Treasury Places Additional Limits on Corporate Inversions
November 2015On November 19, 2015, a few days before the merger of Pfizer and Allergan was announced, the U.S. Treasury and the IRS issued Notice 2015-79 (the “Notice”), which describes regulations that will be issued to further limit corporate inversions. The Notice supplements and complements earlier guidance on corporate inversions announced in Notice 2014-52 during September 2014. The Notice seeks to raise the tax cost of, and limit the tax benefits of, the inversion of a U.S. multinational group. While the forthcoming regulations may discourage certain future transactions, absent legislative changes to section 7704 and section 163(j), corporate inversions are likely to continue as they offer U.S. multinationals significant opportunities for reducing their U.S. corporate income tax liability over the long-term.
Section 7874 was added to the Internal Revenue Code in 2004 to discourage corporate inversions by supplementing certain long-standing rules in section 367. Section 7874 applies to an "expatriated entity," which is defined as a domestic corporation or partnership with respect to which a foreign corporation is a "surrogate foreign corporation." Generally, a foreign corporation is a surrogate foreign corporation if pursuant to a plan or a series of related transactions three requirements are satisfied:
- The foreign corporation, directly or indirectly, acquires substantially all of the properties held, directly or indirectly, by a domestic corporation, or substantially all of the properties constituting a trade or business of a domestic partnership;
- After the acquisition, at least 60 percent of the stock (by vote or value) of the foreign corporation is held by (in the case of an acquisition with respect to a domestic corporation) former shareholders of the domestic corporation by reason of holding stock of the domestic corporation; and
- The “expanded affiliated group” (the “EAG”) that includes the foreign corporation does not have business activities in a foreign country in which the foreign corporation was created or organized that are substantial when compared to the total business activities of the group.
When all of these requirements are satisfied, one of two tax regimes governs the taxation of the surrogate foreign corporation, depending upon the fraction of shares in the foreign corporation owned by the former shareholders of the U.S. corporation (the “ownership fraction”). If the ownership fraction is 80 percent or greater, then the surrogate foreign corporation is treated as a domestic corporation for all U.S. federal income tax purposes. If the ownership fraction is less than 80 percent but at least 60 percent, then the surrogate foreign corporation is respected as a foreign corporation and is subject to U.S. tax on its "inversion gain" recognized during the next 10 years, notwithstanding any contrary treaty provision.
Notice 2014-52 focused on two areas of the law. First, regulations are to be issued to tighten certain aspects of section 7874. Inversions implemented by way of a spinoff (a “spinversion”) will be curtailed, and reductions in the section 7874 ownership fraction either by means of a pre-acquisition distribution or by merging with a foreign target having significant liquid assets will be restricted. Regulations also will be issued to make it more difficult for a U.S. group that inverts to access cash in a controlled foreign corporation (“CFC”) without paying U.S. tax on the associated earnings. Opportunities to decontrol a CFC, to move cash via intercompany stock sales, and loans by CFCs to related foreign companies that are not CFCs also will be limited by regulation.
Discussion of Notice 2015-79
Notice 2015-79 describes regulations to address transactions “contrary to the purposes of section 7874” and regulations to limiting “post-inversion tax avoidance transactions.” The Notice also makes “corrections and clarifying changes” to Notice 2014-52. In general, the regulations described in the Notice will apply to acquisitions completed on or after November 19, 2015.
Modification of the substantial business activities test
As discussed above, an inversion avoids the limitations of section 7874 if the EAG that includes the foreign acquirer has substantial business activities in the country in which the foreign acquirer was formed or organized. This jurisdiction typically will be where the company also is tax resident. There may be cases, however, in which the foreign acquirer is tax resident in another country because it is managed and controlled in that country. Furthermore, the EAG may have substantial business activities in the foreign acquirer’s country of formation or organization, but fail to have substantial business activities in the country in which the foreign acquirer is tax resident.
The Notice states “the Treasury Department and the IRS have determined that the policy underlying the exception to section 7874 when there are substantial business activities in the relevant foreign country is premised on the foreign acquiring corporation being subject to tax as a resident of the relevant foreign country.” Regulations therefore will be issued to provide that an EAG cannot have substantial business activities in the relevant foreign country when compared to the EAG’s total business activities, unless the foreign acquiring corporation is subject to tax as a resident of the relevant foreign country.
New rules for “top hat” transactions
Some inversion transactions have been structured as “top hat” transactions in which a U.S. and foreign group combine beneath a new entity (the “topco”) in a foreign jurisdiction that is different than the jurisdiction in which the parent of the foreign group is formed. For example, a U.S. group and a French group may choose to combine their businesses under a U.K. holding company. The new U.K. holding company would acquire the U.S. and foreign group in exchange for its shares. The Notice states: “the Treasury Department and the IRS have concluded that, when a domestic entity combines with an existing foreign corporation by establishing a new parent for the combined group that is tax resident in a third country, the likelihood that there is sufficient non-tax business purpose for replacing the U.S. parent with a foreign parent is significantly lower than Congress assumed in establishing the 80-percent threshold.”
Regulations will be issued providing that, when applying the ownership test, stock in the topco that is owned by former shareholders of the parent of the foreign group will be disregarded if four requirements are satisfied: .
- The topco acquires substantially all of the properties of the foreign parent;
- The gross value of all property acquired in the foreign parent exceeds 60% of all “foreign group property;”
- The tax residence of the topco is not the same as the tax residence of the foreign parent; and
- The section 7874 ownership percentage is at least 60% but less than 80%, before application of these new rules.
Additional guidance on “tax avoidance property”
In computing the ownership fraction, the regulations under section 7874 provide that “disqualified stock” in not included in the denominator of the fraction. Disqualified stock is stock issued in exchange for “non-qualified property,” (e.g., cash and marketable securities) in an exchange related to the acquisition by the foreign acquirer. Non-qualified property includes property acquired in a transaction related to the acquisition with a principal purpose of avoiding the purposes of section 7874 (“avoidance property”). The regulations offer one example of a transaction involving avoidance property.
The Notice states that the Treasury is concerned that some taxpayers are reading the definition of avoidance properly narrowly. Regulations will be issued to clarify that avoidance property means any property (other than specified nonqualified property) acquired with a principal purposes of avoiding the purposes of section 7874, regardless of whether the transaction involves a transfer of specified nonqualified property. The notice includes an example in which a foreign partnership transfers certain assets to a foreign acquiring corporation in exchange for 25 shares of the acquiring company. The shareholders of domestic target later transfer their shares to the foreign acquiring company for 75 shares. The regulations state that the foreign acquiring company acquired the partnership’s properties with a principal purpose of avoiding section 7874 with the result that the partnership’s 25 shares are considered received in exchange for nonqualified property and not taken into account when computing the ownership fraction..
Expanded definition of “inversion gain”
In the case of an inversion with an ownership fraction less than 80 percent but at least 60 percent, the taxable income of the expatriated entity can be no less than the expatriated entity’s “inversion gain” for 10 years following the inversion. The definition of inversion gain is linked to gain recognition by the expatriated entity directly and does not include gain attributable to indirect transfers of stock or other property.
The Notice offers as an example gain from the disposition of property by a CFC owned by the expatriated entity that gives rise to subpart F income. The Notice states that this limitation on the definition of inversion gain is a concern of the government and is contrary to the policy underlying sections 7874(a)(1) and (e)(1). Accordingly, the Treasury Department and the IRS intend to issue regulations under section 7874(g) expanding the definition of inversion gain to include income arising from such indirect transfers.
Taxation of exchanges of stock of expatriated foreign subsidiaries
Section 367(b) addresses the transfer of stock or securities in a foreign corporation by a U.S. person. In general, regulations issued under section 367(b) require a U.S. person who exchanges stock in a foreign corporation in a transaction that is otherwise tax-free under the Code’s nonrecognition rules to include in income as a deemed dividend the “section 1248 amount” with respect to the stock transferred when the exchange causes the foreign corporation either to cease to be a CFC or the transferring shareholder ceases to be a “section 1248 shareholder.”
Subsequent to an inversion, an expatriated entity may seek to transfer shares in a foreign subsidiary in a transaction that would result in the realization of a section 1248 amount. These transactions may be undertaken, for example, as part of an “out from under” transaction that is intended to dilute the expatriated entity’s interest in the foreign subsidiary. Such transactions, however, do not result in the taxation of gain attributable to unrealized appreciation in the foreign corporation’s assets, because such gain is generally protected from tax by the Code’s nonrecognition rules. The Notice states that the failure to tax such gain is contrary to the policies of section 7874. The Treasury Department and the IRS will amend the regulations under section 367(b) to require the exchanging shareholder to recognize all gain in the stock of the foreign subsidiary in such circumstances.
Corrections and clarifications
The Notice includes several corrections and clarifications. Although the general theme of the Notice is to increase the tax cost of inversion transactions, and the subsequent restructuring that typically follows, the Notice does include a new de minimis exception that is favorable to taxpayers.
The Notice explains that rules announced in Notice 2014-52 could cause section 7874 to apply to an acquisition even though the former owners of the domestic entity own no, or only a de minimis amount, of stock in the foreign acquiring corporation after the acquisition. This could occur when stock of the foreign acquiring corporation is disregarded for purposes of section 7874. The Notice offers an example in which, pursuant to a plan to purchase the stock of a domestic corporation, there is first a “non-ordinary course distribution.” The purchaser later forms a foreign acquiring corporation with cash and the foreign acquiring corporation uses the cash to purchase all, or almost all, of the stock of the domestic corporation. In determining the ownership fraction, the stock received by the shareholders of the foreign acquiring corporation in exchange for cash would be disregarded under the rules of Reg. § 1.7874-4T(b) relating to stock exchange for nonqualified property.
The Notice states that regulations will be issued to include a de minimis exception to the rule described above. Thus, the rule will not apply if shareholders of the domestic corporation own less than 5 percent of the foreign acquiring corporation after the acquisition, before applying the skinny down rule. A similar de minimis exception is provided in Reg.§ 1.7874-4T(d). It applies to a foreign acquisition of a domestic company in which management (or other shareholders of the domestic company) receive an interest (a “rollover”) in the foreign acquiring corporation. Such rollover interests ordinarily are used in order to incentivize the members of the management team who continue to be employed after the inversion.
 The regulations under section 367 were not withdrawn when section 7874 was enacted and continue to apply today. Section 7874(a)(2)(A)(i). Section 7874(c)(1). Section 7874(a)(2)(B). Section 7874(b). “Inversion gain” is any income or gain recognized by reason of the expatriation transaction and certain gain and licensing income recognized by the expatriated entity during the 10 year period. Section 7874(d)(2). Inversion gain may not be reduced by tax attributes such as net operating losses or foreign tax credits. The general rule is subject to various exceptions and modifications. See Notice 2015-79, section 5. Effective Dates. Reg. § 1.7874-4T(b). Reg. § 1.7874-4T(i)(7)(iv). Reg. § 1.7874-4T(j)(8), Example 5. See note 8. See reg. § 1.367(a)-3. See Notice 2014-52 for rules concerning such “skinny down” transactions. Generally, the effect of this rule is to increase the value of the domestic corporation by the amount of the distribution and so increase the ownership fraction.KEYWORD: Corporate Inversions
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