Tax Analysts Blog

Treasury's New Inversion Regs Aren't Just About Inversions

Posted on Apr 7, 2016

In September 2014 Treasury took its first stab at stopping the wave of inversions that some argued was stripping the U.S. corporate base. It issued a finely turned notice targeting the ability of companies to use cash in foreign subsidiaries without paying U.S. tax. Inversions continued. In November 2015 another notice came out, but that same month Pfizer and Allergan announced the largest inversion in U.S. history, a $160 billion deal that incensed some lawmakers.

On April 4 Treasury discarded its delicate, targeted approach to combating inversions and used its nuclear option. The government issued new proposed regulations under section 385 that would not just affect inversions, but would completely change how the United States deals with earnings stripping and debt versus equity capital. In response, Pfizer and Allergan called off their merger April 6.

For years, observers have been urging Congress, the president, and Treasury to stop inversions. U.S. companies merging with foreign companies and locating the headquarters of the new entity outside the United States became an extremely popular tax reduction tactic. Multinationals said this was the only way to level the tax playing field. But policymakers from both sides of the aisle have expressed outrage. Treasury's 2014 and 2015 attempts to wade into the inversion realm temporarily slowed, but didn't stop companies from pursuing these transactions. Pfizer, in particular, remained remarkably defiant, aggressively attempting to find ways to circumvent the new rules.

Some thought that Treasury had gone as far it could. In fact, Treasury officials themselves hinted at this in numerous hearings and public events. It was now in the hands of Congress, they said. Congress, of course, didn't act. Republicans argued that inversions were symptomatic of broader tax system problems, while Democrats wanted direct action. No law was forthcoming.

In July 2014, before Treasury issued its first notice (but after the Treasury secretary hinted that nothing could be done using regulatory power), professor Stephen Shay wrote in Tax Notes that the government should use its powers under section 385 to reduce the benefits of inversions. Shay's suggestion wasn't taken in 2014 or 2015, but Treasury said in the preamble to its notices that it was looking into other ways to approach earnings stripping. Treasury's proposed regulations make extensive use of its authority under section 385.

The proposed regulations will hit a lot more than just inversions. They make for a fundamental rework of how the U.S. tax system approaches debt finance. For decades, U.S. multinationals have been trying to replace equity financing with debt financing to take advantage of favorable tax rules (which allow interest deductions to essentially reduce taxable U.S. income). The new regulations will severely limit that type of transaction, whether it's an inversion or not. Domestic transactions could be just as affected as international deals.

The press has jumped on the new rules as being the latest anti-inversion effort by the Obama administration. But the tax community should take a much broader view. The proposed regulations aren't so much meant to just stop inversions (although as the White House said, the administration isn't shedding any tears over the Pfizer deal's collapse), as to try to stop earnings stripping in general. These are major base erosion provisions that finally go a long way toward preserving what's left of the U.S. corporate base.

 

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