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By Thomas S. Bissell, CPA
This commentary continues the discussion in the author's prior commentary on the potentially disastrous effects on certain foreign corporations of the "cash-box" rule in Notice 2014-52.1 Section 2 of the Notice requires that, in testing the acquisition by a foreign corporation of a U.S. target entity under the "anti-inversion" provisions of §7874, "passive" assets (primarily cash and marketable securities) owned by the foreign acquiring corporation in many cases must be disregarded for purposes of the testing fraction.2 Most of the discussion below explores in greater detail the implications of the Notice for closely-held foreign investment corporations that are owned by a foreign family. At the same time, this commentary also considers the Notice – including the other rules in it that apply to U.S. operating companies (usually publicly held) that are contemplating an inversion with a foreign acquiring corporation that is not subject to the new "cash-box" rule – in the broader context of the ongoing debate over reform of the U.S. international tax rules.
The prior commentary on this subject discussed only so-called foreign "blocker" corporations that are owned by nondomiciled aliens (or by a family of nondomiciled aliens), primarily in order to invest in U.S.-situs assets (usually U.S. equities) that would otherwise be potentially subject to substantial U.S. estate tax if owned directly in the name of the foreign corporation's owner(s). However, in many cases the foreign corporation may own no underlying U.S.-situs assets at all and instead may own only foreign-situs investment assets, so that its first and only contact with the United States may be its acquisition of a U.S. target corporation or partnership (or of the U.S. target's assets). Unfortunately, Notice 2014-52 makes no distinction between U.S.- and foreign-situs passive assets; thus, in both situations the assets must be disregarded for §7874 testing purposes. And because the acquiring corporation's passive assets must be ignored, the relative size of the acquiring corporation and of the target will usually be irrelevant. If the acquiring corporation is worth $10,000,000, and owns only passive assets, and acquires a U.S. target (or its assets) worth only $10,000 in exchange for "stock" in the acquirer, the Notice would convert the acquirer into a U.S. corporation.3
The broad reach of the Notice can be illustrated most dramatically by an example in which the target is not a U.S. corporation but a "domestic partnership." In the example just given – i.e., where the foreign acquiring corporation owns only "passive" assets (which could well be all foreign-situs assets) — assume that the U.S. partnership has no operations within the United States and instead conducts a trade or business within a foreign country. Its partners may even all be nonresident aliens, with the result that the partners are never subject to U.S. income tax on their distributive shares of partnership income. If the foreign corporation acquires all the assets of the U.S. partnership in exchange for its stock, the Notice will disregard all of the acquiring corporation's pre-existing assets, and the acquiring corporation will be converted into a U.S. corporation as a result of the acquisition. The same result would follow if the target company were a U.S. corporation (even though all of its assets were outside the United States), but at least in that example the U.S. corporation would have been subject to U.S. tax under §11 on its worldwide income prior to the acquisition.
It should be noted that §7874(a)(2)(B)(i) does require that in the case of a target that is a U.S. partnership, the anti-inversion rules will apply only if "substantially all of the properties constituting a trade or business of a domestic partnership" are acquired. (Emphasis added.) No similar limitation applies in the case of a target that is a U.S. corporation, so that an inversion can occur if "substantially all of the properties held directly or indirectly by a domestic corporation" are acquired (whether or not those properties are part of a "trade or business"). Under present law, therefore, in the above example if instead the U.S. partnership owns only passive assets (such as marketable securities) that are not part of a "trade or business," an inversion would not occur. It is noteworthy, however, that the Obama Administration's 2016 Budget proposals would eliminate the "trade or business" requirement and apply the anti-inversion rules if "substantially all of the assets of a … domestic partnership" are acquired, apparently without limitation as to whether those assets are located within the United States or abroad, and without regard to whether or not they are "trade or business" assets.4
Because the Notice will only apply in the above example if the foreign acquiring corporation issues "stock" to the owners of the U.S. target entity, it might be contended that it would be unusual for the Notice to apply in practice to a foreign family's offshore investment company. That may be true in many situations, but, as indicated in the prior commentary, there may be business reasons for issuing stock in the acquirer (particularly nonvoting preferred stock, which is not excepted from §7874). In addition, if the acquisition is made for an interest-bearing obligation of the acquirer, in many cases the "debt" might be considered under the "debt-equity" case law under the Code to be de facto equity. As detailed in the prior commentary, if the consideration for the acquisition is in fact "stock," the potential consequences to the foreign acquirer of being transformed into a deemed U.S. corporation under §7874 are truly disastrous.
It must be reiterated that the "cash-box" rule in the Notice appears to have absolutely no basis in §7874, even within the parameters of the discretion granted to Treasury to deal with "tax avoidance" strategies. Treasury was criticized in 2009 for adopting a rule (enshrined in regulations in 2014) requiring that the proceeds from a contemporaneous "private placement" be disregarded for testing purposes – despite clear legislative history that this proposal (in the Senate) was rejected by the House-Senate Conference Committee when §7874 was finally enacted in 2004. But at least the "private placement" rule may conceivably have some legal basis as a result of the authority granted to Treasury to issue rules to combat abusive situations. However, there is no basis for the "cash-box" rule in the statute where the acquiring corporation has owned passive assets for many years with no thought of making a U.S. acquisition. Indeed, the application of the Notice to the $10,000,000/$10,000 example above may recall to readers of a certain age the quotation from a 19th century British judge, "Can the Island of Tobago pass a law to bind the rights of the whole world?," which was often cited in conflict of laws classes in the 1960s.5
Since the Notice was published in September 2014, the other provisions apart from section 2 – most of which are aimed at U.S.-controlled U.S. operating companies – have also been roundly criticized by commentators as having no statutory basis. The provisions relating to §956 have been persuasively refuted by Lowell Yoder,6 and several other provisions in the Notice have been exhaustively and eloquently criticized by Kimberly Blanchard.7 What is particularly unfortunate is that, although a court might well declare most or all of the Notice to be invalid, in the words of the latter commentator, "The provisions of the Notice are manifestly not intended to be challenged at all; they are intended simply to discourage taxpayers from engaging in certain transactions that the Treasury Department (Treasury) and the Internal Revenue Service (the IRS) consider problematic."8
Although as a practical matter the Notice may well be immune from a court challenge, one might nevertheless ask why the Administration has been so aggressive in adopting rules under §7874 that for all practical purposes are extra-statutory. One reason seems to be that so many multinationals have become convinced that "expatriating" themselves is the only way to remain competitive in a world in which other developed countries tax their own multinational companies much less harshly than does the United States – provided that in the act of expatriation the U.S. company can avoid the anti-inversion rules of §7874. The response to these complaints by the Republican majority in Congress has been to propose a dramatic change to the Code's rules for taxing foreign income. Thus, under the so-called "Camp proposals" published by the Ways and Means Committee in 2011 and updated in February 2014, dividends from 10%-or-more-owned foreign corporations would be taxed to a U.S. corporate shareholder at an effective U.S. tax rate of only 1.25% (although many of the Subpart F rules would remain in place, albeit with many changes).9 A paper on "comprehensive tax reform" published in December 2014 by the Republican staff of the Senate Finance Committee adopted a similar position.10 None of these proposals includes any recommendations to strengthen or otherwise modify the anti-inversion rules of §7874 – presumably because the Republican drafters hope that the incentive for U.S. companies to expatriate by means of a successful inversion will be substantially eliminated once the rules for taxing foreign income have been liberalized.
In contrast, the Obama Administration's 2016 Budget (as well as its prior budgets) recommends that §7874 be strengthened by reducing the 80% "deemed domestic corporation" percentage down to 50%, and by closing other "loopholes" in the existing rules (such as the partnership rules, described above).11 None of these proposals has included relief from U.S. tax on dividends paid by 10%-or-more-owned foreign corporations, and indeed the 2016 Budget includes a new proposal to impose a current U.S. tax of 19% on the current earnings and profits (E&P) of all controlled foreign corporations (CFCs), and a 14% tax on the accumulated (and thus not yet distributed) E&P of all CFCs. Accordingly, the Obama Administration appears to be committed to retaining and strengthening the present rules on the taxation of foreign income while at the same time making it increasingly difficult for U.S. companies to expatriate. Viewed in this light, its pronouncements in the §7874 area may well be an attempt to circumvent the Republican majority in Congress which is blocking any legislative change to those rules.
Thus, the increasingly agressive rules that the Administration has been issuing under §7874 can perhaps be better understood in light of the broad debate over reform of the U.S. international tax rules. However the debate ends – and few commentators expect it to be resolved within the next few years – §7874 will remain very much at the forefront of the debate.
This commentary also will appear in the May 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 Income.
Copyright©2015 by The Bureau of National Affairs, Inc.
2 To be accurate, what is disregarded is the percentage of stock in the acquiring corporation that is attributable to "passive" assets, provided that more than 50% of the assets of the acquiring corporation following the acquisition are "passive." In the examples discussed in this commentary, all of the assets of the acquiring corporation prior to the acquisition are "passive." For ease of discussion, therefore, this commentary simplifies the discussion of this rule by assuming that it is the passive assets themselves that are ignored, rather than the stock attributable to those assets.
3 It is assumed throughout this discussion that because the acquiring corporation operates solely as an investment vehicle for the benefit of its owner(s), it does not have "substantial business activities" within the country where it is incorporated within the meaning of §7874(a)(2)(B)(iii) or the regulations thereunder, so as to avoid the application of §7874.
5 According to Google, the quotation is apparently attributed to Lord Ellenborough in the case of Buchanan v. Rider. A photograph of either the high court building or of the parliament building of the Island of Tobago appeared on the frontispiece of the author's conflict of laws textbook at Columbia Law School.
10 The Senate paper specifically discusses the incentive that U.S. companies have to engage in inversion transactions as a result of the present U.S. international tax rules. See Republican Staff, Committee on Finance, United States Senate, Comprehensive Tax Reform for 2015 and Beyond (December 2014), at 273 ff.
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