There is much irony in the US Chamber of Commerce’s desire to prevent the Treasury and the current Administration from stopping inversions, at least unilaterally, by asking a Federal District Court to hold a part of the temporary regulations on inversions invalid. Viewed from a narrow lens of legality (and not legality and tax policy) the recently issued temporary (anti-inversion) regulations stray beyond permitted boundaries of proper rule-making. But looking through a wider lens into tax policy issues, what is the US Chamber of Commerce doing to help with the continuing exodus of US based companies MNEs relocate overseas? Don’t inversions (really limited to U.S. parent corporations based on our worldwide corporate income tax and at the highest corporate income tax rate) result in the loss of tax revenues and the movement of capital and labor outside of the United States? Is that good? If not, then shouldn’t the U.S. Chamber of Commerce simply pound the table to get Congress in a moment of bipartisan “weakness” to lower the corporate income tax rate?
Well the answer to this question must be that they have already been banging the tables of Congress and in submitted testimony that the corporate tax rate is much too high and that we have locked away foreign profits from being repatriated because of a high cost of bringing the monies back home.
So having done that already, and obviously feeling the pressure to “do something” to get the Pfizer inversion (and others) back on track, the U.S. Chamber of Commerce takes on the advocacy of its MNE constituents to keep the doors open to continued globalization and achieving a substantial world-wide reduction in effective tax rates (which are already low). But fighting the Treasury and the Obama Administration to keep the doors wide open for inversion type transactions seems paradoxical given the foreseeable loss of thousands if not millions of jobs, reduction in tax revenues and adverse impact on our middle class.
So, why did the U.S. Chamber of Commerce bring this action? In their view the temporary regulations are invalid, period. That’s their purpose in filing.
For readers of this post who are not students of the inversion provision and related rules, a corporate inversion is a transaction in which a U.S.-parented multinational group or MNE changes its tax residence to reduce or avoid paying U.S. taxes on foreign source income and foreign accumulated earnings and profits. More specifically, a U.S.-parented group engages in an inversion when it acquires a smaller foreign company and then locates the tax residence of the merged group outside the United States, typically in a low-tax country. Typically, the primary purpose of an inversion is not to grow the underlying business, maximize synergies, or pursue other commercial benefits. Rather, the primary purpose of the transaction is to reduce taxes, often substantially. More than 50 U.S. companies have reincorporated in low-tax countries since 1982, including more than 20 since 2012. In some instances a U.S. MNE can achieve an inversion by acquiring a foreign company in a reverse acquisition that is only 25% of its size. This occurred with Medtronic (moved to Ireland in 2015), Actavis (moved to Ireland in 2013) and Burger King (moved to Canada in 2014) just to name a few. See http://www.bloomberg.com/quicktake/tax-inversion
After a corporate inversion, the former U.S.-parented multinational group often uses a tactic called earnings stripping to minimize U.S. taxes by paying deductible interest to their new foreign parent or one of its foreign affiliates in a low-tax country. See §163(j), §7701(l). Other strategies are available to repatriate foreign earnings without triggering U.S. income taxation under the CFC rules contained in Section 956.
Speaking only for myself, as a tax lawyer who has advised many clients on moving business operations overseas, it has frequently crossed my mind as it has many other tax advisors, including tax counsel, that the tax laws of our country actually promote the migration of capital, labor, profits and ultimately tax revenues outside of the U.S. Why? Because we tax U.S. parent companies (as well as U.S. citizens and residents) on their worldwide taxable income, but with allowance for foreign tax credits in certain instances. Not only do we tax resident companies on worldwide taxable income but we presently have the highest corporate tax rate in the world. Because Congress has failed to correct this migration of business, jobs and capital overseas, perhaps the MNEs are already pleased. Those that have escaped worldwide tax really are beyond the problem except perhaps with respect to earnings stripping and foreign dividend plays. Indeed, as to the last item, we have trillions of dollars of foreign profits warehoused overseas and while being warehoused they are building up the economies of other countries. It costs too much to bring the money back for reinvestment in projects here. Perhaps some MNEs just want their worldwide tax rate to be as close to “zero” as possible. Others are more reasonable and would settle for 15% (Canada) or perhaps as much as 20% (United Kingdom). Our 35% federal corporate income tax rate undoubtedly a deterrent to foreign business in expanding operations into the U.S. or, as discussed, causing U.S. MNEs to move its non-U.S. operations overseas so that the parent company is foreign organized and managed.
Recent Issuance of Anti-Inversion Regulations
Last Spring the Treasury and the Internal Revenue Service issued regulations and engaged in other efforts designed, in part, to deter inversions. There was a particular target in mind and that was preventing Pfizer from being acquired by Allergen, an Irish firm. They planned the inversion to avoid Section 7874 through a series of planned acquisitions. If the inversion were successful, that would have been yet another inversion of a U.S. parent corporation to become a controlled subsidiary with or without invoking application of section 7874(b) and related provisions.
The regulations were issued on April 5, 2016 and were again written to block the Pfizer-Allergen deal as well as dissuade others from joining in such efforts. The issuance of the regulation achieved its goal as the Pfizer deal was called off on April 6, 2016 stating that the decision “was driven by the actions announced by the U.S. Department of Treasury on April 4, 2016…” The regulations issued on April 4, 2016, both temporary regulations on inversions and proposed regulations on earnings stripping, made it more difficult for companies to invert by disregarding foreign parent stock attributable to certain prior inversions or acquisitions of U.S. companies within a three year period. The Treasury announced that it is contrary to the purposes of section 7874 to permit a foreign company (including a recent inverter) to increase in its size in order to avoid the inversion threshold under current law for a subsequent acquisition of an American company. This is why the Treasury saw the need for a three year lookback rule, a kind of statutory step-transaction rule commencing with the signing date of the latest acquisition and its adoption in the temporary regulations.
On earnings stripping, the proposed regulations: (i) target transactions that increase related-party debt that does not finance new investment in the U.S. under proposed regulations to section 385; and (ii) make it more difficult for foreign-parented groups to quickly load up their controlled U.S. subsidiaries with related-party debt following an inversion or foreign takeover. This rule would treat as stock an instrument that might otherwise be considered debt if issued by a subsidiary to its foreign parent in a shareholder dividend distribution. The proposed regulations would also challenge other efforts to distribute foreign earnings directly to a foreign parent in avoidance of a dividend paid to the U.S. shareholder of a CFC. The proposed regulations would further treat as stock an instrument that might otherwise be considered debt if it is issued in connection with certain acquisitions of stock or assets from related corporations in transactions that are economically similar to a dividend distribution.
What is the provision that is the subject of the U.S. Chamber of Commerce’s lawsuit, if the so-called lookback rule under the new temporary regulations under section 7874. This rule is used for calculating the denominator in the fraction used to determine whether the former U.S. shareholders own 60% or at least 80% of the surrogate foreign corporation’s stock based on voting and/or value. The regulations exclude from this computation purchases made over the last three years by the foreign acquisition corporation of former U.S. companies.
The Lawsuit Filed in Federal District Court for the Western District of Texas
It was announced in a current issue of Tax Notes (8/8/2016) that the U.S. Chamber of Commerce and the Texas Association of Business filed suit against the IRS and Treasury over their inversion regulations on August 4, on the grounds that the rule-making violates the Administrative Procedure Act (APA). The law suit was filed in Federal District Court for the Western District of Texas, Austin Division. Civil Action No. 1:16-cv-944.
In the first paragraph in its Complaint, the Plaintiffs, Chamber of Commerce of the United States of America and the Texas Association of Business, claimed that the temporary regulation on inversions, which again contains the special three year lookback rule, took “effect immediately without a prior opportunity for notice and comment” to stop otherwise lawful cross-border mergers of private companies that the government does not want to allow. See Treas. Reg. §1.7874-8T. The Executive Branch, the Plaintiffs allege, improperly bypassed Congress in order to “short-circuit” legislative debate. In other words, the Obama Administration re-wrote the Internal Revenue Code in violation of the rule-making requirements of the Administrative Procedure Act (“APA”).
In paragraph 7 of the Complaint, Plaintiffs noted the Obama Administration failed to get Congress to amend Section 7874 to make in more difficult for U.S. corporations to engage in inversions. The Plaintiffs specifically attacked the so-called “multiple acquisition rule” (3 year lookback) which caused the Pfizer inversion transaction to be withdrawn. The Complaint asks that the Court set aside the multiple acquisition rule as violating 5 U.S.C. §706. Other grounds and authorities for relief are recited in the balance of the Complaint which provides a concise history of the inversion phenomenon.
How Strong a Case Does the U.S. Chamber of Commerce Have? Let’s Discuss Standing First.
So does either group have standing to bring this case under 5 U.S.C. §702 (APA)? Traditional standing as announced by the U.S. Supreme Court in Lujan v. Defenders of Wildlife, 504 U.S. 555, 560-561 (1992), consists of three elements: (i) plaintiff must have suffered an “injury in fact”, i.e., an invasion of a legally protected interest which is (a) concrete and particularized, and (b) actual and imminent, not conjectural or hypothetical; (ii) there must be a connection between the injury and the conduct complained to the plaintiff from the defendant and not an independent action of some third party not before the court; and (iii) it must be likely that the injury will be redressed by a favorable decision. Courts have held that “when a plaintiff is not the direct subject of government action but instead when the asserted injury arises from the government’s allegedly unlawful regulation (or lack of regulation) of someone else, satisfying standing requirements will be substantially more difficult. See Frank Krasner Enterprises, Ltd. v. Montgomery County, MD, 401 F.3d 230, 234-35 (4th Cir. 2005). Assuming Lujan, supra still is the applicable standard, expect the government to ask the Court to throw the suit out the door based on lack of standing. See also Patterson v. Segale and City of Burien, Washington, 289 P.3d 657 (Wash. 2012). Doesn’t seem like either Plaintiff qualifies under Lujan, supra.
So, if Pfizer had consummated its deal and not called it off in response to the issuance of the temporary regulations, i.e., if it had decided to fight the regulations under the alleged violations of the APA as well as the overall invalidity of the regulation, then, there would be a justiciable issue in controversy were the government to have challenged the transaction by applying the regulation and treat Allergen as a “domestic corporation”. See §7874(b).
Wouldn’t it be surprising if the Federal District Court Judge in Austin decides to reserve the issue on standing for later or otherwise rule that the Plaintiffs do have standing? Yes that would be very surprising and were that to happen it would undoubtedly be appealed by the government as reversible error. But there is the expression “Don’t Mess With Texas”. Perhaps that’s why the Plaintiffs wanted venue in Texas federal district court. By the way, Pfizer’s headquarters is in New York City.
Obviously, there are apparent defects in the APA rules and therefore it should not be surprising if someone else that does in fact have standing decides to take on the Treasury and Internal Revenue Service. See Altera Corp., 145 T.C. No. 3 (2015)(2003 final regulations on cost-sharing arrangements invalidated on various grounds including violation of the notice and comment rules under the APA); See also August, “Altera: Why the Government Can’t Count on Chevron Step Two”, Tax Notes, June 6, 2016; “Altera and Cost-Sharing Requirements Under Section 482, Another Tax Court Rebuke to the IRS, “18 Business Entities No.1, 4 (January/February 2016).
Moving Past the Standing Issue
So, if the Court wants to hear the case subject to the reversible error (of law) standard if it grants standing to the Plaintiffs, it would hear the evidence Plaintiffs will proffer that there were numerous violations of the APA committed by the Treasury and its delegate in issuing the look-back regulation, including unauthorized agency action, arbitrary and capricious rule-making and failure to provide notice and an opportunity for comment.
Need For Reform: Reduce The Corporate Tax Rate and Allow a Lower Rate for Repatriation of Foreign Earnings; Move to a Sourcing System
The Obama Administration appears to be tone deaf, as do many members of the Democratic side of the Congressional aisle, on the need to restore our Country’s competitiveness in attracting and keeping business based on favorable tax and overall business environment. The inversion phenomenon is by no means new. But the Obama Administration and the Democratic Party just can’t hear the noise that has for years been generated by business, particularly U.S. parent multinational corporations, who are forced, in effect, to consider moving operations offshore even if not part of an inversion, in an effort to be competitive in foreign markets and on an overall basis. We are literally chasing our U.S. parent-MNEs and other U.S. businesses companies.
Blocking inversions when many companies have already exited is a bad remedy for a problem much too big and continuing to cost our country, jobs, capital and tax revenues. We need a far better remedy than a regulation that may not be supportable. We need much lower corporate tax rates and a favorable repatriation of foreign earnings rule. The temporary regulation simply looks like an expedient method for stopping the exodus from continuing until the next session of Congress when hopefully the issue can be addressed and favorably resolved.
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