On June 9, 2009, Treasury issued final and temporary regulations (T.D. 9453) under Sec. 7874 that clarify and expand a number of rules concerning inversions of domestic corporations. These regulations went into effect on June 12, 2009, and replace the prior temporary and proposed regulations issued on June 6, 2006 (T.D. 9265). The 2009 regulations are set to expire on June 8, 2012.
Sec. 7874: General Principles
Sec. 7874 applies to a transaction completed after March 4, 2003, if under a plan or series of related transactions:
- A foreign corporation acquires (directly or indirectly) substantially all the properties of a domestic corporation (or partnership) (the acquisition test);
- The shareholders (or partners) of the domestic corporation (or partnership) acquire at least 60% of the vote or value of the foreign corporation by reason of holding stock in the domestic corporation (or interest in the partnership) (the ownership test); and
- The foreign corporation, considered together with all companies connected to it by a chain of greater than 50% ownership (i.e., the expanded affiliated group, or EAG), does not conduct substantial business activities in its country of incorporation compared with the total worldwide business activities of the EAG (the substantial activities test).
If an inversion transaction meets all the above tests, the foreign acquiring corporation is treated as a surrogate foreign corporation with respect to the expatriated domestic corporation or partnership. The tax treatment of the surrogate foreign corporation varies, depending on the level of shareholder continuity. If the shareholders of the inverted U.S. corporation own, by vote or value, 80% or more of the surrogate foreign corporation following the inversion, the foreign corporation is treated as a domestic corporation for all purposes of the Code and for all U.S. treaty purposes. If the ownership by former shareholders of the inverted corporation is less than 80% but is at least 60%, the surrogate foreign corporation is treated as a foreign corporation. However, the expatriated entity is denied the use of its tax attributes (e.g., net operating losses or foreign tax credits) to offset the inversion gain and certain other income for the succeeding 10-year period.
Changes Included in the 2009 Regs.
The 2009 regulations add to, modify, and clarify the guidance contained in the former 2006 regulations in a number of ways. In general, the 2009 regulations expand the scope of the inversion rules and may capture transactions that otherwise would not have previously fallen within the scope of Sec. 7874.
Substantial Activities Test
Perhaps the most significant change in the 2009 regulations relates to the determination of whether the EAG has substantial business activities in the relevant foreign jurisdiction. The 2006 regulations provided for two alternative tests: a facts-and-circumstances test and a safe-harbor test (former Temp. Regs. Sec. 1.7874-2T(d)). Under the safe-harbor test, the EAG’s business activities in the relevant foreign country were treated as substantial if at least 10% of its employees, assets, and sales were located in or attributable to that foreign country.
The 2009 regulations completely eliminated the safe-harbor test—presumably because it could apply to transactions inconsistent with the intended purpose of Sec. 7874. Instead, taxpayers must now rely solely on the subjective facts-and-circumstances test when determining whether the EAG has a sufficient presence in a foreign jurisdiction (Temp. Regs. Sec. 1.7874-2T(g)). The examples relating to the business activity tests have also been removed. This, no doubt, creates some unwelcome uncertainty. It also does not help that the IRS will not rule as to whether foreign business activities of the EAG meet the substantial activities test (as stated in the preamble to the 2009 regulations).
The elimination of the safe-harbor rule coupled with the absence of any guidance as to the application of the facts-and-circumstances test will make it more difficult for taxpayers to reach a “more likely than not” level of comfort when structuring an inversion transaction, and it will certainly make it easier for the IRS to collapse it. Taxpayers with historical business presence in the foreign parent’s country of incorporation would probably be in a better position to withstand the scrutiny under the new regulations than those without prior business activities in that country.
In the absence of clear guidelines for “substantial business activity,” it may be necessary to resort to the definitions used for other purposes of the Code (e.g., Sec. 884 contains a substantial presence test, and there is an active trade or business test under the limitation on benefits provisions in many U.S. treaties and under Sec. 367). It is, however, questionable how useful such definitions could be, given that they were drafted with public policy objectives unrelated to Sec. 7874 purposes.
Certainly, there could be a different way to deal with the IRS’s concerns about the Sec. 7874 safe harbor. Including additional anti-abuse provisions and examples (i.e., examples relating, at the very least, to some specific fact patterns under which the test would not be met) or even changing the existing safe harbor would be welcome by taxpayers and practitioners.
Another anti-avoidance measure included in the 2009 regulations is that assets, business activities, or employees located in the foreign country in which the foreign acquiring corporation is created or organized are disregarded for purposes of the substantial business activities test if such assets, business activities, or employees were transferred, following the acquisition, to another country under a plan in existence at the time of the acquisition (Temp. Regs. Sec. 1.7874-2T(g)(5)).
Finally, for purposes of the business activities test, a member of the EAG that holds at least a 10% capital and profits interest in a partnership is required to take into account its proportionate share of the items of the partnership (i.e., business activities, assets, income, sales, and employees) (Temp. Regs. Sec. 1.7874-2T(g)(4)).
The 2009 regulations add provisions that aggregate acquisitions by multiple foreign corporations and acquisitions of multiple domestic entities for purposes of the acquisition and ownership tests if such acquisitions are made under a plan or a series of related transactions (Temp. Regs. Secs. 1.7874-2T(d) and (e)). As a result, taxpayers can no longer take a position that a collective acquisition by multiple foreign corporations of the properties held by a domestic corporation does not meet the acquisition test (i.e., because neither foreign corporation, if viewed separately, has acquired substantially all the properties of the domestic corporation or partnership). Likewise, the acquisition of multiple domestic corporations by a single foreign corporation as part of the same plan is treated as a single acquisition of a single domestic corporation (or partnership), thereby causing the former owners of the domestic corporation (or partnership) to meet the 60% stock ownership threshold (which might not have been met had the acquisitions not been aggregated).
The 2009 regulations clarify that the list of transactions identified as indirect acquisitions under the 2006 regulations is not exclusive. In addition, the acquisition of an interest in a partnership is treated as an indirect acquisition of the partnership’s assets (Temp. Regs. Sec. 1.7874-2T(c)(ii)). An indirect acquisition includes a triangular transaction in which the acquiring entity is a partnership and the consideration for the acquisition consists of stock of a corporation that would be treated as a member of the same EAG as the partnership if the partnership were a corporation (Temp. Regs. Sec. 1.7874-2T(c)(iv)). However, if the only consideration issued in the triangular transaction is the partnership interest itself, Sec. 7874 will not apply unless the partnership is publicly traded. Finally, the test for triangular acquisitions has been changed to require the corporations to be members of the same EAG.
“By Reason of” Standard
The 2009 regulations clarify that the “by reason of” standard of the ownership test may be satisfied not only by exchanges but also by distributions (whether or not taxable) or other means (Temp. Regs. Sec. 1.7874-2T(f)). This change eliminated uncertainty as to whether the shareholders of a domestic corporation must give up their shares in order to implicate Sec. 7874 by virtue of the ownership test.
Options and Similar Interests
The rules regarding options and similar interests (e.g., warrants or convertible debt) have been revised. An option or similar interest in a domestic corporation (or a domestic or foreign partnership) will be treated as stock of the domestic corporation (or an interest in the partnership) with a value equal to the holder’s claim on the equity of the domestic corporation immediately before the acquisition (the deemed exercise rule) (Temp. Regs. Sec. 1.7874-2T(j)(1)). Under the 2006 regulations, this deemed exercise rule applied only to options on the stock of the foreign corporation that were received by former shareholders of the domestic corporation (former Temp. Regs. Sec. 1.7874-2T(f)). Since this rule is now expanded to apply to options (or similar interests) on stock of both the domestic and the foreign corporations, the ownership test can no longer be circumvented by substituting options for shares in a domestic corporation, with the options being exchanged for the stock in the foreign corporation.
Substantially Equivalent Interests
To address certain transactions intended to avoid Sec. 7874, the temporary regulations treat as stock interests that, even though not exchangeable for shares, are structured to be substantially equivalent to stock in a foreign acquiring corporation (Temp. Regs. Sec. 1.7874-2T(k)(1)).
Publicly Traded Partnerships
The temporary regulations clarify, for purposes of Sec. 7874, what qualifies as a publicly traded foreign partnership (traded on established markets or tradable on secondary markets) that is treated as a foreign corporation. A publicly traded foreign partnership is a partnership that would, but for Sec. 7704(c), be treated as a corporation under Sec. 7704(a) at the time of the acquisition or at any time after the acquisition under a plan that existed at the time of the acquisition (Temp. Regs. Sec. 1.7874-2T(h)).
Claims by a creditor against a domestic corporation are now treated as stock (or an interest in a partnership in the case of domestic or foreign partnerships) of the domestic corporation for all purposes of Sec. 7874 (Temp. Regs. Sec. 1.7874-2T(k)(2)).
The preamble to T.D. 9453 announces that the IRS will issue additional regulations to address the internal group restructuring exception in the context of divisive transactions. Specifically, this exception would not apply where the shares of a foreign corporation are transferred outside the EAG after the transaction. According to the preamble, the regulations addressing the divisive transactions may apply retroactively to transactions completed after June 9, 2009.
The 2009 regulations went into effect on June 12, 2009, and generally apply to acquisitions completed on or after June 9, 2009. Taxpayers can elect to apply the provisions to acquisitions completed before June 9, 2009, but must do so consistently to all acquisitions completed before that date (Temp. Regs. Sec. 1.7874-2T(o)).
Editor: Kevin D. Anderson, CPA, J.D.
Kevin Anderson is a partner, National Tax Services, with BDO Seidman, LLP, in Bethesda, MD.
For additional information about these items, contact Mr. Anderson at (301) 634-0222 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with BDO Seidman, LLP.