Building Tax Walls in the 21st Century

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By James J. Tobin, Esq., New York, NY
The views expressed herein are those of the author and do not necessarily reflect those of Ernst & Young LLP.

The U.S. government seems to like walls. On the southern border of the United States, the government is building a wall (or in some areas a fence) hundreds of miles long to keep people from coming into the country. At the same time, the United States has built another kind of wall to keep U.S. corporations from leaving the country. This latter wall, constructed by Congress in the American Jobs Creation Act of 2004 in the form of §7874, targets so-called corporate “inversion” transactions. Buoyed by the idea that it is somehow unacceptable for a U.S. corporation to move its place of incorporation outside the United States, §7874 is intended to apply to transactions in which a U.S. parent corporation of a multinational corporate group is replaced by a foreign parent without significant change in the ultimate ownership of the group. And now that wall has gotten a bit higher and a bit stronger with the issuance of new temporary §7874 regulations in June.

Before commenting on the newest changes to the regulations, let me just say that I find the whole premise of §7874 rather odd and for the most part inappropriate from an international tax policy standpoint. America is the land of opportunity. We pride ourselves on being the home of free enterprise and innovation. Yet we have one of the highest statutory corporate tax rates in the world, coupled with a system of taxing foreign income earned by U.S. businesses that is considered by many as the most onerous and complex among OECD countries (and the pending Obama Administration international tax proposals would make those rules even more onerous). If an entrepreneur nevertheless chooses to form his business as a U.S. corporation, §7874 now says that decision is carved in stone. If down the road the entrepreneur discovers that his great new technology has only a limited market in the United States but has limitless potential in Europe or Asia so that it would make sense to reincorporate the business closer to his real market opportunities, he cannot settle up his U.S. tax bill and make that move. Under §7874, the U.S. government will simply pretend that his new foreign corporation is still a U.S. corporation. Brings to mind the Eagles and Hotel California: “You can check out any time you like, but you can never leave.”

Sitting in London, it's interesting to contrast the approaches of the United States and the United Kingdom. Faced earlier this decade with a spate of U.S. companies acting to move their places of incorporation outside the United States, Congress barred the door through the deemed U.S. corporation status created by §7874. When faced just a few years later with an exodus of British multinationals to more tax-favorable jurisdictions, the British government could have reacted similarly. Instead, the government took a hard look at the U.K. international tax system, consulted with industry and tax professionals, and took a very different path, making revisions to the tax system to improve British tax competitiveness, including, most notably, the recent reform of the U.K. foreign profits taxation regime. The U.K. government sought to make sure that U.K. corporations would want to stay, but it did not attempt to bar the door (which admittedly would be a bit more difficult to do under European Union law).

Likewise, contrast even the U.S. rules for individuals, where under §877A a U.S. exit tax is imposed on all gains, realized and unrealized, when an individual chooses to expatriate. An individual can exit the U.S. worldwide tax system by paying the price specified in §877A and will not be deemed to be a U.S. resident until death. To me, a similar exit tax approach would be a more sensible focus for addressing corporate inversions. But instead, the recent changes to the §7874 regulations merely reinforce the wall and add more bolts to the door.

The primary change in the June 2009 regulations is the elimination of the safe harbor relating to the statutory exception to the inversion rules for corporations reincorporating in a country where they have substantial business activities. The regulations also expand the types of transactions that are or could be within the ambit of the inversion provisions and signal that there may be further expansions to come (including the potential coverage of some types of spinoff transactions, which seems pretty far from the original target of §7874). First, some background.

If applicable, §7874 has dramatic effect, essentially recasting a foreign acquiring corporation as a domestic corporation for U.S. tax purposes. Its provisions are complex and, in many respects, fairly vague. Treasury and the IRS have the unenviable task of regulating and enforcing this anti-inversion statute. The guidance saga began in December 2005, and continued in June 2006, when the government issued temporary regulations under §7874. Final regulations addressing some issues were issued in May 2008. The latest round of anti-inversion guidance has come in the form of temporary and final regulations issued in June 2009, replacing the expiring June 2006 regulations.

The June 2006 temporary regulations were particularly important for taxpayers as they clarified some key concepts under §7874. In this regard, the regulations included a safe harbor for purposes of the substantial business activities test, which alleviated some of the uncertainty in the application of an inherently subjective test. Section 7874 targets situations in which a new foreign corporation acquires a U.S.-parented group and the ultimate ownership of the corporate group is not substantially changed. These are viewed under §7874 as transactions that are inappropriately tax-motivated and that should be fully or partially recast. However, §7874 and its recast rules do not apply in situations where the old U.S.-parented group (including its foreign affiliates) historically had business activities in the foreign country of the new parent corporation. This exception seems to reflect a recognition that the historical business connection to the foreign country should allay any concerns about inappropriate tax motivation such that the transaction should be respected. That said, the exception will serve its intended purpose only if taxpayers and the IRS are able to apply it in practice.

The 2006 temporary regulations provided that the question of whether a corporation's expanded affiliated group (EAG) had substantial business activities in the foreign acquiring corporation's country of incorporation sufficient to trigger application of the statutory exception to the anti-inversion rules was, as a general rule, a facts-and-circumstances determination. Those regulations provided the following non-exclusive list of factors to be considered for this purpose:

• Historical presence of continuous business activities in the foreign country by EAG members prior to the acquisition;

• Property owned by members of the EAG in the foreign country;

• Services performed by EAG employees in the foreign country;

• Sales to EAG customers in the foreign country;

• Managerial activities of EAG member officers and employees based in the foreign country;

• The degree of ownership of the EAG by investors resident in the foreign country; and

• The existence of business activities in the foreign country that are material to the achievement of the EAG's overall business objectives.

The 2006 temporary regulations also included a list of factors that would not be considered for this purpose, including any assets temporarily located in such a foreign country at any time as part of a plan the principal purpose of which was to avoid the application of §7874.

The 2006 temporary rules further provided that the presence or absence of any factor, or of a particular number of factors, was not determinative. Similarly, the weight given to any factor depended on the particular case at hand.

In recognition of the inherent uncertainty associated with any facts-and-circumstances test, the 2006 temporary regulations included a substantial business activities test safe harbor. This was not new ground. The safe harbor test was similar to that found in some U.S. income tax treaties for determining the substantiality of business activities for purposes of qualifying for treaty benefits under the active trade or business test of the applicable Limitation on Benefits article.

Under the safe harbor in the 2006 temporary regulations, the EAG would be considered to have substantial business activities in the foreign acquiring corporation's country of incorporation if:

• After the acquisition, the group employees based in the foreign country accounted for at least 10% (by headcount and compensation) of total group employees;

• After the acquisition, the total value of the group assets located in the foreign country was at least 10% of the total value of all group assets; and

• During the testing period, the group sales made in the foreign country accounted for at least 10% of the total group sales.

The 2006 temporary regulations also provided details regarding how employees, assets, and sales would be determined and qualify for this purpose. The “testing period” would be the 12-month period ending on the last day of the EAG's monthly or quarterly management accounting period in which the acquisition was completed.

The 2006 safe harbor was just that: a safe harbor to provide taxpayers (and the IRS) with a much-needed level of certainty with respect to a provision that is inherently subjective but on which the most fundamental of corporate tax determinations (U.S. or foreign residence) turns.

That's all history now. With little explanation, Treasury and the IRS eliminated the safe harbor rule related to the statutory substantial business activities exception that had been provided in the 2006 temporary regulations. According to the Preamble, the government concluded that the safe harbor could apply to some transactions in a way that was inconsistent with the purposes of §7874. The new temporary regulations also did away with the examples illustrating the general facts-and-circumstances determination with respect to the substantial business activities exception that had been included in the 2006 temporary regulations.

Adding more uncertainty to the mix, the government underscored in the Preamble that the IRS will not issue rulings or determination letters on whether a taxpayer has satisfied the substantial business activities exception. In other words, no rulings on what is reasonable and when a transaction will be respected for tax purposes. Given the significance of what is at stake - continuing to be a U.S. corporation or not - this change will make it harder to rely on the substantial business activities exception that is an integral part of the statutory rules.

Treasury and the IRS are seeking comments on the elimination of the safe harbor and the examples, so I will offer one suggestion: Reinstate them. With respect to the safe harbor, Treasury has already given its imprimatur to the 10% test by including it in several U.S. income tax treaties for purposes of determining if a corporation has substantial business activities in its country of residence and thus qualifies for treaty benefits. If it works in the treaty context, why not provide taxpayers with a similar level of certainty when competitive business considerations dictate a move of place of incorporation? It still seems to me the treaty safe harbor threshold is a good starting point in analyzing the question of whether the corporate group has a real business connection to the home country of the new foreign parent. In this regard, it's interesting to note that, in withdrawing the safe harbor, Treasury and the IRS did not indicate, as a safe harbor, that the threshold level of 10% was too low, but indicated only that it could apply to qualify some inappropriate transactions.

It seems no coincidence that this further wall-raising came just a month after the President detailed his proposals to raise more than $200 billion by increasing the U.S. tax burdens on U.S. corporations with global operations. The changes reflected in this newest set of regulations leave little doubt that the U.S. government wants to create a further chilling effect on any thoughts U.S. multinationals might have of moving offshore. Interestingly, the U.S. government's concern seems to be focused entirely on U.S. corporations that would move their place of incorporation without otherwise changing their structure or ownership. The U.S. government does not seem to have any similar concerns about foreign multinationals coming in to acquire U.S. corporations. Indeed, the approach of erecting a wall to keep U.S. multinationals as U.S. corporations despite competitive pressures to reincorporate elsewhere would seem to make those U.S. corporations sitting ducks for foreign acquirers.

Is there a way for a U.S.-based business to avoid the perpetual grip of the U.S. international tax regime short of selling out to a foreign acquirer? Perhaps one way would be not to have your corporation born in the United States in the first place. Maybe our entrepreneur with the great new technology should set up as a Netherlands or Luxembourg corporation from day one. If organized appropriately, there would not be incremental Dutch or Luxembourg tax on the corporation's U.S. and other foreign activities. The corporation would be subject to U.S. tax on the income from its U.S. business, including a potential 5% U.S. branch profits tax in addition to the regular corporate tax rate. However, the successful entrepreneur could grow his business globally without being subject to ongoing U.S. tax on his foreign profits, subject of course to transfer pricing rules that ensure that income attributable to the United States is properly reported and taxed in the United States.

This seems a bit extreme. Our entrepreneur with his head full of ideas and his garage in California full of designs and prototypes is pretty busy chasing the American Dream. Should full realization of that American Dream really require that the entrepreneur also have the foresight to hire a good international tax advisor? And what about those U.S. corporations that were created a generation or two ago by entrepreneurs in garages in Cincinnati or Chicago? Even if they had consulted an international tax advisor in their early days, they couldn't have been warned about the “you can never leave” rules of §7874. Yet §7874 now applies to U.S. corporations created many years before its enactment, and the door is barred for them as well.

On the other hand, at the end of the day, keeping U.S. multinationals - and entrepreneurs - from being able to reincorporate outside the United States may end up being good for U.S. tax policy, but not for the reasons most people think. As an optimist, I'd observe that, as history has shown, although a wall can ensure no one leaves, it eventually can lead to pressure to change the system from within. The best response is to lobby the U.S. government to enact sensible and competitive rules governing international corporate taxation, so that U.S. corporations no longer have any need to invert. With the possibility of major U.S. tax reform on the horizon, if sound tax policy prevails (remember, I am an optimist), we may see the wall of §7874 come tumbling down.

This commentary also will appear in the October 2009 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Streng, 700 T.M.,, Choice of Entity, and Davis, 919 T.M., U.S.-to-Foreign Transfers Under Section 367(a), and in Tax Practice Series, see ¶7130, U.S. Persons' Foreign Activities.