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Taxpayers undertaking ordinary commercial transactions have for some years been stymied by the lack of any guidance issuing from Treasury or the IRS relating to the U.S. tax treatment of foreign forms such as “exchangeable share” or “dual-headed company” structures. A common element of these structures is that a share of stock of one corporation (hereafter, the “shadow share”) carries economic entitlements parallel or closely identical to a share of a different corporation formed in a different country (hereafter, the “shadowed corporation”). Any number of such structures have been used outside the United States. These types of structures have not generally been used in the United States, given the lack of certainty as to how they might be treated. One notable exception is the common use of the so-called “UPREIT” structure in the United States, in which a partnership interest may be exchangeable for stock of a corporation whose sole or principal asset is an interest in the same partnership.

Apparently some taxpayers and their advisors have used shadow shares in an attempt to avoid the strictures of §7874, which was designed to prevent, or impose significant impediments to, inversion transactions. In the classic form of an inversion transaction, shareholders of a U.S. corporation would exchange stock of that corporation for stock of a foreign corporation. Section 7874 generally provides that if shareholders of the U.S. target receive, by reason of owning stock of the U.S. target, 60% or more of the stock of the foreign acquiring corporation, the foreign acquiring corporation, will be treated as a “surrogate foreign corporation” and taxable on certain gains it thereafter realizes. If the ownership overlap is 80% or more, the surrogate foreign corporation will be treated as a domestic corporation.

The IRS issued new temporary regulations under §7874 on June 10, 2009.¹ In a number of respects, these temporary regulations expand upon the rules previously promulgated. This article will focus on only one such expansion, referred to in the Preamble as the new rule for “economically equivalent interests.” The new temporary regulations provide that, for purposes of §7874, any equity interest in a corporation or partnership that is not otherwise treated as stock of a surrogate foreign corporation will be treated as stock of such foreign corporation if two conditions are satisfied:

(1) the interest entitles the holder to distribution rights that are substantially similar in all material respects to the distribution rights to which a shareholder of the shadowed foreign corporation is entitled; and

(2) treating the interest as stock of the shadowed corporation has the effect of treating the shadowed corporation as a surrogate foreign corporation within the meaning of §7874.²

In one case, the shareholders of a domestic corporation (UST) form a new foreign corporation (FC) that issues shares to the public in exchange for cash and then contributes all or part of the cash to a newly formed domestic corporation (S) in exchange for all the stock of S. S then merges with and into UST, with the UST shareholders exchanging their UST stock for a new class of UST stock (class B stock) and cash. FC exchanges its S stock for all of the remaining class of stock of UST (class A stock). FC holds few assets other than the class A stock. The class B stock entitles the UST shareholders to dividend distributions approximately equal to any dividend distributions made by FC with respect to its publicly traded stock, and permits the UST shareholders, in certain cases, to require UST to redeem the class B stock at fair market value. Because FC holds few assets other than the class A stock of UST, the value of the class B stock held by the former UST shareholders is approximately equal to the value of a corresponding amount of FC stock.³

In a second case, set forth in Example 18 of the regulations, the shareholders of UST contribute their shares to a newly formed partnership (FPS) in exchange for class B partnership interests. FC contributed cash raised in a public offering to FPS in exchange for class A partnership interests. The class B partnership interests entitle the former UST shareholders to cash distributions from FPS approximately equal to any dividend distributions made by FC with respect to its publicly traded stock. In certain circumstances, the class B partnership interests also permit the class B holders to require FPS to redeem their interests in exchange for cash equal to the value of an amount of FC stock as determined on the redemption date. Again, FC holds few assets other than its class A partnership interest, such that the value of the class B partnership interests is approximately equal to a corresponding amount of FC stock.

The IRS was concerned that these arrangements give the UST shareholders rights that are economically equivalent to actual ownership of FC shares. The temporary regulations conclude that in each of these cases, the shadow share (or partnership interest) should be treated as stock of FC, the shadowed corporation, if doing so would have the effect of treating FC as a surrogate foreign corporation.

What these examples tell us, at least for purposes of §7874, is that shadow stock (including a partnership interest in a partnership that owns the U.S. target) should be treated as stock of the shadowed corporation. This seems to be an extraordinary piece of guidance, with an uncertain legal foundation. For many years, tax practitioners have been more than curious to know how the IRS felt about the type of exchangeable shares often seen in Canadian acquisition structures: Are they really shares of the parent, into which they are exchangeable and whose economic terms they mimic? Does it matter how “tight” the collar is around the economics? What if the values of the shadow shares and the shadowed shares diverge, for example, because the shadowed corporation acquires other assets? None of these questions seems to be addressed in this casual piece of guidance.

As for Example 18, which addresses a form of UPREIT transaction, the conclusion is purely result-driven. Are interests in a partnership ever the “same as” and assimilated to shares of its corporate partner into which they may be exchanged? If so, under what circumstances? I believe that most practitioners had assumed, based in part on the partnership anti-abuse regulations,⁴ that UPREIT structures would be respected for tax purposes.

The IRS may believe that the economically equivalent rule in the §7874 regulations is limited to, and justified by, the policy underlying that section, and does not represent any generally applicable principle of tax law. However, when one considers that this regulation by definition applies only to treat stock of a domestic corporation as equivalent to stock of a foreign corporation, the rationale for the rule appears even more tenuous than it might be as applied to U.S. shareholders in other factual settings.

Under §7874, ALL shareholders of the domestic target count toward the inversion test, including foreign shareholders. But a foreign shareholder who retains stock of a domestic subsidiary of a publicly traded foreign corporation, or a foreign partner who accepts a partnership interest in a foreign partnership owning a domestic corporation, is not remotely in the “same position” as one who owns stock of an actual foreign acquirer. A foreign shareholder that owns stock of a domestic corporation is subject to U.S. tax on any dividends received from that corporation; a foreign shareholder of a foreign corporation is not. A foreign shareholder of a domestic corporation that is a “U.S. real property holding company” must pay U.S. tax on a sale of the stock; a foreign shareholder of a foreign corporation that owns the same assets is not subject to tax on a sale.

In the same vein, a U.S. shareholder of a domestic corporation, or a U.S. partner in a partnership owning stock of a domestic corporation, is not in the same after-tax economic position as a U.S. shareholder who owns stock of a foreign corporation. The tax differences are too numerous to mention. Similar or even identical distribution rights do not (or should not) imply that tax ownership of domestic shadow stock is identical to (or should be treated as identical to) ownership of foreign shadowed stock. These fundamental cross-border differences in taxation explain why “dual-headed company” structures are used, and why most non-U.S. practitioners view them as viable from a tax perspective. Yet no consideration appears to have been given to these realities by the new temporary regulations.

If the IRS is going to wade into these uncharted waters, it should do so with caution and with due regard to the significant tax differences between ownership of domestic and foreign shares. These issues deserve a more considered and complete consideration, and taxpayers are entitled to more principled guidance as to what “economic equivalence” actually means.

This commentary also will appear in the September 2009 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Streng, 700 T.M., Choice of Entity, and Davis, 919 T.M., U.S.-to-Foreign Transfers Under Section 367(a)and in Tax Practice Series, see ¶7130, U.S. Persons' Foreign Activities.