The Internal Revenue Service (“IRS”) and Treasury Department issued Notice 2014-52 (the “Notice”) targeting corporate inversions on September 22, 2014 (the “Notice Date”) in the U.S. Tax considerations are important for inversion transactions, as they may allow an inverted U.S. multinational to access cash and earnings of its foreign subsidiaries, earnings often designated as permanently reinvested earnings for financial accounting purposes (so-called "trapped cash"). The Notice implements a two-prong strategy to be implemented in future regulations. One prong would limit post-inversion tax planning, including the ability of the new foreign parent in a partial inversion to access trapped cash on a tax efficient basis. The other prong would broaden the rules which determine whether an inverted company is subject to the rules designed to prevent inversions.

An inversion is most commonly structured as an exchange (directly or via merger) by shareholders of their shares of a U.S. parent company for shares of a newly formed foreign parent. At the same time, the newly formed foreign parent acquires a foreign business in exchange for its shares. Under current law, if the former shareholders of the U.S. company hold 80% or more of the new foreign parent, the new foreign parent would be treated for U.S. tax purposes as a U.S. corporation. If the former shareholders of the U.S. corporation own at least 60% but less than 80% of the new foreign parent (a “partial inversion”), the former U.S. parent company, now a subsidiary of the new foreign parent, is subject to certain other adverse tax consequences but the new foreign parent will not be treated as a U.S. corporation. Reflecting the concern for domestic corporations “shopping” for a foreign target to successfully invert, the most serious tax consequences of the Notice are reserved for partial inversions.

Limiting Post-Inversion Tax Planning

The Notice targets three possible transactions available after a successful partial inversion that, in different ways, allow the new foreign parent to access the trapped cash of the foreign subsidiaries of the inverted U.S. corporation (“controlled foreign corporations” or “CFCs”) on a tax-free basis.

“Hopscotch” Loans

When a CFC makes a loan to its U.S. parent, the CFC is treated as paying a taxable dividend to its U.S. parent under section 956 of the Internal Revenue Code. Following a partial inversion, a CFC could lend to the newly formed foreign parent corporation without triggering this deemed inclusion of income. The Notice takes aim at such “hopscotch” loans designed to deploy the trapped cash of the former U.S. parent’s CFCs by bypassing that U.S. parent. Under the Notice, these CFC loans to the foreign parent would trigger the same result as a loan to the U.S. parent, but only for partial inversions completed on or after the Notice Date.

Intercompany Stock Sales

The Notice would end the use of another hopscotch transaction involving an intercompany sale by the new foreign parent of shares of the former U.S. parent to a CFC. This transaction results in the transfer of the CFC’s cash to the new foreign parent and, in certain cases, simultaneously reduces the CFC’s taxable earnings while bypassing the U.S. parent and thereby avoiding any U.S. tax. For intercompany stock sales completed on or after the Notice Date, the gross proceeds of such a sale would be treated as a distribution from the U.S. parent rather than from the CFC acquirer, and therefore may be subject to U.S. withholding tax. This change would not be limited to inversions but instead would affect all structures involving a U.S. corporation sandwiched between a foreign parent and CFC subsidiaries.

Terminating Controlled Foreign Corporation Status

Following a partial inversion, a new foreign parent can purchase newly issued shares of the former U.S. parent’s CFCs, thereby reducing the former U.S. parent’s percentage interest in its foreign subsidiaries. Investments by the new foreign parent that dilute the former U.S. parent’s interest below 50% terminate the CFC status of the subsidiaries and allow the former U.S. parent to avoid the cumbersome CFC regime. The Notice would recast the new foreign parent’s investment as taking place through the former U.S. parent, rather than bypassing the former U.S. parent. Thus, the Notice ends this tax-free decontrol strategy by treating the U.S. parent as continuing to own the foreign subsidiaries, which remain CFCs, but only for partial inversions completed on or after the Notice Date.

Creating Additional Obstacles to Inversion

Effective for transactions that close on or after the Notice Date, the Notice broadens the range of transactions that may be subject to the inversion rules. For many U.S. corporations seeking to invert, one of the challenges is finding a suitably sized foreign target so that the foreign target’s shareholders will own just more than 20% of the resulting inverted foreign corporation. The Notice continues a trend of restricting various pre-inversion techniques to increase the size of the foreign target and/or reduce the size of the domestic corporation.

Foreign corporations already cannot issue new equity as a means to increase their size, because stock that is newly issued for cash, securities or certain types of debt is disregarded for purposes of the 80% test. Initially applied only to public offerings of stock, this provision was extended to private offerings in 2009. However, there was no restriction on the value of passive assets held by a foreign target as long as there was no offering of stock or equity in connection with the inversion. The Notice now restricts the use of such “cash boxes” to create a bigger foreign target. Under the Notice, in calculating the 80% threshold, stock of the foreign target is excluded in proportion to its passive assets, but only if at least 50% of the foreign target’s assets are passive. Banks and financial service companies are exempt from this rule.

The Notice also attacks “skinny down” transactions by disregarding the effect of non-ordinary course distributions by the U.S. parent prior to an inversion designed to reduce the relative size of the U.S. parent. A “non-ordinary course” distribution is any distribution over the course of a year in excess of 110% of the average over the previous three years. Moreover, all distributions will be included regardless of whether they are dividends (including tax-free spin-offs, redemptions, and “boot” in tax-free reorganizations). Finally, the Notice restricts the use of certain “spinversion” transactions involving a spin-off of a newly-formed foreign corporation by a U.S. parent to its shareholders.

Future of Inversions

Most notably, the Notice has substantially decreased the benefits of post-inversion tax planning for partial inversions. It has also clamped down on techniques designed to increase the relative size of foreign ownership. Because of the new restrictions on partial inversions, the Notice has increased the relative advantages of inversions where the former shareholders of the U.S. company receive less than 60% of the new foreign parent and avoid partial inversion status. However, even with these new rules, substantial advantages remain for partial inversions. In a partial inversion, U.S. corporations may still be able to use inter-company debt to reduce U.S. taxable income as the Notice did not address debt pushed into the former U.S. parent or any other form of earnings stripping. A partial inversion also allows for future non-U.S. acquisitions to take place outside the CFC regime.

The Notice has made it all the more necessary to consider the potential application of the inversion rules in the context of all cross-border transactions. Although multinational corporations may grab the headlines, a much wider range of transactions fall within the inversion rules. Any transfer of an interest in a domestic entity by a non-corporate holder to a foreign corporation may result in an inversion. There are no exceptions for non-U.S. shareholders or private transactions. For example, non-U.S. individuals frequently hold U.S. real estate through a “blocker” U.S. corporation. The transfer of such blocker stock to a foreign corporation may result in an inadvertent inversion that could have been easily avoided had the foreign corporation acquired the real estate first.

The pace of inversions had arguably already slowed even before the Notice was issued due to the anticipation of more restrictive rules being implemented. The Notice may limit inversion transactions by increasing their marginal costs and decreasing their marginal benefits. However, given the limited effect of the Notice on blocking inversions, the attractiveness of avoiding the compliance burdens and tax costs of the CFC regime, and the increasing prevalence of cross-border transaction activity, the Notice will not make inversions a thing of the past.