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Here’s How New Regulations Deter Corporate Tax Inversions

  • By John Hintze
  • Published: 5/11/2016

For the first time, the United States Treasury is seeking to eliminate the incentives behind inversions and level the playing field between U.S.-based companies and foreign competitors. But will new rules issued April 4 be enough to deter U.S companies from pursuing the strategy and setting up headquarters in overseas tax havens?

The answer seems to be: Yes. 

Pfizer announced last November its intention to acquire Ireland-based Allergan in a $160 billion megamerger, in one of the largest corporate inversions to date. Pfizer's board nixed the deal after the Treasury Department published two sets of rules on April 4 designed to discourage inversions. Two days later, Pfizer publicly stated that the decision was driven by Treasury's actions, "which the companies concluded qualified as an 'Adverse Tax Law Change' under the merger agreement." 

The new rules are unlikely to halt the inversion strategy altogether, but the second set especially represents a significant development.

"The rules were an important milestone, because now Treasury is attacking the financial incentives that motivate inversions and why it's preferable to be a foreign-based multinational corporation (MNC)," said Bret Wells, an associate professor of law at the University of Houston Law Center specializing in tax laws. "And they did that not just for inverted companies but for all inbound foreign-based companies" acquiring subsidiaries in the U.S."

The April 4 rules codified what had already been issued as Treasury guidance. Those rules fall under Section 7874 of the tax code, which generally favors inversions when the U.S. company makes up less than 60 percent of the merged entity. Ownership between 60 percent and 80 percent may work, but not above 80 percent. 

One entirely new component of the rules says that acquisitions of U.S. subsidiaries by the foreign-based merger partner over the previous three years cannot be included in the percentage calculation. Allergan was acquired by Ireland's Activis a year earlier in a $70 billion deal, so removing that from the equation could have increased Pfizer's share into problematic territory.

The other set of rules published April 4 were issued under Section 385 and impact all corporate groups, whether U.S.- or foreign-based. The Section 385 rules define whether an interest in a corporation is debt or equity. Under the new rules, in certain circumstances, intercompany loans are treated as equity even though they otherwise have entirely debt-like characteristics.

"Among those circumstances are situations where the subsidiary distributes the note to the parent, or a subsidiary acquires the stock of another group member or parent for a note, or it acquires in a reorganization transaction the assets of another company in the group for a note," said Lee Morlock, a partner at Mayer Brown.

In the case of inversions, the strategy is typically to avoid having foreign-sourced income taxed in the U.S. while reducing U.S. taxable income by capitalizing the U.S. subsidiary with debt from its now foreign parent and deducting that interest expense from the U.S. subsidiary's income. Under the new rules, if the notes that reflect such intercompany lending are created through one of the specified forms of transactions, or are linked through a funding rule to such specified transactions, such notes are now viewed as equity for tax purposes. That eliminates the interest-expense deduction that may have been a major source of potential synergies expected form the inversion.

The rule impacts foreign-based companies with U.S. subsidiaries as well. For example, the U.S. subsidiary may be expanding organically or through acquisitions and wish to rebalance its capital structure to be consistent with its increased equity valuation. To do so without incurring third-party borrowing costs, it can distribute a note to the parent. If that parent is domiciled in a country that's a major trading partner with the U.S., there's typically no withholding tax and so no cost to the internal transaction. The U.S. subsidiary then proceeds to pay interest on that note to its parent and deduct that expense on its U.S. taxes. No longer. 

"The treatment of a note distributed by a subsidiary to its parent as a debt instrument dates back in case law more than 50 years," Morlock said. "This new rule reverses the case law, saying that a per se rule, not even just a presumption, all those instruments are automatically considered equity."  

Wells said that the ruling, although ad hoc and only applying to the types of intercompany notes defined in the rule, also starts to level the playing field between U.S.- and foreign-based companies, since the effect of the new rules attacks some of the financial advantages of foreign ownership. Indeed, he added, foreign competitors' competitive advantage stemming from the tax difference—for example, when pursuing acquisitions in the U.S.—have been the main reason behind inversions.

A longer version of this article will appear in an upcoming edition of AFP Exchange.

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