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Part Two: Using Corporate Tax Policy to Stop Corporate Inversions

Published onOct 19, 2014
Part Two: Using Corporate Tax Policy to Stop Corporate Inversions

Politicians, business leaders, and legal professionals have spent a great deal of time this year talking about corporate inversions.  As stated in a previous post, an inversion is a business transaction, perhaps a merger or acquisition, between a U.S. corporation and a foreign corporation with the objective of establishing the headquartering the new combined corporation in the foreign nation to take advantage of a better corporate tax rate.

Opposition to corporate inversions has been widespread and forceful in recent months.  However, it hit a fever pitch when American corporate icon Burger King announced plans to merge with Canada’s Tim Horton’s in order to take advantage of Canada’s lower tax rates.  Politicians, business leaders, and legal professionals were suddenly able to command the newspaper headlines and the lead segments of cable news shows if they had a proposal for how to stop inversions.

The interested parties began rallying support around three very different proposals.  The three proposals, which are not necessarily mutually exclusive, are changing the U.S. corporate tax code, using the bully pulpit to pressure corporations into staying put, and using existing provisions in the tax code to punish and deter inversions.

In a previous post, I described the proposals that Republicans and Democrats have put forward to amend and overhaul the tax code.  In the short time that has passed between post, there have been development on that front as well as others.  In this post, however, I will outline the competing proposal to use existing provisions in the tax code to punish and deter inversions.

The unofficial leader of the movement to curb inversions through the use of existing provisions of the tax code is Professor Samuel C. Thompson.  Professor Thompson is currently a Professor of Law and the Director of the Center for the Study of Mergers & Acquisitions at Penn State Law.  He held the same position at UCLA previously and at the University of Miami before that.  Professor Thompson’s curriculum vitae reveals that he has been living and breathing mergers and acquisitions for decades.  He is a preeminent expert on the subject of inversions that so many of us are only now studying.

Although his mastery of the subject is important, it is perhaps just as important that the professor is well-acquainted with persons and institutions of power who can put his proposal into action.  Professor Thompson has worked with the Treasury Department, the SEC, and the FTC in matters related to mergers and acquisitions.  Scarlett Fu, a host of Bloomberg TV’s Morning Surveillance, recently asserted that Professor Thompson “has Treasury’s ear”.  He certainly does, and that has helped his proposal gain momentum quickly.

President Barack Obama

As recently as this summer, President Obama did not believe his administration had the power to stop inversions without legislative action.  Treasury Secretary Jack Lew said, “we do not believe we have the authority to address this inversion question through administrative action” just a few months ago.  Now, having listened to Professor Thompson and his supporters, President Obama and Secretary Lew have a “very long list” of options for unilaterally curbing inversions.

The proposal Professor Thompson is putting forward is quite simple.  Professor Thompson is proposing that the IRS, under the direction of the Treasury Secretary, utilize US Tax Code Section 385.  This is a 45-year old relatively obscure provision that gives the IRS broad authority to reclassify corporate debt as equity.  The idea behind the provision was that securities with equity qualities were being issued with a debt description in order to give the holder the equity features he wanted while giving the corporation the tax benefits of a debt security interest payments.  Even at the start, Congress intended this provision to be used in combating “the increasing use of debt for corporate acquisition purposes”.

If you followed the link to Section 385 above, you surely noticed that there is not much to this magic section.  Section 385(a) gives the Treasury Secretary authority to “prescribe such regulations as may be necessary or appropriate to determine whether an interest in a corporation is to be treated…as stock or indebtedness”.  Section 385(b) gives some factors for the Secretary to consider, but the list is not exclusive.  Secretary Lew may use whatever factors he likes to reach the conclusion he wants – that corporations who have fled the country through inversion cannot write off their interest debt.

Harvard Law Professor Stephen Shay, who has “two tours as the senior international tax official at Treasury”, has suggested a few instances in which the Secretary would be justified in reclassifying debt to equity under the provisions of Section 385.  First, when the U.S. corporation’s debt-to-equity ratio after the inversion exceeds the firm’s three-year historical average.  This, of course, may be immediately after the inversion is completed.  Second, Professor Shay believes the reclassification would be justified if the foreign corporation begins using debt to strip more than 25% of the U.S. corporation’s average annual income.  Unlike a political or social rationale, these triggers are clearly contemplated by the language of Section 385(b).

At this point, readers are probably wondering why the possibility that Secretary Lew could reclassify debt to equity would weigh so heavily on corporations considering an inversion.  That is a fair question.  To understand the genius of Professor Thompson’s proposal you have to understand the intricacies of a corporate inversion.  Chadbourne, a New York-based international law firm, described those intricacies succinctly in a recent article:

Treasury Secretary Lew

A corporate inversion is where a US corporation with substantial foreign operations inverts its ownership structure to put a foreign parent company on top with the aim of keeping future earnings from its overseas businesses outside the US tax net.  The foreign parent may also “strip” earnings from the US subsidiary by capitalizing the subsidiary with debt so that earnings can be pulled out of the United States as deductible interest on the debt.

In other words, the former subsidiary puts the former parent’s own cash back into it by purchasing debt securities from it.  Then, the cash interest payments flow to the former subsidiary as sums that the former parent can deduct against income on its tax return.  It is very clever.  In fact, I fear a Wake Forest School of Law graduate had something to do it.

The readers of this post are no doubt critical thinkers.  They are wondering how such a simple solution could have gone unnoticed by the people in power.  You are probably thinking it is too good to be true.  I must admit that I too was skeptical the first time I heard Professor Thompson speak.

In looking for opposing views on this politically sensitive issue, I was surprised to see that Professor Thompson’s proposal has not been met with a strong chorus of boos or even sharp academic rebuttals.  Instead, many tax and mergers and acquisitions experts have conceded that “Treasury has the legal authority to curb inversions” through Section 385.  This is a concession made whether or not the speaker believes that Treasury action is the best long-term response “as a policy and political matter”.  As a simple matter of fact, Section 385 is a ready and able tool.

Now that the details of the argument have been laid out, it is important to address two things which may prevent the proposal from ultimately succeeding.  The first is that proponents of the plan have stumbled out of the gate.  Despite the fact that some of those arguing the IRS tax code should be used to punish and deter inversions have been making that argument for over a decade, they have been surprised to find their old ideas are getting fresh attention from President Barack Obama and Secretary Lew.

Their surprise has been a setback to the campaign.  Perhaps the clearest example was when Bloomberg’s Scarlett Fu stated that Professor Thompson had the ear of Treasury.  The Professor, preparing for this interview for a decade, might have finished his pitch with a flourish knowing that viewers were now giving him their full attention.  Instead, he forcefully yet awkwardly denied that he had Treasury’s attention at all.  In doing so, he made it seem as if he was a man wandering in the wilderness and musing to himself about tax policy.  The Professor appeared weak and ineffectual in what should have been a key moment in advancing his proposal.

The second issue that threatens the proposal is that it relies on bureaucratic use of an old administrative law to fight a new crisis.  It seems odd that Secretary Lew could use a 1960’s rule to solve a problem most Americans became aware of over the summer.  It also seems funny that the proposal, if executed as its most ardent supporters believe it should, requires no act of a democratically elected official despite its immediate and powerful effect on international business.  Instead, it will be the work of the always suspect “unelected bureaucrat”.  Even worse, it will be carried out by the same agency that gave us Lois Lerner and the targeting of the President’s political enemies ahead of a national election.  It sounds awful.  The move will look awful in a many little ways.

This isn’t really fair, of course.  But politics and business are decidedly unfair.  Perhaps even more so when they intersect as they do here.  The international law firms and investment banks that enjoy the profits that inversions bring will surely raise the arguments I have in the preceding paragraph.  The political subjects alone – President Obama, Lois Lerner, and Jack Lew – would be easy targets for a TV attack ad.  Given the political price to be paid for unilateral action, will the President really have the political will to nudge the Treasury Secretary forward before mid-term elections?  We will soon know.

*John I. Sanders is a second year law student at Wake Forest University School of Law. He holds a Bachelor of Arts in History, with minors in Economics, from Wake Forest University. He also holds a Masters in Business Administration from Liberty University.  Upon graduation, he intends to practice corporate law.

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