Editorial: Corporate Inversions No Signs Of Slowing Down

by Bilzin Sumberg
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In a corporate inversion, a U.S. corporation — typically the parent of an affiliated group — becomes a wholly owned subsidiary of a foreign corporation through a merger into the foreign corporation's U.S. subsidiary or transfers its assets to the foreign corporation. But at the same time, the company keeps most of its operations in the United States. Inversions are especially popular these days for pharmaceutical and biotechnology companies, where most of the value of the company is found in intangible assets.

The Internal Revenue Code provides two primary incentives for these types of transactions: (1) U.S. corporations are subject to federal income tax on their worldwide income, and (2) U.S. corporations are able to defer from U.S. federal income tax certain categories of income from foreign operations until the income is repatriated to the United States in the form of a dividend. It also doesn't hold that the U.S. corporate income tax rate is 35 percent whereas the European Union has an average corporate income tax rate of 21 percent.

While an inversion transaction is typically a taxable transaction at the shareholder level under Section 367(a), if the transaction is otherwise respected, U.S. federal income tax can be deferred on foreign operation until repatriated, and there are opportunities to reduce the taxable income of the U.S. operations by making deductible payments of interest, royalties, and other fees to the foreign parent.

Under Section, 7874 a foreign corporation is treated as a U.S. corporation for all purposes of the code where, under a plan or series of related transactions:

1. The foreign corporation completes, after March 4, 2003, the direct or indirect acquisition of substantially all the properties held directly or indirectly by a U.S. corporation;

2. Shareholders of the U.S. corporation obtain 80 percent or more of the foreign corporation's stock (by vote or value) by reason of holding their U.S. shares; and

3. The foreign corporation and corporations connected to it by a 50 percent chain of ownership (the "expanded affiliated group") does not have substantial business activities in the foreign corporation's country of incorporation or organization when compared to the total business activities of the group. For this purpose, substantial business activities requires the expanded affiliated group to have at least 25 percent of (a) the group employees; (b) group assets; and (c) group income in the foreign country of incorporation.

The same rule applies where a domestic partnership transfers substantially all the properties of a trade or business to a foreign corporation and the same stock ownership and absence of business activities tests are met. Where, however, the inversion transaction satisfies the above three tests, except that the domestic corporation's shareholders (or a domestic partnership's partners) obtain at least 60 percent but less than 80 percent of the foreign corporation's stock, the foreign corporation is a "surrogate foreign corporation" respected as a foreign corporation.

The inversion gain recognized by the "expatriated entity," however, is taxable in full with no reduction or offset for losses, credits or other tax attributes. Also, for 10 years after the expatriation transaction is completed, the expatriated entity's gain on transfers or licenses to the surrogate foreign corporation or to a "foreign related person" is taxable without offset (with an exception for inventory and like property).

Historically, most inversion transactions were merely internal restructurings where the new foreign parent had little substance in its country of incorporation. In 2012, however, final regulations were issued that moved away from a "facts and circumstances" business activities test and introduced the new 25 percent bright-line test discussed above. It was assumed that these changes would discourage U.S. companies from inverting.

Instead, U.S. companies have simply resorted to acquiring smaller foreign companies. Since Jan. 1, 2012, however, 12 U.S. companies have completed inversions and another seven are pending, including Medtronic Inc.'s planned purchase of Dublin-based Covidien PLC. AbbVie Inc. is moving closer to buying Shire PLC and moving the legal address to Ireland, and Mylan Inc. is buying the generic drug business of Abbott Laboratories and forming a new company incorporated in the Netherlands.

Many of these companies have been acquired at large premiums, in effect paying for the future tax savings. (For example, last May, New Jersey-based Actavis PLC agreed to acquire Ireland's Warner Chilcott at a 34 percent premium over its then-existing stock price). So long as the foreign shareholders own at least 20 percent of the shares of the surviving company, Section 7874 would not apply. The foreign targets typically have been located in low-tax jurisdictions such as Ireland, which has a 12.5 percent corporate income tax rate, or, in the case of the failed Pfizer-Astra Zeneca deal, the U.K., which has favorable regime for the taxation of income derived from patents.

President Barack Obama had proposed raising the threshold for inversions on foreign ownership from 20 percent to 50 percent, with the goal of making them less attractive. In addition, it was recently reported by Senate Finance Committee Chairman Ron Wyden, D-Ore., that a July 22 hearing will be held to discuss options for dealing with corporate inversions, as well as other international tax issues. Wyden said he intends to seek retroactive tax legislation to stop U.S. companies from moving their legal addresses to other countries.

Wyden has proposed legislation that would in effect prevent U.S. companies from acquiring foreign addresses by simply buying smaller competitors. His proposal would be retroactive to May 8. While his preference is to make that change as part of a broader revamp of the tax code in the next 15 months, he also indicated that a heightened pace of inversions may prompt Congress to act on a stand-alone measure more quickly.

Republicans, however, have resisted such legislation, indicating that they would prefer to focus on broader tax changes that would lower the corporate tax rate from the current 35 percent rate and make it easier for companies to repatriate foreign profits back to the United States.

This article is reprinted with the permission from Law360.

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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