totally eliminate corporate inversions, Treasury did not go so far. In fact, in the press release announcing the Notice, Treasury noted that “genuine cross-border mergers make the U.S. stronger by enabling U.S. companies to invest overseas and encouraging foreign investment to flow into the United States.” Rather, Treasury eliminated many of the loopholes allowing inverted companies to maximize the amount of income they can shield from U.S. taxation.
For example, the Notice limits the ability of companies to avoid U.S. tax by making “hopscotch” loans. Under U.S. law, companies must pay tax on the profits of their controlled foreign corporations (“CFC”) when the profits are repatriated. Several events constitute repatriation, including the CFC’s making a loan to the U.S. parent. Some inverted companies circumvent this rule by making loans to the foreign parent, but the Notice closes the loophole by deeming such loans as made to the U.S. parent, thus triggering U.S. tax.
Treasury will also prevent inverted companies from “restructuring a foreign subsidiary in order to access the subsidiary’s earnings tax-free.” A domestic company must generally pay tax upon accessing the deferred earnings of a CFC. Some U.S. companies avoid this tax by inverting and having the foreign parent buy enough stock of their CFCs to take control away from the U.S. parent. The foreign parent can then access the deferred earnings of the CFC without triggering U.S. tax. The Notice will treat the foreign parent as owning stock of the U.S. parent instead of the CFC and the CFC therefore will remain a CFC and subject to U.S. tax on its deferred earnings. Similarly, the Notice prevents inverted companies from evading U.S. tax by having the new foreign parent sell its stock in the former U.S. parent to a CFC in exchange for cash or property of the CFC.
The Notice also makes it more difficult for companies to invert by buttressing the requirement that the former U.S. owners of the company own less than 80% of the new combined entity. Some inverted companies are able to satisfy the less than 80% requirement easily if the foreign parent possesses a significant amount of passive assets, such as cash and securities, that inflate its size yet are not used in daily business functions. For purposes of the 80% requirement, the Notice disregards the stock of foreign parents attributable to passive assets as long as at least 50% of the foreign parent’s assets are passive. This rule does not apply to banks and other financial service companies.
The Notice also disregards extraordinary dividends made by a U.S. company prior to an inversion that reduce the pre-inversion U.S. company’s size and therefore facilitate its ability to satisfy the 80% requirement.
Finally, many large multi-national companies prefer to avoid the significant internal restructuring required by a typical inversion and therefore invert only part of their business. These companies transfer assets from one of their business operations to a newly incorporated foreign corporation and then spin-off the foreign corporation to its public shareholders. The Notice eliminates inversion treatment for these types of transactions and treats the spun-off company as a domestic corporation.
Although the Notice does not eliminate inversions, it does eliminate some of their benefits. Additionally, given that many have called for both regulatory and legislative action against inversions, Treasury’s Notice effectively places the ball in Congress’ court for any future action. Whether or not Congress will act and what type of action Congress may take are issues that only time will tell.