What Are Corporate Inversions?
On May 20, 2014, the ranking member of the Ways and Means Committee, Sen. Carl Levin, D-Mich., introduced the Stop Corporate Inversions Act of 2014. The proposed legislation followed the basic proposal introduced by the president in his fiscal year 2015 budget.
What are corporate inversions and why are they the focus of so much attention?
Worldwide Taxation Versus Territorial Taxation
The U.S. federal corporate tax rate is the highest in the world at 35 percent, plus potential state-level taxation. The U.S. also operates a system of worldwide taxation—all income earned by a U.S. company is subject to taxation at 35 percent, plus potential state-level taxation, once it has been included in the U.S. company’s federal income tax return. There is no exemption for income earned in a foreign country; everything earned by a U.S. company is subject to taxation when earned or at the time it is repatriated.
As a result of our worldwide system of taxation, many U.S. multinational corporations (MNC) have designed complex foreign holding structures that enable them to keep their profits off shore indefinitely without incurring U.S. taxation. However, because the U.S. reserves the right to tax foreign source income once it is repatriated, MNCs are required under generally accepted accounting principles (GAAP) to provide a tax reserve on their financial statements to account for the residual U.S. taxation—the difference in tax rate between the U.S. and the country where the income was earned—that would be payable at some point in the future when the foreign source income is repatriated. For example, if the income was earned in the United Kingdom, where the tax rate is only 21 percent, the residual U.S. tax due on that income when it is repatriated would be 14 percent. The net effect of the requirement to post a reserve on their financial statements eliminates the benefit MNCs may gain from keeping their money off shore. There are exceptions to the requirement, but they require the earnings to be permanently kept off shore. In other words, the cash MNCs earn from their foreign operations can never be brought back to the U.S., which puts U.S. companies at a disadvantage.
Most countries in the world operate a “territorial” tax system, which is the opposite of the U.S. worldwide taxation system. Under a territorial tax system, all foreign income is exempt from taxation once it has been repatriated to the country where the taxpayer has located its parent company. This means MNCs are free to move their foreign earnings back to the home country’s jurisdiction without paying taxes on that income. In this system, there is no need to post a reserve for potential home country taxation or designate the earnings as permanently reinvested to avoid the GAAP reserve requirement. Thus, a territorial tax system offers a huge potential advantage for foreign MNCs by allowing them to use capital more freely to finance their worldwide operations.
Goal of Inversions
Considering the differences between the U.S. worldwide system of taxation and the use of a territorial system of taxation—and the relief from the burdensome requirements of U.S. accounting principles—many companies employ “inversion” transactions.
The goal of an inversion transaction is to find a foreign corporation that operates a similar line of business to the U.S. MNC, at which point a U.S. MNC negotiates a merger with the foreign corporation. As part of that merger, the U.S. MNC’s foreign subsidiaries are transferred out from under the ownership of the U.S. company. The effect of the transaction is that all the foreign income that otherwise would have been subject to U.S. taxation is now held under a new parent company—a foreign company—which typically is organized in a country that employs a territorial tax system.
Thus, with one simple merger transaction, the U.S. MNC can eliminate future liability for the residual U.S. taxation and provide the new parent company the ability to use all the foreign earnings.
Effects of Proposed Law
U.S. tax code prohibits U.S. companies from reincorporating overseas through an inversion unless the stakeholders of the foreign company maintain more than 20 percent of the combined foreign corporation. The Stop Corporate Inversions Act would change the threshold so stakeholders of the foreign company must maintain at least 50 percent of the combined company. The bill also would prohibit U.S. companies from reincorporating overseas through an inversion if the affiliated group including the combined foreign entity is managed and controlled in the U.S. and conducts significant domestic business activities in the U.S.
However, the bill would continue to provide a broad exception from the Section 7874 rules if the affiliated group has substantial business activities—25 percent of employees by number, employees by compensation, assets and income—in the foreign country where the combined entity is domiciled. The proposed legislation would apply to inversion transactions completed after May 8, 2014.
Because of the political deadlock in Washington, the legislation described above has not been considered for passage by Congress.
In light of increased deal flow involving large U.S. MNCs, on September 9, 2014, the U.S. Treasury Department announced regulatory actions designed to curb inversion transactions until the legislation can be passed and signed into law. The regulatory action taken by Treasury includes:
- Making it more difficult for the new foreign parent company of the U.S. MNC to access the cash held in the MNC’s foreign subsidiaries through loan transactions. In other words, if the new parent tries to take a loan from a foreign subsidiary still held by the U.S. MNC after the inversion, the Treasury would treat that loan as if it were made to the former U.S. parent company, making it currently taxable in the U.S.
- Preventing inverted companies from restructuring a foreign subsidiary to access the subsidiary’s earnings tax-free
- Closing the loophole to prevent an inverted company from transferring cash or property from a controlled foreign corporation to the new parent to completely avoid U.S. tax. (These types of transactions involve the new foreign parent company selling its stock in the former U.S. parent to a controlled foreign subsidiary of the former U.S. parent with deferred earnings in exchange for cash or property of the foreign company. The result is effectively tax-free repatriation of earnings that otherwise would have been subject to U.S. taxation.)
- Making 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 through the following new rules:
- Limiting the ability of companies to count passive assets not part of the entity’s daily business functions to inflate the new foreign parent’s size and, therefore, evade the current 80 percent rule, known as using a “cash box”
- Preventing U.S. companies from reducing their size pre-inversion by making extraordinary dividends to reduce the size and value of the U.S. company, known as “skinny down” dividends
- Preventing a U.S. entity from inverting a portion of its operations by transferring assets to a newly formed foreign corporation that it spins off to its shareholders, thereby avoiding the associated U.S. tax liabilities, known as a “spinversion”
Inversion transactions have a simple goal: avoiding U.S. taxation on the foreign earnings of U.S. MNCs. As a result of the latest Treasury actions and the proposed legislation, there has been a slowing of deal movement on inversions. It’s uncertain what the U.S. tax treatment of these transactions will be going forward. Taxpayers should closely monitor new developments to understand the current state of the rules before considering any transaction of this type.