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Final corporate inversion regs retain bright-line substantial business activities test

T.D. 9720, 06/03/2015, Reg. § 1.7874-3

IRS has issued final regs that provide guidance on whether an expanded affiliated group (EAG) has substantial business activities in a foreign country for purposes of determining if it should be treated as a surrogate foreign corporation under Code Sec. 7874(a)(2)(B) for purposes of the rules that tax corporate inversions.

Background. Code Sec. 7874 provides rules for expatriated entities and their surrogate foreign corporations.An expatriated entity is defined in Code Sec. 7874(a)(2)(A) as a domestic corporation or partnership with respect to which a foreign corporation is a surrogate foreign corporation, and also as any U.S. person related to such domestic corporation or partnership.

A foreign corporation is treated as a surrogate foreign corporation under Code Sec. 7874(a)(2)(B) if, under a plan or a series of related transactions: (i) the foreign corporation directly or indirectly acquires substantially all the properties held directly or indirectly by a domestic corporation, or substantially all the properties constituting a trade or business of a domestic partnership; (ii) after the acquisition, at least 60% of the stock (by vote or value) of the foreign corporation is held by (in the case of an acquisition with respect to a domestic corporation) former shareholders of the domestic corporation by reason of holding stock in the domestic corporation, or (for an acquisition with respect to a domestic partnership) by former partners of the domestic partnership by reason of holding a capital or profits interest in the domestic partnership (ownership percentage test); and (iii) the EAG that includes the foreign corporation does not have business activities in the foreign country in which the foreign corporation was created or organized that are substantial when compared to the total business activities of the EAG (substantial business activities test).

An EAG is an affiliated group defined in Code Sec. 1504(a) but without regard to the exclusion of foreign corporations in Code Sec. 1504(b)(3) and with a reduction of the 80% ownership threshold of Code Sec. 1504(a) to a more-than-50% ownership threshold. (Code Sec. 7874(c)(1))

Earlier regs.Temporary and proposed regs under Code Sec. 7874 were issued in 2006 (see Weekly Alert ¶  12  06/08/2006), and, later that year, IRS issued Notice 2006-70, 2006-33 CB 252, announcing that it would change the date of the temporary regs for certain acquisitions initiated before Dec. 28, 2005 (see Weekly Alert ¶  11  08/03/2006).Among other things, the 2006 regs provided that the determination of whether an EAG has substantial business activities in a foreign country is based on all the facts and circumstances, and also provided a safe harbor which generally was satisfied if at least 10% of the employees, assets, and sales of the EAG were in the foreign country.

In 2009, IRS withdrew the 2006 regs and replaced them with new temporary and proposed regs (the 2009 regs; see Weekly Alert ¶  3  06/18/2009).The 2009 regs retained the facts and circumstances general test provided in the 2006 temporary regs, with certain modifications, but removed the safe harbor.

In 2012, IRS issued new temporary regs (the 2012 temporary regs) under which the 2009 regs’ facts and circumstances test was replaced with a bright-line rule describing the threshold of activities required for the EAG to have substantial business activities in the foreign country (see Weekly Alert ¶  14  06/14/2012).

New final regs. Highlights of the new final regs follow.

Threshold of business activities. Under the final regs, as in the 2012 temporary regs, there is a 25% employee, asset, and income bright-line test for when an EAG will be considered to have substantial business activities in the relevant foreign country. Under the final regs, an EAG will have substantial business activities in the relevant foreign country only if:

At least 25% of the group employees are located in the relevant foreign country. All employees of members of the EAG constitute group employees. Reg. § 1.7874-3(b)(1) sets out two calculations, both of which must be satisfied, to meet this condition: (i) on the “applicable date” (see below), at least 25% of the total number of group employees must be based in the relevant foreign country; and (ii) at least 25% of the total compensation of all group employees must be paid to group employees based in the relevant foreign country during the 1-year testing period (see below). Whether individuals are employees must be determined for all members of the EAG under U.S. federal tax principles or for all members of the EAG based on the relevant tax laws. A group employee is considered to be based in the relevant foreign country only if the employee spent more time providing services in such country than in any other single country during the testing period. (Reg. § 1.7874-3(d)(6)) Employee compensation with respect to a particular group employee is treated as incurred when it would be deductible by the employer as compensation, and the amount of employee compensation equals the amount that would be deductible by the employer as compensation. Both the timing and the amount of the deduction for employee compensation must be determined for all group employees under U.S. federal income tax principles or for all group employees based on the relevant tax laws. (Reg. § 1.7874-3(d)(3));
At least 25% of the value of the group’s total assets (i.e., tangible personal or real property used or held in the active conduct of a trade or business by EAG members) is located in the relevant foreign country on the applicable date.(Reg. § 1.7874-3(b)(2)) A group asset is considered to be located in the relevant foreign country only if the asset was physically present in such country at the close of the acquisition date and the asset was physically present in such country for more time than in any other country during the testing period. However, notwithstanding this rule, a group asset that is mobile in nature and is used in a transportation activity (such as a vessel, an aircraft, or a motor vehicle) is considered to be located in the relevant foreign country if the asset was physically present in such country for more time than in any other country during the testing period, regardless of whether the asset was physically present in such country at the close of the acquisition date. The group’s total assets include tangible personal property or real property that is rented by members of the EAG from a person other than a member of the EAG; its value is deemed to be eight times its net annual rent. (Reg. § 1.7874-3(d)(5)); and
…At least 25% of the group’s income (i.e., generally, gross income of EAG members from transactions occurring in the ordinary course of business with unrelated customers) is derived in the relevant country during the 1-year testing period. (Reg. § 1.7874-3(b)(3)) Group income must be determined consistently for all members of the expanded affiliated group either under U.S. federal income tax principles or as reflected in the relevant financial statements. Group income is considered to be derived in a foreign country only if the customer is located in such country. (Reg. § 1.7874-3(d)(7))

An EAG, with respect to an acquisition described in Code Sec. 7874(a)(2)(B)(i), means the affiliated group defined in Code Sec. 7874(c)(1) determined as of the close of the acquisition date, but taking into account all transactions related to the acquisition. Thus, for example, the EAG does not include a corporation wholly owned by a member of the EAG during a portion of the testing period (see below) if, before the end of the testing period, the member sells all of its stock in the corporation to a person that is not a member of the EAG. (Reg. § 1.7874-3(d)(4)) T.D. 9720 notes that the disposition of substantially all the assets of an entity may or may not cause it to cease to be a member of the EAG, depending on whether the entity remains in existence on the acquisition date.

The applicable date is either the date on which the acquisition is completed or the last day of the month immediately preceding the month in which the acquisition is completed. (Reg. § 1.7874-3(d)(2)) The testing period is the 1-year period ending on the applicable date. (Reg. § 1.7874-3(d)(13))

Partnership attribution.The final regs provide that, in determining the corporations that are members of an EAG, each partner in a partnership is treated as holding its proportionate share of the stock held by the partnership (look-through rule).The final regs coordinate the application of the deemed corporation rule (under which a partnership is treated as a corporation that is a member of an EAG if, in the aggregate, more than 50% (by value) of its interests are owned by one or more members of the EAG) with the look-through rule by providing that the look-through rule applies first and without regard to the deemed corporation rule.The result is that the look-through rule applies only for purposes of determining whether an entity that is actually a corporation for U.S. income tax purposes is a member of the EAG.Then, once those corporate entities are identified, the deemed corporation rule applies to treat certain partnerships in which those corporate entities are partners as corporations that are members of the EAG.(Reg. § 1.7874-3(e))

Effective/applicability dates. The final regs are effective for acquisitions that are completed on or after June 3, 2015.For acquisitions completed before June 3, 2015, and on or after June 7, 2012, the 2012 temporary regs apply.For acquisitions completed on or after June 7, 2012, that were either described in a filing with the Securities and Exchange Commission or subject to a written agreement that was binding on that date, taxpayers may apply either the rules in Reg. § 1.7874-2T(g) (revised as of Apr. 12, 2012), or the rules set out in the 2012 temporary regs. (Reg. § 1.7874-3T(f))

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

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