On September 17, 2009, the IRS issued Notice 2009-78, announcing its intention to issue regulations that will identify certain stock of a foreign corporation that is to be disregarded for determining foreign corporation ownership under the requirements of Sec. 7874. In essence, the notice extends the public offering rule of Sec. 7874(c)(2)(B) to certain private placements.
In the notice, the government outlines its concern about application of the ownership test (under Sec. 7874(a)(2)(B)(ii)) in certain transactions. As one example, the notice describes a transaction in which shareholders of a domestic corporation transfer all their stock to a newly formed foreign corporation for 79% of the stock of the foreign corporation and, in a related transaction, an investor transfers cash to the foreign corporation for the remaining 21% of stock. The government views the investor’s acquisition of 21% of the stock (with cash) as inconsistent with the purposes of Sec. 7874. To address the concerns raised by this transaction, the new regulations will provide that if nonqualified property (e.g., cash or marketable securities) is exchanged for stock of a foreign corporation in an acquisition under Sec. 7874, such stock will not be taken into account for purposes of the ownership test.
The notice also describes another transaction in which the shareholders of two publicly traded companies, one foreign and one domestic, transfer all their stock to a newly formed foreign corporation, also publicly traded, solely in exchange for stock of the new foreign corporation. If the new foreign corporation stock received by the shareholders of the old foreign corporation is considered “sold in a public offering,” such stock would not be included for purposes of the ownership test. The IRS concludes that this is not the intended result of the statute.
Once issued, the new regulations will apply to acquisitions completed on or after September 17, 2009.
Surrogate Foreign Corporation Test
Under Sec. 7874(a)(2)(B), a foreign corporation will be considered a surrogate foreign corporation if:
- The foreign corporation acquires substantially all the properties that are held directly or indirectly by a domestic corporation (or that constitute the trade or business of a domestic partnership) (acquisition test);
- After the acquisition, at least 60% of the stock (by vote or value) of the foreign corporation is held by the former shareholders of the domestic corporation or partners in the partnership by reason of holding interest in the domestic corporation or partnership (ownership test). If 80% of the foreign corporation’s stock is held by the former shareholders, the foreign corporation will be treated as a domestic corporation for all U.S. tax purposes (Sec. 7874(b)); and
- The expanded affiliated group (EAG) that includes the foreign corporation does not have substantial business activities in the foreign country where it is created or organized compared with the total business activities of the EAG (substantial business activities test).
The ownership test is met if, under a plan or a series of related transactions, former shareholders of a domestic corporation own at least 60% of the stock of a foreign acquiring corporation by reason of holding stock in the domestic corporation (Sec. 7874(a)(2)(B)(ii)). As such, one of the important components of this test is to identify which stock can be included in determining the percentage of foreign corporation stock held by former shareholders of the domestic corporation. Specifically, the statute states that stock sold in a public offering related to the acquisition cannot be taken into account for purposes of the ownership test, a provision often referred to as the “public offering rule” (Sec. 7874(c)(2)(B)). The rationale behind this rule is to prevent a transaction that otherwise falls within the scope of Sec. 7874 from escaping inversion treatment merely through a sale of shares to the public.
Transactions inconsistent with the policy of Sec. 7874: In the first transaction described in the notice, the shareholders of a domestic corporation (DC) transferred all their DC stock to a newly formed foreign corporation (New FCo) in exchange for 79% of the stock of New FCo. In a related transaction, an investor transferred cash to New FCo in exchange for the remaining 21% of the New FCo stock. By taking the position that the New FCo stock issued to the investor is not sold in a public offering and that the transfer of cash is not part of a plan a principal purpose of which is to avoid the implications of Sec. 7874, the parties to the transaction assert that the investor’s New FCo stock would be taken into account for purposes of the ownership test. As such, the former shareholders of DC would hold only 79% of the stock, in which case DC would be subject to the inversion gain provisions of Sec. 7874(a)(1), but Sec. 7874(b) would not apply to treat New FCo as a domestic corporation for U.S. federal income tax purposes.
The IRS concludes that this result and the position taken by the parties to the transaction are inconsistent with the policy behind Sec. 7874. The notice states that the IRS and Treasury are aware that similar transactions may be structured with respect to the acquisition of a domestic partnership or domestic corporation in a title 11 (bankruptcy) or similar case. They assert that all such transactions are also inconsistent with the purpose of the statute.
In response to its concerns about these transactions, the IRS intends to issue rules providing that stock of a foreign corporation exchanged for nonqualified property in a transaction related to the acquisition described in Sec. 7874(a)(2) (B)(i) will not be taken into account for purposes of the ownership test. This will be the case without regard to whether the stock is publicly traded. The notice explains that the term “nonqualified property” will include:
- Cash or cash equivalents;
- Marketable securities as defined in Sec. 453(f)(2); and
- Any other property acquired in a transaction with a principal purpose of avoiding the application of Sec. 7874.
However, it is expected that the term “marketable securities” generally will not include stock (or a partnership interest) issued by a member of the expanded affiliated group that includes the foreign corporation (after the acquisition), unless a principal purpose of the issuance of the foreign corporation’s stock in exchange for such property is to circumvent Sec. 7874. The notice also promises similar rules to address acquisitions of property by one or more members of the expanded affiliated group in exchange for stock of the foreign corporation, such as under a triangular reorganization.
Thus, whether stock will be taken into account for purposes of the ownership test will depend on the nature of the property provided in exchange for the stock and not solely on whether the stock is publicly traded. The intended regulations thus purport to eliminate the distinction between public offerings and private placements in the context of Sec. 7874.
Clarification of public offering rule: The notice also describes a transaction involving a business combination whereby the shareholders of a publicly traded foreign corporation (FT) and a publicly traded domestic corporation (DT) intend to transfer their FT and DT stock, respectively, to a newly formed foreign corporation (FA) that will be publicly traded, solely in exchange for FA stock. As part of the plan to effectuate the transaction, FA acquires all the FT and DT stock. If the FA stock issued to FT shareholders is considered “sold in a public offering” and thus subject to Sec. 7874(c)(2)(B), the former shareholders of DT would be treated as owning 100% of the FA stock for the purposes of the ownership test. Therefore, under the current rules, FA would be treated as a domestic corporation for U.S. federal income tax purposes.
In this situation, the IRS concludes that treatment of FA as a domestic corporation may not be the intended result of the statute because the stock issuance is viewed as a legitimate transaction, with a business purpose other than the avoidance of Sec. 7874. As such, the notice acknowledges taxpayers’ concerns that the public offering rule could be too broadly applied and states that the new regulations will also clarify circumstances in which certain stock, which might otherwise be described as stock sold in a public offering, will nonetheless be taken into account for purposes of the ownership test.
In light of the notice, taxpayers who contemplate the use of private placements or similar transactions should reevaluate whether they meet the ownership test. The notice and the forthcoming regulations follow on the heels of temporary regulations (T.D. 9453) issued last summer that eliminated the safe harbor related to the substantial business activities test, reflecting an effort by the IRS and Treasury to deter taxpayers from engaging in inversion transactions.
David Kautter retired from Ernst & Young LLP in Washington, DC, in December 2009.
Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.
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