United States: Administrative And Legislative Options To Address US Corporate

Keywords: US Corporate Inversions, tax incentives

The topic of tax incentives for US corporations seeking to "invert" and become a subsidiary of a foreign corporation is receiving heightened attention in Congress and federal agencies.

As two former members of Congress, one Republican and one Democrat, we believe that this attention is being driven by the mid-term election and the belief of Democratic strategists and outside activists that this will help Democratic candidates and put Republican candidates in marginal districts at a disadvantage. As http://themorningconsult.com/2014/08/pol-tax-inversions/ recent polling confirms, opposition to corporate inversions is quite popular across the political spectrum, and especially among Democrats.

We believe the Obama administration and Congressional Democrats will seek to keep the issue in the news in any way they can. It is our position, therefore, that inverting companies, or companies considering an inversion, must consider the potential implications of these actions if the White House moves forward via administrative action.

Obviously, such attention presents potential risks to US companies considering an inversion transaction. Moreover, some of these potential actions could have significant implications for non-US-based multinational corporations doing business in the United States even if not involved in an inversion transaction.

Below, we discuss some of the likely policy options available to the Obama administration and the Congress to prevent or limit inversions.

Potential Compliance and Regulatory Actions

Companies that elect to do business with the US government are subject to a plethora of requirements imposed by the Federal Acquisition Regulation (FAR) and its supplements. FAR 9.108, reflecting a restriction contained in certain appropriations acts (with the FY 2014 amendment pending at the FAR Council), includes a provision that prohibits federal agencies from contracting with any foreign incorporated entity that is treated as an "inverted domestic corporation," or with a subsidiary of such a corporation. A contractor represents by submission of its offer that it is not an "inverted domestic corporation" or a "subsidiary." If a contractor becomes an inverted domestic corporation (or a subsidiary of such a corporation) during performance, the mandatory contract clause at FAR 52.209-10 provides that the "government may be prohibited from paying for contractor activities performed after the date when it becomes an inverted domestic corporation or subsidiary." Note that the Department of Homeland Security has permanent statutory authority prohibiting contracts with inverted companies.

While inclusion of the FAR contract clause is mandatory, analysis of particular transactions and enforcement are the responsibility of the buying agencies and their contracting officers. If concerns develop regarding application of, and compliance with, the FAR provision, greater attention to contractor compliance is a possibility; this may implicate examination of agency and contractor practices by various Inspectors General and/or suspension and debarment officials.

Additionally, if it is perceived that the current clause is insufficient to address inversions, additional regulatory action is possible.

Department of Treasury Administrative Action

The Obama administration is presently weighing administrative actions on inversions. An August 25 Tax Notes Today news analysis entitled "What Can Treasury Do About Inversions?" provides a good summary of options available.

It is not entirely clear what actions, if any, the Treasury Department might take. Among those that have been discussed in the media are recharacterizing intercompany debt incurred by the inverted entity as equity to deny an interest deduction or taxing certain previously deferred earnings of the inverted company that are used post inversion by affiliates.

Legal experts and others disagree about whether President Obama and Treasury Secretary Lew have the authority to write new rules to discourage inversions, and how narrowly such regulations would have to be tailored.

From our conversations with White House officials and other decision makers, however, we feel it is increasingly likely that the Treasury Department will take some type of action to address inversions, especially if Congressional Republicans indicate they do not wish to address the issue legislatively.

Legislative Action

Over the past few months, our government team has been in close contact with senior members of the House and Senate regarding the latest thinking on corporate inversions, as well as on broader corporate tax reform.

To date, two main legislative options have been discussed in response to the increase in corporate inversions: a general reform of the US tax code and specific provisions to deal with taxmotivated international corporate transactions.

Publicly, Democrats support Secretary Lew's position that the corporate ownership test should be changed. They also have staked out the position that the provision should be retroactive to May 2014. Privately, several leading Democrats have acknowledged that overall reform of the corporate tax structure is also needed to truly resolve this issue. However, given the unlikelihood of broader legislative tax reform at the current time, Democrats continue to push narrower fixes and many have called on the administration to take whatever action it can.

Republicans have generally argued that they prefer broad corporate tax reform (reducing rates and possibly eliminating extraterritoriality) to narrow provisions such as the Levin bill. However, there is precedent among Republicans for many of the legislative provisions being offered; the Bush Administration, for instance, supported proposals to amend Section 163(j) of the tax code to reduce income stripping by limiting deductions for interest on certain intercompany debts. Senator Hatch has called for broad reform, but also indicated in private conversations that he would consider some narrow reforms as well.

Senior staff for Democratic and Republican leadership have both indicated in private conversations they would consider a bi-partisan narrow fix (while still holding out for broader tax reform).

Although the window for passage is narrow this fall and, therefore, congressional action is unlikely this year, the issue is sure to be a prominent one in campaigns across the country. Public positioning around this issue during the election season could lock in support for early action in the next Congress.

Congressional activity surrounding corporate inversions has centered around three major ways of addressing the issue, as listed below.

We believe that legislative proposals could have implications for a wide range of companies, including those that are not currently undergoing inversions.

OWNERSHIP MANAGEMENT AND CONTROL TEST

Especially popular among Democratic lawmakers, the ownership management and control test category of legislation would significantly tighten rules under section 7874 of the US Tax Code. Though there have been several pieces of legislation introduced to address this issue, Democratic support has coalesced around the Stop Corporate Inversions Act of 2014, introduced by Sen. Carl Levin (DMI) and his brother Rep. Sander Levin (D-MI).

This bill would significantly lower the ownership ceiling under which a corporation is considered a US entity, from 80 percent to 50 percent. Furthermore, a merged corporation would continue to be treated as a US entity if management and control of the merged company remains in the United States and 25 percent of the entity's employees, employee compensation, income or assets are located or derived in the United States.

Should this legislation be enacted into law, there is a greater risk that more cross-border mergers and acquisitions could suffer the adverse consequences of the anti-inversion rules, even if such transactions were not intended to qualify as a corporate inversion.

EARNINGS/INCOME STRIPPING

Legislation addressing earnings or income stripping is particularly potent due to its ability to attract bipartisan support. If Democrats succeed in turning up the heat on this issue on the campaign trail, Republicans may flock to this type of legislation, which would eliminate or reduce the interest deduction for payments made by a US corporation to its non-US parent.

This approach was strongly supported by George W. Bush's Treasury Department. Sen. Charles Schumer (D-NY), a senior Democratic Finance Committee member, will soon introduce a bill that seeks to roll back earning stripping. Specifically, his bill would:

• Repeal the IRS provision allowing subsidiaries with a debt-to-equity ratio of 1.5 or less to deduct all allowable interest costs;
• Reduce the permitted net interest expense to 25 percent from 50 percent of the subsidiary's adjusted taxable income;
• Repeal the ability to carry forward disallowed interest deductions into future tax years; and
• Require the US subsidiary to obtain IRS preapproval each year on the terms of transactions with the parent company or other related parties for 10 years after a corporate inversion.

Other legislation, currently being crafted by Senator Levin, would modify the earnings stripping rules for ALL US subsidiaries regardless of whether they were involved in a corporate inversion.

These pieces of legislation are still currently being drafted and may or may not be limited to inverted companies.

GOVERNMENT PROCUREMENT

Despite the administration's ability to take executive action as noted above, legislation prohibiting government contracting with entities that have undergone corporate inversions is the third possible way lawmakers may address the issue in the coming weeks and months.

Sens. Richard Durbin (D-IL) and Levin (D-MI) and Reps. Lloyd Doggett (D-TX) and Rosa DeLauro (D-CT) have introduced the No Federal Contracts for Corporate Deserters Act, which would bar the awarding of government contracts to entities which have undergone a corporate inversion after May 8, 2014.

The bill incorporates the 2012 FAR 52.209-10 into legislative language, prohibiting federal agencies from entering into contracts with companies that have inverted. Like the Stop Corporate Inversions Act, this legislation would use a 50 percent ownership threshold in considering whether a corporation is to be considered a US entity. Though the impact of the bill is somewhat unclear as it would restate an existing federal regulation, we believe that this legislation would remove some of the discretionary enforcement of the regulation.

Similar legislative language has also been included in several FY 2015 appropriations bills (as has been the past practice) pending before the Congress.

Recommendations

Clearly, government activity surrounding corporate inversions is not going away. On the contrary, we fully expect a series of actions to be taken in the coming weeks and months, beginning with executive actions and perhaps culminating in legislative activity to address one or more of the issues detailed above.

Our conversations with the various government officials who are addressing corporate inversions make clear that the implications of government action could be varied and far-ranging. In fact, we believe that some of the actions being considered could impact companies who are not even involved in an inversion transaction.

Two types of businesses operating in the United States should consider possible government action on inversions as an enterprise risk.

First, those businesses that have entered into an inversion transaction or are planning to in the future need to include experts who can advocate on their behalf to seek to avoid provisions that would undermine the financial viability of the transaction.

The team should include tax policy, appellate litigation (unilateral administrative action or overly broad legislative action may present constitutional and other appellate issues), and government relations experts who can discuss these issues with high level senior staff in the administration and directly with Members of Congress.

Such a team might be particularly helpful as high-level executives decide whether and when to proceed with such a transaction.

If the company has business as a government contractor, additional expertise with respect to Federal Acquisition Regulations and experience working with policy makers at the agencies are crucial. The team should immediately assess the nature and extent of its federal business. In addition, it should assess possible regulatory and legislative threat(s), inventory the company's and the team's government affairs assets and contacts, and develop a strategic advocacy plan that would exempt the transaction or reduce the tax burden imposed by the new legislation or regulations on it.

Second, businesses not involved in inversion transactions may also be at risk if they have significant operations in the United States and claim interest deductions in respect of debt financing of new US operations.

These multinational corporations could see their tax exposure increase if the Treasury Department issues regulations that are not narrowly tailored to inversions (which could happen to strengthen the statutory authority for unilateral executive action). Similarly, some versions of the income stripping legislation could have a broader tax impact on multinational corporations generally.

To prepare to address these risks, multinational corporations should develop a strategy to avoid broad legislation and regulation and engage a similar team of experts prepared to advocate for this at the highest levels of the US government.

David McIntosh served three terms representing Indiana's Second Congressional District in the US House of Representatives. He also held a variety of positions in both the Reagan and first Bush administrations. David is currently a partner at Mayer Brown where he is co-leader of the firm's US legislative affairs activities and focuses his practice on government affairs.

Anthony "Toby" Moffett served four terms representing Connecticut's Sixth Congressional District in the US House of Representatives. He is currently a senior adviser at Mayer Brown where he co-leads the firm's US legislative affairs activities and is also playing a leading role in expanding Mayer Brown's business in Africa.

Originally published August 28, 2014

Learn more about Mayer Brown's Government Relations, Tax Controversy and Tax Transactions & Consulting practices.

Visit us at mayerbrown.com

Mayer Brown is a global legal services provider comprising legal practices that are separate entities (the "Mayer Brown Practices"). The Mayer Brown Practices are: Mayer Brown LLP and Mayer Brown Europe – Brussels LLP, both limited liability partnerships established in Illinois USA; Mayer Brown International LLP, a limited liability partnership incorporated in England and Wales (authorized and regulated by the Solicitors Regulation Authority and registered in England and Wales number OC 303359); Mayer Brown, a SELAS established in France; Mayer Brown JSM, a Hong Kong partnership and its associated entities in Asia; and Tauil & Chequer Advogados, a Brazilian law partnership with which Mayer Brown is associated. "Mayer Brown" and the Mayer Brown logo are the trademarks of the Mayer Brown Practices in their respective jurisdictions.

© Copyright 2014. The Mayer Brown Practices. All rights reserved.

This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.