By Larry A. Cerutti and Jason Lee
Larry A. Cerutti is the managing partner of the Orange County office of Troutman Sanders LLP, where he focuses his practice on representing clients in matters relating to public and private securities offerings, corporate governance, mergers and acquisitions and general securities and corporate advice. He can be reached at Larry.Cerutti@troutmansanders.com. Jason Lee is an associate in Troutman's Orange County office focusing on corporate transactions, including mergers and acquisitions, private equity transactions, and general corporate matters for both public and private clients, focusing on middle-market and emerging growth companies. Jason can be reached at Jason.Lee@troutmansanders.com.
In recent months, a lot of ink has been spilled and much noise has been made over corporate inversions—a type of transaction through which a U.S. corporation (typically, a U.S. based multinational group) becomes a foreign corporation (usually located in a country with a lower tax rate). With more and more corporate inversions being announced and/or completed, Congress has proposed new legislation to try and curb the growing trend of these transactions( 29 CCW 157, 5/14/14). Discussions regarding corporate inversions were further prompted when President Obama called corporate inversions an “unpatriotic tax loophole” ( 29 CCW 250, 8/13/14). On Sept. 22, the Treasury Department and IRS issued a notice describing regulations the government intends to issue to make tax inversions less attractive.
That said, under current law, corporate inversions generally reduce U.S. income taxes for, and are therefore beneficial to, U.S. corporations. However, before a corporation's directors and/or shareholders decide to complete a corporate inversion, we believe they must undertake a detailed review of the implications for the company, its directors and shareholders under the legal regime of the corporation's proposed new foreign jurisdiction and, for those corporations that are publicly traded, a detailed review of how such a transaction may affect the corporation's Securities and Exchange Commission reporting requirements.
Corporate inversions have become popular among U.S. corporations with foreign source income because inversions allow these corporations to reduce or eliminate U.S. taxes on foreign source income and, through “earnings stripping” or similar transactions, reduce or eliminate U.S. taxes on U.S. source income.
Before a corporation's directors and/or shareholders decide to complete a corporate inversion, we believe they must undertake a detailed review of the implications for the company, its directors and shareholders under the legal regime of the corporation's proposed new foreign jurisdiction.
In general, U.S. federal income tax is imposed on the worldwide income of U.S. corporations (and citizens). Foreign source income of a U.S. corporation is generally subject to U.S. taxes when it is repatriated. Although the U.S. generally provides tax credits for taxes paid in foreign jurisdictions, according to the Organisation for Economic Co-operation and Development, or OECD, the U.S. currently imposes the highest corporate income tax rate of the developed nations at 35 percent. Compare that to Ireland, which currently has a corporate income tax rate of 12.5 percent, and the tax relief a domestic corporation reincorporating to Ireland would receive is evident. In addition, a growing trend among OECD countries is to move to a territorial tax system—generally, a system in which only income earned in such country is taxed.
Additionally, using a new foreign entity, it may be possible to reduce U.S. source income, and, therefore, further reduce U.S. taxes by entering into “earnings stripping” transactions. Generally, “earnings stripping” is accomplished by having the U.S. subsidiary pay deductible amounts, such as interest, to a related foreign entity. It should be noted that there are certain limitations on “earnings stripping” transactions. Senators Schumer and Durbin recently introduced legislation to limit companies' ability to engage in “earnings stripping” ( 29 CCW 283, 9/17/14).
Inversions can generally be structured in two ways. A U.S. corporation can reincorporate in a foreign jurisdiction, usually, by forming a foreign company and conducting a completely internal transaction (i.e., no third parties are involved and the company does not undertake to acquire a foreign entity but instead forms a merger subsidiary under the newly formed foreign company and merges itself with that merger subsidiary). A domestic corporation can usually only take advantage of the tax benefits of a corporate inversion through this method if it has “substantial business activities” in the foreign jurisdiction to which it is reincorporating. For these purposes, a corporation generally will have (continued on page 294)(continued from back page)“substantial business activities” in the foreign jurisdiction if at least (i) 25 percent of its total employees are based in that foreign jurisdiction; (ii) 25 percent of the value of its total assets are located in the relevant foreign jurisdiction; and (iii) 25 percent of its total income is derived from the relevant foreign jurisdiction.
Another way to structure a corporate inversion is to complete a transaction where the U.S. corporation wishing to reincorporate in a foreign jurisdiction, or Repatriating Entity, purchases a foreign corporation, or Foreign Target. Generally, the U.S. corporation will form a foreign corporation, or New Foreign Parent, in the jurisdiction to which it wishes to reincorporate. Next, the New Foreign Parent will form a U.S. merger subsidiary. Then, the Repatriating Entity will merge with the newly formed U.S. merger subsidiary and shares of the New Foreign Parent will be exchanged for shares of the Repatriating Entity. Concurrently with this U.S. merger, the New Foreign Parent will acquire the Foreign Target by cancelling the shares of the Foreign Target and issuing shares of the New Foreign Parent. This type of repatriation could be accomplished with a few variations to the transactions described in this paragraph.
If, immediately after the transaction, at least 60 percent but less than 80 percent of the shares of the New Foreign Parent are held by former shareholders of the Repatriating Entity by reason of holding shares in the Repatriating Entity, the New Foreign Parent will be treated as a foreign corporation for U.S. tax purposes but may face additional U.S. tax burdens. For example, a U.S. tax on any “inversion gain” (the income or gain recognized by reason of the transfer during the applicable period of stock or other properties by an expatriated entity, and certain income received or accrued during the applicable period by reason of a license of any property by an expatriated entity as fully defined in Section 7874(d)(2) of the Internal Revenue Code of 1986, as amended, or “the Code”) cannot be sheltered by the company's net operating losses or other historical tax attributes. However, if after the transaction, 80 percent or more of the shares of the New Foreign Parent are held by former shareholders of the Repatriating Entity by reason of holding shares of the Repatriating Entity, the New Foreign Parent is treated as a U.S. corporation for U.S. tax purposes and is, therefore, subject to U.S. taxes on its worldwide income.
Although corporate inversions may have significant tax benefits to the corporation, and ultimately to its shareholders, these transactions may generate current taxes at the shareholder level. Section 367 of the Code imposes a shareholder level tax on some outbound transfers of U.S. stock even though the shareholder ultimately remains a shareholder of the corporation. Therefore, even without a sale by a shareholder of shares of the Repatriating Entity, it is likely that shareholders of the Repatriating Entity would be subject to capital gains tax on all appreciation that occurred from the time each shareholder purchased the shares of the corporation, to the time of the corporate inversion.
By taking advantage of the current SEC rules, a corporate inversion should have very little impact on the corporation's public filings.
By taking advantage of the current SEC rules, a corporate inversion should have very little impact on the corporation's public filings. After a corporate inversion, the New Foreign Parent should have registered shares and have the same filing status as the Repatriating Entity. Also, the New Foreign Parent should be able to take advantage of its previous reporting history in determining its eligibility to use Forms S-3, S-4 and S-8 and for determining whether it has complied with the current public information requirements of Rule 144 of the Securities Act of 1933, or “Securities Act.”
Registered Shares Under Rule 12g-3 and Filing Status.Rule 12g-3 of the Securities Exchange Act of 1934, or Exchange Act, provides that, in connection with a succession by merger or exchange of securities, newly issued securities to holders of securities of one or more issuers that were registered pursuant to Section 12(b) or (g) of the Exchange Act shall be deemed to be registered securities, with some limited exceptions. Assuming the New Foreign Parent is considered the successor of the Repatriating Entity, the New Foreign Parent will be deemed a registered entity (as long as its predecessors were registered) when the corporation files its Form 8-K pursuant to Rule 12g-3(f). Also, the SEC has taken the position that a successor issuer would be a successor to its predecessor's filing status under Rule 12b-2 of the Exchange Act.
Use of Reporting Histories for Forms S-3, S-4 and S-8.A corporation must meet certain conditions before it is qualified to use Form S-3. By relying on General Instructions I.A.6 of Form S-3 (deeming foreign issuers to have satisfied the requirements to use Form S-3 if the filer files the same reports as a domestic registrant) and I.A.7(b) of Form S-3 (deeming a successor registrant to have satisfied the requirements to use Form S-3 if all predecessors have met the conditions), the New Foreign Parent should qualify to use Form S-3, despite reincorporating in a foreign jurisdiction. Additionally, the New Foreign Parent would also be deemed to meet the requirements for use of Form S-3 in the General Instructions of Forms S-4 and S-8. Although the New Foreign Parent may be eligible to file Forms F-3, F-4 and F-8 if it qualifies as a foreign private issuer, many companies that have recently completed corporate inversions continue to file forms S-3, S-4 and S-8. Additionally, these companies have submitted no action letters to the SEC requesting confirmation that their new foreign parent meets the eligibility requirements for Forms S-3, S-4 and S-8.
Rule 144. Rule 144 under the Securities Act provides a safe harbor exemption from the registration requirements for the sale of “restricted” securities and the sale by or for the account of “affiliates” of an issuer, provided certain conditions set forth in the rules are satisfied. In order for sales of securities to be made in reliance on the safe harbor provided for by Rule 144, adequate current public information must be available with respect to the issuer at the time of a transfer. There are specific filing requirements in order to comply with this standard. The SEC has permitted the use of predecessors' prior reporting histories when determining compliance with the public information requirements of Rule 144. Thus, corporate inversions have no affect on the ability of holders of “restricted” shares or for “affiliate” holders to sell their shares.
Besides tax benefits, directors and shareholders must review other factors when considering if the corporation should reincorporate in a foreign jurisdiction and to which foreign jurisdiction to reincorporate. Once a corporation successfully reincorporates in a foreign jurisdiction, the corporation, its directors and shareholders become subject to the laws of the foreign jurisdiction. These laws could significantly differ from the laws of the U.S. Even the legal framework could differ greatly. The U.S. is a common law jurisdiction, whereby some rules are codified and many others are developed through legal decisions. Whereas, some foreign jurisdictions are civil jurisdictions, emphasizing codified laws over judge-made decisions.
When considering a corporate inversion to a new jurisdiction, differences in various areas of law should be reviewed by the directors and shareholders. Such areas of law include, but should not be limited to: corporate governance, fiduciary duties of directors and various shareholder rights. For the purposes of comparison, some sections within this article will compare U.S. laws with those of Ireland, because many of the publicized corporate inversions have involved reincorporating in Ireland (presumably because it currently has one of the lowest corporate income tax rates).
Corporate Governance. Corporations should review the new jurisdiction's laws concerning corporate governance to identify how different the new jurisdiction's laws are from those in the U.S. For instance, the U.S. has a one-tier board structure, meaning that U.S. corporations will generally have one board of directors that undertakes to manage the corporation. Likewise, Ireland also has a one-tier board structure. However, certain jurisdictions, like Germany, have a two-tier corporate governance system. Under a two-tier system, a corporation will have a board of directors and a supervisory board that exist side by side. The board of directors manages day-to-day operations while the supervisory board oversees the management of the corporation. Special consideration must be given if a corporation must switch from a one-tier to a two-tier governance system. The new governing regime may disrupt the management of the corporation, and additional resources made be needed to properly implement the new governing regime.
Corporations should review the new jurisdiction's laws concerning corporate governance to identify how different the new jurisdiction's laws are from those in the U.S.
Fiduciary Duties.Directors and shareholders must also review what, if any, changes there may be to the duties that directors owe the corporation and its shareholders. Directors' duties are well-established in the U.S. Directors owe a duty of care and loyalty. Also, the business judgment rule, which protects directors' actions, is well-known and understood among directors and legal professionals. Directors in Ireland owe similar fiduciary duties, including the duty to act with due skill, care and diligence.
A director's duties under the new jurisdiction could have significant impact on how directors operate and manage a corporation. Under a jurisdiction where a director's duties, and thus his/her liabilities, are not clear, directors may be reluctant to make decisions or act, to the detriment of the corporation. Additionally, shareholders should be wary of jurisdictions that have less restrictive duty requirements for directors, thereby limiting a director's liabilities and potentially increasing reckless or fraudulent behavior.
Other Shareholder Rights. Shareholders should pay close attention to how their rights will change when they move from being the holder of shares of a U.S. corporation to the holder of shares of a foreign corporation. Any significant change should be reviewed carefully by the shareholders to determine whether such change increases the risk associated with ownership in the corporation and, if so, whether such increased risk is acceptable. Shareholders should consider, among other factors, the following: (i) if and how shareholder proposals are brought before the new board; (ii) how board members are appointed; (iii) what rights a minority shareholder has; (iv) if there are any special voting rights for shareholders; (v) if and how shareholders can bring derivative suits on behalf of the corporation; and (vi) if and how dividends can be distributed.
For example, there are Irish statutes containing procedures that require compliance with specific formalities with regard to removing a director. In addition, Irish shareholders have certain preemption rights when new shares are to be issued for cash. However, corporations may opt out of such preemption rights for up to five years, after which the corporation will need to renew its option to opt out.
Directors have a duty to attempt, within the law, to maximize corporate profits and shareholder wealth. Because of the reduction in tax costs that may arise from completing a corporate inversion, directors should at least review and entertain the possibility of completing such a transaction. However, before a U.S. corporation commits to undergoing a corporate inversion, it must identify, analyze and understand the new foreign legal system to which it might be subject and the differences between it and the U.S. system. While a corporate inversion may provide tax savings to the corporation, the corporation should also focus its efforts on finding a foreign legal system that is similar enough to U.S. corporate law to minimize costs associated with understanding and complying with the new foreign legal system. Consideration should also be given to minimizing shareholder risk and providing directors the ability to fully and confidently govern the corporation.
In addition to legal matters, a corporation also needs to consider other concerns, including public and political criticism. Most recently, Walgreen Co. had an opportunity to reincorporate in a foreign jurisdiction in connection with its acquisition of Alliance Boots GmbH. However, Walgreen Co. ultimately decided not to complete the corporate inversion, after suffering criticism from activists, unions, politicians and potentially facing public backlash ( 29 CCW 250, 8/13/14). Additionally, as mentioned above, it is important to note that proposed legislation has created some uncertainty with respect to future U.S. tax consequences affecting corporate inversions.
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