October 2, 2014

Walgreens threatened to do it but backed down after intense negative publicity. Burger King is moving ahead with its own plans to do it despite the threat of backlash from angry consumers. And until recently, it appeared that the United States government was not in a position to do anything at all to prevent it.

Related article: Corporate Tax Inversion: The Tax Strategy That’s Losing the IRS Big Bucks

“It” is the practice of corporate inversion: the merger of an American corporation with a foreign company. Such mergers are made to facilitate a move to the country where the foreign company is located, allowing the American company to duck the 35 percent corporate income tax rate imposed by the IRS.

It’s estimated that corporate inversions could cost the IRS more than $20 billion in tax revenues from 2015 through 2024. But with the present hyperpartisan state of Congress, it appeared that no action would be taken to address the issue before the November 2014 midterm elections.

Closing the Borders

That was before the Treasury Department decided to step in on its own. Treasury Secretary Jacob J. Lew announced on September 22 that the department was taking independent action to clamp down on corporate tax inversions. In his announcement, Lew stated that the Treasury department is continuing to explore its options to curb corporate tax inversions. (Treasury.gov)

Specifically, Lew announced that going forward, so-called “hopscotch” loans would be prohibited from firms engaging in corporate inversions. “Hopscotch” loans allow US companies to skim their dividend tax obligations by “borrowing” profits made from controlled foreign corporations (CFCs) rather than declaring them as taxable dividends paid to the U.S. parent firm. Before the change in the regulations, such loans were not considered to be American funds – and were therefore not taxed.

The new regulations also cracked down on the practice of de-controlling, which allows foreign companies acquired by corporate tax inversions to avoid ever paying US taxes on the American company’s deferred earnings. In de-controlling, the newly acquired foreign parent company purchases enough of the CFC’s stock to gain control, allowing it to remain a foreign company and immune from American corporate taxes.

Now such transactions would be treated as a transfer of stock to the new foreign parent company from the former American parent company rather than the CFC, whose profits and deferred earnings would remain taxable by the IRS.

Lew also announced strategies to remove the financial incentives for two other strategies employed by companies engaging in corporate tax inversions: spin versions and skinnying down. With spin versions, American companies spin off entire units to foreign acquisitions. Skinnying down, which involves a company’s reducing its size before a merger through paying out special dividends, is also prohibited.

Reversing Course

These new regulations represent a reversal from the position expressed by Lew in July, when he stated that he did not believe the Treasury Department had the authority to stem corporate tax inversions on its own. It is possible that Lew was influenced by legal arguments made by Stephen Shay, professor of practice at Harvard Law School. Shay urged the secretary to take action against corporate tax inversions in an article published by Tax Notes in July. (Tax Analysts)

On the same day that Lew announced the new regulations, Tax Anaylists published an article by Steven Rosenthal, a senior fellow at the Urban-Brookings Tax policy center that supported the move. Rosenthal’s article states that Section 385(a), enacted in 1969 and expanded in scope by Congress in 1989, allows the Treasury department to designate certain obligations of an American company to a foreign affiliate as stock (which is subject to federal taxation) rather than debt (which is not). In other words, the Treasury department is on solid legal ground in its prohibition of “hopscotch” loans and other anti-inversion regulations. (Tax Analysts)

The Uncertain Future

Despite the actions taken by the Treasury Department, the Obama administration has expressed its preference to work with Congress to craft a collaborative approach to the problem. But an anti-inversion bill introduced by Democrats over the summer stalled in Congress. For their part, Republicans are seeking an overhaul in the entire corporate tax code and a lower corporate tax rate. Democrats also want to reform the corporate tax code – but with an emphasis on closing corporate tax loopholes.