You can feel it in the air. The college football season is just around the corner and we are plenty excited. But there’s another high-stakes drama that is almost as captivating to aficionados of tax policy. In case you missed it, the U.S. Chamber of Commerce has filed suit in federal court challenging the Treasury Department and the IRS over their latest anti-inversion regulations.
The most surprising thing about this development is not that some people are upset with the government’s approach to preventing corporate inversions; it’s the identity of the lead plaintiff. Typically, we see aggrieved taxpayers suing to overturn unpopular tax regulations. In this case it’s a representative business association. You can read the chamber’s complaint here.
This post will briefly examine both the substance of the chamber’s complaint and the procedural hurdles it must overcome. First, let’s review a few things about corporate inversions. They should not be confused with runaway factories. Their purpose is not to push manufacturing jobs overseas. In fact, labor costs have nothing to do with inversions. These are paper transactions in which a domestic corporation effectively reincorporates itself as a foreign entity. Little else changes.
Inversions are attractive to multinational corporations because they offer massive tax savings (less so for enterprises with a purely domestic footprint). That’s due to the way our tax code treats foreign profits. The whole point of an inversion is to get a multinational’s foreign subsidiaries out from under the U.S. parent. Another reason why U.S. businesses want to reincorporate overseas is to facilitate access to previously accrued foreign earnings. A foreign-parented group can use unremitted foreign profits without suffering incremental U.S. tax costs. By contrast, a U.S.-parented group risks a large (and avoidable) tax bill if it were to use unremitted foreign profits in the same manner.
But there is a loser when U.S. firms decide to invert: the public fisc. The domestic tax base grows thinner with each corporate departure. As a general rule, politicians don’t like the optics of inversions. The public tends to view these transactions as unpatriotic. (The rebuttal is that corporate boards have an affirmative duty to maximize shareholder value whenever legally permissible, so patriotism has nothing to do with it.)
To that end, the government issued anti-inversion regulations in both 2014 and 2015. Those efforts did relatively little to stem the tide of U.S. companies seeking to invert. One of those companies was Pfizer, the giant pharmaceutical firm that makes Viagra. It found a potential merger partner in Allergan, the Irish pharmaceutical firm that makes Botox.
The proposed inversion, announced in November 2015, would have seen the two firms combine their resources with the newly created parent company being based in Ireland. As a result, future profits attributable to Pfizer’s foreign activities would no longer be caught in the U.S. tax net. Also, the post-merger entity could access Pfizer’s $80 billion stash of unremitted foreign profits. Taken as a whole, the merger represented a sort of perfect storm to corporate tax planners. (Insert your own joke about the benefits to humanity of commingling Botox and Viagra.)
As it turns out, Allergan itself had been a U.S. company until it inverted by merging with Ireland’s Actavis in 2015. That irony is compounded by the fact Actavis had also been a U.S. firm before it inverted by merging with Warner Chilcott in 2013. Thus, the Pfizer-Allergan arrangement loosely resembled an inversion, nested inside another inversion, nested inside yet another inversion. There is no evidence these companies conspired to orchestrate their succession of mergers as a unified plan.
Pfizer shareholders would have held 56 percent of the new foreign parent; Allergan shareholders would have held the remaining 44 percent. Those percentages were purposeful. Under the applicable statutory law (IRC section 7874), an attempted inversion will forfeit most of its tax savings if the shareholders of the U.S. firm hold more than 60 percent of the new parent. From a planning perspective, the general idea is to get that percentage as close as possible to that threshold without exceeding it.
The government didn’t want to see another prominent American company squirm its way around the corporate tax base. The word inside the Beltway was that Treasury wanted to stop the Pfizer-Allergan merger dead in its tracks. It accomplished just that in April of this year, by issuing its third round of anti-inversion rules (T.D. 9761). These are the regulations that inspired the chamber to bring the lawsuit described above.
Almost immediately after the regulations hit the street, Pfizer announced the inversion was off. They had little choice. The new regulations included a “serial-inverter” rule that significantly changed how the stock ownership threshold was calculated. The new rule disregards equity stakes the foreign target issued as part of other U.S. acquisitions during the prior three years. In the case of Allergan, that implicates the shares of stock issued to the former shareholders of Actavis and Warner Chilcott.
Once you re-crunch the numbers, Allergan’s shareholders would hold less than 20 percent of the post-merger entity, meaning Pfizer’s shareholders would hold in excess of 80 percent. That meant Pfizer flunked the stock ownership test and its anticipated tax savings vanished into thin air.
Up Steps the Chamber
The chamber alleges the serial-inverter rule harms its members. It seeks to invalidate the regulations alleging three distinct violations of the Administrative Procedure Act (APA).
The first count argues the numerical stock threshold set forth in section 7874 is a bright-line test that cannot be modified – other than by Congress. The complaint observes that Congress had several opportunities in recent years to modify the workings of section 7874, but declined to act on them. The complaint also argues that nothing in the tax code empowers Treasury to dream up the serial-inverter rule. The only exception would have been a regulation targeting a series of separate transactions undertaken as part of a preconceived plan to avoid the reach of section 7874. (That’s reminiscent of the step-transactions doctrine as used elsewhere in the tax area.) The serial-inverter rule does not fall into that category because it operates without regard to whether the foreign target’s prior stock issuances were part of a coordinated plan.
The second count alleges that the regulations are “arbitrary and capricious” rulemaking in violation of the APA. What they’re getting at here is that Treasury never adequately explained its reasoned basis for adopting the serial-inverter rule. It’s likely to be a point of contention that the rule was specifically drawn up to thwart the Pfizer-Allergan merger, and as such represents “a gerrymandered effort” and therefore an abuse of regulatory discretion. For its part, the government has not conceded that the proposed Pfizer inversion was the sole motivation behind the regulations. It would be interesting to see how a federal court would react if Treasury acknowledged that point. Reasonable minds may differ as to the propriety of the government promulgating tax rules in such a manner.
The third count focuses on the fact that the regulations failed to provide notice and opportunity for comment. The serial-inverter rule was neither previewed nor hinted at in the two earlier regulations addressing inversions. Treasury determined that the usual notice and comment requirements don’t apply, citing the “good cause” exception under APA section 553(b). The rule was designated as a temporary regulation, meaning it’s issued in proposed form and must be finalized within three years. It’s possible the final version of the serial-inverter rule could differ slightly from this proposed version. The chamber does not believe the rule’s temporary status excuses the APA’s notice and comment requirements.
But will the court ever consider any of these arguments? The initial question centers on whether the chamber possesses the necessary standing to bring the legal challenge. That matter is far from settled.
On several occasions the Supreme Court has addressed the matter of representational standing. That body of case law is informative, and suggests the issue functions as a high bar for groups like the chamber to satisfy. The Court is likely to apply a three-prong test to determine whether the chamber has standing to litigate on behalf of its members. The three factors are as follows: (1) Would the association’s members otherwise have standing to sue in their own capacity; (2) Are the interests the association seeks to protect germane to the group’s purpose; and (3) Does the requested relief require the participation of individual members in the litigation?
The first factor is the least problematic. The second factor could present a more serious obstacle. The chamber would need to convince a federal court that helping U.S. businesses reincorporate overseas is germane to their organizational purpose. Again, the optics aren’t ideal because inversions – as discussed -- aren’t like other varieties of corporate mergers and acquisitions. They are not about seeking out economies of scale or enhancing greater efficiencies. These are purely paper transactions designed to minimize taxes. I suspect the chamber will address the “germane to our purpose” factor by rephrasing the issue in terms of global competitiveness. It’s anyone’s guess as to how well that effort will sit with the bench.
The third factor could present the greatest hurdle. Are individual members of the association indispensable to advancing the claim? This is tricky because not every member of the chamber will have suffered the same alleged harm. Not being allowed to invert to Ireland (or the Cayman Islands, or wherever) could be quite detrimental to a pharmaceutical firm like Pfizer, which has an estimated $80 billion of unremitted foreign profits. Not so for other members of the association whose business model is less reliant on intangible assets, such as lucrative patent rights. Think of any firm that doesn’t depend much on royalty income, say big-box retailers. The ability to defer U.S. corporate tax on their foreign profits is far less critical to a Target or a Wal-Mart.
Why does that matter? Recent precedent from the Supreme Court suggests that where individual members of the association suffer varying degrees of harm, their participation in the litigation is required and representational standing fails.
Clearly the chamber is geared up for this fight. They’ve even cherry-picked a venue likely to offer a receptive ear: the U.S. District Court for the Western District of Texas. True, the chamber is based in Washington. For that matter, so is the Treasury Department and the IRS. But it would have been ill-advised for the chamber to have filed this case before the federal courts in our nation’s capital. The D.C. Circuit occasionally seems to look for reasons to toss out tax-related challenges on procedural grounds. It recently rejected a case brought by two state banking associations on the grounds that the action was barred by the federal Anti-Injunction Act.
The conventional standing requirements should be enough of a concern without having to also fend off a procedural challenge based on AIA jurisprudence. Either way, the case will make for great viewing.
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