IRS Holds Its Ground in Substantial Business Activity Regulations

Corporate inversions have recently returned to the forefront of American political speech. Despite recent IRS moves to curb the practice, some multinational corporations display an unfettered determination to leave their American domicile in search of a low-tax jurisdiction. For example, pharmaceutical giant Pfizer announced a proposed $160 billion merger with Ireland-based Allergan.

Politicians, presidential hopefuls, and pundits alike have all chimed in with their own opinions. While some say that corporations that invert are tax dodgers and should pay their fair share for the benefits they receive from being American companies, others say that inversions highlight an antiquated corporate tax system that hurts American corporations that are competing in a global economy. Both sides are seeking new legislation, but, in the meantime, the IRS has released, and will continue to release, regulations addressing corporate inversions.

What is a corporate inversion?

A corporate inversion is a transaction in which a U.S. corporation changes its tax residence to a foreign jurisdiction. Inversions can be done in a number of ways. For example, before Sec. 7874 was enacted in 2004, U.S. corporations could reorganize under a newly created foreign parent. However, current laws and regulations generally limit inversions to acquisitions of U.S. companies by a foreign entity.

Inversions appeal to corporations because of three key benefits. First, the United States has one of the highest corporate tax rates in the world, well above the Organisation for Economic Co-operation and Development (OECD) average. In addition, the United States taxes corporations on their worldwide income, unlike most OECD countries, which employ a territorial tax system that taxes only companies doing business there. Thus, inverting to a lower-tax jurisdiction will generally significantly lower the company’s tax bill.

Second, a foreign parent corporation also allows for earnings stripping, whereby the parent corporation lends money to the U.S. subsidiary, which then repays the debt with deductible interest payments.

Finally, an inversion allows a U.S. corporation to access its offshore foreign earnings. Foreign earnings of U.S. corporations are not taxed until they are repatriated (or deemed to be repatriated) to the United States, which leads many companies to leave the earnings abroad to avoid U.S. taxes. Current estimates suggest that U.S. corporations are holding more than $2 trillion offshore, and, with an inversion, a corporation can use its foreign earnings and not be subject to U.S. taxation.

Sec. 7874 and the general inversion rules

Sec. 7874 and its regulations generally govern corporate inversions. Under Sec. 7874(a), an expatriated entity will face adverse tax consequences if the foreign acquiring corporation is deemed a “surrogate foreign corporation,” which occurs if:

1. A foreign corporation acquires, directly or indirectly, substantially all the properties of a U.S. corporation;
2. After the acquisition, at least 60% of the stock (by vote or value) of the foreign corporation is owned by the former shareholders of the U.S. corporation by reason of holding stock in the U.S. corporation; and
3. After the acquisition, the foreign corporation and its expanded affiliated group (EAG) do not have substantial business activities in the country where the foreign corporation was created or organized.

When a foreign corporation is deemed to be a surrogate, the effect of the transaction will differ depending on the percentage of former shareholders in the domestic corporation who are now shareholders in the new foreign corporation. For example, per Sec. 7874(b), if the former shareholders of the U.S. corporation retain 80% of the ownership in the foreign corporation, then the foreign parent will be treated as a domestic corporation and the foreign subsidiaries will be controlled foreign corporations. Thus, little will change from a U.S. tax perspective.

If the shareholders retain at least 60%, but less than 80% of the stock, then for any tax year during the 10-year applicable period, the taxable income for the U.S. corporation may not be less than the inversion gain, the U.S. corporation cannot use its tax attributes to offset income or gain, and a 15% excise tax applies to certain deferred compensation arrangements. Sec. 7874(d)(2) defines inversion gain as gain recognized when certain property (stock, licenses, and other property) is transferred as part of the acquisition or to a related foreign person after the acquisition. Finally, if the former shareholders of the U.S. corporation retain less than 60% of the stock, Sec. 7874 does not apply.

T.D. 9720 and the final substantial business activities regulations

In June 2015, the IRS issued final regulations on the substantial business activity exception to inversion transactions. Like an acquisition with less than 60% retained ownership, a foreign corporation with retained ownership of over 60% can avoid adverse tax consequences if it has substantial business activities in the country in which it was created or organized. This exception is intended to prevent companies from finding an acquisition partner in a low-tax jurisdiction for purely tax motives. Under Regs. Sec. 1.7874-3(b), an EAG (those connected by 50% ownership) will need to satisfy three requirements if it is to meet the substantial business activity exception: (1) group employees; (2) group assets; and (3) group income.

1. The group employee requirement

The first requirement, group employees, has two parts. Under the first part, 25% of the group employees must be based in the relevant foreign country. An employee is based in the relevant foreign country if he or she spent more time providing services in that country than in any other country during the one-year testing period.

Under the second part, 25% of the total compensation for all group employees must be incurred by employees based in the relevant foreign country. Employee compensation includes wages, salaries, deferred compensation, and employer payroll taxes. Furthermore, whether individuals are employees must be determined for all members of the EAG either under U.S. federal tax principles or based on the relevant tax law to which each member is subject.

2. The group assets requirement

The group assets requirement mandates that 25% of the total value of group assets be located in the relevant foreign country on the applicable date. Under the regulations, group assets include tangible personal property or real property held for use in an active trade or business. Thus, readily transferable intellectual property rights are not included in the group asset calculation. Moreover, a group asset is located in the relevant foreign country only if it was physically present in the relevant foreign country at the close of the acquisition date and the asset was physically present in that country more than any other country during the one-year testing period.

However, mobile assets used in transportation activities need not be physically present in the relevant foreign country at the close of the acquisition date. Instead, they only need to be physically present in the relevant foreign country for more time than any other country.

Finally, the regulations provide guidance on appropriate ways to value assets. Assets must be valued on a gross basis, using either their fair market value or adjusted tax basis. Rented assets may also be included in the group asset calculation, as long as the rented assets come from an unrelated party, are used in an active trade or business, and are rented at the close of the acquisition date. Rented assets are valued at eight times the net annual rent paid or accrued.

3. The group income requirement

Under the final requirement, 25% of total group income must be derived from the relevant foreign country. Group income is derived from the relevant foreign country only if the customer is located in the relevant foreign country. Group income is determined over the course of the one-year testing period and excludes related-party transactions and transactions not in the ordinary course of business.

Finally, group income must be determined consistently for all members of the EAG under either U.S. federal income tax principles or as reflected in the relevant financial statements. For this purpose, relevant financial statements mean financial statements made under U.S. GAAP or IFRS.

Implications

The final substantial business activity regulations do not change the existing framework of Sec. 7874 much. Although relatively few inversions have relied on the substantial business activity exception, the regulations provide a level of certainty to tax planners and their clients. Thus, it is possible that more inversions will use the exception in the future.

However, it is highly unlikely that large multinational corporations will be using the substantial business activity exception. Companies with global business operations will likely not meet the 25% threshold in any country, let alone the low-tax jurisdictions most attractive for inversions. This point was raised as a comment to the proposed regulations, but Treasury and the IRS rejected any changes to the high threshold.

At the same time, in some cases, the substantial business activity exception would be of use. For example, the Burger King-Tim Hortons inversion in 2014 relied on the exception, as Burger King shareholders retained over 60% of the ownership in the new foreign corporation.

In general, the inversion regulations seem to have little effect on corporate plans for inverting. Companies now seek an acquisition partner that is large enough to keep the retained shareholder level below the 60% threshold. For instance, both the Pfizer-Allergan merger and the recently announced Johnson Controls-Tyco merger will avoid the inversion regulations altogether, because the retained shareholder levels will be below the threshold. Thus, so long as U.S. corporations can structure inversions to avoid any substantial adverse consequences, the benefits provided through inversions will keep driving more U.S. corporations abroad. 

—Jesse Scott, J.D., LL.M., is an associate at Holthouse, Carlin & Van Trigt LLP in Los Angeles, Calif.