IRS Provides Additional Guidance on Corporate Inversions
January 2014On January 17, 2014 Treasury and the IRS published temporary regulations under section 7874, the Code’s anti-inversion provision, implementing guidance previously announced in Notice 2009-78. The temporary regulations generally define “disqualified stock” i.e., stock that is not taken account in applying the section 7874 ownership test. These temporary regulations follow the 2009 notice for the most part and are effective retroactively to September 17, 2009. The temporary regulations contain a taxpayer-favorable de minimis rule that previously had not been announced, as well as surprising news that the IRS and Treasury are considering expanding the scope of section 7874.
For at least the last 25 years a small number of U.S. corporations have sought to permanently lower their U.S. tax liability by inverting, i.e., entering into a transaction that causes the U.S. parent company to become a subsidiary of (typically a public) foreign corporation. The benefits of an inversion transaction are substantial and typically include avoiding the anti-deferral rules of subpart F, reducing or eliminating U.S. taxation of foreign source income, and facilitating erosion of the U.S. tax base through deductible payments made to a foreign parent or affiliate. Inversion transactions usually are costly and complex to implement and typically require a significant amount of post-transaction restructuring of the corporate group in order to achieve the desired tax consequences.
Inversion transactions were originally addressed by regulations issued under section 367. However, in 2004, Congress added section 7874 to the Code, which has proved to be a more potent deterrent than section 367. The broad scope of section 7874 makes it a key elements in structuring any cross-border acquisition or inter-group reorganization involving a U.S. and foreign company. In spite of the broad scope of section 7874, inversion transactions have continued after 2004, albeit on a diminished scale.
Inversion transactions defined
In general, section 7874 applies when an acquisitive transaction satisfies three tests: (i) a foreign corporation, pursuant to a plan, acquires substantially all of the properties of a U.S. corporation (or a domestic partnership), (ii) the foreign corporation and its “expanded affiliated group” do not have substantial business activities in its country of incorporation (compared to the business activities of the expanded affiliated group outside such country), and (iii) there is a continuing interest by shareholders of the U.S. corporation (or domestic partnership) in the foreign parent (the “Ownership Test”). When the continuing interest of former shareholders of the U.S. company is at least 80% (measured by vote or value), the foreign parent is treated as a domestic corporation for all U.S. income tax purposes and all U.S. treaty purposes. When the continuing interest of former shareholders is less than 80% but at least 60%, certain types of income recognized in the inversion transaction cannot be reduced by certain tax attributes of the U.S. group for 10 years following the inversion transaction.
The Ownership Test is perhaps the most complex element of section 7874. For purposes of applying the test, the statute provides that all former shareholders are counted (even if they are foreign persons). In addition, the statute provides that shares of the domestic corporation (or partnership interests) held by members of the expanded affiliated group which includes the foreign corporation are disregarded, as are shares of the foreign corporation sold in a public offering related to the acquisition of the domestic corporation (or domestic partnership).
Prior IRS guidance
Treasury and the IRS have issued substantial guidance under section 7874. Much effort has been devoted over the years to addressing when there is sufficiently substantial business activity in a foreign corporation’s country of incorporation to avoid triggering section 7874. This guidance has been revised and tightened recently in order to make it difficult for U.S. companies to successfully invert.
In 2009, the IRS issued Notice 2009-78 (the “Notice”) to provide guidance on the Ownership Test. In the Notice, the IRS announced it would issue regulations in the future (retroactive to September 17, 2009) providing that stock, whether or not issued in a public offering, will not be taken into account for purposes of the Ownership Test when it is received in exchange for certain contributions of “nonqualified property.” “Nonqualified property” is defined in the Notice to include: (1) cash and cash equivalents; (2) marketable securities within the meaning of section 453(f)(2); and (3) any other property acquired in a transaction with a principal purpose of avoiding the purposes of section 7874.
Disregarding stock received in exchange for nonqualified property causes a higher percentage of stock of the foreign corporation at issue to be considered as received by former owners of the domestic entity whose assets or interests were acquired. A foreign corporation therefore is more likely to be subject to the rules of section 7874.
The Notice also announced that certain stock will be taken into account for purposes of the ownership test. Stock of the foreign acquiring corporation issued in exchange for stock (or a partnership interest in) a member of the expanded affiliated group that, after the acquisition includes the foreign acquiring corporation, will be taken into account for purposes of the ownership fraction, unless a principal purpose of issuing stock of the foreign acquiring corporation in exchange for such stock or partnership interest was the avoidance of section 7874. This rule applies even if the stock is issued in a public offering.
The 2014 temporary regulations
The 2014 temporary regulations generally provide that “disqualified stock” is not taken account when applying the Ownership Test in section 7874. Disqualified stock includes (i) stock issued in exchange for “nonqualified property” and (ii) stock that is transferred in exchange for property and, pursuant to the same plan (or series of related transactions), the transferee subsequently transfers such stock in exchange for the satisfaction or the assumption of one or more obligations associated with the property. Disqualified stock does not include stock transferred in an exchange that does not increase the fair market value of the assets, or decrease the amount of liabilities of, the foreign acquiring corporation.
The temporary regulations include a de minimis exception that was not announced in the Notice. Under this rule, the disqualified stock rule does not apply when two conditions are satisfied. First, the ownership percentage determined without applying the disqualified stock rule must be less than 5% (measured by vote and value). Also, after the transaction, former shareholders of the U.S. corporation must own less than 5% of the stock of each member of the expanded affiliated group that includes the foreign corporation. This rule is helpful to taxpayers because it permits all-cash acquisitions in which management is permitted to own an interest in the foreign acquiring corporation as an incentive measure.
The preamble to the temporary regulations also expresses concern with leveraged buyout transactions in which a privately held foreign newco acquires a U.S. public corporation, with U.S. management retaining shares that satisfy the de minimis exception. Subsequently, the foreign newco goes public. The preamble states:
"The IRS and the Treasury Department believe that these transactions, which have the effect of converting a publicly traded domestic corporation into a publicly traded foreign corporation over time, can be viewed as inconsistent with the policies underlying section 7874. The IRS and the Treasury Department are studying these transactions and request comments on the application of section 7874 to such transactions."
This represents quite an expansive reading of section 7874 and its underlying policies by the government. On the facts discussed, there is only a minimal continuing interest by U.S. shareholders. Despite the statute’s broad grant of regulatory authority, without additional legislative support, section 7874 would not appear broad enough to reach these transactions. Moreover, any legislation or regulations that would “clawback” a foreign corporation into the U.S. tax net after a period of time could cause significant concerns with U.S. treaty partners while creating significant uncertainty for investors.
 U.S. companies that have inverted include: Helen of Troy, Accenture, Cooper Industries, Fruit of the Loom, Global Crossing, Ingersoll Rand, Noble Drilling, Seagate Technologies, and Tyco International. Section 7874(c)(1) defines “expanded affiliated group” to mean: “an affiliated group as defined in section 1504(a) but without regard to section 1504(b)(3), except that section 1504(a) shall be applied by substituting “more than 50 percent” for “at least 80 percent” each place it appears.” Thus, it includes a chain of corporations (foreign and domestic) that are more than 50% owned by a common parent. See Reg. § 1.7874-1. See Reg. § 1.7874-3T. Nevertheless, some inversion transactions have been implemented under these regulations. See Reg. § 1.7874-4T(i)(7). The definition generally follows the definition in the Notice.KEYWORDS: Corporate Inversions, Private Equity
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