The Legal and Practical Implications of Retroactive Legislation Targeting Inversions by Yaron Nili, Harvard.edu
The increasing use of corporate inversions, whereby a company via merger achieves 20 percent or more new ownership, claims non-US residence, and is then permitted to adopt that country’s lower corporate tax structure and take advantage of tax base reduction techniques, has been the subject of intense media commentary and political attention. That is perhaps not surprising given the numbers: there was approximately one inversion in 2010, four in each of 2011 and 2012, six in 2013 and sixteen signed or consummated this year to date—or more than in all other years combined. And, the threat of anti-inversion legislation appears only to be hastening the pace at which companies are contemplating such transactions.
The political outcry has come from the President, who called inversions “wrong,” the Treasury Secretary, members of Congress and others. On August 5, three Senators urged executive action to curtail corporate inversions motivated by tax considerations. In a letter to President Obama, Senate Assistant Majority Leader Richard Durbin (D-IL), and Senators Jack Reed (D-RI) and Elizabeth Warren (D-MA), members of the Banking Committee, advocated that the President use executive authority to reduce or eliminate tax breaks for companies that adopt foreign citizenship to avoid paying U.S. taxes.
The Senators’ concerns echoed those of Treasury Secretary Jack Lew, who in a letter to Congress requested legislation stopping U.S. corporations “from effectively renouncing their citizenship to get out of paying taxes” by enacting legislation that would substantially limit tax inversions retroactive to May 2014. The Treasury Department’s Assistant Secretary for Tax Policy, Mark Mazur, argued that there was precedent for retroactive legislation: “Congress has frequently imposed retroactive effective dates for provisions that shut down egregious tax loopholes. In these cases, backdated implementation is often important to ensure that companies do not take advantage of the lengthy legislative process to rush through transactions exploiting the loopholes they know they are about to lose.”
These developments confront companies that have executed agreements to undertake inversions, or are planning to do so, with significant uncertainty. This post explores a number of relevant unsettled issues, including whether Congress can legally pass legislation that applies retroactively to invalidate the tax advantages of inversions at the 20 percent-or-more new ownership level; whether the President via Executive Order or the Treasury Department through its rulemaking authority can enact rules without Congress to the same effect; and in either case, if the rules change, how companies that have signed agreements to invert will be impacted.
In 2004, Congress enacted Section 7874 of the Internal Revenue Code (the “Code”) to address perceived abuses associated with inversion transactions. Section 7874 applies to a transaction if:
- a foreign corporation completes the direct or indirect acquisition of substantially all of the properties held directly or indirectly by a domestic corporation;
- after the acquisition at least 60 percent of the stock of the foreign corporation (by vote or value) is held by former shareholders of the domestic corporation; and
- the expanded affiliated group that includes the foreign corporation does not have “substantial business activities” in the foreign country in which the foreign corporation is created or organized when compared to the total business activities of the expanded affiliated group.
The 60% threshold results in the foreign corporation being treated as a “foreign surrogate corporation,” such that it is not permitted to use deductions to offset gain or income from the inversion transaction. If following the transaction former shareholders of the domestic corporation own 80 percent or more of the foreign corporation, the foreign corporation instead is treated as a domestic corporation for U.S. federal income tax purposes.