At one time, so-called inversion transactions were quite popular. A U.S. corporation — for example, a company such as Ingersoll-Rand or Nabors Industries — would create a new foreign corporation located in a tax haven. The shareholders of the U.S. corporation would convey their stock to the new foreign corporation in exchange for the latter’s stock.
As a result, the U.S. corporation would become a subsidiary of the new foreign corporation. Further, through a series of transactions executed after this relationship was created, the income earned by foreign affiliates of the U.S. corporation could be sheltered from U.S. taxation. Moreover, it was even possible, through the institution of certain intragroup arrangements, to shelter a portion of the domestic income of the U.S. corporation from taxation.
Although the exchange of stock of the U.S. corporation for stock of the new foreign corporation was taxable,1 this “penalty” did not seem to deter U.S. corporations from pursuing the inversion-transaction strategy. Later, legislation was enacted, in the form of Section 7874 of the Internal Revenue Code, that has rendered many (but not all) inversion transactions unattractive. Nevertheless, the Internal Revenue Service felt the need to promulgate additional regulations in response to “abuses” of Section 7874, to “protect” the purposes of the regulation. Accordingly, on September 17, 2009, the IRS issued Notice 2009-78.
The notice observes that Section 7874 provides rules for so-called expatriated entities (EE) and their “surrogate foreign corporations (surrogate).” An EE is a domestic corporation to which a foreign corporation is a surrogate, and any U.S. person related to the domestic corporation. A foreign corporation constitutes a surrogate if three conditions are satisfied:
•The foreign corporation completed the direct or indirect acquisition of substantially all of the properties held by a domestic corporation, after March 4, 2003;
•After the acquisition, at least 60% of the stock of the foreign corporation (by vote or value) was held by former shareholders of the domestic corporation by reason of holding stock in the domestic corporation (the “Ownership Condition”); and
•After the acquisition, the “expanded affiliated group” (EAG) that includes the foreign corporation did not have substantial business activities in the foreign country in which the foreign corporation was created or organized as compared with the total business activities of the EAG.
“The IRS has identified transactions that might unwittingly and improperly be subject to the anti-inversion rules under an expansive reading of the ownership condition.” — Robert Willens
Under Section 7874(c)(2), certain stock of the foreign corporation is not taken into account in determining whether the ownership condition is satisfied. Those shares include stock held by members of the EAG and stock sold in a “public offering” related to the acquisition. Moreover, under Section 7874(c)(4), a transfer of properties or liabilities is disregarded if the transfer is part of a plan whose principal purpose is to avoid the purposes of Section 7874.