The Obama administration continued to take action to combat corporate inversions by issuing two sets of regulations that target inversions and earnings stripping. An inversion results in a U.S. parent corporation of a multinational group being replaced by a foreign parent corporation. The government previously issued guidance in 2014 and 2015 on inversions. At the same time, the government said that Congress needs to enact legislation as part of a more comprehensive strategy on inversions.
Temporary regulations (TD 9761) incorporate the rules from 2014 and 2015 and also impose new limits on transactions that corporations may use to avoid existing restrictions on inversions. The regulations focus in particular on serial inverters, where companies engage in multiple acquisitions of domestic entities. The Treasury Department indicated that the regulations take away a significant amount of the tax benefits from serial inversions. The regulations also address multiple-step acquisitions of property, the substantial business activities test, the calculation of the ownership percentage, and the non-ordinary course distribution rule.
At the same time, the government issued proposed regulations (NPRM REG-108-060-15) that would target earnings-stripping transactions by recharacterizing debt between certain related parties as stock. Treating the debt as equity under Code Sec. 385 would eliminate the debtor’s ability to take significant interest deductions and reduce its federal income tax liability. According to Treasury, the guidance focuses on transactions that generate large interest deductions by transferring debt between subsidiaries without financing new investment in the United States.
The proposed regulations on earnings stripping have three important features: they allow the IRS on audit to divide debt instruments into part debt and part equity; they require large corporations to perform upfront due diligence and documentation of related-party instruments styled as debt; and they target transactions that generate large interest deductions for a U.S. corporation, while shifting the income to a foreign corporation that is not taxed in the U.S. and that may be located in a low-tax jurisdiction. Although the regulations are proposed, the portion of the regulations that identifies suspect transactions will apply to debt issued after April 4, 2016.