United States: Tax Policy Update - July 21, 2014

Last Updated: July 25 2014
Article by Russell W. Sullivan and Danielle R. Dellerson

NUMBER OF THE WEEK: 1,537

The number, at last count, of news stories published online just within the last week related to U.S. corporate "inversions," according to a Google search using the phrase "tax inversion." Today's Tax Policy Update takes a deep dive into the swelling sea of inversions and outlines some of the considerations that lawmakers are — or should be — grappling with as they debate what to do about the growing number of U.S. corporations moving their addresses overseas to lower-tax jurisdictions.

LEGISLATIVE LANDSCAPE

House: Charity-Related Bills Pass. The House passed a tax bill 277-130 on Thursday, July 17, 2014, that includes five tax benefits related to charitable giving.

H.R. 4719, as passed, makes permanent three currently expired "extenders," including the enhanced tax benefit for donation of conservation easements permanent, the rule allowing certain tax-free distributions from individual retirement accounts for charitable purposes, and an expanded charitable deduction for contributions of food inventory.

The legislation also includes two new provisions — one that allows taxpayers to apply charitable contributions made up until April 15 in any given year, to the previous tax year. The other would set a flat 1 percent excise tax rate on private foundations' investment earnings.

Highway Funding Bill Gets Bipartisan Support. Last Tuesday, July 15, the House of Representatives passed H.R. 5021, the highway funding bill that would keep the Highway Trust Fund solvent through May 2015. The measure passed 367-55 after a motion to recommit to the Transportation Committee failed. The $11 billion measure raises revenue from "pension smoothing," which involves a revision to interest rates on pension plan liabilities and a one-year extension of current customs fee authorities through Sept. 20, 2024. The legislation would also transfer $1 billion from the Leaking Underground Storage Tank (LUST) fund.

The White House announced support for the House version of the bill last week, although President Obama chided both the Senate and the House for their failure to come up with a longer-term solution to the highway funding shortage.

The Senate now faces the choice of simply passing the House bill or attempting to pass the Senate's version, which would require a conference or further negotiations with the House. The latter scenario is less likely given the time constraints with the August recess fast approaching and the president's support for the House version.

Senate: Inversion Buzz Grows. Treasury Secretary Jack Lew sent a strongly worded letter to members of Congress on July 15, 2014, urging the top tax policymakers to quickly pass legislation that would halt tax-motivated inversion deals until comprehensive tax reform can be completed. Lew also called for retroactive application of the policy to May 2014, when several U.S. corporations began announcing inversion deals were in the works.

Finance Committee Chairman Ron Wyden (D-OR) has voiced concerns in the past over the spate of recent inversions, and in a statement released July 16, 2014, Wyden called on fellow lawmakers to plug the "inversion loophole." "As the speed of inversions increases, this will only fuel bipartisan urgency to stop companies from deserting the U.S. I'm talking with my colleagues and exploring options for addressing this in the near and long term," Wyden said.

On Thursday, July 17, Sen. Orrin Hatch, the top Republican on the Senate Finance Committee, wrote Treasury Secretary Jacob Lew "to push back against the administration's recent call for 'punitive, retroactive policies designed to force companies to remain domiciled in the United States.' Hatch wrote that the best way to resolve the issue is through comprehensive tax reform," but he also acknowledged that "there may be ways Congress can act in the near-term."

Hatch's sentiment garnered support from House Ways and Means Dems, who tweeted in response: "Sen. Hatch says in letter to Sec. Lew that he is open to short-term steps to address corporate inversions. Will other #Republicans?" Hatch's full statement and Secretary Lew's letter can be viewed here.

The buzz surrounding inversions is expected to hit a crescendo this week. On Friday, July 18, 2014, U.S. pharmaceutical company, AbbVie Inc. announced it had finalized a deal to purchase Shire Plc, which is based in the U.K. where AbbVie plans to move its new parent company, lowering its tax rate from 22 percent (effective rate) to 13 percent. This latest inversion news is sure to be a hot topic at tomorrow's Senate Finance Committee hearing entitled, "The U.S. Tax Code: Love It, Leave It, or Reform It!"

Inversions are complex — both from a legal standpoint and a political and policy perspective. To help us sort it out, McGuireWoods LLP's Mike Rodgers offers his insights below.

DIGGING IN to INVERSIONS

Current tax law allows U.S. multinational companies and their affiliates to use so-called inversion transactions to expatriate to lower tax jurisdictions and significantly reduce their long-term tax burden. While the tax code already employs a variety of rules designed to discourage these transactions, the recent wave of high-profile companies inverting (or considering inverting) has convinced many in Congress that more needs to be done.

In a corporate inversion transaction, a U.S.-based multinational entity ("U.S. parent") restructures its group so that after the transaction, the parent corporation of the group is a foreign entity. For tax purposes, inversion transactions often simply cause the US parent to trade places (i.e., "flip flop") with a foreign corporation. As long as new persons hold more than 20 percent of the shares of the new foreign parent, the inversion will be recognized under U.S. law. However, if stockholders of the U.S. parent prior to the transaction hold at least 80 percent of the stock of the new foreign parent, current tax law treats the new foreign parent as a U.S. corporation, denying it any tax benefits from the inversion.

As a result of the inversion, the U.S. parent avoids application of various anti-deferral rules in the U.S. tax code. For example, under the controlled foreign corporation (i.e., "subpart F") regime, a U.S. taxpayer must report certain types of passive income earned by its foreign subsidiary on a current basis, regardless of whether the income is actually repatriated. Under this regime, a loan made by a controlled foreign corporation to the U.S. parent (which would otherwise allow the parent to reduce its income by making deductible payments abroad) will often also give rise to current income inclusions by virtue of Internal Revenue Code Section 956.

In a nutshell, after an inversion is completed, most US multinationals are in a position where very little has changed from an operational, or even a financial reporting, standpoint. The status-quo of the business essentially continues, albeit with a significantly lower tax bill.

Types of Inversion Arrangements

Mechanically, for tax purposes, an inversion may be achieved one of three ways: (1) a stock transfer, (2) an asset transfer, or (3) a so-called "drop down" transaction.

Stock Transfer

In a stock transfer inversion, shareholders of a U.S. parent corporation exchange stock in the US parent for stock in a foreign subsidiary either directly (by virtue of IRC § 368(a)(1)(B)) or indirectly, by way of a reverse subsidiary merger described in IRC § 368(a)(2)(E). In a less common variation, a U.S. parent can transfer its foreign subs to a foreign parent in a section 351(a) contribution in exchange for a second class of foreign parent stock ("hook stock") immediately before the inversion.

Asset Transfer

In a second variety of inversion, a US parent corporation contributes substantially all of its assets to a foreign subsidiary in a merger, with foreign subsidiary surviving. In this case, the US parent may be treated as undergoing a mere "change in form," by virtue of IRC § 368(a)(1)(F) (i.e., a type "F" reorganization).

Drop Down

A drop down is essentially a hybrid of the stock and asset transfers described above. In a drop down, a US parent distributes assets to a new foreign subsidiary, which then contributes a portion of the assets to its own newly-formed US subsidiary. For tax purposes, to the extent the foreign parent retains the assets originally contributed by the US parent, a drop down triggers the consequences of an asset transfer, while to the extent the foreign parent contributes the assets to the new US subsidiary, tax treatment resembles that of a stock transfer.

Inversion Trends

The 2004 Jobs Act brought about the first wave of inversion reform and resulted in the introduction of IRC § 7874. This rule provided that in cases where original US stockholders of the expatriating US parent held 80% or more of the new foreign parent after the inversion, the new foreign parent would simply be treated as a US company. This effectively prevented the US expatriating entity from benefiting from the inversion. As a result, the rule put an effective end to shifts to zero percent tax havens (such as Bermuda and the Cayman Islands) where, generally, no substantial business activities were taking place.

In recent years, inversions have moved to jurisdictions such as Ireland, the UK, Switzerland and Canada, whose tax laws have a lot to offer US multinational corporations looking to reduce their effective rate. Besides simply having lower corporate rates than the US, these countries offer expansive treaty networks through which a company can benefit from reduced withholding taxes on royalties, dividends, and interest, taxpayer-friendly transfer pricing rules, and other elements of territorial (rather than worldwide) taxation, such as participation exemptions from certain capital gains and gains on dividend distributions. In other words, each of these jurisdictions offers its resident corporations ample planning opportunities to significantly reduce taxes on foreign source income – the key ingredient for a newly inverted enterprise looking to reduce tax leakage within its expanded affiliated group.

The main drivers behind an attractive inversion destination are (1) a low corporate tax rate and (2) a system of taxation that either does not tax foreign source income or allows for a low effective tax rate on foreign source income through special rules and other incentives. For example, many European nations, such as the Netherlands and Luxembourg, have incorporated taxpayer-friendly "patent" or "innovation" box systems potentially allowing for very low effective tax rates on IP related income. Other jurisdictions have become greener pastures for IP companies by featuring transfer pricing rules that are lenient when compared to US transfer pricing rules.

Since 2008, according to a review conducted by Reuters, there have been at least 20 corporate inversion transactions, virtually equaling the total number of such transactions occurring over the previous 25 years. This seems to be proof that the introduction of IRC § 7874 in 2004 has done little to dissuade multinationals from undertaking such transactions.

Proposed Legislation

Under current law, an inversion transaction will be respected where former shareholders of the US parent retain at least 60 percent but less than 80 percent of the stock of the new foreign parent. In such a case, the only downside is that the U.S. corporation and transferring shareholders will pay toll charges under IRC §§ 367 and 7874 against which losses and other tax attributes may not be applied. New law would reduce the 80 percent threshold to 50 percent and impose an additional rule that the inversion will not be respected if the expanded affiliated group of the new foreign parent accounts for more than 25 percent of sales, employees, OR assets remaining in the US. While the change to the 80-percent threshold is a strengthening of current law, this new second prong, the 25-percent requirement, is brand new and is arguably even more restrictive than the first.

S.2360 and H.R. 4679 would both impose these rules retroactively to May 8, 2014, however S.2360 would be in effect only for two years, while H.R. 4679 would remain in place indefinitely.

Bipartisan Solutions?

There are a couple of widely accepted options for dealing with inversion transactions. The first two involve substantial global tax reform, while the third effectively mirrors the current Congressional proposal.

The source of the inversion transactions is almost certainly the comparatively high US corporate tax rate. Lowering the corporate tax rate would thus dis-incentivize inversions. However, some pundits believe that given current revenue concerns, it would be difficult, if not impossible, to reduce the US corporate rate to the level needed to stop the inversions altogether.

As a remedy to this, the US could switch to a territorial tax system, or put into place measures that allow a US multinational to greatly reduce its US tax on income derived from foreign sources. A US person is currently subject to tax on worldwide income, regardless of source.

The current proposal opts for a more immediate approach and attacks the transactions themselves, while leaving the door open for more global tax reform in the future. A downside to this is that the underlying problems remain. Clearly, inversion transactions are a sign that the current corporate tax rules in the US are impacting the ability of our homegrown enterprises to be competitive on the global market. Rather than punishing these businesses for maximizing their competitiveness and honoring obligations to their shareholders, there is a strong argument that a punitive "quick fix" should be forgone in favor of mobilizing the global reform that both Republicans and Democrats agree both inevitable and of paramount importance.

REGULATORY WORLD

IRS Issues Final "Mixed Straddle" Rules. The Internal Revenue Service issued final regulations on Thursday, July 17, 2014, concerning the treatment of unrealized investment gains and losses in so-called mixed straddle deals. The final rule requires taxpayers to account for the gains and losses from the futures contracts as though their subsequent offset investments don't exist. The IRS said the final rules will be effective July 18, 2014, but will only apply to straddles established after Aug. 18, 2014.

COURTS & LEISURE

No Deductions for Fines Paid to European Commission. TThe U.S. Tax Court ruled on July 17, 2014, that a U.S. manufacturer could not deduct, under Internal Revenue Code Section 162(f), fines it paid to the European Commission for its role in a price-fixing cartel. The court said that the EC is an "instrumentality" of the governments of its member states, and Section 162(f) denies deductions for "any fine or similar penalty paid to a government for the violation of any law."

LOOKING AHEAD

In keeping with the "inversion" theme this week, the Senate is expected to vote on legislation that would both limit deductions for companies that outsource and encourage others to move operations to the U.S., according to comments made last week by Sen. Debbie Stabenow (D-MI). The Bring Jobs Home Act (S. 337) would give companies up to a 20 percent credit for some expenses related to relocating the foreign operations of a business to the U.S. Employers are also required to increase their number of full-time, U.S.-based workers to claim the credit. To discourage outsourcing, S. 337 would deny tax deductions for certain expenses related to moving U.S.-based operations overseas.

The House plans to vote on two more tax provisions this week, including H.R. 3393, dealing with college costs, and H.R. 4935, relating to the child tax credit. Both bills passed out of Ways & Means on party-line votes, with Democrats objecting because neither provision is paid for.

Please see below for further detail on these events and others in Washington this week. /p>

Relevant Congressional Activity

Senate Finance Committee

On Tuesday, July 22, 2014, the Senate Finance Committee will hold a hearing on "The U.S. Tax Code: Love It, Leave It or Reform It!: A discussion of the current U.S. system of international taxation." Witness testimony will be given by:

  • Mr. Robert B. Stack; Deputy Assistant Secretary for International Tax Affairs; U.S. Department of the Treasury
  • Mr. Pascal Saint-Amans, Director; Centre for Tax Policy and Administration; Organisation for Economic Co-operation and Development (OECD)
  • Dr. Mihir A. Desai; Mizuho Financial Group Professor of Finance & Professor of Law; Harvard University
  • Dr. Peter R. Merrill; Director, National Economics and Statistics Group; PricewaterhouseCoopers
  • Dr. Leslie Robinson; Associate Professor of Business Administration; Tuck School of Business, Dartmouth College
  • Mr. Allan Sloan; Senior Editor at Large; Fortune

Senate Homeland Security and Governmental Affairs Committee

On Tuesday, July 22, 2014, the Senate Permanent Subcommittee on Investigations will hold a hearing on "Abuse of Structured Financial Products: Misusing Basket Options to Avoid Taxes and Leverage Limits." The Subcommittee will examine a set of transactions that utilize financial engineering and structured financial products to attempt to avoid paying U.S. taxes on short-term capital gains. Witness testimony will be given by:

  • Steven M. Rosenthal; Senior Fellow; Urban-Brookings Tax Policy Center
  • James R. White; Director, Tax Issues; U.S. Government Accountability Office
  • Martin Malloy; Managing Director; Barclays
  • Satish Ramakrishna; Managing Director, Deutsche Bank Securities Inc.; Global Head of Risk and Pricing for Global Prime Finance
  • Mark Silber; Executive Vice President, Chief Financial Officer, Chief Compliance Officer, and Chief Legal Officer; Renaissance Technologies LLC
  • Jonathan Mayers; Counsel; Renaissance Technologies LLC
  • Gerard LaRocca; Chief Administrative Officer, Americas, Barclays; Chief Executive Officer, Barclays Capital Inc.
  • M. Barry Bausano; President and Managing Director, Deutsche Bank Securities Inc.; Co-Head of Global Prime Finance
  • Peter Brown; Co-Chief Executive Officer and Co-President; Renaissance Technologies LLC

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.

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