The US Treasury Department and the Internal Revenue Service recently announced their intention to issue regulations limiting certain tax-driven inversion transactions. In these transactions, a US parent company typically becomes a subsidiary of a company seated in a jurisdiction with a lower effective corporate income tax rate. The proposed regulations tighten the ‘80% ownership’ test, address the tax treatment of loans made by the inverted US company’s foreign subsidiaries to the new foreign parent and intend to achieve policy objectives on shifting US-source income outside the US.
Since the late 1990s, US-based multinationals have been relocating their headquarters to preferred foreign jurisdictions including Ireland, the UK, Switzerland and the Netherlands in an attempt to lower their consolidated corporate tax burden. A recent increase in these ‘inversion transactions’ – to be distinguished from the establishment of letterbox companies – has led to extensive political debate on the need for reforming the US tax system.
In an attempt to discourage inversion transactions and to prevent the erosion of the US tax base, the US Treasury Department and the IRS have announced plans to issue regulations, including:
Tightening the Ownership Test
Current US tax law does not recognise the inversion transaction. For US tax purposes, the new foreign parent company is treated as a US company if the US parent’s former shareholders hold at least 80% of the foreign parent’s shares and no substantial business activities are carried out in the foreign jurisdiction. For US tax purposes, the new foreign parent company will then be treated as a US company.
The proposed regulations tighten the 80% ownership test by disregarding certain non-ordinary course distributions intended to ensure compliance with the 80%-ownership test. Non-ordinary course distributions mean any distributions made by the US company in excess of 110% of the average distributions during the three-year period preceding the inversion. Furthermore, if the new foreign parent company holds a significant amount of passive assets, such as cash, certain shares of the foreign acquirer are disregarded in determining the 80%-threshold.
The treatment of certain intragroup loans as taxable dividend
The inversion transaction may enable the new foreign parent company to access earnings and profits of the inverted US company’s foreign subsidiaries – insofar as these are untaxed – without incurring any US tax liability. The foreign subsidiaries could, for example, grant a loan to the new foreign parent company. Under the proposed regulations, this type of loan is deemed a payment of a taxable dividend to the inverted US company if the loan is made within ten years after the inversion transaction. The US Treasury Department and the IRS also intend to issue regulations aimed at preventing the avoidance of US tax on foreign subsidiaries’ pre-inversion earnings and profits through transactions that terminate the US shareholder’s control or dilute that shareholder’s interest.
Guidance on the limitation of earnings stripping outside the US
The US Treasury Department and the IRS also seek to address post-inversion strategies that result in a reduction of the future US tax burden by shifting or stripping US source taxable earnings to other (lower tax) jurisdictions within the group, such as new intragroup loans.
Since the proposed regulations have not been issued, their impact cannot yet be established. They will, however, apply retrospectively to transactions completed on or after 22 September 2014.