The IRS and Treasury issued temporary (TD 9238) and proposed regulations (REG- 143244-05) to clarify when and how stock held by members of an expanded affiliated group (EAG) should be disregarded for purposes of corporate inversions under Sec. 7874.

Inversions—General Principles

In accordance with 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 former shareholders of the domestic corporation (or former partners of the domestic partnership); and

3. After the acquisition, the EAG (which includes the foreign acquirer) does not have substantial business activities in the acquirer’s country of incorporation.

As a result of such an “inversion,” the foreign acquiring company be-comes a “surrogate foreign corporation” with respect to the domestic corporation or partnership as 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, but any applicable corporate-level income or gain that requires recognition by the expatriated entity (Secs. 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, that foreign corporation will be treated as a domestic corporation for all Sec. 7874(b) purposes.

Disregard of Stock Held by EAG Members

Two categories of stock have to be disregarded for purposes of determining the 60% and 80% stock ownership test: (1) stock of the foreign corporation which is sold in a public offering and (2) stock held by EAG members. The EAG is defined by reference to Sec. 1504(a), except it includes foreign corporations and lowers the affiliation threshold to “more than 50%”; see Sec. 7874(c)(1).

The disregard of EAG stock led to some surprising (and presumably unintended) results. For example, prior to the new regulations, if, in an internal group restructuring, a foreign parent owned 85% and a minority shareholder owned 15% of a domestic company and a foreign holding company, had the foreign parent and the shareholder transferred their stock in the domestic company to the foreign holding company (or if the domestic company had transferred its assets to the foreign holding company), the foreign parent and the shareholder would likely have fallen into the inversion trap. The foreign holding company would have become a domestic corporation, assuming there would be no substantial business activity in its country of incorporation, because the foreign parent’s 85% of the foreign holding company’s stock would have been disregarded as stock held by an EAG member. The shares held by the shareholder, however, would have been fully counted and the shareholder would have been deemed to own 100% of the foreign holding company for Sec. 7874 purposes. The term “disregarded” is naturally understood to mean excluded from the numerator and the denominator of the fraction determining the ownership percentage.

To subject such a transaction to the harsh results of Sec. 7874 seemed inconsistent with the purpose of the EAG rule, which was not supposed to hinder legitimate internal restructurings of multinational groups. Groups that include minority shareholders were put at an unfair disadvantage. This was addressed by Temp. Regs. Sec. 1.7874-1T(b), which first restates the general rule that “stock held by one or more members of the EAG is not included in either the numerator or the denominator of the fraction that determines [the ownership] percentage.” Temp. Regs. Sec. 1-7874-1T(c)(1) then provides an exception (special rule) if (1) the common parent of the EAG (post-acquisition) holds directly or indirectly at least 80% of the domestic entity before such acquisition and (2) the stock held by nonmembers of the EAG does not exceed 20% after the acquisition. If these two requirements are met, the stock held by the EAG member(s) will be included in the denominator but not in the numerator.

According to Temp. Regs. Sec. 1.7874-1T(c)(2), the same rule applies when the former shareholders (or partners) of the domestic entity do not own directly or indirectly, in the aggregate, more than 50% (by vote or value) of the stock of any EAG member. On the other hand, Temp. Regs. Sec. 1.7874-1T(d) provides that “hook stock” (i.e., stock owned by an entity that is itself at least 50% owned by the issuer of such stock) is not taken into account for purposes of (1) determining the percentage of ownership of an entity under the above special rules and (2) the application of the special rule itself.

Examples

Eight examples illustrate the application of the EAG rules; see Temp. Regs. Sec. 1.7874-1T(e). Every example assumes no substantial business activities in the foreign acquiring corporation’s country of incorporation.

Example 1: This example illustrates the application of the “hook stock” rule under Temp. Regs. Sec. 1.7874-1T(d). A domestic corporation, A, forms a foreign corporation, F. A, which is held by a group of individuals, subsequently transfers several foreign subsidiaries to F in exchange for F stock. F then forms a domestic subsidiary that merges into A. A is the surviving entity and a subsidiary of F. The former A shareholders receive F stock in exchange for their A stock, and A continues to hold some F stock. Under Temp. Regs. Sec. 1.7874-1T(b) and (d), the F stock held by A is not included in either the numerator or the denominator of the fraction that determines the percentage of F stock held by former shareholders Thus, 100% of the F stock is deemed held by former shareholders, which makes F a surrogate corporation that is treated as a domestic corporation.

Example 2: P is a parent corporation with a 100% owned U.S. subsidiary, USS. It transfers all its assets to a newly formed foreign subsidiary, FS, in a reorganization under Sec. 368(a)(1)(F). P ultimately ex-changes its USS stock for FS stock. In accordance with Temp. Regs. Sec. 1.7874-1T(c)(1), former shareholders are deemed to own 0/100 of FS. Because all of the foreign acquiring company’s stock is held by EAG members after the acquisition, USS would not have been deemed inverted, even prior to the new regulations.

Example 3: The facts are the same as in Example 2, except P transfers its USS shares to FS in exchange for FS stock. Again, the former shareholder, P, is deemed to own 0/100 of FS under Temp. Regs. Sec. 1.7874-1T(c)(1), and FS is thus not a surrogate corporation.

Example 4: The facts are the same as given in the example at the beginning of this item (involving P and A transferring their USS stock to FS). Under Temp. Regs. Sec. 1.7874-1T(c)(1), P’s 85% of FS stock is excluded only from the numerator because the nonmembers of the EAG (here, A) do not own more than 20% of the foreign corporation, FS. Thus, former shareholders are deemed to own 15/100 (15%) rather than 15/15 (100) of the foreign acquiring corporation.

Example 5: Corporation, M, contributes a domestic subsidiary, S, to a newly formed foreign joint venture company, JV, in exchange for 40% of JV’s stock. An unrelated company, B, contributes foreign subsidiaries in exchange for the remaining 60% of JV. Because M does not own more than 50% of the stock directly or indirectly of any EAG member, the JV stock owned by B is included only in the denominator but not in the numerator of the fraction. Thus, former shareholders of the domestic entity, S, are deemed to own 40/100 (i.e., less than 60%) of the foreign acquirer, which, in turn, is not considered a surrogate foreign corporation.

Example 6: This example illustrates a standard case in which an inversion occurs. Two unrelated corporations, K and L, own 55% and 45% respectively of a domestic company, T, and contribute all their T shares to a newly formed foreign corporation, U, in exchange for a respective number of U shares. The special rule does not apply here and the U stock held by K (the EAG member) must be excluded from the numerator and the denominator in accordance with the general rule. L is deemed to own 45/45 (100%), and U is a surrogate corporation.

Example 7: This example illustrates the application of the special rule in which a foreign corporation acquires a domestic partnership interest rather than a domestic corporation. The implications are similar to those in Example 4.

Example 8: This example shows the result of equal (50-50) partners (one corporate, one individual) transferring their interests in a domestic partnership to a foreign corporation. In such a scenario, there is no expanded affiliated group because no shareholder owns “more than 50%” of the foreign corporation. Thus, no stock can be disregarded, and the former partners of the U.S. business entity are deemed to own 100% of the foreign (surrogate) corporation.

From Martin H. Karges, LL.M., New York NY, and Scott Hendon, CPA, Dallas TX