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IRS’s anti-inversion guidance makes inverting more difficult, but won’t solve problem

Notice 2015-79, 2015-49 IRB

U.S. Department of the Treasury, Fact Sheet: Additional Treasury Actions to Rein in Corporate Tax Inversions (11/19/2015).

IRS has issued a second round of guidance, in the form of a Notice and accompanying fact sheet, as part of its continuing efforts to crack down on corporate inversions. The new Notice, similar to the one issued last fall, previews regs that IRS intends to issue to both make it more difficult for U.S. companies to invert and also reduce the tax benefits of doing so. However, Treasury Secretary Jacob Lew has acknowledged that Treasury’s power in this area is limited and that any definitive action to address inversions must come from Congress.

Background. 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, which was enacted in 2004 as part of the American Jobs Creation Act (P.L. 108-357). Under Code Sec. 7874 , 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 (the “expanded affiliated group,” or EAG), 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))
RIA observation: Put otherwise, in order to avoid being treated as a U.S. corporation under the above rules, the resulting entity must be more than 20% foreign-owned, meaning that the target foreign company must be at least 25% the size of the U.S. corporation.

Substantial business activities, for purposes of (3), above, are defined as 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)) This is sometimes referred to as a “toll charge,” and legislative history described it as being paid on transactions that accompany or follow an inversion transaction and are designed to “remove income from foreign operations from the U.S. taxing jurisdiction.” The lost benefit of otherwise applicable tax attributes like NOLs essentially serves as a penalty.

Notice 2014-42. In September of 2014, after corporate inversions had become an increasingly prevalent and mainstream news topic (and target of various legislative proposals and political discussion), IRS issued Notice 2014-52, 2014-42 IRB 712. In Notice 2014-52, IRS previewed regs, generally applicable to transactions completed on or after Sept. 22, 2014, that it intended to issue under Code Sec. 304(b)(5)(B), Code Sec. 367 , Code Sec. 7701(l), and Code Sec. 7874 with respect to corporate inversion transactions. As described, the regs would prevent inverted companies from using certain techniques to access the overseas earnings of the U.S. company’s foreign subsidiaries without paying U.S. tax, close a loophole to prevent inverted companies from transferring cash or property from a controlled foreign corporation (CFC) to a new parent to completely avoid U.S. tax, and make it more difficult for U.S. entities to invert. (See Weekly Alert ¶  10  09/25/2014 for more details on the Notice and on inversions in general.) Notice 2014-42 also stated that additional guidance to limit both inversions and the benefits therefrom would be issued.

New Notice. Notice 2015-79 provides detailed guidance on the types of transactions that are being targeted and the regs IRS intends to issue.

Section 2 of Notice 2015-79 described regs, effective for acquisitions completed on or after Nov. 19, 2015, that “address transactions contrary to the purposes of” Code Sec. 7874 (i.e., the act itself of inverting), as follows:

New foreign parent must be “tax resident” in country where it is created/organized. IRS is aware of transactions in which the taxpayer asserts that the EAG has substantial business activities in the relevant foreign country (i.e., where the foreign acquiring corporation is created or organized) but the foreign acquiring corporation is not subject to income taxation in the relevant foreign country as a resident. This could occur, for example, if the foreign country determines tax residency based on the location where the entity is controlled, or could also result from a mismatch between the entity classification rules of the U.S. and the foreign country. IRS has determined that the substantial business activities exception described above—where sufficient activities in the foreign country warrant respecting the resulting entity as foreign—is premised upon on the foreign acquiring corporation being subject to tax as a resident of the relevant foreign country. Accordingly, IRS intends to issue regs providing that an EAG cannot have substantial business activities in the foreign country unless the foreign acquiring corporation is subject to tax as a resident of that country.

Ability to choose tax residence using new “third country” parent is limited. IRS is aware that certain acquisitions in which a domestic entity combines with an existing foreign corporation are structured by establishing a new foreign parent corporation for the combined group with a tax residence a different country than the existing foreign corporation (a “third country” that generally has a more favorable tax system). The new third-country parent acquires the foreign corporation’s and the domestic entity’s stock and assets, and the shareholders those entities receive, respectively, more-than-20% and less-than-80% of the stock of the new third-country parent. IRS has determined that, in certain circumstances, the use of a third-country parent is contrary to the policy underlying the 80% test. Accordingly, IRS intends to issue regs that would, if several requirements are satisfied, disregard certain stock of a foreign acquiring corporation that is issued to the shareholders of the existing foreign corporation for purposes of determining whether the 80% threshold is met. According to the Treasury fact sheet, this rule “will prevent U.S. firms from essentially cherry-picking a tax-friendly country in which to locate their tax residence.”

Anti-stuffing rules are strengthened. According to the fact sheet, in some inversions, the foreign acquirer’s size is inflated by “stuffing” assets into it so that the 80% threshold isn’t reached. In measuring the 80% threshold, certain stock of the foreign acquiring corporation is disregarded, including, under, Reg. § 1.7874-4T, stock of the foreign acquiring corporation transferred in exchange for “nonqualified property” (which includes cash, securities, and any other property related to the acquisition with a principal purpose of avoiding Code Sec. 7874) in a transaction related to the acquisition. These “anti-stuffing” rules effectively make the proportion of stock owned by the U.S. entity higher and thus more likely to cross the 80% ownership threshold and render the transaction subject to Code Sec. 7874. However, IRS is concerned that some taxpayers are interpreting Reg. § 1.7874-4T in a way that is inconsistent with the statute and intent of the regs—namely, by taking a narrow reading so as to limit the “nonqualified property” to passive assets. Accordingly, IRS intends to issue regs clarifying that these anti-stuffing rules apply to allassets that were acquired with a principal purpose of avoiding the 80% rule. (Notice 2015-79, Sec. 2)

Section 3 of Notice 2015-79 described regs that would “address post-inversion tax avoidance transactions.”

“Inversion gain” subject to U.S. tax is expanded. IRS is concerned that certain indirect transfers of stock or other property of an expatriated entity have the effect of removing foreign operations from U.S. taxing jurisdiction and, policy-wise, should be treated as giving rise to inversion gain. These concerns could arise in the context of an expatriated entity causing a controlled foreign corporation (CFC) that it owns to make certain property transfers or license property to a specified “related person” (as defined in Notice 2014-52). In this situation, the expatriated entity would have a deemed dividend from the CFC that would be taxable under Code Sec. 951, but would receive the various tax attribute benefits that inversion gain is denied (like NOLs). Accordingly, IRS intends to issue regs that would expand the definition of inversion gain to include these types of income, effective for transfers or licenses occurring on or after Nov. 19, 2015, but only if the inversion transaction is completed on or after Sept. 22, 2014.

Require recognition of built-in gain in CFC stock. Under Code Sec. 367(a)(1), if a U.S. person transfers property to a foreign corporation in connection with an exchange described in Code Sec. 332, Code Sec. 351 , Code Sec. 354, Code Sec. 356, or Code Sec. 361, then the foreign corporation generally isn’t considered a corporation for purposes of determining gain on the transfer—meaning that transfers of property to a foreign corporation that would otherwise be tax-free are treated as taxable exchanges. However, under Code Sec. 367(b)(1), where there is no transfer of property in the exchange, a foreign corporation is considered to be a corporation, except to the extent provided in regs that are necessary to prevent tax avoidance. Among other things, this preserves the potential application of Code Sec. 1248, under which a U.S. person includes in gross income as a dividend (out of the CFC’s untaxed accumulated earnings and profits) any gain recognized on the sale or exchange of a foreign corporation’s stock that was a CFC at any time during the 5-year period ending on the date of the sale or exchange if certain ownership requirements are met.

IRS is concerned that certain nonrecognition transactions that dilute a U.S. shareholder’s ownership of an expatriated foreign subsidiary may allow the U.S. shareholder to avoid U.S. tax on unrealized appreciation in property held by the expatriated foreign subsidiary at the time of the exchange. This could occur, for instance, when the amount of realized gain in the stock of the expatriated foreign subsidiary that is exchanged in the specified exchange exceeds the earnings and profits attributable to such stock for purposes of Code Sec. 1248. Accordingly, to prevent the avoidance of U.S. tax on this unrealized gain, IRS will issue regs requiring the exchanging shareholder to recognize all of the gain in the stock of the expatriated foreign subsidiary that is exchanged, without regard to the amount of the expatriated foreign subsidiary’s undistributed earnings and profits, effective for specified exchanges occurring on or after Nov. 19, 2015, but only if the inversion transaction is completed on or after Sept. 22, 2014. A conforming change will also be made to the regs described in Notice 2014-52. (Notice 2015-79, Sec. 3)

In Section 4 of Notice 2015-79, IRS also made several corrections and clarifying rules to Notice 2014-52 (Weekly Alert ¶  10  09/25/2014). That Notice addressed a number of devices employed to keep the 80% ownership threshold from being met, and changes to them include the following:

Active insurance business income generally isn’t passive. In Notice 2014-52, IRS limited the ability of companies to count passive assets that aren’t part of daily business functions to inflate the new foreign parent’s size (the “cash box” rule). In Notice 2015-79, IRS has corrected the cash box rule to (i) ensure that assets used in an active insurance business (that give rise to income described in Code Sec. 1297(b)(2)(B)) are not treated as passive assets, and (ii) provide that the general definition of foreign group nonqualified property generally does not include property held by a domestic corporation taxed as an insurance company. This correction applies to acquisitions completed on or after Nov. 19, 2015, but taxpayers may elect to apply it to acquisitions completed before that date.

De minimis exception added to extraordinary dividends. IRS also prevented U.S. companies from reducing their size by making extraordinary dividends in Notice 2014-52. In Notice 2015-79, IRS added a de minimis exception for extraordinary dividends if certain requirements are met. This exception is generally aimed toward when the foreign corporation acquires the U.S. company in an all (or mostly) cash acquisition and applies to acquisitions completed on or after Nov. 19, 2015, but can be applied to earlier acquisitions at the taxpayer’s election.

Small dilution exception is clarified. Notice 2014-52 also contained rules to prevent so-called “spinversions,” when a U.S. entity inverts a portion of its operations by transferring assets to a newly formed foreign corporation then spinning off that corporation to its public shareholders. In Notice 2015-79, IRS made a clarifying change to ensure proper application of the “small dilution exception.” Notice 2014-52 provided that the exception applies if: (i) the expatriated foreign subsidiary is a CFC immediately after the specified transaction and all related transactions, and (ii) the amount of stock (by value) in the expatriated foreign subsidiary (and any lower-tier expatriated foreign subsidiary) that is owned, in the aggregate, directly or indirectly by the Code Sec. 958(a) U.S. shareholders of the expatriated foreign subsidiary immediately before the specified transaction and any transactions related to the specified transaction does not decrease by more than 10% as a result of the specified transaction and any related transactions.Notice 2015-79 amends the language in (ii) to refer to the percentage of stock, and not value. (Notice 2015-79, Sec. 4) This exception will apply to specified transactions and specified exchanges completed on or after Nov. 19, 2015, but only if the inversion transaction is completed on or after Sept. 22, 2014.

Treasury/IRS limitations. In a letter sent to several key lawmakers shortly before the new guidance was released, Treasury Secretary Jacob Lew was emphatic that “only legislation can decisively stop inversions.” He wrote that Treasury was working to address the issue within its existing authority, but that “[u]nless and until Congress acts, creative accountants and lawyers will continue to find new ways for companies to move their tax residences overseas and avoid paying taxes here at home.” He also stated in a press conference call that Treasury is continuing its efforts to address inversions and that future guidance may also address the issue from the angle of earnings stripping.

Political response. Ways and Means Committee Chairman Kevin Brady (R-TX) agreed that inversions pose a problem, but stated that “[m]andating new rules to raise taxes on American businesses simply make them more attractive takeover targets for foreign corporations,” and that “Treasury is contradicting its own call to pursue a more competitive tax code in favor of shortsighted counterproductive triage.” Senate Finance Committee Chairman Orrin Hatch (R-UT) similarly warned that “[a] pure anti-inversion approach may have the unintended consequence of encouraging more acquisitions of United States companies by foreign-owned firms” and called for careful scrutiny of the new rules.

Rep. Sander Levin (D-MI), Ranking Member of the Ways and Means Committee, issued a statement in which he agreed with Secretary Lew and said the “Congress should get off the sidelines and take action to change the law to stop these tax-motivated inversions.” Senate Finance Committee Ranking Member Ron Wyden (D-OR) expressed similar sentiments, “welcom[ing] efforts from Treasury” but saying that “it’s up to Congress to deliver tax policy that better equips companies to compete and succeed by staying in the U.S.” and that inversions “are a red flag on the urgent need for tax reform.”

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