Press Room: Tax Release

April 08, 2016

U.S. Treasury Department Issues New Regulations to Curtail Inversions and Recharacterize Intercompany Debt

On April 4, 2016, the Treasury Department released new regulations aimed specifically at undermining tax benefits from reorganizations known as inversions. In an inversion, a U.S. based company acquires foreign residency, usually through a merger with a smaller company based in a tax favorable jurisdiction. However, these new rules have many other far-reaching implications and many of the changes are effective immediately.

Typically, the U.S. company that engages in an inversion transaction borrows a significant amount of funds from the foreign company. As a result, the U.S. company is able to lower its U.S. taxable income because its interest payments are deductible. Meanwhile, the foreign company, or its low-taxed affiliate, records interest income at a lower tax rate compared to that in the U.S., where the deduction is taken. Accordingly, inversions allow the combined company to lower its overall tax obligation, usually by significant amounts.

Under the new regulations, IRS is granted broad authority to treat debt obligations as stock or to bifurcate these arrangements. In the past, the characterization was an all or nothing determination, either only debt or only equity. Now instruments can be bifurcated into part debt and part equity. For example, if IRS determines that a debt instrument is issued with a principal purpose of funding a distribution or acquisition then the debt instrument will instead be treated as an equity transaction not as a debt injection into the U.S. In addition, such a determination may be made whether the debt instrument was issued before or after any distribution or acquisition.

Taxpayers must now be on notice that the after-tax cost of any completed, pending or planned merger based on an inversion type of structure or in a U.S. debt injection has now been significantly increased. While business reorganizations should always be driven by non-tax related business objectives (e.g., acquiring new assets, accessing new markets, achieving operational synergies, etc.), these new regulations aim to significantly reduce – if not effectively eliminate altogether – any tax-driven motivations for initiating an inversion or U.S. debt-injection transaction.

The chilling effect of these rules is that they apply not only to inversions; they also apply to recapitalizations and other transactions of foreign-owned U.S. operations where debt is introduced into the U.S. company, such as by a leveraged distribution by the U.S. company or certain internal reorganizations.

The new rules when finalized will require contemporaneous transfer pricing documentation where related-party and certain other debt is injected into a U.S. group. The proposed documentation rules will apply to publicly traded companies and groups with assets exceeding $100 million or revenue exceeding $50 million.

Companies should immediately re-assess the risk profile of any completed, pending or planned inversion transactions or transactions that would introduce debt into a U.S. subsidiary of a foreign-owned group to evaluate the likelihood that any interest payments to a foreign related party would be recharacterized as distributions on equity. Andersen is staying abreast of these developments. Our professionals are ready to assist you with reviewing your position and understanding what these new regulations may mean for your organization.

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