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By Thomas S. Bissell, CPA
With the publication in September of Notice 2014-52, the IRS has made it extremely difficult for any foreign corporation that is not primarily engaged in an active business to acquire a U.S. business in exchange for its stock without risking being transformed into a U.S. corporation under the anti-inversion rules of §7874. Although the Notice has broad implications for numerous foreign corporations that may be considering a U.S. acquisition, this commentary focuses on foreign corporations that are used as "blockers" by foreign individuals to invest in U.S. assets without risking the imposition of U.S. estate tax on those assets when they die.1 Foreign blocker corporations are much less likely to become aware of the new rule than are other foreign corporations that have some active business operations, because the latter corporations usually have permanent tax advisors that monitor the corporation's ongoing operations.
Section 2 of Notice 2014-52 provides in effect that where a foreign corporation acquires directly or indirectly substantially all of the properties held by a U.S. corporation and where following the acquisition more than 50% of the assets of the acquiring foreign corporation are in the form of "passive" assets, stock that is allocable to the passive assets will be ignored for purposes of the inversion fraction. The new rule is illustrated by the IRS with an example in which three-fifths of the foreign acquiring corporation's pre-existing assets are so-called "passive" assets (primarily cash and marketable securities). The Notice requires in effect that stock of the foreign corporation that is allocable to those pre-existing passive assets be ignored for §7874 testing purposes. Without applying this new rule, the shareholders of the acquired U.S. corporation would have been deemed to own 79% of the foreign acquiring corporation, based on the ratio of the value of the acquired U.S. corporation to the value of all of the foreign corporation's assets after the acquisition, i.e., the value of the U.S. corporation combined with the value of the foreign corporation's pre-existing assets. Because three-fifths of the foreign corporation's pre-existing assets must be ignored for testing purposes, however, the shareholders of the acquired U.S. corporation are deemed to own around 90% of the foreign corporation for §7874 purposes. Because this percentage exceeds the 80% inversion percentage of §7874(b), the foreign corporation is transformed into a deemed U.S. corporation.2 The new rule, which the IRS intends to incorporate into the §7874 regulations, is effective for acquisitions that take place on or after September 22, 2014.
The very broad potential effect of the new rule can be illustrated by the following facts. Assume that a foreign "blocker" corporation has a portfolio of U.S. marketable securities. The shares of the blocker in turn are owned by one or more non-U.S.-domiciled aliens who would not be protected from potential U.S. estate tax on the blocker's underlying assets if they owned those assets directly in their individual names, because the country of their residence does not have an estate tax treaty with the United States. Under the Notice, all of the blocker's assets are "nonqualified property" for §7874 testing purposes. If the blocker decides to acquire an unrelated U.S. corporation (or substantially all of its assets)3 and if it makes the acquisition in return for its stock, the Notice would require all of the blocker's pre-existing assets to be ignored for testing purposes, even though those assets may have been owned for many years by the blocker with no intention on the part of its owners to acquire a U.S. business. Because the pre-existing assets must be ignored, the result would be to transform the blocker into a deemed U.S. corporation under §7874(b). This could occur even though the value of the pre-existing assets of the foreign corporation is very large, and the value of the U.S. target corporation is very small. The result would also be the same even if most or all of the assets of the U.S. corporation are located outside the United States. A similar result would occur if substantially all of the assets of a U.S. partnership were acquired by the blocker in exchange for its stock – again, even if most or all of the assets of the U.S. partnership were located outside the United States.
Because the question of whether a partnership exists at all can often be extremely subjective, as well as the question of whether a partnership is "domestic" or "foreign,"4 a blocker that intends to acquire assets of any kind other than on an established securities market should probably investigate to make certain that the seller is not a U.S. corporation or a U.S. partnership; that the target assets do not constitute "substantially all of the properties" of a U.S. corporation or a U.S. partnership; and/or that the consideration given by the blocker cannot be considered to be "stock" in itself (discussed further below).
The consequences of being transformed into a deemed U.S. corporation could be catastrophic for most blockers. Not only would the foreign shareholders of the acquiring corporation be immediately exposed to potential U.S. estate tax if they should die unexpectedly, but the corporation itself would be subject to corporate income tax under §11 on its worldwide income (including capital gains, which are usually exempt from U.S. tax in the hands of a foreign blocker). In addition, dividends that the blocker paid to its nonresident alien shareholders would be subject to 30% U.S. dividend withholding tax (in the absence of an income tax treaty to reduce the withholding rate).5 Because the rule in §7874 that transforms a foreign acquiring corporation into a deemed U.S. corporation operates on an "all or nothing" basis, it would not be possible to "bifurcate" the acquiring corporation and argue that only the stock that had been issued to the shareholders of the target U.S. corporation should be deemed to be stock in a U.S. corporation, while the stock allocable to the pre-existing passive assets should be deemed to be owned by a foreign corporation.
It should be stressed, however, that the new rule would only apply if the foreign corporation issued stock to the shareholders of the target U.S. corporation, rather than cash or debt obligations. Indeed, it might be unusual for a foreign blocker to issue stock in itself in such a situation. However, the shareholders of the target U.S. corporation may wish to receive stock in the foreign corporation for one of a variety of reasons.6 Under the broad definition of "stock" in Reg. §1.7874-2(i), stock in the foreign corporation that has less rights than common stock (such as limited dividend rights and no voting rights) would probably be treated as stock for §7874 purposes; thus, it would probably not be necessary for the U.S. shareholders to receive voting common stock in the foreign corporation in order for §7874 to apply. Even if the acquisition is fully taxable to the selling U.S. shareholders and the foreign corporation does not issue "stock" as such to them, the corporation should be cautious if it issues debt obligations to them. Depending on the legal rights that are attached to the debt obligations and the course of conduct that occurs after the acquisition, it is possible that in some cases the debt obligations might be considered to be de facto "stock" for §7874 purposes, thus triggering the application of the new rule in Notice 2014-52.
One reason why a typical foreign "blocker" should be concerned about the new rule is because it would be extremely unusual for the blocker to satisfy the rule in §7874(a)(2)(B)(iii) which avoids §7874(b) treatment if the foreign acquirer has "substantial business activities" in the foreign country where it is organized. Because a blocker typically operates as an "incorporated pocketbook," it would usually not have substantial business activities in any country. That might not be true, however, for a foreign corporation that operates partially as a family investment company and partially as an operating company. Although those "hybrid" corporations are beyond the scope of this commentary, it should be stressed that if a hybrid corporation wishes to acquire a U.S. business in exchange for its "stock," it should first analyze carefully the value of its worldwide assets (including the assets of the "expanded affiliated group," as specially defined) in order to determine whether it meets the "more than 50%" passive assets test in Notice 2014-52. If it does meet that test, it will be crucial to determine whether it can avoid the potential effect of the new rule under the "substantial business activities" exception.
It seems reasonable to ask what the statutory basis is for the new rule. Section 7874(e)(2)(B) provides that if stock of a foreign corporation is sold in a public offering that is "related to" the acquisition of a U.S. corporation's stock or assets, it is disregarded. This rule is obviously intended to prevent the acquiring foreign corporation from issuing stock having more than 20% in vote and value from being sold to the general public in order to reduce the holding of the U.S. corporation's shareholders to below 80%. Section 7874(c)(4) also contains a broad rule that disregards transactions pursuant to the restructuring that "are part of a plan a principal purpose of which is to avoid the purposes" of §7874. Subsequently, in Notice 2009-78, the IRS announced that it would issue regulations extending the "public offering" exception to include private placements, where as part of the restructuring more than 20% of the stock of the foreign corporation was issued in return for certain kinds of property that were not owned by the U.S. corporation – specifically cash, marketable securities, or "any other property acquired in a transaction with a principal purpose of avoiding the purposes of section 7874." The Treasury finally issued the promised regulations (in final and temporary form) in January 2014.7
Whereas the "private placement" rule in Notice 2009-78 arguably conforms with the legislative intent of the "public offering" rule, the new rule discussed in this commentary makes a quantum leap into new territory, because it ignores assets that the foreign corporation may have owned for many years with no thought of ever making a U.S. acquisition. It is true that §7874 gives the Treasury broad discretion to promulgate anti-abuse rules, but in the discussion above – and indeed in the example that is contained in Notice 2014-52 itself – the passive assets that are owned by the foreign acquirer were obtained for reasons that have nothing to do with the avoidance of §7874. Thus, it is hoped that the Treasury will either abandon or substantially curtail this rule when it incorporates the remaining rules in the Notice into new regulations.
This commentary also will appear in the January 2015 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 367(a), and in Tax Practice Series, see ¶7150, U.S. Persons — Worldwide Taxation, and ¶7160, U.S. Income Tax Treaties.
1 For a detailed discussion of foreign "blockers," see Bissell, 903 T.M., Tax Planning for Portfolio Investment into the United States by Foreign Individuals. See also Bissell, The Non-Domiciled Alien Whose RPHC Has No Treaty Protection: Coping With the Anti-Inversion Rules of §7874, 43Tax Mgmt. Int'l J. 273 (May 9, 2014).
2 The facts in the example are actually more complex, because, as part of the acquisition of the U.S. corporation, the foreign corporation issues shares of new stock to its pre-existing nonresident alien shareholder in return for cash.
3 Because it is unusual for a U.S. corporation to operate as an "incorporated pocketbook," presumably the target corporation either is engaged in an active business or at the very least owns U.S.-situs real estate (for example, real estate that is used as a personal residence or is rented out or is held for development).
4See Stoffregen, Harris, and Wirtz, 910 T.M., Partners and Partnerships – International Tax Aspects, at II and III.
5 If the foreign corporation is also used by its foreign owners to hold foreign investments, the income from those assets would also become subject to U.S. income tax (albeit subject to the U.S. foreign tax credit rules of §901), and the distribution of that income (net of U.S. and foreign income taxes) would be subject to U.S. dividend withholding tax.
6 If the sellers of the U.S. target corporation are U.S. persons, the transfer of their shares in return for stock of the foreign acquiring corporation can be done tax-free only if the four requirements of Reg. §1.367(a)-3(c)(1) are satisfied. Because one of those requirements is that the foreign acquiring corporation be engaged in an "active trade or business" outside the United States, acquisition by a "blocker" that only holds investment assets would probably not qualify as tax-free; however, a stock acquisition might qualify as tax-free if done by a blocker that conducted an active business in addition to its investment activity. Even though the sale by U.S. persons may be taxable, the sellers may nevertheless wish to receive some form of stock that gives them participation in the future growth of the U.S. target (with or without voting rights). If the sellers of the U.S. target corporation are foreign persons, the sale in exchange for stock would generally be free of U.S. income tax unless the target is a "United States real property holding corporation."
7 T.D. 9654, 79 Fed. Reg. 3094 (Jan. 17, 2014).
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