New guidance describes forthcoming regs cracking down on corporate inversions
New guidance describes forthcoming regs cracking down on corporate inversions
Notice 2014-52, 2014-42 IRB
In a Notice and accompanying Treasury fact sheet, IRS has described regs that it intends 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. In general, the forthcoming regs will 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. The regs will generally apply to transactions completed on or after Sept. 22, 2014.
Background on corporate inversions. In corporate inversions (also called “expatriation transactions”), a U.S. corporation becomes a wholly-owned subsidiary of a foreign corporation (through a merger into the foreign corporation’s subsidiary) or transfers its assets to the foreign corporation. If the transaction is respected, U.S. tax can be avoided on foreign operations and on 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.
Current anti-inversion rules in the Code. Under Code Sec. 7874, which was added to the Code in 2004 to address an inversion-related loophole, a foreign corporation is treated as a U.S. corporation for all purposes 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; 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))
However, where the inversion transaction satisfies the above three tests, except that the domestic corporation’s shareholders (or a domestic partnership’s partners) obtain at least 60% but less than 80% of the foreign corporation’s stock, the foreign corporation is an “expatriated entity.” (Code Sec. 7874(a)(2))
Under Code Sec. 7874(a)(1), the taxable income of an “expatriated entity” for any year that includes any portion of the applicable period (as defined in Code Sec. 7874(d)(1)) shall in no event be less than the inversion gain (as defined in Code Sec. 7874(d)(2)) of the entity for the tax year. An expatriated entity is (i) a domestic corporation or partnership as to which a foreign corporation is a surrogate foreign corporation, and (ii) any U.S. person who is related (under Code Sec. 267(b) or Code Sec. 707(b)) to a domestic corporation or partnership described in (i).
Under Code Sec. 7874(c)(4), a transfer of properties or liabilities (including by contribution or distribution) is disregarded if the transfer is part of a plan a principal purpose of which is to avoid the purposes of Code Sec. 7874.
Code Sec. 7874(c)(2)(B)’s statutory public offering rule provides that stock of the foreign acquiring corporation that is sold in a public offering related to the acquisition described in Code Sec. 7874(a)(2)(B)(i) is excluded from the denominator of the fraction used for purposes of calculating the ownership percentage described in Code Sec. 7874(a)(2)(B)(ii) (ownership fraction). However, this rule is modified by Reg. § 1.7874-4T, which provides that, subject to a de minimis exception, “disqualified stock” (as defined) is not included in the denominator of the ownership fraction.
Other related statutory provisions, as relevant to the forthcoming regs, are covered below.
Inversions in the news. Corporate inversions became a mainstream news topic earlier this year, specifically with Pfizer’s attempted takeover of AstraZeneca and U.S. medical device maker Medtronic’s merger with Irish competitor Convidien. Other prominent deals and potential deals include U.S. drugmaker Abbvie’s merger with Ireland-based drugmaker Shire, American drugstore company Walgreen, Inc.’s planned (but reportedly abandoned) takeover of Swiss company Alliance Boots, and the more recent Burger King/Tim Hortons deal.
Earlier proposals. There have been a number of proposals to address corporate inversions in general, as well as various techniques and maneuvers typically used in conjunction with them. Among the more prominent have been the President’s proposal, in his fiscal year 2015 budget, to broaden the definition of an inversion in Code Sec. 7874 by reducing the 80% test to a greater-than-50% test, eliminating the 60% test altogether, and adding a special rule under which, regardless of the level of shareholder continuity, an inversion transaction will occur if the affiliated group that includes the foreign corporation has substantial business activities in the U.S. and the foreign corporation is primarily managed and controlled in the U.S. Another significant proposal, which correlated with the attempted Pfizer takeover, was the “Stop Corporate Inversions Act of 2014,” introduced by Rep. Sander Levin (D-MI) in the House with a companion bill introduced by Sen. Carl Levin (D-MI) in the Senate. Similar to the President’s proposal, the bills would reduce the current 80% threshold to a more-than-50% threshold, and the bills also contain provisions that would bar companies from shifting tax residence offshore if their management and control and significant business operations remain in the U.S.
New guidance. IRS intends to issue regs under Code Sec. 304(b)(5)(B), Code Sec. 367, Code Sec. 7701(l), and Code Sec. 7874, as described below. The relevant statutory background (other than Code Sec. 7874) is provided in conjunction with each proposal.
… Regs under Code Sec. 7874 to disregard certain stock attributable to passive assets. IRS intends to issue regs under Code Sec. 7874(c)(6) providing that, if more than 50% of the gross value of all “foreign group property” ( any property held by the EAG after the acquisition, with certain exceptions) constitutes “foreign group nonqualified property,” then a portion of the stock of the foreign acquiring corporation will be excluded from the denominator of the ownership fraction. Foreign group nonqualified property, in turn, is foreign group property described in Reg. § 1.7874-4T(i)(7), with certain exceptions. This 50% test is applied after the acquisition and all transactions related to the acquisition, if any, are completed.
The forthcoming regs will also contain a rule that incorporates the principles of Reg. § 1.7874-4T(h) (regarding the interaction of the EAG rules with the rule that excludes disqualified stock from the denominator of the ownership fraction) with respect to stock of the foreign acquiring corporation that is excluded from the denominator of the ownership fraction under the rules described in Section 2.01(b) of Notice 2014-52.
These regs will apply to acquisitions completed on or after Sept. 22, 2014.
… Regs under Code Secs. 7874 and 367 to disregard certain distributions by the domestic entity. In general, under Code Sec. 367(a), if a U.S. person transfers property to a foreign corporation in connection with certain exchanges, then the foreign corporation is not treated as a corporation for purposes of determining the extent to which gain is recognized. Reg. § 1.367(a)-3(c) provides an exception to the general rule of Code Sec. 367(a)(1) for certain transfers by a U.S. person of stock or securities of a domestic corporation (the U.S. target company) to a foreign corporation, but it only applies if certain requirements and conditions are met.
IRS intends to issue regs under Code Sec. 7874 and Code Sec. 367 providing that, for purposes of applying Code Sec. 7874(c)(4), non-ordinary course distributions (as defined) made by the domestic entity (including a predecessor) during the 36-month period ending on the acquisition date will be treated as part of a plan, a principal purpose of which is to avoid the purposes of Code Sec. 7874, and thus will be regarded for purposes of that section. In addition, Reg. § 1.367(a)-3(c) will be modified to include a rule that incorporates the principles described in Section 2.02(b) of Notice 2014-52 for purposes of the substantiality test.
These regs will apply to acquisitions, or to transfers of domestic stock described in Reg. § 1.367(a)-3(c), completed on or after Sept. 22, 2014.
… Regs under 7874—subsequent transfers of stock of the foreign acquiring corporation. IRS intends to issue regs generally providing that if stock of the foreign acquiring corporation described in Code Sec. 7874(a)(2)(B)(ii) is received by a former corporate shareholder or former corporate partner of the domestic entity (transferring corporation), and, in a transaction (or series of transactions) related to the acquisition, that stock (transferred stock) is subsequently transferred, the transferred stock is not treated as held by a member of the EAG for purposes of applying the EAG rules. Accordingly, the transferred stock is included in the numerator and the denominator of the ownership fraction.
These regs will apply to acquisitions completed on or after Sept. 22, 2014, although taxpayers may elect to apply the rule in Section 2.03(b)(iii) of Notice 2014-52 (regarding subsequent transfers of stock of the foreign acquiring corporation when a domestic entity is a member of a foreign-parented group) to acquisitions completed before that date.
… Regs to address acquisitions of obligations and stock that avoid Code Sec. 956. Code Sec. 957(a) defines a controlled foreign corporation as a foreign corporation with respect to which more than 50% of the total combined voting power of all classes of stock entitled to vote or the total value of the stock of the corporation is owned (directly, indirectly, or constructively) by U.S. shareholders, who in turn are defined by Code Sec. 951(b) as a U.S. persons that own 10% or more of the total combined voting power of all classes of stock entitled to vote of the foreign corporation. Under Code Sec. 951(a)(1), every person that is a U.S. shareholder of a CFC and owns stock in the corporation on the last day of the CFC’s tax year must include in its gross income, for its tax year in which or with which such tax year of the CFC ends, the amount determined under Code Sec. 956 with respect to the shareholder for the year (with exclusions). This amount is calculated by reference to the “U.S. property” owned by the CFC, as defined. Code Sec. 956 is intended to prevent a U.S. shareholder from inappropriate deferring U.S. taxation of the CFC’s E&P.
Currently, certain inversion transactions may permit the top corporate parent in the newly inverted group (which is still principally comprised of U.S. shareholders and their CFCs) to avoid Code Sec. 956 by accessing the untaxed E&P of the CFCs without a current tax to the U.S. shareholders. To prevent this result, IRS intends to issue regs providing that, solely for purposes of Code Sec. 956, any obligation or stock of a foreign related person (as defined) will be treated as U.S. property within the meaning of Code Sec. 956(c)(1) to the extent such obligation or stock is acquired by an expatriated foreign subsidiary during the applicable period. According to the fact sheet, this action will remove the benefit of so-called “hopscotch” loans.
These regs will apply to acquisitions of obligations or stock on a non-CFC foreign related person by an expatriated foreign subsidiary completed on or after Sept. 22, 2014, but only if the inversion transaction is completed on or after that date.
… Regs to address transactions to de-control or significantly dilute CFCs. Under Code Sec. 7701(l), IRS “may prescribe regulations recharacterizing any multiple-party financing transaction as a transaction directly among any 2 or more of such parties where the Secretary determines that such recharacterization is appropriate to prevent avoidance of any tax imposed.” Under Code Sec. 964(e)(1), if a CFC sells or exchanges stock in any other foreign corporation, gain recognized on such sale or exchange is included in the gross income of the CFC as a dividend to the same extent that it would have been so included if the CFC were a U.S. person, subject to an exception under Code Sec. 964(e)(2). Code Sec. 954(c)(6)(A) provides that, for purposes of Code Sec. 954(c), dividends, interest, rents, and royalties received or accrued from a CFC which is a related person shall not be treated as foreign personal holding company income to the extent attributable or properly allocable to income of the related person which is neither subpart F income nor effectively connected income. Code Sec. 367(b)(1) provides that, in the case of certain exchanges in connection with which there is no transfer of property described in Code Sec. 367(a)(1), a foreign corporation shall be considered to be a corporation except to the extent provided in regs.
After an inversion, certain inverted groups may cause an expatriated foreign subsidiary to cease to be a CFC using transactions that avoid the imposition of U.S. income tax—thus allowing the expatriated foreign subsidiary to make its pre-inversion E&P available to U.S. shareholders without causing an income inclusion under Code Sec. 956. Accordingly, IRS intends to issue regs under Code Sec. 7701(l) that will recharacterize certain transactions that facilitate the avoidance of U.S. tax on the expatriated foreign subsidiary’s pre-inversion E&P, as well as modify the application of Code Sec. 367(b) so as to require an income inclusion in certain nonrecognition transactions that dilute a U.S. shareholder’s ownership of a CFC.
In addition, IRS intends to issue regs providing that if a deemed dividend is included in a CFC’s income under Code Sec. 964(e) as a result of a specified transaction (as defined) that is completed during the applicable period, the deemed dividend will not be excluded from foreign personal holding company income under Code Sec. 954(c)(6). Notice 2014-52 also sets out certain specified transactions that will not be recharacterized under the forthcoming regs.
IRS also intends to amend the regs under Code Sec. 367(b) to provide that an exchanging shareholder (as defined) will be required to include in income as a deemed dividend the Code Sec. 1248 amount attributable to the stock of an expatriated foreign subsidiary exchanged in a “specified exchange,” (defined as an exchange in which a shareholder of an expatriated foreign subsidiary exchanges stock in the expatriated foreign subsidiary for stock in another foreign corporation pursuant to a transaction described in Reg. § 1.367(b)-4(a)), without regard to whether the conditions set forth in that reg are satisfied. The forthcoming regs will apply (subject to exceptions) to specified exchanges completed during the applicable period.
According to the fact sheet, these rules will treat the new foreign parent “as owning stock in the former U.S. parent, rather than the CFC,” thereby removing the benefits of any such “decontrolling” strategy.
These regs will apply to specified transactions and specified exchanges completed on or after Sept. 22, 2014, but only if the inversion transaction is completed on or after that date.
… Regs under Code Sec. 304 to prevent the removal of untaxed foreign E&P. Under Code Sec. 304(a)(1), if one or more persons are in control of each of two corporations and in return for property one of the corporations (acquiring corporation) acquires stock in the other corporation (issuing corporation) from the person (or persons) so in control, then the property shall generally be treated as a distribution in redemption of the stock of the acquiring corporation. However, if in return for property, one corporation acquires from a shareholder of another corporation stock in such other corporation, and the issuing corporation controls the acquiring corporation, then the property shall be treated as a distribution in redemption of the stock of the issuing corporation under Code Sec. 304(a)(2). Code Sec. 304(b)(2) provides that, in the case of any acquisition to which Code Sec. 304(a) applies, the determination of the amount that is a dividend (and the source thereof) is made as if the property were distributed by the acquiring corporation to the extent of its E&P, and then by the issuing corporation to the extent of its E&P. But under Code Sec. 304(b)(5)(B), the E&P taken into account under Code Sec. 304(b)(2) is limited where the acquiring corporation is foreign, and no E&P are taken into account for purposes of Code Sec. 304(b)(2)(A) (and Code Sec. 304(b)(2)(B) doesn’t apply) if more than 50% of the dividends arising from such acquisition would neither be subject to tax for the tax year in which the dividends arise, nor be included in the earnings and profits of a CFC.
Currently, IRS is aware that taxpayers may be engaging in certain transactions following an inversion that reduce the E&P of a CFC to facilitate repatriation of cash and other property of the CFC. Accordingly, IRS intends to issue regs providing that, for purposes of applying Code Sec. 304(b)(5)(B), the determination of whether more than 50% of the dividends that arise under Code Sec. 304(b)(2) is subject to tax or includible in the E&P of a CFC will be made by taking into account only the E&P of the acquiring corporation (and therefore excluding the E&P of the issuing corporation).
The regs will apply to acquisitions of stock described in Code Sec. 304 completed on or after Sept. 22, 2014.
References: For corporate expatriation transactions, see FTC 2d/FIN ¶ F-5700 et seq.; United States Tax Reporter ¶ 78,744 ; TaxDesk ¶ 236,901 ; TG ¶ 5167