Author: Ryan Kenny, Associate Member, University of Cincinnati Law Review
Since the 1980s, an increasing number of United States-based corporations have been shifting assets overseas into low and no-tax jurisdictions to avoid paying high tax rates in the United States.[1] As a result, the corporate tax base has decreased in size, which creates problems for tax revenues. Some members of Congress have estimated stopping corporate inversions would save the United States’ tax base nearly forty-one billion dollars over ten years, although no study has been officially commissioned by the federal government to verify this number.[2] Although there are often a multitude of reasons why a company may decide to invert, the most prevailing justification is the significant tax savings.[3] The procedure and laws surrounding a company’s decision to invert to a low- or no-tax jurisdiction (“tax havens”), such as the Cayman Islands or Bermuda, are incredibly complex. The federal government has tried several initiatives to curb corporate inversions since the early 2000s, but corporations still find ways to invert. It is important to understand the different ways corporations invert before addressing how to solve the revenue gap created by inversions. While the government has been focusing on how to stop inversions, it would be more economical for the tax system to reexamine how it defines the location of a corporation, or its “residence”. This may provide a way for the Internal Revenue Service (“IRS”) and Congress to fix the unintended consequences of the Internal Revenue Code (“Code”), which have led incentivized corporations to invert.
I. There are a Variety of Methods Corporations Use to Invert.
There are three primary ways corporations invert: stock transaction, asset transaction, and drop-down transaction.[4] Understanding how these transactions function is important to understanding why changing the way the IRS and Congress define corporate residence may help resolve the inversion issue.
A stock transaction functions how one would expect: a domestic United States-based corporation shifts its stock to a foreign-based corporation. These foreign-based corporations typically are based in tax havens. A United States-based corporation may start a new corporation in one of these jurisdictions, typically structured as a holding company.[5] A holding company may be broadly defined as “a company that doesn’t have any operations, activities, or other active business itself. Instead, the holding company owns assets.”[6] This means the company effectively exists only on paper where companies can place different assets, such as stock, into the control of the foreign holding company. The United States-based corporation reduces its tax burden by paying off the stock dividends to the foreign holding company, thereby transferring profits overseas pre-tax. If enough of the domestic United States corporation stock is in a foreign holding company, then the United States-based company becomes a United States subsidiary of a foreign corporation.
Asset transactions are similar to stock transactions, except that it tends to occur over several, smaller transactions.[7] Similar to the stock transaction, the foreign parent company ends up owning a portion of the United States corporation, while the stockholders now own stock in the new foreign-parent corporation. The drop-down transaction is incredibly complicated, so it suffices to know that it is a mixture of elements of the stock and asset transactions.
No matter which transaction is chosen, the end result is relatively the same. By shifting ownership of the United States-based corporation to an overseas holding company in a tax haven, the U.S. corporation gets significant tax savings. This is because the United States is one of the few developed nations that uses a predominately worldwide tax system, whereas most of the developed world uses some variation of a territorial tax system.[8] Under the United States system, a United States-based corporation is taxed on income earned overseas, subject to an applicable tax credit for income already paid, whereas a territorial tax country only taxes income earned within its jurisdiction.[9] By inverting overseas, the United States corporation is no longer subject to the United States’ worldwide taxation, but rather the rules based upon where it “resides” post-inversion. Therefore, if the corporation inverts into a tax haven that has a territorial tax system, it avoids the additional taxation on foreign profits it would otherwise have to pay as a United States-based corporation. The inverting corporation enjoys this benefit even though it may still base all of its operations and management in the United States[10] When a United States-corporation inverts, it acquires an advantage over United States-based corporations, which some would argue is unfair. Not only does the United States corporation avoid double-taxation, but it can also take advantage of interest payment deductions for payments to affiliates in other countries.[11
II. The Suggestions of the Department of Taxation Did Not Translate into Effective Government Action.
“Measures designed simply to halt inversion activity may address these transactions in the short run, but there is a serious risk that measures targeted too narrowly would have the unintended effect of encouraging a shift to other forms of transactions to the detriment of the U.S. economy in the long run.”[12]
The preceding excerpt was the suggestion of the Office of Tax Policy at the Department of Taxation in 2002. Rather than focusing on punitive measures to discourage corporate inversions, the Office of Tax Policy suggested a “comprehensive review” of the current United States tax system, particularly foreign tax treatment, to develop long-term goals of ensuring the United States’ position as the “most desirable location in the world for place of incorporation, location of headquarters, and transaction of business.”[
A. Legislation and Regulations To-Date Have Done Little to Curb Corporate Inversions.
In 2004, Congress enacted the American Jobs Creation Act of 2004 (“Jobs Act”) to address the issue of corporate inversions.[14] The statistics suggest that the Jobs Act had little impact on corporate inversions. Since 1983, about seventy-six companies have either inverted or are planning to invert, with fourteen inversions in 2014 alone, and forty-seven inversions since 2004.[15] In other words, of all corporate inversions that have occurred, over sixty percent have occurred since the Jobs Act was enacted. This suggests that, although the Jobs Act tightened the rules on corporate inversions, corporations were still able to find ways to navigate the new rules and invert, even if the Jobs Act had them thinking twice about inverting.
There have been more rules and regulations from the Treasury Department aimed at making corporate inversions harder.[16] The issue of corporate inversions was addressed by the Obama administration under the Stop Corporate Inversions Act of 2014 (“Stop Act”). The Act proposed amending Code §7874 to treat combined foreign and domestic corporations as domestic corporations for tax purposes if the historic shareholders of the U.S. corporation own more the fifty percent of the combined organization, or if the combined group is (1) managed and controlled in the United States, and (2) “engages in ‘significant domestic business activities’ (25% of employees by number, employees by compensation, assets, or income) in the United States.”[17] However, the last recorded action on the bill says that it was referred to the House Committee on Way and Means, suggesting it died in committee.[18]
It is hard to gauge the effect of the new rules on corporate inversions, because corporate inversions do not happen often. Since 1983, only seventy-six companies have or are planning on inverting.[19] For reference, there are 1.6 million C Corporations in the United States, and that is just one of several business entity formations available under the law.[20] Therefore, one can expect that collecting data can be difficult.
What is clear from all the new regulations is that the already complicated Code rules on international tax have only become more convoluted without any guarantee that inversions have been curbed. In the Stop Act, the Obama administration correctly addressed, even if impliedly, the issue that can not only help solve the corporate inversions issue, but do so without over-complication of the Code: corporate residency.
B. Redefining Corporate Residency as the Place of Management and Control, Can Close the Inversion Loophole without Convoluted Tax Provisions.
The key language from the proposed Stop Act is “if the combined foreign corporation is managed and controlled in the United States . . . .” This is a divergence from how the Code currently defines a domestic corporation. The Code currently considers a domestic corporation a “corporation or partnership [] created or organized in the United States or under the law of the United States or of any State unless” otherwise provided by the Treasury Department.[21] This definition is what currently creates the loophole; a United States-based corporation can reincorporate overseas while still carrying on the bulk of its operations and management in the United States while avoiding taxes. This focuses more on technical form, while the tax system should be focusing on substance. By defining a domestic corporation as a corporation or partnership “managed and controlled” in the United States, the corporate inversion controversy can be solved.
A parallel in other parts of United States law can be found in general jurisdiction in federal civil procedure jurisprudence.[22] One factor that can be considered in whether or not a corporation is “at home” in a particular jurisdiction is where the management of the corporation takes place.[23] This allowed plaintiffs to file suit outside of the corporation’s state of incorporation for personal liability, and also provided protections for defendant corporations. The same jurisprudence should be applied to tax liability within the United States. If a corporation carries on its management and operations within the United States, even if it is incorporated in a holding company in a foreign jurisdiction, it should still be classified as a domestic corporation because it is still effectively a United States-based corporation. Including provisions similar to those in the Stop Act, setting thresholds for management and ownership, can avoid taxing foreign companies that have legitimate operations overseas, and not just holding companies overseas.
Conclusion
By adopting the theory for personal liability found in federal civil procedure jurisprudence, the IRS can tax corporations who do not effectively operate overseas, but rather just use foreign holding companies to avoid taxes. By modifying the definition of corporate “residency” to tax corporations who seek tax shelters overseas, while excluding corporations who invert into a foreign corporation that have actual operations, Congress can provide the clearest and least convoluted path forward on ending tax avoidance by large corporations who reincorporate in tax havens overseas.
[1] Corporate Inversion Transactions: Tax Policy Implications, Office of Tax Policy Dept. of the Treasury at 3 (May 16, 2002), https://web.law.columbia.edu/sites/default/files/microsites/millstein-center/panel_1_001_office_to_tax_policy.pdf.
[2]Rhoades and Brittain, Can Congress Really Stop Corporate Inversion? If So, Should It?, 2016 Emerging Issues 7452 (July 30, 2016), LEXIS.
[3] Corporate Inversion Transactions, at 1.
[4] Id. at 4-5.
[5] Id.
[6] Joshua Kennon, Understanding a Holding Company, The Balance (updated Aug. 27, 2016), https://www.thebalance.com/understanding-a-holding-company-357341.
[7] Corporate Inversion Transactions at 5.
[8] Eloine Kim, Note: Corporate Inversion: Will the American Jobs Creating Act of 2004 Reduce the Incentive to Re-Incorporate? 4 J. Int’l Bus. & L. 152, 155 (Spring 2005), LEXIS.
[9] Id. at 157.
[10] For example: A Corp. is a multinational corporation based in the U.S. with operations all over the world. As a U.S. corporation, A Corp. would pay taxes on all profits it earned in the U.S., as well as taxes on foreign-earned income (subject to a foreign-income tax credit). By inverting to a tax haven, it avoids double-taxation in the U.S. because it is no longer a “U.S. corporation”, even if it still maintains most or all of its operations and management in the U.S. Examples include Medtronic, founded in Minneapolis, which is now an Irish corporation; Burger Kind, founded in Miami, is now a Canadian corporation. Zachary Mider and Jesse Drucker, Tax Inversion: How U.S. Companies Buy Tax Breaks, Bloomberg Quick Take (updated Apr. 6, 2016 at 5:15 p.m. UTC), https://www.bloomberg.com/quicktake/tax-inversion.
[11] Id.
[12] Corporate Inversion Transactions at 2.
[13] Id. at 30.
[14] The Act identified two types of inversions. One type is “as transaction in which (1) a foreign incorporated entity acquires (directly or indirectly) substantially all the properties of a U.S. corporation . . .; (2) the former shareholders . . . hold 80 percent or more (by vote or value) of the stock of the foreign incorporate entity after the transaction; and (3) the expanded affiliated group does not have substantial business activities in the foreign corporations country of incorporation when compared to the total business activities of the group.” For this type of transaction, the attempted inversion is nullified to the extent the corporation will still be taxed as a domestic corporation. The second type of inversion meets all the requirements of the first type except for (2), and is subject to milder sanctions. Kim, Note: Corporate Inversions at 164.
[15] Kyle Pomerleau, Everything You Need to Know About Corporate Inversions, Tax Foundation (Aug. 4, 2014), http://taxfoundation.org/blog/everything-you-need-know-about-corporate-inversions.
[16] The Treasury Department has issued numerous temporary rules to curb corporate inversions, such as Temp. Treas. Reg. §§1.304-7T, 1.367-4T, 1.956-2T, 1.7701(I)-4T, several sections under 26 U.S.C. §7874 (Temp. Treas. Reg. §§1.7874-3T through 1.7874-12T. The Treasury has also proposed several rules which were all issued around April 4, 2016 (Prop. Treas. Reg. §1.385-1).
[17] Simon M. Lorne and Joy Marlene Bryan, Acquisitions and Mergers: Negotiated and Contested Transactions §3:65.60. Tax legislation (11th ed. Nov. 2016 update) WL.
[18] H.R.4679 – Stop Corporate Inversions Act of 2014, https://www.congress.gov/bill/113th-congress/house-bill/4679/actions.
[19] Pomerleau supra Note 15.
[20] Id.
[21] 26 U.S.C. §7701(a)(4); this can be understood to mean if the corporation or partnership is incorporated or based in the United States.
[22] See generally, Int’l Shoe Co. v. Wash., 326 U.S. 310 (Dec. 3, 1945); Perkins v. Benguet Consolidated Mining Co., 342 U.S. 437 (Mar. 3, 1952); Helicopteros Nacionales De Colombia v. Hall, 466 U.S. 408 (Apr. 24, 1984); Goodyear Dunlop Tires Operations, S.A. v. Brown, 564 U.S. 915 (Jun. 27, 2011); Daimler AG v. Bauman, 134 U.S. 746 (Jan. 14, 2014).
[23] See generally, Int’l Shoe Co. and Perkins v. Benguet.
