IRS To Release Additional Rules On Corporate Inversions

This week, the IRS released Notice 2015-79, which describes intended regulations to cover inversions and related transactions.

Colloquially, an inversion refers generally to a transaction in which a domestic corporation is acquired by a foreign corporation. I.R.C. §§ 367 and 7874 operate as the anti-inversion rules; § 367 deals with shareholder-level consequences and § 7874 deals with corporate-level consequences. The Notice deals with transactions the IRS feels are structured to avoid the purposes of §§ 367 and 7874.

The first type of transactions identified in the Notice are transactions in which the expanded affiliated group (EAG) has substantial business activities in the foreign country, but the foreign acquiring corporation is not subject to tax in the foreign country as a resident. The IRS notes that this could happen when, for example, the foreign country determines tax residency based on criteria other than formation (such as location of management or control), and the foreign acquiring corporation is managed in a third country; thus, the foreign acquiring corporation may not be subject to tax as a resident in the relevant foreign country (or possibly any foreign country). This anomaly could also result if disparate entity classification rules exists—for example, the foreign acquiring corporation is treated as a corporation for U.S. tax purposes by operation of the check-the-box rules, but a fiscally transparent entity under the tax laws of the relevant foreign country. In this case, too, the foreign acquiring corporation would not be subject to tax as a resident in the relevant foreign country.

In the notice, the Treasury Department and the IRS conclude that “the policy underlying the exception to section 7874 when there are substantial business activities in the relevant foreign country is premised on the foreign acquiring corporation being subject to tax as a resident of the relevant foreign country.” Consequently, the intended regulations will provide that “an EAG cannot have substantial business activities in the relevant foreign country when compared to the EAG’s total business activities unless the foreign acquiring corporation is subject to tax as a resident of the relevant foreign country.”

The second type of transactions addressed in the Notice are known as “third-country transactions.” Under these transactions, “a domestic entity combines with an existing foreign corporation are structured by establishing a new foreign parent corporation for the combined group with a tax residence that is different from that of the existing foreign corporation.” In effect, the parent corporation of the combined group will be a tax resident of a “third country.”

Generally, Congress believed that “certain transactions in which a U.S. parent corporation is replaced with a new foreign parent corporation have little or no non-tax effect or purpose and should be disregarded for U.S. tax purposes.” On the other hand, though, “in other cases such transactions may have sufficient non-tax effect and purpose to be respected, but warrant that any applicable corporate-level ‘toll charges’ for establishing the inverted structure not be offset by tax attributes such as net operating losses or foreign tax credits.”

In these transactions, the IRS is concerned that a decision to locate the tax residence of the new foreign parent is generally driven by tax planning, including U.S. tax avoidance after the acquisition. This may occur when, for example, the third country has a more favorable income tax treaty than the country of the currently existing foreign parent. Consequently, the Notice concludes that “a third-country parent typically is chosen to facilitate the use of low- or no-taxed entities to erode the U.S. tax base following the acquisition.”

To address these transactions, the IRS plans to disregard “certain stock of a foreign acquiring corporation that is issued to the shareholders of the existing foreign corporation for purposes of determining whether the 80-percent threshold is met.” This rule will apply to acquisitions that satisfy a four-part test identified in the Notice.

The Notice also provides clarifications of regulations under § 1.7874-4T that disregard certain stock transferred in exchange of nonqualified property. The concern in the Notice is that taxpayers may be narrowly interpreting the definition of avoidance property. Thus, the intended regulations will clarify, among other things, that “avoidance property means any property (other than specified nonqualified property) acquired with a principal purpose of avoiding the purposes of section 7874, regardless of whether the transaction involves an indirect transfer of specified nonqualified property.”

The Notice also addresses post-inversion tax avoidance transactions. In inversion transactions, I.R.C. § 7874(a)(1) requires that the “taxable income of an ‘expatriated entity’ for any taxable year that includes any portion of the ‘applicable period’ be no less than the ‘inversion gain’ of the entity for the taxable year.” In effect, § 7874(a)(1), along with § 7874(e)(1), are designed to ensure that “an expatriated entity generally pays current U.S. tax with respect to inversion gain.”

Certain indirect transfers of stock or other property by an expatriated entity, however, “may have the effect of removing foreign operations from U.S. taxing jurisdiction while avoiding current U.S. tax, contrary to the policy underlying sections 7874(a)(1) and (e)(1).” The intended regulations, therefore, will provide that inversion gain includes “income or gain recognized by an expatriated entity from an indirect transfer or license of property, such as an expatriated entity’s section 951(a)(1)(A) gross income inclusions taken into account during the applicable period that are attributable to a transfer of stock or other properties or a license of property, either (i) as part of the acquisition, or (ii) after such acquisition if the transfer or license is to a specified related person.”

The Notice also intends to target certain exchanges of stock of an expatriated foreign subsidiary. Here, the concern is that “certain nonrecognition transactions that dilute a U.S. shareholder’s ownership of an expatriated foreign subsidiary may allow the U.S. shareholder to avoid U.S. tax on unrealized appreciation in property held by the expatriated foreign subsidiary at the time of the exchange.” The intended regulations will address this concern by requiring “the exchanging shareholder to recognize all of the gain in the stock of the expatriated foreign subsidiary that is exchanged, without regard to the amount of the expatriated foreign subsidiary’s undistributed earnings and profits.”

The Notice also provides several corrections and clarifying changes to Notice 2014-52.

You can read Notice 2015-79 here.

The IRS is still requesting comments on approaches to curbing strategies designed to avoid U.S. tax on U.S. operations by shifting or stripping U.S.-source earnings to lower-tax jurisdictions. Information on how to submit comments are found at the end of the Notice.