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By Kimberly S. Blanchard, Esq.
Weil, Gotshal & Manges LLP, New York, NY
On a nearly daily basis, one sees the question raised, "What explains the recent flood of inversions?" One answer that is never given, but should be, is that the IRS has defined inversions so broadly that virtually every cross-border deal has to be designed to avoid that overbreadth. The result is that many otherwise innocuous cross-border combinations look very similar to structured inversions. Neither §7874 nor the regulations thereunder contain any principled standards, so a perfectly innocent combination – even one, as we shall see, in which nothing of moment occurs – can be treated as an inversion. If one needs proof of that proposition, one need look no further than PLR 201432002 (May 1, 2014) (the "PLR").
The PLR appears to be the first and so far the only private letter ruling involving §7874. The transaction there looked nothing like an inversion, but was technically caught up in a §7874 analysis due to the manner in which the IRS treats "F" reorganizations.1 The IRS was able to rule that the transaction escaped the clutches of §7874 only because the transaction did not result in a termination of an "expanded affiliated group" ("EAG"). An EAG is a group described in §1504(a), except that it includes foreign corporations and the relevant ownership threshold is reduced from at least 80% to more than 50%.
The relevant facts and steps were as follows. A foreign corporation (Parent) that indirectly owned more than 50% of a U.S. corporation2 desired to raise capital to construct a facility in the United States through which the U.S. subsidiary's business would be conducted. Rather than attempt to raise capital in the U.S. markets, Parent decided to issue new shares of the U.S. subsidiary's immediate foreign parent, FS2. However, FS2 was formed in Country C, and Parent determined that the offering would get a better reception if the issuer were incorporated in Country G. For that reason, Parent undertook what we would call, and the ruling assumed was, an F reorganization. FS1, the owner of 100% of the stock of FS2, transferred all the shares of FS2 to FA, a new corporation set up in Country G.3 FS2 then made a check-the-box election to become a disregarded entity for U.S. tax purposes. Following this F reorganization, FA issued just under 20% of its shares in a private placement, and more shares pursuant to an IPO. The aggregate amount of new shares issued by FA was less than 49% of the total amount of FA stock outstanding after the issuances. Thus, FS1 retained more than 50% control of FA and the U.S. subsidiary.
A tax layman might inquire, "How is this potentially an inversion?" All that has happened is that FS2 has become FA and has issued new shares to third parties. None of this has any impact on the U.S. tax system. In fact, it is a sort of miracle that Parent's advisors even realized that there was a U.S. tax issue embedded in this simple series of steps. One wonders how many of us would have noticed (assuming we were asked to look at the steps) that this simple series of steps could implicate §7874.
The reason that §7874 is in fact implicated lies in the rather odd manner in which the regulations treat F reorganizations. Rather than disregarding an F reorganization as a mere change in form, as the statute would suggest, the IRS takes the view that an F reorganization, at least in the cross-border context, consists of three distinct deemed transfers. First, the old corporation (FS2 in the PLR) is deemed to transfer all of its assets, subject to all of its liabilities, to the new corporation (FA here) in exchange for FA stock. Second, FS2 is deemed to distribute the FA shares just received to its shareholder(s), here FS1, in a §361(c) liquidating distribution. Finally, the shareholder(s), here FS1, is deemed to exchange its FS2 stock for FA stock.4
It follows that FA is deemed to acquire all of the stock of the U.S. subsidiary owned by FS2. This "acquisition" implicates §7874. There are three requirements to find an inversion; two of those would clearly be met in this case and are not discussed further.5 The main event is the requirement of §7874(a)(2)(B)(ii) that, after the acquisition, at least 80%6 of FA's shares be held by former shareholders of the U.S. target by reason of their ownership of the U.S. target.
Literally, of course, none of the historic shareholders of the U.S. target own any stock of FA. That is because the sole historic shareholder of the U.S. target was FS2, which has been reorganized into FA. Nothing at all has happened to affect the ownership of the U.S. target. But in the deemed steps pertinent to an F reorganization, FS1 is deemed to exchange its FS2 stock for FA stock. If that were all there were to it, FS1 would own all of the stock of FA "by reason of" owning FS2 and an inversion would have occurred. FA would be treated as a U.S. corporation. Pursuant to §7874(c)(2)(B), the FA shares issued in the public offering are not counted in the ownership fraction. Moreover, under Reg. §1.7874-4T(b), the same is true for the stock issued in the private placement. Thus, the ownership fraction would be 100% if the FS1 shares were counted.
This untoward result could be fixed by ignoring the deemed steps in an F reorganization for purposes of §7874, and that would be by far the most straightforward and sensible solution to the problem.7 But that is not a route the IRS has as yet shown a willingness to take. Fortunately for the parties here, an existing exception from §7874 applied. Under §7874(c)(2)(A), stock held by a member of FA's EAG is not taken into account in determining the ownership fraction. Because it just so happened that FS1 owned just over 50% of the stock of FA even after the issuance of stock in the private placement and in the public offering, the FS1 stock was excluded from both the denominator and the numerator of the ownership fraction.8 The result was an ownership fraction of 0/0 and no inversion.
But consider what the result would have been if a third person had owned even a single share of FS2. That share would not be excluded by reason of the EAG exception, with the result that the ownership fraction would appear to be 1/1, and an inversion has occurred. Clearly, this is a result that makes no sense. The IRS addressed a similar problem by adopting a de minimis rule in Reg. §1.7874-4T(d)(1). But that de minimis rule by its terms applies only to turn off the disqualified stock rule of Reg. §1.7874-4T(b), which is implicated only where a foreign acquiror is formed with cash or other non-qualified property. It appears that the exception would not be available in this case, because the exception has not been coordinated with the EAG rule. This glitch was probably unintentional and is yet another example of how the regulations' wooden approach to counting stock ignores and frustrates the purpose of the statute.
Note that the PLR refers to the "frozen numerator" rule of Reg. §1.7874-5T(a). That rule is intended to preserve an inversion even where a shareholder of the U.S. target — who receives foreign acquiror shares "by reason of" owning the U.S. target — subsequently transfers those shares to an unrelated third party. In the deemed steps pertinent to an F reorganization, FS2 was deemed to have distributed the shares of FA it received to FS1 in a §361(c) distribution. Technically, this transfer implicated the frozen numerator rule. But, of course, it had no effect on the EAG rule, because FA was part of the EAG whether one tested by reference to FS2 (FA's predecessor) or by reference to FS1.
Why, then, was the frozen numerator rule mentioned prominently three times in the short PLR? In counting shares under the ownership test, only shares of the foreign acquiror that are held by "former shareholders" of the U.S. target are considered. As noted above, literally no former shareholders of the U.S. target in the PLR owned stock of the foreign acquiror, because the sole former shareholder of the U.S. target, FS2, became the foreign acquiror, FA. It appears that the IRS wanted to make clear that taxpayers cannot rely on the fact that the historic shareholder has disappeared to preclude an inversion.
I noted earlier that it is almost a miracle that the taxpayer even considered the applicability of the inversion rules. The PLR was over a year in the making, and it seems possible that the ruling sought was originally a different ruling,9 and that the inversion aspect was discovered only after the original submission. If that is the case, it could explain why FS1 retained just over 50% of the shares of FA. The original plan may have been to issue more FA stock for cash, which would have eliminated the taxpayer's ability to rely on the EAG exception.
The irony of the PLR is that it involved a foreign-owned U.S. corporation undertaking to finance the expansion of its U.S. operations. One would think that would be something our Treasury officials and politicians would be jumping all over themselves to support — it is the opposite of outsourcing jobs. The fact that this situation implicated the anti-inversion rules is further proof, if any were needed, that those rules are not based on principle, but on xenophobic political expedience.
The PLR also serves as a lesson that every transaction involving any foreign ownership of any U.S. corporation or U.S. partnership10 must be examined for the potential application of §7874. The PLR is also a reminder that an F reorganization is, in the IRS's view, a series of deemed transfers that can have important effects outside of Subchapter C.
This commentary also will appear in the November 2014 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.
1 That is, a tax-free reorganization described in §368(a)(1)(F).
2 It appears that slightly less than 50% of the U.S. corporation was owned indirectly by public shareholders of FS1, an intermediate entity described below.
3 For unexplained reasons, this was done through a disregarded entity, FDE3, set up in yet a third country.
4 Reg. §1.367(b)-2(f).
5 The other requirements are that FA acquire substantially all of a U.S. business, which it clearly is deemed to have done, and that FA not have substantial business activities in the country of its formation, which we can assume is not the case given that the IRS regulations have virtually eliminated this test from the statute by requiring that FA's business be concentrated in a single country in a manner inconsistent with the manner in which most multinationals operate.
6 The inversion rules apply where only 60% of the foreign acquiror's stock is owned by shareholders of the U.S. target. However, it is the higher 80% threshold of §7874(b) that is the focus of most planning in this area, because at that threshold the foreign acquiror is treated as a U.S. corporation.
7 The result could also have been fixed if the "cash is bad" regulations under Reg. §1.7874-4T were amended so as not to apply where the issuance of FA shares for cash has no purpose to avoid §7874. While this is clearly the correct answer to a myriad of problems with the untoward manner in which §7874 operates, don't look for it anytime soon.
8 Reg. §1.7874-1(b).
9 The caveats at the end of the ruling mention FIRPTA, and the ruling was signed by the IRS lawyer in charge of FIRPTA rulings.
10 Section 7874(a)(2)(B)(i) includes an acquisition of substantially all the properties constituting a trade or business of a U.S. partnership. This would cover even a tiny foreign business operation.
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