The Principal Tax-Avoidance Purpose: A Poison Pill for Inversions?

By Ning Xie, J.D., LL.M., Costa Mesa, Calif.

Editor: Kevin D. Anderson, CPA, J.D.

Foreign Income & Taxpayers

Much has been written about inversion transactions and recent developments under Sec. 7874, but little is known about how the IRS might use the principal-tax-avoidance-purpose doctrine to challenge an inversion transaction. This item considers possible challenges by the IRS using the principal tax-avoidance purpose under Sec. 7874.

Sec. 7874 Does Not Override Other Code Sections

Sec. 7874 plainly applies in a corporate setting, but it is unclear whether it applies to a foreign partnership. Treasury solicited comments before issuing temporary regulations in 2005, and one commenter argued that Sec. 7874 should not govern a foreign acquiring partnership (T.D. 9238). But Treasury rejected this argument and stated it believed that a taxpayer's use of the so-called check-the-box election constituted a principal purpose of tax avoidance. Moreover, the IRS and Treasury even threatened to issue retroactive regulations to address these transactions.

A year later, Treasury again considered the applicability of the check-the-box regulations in an inversion context. This time, commenters primarily argued that

the entity classification rules of §§301.7701-2 and 301.7701-3 are intended to allow taxpayers to choose whether a foreign eligible entity is a corporation or partnership for Federal income tax purposes, and section 7874(b) does not impinge on that freedom of choice, but only deems a foreign corporation to be a domestic corporation. [T.D. 9265]

Treasury conceded that this entity-classification argument had "a stronger foundation." In the preamble to the 2006 regulations, the IRS and Treasury "recognize[d] that the use of a foreign partnership that is not publicly traded, or the use of a domestic partnership, to acquire the properties of a domestic corporation might enable taxpayers to avoid the purposes of section 7874 in certain cases"(T.D. 9265).

It seems, therefore, that the principal-tax-avoidance-purpose doctrine under Sec. 7874 should not prevail when this doctrine conflicts with other existing Code sections, unless Congress expressly states otherwise. This is significant for tax planning because taxpayers may rely on other sections to insulate their structure from Sec. 7874. In other words, as long as a transaction does not technically trigger Sec. 7874, then the principal-tax-avoidance-purpose doctrine should not disturb the transaction.

Valid Business Purpose Is Not Enough to Defend a Transaction That Is Technically Governed by Sec. 7874

What exactly is "a transaction that does not technically trigger Sec. 7874"? A recent development provides some guidance. In the only private letter ruling to date substantially regarding Sec. 7874, the IRS found that a Sec. 368(a)(1)(F) reorganization may technically be treated as a Sec. 7874 transaction, even if the transaction has a valid business purpose (Letter Ruling 201432002).

The transaction was fairly straightforward. A foreign parent company wholly owned another foreign company, FS1, which in turn wholly owned foreign corporation FS2 in Country C. FS2 wholly owned the U.S. domestic company. The foreign parent intended to raise capital in the U.S. market. Based on its own analysis, the foreign parent believed that the stock offerings would be more lucrative under Country G law. Hence, the foreign parent and its affiliated group engaged in an F reorganization to facilitate a Country G issuance. FS1 transferred all the shares of FS2 to FA, a newly established Country G company. FS2 then made a check-the-box election to become a disregarded entity. Following this F reorganization, FA issued less than 50% of its shares for private placement and pursuant to an initial public offering (IPO). Thus, FS1 retained more than 50% control of FA and the U.S. subsidiary.

Since the parties engaged in the transaction in anticipation of an IPO, it should have had a strong and valid business purpose. More importantly, the transaction is not the type that Sec. 7874 is intended to address. The Senate Finance Committee's report describes the intention of Sec. 7874 as targeting "inversion transactions resulting in a minimal presence in a foreign country of incorporation [that] are a means of avoiding U.S. tax and should be curtailed" (S. Rep't No. 108-192, 108th Cong., 1st Sess. 142 (2003)). In contrast, this transaction has no impact on the U.S. taxability of the corporate group.

Why was the transaction described in the letter ruling as an inversion? The IRS took the view that this transaction consisted of three deemed fictional transfers: (1) The old corporation (FS2) is deemed to transfer all of its assets, subject to all of its liabilities, to the new corporation (FA) in exchange for FA stock; (2) FS2 is deemed to distribute the FA shares just received to its shareholder (FS1) in a Sec. 361(c) liquidating distribution; and (3) FS1 is deemed to exchange its FS2 stock for FA stock. Hence, FA is deemed to acquire all of the stock of the U.S. subsidiary owned by FS2. This acquisition would thus trigger Sec. 7874. Therefore, the proposed transaction was governed by Sec. 7874, irrespective of its entirely nontax business purposes.

IRS May Allow a Transaction That Does Not Have a Principal Purpose of Tax Avoidance Under Sec. 7874

On the other end of the spectrum, history indicates that the IRS is willing to overlook Sec. 7874 implications if there is little or no evidence of a tax-avoidance purpose, even if the transaction triggers the Sec. 7874 provisions.

The exclusion rule of Sec. 7874 provides that a foreign acquiring corporation's stock should be disregarded for the purpose of the ownership calculation if the stock is issued in exchange for the nonqualified property. Nonqualified property is (1) cash or cash equivalents; (2) marketable securities; (3) a disqualified obligation; or (4) any other property acquired in a transaction (or series of transactions) related to the acquisition with a principal purpose of avoiding the purposes of Sec. 7874 (T.D. 9654, Temp. Regs. Sec. 1.7874-4T(c)). In T.D. 9654, Treasury provided that

[t]he purpose of the exclusion rule is to prevent certain stock of the foreign acquiring corporation that is transferred in a transaction that increases the net assets of the foreign acquiring corporation from inappropriately increasing the denominator of the ownership fraction and thereby reducing the ownership fraction.Thus . . . the IRS and the Treasury Department do not believe that the exclusion rule should apply to transfers of stock by a shareholder of the foreign acquiring corporation to another person because such transfers do not increase the net assets of the foreign acquiring corporation.

The key question is whether the principal-tax-avoidance-purpose doctrine is switched off in such a transaction. Treasury did not answer this question. However, the regulation sets up a limitation on the exclusion rule in Sec. 7874, and the exclusion rule includes the principal-tax-avoidance-purpose doctrine. The principal-tax-avoidance-purpose doctrine thus has logically been turned off by this limitation.

It should be noted that this limitation on the exclusion rule contradicts the logic in the letter ruling, which said that a proposed transaction that is technically within the scope of Sec. 7874 is governed by Sec. 7874, regardless of whether there is a principal purpose of tax avoidance. The reason behind this different treatment is unclear. It could simply reflect an evolving hostility toward inversion transactions in recent years. Therefore, taxpayers should be mindful that even if a proposed transaction contains little or no tax avoidance, Sec. 7874 could still be triggered, and the transaction may be technically governed by Sec. 7874.

Valid Principal Business Purpose as a Defense

A principal valid nontax business purpose is a strong defense for either a step-transaction or economic substance challenge (Gregory v. Helvering, 293 U.S. 465 (1935)).

The key inquiry thus becomes whether a transaction can concurrently contain both a valid principal business purpose and a principal purpose of tax avoidance. Unfortunately, case law has not yet provided a definition for principal purpose of tax avoidance in a Sec. 7874 context. But the Supreme Court did rule that "primarily" in Sec. 1221 means "of first importance" or "principally" (Malat v. Riddell, 383 U.S. 569 (1966)). In other words, the Supreme Court in Riddell suggested that there can be only one principal purpose in a transaction. Therefore, if a transaction contains a principal valid business purpose, it cannot also have a principal purpose of tax avoidance.

So why did the letter ruling discussed above reach a different conclusion? After all, that transaction had a strong valid business purpose, and it did not avoid U.S. tax. The difference is that the transaction described in the letter ruling technically triggered Sec. 7874. Hence, the IRS mechanically relied on the rules of Sec. 7874 to conclude that the transaction was an inversion transaction.


The principal-tax-avoidance-purpose doctrine may not be the sword of Damocles it appears to be. The IRS should have no basis to invoke Sec. 7874 if a taxpayer can show that a proposed transaction is allowed under other Code sections—even if the proposed transaction has a principal purpose of tax avoidance. But if a proposed transaction meets the technical rules of Sec. 7874, then Sec. 7874 alone governs that transaction, regardless of whether there is a principal purpose of tax avoidance.


Kevin Anderson is a partner, National Tax Office, with BDO USA LLP in Bethesda, Md.

For additional information about these items, contact Mr. Anderson at 301-634-0222 or

Unless otherwise noted, contributors are members of or associated with BDO USA LLP.

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