Foreign Income & Taxpayers
In 2004, Congress enacted Sec. 7874 in response to a number of U.S. companies that were reincorporating as foreign (i.e., non-U.S.) corporations (primarily in tax-haven jurisdictions) despite maintaining the majority of their headquarter functions in the United States. In many cases, the U.S. companies performing these “inversion transactions” had few or no business operations in the foreign country of reincorporation; the primary purpose of the transactions was to reduce their overall U.S. federal tax liability by shifting profits to low-tax foreign jurisdictions. U.S. corporations and shareholders of such corporations face potentially harsh tax consequences if they become subject to Sec. 7874.
The financial turmoil of the past few years has caused U.S. companies and foreign investors to take another look at potential Sec. 7874 issues in certain circumstances. The financial crisis has made it difficult for U.S. companies to raise much-needed capital through debt financing. Therefore, some U.S. companies are seeking access to capital by going public on Asia Pacific (ASIA-PAC) stock exchanges. There are many reasons for this trend, but the most prevalent is that countries in the ASIA-PAC region (e.g., China and Hong Kong) have weathered the recession much better than other countries. Due to these countries’ better current financial condition, there may be more investors in ASIA-PAC with capital to invest in initial public offerings (IPOs) than in other markets. Another important factor is that the ASIA-PAC exchanges often have less-stringent reporting and filing requirements than more traditional exchanges such as the New York Stock Exchange or the London Stock Exchange.
U.S. companies going public on an ASIA-PAC exchange may find it easier to do so with a non-U.S. company such as a Hong Kong or a British Virgin Islands–based company. This is achieved by taking a foreign company public and at the same time causing the foreign company to acquire the stock of the U.S. company. The U.S. company’s shareholders receive publicly traded stock in the newly created foreign company in exchange for their stock in the U.S. company. Post-transaction, the former investors in the U.S. company along with the new investors who purchased the IPO shares collectively own the foreign company, which in turn wholly owns the U.S. subsidiary. In this foreign IPO context, Sec. 7874 may create undesirable tax consequences for foreign investors that invest in the new public foreign company.
Application of Sec. 7874 to Foreign IPOs
Sec. 7874 provides rules and thresholds that, if surpassed, trigger harsh federal tax consequences for U.S. companies attempting an inversion. A U.S. company is generally subject to Sec. 7874 if:
- Substantially all of the U.S. company’s property is directly or indirectly acquired by a foreign company; and
- The former shareholders of the U.S. company own at least 60% or 80% (with different tax consequences for each).
Sec. 7874 provides special rules when calculating the 60%/80% ownership thresholds if the inversion transaction involves an IPO. Specifically, Sec. 7874(c)(2) provides that the stock of a foreign corporation that is sold in a public offering and is related to the acquisition of a U.S. company (and indirectly substantially all of the U.S. company’s property) is not included when determining the 60%/80% ownership thresholds. Even if new investors in the IPO acquire a 41% interest in the new foreign company (such that the former shareholders of the U.S. company hold only 59% of the new foreign company), the former shareholders are still deemed to hold 100% of the new foreign company’s stock. Thus, in an IPO context, the foreign company appears to fail the 60%/80% ownership requirement regardless of how much stock is sold to new investors.
If the new foreign company is subject to Sec. 7874 in this case (i.e., more than 80% of the former owners are owners of the new foreign company), the new foreign company is treated as a U.S. company for all federal tax purposes. This provision can have devastating consequences for the new foreign company because it is subject to U.S. federal corporate tax, withholding taxes, and filing and reporting requirements.
Sec. 7874 and U.S. Withholding Taxes
If Sec. 7874 applies to the foreign IPO, as discussed above, interesting issues arise for foreign (i.e., non-U.S.) investors with respect to withholding taxes on dividends they may receive from the newly formed foreign corporation. Under Sec. 881, the United States generally imposes a 30% withholding tax (unless reduced by a U.S. treaty) on dividends paid to foreign investors if the income is from U.S. sources and is not effectively connected with the conduct of a U.S. trade or business. Under Sec. 861, dividends generally are considered to be U.S.-source income if paid from the United States by a U.S. company. Conversely, when a foreign company pays a dividend to a foreign investor, that dividend is not subject to U.S. withholding tax because it is considered to be foreign-source income. However, if the new foreign company is treated as a U.S. company under Sec. 7874, it appears that the United States may recharacterize the dividend paid by the foreign company to the foreign investor as U.S.-source income. As such, the IRS may impose a withholding tax on the dividends under Sec. 881.
In general, the 30% withholding tax imposed by Sec. 881 may be reduced by an applicable U.S. treaty. At first glance, if Sec. 7874 has caused the new foreign company to be a U.S. company for all U.S. federal tax purposes, it follows that the foreign company should be eligible for reduced dividend withholding rates based on the applicable U.S. treaty. Unfortunately, a further analysis of the U.S. treaties leads to a different conclusion.
Looking at the 2006 U.S. Model Income Tax Convention (most U.S. treaties have similar language to the Model Treaty), Article 1(1) states that the treaty’s benefits “shall apply only to persons who are residents of one or both of the Contracting States” (generally the United States and the other treaty participant). Article 4(1) defines a “resident of a Contracting State” as “any person who, under the laws of that State, is liable to tax therein by reason of his domicile, residence, citizenship, place of management, place of incorporation, or any other criterion of a similar nature.” However, the new foreign company is subject to tax in the United States based on an inversion transaction and Sec. 7874 rather than any of the listed criteria in Article 4(1). Thus, it appears that the new foreign corporation is not a “resident” of the United States and is not eligible for treaty benefits. If the reduced dividend withholding rate under the applicable treaty does not apply, the default 30% U.S. withholding tax applies to all dividends paid by the new foreign company to its new foreign investors.
Sec. 7874 and Double Taxation
Foreign investors may also be subject to double taxation on the dividends they receive from foreign companies that are treated as U.S. companies under Sec. 7874. This situation may arise if the foreign country imposes a withholding tax on the dividends paid to the foreign investors. This foreign withholding tax would be in addition to any U.S. withholding tax imposed on dividends.
The ability of the foreign investor to take a foreign tax credit for any U.S. withholding depends on the law of the country in which the foreign investor is a resident. If there is no permissible foreign tax credit, the foreign investor faces the following taxes:
- Personal or corporate income tax on the dividends (assuming the foreign country taxes dividends as income);
- Foreign withholding taxes; and
- U.S. withholding taxes.
This potential for double or multiple taxation may lead to a significant reduction in the after-tax amount that the foreign investor may retain if paid a dividend from such a foreign company.
Based on the foregoing, it can be seen that there are significant potential tax issues for foreign investors that invest in a foreign IPO that is related to the inversion of a U.S. company. It is strongly recommended that foreign investors consult with their tax advisers to consider these issues before making such investments.
Kevin Anderson is a partner, National Tax Services, with BDO USA, LLP, in Bethesda, MD.
For additional information about these items, contact Mr. Anderson at (301) 634-0222 or firstname.lastname@example.org.