The First Lawsuit Challenging the IRS’s New Anti-Inversion Regulations

In International Tax, Inversions, IRS Regulations, Uncategorized by Jason FreemanLeave a Comment

In a suit against the IRS challenging the new anti-inversion regulations, the United States Chamber of Commerce and the Texas Association of Business are attacking the validity of the “multiple domestic entity acquisition rule,” also known as the anti-“serial inverter” rule.  Inversions and Related Transactions, 81 Fed. Reg. at 20,865–66; see 26 C.F.R. § 1.7874-8T.  The suit alleges, among other things, that the new regulation is unlawful under the Administrative Procedures Act, 5 U.S.C. § 706.  The new rules—an effort by the Treasury to curb what it perceives to be abusive inversion transactions—are, like the transactions that they target, controversial.  The plaintiff duo, in its complaint, alleges that:

[the temporary anti-inversion rules are] a clear case of federal Executive Branch officers and agencies bypassing Congress and short-circuiting legislative debate over a hotly contested issue by unilaterally imposing the Administration’s preferred policy result in violation of clear statutory limits.

(Complaint, p. 1.)  The “inversion” debate has been at the center of a broader debate about international tax reform in recent years—and it is a charged topic.  In fact, since just 2005, there have been almost 50 legislative bills introduced seeking to deter inversions. See, e.g., S. 2667, 114th Cong. (2d Sess. 2016); H.R. 3959, 109th Cong. (1st Sess. 2005). None of them, however, have been enacted into law.

The Complaint does a good job of putting the inversion debate into perspective, emphasizing the competitive disadvantage that U.S. corporations often face in the global marketplace:

Because the United States is unique among developed nations both in imposing a high corporate income tax rate and in taxing the profits that U.S. corporations earn through their foreign subsidiaries, U.S. corporations with subsidiaries abroad face higher taxes on their foreign operations than they would if incorporated elsewhere, thus putting them at a competitive disadvantage. This disparity creates significant incentives to incorporate outside the United States in order to shield foreign subsidiaries from burdensome U.S. taxation and thereby remain competitive in a global economy. Corporate “inversions” are a way to accomplish this goal.

Compl., p. 2)  As the Complaint further explains, the rise of inversions is an outgrowth of the U.S. tax system itself:

The rise of inversions is a symptom of the uncompetitive nature of U.S. corporate tax law. Most developed nations do not tax their corporations on all income earned through foreign subsidiaries, and the handful of other nations that do tax worldwide income apply a much lower rate than the United States does. To remain competitive as a global company, a U.S.-based multinational corporation therefore can indefinitely defer the taxes they owe on profits of foreign subsidiaries by declining to repatriate those profits, or engage in an inversion. Inversions thus allow multinational corporations to bring more money earned abroad into the United States, leading to the creation of new American facilities and more American jobs, as well as increased profits for U.S. shareholders. . . . Inversions are nonetheless controversial because they reduce the potential amount of federal income tax for foreign companies with a U.S. presence.

(Compl., p. 6.)  The blame, in other words, lies squarely with the U.S. tax system, according to the plaintiffs.

So, for those initiated to the topic, what exactly is an “inversion?”  In a typical corporate inversion, “a U.S. corporation with foreign subsidiaries engages in a transaction with a foreign corporation whereby the U.S. corporation becomes a subsidiary of a new foreign parent, which is typically incorporated in a lower-tax jurisdiction.”  (Compl., p. 2); See also, Staff of the Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in the 108th Congress (JCS-5-05) (May 31, 2005), at 342.  That’s the idea in a nutshell; and it has proven to be a popular tax planning device for multinational corporations.

As a little statutory background, Congress enacted Section 7874 of the Internal Revenue Code as part of the American Jobs Creation Act of 2004 in an effort to combat what it deemed to be improper inversions.  The provision sets out a comprehensive scheme that governs inversions. Under Section 7874, a foreign corporation that acquires substantially all of the property of a U.S. corporation “pursuant to a plan” will fall into one of three categories for federal tax purposes:

First, if the shareholders of the U.S. corporation receive less than 60% of the foreign parent corporation’s stock in exchange for their stock in the U.S. corporation, the foreign corporation will be treated as a “foreign corporation” and thus not subject to U.S. taxes on income earned outside of the United States. Second, if the shareholders of the U.S. corporation receive at least 60% but less than 80% of the foreign corporation’s stock in exchange for their stock in the U.S. corporation, the foreign corporation will be deemed a “surrogate foreign corporation” and denied certain tax benefits associated with its U.S. subsidiary. Third, if the shareholders of the U.S. corporation receive 80% or more of the foreign corporation’s stock in exchange for their stock in the U.S. corporation, then the foreign corporation will be treated as a “domestic corporation” that may be taxed on its and its subsidiaries’ worldwide income, even though it is incorporated outside of the United States. 26 U.S.C. § 7874(a)–(b). Essentially, the inversion in this latter scenario is disregarded.

(Compl., p. 7)

That is a pretty good high-level summary of how section 7874 works.  And it was against this statutory backdrop that Treasury enacted the new corporate inversion regulations—and the rules being challenged in the lawsuit—in an effort to further curb transactions that allow U.S. corporations to invert into foreign entities.

According to the preamble to those regulations, the Treasury Department and the IRS, in enacting the rule being challenged in the litigation, were concerned that a single foreign acquiring corporation might avoid the application of section 7874 by completing multiple domestic entity acquisitions over a relatively short period of time in circumstances where section 7874 would otherwise have applied if the acquisitions had been made at the same time or pursuant to a plan. In such situations, according to Treasury, the value of the foreign acquiring corporation increases to the extent it issues stock in connection with each successive domestic entity acquisition, thereby enabling the foreign acquiring corporation to complete another, potentially larger, domestic entity acquisition to which section 7874 would not apply. The Treasury Department and the IRS concluded, according to the preamble, that it is not consistent with the purpose of section 7874 to permit a foreign acquiring corporation to reduce the ownership fraction for a domestic entity acquisition by including stock issued in connection with other recent domestic entity acquisitions. Therefore, the new regulations provide that stock of a foreign acquiring corporation that was issued in connection with certain prior domestic entity acquisitions occurring within a 36-month look-back period should be excluded from the denominator of the ownership fraction.  (Preamble, pp. 31-32.)

The litigation will be interesting to watch as it plays out.  While it certainly raises an interesting challenge to important policy decisions, the challenge is likely to face a number of procedural hurdles.  For one thing, the Anti-Injunction Act generally prohibits a challenge of such a nature until the tax is actually assessed (and then a party with standing (i.e., against whom it is assessed) may challenge the regulation).  It is not clear that the Chamber or TAB will be able to overcome these hurdles.

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