News Analysis: Inversion Regs Will Push States to Tackle Complex Questions

Posted on April 26, 2016 by Brian Bardwell

While it is uncertain how Treasury's new inversion regulations will play out in the states, practitioners and experts are beginning to focus on how the new treatment of earnings stripping could both prevent revenue losses and maybe even generate new funds.

The new temporary and proposed regulations target corporate inversions , in which a U.S.-parented multinational group acquires a smaller foreign company and relocates the tax residence of the merged group to a lower-tax jurisdiction, as well as the practice of earnings stripping , in which the multinational reduces its U.S. taxes by paying deductible interest to the new foreign parent or affiliates.

According to Treasury, the new temporary regs would limit inversions by disregarding foreign parent stock attributable to recent inversions or acquisitions of U.S. companies. Meanwhile, proposed debt reclassification rules would allow the IRS on audit to divide debt instruments into part debt and part equity, and generally treat related-party debt as equity unless it facilitates new investment in the borrower's operation; these proposed regs would address earnings stripping and would apply more broadly than the anti-inversion temporary regs. (Prior coverage .)

Addressing the issue could save the government nearly $20 billion over a decade, according to a Joint Committee on Taxation analysis , but according to the Council of State Governments, those revenue effects should trickle down to the states, as well.

"Corporate inversions and the practice of earnings stripping not only deprive the federal government of taxable income, but also reduce state government revenue as well," the group said in a recent report. "What's more, when income is stripped out of the U.S. federal tax base, it is also being stripped out of the state tax base. How much depends on the structure and nuances of individual state tax provisions."

At this point, though, no one seems to have answered that question, either at the national level or even for any individual state.

"People have found it to be a pretty speculative business forecasting the revenue loss from offshoring more generally," said Matthew Gardner of the Institute on Taxation and Economic Policy. "There are numbers out there, but they're at best speculative. We know that they're big numbers. We know that they start with a B in all likelihood, but beyond that it's hard to say."

Individual states' policies would have a major impact on basic questions about setting the baseline income for state tax purposes, Gardner said. But even if different states could see wildly different effects, the regulations would likely have a major impact in protecting state budgets nationally.

"If these regs are successful in preventing more inversions, it will close the floodgates," Gardner said. "It's a lot easier to say that than to say how much water would have been lost."

But the inversion itself is a concern secondary to the effect of earnings stripping, Gardner said.

Elliott Dubin of the Multistate Tax Commission echoed that point, saying that however any specific inversion might play out, earnings stripping is going to cut into state revenues.

"Now they're paying the rents, royalties, and whatever for the use of trademarks and patents -- probably to a Panama shell company or something," Dubin said. "That's the kind of activity that has an adverse effect on the states."

In that area, he said, Treasury's new regulations are likely to have a much greater impact on the states, which are less equipped to deal with these issues and generally rely on federal income calculations to make their own assessments.

States May Take New Rules Further

Beyond the simple knock-on effects of reduced federal income, the regulations are also raising more complicated tax planning questions, according to Eric Tresh of Sutherland Asbill & Brennan LLP.

He said that clients are already asking questions about how revenue departments might apply the new rules to less exotic transactions.

"There is a real question as to whether the proposed regulations under IRC section 385 will have implications for state and local taxes," Tresh said. "What our firm has spent some time on is thinking through what those implications will be for corporate taxpayers . . . whether those ramifications are intended or unintended."

Besides relying on the IRC to calculate income, he said, most states also treat IRS regulations as at least persuasive authority. While the new regulations may be targeted at a different kind of transaction, the parallels may be strong enough that states would be tempted to apply them to purely domestic transactions.

"If I have internal debt from, say, a parent to a subsidiary," he asked, "is that internal debt subject to the same requirements as it would be if this was a transaction under 385 between a U.S. corporation and a related company overseas?"

Although he doubted that any states are already giving these types of questions a hard look, he recommended that taxpayers begin thinking about whether any presumptions built into the new regulations might be applied to intercompany debt within a consolidated group.

"There certainly would be a lot of good reasons why the regulations would not apply or should not apply," Tresh said. "But that's a very big question that the state tax authorities are now going to have to wrestle with and corporate taxpayers are now going to have to consider."

Such an interpretation would be less likely in some states than others -- depending, for instance, on how heavily a state relies on IRS guidance -- but it could have serious implications for taxpayers in any state that adopted it, Tresh said.

More variables will come into play based on the specific features of a state's existing corporate income tax regime, said Dubin.

Provisions addressing combined reporting, transfer pricing, and tax havens will be key, Dubin said, but there will also be differences attributable to the employment profiles of different states, some of which are more reliant on the tech sector and pharmaceutical industry, which seem to be more interested in inverting.

And even then, much of the state-level impact of an inversion would depend on the specifics of the case, Dubin said.

"If they start really moving their operations, assets, and so forth out of the United States, obviously that reduces the tax base available for the states," Dubin said.

But if it's a "true inversion" of the sort that has prompted so much controversy, in which the most important changes are only on paper, he said, not much would change in most states, which allow taxes to be paid on a water's-edge basis.

"In the short run, really nothing happens to them. Just because you're now a 'foreign' company, you're still getting taxed at the U.S. rate," Dubin said.

Gardner agreed, noting that even for a deal as big as the now-scuttled Pfizer-Allergan merger, which was projected to save the company about $1 billion in U.S. taxes annually, the impact would not be too great for most individual states, as their corporate tax rates are on average only about a sixth of the federal rate and account for a smaller share of their budgets.

Divide that amount among the 50 states and the District of Columbia, and the average revenue loss is little more than $3 million -- an amount that many might not notice short of a Kansas-style budget crisis.

Some States Taking Unilateral Action

But that's not to say that the states haven't already begun thinking about how to react to the inversion phenomenon.

In Michigan, for instance, a lawmaker introduced a bill (HB 5920 ) in 2014 that would have imposed a ban on awarding incentives from the Michigan strategic fund to inverted companies for 10 years after their inversion. (Prior coverage .)

New Jersey lawmakers took a similar approach and recently considered bills that would have imposed various penalties on inverted companies. S 1324 would prohibit state pension funds from investing in inverted corporations, but it has not yet had a hearing.

And S 1513 would prohibit the state from awarding contracts or development subsidies to any corporation that had inverted. That proposal passed the Assembly in a previous session but never had a vote in the Senate. (Prior coverage .)

Virginia, meanwhile, was considering the opposite approach: enticing inverted companies to return by offering incentives for capital investments in the state. (Prior coverage .)

That bill (SB 1447 ) also passed its chamber of origin but never made it to the governor.

Although the approaches may differ, they all reflect the conventional wisdom that inversions are a serious problem that needs to be combated.

But Dubin said it still isn't entirely clear whether that would prove true in the long run.

Opponents of legislative and regulatory efforts to address inversions often note that companies with lower taxes have more money with which to create jobs. Dubin suggested that many inversions would be more likely to yield payouts to shareholders or executives instead, but he said those might still inure to the state's benefit.

"If they start giving dividends to shareholders, well that could increase the personal income tax, because in other words, some of their people would be getting dividends from this new company," he said. "While it may decrease their corporate income tax base . . . it may actually increase the individual income tax."