The University of Chicago Law School 66th Annual Federal Tax Conference Corporate Inversions Chicago, Illinois November 8, 2013

Panel ►

Session Chair: Hal Hicks, Skadden, Arps, Slate, Meagher & Flom LLP

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Presenting this Topic: Steven M. Surdell, Ernst & Young LLP

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Commenting on this Presentation: Lewis R. Steinberg, Credit Suisse (USA) LLC, John J. Merrick, Special Counsel to the Associate Chief Counsel (International), Internal Revenue Service

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Premise ►

Inversion (or Expatriation) Transactions are not going away. 

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The competition to acquire productive business assets around the world will continue. This competition will likely be waged primarily by large multinational corporations that are subject to various taxing jurisdictions and thus a myriad of international tax rules. Regardless of one’s broader view of the merits of different international tax regimes (e.g., whether you support “capital export neutrality” or “capital import neutrality”) the application of different international tax regimes to a single set of productive assets will affect the value of those assets in the hands of various bidders. This will force bidders to examine (particularly where the subject assets constitute an important pre-tax strategic opportunity) whether it makes economic sense to consider reincorporating in a jurisdiction whose international tax rules allow it to more efficiently hold (and thus bid on) the productive assets. Although this panel will not comment on the broader issues of the US international tax system cross border merger and acquisition transactions present an excellent prism through which to illustrate those issues. The observation above is supported by decisions taken in at least some of the recent cross border combination transactions.

Premise 

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The phenomenon of locally incorporated entities reincorporating in jurisdictions deemed more advantageous to a multinational corporation is not unique to the US. Consider the recent experience of the UK with its multinationals inverting and how the UK responded to those actions. Significantly, although the conventional wisdom is that new waves of inversions occurred because creative tax planning identified ways to circumvent earlier limitations, in reality the analysis is far more complex. In many circumstances outside economic and legal considerations (which were external to US international tax rules) helped to drive the new wave of inversions.

A Brief History of Inversion Transactions ►

Illustrative Transactions

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Response

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Tax Policy Implicated by Each Response

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1. Hook Stock Inversion (1982) – Illustrative Transaction McDermott International Initial Structure and Transaction

Description ►

McDermott International made an offer to exchange shares of its stock and cash for shares of McDermott Inc. held by the public.

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Prospectus stated “[t]he principal purpose of the reorganization is to enable the McDermott Group to retain, reinvest and redeploy earnings from operations outside the United States without subjecting such earnings to United States income tax. This will enable the McDermott Group to compete more effectively with foreign companies by taking advantage of additional opportunities for expansion which require long-term commitments, the redeployment of assets and the reinvestment of earnings.”

Public 1 McDermott

Int’l shares and cash

McDermott Inc. (US)

2

McDermott Group (US)

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McDermott International (Panama)

McDermott Inc. shares

1. Hook Stock Inversion (1982) – Illustrative Transaction McDermott International Resulting Structure and Response Response / Policy Implicated ►

Public

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McDermott International (Panama)

McDermott Group (US)

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Policy Implicated – Preservation of corporate level tax / prevention of corporation level bailout.

IRS contention that the shareholders engaged in a section 304 transaction. ►

Hook Stock

McDermott Inc. (US)

IRS contention that the transaction was a failed section 355 spin off because import of transaction was a McDermott Inc. redemption of its stock in exchange for McDermott International.

Policy Implicated – Preclusion of shareholder enrichment.

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Both arguments rejected by the courts in Rohinton K. Bhada, 89 TC 959 (1987), aff'd sub nom. Caamano v. CIR, 879 F2d 156 (5th Cir. 1989), and Bhada v. CIR, 892 F2d 39 (6th Cir. 1989).

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Enactment of section 1248(i) which would cause McDermott Inc. to incur the section 1248 amount associated with the McDermott International stock as a dividend. ►

Policy Implicated – Neither corporate bailout nor shareholder enrichment, but rather preservation of the “section 1248 amount” which was a condition to the 1962 acceptance of international deferral. Section 1248 recasts capitalizations into dividends but only from shareholder’s pro rata share of pre existing untaxed earnings.

2. Section 368(a)(2)(E) Inversion (1993) – Illustrative Transaction Helen of Troy Initial Structure and Transaction Description ►

Helen of Troy formed New Helen of Troy (Bermuda).

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New Helen of Troy (Bermuda) formed Helen of Troy MergerCo (US).

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Helen of Troy MergerCo merged with and into Helen of Troy (US) in a transaction intended to qualify as a reorganization under section 368(a)(2)(E). In the merger the shares of Helen of Troy MergerCo were converted into shares of stock of Helen of Troy (US) and the shares of Helen of Troy (US) held by the public were converted into shares of New Helen of Troy (Bermuda).

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Prospectus suggests that CFC assets would be sold to New Helen of Troy (Bermuda) for fair market value consideration in transaction that would not be taxable in the US.

Public Merger of Helen of Troy and Helen of Troy MergerCo

3

Helen of Troy (US)

1

Helen of Troy Group (US)

New Helen of Troy (Bermuda) 2

Helen of Troy CFCs

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Helen of Troy MergerCo (US)

2. Section 368(a)(2)(E) Inversion (1993) – Prototype Transaction Helen of Troy Resulting Structure and Response Response / Policy Implicated Public

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Notice 94-46. Make transaction taxable to shareholders if shareholders of US public have 50% or more of resulting corporations. Policy Implicated – Avoidance of US tax (seemingly subpart F, etc. but possibly future income that could be earned outside the US and that was never earned by a CFC). Political implications?

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New Helen of Troy (Bermuda)

Helen of Troy (US)

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Treas. Reg. §1.367(a)-3(c). Make transaction taxable to US shareholders unless: (i) shareholders of US public receive 50% or less of acquiring corporation; (ii) resulting non-US corporation has a 3 year active business and has no plan or intent to dispose of that business; (iii) transferee foreign corporation greater than or equal to the value of the US target; and (iv) GRA in 5% circumstances. ►

Helen of Troy Group (US)

Helen of Troy CFCs

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Policy Implicated – Preclude avoidance of US tax (presumably subpart F, etc.) similar to the policy of Notice 94-46 outlined above. Allow “real” third party transactions, but forestall non-third party inversions. Mechanic chosen to enforce the policy very different than section 1248(i) in McDermott. Section 1248(i) imposes a corporate level tax (which makes sense in light of the policy) while Treas. Reg. §1.367(a)-3(c) imposes a tax on shareholders. Does taxing the shareholders make sense when the policy concern involves the corporation avoiding tax?

3.

Third Party Transactions Undertaken After Treas. Reg. §1.367(a)3(c) – Illustrative Transaction Vodafone / AirTouch (PLR 199929039) Initial Structure and Transaction

Description

V Public

A Public

Vodafone (UK)

AirTouch (US)

1

AirTouch MergerCo (US)

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2

Merger

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Vodafone formed AirTouch MergerCo (US).

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AirTouch MergerCo merged with and into AirTouch US in a transaction intended to qualify as a reorganization under section 368(a)(2)(E). In the merger the shares of AirTouch MergerCo were converted in shares of AirTouch and shares of AirTouch were converted into shares of Vodafone and some cash. Total combined market cap $110 Billion (in 1999).

3. Third Party Transactions Undertaken After Treas. Reg. §1.367(a)-3(c) – Illustrative Transaction Vodafone / AirTouch (PLR 199929039) Response / Policy Implicated

Legacy V Public

PLR 199929039. Vodafone had traded at a higher market capitalization than AirTouch for all but 3 days of the six month period before announcement. However because Vodafone had agreed to pay a premium for AirTouch (in part because of bid competition) the market capitalization of AirTouch at the time of the merger closing date would in all likelihood exceed that of Vodafone.

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IRS exercised its discretion under Treas. Reg. §1.367(a)3(c)(9) to issue a PLR that the transaction was in substantial compliance with the active trade or business test.

Legacy A Public

Vodafone (UK)

AirTouch (US)

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Policy Implicated – Allow third party transactions to occur even if in a “merger of equals” (or a merger where the US corporation was actually larger) the parties chose a foreign jurisdiction as the resulting corporation.

4. Section 368(a)(2)(E) Inversions Redux (2001) – Illustrative Transaction Cooper Industries Initial Structure and Transaction Description

Public

Cooper Industries (US)

3

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Cooper formed Cooper (Bermuda).

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Cooper (Bermuda) formed Cooper MergerCo.

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Cooper MergerCo merged with and into Cooper (US) in a transaction intended to qualify as a reorganization under section 368(a)(2)(E). In the merger the shares of Cooper MergerCo were converted into shares of stock of Cooper (US) and the shares of Cooper (US) held by the public were converted into shares of Cooper (Bermuda). Intercompany leverage inserted as part of the transaction.

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Section 367(a) and Treas. Reg. §1.367(a)-3(c) “worked” to impose a shareholder level tax. Belief however was that due to large number of institutional shareholders the shareholder level tax did not act as a sufficient impediment to the transaction occurring. In other words external economic factors rendered the Treas. Reg. §1.367(a)-3(c) toll change ineffective in certain cases.

Merger of Cooper Industries and Cooper MergerCo

1

Cooper Group (US)

New Cooper (Bermuda) 2

Cooper CFCs

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Cooper MergerCo (US)

4. Section 368(a)(2)(E) Inversions Redux (2001) – Illustrative Transaction Cooper Industries Resulting Structure and Response Response / Policy Implicated Public

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Section 7874 enacted imposed two sets of rules ►

7874(a). If (i) foreign corporation acquires substantial all of US corporations assets, and (ii) resulting foreign entity does not have substantial business operations in the place of its reincorporation, and (iii) shareholders receive 60% or more (but less than 80%) of resulting foreign corporation by reason of holding US stock then certain attributes limited and excise tax imposed.

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7874(b). All of the above but shareholders receive 80% or more then resulting foreign corporation is a US corp (regardless of place of incorporation).

Cooper Industries (Bermuda) Intercompany debt Cooper Industries (US)

Cooper Group (US)

Cooper CFCs (US)

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Policy Implicated – Concern that corporations continue to conduct business in the same manner as before the inversion but with the result that the inverted entity avoids US tax on foreign operations.

5. Section 368(a)(2)(E) Inversions Redux 2.0 (2009-2011) – Illustrative Transaction Ensco International Initial Structure and Transaction Description

Public

Ensco International (US)

3

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Transactional structure similar to other section 368(a)(2)(E) transactions.

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In response to major FTSE members migrating to Ireland (e.g., WPP PLC, Shirer Pharmaceuticals) UK announced it would move to a modified territorial system.

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UK change caused the following four things to occur: (i) WPP to return (see comments of Sir Martin Sorrell regarding reasons for leaving and why WPP would consider a return to UK); (ii) reportedly other UK multinationals to refrain from leaving; and (iii) caused US corporations like Ensco to consider expatriating to the UK.

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Ensco is a provider of offshore drill rigs for oil companies that have rights to the underlying hydrocarbons. It had provided drill rigs in the UK portion of the North Sea for well over 20 years. It had significant assets, operations, cash flows, employees in the UK. Ensco believe (correctly) that it met the then applicable substantial business activity test of section 7874(a)(2)(B)(iii).

Merger of Ensc International and Esco MergerCo

1

Ensco Group (US)

New Ensco (Bermuda) 2

Ensco CFCs

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Ensco MergerCo (US)

5. Section 368(a)(2)(E) Inversions Redux 2.0 (2009-2011) – Illustrative Transaction Ensco International Initial Structure and Transaction ►

Speaking at the CEO Summit, organized by The Times, [Chancellor of the Exchequer George] Osborne singled out WPP as an example of a UK business that had moved the location of its headquarters from London to Dublin due to stringent tax laws, which mean UK companies are charged corporate taxes for all overseas interests.

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Almost 90% of WPP Group revenue is earned outside the UK.

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Osborne said: "I want to reform the corporate tax system so that international companies locate in Britain rather than leave Britain.“

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In April, Sir Martin Sorrell stated that he would be open to returning WPP's interests to the UK if a new government changed the overseas tax law.

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And following the Chancellor's comments, Sorrell said he was, "delighted to hear the Chancellor’s comment" and to hear the Chancellor and the prime minister "stress that Britain must be open for business.“

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The move reduced the network's effective tax rate from 31.2% in 2008 to 23.5% in 2009.

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[Sir Martin Sorrell] "We made the move because it makes the tax planning process much easier. You don't have to deal with the British Treasury trying to tax any of your foreign profits."

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5. Section 368(a)(2)(E) Inversions Redux 2.0 (2009-2011) – Illustrative Transaction Ensco International Initial Structure and Transaction Response / Policy Implicated Public

Ensco International (UK)

Ensco International (US)

Ensco Group (US)

Ensco CFCs (US)

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Revise substantial business activity rules within Treas. Reg. §1.7874-3T.

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2006 temporary regulations contained a facts and circumstances test and 10% safe harbor (10% of assets, sales and employees).

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2009 draft of temporary regulations removed 10% safe harbor and retained facts and circumstances test.

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2012 draft of temporary regulations removed facts and circumstances test and established a 25% floor. ►

Policy Implicated – 10% was too low so 25% was required? How many companies could possibly meet the 25% test? TD 9592 states “[t]he IRS and the Treasury Department believe the facts and circumstances test of the 2009 temporary regulations should be replaced with a bright-line rule describing [the requisite activity needed to meet the substantial business activity test]. The IRS and the Treasury Department believe that such a rule will provide more certainty in applying section 7874 to particular transactions than the 2009 temporary regulations and will improve the administrability of this provision.”

6. Third Party Acquisition Inversion (2011-?) – Illustrative Transaction Biovail-Valeant Initial Structure

Description

B Public

BVF (Canada)

Foreign Subs

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Biovail (BVF), a Canadian corporation, and Valeant Pharmaceuticals Int’l (VRX), a US corporation, entered into a series of transactions in an effort to effect a merger that would achieve numerous US and foreign tax benefits

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Prior to these transactions, the equity value of BVF was approximately $2.5B and the equity value of VRX was approximately $3.7B

V Public

VRX (US)

BAC (US)

US Subs

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Foreign Subs

US Subs

6. Third Party Acquisition Inversion (2011-?) – Illustrative Transaction Biovail-Valeant Transaction Overview Transaction Steps BVF (Canada)

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VRX obtains a $3B loan from Lenders (the “VRX Debt”).

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VRX distributes $1.3B cash to VRX shareholders. This shrinks the value of VRX from $3.7B to $2.4B (thus making its market cap less than that of BVF).

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Newly formed Merger Sub merges into VRX with VRX surviving the merger. Each VRX share is converted into 1.78 shares of BVF stock.

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BVF guarantees the VRX Debt.

(3b) BVF Stock

BAC (US)

VRX S/hs

(2) $1.3B Distribution

Merger Sub

(3a) Merger

(4) Guarantee

(1) $3B Loan

Lenders

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VRX (US)

6. Third Party Acquisition Inversion (2011-?) – Illustrative Transaction Biovail-Valeant Resulting Structure BVF S/hs

VRX S/hs

~50.5%

~49.5%

BVF (Canada)

BVF historic ops

BAC (US)

VRX (US)

$3B Loan

Lenders

Sources of Deal Consideration (Per Share)

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Value

%

Cash

$16.77

53.5%

Shares

$14.60

46.5%

Total

$31.37

100%

Intended US Tax Treatment ►

Pre- distribution intended to be treated as a Section 301 distribution, not Section 356 “boot” (See Reg. §1.368-1(e)(7), ex. 9).

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Merger intended to qualify as a B Reorganization (Rev. Rul. 74-565).

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VRX shareholders avoid Treas. Reg. §1.368(a)-3(c) shareholder level tax.

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Retention and utilization of BVF’s existing corporate tax structure, which is highly advantageous.

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Insertion of debt in the US.

Biovail-Valeant Inversion Select Key US Tax Issues ►

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Independence of the special distribution from the share-for-share exchange ►

Qualification of the transaction as a B Reorganization

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Relevant to the Section 301 versus Section 356 treatment of the cash received by VRX’s shareholders via the pre-merger distribution?

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Should the BVF guarantee affect the analysis? If so, how?

Establishing the value of VRX on the closing date ►

For the share exchange to remain tax-free, Section 367 requires that the FMV of BVF’s equity equal or exceed the FMV of VRX’s equity at closing

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How do you establish value in the case of a pure share-for-share exchange – fixed exchange ratio?

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Treatment of prior acquisitions by BVF in the 36-month pre-closing period?

Comparison of anti-inversion rules Section 7874

Reg. §1.367(a)-3(c)

Consequence if applicable

BVF will be taxed as a US corporation if 80% owned by former VRX shareholders. Alternatively, if former VRX shareholders own between 60% and 80% of BVF, certain limitations apply to the use of VRX’s attributes to offset “inversion gain”.

Gain or loss recognized by US shareholders of VRX. All shareholders of VRX are presumed to be US persons (subject to rebuttal).

Rule applies if:

(i) BVF acquires substantially all the assets of VRX (the “Acquisition Test”);

(i) More than 50% (by vote or value) of the stock of BVF is received in the transfer by US transferors (presumed to be all VRX shareholders);

(ii) More than 60% (or 80%) of the BVF stock (by vote OR value) is held by the former shareholders of VRX (not just US shareholders) (the “Ownership Test”); AND (iii) BVF does not have substantial business activities in its country of incorporation compared to the activities of the “expanded affiliated group” (EAG) (the “Substantial Business Activities Test”)

(ii) More than 50% (by vote and value) of the stock of the BVF is owned immediately after the transfer by US persons that are either officers or directors of VRX or that are 5% VRX shareholders; OR (iii) BVF fails the active trade or business test. (Also a GRA requirement for 5% shareholders of VRX).

Internal group restructurings

Reg. §1.7874-1(c) provides an “internal group restructuring” exception to the ownership test in which stock held by members of the EAG is included in the denominator for purposes of the Ownership Test Effectively permits certain internal restructurings to avoid application of §7874.

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Section 367(a) applies to internal restructuring transactions without any special exceptions for internal transactions.

Internal transactions remain subject to all of the rules of §367(a) and must satisfy the usual exceptions to qualify for nonrecognition treatment.

Comparison of anti-inversion rules Section 7874

Reg. §1.367(a)-3(c)

Business test

Based on facts and circumstances, including: (1) conduct of continued business activities in Canada by the EAG; (2) amount of (i) EAG property located in Canada , (ii) services performed by employees of the EAG in Canada and (iii) sales by EAG members to customers in Canada ; (3) performance of substantial managerial activities by EAG members, officers and employees based in Canada ; (4) substantial degree of ownership of the EAG by investors resident in Canada ; (5) existence of business activities in Canada that are material to the achievement of the EAG’s overall business objectives. • Business must be performed in BVF’s country of incorporation

(1) BVF or its “qualified subsidiaries” (80%-owned subsidiaries not affiliated with VRX before the transaction and not acquired with the principal purpose of satisfying the active trade or business test) must engage in the active conduct of a trade or business outside the US for the entire 36-month period immediately before the transaction; (2) at the time of the transaction, there can be no intention to substantially dispose of or discontinue such trade or business; and (3) the entire value of BVF (including BVF) must be at least equal to the entire value of VRX. • Active business may be performed outside BVF’s country of incorporation

Effect of acquisition of BVF

-- Might be able to take into account business activities of BVF and its subs to satisfy the Substantial Business Activities Test, if necessary (but only if BVF and subs are organized in same jurisdiction as BVF).

-- Activities of BVF may be relied on to satisfy the active business test.

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-- Cannot rely on business of its CFCs in this case.

Comparison of anti-inversion rules Application of rule

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Section 7874

Reg. §1.367(a)-3(c)

Taxpayers must “fail” one (but not all) of the requirements (the Acquisition Test, the Ownership Test or the Substantial Business Activities Test) to avoid the application of §7874.

Taxpayers must meet all of the enumerated requirements in order to qualify for nonrecognition treatment.

Policy Issues ►

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How do the recent inversion transactions (involving cross border combinations) differ from historic inversion transactions? What underlying international tax policies were furthered by the responses to the various historic inversion transactions? When reviewed collectively did the responses to the various historic inversion transactions constitute a cohesive set of policies? Given the differences between the various historic inversion transactions and the recent cross border combination transactions what international tax policy implications (if any) are raised by the latter transactions? Given that many of the cross border acquisition provisions were enacted or promulgated in response to transactions that occurred in arguably very different economic circumstances is it time to rethink the applicability of all of those provisions? If we are rethinking these issues should broader macroeconomic issues inform the international tax policy analysis of cross border transactions in general?   

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Should we encourage/discourage US multinationals to be the acquirers in these transactions? Should we encourage/discourage non-US multinationals from being the acquirers in these transactions? Should this examination include the consideration of other international tax policy/economic issues such as locations of headquarters, encouragement of employment in particular jurisdictions, etc.