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US Anti-Inversion Regulations - Turning Tax On Its Head

By Editorial
October 19, 2016

Lawmakers and the Government in the United States have had several tries at staunching the flow of corporate "inversions" over recent years, but demonstrably they have failed, as recent developments plainly show. Now the US Treasury is attempting to deliver the coup de grâce to inversions, in the form of new tax regulations released in final form on October 13, 2016.

What's A Corporate Inversion And What Are They Controversial?

Simply put, corporate inversions have been used by US companies when bidding for (generally smaller) foreign companies, as a means of moving away from the high American 35 percent corporate tax rate. A company that merges with an offshore counterpart can move its headquarters abroad (even though management and operations may remain in the US), and take advantage of the lower corporate tax rates in foreign jurisdictions as long as at least 20 percent of its shares are held by the foreign company's shareholders after the merger.

According to the US Commerce Department's Bureau of Economic Analysis, there was a 68 percent hike in foreign direct investment into the United States in 2015, a significant part of which arrived by way of corporate tax inversions. Expenditures by foreign direct investors to acquire, establish, or expand US businesses totaled USD420.7bn last year, compared to only USD250.6bn in 2014. 

However, these figures alone, which would appear positive at first glance, do not tell the whole story. Critics of corporate inversions argue that the benefits of this inward FDI are outweighed by the erosion to the US tax base when a major US company relocates its tax base overseas. What's more, an inverted US company is then likely to invest more in its more lightly-taxed foreign operations, exacerbating the perceived trend of US jobs being "shipped overseas."

It is hard to pinpoint with much certainty just how much tax the US Treasury loses each year as a result of corporate inversions, and there is some debate as to the severity of these losses, or even if inversions impact the US tax base at all. However, one of the firmest estimates comes from the Joint Committee on Taxation, a nonpartisan committee of the United States Congress, which has said that the US Treasury is set to forgo USD33.5bn in corporate tax revenue over ten years as a result of inversions.

Why Has The Government Stepped In To The Inversion Fray?

Essentially, because Congress, while broadly supportive of the notion that the inversion loophole must be plugged, are deeply divided on the necessary fix.

Republicans argue that companies wouldn't be tempted to invert if the US tax code was more competitive than it is at present. Therefore, they argue that conditions must be made much more favorable for US companies to invest domestically, and to repatriate the estimated USD2 trillion-plus in foreign profits "locked out" of the US by the 35 percent corporate tax rate. This would necessitate comprehensive changes to the US corporate tax code, which Republicans have been calling for for several years.

Most Democrats also support tax reform, but not in a way that rewards big companies with large tax cuts. The Democrat approach is much more stick than carrot, and oriented towards forcing big business to pay its "fair share" in corporate tax.

Recent Democrat bills include the Stop Corporate Inversions Act, which would increase the minimum foreign shareholding cap to 50 percent; the Putting America First Corporate Tax Act, which would cancel the provision in the current US tax code that allows corporations to defer paying corporate tax on foreign profits until that money is repatriated back to the US and require corporations to pay US taxes on all future domestic and foreign active income; the Stop Corporate Earnings Stripping Act, which would limit the use of earnings stripping techniques; and the Pay What You Owe Before You Go Act, which would impose a 35 percent "exit tax" with credits for foreign taxes paid against the overseas profits of corporations seeking to invert.

The Proposed Regulations

In the absence of legislative action to discourage inversions one way or another, the Democratic administration of President Barack Obama has taken the opportunity to use its executive authority to propose a solution at regulatory level. And its initial proposals have probably represented the biggest anti-inversion stick yet.

Described by some tax practitioners and academics as the potentially the most far-reaching change in US tax law in 20 years, the regulations, proposed in initial form in April 2016, go after the practice of earnings stripping, whereby US subsidiaries borrow from their new foreign parent company (or another foreign affiliate), increase their interest payments, and reduce their US taxable income by using the interest expense deduction. The regulations therefore permit the Internal Revenue Service to re-characterize certain debt instruments as equity under Section 385 of the Internal Revenue Code, thereby removing the tax benefits of such a tax planning strategy.

The regulations would also deter earnings stripping by targeting transactions that increase related-party debt but do not finance new investment in the US under section 385. Furthermore, as initially proposed in April, the regulations would have allowed the IRS, in a corporate tax audit, to divide debt instruments into part debt and part equity (known as bifurcation), rather than the current system that generally treats them as wholly one or the other.

As some contributors observed during the 90-day comment period, the proposed regulations, with their potentially broad scope, could be described as using a sledgehammer to crack a nut. This is because only a small number of inverted companies would probably be caught by the new rules compared to the large number of domestic firms with foreign affiliates likely to be disadvantaged.

According to a Business Roundtable report, the regulations, as initially proposed, would affect investments by US-based companies and foreign-based firms in the United States. These investments, it warned, would be severely impacted by the new regulations "due to increased financing costs, elevated business risk, added compliance burdens, and a more complex and uncompetitive tax environment." Under one example cited in the report, an inbound company planning to build a new US factory, even if it restructured operations to mitigate the adverse impacts of the proposed regulations, would still face an increase in financing costs equivalent to a seven percent increase in the statutory US corporate tax rate.

The leaders of the tax-writing committees in the US Congress also issued numerous warnings to the US Treasury about the potentially negative economic impact of the proposed anti-inversion regulations under section 385 of the US tax code. "We appreciate the Treasury Department's expressed commitment to making modifications to address some of the identified adverse effects of the proposed regulations," they wrote in a letter to Treasury Secretary Jacob Lew on August 22. "However, based on the information provided by Treasury to date, we are not confident that any such modifications would be sufficient to eliminate the harm that the proposed regulations would inflict on businesses and American workers if they were to be finalized in their current form."

The Final Regulations

The Treasury appears to have taken on board some of the concerns of the business community and members of Congress about the broad scope of the proposed regulations, and they reappeared in somewhat watered-down form when the final version was released on October 2013.

For example, Treasury is providing a broad exemption for cash pools and other loans that are "short-term in both form and substance, and therefore do not pose a significant earnings stripping risk." Treasury and the IRS expect that the exemption will "generally permit companies to continue to treat as debt short-term instruments issued among related entities in the ordinary course of a group's business."

Transactions between foreign subsidiaries of US multinationals and by S corporations are also exempt from the final regulations, as are transactions by mutual funds and real estate investment trusts, other than those owned by affiliated groups of companies.

However, Treasury has retained the retroactive nature of the regulations, in that they still apply to debt transacted or issued on or after April 4, 2016, although it has relaxed the intercompany loan documentation rules to ease compliance burdens. For example, the deadline for documentation has been moved to when the tax return is due, and the regulations also extend the effective date of the documentation rules by one year to January 1, 2018.

Additionally, in the final regulations, Treasury has not included a "bifurcation rule" that would have allowed the IRS to decide that a corporate debt should be treated as a part-debt and part-equity. While Treasury has stated that it "will continue to study this issue," the IRS will now only determine whether a transaction should remain as 100 percent debt, or be treated as 100 percent equity.

The Verdict

It remains to be seen whether the latest weapon in the Government's armoury delivers the fatal blow to inversions, and corporate tax avoidance more widely, that it is hoping for. However, reaction to the final regulations has been mixed to say the least.

Ronald Dabrowski, a principal in the Washington National Tax practice of KPMG LLP observed that the various amendments made by Treasury had improved the situation, but that there remained a number of "problematic features."

"On the plus side, the documentation rule's applicability date of 1/1/18 and the exception—for the time being at least—for foreign issuers were responsive to comments and were absolutely necessary. The carve outs for S corps, RICs, REITs, and certain regulated industries were also welcome," Dabrowski observed.

However, he said that the rules' "general response regarding cash pooling will still be highly burdensome where they apply as will the retroactive application of the re-characterization rules. In addition, the focus will now shift to the states and how they will implement section 385." 

Senator Orrin Hatch (R – Utah), the Chairman of the Senate Finance Committee, was also unimpressed by the new regulations.

 "While the final regulations will need to be scrutinized closely, it is immensely concerning that, despite stark bipartisan concern, the Administration moved forward with completing rules that could jeopardize American businesses and the economy here at home."

"While Treasury has indicated they have attempted to address some of the major concerns such as cash pooling transactions, foreign subsidiary-to-foreign-subsidiary transactions, and S Corporation financing, among others, the devil's in the details," he added. "We'll now have to carefully examine whether the regulations will make the policy less intrusive on some categories of legitimate business transactions."

In addition, both Hatch and Finance Committee Ranking Member Ron Wyden (D – Oregon) expressed their view that only reform of the US tax code would be an effective antidote to corporate inversions. Wyden concluded that what the regulations "do not change is the need for tax reform. For too long Congress has sat on a broken and outdated tax system, which is why the US has resorted to rule changes to respond to wave after wave of tax avoidance."

With presidential candidates Hillary Clinton and Donald Trump proposing markedly different plans to tackle the flaws in the US corporate tax system – largely, it has to be said, along the usual partisan lines – the outcome of the 2016 election will therefore be keenly anticipated by US businesses.


Tags: tax | regulation | business | investment | Tax | United States | interest | tax reform | compliance | law | Finance | Regulations | tax avoidance | trusts | tax planning | exit tax | tax rates | audit | offshore | multinationals | environment



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