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A transaction involving Hewlett Packard Enterprise Co. and U.K.-based Micro Focus International Plc is likely to run into penalties under 2016 inversion regulations.
The deal illustrates the difficulty companies have in complying with the final and temporary anti-inversion rules (T.D. 9761) issued by the Internal Revenue Service in April 2016 under tax code Section 7874, a tax consultant and others say.
According to an Aug. 4 filing with the Securities and Exchange Commission, the HP Enterprise/Micro Focus transaction is expected to violate an ownership rule in the regulations that applies if former shareholders of an acquired U.S. entity own 60 percent or more of the combined foreign acquiring entity, following an acquisition. Companies that surpass the 60 percent threshold are subject to adverse tax consequences.
“It’s the first time we’ve seen these rules really come into play since Pfizer/Allergan aborted their deal,” Robert Willens, president of tax and consulting firm Robert Willens LLC in New York, told Bloomberg BNA Aug. 21. Willens was the first to write that the HP Enterprise and Micro Focus deal would run afoul of the inversion regulations in an Aug. 18 note to clients.
In 2016, Pfizer Inc. and Allergan Plc—an Ireland-based pharmaceutical company—were forced to scrap a $160 billion merger as a result of the anti-inversion rules.
The HP Enterprise/Micro Focus outcome may cause other companies to think twice about engaging in inversion-related transactions, said Luke Watson, an assistant professor in the University of Florida’s Fisher School of Accounting in the Warrington College of Business.
“While this is a fairly high-profile example of one inversion transaction, perhaps the more widespread and important effect is one that we cannot see: would-be inverters that privately decide against inversion, fearing a similar fate,” he said Aug. 21 in an email.
HP Enterprise announced plans for a spinoff and merger of its non-core software assets in September 2016. The company is using a “reverse Morris Trust” transaction, which permits an entity to combine a subsidiary that was spun off with a strategic merger with another company free of taxes—provided that certain requirements are met.
The transaction involves HP Enterprise creating a subsidiary—Seattle SpinCo Inc.—to which HP Enterprise’s software business is conveyed. HP Enterprise will distribute the stock of Seattle SpinCo to its shareholders in a tax-free spinoff, and immediately after, Seattle SpinCo will merge with an indirect wholly owned subsidiary of Micro Focus. Under the terms of the deal, Seattle SpinCo’s shareholders will retain 50.1 percent ownership of the newly formed company.
Absent the Obama-era rules, “the transaction would not be an inversion because the former shareholders of Seattle SpinCo, Inc. will only own 50.1 percent of the stock of MFI, by both vote and value, as a result of their ownership of Seattle SpinCo, Inc. shares,” Willens said in his Aug. 18 note.
However, in calculating “ownership percentage” under the anti-inversion guidance, companies now have to take into account several new rules, Willens said in the note.
“The presence of pre-acquisition, ‘non-ordinary course,’ distributions; and the fact that MFI has issued its stock in prior domestic entity acquisitions, will together conspire to increase the ownership percentage from 50.1 percent to something more than 60 percent” but less than 80 percent, Willens said. “Accordingly, since the expanded affiliated group will not have substantial business activities in the U.K., the country under the laws of which MFI is organized, the transaction will constitute an inversion within the meaning of” Section 7874.
HP Enterprise didn’t respond to Bloomberg BNA’s request for comment.
Seattle SpinCo noted the repercussions of being treated as an inversion under Section 7874 in the filing.
“For purposes of Section 7874 of the Code, after Closing, the former shareholders of Seattle are expected to be treated as owning more than 60 percent (by vote and value) of Micro Focus,” the filing said. “Accordingly, the limitations on the utilization of certain tax attributes (including net operating losses and certain tax credits), and the adverse consequences under the Temporary Section 7874 Regulations, are expected to apply to Micro Focus and its U.S. affiliates,” the filing said.
In the filing, Seattle SpinCo said that neither it nor its U.S. affiliates expect to recognize any inversion gain as part of the merger. “However, there can be no assurance that future transactions undertaken by Micro Focus will not implicate these limitations and trigger adverse consequences,” the company said.
If Seattle SpinCo or its U.S. affiliates engage in any transaction within the first 10 years of the acquisition that results in an inversion gain, the transaction would be fully taxable despite deductions and other U.S. tax attributes that would be available if the Section 7874 rules didn’t apply, the filing said.
“These rules, additional changes to the rules in Section 7874 of the Code or the Treasury Regulations promulgated thereunder, or other changes in law, could adversely affect Micro Focus’ effective tax rate or future planning for Micro Focus that is based on current law,” Seattle SpinCo added in the SEC filing.
Willens said the companies seem to have avoided the most serious penalty, which would transform Micro Focus into a domestic corporation for U.S. federal income taxes purposes. Such would be the case if the Seattle SpinCo shareholders are treated as owning 80 percent or more of the new company.
Seattle SpinCo said it doesn’t expect its shareholders to be treated as owning 80 percent of the new company, but the IRS could disagree. “The IRS may not agree that Micro Focus should be treated as a non-U.S. corporation for U.S. federal income tax purposes following the Merger,” the company said. If the IRS decides Micro Focus should be a U.S. corporation for federal tax purposes, that “could have a material adverse effect on the business, financial condition, results of operation and prospects of the Group.”
“The difficulty in calculating ownership percentage is apparent from this transaction,” Watson said.
“In its SEC Registration Statement filed April 25, 2017, Micro Focus wrote that it expected its merger plan to meet the ownership tests and qualify as a U.K. corporation for U.S. tax purposes,” he said. “In that Statement, it also disclosed the risk of failing the ownership test. Here we are just 4 months later and it appears those expectations have shifted.”
Reuven S. Avi-Yonah, director of the International Tax LLM Program at the University of Michigan Law School, said he thinks relying on shareholder ownership percentages to define an inversion is wrong.
“Relying on location of headquarters is much more sensible,” Avi-Yonah, a member of Bloomberg BNA’s Transfer Pricing Advisory Board, said Aug. 21 in an email. “The Obama administration proposed that but was bound by the current 7874, and now it seems unlikely anything will change.”
Watson said the HP Enterprise/Micro Focus situation is likely to cause some anxiety for other inverters or potential inverters. “The potential tax benefits of inversion are surely attractive, but its risks can be difficult to evaluate particularly in this evolving regulatory environment,” he said.
A paper that Watson recently co-authored found evidence that despite the tax benefits, inverting companies generally don’t outperform their competitors in terms of accounting earnings. “If other firms witness these negative consequences, it could cause them to shun inversions,” Watson said in his email.
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