Via Goldman Sachs' Alec Phillips,
Corporate "inversion" transactions already looked like a potential catalyst for tax reform over the medium term, but an uptick in deal activity seems to have increased the probability of near-term policy activity as well. First, although Congress had looked unlikely to address the issue in the near term, it now appears possible that the issue will debated next month, though at this point we don't expect changes to be enacted into law. Second, President Obama and Treasury Secretary Lew have indicated that the administration is examining ways to intervene without Congress. Our expectation is that such changes might be announced shortly after Congress recesses for the election in early October. Overall, it appears unlikely that Congress or the Treasury will make changes this year that eliminate the tax benefits of inversion, but the probability of incremental changes has increased.
Q: What has changed?
Last week, the Treasury reversed its prior position and stated that it may have authority to partially address tax inversions. A widely held view over the last few months has been that the Treasury lacks the authority to block companies from tax expatriation as long they comply with existing rules. Treasury Sec. Lew himself stated in July that “we do not believe we have the authority to address this inversion question through administrative action.” However, on August 5 the Treasury reversed itself, stating that it is “reviewing a broad range of authorities for possible administrative actions that could limit the ability of companies to engage in inversions, as well as approaches that could meaningfully reduce the tax benefits after inversions take place.” The following day, President Obama explained that the administration is “examining…how existing statutes are interpreted by rule or by regulation or tradition or practice that can at least discourage some of the folks who may be trying to take advantage of this loophole.” While the administration has not committed to making any changes to existing policy, it seems likely in our view that the Treasury will announce at least an incremental change to the rules around inversions.
Q: What can be done without legislation?
Treasury officials have not said what action might be taken, but two areas appear to be in focus based on commentary by tax experts, such as Harvard Law professor and former Treasury official Stephen Shay and from lawmakers, such as House Ways and Means Committee Ranking Democrat Levin, who circulated draft legislation in late July on the issue:
- “Earnings stripping.” The relatively high US statutory tax rate creates an incentive for companies to deduct as large a share of expenses as possible from US income. One means of doing so involves deducting interest in the US on loans from foreign subsidiaries. Rules exist to limit this practice, but the Treasury appears to be looking at tightening these rules. Rep. Levin's draft legislation would also further restrict these strategies.
- Treatment of deferred overseas earnings. US-based companies typically avoid repatriating foreign profits in order to defer US tax on those earnings. The downside of doing so is that it is difficult under existing rules to distribute those earnings to shareholders or invest in US operations. Tax inversions provide companies with much greater flexibility in this area and this is a primary motivation for some companies to expatriate. Shay proposes tightening rules on use of pre-inversion foreign earnings, as does Rep. Levin's draft legislation. However, while nothing can be ruled out, future post-inversion foreign profits do not appear to be a focus.
The Treasury, which oversees the Internal Revenue Service (IRS), may look at other areas as well and there is significant uncertainty regarding how far it can go to limit the tax benefits to companies that expatriate. More importantly, there is even greater uncertainty regarding how far the Treasury will go. Part of the uncertainty has to do with the fact that some changes would probably apply beyond expatriated companies and could affect all US subsidiaries of foreign multinationals. For example, Rep. Levin's draft legislation would apply new restrictions on "earnings stripping" to all foreign-controlled US subsidiaries, not only those that were formally US-based companies. While the Treasury might like to focus any administrative changes it makes on expatriated companies, it is not clear whether it would have the ability to do so.
Q: Where does Congress stand on the issue?
Congressional Democrats have introduced two types of legislation targeting the inversion issue, and they look likely to introduce a third set of proposals soon.
- First, several Democratic lawmakers have proposed raising the existing thresholds for eligibility to move to a foreign jurisdiction. Under current law, a US-based company may move its tax domicile abroad only if, as part of the transaction, the stock ownership changes by at least 20%. The pending proposals follow the President's budget by raising this threshold to 50% and requiring that the new foreign company have substantial business activity in the new tax jurisdiction.
- The second group of proposals would prohibit the federal government from contracting with expatriated companies that do not meet the higher 50% threshold.
- A third forthcoming set of bills would address earnings stripping and potentially other tax-reduction strategies that expatriated companies, among others, use to reduce their US tax rates.
As noted above, Rep. Levin (D-MI) looks likely to introduce legislation targeting these issues in the House, while Sen. Schumer (D-NY) has indicated he will offer legislation in the Senate.
Republicans have not spoken much on this issue. Senator Hatch (R-UT), the ranking Republican on the tax-writing Senate Finance Committee, has stated that while he would like to address the issue he will support a legislative intervention only if it is not retroactive, moves toward a territorial tax system, and does not raise net revenues for the Treasury. House Ways and Means Chairman Camp has pointed to his tax reform plan as the best way to address inversions. House Budget Committee Chairman Paul Ryan (R-WI), who may assume the chairmanship from Rep. Camp next year--Camp is term limited as chairman--has said a short-term fix could make the problem worse. All three of them view tax reform as the ultimate solution.
Q: What happens next?
Congress will be the focus in September. As noted above, additional legislation on the topic is likely to be introduced when Congress comes back into session and there is a chance that this could come up for a vote in the Senate, though passage seems less likely, and reaching the President's desk even less so. A second potential issue to watch will be the possibility that the issue could become wrapped up in the debate over extending government spending authority, which expires September 30. House Minority Leader Nancy Pelosi (D-CA) has raised the possibility of including language to restrict inversion transactions in the upcoming spending bill that will need to pass by September 30 to keep the government operating. This could be an interesting strategy because Republicans, who have often lacked sufficient support among their own members for spending legislation, might need Democratic votes to pass it. That said, the likelihood that Congress enacts inversion-related legislation prior to the election remains low in our view.
Assuming that Congress does not act before it adjourns for the election in early October, the ball will be in the administration's court. Neither the Treasury nor the White House have indicated when they might announce any plans to use their existing authority to rein in inversion activity, but a delay until Congress adjourns seems likely. Not only would Treasury be able to use likely congressional inaction to justify its own approach, but a longer period of uncertainty regarding Treasury's intended policy changes would presumably deter more deal activity. While it is unclear what the Treasury will decide, it seems fairly likely that at least an incremental change related to inversions will be announced.
Following the mid-term election November 4, Congress will return for a "lame duck" session of Congress. The main item of interest will be "tax extenders" legislation to renew a number of expired and soon-to-expire corporate tax provisions. There is nothing in the legislation as it currently stands that addresses inversions, but it is hard to imagine that the issue will not be raised and/or amendments offered when the bill is debated.
Next year, how Congress addresses inversions will depend on two things: whether the pace of inversion transactions continues or eventually slows and whether Congress acts on tax reform. If the pace of deals slows--this could happen because of legislative or regulatory uncertainty or simply because there are not enough suitable acquisition targets for inversions--Congress may do nothing about corporate expatriations. However, if transactions continue at their current pace, an eventual response seems likely. As we recently noted, the inversion trend is renewing interest in tax reform and the increasing focus on the issue seems likely to create an opening for tax reform in 2015.