Temporary Regs Take on Previously Unaddressed Inversion Issues

The IRS and Treasury recently issued the latest set of rules aimed at corporate inversions. The temporary, proposed, and final regulations target:

(1)   transactions structured to avoid the objectives of IRC Section 7874; and

(2)   certain post-inversion tax avoidance transactions. [T.D. 9761 (final and temporary regulations) and 81 FR 20858 and 81 FR 20912 (proposed regulations)].

Included in the temporary regulations in T.D. 9761 are prior rules issued in Notices 2014-52 and  2015-79 and earlier notices that address both certain transactions structured to avoid the purposes of IRC Section 7874 and also certain post-inversion tax avoidance transactions. The temporary regulations also include rules on issues not addressed in the notices. These new rules:

(1) identify a foreign acquiring corporation when a domestic entity acquisition involves multiple steps;

(2) disregard stock of the foreign acquiring corporation that is attributable to certain prior domestic entity acquisitions;

(3) require a controlled foreign corporation (CFC) to recognize all realized gain upon certain  transfers of assets described in IRC Section 351 that shift ownership of those assets to a related foreign person that is not a CFC; and

(4) clarify the definition of group income for purposes of the substantial business activities test. [See Preamble, T.D. 9761].

The temporary regulations also include new definitions for terms used throughout the regulations. Per the preamble to T.D. 9761, the applicability dates for the rules previously issued in Notices 2014-52 and  2015-79 are consistent with the previously-announced dates, and the new rules in the temporary regulations generally apply to acquisitions or post-inversion tax avoidance transactions completed on or after April 4, 2016. This article briefly discusses the rules in T.D. 9761 that pertain to previously-unaddressed issues.

Transactions Structured to Avoid IRC Section 7874 The preamble to T.D. 9761 is in two parts, and Part I describes rules for transactions structured to avoid the purposes of IRC Section 7874. The preamble states that these rules:

(1) identify domestic entity acquisitions and foreign acquiring corporations in certain multiple-step transactions;

(2) calculate the ownership percentage and, more specifically, disregard certain stock of the foreign acquiring corporation for purposes of computing the denominator of the ownership fraction and, in addition, take into account certain non-ordinary course distributions (NOCDs) made by a domestic entity for purposes of computing the numerator of the ownership fraction;

(3) determine when certain stock of a foreign acquiring corporation is treated as held by a member of the expanded affiliated group (EAG); and

(4) determine when an EAG has substantial business activities in a relevant foreign country. [Preamble, T.D. 9761].

Multiple-Step Acquisition Rule. The temporary regulations provide a new Multiple-Step Acquisition Rule, which, as stated in the preamble, treats the subsequent acquisition as a domestic entity acquisition and the subsequent acquiring corporation as a foreign acquiring corporation. This rule addresses the Treasury’s and IRS’s concern for certain transactions that taxpayers may contend are not domestic entity acquisitions but that are in essence contrary to the purposes of IRC Section 7874. The preamble states that as a result of this rule, the stock of the subsequent acquiring corporation that is received, pursuant to the subsequent acquisition, in exchange for stock of the initial acquiring corporation will be treated as stock of the subsequent acquiring corporation held by reason of holding stock in the domestic entity. In addition, the preamble provides that if a foreign corporation, pursuant to the same plan or a series of related transactions, acquires directly or indirectly all of the properties held by a subsequent acquiring corporation in a transaction that occurs after the subsequent acquisition, the further acquisition will be treated under the multi-step acquisition rule as a domestic entity acquisition and the foreign corporation that made such acquisition will be treated as a foreign acquiring corporation.  [Preamble, T.D. 9761].

Multiple-Domestic Entity Acquisition Rule. The temporary regulations also contain a new Multiple-Domestic Entity Acquisition Rule, which addresses the Treasury’s and IRS’s concern that a single foreign corporation may acquire multiple domestic entities over a relatively short period of time to avoid the application of IRC Section 7874, where Section 7874 would otherwise apply if the acquisitions were completed at the same time or as part of a series of related transactions. This new rule is important because in its absence, a foreign acquiring corporation could increase its value with each “successive domestic entity acquisition” and therefore enable the foreign acquiring corporation “to complete another, potentially larger, domestic entity acquisition to which Section 7874 will not apply.” [Preamble, T.D. 9761].

The new rule affects the calculation of the ownership percentage of the foreign acquiring corporation with respect to a domestic entity acquisition. For purposes of making the calculation, the rule excludes from the denominator of the ownership fraction the stock of the foreign acquiring corporation attributable to certain prior domestic entity acquisitions.

The multiple-domestic entity acquisition rule employs a 36-month look-back period pursuant to which the foreign acquiring corporations’ prior domestic entity acquisitions that occurred within the 36-month look-back period will be excluded from the denominator of the ownership fraction. By operation of the rule, the stock attributable to the prior domestic entity acquisitions will be disregarded. [Preamble, T.D. 9761].

Non-Ordinary Course Distributions (NOCD) Rule. The temporary regulations contain the rule, promised in Notice 2014-52 and  Notice 2015-79, that will in effect disregard certain distributions made by a domestic entity prior to its acquisition by the foreign acquiring corporation that would otherwise reduce the numerator of the ownership fraction. This rule is aimed at pre-inversion efforts by a domestic entity to avoid the application of Section 7874 by making certain, non-ordinary course contributions to essentially reduce its size. As stated in the preamble: “The NOCD rule is intended to address transactions in which a taxpayer elects to reduce its size by making distributions outside of the ordinary course to shareholders in order to reduce the amount of foreign acquiring stock that would have to be provided to such shareholders in a subsequent domestic entity acquisition. The new rule, found in new Temporary Regulations Section 1.7874-10(b), states that “. . . for purposes of determining the ownership percentage by value . . . former domestic entity shareholders or former domestic entity partners, as applicable, are treated as receiving, by reason of holding stock or partnership interests in a domestic entity, stock of the foreign acquiring corporation with a fair market value equal to the amount of the non-ordinary course distributions (NOCDs), determined as of the date of the distributions, made by the domestic entity during the look-back period.” The temporary regulations also include rules for determining the amount of NOCDs and a “predecessor rule”, pursuant to which a domestic entity “inherits” distributions made by the domestic entity’s predecessor. [Preamble, T.D. 9761].

Clarification of “Group Income”. The temporary regulations clarify the definition of “group income” for purposes of the substantial business activities test for an EAG. As noted in the preamble to T.D. 9761, to have substantial business activities in the relevant foreign country, 25 percent of an EAG’s group employees, group assets, and group income must be located or derived in the relevant foreign country. The preamble notes that, under Treasury Regulations Section 1.7874-3, generally group income is gross income from transactions occurring in the ordinary course of business with unrelated customers. With respect to group income determined using the EAG’s financial statements, the preamble states that the temporary regulations “clarify that financial reporting principles are only relevant for determining the amount of items of income that are taken into account, as an EAG must take into account all items that its members recognized for financial accounting purposes during the testing period.”  [Preamble, T.D. 9761].

Post-Inversion Tax Avoidance Transactions. Part II of the preamble to T.D. 9761 describes rules that are aimed at certain post-inversion tax avoidance transactions. Among the temporary regulations addressing certain post-inversion tax avoidance transactions not covered in prior guidance is the new asset dilution rule, which requires a CFC to recognize all realized gain upon certain transfers of assets described in Section 351 that shift ownership of those assets to a related foreign person that is not a CFC.

Asset Dilution Rule. The preamble notes that without the asset dilution rule “. . . the transfer could dilute a United States shareholder’s indirect interest in the property and, as a result, could allow the United States shareholder to avoid U.S. federal income tax on realized gain that is not recognized at the time of the transfer.” [Preamble, T.D. 9761]. The preamble states that the IRC Section 367(b) asset dilution rule applies when specified property is transferred by an expatriated foreign subsidiary to a foreign transferee corporation in an exchange described in IRC Section 351 that occurs within the applicable period. [Preamble, T.D. 9761]. The preamble states that under the asset dilution rule, the expatriated foreign subsidiary must recognize all realized gain with respect to the specified property that is not otherwise recognized, unless an exception applies. The rule does not apply to realized loss with respect to the specified property.

The temporary regulations also provide an exception to the asset dilution rule for transfers to a non-CFC foreign related persons in which there is only a de minimis shift of ownership of the specified property. [Preamble, T.D. 9761].