In June 2016, House Republicans unveiled the Better Way for Tax Reform (House Blueprint). This tax reform proposal would transform the existing corporate tax framework and move toward adopting "cash flow" tax principles that allow for the immediate expensing of all depreciable and amortizable new business investment. The House Blueprint also would move toward a destination-based tax, under which tax is imposed based on the place of consumption of goods and services, as opposed to the source of the income or the taxpayer's residence.
The House Blueprint would achieve the destination-based tax through border adjustments that exempt gross receipts from exported goods and services while taxing goods and services imported into the United States. Under the border adjustments, taxpayers would not be allowed any deductions or cost basis for assets purchased outside the United States and would be subject to income tax on goods or services imported from outside the United States. Taxpayers that export goods or services out of the United States would be able to exclude their gross receipts from the sale of the exported goods or services from taxable income while still being allowed a full deduction for their costs.
The border-adjustability feature in the House Blueprint, if enacted, may provide incentives for certain taxpayers to merge in the future. Consider the following:
Example 1: Corporation A is a domestic clothing retailer that purchases goods from countries outside the United States for resale within the United States. Corporation A's sales within the United States are $1,000; its cost to purchase the imported goods for resale is $700; and its incurred labor costs within the United States are $300. Under the current U.S. tax system, Corporation A would not have taxable income or loss. However, under the border-adjustability feature of the House Blueprint, Corporation A would be prohibited from deducting its cost to import its goods for resale and therefore would have taxable income of $700.
Example 2: Corporation B is also a domestic clothing retailer, but it manufactures its goods in the United States for resale outside the United States. Corporation B's sales are $1,000 of exports, and its manufacturing costs are $1,000. Under the current U.S. tax system, Corporation B would have taxable income of $0. However, under the House Blueprint, Corporation B would have a taxable loss of $1,000 because its foreign sales would be exempted from income and it would be entitled to a full deduction of $1,000 because the cost of manufacturing the sold goods was borne fully within the United States.
If the tax profiles of Corporation A and Corporation B remain constant in all future tax years, and assuming that there are no currency adjustments or price increases by either party, Corporation A perpetually will be in a taxpaying position and Corporation B will continue to generate net operating loss (NOL) carryovers under the House Blueprint. Further, the House Blueprint would allow NOLs to be carried forward indefinitely, as opposed to the 20-year carryover in Sec. 172. Because Corporation B will never be in a position to use its NOL carryover, it likely will place a valuation allowance on its NOL carryover for financial statement purposes.
It is important to note that Sec. 382, which limits NOL carryforwards following an ownership change, or Sec. 269, which disallows tax benefits of an acquisition made to evade or avoid income tax, might not survive a rewrite of the Internal Revenue Code such as that proposed by the House Blueprint. However, for purposes of the examples above, this discussion assumes that both provisions survive. Given the tax profiles of Corporation A and Corporation B, both corporations may have an incentive to combine through either a taxable or tax-free exchange prior to, or shortly after, enactment of the House Blueprint. Corporation A could use the deductions and NOL carryovers generated by Corporation B (subject to limitation under Sec. 382) to offset its taxable income in future tax years, while the shareholders of Corporation B could attempt to monetize a tax attribute that they otherwise could not use, by asking for additional sales proceeds. Corporation A still would have to consider Sec. 269.
Under Sec. 269, the IRS may disallow the deduction of an NOL carryover if it finds that control of a corporation, or control of corporate assets, was acquired for the principal purpose of avoiding or evading U.S. federal income tax. Given the subjective nature of Sec. 269, the IRS could seek to use it to challenge a tax benefit derived from the type of transaction described above. However, for Sec. 269 to apply, the transaction must be carried out for the principal purpose of avoiding or evading U.S. federal income taxes.
According to Regs. Sec. 1.269-3(a), tax avoidance is the principal purpose if it exceeds any other purpose in importance. This determination is made at the time of the transaction, but subsequent events may suggest tax avoidance if the acquisition of control was the first step of a much larger transaction (see The Swiss Colony, Inc., 52 T.C. 25 (1969), aff'd, 428 F.2d 49 (7th Cir. 1970)). Thus, the parties to a transaction may carry it out for both valid business reasons and for tax-avoidance purposes, but if the tax-avoidance purpose is the most important reason for effectuating the transaction, Sec. 269 could apply to disallow deductions resulting from the transaction. Therefore, if Sec. 269 were deemed to apply, any benefit that Corporation A achieves from using Corporation B's NOLs could be disallowed permanently.
However, Corporation A could have several nontax reasons for acquiring Corporation B. If Corporation A wanted to reduce its tax costs without acquiring Corporation B, its options could be limited to domesticating its non-U.S. operations or fundamentally altering its supply chain, both of which could have staggering tax and business costs. Because Corporation A and Corporation B are both clothing retailers, a business combination may be beneficial for Corporation A because its purchase of Corporation B will allow it to grow its market share through expansion into non-U.S. markets without having to expend resources to develop the infrastructure necessary to do so on its own. Further, there may be synergies for such a transaction, given Corporation A's lack of sales in non-U.S. markets. Finally, the purchase of Corporation B could have the benefit of eliminating a competitor in the marketplace should Corporation B decide to expand its brand to the United States. Regardless of its motivation for acquiring Corporation B, Corporation A will need to carefully document the nontax business purpose for its acquisition in taking the position that any tax benefits resulting from the acquisition would be permissible under Sec. 269.
The House Blueprint, if enacted, would have sweeping effects on the tax profiles of certain taxpayers. To the extent that taxpayers engage in merger transactions to obtain benefits resulting from enactment of the House Blueprint, proper consideration should be given to the nontax business purpose for the transactions in arguing against a harsh application of Sec. 269.
Annette Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington.
For additional information about these items, contact Ms. Smith at 202-414-1048 or email@example.com.
Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.