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FIVE CHANGES COMING TO U.S. TAX LAW THAT REDUCE THE BENEFITS OF CORPORATE INVERSION TRANSACTIONS

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Since 2011, there have been 37 corporate transactions announced in which U.S. companies sought to reincorporate in other countries where the corporate tax rates are more favorable—a business strategy known as a “corporate inversion” transaction. In 2015 alone, there have been seven tax inversion M&A transactions for a combined total of $181.6 billion in market value.

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FIVE CHANGES COMING TO U.S. TAX LAW THAT REDUCE THE BENEFITS OF CORPORATE INVERSION TRANSACTIONS

  1. 1. FIVE CHANGES COMING TO U.S. TAX LAW THAT REDUCE THE BENEFITS OF CORPORATE INVERSION TRANSACTIONS By Neil Aragones, Esq., LL.M. Since 2011, there have been 37 corporate transactions announced in which U.S. companies sought to reincorporate in other countries where the corporate tax rates are more favorable—a business strategy known as a “corporate inversion” transaction. In 2015 alone, there have been seven tax inversion M&A transactions for a combined total of $181.6 billion in market value. The most recent proposed inversion is perhaps the most staggering: Pfizer, a company that was founded in New York back in 1849, is seeking to merge with Allergan, an Ireland-based pharmaceutical company, as part of a $160 billion deal that would result in Pfizer’s reincorporation outside of U.S. borders. Rise of Corporate Inversions Corporate inversion transactions are not a new phenomenon. Under the President George W. Bush Administration, Congress took action in 2002 by passing laws that were intended to stop them. The number of inversions slowed to a trickle in the years that followed, but resumed toward the end of the decade and have accelerated in recent years. The strategy behind inversions is quite simple: to reduce the amount of money paid in corporate taxes under current U.S. tax law. The foreign company with whom the U.S. company merges essentially becomes the new legal parent company of the multinational operations, even though the U.S. company may continue to function as the parent for management purposes. In fact, in most cases, the executives remain in place, the location of all employees remains unchanged and everything else is business as usual. It would appear the companies that have pursued this strategy have found what they were seeking. A new study from the University of Illinois found that “corporate expatriation inversions generated statistically and economically significant excess returns on the order of 225 percent above market returns in the years following the inversion.” January 2016
  2. 2. The 2014 Effort Lays the Groundwork for Control In 2014, Congress made another attempt to halt the surge in corporate inversions with the introduction of the Stop Corporate Inversions Act of 2014 (H.R. 4679, S. 2360). This bill sought to amend the Internal Revenue Code to revise rules for the taxation of inverted corporations to provide that a foreign corporation that acquires the properties of a U.S. corporation will be subject to U.S. taxation if they pass one of two tests after the transaction is completed: (1) It holds more than 50% of the stock of the new entity; or (2) The management or control of the new entity occurs primarily within the U.S. and the new entity has significant domestic business activities. The bill was referred to the House Ways and Means Committee and the legislation was re-introduced in 2015 (H.R. 415, S. 198). Meanwhile, as to Executive Branch action, in the fall of 2014 the Treasury Department and Internal Revenue Service issued IRS Notice 2014-52, announcing rules that accountants and tax lawyers have come to know quite well over the past year. Although the rules were intended to curtail corporate inversion transactions, U.S. Treasury officials sought to be careful as to not preclude genuine cross-border mergers or foreign investment in U.S. companies. As a result, they took a fairly balanced approach to Notice 2014-52, leaving in place many of the basic rules in the tax code. Five Key Changes Announced in 2015 Against this backdrop, the Department of the Treasury and the IRS issued a notice on November 19, 2015. In announcing the agencies’ intentions to issue additional regulations, IRS Notice 2015-79 takes additional steps to reduce the tax benefits of corporate inversions in order to stop as many of them as possible from taking place. “Last year, Treasury took targeted action to address inversions. This notice made a real difference by reducing some of the economic benefits of inversions, resulting in a decline in the pace of these transactions,” said Treasury Secretary Jacob J. Lew, in the official press release regarding the new notice. “This next action makes it even harder to invert, and further reduces the tax benefits for U.S. companies.” Under the 2014 rules, if the continuing ownership stake in the newly merged company is 80 percent or more, the new foreign parent is treated as a U.S. corporation (despite the new corporate address), thereby nullifying the corporate inversion for tax purposes. If the continuing ownership stake is at least 60 but less than 80 percent, U.S. tax law respects the foreign status of the new foreign parent but other potentially adverse tax consequences may follow. The new notice involves transactions in this continuing ownership range of 60 to 80 percent. Here are five key changes to the U.S. tax law contained in the 2015 notice regarding corporate inversion transactions: 1. Limiting of the ability of U.S. companies to combine with foreign entities when the new foreign parent is located in a “third” country. (Action under section 7874 of the Code) The new notice provides that in certain cases when the foreign parent company is a tax resident of a third country, stock of the foreign parent issued to the shareholders of the existing foreign corporation will be disregarded for purposes of the ownership requirement, thereby raising the ownership attributable to the shareholders of the U.S. entity, possibly above the 80-percent threshold. The rule addressing “third country” inversions will prevent U.S. firms from essentially cherry-picking a tax-friendly country in which to locate their tax residence. 2. Limiting of the ability of U.S. companies to inflate the new foreign parent corporation’s size and therefore avoid the 80-percent rule. (Action under section 7874 of the Code) In some inversion transactions, the foreign acquirer’s size may be inflated by “stuffing” assets into the foreign acquirer as part of the inversion transaction in order to avoid the 80-percent rule. The new IRS notice clarifies that the “anti-stuffing” regulations will be issued and will apply to any assets acquired with a principal purpose of avoiding the 80-percent rule, regardless of whether the assets are passive assets.
  3. 3. 3. Strengthening of the substantial business activities exception. (Action under section 7874 of the Code) Under current law, a U.S. company can successfully invert if, after the transaction, at least 25 percent of the combined group’s business activity is in the foreign country in which the new foreign parent is created or organized. This is the case regardless of whether the new foreign parent is a tax resident of that foreign country. The new regulations will provide that the combined entity cannot satisfy the 25-percent business activities exception unless the new foreign parent is a tax resident in the foreign country in which it is created or organized. This change will limit the ability of a U.S. multinational company to replace its U.S. tax residence with tax residence in another country in which it does not have substantial business activities. 4. Expansion of the scope of inversion gain for which current U.S. tax must be paid. (Action under section 7874 of the Code) Under current law, U.S. corporate profits that have not yet been repatriated are known as deferred earnings. However, to the extent a company has passive income, the U.S. parent is treated as if it received a taxable deemed dividend from the foreign company. The new regulations will expand the scope of inversion gain to include certain taxable dividends recognized by an inverted company. Specifically, when that dividend is attributable to passive income recognized by a foreign company, the inversion gain will be taxable. 5. Requirement that all built-in gain in foreign stock be recognized, without regard to the amount of deferred earnings. (Action under section 367 of the Code) After an inversion transaction, the new foreign parent may acquire stock held by the former U.S.-parented group, with the result that the company is no longer under the U.S. tax net. Now, all the built-in gain in the foreign company stock will be recognized as a result of the post-inversion transfer, regardless of the amount of the company’s deferred earnings, thereby potentially increasing the amount of current U.S. tax paid as a result of the transfer. Conclusion There are no signs that corporate inversion transactions will vanish any time soon, especially now that executives are able to quantify the bottom-line financial benefits of reincorporating outside of U.S. tax rules. Moreover, as we enter an election year, there are likely to be ongoing public debates about the policy implications of inversions. These recent changes to the U.S. tax law are intended to make it more difficult for U.S. companies to invert—and reduce the tax benefits of inversions that have already taken place. Tax law professionals need to stay abreast of these shifting tides. ABOUT THE AUTHOR Neil Aragones, Esq., LL.M., is a member of the LexisNexis® Tax Editorial team, specializing in U.S. Federal and International Taxation, curating federal tax content and writing on federal tax issues. He joined LexisNexis as an editor in 2000 and joined the tax group in 2005. Mr. Aragones attended the University of Pittsburgh for his undergraduate degree and the Cleveland-Marshall College of Law, Cleveland State University for his law degree. In addition, he attended the Case Western Reserve University School of Law for his LL.M. in Taxation. He is admitted to the Ohio Bar and is also admitted to the U.S. District Court, Northern District of Ohio. Prior to obtaining his LL.M., Mr. Aragones was an associate with a law firm in Pittsburgh. LexisNexis and the Knowledge Burst logo are registered trademarks of Reed Elsevier Properties Inc., used under license. Other products or services may be trademarks or registered trademarks of their respective companies. © 2016 LexisNexis. LNL01077-0 0116

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