Notice 2009-78: The IRS Amends §7874 by Notice

The BNA Tax and Accounting Center is the only planning resource to offer expert analysis and practice tools from the world's leading tax and accounting authorities along with the rest of the tax...

By Philip D. Morrison, Esq.
Deloitte Tax LLP , Washington, DC

Section 7874(g) provides extraordinarily broad regulatory authority. That statute provides that regulatory authority can be used to promulgate rules “necessary to carry out this section” or, even broader, rules “providing such adjustments to the application of this section as are necessary to prevent the avoidance of the purposes of this section….” This last statement is unusual: it can be argued to sanction, even encourage, amending the statute by regulations so long as such amendment is “necessary to prevent the avoidance of the purposes of this section.” What else, the IRS is likely to argue, could have been meant by “providing adjustments to the application of this section…”?

For purposes of this commentary, let me stipulate (without conceding) that the authority granted by §7874(g) is broad enough to allow some form of amendment of the statute by regulations. But does such authority allow the IRS to reverse a Congressional decision that is clear from the history of the enactment of §7874? Is it possible to argue successfully that such an action can be necessary to prevent the avoidance of the “purposes” of §7874 if Congress earlier rejected the specific provision added by the regulations? Will a court agree that, in grantingthis authority, Congress said, “We think ‘X’, but if the IRS concludes ‘not X’, then regulations can so provide”?

In Notice 2009-78, 2009-40 I.R.B. 452 (“the Notice”), that is precisely what the IRS has done — effectively amend §7874 so as to reverse a specific and clear Congressional choice. And in public remarks from its drafters, the IRS has defended such amendment by notice and subsequent regulation as necessary to prevent the avoidance of the purposes of §7874. While the validity of such a broad interpretation of regulatory authority may be argued, the cost of losing a challenge to this Notice (having a foreign corporation transformed into a domestic one) will typically be so high rarely will anyone knowingly execute a transaction that would require a validity challenge to the Notice (and the subsequent regulations it promises). In such cases, this cost likely gives the IRS the practical power to promulgate and enforce the Notice, regardless of the boundaries of the regulatory authority under the statute. However, as a matter of the fair and balanced administration of our tax laws, this commentator thinks the exercise of such power is unwise and the Notice should be withdrawn or amended.

Moreover, the Notice is so broad, and so divorced from the statute, that there will likely be more than a few “accidental” inversions caught by these rules. Joint ventures and even private equity buy-outs might appear so far from the intent of §7874 that even a moderately well-advised taxpayer could miss the application under the Notice. In such cases, the stakes are so high that an affected taxpayer will have little choice but to litigate the validity of the Notice (and subsequent regulations). A defeat of the IRS in such a case will, one might speculate, decrease the deference generally given the IRS's interpretation of the Code by courts. This, too, provides a reason for the IRS to reconsider the breadth of the Notice.

Finally, the perception of overreaching by the IRS is likely to make some taxpayers more aggressive in applying other aspects of the §7874 regime. For example, with the removal of the safe harbor for the “substantial business activities” test under §7874(a)(2)(B)(iii) in Regs. §1.7874-2T released in June 2009, that important test has been made entirely subjective (based on all the facts and circumstances). It is not hard to imagine taxpayers, perceiving themselves unfairly foreclosed by the overbreadth of Notice 2009-78 from concluding that there is no problem under §7874 due to modest shareholder interest continuity, claiming substantial business presence in the new foreign corporation's jurisdiction where such a claim is less than solid. This will be a problem for advisors, for the IRS's international examiners, and, eventually, for IRS litigators, since the substantial business activity test is now entirely subjective and, in some cases under the Notice, the shareholder continuity test sympathies will clearly be with the taxpayer.

The Statute

Section 7874, as readers know, will convert an otherwise foreign corporation (“Forco”) into a domestic corporation if: (1) Forco acquires substantially all of the properties of a domestic corporation; (2) after the acquisition there is 80% or more continuity of shareholders' interest (i.e., former domestic corporation shareholders hold 80% or more shares in Forco “by reason of” having held domestic corporation shares); and (3) the expanded affiliated group that includes Forco does not have substantial business activities in Forco's country of incorporation. Section 7874(c)(2)(B) provides that stock sold in a “public offering” cannot count (in the numerator or the denominator) for purposes of the continuity of shareholders' interest test in item (2) above.

In the Senate-passed version of the bill that enacted §7874 (S. 1637), stock sold “in a public offering or private placement” (emphasis added) was excluded for continuity calculation purposes. In the House-passed version (H.R. 4520), the “or private placement” language was omitted — private placement shares were intended to count in the continuity calculation. In the House-Senate Conference on the bill, the House-passed version prevailed — i.e., the “or private placement” language was not included (H.R. Conf. Rep. 108-755). The conference committee and the final bill clearly demonstrate a decision to include stock sold in a private placement as counting for purposes of the continuity of shareholders' interest test in item (2) above.

The difference between the Senate version and the final language of the statute is a clear demonstration of Congressional intent. One body includes a phrase; the other body omits that phrase while otherwise using identical language. The conferees choose the version omitting the phrase. While the Statement of Managers to the Conference Committee Report does not explain the reasons for the choice, there is no question that the choice was made.

There are several possible reasons for the choice. Perhaps the most plausible is that public offerings where historical shareholders do not cash out entirely often leave historical shareholders holding a controlling share, even if a minority share, as the public shares are typically very widely held. In such a case, shareholders of a domestic company have converted their investment to one in a foreign corporation without losing control while gaining liquidity. In a private placement, that is not typically the case. But whatever the reason for rejecting the version that would have not counted shares issued in a private placement, it is clear that Congress did, indeed, reject that language.

The Notice

In Notice 2009-78, the IRS reverses that decision, essentially restoring the intentionally omitted phrase to the statute. The Notice does this by promising regulations, effective for acquisitions on or after September 17, 2009, that would exclude stock issued in exchange for “nonqualified property” from counting (in the numerator or the denominator) for purposes of the continuity of shareholders' interest test. “Nonqualified property” would include cash or cash equivalents or marketable securities. Thus, stock offered in a private placement for cash would not count for shareholder continuity purposes.

Under this formulation, even though new shareholders, in a private placement, inject cash well in excess of 20% of the value of the domestic corporation for use in, for example, rescuing a failing domestic corporation, the shares they get in exchange for that cash injection cannot count for testing shareholder continuity. Thus, if the former shareholders of the domestic corporation retain any interest in the new Forco that acquired the domestic corporation's property, they will be considered the only shareholders that count — continuity will be 100% and Forco will be treated as a domestic corporation.

This commentator thinks such a transaction does not present objectionable policy concerns; it does not seem, even if Congress had been silent on the matter of counting shares issued in a private placement, to subvert the purposes of §7874. Yes, the property of the former domestic corporation is now the property of a Forco, but Forco has greater than 20% new value (the cash injection)—indeed, it might have greater than 50% or 80% new value via the cash injection. That does not seem to be an objectionable “inversion” of a domestic corporation. Forco has enough new capital that it is not the mere continuation of the domestic corporation in a foreign jurisdiction; the old domestic corporation shareholders have a materially different investment. Forco also has enough new shareholders' interest that the old domestic corporation shareholders may have a very much smaller ability to control the new Forco.

Even if the IRS disagrees with this policy conclusion, however, Congress itself clearly made a decision to count shares issued in a private placement in the shareholder interest continuity test. How can the “purposes” of §7874 be served by reversing an explicit Congressional choice? Isn't that Congressional choice indicative of the “purposes” of the section? While §7874(g) authorizes “adjustments to the application of” §7874 by regulation, it is difficult to imagine that Congress intended such an adjustment to include a reversal of a choice that Congress explicitly made.

As mentioned above, given the high costs of losing a validity challenge under §7874, in the typical case taxpayers will avoid planning into a situation where such a challenge would be necessary. This does not mean, however, that the Notice should not be changed. Indeed, in just such a case the IRS opens itself to valid criticism of overreaching—using its authority in a way inappropriate to the fair and even-handed administration of the tax laws. In the long run, this will hurt the IRS. Also, as mentioned above, there are likely to be some cases where the Notice creates “accidental” inversions. In those cases, the taxpayers may be forced to litigate the Notice's validity. A loss in such a case will damage the IRS beyond the narrow bounds of interpreting §7874. Finally, also as mentioned above, taxpayers' perception of overreaching by the IRS in the Notice may have an impact on taxpayers' willingness to be a bit more aggressive in applying the “substantial business activities” test. For all of these reasons, the Notice should be withdrawn or revised to not exclude shares issued in a private placement in the shareholders' interest continuity test, at least where the proceeds of the private placement are retained in the corporation.

This commentary also will appear in the December 2009 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Davis, 919 T.M., U.S.-to-Foreign Transfers Under Section 936, and in Tax Practice Series, see ¶7130, U.S. Persons' Foreign Activities.