H.R. 2937, introduced on June 28, 2007, by Rep. Richard Neal (D-MA) and referred to the House Committee on Ways and Means for further consideration, would amend Section 7874 of the Internal Revenue Code (“Code”) to provide that management and administrative activities are not to be taken into account in determining if an entity has “substantial business activities” in a foreign country to avoid treatment as an expatriated entity.
Section 7874 applies if, pursuant to a plan or series of related transactions:
a foreign corporation acquires, directly or indirectly, substantially all of the properties held a. directly or indirectly by a U.S. corporation (or substantially all of the properties constituting a trade or business of a domestic partnership);
the foreign acquiring corporation (or any affiliated company) does not have “substantial b. business activities” in the foreign country in which the acquiring corporation is organized; and
immediately after the acquisition, the former shareholders of the domestic target corporation c. own at least 60 percent of the vote or value of the foreign corporation by reason of holding stock in the domestic target corporation.
If the former shareholders own between 60–79 percent, the U.S. target is prevented for a 10-year period from using tax attributes to offset income realized on the transfer of stock or assets. If the shareholders own 80 percent or more, the acquiring corporation itself is treated as a domestic corporation for all U.S. tax purposes.
Two sets of temporary regulations were issued under the authority of Section 7874. The second set, in Temp. Reg. § 1.7874-2T(d)(1), provides that a “facts and circumstances” test is applied in determining whether “substantial business activities” are conducted by the affiliated group in the acquiring foreign entity’s country of incorporation. A non-exclusive list of factors is provided which includes employee headcount, sales, management activities, etc. .
Alternatively, a safe harbor test is provided pursuant to which the “substantial business activities” provision will be complied with if three tests (measuring employees, assets and sales) are met.
H.R. 2937 would add Section 7874(a)(4) to eliminate “management and administrative activities” as a factor in determining whether the affiliated group has “substantial business activities” in the country of incorporation of the acquiring entity as compared with the affiliated group’s business activities worldwide. The genesis for the bill, apparently, was one company’s statement that it was moving its headquarters of the operation to a foreign country with no income tax. According to Rep. Neal, “many have speculated that this is really a two-step process: move some administrative functions abroad to establish a minimal presence and then give up U.S. corporate citizenship.”
The bill is broad and would apply to any management and administrative activities extending beyond top corporate management to include management and administration of operational units and would affect both the “facts and circumstances” test as well as the “safe harbor” test. Interestingly, management and administrative activities are not to be counted in the numerator but are to be counted in the denominator of the analysis.
It is not clear how serious an abuse this is and whether taxpayers can really credibly defend against a Section 7874 attack simply by moving management and administrative services, alone, to the acquiring entity’s country of incorporation. This factor, together with the anti-abuse provision of the regulations, would seem to suggest not.
However, it remains to be seen whether significant opposition will be generated from the tax community and lobbyists. No floor action has yet been taken up on the bill.