Beyond Foiling Pfizer, U.S Aims at Intra-Company Loans `Fiction'

What’s Next for Pfizer After Walking Away From Allergan?
  • Treasury's less-noticed proposal may hit thousands of firms
  • Rules target foreign multinationals lending to U.S. units

Escalating a 19-month regulatory assault against U.S. companies’ shifting their tax addresses offshore, President Barack Obama’s administration last week also went after companies that have always been overseas.

A proposed regulation from the Treasury Department targets loans that foreign companies make to their U.S. subsidiaries -- a technique that loads the American units with tax-deductible interest payments while shifting their profits offshore.

The rule is aimed at so-called earnings stripping -- which Treasury officials call a key strategy employed by U.S. companies that have completed “inversions,” the transfer of their tax addresses to lower-tax countries. But it would also apply to any bona fide foreign firm that has a U.S. subsidiary, ranging from manufacturers and distributors to private-equity firms and hedge funds, according to tax lawyers and academics.

The provision “is absolutely breathtaking, very elaborate and very far-reaching,” said H. David Rosenbloom, an international tax lawyer at Caplin & Drysdale in Washington, and a former senior Treasury Department tax official. “This regulation uses inversions as an excuse to do something way beyond inversions.”

‘Profound Impact’

The proposed rule "could have a profound impact on a range of modern treasury management techniques," Big Four accounting firm PricewaterhouseCoopers wrote in a research note last week. Treasury officials say the proposal is designed to catch intra-company loans that don’t result in net new investments in the U.S.

The lending provision was overshadowed in the days following Treasury’s April 4 announcement by the cancellation of a $160 billion merger between Pfizer Inc. and Allergan Plc. That deal, which would have created a new company with a tax address in low-tax Ireland, ended over another new rule that would limit companies’ ability to participate in inversion transactions if they’ve already done them within the past 36 months. Allergan has been involved in repeated mergers in that time frame.

Together, the April 4 measures are the toughest in a series of administration proposals aimed at inversions, which have captured attention in the 2016 presidential race and prompted Democratic and Republican candidates to vow to end the practice. Since the first inversion in 1982, 53 companies have completed them -- 22 of them since 2012. For a QuickTake explainer on Inversions: How Companies Buy Tax Breaks, click here.

The Treasury’s latest proposal will cut a much broader swath than previous rules. While anti-inversion regulations announced in September 2014 and November 2015 took aim at companies that have inverted or are planning to invert, the new rule goes much further, said Bret Wells, an associate law professor at the University of Houston Law Center who studies inversions.

‘Major Driver’

“For the first time, the IRS and Treasury are targeting their attack on the broader U.S. operations of a foreign multinational enterprise, and not isolating their response to solely inverted companies,” Wells said.

Stephen Shay, a senior former Treasury official turned Harvard Law School lecturer, wrote in a 2014 article that tax advantages from intra-company debt “strip the U.S. tax base into a jurisdiction where the interest income will be subject to much lower rates of tax.” The ability to create such transactions constitutes “a major driver of corporate expatriations,” he wrote.

The earnings-stripping rule takes aim at what Rosenbloom called a financial “fiction:” the idea that loans between different units within a single company are actually authentic loans and authentic debt.

They aren’t, he said. That’s because under established law, a loan involves “friction,” or separate interests, between a borrower and a lender. Units within a company by definition don’t have friction because they’re part of the same company and have the same overall interests, he said; one unit wouldn’t sue another for repayment. “Loans have to have substance,” Rosenbloom said, “and there’s no substantive meaning to a ‘loan’ within a company.”

The earnings stripping proposal would treat part or all of most intra-company loans as equity transactions, rather than debt -- canceling interest deductions for the U.S. unit. It would give the Internal Revenue Service the power to determine whether the transactions are taxable stock transactions or interest-deductible debt transactions.

‘Sweeping Alterations’

“The decision by the Treasury Department to issue sweeping alterations to the tax code not only blew up the Pfizer/Allergan deal but, more disconcertingly, made dramatic alterations to the ability of multinational companies to issue debt with any kind of certainty on a go-forward basis,’ investment firm Height LLC wrote Friday morning in a research note.

In 2013, there were 5,691 U.S. units of foreign companies, most majority-owned by their overseas parents, according to the most current data from the National Bureau of Economic Research. Many units are tied to foreign banks and financial firms; the agency doesn’t tally the size of the foreign financial sector relative to other industries.

The proposed earnings-stripping rule targets three kinds of intra-company debt transactions taking place under a single corporate umbrella, according to Patrick Cox, a tax partner at Withers Bergman LLP in New York.

Debt Transfers

The first is the transfer of debt from a subsidiary to a parent company. The second is a subsidiary’s purchase of debt from an affiliated company that resembles a stock dividend. In the third, debt repayments result in cash going to shareholders, akin to a dividend -- a popular transaction with private-equity firms that are keen to move money out of investment funds to shareholders, Cox said. The Treasury’s new proposal says all three may be considered taxable stock transactions, not interest-deductible debt transactions, he said.

The proposal also creates new documentation hurdles that transactions must pass to be eligible for being treated as debt by tax officials. Jason Kaplan, a tax lawyer at Hogan Lovells in New York, said the earnings-stripping rules “potentially cast a shadow beyond inversions over some relatively long-standing tax-planning techniques used by thousands of foreign companies with U.S. subsidiaries.”

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