How Corporate Anti-Inversion Rules Prevent Cross-Border Corporate Relocation
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Corporate Anti-Inversion Rules
Corporate Anti-Inversion Rules Prevent Cross-Border Relocation: The idea behind the IRS Corporate Anti-Inversion Rules for Domestic Corporations is to prevent companies from high-tailing it overseas in order to enjoy tax benefits — in order to artificially reduce their US Tax obligations. The Internal Revenue Code provides certain reorganization rules, which primarily allow a US company to avoid immediate tax implications when shifting certain assets (such as stock transfers between companies). But, when the move is designed to relocate the company overseas, these same rules do not apply in the same fashion. Specifically the term Foreign Corporation no longer qualifies as a “Corporation” under IRC 367. Instead, the foreign company receiving the assets is categorized as a foreign corporation for IRC 367 purposes — and now the transfer becomes taxable — subject to 7874 rules and regulations. Let’s explore the US Corporate Anti-Inversion Rules:
*Please keep in mind that Corporate taxation is very complicated, with several exceptions, exclusions, and limitations that will impact the outcome.
US Tax on US Corporations (Worldwide Income)
Let’s take a brief look at How US corporations are taxed:
26 USC 11
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(a) Corporations in general
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A tax is hereby imposed for each taxable year on the taxable income of every corporation.
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(b) Amount of tax
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The amount of the tax imposed by subsection (a) shall be 21 percent of taxable income.
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26 CFR 1.11-1
(a) Every corporation, foreign or domestic, is liable to the tax imposed under section 11 except
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(1) corporations specifically excepted under such section from such tax;
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(2) corporations expressly exempt from all taxation under subtitle A of the Code (see section 501); and
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(3) corporations subject to tax under section 511(a).
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For taxable years beginning after December 31, 1966, foreign corporations engaged in trade or business in the United States shall be taxable under section 11 only on their taxable income which is effectively connected with the conduct of a trade or business in the United States (see section 882(a)(1)).
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For definition of the terms “corporations,” “domestic,” and “foreign,” see section 7701(a) (3), (4), and (5), respectively. It is immaterial that a domestic corporation, and for taxable years beginning after December 31, 1966, a foreign corporation engaged in trade or business in the United States, which is subject to the tax imposed by section 11 may derive no income from sources within the United States.
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The tax imposed by section 11 is payable upon the basis of the returns rendered by the corporations liable thereto, except that in some cases a tax is to be paid at the source of the income. See subchapter A (sections 6001 and following), chapter 61 of the Code, and section 1442.
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What does this mean?
The general rule is that a US Based corporation is taxed on their worldwide income. So, if a company is based in the US, and earns income from overseas, that income is taxable in the US once it is repatriated (unlike taxation of individuals which is when the income is earned or accrued (subject to PFIC rules). This means that the company cannot obtain the benefits of a generating income in a lower tax rate jurisdiction – and it makes it harder to compete in the world market.
Why?
Let’s looks at a very basic example: Company X is a US Company. It earns significant income in Country Y. The US tax rate is 21%. The foreign tax rate is 6%. Therefore, the Country Y based corporation is more competitive in the global market. It has more wiggle room with pricing, because it is paying significantly less tax on the income generated in that country — and it makes the foreign company more competitive. Therefore, the US company would form foreign entities that operate in those low-taxed jurisdictions and if the money is never repatriated (absent the IRC 965 one-time repatriation tax), then it is not taxed in the US.
But what about companies already in existence?
For current corporation to shift their operations offshore and avoid ongoing US Tax consequences for non-US sourced income , they may consider a corporate inversion.
What is the Basics of the Corporate Anti-Inversion Rules
Here is a common example: a US Corporation and Foreign Corporation first merge, followed by the dissolution of the US Corporation. Next, a new company is formed in the foreign jurisdiction, in which the new foreign entity is controlled by the owners of the original US corporation. The reason why the US Government dislikes this (of course), is because of the tax consequences. Since the company is operating abroad, the US is generally unable to tax the income unless it is US sourced or repatriated. As a Domestic Corporation, it may be subject to rules such as Subpart F Income, GILTI and FDII. And, since the corporation is now a foreign corporation, it is not paying tax on global income as it did prior to the inversion, the tax implications are astounding (billions saved for certain larger companies)
IRC 7874 & Corporate Anti-Inversion Rules
Internal Revenue Code Section 7874 and finalized regulations are designed to curtail corporate inversions, by constricting the ability to move a company overseas without significant tax consequences — including being treated as a Domestic Corporation (DC) post merger.
As provided by the IRS:
IRC 7874 applies to certain inversions of a domestic corporation (DC) or a domestic partnership (P/S) in which a new foreign parent corporation of the domestic target is treated as a “surrogate foreign corporation” (SFC).
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In order for the foreign corporation (FC) to be treated as a SFC, all of the following three tests must be met:
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acquisition test
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ownership test; and
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substantial business activities (SBA) test.
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The tax consequences under IRC 7874 are dependent on satisfaction of the ownership test, which is the necessary percentage ownership of FC held by the former S/Hs/partners of the domestic target “by reason of” having held ownership in domestic target.
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The inversions for which the tax consequences are governed by IRC 7874 are sometimes referred to as “80% inversions” and “60% inversions”.
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As a result, the determination of this ownership threshold is a critical element in determining whether the transaction is governed by IRC 7874.
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Under an 80% inversion, the new foreign parent is treated as a domestic corporation (DC) for all purposes of the IRC. IRC 367(a) does not apply to the domestic target’s shareholders in this case since for U.S. tax purposes there has been no outbound transfer of property and therefore no outbound “toll charge” is imposed on domestic target’s shareholders.
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Under a 60% inversion, the new foreign parent will be respected as a foreign corporation for U.S. tax purposes. However, the taxable income of an expatriated entity shall not be less than its “inversion gain” recognized during the 10-year applicable period. IRC 7874 effectively limits the expatriated entities’ ability to use net operating losses (NOLs) or other tax attributes to reduce U.S. tax on their inversion gain. Most inversions that are subject to IRC 7874 are currently falling into the 60% inversion category.
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What does this mean?
Not all corporate inversions are for tax purposes. But, for those corporate inversions that are for tax purposes, they will still be burdened with US tax implications on worldwide income. That is because they will either be burdened with still being considered a DC (Domestic Corporation) and taxed on worldwide income and/or limited in the number of foreign tax credits they can take.
Corporate Anti-Inversion Rules are Complex
Even with the reduction in corporate tax rate to 21%, corporate inversions are still popular. Studies showed that even with the TCJA one-time repatriation tax (IRC 965) that did not necessarily entice companies to repatriate those funds to the US. Therefore, the IRS will presumably seek to further restrict corporate inversions in years to come. Since the corporate anti-inversion rules are complex, Taxpayers should carefully evaluate the outcomes and how (and when) to proceed.
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