The recent wave of U.S. companies exploring corporate inversions, which has involved mega-billion dollar deals and household brands such as Pfizer and Burger King, has attracted significant attention and fierce criticism. Some people have gone so far as to characterize these U.S. companies as “unpatriotic” or even worse. The combination of inversion activity reaching new heights and the Congressional deadlock has caused the Obama Administration to act unilaterally in an effort to make inversions less attractive.
On September 22, 2014, the IRS released Notice 2014-52 describing regulations to be issued in order to limit the tax benefits of certain inversion transactions. The notice, focusing on certain post-inversion planning techniques, already led to the termination of AbbVie’s $54 billion merger with Shire Plc (triggering $1.64 billion in break-up fees) and impacted other pending deals.
Further developments in this area are to be expected but they would likely depend, on the one hand, on the appetite of dealmakers to pursue additional inversions using tax-enhancing techniques given the current uncertain environment and, on the other hand, on the impact such activity may have on prompting further action by Treasury or breaking the Congressional deadlock.
Inversions and Section 7874
Inversions have been around since the 1980s and they typically come in waves, generating strong public and political reactions that lead to Congressional or regulatory actions. These actions, in turn, require dealmakers to adjust their techniques and the companies they are targeting.
In a typical inversion, a U.S.-based multinational group transforms itself into a foreign-based group. There are many ways to achieve this, but the end result is that the U.S. shareholders of the U.S. inverted company become shareholders of a foreign parent. The relevant foreign country would typically offer a more favorable tax regime as compared to the U.S. tax regime and hence the new address gives the combined enterprise an opportunity to reduce its overall tax bill. The controversy centers around post-inversion strategies that can reduce the U.S. tax burden of the operations conducted in the U.S. and can also facilitate access to earnings that are trapped in foreign subsidiaries of the U.S. inverted company without triggering U.S. tax. The notice attacks a subset of those techniques.
In 2004, in reaction to a wave of “naked” inversions in which the foreign parent was usually a pure shell entity incorporated in countries that impose low or no tax, Congress enacted the anti-inversion provisions of Section 7874. Very generally, unless the group has “substantial” business activity in the foreign country, Section 7874 applies two anti-inversion rules depending on the percentage ownership fraction of the new foreign parent shares held by the former shareholders of the U.S. inverted company. If the percentage ownership fraction equals at least 60% but less than 80%, Section 7874 limits the ability of the U.S. inverted company to shelter gain from certain inversion-related transactions. If the percentage ownership fraction equals at least 80%, the new foreign parent is treated as a domestic company for U.S. tax purposes, thereby largely eliminating any U.S. tax benefits from such transaction.
The Recent Inversion Wave and the Notice
Dealmakers reacted to the enactment of Section 7874 (and Treasury regulations promulgated thereunder) by targeting foreign companies with real operations instead of shell companies. Those foreign companies are relatively significant in size (to avoid tripping the 80% ownership fraction test) but are still typically much smaller than the U.S. inverted companies.
The tsunami of potential inversions, including mega-size deal suitors like Burger King, Pfizer, AbbVie and Medtronic, attracted much publicity and harsh criticism. With the deadlock in Washington making short-term Congressional action extremely unlikely, the administration promised to pursue regulatory measures, leading to the issuance of the notice.
The primary focus of the notice is a set of rules attacking post-inversion tax avoidance strategies that make inversions so attractive. The notice also includes rules intended to protect against manipulation of the ownership fraction tests of Section 7874. These rules will generally apply to transactions that close on or after September 22, 2014, with no grandfathering provisions for signed but not yet completed deals.
While the notice does not formulate anti earnings-stripping rules, it provides that Treasury expects to issue additional guidance to further limit inversions and the benefits of post-inversion tax avoidance transactions, identifying in particular earnings-stripping strategies. Such future guidance is also expected to apply retroactively as of the date of the notice.
Attacking Certain Post-Inversion Tax Avoidance Strategies
The notice attacks the use of “hopscotch” loans from foreign subsidiaries of the U.S. inverted company to the new foreign parent (or other foreign affiliates) by treating any such “hopscotch” loans (and stock investments) made within 10 years after the inversion as transactions that give rise to taxable income to the U.S. inverted company.
The notice also deals with certain tax-free contributions by the new foreign parent (or other foreign affiliates) that are intended to dilute the ownership of the inverted U.S. company in its foreign subsidiaries. Such dilution may reduce and possibly even eliminate future U.S. taxation. One of the measures adopted by Treasury (which some question Treasury’s authority to adopt) is to recast certain transactions that take place within the 10-year period following the inversion as consisting of two back-to-back transactions: one between the new foreign parent and the inverted U.S. company and the other between the inverted U.S. company and its foreign subsidiary, thereby eliminating the dilutive effect.
As a backstop to the above-mentioned recast fiction, the notice requires, in certain cases, the inverted U.S. company to recognize as income the untaxed earnings and profits of its controlled foreign subsidiary, regardless of the extent of the dilution in its ownership thereof.
Tightening the Percentage Ownership Fraction Tests
To combat combinations involving foreign companies with disproportionate large amount of passive assets, the notice provides that if more than 50% of the gross value of the properties of the foreign parent (and its subsidiaries) consists of passive assets (such as cash and marketable securities), a proportionate amount of the newly issued stock corresponding to such passive assets would not count in applying the percentage ownership fraction tests.
The notice makes it harder for U.S. companies to shrink their size to better qualify under the ownership fraction tests by disregarding for those purposes certain non-ordinary course distributions made during the 36-month period ending on the inversion date.
In addition, protecting against the use of spinoffs and other divisive transactions to escape the reach of Section 7874, the notice provides that, in general, if stock of the new foreign parent is received by former shareholders of the U.S. inverted company and such stock is subsequently transferred, it will not be treated as held by a member of the expanded affiliated group for purposes of the ownership fraction tests.
The impact that the notice had on the market could not be disregarded. Several deals, including AbbVie’s $54 billion takeover of Shire and Salix Pharmaceuticals’ $2.7 billion combination with Cosmo Pharmaceuticals were terminated. In addition, a couple of pending deals would have to be adjusted given the post-notice tax environment. Most notably, Medtronic announced that it will alter the financing for its $43 billion takeover of Covidien, eliminating the use of “hopscotch” loans.
However, the notice cannot stop inversions entirely and indeed several pending transactions remain on track and a couple of new inversions were announced after the notice was issued. For now, tax benefits could make inversions attractive depending on the underlying facts and tax planning opportunities (not to mention the business objectives). So what can be expected next?
In the notice, Treasury warned that it continues to consider additional guidance to curb earnings-stripping strategies and asked for comments on such potential future guidance. Some view this as a signal of hesitation on the part of Treasury to take further unilateral action on that front in the very short term, but Treasury’s willingness to act may depend on continuing deal activity and the prospects of Congressional action, especially in light of the upcoming midterm elections. Pursuant to the notice Treasury is also considering tax treaty policy, but those measures, by their nature, may not be implemented unilaterally or quickly.
On Capitol Hill, the desire to pass tax legislation to curb inversions is split—and it is not entirely along party lines. Some, especially those who serve on the tax-writing committees, believe that much more should be done to reduce the attractiveness of inversions from a tax perspective. Others believe Congress should focus on overall tax reform or wait and see the impact of the Treasury regulations on market activity before taking next steps. Some have looked beyond the tax code and have suggested other means to discourage inversions, such as prohibiting government contracts with inverted companies.
It remains to be seen whether dealmakers will have the stomach to pursue more transactions using tax enhancing techniques given the current uncertainty and what impact such activity (or the lack thereof) may have on the likelihood for further action by Treasury and Congress.
Abraham (Avi) Reshtick is a partner at Bracewell & Giuliani in New York. He represents clients on a wide range of tax matters, with a particular focus on international and domestic transactions, mergers and acquisitions, joint ventures, private investment fund structures and capital markets transactions. He can be reached at [email protected].
Curtis Beaulieu is senior counsel at Bracewell & Giuliani in Washington, D.C. He focuses on tax policy, providing advice on federal legislation and regulations. He can be reached at [email protected].