Searching for Principles in the New Inversion Regulations' Example (3)

By Kimberly S. Blanchard, Esq.

Weil, Gotshal & Manges LLP, New York, NY

New regulations were promulgated under §7874 in February.1 These regulations
make good on the IRS's promise, in Notice 2009-78,2 to address the
circumstances under which stock of a foreign acquiring corporation
would be excluded from the denominator of the "ownership condition"
under §7874(a)(2)(B)(ii). Stated briefly, the Notice and these
regulations exclude from the denominator of the ownership fraction
any stock of the foreign acquiring corporation issued for cash or
other nonqualified property. The new regulations define
"nonqualified property" to include: (1) cash; (2) marketable
securities; (3) certain debt obligations; and (4) any other
property where a principal purpose is to avoid the purposes of
§7874.3 "Marketable
securities" is defined to exclude stock of a corporation that
becomes a member of the expanded affiliated group (EAG) that
includes the foreign acquiring corporation, unless a principal
purpose for acquiring such stock is to avoid the purposes of

The new regulations contain various examples of their
application. This commentary focuses on Example (3) set out at Reg.

Example (3) consists of two alternative examples.  In both
alternatives, an existing publicly-traded foreign corporation
designated as "foreign target" (FT) creates a new foreign
corporation that will become the foreign acquiring corporation (FA)
as part of a larger transaction. In the first alternative, FA
creates two new merger subsidiaries, one U.S. (DMS) and one foreign
(FMS).  DMS will be used to combine with a U.S. target
corporation and will not be discussed further here. FMS is merged
into FT with FT surviving.  In the merger, the historic
shareholders of FT receive stock of FA in exchange for their FT
shares, such that FT becomes a wholly owned subsidiary of FA. (The
example does not state what becomes of the presumably single share
of FA owned by FT.)

In the example, because FT is publicly traded, the stock of FT
falls within the definition of "marketable securities" unless the
EAG exception applies. The regulations' analysis of this simple
example thus proceeds from the premise that, absent the EAG
exception, the FA shares issued to FT's shareholders would be
"disqualified stock" not taken into account in the ownership
fraction. Nevertheless, in this example the FT shares qualify for
the EAG exception because FT survives the merger and is wholly
owned by FA. As a result, none of the FA shares issued for FT
shares constitute disqualified stock, and such shares are included
in the denominator of the ownership fraction. 

In the second alternative, FMS is not used.  Instead, FT
merges directly into FA, with FA surviving. The analysis here
proceeds on the theory that FA has acquired the assets, rather than
the stock, of FT. It thus constructs two separate transfers: first,
a transfer by FA of the FA shares to FT in exchange for FT's
assets, and second, a transfer by FT of the FA shares it received
to its own shareholders in exchange for their historic FT shares.5 In the first transfer,
the regulations state that the EAG exception will not apply,
because FT ceases to exist and thus cannot be a member of FA's EAG
following the merger. However, because the example assumes that
none of FT's assets are nonqualified property, none of the FA
shares issued in exchange therefor constitute disqualified
stock.  The negative implication is that to the extent FT's
assets consisted of nonqualified property, the FA shares would in
fact be treated as disqualified stock.

In the second transfer, the analysis states that none of the FA
shares deemed transferred to FT's shareholders in exchange for
their FT shares is disqualified stock, even though the FT shares
constitute marketable securities and hence would otherwise be
treated as nonqualified property, because the transfer of FA shares
by FT "across the top" does not increase the net worth of FA and
thus comes within the exception set out at Reg.
§1.7874-4T(c)(2).  Presumably this exception would apply to
the second transfer even if some of the assets of FT consisted of
nonqualified property.

Before turning to an analysis of Example (3), this commentary
will posit a third alternative that could be used to combine FA and
FT. The third alternative is the same as the first alternative,
except that the directionality of the merger is reversed such that
FMS survives the merger with FT. In that case, the FA shares would
be treated as having been issued for FT assets. FT does not become
a member of the EAG; only FMS does. The third alternative is thus
essentially equivalent to the second alternative, in that the
property being tested consists of the assets of FT, rather than the
stock of FT. Thus, if any of FT's assets constitute nonqualified
property, to that extent the FA shares issued in exchange therefor
would presumably be excluded from the ownership fraction.

Can the question of whether an inversion has occurred possibly
hang on the mere directionality of a merger in which FT is
acquired? The clear implication of Example (3) is that it
can.  Example (3) and the substantive rules illustrated by
that example are flawed, because in this regulatory framework the
IRS is asking the wrong question. The question should not be
whether FT becomes a member of FA's EAG. The question should be
whether FA is being "stuffed" with assets unrelated to the
combination in a manner that artificially reduces the ownership
fraction. None of the above scenarios implicates that question.

This basic flaw emanates, in the first instance, from the choice
the IRS made concerning what constitutes nonqualified property. The
regulations, like the Notice before them, woodenly insist that all
"marketable securities" are nonqualified property unless the EAG
exception is satisfied. While marketable securities of third
parties can be thought of as analogous to cash, securities of a
party to the combination itself should never be.  There is no
substance in a rule that would cause an inversion to occur if FT is
publicly traded, but would not find an inversion on identical facts
where FT is not publicly traded.

It is likely that the EAG exception contained within the
definition of "marketable securities" reflects an understanding of
this basic point. But the EAG exception cannot apply where the
assets, rather than the stock, of FT are acquired.  This makes
no sense. A more principled approach would have been simply to
state that marketable securities of a party to the combination are
never nonqualified property.

It has been reported that a representative of the IRS stated
that if FT were a "cash box," even if old and cold, any FA shares
issued in exchange therefor would be disregarded.6 That
is the clear implication of Example (3) in any case where the
fiction is that FT's assets, rather than stock of FT, is acquired.
But where only FT stock is acquired, nothing in the regulations
supports such an implication. If the IRS were to attempt to reach
the same result in the first alternative, where FA stock is issued
for FT stock, the IRS would be forced to resort to the anti-abuse
rule in the regulations' definition of "nonqualified property":
"[a]ny other property acquired in a transaction (or series of
transactions) related to the acquisition with a principal purpose
of avoiding the purposes of section 7874."7 There
are no principles contained in these regulations providing guidance
as to when the "principal purpose" test is tripped. But it is hard
to understand how the IRS would differentiate a "cash box" from a
bona fide operating company that happens to have a lot of cash in
it. The fact that the IRS would have to stretch to capture a stock
deal in this case simply underscores the fallacy of treating as
nonqualified property any cash of FT where an assets deal is

When asked about the apparent implication that the
directionality of a merger could affect the outcome under these
regulations, the IRS has said that it did not want to accord weight
to whether there is a business purpose for doing a deal (such as a
bona fide combination of two operating companies). The IRS seems
determined to apply its rules woodenly without regard to whether
anything like the kind of inversion targeted by Congress is
occurring. For example, if stock of FA is issued for cash as part
of a §351 transaction, with the cash being used to acquire other
assets related to the business combination, the IRS view appears to
be that the cash constitutes nonqualified property, notwithstanding
the lack of any tax motivation (and in fact a strong non-tax
motivation) for the transfer.  But if that is the case, it is
hard to understand how the IRS could invoke the "principal purpose"
test to attack a transaction based on a wholly formal distinction
of whether stock or assets are deemed acquired for tax

When a U.S. corporation - DT in these regulations - and a
foreign corporation - FT in these regulations - combine, there will
inevitably be forms of combination that can be legally accomplished
in the United States but cannot be legally accomplished in the
country where FT (or FA) is organized.  For example, many
countries do not recognize the concept of a triangular merger such
as the one involved in the example's first alternative.  In
those countries, if FA is to acquire the shares of FT in a manner
that is tax-efficient to FT's local shareholder base, it may be
necessary to effect the combination in a manner that U.S. tax law
would view as an assets acquisition (e.g., via a direct merger of
FT into FA).  There is no reason why being forced to combine
in this manner should trigger an inversion.

The §7874 regulations should be rewritten to follow substance,
not form. As noted above, it would be an easy fix for the EAG
exception to the definition of "marketable securities" to be
replaced with a simple rule that excludes from the definition of
"marketable securities" the shares of a company that is a party to
the combination, which was evidently the intent of the EAG
exception in any case. The regulations should further provide that
cash or other property owned by or transferred to a party to the
combination should be excluded from the definition of nonqualified
property to the extent such cash or other property is held for use
in the ordinary course of the combining company's trade or

This commentary also will appear in the July 2014 issue of
 Tax Management International Journal.  For
more information, in the Tax Management Portfolios, see Streng, 700
, Choice of Entity, Davis, 919 T.M.,
U.S.-to-Foreign Transfers Under Section 367(a), and in Tax
Practice Series, see ¶7150, U.S. Persons - Worldwide


  1 T.D. 9654, 79 Fed. Reg. 3094 (Feb. 3, 2014).

  2 2009-40 I.R.B. 452. This author addressed the
Notice in "Notices 2010-41 and 2009-78: Thoughts on the Scope of
IRS Authority," 51 Tax Mgmt. Memo. 355 (Oct. 11,

  3 Reg. §1.7874-4T(i)(7).

  4 Reg. §1.7874-4T(i)(6).

  5 Note the similarity to the treatment of "F"
reorganizations in the §367 regulations, treating an "F" as a
transfer of assets from the old corporation to a new one and as a
distribution of the stock of the new corporation to the old
corporation's shareholders in liquidation. Reg. §1.367(a)-1T(f) and
Reg. §1.367(b)-2(f).

  6 See "Zent Defends Inversion Regs'
Disqualified Stock Rule," 142 Tax Notes 1175 (Mar. 17,
2014); Sheppard, "Invert Now. Or Else.," 143 Tax
 11 (Apr. 3, 2014).

  7 Reg. §1.7874-4T(i)(7)(iv).