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Temporary regs counter inversions and post-inversion tax avoidance transactions

T.D. 9761, 04/05/2016, Reg. § 1.304-7T , Reg. § 1.367(a)-3T, Reg. § 1.367(b)-4T, Reg. § 1.956-2T, Reg. § 1.7701(l)-4T , Reg. § 1.7874-1T, Reg. § 1.7874-2T , Reg. § 1.7874-3T, Reg. § 1.7874-4T, Reg. § 1.7874-6T, Reg. § 1.7874-7T, Reg. § 1.7874-8T , Reg. § 1.7874-9T, Reg. § 1.7874-10T , Reg. § 1.7874-11T, Reg. § 1.7874-12T, Preamble to Prop Reg04/05/2016

IRS has issued temporary regs that address transactions that are structured to avoid the purposes of Code Sec. 7874 and Code Sec. 367 and certain post-inversion tax avoidance transactions. These regs affect certain domestic corporations whose assets are directly or indirectly acquired by a foreign corporation and certain persons related to such domestic corporations and partnerships. The text of the temporary regs also serves as the text of contemporaneously issued proposed regs.

Background. In general, if three conditions are met, Code Sec. 7874 either prevents the use of certain tax attributes to reduce the U.S. federal income tax owed on certain income or gain (inversion gain) recognized in transactions intended to remove foreign operations from the U.S. taxing jurisdiction, or treats the new foreign parent corporation as a domestic corporation for all purposes of the Code. Code Sec. 7874 applies if: (1) the foreign acquiring corporation completes, after Mar. 4, 2003, the direct or indirect acquisition of substantially all of the properties held directly or indirectly by a domestic corporation (domestic entity acquisition); (2) after the domestic entity acquisition, at least 60% of the stock (by vote or value) of the foreign acquiring corporation is held by former shareholders of the domestic corporation (former domestic entity shareholders) by reason of holding stock in the domestic corporation (this percentage is referred to here as the “ownership percentage,” and, the fraction used to calculate the ownership percentage is referred to as the “ownership fraction”); and (3) after the domestic entity acquisition, the expanded affiliated group (EAG) as defined in Code Sec. 7874(c)(1) does not have substantial business activities in the foreign country in which, or under the law of which, the foreign acquiring corporation is created or organized (relevant foreign country), when compared to the total business activities of the EAG.

In general, in certain inversions, Reg. § 1.367(a)-3(c) causes 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.

In September of 2014, IRS issued Notice 2014-52, 2014-42 IRB 712 (the 2014 Notice), which announced the intention to issue regs to address certain transactions structured to avoid the purposes of Code Sec. 7874 and Reg. § 1.367(a)-3(c) and certain post-inversion tax avoidance transactions. In November of 2015, IRS issued Notice 2015-79, 2015-49 IRB 775 (the 2015 Notice), which announced the intention to issue regs to address certain additional transactions structured to avoid the purposes of Code Sec. 7874 and Reg. § 1.367(a)-3(c) and certain additional post-inversion tax avoidance transactions.

Temporary regs. The temporary regs include the rules in the 2014 and 2015 Notices, with certain modifications. In addition, the temporary regs provide rules for: (i) identifying domestic entity acquisitions and foreign acquiring corporations in certain multiple-step transactions; (ii) calculating the ownership percentage—which includes disregarding certain stock of the foreign acquiring corporation for purposes of computing the denominator of the ownership fraction and, in addition, taking into account certain non-ordinary course distributions (NOCDs) made by a domestic entity for purposes of computing the numerator of the ownership fraction; (iii) determining when certain stock of a foreign acquiring corporation is treated as held by a member of the EAG; and (iv) determining when an EAG has substantial business activities in a relevant foreign country.

The temporary regs provide a rule (the multiple-step acquisition rule) that treats the subsequent acquisition as a domestic entity acquisition and the subsequent acquiring corporation as a foreign acquiring corporation. (Reg. § 1.7874-2T(c)(4)(i)) When the multiple-step acquisition rule applies, the regs treat stock of the subsequent acquiring corporation received, pursuant to the subsequent acquisition, in exchange for stock of the initial acquiring corporation described in Code Sec. 7874(a)(2)(B)(ii) (that is, stock of the initial acquiring corporation that, as a result of the initial acquisition, is by-reason-of stock) as stock of the subsequent acquiring corporation held by reason of holding stock in the domestic entity. (Reg. § 1.7874-2T(f)(1)(iv))

Further, if, pursuant to the same plan (or a series of related transactions), a foreign corporation directly or indirectly acquires substantially all of the properties held by a subsequent acquiring corporation in a transaction that occurs after the subsequent acquisition, the principles of the multiple-step acquisition rule apply to also treat the further acquisition as a domestic entity acquisition and the foreign corporation that made such acquisition as a foreign acquiring corporation. (Reg. § 1.7874-2T(c)(4)(iii)) The multiple-step acquisition rule applies in a similar manner when the domestic entity is a domestic partnership.

Ownership percentage. Reg. § 1.7874-4T modifies the statutory public offering rule of Code Sec. 7874(c)(2)(B) (under which such stock of a foreign acquiring corporation that is sold in a public offering related to a domestic entity acquisition is excluded from the denominator of the ownership fraction) to provide that, subject to a de minimis exception, “disqualified stock” is not included in the denominator of the ownership fraction. Disqualified stock generally includes stock of the foreign acquiring corporation that is transferred to a person (other than the domestic entity) in exchange for “nonqualified property.” The term “nonqualified property” means (i) cash or cash equivalents, (ii) marketable securities, (iii) certain obligations (for example, obligations owed by members of the EAG), or (iv) any other property acquired in a transaction (or series of transactions) related to the domestic entity acquisition with a principal purpose of avoiding the purposes of Code Sec. 7874.

Passive asset rule. Under the passive asset rule (described in the 2014 Notice), the ownership fraction stock of a foreign acquiring corporation that is attributable to certain passive assets is excluded from the denominator, but only if, after the domestic entity acquisition and all related transactions are complete, more than 50% of the gross value of all foreign group property constitutes certain passive assets (i.e., “foreign group nonqualified property”).

Reg. § 1.7874-7T sets out the passive assets rule as described in the 2014 Notice and modified in the 2015 Notice, subject to certain modifications, in part, to address certain rules that could cause Code Sec. 7874 to apply to a domestic entity acquisition even though the former domestic entity shareholders or former domestic entity partners, as applicable, actually own no, or only a de minimis amount of, stock in the foreign acquiring corporation after the domestic entity acquisition. Reg. § 1.7874-7T(c) provides a de minimis exception when two requirements are satisfied: (a) first, the ownership percentage—determined without regard to the application of the passive assets rule, Reg. § 1.7874-4T(b), and the NOCD rule—is less than 5% (by vote and value); and (b) second, on the date that the domestic entity acquisition and all transactions related to the domestic entity acquisition are complete (the completion date), former domestic entity shareholders or former domestic entity partners, as applicable, in the aggregate, own (applying the attribution rules of Code Sec. 318(a) with the modifications described in Code Sec. 304(c)(3)(B)) less than 5% (by vote and value) of the stock of (or a partnership interest in) each member of the EAG.

The temporary regs provide a rule under Code Sec. 7874(c)(6) and Code Sec. 7874(g) that, for purposes of calculating the ownership percentage by value with respect to a domestic entity acquisition (the relevant domestic entity acquisition), excludes from the denominator of the ownership fraction stock of the foreign acquiring corporation attributable to certain prior domestic entity acquisitions. This multiple domestic entity acquisition rule applies if, within the 36-month period ending on the signing date (in general, subject to an anti-avoidance rule, the first date on which the contract to effect the relevant domestic entity acquisition is binding) with respect to the relevant domestic entity acquisition, the foreign acquiring corporation (or a predecessor) completed one or more other domestic entity acquisitions that are not excluded under an exception (each such other domestic entity acquisition, a prior domestic entity acquisition). In general, a domestic entity acquisition is excluded from the definition of a prior domestic entity acquisition if (i) the ownership percentage with respect to such domestic entity acquisition was less than 5%, and (ii) the fair market value of the by-reason-of stock received by the former domestic entity shareholders or former domestic entity partners did not exceed $50 million.

Third-country rule. Under the third-country rule (described in the 2015 Notice), stock of the foreign acquiring corporation held by former shareholders of the acquired foreign corporation by reason of holding stock in the acquired foreign corporation will be excluded from the denominator of the ownership fraction. Reg. § 1.7874-9T sets out the third-country rule, subject to certain modifications. The temporary regs replace the gross value requirement contained in the 2015 Notice with a continuity of interest requirement (i.e., the “foreign ownership percentage”). (Reg. § 1.7874-9T(d)(3), Reg. § 1.7874-9T(d)(4)) In general, this requirement is satisfied if at least 60% of the stock (by vote or value) of the foreign acquiring corporation is held by former shareholders of the acquired foreign corporation by reason of holding stock in the acquired foreign corporation. For this purpose, stock of the foreign acquiring corporation held by former domestic entity shareholders (or former domestic entity partners) is not taken into account. (Reg. § 1.7874-9T(e)(3)(i)) The temporary regs generally retain the domestic entity ownership and tax residency requirements as described in the 2015 Notice, but clarify that the tax residency of the foreign acquiring corporation is determined after the covered foreign acquisition and all related transactions. A covered foreign acquisition is generally defined as a transaction in which there is an acquisition of substantially all of the properties of a foreign corporation—that is, a foreign acquisition—in which the foreign ownership percentage is at least 60%. In addition, the tax residency of the acquired foreign corporation is determined before the covered foreign acquisition and all related transactions.

NOCD. Under the non-ordinary course distributions (NOCD) rule (described in the 2014 Notice), certain distributions made by a domestic entity before being acquired by a foreign acquiring corporation that otherwise would reduce the numerator of the ownership fraction are disregarded. NOCDs are defined as the excess of all distributions made during a tax year by the domestic entity with respect to its stock or partnership interests, as applicable, over 110% of the average of such distributions during the 36-month period immediately preceding such tax year. Reg. § 1.7874-10T(b) generally provides that, for purposes of determining the ownership percentage by value, former domestic entity shareholders or former domestic entity partners, as applicable, are deemed to receive, by reason of holding stock or an interest in the domestic entity, an amount of stock of the foreign acquiring corporation with a fair market value equal to the aggregate value of NOCDs made by the domestic entity (NOCD stock). Thus, similar to the rule under Reg. § 1.7874-2(h)(1) (regarding the treatment of options for purposes of determining the ownership percentage), the NOCD rule doesn’t apply for purposes of determining the ownership percentage by vote. The temporary regs provide that the amount of a distribution (including with respect to property distributed in redemption of stock) is determined based on the value of the property distributed at the time of the distribution. (Reg. § 1.7874-10T(b)) Accordingly, post-distribution fluctuations in the value of the stock or interests of the domestic entity, as applicable, or the value of the distributed property (for example, in the case of a spinoff), do not affect the amount of NOCD stock that is deemed received.

EAG rules. To prevent Code Sec. 7874 from applying to certain transactions that do not give rise to inversion policy concerns, Code Sec. 7874(c)(2)(A) provides that stock of a foreign acquiring corporation that is held by members of the EAG is not included in the numerator or the denominator of the ownership fraction (the statutory EAG rule). However, this rule may not always lead to appropriate results, such as when the domestic entity has minority shareholders. To address these cases, Reg. § 1.7874-1 provides two exceptions to the statutory EAG rule: the internal group restructuring exception; (Reg. § 1.7874-1(c)(2)) and the loss-of-control exception (Reg. § 1.7874-1(c)(3))—together with the statutory EAG rule, the EAG rules. When either of these exceptions applies, stock of the foreign acquiring corporation held by members of the EAG is excluded from the numerator, but not the denominator, of the ownership fraction. In general, the internal group restructuring exception applies when the domestic entity and the foreign acquiring corporation are members of an affiliated group (generally based on an 80% vote-and-value requirement) with the same common parent both before and after the acquisition. The loss-of-control exception applies when the former domestic entity shareholders or former domestic entity partners do not hold more than 50% of the stock of any member of the EAG after the acquisition.

Subject-to-tax rule. Under the subject-to-tax rule (described in the 2015 Notice), an EAG cannot have substantial business activities in the relevant foreign country when compared to the EAG’s total business activities unless the foreign acquiring corporation is subject to tax as a resident of the relevant foreign country. The temporary regs implement this rule without making any substantive changes. (Reg. § 1.7874-3T(b)(4)). The requirement set out in Reg. § 1.7874-3T(b)(4) is in addition to the three quantitative tests for group employees, group assets, and group income set out in Reg. § 1.7874-3(b)(1) through Reg. § 1.7874-3(b)(3).

Under Reg. § 1.7874-3, an EAG is considered to have substantial business activities in the relevant foreign country only if at least 25% of its group employees, group assets, and group income are located or derived in the relevant foreign country. The temporary regs clarify that financial reporting principles are only relevant for determining the amount of items of income that are taken into account, as an EAG must take into account all items that its members (as determined based on the definition of EAG set out in Reg. § 1.7874-3(d)(4)) recognized for financial accounting purposes during the testing period.

Post-inversion tax avoidance transactions. An inversion transaction may permit the new foreign parent of the inverted group, a group still principally comprised of U.S. shareholders and their CFCs, to avoid Code Sec. 956 by accessing the untaxed earnings and profits of the CFCs without a current U.S. federal income tax to the U.S. shareholders. The temporary regs include a rule (the U.S. property rule) that provides that, solely for purposes of Code Sec. 956, any obligation or stock of a non-CFC foreign related person (generally, either the foreign acquiring corporation or a foreign affiliate of the foreign acquiring corporation that is not an expatriated foreign subsidiary) is 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.

Reg. § 1.956-2T(a)(4)(i) provides that, generally, for purposes of Code Sec. 956 and Reg. § 1.956-2(a), U.S. property includes an obligation of a foreign person and stock of a foreign corporation if (A) the obligation or stock is held by a CFC that is an expatriated foreign subsidiary, (B) the foreign person or foreign corporation is a non-CFC foreign related person, and (C) the obligation or stock was acquired either during the applicable period or in a transaction related to the inversion transaction. A non-CFC foreign related person is defined as a foreign related person that is not itself an expatriated foreign subsidiary. (Reg. § 1.7874-12T(a)(16)) The rule applies to obligations and stock acquired during the applicable period or in a transaction related to the inversion transaction, regardless of whether at the time of acquisition the obligation or stock would constitute U.S. property—that is, regardless of whether, at the time of acquisition, the expatriated foreign subsidiary was a CFC or an expatriated foreign subsidiary, and the non-CFC foreign related person was a non-CFC foreign related person.

Reg. § 1.956- 2T(a)(4)(i)(C)(2) clarifies that stock or obligations that otherwise meet the requirements of the U.S. property rule (described in the 2014 Notice) but that were issued prior to the applicable period, in a transaction related to the inversion transaction, constitute U.S. property, provided they are acquired on or after Apr. 4, 2016.

Consistent with the 2014 Notice, Reg. § 1.7874-12T(a)(9)(ii) excludes from the definition of expatriated foreign subsidiary (generally, a CFC with respect to which an expatriated entity is a U.S. shareholder) a CFC that was a member of the EAG on the completion date if the domestic entity was not a U.S. shareholder with respect to the CFC on or before the completion date.

Other provisions. The temporary regs also contain the rules described in various other previous issued Notices on the short-term obligation exception from U.S. property for purposes of Code Sec. 956. (Reg. § 1.956-2T(d)(2)) In addition, the temporary regs provide new definitions in Reg. § 1.7874-12T that define terms commonly used in certain of the regs under Code Sec. 367(b), Code Sec. 956, Code Sec. 7701(l), and Code Sec. 7874.

Effective date. In general, the rules in the regs described in the 2014 Notice are effective on or after Sept. 22, 2014, and the rules in the regs described in the 2015 Notice apply to acquisitions completed on or after Nov. 19, 2015; however, the rule on the application of Code Sec. 304(b)(5) is a generally applicable rule that applies without regard to whether there was an inversion transaction. The new rules included in the temporary regs, including any changes to rules described in the 2014 and the 2015 Notice, generally apply to acquisitions or post-inversion tax avoidance transactions completed on or after Apr. 4, 2016. The new rule that reduces post-inversion tax benefits (by requiring a CFC to recognize all realized gain upon certain Code Sec. 351 transfers) applies only if the inversion transaction was completed on or after Sept. 22, 2014.

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

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