DQ’d: New Inversion Regulations Expand the Reach of the Public Offering Rule and Offer a Few Other Surprises

On January 17, Treasury and the IRS published new temporary and proposed regulations under Section 7874 of the Internal Revenue Code that expand the reach of the so-called “public offering rule” of Section 7874(c)(2)(B) to cover private placements and similar transactions involving the stock of a foreign acquiring corporation that has participated in an inversion transaction (the New Regulations). In brief, under the New Regulations, where a foreign acquiring corporation exchanges its stock for “nonqualified property” (i.e., cash and certain other liquid assets), that stock generally becomes “disqualified stock” and is excluded from the calculation of the ownership fraction described in Section 7874(a)(2)(B)(ii), which is relevant to the determination of whether the foreign acquiring corporation constitutes a “surrogate foreign corporation” and, correspondingly, whether the domestic acquired corporation constitutes an “expatriated entity.” Thus, if a foreign acquiring corporation is capitalized with cash in connection with its acquisition of a domestic corporation, the New Regulations generally provide that the stock of the foreign acquiring corporation issued in exchange for that cash will be excluded from the determination of whether the rules of Section 7874 apply to the inversion transaction.

In addition to expanding the statutory public offering rule, the New Regulations provide guidance and other clarifications in the areas that are summarized below.

  • Transactions that do not change the net assets of the foreign acquiring corporation are not implicated – The New Regulations clarify that the “exclusion rule” (i.e., the statutory public offering rule, as expanded by the New Regulations) generally is not implicated by a transaction in which the assets of the foreign acquiring corporation are not increased or its liabilities decreased. Thus, where shareholders of the foreign acquiring corporation exchange their stock with another person for cash or other nonqualified property, such a transaction generally will not cause the stock of the foreign acquiring corporation to be treated as disqualified stock.
  • Exclusion rule “trumps” statutory public offering rule – The New Regulations describe all situations in which stock will be excluded under Section 7874(c)(2)(B) from the denominator of the ownership fraction of Section 7874(a)(2)(B)(ii). Thus, in a situation where a foreign acquiring corporation issues stock in a public offering, the statutory public offering rule will not exclude such stock from the denominator unless the stock constitutes disqualified stock. As described in the preamble to the New Regulations, this rule is meant to address the potentially “over-inclusive” application of Section 7874 under the statutory public offering rule.
  • De minimis rule added – Where the former shareholders of the domestic acquired corporation own less than 5% of the foreign acquiring corporation’s stock (by vote and value), a new de minimis rule generally prevents those shareholders from causing the foreign acquiring corporation to be treated as a surrogate foreign corporation.
  • No transition rule included in the New Regulations – Most of the rules of the New Regulations are effective as of September 17, 2009, which was the effective date announced in Notice 2009-78, 2009-40 I.R.B. 452. However, where the New Regulations have expanded or otherwise altered the guidance anticipated by Notice 2009-78, such as with respect to “disqualified obligations” (discussed below), the New Regulations are effective as of the date of their publication in the Federal Register, i.e., January 17, 2014.
  • Potential application of “successor” principles to the stock of the foreign acquiring corporation – The New Regulations offer a new rule under Temp. Treas. Reg. § 1.7874-5T(a) that could be described as applying “successor” principles to the stock of the foreign acquiring corporation following an inversion transaction. Specifically, the New Regulations “clarify” (in the words of the preamble) that stock of the foreign acquiring corporation that is described in Section 7874(a)(2)(B)(ii) generally will not cease to be so described as a result of any subsequent transfer of the stock by a former shareholder of the domestic acquired corporation.

Sutherland Observation. Overall, the New Regulations are consistent with the recent approach of Treasury and the IRS with respect to Section 7874; namely, to expand the rules of the statute to cover issues that otherwise had not been anticipated at the time of the enactment of that Code section. While the New Regulations more or less are consistent with Notice 2009-78, in which the IRS announced its intention to issue regulations that would stretch the boundaries of the public offering rule of Section 7874(c)(2)(B) to cover private placements and similar transactions involving the stock of the foreign acquiring corporation, they nevertheless offer a few surprises, including the new rule at Temp. Treas. Reg. § 1.7874-5T(a).

Some background on the New Regulations follows below, along with a brief overview of several other relevant provisions included in those regulations.

Background

Section 7874 provides rules for two types of inversion transactions:

  • First, if a foreign corporation acquires substantially all of the properties held by a domestic corporation, and the shareholders of the domestic acquired corporation receive at least 80% of the vote or value of the foreign acquiring corporation’s stock in that transaction, the foreign acquiring corporation generally will be treated as a domestic corporation for federal tax purposes.
  • Second, if the shareholders of the domestic acquired corporation receive at least 60%, but less than 80%, of the vote or value of the foreign acquiring corporation’s stock in the inversion transaction, then, among other consequences, the use of certain of the domestic acquired corporation’s tax attributes (if any) generally will be limited for a 10-year period.  In this second type of inversion transaction, the foreign acquiring corporation is considered a “surrogate foreign corporation.”

In each type of inversion transaction, the percentage of stock of the foreign acquiring corporation held by shareholders of the domestic acquired corporation is determined under the ownership fraction described in Section 7874(a)(2)(B)(ii). That fraction generally takes into account the outstanding shares of the foreign acquiring corporation in the denominator and the shares of the foreign acquiring corporation that are held by former shareholders of the domestic acquired corporation in the numerator. Accordingly, in the absence of a rule to the contrary, by contributing cash or other liquid assets to the foreign acquiring corporation in exchange for new stock in connection with the acquisition of a domestic corporation, the relative values of the two corporations are altered, and the ownership fraction can be reduced.

Under the public offering rule of Section 7874(c)(2)(B), stock sold in a “related” public offering is not taken into account in calculating the ownership fraction described in Section 7874(a)(2)(B)(ii). In effect, Section 7874(c)(2)(B) works to prevent a public offering of stock completed in connection with an inversion transaction from reducing the percentage ownership of the former shareholders of the domestic acquired corporation in the foreign acquiring corporation.

The New Regulations

As indicated in the preamble to the New Regulations, Treasury and the IRS are concerned that certain transactions involving the transfer of nonqualified property to a foreign acquiring corporation have the potential of reducing the percentage of the stock of the foreign acquiring corporation owned by former shareholders of the domestic acquired corporation. In order to prevent this result, the New Regulations (i) expand the statutory public offering rule (as expanded, the “exclusion rule”), (ii) identify types of nonqualified property that are problematic, and (iii) provide that stock of a foreign acquiring corporation issued in exchange for such nonqualified property constitutes disqualified stock that will not be taken into account for purposes of calculating the ownership fraction of Section 7874(a)(2)(B)(ii).

Under the New Regulations, stock of the foreign acquiring corporation generally will constitute disqualified stock if such stock is transferred in exchange for nonqualified property, but only to the extent the exchange increases the net assets of the foreign acquiring corporation. For this purpose, nonqualified property generally includes:

  • Cash or cash equivalents;
  • Marketable securities;
  • Certain disqualified obligations; and
  • Any other property acquired in a transaction with “a principal purpose” of avoiding the purposes of Section 7874.

The New Regulations provide that disqualified stock can be acquired through an issuance, sale, distribution, exchange, or any other type of disposition, and stock of the foreign acquiring corporation can constitute disqualified stock regardless of whether the stock is transferred by the foreign acquiring corporation or another person. Furthermore, in a situation where the foreign acquiring corporation transfers stock to a shareholder in exchange for hook stock in such shareholder, such as in the case of a subsidiary acquiring stock of its parent corporation, that stock of the foreign acquiring corporation generally will be treated as disqualified stock that is subject to the exclusion rule.

1.       Expansions and Refinements to “Nonqualified Property”

As discussed above, nonqualified property includes (i) cash or cash equivalents, (ii) marketable securities, (iii) certain disqualified obligations, and (iv) any other property acquired in a transaction with “a principal purpose” of avoiding the purposes of Section 7874. The notable provisions of the New Regulations regarding the latter three categories of nonqualified property are summarized below.

  • Certain marketable securities excepted from nonqualified property status – The New Regulations provide an exception from marketable securities for stock of a corporation that becomes a member of the expanded affiliated group (within the meaning of Section 7874(c)(1)) that includes the foreign acquiring corporation in a transaction related to the acquisition. Thus, if the foreign acquiring corporation acquires a domestic corporation and a foreign corporation (or a related party acquires the other foreign corporation), the stock of the foreign acquired corporation generally will not constitute nonqualified property. As a consequence, the stock of the foreign acquiring corporation that is exchanged for stock of the foreign acquired corporation generally will not constitute disqualified stock and can be included in the denominator of the ownership fraction.

  • Disqualified obligations – The New Regulations add certain disqualified obligations to the list of nonqualified property. If the foreign acquiring corporation transfers stock to a person other than the domestic acquired corporation in exchange for, in satisfaction of, or as part of an assumption of an obligation of the transferor, that stock generally will constitute disqualified stock. A disqualified obligation also can arise where the stock of the foreign acquiring corporation is transferred to the domestic acquired corporation and subsequently is used to satisfy an obligation of the domestic acquired corporation.

  • Principal purpose of avoiding the purposes of Section 7874 – Notably, the New Regulations provide an example of a transaction with a principal purpose of avoiding the purposes of Section 7874. The example involves a foreign acquiring entity (in the example, a partnership) that contributes nonqualified property to a new foreign corporation (Newco 1) and, thereafter, exchanges the stock of Newco 1 for the stock of another new foreign corporation (Newco 2). The owner of a domestic corporation then transfers the stock of such corporation to Newco 2 in exchange for 75% of the stock of Newco 2 (75 shares). Based on these facts, the example concludes that the stock of Newco 2 issued to Newco 1 constitutes disqualified stock because the initial transaction involved nonqualified property. As a consequence, the ownership fraction with respect to Newco 2 is 75/75 or 100%.

2.       New De Minimis Rule

If a new foreign corporation (Newco) is organized with cash capital, and the shareholders of a domestic corporation exchange their shares of such corporation for cash and a small percentage of the shares of Newco, that transaction could give rise to a surrogate foreign corporation in the absence of a de minimis rule. Specifically, the cash contributed to Newco constitutes nonqualified property under the rules discussed above. As such, the stock held by the contributors of the cash to Newco constitutes disqualified stock that cannot be included in the denominator of the ownership fraction of Section 7874(a)(2)(B)(ii). Thus, in such a situation, the only stock of Newco that is taken into account for purposes of the ownership fraction is the stock held by the former shareholders of the domestic acquired corporation.

In order to prevent the result described in the preceding paragraph, the New Regulations add a de minimis rule. In particular, where the former shareholders of the domestic acquired corporation hold less than 5% of the vote and value of the foreign acquiring corporation’s stock (taking into account the otherwise disqualified stock), the new de minimis rule generally prevents those shareholders from causing the foreign acquiring corporation to be treated as a surrogate foreign corporation.

Sutherland Observation. Although the new de minimis rule provides a helpful clarification of the manner in which the exclusion rule is meant to operate, the New Regulations nonetheless leave the door open for a relatively small group of shareholders to cause a foreign acquiring corporation to become a surrogate foreign corporation under the rules of Section 7874(a)(2)(B).