Inversions: Recent Developments

Peter J. Connors is a tax partner at Orrick, Herrington & Sutcliffe LLP. Jason M. Halper is a partner in the Securities Litigation & Regulatory Enforcement Practice Group. This post is based on an article authored by Mr. Connors and Mr. Halper, that was previously published in Law360.

In October 2015, press reports began appearing suggesting that Pfizer Inc., one of the world’s largest pharmaceutical companies, and Allergan, an Irish publicly traded pharmaceutical company, were considering entering into the largest inversion in history. Within weeks, the IRS launched its latest missive against inversion transactions. It also put the tax community on notice that more regulatory activity was yet to come.

Companies invert primarily because of perceived disadvantages associated with the U.S. corporate tax system, which has one of the world’s highest tax rates and levies taxes on worldwide income, including income earned by foreign subsidiaries (generally referred to as “controlled foreign corporations”) when repatriated and, at times, prior to repatriation. In its broadest terms, an inversion is the acquisition of substantially all the assets of a U.S. corporation or partnership by a foreign corporation. If a transaction triggers Internal Revenue Code Section 7874, the post-transaction foreign corporation will be treated as a U.S. corporation, and gain that is otherwise recognized on the transaction will not be offset by tax attributes of the U.S. entity, such as net operating losses (NOLs).

Section 7874 applies if three criteria are met: (1) a foreign corporation acquires, directly or indirectly, substantially all the properties of a U.S. corporation (or substantially all the properties that constitute a trade or business of a U.S. partnership); (2) after the acquisition, the former interest holders in the domestic-acquired entity hold 80 percent of stock in the foreign acquiring corporation by reason of their interest in the domestic entity (the ownership test); and (3) after the acquisition, the “expanded affiliated group” does not have substantial business activities in the country in which the foreign acquiring corporation is organized, compared to the worldwide advice of the expanded affiliated group (the substantial business activities test).

Certain adverse tax consequences still occur if continuing domestic shareholders own less than 80 percent but more than 60 percent of the foreign acquiring corporation, including that certain tax attributes such as NOLs cannot offset gain that is recognized on the inversion.

Companies that wish to invert without triggering Section 7874, and thereby avoid being subject to the U.S. tax system, obviously must navigate around these limitations. Most inverting companies do not rely on satisfying the substantial business activities test to do so, but instead, attempt to maintain post-transaction continuing domestic ownership below 60 percent. Among the advantages that inure to companies that successfully avoid triggering Section 7874 are the ability to eliminate tax on earnings from foreign subsidiaries (although this has become increasingly difficult to achieve) [1] and to strip out U.S. earnings to lower tax jurisdictions through interest and other payments (notwithstanding that shareholders often still must recognize gain on the transaction). This is possible because foreign finance affiliates owned by U.S.-based groups will eventually be subject to the controlled foreign corporation rules that currently cause the income to be taxed prior to repatriation. This is often not the case with foreign controlled groups that own U.S. companies.

The IRS and Treasury’s approach to targeting inversions relies heavily on a broad reading of their own regulatory authority. Section 7874(g) authorizes the secretary of the Treasury to issue such regulations as are necessary to implement that provision, including regulations providing for “such adjustments to the application of this section as are necessary to prevent the avoidance of the purposes of this section.”

Avoidance strategies could include (1) the use of related persons, pass-through, or other noncorporate entities or other intermediaries, and (2) transactions designed to have persons cease to be (or not become) members of the expanded affiliated groups or related persons. Section 7874(c)(6) also states that the secretary “shall prescribe” regulations as may be appropriate to determine whether a corporation is a surrogate foreign corporation, [2] including regulations to (a) treat certain financial instruments as stock, and (b) recharacterize stock as nonequity. Past regulatory activity has focused on a multitude of issues, including the continuing ownership test and the substantial business activities test. [3]

The Pfizer-Allergan Transaction

On Nov. 22, 2015, Pfizer and Allergan announced that they had entered into a merger agreement. If it closes, the transaction will take the form of a reverse merger, pursuant to which Watson Merger Sub Inc., a subsidiary of Allergan PLC, will merge with and into Pfizer, a U.S. corporation, with Pfizer surviving as a direct, wholly owned subsidiary of Allergan. The combined company will operate from Ireland. Press reports indicate that the transaction—the largest inversion on record—is expected to lower the combined company’s tax rate from about 25 percent to 17-18 percent. Allergan PLC will then change its name to Pfizer PLC. The transaction is valued at approximately $160 billion.

As reported in our earlier commentary, [4] change-of-law risk is often highly negotiated in inversion transactions. Interestingly, here, the parties equally assumed this risk, agreeing that the party terminating the transaction due to changes of law materially affecting the tax advantages associated with the deal will reimburse the other party only $400 million—an extremely low termination fee of approximately 0.25 percent of the transaction value.

Notice 2015-79

Notice 2015-79—released Nov. 19, 2015—addressed three primary issues. First, it further limited the types of transactions that would survive Section 7874 scrutiny; second, it expanded the amount of gain that would be taxable upon an inversion transaction; and third, it clarified certain aspects of an earlier notice, Notice 2014-52. The clarifications in this third category generally are favorable to taxpayers and largely are the result of comments by industry and professional groups.

In the first category, the notice indicated that future tax regulations would address transactions that are “structured to avoid the purposes of section 7874” by (1) requiring the foreign acquiring corporation to be subject to tax as a resident of the relevant foreign country in order to have substantial business activities in the relevant foreign country; (2) disregarding certain stock of the foreign acquiring corporation in “third-country” transactions for purposes of the continuing ownership test; and (3) clarifying the definition of nonqualified property for purposes of disregarding certain stock of the foreign acquiring corporation in calculating continuing domestic ownership percentages.

The first two categories of transactions arise because it is possible for a corporation to be formed in one jurisdiction but tax-resident in a second. As an example, in the aborted merger of technology companies Applied Materials and Tokyo Electron, the holding company effecting the merger would have been organized in the Netherlands but a tax resident of the United Kingdom. The merger was aborted because the companies could not obtain regulatory approvals, but it received wide press attention when first announced in late 2013. The stock of the Dutch holding company would have been disregarded under the second prong of the anticipated regulations for purposes of computing the continuing ownership test.

In the second category, the notice stated that the Treasury and IRS would issue regulations that address certain post-inversion “tax avoidance transactions.” These regulations would (1) define inversion gain for purposes of Section 7874 to include certain income or gain recognized by an expatriated entity from an indirect transfer or license of property and provide for aggregate treatment of certain transfers or licenses of property by foreign partners for purposes of determining inversion gain, and (2) require an exchanging shareholder to recognize all of the gain realized upon an exchange of stock of a controlled foreign company (CFC) without regard to the amount of the CFC’s undistributed profits if the transaction terminates the status of the foreign subsidiary as a CFC or substantially dilutes the interest of U.S. shareholders in the CFC. This would represent an expansion of the tax base because currently, upon the exchange of the shares of a controlled foreign corporation for the shares of another foreign corporation, only unrepatriated earnings become taxable under Section 1248 of the Internal Revenue Code.

None of the proposals was enough to dissuade Pfizer only days later from entering into its agreement with Allergan. Indeed, the first category of changes would likely not apply at all given the structure of the transaction because no third-country tax-resident corporation is involved. However, it is possible that the second category of changes relating to the amount of gain that would be recognized would apply, but not enough details regarding proposed transfers are publicly available to draw a firm conclusion.

But the concern around the Pfizer-Allergan transaction, with Pfizer being one of the stalwarts of corporate America, may spark some additional regulatory activity beyond that described in the notice.

What Comes Next?

Executive or agency action seems more likely than congressional legislation given the current political environment and a history of repeated false starts by Congress on tax reform. At least two approaches are possible, even likely:

In the final section of the recent notice, the Treasury and IRS make their typical, rather perfunctory, request for comments. Here, rather unusually, they reiterate the request for comments made in Notice 2014-52, pointing out that they expect to issue additional guidance to further limit (1) inversion transactions that are “contrary to the purposes of section 7874,” and (2) the benefits of post-inversion tax avoidance transactions. But they also state that they continue to consider guidance to address strategies that avoid tax on U.S. operations by shifting or “stripping” U.S.-sourced earnings to lower tax jurisdictions, including through the use of intercompany debt. This could result in greater disallowance of related-party interest deductions.

In particular, Section 163(j) of the Internal Revenue Code, which was enacted in 1989, limits the amount of a U.S. person’s interest expense deduction when owed to a related foreign party. In 1991, proposed regulations were issued under this section but they were never finalized. While the existing earning-stripping rules limit related-party interest deductions (which includes third-party debt guaranteed by a related party), interest above the deduction cap remains deductible in the future. Moreover, notwithstanding Section 163(j), U.S.-owned foreign companies remain able to reduce their tax base by paying royalties and management fees to a foreign parent, which in turn would not have a concern about earning-stripping rules. As a result, a U.S. company that is owned by foreign persons has a tax advantage over U.S.-owned groups. It would come as no surprise if the Treasury and IRS tried to expand the scope of those rules in the context of inverted corporations by increasing the amount of and circumstances under which there is interest disallowance.

One legislative proposal would have done just that by revising the earning-stripping rules to the interest expense deduction for inverted companies. [5] A former high-ranking Treasury official, now a professor at Harvard Law School, has gone on record as simply denying the interest deduction for certain excess related-party debt. He would have done so by invoking regulatory authority under Section 385, which addresses the classification of an instrument as debt or equity. [6] Such a step would have bypassed Congress, which appears to have little enthusiasm for tackling sensitive tax issues, including international tax reform.

Government Contracting Bars

Another possible option for executive action against inverted companies does not involve tax-specific issues. This could include prohibiting inverted companies from entering into contracts with the government. [7] However, these efforts recently hit a snag when the U.S. Department of Homeland Security endorsed a legal memorandum that argued that a 2002 law banning such companies from federal contracts was invalid. The memorandum was submitted to the Department of Homeland Security by Ingersoll Rand, one of the largest inverted companies. The company argued in part that U.S. trade agreements with foreign governments invalidated a law that would prohibit it from winning federal contracts. [8]

Other federal and state legislation has been proposed that would prevent inverted companies from entering into contracts with federal or state governments, but such legislation does not seem to be moving forward. [9]


[1] For instance, under Notice 2014-52, former controlled foreign corporations would still be considered controlled foreign corporations for purposes of determining whether application of Section 956 related to “deemed dividends” would be triggered. See Jason M. Halper, Peter J. Connors and William J. Foley, Jr., “New Treasury Regulations Target Corporate Inversions.”
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[2] A “surrogate foreign corporation” is the term used to describe an inverted domestic entity that is treated as a U.S. corporation under the inversion rules. See section 7874(a)(2)(B).
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[3] See Treas. Reg. §1. 7874-1 (disregarding affiliate-owned stock); -2 (surrogate foreign corporation); -3 (substantial business activities); -4T (disregarding certain stock related to the acquisition); -5T (effect of certain transfers of stock related to the acquisition); and Notice 2014-52.
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[4] Jason Halper, Peter Connors, David Keenan and Carrie Lebigre, “The Legal and Practical Implications of Retroactive Legislation Targeting Inversions.”
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[5] Proposal in 2014 by Senator Schumer, available here.
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[6] Stephen Shay, “Mr. Secretary, Take the Tax Juice Out of Corporate Expatriations,” Tax Notes, July 28, 2014, p. 473 . See also J. Clifton Fleming, Jr., Robert J. Peroni and Stephen E. Shay, “Getting Serious About Cross -Border Earnings Stripping: Establishing an Analytical Framework, appearing in N.C. L. Rev. 673(2015).”
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[7] Proposal by Sen. Chuck Grassley, available here.
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[8] Zachary R. Mider, “US Sided with Tax-Avoiding Companies Over Contracting Ban,” July 16, 2015. Despite this victory, Ingersoll Rand has not been immune from attack. Press reports indicate that it settled a costly tax dispute with the IRS earlier this month. Ryan Finley, “Ingersoll-Rand Accepts $86 Million Deficiency for Treaty Dispute,” Tax Notes, Jan. 6, 2016. At issue was whether payments made to its finance affiliate—of the type that would be used to strip earnings out of the U.S.—would be subject to withholding tax. It is hard to say what triggered this audit, but the company’s status as an inverted company may have made them an unsympathetic target to IRS officials.
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[9] See “New Jersey May Be First State to Punish Inversions With Bill.” and “Members Of Congress Say ‘Enough Is Enough’ When It Comes To Corporate Tax Dodging.”
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