Treasury Department Issues Rules on Corporate Inversions

September 24, 2014

pic-irs-tax-smOn Sept. 22, the U.S. Department of Treasury and the Internal Revenue Service (IRS) released a guidance that takes targeted action to reduce the tax benefits of corporate tax inversions. According to the Obama administration, companies are increasingly using inversions, whereby a U.S.-based multinational restructures so that the U.S. company is replaced by a foreign corporation, in order to avoid paying U.S. taxes. Treasury Secretary Jacob Lew has been urging Congress to move forward with anti-inversion legislation, which, according to him, is the only way to fully rein in these transactions.

The regulations are intended to increase the effective tax rate for foreign acquirers of U.S. targets and tighten the anti-inversion rules of section 7874. Specifically, the rules would target three practices: using complicated loan structures to skirt U.S. tax; restructuring foreign subsidiaries to void deferred tax; and tampering with the size of the merger partners to skirt anti-inversion ownership tests currently in place.

First, the proposed rules would prevent inverted corporations from selling stock in the former U.S. parent to a controlled foreign corporation—a foreign subsidiary of the old U.S. parent—in order to repatriate earnings tax-free. Notably, this rule, under section 304(b) of the tax code, would affect already-inverted corporations; the rest would only affect corporations that “flip” their nationality after Sept. 22.

The rules also target so-called hopscotch loans by treating foreign loans funneled through the new foreign parent as U.S. property for tax purposes. Loans from controlled foreign corporations to their U.S. parents are supposed to be taxed, but some corporations avoid the rule by having the controlled foreign corporation lend the money to the new foreign parent and then have them invest in U.S. property without being taxed.

Treasury would prevent inverted firms from restructuring the original U.S. firm’s old foreign branches, which owe U.S. tax on foreign earnings that is typically deferred until repatriation. Currently, the new foreign parent can buy up stock in the controlled foreign corporations as a way of “de-controlling” them in order to access the earnings tax-free.

Finally, the proposed rules would also limit corporations’ ability to count “passive assets that are not part of the entity’s daily business function” toward the requirement that the new foreign parent own at least 20 percent of the merged firm in order to be taxed as foreign. Treasury would also disregard large pre-inversion dividends paid out to shrink the U.S. company’s size before the acquisition.

The issue over tax inversions has been heavily debated by lawmakers this past summer, with Congressional Democrats introducing legislation that would either change the threshold for an inversion to be respected or tighten the earnings stripping rules for inverted companies. Those bills have gained little traction, and Congress adjourned last week without taking any action on the inversion issue.

NSBA continues to call for congressional action on comprehensive tax reform and reiterates to lawmakers our principles of tax reform that should guide Congress’s approach when dealing with problems such as inversions.