IRS Issues Regulations on “Expatriated Entities” Under Sec. 7874

On June 7, the IRS issued temporary regulations governing whether a foreign corporation has “substantial business activities” in the foreign country in which, or under the law of which, the corporation is created or organized, compared to the total business activities of the expanded affiliated group (T.D. 9592). At the same time, it issued final regulations explaining when a foreign corporation is treated as a “surrogate foreign corporation” under Sec. 7874(a)(2)(B) (T.D. 9591). Sec. 7874 is intended to prevent abusive corporate inversion transactions.

Sec. 7874(a) imposes a tax on the inversion gain of an “expatriated entity.” Inversion gain generally is income or gain recognized from the transfer by the expatriated entity of stock or other property in an acquisition described in Sec. 7874(a)(2)(B)(i).

An expatriated entity is a domestic corporation or partnership with respect to which a foreign corporation is a “surrogate foreign corporation” and any U.S. person who is related to such a domestic corporation or partnership (Sec. 7874(a)(2)(A)). A surrogate foreign corporation is a foreign corporation

if, pursuant to a plan (or a series of related transactions), the entity completes after March 4, 2003, the direct or indirect acquisition of substantially all of the properties held directly or indirectly by a domestic corporation or substantially all of the properties constituting a trade or business of a domestic partnership, after the acquisition at least 60 percent of the stock (by vote or value) of the entity is held—in the case of an acquisition with respect to a domestic corporation, by former shareholders of the domestic corporation by reason of holding stock in the domestic corporation, or in the case of an acquisition with respect to a domestic partnership, by former partners of the domestic partnership by reason of holding a capital or profits interest in the domestic partnership, and after the acquisition the expanded affiliated group which includes the entity does not have substantial business activities in the foreign country in which, or under the law of which, the entity is created or organized, when compared to the total business activities of such expanded affiliated group. [Sec. 7874(a)(2)(B)]

To determine whether a foreign corporation has substantial business activities in a foreign country and thus is not a surrogate foreign corporation, in the new temporary regulations, the IRS applies a bright-line rule (replacing a facts-and-circumstances test in earlier temporary regulations). Under the temporary regulations, an expanded affiliated group will have substantial business activities in the foreign country only if at least 25% of the group employees, group assets, and group income are located or derived in the relevant foreign country.

For group employees, two tests must be satisfied, one based on the ratio of the number of employees in that country to the total number of employees and the other on a ratio of compensation for employees in that country to compensation for total employees. Group assets are calculated by taking the assets used in the active conduct of a trade or business (including tangible and real property and certain leased property) and applying the same ratio test as for employees. Group income is calculated using a similar ratio—group income derived in the foreign country divided by total group income during the one-year testing period provided in the temporary regulations. Group income in a country must occur in the ordinary course of business with nonrelated customers located in that foreign country (T.D. 9592).

T.D. 9591 contains final rules for whether options to acquire stock are counted in determining whether at least 60% of the vote or value of a corporation is held by former shareholders or partners, and thus the entity is a surrogate foreign corporation. The rules also address whether the creditors of insolvent entities should be treated as equity holders of the entity, whether two related acquisitions should be treated as one acquisition, and how a downstream merger is treated.

T.D. 9591, which finalizes temporary regulations issued in 2009, applies to transactions completed on or after June 12, 2012. T.D. 9592, which was also issued in proposed form (REG-107889-12), applies to acquisitions completed on or after June 12, 2012. For transactions for which a filing had been made with the SEC on or before June 12, 2012, or that were subject to a written agreement that was binding on that date and after, taxpayers can apply either the old rules under Temp. Regs. Sec. 1.7874-2T(g) or the new rules under T.D. 9592.