Tax News and Developments North America Baker & McKenzie Global Services LLC 300 East Randolph Drive Suite 5000 Chicago, Illinois 60601, USA Tel: +1 312 861 8000 Fax: +1 312 861 2899 Client Alert November 23, 2015 Treasury Takes Another Shot at Stopping Inversion Transactions On November 19, 2015, Treasury followed through on its promise, as described in the previous day's letter by Secretary of the Treasury Lew to the leadership of the Congressional tax-writing committees, to issue further guidance to "deter and reduce further economic benefits of corporate inversions." Similar to Notice 2014- 52 (the "2014 Notice"), last year's guidance on the same subject, this year's guidance was issued in the form of a notice (Notice 2015-79, referred to herein as the "2015 Notice") without immediate legal effect (given that the notice does not have the effect of a temporary or final regulation). While for some companies the 2015 Notice will not appear to be as much of a blow as the left hook dealt by the 2014 Notice, as described below, it promises future regulations (with current effect if issued in temporary and/or final form) in several areas limiting the ability of a company to invert and adversely changing the cost/benefit calculation of post-inversion planning. The 2015 Notice does attempt to fix a few issues created by the 2014 Notice. It still, however, leaves many questions unanswered and is based upon overly broad and false assumptions. Moreover, the 2015 Notice continues to evidence that the Treasury and IRS guidance under Code Section 7874 and other provisions may exceed the regulatory grant of authority. New Provisions Limiting Ability to Invert "Third Country" Inversions The 2015 Notice effectively prevents taxpayers from satisfying the requirements of section 7874 in certain transactions where a US company engages in a business combination transaction with an existing foreign target but the resulting foreign parent of the group is incorporated in a jurisdiction different than that of the foreign target (a "third country" inversion). More specifically, the 2015 Notice announces Treasury's and the IRS's intent to issue regulations providing that, where a transaction satisfies four requirements, stock of the foreign acquiror that the foreign target shareholders receive by reason of owning stock in the foreign target will be disregarded in applying the section 7874 ownership test. The four requirements are generally as follows: • A foreign acquiring corporation acquires, directly or indirectly, and whether through an asset acquisition or an acquisition of stock or partnership interests, substantially all of the assets of an existing foreign target in a transaction "related to" the inversion; • The gross value of the foreign target's assets acquired, directly or indirectly, is more than 60% of the gross value of all of the property held by the "expanded affiliated group" (the "EAG," an affiliated group of Baker & McKenzie 2 Tax News and Developments – Client Alert November 23, 2015 corporations connected through 50 percent stock ownership), except for property that the US company and its subsidiaries held before the acquisition; • The tax residence of the foreign acquiror is not the same as the tax residence of the foreign target. This determination is made before the acquisition of the foreign target and any related transactions, meaning the rules are designed, in part, to prevent a pre-business combination migration of the foreign target's tax residence to another jurisdiction if such migration is related to the business combination transaction; and • Without taking into account the new third country inversion rule, the former shareholders of the US company would own at least 60%, but less than 80%, of the stock of the foreign acquiror after the acquisition, as measured under the general rules of section 7874. If the foreign acquiror acquires multiple foreign targets that are tax residents of the same country, then the transactions will be aggregated for purposes of this rule. The third country inversion rule reflects an assumption by Treasury and the IRS that US tax avoidance purposes motivate the decision to form a new foreign parent in a third country. US and foreign companies entering into a business combination often have sound business reasons for choosing a third country. To give just a few examples, the combined company may wish to establish a global footprint or to select a neutral and mutually convenient location for management or other centralized functions or board meetings. Taxpayers may choose a third country to take advantage of its corporate laws. Taxpayers may also choose a third country based on a desire to minimize foreign taxes, a motive that is generally accepted as a valid business purpose under US law. The 2015 Notice does not provide any exception for transactions motivated by business considerations. This rule applies to acquisitions completed on or after November 19, 2015. Tax Residence Requirement for Substantial Business Activities Test The 2015 Notice bars taxpayers from relying on the substantial business activities test where the foreign acquiror of the inverting US company is not a tax resident of the country in which it is incorporated. Under section 7874(a)(2)(B)(iii), a foreign acquiring corporation is not subject to section 7874 if the foreign acquiror's EAG has "substantial business activities in the foreign country in which, or under the laws of which, the entity is created or organized." Final regulations issued in June 2015 generally provide that an EAG will satisfy the substantial business activities test if at least 25% of its employees (by both headcount and compensation), tangible personal or real property, and income are located or derived in the relevant foreign country. In some cases, a foreign acquiror may not be subject to tax as a resident in its country of incorporation. This situation can arise if, for example, the foreign country of incorporation determines tax residence based on the place of management and control, or if the foreign acquiror is viewed as a transparent entity for local tax purposes. The 2015 Notice provides that Treasury and the IRS intend to issue regulations stating that where a foreign acquiror is not subject to tax as a resident Baker & McKenzie 3 Tax News and Developments – Client Alert November 23, 2015 of the country in which it is incorporated, the EAG will not be treated as having substantial business activities in that country. Interestingly, the 2015 Notice does not change section 7874's general use of place of incorporation to determine the country in which the EAG must have substantial business activities, but rather adds a requirement that the foreign parent company have such activities in the jurisdiction of tax residence as well. Thus, a company that has substantial business activities in the jurisdiction of tax residence would not satisfy section 7874's substantial business activities requirement if it is incorporated in a third jurisdiction. This rule applies to acquisitions completed on or after November 19, 2015. Clarifications to Treas. Reg. § 1.7874-4T The 2015 Notice expands the situations in which stock of the foreign parent will be excluded from the denominator of the section 7874 ownership fraction under Temp. Treas. Reg. § 1.7874-4T by broadening the definition of "nonqualified property" in the temporary regulations as explained below. Temp. Treas. Reg. § 1.7874-4T currently provides, among other things, that stock of the foreign acquiror may be disregarded for purposes of the ownership test under section 7874 if the stock was transferred in exchange for "nonqualified property." Nonqualified property includes (i) cash or cash equivalents, (ii) marketable securities, and (iii) obligations of a member of the expanded affiliated group, a former shareholder or partner of the inverting US company, or an owner of or person related to one of the foregoing. Nonqualified property also includes any other property acquired in a transaction related to the acquisition, with a principal purpose of avoiding the purposes of section 7874 ("avoidance property"). According to an example in the current regulations, if a person transfers nonqualified property to a corporation in exchange for stock in a transaction with an avoidance purpose, the newly issued stock is avoidance property. Treasury and the IRS intend to clarify that avoidance property is a broader category than the example in the regulations might imply. According to the 2015 Notice, avoidance property is not limited to situations involving an indirect transfer of nonqualified property, but can include any property acquired with an avoidance purpose. The 2015 Notice introduces a new example in which PRS, a foreign partnership, contributes business assets to FA, a newly formed foreign corporation, in exchange for 25% of FA stock. In addition, shareholders of DT, a domestic corporation, contribute their DT stock to FA in exchange for 75% of the stock of FA. While none of the PRS assets would otherwise be treated as nonqualified property, the example provides that FA acquires the assets with a principal purpose of avoiding the purposes of section 7874. The example thus concludes that all of the PRS assets should be treated as avoidance property, and therefore all of the FA stock that PRS receives should be excluded from the denominator of the section 7874 ownership fraction. The 2015 Notice proposes a related clarification to the regulations. The regulations provide, and an example illustrates, that "marketable securities" (a type of nonqualified property) do not include stock of a corporation that becomes a member of the foreign acquiror's EAG "unless a principal purpose for acquiring such stock . . .is to avoid the purposes of section 7874." The 2015 Notice provides that the regulations will be changed to delete the quoted language on the ground that it is redundant with the language describing avoidance property. The 2015 Notice consistently indicates that even if stock is not "nonqualified Baker & McKenzie 4 Tax News and Developments – Client Alert November 23, 2015 property" on the basis that it is stock of a corporation that becomes a member of the expanded affiliated group, it can still be nonqualified property on the basis that it is avoidance property. This rule applies to acquisitions completed on or after November 19, 2015. The 2015 Notice does not clarify what constitutes a principal purpose of avoidance. Moreover, the 2015 Notice suggests that the new proposed rule may be redundant, because, in Treasury's and the IRS's view, section 7874(c)(4) already allows the IRS to disregard any transfer of properties that has a principal purpose of avoidance. Provisions Targeted at Limiting Benefits of Post-Inversion Planning Expansion of "Inversion Gain" As described below, the 2015 Notice expands the section 7874(d)(2) definition of the term "inversion gain" to cover indirect transfers of stock or property. Section 7874(a)(1) requires that the taxable income of an expatriated entity (i.e., an inverted US company whose former shareholders own at least 60% but less than 80% of the new foreign parent) be, for each year in the 10-year period following the inversion, no less than its "inversion gain." Section 7874(e)(1) restricts the use of tax credits and losses to offset inversion gain. Certain inverted companies are therefore limited in their ability to transfer subsidiaries or assets to the new foreign parent without paying tax on the resulting gain or income. The "inversion gain" rules as codified apply only to gain and income directly recognized by the former US parent and related domestic entities. The 2015 Notice proposes to expand these rules to cover transfers undertaken by foreign subsidiaries of the former US parent. The 2015 Notice also provides that Treasury and the IRS will issue regulations to expand the definition of "inversion gain" to include gain or income included by the US parent (such as subpart F income) from indirect transfers of stock or property or licenses of property (by, for example, a controlled foreign corporation (“CFC”)) if the transfer or license is made either (i) as part of the inversion or (ii) to a foreign related person. The 2015 Notice provides a limited exception to this rule for transfers of section 1221(a)(1) inventory property. This rule will apply to transfers or licenses occurring on or after November 19, 2015, but only with respect to inversion transactions completed on or after September 22, 2014. Section 367(b) The 2015 Notice proposes to amend section 367(b), as well as the regulations contemplated in the 2014 Notice (although such regulations have not yet been issued), to provide that certain exchanges of CFC stock subject to section 367(b) will now require recognition of all gain in the CFC's stock, including gain in excess of earnings and profits, with any earnings and profits not exceeding such gain treated as a dividend (as it would have been under the 2014 Notice). In the 2015 Notice, Treasury and the IRS announce their concern about transactions subject to section 367(b) where the foreign subsidiary has minimal Baker & McKenzie 5 Tax News and Developments – Client Alert November 23, 2015 earnings and profits, but its stock has a substantial built-in gain. The 2015 Notice specifically identifies situations where the foreign subsidiary holds valuable selfdeveloped intellectual property that has not yet generated earnings and profits. The 2015 Notice proposes amendments to the Treasury Regulations under section 367(b) and the rules described in the 2014 Notice to provide that if a transaction would be otherwise captured under section 367(b), taking into account the 2014 Notice, the expatriated entity must recognize the realized gain in the stock transferred (to the extent such gain is not otherwise recognized as a dividend under the 2014 Notice and subject to any increases in basis resulting from the inclusion of the dividend). The 2015 Notice provides an example of the application of this rule. FA, a foreign corporation, owns DT, a domestic corporation, which owns FT, a CFC. DT is an expatriated entity and subject to these rules. FA also owns FS, a foreign corporation that is not a CFC. DT transfers FT's stock to FS in exchange for 60% of the stock of FS in a section 368(a)(1)(B) reorganization. Although FT remains a CFC, DT is required to include in income both the earnings and profits attributable to FT's stock as well as DT's realized but otherwise unrecognized gain with respect to FT stock. This provision is a substantial expansion of section 367(b), which previously required only the inclusion of earnings and profits, and not the recognition of realized gain in excess of such earnings and profits. The 2015 Notice also amends an exception to the anti-decontrol provisions of the 2014 Notice. The 2014 Notice provided that the anti-decontrol rules under section 7701(l) will not apply if the shareholder includes in income the earnings and profits of the CFC under section 367(b). The 2015 Notice amends these rules to require recognition of the realized gain in the stock of the CFC for the exception to the anti-decontrol rules to apply. These rules will apply to transactions occurring on or after November 19, 2015, but only with respect to inversion transactions completed on or after September 22, 2014. Corrections to Notice 2014-52 While the 2015 Notice primarily broadens the reach of section 7874 and expands the scope of the 2014 Notice, it does include some relief for taxpayers. "Cash Box" Rules The 2015 Notice broadens the exception to the "cash box" rules of the 2014 Notice for passive assets held for use in an insurance business. The 2014 Notice provided that certain stock attributable to certain nonqualified property (e.g., cash or cash equivalents, marketable securities) would be excluded from the denominator of the section 7874 ownership test if the nonqualified property exceeded 50 percent of the foreign acquiror's assets. This would unfavorably increase the section 7874 percentage for transactions involving "cash box" foreign corporations. The 2014 Notice further provided certain exceptions for property giving rise to section 1297(b)(2)(A) income (the PFIC banking exception) or qualifying for the subpart F banking and insurance exceptions under section 954(h) or (i), but not the PFIC insurance exception contained in section 1297(b)(2)(B). The 2015 Notice expands the exceptions to include property giving rise to income qualifying for the PFIC insurance exception. Treasury and Baker & McKenzie 6 Tax News and Developments – Client Alert November 23, 2015 the IRS state in the 2015 Notice that they expect to issue guidance on the PFIC insurance exception of section 1297(b)(2)(B) to prevent abuse of such exception. The 2015 Notice also provides an exception to the nonqualified property rules for property used by a domestic corporation subject to tax as an insurance company under subchapter L provided the property is required to support, or is substantially related to, the active conduct of an insurance business. Finally, the 2015 Notice provides an exception for property held by a domestic corporation that would give rise to income described in section 954(h) if the domestic corporation were a CFC. These rules will apply to acquisitions completed on or after November 19, 2015, although taxpayers can elect to apply them to acquisitions completed before that date. De Minimis Rule for Non-Ordinary Course Distributions The 2015 Notice provides a de minimis exception to the rules of the 2014 Notice that disregard certain distributions for purposes of applying the ownership test of section 7874. The 2014 Notice announced Treasury's and the IRS's intent to issue regulations to disregard certain non-ordinary course distributions made in the 36-month period prior to an inversion, determined according to a bright-line, objective test. Disregarding the non-ordinary course distributions has the result of increasing the ownership percentage of the former owners of the US company for purposes of section 7874. In the 2015 Notice, Treasury and the IRS note that under certain circumstances the non-ordinary course distribution rule could cause section 7874 to apply to an acquisition even though the former shareholders of the US target actually own only a minimal amount of stock of the new foreign parent or even none at all. This situation could arise if, for example, the stock held by other shareholders was disregarded under other anti-abuse rules such as Treas. Reg. § 1.7874-4T(b). The 2015 Notice provides that the non-ordinary course distribution rule will not apply if the former shareholders of the US target own less than 5% of the new foreign parent by vote and value and own less than 5% of any member of the expanded affiliated group by vote and value. This rule will apply to acquisitions completed on or after November 19, 2015. Anti-Decontrol Exception The 2014 Notice provided rules to prevent "decontrol" transactions whereby the new foreign parent (or a non-CFC foreign subsidiary) contributes property to a CFC of the US target to reduce the US target's ownership of the CFC, potentially below 50%. The 2014 Notice provides an exception to contributions where the CFC remains a CFC and the "amount of stock (by value)" owned directly or indirectly by the US target does not decrease by more than 10%. Treasury and the IRS state in the 2015 Notice that they are concerned with taxpayers interpreting this rule to allow a comparison of the value of the stock held by the US target before the "decontrol" transaction with the value of the stock held after the "decontrol" transaction, rather than a comparison of the percentage ownership before and after the transaction. Baker & McKenzie North America Tax Chicago +1 312 861 8000 Dallas +1 214 978 3000 Houston +1 713 427 5000 Miami +1 305 789 8900 New York +1 212 626 4100 Palo Alto +1 650 856 2400 San Francisco +1 415 576 3000 Toronto +1 416 863 1221 Washington, DC +1 202 452 7000 Baker & McKenzie 7 Tax News and Developments – Client Alert November 23, 2015 The 2015 Notice thus modifies the 2014 Notice by substituting the phrase "percentage of stock (by value)" for "amount of stock (by value)" to ensure that the test is measured with respect to the reduction of the US target's percentage of stock rather than the value of the stock. This rule will apply to "decontrol" transactions completed on or after November 19, 2015, but only with respect to inversion transactions completed on or after September 22, 2014. Concluding Remarks There are a number of troubling aspects about the 2015 Notice (and the 2014 Notice), including, but not limited to, (i) Treasury's and the IRS's broad assumptions (and non-rebuttable presumptions) regarding the purposes of all inversion transactions and the lack of commercial benefits or drivers, (ii) the continued expansion and other alterations to the express statutory provisions of section 7874 and other sections of the Code, (iii) the use of notices to announce the future promulgation of rules effective as of the date of the notices without the benefit of the full regulatory and rule making process, (iv) the use of subsequent notices to alter the rules in previous notices that have not yet been put into regulations, and (v) the creation of a separate set of rules for inverted companies under provisions not geared to inversions, such as sections 367 and 7701(l), and, even within that group of companies, separate rules depending on when a company inverts. To date, Treasury has refrained from addressing earnings stripping and continued to emphasize the need for strong anti-inversion action from Congress. Whether the lack of earnings stripping guidance to date is a sign that Treasury believes Congress must address such matter or attributable to something else is unknown. (For the record at least one Treasury official has stated that the absence of guidance in the 2015 Notice should not be viewed as a concession that they do not have the authority to issue such guidance.) Moreover, the 2015 Notice does not mention tax treaty policy as was referenced in the 2014 Notice, potentially because of the intervening updated US Model Tax Treaty "limitation on benefits" and "expatriated entity" provisions. Despite all the uncertainty, what is fairly clear is that the inversion guidance since section 7874 was enacted has gone well beyond the legislative history statements of focusing on transactions with "little or no non-tax effect or purpose" and that have "relatively little operational significance." Tax News and Developments is a periodic publication of Baker & McKenzie's North American Tax Practice Group. This Alert has been prepared for clients and professional associates of Baker & McKenzie. It is intended to provide only a summary of selected recent legal developments. For this reason, the information contained herein should not be relied upon as legal advice or formal opinion or regarded as a substitute for detailed advice in individual cases. The services of a competent professional adviser should be obtained in each instance so that the applicability of the relevant jurisdictions or other legal developments to the particular facts can be verified. To receive Tax News and Developments directly, please contact email@example.com. Your Trusted Tax Counsel® www.bakermckenzie.com/tax www.bakermckenzie.com For additional information please contact the authors of this Client Alert or any member of Baker & McKenzie's North American Tax Practice Group. Jonathan Martin +1 713 427 5062 Jonathan.Martin@bakermckenzie.com Peter Daub +1 202 452 7081 Peter.Daub@bakermckenzie.com Paula Levy +1 650 251 5936 Paula.Levy@bakermckenzie.com Patrick Renckly +1 713 427 5035 Patrick.Renckly@bakermckenzie.com ©2015 Baker & McKenzie. All rights reserved. Baker & McKenzie International is a Swiss Verein with member law firms around the world. In accordance with the common terminology used in professional service organizations, reference to a "partner" means a person who is a partner, or equivalent, in such a law firm. Similarly, reference to an "office" means an office of any such law firm. This may qualify as "Attorney Advertising" requiring notice in some jurisdictions. Prior results do not guarantee a similar outcome.