COMMENTARY: Insurance mergers face U.S. regulatory uncertainty despite inversions clarification

December 28, 2015

By Lawrence Hsieh, Practical Law

Although the pharmaceutical industry has drawn a lot of the attention given to corporate inversions, the regulatory environment for these tax-saving corporate relocation transactions also affects insurance mergers.

The insurance sector faces similar consolidation pressures. They are driven, for example, by declining reinsurance premiums as investors aggressively seek yield in competing products including insurance-linked securities. Proposed anti-inversion regulations contemplated by recently-issued Treasury/IRS Notice 2015-79 help mollify insurers by clarifying the “cash box” issue regarding passive assets, but M&A activity in the insurance sector is still fraught with regulatory uncertainty.

An inversion, or “expatriation,” is any series of ordinary corporate transactions such as an asset deal, stock deal, or reverse triangular merger designed to exploit the divergence in U.S. and foreign tax laws and redomicile a U.S. multinational in a foreign jurisdiction where the tax burden is lower.

Internal Revenue Code Section 7874, enacted as part of the American Jobs Creation Act of 2004, took self-inversions (“DIY” inversions into tax havens) off the table. So today, the typical inversion involves combining a U.S. company with a bona fide foreign company located in a low-tax jurisdiction that operates a “territorial system” of taxation, such as Ireland. In a territorial system, the government collects taxes only on the income generated in that country, and not on any income generated outside of that country.


Insurers will be closely watching how lawmakers and regulators respond to the blockbuster Pfizer/Allergan deal. The proposed deal crystallizes an awkward truth – bright-line government restrictions are no match for private sector legal engineering. The dealmakers designed Pfizer/Allergan to sit just outside of Section 7874, which attempts to deter inversions by pegging the tax consequences to the degree that the former shareholders of the U.S. company (the “inverted company”) remain the controlling shareholders of the post-closing combined company (with the foreign company at the apex). The presumption is that a high degree of “continuing ownership” indicates that the U.S. company entered into the transaction primarily to lower its taxes.

Section 7874 established multiple tiers of post-closing continuing ownership thresholds. The law treats the new foreign parent company as a U.S. corporation for tax purposes (defeating the tax motivation for entering into the transaction) if the deal results in the former shareholders of the inverted company owning 80 percent or more of the combined company.

There is an exception if at least 25 percent of the combined company’s business activity takes place in the new foreign parent company’s home country. In other words, “80 percent or greater” deals are rendered non-tax efficient unless there is a significant non-tax reason for entering into the transaction. The presumption is that substantial business activities in the foreign country indicates that the U.S. company entered into the transaction primarily for business rather than tax reasons.

The law recognizes the foreign parent company as a “surrogate” foreign corporation for tax purposes if the transaction results in the shareholders of the inverted company owning 60 percent or more, but less than 80 percent, of the new foreign parent company, again subject to the substantial business activities exception. These deals are more or less tax efficient, and most deals before Pfizer/Allergen fell in this range.

Inversions that leave shareholders of the inverted company owning less than 60 percent of the new foreign parent company are also tax efficient because they fall outside of Section 7874 (these transactions technically are not even inversions). Basically, the presumption of “primary” tax-motivation goes away when the shareholders of the foreign company end up owning at least 40 percent of the reconstituted foreign parent after the closing. This is where Pfizer/Allergan sits – if all goes according to plan, Pfizer shareholders will own 56 percent of Allergan after the closing.

Query whether the government can curtail inversions by changing the thresholds. The answer is “not likely.” Finance law offers some clues. Banking and consumer finance regulators have tried in vain to stem predatory lending by capping interest rates. These efforts have not suppressed demand for alternative credit, which shadow lenders have been more than happy to supply.

Further, tightening the anti-inversion thresholds will require Congressional action. This is the approach favored by the left. Many on the right (and an increasing number on the left) want to deter inversions through comprehensive tax reform, mainly by lowering the statutory corporate tax rate and moving to a territorial system like the U.K. In this U.S. election cycle, just about everybody is afraid to trigger the takeover of American companies by foreigners, which is one reason why the insurance cash box issue is so interesting.

Insurance Cash Boxes

While Congress contemplates legislative action, the IRS has been busy trying to prevent all the things that dealmakers do to prime their entities and transactions to comply with the statutory thresholds. Last year, the Treasury and IRS issued Notice 2014-52, which curbed methods companies have used to proactively resize themselves before an inversion in order to meet the thresholds.

The notice also provides guidance on the post-inversion side, for example, restricting “hopscotch loans” to the new foreign parent company and other “creative repatriation” strategies that are designed to remove the funds from the U.S. tax net.

Last month, the Treasury and IRS issued a new notice to address concerns raised by stakeholders about the 2014 notice. Among other things, Notice 2015-79 provides relief for foreign insurers by clarifying the insurance sector exceptions to the “cash box” rule. The cash box rule basically makes the foreign company “smaller” relative to the U.S. company by disregarding the foreign company’s “nonqualified property” (passive assets above the specified cap) when determining continuing ownership. The rule makes it more difficult to evade Section 7874 and combine U.S. companies with foreign companies that have substantial passive assets.

Insurers complained that the cash box rule treats insurers differently than banks even though both routinely carry passive assets in the ordinary course of business, such as to meet their capital requirements. The prior notice carved out an exception for bank deposits used in an active banking business (under the banking exception to the passive foreign investment company (PFIC) rules). But the notice did not extend the corresponding accommodation to insurers.

Therefore, under the prior notice, insurers could only rely on the more narrow exception for assets that generate qualified insurance income under the controlled foreign corporation (“CFC”) insurance company rules, which applies only to insurers with mostly domestic business. Reinsurers who routinely write international risk would not qualify, thus deterring their engagement in primarily non-tax motivated corporate transactions.

The new notice extends the PFIC exception to insurers – foreign insurance company assets used in an active insurance business under the PFIC rules will no longer be deemed passive for cash box purposes. The new notice also generally excludes assets held by domestic insurers wholly-owned by foreign acquiring companies. The Treasury and IRS, however, have expressed significant concern about offshore companies who carry assets beyond what is needed to meet their insurance and annuity obligations, or who otherwise do not conduct bona fide active insurance business.

One of the issues that bears monitoring in the coming year is how the government plans to restrict the inappropriate application of the PFIC exception by investment managers who use offshore insurance companies to defer tax on passive income. Another area of interest is the impact of Treasury/IRS cash box action on reserve financing, especially in light of simultaneous moves by insurance regulators to strengthen or loosen insurance reserve requirements.

(Lawrence Hsieh is a senior legal editor for the Practical Law division of Thomson Reuters. The views expressed here are his own. Lawrence is a graduate of the University of Chicago Law School and holds an engineering degree from Cornell University. Lawrence is the author of the Corporate Transactions Handbook.)

(This article was produced by Thomson Reuters Regulatory Intelligence and initially posted on Dec. 14. Regulatory Intelligence provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Regulatory Intelligence compliance news on Twitter: @RiskMgment)

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