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Tax Inversions the Target of New Rules & Regs

Last month, I blogged about the rise of corporate inversions, which are basically strategic international business mergers designed to reduce a company’s tax rate in the United States. I indicated that these mergers were a thorn in the Treasury Department’s side, and speculated that the U.S. would continue to tinker with this area of law. Well… I was right. Only President Obama and the Department of the Treasury have done more than “tinker,” they have put new temporary regulations in place that make inversion-aimed mergers much less desirable, and announced plans to make additional permanent rules designed to shut tax inversions down entirely.

As Jeffrey Zients, the Director of the National Economic Council and Assistant to the President for Economic Policy, explains on the blog, the new regulations limit corporate inversions in two ways:

1. Addressing “serial inverters”: In a “serial inversion,” a U.S. company undertakes an inversion by acquiring a foreign company that itself has inverted or grown larger through acquisitions of U.S. firms. Serial inverters may be able to avoid penalties under existing law that kick in if the foreign firm in an inversion transaction is below a certain size in relation to the U.S. firm that is acquiring it.

To give an example, first, a U.S. company inverts overseas: it moves its residence to another country for tax purposes by acquiring a smaller foreign firm and locating the residence of the combined firm in the foreign country. Next, another U.S. company undertakes an inversion by acquiring the new foreign company that was created in the first transaction. In this way, one tax inversion can beget another tax inversion: One American company can follow another American company out the door.

Treasury’s action restricts serial inversions by not counting inversions or foreign acquisitions of U.S. firms occurring within the last three years when applying the formula that determines whether an inversion is subjected to penalties or blocked by existing tax code rules. That means that companies cannot use a recent inversion or a recent foreign acquisition to enable an inversion and avoid triggering penalties.

2. Addressing “earnings stripping”: Earnings stripping is a tactic that large foreign-based companies use to avoid paying U.S. taxes by artificially shifting their profits out of the United States. They are able to shift profits by having their U.S. affiliate pay interest on a loan from an affiliate in another country, typically a low-tax country. This is a win-win for the corporation: the U.S. affiliate lowers its taxes in the United States by deducting the cost of their interest payments, and then the foreign affiliate owes little or no tax on those interest payments.

The ability to strip earnings out of the United States using such related-party loans is a major incentive for U.S. firms to acquire a foreign tax residence by inverting. Earnings stripping also erodes the U.S. corporate tax base and puts other firms at a competitive disadvantage.

Treasury’s new action addresses earnings stripping by recharacterizing certain related-party interest payments as dividends that cannot be deducted – in other words, preventing debt that doesn’t actually finance new investment in the United States from receiving a tax break.

These new regulations are already having an impact. U.S. pharmaceutical giant Pfizer called off its plans to complete a $160 billion merger with the Irish company Allergan. Other companies who were in the process of merging with a foreign company, or even exploring the possibility, should take a cue from this, and take time to talk to an international tax lawyer about whether the deal still makes financial sense.

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