Building Tax Walls in the 21st Century
By James J. Tobin, Esq.
Ernst & Young LLP, 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.
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