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By Thomas S. Bissell, CPA
An issue that is often overlooked in the discussion of the "anti-inversion" rules of §7874 is an "excise tax" that can be imposed on certain officers and directors of a U.S. corporation that successfully "inverts" into a foreign corporation. If the threshold rules of §4985 are satisfied, then the corporation's employees and directors who are "insiders" (as determined for SEC purposes) are potentially subject to a 15% excise tax on the value of their "specified stock compensation" (referred to herein as "SSC") in the corporation that is being "inverted."1 SSC is broadly defined to include virtually all kinds of equity-based compensation, including but not limited to stock option rights (whether "real" or "phantom"), stock appreciation rights, and restricted stock rights (again, whether "real" or "phantom"), and payments related thereto. The excise tax is not deductible by the individual "insider," and it is apparently not added to the individual's basis in determining any subsequent U.S. income tax that is imposed on the individual with respect to his/her SSC rights.
In order for the tax to apply with respect to any insider, all of the following tests must be met with respect to the corporate restructuring that takes place:
— The insider's SSC rights must have been granted by a U.S. corporation2 that is restructured into a foreign corporation that (after the restructuring) is a "surrogate foreign corporation" under §7874(a)(2)(B). Thus, if after the restructuring the shareholders of the inverted U.S. corporation own less than 60% of the stock of the acquiring foreign corporation by reason of owning stock in the inverted U.S. corporation, the §4985 tax does not apply. Similarly, if after the restructuring they own 80% or more of the acquiring foreign corporation, that corporation would be usually classified as a U.S. corporation under §7874(b) (so that the restructuring in effect would be a "failed inversion"), and the §4985 tax would not apply.
— The §4985 tax is imposed only if gain is "recognized" (in whole or in part) by "any shareholder" in the expatriated U.S. corporation. If the transaction is arranged as a §368-type of reorganization, gain realized by shareholders who are U.S. persons would usually be "recognized" under the two "more than 50%" rules in Reg. §1.367(a)-3(c)(1)3 — unless, of course, all such shareholders realized a loss (or neither gain nor loss) on the exchange of their stock. Similarly, if the restructuring is arranged as a fully taxable transaction, and if any single shareholder realized gain on the exchange, the §4985(c) threshold test would be met; conversely, if every shareholder realized a loss (or realized neither gain nor loss), §4985 would not apply.
— In determining whether gain is "recognized," an interesting issue would arise if all the shareholders in the U.S. corporation were nonresident aliens and/or foreign corporations, and if gain that is "realized" on the restructuring is not actually "recognized" under §871 or §882.4 This would usually happen in situations where the foreign shareholders had been poorly advised when they initially formed or acquired the U.S. corporation, and where they subsequently learn that the corporation's foreign operations should be conducted through "brother-sister" foreign corporations instead of through "controlled foreign corporations." This could also happen even though the U.S. corporation has no foreign operations, but where the nonresident alien shareholders discover that they are exposed to potential U.S. estate tax on their shares in the U.S. corporation, and enter into an inversion transaction so as to eliminate that risk.
— The U.S. corporation must be subject to the requirements of §12 of the Securities Exchange Act of 1934 (the "1934 Act") in order for its officers and directors to be subject to the "insider" rules of §16. Thus, even though the corporation is not "listed" on a stock exchange and even though its shares are not actively traded over-the-counter or in the "pink sheets," the corporation could be subject to the 1934 Act for a variety of reasons. If it is, the §4985 excise tax can potentially apply to officers and directors who own SSC rights.
— Section 4985(e)(1)(B) provides in effect that if the U.S. corporation's officers and directors are not subject to §16(a) of the 1934 Act, the tax may nevertheless apply to them if they "would be subject to such requirements if such corporation … were an issuer of equity securities referred to" in §16. It is not clear from the statute exactly what this means (the Committee Reports do not explain it, and there has been no IRS clarification since the tax was enacted), or how broadly this language extends. In theory, this could mean that a small closely held corporation (such as a "mom and pop" business) is automatically subject to §4985 on a hypothetical basis, and as a result its officers and directors are potentially subject to the tax if they hold any SSC rights in the corporation. In a closely held corporation, however, it would be less likely for officers and directors to hold SSC rights than in a corporation whose stock is publicly traded.
If the threshold requirements are all met with respect to the expatriating corporation, the following are the most important rules that can apply to a particular "insider":
— In order to be subject to the tax, the individual must be a "disqualified individual" within the meaning of §4985(e)(1), i.e., an individual who is subject to the requirements of §16(a) of the Securities Exchange Act of 1934 with respect to the corporation that is being restructured.5 As noted above, however, it is possible that the broadened definition of the term "disqualified individual" in §4985(e)(1)(B) could potentially apply to virtually every U.S. corporation that restructures into a "surrogate foreign corporation," and where some or all of its officers and directors have SSC rights in the corporation.
— The tax is imposed on the "value" of the disqualified individual's SSC rights as of the "expatriation date." The statute provides that this means the "fair value" of stock option or stock appreciation rights, and "fair market value" in the case of other SSC rights. (The Committee Reports give some guidance with respect to these terms.) The tax may also be imposed in the case of SSC rights that are canceled within six months prior to the expatriation date, and SSC rights that are granted within six months after the expatriation date. In the case of restricted stock or restricted stock rights, the value of the SSC rights must be determined without regard to the restrictions.6 It is also clear that the tax can apply to both "vested" and "unvested" SSC rights.
— Although §4985 does not state whether the individual may deduct the amount of the tax for U.S. income tax purposes, the House Report states that "the payment of the tax [by the individual] is not deductible." This seems to be correct based on the provision in §4985(f)(5) to the effect that the tax is considered to be an "income tax" (under Subtitle A). Under §275, no deduction is allowed for U.S. income taxes.
— Although §4985 does not mention the potential effect of the tax on the individual's basis in stock that may be owned or acquired as part of the individual's SSC rights, the House Report states that " … the payment of the tax has no effect on the individual's basis in any [SSC] and no effect on the tax treatment for the individual at the time of exercise of an option or payment of any [SSC], or at the time of any lapse or forfeiture of such [SSC]." This statement appears to be correct for SSC rights that are settled entirely in cash, although, to the extent that actual corporate stock is owned or acquired by the individual at some point in time, there may be an argument under general principles in favor of adding the amount of the excise tax to the stock basis.
— If the corporation reimburses the insider for the tax, §4985(f)(2)(A) treats the reimbursement itself as subject to the tax (although this rule raises obvious "tracing" issues). Thus, if the corporation wishes to "make whole" the insider (as apparently happens in the case of most inversions), an algebraic calculation must be done which takes into account not only the amount of income tax (federal, state, and local) on the amount of the reimbursement, but also social security tax (including in many cases the .9% additional Medicare tax), and the §4985 tax itself (although in all likelihood not the 3.8% "net investment income tax" under §1411). Depending on the individual's facts, therefore, the cost of the gross-up to the corporation could be as high as three times the amount of the reimbursement for the excise tax. In addition, §4985(f)(2)(B) provides that a corporate income tax deduction is denied to the corporation with respect to reimbursement of the tax (including, presumably, the "gross-up" portion of the reimbursement); whether a corporate tax deduction would be allowed for state and local income tax purposes, however, would vary from state to state.
— Section 162(m)(4)(G) provides that, to the extent a corporation does reimburse an employee for the amount of the §4985 tax, the reimbursement must be counted towards the $1,000,000 "cap" on compensation that the corporation may deduct (notwithstanding the fact that a deduction for the reimbursement is denied under §4985(f)(2)(B)).
— The §4985 tax does not apply to incentive stock options under §422, to employee stock purchase plans under §423, or to payments from certain qualified plans in §§401 ff.
— A U.S. citizen or resident alien who is subject to the tax reports it for 2015 on Form 1040, line 62, box c, and enters code "ISC" (for "insider stock compensation") next to the amount of the tax. However, there does not appear to be any requirement on the part of the corporation to report the existence of the SSC rights on IRS Form W-2 (in the case of an employee) or Form 1099 (in the case of a director), or on any other IRS form. Nor does there seem to be a requirement that the corporation identify actual SSC payments or reimbursements as such on any IRS forms, apart from the general rules that apply to all employee compensation and/or all directors' compensation. Thus, in a sense, the excise tax itself is entirely "self-assessed."
— Based on the language of §4985, it does not appear that the excise tax can be imposed on individuals who are "insiders" (whether actual or potential) of the foreign acquiring corporation, and who may have SSC rights in the acquiring corporation.
An unusual feature of §4985 is that it apparently is imposed not only on individuals who are subject to U.S. income tax on their SSC rights — i.e., U.S. citizens and resident aliens, and nonresident aliens with U.S. workdays who are subject to U.S. income tax on their U.S.-source earned income — but also on nonresident aliens who are exempt from U.S. income tax on some or all of their SSC rights or payments because some or all of their earned income is for services performed outside the United States (and is thus foreign-source income exempt from tax under Subchapter N). Because §4985 imposes the tax without regard to whether the SSC gives rise to U.S.-source income, this may be the correct interpretation of the statute, although the Committee Reports nowhere discuss this fact pattern. The IRS is clearly aware of the issue, however, because the instructions to Form 1040NR state that the §4985 tax (if applicable) must be reported on line 61 ("other taxes") in the same manner as the tax is reported by a U.S. citizen or resident alien — although the instructions do not mention the source-of-income issue. Because it has become increasingly common in recent years for nonresident aliens working outside the United States to be classified as "insiders" for SEC purposes, the author will discuss this particular issue (including the tax treaty implications) in a subsequent commentary.
This commentary also appears in the March 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 Taxation.
Copyright©2016 by The Bureau of National Affairs, Inc.
1 Although the maximum potential capital gains tax is now 20% and not 15%, §4985(a)(1) imposes the excise tax at the rate prescribed in §1(h)(1)(C), which is still the 15% rate that it was in 2004 when §4985 was enacted. The 20% capital gains tax rate was enacted subsequently in §1(h)(1)(D) with respect to certain high-income taxpayers, but §4985 was never amended to change the 15% rate to 20%.
4 Unless the U.S. corporation is a "United States real property holding corporation" under §897(c)(2), it would be unusual for the gain to be "recognized" by either a foreign corporate shareholder (under §882) or a nonresident alien shareholder (under §871(a)(2) or §871(b)).
5 Although individual shareholders who own 10% or more of the corporation are usually classified as "insiders" as well, as a practical matter it would be unusual for such a shareholder to be granted SSC rights unless the shareholder also happened to be an officer or director of the corporation.
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