As previously reported, the IRS published in June, 2009, temporary and proposed regulations to §7874 which modified an example contained in former Temp.Reg. §1.7874-2T(e)(5), Ex.3 that may have created an unintended or unforeseen method of avoiding the 80% stock ownership test under §7874(b).
The Notice states that the IRS and Treasury have become aware of transactions intended to avoid §7874 that involve a transfer of cash or other assets to the foreign corporation in a transaction related to the acquisition described in §7874(a)(2)(B)(i). The transaction minimizes the former shareholders’ ownership in the foreign corporation for purposes of falling short of the 80% stock ownership condition. Similar transactions may be structured for the acquisition of a domestic corporation in a bankruptcy reorganization or a case involving a domestic partnership. Also of concern is the possible exploitation of the public offering rule of §7874(c)(2)(B) which applies to all public issuances of stock by a foreign corporation, regardless of the property exchanged for the stock.
A so-called corporate "inversion" transaction involves the restructuring of a U.S. based group of corporations, frequently engaged in multinational operations, so that a newly organized foreign corporation, generally organized in a tax haven or low tax jurisdiction, becomes the parent corporation of the prior U.S. parent corporation and group of subsidiaries. An inversion transaction can be effectuated through the movement of stock or assets, or a combination of both. For example, a stock inversion would involve a parent U.S. corporation forming a new foreign corporation which forms a domestic acquisition subsidiary. The U.S. subsidiary is merged into the U.S. parent corporation surviving as the first tier subsidiary of the foreign parent. The U.S. parent corporation’s shareholders exchange their shares of U.S. (parent) stock for shares of the foreign corporation. An asset inversion achieves the same result but through direct merger of the parent US. corporation into a new foreign corporation. Further restructuring efforts could involve moving U.S. subsidiaries into a foreign grouping.
Prior to the enactment of §7874, inversions had the potential to cause immediate U.S. income taxation to the shareholders exchanging U.S. for foreign parent shares in accordance with §367(a). The transfer of foreign subsidiaries or other assets to the foreign parent corporation also may trigger income taxation for U.S. purposes at the corporation level. With an asset inversion, e.g., direct merger approach, the transferor U.S. parent corporation generally has gain (but not loss) recognition in accordance with §368 and relations. After the inversion is completed, foreign source income of foreign companies are outside of the jurisdiction of the U.S. tax authorities. This reduction in U.S. income tax liability can be further reduced by other earnings stripping strategies involving payment s of deductible amounts of interest, rents, management service fees or royalties, subject to certain policing rules.
Section 7874 was enacted to eliminate the major tax benefits of an inversion involving "expatriated entities," including either a domestic corporation or domestic partnership with respect to which a foreign corporation is a "surrogate foreign corporation," or a company related to such a domestic corporation or partnership. More particularly, a surrogate foreign corporation is a foreign corporation that acquires, directly or indirectly, substantially all of the properties held directly or indirectly by a domestic corporation if at least 60% of the foreign corporation’s stock (by vote or value) after the acquisition is held by former shareholders of the domestic corporation by reason of holding its stock. As to a domestic partnership, a surrogate foreign corporation includes a foreign corporation that acquires, directly or indirectly, substantially all of the properties of a trade or business of a domestic partnership if at least 60% of the foreign corporation’s stock (by vote or value) after the acquisition is held by former partners of the domestic partnership by reason of holding a capital or profits interest. Regardless, a foreign corporation is a surrogate foreign corporation only if, after the acquisition, the "expanded affiliated group" (EAG) does not have "substantial business activities" in the foreign country in which, or under the law of which, the foreign corporation is created or organized, when compared to the total business activities of the EAG.
If §7874 applies, the "foreign corporation" is nevertheless treated as a domestic corporation for U.S. federal income tax purposes regardless of local in which it is organized or managed, provided at least 80% or more of its stock is owned by former shareholders of the now "inverted" domestic corporation. Alternatively, where only 60% or more of the stock is owned by former shareholders of the inverted domestic corporation, then the underlying inversion transaction is respected so that the foreign parent is not "domesticated", but during the ten-year period following the inversion transaction, any applicable gain or income recognition required as a result of the inversion can not be offset by the group’s favorable tax attributes to mitigate the extent of the gain.
Under §7874(c)(2), certain shares of stock of a foreign corporation are ignored in determining whether the ownership tests are met:(i) stock of the foreign corporation held by members of the expanded affiliated group that includes the foreign corporation, and (ii) stock of the foreign corporation sold in a public offering related to the acquisition described in §7874(a)(2)(B)(i). Regulations on the ownership tests were published in 2008 and later in 2009. TD 9399; TD 9453. See §7874(g) which grants the Secretary broad powers to regulate in this area and prevent avoidance. See also §7874(c)(6) as well which permits the issuance of regulations to determine whether a corporation is a surrogate foreign corporation, including regulations to treat stock as not stock.
In TD 9453, the IRS and Treasury modified § 1.7874-2T(e)(5), Example 3, to eliminate an unintended benefit flowing from the public offering rule of §7874(c)(2)(B).
In Notice 2009-78, supra, the Service acknowledged the presence of transactions planned to avoid §7874 which involve a transfer of cash (or certain other assets) to the foreign corporation in a transaction related to the acquisition described in §7874(a)(2)(B)(i), thereby minimizing the former shareholders’ ownership in the foreign corporation to fall below the 80% threshold. In one such transaction, for example, the shareholders of a domestic corporation (DC) transfer all their DC stock to a newly-formed foreign corporation (New FCo) in exchange for 79% of the stock of New FCo and, in a related transaction, an investor transfers cash to New FCo in exchange for the remaining 21 percent of the New FCo stock. Some are of the view that the New FCo stock issued to the investor is not "sold in a public offering" and thus is not subject to §7874(c)(2)(B). It was also stated in the Notice that the IRS and Treasury understand that similar transactions may be structured with respect to the acquisition of a domestic corporation in a title 11 or similar case (as defined in §368(a)(3)) or a domestic partnership.
The IRS and Treasury also understand that taxpayers are concerned the public offering rule of section 7874(c)(2)(B) applies to all public issuances of stock by a foreign corporation, regardless of the property exchanged for the stock. For example, assume that, pursuant to a business combination, the shareholders of a publicly-traded foreign corporation (FT) and a publicly-traded domestic corporation (DT) intend to transfer their FT and DT stock, respectively, to a newly-formed foreign corporation (FA) that will be publicly-traded. To effectuate the transaction, as part of a plan FA acquires all of the FT and the DT stock, respectively, from the FT and DT shareholders in exchange solely for newly-issued FA stock. If the FA stock issued to the FT shareholders is considered "sold in a public offering" and thus subject to §7874(c)(2)(B), the former shareholders of DT would be treated as owning 100% of the stock of FA for purposes of the ownership of stock requirement, and FA would therefore be treated as a domestic corporation for purposes of the Code under §7874(b). A similar result would occur if instead FT merged with and into FA and the FT shareholders exchanged their FT stock for FA stock pursuant to the merger. The IRS and Treasury believe that such a result could be inappropriate in certain cases.
In the Notice, the IRS and Treasury intend to issue regulations identifying stock of the foreign corporation that is not taken into account for purposes of the ownership test. Suchregulations will provide that stock of the foreign corporation issued in exchange for "nonqualified property" in a transaction related to the acquisition described in §7874(a)(2)(B)(i) will not be counted for under the stock ownership condition regardless of whether such stock is publicly traded on the date of issuance or otherwise. The regulations will also address other issues to prevent end runs on §7874.