Corporations & Shareholders
On Jan. 16, 2014, the IRS issued long-awaited temporary regulations (T.D. 9654) providing guidance on when foreign corporate stock is taken into account in determining whether the ownership test is satisfied for Sec. 7874. The temporary regulations also provide guidance on the effect of transfers of stock of a foreign corporation after the foreign corporation has acquired substantially all of the properties of a domestic corporation or of a trade or business of a domestic partnership. The temporary regulations replace guidance provided in Notice 2009-78, which is made obsolete.
Sec. 7874: Background
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 of 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), does not conduct substantial business activities in its country of incorporation compared with the total worldwide business activities of the expanded affiliated group (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 owners of the inverted U.S. entity 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 former shareholders' ownership of the inverted corporation is less than 80% but 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 credits) to offset the inversion gain and certain other income for the succeeding 10-year period.
Public Offering Rule and Notice 2009-78
In determining if former shareholders (or partners) of a U.S. entity meet the ownership test for an 80% inversion or a 60% inversion, stock of the foreign acquiring corporation that is sold in a public offering as part of the acquisition is disregarded under Sec. 7874(c)(2)(B) (public offering rule). This antistuffing provision is intended to prevent the avoidance of Sec. 7874's application by having the foreign acquiring corporation issue stock to the public in exchange for cash to dilute the former owners' interest in the foreign acquiring corporation below the requisite 80% or 60% threshold.
Concerned that the statutory public offering rule is both under- and overinclusive, the IRS announced in Notice 2009-78 its intention to issue regulations (1) expanding the application of the rule to stock issued in private placements while (2) exempting certain nonabusive combinations of publicly traded entities.
Under the notice, stock of the foreign acquiring corporation is not taken into account if it was issued in exchange for "nonqualified property," such as cash, marketable securities as defined in Sec. 453(f)(2) (i.e., any security for which there is a market on an established securities market or otherwise), or any other property acquired with the principal purpose to avoid Sec. 7874. This rule applies regardless of whether the foreign stock is issued in a public offering or a private placement. Marketable securities, however, generally would not include stock (or a partnership interest) issued by a member of the expanded affiliated group that, after the acquisition, includes the foreign acquiring corporation (subject to an antiabuse rule). This provision ensures that a combination of a foreign corporation and a domestic corporation can be effectuated using a new foreign corporation if there is a valid business purpose.
The Temporary Regulations
Consistent with the notice, the temporary regulations do not distinguish between the treatment of foreign acquiring corporation stock issued in a public offering from that issued in a private placement. The temporary regulations provide that if the stock meets the definition of "disqualified stock," it is disregarded when measuring the post-acquisition ownership in the foreign acquiring corporation by the former shareholders of the transferred domestic entity, thereby increasing their ownership percentage and, thus, the likelihood of an adverse result under Sec. 7874.
Although the temporary regulations adopt the general approach of the notice, there are certain modifications and clarifications, most notably including the following:
Expanded definition of the term "nonqualified property": The notice's definition of the term "nonqualified property" is expanded to include "disqualified obligations," which are obligations of members of the expanded affiliated group that includes the foreign acquiring corporation; of former owners of the domestic entity; or of a person that, before or after the acquisition, is related to any such persons (within the meaning of Sec. 267 or 707(b)). Notably, the term "obligation" is defined by reference to Regs. Sec. 1.752-1(a)(4)(ii)) and thus includes any fixed or contingent obligation to make a payment. According to the preamble, the IRS and Treasury believe that a transfer of the foreign acquiring corporation's stock in exchange for a disqualified obligation should be treated similarly to transfers of stock in exchange for cash, cash equivalents, and marketable securities because such transfers present similar opportunities to inappropriately reduce the ownership fraction by increasing the net assets of the foreign acquiring corporation.
New "associated obligation" rule: Under the temporary regulations, "disqualified stock" includes foreign acquiring corporation stock transferred to a person (including the domestic entity) in exchange for property to the extent that, pursuant to the same plan (or series of related transactions), the transferee subsequently transfers the foreign stock in exchange for the satisfaction or the assumption of an obligation associated with the property exchanged. An example of this transaction, not contemplated in the notice, would be where the foreign acquiring corporation issues stock to a domestic entity in exchange for assets of the domestic entity that are not treated as "nonqualified property," with the domestic entity then using the foreign acquiring corporation stock to pay off its liabilities. The IRS and Treasury believe that, in the absence of this rule, the former shareholder's ownership percentage in the foreign acquiring corporation could be inappropriately reduced by using foreign acquiring corporation stock to satisfy the domestic target's creditors.
Liability assumption or satisfaction: Likewise, the foreign acquiring corporation's stock transferred to a person (other than the domestic entity) in exchange for the satisfaction or the assumption of the transferor's obligation is treated as if it is transferred in exchange for cash equal to the fair market value of the stock.
Transactions not increasing net asset value: Disqualified stock does not include a foreign acquiring corporation's stock transferred in a transaction that does not increase its net assets, such as, for example, a shareholder-to-shareholder sale of the foreign acquiring stock for cash or other nonqualified property. The reason for the exception is that such transactions do not increase the net assets of the foreign acquiring corporation and, therefore, there is no dilution of the former owners' post-acquisition interest in a foreign acquiring corporation.
De minimis exception: The IRS and Treasury recognized that the broad application of the statutory public offering rule and the notice, without an exception, could cause Sec. 7874 to apply to transactions that are, in substance, sales of a U.S. business for cash with little continuity of ownership retained by the historic owners of the transferred domestic entity. To avoid this result, the temporary regulations provide a de minimis ownership exception under which the foreign acquiring corporation's stock is not treated as disqualified in situations where (1) the former shareholders' ownership fraction, determined without regard to the exclusion rule, is less than 5% by both vote and value and (2) after the acquisition and all related transactions, the former owners of the domestic entity in the aggregate own (applying the attribution rules of Sec. 318(a)) less than 5% by both vote and value of the stock of any member of the expanded affiliated group that includes the foreign acquiring corporation.
Expanded definition of the term "transfer": Notably, in contrast to the notice, the temporary regulations' use of the term "transfer" is not limited to the foreign acquiring corporation's mere issuance of stock. Rather, this term is defined more broadly to include an issuance, sale, distribution, exchange, or any other type of disposition of foreign acquiring corporation's stock, regardless of whether the stock is transferred by the foreign acquiring corporation or another person.
Interaction with expanded affiliated group rules: Disqualified stock that is excluded from the denominator of the ownership fraction is taken into account to determine whether an entity is a member of the expanded affiliated group and whether an acquisition qualifies for the internal group restructuring or loss-of-control exception.
Effect of subsequent transfer of stock: There is also another set of rules clarifying that a post-acquisition transfer of the foreign acquiring corporation's stock by the former owners of the domestic entity would not be disregarded for purposes of determining the 60% or 80% ownership thresholds, even if the subsequent transfer is related to the domestic entity's acquisition. This essentially means that a prearranged post-acquisition sale of the foreign acquiring corporation's stock by the former owners of the domestic entity would not result in a reduction of their ownership fraction for Sec. 7874 purposes, even though, under the step-transaction doctrine (or other authorities), a shareholder may not be treated as owning stock that it has committed to transfer to a third party.
Applicable dates: The temporary regulations apply to acquisitions completed on or after Sept. 17, 2009. However, modifications to the rules originally published in Notice 2009-78 apply as of Jan. 17, 2014. Taxpayers may elect to apply the new rules to acquisitions that occur on or after Sept. 17, 2009, but before Jan. 16, 2014, if they apply them consistently to all acquisitions completed before Jan. 16, 2014.
The temporary regulations provide some much-needed guidance about the proper application of the concepts contained in the notice. Most practitioners welcome the 5% de minimis rule, as it helps avoid an inappropriate application of Sec. 7874 to a transaction, a predominant effect of which is a sale rather than an expatriation (although the rather low threshold is disappointing to many). However, despite some welcome clarifications and modifications, many practitioners find that the provisions remain overinclusive, potentially producing results that could be inconsistent with the underlying policy of Sec. 7874. As a result, many corporate transactions involving U.S. and foreign parties may unintentionally fall within the scope of Sec. 7874.
Kevin Anderson is a partner, National Tax Office, with BDO USA LLP in Bethesda, Md.
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