The Treasury Department and Internal Revenue Service have issued temporary and proposed regulations intended to limit the use of corporate tax inversions by limiting the benefits that make them appealing for companies.

A corporate inversion is a transaction in which a U.S.-based multinational company changes its tax residence to reduce or avoid paying U.S. taxes. For example, a U.S.-based entity will acquire a smaller foreign company and then locate the tax residence of the merged group in that low-tax country. Critics protest that the primary purpose of inversions is not to grow the underlying business or maximize synergies, but to reduce taxes, often substantially.

In September 2014 and November 2015, the Treasury Department announced guidance that made it more difficult for companies to undertake an inversion and reduced the economic benefits of doing so. On April 4, in a move that took many in corporate America by surprise, it took another swing at the practice with proposed regulations that, in part, address earnings stripping, a commonly used technique to minimize taxes after an inversion.

Multinational corporations often use earnings stripping to minimize U.S. taxes by paying deductible interest to their new foreign parent or one of its foreign affiliates in a low-tax country.

The new measures include limiting inversions by disregarding foreign parent stock attributable to recent inversions or acquisitions of U.S. companies. This will prevent a foreign company (including a recent inverter) that acquires multiple American companies in stock-based transactions from using the resulting increase in size to avoid the current inversion thresholds for a subsequent U.S. acquisition. 

Earnings stripping is addressed by targeting transactions that generate large interest deductions by increasing related-party debt without financing new investment in the U.S. Also, the IRS, during an audit, can divide debt instruments into part debt and part equity, rather than the current system that generally treats them as wholly one or the other.

Improved compliance is facilitated by requiring large corporations to do up-front due diligence and documentation with respect to the characterization of related-party financial instruments as debt. If these requirements are not met, instruments will be treated as equity for tax purposes.

 “Genuine cross-border mergers make the U.S. economy stronger by enabling U.S. companies to invest overseas and encouraging foreign investment to flow into the United States,” a statement issued by the Treasury Department says. “But these transactions should be driven by genuine business strategies and economic efficiencies, not a desire to shift the tax residence of a parent entity to a low-tax jurisdiction simply to avoid U.S. taxes.”

Within hours of their issuance, the new restrictions were already having an effect. On Wednesday morning, pharmaceutical giant Pfizer announced that its the merger agreement with Allergan, a $150 billion deal and one of the largest mergers ever, was terminated. The decision was driven by the Treasury Department’s announcement, “which the companies concluded qualified as an ‘adverse tax law change” under the merger agreement.

In connection with the termination of the merger agreement, Pfizer has agreed to pay Allergan $150 million for reimbursement of expenses associated with the transaction.

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