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By Kimberly S. Blanchard, Esq.
Weil, Gotshal & Manges LLP, New York, NY
As I write this, the new "inversion" guidance of Notice 2015-791 (the "Notice") is hot off the presses. This commentary will simply lay out the important aspects of the Notice and will not, as an earlier piece did, get into authority questions (although there would seem to be many).2 This commentary assumes that the reader is generally familiar with §7874 and prior guidance thereunder.
The Notice augments and in some minor respects modifies Notice 2014-52 (the "2014 Notice"). It is a bit surprising that the IRS issued yet another Notice to deal with inversions before issuing regulations under the 2014 Notice. It had generally been thought that the IRS would soon publish regulations fleshing out the various new rules set out in the 2014 Notice. That would have been nice, since there are many questions raised and left unresolved by that earlier Notice. Now, with the new Notice, we have more unresolved questions to deal with.
The Notice is organized along the same lines as the 2014 Notice. Like the earlier notice, it has a few rules designed to catch more transactions under §7874. And like the earlier notice, it also has a few rules that bite when §7874 applies, that is, where, as a result of the transaction, 60% or more, but not 80% or more, of the stock of the foreign acquiror is held by persons by reason of owning stock of the U.S. target.
Rules Designed to Catch More Transactions as Inversions
Substantial Business Activities
At §2.02(a), the Notice contains an interesting new rule that counts substantial business activities toward the "out" provided by §7874(a)(2)(B)(iii) only if the foreign corporate parent is tax resident in the country in which those activities take place. The concern here was that the foreign parent might be incorporated in a country where substantial business activities take place, but tax resident in a different country under a "mind and management"-type test for corporate residency common outside the United States.
Imagine a foreign corporation whose business activities are centered in a relatively high-tax country but that is managed and controlled in a lower-tax country. Many countries outside the United States employ a tie-breaker residence rule under their treaties that treats the country where the corporation's mind and management (usually its board) is centered as trumping residence by incorporation. That kind of tax break is anathema to the United States, so it is not surprising that the Notice goes after it.
U.S. corporations looking to combine with foreign ones, and that seek to rely on the substantial business activities test to avoid §7874, should be careful to ensure that the foreign corporation involved is tax resident in the country where those activities are centered.
Third-Country Foreign Parents
Section 2.02(b) of the Notice announces a surprising new rule that would exclude stock received by shareholders of a foreign combining corporation from the denominator of the ownership fraction where the transaction is structured using a foreign parent formed in a different foreign country. For example, both the U.S. target and the foreign combining entity, resident in, let's say, Japan, may be acquired by a new foreign parent resident in, let's say, Ireland. Several cross-border mergers have taken this form, often referred to as a "double dummy." Where this occurs, the Notice would treat the stock in the Irish parent received by shareholders of the Japanese corporation in the same way the rules treat stock received by the shareholders of the U.S. target. In most cases, this will result in an ownership fraction of 100% and will cause the Irish parent to be treated as a U.S. corporation. However, this rule applies only if the combination would otherwise be an inversion (i.e., shareholders of the U.S. company would own between 60% and 80% of the foreign acquirer).
The stated rationale for this new rule is that the IRS believes that the use of a third-country parent is tax-motivated. In this author's experience, this is almost never true. Combining companies will always explore the possibility of using a new parent, usually for securities law reasons, sometimes for tax reasons relevant in the foreign country, and for other reasons pertinent to listing the new company if it is to be publicly traded. In some cases, a new foreign parent is used but formed in the same foreign country as the combining foreign corporation. These cases, which are not covered by the Notice, are quite obviously not tax-motivated. But even where a third country parent is used, the tax motivations typically pale in comparison to the business reasons for structuring the combination in this manner.
The Notice justifies this extraordinary restraint on trade by pointing out that the third country may have been chosen for its tax treaty network or prevailing low tax rates. To the extent taxes come into this, this is obviously true. As long as this author has been practicing (sadly, for almost 35 years), in every case where two companies from different countries seek to combine, they will consider three options: (1) put one on top; (2) put the other on top; or (3) put a third-country entity on top. It would be ridiculous in the context not to consider things like tax treaties and local tax rates, as well as the scope of any local CFC rules. So what? If there are good and sufficient business reasons to put a U.S. company on top, and those reasons outweigh the inevitably suboptimal tax results of doing so, that is what the parties will do. If it makes more sense to put the foreign combining company on top, or to use a new foreign entity, that is what the parties will do. For the Notice to put its finger on this scale is truly unprecedented.
There is, moreover, no logic in this rule. The rule treats stock of the foreign acquiror issued to shareholders of the foreign combining company as if that stock had been issued to the shareholders of the U.S. target. The only "logic" offered up in the Notice for this rule is that Congress intended the 80% "pure inversion" rule to apply where the foreign combining corporation's shareholders did not own a sufficient interest in the foreign acquiror to evidence a lack of tax motivation for the combination. But that makes sense only if one supposes that the shareholders of the foreign company end up with less than 20% of the combined entity, which of course is not the case in the situation addressed by this new rule. The obvious purpose of the 80% test was to shut down naked inversions, and the structure targeted by this rule has no resemblance at all to a naked inversion. It is not logically different from a double dummy that uses a new foreign parent formed and resident in the same country as the foreign combining corporation.
Section 2.03 of the Notice seeks to clarify the anti-abuse rule of Reg. §1.7874-4T by emphasizing that the nonqualified property rule extends to property other than cash and marketable securities, where that property is acquired for a principal purpose of avoiding §7874. For the most part, this section of the Notice does nothing more than say "We really meant it!" According to the Notice, some taxpayers construed the principal purpose rule as limited to situations in which cash and marketable securities were put into a corporation, the stock of which was contributed to the foreign acquiror.
The Notice as written is unremarkable in this respect. Stuffing is bad if the principal purpose of stuffing is to avoid §7874. But the Notice then sets out an example that appears to make a distinction between stuffing an existing foreign corporation and contributing assets to a new foreign corporation. The example turns the rule upside down. The example cannot possibly be correct since, among other things, it flatly contradicts Example 3 of Reg. §1.7874-4T(j), which is never mentioned or withdrawn.
In the example, a foreign partnership unrelated to the U.S. target transfers business assets (not nonqualifying property) to a newly-formed foreign acquiror in exchange for its stock as part of a combination in which shareholders of the U.S. target exchange stock of the U.S. target for foreign acquiror stock. The example treats this as a stuffing transaction and accordingly excludes the stock received by the foreign partnership from the denominator of the ownership fraction.
Why does this example conclude, without explanation, that the foreign partnership's contribution of business assets to the foreign acquiror was done with a principal purpose to avoid §7874? If the foreign partnership was not a publicly traded partnership treated as a foreign corporation under Reg. 1.7874-2(g), it could have acquired the U.S. target directly without implicating §7874. It is hard to understand why the taxpayers here could be in a worse position by doing something indirectly than if they had done it directly. It appears from this example that the IRS believes that there is something improper about using stock of a foreign corporation as opposed to an interest in a foreign partnership. Example 3 of the existing -4T regulations involves two scenarios, one involving a double dummy and the other a foreign-to-foreign "F" reorganization. The example concludes that neither implicates the principal purpose test, and that stock of a foreign corporation that becomes a member of the expanded affiliated group is not nonqualifying property. Indeed, no other conclusion could possibly make sense. The sole distinction between that example and the example in the Notice is that the entities involved are all corporations.
If the Notice's innocuous example triggers an anti-stuffing concern, the potential application of the principal purpose test would seem to be unlimited, and no cross-border combination, even well under 50%, could pass muster under §7874. One can always hypothesize a transaction that might have been an inversion but for the fact that qualifying property was acquired, at some point in time, by the foreign acquiror.
New Rules Applicable to 60-80% Inversions
Indirect Transactions Treated as Inversion Gain
It is sometimes forgotten that the first rule of §7874, §7874(a)(1), does nothing more than prohibit the use of losses or other tax attributes to reduce an expatriated entity's "inversion gain." Section 7874(d)(2) defines "inversion gain" to include income earned, during the 10-year period following the inversion, by reason of a sale or license of property to a related foreign person. Section 3.01 of the Notice expands the definition of inversion gain to include Subpart F income earned by the U.S. target attributable to a sale or license by one of its historic CFCs. For example, if following an inversion a CFC of the U.S. target sells property to the foreign acquiror or one of its affiliates, and the sale would give rise to Subpart F income (e.g., because the property is held for investment), the resulting Subpart F inclusion will be treated as inversion gain. Therefore, such inclusion cannot be offset by net operating losses or other tax attributes of the U.S. target.
Given that this rule applies to property that was already held outside the United States, the theoretical basis for the rule is weak. What the IRS is objecting to here is that the property is leaving a CFC. In that sense, the rule is parallel to the §956 "hopscotch" rule in the 2014 Notice.
This new rule is odd in that it can apply only where the indirect transaction results in a Subpart F inclusion. That limitation, of course, is clearly required by the language of the statute. But the result is a rule that is both under- and over-inclusive. If the property were an asset held for use in the CFC's business, it could be transferred without any inclusion, and the new rule would not apply, even if the purpose of the sale was to extract property from the U.S. tax net. If the property is the type of property the sale of which gives rise to a Subpart F inclusion, the gain would be treated as inversion gain even if there were a good business reason to transfer it. In sum, there does not appear to be any logical link between the transaction giving rise to the inclusion and any purpose of avoiding §7874.
The Notice also contains a curious rule stating that if a partnership sells or licenses property, each partner will be treated as having done so, "as determined under the rules and principles of sections 701 through 777." But nothing in those sections (Subchapter K) treats a partner as having engaged in a transaction that the partnership engages in.3 The most that can be said is that the "Brown Group regulations" promulgated under Subpart F can have that effect.
The Expansion of §367(b)
When a nonrecognition transaction has the result of converting a foreign subsidiary of a U.S. parent from a CFC to a non-CFC, the regulations under §367(b) generally require the U.S. parent to recognize income in an amount equal to the unrepatriated earnings and profits ("E&P") of the former CFC. This longstanding rule is based on the corporate dividend model underlying Subchapter C of the Code, under which only the E&P of a subsidiary is taken into account by its parent. For the same reason, §952(c) limits Subpart F inclusions to the amount of a CFC's E&P. Any gain attributable to unrealized appreciation in the CFC's assets is taken into account only when the stock of the CFC (or former CFC) is sold.
It is therefore very surprising that §3.02 of the Notice rewrites Subchapter C to require that, when a CFC ceases to be a CFC or otherwise is subject to the rule in §3.02(e)(ii) of the 2014 Notice (which can apply even if a CFC remains a CFC), the U.S. parent must take into account the full amount of gain inherent in the stock of the CFC. Although the Notice does not say so, one must assume that the U.S. parent's basis in the stock or other property received in the exchange is increased by the amount of gain so included in income.
Other Provisions of the Notice
The Notice makes several clarifying changes to the 2014 Notice, most of which correct the overbreadth of the earlier Notice. It does not, as many anticipated it would, offer new earnings-stripping rules, but again asks for comments on that question.
The provisions of the Notice are generally prospective in application, becoming effective for acquisitions completed on or after November 19, 2015. Several provisions that expand or modify the 2014 Notice also apply on and after November 19, 2015, but only if the underlying inversion occurred after the effective date of the 2014 Notice, i.e., September 22, 2014.
Despite the rather breathless tone of the "Fact Sheet" accompanying the Notice, not all "inversions" involve "multinationals" or even U.S. corporations that own any foreign subsidiaries. Nor are all "inversions" undertaken "in order to avoid U.S. taxes." There is no natural rule dictating that in a cross-border combination the U.S. corporation has to come out on top. Simple cross-border mergers involving U.S. corporations, including those motivated solely by non-tax business goals, can be caught by these rules. Inadvertent inversions are a very real phenomenon.
In its seemingly unending campaign to tighten the screws on cross-border combinations, the IRS (acting at the behest of Treasury, which is no doubt acting at the behest of the White House and perhaps certain members of Congress and certain Presidential candidates) is certainly accomplishing one thing: Any U.S. taxpayer or group of taxpayers considering the creation of a new business that has the potential to expand outside the United States should seriously consider incorporating that business outside of the United States. This is the only avenue available to avoid the increasingly irrational penalties imposed on cross-border combinations.
This commentary also appears in the January 2016 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 Income.
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