IRS instructs its auditors on inversion transactions and their consequences
IRS instructs its auditors on inversion transactions and their consequences
In a recently updated International Practice Unit (IPU), IRS provided guidance to its auditors on when the anti-inversion provisions under Code Sec. 7874 apply and the consequences of an 80% and 60% inversion.
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.
Also 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.)
New IPU. Once an auditor has determined that there has been a direct or indirect acquisition of assets of a domestic corporation by a foreign corporation and the prior shareholders have exchanged their ownership in the target domestic corporation for some percentage of stock ownership in the acquiring foreign corporation, he must proceed with a detailed analysis to determine whether Code Sec. 7874 may be applicable to the transaction. All three of the following tests must be met in order for Code Sec. 7874 to apply to the transaction:
- 1. Ownership Test. This test is satisfied if, after the acquisition (see (2), below) by the foreign corporation, at least 60% of the stock (by vote or value) of the foreign corporation is held by former shareholders of the domestic corporation “by reason of” holding stock in the domestic corporation. The IPU advises that when structuring a corporate inversion, taxpayers may attempt to implement certain tax planning strategies that establish ownership percentages of the target’s former shareholders in the new foreign parent to be less than the specific “ownership test” thresholds. For example, if the taxpayer is successful in diluting the former shareholders’ ownership percentages in the new foreign parent to less than 80% but equal to or greater than 60%, then a 60% inversion will result. If less than 60%, then Code Sec. 7874 will not apply at all. These are the results despite the fact that in either case any resulting expanded affiliated group (EAG) may have no substantial business activities in the foreign country of the foreign parent.
- 2. “Substantially All” Test. The transaction meets the substantially all test if pursuant to a plan, a foreign corporation completes the direct or indirect acquisition in a transaction completed after Mar. 4, 2003 of substantially all of the properties held directly or indirectly by a domestic corporation. If a foreign corporation acquires directly or indirectly substantially all of the properties of a domestic corporation during the 4-year period beginning on the date which is two years before the “ownership test” (see (1), above) is met, then such actions are treated as occurring “pursuant to a plan.” An acquisition by a foreign corporation of stock of a domestic corporation is treated as an acquisition of a proportionate amount of the properties held by the domestic corporation. An acquisition by a foreign or domestic corporation (acquiring corporation) of properties held by a domestic corporation in exchange for stock of a foreign corporation (foreign issuing corporation) that is part of the EAG that includes the acquiring corporation after the acquisition is treated as an acquisition by the foreign issuing corporation. Generally, an acquisition by a foreign corporation of stock in another foreign corporation that owns directly or indirectly a domestic corporation isnot treated as an indirect acquisition.
- 3. Substantial Business Activities (SBA) Test. The SBA test is met if, after the acquisition, the EAG does not have SBA in the foreign country in which, or under the law of which (“relevant foreign country”), the acquiring foreign corporation is created or organized in comparison with the total worldwide business activities of the EAG. The EAG is comprised of the affiliated group (including the foreign acquiring corporation), but substituting “more than 50” for “at least 80%” and may include foreign corporations. For transactions completed on or after June 7, 2012, the EAG will have SBA only if the following three sub-tests are all satisfied in the “relevant foreign country” of the new foreign parent in comparison with the total activities group of the EAG: (a) Group employee requirement: (i) The number of group employees based in the relevant foreign country is at least 25% of the total number of group employees on the applicable date , and (ii) the employee compensation incurred as to group employees based in the relevant foreign country is at least 25% of the total employee compensation incurred as to all group employees during the testing period (1-year period ending on the applicable date); (b) Group assets requirement: The value of the group assets (tangible assets) located in the relevant foreign country is at least 25% of the total value of all group assets on the applicable date; and (c) Group income requirement: The group income derived in the relevant foreign country is at least 25% of the total group income during the testing period. In addition, for transactions completed on or after Nov. 19, 2015, in order for the EAG to have SBA the foreign acquiring corporation must be subject to tax as a resident of the “relevant foreign country”
Tax implications. Code Sec. 7874(b) treats the foreign corporation (new foreign parent) as a domestic corporation since the foreign corporation (based on the above facts establishing an 80% inversion) would be a “surrogate foreign corporation” (SFC) under the definition in Code Sec. 7874(a)(2) by substituting 80% for 60%.
In a transaction described under Code Sec. 367(a) which would constitute an 80% inversion, the foreign acquiring corporation is treated as a domestic corporation for all U.S. tax purposes. Therefore, the transaction (reorganization or Code Sec. 351 exchange) will not be taxable to either the U.S. shareholders of the domestic corporation or the domestic corporation under Code Sec. 367(a). Accordingly, the acquiring corporation will be taxable by the U.S. on its worldwide income, and any controlled foreign corporations (CFCs) owned by domestic corporation immediately before the inversion will remain CFCs immediately after the inversion. In addition, any pre-existing non-U.S. subsidiaries of the new foreign parent could become CFCs post inversion due to the new foreign parent being treated as a domestic corporation.
The IPU notes that inversions may be structured in a way that avoid being 80% inversions under Code Sec. 7874 since this provision basically negates all the tax advantages of entering into such a transaction. The treatment of the new foreign parent as a domestic corporation for all U.S. tax purposes results in no U.S. tax savings being realized by the EAG and could potentially increase the U.S. tax burden. Such increase may result from the application of subpart F to any pre-existing foreign subsidiaries of the new foreign parent or potential transfer pricing issues relating to any transactions with these entities.
Some of the tax consequences of an 80% inversion are:
- …When the acquiring foreign corporation is treated as a domestic corporation under Code Sec. 7874(b) the “conversion” is treated as an inbound Code Sec. 368(a)(1)(F) reorganization (in effect, a deemed change in place of incorporation to the U.S. for U.S. federal tax purposes) occurring at the later of the end of the day immediately preceding the first date properties are acquired as part of the acquisition or immediately after the formation of the foreign corporation. (Reg. § 1.7874-2(j)(1))
- …A foreign corporation which is treated as a domestic corporation under Code Sec. 7874(b) isn’t an eligible entity for entity classification purposes (e.g. check-the-box election), and as such may not elect non-corporate status under the check-the-box rules. Its classification is defined by statute as a domestic corporation. (Reg. § 1.7874-2(j)(2), Reg. § 301.7701-3)
- …Code Sec. 367(a) requires U.S. persons to recognize gain on certain outbound transfers of property to foreign corporations. However, Code Sec. 367(a) doesn’t apply to transfers of property by U.S. persons to a foreign corporation that is treated as a domestic corporation for U.S. tax purposes under Reg. § 7874(b) since no outbound transfer of property has occurred for U.S. tax purposes. In an 80% inversion, Code Sec. 367(a) doesn’t apply to the prior shareholders of a domestic corporation on exchange of their domestic corporation stock for foreign corporation stock because the foreign corporation is deemed to be a domestic corporation. Thus, no Code Sec. 367(a) outbound transfer of stock has occurred since the shareholders of the domestic corporation are deemed to be exchanging domestic stock for domestic stock which will typically receive non-recognition treatment. In addition, there is no requirement for the filing of a gain recognition agreement under Code Sec. 367(a) at the shareholder level in order to secure nontaxable treatment. (Reg. § 1.7874-2(j)(3))
- …The acquiring foreign corporation, treated as a domestic corporation, is taxable by the U.S. on its worldwide income and is required to file a Form 1120. All foreign corporations in which the acquiring SFC has direct or indirect interests exceeding 50%, by vote or by value, are controlled foreign corporations (CFCs) and thus acquiring foreign corporation must file Forms 5471 for these corporations.
- …Code Sec. 367(b) may apply to the deemed conversion of foreign corporation (newly created or existing foreign corporation) into a “new” domestic corporation as a result of the inbound Code Sec. 368(a)(1)(F) reorganization. (Reg. § 1.367(b)-2, Reg. § 1.367(b)-3 and Reg. § 1.7874-2(k) , Example 20) However, in the context of an inversion and depending on how the inversion was structured, a tax domestication of foreign corporation into domestic corporation may have little or no immediate Code Sec. 367(b) consequences if the foreign corporation is a newly established entity with no significant assets or tax attributes (e.g., E&P). If the foreign corporation was in existence prior to the inversion, Code Sec. 367(b) may require taxation to certain exchanging shareholders of the foreign corporation.
If a 60% inversion occurs, then:
- …the foreign corporation is treated as an SFC;
- …the foreign corporation is respected and treated as a foreign corporation for U.S. federal tax purposes; and
- …during the “applicable period,” any “inversion gain” required to be recognized by an “expatriated entity” (e.g., domestic corporation or one of its domestic subsidiaries) may not be offset by certain tax attributes (e.g., net operating losses), and any tax specifically attributable to inversion gain may not be offset by certain tax credits.
In other words, inversion gain of the inverted domestic corporation may include, but is not limited to:
- …Code Sec. 367(a) gain on the outbound transfer of certain assets by a domestic corporation to New Foreign Corporation and/or Code Sec. 367(d) income on outbound transfer of intangible property as part of an asset inversion;
- …related royalties or services income determined underCode Sec. 482 on transactions with related foreign affiliates during the 10-year applicable period and/or
- …gain on sale of property other than property described in Code Sec. 1221(a)(1) (generally inventory property) to a related foreign affiliate during the 10-year applicable period.
In addition to domestic corporation’s potential inversion gain under Code Sec. 7874, gain may also exist at the shareholder level on the outbound transfer of domestic corporation stock for foreign corporation stock under Code Sec. 367(a).
In the event of a 60% inversion, the following attribute restrictions will generally apply at the expatriated entity level: (A) The taxable income of the expatriated entity (e.g. domestic corporation or related U.S. person) for any tax year which includes any portion of the applicable period, must be at least equal to the amount of the entity’s inversion gain for the tax year; (B) If the expatriated entity may otherwise offset its income tax with credits (other than with credits allowed by Code Sec. 901), the expatriated entity’s inversion gain must remain effectively subject to federal income tax at the maximum corporate rate without reduction by those tax credits (other than credits allowed by Code Sec. 901); and (C) For purposes of determining the credit allowed by Code Sec. 901, inversion gain will be treated as U.S. source income.
The above provisions potentially restrict the expatriated entity’s utilization of various tax attributes (e.g., NOLs) to offset any inversion gain and any tax attributable to inversion gain. Tax attribute limitation is the primary tax cost at the expatriated entity level when utilizing a 60% stock inversion structure. However, there may also be tax costs at the expatriated entity shareholder level when utilizing a 60% stock inversion structure (e.g., Code Sec. 367(a) shareholder level gain).
The IPU also addressed various post inversion transactions. Inversions allows for the implementation of a variety of tax planning strategies that may reduce the U.S. tax expense and lower the group’s overall effective tax rate. Some of these tax planning strategies may artificially reduce U.S. tax and hence should be reviewed in the post-inversion years for compliance issues. These strategies include (but are not limited to) changes in transfer pricing (e.g., de-risking of U.S. operations), and increase in intercompany debt owed to the foreign parent or one of its foreign affiliates, which may serve to strip U.S. earnings from the U.S. and “out from under” planning to move CFCs and avoid application of subpart F going forward.
References: For inversions, see FTC 2d/FIN ¶ F-5700 et seq.; United States Tax Reporter ¶ 78,744; TaxDesk ¶ 236,901; TG ¶ 5167.