With the corporate inversion debate having hijacked the political agenda in Washington over the past couple of months, triggered it seems by Pfizer's ambitious bid for Britain's AstraZeneca, this edition of LATN Monthly takes a look at this issue and the new and recycled plans to deal with it.
Background and Current Law
Political concerns have been raised at various points over the last 20 years about the rising number of corporate inversions, transactions the result of which US multinationals are able to shift their tax residence abroad during a foreign takeover to move away from America's high 35 percent income tax rate while retaining much of their management in the United States.
In response to a spate of corporate inversions into tax havens in the late 1990s and early 2000s, the American Jobs Creation Act 2004 added section 7874 to the Internal Revenue Code. The new law effectively negated the tax benefits of inversions into offshore parent corporations where the ownership of the group was not significantly affected by the restructuring.
Section 7874 applies when a foreign corporation acquires the stock or assets of a domestic corporation or partnership if both of the following conditions are satisfied: at least 60% of the stock of foreign corporation is owned, after the acquisition, by former owners of the domestic entity by reason of their former ownership; and the corporate group controlled by foreign corporation after the acquisition does not have business activities in foreign corporation's country of incorporation that are substantial when compared to the total business activities of the group worldwide.
If the level of ownership continuity is between 60% and 80%, the statute imposes a special gain recognition requirement on the US company and any related domestic entities for the ten-year period following the acquisition. If the level of ownership continuity is 80% or more, the statute does not impose the special gain recognition requirement, but instead deems foreign corporation to be a domestic corporation for all purposes of the Internal Revenue Code.
Section 7874 has been modified subsequently by new regulations and guidance. A significant alteration came about in June 2012 when the Internal Revenue Service issued final, temporary and proposed regulations stipulating that an inverted company needs to have at least 25 percent of its employees, property, and income in a foreign country, otherwise the new parent company may be treated as a domestic corporation for US tax purposes.
Inversions on the Rise?
According to the Congressional Research Service, 76 US companies have either inverted or planned to do so since 1983. More than half of these, about 47,have occurred over the last decade, but there appears to have been a spike in corporate inversions in 2014, with 14 having taken place this year. These include Mylan's plans to acquire some of Abbott Laboratories' non-United States businesses, although Walgreens has decided against moving its tax residence from the United States to Switzerland by way of a merger with Alliance Boots, in response to growing political pressure in the US.
In relative terms, the numbers of inversions are miniscule when set against the 1.6m C corporations currently in the US, 400,000 of which are publicly traded. It is said that the current flow of corporate inversions will cost the Treasury around USD20bn in corporate tax revenues over the next ten years. The exact extent of the revenue impact of continuing corporate inversions is not easy to calculate however – some say for example that corporate tax revenue loss could be offset to some extent by increased capital gains tax revenues – and the figures are much disputed. Indeed, given the USD4.5 trillion that the Congressional Budget Office predicts will be raised from corporate tax over the next decade, USD20bn almost seems a drop in the ocean.
Nevertheless, with congressional elections approaching, this has become a very politically charged issue, and concern that the corporate tax base is shrinking has resulted in congressional legislative proposals, and confirmation from the President that he is looking at how he can use his administrative powers to reduce the tax benefits available for inverters. These proposed new measures are summarised next.
Stop Corporate Inversions Act, 2014
The Stop Corporate Inversions Act of 2014 was introduced by Senator Carl Levin (D – Michigan) on May 20, 2014. The bill mirrors proposals included in President Obama's Budget for fiscal year 2015 by increasing the needed percentage change in stock ownership from 20 percent to 50 percent and provides that the merged company will nevertheless continue to be treated as a domestic US company for tax purposes if management and control of the merged company remains in the US and either 25 percent of its employees or sales or assets are located in the US.
The bill provides a two year moratorium on inversions that do not meet the stricter tests in the bill so that Congress can consider a long-term solution as part of general corporate tax reform.
Near-identical legislation was introduced in the House of Representatives by Levin's brother, Sander Levin (D – Michigan), the ranking Democrat on the House Ways and Means Committee. Sander Levin's bill has nine co-sponsors, all of whom are Democrats.
The Fair Federal Contracts Act was introduced in both the Senate and the House of Representatives on July 29, 2014, to add a provision to prohibit federal contracts going to corporations that reincorporate overseas.
The bill would retain the stipulation that American shareholders of the old US corporation should own at least 50 percent, but would also ban federal agencies from awarding contracts to companies that reincorporate overseas and "do not have substantial business opportunities in the foreign country in which they are incorporating."
The bill has been introduced by Democrats in both the Senate – Dick Durbin, the Assistant Majority Leader, and Carl Levin – and in the House – Rosa DeLauro (D – Connecticut) , co-chair of the Democrat's Steering and Policy Committee, and Lloyd Doggett (D – Texas), who serves on the Ways and Means and Budget Committees.
However, it is seen as unlikely that these Democrat proposals will move forward in Congress any time soon, given that the Republican Party has generally been against any short-term solution, and has insisted that the corporate inversion problem should be dealt with only within a comprehensive tax reform solution.
Bring Jobs Home Act
Re-introduced by Democrat lawmakers with the stated objective of placing pressure on American companies moving operations abroad to avoid the high US corporate tax rate, the Bring Jobs Home Act would have provided the tax credit against "eligible insourcing expenses" associated with relocation to the US on the condition that the company increase its workforce of full-time US employees.
Allowable expenses would have included costs incurred by the taxpayer in connection with the elimination of any of its business units (or of any of its affiliates) located outside the US, as well as those incurred by the taxpayer in connection with the establishment of a new business unit to be located in the US.
However, the bill would have also denied businesses any tax deduction for moving expenses if those costs are associated with an elimination of a business unit in the US and the establishment of a new business unit abroad. In addition, a company would have not been able to charge to the capital account or amortize those outsourcing expenses that are deemed to be non-deductible.
The Bring Jobs Home Act was introduced by John Walsh (D – Montana), but it was also pointed out that the bill had remained unchanged since it was introduced two years ago by its current co-sponsor, Debbie Stabenow (D – Michigan), when it was blocked by the Republican Party.
Once again however, the Republican Party in the Senate managed to defeat the bill in a procedural vote that required at least 60 votes to move the bill to a definitive vote.
New proposals, which seek to tackle "earnings stripping," would restrict the ability of an inverted company to use inter-group loans to allocate debt to the US subsidiary after inversion to further reduce tax liability in the US. This could be achieved by amending rules governing the deduction of interest expenses, Senator Charles Schumer (D – New York) has proposed.
Schumer's proposal would revisit the thin capitalization rule that allows companies to have 1.5 times as much debt as equity; reduce the permitted amount of deductible interest for inverted companies to 25 percent of US taxable income from 50 percent; impose restrictions on companies' ability to carry forward interest deductions; and require the US subsidiary to obtain annual pre-approval from the Internal Revenue Service (IRS) for related-party transactions for ten years after an inversion.
One problem that is being seen in drafting anti-inversion legislation is the difficulty in distinguishing between inverted companies now owned by foreign companies, and those that have similar characteristics, but are actually "normal" US subsidiaries of foreign multinationals.
However, the Organization for International Investment has recently warned that the current anti-inversion proposals "threaten to inadvertently impact all American subsidiaries of foreign multinationals and make the country less attractive for future foreign direct investment."
While Democrats in Congress continue to seek a legislative solution to the corporate inversion problem after the summer recess, President Barack Obama has confirmed his intention in the meantime to act quickly by utilizing his administrative regulatory powers.
Answering questions at a press conference after the US-Africa Leaders Summit, Obama confirmed that he is looking to take whatever measures he can, while awaiting congressional action, to reduce tax benefits for inversions.
He said: "We don't want companies who have up until now been playing by the rules suddenly looking over their shoulder and saying, you know what, some of our competitors are gaming the system and we need to do it, too. That kind of herd mentality I think is something we want to avoid. So we want to move quickly – as quickly as possible."
"My preference would always be for us to go ahead and get something done in Congress... So there is legislation working its way through Congress that would eliminate some of these tax loopholes entirely."
"But what we are doing is examining: Are there elements to how existing statutes are interpreted by rule or by regulation or tradition or practice that can at least discourage some of the folks who may be trying to take advantage of this loophole?"
The United States Treasury Secretary Jack Lew has also let it be known that the White House is considering potential action it may be able to take without legislative changes.
It is expected that measures could be found from among the various possible ways in which the Administration could interpret section 7874, while Stephen Shay, a former Deputy Assistant Treasury Secretary for International Tax Affairs, recently suggested that President Obama, by resurrecting a law from 1969, could restrict the use of inter-company loans to US subsidiaries and interest deductions.
However, the White House will also be aware that increased executive action will further raise the hackles of Republicans, who are already accusing the Administration of using its authority in other areas, perhaps illegally, to act where Congress has not.
Short-Term Fix Versus Long-Term Solution
In an op-ed written for the Washington Post, United States Senate Finance Committee Ranking Member Orrin Hatch confirmed that there may be steps that Congress can take in the short-term to address the problem of "corporate inversions," but he continued to urge a cautious approach from lawmakers.
Although concerned by a spate of inversions, Hatch has previously warned that the proposed short-term fixes would be "punitive" and could have unintended consequences, but had also left the door open for further discussions on short-term legislative proposals, acknowledging that an agreement on tax reform could take some time.
In his op-ed, he returned to that theme. While accusing congressional Democrats and the President of "playing election-year politics with the growing challenge of corporate inversions," he also warned that their proposals "contain punitive and retroactive provisions that would exacerbate the problem."
While he made no specific suggestions, he re-confirmed that, in the interim, before comprehensive tax reforms can be agreed, "there may be a way to address inversions in a bipartisan manner." He insisted, however, that such short-term proposals should "be a bridge to our ultimate solution to address the cause of the problem: our obsolete tax code."
Senate Finance Committee Chairman Ron Wyden (D – Oregon) has pledged to announce a solution to the corporate inversion issue in September. But with Democrats preferring legislation which is both "punitive" and retroactive, it is hard to see how a compromise will be arrived at.