[IMGCAP(1)]There once was a time, after the Tax Reform Act of 1986, when the U.S. corporate tax rate was at the low end of corporate tax rates among industrialized economies.

While the U.S. rate went up a bit from 34 percent to 35 percent, other rates around the world decreased, with the result that the U.S. now has one of the highest rates of any industrialized country in the world. That, coupled with the fact that the U.S. taxes earnings on a worldwide basis, while most of the major developed nations tax earnings only in the country in which they are earned, places U.S. companies at a major competitive disadvantage compared to their foreign counterparts. And it’s this competitive disadvantage that spurs corporate inversions.

A corporate inversion allows firms to reduce their level of worldwide taxation. The company that inverts continues to pay the U.S. corporate rate on profits earned through U.S. operations, and foreign profits brought back to the U.S. will get taxed by the U.S. However, the tax on profits earned abroad escape being taxed by the U.S.

One advantage of inversions is the ability to use earnings stripping, in which a company makes an inter-company loan from the foreign company to the U.S. entity and the U.S. entity has debt payments that are deductible and reduce U.S. taxable income.

The U.S. has responded by issuing a series of notices and rules designed to make inversions more difficult. On April 4, the Treasury issued proposed regulations targeting inversions and earnings stripping under Code section 385.

“These are the broadest and the most profound regulations that the IRS has promulgated since the check-the-box regulations,” said Brian Kittle, co-leader of Mayer Brown’s Tax Controversy & Transfer Pricing practice.

Kittle attended a hearing on the proposed regs in mid-July along with Lewis Greenwald, a partner at Mayer Brown who focuses on providing international tax planning for multinational clients. Greenwald testified at the hearing on behalf of the National Foreign Trade Council.

“There is no doubt these changes will impact how companies operate inside the United States as well as around the world,” he said. “This is the biggest change in my career since the Tax Reform Act of 1986.”

“The government is trying to put restrictions on the deductibility of interest,” said Greenwald. “They’re taking the debt instrument, and under certain conditions they’re restricting the deductibility of interest by recharacterizing the debt as equity through section 385. It casts a much wider net than is needed.”

“The breadth of the proposed regs under section 385 is much broader than anyone in the tax community expected,” agreed Kittle. “As a result, the IRS received substantial comments from the taxpaying community pointing out serious issues with respect to the regs, particularly transactions that would be inadvertently included.”

“There were two main themes to the comments,” said Greenwald. “First, the Treasury should withdraw the regs and rewrite and reissue them in proposed form for additional notice and comment. Second, if they’re not willing to do that, they should go back and add in a multitude of exceptions that were identified in the comment letters. Of course, the problem with the second option is that it would make the law much more complex to administer.”

“Intercompany debt is often used by corporations simply to deploy resources to various business operations,” Kittle observed. “Given the breadth of these regs, their adoption will inadvertently catch many ordinary business transactions.”

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