As U.S. Works to Curb Inversions, Talk of ‘Pre-Inverting'

The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing. 

By Alex M. Parker

June 24 — As the Internal Revenue Service and Treasury Department seek more ways to keep U.S. companies—and their intellectual property—from leaving these shores, lawyers and accountants are beginning to ask a question that would have seemed nonsensical a few decades ago: Why don't companies incorporate outside the U.S. to begin with?

The next Google Inc. or Apple Inc. could—in theory—reap the current benefits of being outside the U.S. tax system and bypass recent Treasury regulations aimed at halting corporate expatriations by incorporating itself as foreign entity at its inception.

There is scant evidence that many companies are doing this, except for those that already have significant history in a foreign jurisdiction. It appears, for now, that it is an idea much easier to talk about than to implement.

But people certainly are talking about it.

“We've always tried to tell people to take into consideration how things are ultimately going to play out down the road, in terms of taking tax considerations into account, and that the U.S.-top company may not be your best model,” said Bernie Pistillo, a partner with Morrison & Foerster LLP in San Francisco. “I think those words, up until recently, have fallen onto deaf ears.”

The increased attention on inversions, the heightened focus on international tax planning and companies' desire to escape the sometimes cumbersome U.S. worldwide tax system has now opened those deaf ears a bit.

“People are paying more attention to tax planning from the outset, as opposed to saying ‘it's something I'll deal with later, when the company becomes more profitable,' ” Pistillo said.

New Trend?

Following a surge of inversion activity, Treasury in September 2014 issued guidance (Notice 2014-52) tightening restrictions on inversions, including a block on “hopscotch loans” used by newly inverted companies to gain access to cash that had previously been held offshore (23 Transfer Pricing Report 701, 10/2/14).

In 2015, it followed those rules with new guidance (Notice 2015-79) cracking down on other tactics used in an inversion, including the use of a third country to further reduce the company's effective tax rate (24 Transfer Pricing Report 930, 11/26/15).

In April 2016, Treasury released a new batch of regulations (REG-135734-14, T.D. 9761), using Section 385 to target earnings stripping through intercompany debt—a common post-inversion technique—and enhancing Section 7874 to target so-called serial inverters. The rules caught many by surprise, and likely caused Pfizer Inc. to cancel a planned merger and inversion with Allergan Plc shortly afterward (24 Transfer Pricing Report 1560, 4/14/16) (19 MALR 564, 4/11/16) (31 CCW 106, 4/6/16) (65 TMIN, 4/5/16) (65 International Tax Monitor, 4/5/16).

Given this new government focus—as well as heightened media and political attention describing inverted companies as unpatriotic deserters—those seeking tax advice are becoming more likely to listen when advisers suggest getting out from underneath those regulations.

Remmelt Reigersman, a partner at Morrison & Foerster in New York, said he “routinely” advises clients to consider whether a foreign entity might work from the outset. The recent government activity is giving this advice more weight, he added.

“It increases the stakes of getting it right from the beginning,” he said.

Minimize Complications

One New York tax consultant said companies are pursuing a slight permutation of this strategy, forgoing creating a comprehensive U.S. subsidiary at all.

“I'm seeing more companies, that would otherwise be organized in the U.S., simply incorporate in a foreign country,” Robert Willens said in an e-mail to Bloomberg BNA.

This format, he said, “eliminates some of the complications that arise when a foreign parent group is created, including establishing the intercompany debt needed to accomplish earnings stripping and the various transfer pricing issues that arise when separate, albeit related, entities sell property or perform services for one another.”

Others have suggested that offshore parent companies are becoming more standard in some fields—such as New York's growing financial technology industry.

“Every one of those companies is being advised by their tax advisers, ‘Do not establish yourself as a U.S. corporation,' ” said Peter Scheschuk, senior vice president for taxes at S&P Global Inc., said May 19 during a panel discussion sponsored by the Information Technology and Innovation Foundation in Washington.

“Form yourself as an Irish corporation, or some other foreign company, because you're going to be developing intellectual property, and from a tax perspective, you won't want that to be owned by U.S. companies,” he said.

Long-Term Gain

The idea is conceptually simple—at the time of incorporation, during a company's infancy, simply incorporate a foreign company as the parent of a U.S. subsidiary.

The structure would create few, if any, tax benefits at the start, and comes with significant administrative costs. Presuming that most of the company's activities are still in the U.S., income from those activities would be taxable in the U.S.

But by “pre-inverting,” the company might see a long-term benefit as it grows into a multinational corporation.

To the extent it is able to move U.S.-produced intangible assets offshore, its earnings from those assets would be outside the reach of Subpart F, which taxes some types of income from companies controlled by U.S. residents. Along with the pre-inversion, the company might want to create forward-looking tax structures, such as cost-sharing arrangements, for its first generation of intellectual property, which would allow it to place additional income offshore.

Tax Residency

Because the U.S., unlike most of the world, defines tax residency based on incorporation rather than on the place of management, establishing a foreign parent company wouldn't affect where the company's founders, or chief managers, live as they try to get their new venture up and running.

In one permutation of this strategy, a company might not incorporate a U.S. subsidiary at all, but rather set itself up as a foreign entity with U.S. operations.

While—again, in theory—the pre-inversion could be a structure used by a purely domestic company, it is more often considered by companies that already have some presence abroad, or are planning to quickly emerge in foreign markets.

“I'm not seeing it in purely domestic companies,” said Pistillo of Morrison & Foerster. “I see it either in those with international operations, or they're making significant expansion overseas, or that's where they expect to have a lot of business, because that's where their business plan says they'll have a lot of customers.”

‘Parlor Talk.'

Despite the potential advantages, this strategy faces stiff resistance due to a number of practical reasons—and it is unclear whether it has grown into a significant trend among startups.

Peter Barnes, a senior lecturing fellow at Duke University School of Law and of counsel at Caplin & Drysdale, dismissed the buzz as “parlor talk.”

“There is a lot of chatter by tax professionals that this is a strategy that entrepreneurs should be taking, but very little real world evidence that it is actually occurring,” Barnes wrote to Bloomberg BNA. “Of course it makes sense for a person setting up a new company to adopt this structure. But it is very daunting for a non-lawyer to consider establishing a foreign company as the parent of a US company, incurring both initial costs and future operating expenses, when it is not clear the entrepreneur even has a profitable idea.”

Many of those potential issues were outlined in a 2012 paper co-written by Susan Morse, a professor at the University of Texas School of Law, and Eric Allen, an assistant professor of accounting at the University of Southern California School of Business. The paper found no “exodus” of companies choosing to incorporate in jurisdictions identified as tax havens.

Morse and Allen identified 47 companies headquartered in the U.S. but incorporated in jurisdictions identified as tax havens between 1997 and 2010, including several well-known brands such as Herbalife Ltd. and Warner Chilcott.

Divining whether any of these companies, or companies that have been incorporated offshore since, chose the jurisdiction for tax reasons is all but impossible, however. The decision-making isn't made public, of course, and often there are a myriad of factors, including corporate history, behind the location.

Allen said there has been only a slight uptick of U.S.-based companies incorporating offshore since then.

“Anecdotally, you're definitely starting to hear more of this,” Allen told Bloomberg BNA. “We looked at it six months ago; there was a little bump but it wasn't massive yet.”

Allen added, though, that his analysis was based on companies that had undergone an initial public offering and become publicly traded—something that could occur several years after a startup is incorporated.

Good Problem to Have

Startup founders—whether they are seasoned business professionals or tinkerers in a garage—tend to focus on making the new company viable, to the exclusion of most other long-term concerns. To them, the possibility that it will one day be a profitable global business, facing tax challenges like those of Microsoft Corp. or Amazon.com Inc., is the definition of a good problem to have.

Filing fees and legal costs alone could be prohibitive for a young startup.

“You have two entities, not one; two countries, not one; two sets of lawyers, not one,” Morse of Texas told Bloomberg BNA.

The founders, if they are the company's sole shareholders, may have to deal with additional headaches from Subpart F as well as passive foreign investment company rules if the entity is well-funded.

The gain from these up-front costs and hassles may be years away—and aren't guaranteed, especially considering the shifting political winds of Europe, home to many of the currently tax-friendly jurisdictions one might consider for an early foreign incorporation.

“There's volatility in the outcome because of the political risk,” Morse said. “It's not a sure thing.”

By incorporating offshore, the founders may also lose the ability to claim an immediate deduction on start-up losses, a significant consideration depending on the riskiness of the enterprise.

Venture Capital Funds

But perhaps one of the biggest factors is venture capital funds—the leprechaun pots of the startup world, which, for their own reasons, may only want to invest in U.S.-owned companies.

Venture capital firms decline to invest in foreign-owned companies for reasons ranging from legality to convenience. Furthermore, they often are only invested in companies for a short time, and wouldn't be interested in the gains from long-term tax planning.

“It's the people who take a longer-term view of the company who are the ones who really care about the drag on the valuation that's going to be caused by the tax impact,” Pistillo said.

Some of the same issues might apply for startups hoping to get bought by a larger company—which also might be wary of making huge investments in a foreign jurisdiction where it isn't familiar with the laws or regulatory culture.

However, this norm might be shifting too. The lockout effect caused by U.S. worldwide taxation and deferral may be driving companies to seek out foreign companies. Possible recent examples include Microsoft's acquisition of Skype Technologies SARL and Apple's acquisition of Beats Electronics Holding Ltd., the headphone company co-founded by rapper Dr. Dre and incorporated in Ireland in 2012.

A Default Option?

Given the up-front costs, hassle and uncertainty, this type of structure is a long way from becoming as routine and standard as setting up a Delaware holding company for domestic tax and legal reasons.

Some wonder, though, if that may become the ultimate endgame, as tax advisers and chief officers become more comfortable with the idea.

“Will this work its way to the default?” Allen said.

Bret Wells, a law professor at the University of Houston Law Center, described many of the issues as “friction costs”—hurdles that slow down, but don't necessarily stop, the tax maneuver, and which the market may eventually price into its evaluations of new companies.

“I have no doubt that if it becomes more clear that the most efficient capital structure long-term over the life of the project necessitates a foreign-owned structure on day one, the capital markets would figure that out and act accordingly,” he said. “It's a false hope that we can just have an inefficient tax system that makes it more efficient to be foreign owned, and expect that some other non-tax reason is going to protect the U.S. tax base.”

Early Cost Sharing

Aside from pre-inverting, there are other early international tax planning structures and strategies a startup founder could consider, practitioners said.

Rather than establishing a foreign parent, for instance, a founder could set up a separate foreign entity in a “brother-sister” structure, according to John Warner, a shareholder at Buchanan Ingersoll & Rooney PC in Washington.

In the tech sphere, a new company could also establish an early cost-sharing arrangement for its first generation of intangible assets, drastically reducing future buy-in payments. That strategy could be both lucrative and risky, as it might also prevent a company from claiming losses should the venture not be as successful as hoped.

“I broach it with startup clients, but almost inevitably they say, ‘Well, you know, let's get the U.S. enterprise off the ground,' ” Warner said. “You do need the perfect storm of confidence, and maybe a bit more money than a startup gets, and sophistication about how significant things can get down the road.”

Policy Remedies

There is one other advantage to pre-inverting in that it may not garner the same level of public attention and outrage that was generated when iconic American brands such as Pfizer or Burger King Worldwide Inc. considered or undertook inversions.

“What makes inversions a big issue is that they're public companies, and they have to file public disclosure documents. It's like a big flashing sign which says exactly what's going on,” said Wells of Houston. “Setting up a new company, you're not going to know. There are a lot of companies that are foreign companies that go public. It's difficult to make the connection in the way that an inverting company does.”

However, should the practice gain traction—and public attention—it would likely pose even more vexing policy challenges than true inversions.

One possible remedy would be to enact a “managed and controlled” test in the U.S. to ensure that an entity is a tax resident where its key managers are located. Often floated as a possible, though problematic, answer to inversions, it would likely have an even bigger impact in the startup sphere. A company's founders might be willing to invest the time and resources to set up a company in a foreign jurisdiction—but actually moving there might be a bridge too far.

Others wonder if the market wouldn't be able to find its way around this requirement as well.

“That's a friction cost, but I think it's a weak friction cost,” Wells said. “The CEO community is much more of a global community than it used to be, and I think the Internet, global telecommunications and the globalization of corporate cultures are making that even more true.”

Wells and Allen agreed that focusing on inversions and residency is likely an incomplete solution.

“I think what it fundamentally says is that if you really think this is an issue, there really needs to be a more fundamental reform than just targeting inversion transactions,” Allen said.

To contact the reporter on this story: Alex M. Parker in Washington at aparker@bna.com

To contact the editor responsible for this story: Molly Moses at mmoses@bna.com

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