Each edition of Tax Matters consists of free-flowing responses by three tax practitioners to a question regarding a current issue in tax law and policy. Tax Matters commentaries provide insightful perspectives on a broad range of topics, making important contributions to the dialogue within the tax bar about cutting-edge issues. Although the commentaries are certainly of interest to the academic community, they are primarily directed toward tax professionals and their clients.
United States taxation of worldwide income combined with a high corporate tax rate disadvantages US-headed multinational groups compared with groups with the same income mix but a non-US parent. The disadvantage has become more pronounced in recent years as more countries move to territorial systems and lower rates.
US groups have a strong tax incentive to restructure—including by foreign mergers—so their parent is non-US. They then will never owe US tax on foreign source income earned in subsidiaries of the non-US parent, and so may be able to outbid US competitors for foreign acquisitions. Corporate inversions also enable conversion of US-source income into untaxed foreign-source income through deductible payments to foreign affiliates. Moreover, US dividend withholding tax no longer applies.
Congress and the Treasury have reacted several times to limit inversions. Section 367(a) regulations finalized in 1996 tax US shareholders on gain if together they end up with more than half the shares of the new foreign parent. Enacted in 2004, section 7874 generally treats the new parent as domestic if at least 80% of its shares are held by former shareholders of the inverting domestic corporation by reason of having held its shares, unless the group has substantial business activities in the new foreign parent’s home country. Last year temporary regulations narrowly construed this exception.
Foreign mergers continue to occur notwithstanding section 7874, however, including Perrigo/Elan (Ireland) (announced July 29) and Actavis/Warner Chilcott (Ireland) (announced May 20). Reports of expected tax savings have renewed focus on the policy issues inversions present. Why are they of more concern than decisions to incorporate a new business abroad? To what extent do expected savings arise from deductible related party payments? What do inversions say about whether the United States can sustain a system increasingly out of step with a world of territorial, low-rate systems? Why do inversions reduce effective tax rates if US groups already can permanently defer tax—and book tax expense—on reinvested business income of foreign subsidiaries? What practical effect has section 7874 had? Should tax planners advise more US-headed multinational groups to merge or restructure, planning around section 7874, so that they have a non-US parent? What if any non-US tax constraints limit inversions?
By Robert Scarborough, Lecturer in Law, Columbia Law School