On April 4, Treasury and the IRS issued final and temporary (T.D. 9761) and proposed regulations (REG-135734-14) under sections 7874 and 367 to address certain inversion transactions and certain-post inversion “tax avoidance” transactions. The temporary regulations implement (with some modifications) anti-inversion rules that were issued in two notices in 2014 and 2015. The regulations also implement new rules not previously included in the prior notices, including a rule to address so-called “serial inversions” where a foreign corporation combines with a series of US corporations and where section 7874 would otherwise have applied if the acquisitions had been made at the same time or pursuant to a plan (or series of related transactions). The new rules have already halted at least one major planned combination.
Anti-Inversion Rules in General
In general, an inversion is a transaction in which the US parent of a multinational group is replaced by a foreign parent. (For simplicity, this alert will refer only to inversions involving US corporations. Section 7874 may also apply to acquisitions with respect to US partnerships.) In general, the section 7874 anti-inversion rules may apply when the “ownership percentage” or “ownership fraction” of the foreign acquiring corporation exceeds certain thresholds, discussed below. In general, the ownership percentage or fraction is calculated by dividing the amount of stock of the foreign acquiring corporation held by former shareholders of the US corporation by reason of holding stock in the US corporation (the numerator) by the total amount of stock of the foreign acquiring corporation (the denominator) following the transaction. The calculation of the ownership fraction, however, is subject to a number of statutory and regulatory adjustments. For example, certain “anti-stuffing” rules apply to disregard certain transactions intended to increase the denominator of the ownership fraction.
Section 7874 generally applies when: (i) a foreign acquiring corporation completes the direct or indirect acquisition of substantially all of the properties held directly or indirectly by a US corporation; (ii) after the acquisition, the ownership percentage is 60% or more (by vote or value); and (iii) after the acquisition, the expanded affiliated group (EAG) that includes the foreign acquiring corporation does not have substantial business activities in the acquiring corporation’s foreign country (the substantial business activities test). When these conditions are satisfied, section 7874 either (i) prevents the use of certain tax attributes to reduce the US federal income tax owed on certain income or gain (inversion gain) recognized in transactions intended to remove foreign operations from the US taxing jurisdiction (if the ownership percentage is 60% or greater but less than 80%), or (ii) treats the new foreign parent corporation as if it were a US corporation for all purposes of the Internal Revenue Code (the Code) (if the ownership percentage is 80% or more).
In addition, in certain inversions, Treasury regulations under section 367 may cause US shareholders of a US corporation to recognize gain (but not loss) on the exchange of their stock for stock in a foreign corporation. Such US shareholders may recognize gain unless (i) US transferors in the aggregate receive 50% or less of the vote or value in the transferee foreign corporation, (ii) the transferee foreign corporation satisfies an active trade or business requirement, including a “substantiality test” requiring that the fair market value of the transferee foreign corporation generally is at least equal to the fair market value of the transferred US company, and (iii) certain other conditions are satisfied, including certain reporting requirements.
The Temporary Regulations Under Sections 7874 and 367
Implementation of the Notice 2014-52 and Notice 2015-79
On September 22, 2014, the Treasury Department and IRS issued Notice 2014-52 announcing their intention to issue regulations to address certain inversion transactions and post-inversion tax-avoidance transactions. On November 19, 2015, Treasury and the IRS issued Notice 2015-79 announcing additional rules. These notices included several rules that are described below along with a short description of modifications made to those rules by the temporary regulations. The effective dates for the rules in the temporary regulations that implement the rules previously announced in Notice 2014-52 and Notice 2015-79 are consistent with the dates previously announced (and described below).
Serial Acquisition Rules
The temporary regulations also include certain new rules not included in Notice 2014-52 or Notice 2015-79, including rules intended to address so-called serial inversions. In the preamble to the regulations, Treasury and the IRS state that they are concerned that a single foreign acquiring corporation may avoid the application of section 7874 by completing multiple acquisitions of US entities over a relatively short period of time, in circumstances where section 7874 would otherwise have applied if the acquisitions had been made at the same time or pursuant to a plan (or series of related transactions). In these situations, the value of the foreign acquiring corporation increases to the extent it issues stock in connection with each successive acquisition, thereby enabling the foreign acquiring corporation to complete another, potentially larger, acquisition to which section 7874 will not apply.
Treasury and the IRS state they have concluded that it is not consistent with the purposes of section 7874 to permit a foreign acquiring corporation to reduce the ownership fraction by including stock issued in connection with other recent acquisitions of US entities. To prevent this perceived abuse, the temporary regulations provide that stock of the foreign acquiring corporation that was issued in connection with certain prior US entity acquisitions occurring within a 36-month look-back period will be excluded from the denominator of the ownership fraction.
The exclusion applies only when calculating the ownership fraction by value (and not when calculating the ownership fraction by vote) and uses the fair market value of the class of stock of the foreign acquiring corporation that was received by the former shareholders of the prior US acquired entity, as determined on the date the subsequent acquisition being tested is completed. The temporary regulations include special rules for taking into account the effect of intervening stock redemptions by the foreign acquiring corporation. These rules generally do not attempt to trace redemptions to prior shareholders of US acquired entities, but instead assume that such shareholders were redeemed on a pro rata basis over a specified redemption testing period. Adjustments are also applied to take into account the effect of share splits and similar transactions. A de minimis exception applies when the ownership percentage with respect to a prior US entity acquisition was less than five percent, and the fair market value of the stock received by the former US entity shareholders (or former US entity partners) did not exceed $50 million.
Other New Rules
The temporary regulations also include certain other new rules that address inversion transactions, including:
- A “multi-step acquisition rule” intended to address certain transactions that attempt to circumvent the rules of section 7874 by structuring an acquisition of a US entity (or substantially all of its assets) as multiple transactions completed pursuant to a plan (or a series of related transactions), none of which individually would result in the application of section 7874, by considering such transactions together for purposes of section 7874
- A “section 367(b) asset dilution rule” similar to the section 367(b) stock dilution rule included in Notice 2014-52 (and described below) but that applies to certain transfers by an expatriated foreign subsidiary of property (other than stock of another expatriated foreign subsidiary) to a transferee foreign corporation in certain section 351 exchanges, requiring the expatriated foreign subsidiary to recognize all realized gain with respect to the transferred specified property
- A clarification that, for the purpose of determining the “group income” of an EAG under the substantial business activities test, financial reporting principles are only relevant for determining the amount of items of income that are taken into account (and not in determining the identity of the members of an EAG, which is determined under US tax law)
- Rules announced in Notice 88-108 and Notice 2008-91, as modified by Notice 2009-10 and Notice 2010-12, relating to the “30/60 day exception” for obligations under section 956
The new rules not included in Notice 2014-52 or Notice 2015-79 generally apply to transactions completed on or after April 4, 2016, although the preamble makes clear that the IRS may challenge transactions under the law that applied before April 4. Treasury and the IRS also request comments with respect to certain rules under section 954(c)(6) announced in Notice 2007-9 that were affected by Notice 2014-52.
Rules Issued in Notice 2014-52 and Notice 2015-79
The following describes certain rules first included in Notice 2014-52 and Notice 2015-79 and implemented by the temporary regulations.
Notice 2014-52 included three new rules that would limit the ability of multinational groups to enter into inversions:
- An “anti-cash box rule” intended to prevent the use of contributions of passive assets to the foreign acquiring corporation to increase the denominator of the ownership fraction and to prevent foreign acquiring corporations without active businesses from participating in inversions by disregarding certain stock of a foreign acquiring corporation that holds a significant amount of passive assets. Notice 2015-79 subsequently added an exception for certain assets of foreign insurance companies. The temporary regulations make various modifications to the rules announced in Notice 2014-52 and Notice 2015-79, including adding a de minimis exception, narrowing and clarifying the definition of foreign group property, and addressing the application of the rules to certain controlled partnerships.
- An “anti-slimming rule” intended to prevent the US corporation from distributing property to reduce the numerator of the ownership fraction and help satisfy the substantiality test under the section 367 regulations by disregarding certain “non-ordinary course distributions” (NOCD). The temporary regulations provide that the amount of a distribution is determined based on the value of the property at the time of the distribution. In addition, a corporation or partnership is treated as having made any distributions made by a predecessor entity.
- A “subsequent transfer exception” to the “statutory EAG rule” (which generally excludes stock held by members of the foreign acquiring corporation’s EAG from both the numerator and denominator of the ownership fraction) for certain stock received by a former shareholder of the US acquired corporation and subsequently transferred in a related transaction. The temporary regulations modify an internal group restructuring exception and provide that a pro rata portion of the subsequently transferred stock is treated as consisting of “by-reason-of” stock.
Notice 2014-52 also included four new rules that would address post-inversion transactions that Treasury and the IRS viewed as avoiding US tax in a manner inconsistent with the provisions and purposes of certain rules:
- A “section 304 rule” intended to limit the ability of ability to reduce the earnings and profits of a controlled foreign corporation (CFC) to facilitate repatriation of cash and other property of the CFC by including by taking into account only the earnings and profits of the foreign acquiring corporation for purposes of section 304(b)(5)(B).
- A “United States property rule” intended to prevent the foreign acquiring corporation from accessing the untaxed earnings and profits of CFCs without a current US federal income tax to the US shareholders (and thereby avoiding the rules relating to investments in United States property under section 956) by providing that, solely for purposes of section 956, any obligation or stock of a non-CFC foreign related person is United States property within the meaning of section 956 to the extent such obligation or stock is acquired by an expatriated foreign subsidiary during an applicable period. The temporary regulations provide certain additional clarifications and exclusions.
- An “anti-decontrolling rule” intended to prevent an expatriated foreign subsidiary from ceasing to be a CFC using certain transactions that do not give rise to US federal income tax by recharacterizing these transactions under the multiple-party financing authority of section 7701(l). The temporary regulations include three exceptions for certain fast-pay arrangements, transactions in which the appropriate amount of gain is recognized, and a modified version of the de minimis exception included in Notice 2014-52.
- A “section 367(b) stock dilution rule” intended to prevent US shareholders from diluting their interests in expatriated CFCs by requiring such US shareholders to include a deemed dividend in income in certain circumstances. This rule was expanded upon in Notice 2015-79, as discussed below.
Consistent with Notice 2014-52, the rules as implemented in the temporary regulations apply only to transactions completed on or after September 22, 2014 (except the section 304 rule, which taxpayers could elect to apply to transactions completed before September 22, 2014).
Notice 2015-79 included three new rules that would limit the ability of multinational groups to enter into inversions:
- A “third-country rule” applying where a US corporation combines with a foreign corporation under a foreign parent corporation that is a tax resident of a third country. When the rule applies, it generally excludes from the denominator of the ownership fraction stock of the third-country foreign acquiring corporation held by former shareholders of the foreign acquired corporation by reason of holding stock in the acquired foreign corporation. The temporary regulations clarify the application of the tax residency requirement by providing that the tax residency of the foreign acquiring corporation is determined after the covered foreign acquisition and all related transactions, and that the tax residency of the acquired foreign corporation is determined before the covered foreign acquisition and all related transactions.
- A “subject-to-tax rule” providing that the substantial business activities test under section 7874 (described above) could be satisfied only if the foreign acquiring corporation is subject to tax as a resident in the applicable foreign jurisdiction. The temporary regulations implement the subject-to-tax rule described in Notice 2015-79 without making any substantive changes.
- A rule providing that the anti-stuffing rules under section 7874 (described above) would apply to any assets (including active business assets) acquired with the principal purpose of avoiding the purpose of Section 7874. The temporary regulations implement this rule.
Consistent with Notice 2015-79, the rules as implemented in the temporary regulations apply only to transactions completed on or after November 19, 2015.
Notice 2015-79 also included new rules that would address post-inversion transactions that Treasury and the IRS viewed as avoiding US tax in a manner inconsistent with the purposes of the Code:
- An “inversion gain rule” intended to prevent certain indirect transfers or licenses of property by an expatriated entity (that, absent the rule, could have the effect of removing foreign earnings from the US taxing jurisdiction while avoiding current US federal income tax) by expanding the scope of inversion gain recognized under section 7874 to certain indirect transfers and by providing aggregate treatment for certain foreign partnerships for purposes of determining inversion gain.
- An expansion of the section 367(b) stock dilution rule intended to prevent a US shareholder of a CFC from potentially avoiding US federal income tax on net unrealized built-in-gain in property held by the CFC at the time of the exchange of the stock of the CFC by requiring, in certain circumstances, such shareholder to recognize all realized gain with respect to the stock that is not otherwise recognized. The temporary regulations include two new exceptions, one of which applies an exchanging shareholder is neither an expatriated entity nor an expatriated foreign entity subsidiary and one of which applies when there is only a de minimis shift of ownership
- A clarification of the anti-decontrolling rule under Notice 2014-52 (described above).
Consistent with Notice 2014-52 and Notice 2015-79, the rules as implemented in the temporary regulations apply only to transactions that occur on or after November 19, 2015, and only if the related inversion transaction is completed on or after September 22, 2014.