Blogging has been very light while I am teaching a one-week graduate class before I start parental leave in the Fall. Here is a guest blog post from my friend Adam Rosenzweig.
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Nate has asked me to write a post on some common international tax structures used by multinational corporations to reduce their worldwide tax liability. Originally, the idea was to list several of these into a single post. Rather than do so, however, I thought it might be better to write a series of posts, each one describing a separate strategy.
With that in mind, I thought the best place to start would be where I left off in the prior post – so-called corporate inversions. In particular, I thought this would be appropriate because of recent news that at least one bidder for Dellis considering a form of corporate inversion transaction as a way to use tax savings to finance the acquisition.
Turning to the basic corporate inversion transaction: assume a multinational corporation with the ultimate parent corporation, let’s call it US Parent, legally formed in Delaware. Although the company initially focused primarily on the US market, eventually it expanded operations to other countries as well. For simplicity (it doesn’t matter in the long run) assume that all foreign sales of the company are immediately taxed in the United States. The foreign source income is eligible for foreign tax credits, but assume that due to the business model and tax structuring of the company the foreign tax credits are capped in some way such that there is a net foreign tax being paid in addition to US tax. So long as the foreign operations comprise a small portion of the total income of the company this is just a cost of doing business. But at some point the foreign operations grow to dominate the income of the US operations, say because foreign markets are high growth and US markets are mature.
At this point, the problem is that a primarily foreign company from a sales perspective is being treated as a primarily US company from a tax perspective solely because of its place of legal incorporation. The solution, then, must be to convert the company from a US one to a foreign one for US tax purposes. There is a huge hurdle to this solution, however. Any change in form of a corporation, even a change in state of incorporation, is a realization event for US tax purposes. This means that, absent a non-recognition provision, the owners of the company will have to pay tax on the re-incorporation. Obviously, paying tax now to reduce tax later is not particularly appealing to US Parent.
So to accomplish the move offshore the corporation must find a tax free non-recognition provision, such as a merger. This then raises a second problem – special rules (under Section 367 of the Internal Revenue Code) intended to prevent companies from moving assets offshore in a tax-free manner. These rules “turn off” the non-recognition merger provisions if assets with untaxed US gain are moved offshore in an otherwise tax-free manner. So the challenge is to find a tax-free reorganization provision that can be utilized without triggering these rules.
So here is one solution the market developed (of course, clever tax lawyers have devised others, but they get to a substantially similar result): (1) have US Parent form a “dummy” foreign corporation, let’s call it Foreign Parent, in the desired jurisdiction, say Bermuda, for one dollar; (2) have Foreign Parent form a Merger Sub in Delaware; (3) merge Merger Sub with and into US Parent with US Parent surviving in exchange for stock of Foreign Parent. The result is a strange looking creature – the original shareholding public of US Parent owns 100% of the stock Foreign Parent, which owns 100% of the stock of US Parent, which in turn owns one share of Foreign Parent stock. For specific reasons not particularly relevant to the inversion, it is helpful to leave this one share of stock technically outstanding.
The last step would be for US parent to distribute its foreign business up to Foreign Parent. In this manner, future foreign earnings would be paid directly to Foreign Parent and not US Parent, thereby avoiding US tax. This would be taxable to US Parent absent a non-recognition provision. Sometimes this is ok because there is little gain in those assets and sometimes the distribution can be structured to be considered part of the tax-free reorganization. If neither is applicable, Foreign Parent can just undertake its new foreign investment directly and over time shift foreign profits out of US Parent.
Why this convoluted structure? The tax law disregards transitory steps in a transaction that have no independent economic substance. So the merger of US Parent into Merger Sub with US Parent surviving is treated by the US tax law as an acquisition of the stock of US Parent by Foreign Parent for stock of Foreign Parent. This is the crucial step. Treating this as a stock acquisition means that only the shareholders of Foreign Parent have a realization event and thus need the benefit of a non-recognition provision. Under the Code, a share-for-share exchange in which the former shareholders of the two companies own at least eighty percent of the stock of the resulting corporation is entitled to non-recognition (as either a so-called B Reorganization or collapsed into the formation of Foreign Parent and treated as a Section 351 tax free incorporation). Thus, the public shareholders pay no tax (large public shareholders would have certain paperwork they need to file, but would mostly pay no tax).
Crucially, under this fictional stock sale, technically US Parent never goes out of existence or transfers any of its assets. Thus, there is no realization event at the US Parent level at all (prior to any transfers of its foreign business to Foreign Parent). Consequently, the special rule under Section 367 applicable to corporations moving US assets offshore does not apply as that only kicks in once there has been a realization event.
The final result: all US business of the multinational is owned by US Parent and taxed in the United States, but now all foreign business is owned directly or indirectly by Foreign Parent and no longer taxed by the United States. This is effectively a self-help form of territorial taxation.
As before, any distributions paid by Foreign Corp to US shareholders will be taxable as dividends to US shareholders, but distributions to foreign shareholders are no longer subject to US withholding taxes. So long as Foreign Corp is organized in a country with no withholding taxes no shareholders need pay withholding taxes on dividends ever again. This was the result for a company called “Helen of Troy” that inverted in the 1990s.
The benefits continue. Dividends from old US Parent to Foreign Parent may be subject to US tax, but this can be resolved either by locating Foreign Parent in a country with a tax treaty with the United States (which Helen of Troy did by organizing in Barbados which used to have a tax treaty with the United States) or by managing the cash flow through transfer pricing and other cash management techniques so that US Parent never pays a dividend. The only ongoing cost of the structure is any foreign tax liability incurred by Foreign Corp, but so long as Foreign Corp is organized in a country with little to no corporate income tax this is not an issue either (there will typically be annual franchise taxes or fees but these are typically relatively small). So long as the market does not capitalize a penalty into the price of the shares for owning stock in a foreign corporation rather than a Delaware corporation, which the evidence tends to shows it does not, there is no ongoing cost to shareholders either.
The inversion therefore provides a clean solution to a sticky problem – offshoring the foreign earnings of a US company without changing the actual business activity of the company or the business structure at all, in a tax-free manner.
In response to Helen of Troy, Treasury issued new rules under Section 367 requiring shareholders to recognize gain on a transfer of US stock to a foreign company if the old shareholders end up controlling the new foreign company and the resulting company does not have substantial foreign business. These regulations were supposed to kill inversions by leveraging shareholder interest against corporate interest. Unfortunately, all it seemed to do was force companies (such as Tyco) to wait until a drop in the market, when most public shareholders carried stock at a loss, to enter into inversion transactions.
It is for this reason that inversions, notwithstanding the Helen of Troy regulations, were considered an existential threat to the US corporate tax base. In response, Congress enacted Section 7874 which provides that an inverted company (a technical definition, but Foreign Parent for these purposes) will pay tax on its built in US gain in the year of inversion and, if it remains substantially owned by US shareholders, will be treated as a US corporation notwithstanding that it is legally organized in a foreign country.
There are some minor exceptions to the corporate inversion rule involving acquisitions of US companies by larger foreign competitors and relocations of the actual physical corporate headquarters. Ironically, other than in the context of corporate inversions, the tax law is completely indifferent to these factors. A company legally formed in Delaware is a US corporation regardless of its primary place of business. A merger can be a tax-free reorganization regardless if the larger or smaller business survives. As a general rule, the tax law is supposed to be as neutral as possible to real business decisions; the corporate inversion rules are precisely the opposite, conditioning tax benefits on the changing the real business of the company.
For these reasons, Section 7874 could be considered a somewhat radical solution, and was considered as such at time (at least by the New York State Bar Association). In particular, it represents the first time the US has departed significantly from its traditional “place of incorporation” rule for determining the US status of corporate taxpayers. This could be thought of as, what I call, a “once a US corporation always a US corporation rule.” This brings us full circle back to Dell. Dell is a US company because Michael Dell formed a US corporation when it was a small mail-order computer company. Now that it is a large, multinational public corporation there are significant tax savings to be achieved by unlocking the foreign profits from US tax. The answer is an inversion. The problem is that only a foreign buyer can achieve a corporate inversion without triggering the “once a US corporation always a US corporation” rule. The solution – a foreign hybrid parent entity. That is a topic for another post.