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.
The notice recounts the fact that the IRS and the Treasury Department “have become aware of transactions that involve a transfer of cash (or certain other assets) to the foreign corporation, in a transaction related to the acquisition (of the domestic corporation by the foreign corporation), thereby minimizing the former shareholders’ ownership in the foreign corporation.”
For example, the stock of a domestic corporation is transferred to a newly formed foreign corporation in exchange for 79% of the new company’s stock. As part of the plan, an “investor” transfers cash to the foreign corporation in exchange for the remainder of its stock. The parties, says the IRS, take the position that the stock issued to the investor was not sold in a public offering.
What’s more, the parties also assert that the investor’s transfer of cash was not part of a plan whose principal purpose was to avoid the purposes of Section 7874. Thus, the former shareholders of the domestic corporation would hold only 79% of the stock in the foreign corporation. Accordingly, Section 7874(a)(1) would apply to the domestic corporation (so it will be taxed on its “inversion gains”), but the more-onerous provisions of Section 7874(b) would not apply to treat the foreign corporation as a domestic corporation.
In addition, 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. As a result, the government will take steps to insure that these “non-abusive” transactions are not unfairly brought within Section 7874’s ambit.
For instance, the shareholders of a publicly traded foreign corporation and a publicly traded domestic corporation intend to transfer their stock to a newly formed foreign corporation that will be publicly-traded. The newly formed foreign corporation acquires all of the stock of the foreign and domestic companies, solely in exchange for its stock. If the stock of the newly formed company issued to the foreign company’s shareholders is considered “sold in a public offering,” the former shareholders of the domestic company would be treated as owning 100% of the stock of the newly formed foreign company. Therefore, under Section 7874(b), the newly formed company would be treated as a domestic corporation. This outcome, at least in certain cases, appears to be “inappropriate.”
Thus, the IRS intends to issue regulations addressing the foregoing transactions. The regulations it will issue will provide that stock of the foreign corporation issued in exchange for nonqualified property (NQP) in a transaction related to the acquisition is not taken into account for purposes of the ownership condition. For this purpose, NQP means: (1) Cash or cash equivalents; (2) “marketable securities” as defined in Section 453(f)(2); and (3) any other property acquired in a transaction with a principal purpose of avoiding the purposes of Section 7874. However, marketable securities do not include stock issued by a member of the expanded affiliated group unless a principal purpose of issuing the stock of the foreign corporation in exchange for such property was the avoidance of the purposes of Section 7874.
Therefore, the stock issued to the aforementioned investor in exchange for cash in a transaction related to the acquisition (by the foreign corporation of the domestic corporation) would not be taken into account for purposes of assessing compliance with the ownership condition. The result: under Section 7874(b), the foreign corporation would be treated as a domestic corporation, thwarting the goals of the inversion transaction.
By contrast, in the business-combination case depicted above, the foreign company is a member of the newly formed foreign company’s expanded affiliated group. That means the stock of the foreign corporation (in exchange for which the newly formed company stock is issued in the business combination) is not marketable securities.
So, the stock in the newly formed company issued to the former shareholders of the foreign corporation in exchange for their stock will be taken into account in determining whether the transaction satisfies the ownership condition.
The regulations to be issued in Notice 2009-78 will apply to acquisitions completed on or after September 17, 2009. Moreover, taxpayers will have the opportunity to apply the rules described in the notice to acquisitions completed on or after September 17, 2009, and before the date on which the regulations are published — if the rules are applied consistently with respect to all acquisitions.
Contributing editor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.
1 See Regulation Section 1.367(a)-3(c).