Section 7874's 'Substantial Business Activities' Test—Third Set of Temporary Regs Issued

By Philip D. Morrison, Esq.  

Deloitte Tax LLP, Washington, DC

Section 7874, as readers know, will convert an otherwise foreign corporation ("Forco") into a U.S. corporation if: (1) Forco acquires substantially all of the properties of a U.S. corporation; (2) after the acquisition there is 80% or more continuity of the U.S. corporation's shareholders' interests (i.e., former U.S. corporation shareholders hold 80% or more shares in Forco "by reason of" having held U.S. corporation shares);1 and (3) the expanded affiliated group that includes Forco does not have substantial business activities in Forco's country of incorporation. Twice before, once in 2006 (REG-112994-06, T.D. 9265) and again in 2009 (REG-112994-06, T.D. 9453), the IRS promulgated temporary regulations defining what constitutes "substantial business activities" in Forco's country of incorporation. On June 7, 2012, narrowly avoiding the sunset of the 2009 temporary regulations, the IRS issued a third set (REG-107889-12, T.D. 9592). Unfortunately, it is the most problematic of the three. The new regulations will prevent virtually all large U.S.-parented multinational groups from using the substantial business activities exception to §7874, even those that actually have very substantial business activities in Forco's country of incorporation.

The point of the third of the three statutory requirements noted above, of course, is to not prevent the re-incorporation of a U.S. corporation in a foreign jurisdiction where that corporation has real and significant business activities. The motivation for the enactment of §7874, for the most part, was Congressional concern over U.S. companies expatriating to low-tax jurisdictions where they had no more than a letterbox or small office. The third statutory requirement reflects that thinking by permitting an expatriation to a country where the global group has substantial business.

The 2006 temporary regulations reasonably interpreted the statute by providing for a facts and circumstances test supplemented by a safe harbor. The safe harbor was met if 10% of: (1) global group employees (by headcount and compensation); (2) group assets (by value); and (3) group sales, were located in (or, for sales, were "made in") the foreign country in which the U.S. corporation was re-incorporating itself. Relevant factors for the facts and circumstances test, in addition to the safe harbor factors, included historical presence, management activities, ownership, and "strategic factors" (i.e., business activities that are material to the achievement of the global group's overall business objectives).

While the 2006 regulations prevented the sorts of letter-box-company expatriations that motivated Congress to enact §7874, apparently the IRS and Treasury had second thoughts about the safe harbor. Although it made sense for the typical, globally dispersed multinational enterprise, especially since it was a safe harbor and not a "floor," apparently it was thought inappropriate for an enterprise that had operations predominantly in the United States and very little abroad. After further thought, apparently a corporate group with 10% of its assets, employees, and sales in Switzerland, and over 80% of its assets, employees, and sales in the United States did not appear to the regulation writers to be a sympathetic candidate for an automatically permitted expatriation.

The 2009 regulations remedied this perceived problem by dropping the safe harbor. Those regulations retained the facts and circumstances test, including the non-exclusive list of relevant factors. They also added verbiage to make clear the point that "substantial business activities" in a particular jurisdiction was a relative thing-it had to be measured by comparing business activities in the desired jurisdiction to global business activities of the group. While less easy to opine upon, and less easy for the IRS to administer, at least the 2009 regulations did not prevent the use of the substantial business activities approach to avoiding the application of §7874. Abusive expatriations would be prevented; expatriations to countries where a global group had real and substantial business activities could proceed.

After the promulgation of the 2009 regulations, there were rumors that some advisors were willing to opine that a global group had substantial business activities even if it failed to meet the prior, 2006 regulations' 10% safe harbor. While that seemed unlikely to this author, and following such advice even unlikelier given the draconian result if such advice was wrong (i.e., a foreign corporation being considered U.S.), apparently the regulation writers still had third thoughts about the rule. Unfortunately, the third approach appears to have gone further than reasonably necessary and effectively repeals the substantial business activities exception to §7874.

The new temporary regulations abjure the use of either a safe harbor or a facts and circumstances test. Instead, they set a quantitative threshold or "floor" for required business activities in the country of incorporation of Forco. They use the three factors used for the 10% safe harbor in the 2006 regulations, though the sales or income factor is altered in a way that makes it extraordinarily difficult to meet (likely impossible for large multinational groups).

The three-factor floor of the new regulations requires that each of the three factors equal or exceed 25%. That is, group employees, group assets, and group income located or derived in Forco's country of incorporation must equal at least 25% of worldwide group employees, assets, and income.

The employee factor is defined in the same manner as the employee factor in the 2006 regulations' safe harbor. Thus, both the number of Forco group employees located in Forco's country of incorporation and their compensation must be at least 25% of the global Forco group's total number of employees and their total compensation. 

The asset factor is also generally defined in the same manner as its 10% analog in the 2006 regulations. Thus, 25% of the value of worldwide group assets must be located in Forco's country of incorporation. Group assets are defined as tangible personal property and real property used or held for use in the active conduct of a trade or business.

The sales or income factor in the new regulations' 25% floor is changed markedly from the analogous factor in the 10% safe harbor of the 2006 regulations. The 2006 regulations defined "group sales" as sales and the provision of services measured by gross receipts from such sales and services. Critically, the 2006 regulations provided:

A group sale is considered to be made in a country only if the services, goods or other property transferred by such sale are sold for use, consumption or disposition in such country.  [2006 Regs. §1.7874-2T(d)(3)(iii)]

Thus, a group that manufactured goods in a country, and sold them to a distributor affiliate with title passage in that country, likely could count income from such sales as derived in that country since they were sold, in such country, for further disposition by the distributor affiliate, even though such affiliate's ultimate, unrelated customers might be in another country.

The group income factor in the new regulations' 25% threshold is tougher to meet, both because it is a 25% floor rather than a 10% safe harbor, of course, but more importantly because the definition of "group income" is different. Under the new regulations, group income (25% of which must be in Forco's country of incorporation) means gross income of members of the global group from transactions in the ordinary course of business with customers that are not related persons. Moreover, group income is considered to be derived in a foreign country only if the customer is located in such country. Location of a customer is not defined.

Thus, even if the entirety of a multinational group's manufacturing is in Forco's country of incorporation, if less than 25% of sales to customers are in that country, Forco will not be respected as incorporated in that country for U.S. tax purposes and, instead, will be treated as a U.S. corporation. This seems illogical. 

Assume, for example, that a large German manufacturer that has produced goods in Germany for over a century and sells them worldwide under a well-recognized brand name (G) were to merge with an even larger U.S. manufacturer (U.S.) and the desire was to have the parent company be German. Assume further that, based on current market capitalization and recent years' sales and production figures, such a merger would result in U.S.'s shareholders obtaining more than 60% (though less than 80%) of the resulting merged group's shares.

Notwithstanding meeting §7874's continuity requirement, one would think that the merged group would nevertheless have substantial business activities in Germany. A vast majority of G's production and a significant piece of U.S.'s production are in Germany. Therefore, a very large number of employees and assets are located in Germany. G and U.S. have long had a very significant manufacturing presence in Germany. G has been headquartered there for nearly a century. Nevertheless, because less than 25% of the combined group's unrelated customers are in Germany, the resulting combined group would not be considered to have substantial business activities in Germany under the new regulations. This seems wrong.2

Other cases could be even more extreme. If two corporations planning to merge (one U.S., the other U.K.) had all of their manufacturing facilities in the United Kingdom, plus most of their headquarters personnel and a majority of their shareholders there as well, under the new regulations the resulting corporate group would nevertheless not be considered to have substantial business activities in the United Kingdom unless 25% or more of sales to unrelated customers were made there. For any large multinational group that has unrelated customer sales all over the world, or even just in Europe and North America, that is highly unlikely. Thus, despite having its clear and indisputable center of gravity in the United Kingdom, such a corporation would not be considered to have substantial business activities in the United Kingdom.

While ordinarily this author might consider such an extreme interpretation of the statutory phrase "substantial business activities" to be, as a matter of law, arbitrary, capricious, and unreasonable, §7874(g) gives the Treasury and IRS such broad regulatory authority that any validity challenge could be problematic.  Still, given the very broad reach of Notice 2009-78,3 there are likely to be cases where taxpayers inadvertently fall into §7874. If, or perhaps when, that happens, the results are so harsh that it is likely a taxpayer would challenge the validity of both Notice 2009-78 and these new substantial business activity regulations. Given a case where the continuity of domestic shareholder interest is small (though large if cash-outs are ignored per Notice 2009-78) and the quantum of business activities in Forco's country of incorporation under a common sense interpretation of substantial business activities is large, such a taxpayer just might win.

This commentary also will appear in the August 2012 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.

 1 If there is between 60% and 80% continuity of former U.S. corporate shareholders, §7874 will, among other things, prevent the use of NOL carryforwards to shelter "inversion gain" (as defined by §7874(d)(2)). 

 2 Because the continuity of former U.S. shareholders in the merged group would likely be between 60% and 80%, the German parent of the newly merged group would not be treated for U.S. tax purposes as U.S. It would, however, be unable to shelter any inversion gain with U.S.'s NOL carryforwards, as well as suffer other negative impacts. 

 3 See Morrison, "Notice 2009-78: The IRS Amends §7874 by Notice," 38 Tax Mgmt. Int'l J. 699 (12/11/09).