T.D. 9834, 7/11/2018; Reg. § 1.304-7, Reg. § 1.367(a)-3, Reg. § 1.367(b)-4, Reg. § 1.367(b)-6, Reg. § 1.956-2, Reg. § 1.7701(I)-4, Reg. § 1.7874-1, Reg. § 1.7874-2, Reg. § 1.7874-3, Reg. § 1.7874-4, Reg. § 1.7874-5; Reg. § 1.7874-6, Reg. § 1.7874-7, Reg. § 1.7874-8, Reg. § 1.7874-9, Reg. § 1.7874-10, Reg. § 1.7874-11, Reg. § 1.7874-12
IRS has issued final regs that address transactions that are structured to avoid the purposes of the anti-corporate-inversion rules contained in Code Sec. 7874 and Code Sec. 367 and address certain post-inversion tax avoidance transactions.
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:
- 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;
- 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”). (This percentage is termed “the ownership percentage,” and the fraction used to calculate the ownership percentage is termed ” the ownership fraction”); and
- the expanded affiliated group (the foreign corporation, and corporations connected to it by a 50% chain of ownership; the EAG), doesn’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 applies 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, such a foreign corporation is a “surrogate foreign corporation” that gets some, but not all, of the tax benefits associated with being a foreign corporation, 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.
Background—previous IRS pronouncements. 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.
In April of 2016, IRS issued temporary regs (the 2016 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 (see Temporary regs counter inversions and post-inversion tax avoidance transactions, 4/7/2016). The 2016 regs include the rules in the 2014 and 2015 Notices, with certain modifications, as well as new rules.
In general, the rules in the 2016 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, a 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 2016 regs, including any changes to rules described in the 2014 Notice or the 2015 Notice, generally apply to acquisitions or post-inversion tax avoidance transactions completed on or after Apr. 4, 2016. A 2016 temporary reg rule that reduces post-inversion tax benefits (by requiring a controlled foreign corporation (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.
Final regs generally follow temporary regs. The new, final regs, like the temporary regs, address transactions that are structured to avoid the purposes of Code Sec. 7874 and Code Sec. 367 and certain post-inversion tax avoidance transactions. They generally follow the temporary regs. Here are some of the changes/additions made by the final regs.
1. Rules addressing certain transactions that are structured to avoid the purposes of Code Sec. 7874.
… Calculation of the ownership percentage. The final regs contain changes to the rules for determining what percentage of the foreign corporation’s stock (by vote or value) the U.S. corporation shareholders obtained by reason of holding their U.S. shares.
Reg. § 1.7874-7T of the 2016 regs provides a rule (the passive assets rule) that excludes from the denominator of the ownership fraction, stock of the foreign acquiring corporation attributable to certain passive assets. Under the 2016 regs, the passive assets rule applies for purposes of determining the ownership percentage by vote and value. IRS has determined that applying the rule for purposes of determining the ownership percentage by vote could give rise to administrative complexities. Under the final regs, the rule only applies for purposes of determining the ownership percentage by value. (Reg. § 1.7874-7(b))
The 2016 regs contain various rules under which certain stock is excluded, i.e., disregarded, for purposes of the ownership percentage rules. The final regs modify the passive assets rule so that stock excluded under any of the stock exclusion rules is not taken into account in applying the passive assets rule. (Reg. § 1.7874-7(b)(1))
Code Sec. 7874(b)(4) provides that the transfer of properties or liabilities (including by contribution or distribution) is disregarded if it is part of a plan a principal purpose of which is to avoid the Code Sec. 7874 inversion rules. Reg. § 1.7874-10T of the 2016 regs provides a rule (the non-ordinary course distribution (NOCD) rule) that, for purposes of determining the ownership percentage by value, former domestic entity shareholders or former domestic entity partners 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.
The final regs include seven clarifications or modifications to the NOCD rule. For example, the regs clarify and refine the definition of distribution. The 2016 regs define the term broadly but provide several exclusions, including, in general, an exclusion for a distribution that occurs pursuant to an asset reorganization. The final regs clarify that the exclusion does not apply to a distribution to which Code Sec. 355 applies, regardless of whether in connection with a reorganization described in Code Sec. 368(a)(1)(D). (Reg. § 1.7874-10(k)(1)(i)(C))
…Coordination of rules affecting the ownership fraction with the EAG rules. Existing regs under Code Sec. 7874 coordinate the application of (i) rules that disregard certain stock of the foreign acquiring corporation for purposes of determining the ownership fraction, with (ii) the EAG rules. See Reg. § 1.7874-4(h) (regarding the interaction of the EAG rules with the rule that disregards disqualified stock) and Reg. § 1.7874-7T(e) (regarding the interaction of the EAG rules with the rule that disregards certain stock attributable to passive assets).
The final regs broaden this coordination to other rules that similarly disregard certain stock of the foreign acquiring corporation for purposes of determining the ownership fraction—namely, the serial acquisition rule in Reg. § 1.7874-8and the third-country rule in Reg. § 1.7874-9, as well as Code Sec. 7874(c)(4) generally, the application of which in certain cases would similarly disregard stock of the foreign acquiring corporation. (Reg. § 1.7874-1(d)(1))
… The substantial business activities test.Reg. § 1.7874-3T(b)(4) of the 2016 regs provides that, for an EAG to be considered to have substantial business activities in the relevant foreign country, the foreign acquiring corporation must be subject to tax as a resident of the “relevant foreign country” (the tax residence requirement).
The final regs define a tax resident of a country as a body corporate liable to tax under the laws of the country as a resident. (Reg. § 1.7874-3(d)(11)) And the final regs provide that when the relevant foreign country is a country that does not impose corporate income tax, the tax residence requirement does not apply. (Reg. § 1.7874-3(b)(4))
2. Rules addressing certain post-inversion tax avoidance transactions. As described in the preamble to the 2016 regs, certain inversion transactions are motivated in substantial part by the ability to engage in tax avoidance transactions after the inversion transaction that would not be possible in the absence of the inversion transaction. The 2016 regs provided rules to reduce the tax benefits of certain post-inversion tax avoidance transactions.
A U.S. shareholder of a CFC includes in income a pro rata amount based on the CFC’s investments in U.S. property, whether held directly or indirectly. (Code Sec. 956) An expatriated foreign subsidiary (EFS) is a foreign corporation that is a CFC in which an expatriated entity (the domestic corporation or partnership as to which a foreign corporation is a surrogate foreign corporation) is a U.S. shareholder. (Reg § 1.7874-12T(a)(9)(i); Reg § 1.7874-12T(a)(20))
Reg. § 1.956-2T(a)(4)(i) of the 2016 regs provides that, generally, for purposes of Code Sec. 956, United States property includes an obligation of a foreign person and stock of a foreign corporation if (i) the obligation or stock is held by a CFC that is an EFS, (ii) the foreign person or foreign corporation is a non-CFC foreign related person, and (iii) the obligation or stock was acquired either during the applicable period or in a transaction related to the inversion transaction.
For purposes of determining whether an entity is an EFS, the final regs provide that downward attribution from a non-United States person to a United States person does not apply. Absent this modification, in certain cases the term EFS would be over-inclusive and, as a result, the term non-EFS foreign related person would be under-inclusive. (Reg. § 1.7874-12(a)(9)) Similarly, the final regs provide that, when determining if an entity is a CFC for purposes of Reg. § 1.304-7, downward attribution from a non-United States person to a United States person does not apply. (Reg. § 1.304-7(b))
Effective/applicable dates. The applicability dates of the rules in the final regs are generally the same as the applicability dates of the rules as set forth in the 2016 regs. Accordingly, the applicability date of some provisions in the final regs corresponds to the date the 2016 regs were filed with the Federal Register, and the applicability dates of other provisions in the final regs predate the filing of the 2016 regs and correspond to the issuance of the 2014 Notice, which was issued on Sept. 22, 2014, or the 2015 Notice, which was issued on Nov. 19, 2015.
However, differences between the final regs and the 2016 regs generally apply on a prospective basis, with an option for taxpayers to apply the differences retroactively. (T.D. 9834, 7/11/2018)
References: For inversions, see FTC 2d/FIN ¶ F-5700 et seq.; United States Tax Reporter ¶ 78,744.