Congress Turns Tax World Upside Down with New Focus on Corporate Inversions

by K&L Gates LLP
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Interest in corporate inversions has revived on Capitol Hill. Recent publicity surrounding pending deals has triggered comments and legislative proposals from tax writers and other members and stirred up the debate about international tax reform. This alert provides a brief overview of inversions, including why some consider it a loophole; describes what policymakers are doing to address the practice; and considers the prospects for any meaningful action by Congress.

What is a corporate inversion and why do some consider it a loophole?

In general, a corporate inversion is a transaction where a U.S. corporation becomes a subsidiary of a foreign entity; after the transaction, the former shareholders of the U.S. corporation hold (by reason of the stock they held in the U.S. corporation) 80 percent or more (by vote or value) of the stock of the foreign entity; and the foreign entity does not have substantial business activities in the country in which it was created, compared to its worldwide business activities. Put simply, an inversion occurs when a U.S. company is acquired by a foreign company, the owners of the old U.S. company have at least 80 percent control of the foreign company, and most of the business activity occurs somewhere other than in the country where the foreign parent is organized.

Under current anti-inversion rules enacted in 2004, the new top-tier foreign corporation is treated like a U.S. domestic corporation for all U.S. federal tax purposes. To avoid being considered a domestic company, transactions are structured so the continuity of ownership is less than 80 percent. Current rules limit certain tax benefits if the continuity of ownership is between 60 percent and 80 percent, but the foreign status of the entity is respected for tax purposes.

Before the transaction, the worldwide earnings of the old U.S. company were subject to U.S. tax. After the transaction, assuming the 80 percent continuity test is not met, only the income earned in the U.S. is subject to U.S. tax. In the case of an inverted U.S. multinational corporation with substantial non-U.S. income, this could significantly reduce U.S. taxable income subject to higher U.S. tax rates, while significantly reducing worldwide tax liability because most revenues would be taxed at lower tax rates throughout the rest of the world on a territorial, not worldwide, basis.

This potential for significant tax savings has caused some to call corporate inversions a tax loophole, especially when the primary motivation for a transaction appears to be tax savings, and business operations, including management and control, are largely unaffected by the restructuring. Regardless, it is generally agreed that there is nothing illegal about inversions under the current U.S. tax system.

What does Congress want to do?

Reactions on Capitol Hill to the recent flurry of inversion activity are mixed.  Some members want to take targeted action right away, while others maintain this is an issue best left for comprehensive tax reform down the road.

Senate Finance Committee Chairman Ron Wyden (D-OR) has straddled both approaches.  On May 8, 2014, he put companies considering inversion transactions on notice, saying he wanted to take some “short-term steps” to combat inversions. In a Wall Street Journal op-ed the next day, Chairman Wyden articulated his plan for a retroactive approach:  “While they may not be breaking U.S. tax laws, many of these companies are navigating a loophole in America’s broken and dysfunctional tax code.... Legal or not, this loophole must be plugged.” For all inversion transactions taking place from May 8, 2014 forward, Chairman Wyden would require that the foreign parent own at least 50 percent (compared to the current 20 percent) of the inverted corporation. He further stated in the op-ed that he is “committed to making this happen and including changes in the inversion rules as part of a tax overhaul.” After Senator Carl Levin (D-MI) and House Ways and Means Committee Ranking Member Sander Levin (D-MI) introduced their respective anti-inversion bills on May 20, Chairman Wyden reiterated that he thinks this issue is best addressed as part of comprehensive tax reform rather than a piecemeal provision.

Following the announcement of another inversion transaction in June, Chairman Wyden announced his concern that the America should not be “part of a race to the bottom” and that “gaming the system” would not allow U.S. companies to avoid paying taxes. Chairman Wyden followed up on these comments by noting that inversions illustrate that the U.S. corporate tax rate isn’t very efficient and that the next 15-month window is critical to passing corporate tax reform.

Senate Finance Committee Ranking Member Orrin Hatch (R-UT) has made it clear he thinks this is an issue to be considered as part of a tax reform effort, and that the focus should be on the carrot, not the stick. Elaborating on this in a floor statement, he said there are two ways to address the problem of inversions: “The first way is to make it more difficult for a U.S. corporation to invert.… The second way is to make the United States a more desirable location to headquarter one’s business. I believe the latter is the better way.”

Despite these differences, both Chairman Wyden and Ranking Member Hatch have agreed to hold a tax reform hearing on corporate taxation, which is expected to highlight corporate inversions.

Meanwhile, Ways and Means Committee Chairman Dave Camp (R-MI) indicated he believes this is an issue better addressed in comprehensive tax reform. His comprehensive tax reform draft included several provisions intended to protect the U.S. tax base.

Other members on and off the tax-writing committees have been taking their own steps to address the issue. On May 20, 2014, Senator Levin and House Ways and Ranking Member Levin introduced companion legislation to limit corporate inversions. The “Stop Corporate Inversions Act of 2014” would reduce the current continuity of U.S. ownership test from 80 percent to 50 percent for purposes of determining whether an inverted company would be treated as a domestic entity for U.S. tax purposes. As an alternative to the percentage test, the legislation also would treat an inverted entity as a domestic company if the management and control of the business occurs within the U.S. and the entity has significant U.S. business activity. It would eliminate the 60 percent test, treating an entity as fully inverted or not at all.

The Levin bills are nearly identical, with the notable exception that the Senate version includes a two-year sunset to give Congress time to pursue comprehensive tax reform, while the House version does not. The revenue estimates reflect this difference:  the permanent bill is estimated to raise $19.5 billion over the ten-year budget window, while the temporary bill is estimated to raise $791 million over the same period. This difference in the scores may result, in part, from the likelihood that some deals may be postponed until after the sunset, but not abandoned.  In general, the Levin legislation draws from an Obama Administration budget proposal and existing inversion rules and regulations. The Senate bill has 19 co-sponsors and the House bill has 9. 

Can the Internal Revenue Service do anything?

The agency issued regulations on inversions as recently as January of 2014. IRS Commissioner John Koskinen recently stated he does not think there is anything more the IRS can do to clamp down on inversions without a change in the tax laws.

What about the White House?

President Obama’s budget eleased earlier this year includes an anti-inversion proposal that appears to be the model for the Levin legislation. It drops the continuity of U.S. ownership threshold from 80 percent to 50 percent, and eliminates the separate 60 percent category. It also includes a “management and control” feature that would treat an inverted corporation as a U.S. company even if the 50 percent threshold is not met. Aside from the budget proposal, the White House has not aggressively marketed the proposal to Congress.

Are Inversions a Big Deal?

About 50 U.S. corporations have inverted over the past 30 years. In the late 1990s and early 2000s, there was a flurry of inversion activity. In response, then-Senate Finance Committee Chairman Max Baucus (D-MT) and Ranking Member Chuck Grassley (R-IA) joined forces to put companies considering inversions on notice that they would proceed at their own peril, introducing retroactive anti-inversion legislation in 2002. Chairman Wyden’s approach is similar, although not bipartisan. It wasn’t until October 2004 that anti-inversion legislation was enacted, but notably it was effective for inversions in taxable years beginning after March 4, 2003—the same retroactive approach Chairman Wyden has warned about. This legislation established the 80 percent threshold, which some now consider inadequate to stem the flow of U.S. businesses to foreign owners.

What happens next?

The debate over corporate inversions and their effect on the U.S. economy, U.S. jobs and the U.S. tax base is probably here to stay—at least until addressed as a stand-alone bill or as part of comprehensive tax reform.

Anti-inversion legislation is likely to be met with strong opposition from the U.S. business community for several reasons. There are many U.S./foreign transactions not motivated primarily by tax considerations; even if they are, there are fiduciary considerations to shareholders, which include minimizing taxes in order to increase cash income and enhance competitiveness. Particularly when the prospects of a reduced U.S. corporate tax rate through tax reform appear to be diminishing, companies seeking lower tax rates and tax rate certainty may consider an inversion more seriously. Further, it will be very difficult to “thread the needle” to draft legislation that would deter “loophole” transactions but not quash transactions driven by strategic and operational considerations. Many will argue such legislation will have exactly the opposite effect than intended, stimulating an even greater exodus of companies from the U.S., depressing U.S. economic growth and job creation, and deterring foreign investment in the United States. Finally, there is the belief that such significant international tax law change should only be in the context of comprehensive tax reform, not in a one-off manner. 

On Capitol Hill, work on tax reform is expected to continue, and inversions will be part of the discussion. Chairman Wyden and Ranking Member Hatch agree the issue should be addressed as part of comprehensive tax reform, as has current Ways and Means Chairman Camp. Mr. Wyden has indicated he intends to pursue reform in 2015. Presumed new Ways and Means Chairman Paul Ryan (R-WI) has included tax reform in his recent budget proposals, and Ways and Means Ranking Member Levin can be expected to continue to push for consideration of his legislation both in the context of tax reform and separately.

Other members can be expected to push for a stand-alone remedy, as well. Although Sen. Carl Levin is retiring from the Senate, he leaves a legacy of work on offshore tax abuse, and his anti-inversion co-sponsors can be expected to carry on where he left off. With an estimated revenue score (without sunset) of almost $20 billion, anti-inversion legislation is likely to be proposed as a revenue offset for other legislation by other members.

Chairman Wyden’s warning about a retroactive approach, the introduction of the Levin brothers’ legislation, potential hearings, and the ongoing threat of using anti-inversion legislation as an offset will create significant uncertainly in the business community, as strategic and operational decisions that cannot wait are being made. While not directly related to anti-inversion rules, the Organization for Economic Cooperation and Development’s base erosion and profit shifting process, with its focus on protecting the tax base of jurisdictions, also contributes to the uncertainty hovering over corporate strategic and organizational decisions. 

What should I do?

U.S. companies considering transactions involving foreign entities should not disregard the renewed interest in inversion activity. It will be difficult for Congress to draw the line between an abusive transaction and one that is not, so transactions not intended to be caught up in anti-inversion legislation could be included, especially when existing proposals rely heavily on subjective terms such as “substantial or significant” when testing for the extent of business activity. Even if a transaction does not fall within the parameters of proposed legislation, attention to transactions involving U.S. and foreign companies may also create reputational risk that is difficult to overcome. It would be prudent for any U.S. company considering a transaction with a foreign corporation to consider weighing in with members of Congress on this very important and significant matter. 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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