On Monday April 4, 2016, the U.S. Treasury Department released a comprehensive set of temporary regulations that are designed to stop the flow of headline-grabbing U.S. corporate expatriation transactions commonly referred to as "inversion transactions." These inversion regulations introduce certain new measures, including a rule targeted at so-called "serial" inverters, which can have a devastating tax impact on transactions within its scope. This new provision, for example, caused the prompt derailment of Pfizer's pending $160 billion inversion transaction with Ireland-based Allergan (at a reported cost to Pfizer of $150 million in breakup fees). These anti-inversion rules (and certain related party debt rules introduced in tandem as described below) are of particular relevance to Canadian companies for three principal reasons:
- First, although these regulations combat inversion transactions by extending the reach of the anti-inversion rules and blunting the effectiveness of conventional post-inversion tax planning, they do not address the underlying tax fundamentals and market forces that are driving U.S. companies to seek to invert: the 35% U.S. corporate tax rate is higher than most other developed countries, and it applies to all global earnings that are repatriated to the U.S. As a result, we expect that there will continue to be strong motivation for U.S. corporations to pursue inversion-style transactions and that, given the strong economic and geographical connection between Canadian and U.S. markets, Canada will become an increasingly attractive M&A destination for these U.S. companies.
- Second, given the extraordinarily broad reach of these anti-inversion and related-party debt rules, their impact will be felt far beyond the domain of inversion transactions. We expect that these new rules will spill-over into mainstream cross-border M&A transactions that have no underlying "inversion" motivation and may profoundly impact these deals in ways that may not be obvious or predictable. In particular, it seems clear that these new rules will have an important effect on the manner in which cross-border Canada-U.S. acquisition transactions are structured, diligenced and financed.
- Third, the new regulations serve as a reminder that once a business is incorporated in U.S. corporate form, it is extraordinarily difficult to exit the U.S. tax net. Accordingly, careful consideration should be given when starting a new business to incorporating in a jurisdiction outside of the U.S. at the outset (i.e., in Canada).
As a general matter, other than the "serial" inverter rule noted above, most of the content included in this important regulatory action is not "new" in the sense that these rules implement anti-inversion measures that had been previously announced in IRS Notices issued in 2014 and 2015. However, these new inversion regulations were introduced in tandem with sweeping new proposed U.S. tax regulations governing related party debt arrangements. If enacted in their current form, these new debt rules would not only be a powerful tool for the IRS in its efforts to combat inversion transactions, but given their extraordinarily broad scope, these rules would fundamentally change the manner in which Canadian corporations finance their U.S. subsidiaries with related-party cross-border debt. To review Osler's summary of these new debt regulations, please click here.
Generally, an inversion occurs when a non-U.S. company (i.e. a Canadian company) buys a U.S. company, and the shareholders of the U.S. company retain a substantial ownership in the foreign (i.e. Canadian) acquirer. After the acquisition, the combined group arranges its affairs so that (a) a portion of revenue is earned outside of the U.S., and (b) revenue earned within the U.S. is reduced as a result of interest payments or other intercompany transfers. Under the U.S. federal tax system, U.S. companies are taxed on their worldwide income, except that active income earned in foreign subsidiaries is taxed only when brought back to the U.S. An inversion sets the stage, structurally speaking, for a U.S. corporation to attempt to reduce its combined companies' gross U.S. tax payments on U.S. source income and avoid U.S. tax on non-U.S. source income through post-inversion restructuring and recapitalizations. The net impact of this post-inversion tax restructuring is to dramatically reduce the effective rate of U.S. taxation borne by the inverting enterprise. This reduction in U.S. tax burden can significantly increase the present value of a U.S. corporation's future stream of free cash flows, which serves as a powerful economic incentive to pursue this strategy. Canada has been considered an attractive home for inverted companies because the Canadian corporate tax rate (25%) is lower than the U.S. corporate tax rate (35%), and Canada generally provides an exemption for foreign-source active business income earned in over 100 countries.
The new U.S. regulations are the latest installment in a long line of regulatory actions designed to curb or kill the expatriation of U.S. corporations through inversion. While the anti-inversion rules have become extremely complicated, their basic architecture is relatively straightforward. Specifically, when a U.S. corporation and non-U.S. corporation merge or otherwise combine in a cross-border transaction, that combination will be subject to the U.S. anti-inversion rules if the former owners of a U.S. business own, by virtue of that former ownership, at least 60% (a 60% inversion) or 80% (an 80% inversion) of a foreign acquiring company (an FAC) after the combination. In an 80% inversion, the FAC is treated as a domestic corporation for all U.S. federal income tax purposes (which would completely frustrate the U.S. tax purposes of engaging in the transaction in the first place). In a 60% inversion, the FAC continues to be treated as a foreign corporation for tax purposes, but adverse tax consequences apply that, among other consequences, restrict the use of tax attributes to reduce U.S. taxable income of the group. Exceptions to the rules apply if the FAC, together with its affiliates, conducts substantial business activities in the country in which the FAC is created or organized. Substantially all of the high-profile inversions that have occurred over the past four years have been transactions that are 60% inversions.
New "serial inverter" measures
As noted above, an inversion analysis starts with computing a fraction, the numerator of which is the stock in the FAC owned by such former U.S. owners, and the denominator of which is the stock of the FAC owned by all shareholders. In an effort widely believed to have been intended to kill transactions like the Pfizer-Allergan transaction (where Allergan was only large enough to avoid the scope of certain inversion rules because of its previous combination with Actavis), the new regulations provide that if the FAC has acquired other U.S. companies within the 36 month period prior to the signing date of the U.S. acquisition (even in deals wholly unrelated to the inversion) then the value of the stock of the FAC that goes in the denominator is reduced by the value of those other deals (based on the value of the stock at the time of the subsequent acquisition), as illustrated in the following example:
Note, this example is meant to be an illustration only and is based on several assumptions regarding the share price, redemptions, and distributions of the FAC between the two testing dates.
These new measures, introduced for the first time in the April 4 temporary regulations, are generally effective as of April 4, 2016.
Confirmation and details of existing anti-inversion rules
For the most part, the anti-inversion regulations issued on April 4, 2016 do not contain new rules. Rather, these regulations confirm and implement the anti-inversion measures that were previously announced by the IRS in Notices issued in 2014 and 2015. See Notice 2014-52, 2014-42 IRB 712 (Sept. 23, 2014); Notice 2015-79, 2015-49 IRB 775 (Nov. 20, 2015). Most significantly, these regulations provide technical and clarifying language to implement the following previously announced rules:
- Non-ordinary course distributions: This rule (which was included in the 2014 IRS Notice) broadens the reach of the anti-inversion rules by providing that any "non-ordinary course distributions" made by a U.S. corporation in the 3-year period prior to a potential inversion will effectively be added back to the value of the U.S. corporation for purposes of testing whether the subsequent combination transaction is treated as an inversion. This effectively prevents pre-inversion transactions that are intended to "shrink" the size of the U.S. corporation so that its subsequent combination with a foreign merger partner does not qualify as a 60% or 80% inversion. For purposes of these regulations, a non-ordinary course distribution is a distribution during a taxable year that is in excess of 110% of the average distributions made in previous taxable years. Importantly, the new temporary regulations clarify that it is the value of the property distributed at the time of its distribution that is relevant for purposes of determining the hypothetical value of the U.S. corporation at the time of the potential inversion for purposes of applying this rule. This removes some of the ambiguity that previously surrounded this rule but leaves important questions unanswered. For example, in cases where a Canadian corporation acquires a U.S. target for consideration that includes cash and it appears that at least some portion of that cash consideration is financed from the U.S. target's balance sheet, the non-ordinary course distribution rule may potentially operate in unexpected ways to make that acquisition subject to the anti-inversion rules. Counterintuitively, this means that even in a deal that involves a Canadian acquiring company buying a U.S. target largely for cash, an inversion analysis may be required.
- Cash-box rule: The new regulations implement the so-called "cash box" rule that was announced by the IRS in the 2014 Notice. Under this rule, if more than 50% of the assets of a foreign corporation (that would be a merger partner in a potential inversion transaction) are comprised of "nonqualified property" (generally, cash, cash equivalents and marketable securities) then a portion of the foreign acquiring corporation's shares will be ignored for purposes of applying the 60% or 80% inversion test when that foreign corporation acquires a U.S. company. Broadly speaking, this rule neutralizes the ability of parties to manipulate the 60% or 80% testing fraction by "bulking up" the foreign corporation with passive, non-business assets. This rule is particularly problematic for Canadian special purpose acquisition companies (or SPACs) that seek to acquire U.S. target corporations with consideration that includes SPAC shares. The cash-box rule will, in many cases, cause such acquisitions to be 80% inversions, with the potentially awkward result that the SPAC would be concurrently treated as both a Canadian corporation for Canadian tax purposes and a U.S. corporation for U.S. tax purposes (by operation of the anti-inversion rules). The Canada-U.S. Tax Treaty does little to ameliorate the tax position of a corporation that finds itself in this position, which would result in the corporation being subject to full corporate taxation in both Canada and the U.S.
- Third-country parent rule: The April 4 anti-inversion regulations also provide more guidance on the "third-country rule," which provides that if a foreign company and a U.S. company combine under a new foreign company that is resident in a third country, the transaction is much more likely to be an inversion. We expect that this rule will limit the number of "destination" jurisdictions into which an inversion transaction may be successfully completed. Merger partners will not have as much flexibility to select a desired location for the new post-merger corporation, but will instead be constrained to relocating to the jurisdiction in which the foreign merger partner is organized. We anticipate that this rule, together with the new "serial inverter" rule, may have the result of causing U.S. corporations to look more closely at Canadian and U.K corporations as potential cross-border merger partners.
- Rules combatting the
effectiveness of post-inversion tax planning: The
April 4 anti-inversion regulations also provide for technical
implementation of a number of previously-announced measures that
were designed to nullify the effectiveness of common post-inversion
restructuring techniques. In particular, these regulations
combat two areas of post-inversion tax planning:
- "Hopscotch" loans: After an inversion transaction, an inverted U.S. corporation would frequently attempt to access previously inaccessible offshore earnings of foreign subsidiaries through the use of so-called "hopscotch" loans. Under these loans, foreign subsidiaries of the inverted U.S. corporation would lend cash directly to the new foreign parent, effectively bypassing the U.S. corporation and avoiding the material U.S. tax cost that would arise if those amounts had instead been repatriated to the U.S. shareholders. The rules, which were announced in 2014, frustrate this tactic by causing these loans to be subject to the U.S. subpart F anti-deferral rules which would frequently result in a significant current U.S. tax cost.
- Decontrolling transactions: After an inversion transaction, an inverted U.S. corporation may try to eliminate or minimize the U.S. tax cost of repatriating offshore earnings by having the new post-inversion foreign parent acquire a significant ownership interest in the inverted U.S. corporation's non-U.S. subsidiaries. These arrangements were designed to "de-control" the foreign subsidiaries from their former U.S. shareholder and thereby turn off the U.S. subpart F rules. The new regulations implement rules that combat these arrangements by effectively deeming the U.S. corporation's ownership in these entities to not be diluted.
The parts of the new April 4 Temporary Regulations that implement the measures described above are generally effective as of the date of the IRS Notice that originally announced these measures (September 22, 2014, in the case of the 2014 IRS Notice and November 19, 2015, in the case of the 2015 IRS Notice).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.