The Treasury Department and the IRS continue to focus significant resources in an effort to curb transactions in which U.S. corporations transform themselves into foreign corporations (inversion transactions); thereby reducing their U.S. tax liabilities. On Thursday, November 19, 2015, the Treasury Department and the IRS issued Notice 2015-79 (2015 Notice) which announced the intention to issue regulations that would make it more difficult to avoid the application of existing inversion rules and further limit tax benefits from transactions that take place post-inversion. The 2015 Notice also provides relief from certain harsh rules, including those applicable to non-U.S. insurance companies, that the Treasury Department and the IRS had previously announced in Notice 2014-52 (2014 Notice).1
The rules described in the 2015 Notice are generally effective for transactions completed on or after November 19, 2015, but taxpayers can elect to apply the new relief provisions to transactions occurring before that date.
Although the 2015 Notice does not contain any new earnings stripping rules, the IRS and the Treasury Department reiterated that they continue to consider guidance to prevent shifts of income to lower tax jurisdictions (e.g., through intercompany debt), and reiterated their request for comments made in the 2014 Notice.
The New Anti-Avoidance Rules
Under the 2015 Notice, the following new rules would make it more difficult for taxpayers to avoid the application of the inversion rules under Section 7874 of the Internal Revenue Code of 1986 (the Code). These rules are effective for inversions completed on or after November 19, 2015:
Tax Residency Requirements for Substantial Business Activities. An inversion transaction is not subject to Section 7874, if the foreign acquiring corporation has substantial business activities in its foreign jurisdiction. Under the 2015 Notice, this exception will apply only if the foreign acquiring corporation is subject to tax as a resident in the foreign jurisdiction. This rule is intended to primarily target tax residence rules of foreign countries that differ from U.S. residence rules (e.g., place of management tests) and foreign acquiring entities that are treated as fiscally transparent in their home countries. It is not yet clear if this new rule would disregard substantial business activities conducted in a jurisdiction that does not subject its residents to tax.
Third Country Transactions. Under the existing inversion rules, the foreign acquiring corporation in an inversion transaction is subject to tax as a U.S. corporation if the former shareholders of the U.S. corporation own at least 80 percent of the voting power or value of the foreign acquiring corporation’s stock. Under the 2015 Notice, where the U.S. corporation combines with an existing foreign corporation by forming a new foreign holding company for both corporations that is a tax resident in a third country, the stock issued to the shareholders of the existing foreign corporation will be disregarded for purposes of determining whether the 80 percent threshold is met (thus increasing the ownership percentage of the former shareholders of the U.S. corporation in the new foreign corporation). This rule applies, however, only if the following conditions are met:
the new foreign parent directly or indirectly acquires substantially all the properties of the existing foreign corporation (including through an acquisition of its stock);
the new foreign parent acquires more than 60 percent of the gross value of the property of the group (other than the property previously held directly or indirectly by the U.S. corporation, and other than cash, marketable securities and certain other assets);
the tax residency of the new foreign corporation is different from the tax residency of the existing foreign corporation (as determined prior to any related transaction); and
the ownership percentage of the shareholders of the U.S. corporation in the new foreign corporation is at least 60 percent but less than 80 percent (before the application of this new rule).
Clarification of “Anti-Stuffing” Rules. Under existing Treasury Regulations, certain transactions designed to reduce the ownership percentage of the former shareholders of the U.S. corporation in the foreign acquiring corporation are disregarded (commonly known as stuffing transactions). In particular, stock issued by the foreign acquiring corporation in a transaction related to the inversion is disregarded if it was issued in exchange for passive assets (such as cash, marketable securities and certain obligations) or any “other property” acquired with a principal purpose of avoiding the inversion rules. The 2015 Notice clarifies that such “other property” includes any property and is not limited to property (such as stock of another corporation) used to indirectly transfer cash, marketable securities and obligations to the foreign acquiring corporation. For example, if business assets were transferred to the foreign acquiring corporation in exchange for stock in connection with the inversion and for the principal purpose of “stuffing” the foreign acquiring corporation to dilute the ownership percentage of the former shareholders of the U.S. corporation, the stock issued in exchange for the business assets would be disregarded.
The New Rules for Post-Inversion Transactions
The 2015 Notice further limits tax benefits sought by taxpayers from post-inversion transactions. These limitations apply to post-inversion transactions occurring on or after November 19, 2015, but only if the inversion is completed on or after September 22, 2014:
Expanding Inversion Gain to Indirect Transfers. Under current law, an inverted U.S. corporation is unable to use its tax attributes (such as its NOLs) to shield the tax on certain gain classified as “inversion gain.” This is designed as a “toll charge” on U.S. corporations involved in inversion transactions. The 2015 Notice expands the definition of “inversion gain” to include income (such as Subpart F income) from an indirect transfer or license of property as part of the inversion transaction or to specified related persons as part of a post-inversion transaction. This will limit the ability of domestic corporations to use their U.S. tax attributes to shield the tax on transfers or licensing of property by their controlled foreign corporations (CFC). The 2015 Notice further provides that transfers or licensing by foreign related partnerships will be attributable to the partners for purposes of determining inversion gain.
Gain Recognition on Stock of CFCs. Under the 2014 Notice, taxpayers generally are required to include, as a deemed dividend, the “Section 1248” amount (representing certain undistributed earnings) with respect to stock of a CFC that, during the 10-year period after the inversion, is exchanged for stock in another foreign corporation in an otherwise tax-free exchange. The 2015 Notice extends this rule to require the recognition of any remaining built-in gain realized on such transfer, thus converting an otherwise tax-free exchange into a fully taxable exchange. This rule is subject to a de minimis exception for certain exchanges that do not decrease the U.S. shareholder’s interests in the CFC by more than 10 percent.
Clarifications Related to the 2014 Notice
The 2015 Notice also corrects and clarifies the 2014 Notice in certain respects:
Relief for an Active Conduct of an Insurance Business. Under the 2014 Notice, certain stock of the foreign acquiring corporation attributable to passive assets is not taken into account in determining the ownership percentage of the former shareholders of the inverted U.S. corporation (thus increasing their ownership percentage in the foreign acquiring corporation and making it more difficult to avoid the application of the inversion rules). The 2014 Notice provided that passive assets do not include assets that give rise to income eligible for the banking exception to the passive foreign investment company (PFIC) rules and the active financing, banking and insurance exceptions to Subpart F income. The 2015 Notice extends such relief to assets that give rise to income from the active conduct of an insurance business (i.e., the PFIC insurance exception). Similarly, because the rules might also apply to assets held by domestic corporations that were subsidiaries of the foreign acquiring corporation before the inversion, the 2015 Notice also excludes property held by a domestic insurance company that is required to support, or is substantially related to, the active conduct of an insurance business, as well as property held by a domestic corporation that would have otherwise qualified for the active banking and financing exceptions. This rule is effective for inversions completed on or after November 19, 2015, but taxpayers may elect to apply it to inversions completed before that date.
The Treasury Department and the IRS were careful to note, however, that they have “significant concerns” about certain foreign companies that do not conduct bona fide active insurance business or whose investment assets exceed those that are necessary to meet the company’s insurance and annuity obligations. This alludes to the proposed Treasury Regulations issued earlier this year to curb the use of offshore insurance companies by alternative investment managers to defer tax on otherwise passive income. In the 2015 Notice, the Treasury Department and the IRS announced that they expect to issue separate guidance under Section 1297 to prevent companies from inappropriately applying the PFIC insurance exception.2
New De Minimis Exception to Pre-Inversion Distributions. In order to avoid a U.S. corporation from reducing its size prior to an inversion transaction so as to reduce the ownership percentage of its shareholders in the foreign acquiring corporation, the 2014 Notice generally provided that non-ordinary course distributions made during the three-year period before the inversion are disregarded. The 2015 Notice provides a new de minimis exception to this rule where (i) the ownership percentage of the shareholders of the U.S. corporation in the foreign acquiring corporation is less than five percent (by vote and value and determined taking into account certain stock that would otherwise be disregarded) and (ii) after the acquisition and related transactions, persons that held stock in the U.S. corporation before the inversion transaction own, directly, indirectly or constructively, less than five percent (by vote and value) in any member of the expanded affiliated group of the foreign acquiring corporation. This rule is effective for inversions completed on or after November 19, 2015, but taxpayers may elect to apply it to inversions completed before that date.
Clarifying the Small Dilution Exception. The 2014 Notice provided that certain transactions designed to dilute the interests of a U.S. shareholder in a CFC after an inversion may be subject to recharacterization. An exception to such recharacterization is generally provided for transactions where the amount of stock owned by the U.S. shareholders does not decrease by more than 10 percent as a result of the transactions. For example, the exception applies where a CFC of a U.S. corporation issues stock to the foreign acquiring corporation in return for cash, thereby diluting the percentage owned by U.S. shareholders. The 2015 Notice clarifies that the 10 percent dilution is not measured by the change in the value of the stock (which might remain the same in the example above) but rather by the change in the percentage ownership (by value) in the CFC. A similar clarification will be made with respect to the de minimis exception described above under Gain Recognition on Stock of CFCs. These clarifying changes apply to exchanges completed on or after November 19, 2015, but only if the inversion is completed on or after September 22, 2014.
Future Guidance on Income Stripping
The 2015 Notice states that the IRS and Treasury Department intend to issue additional guidance to further limit inversion transactions that are contrary to the purposes of the Code and the benefits of post-inversion tax avoidance transactions. In particular, IRS and the Treasury Department reiterated that they continue to consider guidance to prevent earnings stripping that shifts income from the United States to lower tax jurisdictions (e.g., through intercompany debt), and reiterated their request for comments made in the 2014 Notice.