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By Edward Tanenbaum, Esq. Alston & Bird LLP, New York, NY
Treasury and the IRS have been hard at work for a number of years writing regulations on the §7874 corporate expatriation provisions.
Enacted as a part of the American Jobs Creation Act of 2004, §7874 applies if, pursuant to a plan or series of transactions: (1) a foreign corporation acquires, directly or indirectly, substantially all of the properties held directly or indirectly by a U.S. corporation; (2) the foreign acquiring corporation or any affiliated company (based on a greater than 50% common ownership) does not have substantial business activities in the country in which the foreign corporation is organized; and (3) immediately after the transaction, former shareholders of the domestic corporation own at least 60% of the voting power or value of the stock of the foreign corporation by reason of holding stock in the domestic corporation. The stock ownership test disregards stock held by members of the expanded affiliated group (“EAG”) which includes the foreign corporation (for this purpose, “affiliated” being defined as more than 50% ownership).
If former shareholders hold at least 60% (but less than 80%) of the stock of the foreign corporation, a special tax regime applies for a 10-year period pursuant to which the U.S. company is restricted from using certain tax attributes to offset income realized on the transfer of stock or properties, including by way of license, as a part of the inversion transaction or to a foreign related person. If the former shareholders own 80% or more of the stock, the foreign acquiring corporation is treated for all tax purposes as a U.S. corporation.
In December of 2005, temporary regulations were issued dealing with the EAG definitions and the disregard of affiliate-owned stock. These regulations were finalized in 2008 and provided for some key exceptions to what could have been ongoing traps for the unwary in the calculation of the shareholder test.
In 2006, Treasury and the IRS issued a second round of temporary regulations (the initial -2T regulations) defining terms such as “directly or indirectly,” “substantial business activities,” and “by reason of holding stock in the domestic target corporation.” By and large, these were a good set of regulations and helped to shed light on a number of key statutory terms.
At the same time, however, both the initial -2T regulations and the final -1 regulations came with a number of admonitions regarding transactions that Treasury and the IRS regarded as abusive and not at all consistent with the purposes of §7874.
For example, in the initial -2T regulations, Treasury and the IRS dealt with perceived-to-be abusive inversions involving publicly traded partnerships with respect to which the regulations now treat certain publicly traded foreign partnerships (i.e., partnerships traded on an established market or readily tradable on a secondary market at anytime during the two-year period following the acquisition) as foreign corporations for purposes of determining whether they are surrogate foreign corporations, even if they are not otherwise treated as corporations due to the exemption provided by §7704(c) (relating to the exemption from treatment as a corporation if 90% or more of the partnership's gross income consists of qualifying passive income).
These regulations also dealt with avoidance techniques involving options and similar interests in which the regulations treat all such interests as having been exercised if the effect is to treat the foreign acquiring corporation as a surrogate foreign corporation.
So, too, in the finalization of the -1 regulations, Treasury and the IRS enumerated a number of areas in which it would issue regulations aimed at curbing abuses. For example, the IRS warned that it would issue regulations treating creditors in title 11 or similar cases as former shareholders of the U.S. target for purposes of determining whether stock in the foreign acquiring corporation is issued to them “by reason of holding stock” in the domestic entity.
In addition, the IRS promised regulations dealing with multiple domestic corporate transferors acquired by a foreign corporation as well as regulations dealing with attempts to avoid the clutches of §7874 through the use of intervening partnerships.
Well, a lot of these admonitions have come to pass in the adoption of the new -2T regulations which replace the now withdrawn 2006 initial -2T regulations. Indeed, while the new -2T regulations provide helpful guidance in a number of areas, they are replete with enhanced anti-abuse provisions. Perhaps most puzzling, if not disappointing, is the elimination of the safe harbor tests and illustrative examples in the definition of “substantial business activities,” the core of the initial -2T regulations. One gets the distinct impression that §7874 transactions are close to number one on the Treasury/IRS hit list.
The revised -2T regulations make a number of clarifying changes to the initial temporary regulations relating to stock held by partnerships and indirect acquisitions. However, some of the more significant changes/additions are as follows:
1. Acquisitions of a domestic corporation by multiple foreign corporations will result in each foreign corporation being treated as a surrogate foreign corporation if done pursuant to an overall plan. Thus, it cannot be claimed that each foreign corporation, separately, has not acquired “substantially all” of the properties of the U.S. target.
2. Acquisitions by a foreign corporation of multiple domestic corporations will be treated as the acquisition of a single entity if effected pursuant to an overall plan. As such, it cannot be claimed that, in determining whether the foreign corporation is a surrogate foreign corporation, the ownership percentage is computed separately with respect to each domestic corporation.
3. The acquisition of 60% or more of the stock of the foreign corporation “by reason of holding stock in the domestic corporation” now includes an acquisition of stock by the shareholders of the domestic corporation occurring by reason of an exchange or via a taxable or non-taxable distribution.
4. The safe harbor for determining whether the EAG which includes the foreign acquiring corporation has “substantial business activities” in the foreign acquiring corporation's country of incorporation has been removed as have the various examples initially set forth in the regulations. Thus, what was the core of the initial -2T regulations is no longer available as guidance. Reference is made to Treasury/IRS's belief that the safe harbor tests “may apply to transactions that are inconsistent with the purposes of §7874 which is meant to prevent certain transactions that seek to avoid U.S. tax by merely shifting the place of organization of a domestic corporation (or partnership).” Thus, taxpayers no longer have the ability to rely on the safe harbor or the examples and are left with determining their fate under the general facts and circumstances test.
5. The publicly traded foreign partnership rule, which, under certain circumstances, treats the partnership as a corporation for purposes of determining whether it may be a surrogate foreign corporation, has been expanded to include not only those publicly traded partnerships treated as corporations during the two-year period following the proscribed acquisition but also to partnerships whose interests become publicly traded outside of the two-year period if the public trading occurs pursuant to a plan that existed at the time of the acquisition.
6. A number of changes and clarifications have been made with respect to options and similar interests held in the domestic corporation or foreign acquiring corporations, especially in terms of determining the value of the options which are treated as stock.
7. The revised -2T regulations also deal with another perceived abusive transaction pursuant to which taxpayers use interests which, although not in a form convertible or exchangeable into stock of the foreign acquiring corporation, are the equivalent of having an equity interest in the foreign corporation. For example, a specifically targeted transaction involves a newly-formed publicly traded foreign corporation which acquires stock in a domestic corporation in the course of a merger, with the U.S. shareholders taking back a special class of stock in the resulting U.S. corporation. The class of stock held in the U.S. corporation by the former shareholders of the U.S. target company entitles such shareholders to dividend distributions equivalent to distributions made by an foreign acquiring corporation to its public stockholders and has mandatory redemption features. The regulations provide that the transaction will be treated as if the shareholders of the domestic corporation are shareholders of the foreign acquiring corporation for purposes of determining whether the shareholder test is met if the interest in the domestic corporation entitles the holder to distribution rights substantially similar to those to which the shareholders of the foreign corporation are entitled and if treating the stock as stock of the foreign corporation would have the effect of treating the foreign acquiring corporation as a surrogate foreign corporation.
8. As promised, the revised -2T regulations provide that, in the context of a title 11 or similar insolvency situation, the creditors of the insolvent corporation will be regarded as stockholders of the domestic target corporation who have received their stock in a foreign acquiring corporation “by reason of holding stock in the domestic corporation” (thereby precluding any claims that they did not receive stock in the foreign acquiring corporation “by reason of holding stock in the domestic corporation”).
9. Finally, the new -2T regulations provide their own set of warnings of regulations to be issued addressing the internal restructuring exception contained in the final -1 regulations, the upshot of which would be to deny the exception to certain divisive transactions in which all or a part of the stock of the foreign acquiring corporation is transferred out of the EAG that includes the foreign acquiring corporation.
So, where are we? We have a revised set of regulations replete with anti-abuse provisions. But, in addition, Treasury/IRS have gone further in pulling from the initial -2T regulations the safe harbor and illustrative examples in the area dealing with what constitutes “substantial business activities” of the EAG. This is not to say that some of the anti-abuse regulations are not warranted, but it seems like Treasury/IRS must have had a “bad 7874 day” and, as a result, went after this section with a vengeance.
Most importantly, however, it is not clear to me why the safe harbor and examples were yanked. Sure, people have been known to structure into safe harbors and to attempt to fit within particular examples. But isn't that what a safe harbor is all about? Shouldn't there be an understanding that a safe harbor is designed to give a clean demarcation between what should be OK and what shouldn't? Will we see our treaties applied in a different manner now, recognizing that the safe harbor was modeled after the safe harbor provided in many of our treaties as it relates to the “active trade or business” determination within the “limitation on benefits” provisions?
It is unfortunate that not only has §7874 been significantly tightened, it has become even more difficult to make a comfortable determination as to its applicability. Surely there could have been another way to deal with Treasury/IRS concerns, as, for example, by drafting additional anti-abuse regulations, providing for appropriate exceptions and additional examples, or by changing the safe harbor itself. We're left with just the general facts and circumstances test. What we now have is greater uncertainty amid even greater complexity.
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.
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