2014 - Issue 19—With the second-highest corporate tax rate in the world, it’s easy to understand why a U.S. corporation may seek to find a more tax-friendly jurisdiction to conduct business. Many European countries have welcomed U.S. corporations with open arms with tax rates, incentives and holidays aimed at attracting U.S. multinationals. A few of the usual suspects include Ireland, Luxembourg, the Netherlands and Switzerland, and with recent reductions to the U.K. corporate tax rate (now down to 21 percent) coupled with its patent box regime, the U.K. is quickly becoming a contender to attract U.S. corporations. In an effort to lower effective tax rates, many U.S. corporations focus on migrating revenue to foreign subsidiaries located in low-tax jurisdictions, but this leaves the somewhat complex task of redeploying excess offshore cash without triggering U.S. tax. The “holy grail” of migrating revenue to a lower-tax jurisdiction involves migrating the tax residence of a U.S. corporation to a low-tax jurisdiction (an “inversion transaction”) because if properly executed, the U.S. corporation departs the U.S. taxing jurisdiction altogether.
For U.S. federal income tax purposes, a corporation generally is considered tax resident in the place of its incorporation. Inversion transactions take many forms but ultimately result in the reincorporation of a U.S. corporation in another jurisdiction. One of the early inversions was the “Helen of Troy” inversion in 1994, in which the stock of Helen of Troy, a publicly traded U.S. corporation, was transferred to a newly formed Bermuda corporation in a non-taxable Section 351 exchange. As a result of the transaction, the former shareholders of Helen of Troy held stock in a publicly traded Bermuda corporation. In response to this transaction, the Treasury Department issued Treas. Reg. 1.367(a)-3(c), which provides that an outbound transfer of stock and securities in a domestic corporation by a U.S. person to a foreign corporation is a taxable exchange unless certain exceptions apply, one of which is that the U.S. transferors receive no more than 50 percent of both the voting power and value of the stock of the foreign transferee in the transaction. Thus, the Helen of Troy transaction would now be taxable to shareholders under the Section 367 Regulations.
From 1994 to 2004, the only hurdle to exit the U.S. tax system was the potential for tax on shareholder-level gain under Section 367. In the early 2000s, a new wave of U.S. corporations inverted, taking advantage of falling stock values resulting from the stock-price bubble that effectively burst in 2001, which resulted in little to no shareholder gain recognition. Companies that inverted in the period from 2002 to 2004 included Accenture, Cooper Industries, Everest Re Group, Foster Wheeler, Fruit of the Loom, Global Crossing, Ingersoll Rand, Leucadia National Group, Nabors Industries, Noble Drilling, Seagate Technologies, Trenwick Group, Triton Energy Corp. and Tyco International.
Beginning in 2004, the U.S. began to take steps to quell U.S. companies’ efforts to reincorporate in a low-tax jurisdiction by enacting the so-called “anti-inversion” rules under Section 7874. Section 7874 became effective for tax years ending on or after March 4, 2003. Under current law, the anti-inversion rules of Section 7874 apply if three requirements are met:
(1) There is an acquisition of “substantially all of the properties” of a U.S. entity by a foreign company;
(2) The former shareholders of the U.S. entity own at least 60 percent (by vote or value) of the new or surviving foreign company; and
(3) The foreign corporation or its “expanded affiliated group” does not have “substantial business activities” in its country of incorporation.
The term “expanded affiliated group” means the foreign corporation and all subsidiaries in which the foreign corporation, directly or indirectly, owns more than 50 percent of the stock by vote and value. Treasury issued regulations in 2009 and 2012 addressing what constitutes “substantial business activities” and currently the regulations impose a bright-line test that requires the expanded affiliated group to have 25 percent of its employees (by number and compensation), asset value and gross income based, located and derived, respectively, in the relevant foreign country.
If a transaction is subject to Section 7874, the impact of Section 7874 depends on the percentage of stock the former shareholders of the U.S. entity own in the foreign acquiring corporation. If the former shareholders of the “expatriated entity” own 60-80 percent (by vote or value) of the foreign acquiring corporation, then:
(i) The expatriated entity recognizes inversion gain (such gain is generally the income or gain recognized by the entity for 10 years following the inversion);
(ii) Certain tax attributes, including net operating losses, cannot be used offset such gain; and
(iii) Certain share-based executive compensation is subject to excise tax.
If former shareholders of the expatriated entity own greater than 80 percent (by vote or value) of the foreign acquiring corporation, then there is no gain to expatriated entity but the foreign acquiring corporation is treated as a domestic corporation. This status as a domestic corporation is permanent: The Hotel California rule — you can check out anytime you like, but you can never leave . . .
As described in our August 2012 Tax Advisor Weekly article, “Offshore ‘Inversion’ Transactions Increasingly Difficult, but Still Possible in Limited Circumstances,” Treasury issued regulations in 2009 and 2012 that limited the ability of a foreign acquiring or surviving corporation to satisfy the “substantial business activities” test. In addition, Treasury issued regulations effective January 21, 2014, that also limited the ability to include certain foreign affiliates into the expanded affiliated group. Further, Treasury has not issued guidance on what constitutes “substantially all the properties” and the IRS continues to decline to issue private letter rulings to provide guidance to taxpayers. The actions of Treasury and the IRS actions were thought to have a chilling effect on inversion transactions. However, recent trends suggest an uptick in inversion transactions.
The following table is a sample of inversion transactions that have been announced or completed within the past two years:
As reflected in the table above, the majority of these inversions are in the healthcare and pharmaceutical industries, although other industry sectors have seized the opportunity to invert as well. The transactions listed above involve merger & acquisition deals in which either the transactions result in “a merger of equals” or the combination of stock and cash consideration in the deal would result in the former shareholders of the U.S. corporation owning less than 60 percent (and in some cases less than 50 percent) of the stock of the resulting foreign corporation, thus bypassing the application of Section 7874.
In addition to inverting through M&A deals, inverting through a spin-off (so called “spin-versions”) transaction appears to be gaining some traction. For example, Theravance, Inc. announced its intent to contribute its drug discovery and development business to a newly formed Cayman subsidiary, Theravance Biopharma, Inc., and distribute the stock to its shareholders.
While Ireland and the Netherlands have been popular jurisdictions for inversions, Switzerland has historically been a favored locale as well. With the recent reduction in corporate income tax rates in the U.K. (as well as a zero withholding tax on dividends between the U.K. and U.S.), we would also expect the U.K. to become a viable alternative jurisdiction for future inversion transactions.
Recent Anti-inversion Proposals
The recent spate of inversions has — unsurprisingly — caught the attention of the U.S. government. In its 2015 budget proposal, the Obama administration stated that
"inversion transactions raise significant policy concerns because they facilitate the erosion of the U.S. tax base through deductible payments by the remaining U.S. members of the multinational group to the non-U.S. members and through aggressive transfer pricing for transactions between such U.S. and non-U.S. members. The resulting group’s U.S. taxes also may be reduced because foreign subsidiaries may no longer qualify as controlled foreign corporations, thus permitting the group to avoid U.S. taxation on passive and other highly mobile income that it earns abroad and that would otherwise be currently included in the U.S. tax base under subpart F of the Code."
The 2015 budget proposes to lower the 80 percent stock ownership threshold to treat a foreign corporation as a U.S. domestic corporation to a 50 percent threshold, thereby significantly expanding the scope of Section 7874. The Obama proposal also contemplates a backstop to the mechanical ownership percentage rules with an additional, more substantive test, whereby the inversion rules would apply if the new foreign entity has substantial business activities in the U.S. and is primarily managed and controlled in the U.S. Finally, the proposal would amend Section 7874 to provide that an inversion transaction can occur if there is an acquisition either of substantially all of the assets of a domestic partnership (regardless of whether such assets constitute a trade or business) or of substantially all of the assets of a trade or business of a domestic partnership. If enacted, the amendments to Section 7874 would be effective for transactions that close after December 31, 2014.
Taking an alternative tack, Dave Camp (R-Mich.), Chair of the House Ways and Means Committee, recently suggested a wholesale reduction in U.S. corporate tax rates to 25 percent. While Rep. Camp does not specifically address inversions, his proposal would align the U.S. statutory tax closer to statutory rates in jurisdictions like the U.K., thus reducing the motivation to reincorporate outside the U.S.
Alvarez & Marsal Taxand Says:
Historically, waves of corporate inversions have triggered a government response to tamp down on corporations leaving the U.S. taxing jurisdiction. The recent upswing in corporate inversions suggests that a legislative response may be in the offing, but policy-makers and pundits indicate that the Camp proposal has greater appeal and viability than Obama’s 2015 budget proposal. Notwithstanding, the general sentiment is that no significant legislation or tax reform will occur prior to the next Presidential election. Absent any immediate efforts to shut down these transactions, we would expect U.S. companies to continue to take advantage of inversion transactions before the window of opportunity potentially closes.
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The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.
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