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By: Paul Determan, Michael Steffany & Jason Jointer.

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1 By: Paul Determan, Michael Steffany & Jason Jointer

2 What is an Inversion? U.S.-based multinational changes its corporate structure, via merger, so that the new foreign corporation replaces the U.S. Target Co. Target Co. changes its country of residence Usually in low or no tax jurisdiction US Target Co. Foreign Parent (X) US Target Co. US SH Foreign Corp (X) F SH Assets/Stock F SH

3 Q: Why Corporations Invert U.S. tax policies create an incentive to shift ownership away from U.S. based companies Foreign Inc. Low/No Tax Rate Territorial Tax U.S. Inc. Corp. Tax Rate Worldwide Tax Competitiveness

4 Putting it all Together A: To gain access to foreign earnings and reduce U.S. earnings

5 Inversion Arguments Erosion of the U.S. tax base (Base Erosion) Fairness Purely for tax reasons IRS & Treas. Operational flexibility Improved cash management Access to international markets Corporations

6 Inversion Activity The statutory framework has existed for years Increase in frequency, size and visibility

7 IRS and Treas. Action Incremental changes to deter inversions techniques when they see a flare up in activity benefitting corporations The Notice is the most recent example of this behavior. Notice Inversions ?9084-Whack-A-Mole

8 Early Inversion Activity Naked inversion- U.S. parent corporation inverts into its own foreign subsidiary Many of these inversions lacked clear business purpose and primarily motivated by tax avoidance Substantially the same owners Inversion without ownership or control limits Determined to be tax abusive Led to the enactment of anti-inversion rules under § 7874

9 § 7874 Restricts the tax benefits of an inversion When the owners of the new company are not substantially different from the owners of the original company. Requires the ownership of the new foreign parent to be in a range of 60% to 80% by the former domestic shareholders Allows for a safe harbor for substantial business activities

10 Substantial Business Activities Safe harbor from § 7874 anti-inversion provisions If the affiliated group’s post-­merger activities are at least 25 percent in each category: employees, assets, and income These activities must be located or derived in the foreign jurisdiction where foreign parent is incorporated.

11 Ownership Thresholds Inversion Disregarded The foreign parent is treated as a domestic corporation. Denies the firm any tax benefits of the inversion Combined group is taxed on the worldwide income >80% Successful inversion §367 – Anti inversion consequences 60% - 80% The foreign parent is not treated as a surrogate foreign corporation. Denies the firm any tax benefits of the inversion Transactions is treated like any merger, there is just a foreign party in the transaction <60% Does not deter inversions, corporations are willing to accept penalties

12 § 367- Anti-inversion penalties Shareholders are taxed on inversion gain Target Co.’s taxable income cannot be less than the inversion gain until 10 yrs. after the inversion Inversion cannot be offset by NOLs, FTCs or other tax attributes Doesn’t discourage inversions Corporations wait till the 10 years lapses

13 IRS & Treasury’s Intentions

14 IRS Notice Treasury and IRS intend to issue regulations addressing inversions and post-inversion transactions. The notice describes the substance of these future regulations. However: the Treasury and IRS expect to issue additional guidance to further limit inversions and specifically will address earnings stripping. Both the described and undescribed future guidance applies to companies that complete inversion on or after September 22, 2014.

15 Example Described Regulation SECTION 3. REGULATIONS TO ADDRESS POST-INVERSION TAX AVOIDANCE TRANSACTIONS.01 Regulations to Address Acquisitions of Obligations and Stock that Avoid Section 956 (a) Section 956 Background Section 957(a) defines a CFC as a foreign corporation with respect to which more than 50 percent of the total combined voting power of all classes of stock entitled to vote or the total value of the stock of the corporation is owned (directly, indirectly, or constructively) by United States shareholders (U.S. shareholders). Section 951(b) defines a U.S. shareholder as a U.S. person that owns (directly, indirectly, or constructively) 10 percent or more of the total combined voting power of all classes of stock entitled to vote of the foreign corporation. Section 951(a)(1) provides that every person that is a U.S. shareholder of a CFC and owns (within the meaning of section 958(a)) stock in the corporation on the last day of the CFC’s taxable year must include in its gross income for its taxable year in which or with which such taxable year of the CFC ends the amount determined under section 956 with respect to the shareholder for the year (but only to the extent not excluded from gross income under section 959(a)(2)). [Omitted: Pertinent sections of Code Section 956 provided here] Section 956(c)(2) provides exceptions that apply to the definition of United States property, including exceptions that limit the scope of obligations of U.S. persons and stock of domestic corporations that will be treated as United States property to obligations of sufficiently related U.S. persons and stock of sufficiently related domestic corporations. See sections 956(c)(1)(B) and (C) and 956(c)(2)(F) and (L). Section 956 is intended to prevent a U.S. shareholder of a CFC from inappropriately deferring U.S. taxation of CFC earnings and profits by “prevent[ing] the repatriation of income to the United States in a manner which does not subject it to U.S. taxation.” H.R. Rep. No. 1447, 87th Cong., 2d Sess., at 58 (1962). In the absence of section 956, a U.S. shareholder of a CFC could access the CFC’s funds (untaxed earnings and profits) in a variety of ways other than by the payment of an actual taxable dividend, such that there would be no reason for the U.S. shareholder to incur the dividend tax. Section 956 eliminates this disincentive to pay a dividend by ensuring parity of treatment for different ways that CFC earnings can be made available for use in the United States or for use by the U.S. shareholder. Accordingly, under section 956, the investment by a CFC of its earnings and profits in United States property is “taxed to the [CFC’s] shareholders on the grounds that this is substantially the equivalent of a dividend.” S. Rep. No. 1881, 87th Cong., 2d Sess., at 88 (1962). Section 956(e) provides the Secretary with authority to “prescribe such regulations as may be necessary... to prevent the avoidance of the provisions of [section 956] through reorganizations or otherwise.” (b) Transactions at Issue and Regulations to be Issued An inversion transaction may permit the top corporate parent in the newly inverted group, a group still principally comprised of U.S. shareholders and their CFCs, to avoid section 956 by accessing the untaxed earnings and profits of the CFCs without a current tax to the U.S. shareholders. This is a result that the U.S. shareholders could not achieve before the inversion. The ability of the new foreign parent to access deferred CFC earnings and profits would in many cases eliminate the need for the CFCs to pay dividends to the U.S. shareholders, thereby circumventing the purposes of section 956. Section 956(e) directs the Secretary to prescribe regulations to prevent the avoidance of the provisions of section 956 through reorganizations or otherwise; an inversion is an example of such a transaction. In order to prevent this avoidance of section 956, the Treasury Department and the IRS intend to issue regulations under section 956(e) providing that, solely for purposes of section 956, any obligation or stock of a foreign related person (within the meaning of section 7874(d)(3) other than an “expatriated foreign subsidiary”) (such person, a “non-CFC foreign related person”) will be treated as United States property within the meaning of section 956(c)(1) to the extent such obligation or stock is acquired by an expatriated foreign subsidiary during the applicable period (within the meaning of section 7874(d)(1)). For purposes of this notice, except as provided in the succeeding sentence, an expatriated foreign subsidiary is a CFC with respect to which an expatriated entity (as defined in section 2.01(a) of this notice) is a U.S. shareholder. An expatriated foreign subsidiary does not include a CFC that is a member of the EAG immediately after the acquisition and all transactions related to the acquisition are completed (completion date) if the domestic entity is not a U.S. shareholder with respect to the CFC on or before the completion date. In addition, for purposes of this section, an expatriated foreign subsidiary that is a pledgor or guarantor of an obligation of a non-CFC foreign related person under the principles of section 956(d) and § (c) will be considered as holding such obligation. The Treasury Department and the IRS are considering, and request comments on, whether any exceptions under section 956(c)(2) or § should apply to an obligation or stock of a foreign related person that is determined to be United States property within the meaning of section 956(c)(1) pursuant to the regulations described in this section 3.01(b). However, the exception to the definition of obligation provided by Notice , C.B. 446, will not apply to such obligations.

16 Future Earnings Stripping Regulation Description: ”The Treasury Department and IRS expect to issue additional guidance to further limit inversion transactions contrary to the purpose of section 7874 and the benefits of post-inversion tax avoidance transactions. In particular the IRS and Treasury Department are considering guidance to address strategies that avoid U.S. tax on U.S. operations by shifting or ‘stripping’ U.S.-source earnings to lower-tax jurisdictions, including through intercompany debt. Comments are requested regarding the approaches such guidance should take.”

17 Notice’s Inversion Ownership Threshold Proposed Regulations Future regulations will limit the ability of U.S. Corporations to meet the ownership threshold required by: Limiting a U.S. Corporation’s ability to invert with a foreign corporation that has subsantial passive or liquid assets. In many cases, stock attributed to such assets will not impact the ownership fraction. Limiting a U.S. Corporation’s ability to meet the ownership tests by making “skinny down” distributions. Limiting a U.S. Corporations ability to take advantage of the internal group restructuring exception.

18 Notice’s CFC Earnings Access Proposed Regulations Future regulations will provide that for 10 years after inversion, the new foreign parent’s ability to access CFC earnings will be limited: New Foreign Parent cannot access earnings of CFC’s via a “hopscotch” loan. New Foreign Parent cannot access earnings of CFC’s via a “de-controlling” transaction. New Foreign Parent cannot receive U.S. tax free transfers of property or cash from a CFC via certain section 304 transfers.

19 Post-Notice Effect on Inversions ENDED: AbbieVie/Shire: abandoned on October 20. The cancellation resulted in a (deductible!) $1.635 billion break up fee paid by AbbieVie. Salix Pharmaceuticals and Cosmo: abandoned on October 3. NEW PARTNER: Auxilium/QLT abandoned Auxilium has made a deal to be acquired by Endo Chiquita/Fyffes abandoned Chiquita/Cutrale-Safra are in discussions for inversion to Brazil. Pfizer/AstraZeneca failed prior to the Notice Pfizer CEO publicly stated that the corporation is still looking for an inversion opportunity

20 Post Notice Effect on Inversions RESTRUCTURED: Medtronic/Covidien: restructured deal with new financing terms specifically to mitigate the effects of the Notice Mylan/Abbott Laboratories: restructured deal, and “announced adjustments” to their deal on October 22 NEW INVERSIONS: Civeo Corp. of Texas announced on Sept. 29 it would be “redomiciling” in Canada Steris Corp. of Ohio announced on October 13 it would acquire Synergy Health Plc, and invert to the UK.

21 Potential Challenges to Notice Authority to issue Regs. Judicial review and deference given to the Regs. Effective date of the Regs.

22 Service and Treasury Authority The Notice proposes substantial regulations on a variety of statutes, most notably IRC 956, 7701, 304, and 7874 Each of these statutes has a specific grant from Congress to issue subsequent regulations. Specifically 956(e), 7701(l), 304(c), and 7874(g) The Service will argue that these are full legislative regulations and should likewise be given full deference by the Court.

23 Weight of Proposed Regs. Because there is a Congressional grant to write regs. under these statutes, the Regs. will likely be afforded a great deal of deference by the Courts. Typically Courts grant legislative regs. Chevron deference. Meaning that the agency’s interpretation will be respected as long as it is based on a permissible construction of the statute. ( Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc. 467 U.S. 837 (1984)

24 Weight of Proposed Regs. However there is a long history of Courts respecting transactions with reasonable business purposes and the same could happen here. Additionally the argument may be made that because of the nature of the proposals the Secretary is going further than the Congressional grant to interpreting existing statues and write regs. and is effectively creating new law thus exercising a power not reserved for the executive.

25 Effective Date of Regs. 26 U.S. Code § Rules and regulations (b) Retroactivity of regulations (1) In general Except as otherwise provided in this subsection, no temporary, proposed, or final regulation relating to the internal revenue laws shall apply to any taxable period ending before the earliest of the following dates: (C) The date on which any notice substantially describing the expected contents of any temporary, proposed, or final regulation is issued to the public.

26 Two further exceptions for retroactivity are carved out within IRC (b)(6) Congressional authorization The limitation of paragraph (1) may be superseded by a legislative grant from Congress authorizing the Secretary to prescribe the effective date with respect to any regulation. There is no such grant related to Earnings Stripping mentioned in the Notice. 7805(b)(3) Prevention of abuse The Secretary may provide that any regulation may take effect or apply retroactively to prevent abuse. While the IRS may issue retroactive regs. to prevent abuse, Congress has neither defined the term nor given anyone else power to do the same. Effective Date of Regs.

27 The Notice makes clear that the regulations will have an effective date that relates back to the date of the Notice IRC 7805(b)(1)(c) allows for regulations to date back to the date of a notice that substantially describes the expected contents of the future regulations. Here the notice discusses changes to 956, 7701, 304, and 7874 at length. It is likely the regs. will be allowed to relate back to the date of the notice.

28 End Result of Regs. The proposed changes the Notice details are likely authorized by the specific Congressional grant contained in statute. Their effective date is also likely to be upheld as to the date of the Notice as it describes the proposals in detail. While the changes to statute are likely authorized, whether they are upheld in Court is a different issue. Attacking them will take a plaintiff willing to litigate whether they are a reasonable interpretation of statute and whether they are in effect creating new law.

29 Earnings Stripping In contrast to the verbosity with which the Notice discusses the proposed regulations, Section 5 of the Notice merely makes mention of the desire to take further action on earnings stripping.

30 Example Described Regulation: SECTION 3. REGULATIONS TO ADDRESS POST-INVERSION TAX AVOIDANCE TRANSACTIONS.01 Regulations to Address Acquisitions of Obligations and Stock that Avoid Section 956 (a) Section 956 Background Section 957(a) defines a CFC as a foreign corporation with respect to which more than 50 percent of the total combined voting power of all classes of stock entitled to vote or the total value of the stock of the corporation is owned (directly, indirectly, or constructively) by United States shareholders (U.S. shareholders). Section 951(b) defines a U.S. shareholder as a U.S. person that owns (directly, indirectly, or constructively) 10 percent or more of the total combined voting power of all classes of stock entitled to vote of the foreign corporation. Section 951(a)(1) provides that every person that is a U.S. shareholder of a CFC and owns (within the meaning of section 958(a)) stock in the corporation on the last day of the CFC’s taxable year must include in its gross income for its taxable year in which or with which such taxable year of the CFC ends the amount determined under section 956 with respect to the shareholder for the year (but only to the extent not excluded from gross income under section 959(a)(2)). [Omitted: Pertinent sections of Code Section 956 provided here] Section 956(c)(2) provides exceptions that apply to the definition of United States property, including exceptions that limit the scope of obligations of U.S. persons and stock of domestic corporations that will be treated as United States property to obligations of sufficiently related U.S. persons and stock of sufficiently related domestic corporations. See sections 956(c)(1)(B) and (C) and 956(c)(2)(F) and (L). Section 956 is intended to prevent a U.S. shareholder of a CFC from inappropriately deferring U.S. taxation of CFC earnings and profits by “prevent[ing] the repatriation of income to the United States in a manner which does not subject it to U.S. taxation.” H.R. Rep. No. 1447, 87th Cong., 2d Sess., at 58 (1962). In the absence of section 956, a U.S. shareholder of a CFC could access the CFC’s funds (untaxed earnings and profits) in a variety of ways other than by the payment of an actual taxable dividend, such that there would be no reason for the U.S. shareholder to incur the dividend tax. Section 956 eliminates this disincentive to pay a dividend by ensuring parity of treatment for different ways that CFC earnings can be made available for use in the United States or for use by the U.S. shareholder. Accordingly, under section 956, the investment by a CFC of its earnings and profits in United States property is “taxed to the [CFC’s] shareholders on the grounds that this is substantially the equivalent of a dividend.” S. Rep. No. 1881, 87th Cong., 2d Sess., at 88 (1962). Section 956(e) provides the Secretary with authority to “prescribe such regulations as may be necessary... to prevent the avoidance of the provisions of [section 956] through reorganizations or otherwise.” (b) Transactions at Issue and Regulations to be Issued An inversion transaction may permit the top corporate parent in the newly inverted group, a group still principally comprised of U.S. shareholders and their CFCs, to avoid section 956 by accessing the untaxed earnings and profits of the CFCs without a current tax to the U.S. shareholders. This is a result that the U.S. shareholders could not achieve before the inversion. The ability of the new foreign parent to access deferred CFC earnings and profits would in many cases eliminate the need for the CFCs to pay dividends to the U.S. shareholders, thereby circumventing the purposes of section 956. Section 956(e) directs the Secretary to prescribe regulations to prevent the avoidance of the provisions of section 956 through reorganizations or otherwise; an inversion is an example of such a transaction. In order to prevent this avoidance of section 956, the Treasury Department and the IRS intend to issue regulations under section 956(e) providing that, solely for purposes of section 956, any obligation or stock of a foreign related person (within the meaning of section 7874(d)(3) other than an “expatriated foreign subsidiary”) (such person, a “non-CFC foreign related person”) will be treated as United States property within the meaning of section 956(c)(1) to the extent such obligation or stock is acquired by an expatriated foreign subsidiary during the applicable period (within the meaning of section 7874(d)(1)). For purposes of this notice, except as provided in the succeeding sentence, an expatriated foreign subsidiary is a CFC with respect to which an expatriated entity (as defined in section 2.01(a) of this notice) is a U.S. shareholder. An expatriated foreign subsidiary does not include a CFC that is a member of the EAG immediately after the acquisition and all transactions related to the acquisition are completed (completion date) if the domestic entity is not a U.S. shareholder with respect to the CFC on or before the completion date. In addition, for purposes of this section, an expatriated foreign subsidiary that is a pledgor or guarantor of an obligation of a non-CFC foreign related person under the principles of section 956(d) and § (c) will be considered as holding such obligation. The Treasury Department and the IRS are considering, and request comments on, whether any exceptions under section 956(c)(2) or § should apply to an obligation or stock of a foreign related person that is determined to be United States property within the meaning of section 956(c)(1) pursuant to the regulations described in this section 3.01(b). However, the exception to the definition of obligation provided by Notice , C.B. 446, will not apply to such obligations.

31 Future Earnings Stripping Regulation Description: ”The Treasury Department and IRS expect to issue additional guidance to further limit inversion transactions contrary to the purpose of section 7874 and the benefits of post-inversion tax avoidance transactions. In particular the IRS and Treasury Department are considering guidance to address strategies that avoid U.S. tax on U.S. operations by shifting or ‘stripping’ U.S.-source earnings to lower-tax jurisdictions, including through intercompany debt. Comments are requested regarding the approaches such guidance should take.”

32 Authority to Issue Regs. on Earnings Stripping Unlike the proposed regs. no specific statute relating to earnings stripping activity is mentioned in the Notice. As such the Notice does not point to any specific Congressional grant of authority to issue regulations on the subject.

33 Weight Given to Earnings Stripping Action Because the Notice doesn’t mention any proposed changes, it is difficult to determine what weight they will be given. The weight that these regulations will be given depends upon the statutory language that they are tied to and whether it grants the Secretary Congressional Authority to issue Regs. However they too will have to be a reasonable interpretation of statute and pass any challenges presented by litigation.

34 Effective Date of Earnings Stripping Action. Section 5 of the notice indicates that future action on earning stripping and the use of intercompany debt is going to be forthcoming, and that any future regulation in the arena will be prospective but will relate back to the date of the notice for companies that have inverted on or after 9/22/14 (date of the notice). However the Notice does not “substantially describe” the contents of future regs. on earnings stripping.

35 Retroactivity is the exception to the normal rule making process of the IRS, and is generally disfavored. To the extent that the Notice is attempting to relate future regulation on earnings stripping back to the date of the notice the IRS will likely be unsuccessful based on 7805(b)(1)(c) given that the Notice does not describe the contents of future changes at all. Further the Notice does not point to any legislative grant to write regs. on Earnings Stripping, which renders 7805(b)(6) inapplicable. Effective Date of Earnings Stripping Action.

36 Congress has not defined abuse nor have they given the Secretary that authority to create one. Absent a clear finding that earnings stripping is abusive this likely renders the Services efforts to relate back based on 7805(b)(3) ineffective. Further Courts have be hesitant to hold retroactive regs. as valid in many instances and largely respect transactions with legitimate business purposes.

37 Cases that have denied Relation back Murfam Farms, LLC v. United States, 88 Fed. Cl. 516 (2009) (regulation (basis reduction for transfers of contingent obligations to partnership) cannot be applied retroactively b/c of limitation in 7805) (also speaks to three step process, one retroactivity is generally barred absent an exception, reg is not a valid interp. Under Chevron, reg failed notice and comment under APA)88 Fed. Cl. 516 Stobie Creek Invs., LLC v. United States, 82 Fed. Cl. at 667–671 (regulation cannot be applied retroactively); exceeded scope of specific authorization granted IRS under applicable law. fact that taxpayers may have had notice via Notice , CB 255 didn't otherwise justify retroactive reg application Sala v. United States, 552 F. Supp. 2d 1167 (D. Colo. 2008)552 F. Supp. 2d 1167 Klamath Strategic Inv. Fund, LLC v. United States, 568 F.3d 537, 546 (5th Cir. 2009).568 F.3d 537

38 IRS may have difficulty with implementing the proposed changes and face litigation based on the possible impermissible creation of new law rather than the creation of regs. Additionally Courts may find that certain transactions have valid business purposes and choose not to adhere to the new regs. As it relates to earnings stripping there is no legislative grant, abuse is not defined, and the notice inadequately describes the activity for purposes of relating back. Future of Notice 14-52


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