On January 16, 2014, temporary regulations were issued by the U.S. Department of the Treasury and the Internal Revenue Service (IRS) with respect to corporate inversions under Section 78741 (the "New Regulations"), which implement and expand rules first announced by the IRS in 2009 (See Notice 2009-78, 2009-40 IRB 452) and introduce a new de minimis exception. For those who can qualify, the de minimis exception offers a previously unavailable option to allow some continuing involvement by former shareholders of a U.S. corporation without triggering the punitive rules of Section 7874. However, the New Regulations' expansion of certain rules contained in Notice 2009-78 may make it more challenging for foreign acquirers to side-step the Section 7874 hurdles.
Under Section 7874, a foreign corporation may be treated as a U.S. corporation for U.S. federal income tax purposes (subject to U.S. tax on its worldwide income) even though it is organized under the laws of a foreign jurisdiction and would otherwise be treated as a foreign corporation for U.S. federal income tax purposes. In the case of an inversion of a U.S. corporation, a foreign corporation will be treated as a U.S. corporation under Section 7874 if, pursuant to a plan or series of related transactions:
- the foreign corporation directly or indirectly acquires substantially all of the properties held directly or indirectly by the U.S. corporation;
- after the acquisition, at least 80 percent of the stock of the foreign corporation (by vote or value) is held, or deemed to be held, by former shareholders of the U.S. corporation by reason of the former shareholders' holding stock in the U.S. corporation; and
- after the acquisition, the expanded affiliate group2 that includes the foreign corporation does not have substantial business activities in the foreign country in which the foreign corporation is created or organized when compared to the total business activities of the expanded affiliated group.
If an inversion meets all three of these criteria or would meet the criteria but for the fact that less than 80 percent but at least 60 percent of the stock of the foreign corporation (by vote or value) is held, or deemed to be held, by former shareholders of the U.S. corporation by reason of the former shareholders' holding stock in the U.S. corporation, then the foreign corporation will not be treated as a U.S. corporation, but certain limits will be imposed on the U.S. corporation's ability to use its tax attributes (such as net operating losses). Similar rules apply to a foreign corporation acquiring substantially all of the assets of a trade or business of a U.S. partnership and the income or gain recognized by its partners in connection with an inversion.
Under Section 7874, stock of the foreign acquirer that is sold in a "public offering" related to the inversion is not taken into account for purposes of calculating the ownership fractions of stock held, or deemed to be held, by former shareholders of the U.S. corporation by reason of the former shareholders' holding stock in the U.S. corporation ("the public offering rule"). Accordingly, under the Code, stock sold in such an offering would not dilute the continuing U.S. ownership for purposes of the ownership fraction. However, because the term public offering was not defined in the Code for these purposes, uncertainty surrounded the scope of this rule.
Notice 2009-78 announced that regulations would be issued that would effectively apply the public offering rule of Section 7874 to private offerings by introducing a new exclusion rule (the "Exclusion Rule") for transactions occurring on or after September 17, 2009. Under the Exclusion Rule, the issuance of stock of a foreign corporation for cash or other "nonqualified property" in any transaction that is related to the acquisition of substantially all of the properties of a U.S. corporation is not to be taken into account for purposes of determining the 80-percent and 60-percent ownership tests. Under Notice 2009-78, "nonqualified property" means cash or cash equivalents, marketable securities and any other property acquired in a transaction with a principal purpose of avoiding the purposes of Section 7874.
The New Regulations
The New Regulations set forth the rules described in Notice 2009-78, with certain modifications to the Exclusion Rule, and identify certain stock of a foreign corporation that is disregarded for purposes of determining the ownership fraction. They also provide guidance with respect to the effect of post-acquisition stock transfers.
The New Regulations describe all situations in which stock will be excluded from the denominator of the ownership fraction and expand the definition of nonqualified property for purposes of the Exclusion Rule to include certain obligations. The New Regulations exclude from the ownership fraction (but only to the extent such transfers increase the fair market value of the assets or decrease the amount of liabilities of the foreign corporation):
- stock of the foreign acquirer transferred to any person (including the U.S. corporation) in exchange for property to the extent, pursuant to the same plan (or series of related transactions), the stock is subsequently transferred in exchange for the satisfaction or the assumption of an obligation associated with the property exchanged; and
- any stock of the foreign acquirer transferred in exchange for nonqualified property by any person (including an unrelated person) in connection with the potential inversion transaction.
The New Regulations add an exception to the Exclusion Rule when former owners of the U.S. corporation retain a de minimis (less than 5 percent) interest in the foreign acquirer. Specifically, this exception will apply if:
- the ownership fraction determined without regard to the Exclusion Rule is less than 5 percent (by vote and value);
- after the acquisition and all transactions related to the acquisition, former shareholders of the U.S. corporation, in the aggregate, own directly or indirectly less than 5 percent (by vote and value) of the stock of any member of the expanded affiliated group that includes the foreign corporation; and
- stock of the foreign corporation that would otherwise be excluded from the denominator of the ownership fraction was not transferred in a transaction related to the acquisition with a principal purpose of avoiding the purposes of Section 7874.
The New Regulations are generally effective for transactions occurring on or after September 17, 2009 (for matters addressed in Notice 2009-78), and (unless the taxpayer elects otherwise) on or after January 16, 2014, for matters not covered in Notice 2009-78.