The dangerous anti-inversion debate

You'll probably have noticed that there's a highly-charged debate going on in Washington DC at the moment about tax inversion – a process whereby a company uses a cross-border merger as a pretext for reincorporating in a more tax-friendly jurisdiction (like Bermuda).

Just last week President Obama joined the fray, telling CNN that US companies emigrating overseas for tax purposes were being unpatriotic. Democrats in Congress have already introduced legislation intended to make inversions tougher.

But this is all more than just an interesting diversion for political enthusiasts within the industry. These proposals could make it especially difficult for private fund managers to legitimately build multinational businesses with a US presence.

Under current law, a US company can’t actually relocate its headquarters abroad for tax purposes simply by merging with a foreign company if the original US company shareholders end up owning at least 80 percent of the combined business. That stops US corporations from setting up shells in Bermuda – but it doesn't stop major US corporations being swallowed up by smaller foreign rivals in places like the UK and Ireland, where the corporate tax rate is much lower, to successfully invert their tax residency.

Inevitably, that’s exactly what’s been happening in the M&A markets in recent years – and it has eventually caught the attention of Congress. The new legislative proposals want the ownership threshold reduced to 50 percent, meaning US companies (which are taxed as high as 35 percent) can only be inverted for tax purposes by finding a foreign rival of equal size. Moreover, the proposals designate a multinational company as domestic for US tax purposes if the US accounts for at least 25 percent of its staff, employee compensation, assets or income.

How does this impact private funds? Well, the proposed 50 percent threshold means a private equity-backed US company (for example) can no longer merge with a foreign entity, in the hopes of inversion, without ceding control of the combined entity. That might not pose a problem in the public markets; but GPs will certainly not be keen on the idea of losing majority control of their portfolio companies.

The proposals also call for a merged entity to be treated as a US corporation for tax purposes if it conducts a certain amount of business in the US, and not enough in its place of incorporation. This, too, could create tax obstacles for GPs that rely on bolt-on acquisitions. Say a UK-based portfolio company achieves so much growth in the US that its total UK revenue or employee count dips below the relevant threshold; if it attempts to acquire a US company down the line, it may find itself treated as a US corporation for tax purposes.

Worse still, the US Internal Revenue Service has “pretty broad authority” to tax a multinational company as a US entity if it feels that the business is mostly being run in the US under a new “management and control” test, says Pepper Hamilton tax partner Steven Bortnick.

Given the Republicans in Congress, these proposals remain a long shot, for now. But it’s certainly not implausible that they become law as part of wider planned tax reform; with the midterm elections coming up in November, Republicans may cede the issue if it starts to drag on their polling numbers. At any rate, GPs should be aware that the growing political debate around inversions potentially represents a serious tax issue.