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By Kimberly S. Blanchard, Esq.
Weil, Gotshal & Manges LLP, New York, NY
Corporate lawyers use the word "bust" as a noun when they want to admit that there is a mistake in a document, usually a cross-reference that no longer makes sense because the thing cross-referenced no longer exists in a new version of a document. "It's a bust," they say, and we all know what is meant.
Notice 2014-52,1 which sets out some rules to apply §7874, contains a provision, at §2.02 thereof, that is a bust. Read literally, §2.02 busts an existing regulation under the same Code section, Reg. §1.7874-3T(c)(1). It's pretty clear that the IRS did not mean to do this. But it's not surprising that it happened. Whereas the regulation respects the statutory language of §7874(c)(4), which incorporates a principal purpose test, the provision in the Notice ignores the language of the statute and imputes a bad purpose even where there is obviously none.
Section 7874 will apply to find an inversion where three tests are met. First, a foreign corporation (FA) must acquire substantially all of the properties of a domestic target corporation (DT) directly or indirectly (including by acquiring the stock of DT). Second, at least 60% of the counted stock of FA must be owned by shareholders of DT by reason of their ownership of DT (the "Ownership Condition"). Finally, the FA-DT group must flunk the "Substantial Business Activities Test."2 The group passes the Substantial Business Activities Test if it has substantial business activities in the country where FA is formed.
In response to political pressure to curb what many viewed as a "loophole" in the Ownership Condition, and to limit the tax planning opportunities attendant to an inversion, the IRS issued the Notice, proposing several new rules to be reflected in forthcoming regulations intended in part to treat more foreign acquisitions of domestic targets as inversions. One of the new rules in the Notice, contained in §2.02 thereof, targets pre-combination distributions by DT that could be motivated by a purpose to reduce the relative size of DT, thereby avoiding triggering the Ownership Condition.3 This new rule provides that certain distributions, referred to as "non-ordinary course distributions" or NOCDs, "will be treated as part of a plan a principal purpose of which is to avoid the purposes of section 7874" and will therefore be "disregarded." This rule is issued under the authority of §7874(c)(4), which provides:Certain Transfers Disregarded – The transfer of properties or liabilities (including by contribution or distribution) shall be disregarded if such transfers are part of a plan a principal purpose of which is to avoid the purposes of this section.
The Notice defines a NOCD as any distribution that exceeds 110% of the average of all distributions made by DT (or its predecessor) during a specified 36-month look-back period. It counts all distributions with respect to DT stock, including dividends, redemptions, distributions made pursuant to §355 spin-offs, and distributions of boot in reorganizations.
The NOCD rule applies even in the absence of any purpose to avoid §7874. This is so, notwithstanding that the rule is predicated upon the authority of §7874(c)(4), which expressly incorporates a principal purpose test. The rule of the Notice is a per se rule. This raises the question whether the per se approach of the Notice to §7874(c)(4) might be applied to other aspects of §7874.
One particular rule that might be implicated, unrelated to the Ownership Condition, is found in Reg. §1.7874-3T(c)(1). That regulation describes the manner in which the Substantial Business Activities Test is to be applied. Generally, a FA-DT group will be treated as having substantial business activities in the country in which FA is formed if 25% or more of each of three factors is located in that country. The three factors are set forth in Reg. §1.7874-3T(b)(1) - §1.7874-3T(b)(3), and consist of: (1) employees; (2) assets; and (3) income. A specific anti-avoidance rule provides as follows:
The following items are not taken into account in the numerator, but are taken into account in the denominator, for each of the [25%] tests described in paragraphs (b)(1) through (b)(3) of this section:
(1) Any group assets, group employees, or group income attributable to business activities that are associated with properties or liabilities the transfer of which is disregarded under section 7874(c)(4).
Note that this regulation refers to transfers, including distributions, described in §7874(c)(4); that is, distributions motivated by a principal purpose to avoid §7874. The regulation is a sensible rule in the context of such a tax-motivated distribution. For example, suppose that prior to its acquisition by an FA formed under the laws of Country A, DT owned 100% of the stock of a subsidiary, USS. Suppose that all of the assets, employees, and income of USS were located within the United States, and that USS is for all relevant purposes four times larger than DT. Finally, suppose that FA has no counted assets, employees, or income and that all of DT's assets, employees, and income are located in Country A.
If DT were to spin off all of the stock of USS to its shareholders with a purpose to qualify under the Substantial Business Activities Test, the above anti-abuse rule could apply. Under the anti-abuse rule, the assets, employees, and income of USS would be added back to the denominator of the fraction, yielding a fraction of 20%,4 such that the Substantial Business Activities Test would not be met. If instead the purpose of the spin off – let's assume made two years prior to the FA acquisition before the acquisition was even dreamed of by either party – was to comply with an anti-trust order, the rule by its terms would not apply, and the Substantial Business Activities Test would be available.
But if the IRS were to apply a per se approach to §7874(c)(4) in this context, the above case would flunk the Substantial Business Activities Test under either assumption. Even more surprisingly, the following case, involving no possible potential abuse, would be covered: Suppose that each of DT and USS have exactly 30% of their assets, employees, and income in Country A, and that DT spins off USS. Assuming that the spin-off is a distribution that exceeds 110% of the average of the counted distributions during the 36-month look-back period, under the Notice it would be "disregarded," and the Substantial Business Activities Test would be flunked. The fraction would be again reduced to 20% of what it would otherwise have been, here from 30% to 6%, because the factors of USS would be added to the denominator but not the numerator of the fraction.5 Obviously, no possible anti-inversion policy is served by applying the approach of the Notice to §7874(c)(4) in this way, since the Substantial Business Activities Test would have been separately satisfied by both DT and USS.
It might even be suggested that the Substantial Business Activities Test could be flunked where all of the attributes of DT and USS are located in Country A. The regulation, like the statute, speaks in terms of "disregarding" the distribution. If the assets transferred pursuant to the distribution were deemed held by the FA-DT group after the distribution, but were deemed held outside Country A, the test would be flunked. This of course is a ridiculous proposition.
Logically, there is no reason why the per se approach of the Notice has any relevance to any other context in which §7874(c)(4) might apply. Just because the Notice reads out the principal purpose test for purposes of disregarding NOCDs and determining whether the Ownership Condition is met is no reason to suppose that the principal purpose test does not continue to apply for other purposes, including for purposes of Reg. §1.7874-3T. But the drafting of the Notice leaves much to be desired in terms of logic. The Notice begins by discussing the concern to which the NOCD rule was addressed, which concern has nothing to do with the Substantial Business Activities Test and implicates only the Ownership Condition. But the Notice goes on to summarize the rule in a way that appears to apply it for all purposes of §7874:For purposes of applying section 7874(c)(4) (which disregards transfers of properties or liabilities if the transfer is part of a plan a principal purpose of which is to avoid the purposes of section 7874), non-ordinary course distributions (defined below) made by the domestic entity (including a predecessor) during the 36-month period ending on the acquisition date (within the meaning of §1.7874-3T(d)(1)) will be treated as part of a plan a principal purpose of which is to avoid the purposes of section 7874. Accordingly, such distributions will be disregarded for purposes of section 7874.
It is interesting to note that the existing regulation at Reg. §1.7874-3T(c) takes a very different view of what it means to "disregard" a distribution than the view apparently taken in the Notice. The Notice seems to contemplate that a distribution would be added back in full, affecting the calculation of both the numerator and the denominator of the Ownership Condition fraction. The regulation, on the other hand, assumes that the statutory injunction to "disregard" a distribution made for tax avoidance purposes requires that its intended abusive effect be nullified. The regulation would nullify the abuse set out in the example above by adding back the assets, employees, or income — distributed out with an avoidance purpose — only to the denominator, an approach tailored to remedy the abuse. If instead the regulation added back the distributed attributes to the numerator as well, the company would be returned to status quo ante, and the regulation would have accomplished nothing.
Because it requires a finding of a principal purpose, and operates in a manner to nullify an abusive purpose, Reg. §1.7874-3T(c) can be defended as a proper exercise of the IRS' §7874(c)(4) authority. That cannot be said of the NOCD rule in the Notice. By abandoning any pretense that the taxpayer's purpose is relevant, and substituting a per se rule that is much broader than needed to deal with the identified "abuse," the Notice upends the statutory design. It is thus not surprising that it would give rise to obviously incorrect results in other contexts.
This commentary also will appear in the March 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.
Copyright©2015 by The Bureau of National Affairs, Inc.
3 We put aside, for purposes of this commentary, the fact that this makes sense only if one presumes that FA would have paid for the DT shares that received the distribution in the form of additional FA shares, a presumption that is unprovable and often wrong in fact.
5 That is, assuming that the "value" of DT's total attributes is $100, $30 would be attributable to Country A. Before the add-back, the fraction would be 30/100. After the add-back, the fraction would be 30/(100+400). The test is flunked because USS's foreign attributes of $120 are not added back to the numerator.
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