The topic of tax reform made the news on Monday as the Obama Administration simultaneously took regulatory steps to further limit corporate inversions and released an update to its 2012 Framework for Business Tax Reform. The inversion regulations make it more difficult for companies to move their headquarters abroad, while the tax proposal offers the Administration's views on an area that has potential for bipartisan compromise.
For companies with a tax residence in the United States, the federal government currently taxes the active income they earn abroad when it is repatriated to the U.S., and taxes passive (financial income) in the year it is earned. An inversion involves a large U.S. company acquiring a smaller foreign company and then moving its tax residence abroad to avoid taxation. Current anti-inversion rules consider a business a U.S. company for tax purposes if at least 80 percent of it is owned by U.S. shareholders, thus when inverting, companies will work to ensure that there is at least 20 percent foreign ownership in the resulting company. Rules issued by the Obama Administration in 2014 and last year limit the ability of companies to game the 80 percent threshold and limit the ability of inverted companies to repatriate income tax-free.
The rules released this week take additional steps to discourage inversions. The first rule restricts a foreign company from gaming the 80 percent shareholder rule by acquiring multiple U.S. companies in quick succession; specifically, the rule disregards a foreign company's acquisition of any U.S. stock in the past three years from the threshold calculation. Presumably, this rule targets recently inverted companies that use their increasingly larger size to quickly invert larger U.S. companies.
The second rule addresses "earnings stripping," a technique inverted companies use to lower federal tax obligations by having the U.S. company borrow from a related foreign company and pay tax-deductible interest payments to the related company. The rules related to earnings stripping would consider any debt-related distribution to the foreign company non-deductible stock, as long as the debt is not associated with actual business investment in the U.S. The rule would also allow the IRS to treat a debt instrument as part-debt and part-equity if appropriate.
The accompanying Framework for Business Tax Reform notes that current tax regulations are inadequate to wholly address the issue of inversions, and the President's budget proposes further policies to lower the U.S. shareholder threshold to 50 percent as well as limit interest deductions. The Framework also acknowledges other issues with business taxation beyond inversions like the high statutory tax rate; distortions among industries, debt and equity, and types of business organizations; a narrow tax base; and complexity.