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Delphi wins IRS inversion challenge & so is not treated as U.S. corporation

In a filing with the U.S. Securities and Exchange Commission (SEC), Delphi Automotive PLC (Delphi) announced that it is has won an appeal with IRS allowing the company to be treated as a U.K. tax resident for U.S. federal tax purposes. IRS had asserted that Delphi should be treated as a U.S. company under Code Sec. 7874(b), after the company reincorporated in the U.K. The announcement comes just days after U.S.-based Pfizer abandoned its merger plans with Irish-based Allergan in response to new temporary regs issued by Treasury that further target corporate inversions.

Background on corporate inversions. Corporate inversions (also called “expatriation transactions”) generally involve a U.S. corporation that engages in a series of transactions with the effect of moving its headquarters from the U.S. to a lower-taxed foreign jurisdiction. The transactions might be effected by the U.S. corporation becoming a wholly owned subsidiary of a foreign corporation (through a merger into the foreign corporation’s U.S. subsidiary) or by transferring its assets to the foreign corporation. If the transaction is respected, U.S. tax can be avoided on foreign operations and distributions to the foreign parent, and there are opportunities to reduce income from U.S. operations by payments of fees, interest, and royalties to the foreign entity.

Inversion transactions are generally governed by Code Sec. 7874, under which a foreign corporation is treated as a U.S. corporation for all purposes (i.e., the benefits of being treated as foreign are lost) of the Code where, under a plan or series of related transactions:

1. the foreign corporation completes, after Mar. 4, 2003, the direct or indirect acquisition of substantially all the properties held directly or indirectly by a U.S. corporation;
2. shareholders of the U.S. corporation obtain 80% or more of the foreign corporation’s stock (by vote or value) by reason of holding their U.S. shares (the “80% test”); and
3. the foreign corporation, and corporations connected to it by a 50% chain of ownership, don’t have “substantial business activities” in the foreign corporation’s country of incorporation or organization when compared to the total business activities of the group. (Code Sec. 7874(b); Code Sec. 7874(a)(2)) “Substantial business activities” means, for this purpose, 25% of the firm’s employees, assets, and sales being in the foreign country. (Reg. § 1.7874-3)

A separate set of rules apply to inversion transactions where the domestic corporation’s shareholders obtain at least 60% but less than 80% of the foreign corporation’s stock (the “60% test”). In general, the tax benefits associated with being a foreign corporation are reduced, and the expatriated entity’s “inversion gain” (defined as any income recognized during a 10-year period by reason of the acquisition, not offset by a net operating loss (NOL) or foreign tax credit) is taxed at the maximum corporate rate. (Code Sec. 7874(a)(2)(B)) These rules effectively penalize, but don’t prohibit, inversions.

Also, in certain inversions, Reg. § 1.367(a)-3(c) may cause a U.S. person that is a shareholder of the domestic parent corporation to recognize gain (but not loss) on the exchange of its stock in the domestic corporation.

On April 4, IRS issued temporary regs intended to address transactions that are structured to avoid the purposes of Code Sec. 7874 and Code Sec. 367, as well as certain post-inversion tax avoidance transactions (see Weekly Alert ¶  24  04/07/2016). The temporary regs include rules that are aimed at “serial inverters” and that limit a company’s ability to participate in successive inversions within a relatively short time frame. For purposes of meeting the above 60% and 80% tests, the regs change the current rules so as to not take into account certain U.S. assets that the foreign corporation acquired within the past three years (effectively decreasing the size of the foreign corporation for purposes of those tests, and thus making the transaction less likely to qualify for the benefits associated with inverting). They also generally incorporate the rules in two Notices that IRS issued in 2014 and 2015 (Notice 2014-52, 2014-42 IRB 712, covered at Weekly Alert ¶  10  09/25/2014, and Notice 2015-79, 2015-49 IRB 775, covered at Weekly Alert ¶  1  11/25/2015), with certain modifications.

On April 4, IRS issued proposed regs under Code Sec. 385 that target U.S. earnings stripping, referring to a practice of related parties engaging in certain transactions to interject excessive indebtedness in the U.S.—generally, by a U.S. subsidiary issuing excessive debt to a foreign parent—and effectively wiping out U.S.-source earnings through interest deductions. The new proposed regs would generally make earnings stripping more difficult by, among other things, treating certain related-party interests as part debt, part stock. (See Weekly Alert ¶  43  04/07/2016 for more details.)

Reaction and response. On the same day, Allergan CEO Brent Sauders told CNBC’s “Squawk on the Street,” “For the rules to be changed after the game has started to be played is a bit un-American, but that’s the situation we’re in.” Saunders indicated that Allergan had been blindsided by Treasury’s announcement. “We built this deal around the law, the regulations, all the notices that were put out by the Treasury and it was a highly legal construct,” he added. “We followed the rules that Congress had set for companies looking to move to foreign domicile.”

In a press briefing on April 6, White House press secretary Josh Earnest stated,

We were clear yesterday that the steps that the Treasury Department was taking was [sic] not focused on any one particular transaction, but rather was [sic] focused on a loophole that we knew certain corporate interests either had previously taken advantage of or were looking to take advantage of. And so that’s why they took steps to close that loophole. That, of course, does not eliminate the need for Congress to take action with regard to corporate inversions.

Delphi’s SEC filing. According to Delphi’s April 8 SEC filing , IRS issued the company a Notice of Proposed Adjustment (NOPA) on June 24, 2014 asserting that Code Sec. 7874(b) applied to Delphi Automotive LLP, a wholly-owned Delphi subsidiary, in which case both Delphi Automotive LLP and Delphi Automotive PLC would have been treated as domestic corporations for U.S. federal income tax purposes retroactive to Oct. 6, 2009. If Delphi Automotive LLP and Delphi Automotive PLC were treated as domestic corporations for U.S. federal income tax purposes, Delphi would have been subject to U.S. federal income tax on its worldwide taxable income. Delphi contested the conclusions reached in the NOPA through the IRS’s administrative appeals process.

On Apr. 8, 2016, the IRS Office of Appeals issued fully-executed Forms 870-AD, concluding that Code Sec. 7874(b) does not apply to Delphi, and therefore, no adjustments for the tax years subject to the appeals process (2009 and 2010) are necessary. Therefore, consistent with the IRS’s determination and conclusion related to this matter, Delphi will continue to be treated as a U.K. tax resident.

RIA observation: Delphi’s April 8 SEC filing does not mention any other adverse tax consequences under the anti-inversion rules (e.g., limiting the use of certain tax attributes to reduce the U.S. federal income tax owed on the inversion gain). As noted above, even if the U.S. tax law respects the foreign status of the foreign acquiring corporation, other potentially adverse tax consequences may follow if continuing ownership stake of the former domestic entity shareholders is at least 60%.

References: For inversions, see FTC 2d/FIN ¶  F-5700  et seq.; United States Tax Reporter ¶  78,744; TaxDesk ¶  236,901; TG ¶  5167.