Treasury’s New Inversions Rule (Apr. 8)

Mike & Co — 

The week opened with an announcement by Treasury of rules designed to curb corporate inversions.  By week’s end, the rules — which take effect on Monday — had their first success, or victim, depending on your perspective, as the proposed $70 billion Pfizer/Allergan merger was called off.  

Secretary Clinton released a statement on the new rules, implying that she would go further than the Treasury by imposing an “exit tax” on any company trying to leave the US to lower its tax bill.   “We need to close the loopholes that let corporations escape paying their taxes.”

Next: a look at Sanders’ statements to the NY Daily News about banks?  Or in/action on the SEC nomination front?  You decide. 

Good weekends all,

Dana 

——–

Operation of the Rules 

Proponents say the rule help to make inversion deals less palatable to foreign firms, while critics claim it only raises the cost of capital for foreign firms doing business in America which will ultimately lead to a decrease in international business activity here.

The main culprit in Treasury’s eyes, is earnings stripping — agent a foreign acquiring company “loans” a large amount of money to its new domestic subsidiary (actually, the U.S. firm just             distributes a note to its parent company and pays interest thereafter), to take advantage of the tax deductibility of interest payments.

Previous rules to curb inversions have led to an increase in mergers between roughly equally sized companies and large foreign firms buying up small American ones.  Monday’s rules will apply to all cross-border combinations, meaning that it will affect companies of any size, leveling the playing field for large, medium, and small businesses which may be inversion targets.

The rule defines related-party debt as stock under certain circumstances.   Under the new rules the IRS would have the authority to designate the note created by these deals as stock, not debt – making the interest payments into dividend payments, not eligible for tax deductions.

Per Treasury: “Specifically, the proposed regulations require key information be documented, including a binding obligation for issuer to repay the principal amount borrowed, creditor’s rights, a reasonable expectation of repayment, and evidence of ongoing debtor-creditor relationship.”

Current inversion laws require that a foreign parent company own a certain amount of stock in the company it targets for an inversion – the new rules state that stock owned by a foreign parent company that was acquired through a separate inversion within three years will not count toward that minimum.

Legal Challenges

There are two areas where Treasury is thought to be on thin ice legally — its rule to limit “recidivist” corporate inverters by tackling multi-step inversions and the guidance on earnings stripping that usesauthority granted to Treasury in 1969 through Section 385 of the tax code.  385 allows Treasury to distinguish debt from equity, but some tax lawyers consider it to be superseded by more recent legislation.  The former problem, regulating multi-step inversions, may run up against the challenge that Treasury cannot decide to unilaterally ignore the manner in which stock is accumulated for inversion purposes.

Although administration officials have claimed that the IRS’ ability to consider some debt as stock would only be utilized under specific conditions, industry lobbyists have claimed that the rule’s broad scope would act to increase the cost of capital for all foreign firms in the United States.

Congressional Action 

Treasury Secreatary Lew said after the release of these new rules that it’s up to Congress to put a stop to inversions permanently – saying that until such legislation passes “… creative accountants and lawyers will continue to seek new ways for companies to move their tax residences overseas and avoid paying taxes here at home.”

Earnings stripping has been the subject of debate for some time now, with Reps. Levin and Van Hollen putting forward a bill to deal with the tactic in February of this year.  Senator Schumer has argued in the past that earnings stripping is the primary reason driving inversions in the first place, saying “the only way to slam the door on inversions for good is to pass tough, strong legislation and reform our tax laws.”

GOP reactions are predictably negative, with Rep. Charles Boustany claiming that “This proposal will do little to stop actual inversions, but will make it more difficult for foreign firms to invest in the United States.”  The new proposals, American Action Forum President Doug Holtz-Eakin said, “have nothing to do with inversions.”

Eye of the Beholder

Complicating matters is that the two parties see earnings stripping in vastly different lights — to Democrats the tactic is a key motivating factor in inversion agreements (See: Sen. Schumer), while Republicans think inversions are driven by a hostile domestic tax system for companies.  JCT last year pointed out that a 2007 Treasury report “did not find conclusive evidence that foreign-controlled domestic corporations are engaged in earnings stripping, and could not determine with precision whether Code section 163(j) is effective in preventing earnings stripping by foreign-controlled domestic corporations.”

Under the new rules, the IRS would have the authority to designate the note created by these deals as stock, not debt – making the interest payments into dividend payments, not eligible for tax deductions.  Treasury: “Specifically, the proposed regulations require key information be documented, including a binding obligation for issuer to repay the principal amount borrowed, creditor’s rights, a reasonable expectation of repayment, and evidence of ongoing debtor-creditor relationship.”

Current inversion laws require that a foreign parent company own a certain amount of stock in the company it targets for an inversion – the new rules state that stock owned by a foreign parent company that was acquired through a separate inversion within three years will not count toward that minimum.

Treasury Secreatary Lew said after the release of these new rules that it’s up to Congress to put a stop to inversions permanently – saying that until such legislation passes “… creative accountants and lawyers will continue to seek new ways for companies to move their tax residences overseas and avoid paying taxes here at home.”

Earnings stripping has been the subject of debate for some time now, with Reps. Levin and Van Hollen putting forward a bill to deal with the tactic in February of this year.  Senator Schumer has argued in the past that earnings stripping is the primary reason driving inversions in the first place, saying “the only way to slam the door on inversions for good is to pass tough, strong legislation and reform our tax laws.”

Republican reactions are predictably negative, with Charles Boustany claiming that “This proposal will do little to stop actual inversions, but will make it more difficult for foreign firms to invest in the United States.”  The new proposals, American Action Forum President Doug Holtz-Eakin said, “have nothing to do with inversions.”

For Democrats’ part, it’s rapidly become gospel that earnings stripping is a critical issue in the inversion problem.  Considering the general strength of feeling that each party has on the matter, support for the new rules will come down along party lines.

Although administration officials have claimed that the IRS’ ability to consider some debt as stock would only be utilized under specific conditions, industry lobbyists have claimed that the rule’s broad scope would act to increase the cost of capital for all foreign firms in the United States.

“Glad to hear Pfizer is calling off the merger.  We need to close the loopholes that let corporations escape paying their taxes,” Clinton said on Twitter.  HRC  would impose further “exit tax” on any company trying to leave U.S. to lower its tax bill.

 

 

 

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