Corporate Inversions: Slowed But Not Stopped

Corporate Inversions: Slowed But Not Stopped

November 20, 2014 | By Keith Martin in Washington, DC

The US Treasury outlined six measures in late September that the Internal Revenue Service plans to implement in future regulations to discourage US companies from inverting.

The measures will apply to companies that invert on or after September 22, 2014. They are described in IRS Notice 2014-52.

The Treasury is still considering whether to take additional steps to discourage “earnings stripping.” However, any such action could affect European and Asian companies with US subsidiaries since such companies tend to capitalize their US operations with part debt and part equity. The debt allows US earnings to be brought home in the form of interest, allowing it to be deducted in the United States. Any action to limit earnings stripping could increase the tax burden on inbound US investment.


In a corporate inversion, a US company with substantial foreign operations inverts its ownership structure to put a foreign parent company on top with the aim of keeping future earnings from its overseas businesses outside the US tax net. The foreign parent may also strip earnings from the US subsidiary by capitalizing the US subsidiary with debt so that earnings can be pulled out of the United States as deductible interest on the debt.

Congress amended the US tax code in 2004 to make it painful for US companies to invert. Most inversions today involve a merger of a US corporation with a smaller foreign corporation. The shareholders of the US company retain less than 80% of the shares of the combined enterprise. If they retain 80% or more, then the IRS will treat the foreign parent as a US corporation, subjecting it to tax in the United States on its worldwide earnings. If they retain at least 60%, then a toll charge is collected on any appreciation in asset value when the company leaves the US tax net. A merger done properly allows the merged company to incorporate in a third country with lower taxes.

US multinational corporations have $1.95 trillion parked in offshore holding companies. The earnings cannot come back to the United States without being taxed. A key driver in many inversions is greater flexibility where to invest offshore earnings without subjecting them to US tax.

New Obstacles

The aim of the new Treasury measures is to make deals in the 60% to 80% range less economically appealing. The Treasury took three steps to prevent companies from circumventing existing US anti-inversion rules and three steps to prevent the new foreign parent from tapping into earnings in offshore subsidiaries without triggering US taxes on them.

It tightened existing anti-inversion measures as follows. First, it made it harder for inverting companies to use “cash boxes” by stuffing passive assets, like cash and marketable securities that are not used for daily business functions, into the foreign parent to ensure US shareholders do not own 80% or more of the foreign company. The Treasury said it will ignore shares in the foreign parent that are attributable to such passive assets when testing for whether shareholders of the inverted US company continue to own 80% or more of the redomiciled combined enterprise. However, this would only apply for a foreign corporation with at least 50% passive assets.

Second, the Treasury said it would also ignore “skinny-down dividends” — extraordinary dividends paid by the US company in the 36 months before the inversion to try to reduce the US company’s size so that its shareholders will not end up owning 80% or more of the merged enterprise.

Third, the Treasury took aim at “spinversions,” where a large diverse US company drops part of its assets into a newly-formed foreign subsidiary and then spins off the subsidiary to its public shareholders. The Treasury said it will continue to treat the spun-off foreign corporation as if it were a US company.

Three new steps are being taken to prevent the new foreign parent from getting access to earnings trapped in offshore subsidiaries without paying US taxes on them.

The United States taxes US corporations on their worldwide earnings. It taxes foreign corporations only on income from US sources. Therefore, many US multinationals are careful to own their investments and business operations outside the United States through offshore holding companies. The earnings are pooled in the offshore holding companies for reinvestment outside the United States. As long as the foreign earnings are from active businesses, they are not subject to US taxes until they are repatriated to the United States. However, if they are passive income like interest or dividends, then the US will look through the offshore holding companies and tax the US parent on the earnings without waiting for the earnings to return to the United States.

US multinationals look for ways to have the use of the earnings in the United States without formally repatriating them. Section 956 of the US tax code makes this difficult. That section treats any investment of the earnings in the United States as effective repatriation. Lending the money to the US parent or using it as collateral to allow the US parent to borrow from a third party is caught by section 956.

Some inverted companies get around the section by having the offshore holding companies make loans to the new foreign parent, bypassing the now intermediate US parent. These “hopscotch loans” are not considered investments in US property. The Treasury said new regulations will treat buying debt or stock of a foreign related person as an investment in US property, thus tripping section 956, when the debt or stock is acquired by an expatriated offshore holding company.

Section 956 only applies to offshore holding companies that are owned 50% or more by US shareholders — so-called “controlled foreign corporations.” In some inversions, the new foreign parent buys enough stock of an offshore holding company to reduce the US shareholders to under 50%. These “out-from-under transactions” then give the foreign parent access to the deferred earnings of the offshore holding company without ever paying US taxes on them. The Treasury said new regulations will prevent the new foreign parent from pulling the inverted offshore holding companies under it for 10 years after the inversion. Such companies will continue to be treated as controlled foreign corporations during this period.

Finally, the Treasury said some inverted companies are draining earnings from offshore holding companies by having the new foreign parent sell stock of the US parent — now its US subsidiary — to the offshore holding company. This has the effect of moving deferred earnings in the offshore holding company to the foreign parent. The stock sales proceeds will be treated as a dividend to the US subsidiary.

Earnings Stripping

The Treasury continues to look for ways to attack earnings stripping to drain earnings from US companies after inversions.

It said any such actions will apply prospectively after they are announced, unless the Treasury can figure out a way to limit the new rules solely to inverted groups, in which case they will apply to companies that inverted on or after September 22, 2014.

Brenda Zent, a tax specialist who works under the international tax counsel at Treasury, told a DC Bar tax section luncheon at the end of October that among the steps the Treasury is weighing are reducing the available interest deductions or reclassifying some debt as equity. “It’s possible that earnings stripping rules could be limited to inverted companies. And it’s also possible that [they] wouldn’t be limited,” Zent said at another conference the same day. “Inverted groups will definitely be targeted; the question is will other groups.” Douglas Poms, a senior counsel in the same office, said in early November that one or more additional notices are possible. One may address additional inversion issues, and the other would address earnings stripping. However, he said the timing of any additional guidance is uncertain.

Meanwhile, the likelihood of action by Congress to stop inversions has receded at least in the near term. Republicans will control both houses in the new Congress. Republican leaders believe the way to fight inversions is to reduce the corporate income tax rate and believe that narrowly-targeted measures will ultimately prove ineffective.

Market Reaction

Early evidence is that the Treasury actions in September may deter some companies from inverting, but will not halt all inversions.

Four deals appear to have unraveled as a consequence of the Treasury action. A merger of Irish food company Ffyfes Plc with larger US rival Chiquita Brands International was called off. US drugmaker AbbVie abandoned plans for a $55 billion inversion with Irish competitor Shire Plc. AbbVie said the new rules “reinterpreted longstanding tax principles in a uniquely selective manner designed specifically to destroy the financial benefits of these types of transactions.” AbbVie said it would pay Shire a breakup fee of $1.64 billion. Auxilium Pharmaceuticals Inc. cancelled an inversion with QLT Inc., a Canadian biotechnology company. Salix Pharmaceuticals Ltd. dropped plans to merge with Cosmo Pharmaceuticals SpA in Italy.

At least five deals that were in play before September 22 are still moving forward, including a plan by Burger King Worldwide Inc. to merge with Tim Hortons Inc. and move to Canada.

At least three new inversions were announced after the Treasury action.

Wright Medical Group Inc. said in late October that it will merge with Tornier N.V. in The Netherlands. Both companies make orthopedic implants. The new company will have its tax domicile in Holland but keep its US headquarters in Memphis. Wright shareholders will own 52% of the combined company. Steris Corp offered to buy Synergy Health Plc in the United Kingdom. Civeo Corp., an oilfield housing supplier in Houston, said it will move to Canada for tax purposes.

The CEO of US pharmaceutical company Pfizer said in late October that the company has not ruled out inverting, but he acknowledged concern about the possibility of additional Treasury actions.

There is speculation that eBay and PayPal could become merger and inversion targets. eBay is spinning off PayPal. eBay had $14 billion in offshore earnings at the end of 2013. Both companies draw an increasing share of their earnings from outside the United States.

Forty-one companies reported lobbying on inversions and related issues in the latest lobbying filings for the quarter ending on September 30, up from 16 in the previous quarter. Many could be affected by any future limits on earnings stripping.