US plans to curb tax 'inversions' could hit foreign companies

Planned changes that President Barack Obama says are aimed at ensuring American companies do not avoid tax by shifting their headquarters overseas could also force foreign companies to adopt more conservative US tax-planning strategies.

One of the measures restricts the ability of US subsidiaries of foreign companies to deduct the interest they pay on loans from their parent firms from their taxable income.

It aims to stop a redomiciled American firm from reducing its US tax bill by piling inter-group debt on its US operations, and effectively shifting profits overseas.

But it could also affect European companies that use similar strategies to reduce their tax bills in the United States after buying US firms.

The new rules announced by the Treasury department this week aim to curb so-called 'inversions' - where a US group acquires a smaller overseas company and shifts its domicile to a lower-tax jurisdiction.

Drugmaker Pfizer's plan to buy rival Allergan and move to Ireland was one of the planned inversions that prompted the Obama administration to act. The $160 billion deal fell apart last week as a result of other aspects of the Treasury reforms.

Under the new rule regarding debt, if a US subsidiary transfers money to its overseas parent within three years before or after borrowing money from it, by paying a dividend or buying shares in the parent, then US tax authorities could potentially treat the loan as if it was equity.

This means the interest on the debt would not be deductible for US income tax purposes.

Experts said that European companies would still be able to shift profits via inter-group debt, but may have to do so gradually over a longer period of time.

"It, without doubt, significantly changes the rules of the game," said Stephen Shay, professor of law at Harvard University.

"In the old days you bought and then you levered up as much as you can and that is not going to happen in the same way, but how much of a constraint that becomes is unclear," he added.

Nancy McLernon, president of the Organisation for International Investment, a trade group for the US subsidiaries of foreign companies, denied non-US groups were routinely shifting profit overseas through debt.

"Where's the problem they (US authorities) are trying to fix? It feels more like a tax grab," she said.

She said the complexity of the issue and uncertainty over how the Internal Revenue Service (IRS), the US tax authority, would seek to use their new powers would make investing in new US projects less attractive.

"It will have a chilling effect on foreign direct investment in the United States," McLernon added.

The Treasury says it is targeting situations where large debts are incurred to fund dividends shortly after an inversion or foreign acquisition, rather than the most common way US subsidiaries accumulate inter-group debt. That is by having the subsidiary gradually pay all its profit to its parent as dividends and then borrow money from its parent for new investment.

"The proposed regulations generally do not apply to related-party debt that is incurred to fund actual business investment, such as building or equipping a factory," a Treasury factsheet released last week said.

Providing the money a foreign company takes out of its US subsidiary is in line with the US company's profits, the transactions should escape IRS scrutiny, Shay said.