You may have read recently that Burger King is acquiring Tim Hortons Inc, a Canadian coffee and donut chain. What has attracted attention is the deal is structured as an inversion, which means that the American company (Burger King) will be moving its tax residency to Canada. I suppose it was hypothetically possible that the deal could have moved Tim Hortons Inc to the U.S. (think of it as a reverse inversion), but that would not have drawn the attention of the politicians.
The combined company will be the world’s third-largest fast-food company, right behind McDonalds and Yum! Brands (think KFC and Taco Bell). While the U.S. will have by far the largest number of locations, the majority of the revenue – again by far – will be from Canada.
An issue at play is that U.S. companies face a very harsh tax system, one in which they are to pay U.S. tax on all profits, even if those profits originated overseas and may never be returned to the U.S. Combine that with the world’s highest corporate tax rate, and it becomes fairly easy to understand why companies pursue inversions. In certain industries (such as pharmaceuticals), it is virtually imperative that the some part of the company be organized overseas, as the default tax consequences would be so prohibitive as to likely render the company uncompetitive.
Let’s talk a bit about inversions.
Inversions first received significant Congressional scrutiny in the 1980s, when McDermott Inc did the following:
- McDermott organized a foreign subsidiary, treated as a controlled foreign corporation for U.S. tax;
- The subsidiary issued stock in exchange for all the outstanding stock of McDermott itself; and
- Thus McDermott and its subsidiary traded places, with the subsidiary becoming the parent.
In response Congress passed IRC Sec 1248(i), requiring any future McDermott to report dividend income – and pay tax – on all of its subsidiary’s earnings and profits (that is, its undistributed profits).
In the 1990s, Helen of Troy Corp had its shareholders exchange their stock for stock of a new foreign parent company.
In response the IRS issued Reg 1.367(a)-3(c), requiring the U.S. shareholders to be taxable on the exchange because they owned more than 50% of the foreign company after the deal was done.
In the aughts, Valeant Pharmaceuticals paid a special dividend to its shareholders immediately before being acquired by Biovail, a Canadian corporation. Valeant paid out so much money - thereby reducing its own value - that the Valeant shareholders owned less than 50% of the foreign company.
Interesting enough, this did not (to the best of my knowledge) draw a government response. There is a “stuffing” rule, which prohibits making the foreign corporation larger. There is no “thinning” rule, however, prohibiting making the U.S. company thinner.
Then there was a new breed of inversions. Cooper Industries, Nabors Industries, Weatherford International and Seagate Technologies did what are called “naked” inversions. The new foreign parent incorporated in the Cayman Islands or Bermuda, and there was no effort to pretend that the parent was going to conduct significant business there. The tax reason for the transaction was stripped for all to see – that is, “naked.”
That was a bridge too far.
Congress passed IRC Sec 7874, truly one of the most misbegotten sections in the tax Code. Individually the words make sense, but combine them and one is speaking gibberish.
Let’s break down Section 7874 into something workable. We will split it into three pieces:
(1) The foreign company has to acquire substantially all the assets of a domestic company. We can understand that requirement.
(2) The U.S. shareholders (referred to “legacy” shareholders) own 60% or more of the foreign parent. There are three sub-tiers:
a. If the legacy shareholders own at least 80%, the IRS will simply declare that nothing occurred and will tax the foreign company as if it were a U.S. company;
b. If the legacy shareholders own at least 60% but less than 80%, the IRS would continue to tax the foreign company on its “inversion gain” for 10 years.
i. What is an “inversion gain?” It involves using assets (think licenses, for example) to allow pre-inversion U.S. tax attributes to reduce post-inversion U.S. tax. The classic tax attribute is a net operating loss carryover.
c. If the legacy shareholders own less than 60%, then Section 7874 does not apply. The new foreign parent will generally be respected for U.S. tax purposes.
But wait! There is a trump card.
(3) The IRS will back off altogether if the foreign company has “substantial business presence” in the new parent’s country of incorporation.
There is something about a trump card, whether one is playing bridge or euchre or structuring a business transaction. The tax planners wanted a definition. Initially the IRS said that “substantial business presence” meant 10% of assets, sales and employees. It later changed its mind and said that 10% was not enough. It did not say what would be enough, however. It said it would decide such issues on “facts and circumstances.” This sounds acceptable, but to a tax planner it is not. It is the equivalent of saying that one need not stop at a stop sign, as long as one is not “interfering” with traffic. What does that mean, especially when one has family in the car and is wondering if the other driver has any intention of stopping?
After three years the IRS said that it thought 25% was just about right. Oh, and forget about any “facts and circumstances,” as the IRS did not want to hear about it.
The 25% test was a cynical threshold, figuring that no one country – other than the U.S. – could possibly reach 25% by itself. Even the E.U. market – which could rival the U.S. – is comprised of many individual countries, making it unlikely (barring Germany, I suppose) that any one country could reach 25%.
Until Pfizer attempted to acquire AstraZeneca, a U.K. based company. The White House then proposed reducing the 80% test to a greater-than-50% test and eliminating the 60% test altogether. It also wanted to eliminate any threshold test if the foreign corporation is primarily managed from the United States.
The Pfizer deal fell through, however, and there no expectation that this White House proposal will find any traction in Congress.
And there is our short walk through the minefield of tax inversions.
There is one more thing, though. You may be wondering if the corporate officers and directors are impacted by the tax Code. Surely you jest- of course they are! There is a 15% excise tax on their stock-based compensation. How does this work out in the real world? We will talk about this in our next article, when we will discuss the Medtronic – Covidien merger. (see Let's Talk Tax Inversions - Part Two)
About the author
Steven D. Hamilton is a career CPA, with extensive experience involving all aspects of tax practice, including sophisticated income tax planning and handling of tax controversy matters for closely-held businesses and high-income individuals.