From Business Law Center: Tax Conditions In Inversion Mergers

August 22, 2014

Tax stock calculation sheetWhether one believes U.S. companies reorganize abroad to escape this country’s “repugnant … tax treatment of corporate income (Galvin, Why Corporate Inversions Are All the Rage, Wall Street Journal, Jul. 27, 2014),” or “just to avoid paying their fair share (Obama, Weekly Address: Closing Corporate Tax Loopholes, Jul. 26, 2014),” there is broad agreement that inversion mergers are about taxes.

The U.S. corporate tax rate is among the highest in the world, and the U.S. is the only “large rich country” taxing income generated by foreign operations (How to stop the inversion perversionThe Economist, Jul. 26, 2014).  The foreign income of U.S. corporations is taxed twice – first in the country where it is generated, and again when it is repatriated to the United States.

In a recent TaxAnalysts article, Stephen Shay identifies two tactics inverted corporations have employed to immediately capitalize on the tax benefits of having a non-U.S. parent. The first, called “earnings stripping,” involves “introducing substantial intercompany debt into the U.S. group” so that interest payments to a foreign affiliate may be deducted against U.S. income, effectively transferring U.S. earnings to the foreign affiliate’s lower-tax jurisdiction. The second, know as a “hopscotch loan,” allows the inverted company to access un-repatriated foreign earnings by lending them to other non-U.S. affiliates to repay debt, or fund distributions of stock (Shay, Mr. Secretary, Take the Tax Juice Out of Corporate ExpatriationsTaxAnalysts, Jul. 28, 2014).

Over the years, the U.S. government has tinkered with the Internal Revenue Code to create penalties to discourage companies from expatriating. Amendments to IRC s. 7874 (26 U.S.C.A. 7874), adopted by the 2004 Jobs Creation Act, mandate the following: if, after an inversion expatriation the stockholders of the former U.S. entity own more than 80 percent of the new foreign company, the merger is disregarded and the new, foreign company is treated, for tax purposes, as a U.S. company. If the former shareholders of the U.S. entity control between 60% percent and 79 percent of the new foreign parent, the new company’s foreign status is respected, but a rule limits transfers of assets out of the U.S. The proposed Stop Corporate Inversions Act of 2014 (2013 CONG HR 4679) would disregard expatriations where the former U.S. holders retain more than 50 percent of the new company, and would impose a U.S. “management and control” test on any expatriated business. A different sort of penalty is contemplated by the self-explanatory No Federal Contracts for Corporate Deserters Act.

While tax savings may be the paramount concern in inversions, our survey of inversions since 2012 demonstrates that only about half of these mergers were made contingent on the tax treatment of the merged entity. Davis Polk tax partners Neil Barr and Michael Mollerus suggest that many merger parties felt such tax conditions were unnecessary because Congressional gridlock made it “unlikely” that inversion reform proposals would become law (Barr & Mollerus, Corporate Inversions: Where we are and where we might be going, Aug. 7, 2014). Barr and Mollerus added that potential inversion parties might have more reason to fear changes in administrative law following the Treasury Department’s recent threat to “materially change the economics of inversions” (Davis, White House Weighs Actions to Deter Overseas Tax FlightNew York Times, Aug. 5, 2014).

Date Parties Tax Condition New Domicile Projected Tax Rate % of newco owned by US holders
2/5/13 Liberty Global / Virgin Media NONE UK 23% 64% (74% of votes)
5/19/13 Actavis / Warner Chilcott 1. No change in tax law that would cause newco to be treated as a US company, 2. Auditor opinion Ireland 17% (actual) 77%
7/28/13 Perrigo / Elan NONE Ireland 12.50% 71%
9/24/13 Applied Materials / Tokyo Electron Opinion of counsel that newco will not be treated as a US co Netherlands 25% 68%
2/27/14 Forest Labs / Actavis 1. No change in tax law that would cause newco to be treated as a US company, 2. Auditor opinion Ireland N/A 65%
3/10/14 Chiquita / Fyffes NONE Ireland 12.50% 50.70%
3/18/14 Horizon Pharma / Vidara NONE Ireland Low 20% 74%
4/5/14 Questcor / Mallinckrodt No change in tax law that would cause newco to be treated as a US co Ireland N/A 49.50%
6/14/14 Medtronic / Covidien No change in IRC 7874 that would cause newco to be treated as a US co Ireland reduced by one or two percentage points 70%
7/8/14 Salix / Cosmo No change in IRC 7874 that, in the opinion of counsel, would cause newco to be treated as a US co Ireland Low 20% 80%
7/13/14 Mylan / assets of Abbott NONE Netherlands high teens 79%
7/18/14 AbbVie / Shire No change in tax law that would cause newco to be treated as a US co UK 13% 75%