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By Edward Tanenbaum
Alston & Bird LLP, New York, NY
It came as no surprise when Treasury released its final regulations under Reg. §1.7874-31 confirming its approach taken in earlier temporary regulations dealing with the definition of "substantial business activities" in the context of inversions. Practitioners and taxpayers had hoped for a relaxation of the rules but, alas, it was not forthcoming.
Recall that an inversion under §7874 applies if, pursuant to a plan or series of related 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. immediately after the acquisition, the former shareholders of the U.S. target corporation hold at least 60% of the vote or value of the foreign corporation by reason of holding stock in the U.S. target corporation; and
3. after the acquisition, the expanded affiliated group that includes the foreign corporation (EAG) does not have substantial business activities in the foreign country in which the acquiring corporation is organized when compared with the total business activities of the EAG.
If the former shareholders own between 60–79%, the U.S. target is prevented for a ten-year period from using tax attributes to offset income realized on the transfer of the stock or assets. If the shareholders own 80% or more, the acquiring corporation itself is treated as a U.S. corporation for all U.S. tax purposes.
Temporary regulations issued back in 2006 interpreting the term "substantial business activities" provided for a two-fold approach. First, there was a "facts and circumstances" test involving both a qualitative and quantitative test. A non-exclusive list of factors was provided: employee headcount, payroll, property, sales, management activities, etc.
Alternatively, a safe harbor test was provided calling for each of three tests to be met:
1. The EAG's employees in the country of incorporation account for at least 10% (by headcount and compensation) of total EAG employees;
2. The total value of the EAG's assets in the foreign country represent at least 10% of the total value of all EAG assets; and
3. Sales in the foreign country during the testing period account for at least 10% of the total value of all EAG sales.
The initial temporary regulations dealing with the definition of "substantial business activities" were replaced in 2009 by a revised set of temporary regulations which eliminated the safe harbor tests altogether as well as the various illustrative examples interpreting the meaning of substantial business activities. The reason offered up by Treasury was that the safe harbor tests "may apply to transactions that are inconsistent with the purposes of §7874 which is meant to prevent certain transactions that seek to avoid U.S. tax by merely shifting the place of organization of a U.S. corporation (or partnership)." Obviously, the 10% safe harbor tests were deemed to be too easy a grant of authority to taxpayers to structure into these safe harbors. The result was that taxpayers were left having to rely on a murky general facts and circumstances test.
In 2012, revised temporary regulations decimated the facts and circumstances test and replaced it with a bright-line rule under which an EAG would be considered to have substantial business activities in the foreign acquiring entity's country of incorporation only if at least 25% of the group's total number of employees, employee compensation, assets, and income were located or derived in the relevant foreign county. Group assets, employees, or income that were either related to an avoidance plan or subsequently transferred out of the relevant foreign country pursuant to a plan were excluded from the numerator of the threshold factors. The 2012 temporary regulations also provided that more-than-50%-owned partnerships would be treated as members of the EAG (the "deemed corporation" rule).
Needless to say, taxpayers and practitioners alike criticized the notion of a hard-and-fast, bright-line rule with such high thresholds, especially given the realities of how multinationals operate and do business today. It is hardly imaginable that, in today's globalized internet world, a multinational enterprise could end up meeting such high thresholds (especially the income bright-line rule) in a single country.
It was fairly obvious to all that Treasury was out to curb inversions from various angles, including via the definition of "substantial business activities." And, in fact, in June of this year final regulations were released which, for the most part, confirm the 2012 temporary regulations.
The recently finalized regulations unfortunately maintain the strict 25% bright-line tests of the 2012 regulations to determine whether a group satisfies the substantial business activities condition of §7874. Moreover, the regulations include several "operational" rules for applying the bright-line tests. Items disregarded under §7874(c)(4) (relating to avoidance transfers) are excluded from both the numerator and denominator of the relevant fractions. The timing and amount of employee compensation for purposes of the 25%-group-employees test must be determined under U.S. income tax principles, although the issue of whether an individual is an employee of an EAG member can be resolved under U.S. income tax law or applicable foreign law—provided the same standard applies to all EAG members. The group assets test is modified to provide that assets that are mobile in nature and are used in transportation activities do not have to be physically located in the relevant country at the close of the acquisition date and need only be present in that country for more time than any other country during the testing period. The 2015 regulations simplify the group income test, which now requires only that group income be determined consistently for all EAG members using U.S. income tax principles, U.S. generally accepted accounting principles (GAAP), or International Financial Reporting Standards (IFRS).
The new regulations also "clarify" certain rules for determining the members of an EAG. An entity that is not a member of an EAG on the acquisition date will not be a member of the EAG even though it was a member earlier in the testing period (i.e., the one-year period ending on the date the acquisition was completed or the last day of the month preceding the acquisition month). Further, the members of an EAG are determined by taking into account all transactions related to an acquisition, even those that occur after the acquisition.
The 2015 regulations also coordinate application of the 2012 regulations' "deemed corporation" rule with a partnership "look-through" rule. The look-through rule treats each partner in a partnership as holding its proportionate share of stock held through the partnership. The Preamble to the regulations states that the look-through rule will apply first to identify the actual corporations included in an EAG. Then, the deemed corporation rule applies to treat partnerships in which those corporations own more than 50% interests as corporations and, therefore, members of the EAG.
The retention in the final regulations of the high-threshold, bright-line tests, together with the panoply of other final regulations and IRS notices under §7874 issued over the past few years, reflects an aggressive approach and a concerted effort on the part of the government to close down inversions in whatever way they can. It will be a rare situation in which a taxpayer wishing to invert will rely on the substantial business activities test as the basis for a successful inversion.
This commentary also appears in the October 2015 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©2015 by The Bureau of National Affairs, Inc.
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