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International Tax Journal

Puerto Rico And The Anti-Inversion Challenge

Ralph J Jr Sierra

July 1, 2003
Copyright © 2003 International Tax Journal, ProQuest Information and Learning. All rights reserved. 
Copyright © 2003 Aspen Publishers, Inc. Summer 2003

Volume 29, Issue 3; ISSN: 0097-7314

The benefits of Internal Revenue Code (Code) Section 936, which generally exempts from federal income tax the foreign source income of stateside companies that conduct the principal portion of their business operations in Puerto Rico, were terminated in 1996 with a phase-out period culminating with tax years beginning in 2005. Those 936 companies that have been waiting for the Code Section 956 amendments proposed by the Government of the Commonwealth of Puerto Rico to be enacted into law before converting to a controlled foreign corporation (CFC) may find themselves having waited too long. During the 107th session of the U.S. Congress (2001-2002), in response to concern about an apparent trend whereby U.S. corporations were converting into foreign corporations and thereby avoiding federal income tax liability, a series of bills was presented that would put severe restrictions on conversion of a stateside company into a foreign corporation (referred to as anti-inversion legislation).

These proposals were supported by the argument that these companies were avoiding their patriotic duty to support the U.S. war on terrorism, which officially began with the September 11, 2001 destruction of the World Trade Center towers in New York and the accompanying loss of approximately 3,000 lives. As the various bills progressed, consideration also was given to liberalizing the ability of CFCs to generate income earned outside the United States (referred to as extraterritorial income or ETI) without imputing that income to the stateside parent company under the rules of Subpart F of the Code to allow them to more readily compete in the global economy.

Although since enactment of the Jones Act of 1917, all persons born in Puerto Rico are U.S. citizens, by process of elimination under Code Section 7701 (a) and its predecessor provisions, a corporation organized under the laws of the Commonwealth of Puerto Rico is a foreign corporation for federal income tax purposes. Accordingly, legislation with respect to both the anti-inversion proposals and the alleviation of the Subpart F rules may have a negative impact on the Puerto Rico economic development program unless Puerto Rico can successfully lobby for economic protection under the alternative proposals.


It all started on March 6, 2002, when Representative Scott McInnis (R-Colo.), a member of the Ways and Means Committee of the U.S. House of Representatives, presented a bill (H.R. 3857) that would treat these new CFCs as domestic (to wit, stateside, corporations). On that same day, a very similar bill (H.R. 3884, the Corporate Patriot Enforcement Act of 2002) was presented by Representative Richard E. Neal (D-Mass.), likewise a member of the Ways and Means Committee.

H.R. 3857 calls for a corporation that would otherwise be treated as a foreign corporation to be treated as a domestic corporation if it meets the definition of being an inverted domestic corporation. An inverted domestic corporation is defined in H.R. 3857 as a foreign corporation (a Puerto Rico corporation, a Swiss corporation, etc.) to which property is transferred, directly or indirectly, by a domestic corporation (a 936 company) if immediately after that transaction more than 80 percent of the stock of the foreign corporation (measured by voting power or value) is held by the former share-holders of the domestic corporation by reason of their holding stock in the domestic corporation. As a result, the CFC would be treated for federal income tax purposes as a domestic corporation subject to federal income tax. This 80 percent threshold would be reduced to 50 percent if the foreign company was publicly traded on a U.S. exchange, derived less than 10 percent of its gross income from its country of organization, and had fewer than 10 percent of its employees in that country.

H.R. 3857, which has been referred to the House Ways and Means Committee, if approved as submitted, would have become effective with transactions occurring after 2001.

H.R. 3884 likewise calls for a corporation that would otherwise be treated as a foreign corporation to be treated as a domestic corporation if it results from a corporate expatriation transaction (and, therefore, would remain subject to U.S. tax). Two tests areprovided to determine whether a corporate expatriation transaction has occurred:

1. Shareholder Test: A "nominally foreign corporation" acquires substantially all the property of a U.S. corporation and more than 80 percent of the stock of the foreign corporation is held by former shareholders of the U.S. corporation.

2. Lower Stock Test: In certain cases, 50 percent stock ownership will suffice to constitute a corporate expatriation transaction when the foreign acquiring corporation does not have substantial business activity in the host foreign country and its stock is publicly traded principally in the United States.

H.R. 3884 has a retrospective effective date of September 11, 2001. In addition, if the corporation succeeded in inverting before then, its foreign residence would nonetheless be ignored beginning in 2004.

Similar legislation, S. 2050, was presented in the Senate by the late Senator Paul Wellstone (D-Minn.) on March 21, 2002.

Subsequently, Senator Max Baucus (D-Mont.), then Finance Committee chairman, and Senator Charles E. Grassley (R-Iowa), then ranking member of the Finance Committee, jointly introduced on April 11, 2002, the Reversing the Expatriation of Profits Offshore (REPO) Act (S. 2119). The bill would require the Internal Revenue Service (IRS) to look at where a company is controlled subsequent to inversion. If a company remains controlled in the United States, the bill will require the company to pay its fair share of federal income tax.

Resorting to patriotism in the presentation of this anti-inversion proposal, the senators stated:

"These expatriations aren't illegal. But they're sure immoral. During a war on terrorism, coming out of a recession, everyone ought to be pulling together. If companies don't have their hearts in America, they ought to get out. Adding insult to injury, some of these companies have fat contracts with the government. So they'll take tax dollars, but they aren't willing to pay their share.

"Our bill requires the IRS to look at where a company has its heart and soul, not where it has a filing cabinet and a mail box. If a company remains controlled in the United States, our bill requires the company to pay its fair share of taxes, plain and simple."

The amendment of Code Section 956 has significant implications for the efforts of the government of the Commonwealth of Puerto Rico because it would encourage corporations currently conducting operations in Puerto Rico to convert to CFCs in order to continue conducting those operations in Puerto Rico as well as encourage other stateside entities to establish CFC operations in Puerto Rico. Hence, the Press Briefing Memo issued with respect to S. 2119 is reprinted in full in Appendix A. The Puerto Rico proposal to amend Section 956 would reduce the Subpart F dividend related to stateside parent company imputation when a CFC repatriates funds into the United States by 90 percent of the deemed dividend to the extent that the dividend emanates from earnings and profits earned by the CFC in Puerto Rico. Note that, under S. 2119, if a CFC conducting operations in Puerto Rico is incorporated under the laws of the Commonwealth of Puerto Rico (as contemplated by the Puerto Rico proposal in S. 1475, submitted September 26, 2001, to amend Section 956, as opposed to the Puerto Rico proposal in H.R. 2550, submitted July 18, 2001, which would confer the benefits on a CFC irrespective of the foreign jurisdiction in which it is incorporated), the inversion of the 936 companies into Puerto Rico corporations could survive the anti-inversion proposals of Senators Baucus and Grassley with little, if any, negative impact.

On April 26, 2002, Senate Finance Committee member John F. Kerry (D-Mass.), joined the anti-inversion invasion by unveiling another piece of legislation, the Tax Haven and Abusive Tax Shelter Reform Act (S. 2339), addressing the perceived tax abuses involving identified tax havens and disallowing tax benefits claimed on transactions without substantial economic substance.

In presenting his bill, Senator Kerry had this to say:

"The Tax Haven and Abusive Tax Shelter Reform Act of 2002 would impose strict measures against nations identified as uncooperative tax havens which use confidentiality rules and practices to undermine tax enforcement and administration or refuse to participate in effective information exchange agreements. The legislation would limit foreign tax credits claimed by taxpayers operating in uncooperative tax havens. It would require a strict reporting of outbound transfers by U.S. taxpayers. The bill imposes a new civil penalty on U.S. taxpayers who fail to report an interest in an offshore account. Finally, it mandates a comprehensive review of the offshore tax evasion problem, including specific mechanisms used by taxpayers to shelter income and assets. By imposing real consequences for jurisdictions which are identified as uncooperative tax havens, the bill pierces the veil of secrecy which shields tax cheats from scrutiny and provides a strong incentive for otherwise uncooperative tax havens to enter into commitments with the United States to reform their practices.

"The peddling of abusive corporate tax shelters also demands attention. Pre-packaged, tax-motivated transactions with no real economic risk or business purpose-but which capitalize on technical ambiguities in the tax code-are sold to corporations by creative practitioners to generate artificial losses and deductions. Provisions in the Tax Haven and Abusive Tax Shelter Reform Act of 2002, . . . would disallow tax benefits from transactions that have no real business purpose other than tax savings. In addition, they expand disclosure requirements so that the IRS is fully aware of dubious tax schemes and tighten penalties against gross underpayments resulting from illegal tax shelters."

Overall, Senator Kerry's bill is characterized as enforcement measures that would not interfere with legitimate tax planning and business activity but would "create real consequences for those individuals who flout the law, and those businesses who engage intransactions with no real business purpose other than generating artificial losses and deductions." The bill is represented as a first step toward restoring confidence in the integrity and fairness of the U.S. tax system. "A tax system which asks working families topay their fair share, but gives large corporations such as Enron a free ride, is a national disgrace," the senator pronounced while introducing his bill.

S. 2339 would codify the economic substance doctrine to uniformly disallow tax benefits from transactions that serve no economicpurpose other than to generate tax savings. That is, it would seek to put an end to the use of "pre-packaged, tax-motivated transactions" that lack business purpose while capitalizing on technical federal income tax law ambiguities. The economic substance doctrine contemplates a transaction that would change the taxpayer's economic position in a meaningful way combined with a transaction that the taxpayer has a substantial non-tax purpose for undertaking.

Senator Kerry's proposal also would impose penalties on the "substantial promoters" of tax shelters and increase the penalties for underpayment of tax resulting from a taxpayer's substantial understatement or negligence because of use of an abusive tax shelter. It would allow the IRS to impose a 40 percent penalty when there is an underpayment attributable to a disallowance on transactions that lack economic substance or a business purpose. In the same vein, it also would chastise promoters of a disallowed tax shelter by imposing a penalty in an amount equal to 100 percent of the gross income derived through the shelter strategy. A promoter that offers a strategy to more than one participant and that receives fees in excess of $500,000 regarding a strategy would be considered to be a "substantial promoter."

S. 2339 also would increase the penalty on U.S. taxpayers (which by general operation of federal income tax law includes a bona fide resident of Puerto Rico) who fail to report interests held in foreign financial accounts. The bill would be effective for transactions occurring after the date of enactment into law.


On May 17, 2002, the Office of Tax Policy of the U.S. Department of the Treasury issued a "Preliminary Report on the Tax Policy Implications of Corporate Inversion Transactions." U.S. Treasury Secretary Paul O'Neill indicated in this regard that "When we have a tax code that allows companies to cut their taxes on their U.S. business by nominally moving their headquarters offshore, then we need to do something to fix the tax code." This comment, nevertheless, was accompanied with the observation:

"If the tax code disadvantages U.S. companies competing in the global market place, then we should address the anti-competitiveprovisions of the code . . . I don't think anyone wants to wake up one morning to find every U.S. company headquartered offshore because our tax code drove them away and no one did anything about it."

The report calls for ensuring that the federal income tax system does not operate to place companies based in the United States at a competitive disadvantage in the age of globalization. Although acknowledging that the recent inversion activity by state side-based companies has given rise to serious tax policy issues, the report highlights as both appropriate and timely the need for a comprehensive review of the federal tax system, particularly the international tax rules, with a view to maintaining the position of the United States as the most desirable location in the world for place of incorporation, location of headquarters, and transaction of business.

The debate on the pervasive issue of how to tax the offshore income earned by stateside-organized entities and at the same time make their position in the global market competitive is progressing at all levels, among politicians, academicians, and tax practitioners. The U.S. Treasury Report has poured more fuel on the flames of discussion.


A bill placing a moratorium on inversions for the period retroactive to September 11, 2001, through December 31, 2003, to allow Congress to thoroughly examine the many issues raised by these transactions and work out a comprehensive solution, was submitted by Representative Nancy Johnson (R-Conn.) on May 16, 2002. Her bill (H.R. 4756), consistent with the patriotic thrust of this anti-inversion movement, is entitled the "Uncle Sam Wants You Act of 2002."

During the designated period, no corporation or partnership would be allowed to transfer assets to a foreign corporation by means of expatriation. That is, if during the specified time frame, a 936 company were to go to sleep at the close of business on one day, transfer all its assets overnight to a Bermuda (for example) corporation, and wake up as that Bermuda corporation the next day, it still would be considered a domestic corporation and, thus, subject to federal income tax; however, this would not necessarily be the case for expatriations occurring after 2003.


The House Ways and Means Committee tried to hold a hearing on June 6, 2002, on corporate inversion transactions; however, the meeting was unfortunately cut short when partisan politics upstaged the event. Only one witness, of several that were scheduled, was allowed to speak. The sole person heard was Acting Assistant Treasury Secretary for Tax Policy Pamela Olson. Olson's presentation was basically a review of the "Preliminary Report on the Tax Policy Implication of Corporate Inversion Transactions."

The AFL-CIO was not scheduled to appear but submitted written testimony for the record. This document addressed issues of comparative corporate law that the AFL-CIO felt should be kept in mind by shareholders when called on to approve a corporate inversion. The pertinent comments were as follows:

"Delaware is the state of incorporation for 60% of Fortune 500 companies, according to the Delaware Division of Corporations. We believe that so many companies choose to incorporate in Delaware because it has an advanced and flexible corporate law, expert specialized courts dealing with corporate-law issues, a responsive state legislature and a highly-developed body of case law that allows corporations and shareholders to understand the consequences of their actions and plan accordingly. Bermuda, by contrast, does not even have published reports of legal cases, making it difficult to determine how the courts have ruled on corporate law issues. It is also difficult to obtain access to books on Bermuda law, since public law library resources are almost non-existent. We believe the stability, transparency and predictability of Delaware's corporate-law framework are superior to Bermuda's and provide advantages to shareholders.

"While many investors have concerns about aspects of corporate law statutes and the interpretation of those statutes in Delaware, and shareholder activists have long worried that incorporation in Delaware represented a race to the bottom, Delaware law is clearly superior to Bermuda law from a shareholder perspective.

"Reincorporation in Bermuda substantively reduces shareholder rights and corporate accountability. In those areas of the law under which shareholders continue to enjoy the same rights-for example federal securities law-shareholders' substantive rights may not be affected by the reincorporation, but their procedural ability to enforce those rights is weakened.

"By incorporating in Bermuda companies may make it more difficult for shareholders to hold companies, officers and directors legally accountable in the event of wrongdoing. It is crucial that shareholders have ability to pursue legal remedies to deter wrongdoing. If a company reincorporates to Bermuda, it may be more time consuming and expensive to hold that company or its officers and directors accountable in U.S. courts for several reasons.

"A judgment for money damages based on civil liability rendered by a U.S. court is not automatically enforceable in Bermuda. The U.S. and Bermuda do not have a treaty providing for reciprocal enforcement of judgments in civil matters. A Bermuda court may not recognize a judgment of a U.S. court if it is deemed contrary to Bermuda public policy, and Bermuda public policy may differ significantly from U.S. public policy.

"Unlike Delaware, Bermuda does not generally permit shareholders to sue corporate officers and directors derivatively-on behalf of the corporation-to redress actions by those persons that harm the corporation. Shareholder derivative suits recognize that a corporation is unlikely to pursue claims against the same officers and directors who control it and provide, we believe, a critical mechanism for remedying breaches of fiduciary duty, especially breaches of the duty of loyalty. Derivative litigation also, in our opinion, serves to protect the market for corporate control and thus promotes efficiency and accountability.

"Bermuda law differs from Delaware law in ways that may limit shareholders' ability to ensure accountability and participate in corporate governance. Bermuda law requires unanimous written consent of shareholders to act without a shareholders' meeting. Delaware law contains no such prohibition, although it allows companies' charters to limit the right. In the event a Delaware company does elect to include such a provision in its charter, shareholders can request that the board initiate a charter amendment to remove it.

"Unlike Delaware law, Bermuda law does not require shareholder approval for a corporation to sell, lease or exchange all or substantially all of the corporation's assets. Thus, a Bermuda company can significantly change its business without seeking shareholder approval."

In these times when the integrity of American capitalism is under serious challenge, the AFL-CIO commentary provides an interesting non-tax perspective on the practice of inversion.


On June 21, 2002, the U.S. House of Representatives approved the Permanent Retirement Security and Pension Reform Act of 2002 (H.R. 4931) on a vote of 308 to 70, picking up the support of 115 Democrats along the way. Although pension reform was supposed to be the topic of the day, lawmakers from both sides of the aisle sparred over proposed corporate governance modifications and corporate expatriation (i.e., inversion) penalties that Democrats insist are needed to curb abuses in the business community.

For example, Representative Neal said that Democrats would be boosting their efforts to force lawmakers to put their "fingerprintson the Bermuda situation" and likewise pledged to bring his corporate expatriation bill (H.R. 3884) to the floor throughout the remainder of the session. Neal was able to force a vote on his anticorporate-reincorporation language by attempting to link it to H.R. 4931; however, the motion failed on a vote of 192 to 186. His motion to recommit picked up two Republican supporters, while a lone Democrat voted against the proposal. House Ways and Means Committee ranking member Charles B. Rangel (D-N.Y.) accused Republicans of siding with big business over ordinary taxpayers by blocking the Neal legislation but vowed to keep the issue on the front burner for weeks to come.

Prior to the floor's consideration of H.R. 4931, House Majority Leader Richard K. Armey (R-Tex.) released a statement defending businesses that enter into corporate inversion transactions to minimize their U.S. tax obligations. In the statement, he noted that "Tax competition is a fact of life," and compared the reincorporating companies to businesses that relocate in states that provide favorable tax treatment. He criticized legislative proposals that would levy taxes on U.S.-based companies that establish themselves as foreign-based corporations in a low- or no-tax country. "This is akin to punishing a taxpayer for choosing to itemize instead of taking the standard deduction," he stated.

U.S. House Ways and Means Committee Chairman William M. Thomas (R-Cal.) indicated that he proposed to introduce and believed that the House of Representatives would approve a new tax competition plan engineered to equalize international tax treatment among businesses and halt corporate tax avoidance. According to Thomas, his all-inclusive American Competitiveness and Corporate Accountability Act of 2002 (subsequently presented on July 11, 2002, as H.R. 5095) would not only address the World Trade Organization (WTO) dispute between the United States and the European Union (see below) by replacing the U.S. Foreign Sales Corporation (FSC) Repeal and Extraterritorial Income Exclusion Act, but also would make significant strides on both the corporate inversion and abusive corporate tax shelters fronts. Nevertheless, House Speaker J. Dennis Hastert (R-Ill.) urged his fellow members of Congress to study in depth the "grave" issue of inversions and the FSC revamp.

Once again, however, bipartisan politics reared its head as House Ways and Means Committee ranking member Rangel strongly criticized Thomas for proposing a partisan corporate tax fix that fails to note that "Tax reductions on overseas business operations, when coupled with tax increases on U.S. operations, will create incentives for businesses to move overseas." Rangel further argued that the proposal, although easing the burden on corporate expatriates by heaping higher taxes on unsuspecting U.S. exporters, "muddies the water and shows our disarray to the international community."

On September 22, 2002, the Congressional Research Service (CRS) issued its report on the changes proposed by the American Competitiveness and Corporate Accountability Act to the federal income tax treatment of foreign-source income earned by stateside companies, either directly or through foreign subsidiaries. Appendix B includes the transcript of the summary of the report and the contents of the two sections of H.R. 5095 that will have the most significant effect on operations conducted in Puerto Rico by these companies: (1) the major revisions to the imputation of income earned by a CFC to its stateside parent company, generally referred to as Subpart F income and (2) the curtailment of corporate inversions, whereby income previously earned by a stateside entity (such as a 936 Company) is henceforth considered as earned by a CFC and, accordingly, not subject to federal income tax until repatriated to the United States. [Footnotes have been omitted.]


In the meantime, on August 30, 2002, the WTO ruled that the European Union (EU) may impose sanctions of up to $4 billion against the United States with respect to what it considers to be illicit special federal (United States) income tax breaks for U.S. exporters that the WTO considers to be in violation of the free trade rules. As a result, Thomas called for urgent consideration of his bill. In this regard, H.R. 5095 seeks to address the EU concern with respect to U.S. exporters in a manner that would mitigate or even make it unnecessary for the WTO to impose sanctions.

Unfortunately, H.R. 5095 not only addresses the concerns of the WTO but also addresses the concerns of the U.S. Congress with respect to the stateside companies that have expatriated and reorganized under the laws of foreign countries (popularly identified as Barbados, Bermuda, British Virgin Islands, Cayman Islands, Commonwealth of the Bahamas, Cyprus, Gibraltar, Isle of Man, the Principality of Liechtenstein, the Principality of Monaco, and the Republic of the Seychelles, among others). The adverse effect that these anti-inversion provisions may have on Puerto Rico's pursuit of stateside-owned controlled foreign corporations establishing operations in Puerto Rico is discussed below.


None of the anti-inversion or Subpart F revision bills was enacted during the 107th Session of Congress. Nevertheless, these proposals are expected to surface again during the 108th Session (2003-2004). Given the predominance of the Republican party in the November 5, 2002, elections, in which that party regained control of the Senate and broadened its margin of control of the House of Representatives, the two bills most likely to be taken into serious consideration are S. 2119 (the cosponsor of which is Senator Grassley, who is destined to become the Senate Finance Committee chairman) and H.R. 5095 (whose cosponsor, Representative Thomas, holds the similarly prestigious rank of chairman of the House Ways and Means Committee). These bills are respectively reviewed in Appendixes A and B.

The various anti-inversion proposals and the adverse effect that the passage of any of them could have on the continued socioeconomic development of Puerto Rico have yet to receive any input from the government of Puerto Rico, either directly or by those who have previously represented Puerto Rico before Congress and/or Treasury when tax legislation is being contemplated. Recent lobbying efforts have focused on the termination of Code Section 936 and, more recently, the proposed amendment to Code Section 956.

As is commonly known, Code Section 936 was terminated for new entities (with stringent exceptions) by the Small Business Job Protection Act of 1996, and for those companies with an election in effect on October 13, 1995, the benefits expire with the end of the tax year beginning in 2005. Certain additional restrictions were imposed during the latter period, including placing a cap on the profits that could be sheltered by the tax-sparing credit accorded by Code Section 936 and placing a restriction on bringing new products under the coverage of that credit. Section 936 (like its predecessor provisions since 1921) has been instrumental in Puerto Rico's pursuit of socioeconomic development for the almost 4 million U.S. citizens currently living on the island on par with that enjoyed by fellow citizens in the 50 states. In pursuit of this goal, Puerto Rico has a long-established local tax incentive program.

When establishing the Section 936 regime in 1976, as a replacement for the prior Code Section 931 arrangement, Congress acknowledged that the significant local tax incentives that Puerto Rico provided would no longer be effective to attract investments by stateside companies were these companies to be fully subject to federal income tax. In view of the impending loss of the benefits accorded these companies under Section 936, there has been an active movement by many of these companies to convert their Puerto Rico operations to controlled foreign corporation status. The Puerto Rico government agency with the principal responsibility for promoting, among other things, stateside investments in Puerto Rico (the Puerto Rico Industrial Development Company), has estimated that close to 70 such conversions have taken place since enactment of the 1996 legislation putting an end to the Section 936 tax-sparing credit. This conversion is essential if such companies are to continue operating in Puerto Rico, where such operations are still conducted under the U.S. flag. The legislative history of the 1976 enactment of Section 936 establishes that Congress, when approving that legislation, acknowledged that special preference had to be given to Puerto Rico in view of the applicability to the island of the minimum wage and U.S. flagship laws. These laws result in a substantial increase in labor costs, transportation costs, and other costs of establishing operations in Puerto Rico.

Of principal concern regarding the anti-inversion proposals is that a broadly sweeping bill could do irreparable harm to the continued socioeconomic development of Puerto Rico, as well as to the other possessions and territories of the United States. Therefore, it is time to consider a kind of "Marshall Plan" for U.S. possessions and territories. As the anti-inversion bills reach the level of serious consideration, it is hoped that Congress will back a proposal (which appears to be plausible under the Baucus-Grassley bill, S. 2119) that would, at a minimum, allow the conversion of a stateside corporation into a corporation organized under the laws of the possession or territory (including the Commonwealth of Puerto Rico) in which the company is principally engaged in trade or business.

As Congress seeks to approve a series of bills addressing corporate patriotism in the aftermath of September 11, 2001, another anti-inversion bill that can have a seriously adverse effect on Puerto Rico and that appears to be on its own fast track is the American Competitiveness and Corporate Accountability Act.

Of the many companies operating in Puerto Rico that have inverted since 1996, few, if any, became Puerto Rico corporations. The overwhelming majority reincorporated in what the IRS considers to be tax haven jurisdictions (e.g., Bermuda, Cayman, etc.) and they would be affected by any anti-inversion law, depending on its effective date. Reincorporation by a heretofore 936 company in a jurisdiction other than Puerto Rico is done because, unlike the country in which the company reincorporates, Puerto Rico, like the United States, taxes all income, including income earned outside Puerto Rico, of its domestic corporations (those organized under the laws of the Commonwealth of Puerto Rico). Foreign corporations (those organized under the laws of a jurisdiction other than Puerto Rico) doing business in Puerto Rico are taxed under Puerto Rico income tax law only on the income they earn that is tainted as Puerto Rico-source income under Section 1231(b) of the Puerto Rico Internal Revenue Code of 1994, as amended.

Like all the other anti-inversion proposals, H.R. 5095 would treat as a stateside corporation for federal income tax purposes any CFC that is formed by a U.S. corporation transferring its assets and operations to the CFC, which means that its current earnings would be subject to federal income tax. Thus, the conversion of a 936 company into a CFC would not serve to avoid federal income tax. Conversion into a CFC by those 936 companies that have not yet done so is expected to occur by 2005, at the latest, because that is the last tax year that 936 companies will enjoy exemption from federal income tax. Conversion into a CFC generally would have prolonged that benefit indefinitely until dividends were paid, and by certain multinational tax planning arrangements the federal income tax on dividends can be significantly reduced or eliminated.

H.R. 5095 would by operation of law subject all CFCs formed by the inversion of a stateside company (including 936 companies) during the period from March 21, 2002, through March 20, 2005, to federal income tax like any stateside corporate taxpayer. Thus, those 936 companies that seek to convert into a CFC during this period would become subject to federal income tax prior to the expiration of Section 936 benefits. H.R. 5095 also mandates the U.S. Treasury Department to render a report on inversion activity and revenue implications by no later than December 31, 2004. The purpose of this report is to determine how inversions should be treated thereafter.

It has been argued by some that the anti-inversion provision in H.R. 5095 would not apply to the conversion by a 936 company that is a subsidiary of a stateside entity (which is virtually the universal rule of the 936 company) into a CFC because the technicalexplanation of H.R. 5095 prepared by the staff of the Joint Committee on Taxation states, among other things, that ". . . if a U.S. parent corporation converts an existing wholly owned U.S. subsidiary into a new wholly owned controlled foreign corporation, the stock of the new foreign corporation would be disregarded [in determining whether a transaction would meet the definition of an inversion]." This provision, however, intended to exclude, among other transactions, the conversion of a 936 company into a CFC from the definition of an inversion, should be written into the statute itself, so that companies do not have to rely solely on the conclusions provided by the staff of the Joint Committee on Taxation.

This is so for a variety of reasons. Even if the Joint Committee is correct in its understanding of the congressional intent to place arestriction on the broad scope of the terminology otherwise used in the bill, this would have no effect at all until the U.S. Treasury gives its blessing to that restrictive interpretation through the promulgation of regulations incorporating that interpretation. Pending the issuance of such regulations, conversion is at risk of being challenged by the IRS. If challenged and the exception from inversion status of a 936 company conversion into a CFC is litigated, courts typically will not consult the statute only when the Joint Committee is ambiguous in its conclusions as to what Congress intended. To the contrary, whereas the findings of the Joint Committee are relevant guides to congressional intent and, therefore, entitled to respect, courts may be expected to disregard those findings if there is no corroboration in the actual legislative history (such as a significant colloquy on point in both the Senate and the House of Representatives) of the Joint Committee's interpretation. Accordingly, absent an amendment to H.R. 5095 actually incorporating an exception to the definition of the inversion transaction that would salvage the status of the conversion of a 936 company into a CFC, the intended federal income tax benefits of these conversions remain susceptible to challenge.

In addition, H.R. 5095 modifies the current Subpart F provisions concerning CFCs that can give rise to the imputation or deeming of a dividend to the CFC's stateside parent when business is conducted between or among related CFCs. Under this proposal, the only time the stateside parent would be susceptible to a dividend imputation on such business would be when the products are sold or purchased in the United States for ultimate sale in the United States. The modification of subpart F, a linchpin of the current problems of CFCs, to the extent that their operations do not entail sales to the United States or the sale of items produced in the United States and resold to the United States, means that even a Puerto Rico CFC that did not result from an inversion can have federal income tax problems if, as is so common with a 936 operation, its business is basically "round-tripping" (that is, acquiring raw materials from stateside affiliates for the production in Puerto Rico of goods or products destined for sale in the United States).

The need to clarify the applicability of S. 2119 and/or H.R. 5095 to Puerto Rico is evident in view of the strong uncertainty as to how operations of stateside organizations in Puerto Rico will be handled henceforth. Pending favorable treatment for Puerto Rico, it could be perceived as easier and more prudent and safer for certain companies, such as those in light industry currently operating in Puerto Rico (for example, electronics), to form a foreign corporation elsewhere, such as Singapore or Ireland, purchase outright new light industry machinery and equipment, and conduct operations there rather than waiting to see how the Congress ultimately will treat Puerto Rico. The new Singapore or Irish corporation would not be affected by the anti-inversion penalties because it would not fall within the definition of an inverted stateside company.


In view of the foregoing discussion, clearly Puerto Rico should have a major interest in the outcome of this proposed legislation. Unless Puerto Rico receives a special benefit (such as the 85 percent dividends-received deduction), it can anticipate a major hurdle to overcome when seeking to attract stateside investors to establish operations in Puerto Rico. Considering the presence in Puerto Rico of almost 4 million U.S. citizens, the issue should be one of major concern for the U.S. Congress as well. In addition, Puerto Rico will have to significantly revamp its tax and incentives laws to accommodate the presence of stateside-owned CFCs in Puerto Rico.

With all this brouhaha taking place in the nation's capital, it is urgent that local government officials carefully monitor the situation to ensure that Puerto Rico's continued efforts to retain stateside investments in operations in Puerto Rico, as well as to induce new investments, are not defeated by oversight. As with the Puerto Rico proposals for amending Code Section 956 to ensure the continued socioeconomic development of Puerto Rico, this is not a matter that can be left solely to the government to address. Once again, full cooperation from the various organizations and institutions involved in this development process, both Puerto Rico and stateside, is essential.

Ralph J. Sierra, Jr. is a partner at Sierra/Serapion, PSC.


* Footnotes in Appendix B have been omitted.


Press Briefing Memo Issued With Respect To S. 2119





APRIL 11, 2002


Senate Finance Committee Ranking Member Chuck Grassley (R- IA) and Chairman Max Baucus (D-MT) today announce their legislative response to the growing problem of corporate inversions. Generally, corporate inversions result in the removal of foreign assets of a U.S. corporation from the United States' taxing jurisdiction, which may lead to a significant erosion of the U.S. tax base.

An inversion transaction typically involves the formation by a U.S. corporation of a subsidiary in a foreign tax haven. Certain of these tax havens do not share tax, banking, or other financial information with the United States. After forming the foreign subsidiary, the U.S. corporation causes the foreign subsidiary to become the parent corporation of the U.S. corporation itself, thereby "inverting" the corporate chain of ownership. This is generally accomplished by inducing the shareholders of the U.S. corporation to exchange their shares in the U.S. corporation for shares in the foreign subsidiary. This share exchange will cause the foreign subsidiary to simultaneously "invert above" the U.S. corporation and hold all (or nearly all) of the U.S. corporation's outstanding shares.

Once this inversion structure is in place, the new foreign "parent" corporation may cause the U.S. corporation (which is now a subsidiary of the foreign parent) to transfer its foreign assets and subsidiaries to the foreign parent corporation. When these assets and subsidiaries are moved under the ownership of the new foreign parent corporation, they are no longer subject to U.S. tax because the United States' taxing jurisdiction does not tax the foreign operations of a foreign corporation. Consequently, under this inversion structure, the United States' taxing jurisdiction is limited to the U.S. operations of the U.S. corporation itself. To further exacerbate this erosion of the U.S. tax base, many inversion schemes "strip" earnings out of the U.S. corporation by creating a U.S. deduction for payments to a foreign related party, with the related party receiving the payment in a tax free jurisdiction.

Some commentators have noted that inversion transactions are defensible as an elective territorial tax system. The territorial systems of most developed countries require that passive income remain taxable in the taxpayer's home country. The inversion structures, however, would block U.S. taxation of passive offshore income, and in this respect, yield a more advantageous result than would be allowed by most territorial tax systems.

An equally troubling aspect of inversion transactions is that the new foreign parent corporation is usually an inactive "shell" corporation, having no substantial operations or activities in its country of formation. Often, these foreign parent corporations are nothing more than a sheet of paper in a filing cabinet. Thus, the U.S. company that initiates a corporate inversion may escape U.S. taxation on foreign earnings through a purely paper transaction, with no substantive change in the current business operations of the U.S. corporation or its foreign subsidiaries.

Current U.S. tax laws permit inversions, but attempt to stem erosion of the U.S. tax base by capturing untaxed value that is migrating outside the U.S. taxing jurisdiction. For example, current law imposes income tax on U.S. shareholders when they exchange their U.S. corporation shares for shares in the foreign subsidiary. Tax is generally imposed on the difference between the fair market value of the shares and the shareholders' cost bases. This provision, however, may be ineffective when the shares' market values are severely depressed by recession or external events (such as the terrorist attacks of September 11th), or when the shares are held by institutional investors that are not subject to income tax.

Current tax laws may also impose tax on the U.S. corporation itself when it transfers its foreign assets and foreign subsidiaries to the newly formed foreign parent corporation. This tax is imposed on untaxed earnings and appreciation in value that may be imbedded in those foreign properties. This corporate level tax, however, may be offset by other corporate tax attributes, such as net operating loss carryforwards (which may accrue during a recessionary period) or minimized by suppressed asset values (which can be affected by recession and external events).

Senator Grassley and Senator Baucus believe that the current tax law provisions are ineffective in stemming the rising tide of corporate inversions. They are extremely displeased that corporations (and some partnerships) are capitalizing on a period of recession and terrorism to maximize their opportunities to escape U.S. taxation on foreign earnings. At the same time, the senators do not wish to impede cross-border transactions that are entered into for legitimate non-tax business reasons. Accordingly, the senators offer their bill, "Reversing the Expatriation of Profits Offshore" (REPO) Act, to remove the tax incentives associated with these corporate "expatriation" inversion schemes.


The REPO Act addresses two different classes of inversion transactions-the typical "pure" inversion and "limited" inversions.

Pure Inversions

The first class of inversion transactions are the "pure" inversions, in which:

1. A U.S. corporation becomes a subsidiary of a foreign corporation or otherwise transfers substantially all of its properties to a foreign corporation,

2. The shareholders of the U.S. corporation end up with 80 percent or more of the vote or value of the stock of the foreign corporation immediately, and

3. The foreign corporation, including its subsidiaries, does not have substantial business activities in its country of incorporation.

Corporations with no significant operating assets, few or no permanent employees, or no significant real property in the foreign country do not meet the substantial business activity test. Under this legislation, companies are not considered to be conducting substantial business activity in the country of reincorporation by merely conducting board meetings in the foreign country or by relocating a limited number of executives to the foreign jurisdiction. The purpose of this substantial business activity requirement is to attack inversion structures that utilize a manila folder in a filing cabinet or a foreign post office box to establish their corporate presence.

For corporations that engage in a pure inversion transaction, the new foreign parent corporation would be deemed a domestic corporation for U.S. tax purposes. By dragging the foreign shell corporation back onto U.S. shores, the anticipated benefit of escaping U.S. tax on foreign operations would be completely denied. This pure inversion legislation will extend to U.S. partnerships that invert into a foreign corporation.

Limited Inversions

Limited inversions are similar to pure inversions, except that the shareholders of the U.S. corporation end up with more than 50 percent and less than 80 percent of the vote or value of the stock of the foreign corporation. Limited inversions capture inversion transactions that are structured to evade the 80 percent test of the pure inversion provisions, while at the same time allow the U.S. shareholders to effectively control the new foreign parent corporation. Limited inversions, which include inverted partnerships, will be treated in the following manner:

1. Unlike pure inversions, the foreign parent corporation created by limited inversion transactions will not be treated as a U.S. corporation.

2. The current law provisions that impose tax on the U.S. corporation when it transfers its foreign assets and foreign subsidiaries to the newly formed foreign parent corporation would be strengthened. Specifically, the REPO Act would not allow the tax imposed on the untaxed earnings and appreciation in value of foreign properties to be reduced by any corporate tax attribute, credit, or other means. This is intended to strengthen the current law provisions that impose the corporate-level "toll charge" for moving assets out of the U.S. taxing jurisdiction.

3. Limited inversion structures will be monitored to ensure that income cannot be stripped out of the U.S. corporation through transactions with foreign related parties. The REPO Act will require that, before any related party deduction is allowed, the U.S. corporation must obtain IRS approval of the terms of their related-party transactions annually for 10 years following the inversion. This would cover all related party transactions, including intangibles transfers, cost sharing arrangements, and similar transactions. As a further measure to prevent income stripping, the REPO Act will modify current law to substantially reduce the amount of interest expense that may be deducted by a U.S. corporation for interest payments remitted to a related foreign party after an inversion transaction.


During the Finance Committee hearing on March 21, 2002, Senator Grassley and Senator Baucus made clear that any corporations engaging in inversion transactions would do so at their own peril. Accordingly, the REPO Act is generally effective for inversions occurring on or after March 21, 2002.

Numerous U.S. companies have engaged in inversion transactions prior to March 21, 2002. The REPO Act would not reverse those transactions, even if they were pure inversions. However, concern remains that certain of those prior inversions were structured to inappropriately strip-out the earnings of the U.S. company that is now a subsidiary of a foreign corporation. Accordingly, these companies will be subject to the 10-year IRS deduction approval process otherwise imposed on limited inversion transactions. In addition, any asset transfers by those companies on or after March 21, 2002, will be subject to the limited inversion provisions prohibiting reduction of the corporate-level tax "toll charge" for moving assets out of the U.S. taxing jurisdiction.


Senators Grassley and Baucus are committed to halting corporate inversions. Nonetheless, the senators also recognize that the rising tide of corporate expatriations demonstrates that our international tax rules are deeply flawed. In many cases, those flaws seriously undermine an American company's ability to compete in the global marketplace. This competitive disadvantage is often cited by companies that engage in inversion transactions.

The senators believe that we need to bring our international tax system in line with our open market trade policies. They wish to affirm their view that reform of our international tax laws is necessary for our U.S. businesses to remain competitive in the global marketplace. Moreover, those U.S. companies that rejected doing a corporate inversion are left to struggle with the complexity and competitive impediments of our international tax rules. This is an unjust result for companies that chose to remain in the United States of America. The senators are committed to remedying this inequity.

* * * * *

Senators Grassley and Baucus welcome public comment on the new inversion proposal. Please direct your comments to John Angell, Majority Staff Director, and Kolan L. Davis, Republican Staff Director, of the Senate Finance Committee, 219 Dirksen Senate Building, Washington, D.C. 20510.



On July 11, 2002, House Ways and Means Committee Chairman William Thomas introduced H.R. 5095, the American Competitiveness and Corporate Accountability Act. The focus of this report is the bill's proposed changes in U.S. taxation of income from international transactions. The bill also contains provisions designed to restrict corporate tax shelters; the report does not discuss these.

The bill's international proposals are in three general areas. First, the bill would repeal the extraterritorial income (ETI) tax benefitfor exporting, thereby attempting to end a long-running dispute between the United States and the European Union (EU) over whether the U.S. tax benefit is an export subsidy prohibited by the World Trade Organization agreements. Second, the bill contains proposals aimed at offshore corporations with subsidiaries in the United States. In part, these proposals are aimed at corporate "inversions" where some U.S.-owned firms have reorganized to include paper parent corporations chartered in "tax haven" countries. In part, these proposals also address "earnings stripping," or the shifting of U.S. profits abroad by means of intrafirm transactions. Third, H.R. 5095 contains proposals altering the tax treatment of U.S. firms with foreign operations and investment. The bill terms these changes international tax "simplification"; the bulk of the provisions would have the effect of reducing U.S. tax on foreign-source income. The chief areas that would be affected are rules related to the foreign tax credit and provisions affecting the "deferral" tax benefit for overseas business operations.

This report does not attempt a comprehensive economic analysis of H.R. 5095. Several likely broad effects, however, can be identified. First, taken alone, repeal of the ETI export benefit would likely not increase the U.S. trade deficit, but would reduce the overall level of U.S. trade-exports and imports alike-by a small amount. Because export subsidies generally reduce the aggregate economic welfare of the subsidizing country, repeal of the ETI provisions would likely increase U.S. economic welfare, while leading to a small contraction of the export sector and a small expansion of import competing sectors. Second, tax-motivated inversions are apparently events that chiefly occur on paper, involving little alteration of the location of economic activity. Their chief economic impact is probably a reduction in U.S. tax revenues. Thus, the chief impact of H.R. 5095's inversion provisions would probably be to reduce the extent to which inversions erode U.S. corporate tax collections. The bill's earnings stripping provisions may likewise reduce erosions in U.S. tax collections but an assessment of whether these provisions would reduce foreign investment in the United States is not attempted here. Third, the bill's foreign-source income provisions would likely reduce the tax burden on foreign-source income. As a result, their impact would probably be to increase the level of U.S. investment abroad beyond what would otherwise occur. Preliminary estimates by the Joint Committee on Taxation indicate the bill would increase tax revenue by a net of $6.4 billion over five years and a net of $1.1 billion over 10 years.

Sales and Services Income Subject to Subpart F

H.R. 5095's most important change to Subpart F is likely its proposal to remove sales and services income from the provision's coverage. As defined under current law these categories of income-termed "foreign base company sales income" and "foreign base company services income"-consist (respectively) of income from sales to a related corporation where the property is both produced and used outside the related corporation's country of incorporation, and income from the provision of services to a related corporation, outside the CFC's country of incorporation. H.R. 5095 would retain Subpart F coverage for sales of U.S. products back to the United States, thus apparently restricting the ability of firms to apply the deferral benefit to what might be U.S.-source income.

Given the elimination of the extraterritorial income (ETI) tax benefit for exporting by other parts of H.R. 5095, the question of whether or not the bill's repeal of foreign base company sales and services income could pose a replacement export benefit is relevant. Suppose, for example, a U.S. exporting corporation sells its exports to a subsidiary foreign corporation chartered in a low-tax country, and the foreign subsidiary, in turn, sells the exports in various foreign markets. To the extent export income is allocated for tax purposes to the foreign subsidiary rather than the U.S. parent, an export tax benefit results. Further, it is not clear whether continuing to apply Subpart F coverage to sales of products back to the United States while exempting exports would run afoul of the WTO agreements.

Absent stringent regulations governing the allocation of income, a firm might be able to achieve such an export benefit by, for example, charging an unrealistically low price for exports sold to its foreign subsidiary; such a technique would make the foreign subsidiary's income unrealistically high and the U.S. parent's income unrealistically low. However, the internationally-accepted norm for allocating income between related entities for tax purposes is a method known as "arm's length pricing"-a method that approximates the division that would occur if the different parts of the firm were, in fact, unrelated. And where "arm's length pricing" rules are followed in allocating income between a U.S. parent and its foreign sales subsidiary, little or no export income can be allocated to a foreign sales subsidiary. IRS regulations issued under section 482 of the Internal Revenue Code generally require arm's length pricing to be used in allocating income. Some observers, however, have expressed concern over potential manipulation of transfer prices so as to shift export income abroad.

Provisions Directed at "Earnings Stripping" and Corporate "Inversions" or "Expatriation"

Recent news reports and articles in professional tax journals have drawn the attention of policymakers and the public to a phenomenon sometimes called corporate "inversions" or "expatriation"-instances where firms that consist of multiple corporations reorganize their structure so that the "parent" element of the group is a foreign corporation rather than a corporation chartered in the United States. Firms engaged in the inversions cite a number of reasons for undertaking them, including creating greater "operational flexibility," improved cash management, and an enhanced ability to access international capital markets. Prominent, if not primary, however, is the role of taxes: firms that undertake inversion have indicated they expect significant tax savings from the reorganizations.

A prototypical inversion begins with a firm with operations in both the United States and abroad, but whose parent corporation-thecomponent of the firm whose stock is traded on the stock exchange-is chartered in the United States. Thus, the firm may use the deferral tax benefit for its foreign operations, but its foreign income is ultimately subject to U.S. tax when it is repatriated to the United States, The firm in question inverts by creating a foreign corporation chartered in a low tax country-Bermuda and the Cayman Islands have been cited as popular destinations. The firm reorganizes so the new foreign corporation becomes the parent of the U.S. corporation that was formerly the parent firm; the former U.S. parent transfers its foreign subsidiary corporations to the new foreign parent. The stockholders of the erstwhile U.S. parent firm automatically become stockholders of the new foreign parent.

Inversions need not involve the shift of economic activity from the United States abroad, and those that have been prominently featured in the recent controversy have apparently been accomplished entirely on paper. The transaction does, however, produce tax savings from two general sources. First, as described above, although the United States does not tax the foreign-source income of foreign subsidiaries immediately, it does tax their income when it is ultimately remitted to the United States. An inversion eliminates this deferred tax liability by placing the ownership of foreign subsidiaries in the hands of the new foreign parent.

A second source of tax saving from an inversion-known as "earnings stripping"-actually applies to U.S. rather than foreign-source income. The practice of earnings stripping involves a U.S. subsidiary corporation essentially shifting U.S.-source income out of the U.S. tax jurisdiction, from the hands of a taxable U.S. corporation into the hands of a foreign corporation. In general, the U.S. subsidiary of a foreign corporation makes tax-deductible payments (e.g., interest or royalties) to its foreign parent firm in compensation for intrafirm loans or the use of patents or copyrights. The tax deduction reduces the taxable income of the U.S. subsidiary, while increasing the income of the foreign subsidiary. Given that foreign corporations are subject only to U.S. corporate income tax on the active conduct of a U.S. trade or business, the interest or royalty income is removed from the U.S. tax base. Note that earnings stripping is not unique to inverted U.S.-owned firms, but can be practiced by foreign-owned firms that invest in the United States through U.S.-chartered subsidiaries. Indeed, in 1989 provisions designed to curtail earnings stripping were enacted with section 163(j) of the Internal Revenue Code.

H.R. 5095 contains provisions that would curtail each of these sources of tax savings. First, it would revamp existing restrictions on earnings stripping contained in section 163(j). Under current law, deductions are denied for interest paid to related entities if the payor's debt-to-equity ratio exceeds 1.5 to 1; the deduction is generally denied for interest exceeding 50 percent of its taxable income, after certain adjustments. Denied deductions are permitted to be carried forward indefinitely, and used to reduce taxable income in the future. H.R. 5095 would redesign the restrictions by removing the debt-to-equity test and reducing the percentage threshold to 35 percent from 50 percent. The bill would also limit the carryforward of interest to five years.

In addition to these changes, H.R. 5095 would disallow a portion of interest deductions if a domestic subsidiary's indebtedness is out of proportion to the entire corporate group's indebtedness, and the indebtedness consists of debt to related entities. More specifically, the deductibility of interest on related party debt would be disallowed to the extent the subsidiary's total debt (to both related and unrelated entities) exceeds a share of the entire group's external debt equal to the subsidiary's share of the group's assets.

H.R. 5095 addresses inversions' savings on foreign-source income with a temporary measure that would treat the new foreign parent firms created in an inversion transaction as U.S. firms. The foreign parents' foreign-source income would thus be subject to U.S. taxation upon its receipt. The provision would apply to transactions where the shareholders of the former U.S. parent corporation own 80 percent or more of the new foreign-chartered parent, and the foreign parent does not have substantial business activity in its country of incorporation. The provision would apply for inversions occurring during the three-year period spanning March 20, 2002 to March 20, 2005.

An additional inversion provision under the bill would apply to transfers of foreign stock by a U.S. corporation (e.g., a former parent corporation) to a new foreign parent firm. Under current law, such transfers are in principle subject to U.S. tax, but U.S. tax can be offset by foreign tax credits or net operating losses. H.R. 5095 would prohibit such "toll taxes" from being offset by tax credits and other tax attributes. This provision would apply to transactions where 60 percent or more of the foreign parent company is owned by stockholders of the former U.S. parent. The provision would be permanent rather than limited to three years.

In contrast to the tax savings inversions can generate at the corporate level, individual stockholders of an inverting firm are generally required to recognize any gain embedded in their stock at the time of inversion. In contrast, current law provides that persons holding stock options are not subject to U.S. tax until the option is exercised. Accordingly, persons holding stock options in inverting firms-for example, corporate officers-could avoid the capital gains tax that would ordinarily apply when an inversion occurs. H.R. 5095 would impose a 20 percent excise tax on certain holders of an inverting firm's stock options, including officers, directors, and persons owning 10 percent or more of the firm's stock. The tax would be imposed on gain determined by reference to an option-pricing model specified by the Treasury Department.

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