The U.S. government’s crackdown on tax inversion transactions is coming under fire from the business world.
Two large business groups recently sued the Treasury Department and the Internal Revenue Service (IRS) for abusing power and violating the law.
The U.S. Chamber of Commerce and the Texas Association of Business filed a lawsuit to challenge the “Multiple Acquisition Rule,” the IRS’s new regulation that blocks certain corporate mergers for tax inversion.
“Treasury and the IRS ignored the clear limits of a statute, and simply rewrote the law unilaterally. This is not the way the government is supposed to work in America,” stated U.S. Chamber President and CEO Thomas J. Donohue in a press release on Aug. 4.
The new regulation, announced by the Treasury and IRS on April 4, aims to stop corporate mergers for tax inversion purposes. In this strategy, American companies merge with foreign companies and reincorporate abroad to avoid higher U.S. corporate taxes.
Tax inversion has been a major driver of global mergers and acquisitions for the past few years, particularly in the pharmaceutical industry.
The new regulation blocked New York-based Pfizer (NYSE: PFE) from completing its proposed $160 billion merger deal with Ireland-based Allergan (NYSE:AGN). Pfizer ended up paying Allergan a $150 million termination fee.
Through the planned merger with Allergan, Pfizer aimed to move its tax domicile to Ireland, where the corporate tax rate is one of the lowest in the world.
“Instead of breaking the rules to punish companies engaged in lawful transactions, Washington should just do its job and comprehensively reform the tax code,” Donohue stated.
“The real solution is tax reform that lowers rates for all businesses, allowing American companies to compete globally and the United States to attract foreign investment.”
According to the complaint filed, the business groups accused the Treasury and the IRS of issuing a series of new rules in April designed to block the Pfizer–Allergan deal.
The Multiple Acquisition Rule, in particular, drastically eliminated the tax benefits of the merger. The rule directly targeted Allergan, which had grown through serial inversions since 2013.
In calculating the size of Allergan, the rule ignored the transactions already completed during the last three years. With a smaller size, Allergan would not be able to take over Pfizer and change its domicile.
As long as the shareholders of the foreign company buying the U.S. company own more than 40 percent of the combined entity, the transaction will not be treated as an inversion, according to Section 7874 of the Internal Revenue Code.
However, the Treasury and the IRS allegedly ignored the limits of the tax code and modified its application unilaterally.
“Treasury and the IRS rewrote the Internal Revenue Code and steamrolled over the Administrative Procedure Act, which requires that an agency provide interested parties with notice and an opportunity to comment before a rule becomes effective,” stated Lily Fu Claffee, chief legal officer of the U.S. Chamber of Commerce, in a press release.
“Treasury and the IRS admitted to skipping over any prior notice or opportunity to comment on their Multiple Acquisition Rule, but offered no justification for dodging their legal obligations in this way.”
Earnings Stripping
The new regulations also allowed the Treasury to curb the use of earnings stripping. Earnings stripping is a tax strategy that allows U.S. subsidiaries to pay interest through internal borrowing and hence reduce the taxable income in the United States.
“The new rules would allow the IRS to scrutinize all debt instruments among affiliates,” stated a Washington, D.C.-based think tank, the Tax Foundation, in its report.
The Treasury’s proposal included ending the deductions by reclassifying the debt as equity.
“These regulations, of course, come with a cost. … Business operations are going to be significantly affected by the rule, making the compliance quite costly,” stated the Tax Foundation.
Businesses and trade groups reacted to the Treasury’s proposal by claiming it would disrupt business operations and create an excessive bureaucracy, according to a Reuters report.
Exodus of US Corporates
The U.S. corporate income tax rate of 35 percent is the highest among Organization for Economic Co-operation and Development (OECD) countries. Moreover, the United States makes companies pay that rate on all their foreign earnings as soon as these earnings are repatriated.
U.S. Fortune 500 companies held $2.4 trillion of their cash overseas as of the end of 2015, according to a report by the think tank Citizens for Tax Justice.
“The build-up of cash, led by companies such as Apple, Microsoft, and Google partly results from companies holding cash overseas to avoid taxes upon repatriation,” stated a report by Standard & Poor’s.
The United States is not the only country dealing with tax inversion controversy. The United Kingdom had a similar problem less than a decade ago. Its complicated tax system drove companies abroad.
However, it reversed the inversion trend by gradually reducing the corporate income tax rate from 28 percent in 2010 to 20 percent in 2015. It also switched to a territorial tax system, which does not double tax foreign income of U.K. companies.
“The U.K. is a prime example of how lower rates and a territorial tax system can help restore competitiveness to a country’s tax code while ensuring adequate revenue,” stated William McBride, the Tax Foundation’s chief economist, in an article.
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