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Focus on Regulation

Proposed legislation would impose new test for domestic inverted corporations

On July 29, 2014, Democratic lawmakers in both the House and the Senate proposed new legislation that would block federal contract awards to certain companies that reincorporate in foreign countries. The “No Contracts for Corporate Deserters Act” (H.R. 5278, S. 2704), would alter the existing statutory rules on certain “inverted domestic corporations.” One of the collateral effects of the legislation is that companies that reorganize abroad may avoid the tax code coverage going forward, but find themselves unable to receive federal contracts. Additionally, some Members of Congress are urging President Obama to issue an Executive Order to take further action to preclude companies that reincorporate overseas from receiving government contracts while others are seeking to incorporate the substance of the legislation in pending appropriations bills.

Current Law:  Under current law and the Federal Acquisition Regulation, there is already a ban on contracting with certain inverted domestic corporations using appropriated funds. The applicable statutory test for an inverted domestic corporation is generally triggered by a transaction if (i) it results in 80% of the stock of a foreign incorporated entity being held by former shareholders of a domestic entity and (ii) the foreign entity does not have substantial business activities in its country of incorporation.

The Proposed Legislation:  The pending legislation would revise the current statutory test in two ways. First, it would include a U.S. ownership threshold of 50 percent rather than the current 80 percent test. Additionally, the legislation would flip on its head the substantial business activities test by focusing on whether the entity has significant domestic business activities.

In short, the new inverted domestic corporation test under the legislation would be as follows:

1) the entity completes the direct or indirect acquisition of substantially all the properties of a domestic corporation; 2) after the acquisition: a) at least 50 percent of the stock of the new entity is held by the former shareholders of the domestic corporation; or b) the management and control of the new entity occurs in the U.S. and the new entity has significant business activities in the U.S.

Potential Disconnect  Between Procurement and Tax Law:  The proposed legislation could significantly alter the landscape for companies that hold any federal contracts and are contemplating foreign reorganizations. Companies contemplating reorganization may be seeking to meet the current 80 percent threshold test because that threshold is used in both the tax code and the federal contracting statutes. Yet this proposed legislation only changes the threshold for the federal contracting prohibition, leaving intact the 80 percent test for taxes. This inconsistency could lead to companies that reorganize abroad avoiding the tax code coverage, but still finding themselves unable to receive federal contracts. Moreover, it is not inconceivable that ineligibility for federal contracts could trigger questions to be raised about eligibility to receive Medicaid reimbursement for some companies, such as pharmaceutical suppliers to the Veterans Administration.

The prospects for this bill’s passage remain uncertain (no Republican Congress member has signed on to the bill), but even if the bill does not pass on its own, the bill language could appear in the next appropriations act as a temporary measure. The Executive Branch has also expressed interest in tightening the inverted domestic corporation rules. Treasury Secretary Jacob Lew has said that his agency is reviewing possible mechanisms under existing law to discourage such corporate maneuvers. In addition, if Congress fails to act, an Executive Order tightening the prohibition on federal contracting with inverted domestic corporations may be waiting in the wings