In 2004, Congress enacted §78741 to put an end to certain perceived abuses associated with ‘‘inversion transactions,’’ i.e., transactions in which a U.S.-based multinational corporation migrates to a lower-tax jurisdiction in order to reduce U.S. taxation.2 In particular, in enacting §7874, Congress was concerned that ‘‘inversion transactions resulting in a minimal presence in a foreign country’’ were simply a ‘‘means of avoiding U.S. tax and should be curtailed.’’3

Section 7874 applies to a transaction in which: (1) a foreign corporation completes a direct or indirect acquisition of substantially all of the properties held directly or indirectly by a U.S. corporation or substantially all of the properties constituting a trade or business of a U.S. partnership; (2) after the acquisition, at least 60%4 of the stock of the foreign corporation (measured by vote or value) is held by former shareholders or partners of the U.S. corporation or partnership by reason of holding stock or a capital or profits interest in the target U.S. person; and (3) after the acquisition, the ‘‘expanded affiliated group’’ (the ‘‘EAG’’) of the acquiring foreign corporation does not have substantial business activities in the foreign country in which the acquiring foreign corporation is organized when compared to the total activities of the EAG. Thus, if a foreign corporation can prove that its EAG will be engaged in substantial business activities in the foreign corporation’s country of organization, it will not be subject to the burdens of §7874 when acquiring a U.S. business.

The standard for determining whether an EAG is engaged in substantial business activities in the country of organization of its foreign parent corporation has changed significantly between 2006 and the present. Since 2006, Treasury and the IRS have issued three sets of temporary regulations specifically addressing when an EAG will be considered to be engaged in substantial business activities in a foreign country. On June 7, 2012, Treasury and the IRS issued the third set of temporary regulations (the ‘‘2012 Temporary Regulations’’), effective for transactions completed after June 7, 2012.5 Under the 2012 Temporary Regulations, Treasury and the IRS have implemented a bright-line, mechanical test that will likely affect foreign acquirors that, as a policy matter, should arguably not be subject to §7874 on the acquisition of a U.S. business.

For example, Canco, a publicly traded corporation incorporated in Canada, is engaged in the business of exporting widgets. All of its assets and employees are located in Canada, and it manufactures all of its widgets in Canada, but Canco makes all of its widget sales to buyers in Europe, Asia, and Latin America. Canco desires to acquire all of the assets of USco, a U.S. manufacturer of widgets, in exchange for Canco stock. As described in more detail below, the 2012 Temporary Regulations could potentially subject Canco to §7874 on the acquisition of USco, simply because all of its income is derived from sales to customers that are not located in Canada. Although Canco is a publicly traded corporation, is located in a jurisdiction with a comprehensive corporate tax regime, and performs all of its business activities in Canada, the 2012 Temporary Regulations would deem Canco not to be engaged in substantial business activities in Canada because all of its income is derived from exporting widgets. As a result, if more than 60% of Canco were held by former shareholders of USco, Canco would be subject to §7874.

As demonstrated by the above hypothetical and as discussed in more detail below, it is possible that a foreign multinational public company’s acquisition of a U.S. business could potentially be subject to §7874, not because such acquisition would be done to avoid U.S. tax or because the foreign country in which the foreign public company is organized is a low-tax, abusive jurisdiction, but rather because the 2012 Temporary Regulations’ high threshold, inflexibility, and unreasonable definitions and exclusions could prevent the foreign public company from being considered engaged in substantial business activities in its country of organization.

This article provides an overview of the 2012 Temporary Regulations and calls attention to some problems with their application, as highlighted by the potential issues that could arise in the context of an acquisition of a U.S. business by certain Canadian public corporations. This article also considers whether the 2012 Temporary Regulations might be considered to exceed Treasury’s rulemaking authority, and offers recommendations for a more reasonable test.


In 2006, Treasury and the IRS issued temporary regulations to clarify when an EAG would be considered engaged in substantial business activities in the foreign parent corporation’s country of organization, under either a facts-and-circumstances approach or a safe harbor (the ‘‘2006 Safe Harbor’’). Under the 2006 Safe Harbor, an EAG would be considered to have substantial business activities in the acquiring corporation’s foreign country if the EAG met a threeprong threshold in such foreign country: (1) 10% of its employees (by headcount and compensation); (2) 10% of the gross basis of its tangible business assets; and (3) 10% of its gross receipts from sales of goods or services.6 On June 12, 2009, Treasury and the IRS issued a new set of temporary regulations and, in doing so, removed the 2006 Safe Harbor, leaving only the facts-and-circumstances approach.7 Moreover, the examples that had been provided in 2006 to demonstrate application of the facts-and-circumstances approach were also removed, leaving taxpayers with very little guidance on when a corporation would be considered engaged in substantial business activities.8

Under §7805(e), temporary regulations expire within three years after the date of issuance, which means the temporary regulations issued in 2009 were set to expire after June 11, 2012.

On June 7, 2012, Treasury and the IRS issued the 2012 Temporary Regulations, effective for transactions completed after June 7, 2012,9 to replace the 2009 temporary regulations on substantial business activities. The 2012 Temporary Regulations removed the facts-and-circumstances approach promulgated in the earlier regulations, and replaced this approach entirely with a mechanical test requiring the EAG of a foreign parent corporation to have 25% of its employees, assets, and income located in the country of organization of the foreign parent corporation (the ‘‘25% Test’’).10 Under the 25% Test, an EAG will be considered to have substantial business activities in the ‘‘relevant foreign country’’ (i.e., the jurisdiction where the acquiring foreign corporation is created or organized) only if all four of the following conditions are satisfied: (1) the number of employees in the relevant foreign country is at least 25% of the total number of the EAG’s employees on the ‘‘applicable date’’11 (the ‘‘Headcount Test’’); (2) the employee compensation incurred in the relevant foreign country is at least 25% of the total employee compensation incurred with respect to all EAG employees during the ‘‘testing period’’ (the ‘‘Compensation Test’’); (3) the value of all EAG tangible assets (determined consistently across the EAG on a gross asset or fair market value basis) located in the relevant foreign country is at least 25% of the total value of all ‘‘group assets’’ on the applicable date (the ‘‘Asset Test’’); and (4) the EAG income derived in the relevant foreign country is at least 25% of the total EAG income during the testing period (the ‘‘Income Test’’).12 If a foreign corporation’s EAG fails to meet any of the components of the 25% Test, it will not be considered engaged in substantial business activities in the relevant foreign country and, accordingly, could be subject to §7874 on an acquisition of a U.S. business.

There are several definitional refinements that affect these four prongs of the 25% Test:

  • For purposes of the Headcount Test and the Compensation Test, an employee of the EAG is only considered based in the relevant foreign country if such employee spends more time providing services in the relevant foreign country than in any other country during the testing period.13
  • The term ‘‘testing period,’’ which is relevant to the Compensation and Income Tests, is defined as the one-year period ending on the applicable date.14 
  • The Asset Test is measured based only on ‘‘tangible personal property or real property used or held for use in the active conduct of a trade or business’’ by EAG members on the acquisition date.15 
  • Under the Income Test, income is considered derived in the relevant foreign country only if it is derived from a transaction with a customer located in that country.16 
  • A partnership is considered a member of an EAG (and, thus, its employees, its assets, and its income will only be included in the EAG’s total assets) only if one or more EAG members own, in the aggregate, more than 50% (by value) of the interests in such partnership.17

Furthermore, certain amounts are not taken into account for purposes of the 25% Test in situations where there is the potential for abuse (‘‘Abusive Items’’). Assets, employees, and income of the EAG are considered Abusive Items and are not taken into account if: (1) such items are associated with properties or liabilities, the transfer of which would be disregarded as part of a plan with a principal purpose of avoiding §7874; (2) such items are located in or derived in the relevant foreign country as part of a plan with a principal purpose of avoiding the purposes of §7874; or (3) in the case of an acquisition of substantially all of the assets of a U.S. partnership’s trade or business, such items are transferred to another country following the acquisition in connection with a plan that existed at the time of the acquisition.18


In theory, the 25% Test could prove to be a useful tool for foreign corporations, since it provides a bright-line, mechanical rule for them to follow. Since the 2006 Safe Harbor was removed in 2009, taxpayers have not had any clarity on when an EAG would be considered engaged in substantial business activities, 19 and commenters requested that the 2006 Safe Harbor, or some form of it, be promulgated to provide more certainty to taxpayers. The New York State Bar Association Tax Section, in a report on §7874 (‘‘NYSBA Report’’), even suggested using a 25% level for a safe harbor that would have applied only where, following the acquisition, the EAG conducted more than 50% of its activities in the United States.20

The 25% Test goes well beyond the proposed treatment in the NYSBA Report, as the 25% Test is applied to every EAG, not only those that conduct significant activities in the United States. Even more importantly, the 25% Test is not merely a safe harbor — failure to meet any one of the four elements of the 25% Test means that the EAG will not be eligible for the substantial activities exception. For ‘‘true’’ multinational corporations, with their operations spread across the globe, satisfaction of the 25% Test may prove extremely onerous and could result in structuring nightmares if they are looking to acquire substantial U.S. businesses with stock consideration.

The problems with the 25% Test discussed herein can be illustrated by attempting to apply the components of the 25% Test to publicly traded, multinational companies. In this regard, the authors thought it would be useful to look at a random selection of a few public companies that are organized or created in Canada, the largest trading partner of the United States and the country with whom the United States shares its longest border. Canada seems like a particularly apt choice for this exercise because there have been a number of strategic acquisitions of U.S. targets by Canadian multinationals. Of the 67 largest Canadian corporations,21 57 (or roughly 85%) have operations outside Canada.22 In an acquisition of a U.S. business by a Canadian acquiror, Canada would be the relevant foreign country for purposes of the 25% Test.

Application of the Headcount and Compensation Tests

Thomson Reuters, a Canadian publicly traded corporation that employs 60,500 employees worldwide23 (a level of employees that may be typical of other foreign-based multinationals), reported that 28,500 of those employees are based in ‘‘the Americas.’’24 Even if we assume that as much as half of those employees are based in Canada on the applicable date, then Thomson Reuters would fall short of the 25% threshold for the Headcount Test.

For purposes of the 25% Compensation Test, only employees who spend more than half of their time in the relevant foreign country are treated as based in such country.25 In today’s multinational environment, where employees are mobile and often work out of more than one office or location, it may prove difficult to track them. For example, Thomson Reuters would likely need to develop an entirely new internal tracking system for its 60,500 employees just to be able to determine whether it satisfies the Compensation Test. This could be extremely time-consuming and burden-some.

The Compensation Test also could produce unreliable results because many multinational corporations may not necessarily base their higher-paid employees in the relevant foreign country or in the same country in which a significant number of their employees are located. To continue with Thomson Reuters for a moment, its corporate headquarters is in New York, and it has key operations in the United Kingdom, India, Minnesota, and Connecticut.26 Here, one could speculate that having its headquarters and its key operations in jurisdictions other than Canada may cause a corporation like Thomson Reuters to fail the Compensation Test, as its highest-paid employees are likely located in those jurisdictions.

Application of the Income Test

The Income Test considers income to be derived in the relevant foreign country only if the income is derived from a customer that is also located in-country. This may give rise to problems for corporations that engage in exporting goods, like the Canco in our hypothetical above.27 For a real-world example, Teck Resources Limited, a Canadian mining company, reported $11.5 billion in revenues in 2011. Of that total, only $678 million, or 5.89%, was attributable to sales to Canadian customers,28 and thus Teck would fail the Income Test. Additionally, a ‘‘true’’ multinational that is engaged in business in many countries may fall short of the 25% threshold. For example, Talisman Energy, Inc., one of Canada’s largest petroleum companies, reported having $1.127 billion in revenues in Canada in 2011.29 Although this seems like a substantial amount of income, the total worldwide revenue was $8.194 billion,30 putting Canada’s revenue at a mere 13.75% of the EAG’s total revenue. Accordingly, Talisman and other well-diversified multinationals may have a difficult time meeting the Income Test.

Application of the Asset Test

Because the Asset Test looks only to active business assets, no fully passive company will be able to meet the 25% Test. Corporations that operate large real estate portfolios, but rely on third-party managers to manage their properties, could have difficulty meeting this active business requirement.

Further, companies that have intangible assets with significant value (including goodwill) are at a disadvantage, because those assets are not counted in the Asset Test.31 The treatment of intangibles for purposes of the Asset Test is especially troublesome in the context of corporations engaged in an active trade or business that is based largely on exploiting the value of intangible goods or services. For example, Thomson Reuters, a Canadian multinational company that provides ‘‘intelligent information’’ to businesses and professionals, reported having software, goodwill, and other intangible assets with a value constituting approximately 80.19% of its total assets in 2011.32 Similarly, Valeant Pharmaceuticals International, Inc., a pharmaceutical company based in Canada, reported having approximately $5.25 billion in intangible assets, including in-process research and development, while its total assets were approximately $6.22 billion (for 2010).33 This leaves Valeant with a mere 15.5% of ‘‘hard’’ assets that would be counted for purposes of the Asset Test.34 For these companies, whose active businesses are built around the value of intangible assets, it is unreasonable to exclude intangible assets from the Asset Test.

Furthermore, mining and exploration companies that are headquartered in one foreign country but operate mining and exploration projects in other countries may not satisfy the Asset Test. Yamana Gold Inc., a Canadian publicly traded gold producer, reported more than half of its revenue in Canada, yet less than $10,000 of its $9 million in assets is located in Canada.35 As a result, Yamana Gold Inc. and other similar mining and exploration companies would likely fail the Asset Test.

Other issues arise under the 2012 Temporary Regulations as well.

For example, the testing period, which is relevant for the Compensation and Income Tests, is the year prior to the applicable date. The use of a retrospective testing period contradicts the plain statutory language of §7874, which looks to whether the EAG that includes the foreign corporation has substantial business activities in the relevant foreign country ‘‘after the acquisition.’’ Further, newly formed corporations or existing corporations that are looking to expand in the relevant foreign country seemingly never will be able to pass the Compensation and Income Tests based on such a one-year lookback, although the treatment is far from clear in cases where, during the testing period, the relevant foreign country’s proportion of the EAG’s employees or income is zero over zero (0/0).

Another problem with the 2012 Temporary Regulations is that the 50% threshold for inclusion of a partnership’s assets, income, and employees could adversely affect multinationals that own minority interests in joint ventures (even if the EAG has voting control over the joint venture, since the threshold is measured by value). In many circumstances, such items of a partnership without a majority owner (for example, three partners each own one-third of the joint venture) could not be counted in calculation of any EAG’s compliance with the 25% Test. This approach is inconsistent with the aggregate approach often accorded to partnerships when determining asset ownership (e.g., under FIRPTA).36

Similarly, application of the exclusion of Abusive Items that are considered abusive because they are part of a plan to avoid §7874 will be uncertain in practice, departing from the benefits of a strictly objective test.


Since the U.S. Supreme Court’s decision in Mayo Foundation for Medical Education and Research,37 it is clear that Treasury regulations, like any other administrative regulations, are entitled to deference under the test articulated in Chevron U.S.A. Inc. v. Natural Resources Defense Council, Inc.38 Under that twopart framework, administrative regulations are analyzed to determine whether: (1) Congress has ‘‘directly addressed the precise question at issue’’39 (i.e., whether the statute is ambiguous and leaves room for interpretation); and (2) whether the regulation is ‘‘arbitrary or capricious in substance, or manifestly contrary to the statute.’’40

The phrase ‘‘substantial business activities,’’ without any definition, cross-reference, or other indication of its meaning, is ambiguous and is precisely why compliance with the temporary regulations that were issued in 2009, which were based on a facts-andcircumstances approach with no interpretive examples, proved challenging for taxpayers. The 2012 Temporary Regulations thus pass the first prong of the Chevron test.

The second prong looks to whether the regulation is arbitrary, capricious, or contrary to the statute. One could assert that the 25% Test is arbitrary and capricious in light of the fact that very few multinationals engaging in operations around the globe will be able to comply with the 25% Test.41 In enacting §7874, Congress was concerned that ‘‘inversion transactions resulting in a minimal presence in a foreign country’’ were simply a ‘‘means of avoiding U.S. tax and should be curtailed.’’42 Requiring a multinational corporation to have more than 25% of its income, its assets, and its employees (based on two separate tests) in the relevant foreign country in order to acquire a U.S. business is a more stringent standard than simply requiring that a corporation have more than a minimal presence in the relevant foreign country.

Another indicator of the arbitrary and capricious nature of the 25% Test is that the test will undoubtedly subject multinational, publicly traded companies that are engaged in legitimate businesses in high-tax foreign jurisdictions, such as Canada, to §7874, whereas Congress was specifically focused on eliminating inversion transactions where the acquiror was located in ‘‘a low- or no-tax country. . .largely because of the tax savings available.’’43 The 25% threshold may prove to be a standard that is virtually impossible to meet. Thus, requiring compliance with the 25% Test in order to avoid the disastrous effects of §7874 (including subjecting such multinational parent corporations to U.S. tax) seems more than unreasonable.

There are several other aspects of the 25% Test that could also be viewed as arbitrary or capricious. As illustrated by the application of the Asset Test to both Thomson Reuters and Valeant Pharmaceuticals International, Inc. above, the exclusion of intangible assets from the determination of whether an EAG has sufficient assets in the relevant foreign country could adversely affect companies that are engaged in active businesses and derive their primary value from intangible assets, whereas companies that have asset bases comprised largely of ‘‘hard’’ assets may fare better under the Asset Test. This is an arbitrary standard for interpreting whether a company is engaged in substantial business activities, especially in light of the global expansion of businesses that are based predominantly on the use and development of intangibles.

The exclusion of income from sales to out-ofcountry customers is also arbitrary. It may cause companies that are engaged in a significant exporting business within a foreign country to be excluded. Teck Resources Limited, for example, a corporation with significant assets, book income, and Canadian taxable income in Canada, may fail the Income Test due to the exclusion of its sales outside Canada.

Finally, the definition of the term ‘‘testing period,’’ which is relevant to both the Compensation Test and the Income Test, is manifestly contrary to the statute. The testing period, per the 2012 Temporary Regulations, is defined as the one-year period ending on the applicable date. Section 7874, however, only requires that the EAG have substantial business activities in the relevant foreign country ‘‘after the acquisition.’’44 One year prior to an acquisition, as opposed to ‘‘after’’ an acquisition, are contrary principles.

Based on all of the above, it is possible that some, if not all, of the 25% Test could be successfully challenged under Chevron principles as exceeding Treasury’s authority under §7874. As a practical matter, it may be that no acquiror would ever run the risk of completing an acquisition that clearly fails the substantial business activities test in the 2012 Temporary Regulations, even if the acquiror did strongly believe that the regulations were invalid. However, when regulations are so flawed as to be vulnerable to challenge on grounds of invalidity, it would be bad policy for Treasury and the IRS to leave them in place just because no taxpayer would dare take an inconsistent reporting position.


As demonstrated by a hypothetical application of the 25% Test to certain publicly traded Canadian multinational corporations, the 25% Test contained in the 2012 Temporary Regulations is far too difficult to meet, and several components of the 25% Test are unreasonable. Section 7874 was not intended to apply to acquisitions of U.S. businesses by legitimate, multinational corporations such as these.

In many U.S. income tax treaties, the Limitation on Benefits (LOB) article contains a provision that allows a resident to claim benefits under the treaty with respect to certain income if such resident is engaged in an active trade or business, the income is connected with that trade or business, and the trade or business in the state of residence is substantial in relation to the activity in the other state where the income is generated. In such treaties, the ‘‘substantiality’’ portion of the standard is generally met if, with respect to the factors of payroll, asset value, and gross income, each factor in the state of residence is at least 7.5% of the factor in the other state, and the average of the three ratios exceeds 10%.45 There are also some treaties that employ a facts-and-circumstances analysis but use the preceding formula as a safe harbor.46

The authors believe that a similar approach could be taken when finalizing the regulations for the substantial business activities exception. In particular, we would recommend using only one employee test — headcount or compensation — instead of both. Such an approach would be consistent with the payroll approach taken in LOB articles.

Additionally, we would recommend that a lower threshold be applied to each factor, and that an average of the three be required.47 If a 7.5% threshold for each factor, with a required 10% average, is sufficient for a company to be considered engaged in a substantial business in its home country such that it is entitled to benefits under a U.S. income tax treaty, it seems reasonable to apply such a standard to foreign corporations under §7874. Moreover, although the Service was concerned that 10% was too low of a ‘‘safe harbor,’’ especially in light of corporations that structured their expatriation transactions with 90% of their business in the United States and 10% in the acquiring foreign jurisdiction,48 such a concern could be addressed with anti-abuse rules, such as those suggested in the NYSBA Report, rather than forcing legitimate businesses to be subject to §7874.49

In addition to removing one of the employeerelated tests and lowering the threshold for nonabusive transactions, we would also recommend improving the substantial business activities exception by: (1) allowing for the inclusion of intangible assets in any applicable asset test; (2) including partnership income, assets, and employees on a look-through basis; and (3) including all third-party sales made by an EAG’s business in a relevant foreign country (including those to customers outside the country) in calculating the EAG’s income realized in the relevant foreign country, provided that such income is included in the EAG’s taxable income or book income in that country.50