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  • Treasury Acts Creatively to Limit Corporate Inversions
    September 2014

     
    On September 22, 2014, the Treasury and the IRS issued Notice 2014-52, which announces regulations that will be issued to limit some of the benefits of corporate inversions. The regulations described in the notice will have an effective date of September 22, 2014, with no provision to grandfather inversion transactions currently in progress. The regulations will (i) tighten the anti-inversion rules of sections 7874 and (ii) expand the scope of sections 304, 367, 956 and 7701(l) to address transactions that some inverted corporate groups may implement to reduce their U.S. federal income tax liability, particularly when moving cash between members of the group.
     
    The most likely effect of these regulations is to discourage certain types of inversions, i.e., transactions motivated primarily by a desire to access cash accumulated in non-U.S. subsidiaries of the U.S. group without paying additional U.S. tax, transactions with a marginal business purpose, and inversions accomplished by a spinoff (“spinversions”).  The regulations described in the notice would not significantly limit the opportunity that an inversion provides a multinational group to develop and grow non-U.S. operations beneath the new foreign holding company thereby avoiding U.S. tax on those earnings over the long run. U.S. multinational groups with substantial non-U.S. operations, particularly in the technology and life sciences industries, are likely to continue to find inversions accomplished through the acquisition of smaller foreign companies to be attractive should a suitable partner be available.
     
    Overview of Section 7874
     
    Section 7874 was added to the Internal Revenue Code in 2004 to further discourage corporate inversions by supplementing certain long-standing rules in section 367.[1] 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."[2] Generally, a foreign corporation is a surrogate foreign corporation if pursuant to a plan or a series of related transactions:
     
     
    1. The foreign corporation, directly or indirectly, acquires substantially all the properties held, directly or indirectly, by a domestic corporation, or substantially all the properties constituting a trade or business of a domestic partnership;
     
     
    1. 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
     
     
    1. The “expanded affiliated group” 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 such group.[3]
     
    When all of these conditions 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 more, then the surrogate foreign corporation is treated as a domestic corporation for all U.S. federal income tax purposes.[4] 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 it is subject to U.S. tax on its "inversion gain" recognized during the next 10 years, notwithstanding any contrary treaty provision.[5]
     
    Overview of the Notice
     
    The notice focus on two areas of the law. First, regulations will 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 significantly 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.
     
    Significantly, the notice does not announce any regulations to be issued under section 163(j), the U.S. earnings stripping rules.[6] The Treasury did not foreclose issuing additional regulations in the future, however, and suggested that in some cases any such regulations could be retroactive to September 22, 2014. We discuss first the regulations under section 7874 and then the regulations to be issued under other Code sections.
     
    Regulations to address inversion transactions
     
    The Treasury is concerned with pre-inversion transactions that have the effect of reducing the ownership fraction (making it more likely that a transaction will escape the consequences of section 7874) and with certain provisions in current law concerning the calculation of the ownership fraction that permitted transactions that the IRS would like to bring within the ambit of section 7874. Regulations would address both issues.
     
    Non-ordinary course distributions to be disregarded
     
    Under current law, a U.S. multinational group may distribute assets to its shareholders prior to an inversion in order to reduce its size and therefore reduce the section 7874 ownership fraction. Such “slimming” transactions may be undertaken when a suitable merger partner is small enough that an inversion would trigger section 7874 (i.e., because the ownership fraction would be at least either 80 percent or 60 percent). The notice states that regulations will be issued that will disregard “non-ordinary course distributions”[7] made by a domestic entity during the 36-month period ending on the date of the inversion transaction.
     
    Shares attributable to passive assets to be disregarded
     
    The notice states that the government is aware that taxpayers “may be engaging” in transactions with foreign corporations having significant cash or other liquid assets. A foreign entity “inflated” with such assets could engage in an inversion transaction having a relatively smaller ownership fraction than an entity without such assets. Regulations will be issued that would exclude from the denominator of the section 7874 ownership fraction a portion of the stock of a foreign acquiring corporation to the extent attributable to “foreign group nonqualified property.” [8]  This rule will apply only when more than 50 percent of the gross value of all “foreign group property” is “foreign group nonqualified property.” Excluding such stock from the denominator results in a larger ownership fraction therefore bringing more transactions within the scope of section 7874.
     
    “Spinversions” blocked
     
    The current regulations under section 7874 permit certain transactions in which a multinational group contributes all of the shares of a domestic corporation to a foreign corporation and then distributes the shares of the foreign corporation to the group’s shareholders. When such a transaction qualifies as a tax-free spinoff under U.S. law, the inversion is accomplished tax-free. The notice states that regulations will be issued under section 7874 that will treat stock distributed in certain spinoff transactions as not held by a member of the expanded affiliated group. Such stock therefore will be included in the numerator and denominator of the section 7874 ownership fraction, which will make the transaction likely to fall within the scope of section 7874.
     
    Regulations to address post-inversion transactions
     
    The notice also announces regulations that will be issued to tax otherwise tax-free transactions that move cash or assets out of CFCs to foreign members of the group that are not CFCs. These regulations will perhaps be the most effective at discouraging inversions.
     
    Hopscotch loans to trigger section 956
     
    Under current law, an investment in “United States property” by a CFC may give rise to an inclusion in income by the U.S. shareholders of the CFC. Section 956 defines an investment in United States property to include a loan by a CFC to certain related U.S. persons. Thus, a U.S. parent company generally may not gain access to cash accumulated in a CFC by means a loan by the CFC to the U.S. parent without paying U.S. tax on an equivalent amount of earnings of the CFC.
     
    The definition of United States property does not include a loan to a related foreign person. Subsequent to an inversion, a CFC therefore may make a loan to the multinational group’s new foreign parent (or a foreign subsidiary that is not a CFC ) that “hopscotches” the U.S. parent and avoids creating a U.S. tax liability for the U.S. parent. Representative Sander Levin recently proposed legislation that would amend section 956 in order to make such loans taxable.
     
    The notice states that the government will exercise its regulatory authority under section 956(e)[9] to treat any obligation or stock of a “foreign related person” other than an “expatriated foreign subsidiary” as United States property to the extent such obligation or stock is acquired by an expatriated foreign subsidiary during the 10-year  period following the inversion. Significantly, the regulation will apply to both pre-and post-inversion earnings of the CFC (but the inversion must be completed on or after September 22, 2014).
     
    Transactions to Decontrol a CFC to Be Recharacterized
     
    After an inversion, the new foreign parent of the multinational group (or another non-CFC foreign related person) may acquire sufficient shares in a foreign subsidiary that is a CFC to dilute the ownership interest of U.S. shareholders of the CFC below 50 percent. Thus, the foreign corporation ceases to be a CFC[10] and is no longer be subject to the rules of subpart F (including section 956 discussed above).
     
    The notice states that the government will exercise its regulatory authority under section 7701(l)[11] to recharacterize transactions in which shares of the CFC are transferred, in exchange for property, to a non-CFC related person.  Regulations will recharacterize this transaction as (i) a transfer of property by the non-CFC foreign related person to the U.S. shareholder of the CFC in exchange for instruments deemed issued by the U.S. shareholder, and (ii) a contribution of the property by the U.S. shareholder of the CFC to the CFC in exchange for shares of the CFC. The deemed instrument issued by the non-CFC foreign related person will have the same terms as the shares issued by the CFC, with the result that any distributions by the CFC will be treated as made to the U.S. shareholder followed by equivalent distributions by the U.S. shareholder to the non-CFC foreign related person.  This recharacterization rule does not apply if the decontrolling transaction would otherwise be taxable to the U.S. shareholder of the CFC or if the CFC does not cease to be a CFC immediately after the transaction.  Regulations also will be issued under 367(b) to tax otherwise nontaxable reorganizations that would result in the decontrol of the CFC following an inversion.
     
    Moving Earnings by Sales of Shares to Related Parties
     
    Section 304 treats certain related party share sales as redemptions, rather than respecting their form. For example, if a taxpayer sells shares in a parent corporation to a subsidiary of the parent, the transaction is treated as a distribution to the taxpayer by reference to the earnings of the subsidiary and then the parent. The rationale for this treatment is that the taxpayer remains in control of the parent and has received a distribution of the subsidiary’s (or parent’s) earnings.
     
    When the acquiring corporation is foreign, section 304(b)(5)(B) limits the earnings of the acquiring corporation that may give rise to a dividend in order to prevent those earnings from being deemed distributed to a foreign taxpayer thereby avoiding U.S. tax.  The notice states that the government understands “taxpayers may interpret section 304(b)(5)(B) not to apply when more than 50% of the dividend arising upon application of section 304 is sourced from the domestic [parent] corporation . . . . Under this position, the dividend sourced from earnings and profits of the CFC would never be subject to U.S. tax.”
     
    The notice goes on to state that the government will issue regulations providing that in determining whether section 304(b)(5)(B) applies, only the earnings and profits of the acquiring corporation will be taken into account, i.e., the earnings of the issuing (or parent) corporation will be ignored.
     
    An example illustrates the government's concern. Assume that foreign parent owns U.S. subsidiary, which owns CFC. Foreign parent sells some of the shares of U.S. subsidiary to CFC. Under the reading of section 304(b)(5)(B) taken by some taxpayers, the earnings of CFC would be deemed distributed to foreign parent. Subsequent to that deemed distribution, CFC could make a distribution of cash to the U.S. subsidiary which would not be treated as a dividend (or as a smaller dividend) because the CFC had no (or reduced) earnings and profits.
     
    Observations
     
     
    • Overall, the regulations described in the notice are a thoughtful and creative effort by the Treasury and the IRS to respond to the President’s directive to limit the attractiveness of corporate inversions by regulation. They are particularly impressive given the brief time in which they were crafted.
     
     
    • Over time, the changes to be made to section 7874 probably will prove to be not particularly far-reaching, other than the regulations curtailing “spinversions.” These regulations also appear to be within the Congressional grant of regulatory authority to the Executive branch, and so are unlikely to be successfully challenged in the courts.
     
     
    • The anti-hopscotch regulation to be issued under section 956(e) and the regulations to prevent the decontrol of a controlled foreign corporation under the authority of section 7701(l) could be the most effective part of Treasury’s effort over the long-term.  The regulations to be issued under section 956(e) appear to rest on relatively firmer statutory authority than those to be issued under section 7701(l).
     
     
    • The regulations to be issued under section 7701(l) are a rather bold move to enlarge subpart F by regulation, and they are critical to the success of the Treasury’s effort. If a CFC of an inverted U.S. group can be decontrolled, then section 956 can be avoided. In the past, the Treasury has aspired to expand subpart F by regulation and was forced to abandon that effort under pressure from Congress and the private sector.[12] History shows that determining the proper boundaries of subpart F is a highly political process, and all in Congress may not agree with the Treasury’s approach in this case.
     
     
    • The Treasury’s authority to rely on section 7701(l) to effectively expand subpart F also may be challenged in the courts. Although the Supreme Court’s 2011 decision in Mayo Foundation for Medical Ed and Research v. United States[13] increased the judicial deference due Treasury regulations, it is at least plausible that a court could find the regulations invalid, particularly given the relatively narrow language of the statute.
     
     
    • Overall these regulations do not significantly limit the opportunity that an inversion provides a multinational group to develop and grow non-U.S. operations beneath a new foreign holding company thereby avoiding U.S. tax on those earnings over the long run. U.S. multinational groups with substantial non-U.S. operations, particularly in the technology and life sciences industries, are likely to continue to find inversions accomplished through the acquisition of a smaller foreign entity to be attractive should a suitable partner be available.
     
    [1] The regulations under section 367 were not withdrawn when section 7874 was enacted and continue to apply today.
    [2] Section 7874(a)(2)(A)(i).
    [3] Section 7874(a)(2)(B).
    [4] Section 7874(b).
    [5] “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.
    [6] On September 11, 2014, Senator Charles Schumer of New York introduced legislation to apply stricter earnings stripping rules to inverted companies (The Corporate Inverters Earnings Stripping Reform Act of 2014).
    [7] A "non-ordinary course distribution" means the excess of all distributions made during a taxable year by the domestic entity with respect to its stock (or partnership interests) over 110 percent of the average of such distributions during the 36 month period immediately preceding taxable year. Distributions include dividends, redemptions of stock, and cash distributed in certain acquisitions and reorganizations.
    [8] Foreign group nonqualified property will be defined to include, inter alia, cash and marketable securities.
    [9] Section 956(e) authorizes regulations to prevent the avoidance of the provisions of section 956 through reorganizations.
    [10] A CFC is defined as a foreign corporation if more than 50 percent of the combined voting power or the value of the shares of the foreign corporation are owned by United States shareholders. A United States shareholder is defined as a U.S. person that owns, directly or indirectly, 10 percent or more of the combined voting power of the shares of the foreign corporation.
    [11] Section 7701(l) provides: “The Secretary may prescribe regulations recharacterizing any multiple-party financing transaction as a transaction directly among any 2 or more of such parties where the Secretary determines that such recharacterization is appropriate to prevent avoidance of any tax imposed by this title.”
    [12] In 1998, the IRS proposed regulations to curtail the use of hybrid entities to avoid subpart F.  See Notice 98-35.  That Notice was withdrawn in 1999.
    [13] 562 U. S. ___ (2011).