Senators Urge IRS to Strengthen Rules Against Tax Inversions

Sen. Carl Levin, D-Mich., Sen. Jack Reed, D-R.I., Sen. Mazie Hirono, D-Hawaii, Sen. Tammy Baldwin, D-Wis., and Sen. Dick Durbin, D-Ill., called for the IRS to take action stop companies, like Burger King, from establishing holding partnership structures designed solely for tax avoidance.

The Burger King-Tim Hortons merger is the first to employ such a novel structure, and some experts have suggested that the structure could be widely adopted by other companies in inversion transactions. In addition, the senators urged Treasury and the IRS to take action to discourage the practice of 'earnings stripping,' to strengthen the prohibition of 'hopscotch loans,' and to work with other federal agencies to ensure that restrictions on awarding federal contracts to inverted corporations are properly enforced.

With respect to the structure designed to avoid gain recognition by shareholders, the senators wrote, "Clearly, the sole purpose of this special purpose, pass-through limited partnership structure is U.S. tax avoidance."

In addition, the senators urged the IRS to expand the prohibition on hopscotch loans "to cover all foreign entities with a U.S. subsidiary, regardless of whether the entities' foreign status is the result of an inversion or not." The current proposal, announced by the Department of Treasury in September 2014, would cover only companies that are inverted, and among inverted companies, only those that invert after Treasury's announcement.

The senators also encouraged the IRS to work with the Federal Acquisition Regulatory (FAR) Council to determine additional steps to ensure that federal contracts are awarded to U.S. companies rather than inverted corporations.

Full text of the letter is available at this link: http://levin.senate.gov/download/?id=CDC02636-02C0-4101-B7E1-6140C21DD593

We write to commend your recent actions to eliminate unjustified tax loopholes relating to corporate inversions. We encourage you to continue to pursue steps to deter tax-motivated corporate inversions and use all legal authority available to you to limit the tax benefits available to those American corporations who renounce their U.S. citizenship for tax purposes.

We share your concern that many inverted corporations may receive significant benefits as a result of "earnings stripping," and urge you to promptly take action to discourage this practice. As you know, the Department of Treasury determined in 2007 that "there is strong evidence of earnings stripping by . . . inverted corporations."² That concern remains today, and will only worsen if more corporations choose to give up their U.S. citizenship for tax gains, so they can take advantage of this tax loophole. We encourage you to use the authorities available to you to prevent abusive earnings stripping practices including the authorities you may have under U.S. tax treaties³ and Section 385 of the Internal Revenue Code.⁴

We also urge you to place companies on notice that the IRS will not look favorably upon schemes intended to avoid gain recognition in inversion transactions. As you know, the TRS issued Notice 94-46⁵ in 1994 to discourage tax inversions by requiring shareholders to recognize built-in gains when a U.S. corporation moves overseas through a tax inversion. Notably, that gain recognition provision applies to any shareholders of a U.S. company that moves its tax domicile overseas while at least 50% of the company's ownership is retained by its historic shareholders. This shareholder-level gain should therefore apply to nearly every corporation involved in the recent wave of tax inversions, even though other anti-inversion provisions of the tax code, which require an 80% level of shareholder continuity, may not be applicable.⁶ Since issuance of Notice 94-46, a number of corporations have attempted to structure inversions in a variety of ways to shield their shareholders from gain recognition.⁷ However, in nearly every case, the IRS has acted promptly to make clear that it would not allow schemes designed to avoid the application of Section 367.⁸

The latest scheme designed for shareholders of inverting companies to avoid Notice 94-46 and paying taxes on recognized gain is being offered in the Burger King-Tim Hortons merger. In the current Burger King structure, a special-purpose limited partnership is slid in between the newly merged Canadian-incorporated Burger King-Tim Hortons Corporation (BKTH) and the Burger King shareholders who choose to exchange their Burger King shares for units in that partnership that in turn will own only shares of BKTH. By receiving these limited partnership units instead of shares of BKTH, current Burger King shareholders will receive economic benefits that are essentially identical to those of holders of BKTH shares directly, including dividends and distributions, voting rights and freely marketable interests, without having to recognize gain under Notice 94-46 and pay taxes. Clearly, the sole purpose of this special purpose, pass-through limited partnership structure is U.S. tax avoidance. We urge you to make clear to taxpayers that this and similar structures will be disregarded for purposes of determining shareholder-level taxable gain under Notice 94-46.⁹

We also urge you to strengthen the prohibition of "hopscotch loans" included in Notice 2014-52. Under the terms of that Notice, a loan made from a Controlled Foreign Corporation (CFC) directly to a foreign parent (bypassing a U.S. intermediary) is treated as taxable subpart F income, but only for corporations that invert after the date of the Notice. We believe that this prohibition on hopscotch loans should be expanded to cover all foreign entities with a U.S. subsidiary, regardless of whether the entities' foreign status is the result of an inversion or not. Without such a change, previously inverted corporations, or other foreign corporations who have never inverted, may be able to use built-in earnings of CFCs to acquire new U.S. companies in future transactions with a significant advantage over U.S. bidders.

Our concern about the use of hopscotch loans by previously inverted corporations is not merely theoretical. In recent weeks, two inverted corporations not subject to the new hopscotch loans rule -- Valeant Pharmaceuticals and Actavis -- engaged in a bidding war to acquire American pharmaceutical manufacturer Biovail. Although it is not clear whether the winning bidder plans to exploit this loophole, such transactions could be structured to attempt to do so.

In addition to limiting the tax benefits of inversions, we also encourage you to work closely with other federal agencies to ensure that existing restrictions on awarding federal contracts to inverted corporations are properly enforced. In particular, we urge you to work with the Federal Acquisition Regulatory (FAR) Council and other officials to determine further steps that can be taken to ensure that taxpayer-funded federal contracts are awarded to U.S. companies, rather than to inverted corporations. A first step in this process should be to finalize the FAR rule currently awaiting review by the Office of Information and Regulatory Affairs.¹⁰

A second step could be for the FAR rules regarding contracting with inverted corporations to be coordinated with your new tax regulations. It has been a longstanding principle of federal contracting law that corporations who leave the United States through a tax inversion should not receive federal contracts, even if the inverted corporation is exempt from tax penalties on the inversion transaction due to a grandfather clause in the tax code. Under this principle, companies that have inverted by using the "cash box" and hopscotch loan loopholes should be banned from receiving federal contracts, and we hope the FAR would be amended to do so immediately.

Again, we commend your recent action to stop some of the most unjustified aspects of tax inversions, and we believe your actions are an important step toward eliminating the corporate inversion tax loophole. We also appreciate the Administration's legislative proposals to combat tax inversions that were included in the FY2015 budget. It is clear that inversions remain a significant tax avoidance concern, and only Congress can fully eliminate these abusive transactions. We appreciate your leadership on this issue, and look forward to working with you to craft a comprehensive, legislative solution to fully eliminate the tax inversion loophole. There are many ways Treasury and the IRS can act to reduce the utility of the inversion loophole, and we strongly encourage you to do so.

² Dep't of Treas., Report to The Congress on Earnings Stripping, Transfer Pricing and U.S. Income Tax Treaties (Nov. 2007) (available at http://www.treasury.gov/resource-center/tax-policy/documents/ajca2007.pdf).

³ It has been suggested that, under the U.S.-U.K. and U.S.-Ireland tax treaties, each government retains the right to determine whether a particular payment is considered "interest" and thus exempted, under the tax treaty terms, from that country's withholding requirements. Under this authority, it has been suggested that Treasury could determine that interest payments made from a U.S. subsidiary to an ostensibly foreign parent are not truly cross-border interest payments, and thus are not exempted under the relevant tax treaty when the foreign parent is actually owned primarily by shareholders of a formerly U.S. corporation. Disallowing the treaty benefits for such payments would trigger standard withholding requirements, likely resulting in a 30% withholding charge and presumably crippling any earnings stripping strategy. See Convention Between The Government Of The United States Of America And The Government Of Ireland For The Avoidance Of Double Taxation And The Prevention Of Fiscal Evasion With Respect To Taxes On Income And Capital Gains, Signed At Dublin On July 28, 1997, Together With A Protocol And Exchange Of Notes Done On The Same Date, U.S.-Ir., July 28, 1997, S. Treaty Doc. No. 105-31; Convention Between The Government Of The United States Of America And The Government Of The United Kingdom Of Great Britain And Northern Ireland For The Avoidance Of Double Taxation And The Prevention Of Fiscal Evasion With Respect To Taxes On Income And On Capital Gains, U.S.-U.K., July 24, 2001, S. Treaty Doc. No. 107-19.

⁴See, e.g. Steven E. Shay, Mr. Secretary, Take the Tax Juice Out of Corporate Expatriations, TAX NOTES, July 28, 2014.

⁵ I.R.S. Notice 94-46, 1994-1 C.B. 356.

⁶ In particular, Section 7874(b), which treats inverted corporations as domestic corporations for tax purposes, only applies to inversions where the merged entity has 80% of shareholders in common with the former U.S. entity.

⁷See, e.g., Form 8937, furnished by Liberty Global to shareholders, 2013 (asserting that "gain or loss should not be recognized by the shareholder in respect of the exchange of Liberty Global shares for New Liberty Global shares" in the 2013 merger-inversion of Liberty Global and Virgin Media, available at http://www.libertyglobal.com/PDF/IR/LGI-Form-8937-FlNAL-VERSION.pdf).

⁸See, e.g., T.D. 9526, 2011-24 I.R.B. 869 and I.R.S. Notice 2014-32, 2014-20 I.R.B. 1006 (combating "Killer B" structures designed to avoid the application of Section 367 in certain inversion transactions, including the Liberty Global structure).

⁹See, e.g. Samuel C. Thompson, Cat-and-Mouse Inversion Game With Burger King, TAX NOTES, Sept. 16, 2014 (suggesting that, if not challenged, similar partnership structures could be used to avoid gain recognition in a wide variety of both inversion and non-inversion transactions).

¹⁰ Prohibition on Contracting with Inverted Domestic Corporations, FAR Case 2014-017 (2014) (published in Fall 2014 Unified Agenda).