Bright-Line Test Determines Substantial Business Activities Under Inversion Rules

The IRS issued final regulations (T.D. 9720) on Wednesday for determining when an expanded affiliated group (EAG) will be considered to have substantial business activities in a foreign country, which allows a foreign corporation to escape application of the inversion rules under Sec. 7874(a)(2)(B), if, after an acquisition, the EAG has substantial business activities in the foreign country. The regulations finalize temporary rules issues in 2012 (T.D. 9592) with some changes (and remove the temporary regulations) but retain the bright-line test for determining substantial business activities.

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.” Any U.S. person who is related to the domestic corporation or partnership is also an expatriated entity (Sec. 7874(a)(2)(A)). A surrogate foreign corporation is a foreign corporation if:

1. Under 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;
2. After the acquisition, at least 60% of the stock (by vote or value) of the entity is held, in the case of an acquisition of 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 of a domestic partnership, by former partners of the domestic partnership by reason of holding a capital or profits interest in the domestic partnership; and
3. After the acquisition the EAG that 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 the EAG (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, the IRS applies a bright-line rule (replacing an earlier facts-and-circumstances test). Under the regulations, an EAG 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.

The IRS adopted the temporary regulations with a few clarifications in response to comments. First, it rejected comments that criticized the bright-line test and asked for a return to the facts-and-circumstances test in effect under the old rules. The IRS stated that the bright-line test supports the purpose of Sec. 7874 and has proved to be easier to administer than the earlier test. The IRS also rejected as contrary to the purpose of Sec. 7874 a suggestion that the three tests be applied either as an average of the three or as met if an EAG met two out of three.

One change that was made in the final rules was that, in determining whether corporations are members of the EAG, each partner in a partnership is treated as holding its proportionate share of the stock held by the partnership (lookthrough rule). This treatment is consistent with the rules in Regs. Sec. 1.7874-1(e) (disregarding certain affiliate-owned stock) and Notice 2014-52 (addressing later transfers of the foreign acquiring corporation’s stock). The final rules coordinate the application of the deemed corporation rule with the lookthrough rule by providing that the lookthrough rule applies first and without regard to the deemed corporation rule. As a result, the lookthrough rule applies only to determine whether an entity that is actually a corporation for U.S. income tax purposes is a member of the EAG. Then, once those corporate entities are identified, the deemed corporation rule applies to treat certain partnerships in which those corporate entities are partners as corporations that are members of the EAG.

In addition, the final rules make some changes to the anti-abuse rule under which certain items are excluded from the numerator but not the denominator for purposes of calculating the three 25% tests when the items can be attributed to avoiding Sec. 7874. They also specify a standard to be applied to determine whether individuals are employees for the group employees test. However, the IRS declined to adopt the suggestion that independent contractors be included as employees in certain circumstances for purposes of the test. Under the final rules, determining the amount and timing of compensation for members of the EAG must be done for all group employees under U.S. federal income tax principles or for all group employees based on the relevant tax laws of the other country.

A final significant change was in determining where an asset is located for the asset test. According to a number of comments, the existing test, which looked to whether the asset was physically present in a country (1) at the close of the acquisition date, and (2) for more time than in any other country during the testing period, would not work for mobile assets that are used in transportation activities, such as ships or airplanes. Although the IRS declined to provide special rules for all assets, it did for mobile ones. Therefore, mobile assets do not have to be physically present in the foreign country at the close of the acquisition date and need only be physically present in that country for more time than in any other country during the testing period to be considered present in the relevant foreign country.

The final regulations apply to acquisitions completed on or after June 3, 2015.