In Notice 2015-79 (the “2015 Notice”), released on November 19, 2015, the Internal Revenue Service (the “IRS”) and the Treasury Department (“Treasury”) announced their intention to issue additional Treasury regulations targeting so-called corporate inversions. The 2015 Notice builds upon, supplements and, in parts, clarifies the guidelines released in Notice 2014-52 (the “2014 Notice”). The 2015 Notice contains rules that apply to the inversion transaction itself, rules that apply to post-inversion transactions and rules that clarify certain aspects of the 2014 Notice. The new rules on inversion transactions include: (1) tax residency rules; (2) third-country transaction rules; and (3) nonqualified property rules. In the context of post-inversion transactions, the Treasury regulations contemplated by the 2015 Notice significantly expand the definition of “inversion gain” and require recognition of unrealized gain in certain restructurings of controlled foreign corporations (“CFCs”). Finally, the 2015 Notice clarifies the definition of foreign group nonqualified property, creates a de minimis exception to the “skinny down” rule of the 2014 Notice and clarifies the small dilution exception for decontrolling or diluting ownership of CFCs.
This update summarizes certain key provisions in the Notice that may be relevant to your business.
1. Inversions and Section 7874 in General
Section 7874 targets the so-called corporate inversion, which is a transaction in which a public U.S. company migrates to a foreign country, typically by merging with a smaller foreign target company and thereby becoming a subsidiary of a new public foreign company (“Foreign Parent”). Very generally, in order to have a “successful” inversion transaction under section 7874, either the shareholders of the formerly public U.S. company must own less than 80% of the stock of Foreign Parent after the merger (i.e., the smaller foreign company cannot be too small), or Foreign Parent must have substantial business assets and operations in the jurisdiction in which it is created or organized. If an inversion transaction fails to satisfy the requirements of section 7874, Foreign Parent would be treated as if incorporated in the United States for income tax purposes; that is, Foreign Parent would be a full U.S. taxpayer despite the fact that it is organized in a foreign jurisdiction. If, however, the shareholders of the former U.S. corporation own between more than 60% but less than 80% and Foreign Parent had no substantial business assets and operations in the jurisdiction in which it is created or organized, then section 7874 prevents the U.S. corporation from using tax attributes to offset the gain from certain post-inversion transfers or licenses of property (the “Toll Charge”).
Among the major proposals in the 2014 Notice were rules designed (i) to tighten the application of the stock ownership test of section 7874, (ii) to prevent the repatriation to Foreign Parent of earnings from foreign subsidiaries of the inverted U.S. company without U.S. income taxation and (iii) to limit the availability of post-inversion restructuring with respect to those foreign subsidiaries. Treasury regulations implementing the 2014 Notice have yet to be issued.
2. Tax Residency Rule
The IRS and Treasury noted that in some inversion transactions, U.S. corporations are combining with Foreign Parents that have substantial business activities in their home jurisdictions even though the Foreign Parents are not subject to income tax in those jurisdictions. For example, Foreign Parent may be a corporation for U.S. tax purposes, but a pass-through entity for foreign tax purposes. The IRS and Treasury believe that this result is contrary to the policy of the substantial business activity exception. Therefore, future Treasury regulations will provide that the substantial business activities exception will not apply unless Foreign Parent is subject to income tax as a resident of the relevant foreign jurisdiction.
3. Third-Country Transactions
The IRS and Treasury believe that the 80% threshold of section 7874 reflects a Congressional determination that, if the former shareholders of the foreign target company own at least 20% of Foreign Parent after the inversion, then the inversion has sufficient non-tax business purposes such that Foreign Parent should not be deemed a U.S. corporation. However, in the 2015 Notice, the IRS and Treasury point to transactions where a U.S. corporation and a foreign target corporation (the “Combining Foreign Corporation”) combine to form a new Foreign Parent that is not resident in the same foreign country as the Combining Foreign Corporation. In their mind, the chances that non-tax business purposes motivated the inversion are significantly lower in such third-country combinations. Thus, the 2015 Notice indicates that in certain circumstances the stock of Foreign Parent acquired by the shareholders of the Combining Foreign Corporation will be disregarded in determining whether the former shareholders of the U.S. corporation own 80% or more of Foreign Parent.
The new rule will apply only in circumstances where: (1) in a transaction related to the acquisition of the U.S. company, Foreign Parent acquires directly or indirectly substantially all of the properties held by the Combining Foreign Corporation; (2) the gross value of the property acquired by Foreign Parent in the acquisition of the Combining Foreign Corporation exceeds 60% of the gross value of the foreign group property (without regard to nonqualified foreign group property); (3) the tax residence of Foreign Parent is different from that of the Foreign Combining Corporation; and (4) without regard to this new rule, the former shareholders of the U.S. corporation would own more than 60% of Foreign Parent. The 2015 Notice provides the example of FA, a corporation that is a resident of country Y, which acquired DC, a U.S. corporation, in exchange for 65 shares of FA stock. FA also acquires FT, a resident of country X, for 35 shares of FA. Thus, the FT’s former shareholder’s ownership of FA stock is disregarded in determining the ownership percentage of the former DC shareholders, who therefore own 100% of FA for purposes of applying section 7874. Note also that if FT has reincorporated in country Y in a related transaction, the reincorporation would be ignored, and the result would be the same.
4. Nonqualified Property
Section 7874(c)(2)(B) states that stock issued by Foreign Parent in a public offering related to the acquisition of the U.S. company is excluded from calculating the percentages in the section 7874 ownership test. Temporary regulations expand on this exclusion, stating that “disqualified stock” is not taken into account and defining disqualified stock as stock received in exchange for cash or cash equivalents, marketable securities, certain obligation or other property acquired with a principal purpose of avoiding section 7874. The 2015 Notice refers to this last category as “avoidance property” and notes that taxpayers are inappropriately interpreting the definition too narrowly. The 2015 Notice stated that future Treasury regulations will remove the implication in the Temporary regulations that avoidance property only includes property used indirectly to transfer nonqualified property to Foreign Parent. The future Treasury regulations will state simply that avoidance property means any property acquired with a principal purpose of avoiding section 7874.
5. Post-Inversion Transactions
The Toll Charge discussed above applies to certain transfers by the U.S. corporation after the inversion by restricting the use of certain offsets against the income arising from such transfers (“Inversion Gain”). The 2015 Notice notes that certain types of income escape the current definition of Inversion Gain. For example, if an upper-tier CFC sells a lower-tier CFC, the upper-tier CFC generally will have subpart F income under section 951 from that sale. While the U.S. shareholder will recognize this Subpart F income, prior to the 2015 Notice, the Subpart F income was not subject to the Toll Charge. Therefore, future Treasury regulations will include within the scope of Inversion Gain the gain from indirect transfers or licenses of property if the transfer or license is part of the inversion transaction or, for post-inversion transactions, if the transfer or license is to a related person.
Furthermore, the 2015 Notice recognizes that under current law, a U.S. shareholder is required to recognize a deemed dividend under section 367(b) and section 1248 after a transaction that results in a CFC no longer being a CFC or that dilutes the U.S. shareholder’s ownership of the CFC. Under these rules, the deemed dividend is only to the extent of earnings and profits of the CFC. The IRS and Treasury believe that the current law allows taxpayers to avoid tax on appreciated property, even though the same policy reasons for taxing the earnings and profits apply to taxing the unrealized gain in appreciated property. For example, a CFC may have significant self-developed intangible property but may not yet have earnings and profits. Therefore, the IRS and Treasury intend to issue Treasury regulations that require the U.S. shareholder to recognize the full unrealized appreciation in the stock of a CFC even if the gain exceeds earnings and profits. The rules will take into account any basis increase due to the deemed 1248 dividend.
The 2015 Notice clarifies or modifies the 2014 Notice in three respects. First, the 2015 Notice excludes from the definition of foreign group nonqualified property: (i) property producing certain passive income as defined in the passive foreign investment company exception for insurance, (ii) certain property held by U.S. insurance companies and (iii) certain property giving rise to active banking or financing income.
Second, the 2015 Notice announces the intent to create a de minimis exception to the “skinny down” rules of the 2014 Notice. The 2014 Notice requires the U.S. corporation to count as part of its equity value the amount of certain extraordinary distributions undertaken prior to the inversion, and then determine whether its shareholders should have received 80% or more of Foreign Parent stock had the extraordinary distributions not occurred. Under the 2015 Notice, an extraordinary distribution will be disregarded if (1) the ownership percentage is less than 5% (by vote and value) without regard to the other rules and (2) no former shareholder of the U.S. corporation owns 5% or more of any member of the expanded affiliated group that includes Foreign Parent.
The final clarification notes that taxpayers were misinterpreting the small dilution exception of the 2014 Notice, which created an exception for the CFC dilution rules where the ownership percentage did not decrease by more than 10%. The future Treasury regulations will state that the correct measure is the percentage of the CFC’s stock by value.
7. Effective Dates
The future Treasury regulations discussed in the 2015 Notice generally will be effective as of November 19, 2015, the date of issuance of the 2015 Notice. However, future Treasury regulations that govern post-inversion transactions (e.g., the expansion of Inversion Gain to include subpart F income and the gain recognition rule) will be effective as of November 19, 2015, but only for inverted companies that completed an inversion transaction on or after September 22, 2014, the date of the 2014 Notice. Finally, taxpayers may elect to apply the modified definition of foreign group nonqualified property and the de minimis exception to the skinny down rule to transactions occurring before November 19, 2015.