Joint Committee Report Questions Obama’s Corporate Inversion Proposal
December 2014In December 2014, the staff of the Joint Committee on Taxation released a report entitled: Description of Certain Revenue Provisions Contained in the President’s Fiscal Year 2015 Budget Proposal. The report includes an analysis of President Obama’s proposal to limit the ability of U.S. corporations to expatriate through a corporate inversion transaction. The report is noteworthy because it raises some fundamental policy questions about expansion of U.S. anti-inversion rules.
Section 7874 was enacted by Congress to specifically address corporate inversions. In general, section 7874 applies when an acquisitive transaction satisfies three tests: (i) a foreign corporation, pursuant to a plan, acquires substantially all of the properties of a U.S. corporation (or a domestic partnership), (ii) the foreign corporation and its “expanded affiliated group” do not have substantial business activities in its country of incorporation (compared to the business activities of the expanded affiliated group outside such country), and (iii) there is a continuing interest by shareholders of the U.S. corporation (or domestic partnership) in the foreign parent. When the continuing interest of former shareholders of the U.S. company is at least 80 percent (measured by vote or value), the foreign parent is treated as a domestic corporation for all U.S. income tax purposes and all U.S. treaty purposes. When the continuing interest of former shareholders is less than 80 percent but at least 60 percent, certain types of income recognized in the inversion transaction cannot be reduced by certain tax attributes of the U.S. group for 10 years following the inversion transaction.
President Obama’s proposal
The President’s proposal would reduce the historic stock ownership threshold at which a foreign incorporated entity is treated as a domestic corporation from 80 percent to 50 percent. Thus, if an acquisitive transaction otherwise satisfying the requirements of section 7874, the historic shareholders of the U.S. corporation owned more than 50 percent of the stock of the foreign corporation (measured by either vote or value) after the acquisition, the foreign corporation would be treated as a domestic corporation for all purposes of the Internal Revenue Code.
The President’s proposal further provides that if a transaction would otherwise satisfy the requirements of section 7874 as modified above, except for the new lower 50-percent ownership test, the foreign corporation would be treated as a domestic corporation if (i) the expanded affiliated group that includes the foreign corporation has substantial business activities in the United States and (ii) the foreign corporation is primarily managed and controlled in the United States.
Issues raised by the report
The report begins by noting that the President’s proposal is not limited to transactions in which a U.S. corporation is merely re-domiciled. It therefore may have the effect of discouraging some cross-border mergers and acquisitions. The President’s proposal therefore raises a more general question of what should be the objective of U.S. tax rules concerning cross-border transactions. The report notes that protecting the U.S. tax base may be in tension with other tax policy goals, such as neutrality towards cross-border transactions and minimizing the extent to which U.S. tax rules concerning cross-border transactions reduce U.S. investment or employment. The report points out that companies contemplating transactions that would be within the ambit of the President’s proposal might respond by moving senior managers and executives outside the United States. It also notes that such a proposition would be difficult to test.
The report also considers the type of cross-border acquisition that should be considered objectionable as a U.S. tax policy matter. Current law focuses on the extent to which the owners of the former domestic parent continue as owners of the new foreign parent and the location of the business activities of the group. The President’s proposal adds a third criterion: whether the group is primarily managed and controlled in the United States.
It may be that other criteria are more appropriate determinants of when a corporation should be treated as a domestic corporation. For example, if a reason to impose income tax on a corporation is to ensure that owners of the corporation are taxed on their shares of corporate income, the best criterion for whether a foreign parent corporation should be treated as a domestic corporation after an acquisition may be the extent to which owners of the foreign parent corporation are themselves U.S. persons.
The report also asks if management and control is a relevant criterion for determining corporate domicile, why the President’s proposal should apply only in the context of a cross-border acquisition. For example, consider two corporate groups with foreign parents that are managed and controlled in the United States. One foreign parent has historically been managed and controlled in the United States and the other is a result of a cross-border merger. Only the latter would be treated as a domestic corporation under the President’s proposal.
The report also points out that the President’s proposal does not address certain aspects of the Internal Revenue Code that encourage corporate inversions. For example, the disparity in the U.S. taxation of domestic and foreign corporations is often cited as encouraging corporate inversions. Thus, the President’s proposal might not stop transactions that are viewed as objectionable. Instead, the report suggests it might be more productive to reform the U.S. tax system to reduce those disparities. The report identifies broadening the U.S. tax base for taxing foreign parented companies, or easing U.S. taxation of the foreign business earnings of U.S. parented groups as possibilities.
Finally, the report raises administrative and compliance concerns. Under current law, corporate domicile is a simple formal rule, place of incorporation. The President’s proposal would make corporate domicile, at least subsequent to a cross-border merger, turn on the location of a company’s management, employees, tangible assets and sales. Certain aspects of this test are subjective, and it may be difficult for the IRS to ascertain the company’s primary place of management and control. Moreover, this locus may change from year to year depending upon the facts and circumstances.
President Obama has indicated a willingness to work with the Republican-controlled Congress to address tax reform during the final two years of his administration. For many involved in the tax reform process, addressing corporate inversions is likely to be a political imperative.
As the report points out, efforts to address corporate inversions raise a range of fundamental policy questions about corporate taxation and corporate domicile. Resolving such issues would be contentious were the President and Congress of the same party. The author views the odds that Congress will pass and the President will sign legislation expanding the scope of section 7874 during the next two years as quite low.
 JCS-2-14. Section 7874(c)(1) defines “expanded affiliated group” to mean: “an affiliated group as defined in section 1504(a) but without regard to section 1504(b)(3), except that section 1504(a) shall be applied by substituting “more than 50 percent” for “at least 80 percent” each place it appears.” Thus, it includes a chain of corporations (foreign and domestic) that are more than 50 percent owned by a common parent. The President's proposal also includes a provision relating to the acquisition of a domestic partnership by a foreign corporation, which is not discussed here. The report is 277 pages in length, and only 13 pages are devoted to an analysis of the President’s anti-inversion proposal.
KEYWORD: Corporate Inversions
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