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Stephen Ehrenberg
Stephen Ehrenberg

Corporate tax inversions

U.S. tax authorities act to reduce inversion activities.

October 30, 2014
by Stephen J. Ehrenberg, CPA

As the U.S. economy continues to rebound, corporate America has sought to further improve its bottom line. From reducing property and payroll costs to tightening budgets, the incentive to increase the wealth and satisfaction of shareholders is an ever-present goal for corporate taxpayers.

One means of achieving that goal, which has received much scrutiny in recent months, involves corporate inversions. Both taxpayers and taxing authorities face a dilemma in determining if these are indeed tax loopholes and, if they are, should the loopholes be closed? In response, the Treasury Department issued Notice 2014-52 in September to curb future inversion activity.

Corporate tax inversions: What are they?

Corporate tax inversions are governed by Sec. 7874 and the corresponding regulations. These provisions were enacted to restrict expatriation transactions, in which a corporation seeks to relocate its headquarters to a lower-tax foreign jurisdiction while operations remain in a higher-tax jurisdiction (usually the jurisdiction where the corporation originated). By relocating or inverting its structure so that the new parent corporation has its headquarters in a low-tax or no-tax foreign jurisdiction, the corporation can avoid U.S. taxes without substantially affecting its current operations.

This strategy has caused much debate in recent years. U.S. corporations, on the one hand, have argued that foreign relocation using inversion techniques benefits the economy by spurring cross-border activity. The IRS and Treasury, as well as President Barack Obama and his congressional supporters, on the other hand, argue that the corporate inversions are inconsistent with those Code provisions that govern daily operations, as well as mergers and acquisitions, with foreign corporations.

Notice 2014-52

In response to the perception that corporate inversions are increasing, Treasury issued Notice 2014-52 in an attempt to curtail inversion activity, including, but not limited to, announcing the intent to issue regulations under Secs. 367, 956, and 7874. The Fact Sheet explaining what Notice 2014-52 was attempting to accomplish under the new rules, which are effective Sept. 22, 2014, can be compared to the tax law in place before this development:

  • Prevent tax-deferred access to foreign subsidiary earnings through “hopscotch loans”:
    • Under the prior rules, U.S. corporations owed tax on the profits of their controlled foreign corporations (CFCs). However, this tax would be deferred until the profits were repatriated (typically in the form of a dividend). Rather than paying a dividend to the U.S. parent, corporations would use “hopscotch loans” (i.e., loans to the foreign parent as opposed to a U.S. domestic entity) to defer tax on these earnings.
    • Notice 2014-52: Hopscotch loans, which allow the U.S. entity to access the cash of the foreign subsidiary before recognizing the income, are now considered investments in U.S. property and thus are deemed to be constructive dividends under Sec. 956.
  • Prevent tax-deferred access to foreign subsidiary earnings through foreign restructurings:
    • Under the prior rules, a foreign parent would purchase a controlling amount (at least 80% of the vote or value of the stock under Sec. 1563) of a CFC’s stock from the former U.S. parent, which enabled the foreign corporation to access earnings without paying U.S. tax.
    • Notice 2014-52: The foreign parent is deemed to own the stock of the former U.S. parent, which subjects the earnings to U.S. tax.
  • Prevent tax-free transfers of cash from the CFC to the foreign parent:
    • Under the prior rules, the foreign parent would sell the stock in the former U.S. parent to a CFC in exchange for cash and property of the CFC, which allowed the foreign parent to access the CFC’s cash without recognizing the earnings.
    • Notice 2014-52: These types of tax-free cash transfers are no longer permitted.
  • Disregard passive assets in meeting the 80% ownership tests:
    • Under the prior rules, for a corporate inversion to occur, the shareholders of the former U.S. parent had to own less than 80% of the asset value of the new foreign entity. Before Notice 2014-52 was issued, all the assets of the new foreign entity would be included in this 80% test, including passive assets that were not used in daily operations.
    • Notice 2014-52: Passive assets, provided they make up at least 50% of the total asset base of the foreign corporation, are excluded for purposes of the 80% test.
  • Disregard preinversion extraordinary dividends for purposes of the 80% ownership tests:
    • Under the prior rules, a U.S. entity could pay out large dividends preinversion to reduce its size and meet the 80% threshold, also known as “skinny-down” dividends.
    • Notice 2014-52 would disregard these preinversion extraordinary dividends for purposes of the ownership requirement, thereby raising the U.S. entity’s ownership, possibly above the 80% threshold.
  • Prevent a U.S. entity from inverting a portion of its operations by transferring assets to a newly formed foreign corporation that it spins off to its shareholders (spinversion).
    • Under the prior rules, a U.S. entity could invert a portion of its operations by transferring a portion of its assets to a newly formed foreign corporation and then spinning off that corporation to its public shareholders.
    • Notice 2014-52: The spun-off foreign corporation would be treated as a domestic corporation, eliminating the use of this technique for these transactions.

Conclusion

News of corporate inversions has dominated the corporate tax landscape in recent months (and also has dominated the business news media). For instance, just last week, Ireland acted to close a tax loophole that gave multinational corporations a substantial tax incentive, colloquially called the “double Irish,” which involves setting up two Irish subsidiaries and funneling profits to a no-tax jurisdiction such as Bermuda (see article here). While corporate inversions will undoubtedly continue to receive attention, both domestic and foreign taxing authorities have taken notice and are acting to close or significantly reduce access to these loopholes.

Any U.S. company still considering an inversion transaction should consult its tax adviser, as the rules governing these transactions, both domestically and abroad, are complex and require intricate analysis to achieve the desired results.

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Stephen J. Ehrenberg, CPA, MBT, is a tax principal in the Los Angeles office of Holthouse Carlin & Van Trigt LLP.