On July 11, 2018, the U.S. Treasury Department (“Treasury”) published final regulations (the “Final Regulations”) that address transactions that, in Treasury’s view, are structured to avoid the purposes of sections 7874 and 367 of the Internal Revenue Code (the “Code”). Although the Final Regulations largely adopt previously announced guidance, including finalizing proposed regulations, they contain some significant revisions to such guidance, as discussed below.
Significantly, despite the Final Regulation’s addition of various clarifications and exceptions, the section 7874 regulations remain highly complex, expand the reach of section 7874 beyond the face of the statute, and contain a number of traps for the unwary. Accordingly, taxpayers should give critical consideration to, and obtain tax advice on, any transaction in which a foreign corporation is acquiring an equity interest in, or acquiring the assets of, a domestic corporation or domestic partnership. Section 7874 was added to the Code in 2004 to counteract certain transactions commonly referred to as “inversions.” A transaction is subject to section 7874 if a foreign corporation (i) directly or indirectly acquires substantially all of the assets of a U.S. corporation or substantially all of the assets of a trade or business of a U.S. partnership, (ii) the percentage of stock in the foreign corporation received by the former shareholders or partners of the U.S. entity (the “ownership percentage”) pursuant to the transaction exceeds certain thresholds, and (iii) the foreign corporation and certain affiliates (together, the expanded affiliated group or “EAG”) does not have substantial business activities in the same country where the foreign corporation is organized. With regard to the second prong, there are two applicable ownership thresholds — 60 percent and 80 percent (measured by vote or value) — which, if met, result in certain punitive consequences. The more severe consequence applies at the 80-percent threshold, in which case the foreign corporation is treated as a domestic corporation for all U.S. federal income tax purposes. This treatment results in the foreign corporation’s income being subject to U.S. tax in the same manner as any other domestic corporation, regardless of the source of that income.
On April 4, 2016, the Treasury published hundreds of pages of section 7874 final, temporary, and proposed regulations and associated guidance. The Final Regulations largely adopt 2016 proposed regulations as final regulations, with some important revisions. The following listing summarizes the most significant of these revisions.
- Passive Asset Rule. In determining the ownership percentage, the passive asset rule of Treasury Regulations § 1.7874-7 (the “Passive Asset Rule”) generally excludes from the denominator of the ownership fraction stock of a foreign acquiring corporation attributable to certain passive assets. The Final Regulations:
- revise the Passive Asset Rule to only apply for purposes of determining the ownership percentage by value, and not for purposes of determining ownership by vote; and
- revise the Passive Asset Rule to take into account the other stock exclusion rules under the Final Regulations in determining the ownership percentage.
- Serial Acquisition Rule. The serial acquisition of domestic entities rule of Treasury Regulations § 1.7874-8 (the “Serial Acquisition Rule”) generally provides that stock attributable to certain prior domestic entity acquisitions is excluded from the denominator of the ownership fraction. The Final Regulations:
- clarify that the Serial Acquisition Rule does not take into account stock of a foreign acquiring corporation deemed to have been received in a prior domestic entity acquisition under the non-ordinary course distribution rule of Treasury Regulations § 1.7874-10 (the “NOCD Rule”) or under section 7874(c)(4) (which disregards certain transfers if part of a plan to avoid the purposes of section 7874);
- provide an exception to the Serial Acquisition Rule for a domestic entity acquisition that occurs within a foreign parented group and qualifies for the internal group restructuring exception of Treasury Regulations § 1.7874-1(c)(2); and
- provide a definition for a predecessor of a foreign acquiring corporation for purposes of the Serial Acquisition Rule.
- Third-Country Rule. The third-country rule of Treasury Regulations § 1.7874-9 (the “Third-Country Rule”) generally provides that stock of a foreign acquiring corporation is excluded from the denominator of the ownership fraction when a domestic entity acquisition is a “third-country transaction.” The Final Regulations:
- provide an exception to the Third Country Rule if the EAG has substantial business activities in the third country compared to the total activities of the EAG; and
- provide a second exception to the Third Country Rule if both the foreign acquiring corporation and the acquired foreign corporation (i) are created or organized in a foreign country that does not impose corporate income tax, and (ii) are not tax residents of any other foreign country.
- NOCD Rule. The Non-Ordinary Course Distribution rule (the “NOCD Rule”) generally provides that, for purposes of determining the ownership percentage by value, former domestic entity shareholders or partners are deemed to receive an amount of stock (“NOCD Stock”) of a foreign acquiring corporation with a value equal to the aggregate non-ordinary course distributions made by the domestic entity. The Final Regulations:
- refine and limit the definition of distribution for purposes of the NOCD Rule;
- modify a special rule that applies when a domestic corporation distributes stock of another domestic corporation pursuant to a transaction described in section 355 of the Code;
- clarify how the NOCD Rule interacts with the rules relating to EAGs;
- provide guidance on how to allocate NOCD Stock among the former domestic entity shareholders, with such allocations generally made based on the amount of NOCDs each person is treated as receiving;
- provide guidance as to which corporation(s) the NOCD Stock is considered comprised of when multiple foreign acquiring corporations complete a domestic entity acquisition;
- address how the NOCD Rule applies when two or more domestic entities are treated as a single domestic entity; and
- confirm that NOCD Stock is included in both the numerator and the denominator of the ownership fraction, except to the extent that the NOCD Stock is treated as held by a member of the EAG and excluded from the numerator or both the numerator and denominator, as applicable, under the rules relating to EAGs.
- De Minimis Exceptions. Certain of the stock exclusion rules under section 7874 contain a de minimis exception. The Final Regulations:
- expand the de minimis exceptions such that only former domestic entity shareholders or former domestic entity partners that own (taking into account applicable attribution rules) at least 5% of the stock of (or a partnership interest in) the domestic entity need be identified. If none of the former domestic entity shareholders or former domestic entity partners own such amount of stock or partnership interests, then the de minimis exceptions will be satisfied.
- Coordination of Rules Affecting Ownership Fraction with EAG Rules. The Final Regulations broaden the coordination between the rules relating to EAGs and the rules that disregard certain stock of a foreign acquiring corporation for purposes of determining the ownership fraction — namely, the Serial Acquisition Rule and the Third-Country Rule.
- The Substantial Business Activities Test. The substantial business activities test of Treasury Regulations § 1.7874-3 generally provides that, for an EAG to be considered to have substantial business activities in a foreign country, the foreign acquiring corporation must be subject to tax as a resident of the relevant foreign country.
- The Final Regulations define a tax resident of a country as a body corporate liable to tax under the laws of the country as a resident, and provide that if the relevant foreign country is a country that does not impose corporate income tax, the tax residency requirement does not apply.
- Rules Addressing Certain Post-Inversion Tax Avoidance Transactions. To reduce the tax benefits of certain post-inversion tax avoidance transactions, the 2016 Regulations provided rules under sections 304(b), 367, 956(e), and 7701(l).
- For clarity, the Final Regulations use the term “non-EFS foreign related person” instead of the term “non-CFC foreign related person.” For this purpose, “EFS” stands for “expatriated foreign subsidiary.” In addition, the Final Regulations modify various examples involving foreign corporations that were not controlled foreign corporations (“CFCs”) prior to the legislation commonly referred to as the Tax Cuts and Jobs Act, which amended section 958(b) so as to provide “downward attribution” of stock from foreign persons to United States persons.
- The Final Regulations provide that, for purposes of determining (i) whether an entity is an EFS, and (ii) whether an entity is a CFC for purposes of Treasury Regulations § 1.304-7, downward attribution from a non-United States person to a United States person does not apply.