Planning for domestication transactions

Editor: Christine M. Turgeon, CPA

More foreign companies recently have been considering establishing or expanding their presence in the United States. Shifting global markets, combined with changes made by the law known as the One Big Beautiful Bill Act, H.R. 1, P.L. 119–21, have made a U.S. footprint more attractive. For some businesses, that means going a step further and converting a foreign corporation into a U.S. corporation through a domestication transaction.

Why domesticate?

Domestication can offer practical business advantages, from improved access to U.S. capital and customers to the benefit of operating in a stable, well–regulated investor environment. It also could open the door to meaningful tax benefits, including deductions related to foreign–derived deduction–eligible income (FDDEI); net controlled foreign corporation (CFC) tested income (NCTI); the Sec. 245A dividends–received deduction (DRD) for residual foreign earnings; and immediate expensing for certain costs such as U.S. research and development under Sec. 174A, qualified tangible property under Sec. 168(k), and qualified production property under Sec. 168(n).

Pillar Two of the Organisation for Economic Co–operation and Development (OECD)/G20 Inclusive Framework on Base Erosion and Profit Shifting’s solution to address the tax challenges arising from the digitalization of the economy and the recent OECD Side–by–Side Package have increased global tax stability. Pillar Two’s stated objective is to ensure large multinational companies pay a minimum tax on their income in each jurisdiction where they operate, thereby reducing incentives for profit shifting to low– or no–tax jurisdictions and limiting harmful tax competition. The increased interest in domestication could be viewed as evidence of Pillar Two’s success in neutralizing the benefits of tax havens. Foreign companies that previously left the United States (i.e., through an inversion transaction) or that otherwise have a material U.S. presence now could be able to align their top company and executives with that presence without suffering tax detriments.

This item explores some of the issues and key considerations that companies should consider in domestication transactions.

Structuring

The first question is how a company can effectuate a domestication transaction. There is no “one–size–fits–all” structure; however, options generally include (1) a Sec. 351 stock acquisition (described below) by a newly formed U.S. corporation of the stock of the foreign parent, followed by an inbound F liquidation; (2) a foreign parent inbound liquidation, where shareholders exchange foreign shares for shares of a new U.S. parent; and (3) a cross–border merger of the foreign entity into a U.S. entity. In a cross–border merger in which a foreign parent merges into a U.S. company in a Sec. 368 reorganization, or in an inbound asset reorganization or liquidation, the shareholders are subject to the rules of Regs. Sec. 1.367(b)-3.

Regs. Sec. 1.367(b)-3 generally requires U.S. holders of stock in a foreign corporation to recognize gain or include in income as a deemed dividend the “all earnings and profits amount” (all E&P amount), in which a domestic corporation acquires the assets of a foreign corporation pursuant to an otherwise tax–free asset reorganization under Sec. 368 or a tax–free liquidation under Sec. 332 (Regs. Secs. 1.367(b)-3(a)–(c)).

The consequence for an exchanging shareholder depends on their ownership in the foreign corporation.

10% U.S. shareholders: U.S. persons owning at least 10% (by vote or value) of the foreign parent generally must pick up income as a deemed dividend equal to the all E&P amount attributable to their shares (Regs. Sec. 1.367(b)-3(b)). The all E&P amount is that shareholder’s share of the foreign corporation’s accumulated, previously untaxed earnings that built up during the time the shareholder held the stock (Regs. Sec. 1.367(b)-2(d)). The amount generally is computed using principles similar to Sec. 1248, but it is determined without regard to whether the foreign corporation is a CFC, and it is not capped by the shareholder’s built–in gain on the stock. A comparable rule also can apply when the exchanging shareholder is a foreign corporation that has a U.S. shareholder.

Non–10% U.S. shareholders: U.S. holders that are not 10% U.S. shareholders and that do not qualify for the de minimis exception (i.e., their shares in the foreign corporation have a fair market value (FMV) of $50,000 or more) must recognize gain (but not loss) with respect to their shares in the foreign corporation unless they affirmatively elect to include in income the all E&P amount (Regs. Secs. 1.367(b)-3(c)(1)–(3)). Inbound asset transactions therefore can trigger U.S. tax on either the undistributed foreign–source earnings of the foreign parent or result in gain recognition for U.S. holders that own less than a 10% interest in the foreign parent.

For companies seeking to avoid immediate tax consequences on shareholders, a Sec. 351 stock acquisition is an attractive alternative. Under this approach, a newly formed U.S. corporation acquires the stock of a foreign parent in a tax–free Sec. 351 transaction. Regs. Sec. 1.367(b)-3 does not apply because there is no asset acquisition of a foreign company by the U.S. corporation. A subsequent Sec. 332 liquidation of the foreign parent into the new U.S. corporation or an inbound F reorganization, however, would subject the newly formed U.S. corporation to an inclusion of the all E&P amount. Companies should consider whether the all E&P amount, which is a dividend for all purposes of the Code, is eligible for a Sec. 245A DRD, including satisfaction of the one–year holding period under Secs. 246(c)(1) and (5), or whether the earnings are ineligible because they are either attributable to effectively connected income or dividends from domestic corporations described in Sec. 245(a)(5).

Timing for integrating the foreign parent into the new U.S. top company is a key consideration of structuring. Many companies will want to quickly bring their existing U.S. group into consolidation with the new U.S. top company, but an all E&P amount resulting from an inbound liquidation or reorganization of the foreign parent in the year of domestication will not satisfy the holding period, making the Sec. 245A DRD unavailable. Domesticating companies would need to quantify the all E&P amount and determine whether to proceed with a taxable all E&P amount or wait until the holding period is satisfied.

In assessing how to appropriately structure the domestication, consideration should be given to exit taxes and foreign law restrictions. For example, while most European Union (EU) countries permit cross–border mergers between EU companies (provided all legal requirements are met), many EU jurisdictions do not permit direct mergers into the United States.

Post-acquisition considerations

In addition to bringing the U.S. entities together structurally, companies must consider aligning intangible property (IP) and other assets and financing within the new structure once under a new U.S. top company.

If the company already has a U.S. consolidated group, the company should evaluate how to integrate the existing U.S. companies under the new U.S. parent. Where the existing U.S. group has material tax attributes (e.g., net operating losses (NOLs), capital losses, disallowed interest carryforwards, or FTC carryforwards), an analysis is required to determine whether the consolidated return separate return limitation year (SRLY) limitations under Regs. Secs. 1.1502–15 and –21 could restrict the post–transaction use of those attributes.

Companies that have a profitable foreign business subject to foreign tax but generate an overall U.S. loss should model the interaction of NCTI, the Sec. 250 deduction, U.S. NOLs, and foreign tax credits (FTCs). The Sec. 250 deduction is limited by taxable income and is computed after current–year losses and NOLs are taken into account. As a result, domestic losses (or NOL use) can reduce or eliminate the Sec. 250 benefit and cause the NCTI inclusion to be offset by NOLs at a 21% rate, rather than benefiting from the reduced effective rate of 14% associated with Sec. 250. Because NCTI FTCs cannot be carried forward, using NOLs to offset the NCTI inclusion can eliminate FTC capacity that otherwise might reduce residual U.S. tax. Taxpayers with this fact pattern should consider the implications of overall domestic loss and the separate limitation loss rules for future FTC use. Accordingly, these interactions should be evaluated through transaction–specific modeling.

IP and asset realignment

Companies may consider moving their IP into the United States to align with U.S. operations and to qualify for a reduced tax rate under the FDDEI regime. Consideration must be given, however, to other tax provisions that could affect U.S. tax liability. For instance, companies need to consider potential base–erosion and anti–abuse tax (BEAT) implications when acquiring amortizable property from offshore.

In general, the Sec. 59A regulations exclude acquisitions of amortizable IP by U.S. taxpayers from foreign affiliates in certain nonrecognition transactions (including those under Sec. 332 and Sec. 368(a)(1)(F)) from creating base-erosion payments when claiming amortization deductions on that IP unless to the extent of “boot” issued in the exchange. If, however, the IP is acquired in a taxable transaction, any future amortization of the IP is expected to be a base-erosion payment under Regs. Sec. 1.59A-3(b). Accordingly, taxpayers need to evaluate whether the addition of this payment to the BEAT computation would cause them to exceed the 3% base-erosion threshold (Sec. 59A(e)).

For some companies, maintaining IP offshore could be more advantageous from a business or operational standpoint. Regardless, taxpayers that want to realign IP and to do so in a taxable transaction should consider acting before the company becomes U.S. parented and subject to U.S. tax. Taxpayers could consider transactions that are either (1) taxable from a U.S. federal income tax perspective but disregarded for foreign tax purposes or (2) taxable from both the U.S. and foreign tax perspectives. In the former case, the basis in the assets would be increased to FMV for U.S. federal income tax purposes and would provide for a future amortization benefit without incurring any additional foreign tax. However, the downside of these types of transactions is that Sec. 901(m) (which limits a U.S. taxpayer’s ability to claim FTCs with respect to income under foreign law that was offset by increased tax basis under U.S. federal income tax law) would apply on a go-forward basis, resulting in potential foreign tax disallowances in proportion to the respective basis differences. To mitigate the Sec. 901(m) impact, taxpayers could consider entering into a transaction that is taxable for both U.S. and foreign tax purposes; however, this approach generally is advantageous only when foreign tax attributes (such as NOLs) are available.

Planning and alignment

As domestication transactions continue to increase, careful evaluation of the associated tax implications is increasingly important. Proactive planning and alignment of the new structure could help taxpayers manage the transition more effectively while mitigating unintended tax consequences.

Editor

Christine M. Turgeon, CPA, is a partner with PwC US Tax LLP, Washington National Tax Services, in New York City.

For additional information about these items, contact Turgeon at christine.turgeon@pwc.com.

Contributors are members of or associated with PwC US Tax LLP.