Temp and Prop Regs Combat Corporate Inversions and Earnings Stripping.

(Parker Tax Publishing APRIL 2016)

The IRS has issued temporary and proposed regulations addressing transactions that are structured to avoid existing limits on corporate inversions, along with post-inversion tax avoidance transactions. In addition, the IRS has released proposed regulations that would treat related-party interests in a corporation as indebtedness in part and stock in part, in order to address earnings stripping transactions. T.D. 9761; REG-135734-14; REG-108060-15.

Background

A corporate inversion is a transaction in which a multinational group with a U.S. parent changes its tax residence to reduce or avoid paying U.S. taxes. In specific, a group with a U.S. parent engages in an inversion when it acquires a smaller foreign company and then locates the tax residence of the merged group outside the U.S., typically in a low-tax country. Generally, the primary purpose of an inversion is to reduce taxes, often substantially. After a corporate inversion, multinational corporations often use a tactic called earnings stripping to minimize U.S. taxes by paying deductible interest to their new foreign parent or one of its foreign affiliates in a low-tax country.

In September 2014 and November 2015, the IRS issued guidance (Notice 2014-52 and Notice 2015-79, respectively) that made it more difficult for companies to undertake an inversion and reduced the economic benefits of doing so. The notices also announced the IRS's intention to issue regulations to address corporate inversions.

The IRS has now issued temporary and proposed regulations which further limit corporate tax inversions, and reduce the benefits of doing so by addressing earnings stripping.

OBSERVATION: One of the first casualties of the regulations was a merger deal that had been planned between two pharmaceutical companies, Pfizer and Allergan. The deal was attractive to Pfizer because of Allergan's tax domicile in Ireland. The regulations made the deal much less attractive and the merger has been called off.

Temporary Regulations Make It More Difficult for Companies to Invert The temporary regs (T.D. 9761) limit inversions by disregarding foreign parent stock attributable to certain prior inversions or acquisitions of U.S. companies. The text of the temporary regs also serves as the text of the proposed regs (REG-135734-14).

The IRS noted that some foreign companies may avoid Code Sec. 7874 - the tax code's existing curb on inversions - by acquiring multiple U.S. companies over a short window of time or through a corporate inversion. The value of the foreign company increases to the extent it issues its stock in connection with each successive acquisition, thereby enabling the foreign company to complete another, potentially larger, acquisition of a U.S. company to which Code Sec. 7874 would not apply. Over a relatively short period of time, a significant portion of a foreign acquirer's size may be attributable to the assets of these recently acquired U.S. companies.

The IRS stated that it is inconsistent with the purposes of Code Sec. 7874 to permit a foreign company (including a recent inverter) to increase in its size in order to avoid the inversion threshold under current law for a subsequent acquisition of a U.S. company. For the purposes of computing the ownership percentage when determining if an acquisition is treated as an inversion, the temporary regulations exclude stock of the foreign company attributable to assets acquired from U.S. companies within three years prior to the signing date of the latest acquisition.

The temporary regulations also set forth additional rules that disregard foreign parent stock attributable to certain prior acquisitions of U.S. companies, including:

(1) A rule that addresses a technique by which U.S. companies may seek to avoid Code Sec. 7874 by structuring an inversion as a multistep transaction using back-to-back foreign acquisitions; and

(2) A rule that requires a foreign subsidiary of the inverted U.S. group to recognize all realized gain upon certain post-inversion transfers of assets that dilute the inverted U.S. group's ownership of those assets.

The temporary regulations are effective on April 8, 2016.

Proposed Regulations Address Earnings Stripping

In addition to the temporary regulations, proposed regulations (REG-108060-15 (4/8/16)) were issued which target transactions that increase related party debt that does not finance new investment in the U.S.

Under current law, following an inversion or foreign takeover, a U.S. subsidiary can issue its own debt to its foreign parent as a dividend distribution. The foreign parent, in turn, can transfer this debt to a low-tax foreign affiliate. The U.S. subsidiary can then deduct the resulting interest expense on its U.S. income tax return at a significantly higher tax rate than is paid on the interest received by the related foreign affiliate. The related foreign affiliate can also use various strategies to avoid paying any tax at all on the associated interest income. The IRS stated that when available, these tax savings incentivize firms with a foreign parent to load up their U.S. subsidiaries with related party debt.

The proposed regulations makes it more difficult for groups with a foreign parent to quickly load up their U.S. subsidiaries with related party debt following an inversion or foreign takeover, by treating as stock the instruments issued to a related corporation in a dividend or a limited class of economically similar transactions.

For example, the proposed regulations:

(1) Treat as stock an instrument that might otherwise be considered debt if it is issued by a subsidiary to its foreign parent in a shareholder dividend distribution;

(2) Address a similar two-step version of a dividend distribution of debt in which a U.S. subsidiary borrows cash from a related company and pays a cash dividend distribution to its foreign parent; and

(3) Treat as stock an instrument that might otherwise be considered debt if it is issued in connection with certain acquisitions of stock or assets from related corporations in transactions that are economically similar to a dividend distribution.

In addition, the proposed regulations allow the IRS on audit to divide a purported debt instrument into part debt and part stock. An interest in a corporation is generally treated as entirely debt or entirely equity for federal tax purposes. The IRS noted this all-or-nothing approach can create distortions when the facts support treating a purported debt instrument as part debt and part stock. The proposed regulations would allow the IRS to treat an instrument issued to a related party as being part debt and part equity to eliminate these distortions.

The proposed regulations also require documentation for members of large groups to include key information for debt-equity tax analysis. The IRS noted that under current law it can be difficult for it to obtain information to conduct a debt-equity analysis of related party instruments, especially information that demonstrates the intent to create a genuine debtor-creditor relationship.

Lastly, under the proposed regulations, companies are required to undertake certain due diligence and complete documentation up front to establish that a financial instrument is really debt. Specifically, the proposed regulations require key information be documented, including a binding obligation for an issuer to repay the principal amount borrowed, creditor's rights, a reasonable expectation of repayment, and evidence of an ongoing debtor- creditor relationship. If these requirements are not met, instruments will be characterized as equity for tax purposes.

The proposed regulations generally apply to instruments issued after April 4, 2016.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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