US Treasury Department takes its "initial step in addressing inversions" by issuing Notice 2014-52
Notice 2014-52, released by the US Treasury Department on September 22, 2014, is intended to disrupt, and in some cases prevent, so-called corporate inversion transactions that have not been completed prior to the notice's release. Although the notice includes very detailed rules, it very generally takes a two-pronged approach to discourage inversions after September 21, 2014.
Background on US "anti-inversion" rules
Internal Revenue Code ("Code") section 7874, enacted as part of the American Jobs Creation Act of 2004, subjects expatriated entities (and their affiliates) to adverse US tax consequences. Generally, if a US company transfers its properties to a foreign corporation and at least 80 percent of the stock (by vote or value) of the new foreign parent company is held by former shareholders of the US company, then the new foreign parent company (the "surrogate foreign corporation") will be subject to US tax as though it were a US corporation, notwithstanding its foreign incorporation. If at least 60 percent (but less than 80 percent) of the stock (by vote or value) of the new foreign parent company is held by former shareholders of the US company, then the foreign status of the surrogate foreign corporation is respected for US tax purposes, but any gain on the inversion transaction is generally subject to US income tax, notwithstanding any exclusions, exemptions and credits (other than the foreign tax credit) that would otherwise reduce the US tax on the inversion gain. These anti-inversion rules apply only if, after the acquisition, the surrogate foreign corporation and its subsidiaries (the "expanded affiliated group") do not have "substantial business activities" in the surrogate foreign corporation’s home country, compared to the total business activities of the expanded affiliated group. Temporary regulations issued in June 2012 made this "substantial business activities" test harder to meet. See "IRS Clarifies and Tightens New "Anti‑Inversion" Regulations."
Two-pronged approach of Notice 2014-52
First, the notice announces three changes to the regulations under section 7874, the basic anti-inversion rule in the Code. These changes are intended to cause more transactions to be caught by the adverse rules of section 7874. The changes would prevent would-be inverters from
- Using a foreign "cash box" to ensure that the foreign partner in the acquisition is large enough to avoid crossing the 60% or 80% thresholds of section 7874;
- "Skinnying down" a domestic corporation by making distributions prior to the transaction to avoid exceeding the 60% or 80% thresholds of section 7874 or the adverse rules of section 367; and
- Undertaking a "spinversion" where a company transfers a portion of its assets to a newly-formed foreign corporation and then spins off that foreign corporation to its shareholders.
Note that the newly-announced rules do not require the parties to have taken the proscribed actions with the intent of avoiding section 7874. The notice conclusively presumes that the "skinnying down" limitation applies to distributions above 110% of the preceding 3-year average. The limitations on foreign corporate "cash boxes" applies to any foreign corporation holding foreign passive assets that exceed a 50% threshold.
Second, the notice expands the US tax net to catch four types of transactions:
- Applying a new "hopscotch" rule under section 956 to tax loans made by a foreign subsidiary to the new foreign parent company created by an inversion;
- Using authority under section 7701(l) to re-characterize transactions that seek to "decontrol" a controlled foreign corporation ("CFC") following an inversion transaction by transferring it so that it lacks sufficient US ownership to continue to be treated as a CFC; and
- Subjecting certain post-inversion transfers of CFC stock to new rules under section 367(b) so that they are subject to US tax; and
- Subjecting certain transfers of foreign or domestic corporations to greater US tax under section 304 where the section 304 dividend would otherwise escape the US tax net.
The first set of changes apply only to acquisitions on or after September 22, 2014. For the second set of changes, the new rules for section 956, section 7701(l), and section 367(b) apply only to transactions that involve an inversion transaction that has occurred on or after September 22, 2014. The new rules under section 304, however, apply to acquisitions of stock completed on or after September 22, 2014, regardless of whether an inversion transaction has occurred.
Effect of Notice 2014-52 on potential transactions
The first set of changes--dealing with skinnying down the US company or bulking up the foreign corporation or so-called "spinversions"--could cause a transaction that was structured to be below the 80% or 60% thresholds of section 7874 now to exceed those thresholds. In that case, revisions to the planned transaction are necessary. The second set of changes--the new rules under sections 956, 7701(l), 367(b), and 304--can affect the planned economics of an inversion transaction and therefore cause one to re-think at least features of any transaction on the drawing board. Despite the goal of the notice, however, few if any companies have stated their intent to abandon any previously announced transactions. Tax advantages still remain after an inversion transaction with respect to the ability to make future non-US investments outside of the US tax net. Although the US Treasury Department is likely to propose additional rules that prevent reducing the US tax base, these potential changes would not affect new foreign businesses that would be owned by the surrogate foreign corporation that are commenced after an inversion transaction. Thus, if the proposed inversion transaction has compelling economic advantages apart from unlocking US tax benefits related to "trapped CFC cash," the proposed transaction will likely proceed.
Companies that are considering a cross-border acquisition or merger need to take a close look at the notice to see how it affects transactions they were considering. Moreover, because the new section 304 rules apply irrespective of whether an inversion has occurred, even those companies that have no inversion plans at all should take into account how those new rules will affect them.
Even though the US Treasury Department describes Notice 2014-52 as the first step of regulatory action, the issuance of the notice effectively shifts pressure from the Obama Administration back to Congress regarding next steps. Indeed, by issuing a notice that includes so many technical provisions, the Administration may have done as much as it can to disrupt potential transactions, considering its limited options. Even though the spotlight may be back on Congress on this issue, it is difficult to see Congress agreeing on a legislative proposal in 2014. So, companies likely will have to continue to make decisions unsure as to whether (or when) current law will be changed.