Corporate inversions are back in the news this week following the Treasury Department’s release of temporary regs aimed at curbing the practice. Treasury also issued proposed regs aimed at the practice of “earnings stripping.” The regs received a mixed reaction, as expected, with some questioning whether the rules exceed Treasury’s authority. U.S. tax rules are more difficult to sue over than other types of government regs due to a number of factors, including the Anti-Injunction Act. A number of prominent tax experts spoke about these difficulties and the prospects of mounting a legal challenge to the new regs.
Background. Corporate inversions (also called “expatriation transactions”) generally involve a U.S. corporation that engages in a series of transactions with the effect of moving its headquarters from the U.S. to a lower-taxed foreign jurisdiction. The transactions might be effected by the U.S. corporation becoming a wholly owned subsidiary of a foreign corporation (through a merger into the foreign corporation’s U.S. subsidiary) or by transferring its assets to the foreign corporation. If the transaction is respected, U.S. tax can be avoided on foreign operations and distributions to the foreign parent, and there are opportunities to reduce income from U.S. operations by payments of fees, interest, and royalties to the foreign entity.
Inversion transactions are generally governed by Code Sec. 7874, under which a foreign corporation is treated as a U.S. corporation for all purposes (i.e., the benefits of being treated as foreign are lost) of the Code where, under a plan or series of related transactions:
- The foreign corporation completes, after Mar. 4, 2003, the direct or indirect acquisition of substantially all the properties held directly or indirectly by a U.S. corporation;
- Shareholders of the U.S. corporation obtain 80% or more of the foreign corporation’s stock (by vote or value) by reason of holding their U.S. shares (the “80% test”); and
- The foreign corporation, and corporations connected to it by a 50% chain of ownership, don’t have “substantial business activities” in the foreign corporation’s country of incorporation or organization when compared to the total business activities of the group. (Code Sec. 7874(b); Code Sec. 7874(a)(2)) “Substantial business activities” means, for this purpose, 25% of the firm’s employees, assets, and sales being in the foreign country. (Reg. § 1.7874-3)
A separate set of rules apply to inversion transactions where the domestic corporation’s shareholders obtain at least 60% but less than 80% of the foreign corporation’s stock (the “60% test”). In general, the tax benefits associated with being a foreign corporation are reduced, and the expatriated entity’s “inversion gain” (defined as any income recognized during a 10-year period by reason of the acquisition, not offset by a net operating loss (NOL) or foreign tax credit) is taxed at the maximum corporate rate. (Code Sec. 7874(a)(2)(B)) These rules effectively penalize, but don’t prohibit, inversions.
Also, in certain inversions, Reg. § 1.367(a)-3(c) may cause a U.S. person that is a shareholder of the domestic parent corporation to recognize gain (but not loss) on the exchange of its stock in the domestic corporation.
New regs. Earlier this week, IRS issued temporary regs intended to address transactions that are structured to avoid the purposes of Code Sec. 7874 and Code Sec. 367, as well as certain post-inversion tax avoidance transactions. The temporary regs include rules that are aimed at “serial inverters” and that limit a company’s ability to participate in successive inversions within a relatively short time frame. For purposes of meeting the above 60% and 80% tests, the regs change the current rules so as to not take into account certain U.S. assets that the foreign corporation acquired within the past three years (effectively decreasing the size of the foreign corporation for purposes of those tests, and thus making the transaction less likely to qualify for the benefits associated with inverting). They also generally incorporate the rules in two Notices that IRS issued in 2014 and 2015.
The same day, IRS issued proposed regs under Code Sec. 385 that target U.S. earnings stripping, referring to a practice of related parties engaging in certain transactions to interject excessive indebtedness in the U.S.—generally, by a U.S. subsidiary issuing excessive debt to a foreign parent—and effectively wiping out U.S.-source earnings through interest deductions. The new proposed regs would generally make earnings stripping more difficult by, among other things, treating certain related-party interests as part debt, part stock.
Potential challenges to new guidance. The day after the regs were released, the $160 billion merger of U.S. drugmaker Pfizer Inc and Ireland-based Allegan Plc was called off. It was not clear whether either company or anyone else would sue the Treasury Department.
However, the head of the largest U.S. business lobbying group, U.S. Chamber of Commerce President Tom Donohue, floated the possibility of such a lawsuit on Wednesday when he told CNBC that he had asked people, “What is the scope of their authority, and is it something you’d sue about?” Donohue said, though, that a potential lawsuit would take a long time and corporations would need to deal with the regs “for a while.” A Chamber spokeswoman, Blair Holmes, said later in an email that it was too early to decide about a possible lawsuit.
Another trade group chief, Organization for International Investment President Nancy McLernon, also would not rule out a legal challenge.
Any such challenge to the regs wouldn’t be without difficulty—including one that is largely procedural. Under the Anti-Injunction Act (AIA; Code Sec. 7421), no suit for the purpose of restraining the assessment or collection of any tax can be maintained in any court by any person, whether or not that person is the one against whom the tax is assessed, unless an exception applies. In effect, this prevents taxpayers from contesting a tax in court before it is assessed, functioning essentially as a jurisdictional threshold.. Under the AIA’s bar, a company such as Pfizer would need to actually move forward with a merger before it could sue, lawyers said, and it is not clear whether shareholders could stomach the uncertainty for so long. “For better or worse, there really aren’t timely ways of challenging a tax regulation like this,” said Edward Kleinbard, a professor who specializes in tax law at the University of Southern California.
Patrick Smith, a tax lawyer in Washington who is a partner at the law firm Ivins, Phillips & Barker, wrote in a tax journal last year that the courts might be open to a faster, more aggressive alternative. He said any business contemplating an inversion might be able to sue in federal district court under the Administrative Procedure Act (APA), which states that agency action is generally reviewable “except to the extent that…[i]t is committed to agency discretion by law” (5 USC 701(a)) and which requires a court to “hold unlawful and set aside agency action, findings, and conclusions” that are “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with the law.” (5 USC 708(2)(A) Such an approach is untested, however. “It’s novel thinking that’s basically unchartered territory,” Smith said.
Beyond procedural hurdles, a plaintiff would face a steep climb trying to argue that the Treasury Department exceeded its legal authority, tax lawyers said. For the proposed earning stripping regs, the Treasury Department is relying on Code Sec. 385(a), which expressly authorizes Treasury to prescribe regs to determine whether an interest in a corporation is to be treated as stock or indebtedness (or a combination of the two). Congress intended the section to give the department broad authority, according to research by Steven Rosenthal, a senior fellow at the Urban-Brookings Tax Policy Center, although a plaintiff could try to argue the opposite.
Another question would be whether a provision in the anti-inversion regs addressing serial acquisitions by a non-U.S. company would—in the case of Allergan—be unlawfully retroactive. Tax lawyers said, though, that the government could reasonably argue that the rules apply only to a deal that has not closed, such as the Allergan-Pfizer merger.
As with all regs, federal agencies have some leeway to make reasonable interpretations of the law, lawyers said. “In the past, the courts have tended to give significant deference to Treasury on how to interpret and apply their code,” said Adam Rosenzweig, a law professor at Washington University in St. Louis.