The Internal Revenue Service (IRS) and the U.S. Department of Treasury issued a Notice (Notice 2014-52) last Monday that would further their efforts to prevent U.S. companies from using an increasingly prevalent tactic known as inversion to lower their tax bill. Conventionally, an inversion is a negotiation in which a U.S. multinational company restructures with a foreign company, which then proceeds to take over the parent company for tax benefits. These benefits enable U.S. businesses to lower their tax brackets by acting as newly configured foreign companies taxed under the foreign country’s tax brackets rather than under the U.S. brackets—which are the highest of any developed country.
This is an especially huge incentive for U.S. companies with large overseas markets because the U.S. tax code imposes income taxes on profits earned abroad in addition to domestic profits. Inversion can offer huge tax breaks.
Companies have numerous ways to use inversions to their advantage under current law. Inverted companies can make “hopscotch” loans–loans made by a company’s foreign subsidiary to a foreign parent company created through an inversion, enabling a bypass of IRS taxes. They may avoid U.S. taxes on pre-inversion earnings of foreign subsidiaries by causing the domestic parent company to give up control of the foreign subsidiaries and their profits to the new foreign parent. Additionally, stripping is a form of lending where the new parent company lends money to its U.S. companies who will have to pay back the loan. Thus, the U.S. firms are able to deduct the interest payments from taxable income, consequently stripping taxable profits.
The U.S. has the highest nominal tax rate in the world, 39.6 percent, so it’s no surprise that businesses want to play hooky and skip out on taxes by moving their legal headquarters to countries with excitably lower tax brackets such as Ireland. A recent target relocation point for many companies, Ireland has a current standard rate of corporate taxation of 12.5 percent.
Companies also have considerable motivation to create new homes in Bermuda. In 2011, Google Inc. dodged roughly $2 billion in taxes by legally transferring $9.8 billion in foreign revenues to a shell company, Google Netherlands Holdings, in Bermuda from overseas subsidiaries. Bermuda does not have any corporate income tax. Nike also admitted to tax dodging, having a dozen subsidiaries in Bermuda.
According to a study just released by the Congressional Research Service, while only 29 inversion deals occurred in the 21 years leading up to 2003, the past decade has seen 47 negotiations and more spawning. An operation that first became prevalent in the 1990s, it is enjoying a new vogue and proving to be a quickly growing phenomenon in the U.S.
Section 7874 of the Internal Revenue Code was enacted in 2004, shortly after Congress realized that numerous companies were inverting. The regulation quickly negated tax breaks produced by inversions into corporations where proprietorship was not greatly affected. It also created a stipulation where U.S. businesses had to merge with a foreign partner in order to invert themselves as a foreign company.
However, there was a provision gain for corporations included in Section 7874. It stipulated that if a foreign corporation is a surrogate foreign corporation and the former owners of the expatriated company receive at least sixty percent of the foreign firm but less than eighty percent, it will not be treated as a U.S. corporation for tax purposes. There are plenty of other ways to work around Section 7874 as well.
The Obama administration is looking for ways to stem inversions. Treasury Secretary Jacob J. Lew stated last week, “While comprehensive business tax reform that includes specific anti-inversion provisions is the best way to address the recent surge of inversions, we cannot wait to address this problem. Treasury will continue to review a broad range of authorities for further anti-inversion measures as part of our continued work to close loopholes that allow some taxpayers to avoid paying their fair share.”
The latest Notice 2014-52 was prompted by the latest inception of a business deal between Burger King and Canada’s Tim Hortons, a multinational café and bake shop renowned for its coffee and doughnuts. The $12.5-billion deal would restructure the world’s third-largest fast food chain as a Canadian company. Canada’s highest nominal federal tax rate is only 29 percent, a staggering 10.6 percent drop from the U.S. Patrons instantly jumped on board and called for consumer boycotts on Burger King’s Facebook page. Almost immediately, the fast food giant replied to the extreme retaliation by stating “We hear you. The decision to create a new global QSR leader with Tim Hortons is not tax-driven. BKC will continue to pay all of our federal, state and local U.S. taxes.”
Both Tim Hortons and Burger King deny these tax-avoidance accusations. Canadian Finance Minister Joe Oliver retorted, “We believe this has been a constructive move that is designed to retain capital in this country.” Before this business deal can be finalized, Tim Hortons shareholders still have to approve it and regulatory approval must be received from both Canada and the U.S.
The Treasury published the Notice regardless. It reduces the benefits of hopscotch loans by treating any hopscotch loans or stock investments made within ten years of an inversion as taxable and an investment in U.S. property. Additionally, any foreign subsidiary pre-inversion earnings given up by the domestic parent company used to purchase property within ten years would also count as taxable.
The Notice tightens the ability for businesses to count in the sixty percent to less than eighty percent range by excluding a percentage of passive assets from the ownership calculation. It also disregards dividends made during the 36 months leading up to the acquisition. The Notice further prevents companies from shrinking their pre-inversion size by making sizeable dividends.
The IRS and Treasury have made it clear that they also plan to put into place additional new rules regarding inversion. President Barack Obama has also incorporated provisions to limit inversions in his 2015 budget request.
Other controversial pending inversion transactions are notably transpiring. Chicago-based biopharmaceutical company, Abbvie, has plans to acquire Shire; Abbvie plans to restructure itself on Britain’s small island of Jersey. Minneapolis-based Medtronic, a medical device company, has pending plans to acquire Covidien and is attempting to relocate to Ireland. Three other drug companies such as Mylan, Salix, and Auxilium all have plans to relocate upon acquiring foreign firms. Chiquita Brands International also has plans to transfer its legal headquarters.
Nonetheless, Notice 2014-52 went into effect on September 22, 2014 and must be regarded by all business deals completed on or after September 22.