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IRS Issues Additional Guidance on Sec. 7874 Inversions Sec. 7874 was enacted in 2004 to combat certain expatriations of U.S. companies to foreign (and presumably low-tax) jurisdictions (hereafter referred to as “inversions”). Treasury and the Service continue to expand the guidance on this Code provision; see Karges and Hendon, Tax Clinic, “Corporate Inversions and the Affiliated-Owned Stock Rule,” TTA, May 2006. New proposed and temporary regulations provide welcome clarifications as to what constitutes a “surrogate foreign corporation”; see REG-112994-06 and TD 9265 (both dated 6/5/06). The new temporary and proposed regulations address the exception for “substantial business activities” in the foreign country, for purposes of determining whether the foreign entity is treated as a surrogate foreign corporation under Sec. 7874(a)(2)(B). The new rules also attempt to clarify the meaning of “indirect acquisition” of properties and ownership “by reason of” holding stock in the domestic corporation (or an interest in the domestic partnership). In addition, the new regulations contain anti-abuse provisions to target the use of publicly traded foreign partnerships, options and similar interests to avoid Sec. 7874. General Principles Under Sec. 7874(a)(2)(B), a corporate inversion may generally occur when three requirements are met: 1. A foreign corporation acquires (directly or indirectly) substantially all of the properties of a domestic corporation (or the trade or business of a domestic partnership); 2. After the acquisition, at least 60% of such foreign corporation’s stock (determined by vote or value) is held by the domestic corporation’s former shareholders (or the domestic partnership’s former partners) “by reason of” holding stock in the domestic corporation or an interest in the domestic partnership; and 3. After the acquisition, the expanded affiliated group (EAG) (which includes the foreign acquirer) does not have substantial business activities in the acquirer’s country of incorporation, when compared to the total business activities of such EAG. The result of such an “inversion” is that the foreign acquiring company becomes a surrogate foreign corporation with respect to the domestic corporation or partnership that is the expatriated entity. The tax treatment of the surrogate foreign corporation varies, depending on the level of shareholder continuity. If the percentage of stock (by vote or value) in the surrogate foreign corporation held by former shareholders is 60% or more (but less than 80%), the entity is treated as a foreign corporation; however, any applicable corporate-level income or gain required to be recognized by the expatriated entity (under Sec. 311(b), 304, 1248, etc.), or any income or gain recognized by reason of the transfer or license of property (other than inventory or similar property), cannot be offset by the expatriated entity’s net operating losses or credits. The treatment of the expatriated entity will apply for a 10-year period following the completion of the acquisition. Perhaps more significantly, when the former shareholders or partners of the domestic entity hold at least 80% of the foreign surrogate corporation, the latter will be treated as a domestic corporation for all Code purposes, under Sec. 7874(b). Indirect Acquisition of Properties Under Sec. 7874, a foreign corporation is deemed to have indirectly acquired a domestic corporation’s properties if it acquires the stock of such domestic corporation, either (1) directly or (2) indirectly, through the acquisition of another domestic corporation or of a domestic or foreign partnership owning the respective shares. In contrast, the acquisition of a foreign corporation that, in turn, owns a domestic corporation, is not an indirect acquisition of such domestic corporation for Sec. 7874 purposes. Example 1: Foreign corporation Y acquires foreign corporation X. This acquisition will typically not trigger an inversion, even if X owns shares in U.S. corporations or interests in U.S. partnerships. This exception seems reasonable. The acquired U.S. corporation had been under foreign control already; continuing such foreign control under a different structure should have no adverse effect. However, an indirect acquisition is possible if the domestic entity’s stock or assets are acquired for shares of a foreign controlling corporation. Example 2: Foreign parent FP forms new foreign subsidiary FS. FS acquires the shares of U.S. company Z in exchange for FP shares. FP (rather than FS) would be deemed to have acquired indirectly Z’s shares and, thus, could become a surrogate corporation (to be treated as a U.S. corporation). “By Reason of” Rule For purposes of determining the 60%-ownership threshold in the foreign acquiring corporation, the former shareholders need only count the (foreign) stock they own as a result of the transfer of their domestic interests. Example 3: A holds all the stock of a domestic corporation (DC) and of a foreign corporation (FC). DC’s outstanding stock is worth $30; FC’s stock is worth $70. A contributes DC and FC to FH, a foreign holding company, in exchange for 100% of FH’s stock (a Sec. 351 transaction). For Sec. 7874 purposes, A is deemed to hold 30% of the FH shares “by reason of” holding stock in DC, because the remaining 70% of his FH shares are owned by reason of contributing other assets (FC shares) to the foreign corporation. No inversion would have occurred, because A would not be deemed to own at least 60% of FH for Sec. 7874 purposes. Substantial Business Activities of the EAG For purposes of avoiding the inversion rule when substantial business activities exist, taxpayers must understand EAGs. EAGs are defined by reference to Sec. 1504(a), except that they include foreign corporations and lower the affiliation threshold to “more than 50%.” This is a very broad definition; in the case of a multinational, it will often include virtually the entire group. If an EAG has substantial business activities in the foreign country in which the acquiring corporation is organized, an inversion can generally be avoided, even if the former shareholders are deemed to own 60% or more of the acquiring foreign corporation. Three questions are crucial in determining whether the substantial business activities exception applies: What constitutes the EAG? Which factors determine the presence of substantial business activities in the foreign country of incorporation? Can the safe-harbor test be met? The definition of “substantial business activities” forms the cornerstone of the new regulations. For the business activities in the foreign country in which the acquiring corporation is organized to be substantial, they must be substantial when compared to the total business activities of the entire EAG. The acquiring corporation itself does not necessarily have to have an active business; any EAG member’s business activity in that country counts. The regulations provide two tests for determining whether the EAG has substantial business activities in the acquiring foreign entity’s country of incorporation. Facts-and-circumstances test: The first test, in Temp. Regs. Sec. 1.7874-2T(d)(1)(ii), is based on the facts and circumstances that have to be taken into account to determine substantial presence. Factors to consider include:
In contrast, assets or activities transferred or contributed to the foreign country for the purpose of avoiding the application of Sec. 7874 cannot be considered; see Temp. Regs. Sec. 1.7874-2T(d)(1)(iii). Safe harbor: The second test, in Temp. Regs. Sec. 1.7874-2T(d)(2), is a safe-harbor test, in which the EAG will be deemed to have substantial business activities in the foreign country if it meets all of the following conditions:
Temp. Regs. Sec. 1.7874-2T(d)(3) includes detailed definitions for the terms “employee,” “group asset” and “group sales” (not further discussed here). However, it appears that this safe-harbor test can be particularly difficult to meet by large multinational corporations with a global presence. Because these global players will often have such widespread operations, no single foreign country can ever come near the required 10% thresholds, at least not in all three categories. Other Issues The regulations also target two structures that the IRS perceives as abusive. First, the use of publicly traded foreign partnerships can generally not avoid the application of Sec. 7874; such partnerships are treated as foreign corporations and EAG members for purposes of determining the existence of a surrogate foreign corporation; see Temp. Regs. Sec. 1.7874-2T(e). Second, options or similar interests (e.g., warrants, convertible debt) in the foreign acquiring corporation held by a former shareholder or partner of the expatriated entity must be treated as exercised, under Temp. Regs. Sec. 1.7874-2T(f). Thus, the option holder will be taken into account for purposes of determining the 60%/80% continued-ownership threshold. Effective Date The temporary regulations apply to acquisitions completed after June 5, 2006. In addition, taxpayers may choose to apply the regulations before June 6, 2006; however, they must be applied consistently to all covered acquisitions. From Martin H. Karges, LL.M., BDO Seidman, New York, NY, and Scott Hendon, CPA, BDO Seidman, Dallas, TX (Not affiliated with CPAmerica International) |
