Monday the U.S. Treasury took action to discourage U.S. companies from undertaking a corporate inversion for the purpose of avoiding U.S. taxes. Treasury said it was only going after “serial inverters” or companies that have engaged in multiple inversions.
Because of Treasury’s actions and the resulting breakup of a major merger, you need to understand how the inversion process works and how it can impact the stock market under the new Treasury rules.
The U.S. Department of the Treasury defines a corporate inversion as a “transaction in which a U.S.-parented multi-national group changes its tax residence to reduce or avoid paying U.S. taxes.”
Even though U.S. law provides penalties for companies that undertake inversions to avoid taxes, many companies do it anyway since the benefits outweigh the penalties.
How It Works
The mechanism is fairly simple. An American company acquires a smaller company in another country and moves the new combined company’s tax residence outside the U.S. – typically to a country with low taxes. This can reduce or, in some cases eliminate, U.S. taxes on the company if it becomes a foreign-based company.
There are specific rules about this regarding the valuation of both the U.S. based part of the company and the part that is based overseas. That part can get fairly complicated.
According to the existing rules, when companies merge, if the shareholders of the former U.S. company own at least 80% of the new combined company, the new company is considered fully subject to U.S. taxes.
If those shareholders own at least 60% (but less than 80%) there are some restrictions but the company is considered foreign-owned. If the shareholders own less than 60%, the anti-inversion rules do not apply at all.
The new rules announced by Treasury Monday further restrict the benefits of inversion by disregarding American assets acquired by the foreign-based part of the company for the previous 3 years, thereby decreasing the size of the foreign-based part substantially.
The new rules also limit "earnings stripping," in which foreign companies lend money to their (now) U.S. subsidiaries. This creates interest payments that can be deducted on U.S. taxes owed by the U.S. part of the company.
What It All Means
The combined old and new rules do not prevent inversions but they make many inversions far less attractive from a tax perspective than has been the case in the past.
According to Treasury Secretary, Jack Lew, the ultimate decision about what to do lies with Congress. Unfortunately, there is little likelihood Congress will act anytime soon.