The Treasury Department's notice of proposed regulations to curb so-called inversions is smart and narrowly tailored. The new rules would take away some — but not all — of the reasons that a company might want to give up United States citizenship.
Indeed, most proposed inversions are likely to go forward, especially those that make sense as a business matter above and beyond the tax benefits, some of which the new rules will curtail.
Companies still searching for a suitable foreign merger partner will find it harder make a match. And in some cases, the loss of tax benefits will mean the search is not lucrative enough to be worth the bother.
Under current law, inversions require merging with a foreign company, with a new "inverted" foreign company becoming the parent company of the combined operations. Since 2004, it has not been possible to do an inversion purely on paper. A United States corporation looking to reincorporate abroad must find a real life merger partner at least one-quarter its size. That way, less than 80 percent of the shareholders of the combined entity will be former shareholders of the United States corporation, thereby clearing one of the critical hurdles of the current inversion rules as laid out in Section 7874 of the tax code.
Finding a suitable merger partner is a friction — a nontax business factor that constrains tax planning — because many mergers do not make sense from a business perspective. The goal of tax planning, after all, is to maximize after-tax income, not to minimize tax liability. It might be difficult for a pharmaceutical company to integrate its business with, say, a company that makes pants. It's not that much easier for companies in the same industry; merger synergies are often elusive. In the recent wave of inversions, however, more companies have been able to overcome the frictions of existing law and pursue the tax savings that an inversion promises.
The Treasury Department's strategy is modest: increase frictions and take away some of the tax benefits of inversions.
Consider the three main reasons a United States corporation might try to become a foreign corporation for tax purposes.
Avoid United States tax on future foreign earnings
Our tax system attempts to tax United States citizens, including corporations, on their worldwide income with a credit for any foreign taxes paid. To the extent that business income derived from foreign sources is untaxed by foreign jurisdictions, those profits may be deferred indefinitely by keeping the profits overseas. The profits are taxed when cash is repatriated.
The first motivation to give up citizenship is to avoid taxes on this "residual" foreign source income.
This tax on residual income is baked into the current structure of the tax code and beyond the Treasury's legal authority to change. Many in Congress wish to remove this incentive to invert by changing to a "territorial" tax system, under which the United States would give up any claim to business income from foreign sources. Such a unilateral disarmament would have to come from Congress, not the Treasury, and may not be good tax policy in any event.
Instead, the Treasury's tactic is to increase frictions, making it more difficult to invert. Congress established two frictions earlier. First, shareholders of inverting corporations must pay an "exit tax" under section 367, which is painful if the stock they hold has appreciated. Second, under section 7874, a United States company must find a suitable foreign merger partner so that less than 80 percent of the shareholders of the combined entity would be former shareholders of the United States company.
The "exit tax" has proved largely ineffective as a friction because the long-term benefits of an inversion can often exceed the short-term cost to shareholders.
The 80 percent rule — 60 percent in some circumstances — has been more effective. For companies seeking to minimize the friction, the ideal merger partner, therefore, would be exactly one-fourth the size of the United States company seeking to invert.
Clever deal makers have figured out that size can be adjusted on either size of the equation. The United States company can "skinny down" by paying a special dividend to shareholders. Or the domestic company or the foreign target can spin off just the right amount of assets into a new subsidiary. The proposed regulations would disregard some, but not all, of these types of adjustments. Treasury's goal here is primarily forward-looking. By narrowing the pool of potential merger partners, fewer companies will find that it makes business sense to invert.
Similarly, deal makers have sought to reduce frictions by making the merger partner into a cash box, holding mostly securities or other passive assets. The proposed regulations would eliminate that strategy.
Avoid United States tax on past foreign earnings
Inversions are also motivated by a desire to repatriate deferred foreign earnings without paying tax. This is perhaps the most practically significant portion of the proposed regulations because the new rules would take away much of the motivation for inverting for companies, like Medtronic, with a lot of overseas cash. The regulations seek to end so-called hopscotch loans, where inverted companies gain access to previously untaxed foreign earnings, and certain other actions that move earnings out from under the United States tax base.
Avoid United States tax on income derived in the United States
Inversions are also motivated by the possibility of using tax gamesmanship to avoid United States tax on United States source income, primarily by aggressive use of transfer pricing rules and by using related party loans to strip earnings out of United States subsidiaries. The proposed regulations do not address earning stripping, although the Treasury has not ruled out further regulatory action in the future.
Treasury may opt to wait for Congress to take the lead on earnings stripping. After all, not only foreign companies can exploit these rules. United States companies play the same game. It is not necessary for Apple, for example, to become an inverted Irish company to avoid paying a lot of United States tax.
In sum, the proposed regulations will deter future inversions where the primary motivation is tax savings. Where there is a significant business reason for the merger, however, the new rules will most likely not affect the deal. Burger King's proposed merger with Tim Hortons is a good example.
It is harder to predict what might happen with deals that appear to be mostly motivated by taxes, like Medtronic's proposed merger with Covidien. The deal documents include an "out" if new rules would treat the inverted company as a United States corporation. But that is not the effect of the new rules. Instead, the rules would reduce the effectiveness of the inversion by denying access to Medtronic's offshore cash.
Whatever happens with the inversions that have already been proposed, the new rules will help deter new deals that lack a real business purpose.
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