On July 9, 2012, the IRS issued new temporary and proposed regulations under Section 7874 of the Internal Revenue Code.1 These regulations, which are effective as of June 12, 2012, provide guidance regarding whether a foreign corporation has substantial business activities in the foreign country in which, or under the law of which, the foreign corporation is created or organized.
Under Section 7874(a), a tax is imposed on the inversion gain of an “expatriated entity.” Inversion gain generally means the income or gain recognized in connection with the transfer of stock or other property by an expatriated entity, as well any income received or accrued as part of a Section 7874(a)(2)(B)(i) acquisition.
In turn, an expatriated entity is a domestic corporation or partnership, or any U.S. person related to the domestic corporation or partnership, with respect to which a foreign corporation is a surrogate foreign corporation. A surrogate foreign corporation is a foreign corporation if, pursuant to a plan (or a series of related transactions), it meets the following three requirements:
- the entity completes after March 4, 2003 the direct or indirect acquisition of substantially all of the properties held directly or indirectly by a domestic corporation or substantially all of the properties constituting a trade or business of a domestic partnership;
- after the acquisition at least 60% of the stock (by vote or value) of the entity is held— (I) in the case of an acquisition with respect to a domestic corporation, by former shareholders of the domestic corporation by reason of holding stock in the domestic corporation, or (II) in the case of an acquisition with respect to a domestic partnership, by former partners of the domestic partnership by reason of holding a capital or profits interest in the domestic partnership; and
- after the acquisition the expanded affiliated group which includes the entity does not have substantial business activities in the foreign country in which, or under the law of which, the entity is created or organized, when compared to the total business activities of such expanded affiliated group.2
The recently issued temporary and proposed regulations help determine whether a foreign corporation has substantial business activities in a foreign country for purposes of determining whether it is a surrogate foreign corporation. In the new temporary regulations, the IRS has adopted a bright-line rule. The bright-line rule now deems that an expanded affiliated group will have substantial business activities in the foreign country only if at least 25% of the group employees, group assets and group income are located or derived in the relevant foreign country, determined as follows:
The temporary regulations provide two tests for calculating group employees, both of which must be satisfied. The first test is calculated as the number of group employees, which includes the number of employees of members of the expanded affiliated group, based in the relevant foreign country divided by the total number of group employees. The first test is measured with respect to the applicable date, which the IRS defines in the regulations as either the date on which the acquisition is completed or the last day of the month immediately preceding the month in which the acquisition is completed. The second test is calculated as the dollar amount of employee compensation with respect to group employees based in the relevant foreign country divided by the total employee compensation with respect to all group employees determined during the one-year testing period. The applicable date definition is also used to determine the testing period.
The group assets test is calculated as the value of the group assets located in the relevant foreign country divided by the total value of all group assets determined on the applicable date. The term group assets generally encompasses tangible personal property or real property used or held for use in the active conduct of a trade or business by members of the expanded affiliated group. Group assets also consist of rental property held for use in the trade or business. Rental property is valued at eight times the net annual rent paid or accrued.
Finally, the group income test is calculated as the group income derived in the relevant foreign country divided by the total group income determined during the one-year testing period. Group income includes gross income of members of the expanded affiliated group from transactions occurring in the ordinary course of business with customers that are not related persons. Group income is considered to be derived in a foreign country only if the customer is located in that foreign country.
In sum, although the temporary regulation’s bright-line test provides clarity when determining whether a foreign corporation is a surrogate foreign corporation and, ultimately, whether certain gains will be subject to inclusion under Section 7874, it also presents obstacles because the IRS’s new bright-line test replaces the previous facts and circumstances standard. For example, it is possible to meet two of the three requirements, but narrowly miss satisfying the final requirement. As a result, a surrogate foreign corporation would not be treated as having substantial business activities in the relevant foreign country and any applicable inversion gain would be subject to current inclusion under Section 7874.