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June 2, 2014
Inversion Rule Tightening to Wait for Tax Reform, Wyden Says
by Andrew Velarde and Lindsey McPherson

Full Text Published by Tax Analysts®

Just after Michigan Democrats and brothers Sen. Carl Levin and Rep. Sander M. Levin introduced legislation May 20 to tighten inversion rules under section 7874 that attempt to prevent U.S. companies from moving their tax residence overseas to avoid U.S. taxation, the top Senate taxwriter threw cold water on the idea of changing stock ownership rules before enacting comprehensive tax reform.

"I think it's pretty obvious the Senate is having some challenges right now ordering a Coca-Cola, let alone passing a major piece of legislation," Senate Finance Committee Chair Ron Wyden, D-Ore., told reporters May 20. "What I tried to do in effect is put everybody on notice what the rule would be as part of tax reform."

Wyden was referring to a May 9 op-ed he wrote in The Wall Street Journal calling for an increase in the percentage of foreign ownership of an inverted corporation for it to be deemed a foreign corporation not subject to U.S. worldwide taxation. Under section 7874, an inverted company is considered domestic if at least 80 percent of its stock is held continuously by owners of the former domestic business; lawmakers often speak of the provision as implicitly setting a floor of 20 percent for stock owned by foreign investors

"As chairman of the Senate Finance Committee, I am committed to raising this floor to at least 50 percent for all inversions taking place from May 8, 2014, on," Wyden wrote in the op-ed. "I don't approach retroactivity in legislation lightly, but corporations must understand that they won't profit from abandoning the U.S."

In the Stop Corporate Inversions Act of 2014, introduced as companion legislation in the House (H.R. 4679) and Senate (S. 2360), the Levins would lower the section 7874 ceiling to 50 percent, similar in effect to Wyden's plan. The legislation also provides that a merged company would continue to be treated as domestic if management and control of the merged company remains in the United States and 25 percent of its employees, employee compensation, income, or assets are located or derived in the United States. The legislation treats management and control as occurring in the United States if substantially all of the executive officers, senior management, and individuals who exercise day-to-day responsibility for making strategic, financial, and operational policy decisions are based within the United States.

The Senate version of the bill differs from the House version (H.R. 4679) in that it would sunset after two years. Both have a retroactive May 8 effective date.

Sen. Levin said he sees his version as a way to "stop the bleeding" until lawmakers enact comprehensive tax reform. He acknowledged that he included the sunset provision as a way to appeal to Republicans who say that reform of the international tax system will solve the inversions problem. Rep. Levin, ranking minority member of the House Ways and Means Committee, said he decided against including the sunset in his version because he sees inversions as a growing problem that tax reform cannot fully resolve. However, both said Congress cannot wait to act on the inversion issue, especially given the political uncertainty surrounding a tax code overhaul.

Asked if Wyden's disinterest in addressing inversions outside of tax reform effectively killed his bill, Sen. Levin said, "No, because we can always try to find a bill on the floor to offer [our bill to] as an amendment." He added, "If there's a vote on the floor, it may be different. What [Wyden] does in committee may be different from how he votes."

Wyden said he believes international tax reform alone will not prevent companies from inverting for tax purposes. "I think you're going to need to deal with inversions specifically, but certainly the best way to do it is part of comprehensive tax reform," he said. Wyden said he and Finance Committee ranking minority member Orrin G. Hatch, R-Utah, are planning to soon hold a series of hearings on comprehensive tax reform, including one on the international tax system that would touch on the inversion issue.

Asked about the possibility that lawmakers would not agree to the retroactive date for the inversion rules as part of comprehensive tax reform, Wydendemurred, saying that the Finance Committee has taken a retroactive approach in the past. "This is not some kind of unprecedented thing," he said.

Wyden said his op-ed was meant to "freeze the linebackers" by putting companies on notice that retroactive changes to inversion rules are coming. But companies and practitioners might not take the May 8 effective date seriously, a practitioner at a top-tier U.S. law firm said, speaking on condition of anonymity.

"I don't know of any [tax] bill that has ever been retroactive to introduction," the practitioner said. "It may have an effect of creating a rush [of inversions], in the meantime, if companies don't take the effective date seriously." He added that even if the bill were to be enacted today, a company could still avoid the bill's provisions by merging with a bigger foreign company and not having substantially all the management of the combined company in the United States.

Carol P. Tello of Sutherland Asbill & Brennan LLP said the inclusion of the two-year moratorium in the Senate bill -- designed to permit Congress to enact more comprehensive tax reform -- "makes a great deal of sense." She added that she found it interesting that the legislation is "tinkering with the percentages on the foreign substantial business activities test." The test provides an exception to treating a company as an inverted domestic corporation if the corporation has substantial business activities in the foreign country of organization.

"Buried in there is the fact that the IRS has the authority to change that percentage because it is not statutory," Tello said. "It's at 25 percent now . . . but the IRS made up that rule; it's a regulatory rule, so they can change it anytime they want."

"One could infer from that being in the statutory proposal that [lawmakers] are inviting the IRS to raise the threshold," Tello added.


Reaction to Pfizer?

Inversions have been getting attention from lawmakers lately, largely because of the previous plan of pharmaceutical giant Pfizer Inc. to merge with the much smaller U.K. company AstraZeneca PLC. The proposed merger would have allowed Pfizer to relocate its tax residence to the United Kingdom and possibly save the company $1 billion or more in taxes each year. Congressional Republicans blame the potential inversion of the company on the high U.S. corporate tax rate. Executives from AstraZeneca have opposed the merger, arguing that the valuation Pfizer places on the U.K. company for the potential deal is too low. On May 19, AstraZeneca's board announced in a release that it had rejected Pfizer's "final proposal."

"This has never been about one deal," Sen. Levin said. "The Pfizer deal is just in some ways the tip of the iceberg." Pfizer's actions have led shareholders of other companies to put pressure on their executives to pursue a similar tax avoidance strategy, he added.

Although the Pfizer merger may never to come to fruition, it has refocused lawmakers' attention on inversions and the need to reform the international tax system. Comparing the growing interest to a nasty fever, Rep. Levin said, "The temperature on inversions may not be 105, but it's a long way from 98.6."

House Speaker John A. Boehner, R-Ohio, said that inversions like Pfizer's are an issue that the House should act on and one reason the United States needs to enact tax reform.

"U.S. companies have . . . $2.2, $2.3 trillion worth of corporate profits sitting overseas. And because of our broken tax code, we make it virtually impossible for them to bring that back here, [but] they've got a responsibility to their shareholders," Boehner said. "And so, we bear some of the responsibility in forcing companies to actually take steps like this, because we make it so expensive for them to bring those earnings back here. And so fixing that is frankly a big priority of ours."

Joseph Calianno of Grant Thornton LLP said the legislation would significantly increase the likelihood under the inversion rules of the top tier corporation being treated as a domestic corporation after a restructuring transaction.

"Some legislators are seeking to use the inversion rules as a stick," Calianno said. "It seems as if the focus of Congress and the administration should be on trying to make the United States more competitive from a business perspective through corporate rate reduction and other measures designed to attract and retain companies, rather than focusing on tightening the inversion rules."

The Alliance for Competitive Taxation was similarly critical of the proposed legislation. "If we want to encourage companies to locate, invest, and create jobs in the U.S., then we have to address the root cause -- America's broken tax code," the group said in a release "We have serious concerns that the legislation proposed by Senator Levin and Congressman Levin would do nothing to address the competitive disadvantages inherent in our tax code. It would actually make the situation worse and could lead to even more jobs and businesses leaving America."

Under current law, section 7874 generally provides that some adverse tax consequences apply if substantially all of the assets of a domestic corporation are acquired by a foreign acquiring corporation, the owners of the domestic corporation retain a sufficient ownership interest in the foreign acquiring corporation, and the expanded affiliated group does not conduct substantial business activities in the country in which the acquirer is created or organized. If the continuing ownership of shareholders of the domestic corporation in the foreign acquiring corporation is 80 percent or more, the new foreign parent corporation is treated as a domestic corporation for all U.S. tax purposes (the 80 percent test). If shareholders continue to own 60 percent of the company, foreign status is respected, but other adverse tax consequences may apply, including imposition of an excise tax on share-based executive compensation and disallowance of the use of net operating losses against inversion gain (60 percent test).

It is unclear how much these other adverse tax consequences discourage inversions for companies that only fail the 60 percent test, but avoid being re-domesticated under the 80 percent test, when potential tax savings can be so lucrative. Companies have proved willing to pick up the tab and pay the excise tax for their executives upon an inversion, as was the case recently with Endo International PLC, which had previously inverted into Ireland with its former shareholders retaining 79 percent ownership in the new company. In its most current Form 10-Q filing, Endo revealed that it planned to pay $60 million in excise tax owed by its top executives under section 4985 as a result of the company's expatriation. As explained in its Form S-4/A filing in January, Endo concluded that "it would not be appropriate to permit a significant burden arising from a transaction expected to bring significant strategic and financial benefits to Endo and its shareholders . . . to be imposed on the individuals most responsible for consummating the transaction."


Similarities to Obama Budget Proposal


The Levins' legislation resembles an international provision proposed by the Obama administration in its fiscal 2015 budget, released in March, that would broaden the definition of inversion by reducing the 80 percent test to a 50 percent test and eliminating the 60 percent test. The proposal would add a special rule in which, regardless of the level of shareholder continuity, an inversion transaction would be deemed to occur if the affiliated group that includes the foreign corporation has substantial business activities in the United States and the foreign corporation is primarily managed and controlled in the United States.

As noted by the Treasury Department in its green book explanation released concurrently with the budget, "there is no policy reason to permit a domestic entity to engage in an inversion transaction when its owners retain a controlling interest in the resulting entity, only minimal operational changes are expected, and there is significant potential for substantial erosion of the U.S. tax base." But practitioners have worried that the Obama proposal could produce absurd results by possibly bringing some foreign corporations under the umbrella of U.S. taxation for a result that was never intended by section 7874.

Given its management and control test, the Levins' legislation could seemingly lead to the same unintended results that would occur under what was previously proposed by the Obama administration.

"It seems to say [that] if you have a foreign company that is already primarily managed in the U.S., and it acquires a U.S. company, then even if the foreign company is much bigger it becomes a U.S. company," Michael L. Schler of Cravath, Swaine & Moore LLP said. Having the potential for a preexisting foreign company to be swept up into U.S. taxation under inversion rules, even in the case of an acquisition of stock or assets of a small U.S. company for cash, would be an "extreme result," he said.

Luca Gattoni-Celli contributed to this article.

Correction, May 27, 2014: The article incorrectly said the Stop Corporate Inversions Act of 2014 would raise the minimum threshold for foreign ownership of inverted companies above which an inverted business would be considered foreign-domiciled. In fact, the bill would limit continuous ownership of the newly inverted company by former shareholders or partners in the original domestic business, treating the new company as domestic for tax purposes if such owners hold more than 50 percent of its stock.

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