IRS issues guidance on inversions and earnings stripping
TAX ALERT |
The Treasury and IRS recently issued temporary and proposed regulations to address the continued erosion of the U.S. corporate tax base through inversions, specifically targeting earnings stripping transactions. While the regulations will likely slow the pace of U.S. corporations seeking inversions, Treasury Secretary Jacob J. Lew urged Congress to enact anti-inversion legislation in order to fully stop inversions. The regulations are already having a huge impact on previously announced inversions such as the Pfizer-Allergan transaction, which was scuttled following the issuance of these regulations. Broadly speaking, the regulations address two areas, as described below.
Disregarding foreign stock in inversion transactions
Generally, a corporate inversion is a transaction in which a U.S. domiciled corporation changes its tax residence to a foreign country through a combination with a foreign target entity. While U.S. businesses often expand their operations through combinations with foreign companies, companies that invert may achieve significant U.S. tax benefits. Section 7874 of the Internal Revenue Code limits the tax benefits of certain inversions when the historic U.S. shareholders retain too much ownership in the newly re-domiciled corporation.
The Treasury noted that certain transactions have been designed to circumvent the limitations of section 7874 by engaging in a series of acquisitions over time thereby keeping the historic U.S. shareholders' ownership in the new foreign corporation below the section 7874 thresholds. The regulations limit such creeping inversions by disregarding foreign parent stock attributable to certain prior transactions involving U.S. companies. Under the new rules (T.D. 9761), stock in the foreign company attributable to assets acquired from U.S. companies within the prior three years will not be counted for purposes of determining the section 7874 ownership thresholds. The regulations, as they relate to the new rule for disregarding foreign parent stock, generally applies to acquisitions or post-inversion tax avoidance transactions completed on or after April 4, 2016. Taxpayers considering an inversion transaction should carefully consider the application of these rules.
Debt recharacterization proposed regulations (earnings stripping)
The proposed regulations issued April 4, 2016, under section 385 (REG-108060-15) would recharacterize certain related party debt instruments as equity. They would generally apply to affiliated corporations, whether foreign or domestic. An exception is provided for debt instruments issued within a group of corporations filing consolidated federal income tax returns. That exception, however, may not protect U.S. consolidated groups from adverse state tax consequences under the regulations.
The proposed regulations would make significant changes to federal tax debt characterization rules in three categories. They would:
- Authorize the IRS (but not taxpayers) to conclude that an instrument should be characterized as part debt and part equity
- Require taxpayers to maintain documentation with respect to certain related company debt
- Require equity treatment of debt issued to related corporations in specified distribution, asset acquisition and stock acquisition contexts
Exceptions would apply to categories 2. and 3. above, but not category 1. Category 2–the documentation requirement–would only apply to corporate groups that either (a) have publicly traded stock, (b) show total assets exceeding $100 million, or (c) have annual total revenue exceeding $50 million. Category 3–equity treatment for certain intragroup debt–would not apply to (a) certain debt issued in an amount that does not exceed the issuer’s current year earnings and profits, (b) other debt that does not exceed a $50 million threshold (tracked cumulatively), and (c) debt issued to acquire stock newly issued by a subsidiary (i.e., not debt issued to purchase stock that was previously outstanding).
The proposed regulations have a general effective date of April 4, 2016, but the documentation requirements would generally be effective when final regulations are issued. The proposed regulations target transactions with or among foreign corporations that can have significant tax effects due to introduction of related company debt, but have limited non-tax economic effects. They exclude transactions within federal consolidated groups. However, they could have significant state tax effects, given that many states do not conform to the federal consolidated return rules. Taxpayers engaging in restructurings that might otherwise result in federal or state tax benefits resulting from related company debt should review the prospective tax results before engaging in a debt dividend, intercompany debt financing, or other transaction that may trigger applicability of the proposed regulations.