United States: Obama Budget Proposes Further Restrictions On Corporate Expatriations And Limits On Deductibility Of Interest Paid To Foreign Parent

President Obama's budget proposal, which was submitted to Congress on March 4, 2014, includes a provision that, if enacted, would further restrict domestic corporations from expatriating through so-called corporate inversion transactions. The proposals also limit the U.S. tax benefits that can be realized through expatriation transactions.

The President's tax proposals are divided into two categories: (1) general tax revisions intended to reduce the deficit (achieved mainly by increasing the tax burden on upper income individuals) and (2) a revenue neutral package, including the anti-inversion proposals, that are meant to be enacted as part of comprehensive tax reform. Although most observers judge comprehensive tax reform unlikely in the near term, the anti-inversion legislation is significant because it highlights the Treasury Department's awareness that corporate expatriations can be achieved through cross-border business combinations.

In an inversion, the corporate structure of a U.S.-based multinational group is altered so that the historic U.S. parent company becomes a subsidiary of a corporation organized in a foreign jurisdiction. Typically, that foreign jurisdiction (e.g., Ireland, the UK and Switzerland,) affords a preferential tax regime (a tax system with relatively low effective rates and broad exclusions for income earned by or received from foreign subsidiaries) and a tax treaty with the United States. Critically, a non-U.S. organized parent permits planning to reduce the taxable income of U.S. operations through tax deductible payments to the foreign parent, often consisting of interest or royalties, and by facilitating ownership of non-U.S. assets, including subsidiaries, outside of the U.S. tax net.

In the last two decades, legislative and regulatory changes have restricted the opportunities and increased the costs of corporate expatriations. But a remaining strategy for achieving expatriation is for a U.S. company to combine with a non-U.S. entity, which becomes the parent of the combined group with the non-U.S. entity's historic shareholders continuing to own at least 20 percent of the non-U.S. parent shares.

Inversions under current rules are generally permitted if following the inversion the domestic corporation's historic shareholder base owns less than 80% of the foreign acquiring corporation (the "80% test"). If the 80% test is not met, the foreign acquiring corporation is treated as a domestic corporation for all U.S. tax purposes, absent certain difficult to meet exceptions, including where the foreign parent has substantial assets, employees and local customer revenue in the foreign parent's place of organization (the "substantial business exception"). The current anti-inversion rules also can eliminate certain historic U.S. tax assets where pre-combination owners of the domestic corporation continue to own at least 60% of the post-combination foreign parent company (the "60% test").

According to the President's proposal and its official explanation, the adverse tax consequences associated with inversions that meet the 80% test, but fail the 60% test, have not prevented these transactions from occurring, and the increase in inversions in recent years has facilitated the erosion of the U.S. tax base.

The proposal, which would be effective for transactions completed after December 31, 2014, would, among other things:

1) reduce the 80% test to a greater than 50% test, meaning the transaction would need to result in a transfer of a majority of shares to foreign owners;

2) eliminate the 60% test;

3) provide that regardless of the level of shareholder continuity, an inversion will occur if the affiliated group that includes the foreign corporation has substantial activities in the United States and the foreign corporation is primarily managed and controlled in the United States; and

4) provide that an inversion can occur if there is an acquisition either of substantially all of the assets of a domestic partnership (regardless of whether such assets constitute a trade or business), or of substantially all of the assets of a trade or business of a domestic partnership.

The proposal has two key aspects. First, it would prevent domestic corporations from using "reverse acquisitions" (transactions where a larger domestic entity is effectively acquired by a smaller foreign corporation, but the domestic corporation's shareholders and management remain in control of the post-combination group). The proposal also would prevent domestic corporations from relying on the "substantial business exception" to the current inversion rules, if the inverted company is managed and controlled within the United States.

The budget proposal also includes a new rule to limit the U.S. tax deductibility of interest expense payable to a foreign parent when a multinational group's U.S. operations are over-leveraged relative to the group's worldwide operations. Specifically, the U.S. interest expense deduction of any member of a group that prepares consolidated financial statements would be limited to the member's interest income plus the member's proportionate share of the financial reporting group's net interest expense computed under U.S. income tax principles (based on the member's proportionate share of the group's earnings as reflected in the group's financial statements). This provision, which appears to broaden Administration budget proposals to tighten limitations on the deductibility of interest paid by an "expatriated entity" to related persons, would significantly curtail a key earnings stripping strategy. Nonetheless, opportunities would remain for expatriated groups where the foreign parent (or its non-U.S. affiliates) can license intellectual property to the U.S. group.

Finally, although the anti-earning stripping proposal is included in the President's comprehensive tax reform proposals, the Congressional Budget Office indicates it would raise significant revenue. Revenue raisers (to a lesser extent descriptive of the anti-inversion legislation previously discussed) can be attractive provisions to attach to other bills. In this regard, a variation of the anti-earnings stripping proposal was included in Chairman Camp's Proposal for Tax Reform.

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