Non-U.S. persons often wish to set up a new U.S. corporation (USCo) to conduct business in the United States, frequently in very short order. While there are many advantages to conducting business in the United States through a corporate entity (rather than a U.S. branch or a pass-through entity like a partnership), these advantages can be negated if certain tax aspects of setting up USCo are not addressed.
For non-U.S. individuals, shares of USCo are U.S.-situs assets, which are potentially subject to U.S. estate tax upon death. This can be avoided by having a non-U.S. entity that is treated as a corporation for U.S. tax purposes hold the shares of USCo. For Canadians, this would be a Canadian entity that is treated as a corporation for U.S. tax purposes (Canco). Interests in Canco that are held by non-U.S. individuals are not subject to U.S. estate tax.
Due to time constraints, we are frequently asked whether it is possible to transfer the USCo shares to Canco at a later date. This creates a potential tax trap—the application of the U.S. anti-inversion rules.
The anti-inversion rules will treat Canco as a U.S. corporation for all U.S. tax purposes, including being subject to federal income tax on its worldwide income and its shares being U.S.-situs assets for estate tax purposes, if:
- Canco acquires substantially all of the interests in or assets of USCo (or a U.S. partnership).
- The former shareholders of Canco hold (by reason of holding stock in USCo) 80 percent or more (by vote or value) of the stock of Canco after the transaction.
- Canco, considered together with all companies connected to it by a chain of greater than 50 percent ownership (i.e., the expanded affiliated group [EAG]) does not conduct substantial business activities in Canada compared to the total worldwide business activities of the EAG.
There are also tax consequences if the ownership threshold in the second bullet point is at least 60 percent and less than 80 percent, though in that case, Canco generally will be respected as a non-U.S. corporation for tax purposes.
If USCo is formed, whether by a U.S. or non-U.S. individual or entity, and its shares are transferred to Canco even a day or two later, the first two prongs of the anti-inversion rules will generally be met. At that point, the critical inquiry is whether the “substantial business activities” test in the third bullet point is met, which is a highly fact-specific inquiry. Under current temporary regulations, an EAG will have substantial business activities in the foreign country of incorporation only if at least 25 percent of the group’s employees (both by head count and compensation), gross tangible assets, and gross income are located or derived in that foreign country.
Accordingly, if Canco is newly-formed and not part of an EAG, the third prong of the inversion test will automatically be met, and Canco will thereafter be treated as a U.S. corporation for tax purposes. However, if Canco is pre-existing or is part of an EAG, further analysis is required to determine whether an inversion will occur if the USCo shares are transferred to Canco. Because of the specific requirements of the substantial business activities test, it is usually very difficult to meet.
To avoid the application of the anti-inversion rules, careful consideration should be given to establishing the proper ownership of USCo when it is formed, as later transfers of the USCo shares can cause unforeseen U.S. tax issues.