Service Recently Issued Final Regulations on Taxation of Corporate Inversions
With baseball season in full swing this Spring, many following America’s favorite pastime may have overlooked the issue of important and final regulations on the taxation of corporate inversions under §7874. The IRS issued final regulations on May 19, 2008 on the taxation of corporate inversions in which U.S. companies effectively reincorporate offshore by merging into a foreign surrogate.
As background, during the 1990s and early 2000s, several large, public, domestic corporations, reincorporated as foreign corporations, i.e., by establishing a foreign parent holding company over the U.S. subsidiary group, without changing the mode of their business operations or management oversight conducted primarily within the U.S. Inversion transactions can be effectuate several ways, including asset inversions, stock inversions or a combination of the two. Thus, for example, a stock inversion is effectuated by a U.S. corporation forming a foreign (parent) corporation, which then organizes a domestic merger subsidiary. The U.S. merger subsidiary then merges into the U.S. corporation with the U.S. corporation surviving (reverse triangular merger). The U.S. shareholders exchange stock of the foreign corporation for their U.S. shares. As part of the inversion planning, the U.S. corporation may transfer some or all of its foreign subsidiaries directly into the new foreign parent corporation or other related foreign corporations. Additional features of the well-designed inversion included earnings stripping exercises such as payments of interest, rents, fees or royalties to the new foreign parent or other foreign affiliates.
Inversion transactions are typically not tax-free to all participants. U.S. shareholders generally must recognize gain (but not loss) under §367(a), upon exchanging stock of a domestic corporation for shares of the new foreign parent. A domestic corporation may also recognize gain on transferring stock of a foreign subsidiary or other assets to a foreign member of the newly constituted group. For example, a domestic corporation recognizes gain under § 367(b) on the exchange of stock of a controlled foreign corporation (“CFC”) for stock of another foreign corporation which is not a CFC.
What §7874 attacks, which generally applies to inversions occurring after March 4, 2003, is by providing that the foreign corporation following an inversion will still be considered as “domestic” corporation for U.S. tax purposes, even though it is organized under the laws of a foreign country, if at least 80% of its stock is owned by former shareholders of the inverted domestic corporation. Where ownership by former shareholders of the inverted corporation is less than 80% but 60% or more, special rules apply to ensure that the corporation pays U.S. tax on gains recognized in transactions carried out to effectuate the inversion. Recognizing that the U.S. shareholders were required to pay capital gains taxes on the exchange, Congress also decided to imposed a 15% excise tax on the value of options and other stock-based compensation outstanding when a corporation inverts. The statute sets forth a set of complex definitions and applicable rules pertaining to a so-called “expatriated entity” which includes a domestic corporation or partnership to which a foreign corporation is a “surrogate foreign corporation.”
The IRS issued final regulations (T.D. 9399) maintain much of the provisions set forth under the temporary regulations in determining the scope of the inverted company’s expanded affiliate group of subsidiaries. Many tax practitioners have been reported by the tax press to be concerned about the overbreadth of the final regulations, in particular, the failure for the Service to provide an exception for the issuance of plain vanilla preferred stock in apply the stock percentage tests. Yet, on the other hand, certain rules pertaining to ownership by affiliates seems to make it easier to avoid the inversion provision. The final regulations add that Treasury is aware some taxpayers may be attempting to avoid the application of §7874 by structuring the inversion of a U.S. entity into a foreign entity through the use of intervening partnerships, resulting in an ownership fraction of zero. The IRS announced it was considering publishing additional regulations to address end around inversion strategies that in substance fall within Congress intent as what would constitute an inversion transaction for purposes of §7874.
