Last week, the Internal Revenue Service and Treasury Department announced a number of new regulations intended to make it more difficult to qualify for tax advantages associated with inversion transactions and reduce certain of those benefits. Nonetheless, the regulations, which are not retroactive and therefore only affect future deals or pending transactions that have not yet closed, appear unlikely to strip so much of the tax advantages associated with inversions as to stem the inversion trend. In announcing the regulations, however, Treasury Secretary Lew suggested that additional rule-making was likely, thereby holding open the possibility that future regulations may further reduce the tax benefits to be secured from inversions. We discuss below the new regulations, what they mean for companies that have signed agreements to merge but not yet consummated the transactions and the potential scope of future rulemaking by Treasury.

A corporate inversion is a transaction whereby a domestic company merges with a foreign entity (usually one that is domiciled in a more "tax friendly" country), achieves more than 20% new ownership, and is then able to claim non-U.S. residence and adopt the foreign country's lower corporate tax structure.1 Over the last few months, there have been a number of high profile U.S. companies seeking to invert, including Burger King (Canada), Medtronic (Ireland), AbbVie (Ireland) and Mylan (Netherlands).

The response to these transactions from those in the political sphere has been unsurprising: President Obama has called inversions "wrong" and "unpatriotic," while Treasury Secretary Lew wrote a letter to Congress requesting legislation stopping U.S. corporations "from effectively renouncing their citizenship to get out of paying taxes."2 Senators Schumer and Durbin quickly introduced legislation to combat inversions by restricting the deductibility of interest expenses and requiring IRS approval for foreign related-party transactions, although there seems little chance of Congressional action before mid-term elections.

There are, of course, existing laws that were enacted to make inversion transactions more difficult. As noted previously by the authors,3 section 7874 of the Internal Revenue Code (the "Code") seeks to prevent (by negating the tax benefits) U.S. entities from transferring stock or assets to foreign corporations, unless there is a significant change in ownership (i.e., no more than 60% of the stock of the newly constituted foreign corporation is held by former shareholders of the domestic entity). If the 60% threshold is crossed, the new foreign corporation is treated as a "foreign surrogate corporation," meaning that while it is generally respected as a foreign corporation for tax purposes, it is not permitted to use deductions to offset gain or income from the inversion transaction. If, however, 80% or more of the newly constituted foreign corporation is still owned by the former domestic shareholders, the entity will be treated as a domestic corporation for U.S. federal income tax purposes. An older Code provision, section 367, denies tax free status to certain transfers of stock of U.S. corporations to foreign corporations. Unlike section 7874, section 367 does not cause the foreign corporation's status as a foreign corporation to be recast. Instead, the transaction in question is subject to taxation.

Following the political uproar over inversions, on September 22, 2014, the IRS and Treasury Department issued Notice 2014-52 (the "Notice") indicating their intent to publish regulations that are intended both to make inversion transactions more difficult to accomplish and reduce their benefits. The new rules take a two-prong approach.

First, the regulations will seek to address transactions that are structured to avoid the application of sections 7874 and section 367. In particular, the new regulations will: (i) in calculating ownership of the merged entity for purposes of section 7874's 80% threshold, forbid inflating the size of the foreign acquirer by including "passive assets" (such as cash or marketable securities) that are not part of the foreign entity's daily business function;4 and (ii) disregard large, pre-inversion dividend payments or distributions (including spin-offs) by the domestic entity designed to reduce its size in order not to exceed the 80% threshold.5 Both of these provisions will make it harder for a domestic entity to effect an inversion, either because it will be more difficult to stay under the 80% threshold or because the transfer itself will be taxable under section 367.6 The Notice also addresses post-acquisition transfers of stock of the foreign acquiring corporation. Prior to the Notice, because the present regulations disregard post-acquisition transfers, one could claim exclusion from inversion treatment merely because an intermediate step in an acquisition involved a transfer to a member of the expanded affiliated group ("EAG"), a chain of corporations connected through stock ownership by a common parent where the parent owns more than 50% of the each corporation's stock. To eliminate this possibility, the Notice includes a provision that prevents the application of this rule if the foreign acquiring corporation's stock is later transferred in a transaction related to the acquisition to a person or entity that is not an EAG member.7

Second, taking aim at post-inversion restructuring, the Notice targets transactions involving controlled foreign corporations ("CFC") of the domestic entity.8 For example, to prevent companies from accessing CFC earnings tax free, the regulations will count as taxable U.S. property any loans made by the CFC to the new foreign parent (i.e., "hopscotch" loans). Additionally, the new rules will prevent the domestic entity from "de-controlling" its CFCs, i.e., having the new foreign parent purchase stock in the CFC in order to protect the CFC's deferred earnings from U.S. taxes. To accomplish this, the regulations will consider the new foreign corporation as owning stock in the former domestic entity, not the CFC, thus subjecting the CFC to U.S. taxation.9 Finally, the new rules will seek to limit the ability of the new foreign parent to avoid repatriation of cash or property by selling the stock of the former domestic corporation to CFCs in so-called "section 304 transactions."Under section 304, sales of stock to related entities are normally treated as dividends, rather than sales.10 Prior to the Notice, it was possible to take the position that no dividend was created by reason of the transfer. This will no longer be possible. Each of these provisions will be generally effective for acquisitions or transfers completed on or after September 22, 2014.

The impact of the Notice remains to be seen. The Treasury Department expressed measured optimism that the regulations would "significantly diminish the ability of inverted companies to escape U.S. taxation." Indeed, Treasury Secretary Lew said that "for some companies considering deals, [the new regulations] will mean that inversions no longer make economic sense." Secretary Lew also both called on Congress to enact additional reforms and suggested that further regulatory reform was forthcoming, noting that the new regulations were only the "first, targeted steps" designed to make "substantial progress in constraining the creative techniques used to avoid U.S. taxes."

The Notice itself stated that Treasury and the IRS "expect to issue additional guidance to further limit inversion transactions," including with respect to corporate strategies that "avoid U.S. tax on U.S. operations by shifting or 'stripping' U.S.-source earnings to lower tax jurisdictions." The Notice adds that the Treasury Department is also "reviewing its tax treaty policy regarding inverted groups and the extent to which taxpayers inappropriately obtain tax treaty benefits that reduce U.S. withholding taxes on U.S. source income."

So far, few of the companies involved in pending but unconsummated inversion transactions have commented,11 although it appears unlikely that the new regulations would permit a merging party to exit the deal even where the relevant merger agreements contain a provision that conditions the inverting company's obligation to close on there being no change in the applicable tax law. For example, the merger agreement between Medtronic and the Irish company Covidien contains a clause that the acquisition is subject to the condition that:

there shall have been no change in applicable Law . . . with respect to Section 7874 . . . or official interpretation thereof as set forth in published guidance by the IRS . . . [that] would cause [the new foreign corporation] to be treated as a United States domestic corporation for United States federal income tax purposes.12

At this point, it seems unlikely the new rules would permit Medtronic (or the various other domestic entities with largely identical provisions in their inversion agreements) from backing out of the deal (at least without paying a sizeable break-up fee) because the regulations do not actually change section 7874 to prevent a corporate inversion, but instead raise the bar to inverting and/or eliminate some of the benefits to such a transaction. Nonetheless, the regulations contemplated by the Notice, as well as the potential for additional rule making, very well may change the terms or scuttle pending or contemplated deals. As just one example, recent media reports suggest that Medtronic may attempt to restructure portions of its deal with Covidien, including by lowering its purchase price or asking Covidien to accept more stock and less cash.13

Footnotes

[1] For more on corporate inversion transactions, see Jason Halper, Peter Connors et al., The Legal and Practical Implications of Retroactive Legislation Targeting Inversions, The Harvard Law School Forum on Corporate Governance and Financial Regulation, Sept. 16, 2014, available at: http://blogs.law.harvard.edu/corpgov/2014/09/16/the-legal-and-practical-implications-of-retroactive-legislation-targeting-inversions/.

[2] Interestingly, former President Bill Clinton recently refused to call corporate inversions unpatriotic, noting that companies "answer[] to shareholders" and thus "feel duty-bound to pay the lowest taxes they can pay." Clinton continued that the U.S. has the "highest overall corporate tax rates in the world" and that "the best discouragement [of corporate inversions] is to reform taxes." Kevin Cirilli, Bill Clinton Shies Away from 'Unpatriotic' Label, The Hill, Sept. 23, 2014.

[3] See supra, note 2.

[4] Notice, §2.02(b). If more than 50% of the assets of the foreign entity are "passive," a proportionate amount of that entity's stock will not be counted for the purposes of section 7874's 80%-20% test.

[5] Notice 2014-52, §2.02(b). These pre-inversion distributions, which are often called "skinny-down" dividends, reduce the value of the domestic corporation, which, in turn, reduces the number of shares its former shareholders receive in the inversion transaction so that they will hold no more than 79% of the new entity. The new regulations will disregard any extraordinary dividends made within 36 months of the closing of the transaction.

[6] Section 367 imposes a tax on shareholders of a domestic company acquired by a foreign acquirer unless the value of the transferee foreign corporation is at least equal to the fair market value of the U.S. target company. In addition to disregarding large distributions designed to get under section 7874's 80% threshold, the new regulations will disregard transfers intended to avoid taxation under section 367.

[7] Notice 2014-52, §2.03(b)

[8] Notice 2014-52, §3.01(b). A CFC is a foreign corporation in which more than 50% of the stock is owned by certain classes of U.S. voting shareholders.

[9] Notice 2014-52, §3.02(e).

[10] Notice 2014-52, §3.02(b),

[11] A spokesman for Tim Horton's Inc., the Canadian company involved in the Burger King inversion transaction, said that the deal "is moving forward as planned," and noted that the merger was driven by long-term growth rather than tax benefits. Additionally, the CEO of AbbVie recently stated that he is "more confident than ever about the potential of [the] combined organizations."

[12] For a list of all inversion transactions since February 2014 and the substance of any no-change-in-law provisions in the relevant merger agreements, see supra, note 2.

[13] Katharine Grayson, Medtronic and Covidien are likely to renegotiate purchase terms: report, Minneapolis/St. Paul Business Journal, Sept. 29, 2014.

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