Expanding the Exclusion: The New §7874 Temporary Regulations

Edward Tanenbaum, Esq.

Alston & Bird LLP, New York, NY

This is the sixth in a series of commentaries I have written
about §7874 over the past few years. What that tells me (and it is
no secret) is that corporate inversions are thriving as Treasury
and the IRS (as well as the Administration) grapple with plugging
the holes and preventing a potential major drain of the U.S. tax
base.

First, the basics: Section 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 (or
substantially all of the properties constituting a trade or
business of a U.S. partnership);

2. the foreign acquiring corporation (or any affiliated company)
does not have substantial business activities in the
foreign country in which the acquiring corporation is organized;
and

3. immediately after the acquisition, the former shareholders of
the U.S. target corporation own at least 60% of the vote or value
of the foreign corporation by reason of holding stock in the
U.S. target corporation
.

If the former shareholders own between 60 - 79%, the U.S. target
is prevented for a 10-year period from using tax attributes to
offset income realized on the transfer of the stock or assets as
part of the inversion and also to offset income realized after the
inversion by way of license to a foreign related person.  If
the shareholders own 80% or more, the acquiring corporation itself
is treated as a U.S. corporation for all U.S. tax purposes.

In determining stock ownership under the statute, certain stock
is disregarded. In the first of two statutory "disregards," stock
held by members of the expanded affiliated group which includes the
foreign acquiring corporation (for this purpose, "affiliated" being
defined as more than 50% ownership) is disregarded (with some
regulatory exceptions for internal group restructurings and certain
acquisitive transactions). For example, if P owns 70% of S and X
owns the remaining 30%, and if they transfer their stock to a
foreign corporation taking back 70% and 30% respectively, the stock
of P is disregarded and X would then be considered as owning 100%
of the foreign corporation resulting in an inversion.

In the second statutory "disregard," stock of the foreign
acquiring corporation that is sold in a public offering related to
the acquisition is also disregarded. The purpose of this rule is to
prevent an end-run around §7874 by allowing cash or other property
to be transferred to the foreign corporation in a public offering,
thereby diluting the ownership of the former shareholders of the
expatriating entity to below the 60% (or 80%) mark.

You read that right - stock sold in a
public offering, with the implication being that
stock issued in a private placement would be taken
into account, thereby (favorably) increasing the denominator of the
stock ownership fraction in testing for inversions.

Well, not so fast. Along comes Notice 2009-78 telling us that
stock of a foreign acquiring corporation issued in exchange for
"nonqualified property" in a related transaction will not be taken
into account for purposes of the threshold stock amounts. For
example, if the individual shareholders of a U.S. target transfer
shares to a foreign corporation in exchange for 79% of the stock
and an investor transfers cash for 21%, the stock received in the
exchange for the cash transfer will be disregarded (and not counted
in the ownership fraction, resulting in an inversion).

Nonqualified property would include cash, cash equivalents,
marketable securities as defined in §453(f)(2), and any other
property acquired in a transaction the principal purpose of which
is to avoid the purposes of §7874.

An example of the anti-abuse provision would be if, in a related
transaction, a partnership were to transfer marketable securities
to a newly formed foreign corporation whose stock is then
transferred to the foreign acquiring corporation. In that case, the
stock of the foreign acquiring corporation issued to the
partnership in exchange for the newly formed target foreign
corporation is disregarded because the principal purpose is the
avoidance of the purposes of §7874.

At the same time, however, Notice 2009-78 stated that certain
stock otherwise excluded under the statutory public offering rule
should still, in fact, be taken into account because a contrary
result would seem inappropriate. For example, if a publicly held
U.S. corporation and a publicly held foreign corporation are
acquired by a foreign acquiring corporation, the foreign acquiring
stock issued in exchange for the stock of the publicly held foreign
corporation would not be considered as sold in a public offering
and would not be excluded from the ownership fraction.

On January 16, 2014, Treasury and the IRS issued new temporary
and proposed regulations under §7874 implementing the provisions of
Notice 2009-78. Thus, in the first instance, "disqualified stock"
(i.e., stock of the foreign acquiring corporation issued in
exchange for "nonqualified property") will be disregarded and
excluded from the denominator of the ownership fraction.
"Non-qualified property" has the same meaning as that contained in
Notice 2009-78 except that it also includes "disqualified
obligations," i.e., an obligation of a member of the expanded
affiliated group that includes the foreign acquiring corporation,
or an obligation of a former shareholder or partner of the acquired
U.S. entity, or a person who, before or after the acquisition,
either owns stock of a person described above or is related to any
such person. Disqualified stock also includes stock of a foreign
acquiring corporation transferred to a person in exchange for
property when, pursuant to a plan or series of transactions, the
stock is subsequently transferred for the satisfaction or
assumption of an obligation associated with the exchanged
property. 

However, in a nod toward narrowing the statutory public offering
rule as contemplated in Notice 2009-78, marketable securities will
not include stock of a corporation that becomes a member of the
expanded affiliated group that includes the foreign acquiring
corporation in a transaction related to the acquisition unless the
principal purpose of the acquisition is the avoidance of
§7874.  Thus, publicly traded stock of such a foreign target
corporation does not constitute marketable securities and,
therefore, is not nonqualified property.

Stock of a foreign acquiring corporation may be disqualified
regardless of whether it is transferred by issuance, sale,
distribution, exchange, or other disposition, or transferred by the
foreign acquiring corporation to another person.

However, only acquisition-related transactions that increase the
net assets of the foreign acquiring corporation (or decrease its
liabilities) can give rise to disqualified stock.  For
example, the exclusion rule generally does not apply to transfers
of stock by a shareholder of the foreign acquiring corporation to
another person.

There is some liberalization, however, contained in the
regulations in that a de minimis exception provides
that the exclusion rule will not apply to certain transactions with
unrelated parties if the ownership fraction (without regard to the
rule) is less than 5% by vote and value. Thus, if less than 5% of
the foreign acquiring corporation's stock is issued to shareholders
of the target company, the regulations recognize that the
transaction is more like a sale with only a small number of
shareholders retaining ownership. Reasonable people may disagree as
to whether the percentage should be higher and the IRS has signaled
that it is willing to listen to comments.

A significant issue that's gotten a lot of press in the context
of the exclusion rule is the apparent disparity between the
exchange of stock for shares of the foreign acquiring corporation,
on the one hand, and the exchange of assets for shares of the
foreign acquiring corporation, on the other.

The Preamble makes clear that there was a conscious decision to
distinguish between the two types of transactions, with stock of
the foreign acquiring corporation issued for stock of a foreign
target not constituting nonqualified property (regardless of
whether the foreign target holds nonqualified property) and with a
transaction structured as an asset acquisition being subject to the
exclusion rule depending on the assets involved. Treasury and the
IRS apparently felt that harmonizing the two types of transactions
(via a look-through rule or otherwise) would add too much
complexity.

Another interesting (but complicated) area relates to the
interaction of the exclusion rule and the expanded affiliated group
rule. The temporary regulations establish the concept that each
rule operates independently of the other. Thus, stock of the
foreign acquiring corporation is not taken into account in the
denominator of the ownership fraction if either the exclusion rule
or the expanded affiliated group rule applies, although the
exclusion rule does not apply for purposes of actually applying the
expanded affiliated group rule. Make sense?

An "easy" example is provided in the regulations: P corporation
transfers 85 shares of a U.S. corporation, and individual A
transfers the remaining 15 shares in the U.S. corporation, to a
foreign acquiring corporation, in exchange for 85 shares and 15
shares, respectively, of the foreign acquiring corporation, while
PRS (a partnership) transfers $75 cash to the foreign acquiring
corporation for 75 shares. Under the exclusion rule, PRS's 75
shares in the foreign acquiring corporation are not counted in the
denominator.  So the "initial" denominator of 175 becomes 100
(thereby potentially increasing the possibility of an
inversion).

However, in testing whether the expanded affiliated group
exclusion applies (and/or the internal group restructuring
exception), the shares of excluded stock held by PRS are included
in the denominator.  So, if P owns 85 shares out of 175
shares, its percentage ownership is only 48.6%; therefore, it is
not part of an expanded affiliated group and its shares of stock
count in the ownership fraction (and the internal group
restructuring exception does not apply because it does not own 80%
or more of the foreign acquiring corporation after the
acquisition). Bottom line: P's 85 shares and A's 15 shares count in
the numerator (for a total of 100) and, with the denominator being
100 (because of the general exclusion rule applicable to PRS's
shares), an inversion occurs (100/100).

Along the same lines, try this one on for size: P owns 85 shares
of the foreign acquiring corporation and PRS contributes $15 cash
for 15 shares. Under the exclusion rule, the 15 shares are
excluded. In testing P under the expanded affiliated group rule,
however, the excluded shares count in the denominator. So, P owns
85 out of 100, qualifying as part of the expanded affiliated group
which includes the foreign acquiring corporation. Thus, its 85
shares are excluded under the statutory rule and under the internal
group restructuring exception. PRS's 15 shares are also excluded in
the equation, which means no inversion.

While the temporary regulations bring some welcome changes,
e.g., the de minimis exception and the narrowing of
the statutory public offering rule, the temporary regulations will
make falling outside of §7874 more difficult, especially coupled
with the relatively new bright-line test for "substantial business
activities" set forth in the 2012 regulations. Moreover, Treasury
and the IRS have promised that they will continue to study the
potential for abuse in this area and further means to prevent it.
There will be more forthcoming "guidance" to be sure.

This commentary also will appear in the May 2014 issue of
the
 Tax Management International Journal.  For
more information, in the Tax Management Portfolios, see Streng, 700
T.M.
, Choice of Entity, 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.