Will the Dems Halt Inversions – Or Not?

What is an inversion and why did they become so popular so suddenly?

Quite simply, tax inversions are where one company merges with another and the combined company is domiciled outside the United States, often where the target company is based. American companies’ desire to “invert” as part of a business-driven cross-border merger is compelled by a combination of factors – the main one being that U.S. tax code imposes income tax at a comparatively high rate and on profits earned abroad by American corporations.

The U.S. corporate income tax rate is about 39.1%, the highest among the developed countries that form the Organization for Economic Cooperation and Development, according to that organization. Moreover, the United States is one of the few countries that taxes profits earned abroad, albeit on a deferred basis upon repatriation of earnings. Most other countries only tax business profits earned within their borders.

Typically, a U.S.-based company will purchase an often-smaller foreign company in Canada, the U.K., Ireland or one of several other European countries with more favorable tax structures than the United States. The company then domiciles in the new country to take advantage of its corporate tax rate and its territorial tax system. In Ireland, for instance, the tax rate is only 12.5%.

Earlier this year, Pfizer’s pursuit of a merger with U.K.-based rival AstraZeneca put inversions on the front pages of major newspapers.  High on Pfizer’s list of reasons for the merger was taking advantage of the lower U.K. corporate tax rate AstraZeneca enjoys (20% in 2015) and its territorial tax regime for foreign business profits. Pfizer CEO Ian Read listed an additional impetus for Pfizer to relocate to the U.K.: Britain’s so-called “patent-box scheme” wherein the British government provides corporate-tax breaks to companies that commercialize patents in the U.K.

While the merger would have provided obvious advantages for Pfizer, it was ultimately rebuffed by AstraZeneca.

In the biggest inversion deal to date, U.S.-based AbbVie announced in July that it would pay $54 B for Dublin-based drug maker Shire. The move by AbbVie, which plans to keep its operational base in North Chicago, IL, will lower its effective tax rate from 22% today to 13% by 2016.

Inversions are not a uniquely healthcare phenomenon.  As of September 1, Burger King is in talks to purchase coffee chain Tim Hortons in a deal that would move the burger giant to Canada as an inversion play. Canada lowered its corporate tax rate to 15% in 2012 and also has a territorial tax regime for international business profits.

A majority of inversion deals this year, however, do involve pharmaceutical and other healthcare companies.

Will the President or Congress Stop Inversions?

With the specter of continuing to lose large U.S. corporations – and their taxable corporate income — to other countries, it’s clear why many in the government have called for actions to halt inversions. While most policymakers agree that corporate tax reform is the only way to address inversions in the long-term, Democrats have called for short-term action that would either make it harder to invert or reduce some of the U.S. tax advantages that result from being a foreign-parented multinational.

In May, Sen. Carl Levin (D-MI) and his brother, Rep. Sander Levin (D-MI) introduced draft legislation to address tax inversions. The bills are identical, except Sen. Levin’s bill would sunset after two years. The bill largely mirrors the President’s budget provision. Under current rules, shareholders of a U.S. company must own more than 20% of the merged company’s shares in order for the parent corporation of the merged company to be domiciled outside the United States. This is known as the 80% threshold. Levin (and the Obama Administration) propose to change the threshold to 50%, meaning a U.S. company would typically have to merge with a foreign company larger than itself in order to take advantage of a tax inversion.

In its FY15 Revenue Proposals (also known as the Green Book), the Treasury Department estimated that applying the rule change for inversions that take place after December 31, 2014 would raise tax revenue by $17 B over 10 years.

Rep. Levin’s bill, effective for inversions that take place after May 8, 2014, is estimated to raise $19.5 B in taxes over 10 years. Senate Finance Committee Chairman Ron Wyden (D-OR) now wants to address the issue in a bipartisan manner with Ranking Member Orrin Hatch (R-UT).

Republicans are not playing ball on “fixing” inversions and highlight the issue as another reason to pursue comprehensive tax reform. Senator Hatch has expressed an openness to addressing inversions outside of tax reform, but has stipulated that any such legislation must: (1) be a bridge to tax reform; (2) not be retroactive; (3) move the U.S. toward a territorial system; and (4) be revenue neutral.

Democrats’ best shot at addressing inversions in the near term comes via administrative action, which could happen even before the mid-term elections this fall.

After publicly stating that the Treasury Department could do no more to address inversions, President Obama and the Treasury Department announced this summer that they will continue to look at their legal authority to unilaterally address inversions, which they view as an affront to “economic patriotism.”

So how could they address inversions, specifically?

Earnings stripping is high on the target list and also appears in Sen. Charles Schumer’s (D-NY) draft inversion bill, expected to be released this fall. “Earnings stripping” is a practice where foreign-parented multinational corporations cut their tax bills by shifting profits out of the United States through related party debt, allowing them to write off their interest expense against their U.S. corporate tax bills.  Section 163(j) of the Internal Revenue Code lays out limits on how much interest can be deducted, while Section 385 could potentially be used by the U.S. government to re-characterize this debt as equity.

The U.S. could also combat the practice of “hopscotching.” This involves a scenario where a foreign subsidiary of a U.S. parent (or a “CFC”) has foreign earnings that have been subject to foreign tax, but not U.S. tax. When the inversion occurs there is a new foreign corporation as the ultimate parent. Hopscotching generally involves loaning the untaxed foreign dollars of the CFC to the new foreign parent for its use, which could include making investments in the U.S. While it seems complicated, the idea is that if one wants to get the cash to the new foreign corporation it can either (a) loan it into the U.S. or (b) pay shareholders, as the dollars cannot be run through the intermediate U.S. parent corporation first because even a loan from the foreign subsidiary to the U.S. parent would be a deemed repatriation and therefore subject to full U.S. tax.

So instead, the foreign subsidiary lends the cash directly to the new foreign parent thereby “hopscotching” over the intermediate U.S. parent. Now, the earnings stay in the U.S. tax bucket, so moving the cash does not mean it is permanently tax-free. But it does free up the cash without incurring an immediate tax hit. Former Treasury Official Stephen Shay proposed to prevent this result by deeming the loan to the new ultimate foreign parent as a back-to-back loan to the intermediate U.S. parent instead of to the ultimate foreign parent.

Any efforts to address inversions likely will not be retroactive, meaning that tighter rules could deter future inversions but are unlikely to cause a change in course for most pending inversion deals.

Lobbying Ramps Up

Not surprisingly, lobbying has been active on the inversions issue.

In June, Medtronic hired Breaux-Lott Leadership Group for $200,000 to block the proposed anti-inversion legislation from moving forward. Medtronic is trying to acquire Ireland-based Covidien.

One company that hasn’t publicly announced intent to move its address abroad — Kimberly-Clark Corp., the Dallas-based health care device manufacturer — added opposition to such legislation to its lobbying report. Kimberly-Clark is spinning off a healthcare unit.

What now?  

Expect more headlines from the Obama administration, with an executive order or Treasury action possible this fall.

Watch for Democrats to threaten a government contract ban with respect to inversion companies in appropriations bills and/or a Continuing Resolution (CR).

Finally, more legislation could be unveiled this fall – Senator Schumer’s bill and possibly even legislation from the bipartisan Senate Finance duo: Chairman Wyden & Ranking member Hatch. Whether the Senate bill(s) can pass the full Senate or the House is another matter altogether.

Expect more inversion deals, as companies race to beat a change in U.S. tax policy.

Morning Consult