The U.S. Department of the Treasury (Treasury Department) and the Internal Revenue Service (IRS) continue to focus significant resources on curbing transactions in which U.S. corporations transform themselves into foreign corporations (inversion transactions) thereby reducing their U.S. tax liabilities. On Monday, April 4, 2016, the Treasury Department and the IRS released comprehensive temporary regulations (the 2016 Regulations) that make it more difficult to avoid the application of existing inversion rules and further limit the U.S. tax benefits following an inversion. The 2016 Regulations not only implement the rules announced in Notice 2014-52 (the 2014 Notice) and Notice 2015-79 (the 2015 Notice, and together, the Notices),1 but also include additional restrictions on inversion transactions, such as a new rule making it more difficult for serial inverters to avoid the anti-inversion rules.
The 2016 Regulations implementing the rules announced in the 2014 Notice and the 2015 Notice are generally effective for acquisitions and post-inversion transactions completed on or after September 22, 2014 and November 19, 2015 (respectively). The additional restrictions and any changes to the Notices generally apply to acquisitions and post-inversion transactions completed on or after April 4, 2016.
Simultaneously with the 2016 Regulations, the Treasury Department and the IRS issued proposed regulations that are intended to curtail earning stripping transactions by way of intra-group debt that generates U.S. interest deductions. A separate Sidley Update will be issued shortly on these proposed regulations.
Inversion transactions are generally transactions in which the U.S. corporate parent of a multi-national group transforms itself into a foreign corporate parent of that group in order to minimize U.S. tax on U.S. and non-U.S. income. Section 7874 of the Internal Revenue Code of 1986, as amended (the Code) generally applies to inversion transactions only if (a) there is an acquisition of a U.S. entity by a foreign acquiring entity, (b) the former shareholders of the acquired U.S. entity own at least 60 percent of the stock of the combined foreign acquiring entity following the acquisition (the Ownership Fraction) and (c) the foreign acquiring corporation does not have substantial business activities in its country of incorporation. If the Ownership Fraction is at least 80 percent, Section 7874 of the Code treats the foreign acquiring corporation as a U.S. corporation for U.S. tax purposes, thereby denying all the intended U.S. tax benefits to the inversion transaction. Historically, the adverse consequences attached to a 60 percent Ownership Fraction were not significant compared to the U.S. tax benefits that were obtained following an inversion. The recent Notices, which the 2016 Regulations generally implement, were intended not only to make it more difficult to manipulate the Ownership Fraction, but also to deny many of the U.S. benefits that were available to inverted corporations following the inversion transaction.
New Restrictions on Inversion Transactions
The 2016 Regulations expand the scope of the Notices by adding two rules that make it more difficult for taxpayers to avoid the application of the inversion rules under Section 7874 of the Code.
- Multiple Domestic Entity Acquisition Rule (or Anti-Serial Inverters Rule). The 2016 Regulations include a new rule under which stock of the foreign acquiring corporation attributable to acquisitions of U.S. corporations and domestic partnerships that occurred during the three-years prior to the acquisition being tested would be excluded from the denominator of the Ownership Fraction, even if the acquisitions were not related to one another. This rule is intended to prevent cascading increases in the value of the foreign acquiring corporation after each acquisition of a U.S. corporation, thus permitting acquisitions of even larger U.S. corporations without falling within the scope of the anti-inversion rule. The three-year period ends on the signing date of the acquisition being tested, with an anti-abuse rule designed to disregard terminations of existing deals that are replaced with new, later-in-time deals. The value of the stock that is excluded from the denominator is determined based on the current value of the shares of the foreign acquiring corporation (as of the closing of the acquisition being tested) that were issued in the prior acquisitions (adjusted for redemptions, stock splits, reverse stock splits, stock distributions, recapitalizations and similar transactions). Prior acquisitions of U.S. entities are disregarded for purposes of this rule if, with respect to any such acquisition, the Ownership Fraction of the shareholders of the U.S. entity being acquired was less than 5 percent and the fair market value of the stock received by such shareholders did not exceed US$50 million (each as of the closing of such acquisition). This new rule is effective for transactions completed on or after April 4, 2016, regardless of when the prior acquisitions were completed.
- Multiple-Steps Acquisitions of U.S. Entities. Under the current regulations, the inversion rules generally do not apply to an acquisition by a foreign corporation of the stock of another foreigncorporation (a subsequent acquisition), even if the acquired foreign corporation owns, directly or indirectly, a U.S. corporation. Under the 2016 Regulations, the inversion rules would apply to a subsequent acquisition where the acquired foreign corporation was itself previously involved in an inversion transaction and the subsequent acquisition was part of the same plan (or series of related transactions) that included the initial inversion. This new rule is effective for acquisitions completed on or after April 4, 2016.
Certain Key Aspects of the Implementation of the Notices
The 2016 Regulations implement, with certain modifications, the anti-inversion rules first established in the Notices. The following is a brief description of some of these rules and modifications.
- Non-Ordinary Course Distributions (or “Skinny Down Rule”). One of the most controversial rules in the Notices was the rule that targeted non-ordinary course distributions (NOCD) of U.S. corporations prior to an anticipated inversion (also known as the “skinny down rule”). The rule is intended to prevent a U.S. corporation from reducing its size prior to the inversion in order to reduce the Ownership Fraction of its former shareholders in the foreign acquiring corporation. This rule applies to dividends, stock buybacks and Section 355 tax-free spin-off transactions. For this purpose, a 36-month look back period applies. The NOCD concept applies in the Notices and the 2016 Regulations as a per se rule (i.e., it did not matter whether the “skinny down” transaction was actually undertaken with a view to facilitate the subsequent inversion transaction). This per se rule was heavily criticized. Commenters argued for a rebuttable presumption that a “skinny down” transaction within the 36-month period was undertaken to facilitate the inversion. In the 2016 Regulations, the Treasury Department and the IRS rejected this comment on the ground that it would be administratively too burdensome and would lead to significant uncertainty. The 2016 Regulations therefore incorporate the “skinny down rules” substantially unchanged, except that the 2016 Regulations provide significant mechanical details regarding the operation of the rule. In addition, under the 2016 Regulations, a new special spin-off rule provides that the direction of a Section 355 spin-off (i.e., the unwanted business is spun off or the wanted business is spun off) does not matter for purposes of the calculations under the skinny down rule. The NOCD rule is subject to a de minimis exception if the former shareholders of the U.S. entity own less than 5 percent (by vote or value and without regard to the inversion rules) of the stock of the foreign acquiring corporation and the expanded affiliated group (EAG).2 The NOCD rules are generally effective for acquisitions completed on or after September 22, 2014. The de minimis exception is applicable for acquisitions completed on or after November 19, 2015, but a taxpayer may elect to apply it to prior transactions. The special spin-off rule is applicable to acquisitions completed on or after April 4, 2016.
- Third-Country Transactions. The 2016 Regulations implement the third-country transaction rule included in the 2015 Notice with minor modifications. Under the existing inversion rules, the foreign acquiring corporation in an inversion transaction is subject to tax as a U.S. corporation if the Ownership Fraction is at least 80 percent. Under the 2016 Regulations, where the U.S. corporation combines with an existing foreign corporation (resident of country A) by forming a new foreign holding company for both corporations that is a tax resident in a third country (country B), the stock issued by the new foreign holding corporation (the country B company) to the shareholders of the existing foreign corporation (the country A company) is disregarded for purposes of determining whether the 80 percent Ownership Fraction is met (thus increasing the Ownership Fraction of the former shareholders of the U.S. corporation in the new foreign holding corporation (i.e., the country B company)). This rule applies, however, only if four conditions are met:
- the new foreign parent directly or indirectly acquires substantially all the properties of the existing foreign corporation (including through an acquisition of its stock) pursuant to a plan (or series of related transactions) that includes the acquisition of the U.S. corporation;
- with respect to the acquisition of the foreign corporation, the percentage of stock in the new foreign parent held by former shareholders of the acquired foreign corporation is at least 60 percent,3 disregarding for this purpose stock held by the former shareholders of the acquired U.S. corporation and applying the same principles used for purposes of determining the Ownership Fraction with certain modifications;4
- after any related transaction, the new foreign parent is not subject to tax as a resident in the same foreign country in which the acquired foreign corporation was subject to tax as a resident, as determined prior to any related transaction (treating a change of the tax residency of a corporation as a “transaction” for this purpose);5 and
- the Ownership Fraction of the shareholders of the U.S. corporation in the new foreign parent is at least 60 percent (prior to the application of this third-country transaction rule).
These rules are applicable to domestic entity acquisitions completed on or after November 19, 2015. For acquisitions completed after November 19, 2015 and prior to April 4, 2016, taxpayers may elect to apply a gross value test (similar to the one set forth in the 2015 Notice) instead of the 60 percent ownership test described in the second bullet above.
- Passive Asset Rules. Consistent with the Notices, certain stock of the foreign acquiring corporation attributable to passive assets is not taken into account in determining the Ownership Fraction of the former shareholders of the inverted U.S. corporation (thus making it more likely that the 60 percent Ownership Fraction will be met). The rule applies only if a substantial portion of the foreign acquiring corporation’s assets are cash, marketable securities and certain obligations. The 2016 Regulations implement all the exceptions included in the Notices. In particular, the 2016 Regulations implement the important exception for the investment assets of insurance companies that give rise to income that is not passive for purposes of the passive foreign investment company (PFIC) rules because these assets are used in the active conduct of an insurance business). The 2016 Regulations provide a new de minimis exception where the former shareholders of the U.S. entity own less than 5 percent (by vote or value) of the stock of the foreign acquiring corporation and the EAG. Certain other modifications to the Notices were also provided. The passive asset rules are generally applicable to acquisitions completed on or after September 22, 2014. The modified rules described above are generally applicable to acquisitions completed on or after April 4, 2016, but taxpayers may elect to apply them to prior transactions. Some of the relief rules described above (such as the insurance related exceptions) apply to acquisitions completed on or after November 19, 2015, but taxpayers may elect to apply these exceptions to prior transactions.
- Tax Residency Requirements For Substantial Business Activities. An inversion transaction is not subject to restrictions if the foreign acquiring corporation has substantial business activities in its foreign jurisdiction. Under the 2016 Regulations, implementing the 2015 Notice, this exception will apply only if the foreign acquiring corporation is subject to tax as a resident in the foreign jurisdiction. This rule is intended to address tax residence rules of foreign countries that differ from U.S. residence rules (e.g., place of management tests) and foreign acquiring entities that are treated as flow-through entities in their home countries. It is not clear if this new rule would disregard substantial business activities conducted in a jurisdiction that does not subject its residents to tax. This rule is applicable to acquisitions completed on or after November 19, 2015.
- Restrictions on Tax Benefits from Post-Inversion Transactions. The 2016 Regulations further limit tax benefits sought by taxpayers from post-inversion transactions intended to reduce taxable income in the U.S., and generally implement the 2014 Notice and the 2015 Notice:
- United States Property Rule. The United States property rule is designed to prevent the inverted foreign corporation from accessing the cash that the acquired U.S. entity previously held offshore through controlled foreign corporations (CFCs) and which could not be repatriated to the U.S. without incurring U.S. tax. Under the general rules of Section 956 of the Code , if a CFC of a U.S. parent makes a loan to, or acquires the obligations or stock of, the U.S. parent, that investment in “U.S. property” (i.e., the loan, obligation or stock of the U.S. person), in broad terms, is treated as a taxable distribution of the CFC’s untaxed earnings and profits to the U.S. parent resulting in U.S. corporate tax in the hands of the U.S. parent. Because Section 956 of the Code is limited to investments in “U.S. property,” it was not effective in preventing the inverted foreign corporation from accessing this offshore cash in the same way. In the context of an inversion (i.e., where the Ownership Fraction is at least 60 percent), the 2016 Regulations implement the 2014 Notice and extend the Section 956 rules by treating an investment by a CFC of the acquired U.S. corporation (an expatriated CFC) in the stock and obligations of a foreign related party as an investment in U.S. property. As a result, the U.S. inverted entity will be required to pay U.S. tax on the invested cash as though it was repatriated. This rule applies if the expatriated CFC acquires the stock or obligations of a non-CFC foreign related person during the 10-year period after the inversion. The 2016 Regulations expand the 2014 Notice by also including stock or obligations acquired by the expatriated CFC prior to the inversion in a transaction related to the inversion. Similar rules apply with respect to pledges or guarantees by expatriated CFCs of obligations of a non-CFC related person. The 2016 Regulations generally exclude from this rule acquisitions by certain CFCs of U.S. corporations that were owned by the foreign acquiring corporation prior to the inversion (but acquisition of the stock or obligations of such CFCs may be subject to these rules, as such CFCs are considered non-CFC foreign related persons). Consistent with the general exceptions to the rules under Section 956 of the Code, these new rules contain exceptions for certain ordinary business transactions. These rules generally apply to obligations and stock acquired on or after September 22, 2014, but only if the inversion transaction was completed on or after September 22, 2014 .
- Recharacterization Rule to Address Transactions to De-Control or Dilute Ownership of CFCs. Consistent with the 2014 Notice and the intent of limiting tax-free access to the offshore cash of expatriated CFCs, the 2016 Regulations generally provide that when an expatriated CFC issues stock to a non-CFC foreign related person (or a domestic partnership or trust in which a non-CFC foreign related person is a partner or beneficiary) (a Specified Related Person), the issuance is recharacterized as an issuance of stock by the expatriated CFC to its U.S. parent, followed by an issuance of stock having similar terms by the U.S. parent to the Specified Related Person (such as the new foreign parent of the group). Likewise, when stock of the expatriated CFC is transferred by its shareholders to a Specified Related Person in return for property, the transfer is recharacterized as an issuance of stock by the inverted U.S. shareholder to the Specified Related Person in return for the property (and if the transferor is not the U.S. shareholder, the deemed issuance is followed by a transfer of such property to the selling shareholder in return for equity interests in such shareholder). In both cases, the U.S. shareholder is interposed as an intermediary between the Specified Related Person and the expatriated CFC, thus preserving the ownership of the U.S. shareholder in the CFC and retaining the earnings of the CFC within the U.S. tax base . The rules only apply to transactions occurring during the 10-year period after the inversion. Exceptions to the recharacterization rules apply for fast-pay arrangements, transactions in which an appropriate amount of gain is recognized, and certain de minimis transactions resulting in a dilution of no more than 10 percent in the ownership interests in the CFC by persons other than non-CFC related persons (i.e., the dilution of the U.S. shareholder’s interest in the CFC by unrelated persons is not taken into account). The recharacterization is generally unwound when the CFC ceases to be a foreign related person and in certain other situations. If a CFC is a transferor of the stock of another CFC in a transaction described above, any amount included in gross income as a dividend as a result of such transfer is ineligible for the look-through exception from Subpart F income. These rules are generally effective for transactions completed on or after September 22, 2014, but only if the inversion transaction was completed on or after September 22, 2014 (with certain rules applicable after April 4, 2016).
- Stock Dilution Rule. The 2016 Regulations implement the stock dilution rules in the 2014 Notice, as expanded in the 2015 Notice, with certain modifications. Under the 2016 Regulations, taxpayers are generally required to include, as a deemed dividend, the “Section 1248” amount (representing certain undistributed earnings) with respect to stock of a CFC that, during the 10-year period after the inversion, is exchanged for stock in another foreign corporation in an otherwise tax-free exchange. This rule also requires the recognition of any remaining built-in gain realized on such transfer, thus converting an otherwise tax-free exchange into a fully taxable exchange. This rule is subject to a de minimis exception for certain exchanges that do not shift more than 10 percent of the CFC’s stock to non-CFC foreign related persons and a new exception that applies if the exchanging shareholder is neither an expatriated entity nor an expatriated CFC. The income recognized under these rules is ineligible for the look-through and same country exceptions to Subpart F income. These rules are generally effective for transactions completed on or after September 22, 2014, but only if the inversion transaction was completed on or after September 22, 2014.
- Asset Dilution Rule. The 2016 Regulations extend the stock dilution rule, by also requiring the recognition of gain (but not loss) when, during the 10-year period after the inversion, an expatriated CFC transfers property to a foreign transferee corporation in an exchange otherwise described under Section 351 of the Code. This rule is also subject to a 10 percentde minimis exception where there is only a small shift in the interests in the transferred property to non-CFC foreign related persons. This rule is applicable to transfers completed on or after April 4, 2016, but only but only if the inversion transaction was completed on or after September 22, 2014.