Corporate inversions have been at the forefront of discussions regarding international tax reform. In its most recent attempt to curb inversions, on April 4, 2016, the Treasury Department released proposed and temporary regulations (“Regulations”) aimed at making inversions more difficult and eliminating many of the tax minimization strategies that are often put in place following an inversion.

The Regulations implement many of the rules that the Internal Revenue Service (“IRS”) previously described in two IRS Notices issued in 2014 and 2015 (those rules and the notices generally are not described in this article). In addition, the Regulations (i) subject more transactions to the statutory and regulatory rules that apply to inverted companies, and (ii) would recharacterize certain debt instruments between related parties as equity and grant the IRS authority to recharacterize a portion of such instruments as equity. The debt recharacterization rules are not limited to debt established in connection with inversions and thus will have far-reaching implications for debt between related parties in non-inversion contexts as well.

The Regulations have been criticized for hindering U.S. companies’ ability to compete in the global marketplace. Furthermore, some have questioned whether the Treasury has overstepped its authority in issuing the debt recharacterization rules, which represent a major departure from current law.

Although the full effect of the Regulations remains to be seen, just days after the new rules were published, Pfizer terminated its pending merger with Irish-based Allergen. On the other hand, Johnson Controls recently stated that it intends to complete its combination with Irish-based Tyco notwithstanding issuance of the Regulations.


Many domestic corporations have used inversions to reincorporate in lower tax jurisdictions in an effort to decrease their U.S. taxes. Inversions are generally accomplished by combining a domestic corporation with a foreign corporation that becomes the parent of the combined group. Recognizing that a corporation could reduce its taxes by simply “changing its address,” in 2004 Congress added Section 7874 to the Internal Revenue Code (all section references are to the IRC). That section states that if (i) a domestic corporation becomes the subsidiary of a foreign corporation (or otherwise transfers substantially all of its properties to the foreign corporation), (ii) the percentage of foreign acquirer stock owned by the former shareholders of the domestic corporation (“ownership fraction”) is at least 80% (by vote or value) and (iii) the foreign corporation does not conduct a substantial amount of its business activities in its country of incorporation, then the foreign corporation is treated as domestic for U.S. tax purposes, thus negating any tax benefits of the inversion. (Section 7874 also applies to acquisitions of domestic partnerships or their assets, but for simplicity this article refers to acquisitions of domestic corporations.) If the above test is met but the ownership fraction is between 60% and 80%, the foreign corporation is respected as foreign, but certain negative consequences apply.

Following the enactment of Section 7874, many companies have structured inversion transactions where the post-inversion ownership fraction either falls below 60% or is between 60% and 80% but the benefits obtained through post-inversion tax minimization strategies outweigh the negative consequences. If the foreign parent’s status as foreign is respected (i.e., the ownership fraction is below 80%), the domestic corporation can engage in two broad types of tax-minimizing strategies: (1) reduce or eliminate U.S. tax on non-U.S.-sourced income by tax-efficiently transferring assets or stock of foreign subsidiaries to the foreign parent or its affiliates, and (2) reduce tax on U.S. income through earnings stripping and other methods.

Earnings stripping is often achieved by a domestic corporation issuing debt to its foreign parent or a foreign affiliate. The domestic issuer can deduct the interest, while the recipient is generally taxed on the interest income at a low rate and with little or no U.S. withholding tax.

In response, in 2014 and 2015 the IRS issued Notices 2014-52 and 2015-79 ("Notices"). The Notices announced that the IRS would issue regulations that would effectively (i) render it more difficult to invert with a low ownership fraction (including by disregarding (x) certain pre-inversion contractions by the domestic corporation and (y) equity of the foreign acquirer attributable to certain passive assets) and (ii) shut down certain post-inversion tax minimizing strategies for inversions with an ownership fraction between 60% and 80%. The Regulations implement many of the rules described in the Notices, which generally apply to acquisitions completed on or after the dates of the applicable Notice (Sept. 22, 2014, and Nov. 19, 2015, respectively).

Multiple Acquisition Inversions

In addition to implementing the rules described in the Notices, the Regulations address two types of inversion transactions that involve multiple acquisitions, which are effective for transactions completed after April 4, 2016.

(i)  Multiple Domestic Entity Acquisitions.

Some foreign corporations have acquired multiple domestic entities over a short period of time. Each acquisition increases the value of the foreign acquirer and enables it to then pursue a larger acquisition of a domestic entity without surpassing either the 60% or 80% ownership fraction. Under the Regulations, subject to certain de minimis exceptions, stock of the foreign acquirer that was issued to acquire stock or assets of one or more domestic corporations in the 36 months preceding the signing date of an acquisition is not taken into account when measuring the ownership fraction of the second acquisition.

Example: F1, a foreign corporation with 100 outstanding shares, acquires all of the stock of US1, a domestic corporation, in exchange for 100 shares of F1 when the value of each F1 share is $1. Within 36 months, F1 enters into a binding contract to acquire the stock of US2, a domestic corporation, in exchange for 150 shares of F1. On the date that the US2 acquisition is completed, each F1 share has a value of $1.50. Under the Regulations, $150 ($1.50*100, which is the number of F1 shares issued to acquire US1) is excluded from the value of F1 in computing the ownership fraction of the US2 acquisition. Therefore, the ownership fraction of the US2 acquisition is 60% (225 ($1.50*150)/375 ($1.50*250). Prior to the Regulations, the denominator of the ownership fraction with respect to the US2 acquisition would be 525 ($1.50*350), resulting in an ownership fraction of only 42.8%.

(ii)  Multiple-Step Acquisitions.

The Regulations also address acquisitions in which a foreign corporation acquires a domestic entity, and then, as part of a plan or series of related transactions, another foreign corporation acquires the first foreign corporation. In such a case, the two acquisitions will be collapsed and the second foreign acquiring corporation will be treated as having issued stock directly in exchange for stock of the domestic entity that was issued in the first acquisition.

Example: A owns all 70 shares of DC1, a domestic corporation, and B owns all 30 shares of F1, a foreign corporation. F1 acquires all of the stock of DC1 solely in exchange for 70 newly issued shares of F1. If F1 conducts a substantial amount of business activities in its country of incorporation, the acquisition will not be subject to the inversion rules. Pursuant to a plan that includes the DC1 acquisition, F2, a newly formed foreign corporation organized in a different jurisdiction than F1 and not engaged in substantial business activity in its country of incorporation, acquires all of the stock of F1 solely in exchange for 100 newly issued shares of F2 stock. After the second acquisition, A owns 70% of F2 and DC1 is an indirect subsidiary of F2. Under the Regulations, F2 is treated as acquiring the stock of DC1 in exchange for 70 F2 shares. Because F2 is not engaged in substantial business activity in its country of incorporation, and the ownership fraction is 70%, the F1 acquisition is an inversion transaction.

Recharacterization of Certain Debt as Stock

The Regulations recharacterize, or authorize the IRS to recharacterize, debt between members of an “expanded group” as equity in certain contexts. An expanded group generally is a group of entities at least 80% (by vote or value) of whose interests (other than equity of the parent member) is owned, directly or indirectly, by other group members. However, the Regulations would not apply to debt between members of a group that file a consolidated tax return.

(i)  Bifurcation of a Debt Instrument as Part Debt, Part Equity.

In determining the characterization of an instrument as debt or equity, courts and the IRS have historically treated the instrument as one or the other but not a hybrid. However, the Treasury stated that the all-or-nothing approach traditionally applied to debt-equity determinations at times fails to accurately reflect economic substance. The Regulations grant the IRS the ability to bifurcate a debt instrument and treat it as part debt and part equity if warranted under general federal tax principles based on the facts and circumstances. That condition could arise, for example, if there were a reasonable expectation that only a portion of the principal would be paid back.

In addition, while a holder of an instrument generally can treat the instrument (as either debt or equity) differently than can the issuer, provided the holder discloses the inconsistent treatment on its tax return, if the holder and issuer are members of an expanded group, the holder must treat as debt any instrument that is treated as debt by the issuer.

(For the purposes of these rules, the expanded group is based on 50%, rather than 80%, common ownership and includes individuals and trusts that own at least 50% of a group member.)

This Regulation is proposed to apply to debt instruments issued after the Regulations are finalized.

(ii)  Documentation Requirements.

The Regulations set forth documentation requirements that must be maintained in order for a debt instrument between members of an expanded group, in certain circumstances and subject to a reasonable cause exception, to be treated as debt for federal income tax purposes. The documentation requirements apply if (i) the stock of any member of the expanded group is publicly traded, or (ii) all or any portion of the financial results of an expanded group member is reported on (x) financial statements filed with the SEC or provided to another governmental agency, or (y) certified audited financial statements prepared for a substantial non-tax purpose (such as reporting to shareholders or creditors), in each case showing total assets exceeding $100 million or total revenue exceeding $50 million.

The taxpayer must document the following:

  • A binding obligation to repay the funds advanced.
  • Creditors’ rights to enforce the terms of the debt.
  • A reasonable expectation that the debt will be repaid.
  • Actions evidencing an ongoing genuine debtor-creditor relationship (e.g., (i) timely payment, or (ii) the holder's reasonable exercise of the diligence and judgment of a creditor following a default).

The documentation requirements with respect to the first three items must be prepared within 30 days of issuance. The documentation with regard to the fourth requirement can be timely prepared within 120 days after a payment or the occurrence of a relevant event.

The Regulations do not require that the taxpayer furnish the documents to anyone once they are prepared. Furthermore, meeting these documentation requirements does not guarantee that the interest will be treated as debt. However, if the documentation is not provided to the IRS upon request, the debt automatically will be treated as equity.

This Regulation is proposed to apply to debt instruments issued after the Regulations are finalized.

(iii)  Certain Distributions of Debt Instruments and Similar Transactions.

The Regulations provide that debt held by a member of an expanded group will be treated as equity if the debt is issued as follows:

  • In a distribution.
  • In exchange for stock of an expanded group member (other than in an exempt exchange).
  • In exchange for property in certain asset reorganizations.

In addition, debt issued to an expanded group member will be recharacterized as equity if it is issued for the principal purpose of funding a distribution or acquisition of the types described above. Although the determination of whether the debt was issued with the principal purpose of funding a distribution or acquisition is based on all of the facts and circumstances, under a per se rule a debt instrument will be treated as such if it is issued within 36 months of the date of the acquisition or distribution (whether before or after) and does not arise in the ordinary course of the issuer’s trade or business.


The Regulations provide three principal exceptions to this third recharacterization rule:

  1. Current-year earnings and profits. Distributions or acquisitions are not subject to this recharacterization rule to the extent they do not exceed current earnings and profits.
  2. Dollar threshold. A debt instrument will not be treated as equity under this rule if, when the debt is issued, the aggregate adjusted issue price of all expanded group debt instruments that would be treated as equity under this rule, including the newly issued debt, does not exceed $50 million. Once the $50 million threshold is surpassed, all of the expanded group debt that, but for the threshold exception, would have been treated as equity under this rule is recharacterized (rather than just the amount by which such debt exceeds $50 million).
  3. Funded acquisitions of subsidiary stock by issuance. An acquisition of expanded group stock would not be subject to this rule if (i) the acquisition resulted from a transfer of property by a funded member (the transferor) to an issuer in exchange for stock of the issuer; and (ii) for the 36-month period following the issuance, the transferor held, directly or indirectly, more than 50% of the issuer (by vote or value).

This Regulation is proposed to apply to debt issued on or after April 4, 2016, but will not result in such debt being treated as equity until 90 days after the Regulations are finalized (at which time the debt instrument would be deemed exchanged for equity).