IRS and Treasury Issue Final Regulations on the “Substantial Business Activities” Exception to Section 7874

SUMMARY

On June 3, 2015, the IRS and Treasury Department released final regulations (the “Regulations”) adopting the 2012 temporary regulations’ exclusive bright-line rule to determine when a foreign corporation or publicly traded foreign partnership will be covered by the “substantial business activities” exception to the definition of a “surrogate foreign corporation,” subject to a few modifications, additions and clarifications.1 Under the bright-line rule, an “expanded affiliated group” will have substantial business activities in a foreign country only if at least 25% of the group’s employees (both by head count and compensation), gross tangible assets, and gross income are located or derived in the foreign country.

The Regulations apply to acquisitions that are completed on or after June 3, 2015.

BACKGROUND

Section 7874 generally disregards any “inversion” or “expatriation” transactions – and therefore, the expatriated entity is treated as continuing to be domestic – in which a foreign corporation or publicly traded foreign partnership acquires substantially all of the assets of a U.S. corporation or partnership (including by way of acquiring the ownership interests in such corporation or partnership), and 80% by vote or value of the foreign entity is held by the former shareholders or partners of the expatriated entity.2 If 60% or more by vote or value, but less than 80%, is held by the former shareholders or partners, the transaction is respected, and the expatriated entity is treated as foreign but is subject to U.S. tax on the “inversion gain” recognized in the next ten years, notwithstanding any contrary tax treaty provision.3 However, Section 7874 will not apply if, after the acquisition, the “expanded affiliated group”4 including the foreign entity has “substantial business activities” in the foreign jurisdiction in which (or under the law of which) the foreign entity is created or organized.5

THE REGULATIONS

After experimenting with a facts and circumstances test and a 10% safe harbor,6 the IRS adopted a 25% bright-line rule in the 2012 temporary regulations. The Regulations retain this bright-line rule that an expanded affiliated group will have “substantial business activities” in a foreign country only if at least 25% of the group’s employees (both by head count and compensation), gross tangible assets, and gross income are located or derived in the foreign country, subject to a few modifications, additions, and clarifications.

A. PARTNERSHIP “LOOK-THROUGH” RULE

In determining whether an expanded affiliated group meets the 25% threshold for each of the “substantial business activities” tests, the Regulations and the 2012 temporary regulations provide that a partnership’s employees, assets, and gross income are taken into account if one or more members of the group holds, in the aggregate, more than 50% (by value) of the interests in the partnership. If the 50% ownership threshold is met, then the partnership is treated as a corporation that is a member of the expanded affiliated group (the “deemed corporation rule”).

The Regulations have added a new “look-through” rule, under which, in determining the members of the expanded affiliated group, each partner in a partnership is treated as owning its proportionate share of any stock held by the partnership. For example, under this rule, if corporation P owns a 75% interest in partnership PS, and PS owns 100% of the stock in another foreign corporation FA, then P would be treated as owning 75% of FA’s stock for the purposes of determining the Section 7874 expanded affiliated group.

The Regulations specify that the “look-through” rule is applied first to determine whether a corporate entity is a member of an expanded affiliated group. Then, the deemed corporation rule is applied to treat partnerships in which those corporate entities are partners as corporations within the expanded affiliated group.

B. OTHER CHANGES

1. Anti-Abuse Rule

The 2012 temporary regulations contain an anti-abuse rule under which group assets, employees, and income attributable to business activities transferred principally to avoid the application of Section 7874 will not be taken into account in the numerator, but will be taken into account in the denominator, for purposes of the group employees, group assets, and group income tests. In modification of the 2012 temporary regulations, the Regulations provide that any such disregarded items transferred to the expanded affiliated group are eliminated from both the numerator and the denominator for each of the group employees, group assets, and group income tests.

2. Group Employees, Mobile Assets, and Group Income

In an effort to clarify the 2012 temporary regulations, the Regulations elaborate upon the definitions of some of the terms necessary to determine group employees, group assets, and group income.

a. Group Employees

The Regulations provide that the determination of whether individuals are “employees” (rather than independent contractors, for example) must be made either (i) for all members of the expanded affiliated group under U.S. federal tax principles, or (ii) for each member, based upon the tax laws to which that specific member is subject. The Regulations also clarify the meaning of “employee compensation,” providing that compensation is treated as incurred when it would be deductible as compensation by the employer, and that the amount of such compensation is equal to the amount that would be deductible by the employer as compensation. Both the timing and amount of this deduction must be determined for all group employees under U.S. federal tax principles, or in the alternative, for all group employees based upon the relevant tax laws (i.e., the tax laws to which an employing member is subject).

b. Mobile Assets

In general, the Regulations provide that a group asset is considered to be located in a foreign jurisdiction if it is physically located in that jurisdiction at the close of the acquisition date, and for more time than in any other single country during the one-year “testing period” ending on the acquisition date (or the last day of the month immediately preceding the month in which the acquisition is completed). However, the Regulations modify the general rule in the case of “mobile assets,” such as planes, ships, and motor vehicles. Such assets need not be physically present in the relevant foreign country at the close of the acquisition date; so long as the assets are physically present in a country for more time than in any other single country during the testing period, they will still be considered to be located in that country.

c. Group Income

The Regulations specify that group income must be determined consistently for all members of the expanded affiliated group using either U.S. federal income tax principles, or as reflected in the “relevant financial statements.” The “relevant financial statements” are generally defined as financial statements prepared in accordance with U.S. Generally Accepted Accounting Principles (U.S. GAAP), or International Financial Reporting Standards (IFRS).

3. Expanded Affiliated Group

In general, for the purposes of Section 7874, an expanded affiliated group (“EAG”) is a group of corporations connected by one or more chains of greater than 50% ownership (as measured by vote and value).7 The Regulations further clarify this definition, providing that members of the EAG are to be determined taking into account all transactions related to the acquisition, even those occurring after the acquisition date, and that an entity which is not a member of the EAG on the acquisition date (e.g., because it was sold prior to the acquisition date) will not be considered a member of the EAG.

C. APPLICABILITY DATE

The Regulations apply to acquisitions that are completed on or after June 3, 2015.