Statement of Pamela F. Olson, Acting Assistant Secretary
for Tax Policy,
U.S. Department of the Treasury
Testimony Before the House Committee on Ways and Means
Hearing on Corporate Inversions
June 6, 2002
Mr. Chairman, Congressman Rangel, and distinguished Members of the Committee, we appreciate the opportunity to appear today at this hearing on corporate inversion transactions.
In recent months, several high-profile U.S. companies have announced plans to reincorporate outside the United States. The documents prepared for shareholder approval and filed with the Securities and Exchange Commission cite substantial reductions in overall corporate taxes as a key reason for the transactions. While these so-called corporate inversion transactions are not new, there has been a marked increase recently in the frequency, size, and profile of the transactions.
On February 28, 2002, the Treasury Department announced that it was studying the issues arising in connection with these corporate inversion transactions and the implications of these transactions for the U.S. tax system and the U.S. economy. On May 17, 2002, the Treasury Department released its preliminary report on the tax policy implications of corporate inversion transactions. (A copy of the Treasury preliminary report is attached.) The Treasury preliminary report describes the mechanics of the transactions, the current tax treatment of the transactions, the current tax treatment of the companies post-inversion, the features of our tax laws that facilitate the transactions or that may be exploited through such transactions, and the features of our tax laws that drive companies to consider these transactions.
Inversion transactions implicate fundamental issues of tax policy. The U.S. tax system can operate to provide a cost advantage to foreign-based multinational companies over U.S.-based multinational companies. The Treasury report identifies two distinct classes of tax reduction that are available to foreign-based companies and that can be achieved through an inversion transaction. First, an inversion transaction may be used by a U.S.-based company to achieve a reduction in the U.S. corporate-level tax on income from U.S. operations. In addition, through an inversion transaction, a U.S.-based multinational group can substantially reduce or eliminate the U.S. corporate-level tax on income from its foreign operations.
The Treasury preliminary report discusses the need for an immediate response to address the U.S. tax advantages that arise from the ability to reduce U.S. corporate-level tax on income from U.S. operations. My testimony today will focus on several specific actions that we believe are urgently needed to eliminate these opportunities to reduce inappropriately the U.S. tax on U.S. operations and thereby to ensure continued confidence in the U.S. tax system. We believe that addressing these opportunities will have an immediate effect on the corporate inversion activity that is now occurring by eliminating the substantial upfront tax reductions that can be achieved through these transactions. This approach also addresses the similar tax reduction opportunities that are available to companies that form offshore from the outset and to foreign companies that acquire U.S. businesses, and therefore avoids advantaging companies that begin as non-U.S. companies over those that begin here in the United States.
The Treasury preliminary report also discusses the need to address the U.S. tax disadvantages that are caused for U.S.-based companies because of the U.S. tax treatment of their foreign operations. We must evaluate our tax system, particularly our international tax rules, relative to those of our major trading partners, to ensure that the U.S. tax system is competitive.
An inversion is a transaction through which the corporate structure of a U.S.-based multinational group is altered so that a new foreign corporation, typically located in a low- or no-tax country, replaces the existing U.S. parent corporation as the parent of the corporate group. In order to provide context for consideration of the policy issues that arise, the Treasury preliminary report includes a technical description of the forms of the inversion transaction and the potential tax treatment of the various elements of the transaction under current law. The transactional forms through which the basic reincorporation outside the United States can be accomplished vary as a technical matter, but all involve little or no immediate operational change and all are transactions in which either the shareholders of the company or the company itself are subject to tax. This reincorporation step may be accompanied by other restructuring steps designed to shift the ownership of the group’s foreign operations outside the United States. The restructuring steps involving movement of foreign subsidiaries are complex and varied, but, like the reincorporation itself, are transactions that are subject to tax. When all the transactions are complete, the foreign operations of the company will be outside of the U.S. taxing jurisdiction and the corporate structure also may provide opportunities to reduce the U.S. tax on U.S. operations.
Market conditions have been a factor in the recent increase in inversion activity. Although the reincorporation step triggers potential tax at the shareholder level or the corporate level, depending on the transactional form, that tax liability may be less significant because of current economic and market factors. The company’s shareholders may have little or no gain inherent in their stock and the company may have net operating losses that reduce any gain at the company level. While these market conditions may help facilitate the transactions, they are not, however, what motivates a company to undertake an inversion. U.S.-based companies and their shareholders are making the decision to reincorporate outside the United States largely because of the tax savings available. It is that underlying motivation that we must address.
The ability to achieve a substantial reduction in taxes through a transaction that is complicated technically but virtually transparent operationally is a cause for concern as a policy matter. As we formulate a response, however, we must not lose sight of the fact that an inversion is not the only route to accomplishing the same type of reduction in taxes. A U.S.-based start-up venture that contemplates both U.S. and foreign operations may incorporate overseas at the outset. An existing U.S. group may be the subject of a takeover, either friendly or hostile, by a foreign-based company. In either case, the structure that results provides tax-savings opportunities similar to those provided by an inversion transaction. A narrow policy response to the inversion phenomenon may inadvertently result in a tax code favoring the acquisition of U.S. operations by foreign corporations and the expansion of foreign controlled operations in the United States at the expense of domestically managed corporations. In turn, other decisions affecting the location of new investment, choice of suppliers, and employment opportunities may be adversely affected. While the openness of the U.S. economy has always made -- and will continue to make -- the United States one of the most attractive and hospitable locations for foreign investment in the world, there is no merit in policies biased against domestic control and domestic management of U.S. operations.
The policy response to the recent corporate inversion activity should be broad enough to address the underlying differences in the U.S. tax treatment of U.S.-based companies and foreign-based companies, without regard to how foreign-based status is achieved. Measures designed simply to halt inversion activity may address these transactions in the short run, but there is a serious risk that measures targeted too narrowly would have the unintended effect of encouraging a shift to other forms of transactions and structures to the detriment of the U.S. economy in the long run.
An immediate response is needed to address the U.S. tax advantages that are available to foreign-based companies through the ability to reduce the U.S. corporate-level tax on income from U.S. operations. Inappropriate shifting of income from the U.S. companies in the corporate group to the foreign parent or its foreign subsidiaries represents an erosion of the U.S. corporate tax base. It provides a competitive advantage to companies that have undergone an inversion or otherwise operate in a foreign-based group. It creates a corresponding disadvantage for their U.S. competitors that operate in a U.S.-based group. Moreover, exploitation of inappropriate income-shifting opportunities erodes confidence in the fairness of the tax system.
In the case of inversion transactions, the ability to reduce overall taxes on U.S. operations through these income-shifting techniques provides an immediate and quantifiable benefit. Because of the cost and complexity of these transactions, the immediate and quantifiable benefit from reducing U.S. tax on U.S. operations is a key component of the cost-benefit analysis with respect to the transaction. In other words, the decision to consummate the inversion often is dependent upon the immediate expected reduction in U.S. tax on income from U.S. operations. Accordingly, eliminating the opportunities to reduce inappropriately the U.S. tax on income from U.S. operations will eliminate the upfront tax reductions that are fueling the inversion transaction activity.
We believe there are several specific areas in which changes are urgently needed. The statutory rules regarding the deductibility of interest payments to related parties must be tightened to prevent the inappropriate use of related-party debt to generate deductions against income from U.S. operations that otherwise would be subject to U.S. tax. We must undertake a comprehensive review of the rules governing the transfer of assets among related parties and establish a revitalized compliance program to ensure adherence with the arm’s-length standard for related party transfers. We must undertake a comprehensive review of our income tax treaties and make the modifications to particular treaties necessary to ensure that they do not provide inappropriate opportunities to reduce U.S. taxes. We must promulgate reporting requirements to provide the IRS with information to ensure that shareholders are paying the tax owed on the gain recognized in an inversion transaction. We also are working on other areas where further study is needed.
In addition, we must continue to work to address the U.S. tax disadvantages faced by U.S.-based companies that do business abroad relative to their counterparts in our major trading partners. We look forward to working closely with the Committee on this important issue.
Interest on Related Party Debt. One of the simplest ways for a foreign-based company to reduce the U.S. tax on income from U.S. operations is through deductions for interest payments on intercompany debt. The U.S. subsidiary can be loaded up with a disproportionate amount of debt for purposes of generating interest deductions through the mere issuance of an intercompany note, without any real movement of assets or change in business operations. Interest paid by a U.S. subsidiary to its foreign parent or a foreign affiliate thereof gives rise to a U.S. tax deduction but the interest income may be subject to little or no tax in the home country of the foreign related party recipient. It is important to recognize that a U.S.-based company could not achieve such a result. Indeed, the rules governing the allocation of interest expense to which U.S.-based companies are subject can operate effectively to deny a U.S. company deductions for interest expense incurred in the United States and paid to an unrelated third party.
The potential to use foreign related-party debt to generate deductions that reduce taxable income in the United States is not unique to inversion transactions, and concern about this technique is not new. Section 163(j) of the Internal Revenue Code was enacted in 1989 to address these concerns by denying U.S. tax deductions for certain interest expense paid by a corporation to a related party. Section 163(j) as it currently exists applies only where (1) the corporation’s debt-equity ratio exceeds 1.5 to 1, and (2) its net interest expense exceeds 50 percent of its adjusted taxable income (computed by adding back net interest expense, depreciation, amortization and depletion, and any net operating loss deduction). If the corporation exceeds these thresholds, no deduction is allowed for interest in excess of the 50-percent limit that is paid to a related party and that is not subject to U.S. tax. Any interest that is disallowed in a given year is carried forward indefinitely and may be deductible in a subsequent taxable year. Section 163(j) also provides a four-year carryforward for any excess limitation (i.e., the amount by which interest expense for a given year falls short of the 50 percent of adjusted tax income threshold).
A revision of these rules is needed immediately to eliminate what is referred to as the real “juice” in an inversion transaction. The prevalent and increasing use of foreign related-party debt in inversion transactions demonstrates the importance to these transactions of the tax reductions achieved through interest deductions and the need to act now to eliminate this benefit. Accordingly, we propose statutory changes to tighten the interest disallowance rules of section 163(j) in several respects. Moreover, the opportunities for generating interest deductions that reduce U.S. taxable income are not limited to inversion transactions. These U.S. taxable income minimization strategies, which are not available to U.S.-based companies, are possible as well in cases where a U.S. business is structured from the outset with a foreign parent and in cases where a foreign corporation acquires a U.S. operating group. Therefore, we believe these revisions to section 163(j) should not be limited to companies that have inverted but should apply across the board. There is no reason to allow companies to reduce income that would otherwise be subject to U.S. tax through deductions generated simply by putting in place debt owed to related parties.
The fixed debt-equity test of current law effectively operates as a safe harbor for corporations with debt-equity ratios of 1.5 to 1 or lower. We propose replacing the safe harbor protection currently available under the fixed 1.5 to 1 debt-equity test with a test that would deny a deduction for related party interest to the extent that the corporate group’s level of indebtedness in the United States exceeds its worldwide level of indebtedness. This worldwide test would compare (i) the ratio of indebtedness incurred by the U.S. members of the corporate group to their assets, with (ii) the ratio of the entire corporate group’s worldwide indebtedness (excluding related party debt) to its worldwide assets. Interest that is paid to related parties and that is not subject to U.S. tax would be denied deductibility to the extent it is attributable to indebtedness in excess of the worldwide ratio.
With this approach, the 50-percent of adjusted taxable income test would operate as a second, alternative test applicable in cases where the U.S. debt-to-assets ratio does not exceed the worldwide ratio. We propose modifying the 50-percent test by revising the definition of adjusted taxable income to eliminate the addback of depreciation, amortization and depletion. This would have the effect of appropriately focusing the test on net interest expense as a percentage of income rather than cash flow.
We also propose curtailing the carry over rules applicable under section 163(j). Although the current carryforwards appropriately provide relief to those taxpayers whose interest-to-income ratio may be subject to unanticipated fluctuations due to business fluctuations, an indefinite carryforward has the effect of dampening the impact of the deduction denial. This consequence is further exacerbated by the ability under current law to carry forward excess limitation to shelter additional interest deductions in future years. Accordingly, we propose eliminating the carryforward of excess limitation and limiting the carryforward period for disallowed deductions to 5 years.
Income Shifting and Transfers of Intangibles. Another way for a foreign-based company to reduce the U.S. tax on income from U.S. operations is through related-party transactions for other than arm’s length consideration. Many inversion transactions involve the movement of foreign subsidiaries out of the U.S. group so that they are held directly by the new foreign parent. Some inversion transactions involve transfers of intangible or other assets, or business opportunities, to the new foreign parent or its foreign subsidiaries. This type of movement of foreign subsidiaries, assets, and opportunities is not unique to inversion transactions. The same sort of restructuring transactions are common whenever a multinational group is acquired or makes an acquisition. Cross-border transfers of subsidiaries and assets can give rise to significant valuation issues, and the ongoing transactions between the various entities can give rise to significant income allocation issues.
The outbound transfer of subsidiaries and assets to a related person in a taxable transaction is subject to the transfer pricing rules of section 482 and the regulations thereunder, which provide that the standard to be applied is that of unrelated persons dealing at arm’s length. In the case of transfers of intangible assets, section 482 further provides that the income with respect to the transaction must be commensurate with the income attributable to the intangible assets transferred. The magnitude of the potential tax savings at stake in substantial outbound transfers of assets, especially intangible assets, puts significant pressure on the enforcement and application of the arm’s length and commensurate with income standards. Where the arm’s length standard is not properly applied or enforced, the inappropriate income shifting that results can significantly erode the U.S. tax base.
Treasury will undertake a comprehensive study focusing on the tools needed to ensure that cross-border transfers and other related party transactions, particularly transfers of intangible assets, cannot be used to shift income out of the United States. This will include a review and appropriate revisions of the contemporaneous documentation and penalty rules and of the substantive rules relating to transfers of intangible property and services and cost sharing arrangements. It also will include an administrative compliance initiative. While there is much that can and will be accomplished in this area through regulatory guidance and enhanced enforcement efforts, Treasury will report to the Congress on any need for statutory changes or additions.
Treasury and the IRS will undertake an initiative to review current practices related to the examination of transfer pricing issues and the imposition of transfer pricing penalties, with a particular emphasis on transactions in which intangibles are transferred. The volume and complexity of cross-border related party transactions have grown significantly in recent years, and a number of U.S. trading partners have undertaken broad compliance initiatives relative to transfer pricing. The purposes of this comprehensive review will include ensuring that contemporaneous documentation from taxpayers is utilized effectively by the IRS and that transfer pricing penalties are imposed where warranted on a fair and consistent basis. This focused review also will help identify potential improvements to existing rules, including the provisions regarding penalties, reporting, and documentation, that would enhance transfer pricing compliance.
We will revise the current section 482 cost sharing regulations with a view to ensuring that cost-sharing arrangements cannot be used to facilitate a disguised transfer of intangible assets outside the United States in a manner inconsistent with the arm’s length standard, as reinforced by the commensurate with income standard. The purpose of the cost sharing regulations is to facilitate the allocation among related taxpayers of future income attributable to future intangible property in a manner that reasonably reflects the actual economic activity undertaken by each related taxpayer to develop that property. This work will focus initially on the effectiveness of the current rules intended to apply the arm’s length standard to taxpayers that contribute to the cost sharing arrangement the right to use existing intangible property, such as know-how or core technology, which often constitutes the most important and valuable input into the development of future intangible property.
We also will review the section 482 regulations applicable to transfers of intangible assets to ensure they do not operate to facilitate the transfer of intangible property outside the United States for less than arm’s length consideration. These regulations relating to the transfer of intangible assets implement the arm’s length and commensurate with income standards by allowing periodic adjustments to transfer prices in limited circumstances based on objective standards. While these objective standards have provided certainty and minimized disputes in this otherwise contentious area, focus is needed on ensuring the proper operation of the periodic adjustments provisions.
Finally, as part of an ongoing project to update the 482 regulations applicable to services, we will work to mitigate the extent to which the structuring or characterization of a transfer of intangible assets as the provision of services can lead to inappropriate transfer pricing results. The differences between the section 482 regulations relating to the provision of services and those relating to the transfer of intangible property could be exploited through the characterization of a transfer of intangible property as a provision of services. While a transfer of intangibles through a license in return for royalty payments and the provision of technical services utilizing the intangibles in return for a service fee, for example, may be similar from an economic perspective, the transfer pricing results may differ depending on whether the transfer pricing regulations related to services or intangible property are applicable. The transfer pricing rules should reach similar results in the case of economically similar transactions regardless of the characterization or structuring of such transactions.
Because the potential to use related party transactions to reduce the U.S. tax on income from U.S. operations is not unique to inversion transactions, our proposals in this area are not limited in scope to corporations that have inverted.
Income Tax Treaties. The United States imposes a withholding tax at a rate of 30 percent on payments of interest and royalties (as well as dividends) from a U.S. corporation to a foreign affiliate. This withholding tax may be reduced or eliminated in certain circumstances under an applicable income tax treaty. The cost advantage achieved by shifting income by means of deductible payments to foreign related parties is most effective when the payments are to a foreign related party that is eligible for benefits under a comprehensive U.S. income tax treaty and, in addition, is not subject to significant local tax on the income.
Most inversion transactions have involved a reincorporation into a foreign jurisdiction either that does not have a tax treaty with the United States or whose treaty with the United States does not generally reduce U.S. withholding tax rates. However, many of the newly created foreign parent corporations may be considered resident for treaty purposes in a country that has a comprehensive tax treaty with the United States and that does not subject certain payments received by its corporations to significant local income tax. Through such a structure, the cost advantage achieved by shifting income can be maximized. Similar results may be obtained through the use of finance subsidiaries located in certain treaty jurisdictions.
We must review and evaluate our tax treaties to identify any inappropriate reductions in U.S. withholding tax that provide opportunities for shifting income out of the United States. U.S. income tax treaties are intended to prevent the double taxation by the United States and its treaty partner of income earned by residents of one country from sources within the other. Thus, the United States does not enter into income tax treaties that lower the rates of U.S. withholding tax on U.S.-source income (e.g., U.S.-source interest and royalties) with jurisdictions that do not have a comprehensive income tax system. In such a case, there is no need to reduce the U.S. withholding tax because there is no risk of double taxation. We must make certain that the operation of our treaties is consistent with the expectation of the United States and its treaty partners that treaties should reduce or eliminate double taxation of income, not eliminate all taxation of income. If a current or prospective treaty partner does not tax a particular category of U.S.-source income earned by its residents, either because of a general tax exemption or a special tax regime, reduction of U.S. withholding tax on that category of income may not be appropriate.
We also must consider whether anti-abuse mechanisms already within our treaties are operating properly. Because U.S. tax treaties are intended to benefit only residents of either the United States or the treaty partner, U.S. income tax treaties include detailed limitation on benefits provisions, to prevent the misuse of treaties by residents of third countries. Those limitation on benefits provisions are important for ensuring that a resident of a third country cannot benefit inappropriately from a reduction in U.S. withholding tax by structuring a transaction, including a transaction designed to generate deductible payments, through a treaty country. One of Treasury's key tax policy goals in modernizing our network of existing tax treaties is to bring the limitations on benefits provisions in all our treaties up to current model standards so as to remove the opportunity for such misuse.
Reporting Requirements. In many inversion transactions the company’s shareholders are required to recognize gain. Current Treasury regulations generally require Form 1099 reporting to the IRS of the gross proceeds from any sale for cash effected by a broker in the ordinary course of its business. However, there are no similar reporting obligations in the case of an inversion where a shareholder exchanges stock of one corporation for stock in another corporation. We intend to establish a Form 1099 reporting requirement for stock transfers in inversions and other taxable reorganization transactions. Requiring reporting of these transactions will increase the IRS’s access to information about the transactions. It also will serve to remind shareholders of the tax consequences to them from the company’s transaction and of their obligation to report any gain.
Other Areas of Further Study. There are two other areas where we believe that further study is needed and we have begun careful consideration of these areas.
A comprehensive review of the corporate organization and reorganization rules is needed in light of the increasing pressure put on these rules through the larger and more complicated international restructuring transactions that are becoming commonplace. The corporate organization and reorganization rules, as well as the other related rules affecting corporations and their stock and option holders, were written largely for purely domestic transactions. Section 367, and the lengthy regulations there under, modify those rules for application in the case of cross-border transactions. With the increasing globalization of both U.S. companies and foreign companies, these rules are being applied more frequently and to larger and more complicated cross-border transactions. It is critical that the rules governing cross-border reorganizations keep up with these developments. The current cross-border reorganization rules are something of a patchwork, developed and revised over the last twenty years. One focus in this reconsideration of the current-law rules will be on achieving greater consistency in treatment across similar transactions, in order to avoid both traps for the unwary and opportunities for taxpayers to exploit the rules to reach results that are not intended. Moreover, clearer rules will help provide greater certainty to taxpayers and the government in this complex area.
A careful review also is needed of the income-shifting issues that arise in the context of the several inversion transactions that have involved insurance and reinsurance companies. The initial reincorporation outside the United States typically has been accompanied by a shift of some portion of the existing U.S. insurance business through reinsurance with a related foreign affiliate. An evaluation must be made as to whether the use of related party reinsurance permits inappropriate shifting of income from the U.S. members of a corporate group to the new foreign parent and its foreign affiliates, and whether existing mechanisms for dealing with such related party transactions are sufficient to address these opportunities. In this regard, further analysis is appropriate to consider and evaluate the approaches used by our trading partners in taxing insurance companies, including, for example, the use by some countries of a premium-based tax that captures within the country’s tax base all business written on risks within the country.
Finally, we must continue our work to address the U.S. tax disadvantages for U.S.-based companies that do business abroad relative to their counterparts in our major trading partners. The U.S. international tax rules can operate to impose a burden on U.S.-based companies with foreign operations that is disproportionate to the tax burden imposed by our trading partners on the foreign operations of their companies. The U.S. rules for the taxation of foreign-source income are unique in their breadth of reach and degree of complexity. Both the recent inversion activity and the increase in foreign acquisitions of U.S. multinationals are evidence that the competitive disadvantage caused by our international tax rules is a serious issue with significant consequences for U.S. businesses and the U.S. economy. A comprehensive reexamination of the U.S. international tax rules and the economic assumptions underlying them is needed. As we consider appropriate reformulation of these rules we should not underestimate the benefits to be gained from reducing the complexity of the current rules. Our system of international tax rules should not disadvantage U.S.-based companies competing in the global marketplace.
As we work to address these important issues, we must keep our focus on the overarching goal of maintaining the attractiveness of the United States as the most desirable location in the world for incorporation, headquartering, foreign investment, business operations, and employment opportunities, in order to achieve an ever higher standard of living for all Americans.
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