Treasury Stops Short of Toughest Action on Offshore 'Inversion' Tax Moves

The U.S. Treasury Department sought to avoid legal thin ice in its crackdown on corporate inversions.

Steering clear of some of the most aggressive possibilities, the Obama administration stuck to areas where it has the clearest legal authority and can limit the effects to a discrete set of companies.

In announcing rules intended to make it harder for companies to reduce taxes by moving their address outside the U.S., Treasury largely relied on sections of the tax code that allow it to write rules without congressional action.

Treasury didn’t address — at least not yet — moves known as earnings stripping that many companies use to erode the U.S. tax base after completing an offshore deal.

“Whether one agrees with it or not, it does reflect a very considered approach by the part of the Treasury Department as to the underlying authority,” said Neil Barr, co-head of the tax department at Davis, Polk & Wardwell LLP in New York.

The rules won’t deter drugmaker Pfizer Inc., which is exploring a possible acquisition of Actavis Plc and its Irish tax address, said a person with knowledge of the matter. Burger King Worldwide Inc. is moving forward with its deal to buy Tim Hortons Inc. and move its address to Canada, said Scott Bonikowsky, a Tim Hortons spokesman.

Still, some companies with pending inversions, including Medtronic Inc. and AbbVie Inc., may recalibrate their plans. Treasury’s action also might discourage some deals that were being considered but hadn’t been announced.

Daunting Prospect

No matter how far the government goes in trying to stop such deals, for a company the prospect of inverting, being audited and then challenging the regulations is daunting.

“Firms have no immediate judicial recourse, and what board is going to roll the dice on the prospect of setting aside the notice’s rules years down the road?” Edward Kleinbard, a tax law professor at the University of Southern California, wrote in an e-mail.

Treasury’s actions are well-grounded in the statute and the regulatory guidance makes the government’s interpretations clear, a senior Treasury official told reporters on a conference call yesterday. The official spoke on condition of anonymity to discuss the process.

For example, section 956 of the tax code, which was used to address so-called hopscotch transactions, gives the government authority to write “such regulations as may be necessary,” specifically including rules “to prevent the avoidance” of the law through reorganizations.

Government Intent

As is typical when Treasury addresses perceived abuses, the announcement is a notice of the government’s intent to issue formal rules, coupled with a declaration that they will apply to transactions completed Sept. 22 or later.

Even as the government limited the benefits of hopscotch loans and other tactics that such companies use to escape taxes on their foreign earnings, the Treasury Department’s action is notable for what it doesn’t include.

The government didn’t act in three areas that could have spurred court challenges.

The proposal generally doesn’t touch completed deals, leaving companies such as Tyco International Ltd. and Horizon Pharma Inc. unscathed.

“The administration will be able to combat, at least in part, the sure-to-come charges of executive overreach” and also keep the rules “on the right side of the legality/authority question during what is very likely to be a spirited opposition campaign,” Henrietta Treyz, an analyst at Height Securities LLC, wrote in a note to clients.

Eliminate Deductions

The government also didn’t try to use Section 385 of the tax code to reclassify inverted companies’ debt as equity and effectively eliminate some deductions, as had been recommended by Stephen Shay, a former Treasury international tax official.

Treasury’s previous efforts to issue regulations under this section of the tax code have run into trouble because of the difficulty of writing clear rules that distinguish deductible debt from equity.

Treasury didn’t use any section of the tax code to address the practice known as earnings stripping, a set of post- inversion maneuvers that companies use to reduce taxes on U.S. income.

Instead, Treasury Secretary Jacob J. Lew reserved that issue for a potential second round of guidance, maintaining uncertainty for companies and keeping pressure on Congress.

Deduction Limit

Action on earnings stripping would raise problems for Treasury. Current law limits deductions to 50 percent of U.S. taxable income. Lowering that number would place a tighter cap on companies’ ability to load their U.S. operations with debt. Treasury, though, can’t lower that number without congressional action.

Earnings-stripping curbs might also affect foreign-based multinational companies that aren’t involved in inversions. The administration doesn’t want to hurt foreign direct investment in the U.S. by companies such as Nestle SA and Siemens AG.

Congress has been deadlocked on legislative proposals to curtail inversions.

“The administration has made a good effort but administrative action can only go so far,” Senator Charles Schumer, a New York Democrat who has sponsored earnings stripping legislation, said in a statement. “This rule may make some companies think twice before inverting, but legislation is still sorely needed.”