On July 11, 2018, the U.S. Treasury Department and the Internal Revenue Service (the IRS) issued final regulations under Section 78741 and related sections of the Internal Revenue Code of 1986, as amended, (the Code) addressing corporate inversions and certain post-inversion tax avoidance transactions.
Section 7874 provides that "surrogate foreign corporations" are subject to special rules under the Code. Generally, a foreign corporation is a surrogate foreign corporation if: (i) after March 4, 2003, the foreign corporation acquires substantially all the properties of a domestic corporation or substantially all of the properties constituting a trade or business of a domestic partnership; (ii) after the acquisition, the former shareholders of the domestic corporation or partners of the domestic partnership hold at least 60 percent (by vote or value) of the foreign acquiring corporation's stock by reason of their ownership of the domestic corporation or partnership (referred to as the "ownership percentage," or "ownership fraction" when expressed as a fraction); and (iii) the foreign corporation's expanded affiliated group does not have substantial business activities in its country of organization (the "substantial business activities" exception). If the ownership percentage is at least 80 percent, the surrogate foreign corporation is treated as a domestic corporation for U.S. federal income tax purposes. If the ownership percentage is at least 60 percent but less than 80 percent, the surrogate foreign corporation generally is respected as a foreign corporation but is subject to special rules intended to reduce the tax benefits of the inversion transaction.
Section 7874 delegates authority to the IRS to promulgate regulations addressing inversions to carry out and prevent the avoidance of the purposes of Section 7874. On April 8, 2016, the IRS published final, temporary, and proposed regulations under Section 7874 (the 2016 Regulations). Certain parts of these rules were revised and finalized in 2017 in response to comments received by the IRS. The remaining 2016 Regulations have now been revised and issued in final form, effective as of July 12, 2018 (the 2018 Regulations). While many aspects of the 2018 Regulations remain largely unchanged from the 2016 Regulations, certain changes reflected in the 2018 Regulations are discussed below.
Serial Acquisition Rule
Under a rule addressing serial acquisitions, a foreign corporation can become a surrogate foreign corporation as a result of the acquisition of multiple domestic entities. Under this rule, the ownership percentage of a domestic entity acquisition is determined by excluding any stock of the foreign acquiring corporation that is attributable to previous acquisitions of domestic entities during the 36-month period ending on the date of the tested domestic entity acquisition. The serial acquisition rule was released in temporary form in the 2016 Regulations but was invalidated by litigation in 2017 on procedural grounds because it was not subjected to prior notice and comment.1 However, in the preamble to the 2018 Regulations, the IRS observed that the district court also concluded that the rule was substantively valid under the Code and federal administrative law.
The 2018 Regulations include the serial acquisition rule, with revisions to address comments received by the IRS. The final serial acquisition rule clarifies that stock of the foreign acquiring corporation deemed to have been received under an anti-avoidance rule or the non-ordinary course distribution rule (discussed below) is not treated as foreign acquiring corporation stock attributable to a prior acquisition of a domestic entity. Second, the final rule contains an additional exception for certain prior domestic entity acquisitions in connection with internal group restructurings. The final rule also incorporates the concept of a predecessor of the foreign acquiring corporation.
Rules Relating to Foreign Tax Status
Certain regulations under Section 7874 focus on the foreign tax status of a foreign acquiring corporation in determining the extent to which Section 7874 applies to an acquisition of a domestic entity. First, the 2016 Regulations interpreting the "substantial business activities" exception to Section 7874 required that a foreign acquiring corporation be "subject to tax as a resident" of the country in which it was organized. Second, under the 2016 Regulations, the "third-country" rule generally excluded stock of a foreign acquiring corporation from the denominator of the ownership fraction where such corporation acquired both another foreign corporation and a domestic entity, and the two foreign corporations were not "subject to tax as a resident" of the same country. A comment suggested that the IRS consider adding exceptions to the "third-country" rule to better tailor its application to domestic entity acquisitions in which tax planning drives the use of a third country.
The 2018 Regulations replace the phrase "subject to tax as a resident" with "tax resident," which the 2018 Regulations define as "a body corporate liable to tax under the laws of a country as a resident." The IRS has indicated that this change obviates the need to examine whether a foreign corporation is fiscally transparent under its local law. The 2018 Regulations provide that, even if the relevant foreign country does not impose corporate income tax, the "substantial business activities" exception nevertheless may apply. Similarly, the "third-country" rule generally does not apply where both of the foreign corporations that are parties to the acquisition of the domestic entity are organized in a country that does not impose corporate income tax. To qualify for this exception to the "third-country" rule, neither foreign corporation may be a tax resident of any other country.
The 2018 Regulations provide a second new exception to the "third-country" rule where the foreign acquiring corporation and certain of its affiliates have substantial business activities in the third country. However, the 2018 Regulations also expand the reach of the "third-country" rule by treating a change in tax residency (such as through the migration of a foreign corporation's "management and control") as an acquisition of a foreign corporation that may trigger the rule.
Non-Ordinary Course Distribution Rule
Certain non-ordinary course distributions (NOCDs) made by a domestic entity during the 36-month period ending on the date of the acquisition of the domestic entity are disregarded for purposes of calculating the ownership percentage. Instead, the recipients of such NOCDs are deemed to receive, by reason of holding an interest in the domestic entity, an amount of stock of the foreign acquiring corporation equal to the aggregate value of the NOCDs, thereby increasing the ownership percentage and the likelihood that the foreign acquiring corporation is treated as a surrogate foreign corporation. Distributions are generally considered NOCDs to the extent that they exceed a specified threshold (determined based on the quantity of distributions made by the domestic entity prior to the date of the acquisition) unless they fall within an exception. The NOCD rule was released in temporary form in the 2016 Regulations and the 2018 Regulations retain the rule with certain revisions.
The temporary NOCD rule set forth in the 2016 Regulations provided several exclusions to the definition of a distribution. Under the 2016 Regulations, one exclusion is that a distribution by a domestic entity in an asset reorganization (e.g., the distribution of the acquiring corporation's stock by the target corporation in a "forward" reorganization under Section 368(a)(1)(A)) would not be an NOCD. The 2018 Regulations retain this exception but clarify that the distribution in a tax-free spinoff under Section 355 is not covered by the exception (and therefore could be an NOCD), regardless of whether the spinoff qualifies as a divisive reorganization under Section 368(a)(1)(D). The regulations also clarify that a deemed distribution under Section 752(b) resulting from a change in the partners' shares of partnership liabilities will not be treated as a distribution for this purpose if the transaction giving rise to the deemed distribution does not involve a reduction in the partnership's value.
The 2018 Regulations make certain other clarifying and technical revisions to the framework of the NOCD rule set forth in the 2016 Regulations. For example, a special rule for Section 355 spinoffs (which, if applicable, treats the controlled corporation as the distributing corporation for purposes of calculating the amount of NOCD) only applies if the fair market value of the distributing corporation's ownership interest in the controlled corporation exceeds 50 percent of the value of the distributing corporation. In contrast, the 2016 Regulations applied this rule where the fair market value of the controlled corporation (rather than just the distributing corporation's interest in the controlled corporation) represented more than 50 percent of the fair market value of the stock of the distributing corporation immediately before the spinoff. The 2018 Regulations also clarify how stock that is deemed issued with respect to NOCDs is allocated among the former domestic entity shareholders, which corporation's stock is deemed to be issued in transactions involving multiple foreign corporations, and that NOCD stock is generally only considered for purposes of calculating ownership percentages and not for other aspects of the Section 7874 rules (such as the "expanded affiliated group" rules).
De Minimis Exceptions
The 2018 Regulations also revise the de minimis exceptions to the NOCD rule and certain other rules that increase the ownership percentage. In general, the de minimis exceptions prevent the application of Section 7874 to an acquisition that largely resembles a cash purchase. The de minimis exceptions generally apply only in cases where there is limited overlapping ownership between the shareholders of the foreign corporation and former owners of the domestic entity: the ownership percentage (disregarding the NOCD rule and certain other rules that increase the ownership percentage) must be less than 5 percent (by vote and value), and after the domestic entity acquisition and all related transactions, former owners of the domestic entity must own less than 5 percent (by vote and value) of the stock of the foreign corporation and certain of its affiliates.
The latter requirement tests the ownership by former owners of the domestic entity individually, such that it generally would be satisfied so long as no former owner of the domestic entity owned 5 percent or more of the stock of the foreign corporation and its applicable affiliates. The 2018 Regulations further provide that only former domestic entity owners who owned (taking into account certain attribution rules) at least 5 percent of the domestic entity must be considered in determining whether the requirement is satisfied. This change is intended to ease compliance and administrative burdens in testing whether the de minimis exceptions apply and likely will be particularly helpful where the domestic entity is publicly traded or has a complex ownership structure.
Passive Assets Rule
The 2018 Regulations finalize the "passive assets rule," which excludes stock of a foreign acquiring corporation that is attributable to certain passive assets from the denominator of the ownership fraction. Like the 2016 Regulations, the 2018 Regulations limit this rule to acquisitions in which more than 50 percent of the gross value of the foreign acquiring corporation's property gives rise to certain kinds of passive income. Where the rule applies, the amount of stock excluded from the denominator of the ownership fraction generally is proportional to such percentage. The 2018 Regulations also provide additional guidance on how the passive asset rule coordinates with certain other rules under Section 7874, such as the serial acquisition rule and the "third-country" rule. Finally, the 2018 Regulations deviate from the 2016 Regulations in excluding stock of a foreign acquiring corporation from the denominator of the ownership fraction only for purposes of the value test, and not the vote test, in determining whether the 60 and 80 percent thresholds are met.
Additional Guidance
The 2018 Regulations extend beyond inversions by finalizing an exception to the definition of "U.S. property" under Section 956 for "short-term obligations." This exception was introduced in the 2016 Regulations and generally exempts from the definition of "U.S. property" an obligation of a U.S. person that is collected within 30 days from the time it is incurred, unless the holder of such obligation owns any other obligation that, absent the exclusion, would constitute "U.S. property" for 60 or more days during the taxable year. In addition, the 2016 Regulations contained rules regarding the treatment of certain debt or equity instruments issued by foreign persons as "U.S. property" under Section 956 where such instruments were acquired in a transaction related to, or within a certain amount of time of, an inversion. While the 2018 Regulations finalized these rules, the preamble notes that the IRS continues to study comments that would extend them to all foreign-parented groups, and not only those that are foreign parented as a result of an inversion transaction.
