At the end of 2014, the published number of U.S. individual citizens revoking their U.S. citizenship for another home country hit an all-time high of just over 3,400. Through the third quarter of 2015, over 3,200 individuals renounced their U.S. citizenship. Thus, things were definitely on pace for another record-setting year. Most tax practitioners speculate that the ever-increasing complexities of U.S. tax compliance and the Foreign Account Tax Compliance Act (FATCA) have largely fueled the growing number of individual expatriations.
On the flip side of the coin, there has been a similar trend in the corporate arena. One of the more controversial tax topics inside the Beltway in the last couple of years has been the resurgence of corporate tax inversions. With over 50 inversions completed in the last decade, of which approximately 25 percent occurred in the last couple of years, what is fueling this disturbing trend? Just follow the cash. It’s no secret that U.S. multinationals have stockpiled over $2.1 trillion in foreign profits offshore since 2005 because the U.S. taxes worldwide income (e.g., the combined federal and state rate can exceed 40 percent) – either currently or at some future date. This disincentivizes many U.S. multinationals to repatriate foreign earnings to defer this incremental U.S. taxation.
During earlier, weaker economic times, U.S. companies perhaps took a wait-and-see approach to what corporate tax reform (e.g., a shift to territorial taxation) might happen and/or whether another “one-time” tax-favored repatriation holiday would be reintroduced (similar to the one a decade ago) to encourage repatriation. Companies also focused intensely on delivering incremental shareholder value by implementing cost-cutting initiatives and have likely capped out and exhausted those measures. As the global economy has strengthened and there has been a surge in strategic transactions, U.S. multinationals tapped into corporate tax inversions to deliver significant shareholder value a different way – a reduced U.S. tax bill.
What Is an Inversion?
Simply put, inversion is the process whereby a U.S. multinational group essentially redomiciles outside the United States. That is, the U.S. parent company of the group is either replaced with a non-U.S. parent company or, perhaps, becomes a subsidiary of a foreign parent corporation, even if all the current executives remain in the United States after the inversion. Under current legislation, a strategic transaction with a foreign company provides the only palatable opportunity to accomplish an inversion. A full takeover does not work, but a merger might. The ideal foreign target corporation for a U.S. multinational should be big enough to constitute at least 25 percent of the merged group but smaller than the U.S. multinational, such that the foreign target shareholder proportion in the merged group falls within at least a 20 to 40 percent range.
Furthermore, a U.S. multinational group that is no longer domiciled in the U.S. is typically and consequently no longer subject to U.S. taxes on its foreign income (i.e., territorial taxation – taxation only in the jurisdiction where the income is earned). The existing U.S. operations/jobs generally remain intact – that is, there is not a significant exporting of U.S. jobs offshore. The gravy in some inversion transactions beyond the self-help territorial taxation can be the use of intercompany debt to leverage up the U.S. operations, which, subject to existing so-called earnings-stripping limitations, reduces the U.S. cash tax burden while achieving a favorable tax rate arbitrage on the interest.
The upshot of an inversion is simple: global access to the foreign “trapped” cash while potentially bypassing the U.S. tax net. Just how powerful is this? With the prospect of having an effective tax rate that could be reduced by 35 to 50 percent, for example, U.S. multinationals are willing and/or able to pay a considerable premium for a foreign target corporation that in some (not all) cases makes it too difficult for the foreign target shareholders to refuse. Of course, the proverbial “tax tail” does not (and should not) wag the dog, and thus any strategic transaction would primarily be executed first and foremost to create and drive value to the shareholders, typically inured through posttransaction operational synergies. Naturally, due consideration must also be given to a whole host of other factors (e.g., change in control issues, public policy and political issues, access to capital, SEC requirements, financial reporting requirements, national security regulatory considerations, etc.) when analyzing the cost-benefit analysis of undertaking an inversion.
The Congressional Reaction
What has been Congress’ response to the increased incidences of companies announcing their intention to invert? After several legislative and administrative proposals and congressional debate over what type of legislative action would be appropriate to tighten the rules on inversions and thus halt (or at least significantly slow down) the rising number of companies looking to invert with strategic third-party transactions, the Treasury Department took its first shot across the bow and issued Notice 2014-52 on September 22, 2014, which not only tightened the noose on the existing anti-inversion legislation but also aimed to complicate any postinversion planning. This notice effectively served as a stun gun on inversions. That is, it did have some quick-hit impact, which resulted in a few large inversions being called off within weeks of its issuance. In other cases, it may not have halted an inversion but certainly increased the anticipated cost of the transaction by causing the U.S. corporation to have to seek more expensive external financing (as opposed to internal financing with existing offshore cash) to complete the transaction.
More recently, the Treasury Department issued Notice 2015-79 on November 19, 2015, which is further aimed at making inversions less attractive, albeit much of the guidance is effective on a prospective basis. The most notable provision in this recent guidance that is surprising to tax practitioners is a potential limitation tied to where the foreign target is located. That is, up to now, the jurisdiction of the foreign target corporation has not been problematic. This provision is broadly designed to stop companies from cherry-picking a tax-friendly country for their tax residence. It remains to be seen if perhaps the government is going a little too far and interpreting their authority too broadly.
Will inversions continue? Yes, just ask Pfizer, which recently announced its intention to merge with Dublin-based Allergan, creating what will be the largest inversion to date in U.S. history. And this was not the only inversion in 2015. Under current law, the Treasury Department, despite its recent attempts, is limited in its ability to fully address and stop inversions, and there really is no guarantee that the provisions described above would even hold up in court if tested.
In summary, the history of inversions has proven to be a little bit like the Whack-A-Mole game, and congressional action is likely key to fully addressing inversions. That said, the optimal long-term solution would be best derived through comprehensive tax reform (e.g., territorial taxation with perhaps a U.S. corporate tax rate reduction), which takes time. It would similarly take some comprehensive tax reform to slow down the rising individual expatriation rate. In all likelihood, 2017 is looking like the earliest any such comprehensive tax reform could occur.
Timothy R. Larson, Partner-in-charge of the tax and business services department for Marcum’s New York City office and national partner-in-charge of International Tax Services group. timothy[email protected]
Published January 5, 2016.
